Vera Bradley Management Discusses Q2 2014 Results - Earnings Call Transcript

| About: Vera Bradley (VRA)

Vera Bradley (NASDAQ:VRA)

Q2 2014 Earnings Call

September 11, 2013 4:30 pm ET

Executives

Paul Blair

Michael C. Ray - Director

Kevin J. Sierks - Interim Chief Financial Officer, Chief Accounting Officer, Vice President and Corporate Controller

C. Roddy Mann - Executive Vice President of Strategy & Business Development

Joseph Teklits - Senior Managing Director

Analysts

Mark R. Altschwager - Robert W. Baird & Co. Incorporated, Research Division

Evren Dogan Kopelman - Wells Fargo Securities, LLC, Research Division

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

Neely J.N. Tamminga - Piper Jaffray Companies, Research Division

Oliver Chen - Citigroup Inc, Research Division

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

Janet Kloppenburg

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to today's Vera Bradley Fiscal 2014 Second Quarter Results Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the call over to Paul Blair of Vera Bradley's Investor Relations Department. Please go ahead, sir.

Paul Blair

Good afternoon, and welcome. We'd like to thank you for joining us this afternoon for Vera Bradley's Fiscal 2014 Second Quarter Results Conference Call. Some of the statements made on the conference call during our prepared remarks and response to your questions may constitute forward-looking statements made pursuant to and within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended. Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from those that we expect. Please refer to today's press release and the company's Form 10-K for the fiscal year ended February 2, 2013, filed with the SEC, for a discussion of known risks and uncertainties. Investors should not assume that the statements made during the call will remain operative at a later time. The company undertakes no obligation to update any information discussed on the call. We understand that this is a busy period for reporting and intend to keep today's call to 1 hour in length.

[Operator Instructions] I will now turn the call over to Vera Bradley's CEO, Mike Ray.

Michael C. Ray

Thank you, Paul. Good afternoon, everyone, and thank you for joining us today. With me are Kevin Sierks, our Interim Chief Financial Officer; and Roddy Mann, our Executive Vice President of Strategy and Business Development.

Fiscal 2014 has been a unique year for the business and for me, not only because of my decision to retire as CEO of the company, but because of the considerable headwinds we have experienced. In the second quarter, while our results exceeded our expectations, they were a challenge to achieve. Nonetheless, we delivered $0.37 of earnings per share on $125 million in revenue -- consolidated revenue.

While gross margin expansion of 148 basis points was lower than our guidance, our continued focus on cost management helped us achieve net income results slightly above our guidance.

Based on our merchandise sales throughout the quarter, we believe our continued soft performance is related to our product offering, that is, our overall assortment and how we manage and present it in each of our channels. In addition, we believe that ongoing economic conditions have impacted traffic and consumer spending. As a result, the competitive space was particularly promotional.

Looking forward, we've revised our outlook for the remainder of the year based on these softer trend lines and a challenging consumer and competitive environment. Specifically, full-year revenue and earnings per share are expected to be in the range of $535 million to $540 million and $1.47 to $1.52, respectively. Kevin will provide more details on the quarter and outlook in a moment.

We continue to make progress on our 4 key strategic initiatives and have intensified our urgency to take near-term actions in supporting them. As a reminder, our 4 strategies are: One, to optimize our offering to the customer; two, evolve verabradley.com to a primarily full-price channel; three, to enhance the overall productivity of the Indirect segment; and four, to deliver operational excellence and improved profitability.

First, our primary goal in optimizing the offering to the customer is to energize the line by striking a better balance between the classic and aspirational aspects of our core business. For example, looking back, we believe that the fashion-forward nature of certain patterns did not connect with some of our core customers. Looking forward, we are utilizing improved methodologies to best determine the most resonant patterns for a season.

In addition, we continue to invest in our growing solid business, providing both core and new customers a new pattern alternative. We've also determined with greater clarity that our performance is not only being influenced by what we are offering, but by the breadth of the assortment itself. Although we are making headway in rationalizing our current offering, we believe we have much further to go, and in the near-term, we will be focusing a large amount of our merchandising efforts on developing a more productive assortment.

In addition to improving merchandise productivity and simplifying inventory management, our refined assortment will most importantly enhance our customer shopping experience and make each print and style on the line more special to her.

To support these efforts, we recently updated our New York showroom to act as a visual laboratory for our creative team, and our Fort Wayne store is now a testing ground for assortment changes. Successfully energizing the offering is a multi-quarter endeavor, but I'm optimistic that we can quickly make headway in the strategic areas.

Second, evolving verabradley.com can enhance consumer perception of the brand and improve the overall profitability of the Direct segment. To be successful in this evolution, we will need to grow our business and current full-price styles and patterns, while thoughtfully managing down the growth of our retired, discounted merchandise, which has historically been driven by an avid value-minded segment of customers. This quarter, we began segmenting all e-mail campaigns by customer type and shopping behavior. We believe that this will better capitalize our marketing efforts to our full-price customer. In addition, we feel that we have the opportunity to actively ship some of our retired merchandise sales from the web to our outlet store channel over time.

