J. Crew Group, Inc. Q3 2009 Earnings Call Transcript

Nov.24.09 | About: J CREW (JCG)

J. Crew Group, Inc. (JCG) Q3 2009 Earnings Call November 24, 2009 4:30 PM ET

Executives

Allison Malkin - ICR

Millard Drexler - Chairman and CEO

Jim Scully - CFO

Tracy Gardner - President, Retail & Direct

Analysts

Paul Lejuez - Credit Suisse Group

Michelle Tan - Goldman Sachs Asset Management

Roxanne Meyer - UBS

Brian Tunick - JPMorgan and Chase

Lorraine Hutchinson - Bank of America

Kimberly Greenberger - Citigroup

Janet Kloppenburg - JJK Research

Adrienne Tennant - FBR Capital Markets

Dana Telsey - Telsey Advisory Group

Richard Jaffe - Stifel Nicolaus & Company, Inc.

John Morris - BMO Capital Markets

Christine Chen - Needham & Company

Jennifer Black - Jennifer Black & Associates

Sam Panella - Raymond James and Associates

Barbara Wyckoff - Jesup & Lamont

Operator

Welcome to the J. Crew Inc. third quarter fiscal 2009 results conference call. (Operator Instructions) It is now my pleasure to introduce your host, Allison Malkin of ICR. Thank you Ms. Malkin you may begin.

Allison Malkin

Thank you and good afternoon. Before we get started I would like to remind you of the company's Safe Harbor language, which I am sure you're all familiar with. The statements contained in this conference call which are not historical facts may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results might differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC.

Now I'd like to turn the call over to J. Crew's Chairman and CEO, Millard Drexler.

Millard Drexler

Hi, everyone. Thanks for joining us. I am here with Jim Scully, along with Tracy Gardner, Jenna Lyons, Libby Wadle and other senior partners at the company. I will begin with a quick summary of our third quarter results and Jim will go through our financials in more detail and update our outlook for the fourth quarter. We will keep this short so we can move quickly to your questions.

We are very pleased with our better than expected third quarter results. Revenues were up 14%, driven by an 8% increase in comp store sales and a 4% increase in direct sales. Our gross margin expanded almost seven points to 48.4% and operating margin more than doubled to 18.2%, which both represented historical highs for us.

Regardless of the economic environment, our long-term mission does not change. It’s about product, it’s about quality, it’s about design, it’s about service, it’s about creativity. It might sound simple, but in this business sometimes the simplest things are the hardest to achieve.

To quote Bruce Springsteen, ‘we have been practicing for this moment everyday of our lives.’ In other words, everyday we are practicing for tomorrow. Our goal is to continue to be innovate in everything we do. Whether it’s how we connect with our customers each and every one of us is responsible for each and every one of our customers. So how we design our products down to the smallest details and use the best factories and mills in the world to offer the highest quality.

So how we look to grow new opportunities from our men’s business to our crewcuts business, to our wedding business, to our branded partnership businesses such as Alden, handcrafted men’s shoes from a family owned New England factory. Belstaff from an English company dating back to 1924, and [Quarty] handmade Moccasins from Perry Maine to name just a few. We were acting as editors, finding and searching for the best quality, timeless products in the world and giving our customers access to them.

We feel we are creating a very unique approach and our customers are clearly getting it. So Madewell, where we have been really excited with the response. Our customers are loving the tweaks we have been making to our assortments and we've been getting some really nice press. I think we're really well positioned as we move toward launching a Madewell e-commerce site next year.

Of course we continue to grow and invest in our women's business, where we are competing on a number of different levels with designer business again through our investment and quality style and design. While we're very pleased with our third quarter results, we continue to forecast our inventory conservatively as we enter the holiday shopping period. While as we have said, we're up against 90 snow days in the fourth quarter, the macro as well as the competitive environment remains uncertain as the holiday period as always all the time been more price driven. Our focus remains on driving long-term high quality earnings growth.

With that, I'll turn the call over to Jim to review our third quarter results and fourth quarter outlook in more detail.

Jim Scully

Thanks, Mickey. Turning to the details for the third quarter. Total revenues increased 14% in the third quarter to $414 million. Our store sales increased 20% to $300 million. This was driven by an 8% increase in comp store sales coupled with an 8% increase in net square footage. Our comp store sales declined at 3% last year in the third quarter.

In addition, direct sales increased 4% to $105 million on top of a 13% increase last year. Gross profit dollars for the third quarter increased 33% to last year to $200 million, with our gross profit margin expanding 680 basis points to 48.4%. The expansion in gross profit margin was driven by 570 basis points increase, in our merchandise margin coupled with 110 basis points of buying and occupancy leverage.

The merchandise margin performance was significantly better than anticipated representing a historical high for us, resulting from a substantial increase in full price sell-through, this drove a significant increase in AUR versus expectations.

SG&A expenses for the third quarter increased 6% to $125 million, resulting in 240 basis points of leverage with the rate declining to 30.2%. The significant driver of the year-over-year increase and expenses was related to variable expenses and higher sales this year.

Operating income more than doubled to $75 million from $33 million last year, with the operating margin also essentially doubling to 18.2%. Net interest expense for the third quarter totaled $1.1 million compared to net interest expense of 600,000 in the third quarter of last year. Net income for the quarter was approximately $44 million, or $0.67 per diluted share, compared to net income of $19 million or $0.30 per diluted share in the third quarter of last year.

Turning to key balance sheet highlights. Cash and cash equivalents were $247 million at the end of the third quarter compared to $11 4million last year.

Total debt was approximately $99 million at the end of the quarter. Inventories at the end of the third quarter were $224 million representing a 10% decrease versus the last year and were down 17% on a per square foot basis. Finally, capital expenditures for the third quarter were $8 million.

Turning to our outlook, given the continued uncertainties surrounding the economy and the consumer, we continue to be conservative in our planning and expectations. For the fourth quarter, we expect diluted earnings per share in the range of $0.37 to $0.42.

Our fourth quarter outlook reflects comp store sales growth in the high single digits, direct sales growth in the mid to high single digits, gross margin expansion of approximately 1,200 to 1,300 basis points over the last year and SG&A expense dollars increasing in the mid-single digits versus the fourth quarter of 2008.

Net square footage growth will be approximately 5% on a consolidated basis and 4% excluding Madewell. We opened our 24th new store earlier this month and have no new store openings planned for the remainder of the fiscal year.

Capital expenditures for the full-year will be approximately $45 million to $50 million with depreciation and amortization of approximately $52 million versus $44 million last year. We are assuming an effective tax rate of approximately 40% and approximately 65 million diluted shares outstanding for the full-year.

Our annual forecast includes $14 million to $15 million in losses associated with our Madewell business, excluding one-time costs related to store closure and store impairment charges.

Operator, we will now like to open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Paul Lejuez with Credit Suisse Group. Please proceed with your question.

Paul Lejuez - Credit Suisse Group

Jim, just wondering, you mentioned the third quarter of full price selling, I think was historical peak. Just wondering how to think about that 1,200 to 1,300 basis point increase in gross margin expected for 4Q. What level of full price selling does that assume? Are you also assuming peak level of full price selling in 4Q and then Mickey I am just wondering, just given the pressures in US overall, if you are thinking any differently about international growth, thank you?

Millard Drexler

Hey, Paul, so I’ll go first. The way we look at it is we kind of triangulated the gross margin for Q4. Originally we had given a sequential decline from Q3 to Q4, which was basically we sit down 600 basis points from our previous estimate of being up by a 100 basis points. Given that we’ve come in around 680 basis points higher than last year, we’ve converted over this 1,200, 1,300 year-over-year and it really gets you back to where we were on revised guidance. The way we’re looking at it is this gets us back to 2006, 2007 levels. It’s about somewhere between 1,500 basis points short of our peak margin in Q4. So given that where we are in the quarter, we think this is the appropriate way to be looking at Q4 given historical trends.

Jim Scully

Regarding international growth and we look at ourselves as not as a terribly large company in America with lots of -- I think recently okay opportunity, could mean to sell more clothes. We have no plans for bricks and motor whatsoever and I've been dealing with this issue for kind of almost decades. I'm waiting to look at international growth that has increased, I am talking about pure economic retail place. I'm not talking about wholesale, it's clearly it's a different thing. We are not wholesalers nor do we really understand how to be both.

But I don't see many examples over the last many years of international specialty fashion retailers with the values of companies have in fact increased appropriate with the investment and time spent. I've been actually asking always to see that. I don't see it. My own experience and my other job was lower returns, lots of tail wagging the dogs stuff, social regulations and rules that it's hard enough to run a company say in North America or Canada, I don't include as international but we have no plans to go there.

So the answer is, unless we see a viable opportunity, to seamlessly manage our business beyond North American. No, I don't see it out there for us. But everyone again and every company has a different perspective and a different point of view. And I have actually yet to see financial and P&Ls on international returns on investments. As an important shareholder in the company, I don't see the numbers that's support.

More importantly, we kin of don’t want to say, we think we are small in America, but we are not that large to think we need to go there. So, I could be wrong, its just an opinion we have here. We believe we look at it regularly, because there's long lines warnings us, but on the other hand, we think we could do direct. We are looking at that down the road. So right now no plans, but things always can change.

Operator

Our next question comes from the line of Jeff Klinefelter with Piper Jaffray and Company. Please proceed with your question. Mr. Klinefelter, please go ahead with your question.

Unidentified Analyst

Hi guys this step for Stef for Jeff Klinefelter, I apologize for the confusion. Mickey just a question for you with regards to your comments regarding pricing quality. What opportunity you think you have in terms of capturing share from the luxury or the department store channel or other specialty retailers, just Jim, a clarification question on the SG&A rate of sales. Is that a sustainable level that you are giving us in Q4 as a guided level that what we should assume for 2010 as well? Thanks guys.

Jim Scully

We really haven’t given the 2010 number, yet, so I would refrain. But I will say that what we’ve seen in Q3 and Q4 as we are seeing significant leverage on total revenue in the low-single to mid-single digits, which has been a result of the cost reductions that we have taken. Next year we’ve got some expenses coming back at us in terms of Meridian 401(k) that will be looking to offset. So I think we’ll have more clarity on that when we give guidance in March.

Millard Drexler

In regarding us taking share, couple of things, I’ll try to be brief. We are actually not specifically looking at where our customers comes from, of course when we visit the stores which is regularly we’d like to know where they are coming from. But I think there is a few Gibbons in the world today and I think that’s why I like the position of where we are.