Because we have relatively few outlet stores today and because there is little overlap between our full price and the outlet store customers, we plan to lean forward on outlet store openings as we look into fiscal '15. By providing more capacity for retired merchandise sales outside of the website, we believe that we will be better able to maintain overall sales levels, while concurrently migrating verabradley.com sales to a more full-price mix. At the same time, we continue to make strides in our pricing strategies within the outlet store channel, giving us confidence that we can maintain this healthy margin profile over the long-term.

Turning to our third strategy. We are working diligently to enhance the productivity of our Indirect business. To start, I'd like to point out that we've always had great specialty retail partners across the U.S. who are productive and represent the brand especially well. However, as we've shared before, there are distribution points that do not align with our longer-term strategies for the brand, and our efforts to remediate this challenge continue to be a focus.

In addition, given recent merchandise performance, many specialty retail partners have held back for more fully investing in the brand. While over time, we expect our efforts to optimize the offering to rekindle growth in that channel, we anticipate exiting fiscal '14 with as many as 500 fewer doors than when we began. This will come from our remediation efforts, normal attrition and the fact that we are being very selective in opening new specialty retail doors.

At the same time, we're making sure our resources are focused in the right places. While our retail partners have encountered the same headwinds as we have faced, many continued to execute the Vera Bradley brand in ways that will ensure long-term success for themselves and growth for us. We have fantastic specialty partners such as Occasionally Yours in Dayton, Ohio and other Midwestern markets, and Wrapsody in Birmingham and Auburn, Alabama, to name 2. And we have terrific key account partnerships such as with Dillard's. These partnerships are some of the most productive and also some with the greatest potential.

Our last strategic initiative is that of operational excellence. This is not only an exercise in improved cost management and leaner operations, as we shared in the first quarter call, it's a strategy rooted in delivering service excellence across the board to both internal and external customers. Throughout the year, there's been a broad effort across the Vera Bradley team in positioning the brand and company for the future. The resulting new efficiencies and processes, both small and large, are a result of this initiative. As such, I'm confident that when we overcome the business headwinds, we'll be a much healthier organization as a whole.

Our uphill climb this year has not been without moments of optimism, which underscore the enduring equity in our brand and the progress we've made in continuing to improve it. Recent top line numbers from this year's brand equity study show that we've extended our brand awareness levels across all regions with a mid-single digit increase over last year, to the lower 60-plus percent range.

In addition, while awareness has increased, we've been able to maintain our brand conversion level at a rate that is still higher than many other fashion accessory brands in our peer group. I believe this continues to speak to the timeless appeal of Vera Bradley. We have a special brand, and short-term headwinds cannot erode that fact.

Before I turn it over to Kevin, I'd like to take a moment to address our CEO search. As announced in June, our search committee and our Board's conducting a comprehensive process to identify my successor with the assistance of Spencer Stuart. This process has been thoughtful and rigorous, and the committee has made meaningful progress. We are looking for a number of qualities in Vera Bradley's next leader. The committee has identified strong candidates who have extensive retail and brand management experience, proven leadership skills and strong track records of driving growth. The committee has met with a number of highly-qualified candidates and is now in the process of narrowing this list. While we won't provide an estimate on timing, I can assure you that they are moving quickly to identify the right and most-qualified next leader for Vera Bradley. As for me, I will remain CEO until we appoint my successor and will stay on through our transition period to ensure a seamless handover of responsibilities.

Throughout the course of this year, I've been constantly encouraged by the energy with which the Vera Bradley team responded to the challenges we face. Together, we're actively and effectively working to position the brand and the company for the future. I believe this collective spirit of resolute optimism is the hallmark of our culture and will be easily leveraged by my successor to continue moving us forward.

I will now turn the call over to Kevin Sierks, our Interim Chief Financial Officer, who will provide additional details regarding our second quarter financial results, as well as guidance for our fiscal 2014 third quarter and full year.

Kevin J. Sierks

Thanks, Mike, and good afternoon. I will begin my remarks with the review of our fiscal 2014 second quarter, and then provide you with our outlook for the remainder of the year.

As Mike mentioned, we are pleased with our second quarter performance, delivering top and bottom line financial results at or above our expectations. Net revenues for the second quarter increased 2% to $125.4 million, compared to $123 million in the prior-year quarter, which is on top of revenue growth of 19% in the second quarter of last year.

In the Direct segment, net revenues increased 14% to $75 million, driven primarily by increases across our full-price and outlet stores. The Direct segment accounted for 60% of total net revenues in the second quarter versus 53% in the prior year. The revenue increase resulted primarily from the opening of 20 new full-price stores and 4 outlet stores during the past 12 months. We ended the quarter with 80 full-price and 14 outlet stores.

Comparable store sales decreased 3.7% during the quarter, due to underperformance of our product offering and reduced traffic in the quarter.

E-commerce sales represented 22% of total revenues for the second quarter and increased $0.4 million or 1%.

Traffic on the Web continue to be strong, increasing 20%. However, the increased traffic was nearly offset by reduced conversion rates.