If you want J. Crew product worldwide and by the way I think there is a, what I call the online price checking we all play. Show me a product and go online and check the price, in fact, we all know that, go online and check the price, where I think it helps us. As we go online and check the prices, you can not buy J. Crew any place else but in our stores or online, we control our distribution and our pricing that is so critical to us in our business today that I don’t know if we are getting share or not, but I do know that if you sell a product that sold in other places today, you better be prepared to meet prices or lose customers.

All I know was in my early days in the department store business, my inventories were in fact managed too often by my competition, because in those days, you met price. So as I look at it, if we can offer equivalent or better style, better value, better service, I don’t think the customer really leaves someone but she joins someone else. It’s kind of like some car companies 20 years ago stopped doing what they had to do.

So we have a vision, a point of view on where we want to be and I would guess that since the recession was tsunami, people have changed their shopping habits around the world, more value, fairer pricing, do I need it or not, higher savings rated led as we as we see in our consumers do much more careful shopping. We think at the end of the day, if you have and this is old news, but always the right news is good product, good service, good delivery, integrity and pricing, some scarcity and not huge over assortments, you’re going to take business whoever is not doing it as well.

Operator

Our next question comes from the line of Michelle Tan with Goldman Sachs Asset Management. Please proceed with your question.

Michelle Tan - Goldman Sachs Asset Management

I was wondering, Mickey, you mentioned some of the tweaks that made well. I was wondering, if you could give us anymore specifics there and then any more detail on kind of how the trends are going, any metrics you could put around it, when can we start to expect, maybe comps or sales numbers for Madewell that would be great? Thanks.

Millard Drexler

Metrics, well we do announce we have annual, Jim, metrics…

Jim Scully

I mean, we talked, Michelle, the comps are included in the aggregate store comp. We don’t have any plans right now in terms of breaking that out. But we do, do start the overall aggregate.

Millard Drexler

Yes, I know at some point it gets broken when it’s meaningful to the total. Announcing it quarterly puts, it’s when it’s right and ready for our shareholders we’ll do it. In the meantime it’s still somewhat incubation stage if you will. When I say tweaking, I think what we’ve done over the last six months to a year is we’ve moved, look the customers are so moving quickly worldwide on fashion, we’ve stepped it up, we’ve got rid of, I’ll call the so-called classic Tee shirt category as a major investment, which you have to do today or else the cheaper, people will take it away from you, that’s the game going on.

But right now we’re selling a lot more fashion which is kind of a funny name, but its fashion, its Plaid and [Shambrey] shirts, silk tops, its embellished knits, Denim Leggings, our famous Rail Straight Jeans, jewelry has really been fantastic. We sold that with blazers. We have developed new privacy in our Boot hut, in every store and we have six or eight boots that we went after, we invested in.

So I think all of that it's a building process. We are still a relatively unknown entity in Madewell as we look around, but we're quite pleased with the trend, I'm not saying here it's there and it's ready for an aggressive rollout, which relates to not just Madewell but to what the market looks like, real estate wise. But I would say the customers in our stores are really pleased with where we’re going. We've gotten over some of those early real estate slow starts in an unknown brand.

So we're pretty pleased about where it's going. I think very importantly getting online has been a huge negative force that we haven't been there. The next time we would do this, we go much more quickly and we're still very unknown based on our own internal surveys and travelling to countries. So I think online will really make a big difference.

Operator

Our next question comes from the line of Roxanne Meyer with UBS. Please proceed with your questions.

Roxanne Meyer - UBS

Great, thanks and congratulations on a terrific quarter. I'm just wondering if you can discuss what your promotional strategy is for holidays, just given the environment and given your inventory positions and then also if you have any comments on how some of your initiatives, kind of the results of some of your initiatives related to your credit card customer, your credit card holders and I know you've been giving out some gift cards and has that been a nice incremental driver of you and anything else related to testing of programs related to your credit cards that have been helpful?

Millard Drexler

On promotional events, we actually, our mission in our dream is no promotions. Its promotions in, I think in America really reflection of longer access inventory or and that just in value [coming] that’s the name of the game. So for us, what our inventories levels are, they are public. As you can see we are in, – I would relatively good inventory condition, we have 17% less per square foot than we did a year ago. We have always had friendly priced items throughout the year particularly in men’s, because men’s get much more value fourth quarter when buy a gift quickly get out and don’t spend too much money. So we have done that.

But unlike roll up against the promotions of the century last year, but we have no over arching promotions that are meaningful and for us the environment is about so being focused on the right assortments, the right pricing upfront and we all came in very worried about second, third, fourth quarter just begins, I think now begins that incredibly difficult rate between today read like crazy about Friday, Saturday, Sunday people get little depressed next Tuesday and then two weeks in front of Christmas we’ll get a little happier again and we’ll know within five days before December 25th, how good it’ll be.

So it’s a waiting game, but long short answer is we don’t have any great promotion we came and saying we’re going to have less inventory and we have less and as I said you can’t, if you buy the right stuff you kind of have higher margins in the comps are helpful. So I hope this doesn’t change in two or three weeks. You might see if I don’t know what are competitive environments like, but last year, we are also everyday looking at the consumer seeing out there. So we're no more day-to-day and this December month is always kind of the one that stretches that. On credit cards, Jim, do you want to answer?