Indirect net revenues decreased 12% to $50.4 million, slightly better than our guidance for the quarter.

Consolidated gross profit for the second quarter increased 5% to $71.8 million, resulting in a gross margin of 57.2%, compared to 55.8% in the prior year. The increase in gross margin was primarily due to expedited shipping provided to the specialty retailers in the second quarter of last year, which was not repeated in the current year.

In the Direct segment, we were slightly more promotional in the current year than we had originally planned as we responded to a highly-promotional environment throughout the retail industry. In addition, capitalizing on the success of our relationship with Dillard's, we invested in Vera Bradley fixtures in approximately 100 more stores. The majority of this investment was originally planned in the second half of this year.

Total SG&A expense was $48.3 million for the second quarter, compared to $47.8 million in the prior year, an increase primarily due to opening new stores. SG&A as a percentage of net revenues was favorable by 30 basis points versus the prior year, due primarily to the team's continued focus on cost management measures in light of the weakness in our top line. These efforts have primarily focused on discretionary spending, headcount management and successful contract negotiations with our suppliers.

In addition, SG&A was favorably impacted by a reduction in variable management compensation expenses associated with company performance.

Operating income for the second quarter increased 10.4% to $24.1 million, or 19.2% of net revenues, compared to $21.8 million or 17.7% of net revenues in the prior year. Operating income in our Direct segment increased by 18% to $19.1 million, with an operating margin of 25.5% in the second quarter this year, compared to 24.7% last year second quarter.

Operating income in our Indirect segment decreased by 7.9% to $21.8 million, compared to $23.7 million in the same period last year, with operating margins of 43.3% compared to 41.3% the second key of last year. Improved operating margin resulted from an increase in gross margin, a decrease in variable compensation expense and a benefit from cost management measures, as well as additional Dillard's doors.

The effective tax rate for the quarter slightly decreased to 37.7%, compared to 38.2% in the prior year.

Net income for the second quarter increased 12% to $15 million, or $0.37 per diluted share, compared to net income of $13.4 million or $0.33 per diluted share in the prior year.

The reduction in variable management compensation favorably impacted earnings per share by approximately $0.02 compared to our guidance.

Key balance sheet highlights as of the end of the second quarter include: Cash and cash equivalents of $9.3 million, with our revolver being paid off during the quarter; accounts receivable of $35.5 million, compared to $49.3 million in the prior year; and related day sales outstanding of 60 compared to 74 in the prior year. The reduction in accounts receivable is principally the result of reduced Indirect segment sales in the quarter.

Inventory at the end of the second quarter was $142.9 million, compared to $117.9 million in the prior year, an increase of 21% compared to revenue growth of 2%. This growth is in line with our guidance.

I would now like to review our outlook for fiscal 2014 third quarter, as well as the full year.

In the third quarter of fiscal 2014, we expect net revenues to be in the range of $128 million to $130 million, compared to $138 million in the prior year. We expect the Direct segment net revenue growth to be in the mid-single digits, with the comparable store sales decline in the mid- to high-single digits. Indirect net revenues are anticipated to decline by mid- to high-teens. This decline is more than we originally expected, as we position the segment to be more productive over the long-term.

Gross margin for the third quarter is expected to decline by 280 to 300 basis points, primarily due to the sales mix between the full-price and discount channels and increased promotional activity compared to the prior year.

SG&A, as a percentage of net revenue, is expected to be approximately 38.5%, or 38% net of other income, as we continue to work to manage costs in light of the revised top line performance.

Diluted earnings per share are expected to be in the range of $0.33 to $0.35.

Our earnings per share estimate assumes an effective tax rate of 38% and fully-diluted weighted average shares outstanding of 40.6 million.

For the full year fiscal 2014, we expect net revenues to be in the range of $535 million to $540 million, compared to our previous guidance of $570 million to $575 million. This includes the Direct segment net revenue growth in the low-teens, with comparable store sales decline of low- to mid-single digits. Indirect net revenue is expected to decline in the high-teens.

We expect gross margin to decline 100 to 125 basis points for the full year, down from our previous guidance of a decline of 20 basis points. This reflects the reduced revenue expectation through the year, which results in deleverage of fixed costs, as well as the shift of sales to the outlet channel within the Direct segment.

SG&A as a percentage of net revenue is expected to be approximately 38.3% or 37.5% net of other income, reflecting the deleverage of fixed cost due to the softer top line.

We expect diluted earnings per share for the full year to be in the range of $1.47 to $1.52. This estimate includes an effective tax rate of 38% and fully-diluted weighted average shares outstanding of 40.6 million.

Turning to inventory growth expectations for the remainder of the year. Given our revised revenue expectations, we expect inventory to continue to be elevated in the third and fourth quarters. We estimate inventory to be in the $155 million to $160 million range for both quarters. Consequently, we anticipate that retired inventory will rise as a portion of total inventory in the future quarters, continuing to impact consolidated gross margin over the next 12 months.