Jim Scully

Sure. So, Roxanne, I think the royalty program currently is tied to our J. Crew credit card, but our focus has been and always will be on our favorite customers whether they are just a J. Crew credit card or our top spenders. I mean we focus on it is to make them feel especially either through the rewards program or also just one-time gifts that come from Mickey and make the customer feel special with us. So the royalty program is tied to the credit card, but our overall appreciation with our favorite customers is not necessarily comes from our entire file.

Operator

Our next question comes from the line of Brian Tunick with JPMorgan and Chase. Please proceed with your question.

Brian Tunick - JPMorgan and Chase

I guess Mickey on your comment about the 90 snow days last year. I was wondering if you guys can give us a sense of how the quarter played out in terms of comps between the months just a general sense and also maybe how Cyber Monday was for you guys last year versus your expectations given what was going on with inventory and systems.

Then, of course, Jim, as we look here, we expect you guys to exceed your peak EBIT margins now this year. To the two businesses direct and factory, is there any reason I think that can allow you guys to be a high-teen operating margin business in the next couple of years?

Millard Drexler

So a bunch of questions there, Brian, I'll do my best to hit most of them. So the good thing about being a quarterly comp filer is that we don't talk about the interim months. I would say that we saw a lot of consistency throughout the period, but that’s as far I’ll go in terms of Q3. In terms of Cyber Monday, it’s an opportunity for us this year because last year we had a lot of difficulty. We were down for about six hours on Cyber Monday last year, so we see, obviously, an opportunity this year.

Jim Scully

That was 10 of the snow days.

Millard Drexler

So, we’ve been testing, we feel ready for this year with the website and we’ve gone through a [simple] testing and we are ready. So, in terms of peak margins, I am not sure that the guidance for Q4 gets us to peak, a historical peak given that the front half of this year was actually down year-over-year and down from our peak levels. Q3, obviously is by far our highest EBIT margin that we’ve experienced at 18.2, I think our previous high was at 15.6 in the first quarter of 2008.

But what it does tell you is and we've never said that the mid-teens was our cap, we’ve said that we did see a path higher. I think this year as the [mob] can get into the mid to high teens and we just have to do on a consistent basis throughout each quarter. I do think that direct and factory channels give us that ability, given the mix of businesses that we have with direct being approximately 30% of the business. We did managed the factory margins give us I think overtime and it all gets back to when we can get to the productivity levels and we see what kind of shape recovery we have coming out of this.

Operator

Our next question comes from the line of Lorraine Hutchinson with Bank of America. Please proceed with your question.

Lorraine Hutchinson - Bank of America

Can you give us an update on your discussions with the landlords? Are the deals getting any better? Are you seeing any movement there? Have you changed your thoughts on square footage growth for 2010?

Jim Scully

Lorraine, the big thing for us is we've always said that it’s not being the best and not the biggest, so for us it’s about an allocation of resources against the best opportunities and the highest margin opportunities and when we look out to 2010 and beyond, our focus has been primarily getting the productivity back that we lost because obviously comp drives the greatest margin improvement and we saw that in Q3.

The second is the direct opportunity that we have given when we just talked about having a disproportionate operating margin advantage. So that has always been really our focus point and more or so on productivity given that we gave up some in 2008.

With respect to the conversations with landlords, we have seen the willingness not only existing to little bit but also we see rents coming in line. But you got to remember that we have a nine-month lead time on stores. So we're pretty much committed for next year.

Likely then on inventory, we're going to conservative on real estate. It's paid off, being conservative inventory to be able to stretch margins and same thing on the rent structure is the 10-year deal. So we think six months of patience really is going to pay off over a 10-year lease and if the deal works, we're going to do it.

The important thing is, we've always said we felt comfortable with 300 retail stores and a 100 factory stores. We still feel comfortable with the unit opportunities that we have. It's just going to lumpier than we thought. In the past, we thought it's going to be more consistent, more linear, we've got 79% square footage grow at each year. It's just going to be a little bit lumpier as we see the deals present themselves here and out.

Operator

Our next question comes from the line of Kimberly Greenberger with Citigroup Inc. Please proceed with your question.

Kimberly Greenberger - Citigroup

A big acceleration in your comps from the first half of '09 here into the second half of the year, I'm wondering if you can just sort of sit back and tell us, as you read your business, was it a change in the product execution? Was it better inventory control that allowed you to hold the price a bit better? Was it the customer mindset got better or are you attracting a whole new sort of wave of customers through your business? Can you just tell us what do think are the various drivers that has have contributed to this acceleration?

Millard Drexler

Well, I’m going to give you a same old answer here. At the end of the day, it’s about the design and creativity factor in this company has grown dramatically. I think again the tsunami recession kind of clearly made that a case. If you look at successful companies around the world, they are moving forward, they are creating and not moving back and I think Jenna, Frank, Kenly and all the teams and also design team and the marketing teams although we start, we start to run the business and continue to look forward and we are acting not afraid to take risks and go forth.

In fact that’s the only way companies grow our role model companies worldwide, or companies that appeal on a design, functional motional basis to consumers. I think the world is not what it was and in fact its never what it was it will be, what it is and we’re always figuring out where its going, that plus really strong micro management of the cash in this company. And that was a word that years ago were micromanaging I love management that micromanage. We love managements that call back customers. We love managements that send out notes. We love managements that say yes I sold five million iPods last year but I am going to make a better one this year. And whatever that company has to beat.

So I think first and foremost last year said through us we need to move forward. we need to lock five things we don’t love that are old and safe, because then in this environment there’s so many great quick merchants who get it out there, they get it quickly, they put a price on it and you know something a lot of them are really doing well. We flow more newness in, and we also know that we’ve learned a big thing, inventory does not correlate to earning and it really never has.

The other thing we do is every single day, we are the personal shoppers and our phone shoppers and all of us looking for more customers and contacting more customers and there is not a job too small that any of us can get involved in. I think it's an attitude, I think it’s a value system, I think it’s a culture and then of course you have to be really shrewd on the investment and it gets down to investing.

When I was a buyer of four million, years ago I always knew that the next year I needed less to make more money because you eliminate the mistakes. I think as a small store operator said to me few weeks ago, she said, I am really doing well this year, less inventory and I only brought what I love. That plus, you know the creative investments in this company investing in new samples in this company where everything we see before we buy, every color is dyed in that color room, it makes a huge difference and the days of putting the goods down on the floor and thinking they are going to sell. We don’t think those days were ever there for maximum return on investments, but that has so happened more so this year than ever before and we bless our customers everyday, we shop with it and we listen to them everyday.

Operator

Our next question comes from the line of Janet Kloppenburg with JJK Research. Please proceed with your question.

Janet Kloppenburg - JJK Research

Mickey on that note of how you are building the sales that you are building. I suspect, you are taking share from the department stores, but I am wondering and talking to your customers what have you guys did you guys learnt;, where is the market share coming from and what’s the opportunity going forward?

Millard Drexler

Well, okay in the talking to them it’s where we’re getting, look we’re getting customers who frankly, I am not going to mention any names, but when you look at the prices today everything has been adjusted in prices and I am not sure apparel has been adjusted the same way, as stock prices have been, homes have been, et cetera. So, they are looking at value, they are looking at the integrity and quality, we keep talking about, the mills we do business with. If you walk in and you start to see things that we make and it takes a long time. No company gets built in a year or two or three. We’ve been working this game while we’ve been practicing everyday of our life, to quote Bruce.

But the fact of the matter is, he does say that in his early concerts, should we go to work everyday and everyday we’re trying to figure out where its going and is importantly start to bring in high integrity products from not only our make and design, but from anyone around the world, we planned a trip around the world about a month or two ago, visiting places in way out locations.

Some of the visit to the vendors maybe a waste, others were terrific, but I think when you start surrounding your merchandise online and in stores with other like merchandise at customer desires and when you edit it like crazy, when you select it, when you pick it and pretty much the people in this room here, the ones that pick, select and meet with all the vendors or pick all the goods, I think at the end of the day and it takes time to come from where we’ve been.

But it really does, because you got to keep pushing the envelope and reaching, because we've never been in the position of having to even think about competing at the higher end and that plus in no small way our catalog business, our online business and our real estates strategy has done a lot to reinforce to the team here and through our customers that we're very serious about being as good as we can be and I think customers especially in fashion, more women than men, women will switch, men don't and we decided to get the men to switch.

We needed to bring in some outside, high worthy, iconic historical brands but, yes, I think we're probably getting them, but I think at the end of the day we don't care that much as I said where they come from, but I think a customer today, I think now you can take all the surveys in the world but people will not say, well, I'm buying, they're buying cheap clothes, they don't expect to keep them. But I think we buy clothes today. You want to look and say, well, I own that, I could be wrong [as the guy think] only after the next year or two without throwing it out from paying a lot of money for it.

So we may go to Italy. We make our shoes. We have them at reasonable prices. We want to own ballet flats. We want to own jewelry. We want to own cashmere. We want to own blazers and so we select category by category, look at the weaknesses and the strengths of the market and even in our men's suiting, we have two suits, Ludlow and Aldridge. Today from a customer e-mail, we said we're doing more double vented younger, like what's that younger customer said, he took a survey among his friends and they all like double vent two buttons. We had one double vent two buttons. We had a meeting today on suits and said, we want to own men's suits because we have arguably one of the great values and you pay $650 versus $3000 Italian fabric, great mates, the needles are very good worldwide with the factories we're in.

So a long answer Janet, we're passionate. We want the best and no detail is too small for us to pay attention to.

Operator

Our next question comes from the line of Adrienne Tennant with FBR Capital Markets. Please proceed with your question.

Adrienne Tennant - FBR Capital Markets

It's truly an 18% margin and it's fabulous at any time. My question is on inventory, it seems like you have become so effective in driving the sales, full price sales of the inventory. I was wondering where should we see that inventory plan for the fourth quarter, and at what point do you feel that you will actually need to buy up the inventory on a year-on-year basis?

Millard Drexler

If we look at how we are projecting being at the end of Q4, we are going to be down low to mid-single digits on a per square foot basis at the end of the year. Now, that’s a point in time. How we are thinking about the first half of next year is, basically being flat and even average inventory for the first half of next year, but you need to remember we came in last year a little heavy in Q1 and kind of manage our way through it into Q2. So, but right now we are thinking about flat and then in terms of increasing when we’d have to start reinvesting in inventory increases would be for Q3 of next year.

Operator

Our next question comes from the line of Dana Telsey with Telsey Advisory Group. Please proceed with your question.