With regard to capital spending, during the quarter, we announced our plan to consolidate all office personnel into 1 campus at our current distribution and design centers. This will promote greater levels of collaboration, improved operational efficiencies and reduce costs over the long term. The estimated $27-million project is expected to be complete in late fiscal 2015. Of the total project cost, $10 million of the investment is projected to occur in fiscal 2014, bringing our capital expenditure guidance to approximately $30 million for the full year.

Regarding our Japanese operations, we continue to meet with potential partners and are encouraged by the amount of interest we have received. We have met with a number of candidates and are narrowing our focus to the most capable and suitable finalist. While we have not yet reached a decision to enter into a partnership, all indications point to it being the best avenue for us to establish a meaningful business in the Japanese market in the most efficient, effective manner.

Before I turn the call back over to Mike, I'd like to let you know that Paul has taken a position with an area college to head their business department. He has been instrumental as a consultant for Vera Bradley during the past couple of years to help us establish our Investor Relations Department. We want to thank him for his contributions and wish him the best as he enters a new chapter in his career.

With that, I will turn the call back over to Mike for some closing remarks.

Michael C. Ray

Thanks, Kevin. I'd like to finish by reminding everyone that we have an exceptionally strong brand, a loyal and growing consumer following. We have an incredibly productive -- we have incredibly productive stores and a significant e-commerce business, yet we are in the early innings of our retail growth. We also continue to be highly-profitable with the financial wherewithal to make prudent investments.

Despite our current challenges, we have solid strategies in place to achieve our long-term vision for growth. And I'd like to thank all of our stakeholders, our employees, retail partners and investors, for their ongoing support. Operator, we're now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question will come from Mark Altschwager with Robert W. Baird.

Mark R. Altschwager - Robert W. Baird & Co. Incorporated, Research Division

Could you start off by just addressing inventory in Indirect channel? Just how do you feel about the level there. And what is the mix today of the more current patterns versus the carryover from last winter and the spring?

Michael C. Ray

This is Mike. At any point in time, there's certain segment of that channel that may have elevated inventory levels, and we certainly expect that, to some degree, at this point. We don't feel that, that's a significant issue for us. Really, what we're seeing on the Indirect side, especially on specialty store channel, is really kind of a cautious approach to investing in our line. They're certainly experiencing the same things that we are relative to the performance of the assortment, relative to the challenging consumer environment, but they're also just being cautious at this point. But we don't believe that, that's a result of a significant amount of inventory in the channel.

Mark R. Altschwager - Robert W. Baird & Co. Incorporated, Research Division

Okay. As a follow-up, you mentioned the caution in that channel. With the guidance reduction, I mean, how much of that is attributable to the caution among the Indirect retailers versus the fact that you expect 500 fewer doors there by the end of the year?

Michael C. Ray

Kevin?

Kevin J. Sierks

Yes, Mark. This is Kevin, Mark. The majority of it does relate to the segment as a whole. Obviously, the reduction in the 500 accounts plays a role on that, but a lot of those accounts aren't very productive and are very low-volume accounts. So the majority of it is truly the performance we're expecting to see out of that segment.

Operator

And next we'll hear from Evren Kopelman with Wells Fargo.

Evren Dogan Kopelman - Wells Fargo Securities, LLC, Research Division

I wanted to ask first about your store opening plans, if you can tell us for the third and fourth quarter. And then I think you made a comment about next year leaning toward more outlet openings. If you can give us a little bit more color on that. Also, if there's a thought of slowing down openings, given some of the weakness in sales?

C. Roddy Mann

Evren, this is Roddy. I'll start by speaking to next year. So as we mentioned in the last call, we're sort of narrowing our focus. We have, typically, 14 to 20 stores that we look to fill. We have personally filled that, roughly, say, half of those stores, and we're sort of holding back on additional full-price stores. However, as Mike mentioned, we may lean forward in some additional outlet stores as we look into next year.

Kevin J. Sierks

Yes. And we've opened -- Evren, we've opened 14 stores this year thus far. So we have 9 more to open in the back half of the year, in both current and new markets.

Evren Dogan Kopelman - Wells Fargo Securities, LLC, Research Division

Okay. And how is the new store productivity? Is it seeing kind of the similar -- some of the comp declines for the whole chain? Are you seeing lower kind of new store productivity relative to where stores had been opening in prior years?

Kevin J. Sierks

Yes, stores are still very productive. When we open a store, we still have very high sales per square foot. And we're still tracking to that range in the 620 to 710 per square foot on those doors we opened in the last 12 months. So it's still very productive. Obviously, with the comps that we've had not performing quite as well as we would like them to.

Evren Dogan Kopelman - Wells Fargo Securities, LLC, Research Division

Great. And now, the last question for me is a little bit more big picture. When I look at your product, the look and feel of it hasn't necessarily changed that much since I've been following this story. I'm curious why you think some of the decline, especially in wholesale, but also in your own stores. Why now is it to such a greater degree? That's my question.