Dana Telsey - Telsey Advisory Group

I thought the special section at Fred Segal's also was terrific. Just a couple of quick questions on inventory, how do you feel about inventory peaking, how are you thinking about spring given the business that you have seen so far and which categories do you see any changes in investment? Thank you.

Millard Drexler

Dana as we just said in terms of the spring of next year is going to be flat year-over-year in terms of the per square foot basis just because again we came in a little bit heavy. In terms of categories of business, I don’t think we've really started talking about spring of next year. We kind of focused on Q4 at this point. We can talk a little bit more about it in March of next year.

Dana Telsey - Telsey Advisory Group

And categories?

Millard Drexler

Well, jewelry will continue. Our new versions, we think, I don't want to say we'll continue. If the customers change their mind, it won't continue. Our new versions of [Artis], we've kind of created a whole new world of business, a blazers we I think we kind of hit the right trend on jackets and blazers for women's. We are expanding our dress presence because it's one of the always feedbacks we get because we just never have enough and of course that be the right inventory.

The boy, the kind of swimwear fit shirts, ruffled blouses unbalanced will we hope continue. It's hard to describe, I'm not very good verbally at what the goods look like but men's suiting’s but I'm going to ask my partner Tracy if she has anything to add on what we see happening through spring.

Tracy Gardner

I think Mickey really hit the highlights. We are going to continue on our great franchises. Men's suit is going to be very important. We are building an incredible shirt franchise in men's. Jewelry isn't mentioned, we are really going to see expanding that business. We continue to see enormous opportunity in wedding online. We also are really going after the [non-apparel] business of handbags, shoes online. You'll see us [play round loose] format, Crewcuts rate opportunity for us. You are going to see us circulating our catalog more often than regular. We see just a lot of good growth ahead of us.

Millard Drexler

To add to that, Dana, it's kind of not too good itself but developing the relationships we have with our customers. We have this weird thing. We think we are very small company. We think each of us is in fact responsible for every customer e-mail letter and we also think that over time you do good things to your customers. They in kind like us for that.

Now of course if the goods aren't right, they leave you quite quickly. But that all being said, as we have enormous intensive effort to continue to connect personally and emotionally with our customers through, even Jenna's picks, Jack knows best, [Cooper’s] picks. I have my own picks, but they are all private to my friends, and things we think they should buy.

But I think the personal aspect of weekly call to us, to our directors, it all kind of hopefully accumulates into energy in the field that customers truly get respected come first and if you don’t feel you can’t be in the organization. So that’s another, it’s not a merchandize strategy, but its part of, we want people to know we are small and to mid company strategy.

Operator

Our next question comes from the line of Richard Jaffe with Stifel Nicolaus. Please proceed with your question.

Richard Jaffe - Stifel Nicolaus & Company, Inc.

A question about the catalog distribution and I guess the declining need for catalog given the success on the internet. The outlook for the Madewell introduction to the e-commerce side and will it be the same side as J. Crew they’ll be linked and able to shop? Then the future of the collections looks terrific both downtown and uptown, wondering if there’s an opportunity to have a separate spot on the website for that?

Millard Drexler

You want to do…

Tracy Gardner

I will trust the catalog. I want to clarify something. The catalog is very important to us and I think what we’re seeing it as, it’s a place where you can see what we’re about both in style, design, what we’re loving, we no longer see ourselves though in the catalog business, it is a marketing vehicle and hopefully when you get the catalog and you page through it, you’re going to see or eat those things we love. We're excited about. We like to distort in our catalog. What we want to buy and we'll tell the story about our products.

Now what you maybe referencing, in you circulation is down, all we keep doing and we've said this before. We're taking circulation that is not serving us, serving us in terms of profit and sales and reinvesting that in our customers, the store experience, we're reinvesting it in marketing on the web. We're going after search; we're going after affiliate marketing. We're also advertising more, you're noticing us on New York Times website we have taken over the tiles there.

So we've basically taken all of that debt circulation and thrown it at more aggressive marketing on the web affiliate and you're also going to see us launch a great campaign through Q4. So the catalog is not declining in importance at all and it really is where you access us, web, store, through our customer service representatives both on the phone and in the store.

Millard Drexler

Rich, in terms of Madewell, in terms of the platform, you'll be leveraging the same architecture underneath, but it will be a separate type and it will not be a link between J. Crew and Madewell, but we will be leveraging the investment that we’ve made in the overall architecture.

Tracy Gardner

We do reference it sometimes on Janet picks only if we look and we pick our favorite items and we'll reference it there.

Richard Jaffe - Stifel Nicolaus & Company, Inc.

On collection, what's happening is where kind of collection merges a bit into the normal assortment, because you know we started collection well a number of years ago, there's was big dichotomy between normal J. Crew goods and collection. I think overtime with the intensive creative efforts, they’ve merged a bit but just specifics, we have Downtown, Prince Street as you know and I'm really pleased. I think I can say that men's left and were pumping prints without men’s which is pretty exciting to us, we didn't plan it that way.

But I think as you present better goods and I think it gets back to the two comments on may be designer, because if you look at prints post and pray, three men’s going out, different store different field, we expanded women, we expanded kids and all of a sudden the store without spending much money at all the [store read] differently. We have East Hampton, which speaks the collections, South Hampton speaks the collection, more and more in our catalogue and online we speak to collection. Miami, Lincoln Road opened last week.