Michael C. Ray

Yes, I think much of it has to do, not with the product design itself, Evren, but just the breadth of the assortment overall. We've spoken to this in the past. We're over-assorted. We have too many patterns in the line, too many styles in the line. And when a consumer comes into our stores, at times, I think that they are overwhelmed by the offering. Too much selection. No single pattern is as special as it used to be when we had fewer patterns in the range itself and fewer patterns launched over the course of the year. So really, it's not a design issue. And I want to make sure that everyone's clear on that. It's really -- it goes to how we're managing the assortment overall. And our big focus of the merchandising team in the near term here is to start to rationalize significantly the offering. And we've made some good headway. For spring next year, the team cut about 20% of the SKUs from the assortment, and we believe that's a good start. And we believe we have further to go. So I would say, the other thing, a good example of the pattern that hasn't connected the way we initially thought it would is Cocoa Moss, and it's part of the Back to Campus launch this fall. And I think in just in kind of the postmortem that the team has done, they would acknowledge that it's probably a little more fashion-forward than the core customer is used to. And so, there are efforts underway to mitigate that going forward. And we've actually already seen the results of kind of that recognition, as they work to improve the range of patterns for next fall's Back to Campus season. So the team's mindful of that, and we're already seeing some positive changes going forward.

Operator

And moving on, we'll hear from Edward Yruma with KeyBanc.

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

Just a follow-up on Evren's question, I guess I'm just not clear on why you believe the poor performance is due to assortment and not a more significant design issue, particularly in light of how weak the upcoming results look to be.

Michael C. Ray

Yes, I -- it goes to really how we're managing. It is partly is the breadth. It's also just making sure that we have kind of in that base replenishment level of our offering, patterns that connect with the core customer. Some of the more fashion forward patterns that we've introduced, they have a role in the line, we need to manage them differently. And we can't expect the same results from some of those in terms of kind of a replenishment pattern. So we think of those going forward as being kind of in and out, probably a narrower range of styles and probably offered in our Direct channel as opposed to trying to offer those across the full range of our distribution.

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

Got it. And I guess, when you look at specific markets, are you seeing markets where total sales for the entire market are falling? I guess I'm just trying to hit upon the bigger picture, question of saturation in some of these more developed markets.

Michael C. Ray

Yes, there's nothing we draw a conclusion on by geography. From an e-commerce perspective, we continue to see more traffic growth in the West. But as far as purely sales, we don't see a specific geography performing much, much better than another, or a specific geography performing much lower than another.

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

Great. And my final question. With the guidance you provided as it relates to comps, how should we think about the performance differential of outlet versus full-price, particularly since it looks like you're going to be using the outlets to clear some of this excess inventory?

Michael C. Ray

Yes, the comps on the full-price outside and definitely more challenging for us because of the product assortment issue we have right now that we're working through. The outlet continue to perform pretty strong for us. Typically, any pattern that moves over into the outlet stores typically performs very, very well because it's a different customer, it's more of a value-oriented customer. So when we've moved this product that may be a little more fashion forward into the outlet channel, is tended to perform fairly well. So it's more of the full-priced stores that are challenged right now from a comp perspective

Operator

And next, we'll go to Neely Tamminga with Piper Jaffray.

Neely J.N. Tamminga - Piper Jaffray Companies, Research Division

I just had 2 follow-up questions, if I may. First, on the inventory. Is there any thought about possibly going back and using some of the third-party -- jobbers basically to kind of clear through some of this overage? Or do you plan on clearing this solely through your outlet? And I guess one step further to that is how do you feel about the ability to kind of clear through at reasonable margins -- outlet appropriate margins of that product if you're going to keep it in your outlet? And then, secondly, on the rationalizing the offering and the SKUs, I'm just wondering how if potentially you might take that down one step further. I know you talked about patterning differently between Indirect and Direct next year. Could you potentially also be offering different SKUs down to the channel, as well as different SKU offerings for Indirect versus Direct. Some strategy around that will be helpful.

C. Roddy Mann

Neely, this is Roddy. I'll start with your last question about the patterns into the SKUs and how if I look at differently in the channels. We'll definitely be thinking differently about patterns. And to be clear, we're not only thinking about -- when we say SKU rationalization, it's not necessarily only at the category level, it is also looking at the pattern level. And particularly, as we think about patterns and their lifespan, we mentioned last quarter, and this will be coming up, La Neon Rose is a more fashion-forward pattern that will only be offered in Direct in the smaller assortment and for a much more limited life. So we may do more of that in the future and actually manage that in our own channel. As far as the overall assortment, how it looks in the different channels, there may be, because we tend to have a more traditional core customer on the specialty side of the business, we may end up with a more of a de facto assortment that is what we tend to call signature that the classic patterns and quilter cotton in those lines. So it may evolve to that. At the same time, we have spoken the past about being a little bit more prescriptive on the assortment that we're offering to our retail partners, just based on, say, the evidence that we see and how things are selling in Dillard's. So we look to possibly continue doing that as we look into next year.

Kevin J. Sierks

Yes, Neely, this is Kevin. With regard to inventory, we always are open to the idea of selling to a liquidator to the extent we think we need to. Most of the inventory that we have right now is in good patterns and styles, especially with regards to selling it in the outlet channel. Our outlet channel, as you know, is 50% margin, sometimes better than that. So it's still a very good margin in that business. SO to the extent we sell a little bit more in that, which is what we stated in our script. The overall impact of the consolidated margin isn't huge. But nevertheless, we expect, going forward, more of our product will be moved through the outlet channels than our full priced channel given the assortment challenge. With regard to our liquidator, there are sometimes styles we buy on a onetime basis. And that's how we have to buy those house and sometimes when you all sell through those, it makes more sense to sell through a liquidator. So we're open to that, but we don't foresee a huge sale through a liquidator to be able to move through the inventory. Also, if you look at what we call kind of our challenged inventory, 18 months ago, we started with about $12 million, that was really difficult for us to sell through. We sold through about $11 million of that. So we're under $1 million. This challenge number that we're constantly managing right now is about $5 million, but not a huge number to us. So we feel really good about the inventory as far as the health of the inventory. Nevertheless, we do believe we have too much inventory, and that's the reason we'll have to sell that through the outlet channel.

Operator

And moving on, we'll go to Oliver Chen with Citi.

Oliver Chen - Citigroup Inc, Research Division

Regarding the Indirect channel and your decision to exit some of the points of distribution, how do we think about that on a longer-term basis? Are you going to continue to do that? And should we kind of incorporate that into our model as you reduce the number of doors in the out years? And then just as a follow-up, how should we think about timing from which you're -- what seems like prudent strategies on product breadth and visual merchandising should positively impact your gross margin and comps? Is it midway into next year? Or what are the parameters from which the fixes takes place?

Michael C. Ray

Oliver, I'll take at least the first part as it relates to Indirect. We feel comfortable that, that guidance of exiting as many as 500 fewer is right, when you look at the levels of attrition that we typically expect as well as the number of doors that will close that we don't feel representing the brand in the best way. The next up is really turning our attention and focusing on the rest of the base and making sure they're more productive. We can't really state right now if there'll be further remediation efforts because we're really not sure you really turn to a market level strategy at that point in thinking how best to grow at the market level when you look at it, all the distribution points, including our own, including department stores and other key accounts, as well as the specialty.

C. Roddy Mann

And I'll speak to the timing. On the rationalization, Mike mentioned, we're cutting about 20% of SKUs in the line as we look into spring. We're going to be actively looking and seeing how we can continue that effort as we're going forward. As far as what -- when we might see the positive impacts, we do feel very strongly about, not only from just cleaning up the assortment perspective, but also just the patterns that are coming in to the line and the new styles and how they might be performing as we look into fall and winter of next year. And a lot of that's supported by the -- we mentioned some updated methodologies that we're using, some testing methods, including biometric testing that gives us a better sense for how patterns might perform in the space. And actually, more importantly, allows us to early in the process, identify and edit the portfolio for a given season. That season that were going to be impacting first is fall. So we feel good about that at that point. As far as visual merchandising aspects, we're actively working on that now. We'd love to see a positive impact just going into this year.

Nonetheless, we're being cautious about our outlook.

Oliver Chen - Citigroup Inc, Research Division

Okay, and if I may, just a follow-up. What about your general views on the health of the consumer? It feels like from the analyst perspective are getting mixed reads with better housing and stock market. On the other hand, traffic has been tough for most retailers. So I'm just curious about your thoughts on how he or she feels now.

Michael C. Ray

Yes, that's definitely one of the things that impacted our guidance for the rest of the year. When we guided coming out of the Q1 call, there was an expectation the consumer was going to come back. And I think, since we navigated through the Back to Campus or back-to-school season and saw softness there, we are cautious about the remainder of the year. I think there is a correlation between back-to-school and holiday, at least that's our view. And so we baked that into our expectations going forward.

Operator

From Lazard Capital Market, we'll hear from Jennifer Davis.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

And most of my questions have been answered but a quick one. How many fewer Indirect doors are open right now? I'm just trying to get the sense of how many will close in the back half versus how many have already closed this year? Does that make sense?

Joseph Teklits

Yes, Jennifer. Through Q2, there's about 100 doors less than we started the year with.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Okay, through the end of the second quarter?

Kevin J. Sierks

Yes. But I would keep in mind those additional call it, 400 doors. A lot of those are very low volume. So to try to come up with a sales per door, a lot of times that won't make a lot of sense. But nevertheless, we reduced about 100. And we expect to reduce about another 400. I'd also keep in mind the reduction often occurs than normal attrition often occurs after the holiday period. So it's normal for us to reduce our doors a lot more in the back half of the year than the first half of the year.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Great, okay. And then, Mike, well, I guess actually hold on, sorry, 2 more. How -- can you just remind us your testing process right now how you kind of test the patterns before you launch them?