We’re really excited about that. Malabo, so you are seeing more and more what it does for us and as importantly what the catalogue and online do this continues to get that after a long width, some of the very prestigious brands that kind of sell themselves that we carry in our best stores that we carry online and that we really drive a level of high expectation and then deliver what we need customers to expect. So but I think for us again we are not giving up opening price points we are not giving up friendly but we also are chasing an expansion of our existing base. People are buying more carefully and I think that helps us.

Operator

Our next question comes from the line of John Morris - BMO Capital. Please proceed with you question.

John Morris - BMO Capital Markets

But, I got a few follow ups. Jim and (inaudible) earlier. Can you talk a little bit about some of the benefits you are seeing in sourcing cost of goods sold, order of magnitude of how much that’s helping on the margin and how far out you have see that benefit continuing. Is it all the way out as you think about may be even your fall orders at this point and I think for Mickey on jewelry and accessories, which is such a great category right now for you, how big is that as a mix currently? How big do you see it getting and your thoughts on continuing to grow that piece of the business? Thanks.

Jim Scully

Hey, John, it's Jim. So the first question in terms of the cost benefit on [AUC], we said earlier in the year that we anticipate having benefits about 3% to 5% in the back half of the year and I'd say that we've been pleased with the results and we've been able to capture by the high end of that range in Q3. We would expect that in Q4 and for next year, I think the goal is going to be to maintained prices. We don't see it going much lower, but I think to keep them flat would be a real accomplishment.

Millard Drexler

We don't breakout how big the jewelry business is. It's typically around 12%, 13% of the overall business. If you think we have an opportunity to grow the business significantly at the end of the day, it's really not going to move the overall needle. It's really reallocation underneath that 12% to 13% on the accessory side.

Operator

Our next question comes from the line of Christine Chen with Needham & Company. Please proceed with your question.

Christine Chen - Needham & Company

I wanted to ask how much longer do you think you'll continue to see sourcing benefits? If the economy improves, could you see yourself maybe taking price points back up?

Jim Scully

Well, I'll do cost real quick...

Millard Drexler

As I just mentioned I think the benefits we're seeing is really the back half of this year going it to next year, its going to be really our goal to maintain at the cost structure that we are putting into place in the back half of this year in terms of pricing.

Jim Scully

Well, we price based on how many we buy. We price based on uniqueness. We price based on scarcity. We price based on how many we might want to sell. We price based on price. In other words, the higher the price is, we're normally going to sell or buy less. But no, we don’t look to take prices up, we look to price goods competitively everything we price looks at, and by the way its not a price or averaging the retail issue here. It’s all the metrics in the company.

But everything we look at we say fill in the blank what is so and so sell that for? What is so and so retail? What is out retail? What is their quality? What is there out and how is it important? Most perception of quality of a company drives so much retail today, you dissect a lot of very expensive clothes and you will find if you did it clinically that could be a lesser make, a lesser fabric, a fancier label and lo and behold, the price is higher.

We are battling that always, but we take apart our products, we take apart theirs and I think we have to continue to earn our stripes with high integrity. With not having, and most people in our industry don’t talk about the sale factor which I am actually surprised at because you look at sale goods around and it’s almost just quite little thing about who is doing sale business.

But then when you look at the sale companies, the worth price companies, the designer worth of price companies, I don’t kind of understand it how, It’s okay if we saw last year’s best sales from every designer. I have to say, we like that, it helps us. So the price thing is what is worth and what is it worth if a customer thinks they're paying a fair price for something and they don't have to find it online at a certain which price which is actually 30, I buy certain things. We all do.

We have that favorable site, one-third off most of the goods you would buy in certain stores. They're out there, people are buying them and sometimes you don't pay sales tax, whatever the rules and policies are. But there is so much available out there. So when I look at prices for us, I look at the price on the ticket, then you look at the prices going on sale. Then you look at friends and family, daily crisis and we price the goods, to put them out there, where we'd like to sell them through and get a fair margin and return on our investment.

So if you start to really look at the underlying, online pricing strategy, price in a lot of cases are not what they're seeing. But our prices are based on sale return and it's also science as well as an art. But more retail will get us more business, more of the best goods at fair retails, will get us more customers. We'll then get us more business because hopefully they trust this and like us. And by the way, I might add, this has been really terrific result I guess.

On the other hand, we start tomorrow after that goes into the next quarter. We had a nice quarter. We've invested reasonably well. The goods have looked good but in a way, we're always on guard.

Operator

Our next question comes from the line of Jennifer Black with Jennifer Black & Associates. Please proceed with your question.

Jennifer Black - Jennifer Black & Associates

Let me add my congratulations as well. I just have a couple of questions. I wondered, one, if you though about doing hop up stores when there's an opportunity especially in test markets and then I also wondered how your plans were coming for your private salon. Then I also wondered if you have plans to do any more third-party relationships. Thanks.

Millard Drexler

I am getting wisp here, hold on. Okay. So now let's talk about wedding, is that what you said? Okay, give me this again here. I was just, so I am sorry, Jennifer. Pop-up stores, they are nice, no. We're just not looking for, we just not looking forum because, no, that’s the answer. But, what did you say? Look, you get up everyday, you're kind of wondering around, yeah, sometimes we look at an empty store downtown, we call Holly, the real estate parties and say, Holly, what’s that store for rent? How clean is it? Then we come up. We say it might be fun. So far we haven't hit yet. In key markets…

Jim Scully

Consider the key market, not test market.