Michael C. Ray

Yet. So we, Jen, we used to we just transitioned from essentially a survey method based on purchase preference to a newer method. I mentioned biometrics, where we're essentially looking at how the respondents body reacts to the actual pattern itself, and then coupling that with purchased preference information. Once that's done, it's given us a much better read as we look forward as far as from a forecasting perspective. And we started using that as we look into the early parts of next year. What's nice about the process is we found that the results are the same online, as we are doing with the actual product in person. And so since we can do it online, we can do it in sort of the virtual world much earlier in the process such that we can test a broader portfolio for, say, fall of 2014, and then narrow that down to a better mix or what we would like to think as the optimal mix for that particular season.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Okay. And then for Mike, you mentioned Coco Moss as being a more fashion forward pattern. Is that right?

Michael C. Ray

Yes.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

I guess what gives you the conviction that -- or the confidence that, that pattern didn't perform as well because you think it was more fashion forward? Like my guess, would have been just it has less color with the brown and olive green and maybe that is -- your customer likes color more. So I guess what tests have you done our what follow-ups or what makes you think that this kind of too fashion forward?

Michael C. Ray

Some of it had to do, Jen, with the team's assessment kind of post-launch of that product. Some of it had to do with the styles that were, that made up the composition of the sales in that particular pattern. And certainly some, of this is a judgment call. But based on what we know today, based on the data that we have access to, I think it was safe for us to say that, that one did not connect with the core customer and this evidence to say that is probably a little more fashion forward that other patterns. When we launched that, we launched it Back to Campus and we marketed to the high school and college students, and we found that best just didn't connect in the ways other certain patterns do.

Operator

Next, we'll go Ike Boruchow with Sterne Agee.

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

I guess this question is for Kevin. I'm going to focus on the SG&A. So SG&A dollars were only up slightly in the quarter, which is very different from the other high teens growth you guys have been putting up for a while. And I believe the guidance you're giving for Q3 and Q4 implies SG&A dollars down mid-single digits and I think double-digits in Q4. Can you just walk us through, especially since you're going to be operating with around 25 additional stores year-over-year? Where are the cost cuts coming from, and how sustainable are they into next year? And just help us walk through the expense structure, if there's low-hanging fruit you guys are finding or just anything there?

Kevin J. Sierks

Yes, good question. I think that's the first thing to recognize is that compensation expense has played a role in those numbers. So because of the outlook for the remainder of the year, we didn't have a way to win in terms of from a bonus perspective. So the executive bonus here has been reduced to 0. And that's a pretty big impact to the year. So it's about $0.02 on for our $0.37 related to the quarter in particular. And then it also has an impact to the rest of the year. But you're right, the SG&A flat dollars were up a little bit. But nevertheless, our percent was managed pretty well. There is still a fair amount of cost containment measures that we've been taking. So from a headcount perspective, if you look at your end versus today, we've managed head come down and the corporate area as well as in the operations area. So we've managed headcount really well. Travel and expense, we've managed down as well. So the management team is showing they can do it now for 2 quarters, and we're expecting that in the back half of the year as well. Other things that we've done is pushed on our suppliers. So a few notable contracts. We've had some IT maintenance contracts that we've been able to negotiate down. We've negotiated with our freight supplier, and those savings will be in the back half of the year. We've also done an RFP with armored truck contract. And we've been able to negotiate those down. So there's been a number of contracts we've been able to manage down. That being said, I don't feel like we're cutting so much of that we're impacting the business long term. We definitely wouldn't do that. Most of what we're cutting is to suppliers and holding off on headcount. Given the lack of top line growth, we're obviously able to work with the same headcount we have today. So I don't feel like it's extraordinary to be able to hit the SG&A numbers in the back half of the year, especially if you look at what we're able to do in Q1 and Q2.

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

Okay. And then I guess taking a step back, and when you look at your margin profile for the last 3 or 5 years, this has been a 20%, 21% margin business. It's going to be lower this year. Do you think that the business needs to normalize lower to a lower level of a profit rate, as you kind of close some doors and reassess the retail footprint? When you look out over the next couple of years, how do you view the business versus the past couple of years?

Kevin J. Sierks

Yes. I think this year is a bit of a pause, for sure. But we view it as a speed bump, and we're going, I'd say, to get our act together on the assortment side. And I think we're doing a lot of other things structurally. So in our stores, a visual we keep spending time on that. We talked about it on the last quarter, and we really refined the assortment in the stores. I think that'll pay dividends. We're investing in new fixtures in about 20 of our stores here in Q3. So we're spending money there to make sure we can put our best foot forward when the customer comes back and when our assortment is a little more compelling. Specific to profitability, if I took the segment separately, I think the Indirect segment, we can improve our profitability as you look to this year compared to going forward over the next couple of years. I think what you'll see there is we'll want to invest a little bit more money in the key accounts but the expense structure on the specialties side will probably go down a little, so you'll see a reallocation there. But I think the profitability in the Indirect segment be pretty consistent over time. And it's been a place of a lot of our cash, and it's been able to fund the Direct side. I think on the Direct side, we're relatively early in our growth with having only about 1/4 to 1/3 of our doors. And I think we'll be able to leverage the Direct corporate costs there as we move forward. We also are starting to get our hands around being able to manage payroll a little bit better in our full-price stores. That is a big opportunity to be able to leverage. And I think it's just as we can start comping our doors as we have a better assortment the consumer comes back, that will allow us to leverage as well. So I see the Direct segment operating profit being able to improve over the next couple of years, and I see the Indirect segment probably flat.

Irwin Bernard Boruchow - Sterne Agee & Leach Inc., Research Division

Great. Just one last quick one. The wholesale doors that you're closing this year, I think you said 500. How should we think about next year as we start to build our models out for fiscal '15?

Kevin J. Sierks

What we've done is we've taken that population of doors, so we'll reduce by about 500 this year. If we exit the year, call it around 3,000 doors. There's still some of those stores that we're working with that the kind of in the middle, they're not great at the brand and high-volume, high productive, but they're not necessarily those accounts would don't want to partner with. And those are the accounts we're focused on to move them up and to the right in our 9-box. And I think as we do that, we'll understand it a little bit better. So we don't have that all done in terms of what number of doors we want and with. But we know that the 500 is kind of the obvious number. And we'll continue to look at that and challenge ourselves as we go forward.

Operator

[Operator Instructions] Next, we'll go to Janet Kloppenburg with JJK Research.

Janet Kloppenburg

I just wanted to talk a little bit more about the product assortments. I think what I'm hearing is that some of the product is a little bit too forward, and you were overassorted. So I guess what I'm hearing is you're going to go back to a more traditional product assortment, one you've been more successful, and you're going to narrow the line, I was wondering -- narrow the SKU count -- when should we expect that, in the spring season?

Michael C. Ray

Janet, we'll start heading in that direction with the spring season. Actually, I should -- we've been heading in that direction for a while, we talked -- we've known that we're over-assorted and been doing a good job there. I wouldn't think about it as getting back to the assortment that we had 3 or 4 years ago. This is about balancing, balancing the classic aspects of the brand with some more aspirational aspects that could be with new fabrications. It could be new looks, not simply just additional quilted cotton bags. That's sort of built on the brand from there. Really focusing on our core categories of travel hand bags and accessories. So we definitely want to make sure that's the core is growing. And as we think around that, we'll be -- we'll definitely be taking a selective eye to the categories around that, the ancillary categories and what they're contributing and how we might narrow those down. And lastly, at the same time, you did mention, to Neely's question, we will be also looking at the patterns not only a pattern count, but the amount of time that a pattern stays in its life. We have traditionally managed all patterns equally. With that we've said 12 to 18 months. And some may have a much shorter lifespan and then others could be more than the basic Vera Bradley 12 to 18 months life. We expect to see that sort of beginning of next year.

Janet Kloppenburg

Right, but I just want to get a -- say that again. When?

Kevin J. Sierks

We'll expect to see that getting into next year, really, as we think about the fall. We don't really want -- can give any specific timing as far as broader rationalization efforts at this point.

Janet Kloppenburg

Okay. And have you thought of taking a look at your Indirect accounts? I guess you'll have about 3,000 at the end of this year. Have you scrutinized that list and thought about the business and the growth in the retail stores and the outlet stores and thought about perhaps what the optimal level is, and of course, thinking about minimum order sizes, et cetera? I mean, could we see that shrink pretty significantly going forward in order to get the appropriate returns in that channel?

Michael C. Ray

We're definitely looking at the optimal model. That optimization is at the market level. And so it's a little bit more complex as they set up models and really and how we want to grow our business in different parts of the country. We are -- we still have a lot of expansion opportunities in the West. And as we look West, that's definitely an opportunity for us to lean forward, either with our own stores, department stores, or just a different manner than we've traditionally done. We're really not in a point where we can say that the channel would shrink dramatically more than that at this point because when you really need to do that market level analysis for the market level analyses and add those up and then see what the specialty channel looks like, the department store channel looks like, our own channels look like.

Janet Kloppenburg

Okay. And in light of the downsizing of the 500 stores and perhaps a more cautious outlook on the Direct side of the business, I know you said that you've done a good job on cost reduction, but are there any strategies in place to downsize the cost structure of the company and infrastructure in order to align it appropriately with the sales expectation?

Kevin J. Sierks

Janet, this is Kevin. We'll continue to challenge ourselves, as we always do, on the top line opportunities as well as the cost structure, and we at least acknowledge within the Indirect segment that they key accounts have been growing. So Dillard's is performing very well. Our military accounts are performing very well, along with QVC and a few other key accounts. They're growing very well. The top doors of Dillard's are growing as well, so that should be noted. And that group of accounts deserve a certain amount of attention. And I think we can give it more attention, and we can probably have less resources focused on some of those specialty doors, especially as we remediate some of them. So I think over time you'll see some of that cost structure moved between the specialty accounts and more support to the, key accounts like Dillard's.

Operator

As there are no other questions at this time, I would like to turn the conference back over to Mike Ray for any additional or concluding remarks.

Michael C. Ray

I just want to say thank you for listening to us today and for your continued interest in Vera Bradley. We look forward to speaking with you during our third quarter conference call, which will be held on December 11 at 4:30 p.m. Thanks.

Operator

And ladies and gentlemen, this does conclude today's presentation. We do thank everyone for your participation.

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