Millard Drexler

Yeah.

Jim Scully

Not test market.

Jim Scully

For the pop up? We're not – pop-ups are creative visions, it's kind of like, it's kind of a new little thing that we think, but we haven't done them actually. Yeah, we've haven't done it. We are kind of looking, but right now we are not looking.

Our third-party relationship, it's the same as our own design. We are constantly looking for things that we think will go well with our mix and with our customers and everyday, we're looking or not looking, but the online world makes everything very quick, speedy and accessible, someone mentioned, the very interesting boot company in the European City, small company went online not us.

So it's easy to look at that and but wedding is a key business for us and it's a really big opportunity online and we keep opening in more stores as appointment-only thing and we're really getting nice actions, in Chicago, in Short Hills, New Jersey, in Manhattan and we are moving forward.

Operator

Our next question comes from the line of Sam Panella with Raymond James and Associates. Please proceed with your question.

Sam Panella - Raymond James and Associates

In terms of the direct business, it comprised about 26% of total revenue. Just wondering why was that down from I think it was 28% or 29% the past two years in the third quarter, how should we think about your ability to grow that as a percentage of the overall revenue, and then also along those lines why was other revenue down year-over-year? Thank you.

Millard Drexler

So I'll start with the other revenue. It's really a bunch of things that are in there. There is three different things that are really driving them there, believe it or not, one is the insurance proceeds we have last year and the other is, we had a little more free shipping related to Crewcuts and the other is, we discontinued our Japanese licensing agreement last year. So we had less royalty income. So they are all about the same that drove the difference in other revenue.

The other question, direct, is if you look at the penetration, if you look at the first nine months of this year, it's interesting. We look at comp versus the direct business because we kind of a strip out the new unit growth and you look at it, comp is essentially flat this year and direct is actually up 1% for the first nine months. We do see direct growing obviously in Q4 and the penetration is stabilizing. You have to look at the two-year growth if you look at it in Q3 because direct was actually up 17% for the last two years where the comp was up 5%.

So we do see that recovery and we do see an opportunity to as we anniversary some of the site difficulties we had last year. It’s a primary focus us. We look at the penetration and over the next two to three years, we’ll definitely drive direct growth greater than the comp.

Operator

Our next question comes from the line of Barbara Wyckoff with Jesup & Lamont. Please proceed with your question.

Barbara Wyckoff - Jesup & Lamont

Here is my question. What could you have done better Mickey, did you leave some business on the table and any classifications?

Millard Drexler

That’s a good question, Barbara. Yes, as Tracy just said, always a little more aware now. We probably didn’t want to own as many wool coats as we owned. We could have bought less of, what?

Tracy Gardner

Less corduroy.

Millard Drexler

Less corduroy jeans, but what I think the team has done, it's an interesting thing. The days of narrow, deep, big are over and we’re allergic to piling and some of us kind of invented it million years ago, piling it up on the table unless it’s a priced value business, but I think what’s happened now is, it’s kind of like, I was having dinner the other night in a restaurant my family and there was a very famous chef there.

Well, he is not a TV guy, just it’s really good restaurants and he said and I heard what he was ordering and I said to my little and he said, I said you tried the lamb, but the lambchop what we had ordered already and I said if he is having the lambchops, I am going to try them. He came over Houston, I was impressed and he validated the restaurant.

So he said and I said cheese, but I loved the artichokes, the fried artichokes, the [pizza] or whatever. He said I always learn when you cook. If you want more, don’t order more. Now it's a little restaurant, that's famous, that sells all little dishes in California and New York. I think that's about the goods. You can go for the last item, but I think what we've done is run out, but when you run out, the oxygen comes in when new goods come in. I think what we're finding is they're our best customers. Those customers that want to see what's new, it's astounding on the what's new part of our business and I think Tracy and Jenna, Trish and the team and in factory the same thing with Libby have taken it and increased flow dramatically.

So what have we left on the table. Yes, there are always things that we didn't have enough of, but you always got to try to save some for the next year and I don't know any retailer wouldn't give you, anyone in any business doesn't give you the mistakes you make, things we overbought, things we didn't buy enough of, we could have done a heck of lot more jacket business in Madewell this year. We sold out real fast. We could have done lot more jacket business at J. Crew. We sold out real fast and so we're going to fix it, but the only thing we'll not do which we've learned is, don't buy last year's hot items next year.

That's a thing and I think the design elements in our company really prevents that, because Jenna and the team, newness with evolving and sharpening edge on what's been right, the pixie pant, the mini pant has become for us an iconic pant. It's an amazing pant. It makes every women look good. We blew out of the better version of the mini at a $168 and we are learning but this is the balance that they will pay. They, meaning customers will pay without credibility a lot more money than we used to think they pay for our goods at the better levels because there is a trust factor. We sold that for $168 whatever that trapper hat (inaudible), sold out like overnight in online to men's trapper hat. So we keep learning. Everyday is school day. Everyday we come to work we're learning, but we always make a fair amount of mistakes. Is there a last question?

Operator

There are no further questions.

Millard Drexler

Thank you all for joining us and we appreciate the support. We'll speak to you all in March when we report fourth quarter and hope everyone has a great, great Thanksgiving and a happy holiday season. Take care.

Operator

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.

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