JCPenney Q3 2006 Earnings Call Transcript

JCPenney, Inc. (JCP)
Q3 2006 Earnings Conference Call
November 9, 2006 9:30 am ET

Executives

Mike Ullman - Chairman, CEO
Bob Cavanaugh - CFO
Bob Johnson - IR

Analysts

Deborah Weinswig - Citigroup
Charles Grom – JP Morgan
Jeff Klinefelter - Piper Jaffray
Michelle Clark - Morgan Stanley
Stacy Turnof - Merrill Lynch
Adrianne Shapira - Goldman Sachs
Dana Cohen - Banc of America
Christine Augustine - Bear Stearns
Hillary Morrison - Lehman Brothers
Bernard Sosnick - Oppenheimer
Liz Dunn - Prudential
David Glick - Buckingham Research
Michelle Tan - UBS
Dana Telsey - Telsey Advisory Group

Presentation

Operator

Welcome to the JCPenney third quarter 2006 earning's release conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Mr. Bob Johnson, Vice President of Investor Relations. Sir, the floor is yours.

Bob Johnson

Thank you for joining us on the call this morning to review JCPenney's third quarter earnings. We scheduled the call today to last about 45 minutes, which includes time for questions and answers.

Before we begin, let me remind everyone that the discussion this morning includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which reflect the Company's current view of future events and financial performance. The words expect, plan, anticipate, believe, and similar expressions identify forward-looking statements. Any such forward-looking statements are subject to risks and uncertainties and the company's future results of operations could differ materially from historical results or current expectations. For more details on these risks, please refer to the company's Form 10-K and other SEC filings.

Also, please note that no portion of this call may be rebroadcast in any form without the prior written notice and consent of JCPenney. Replays of today's webcast will be available for 90 days. For those listening after November 9, 2006, please note that this recording will not be updated and it is possible that the information discussed will no longer be current.

On this morning's call, we will have two speakers. First, Bob Cavanaugh, Chief Financial Officer, will discuss operating results and review our financial condition. Michael Ullman, Chairman and Chief Executive Officer, will conclude the formal remarks with his observations. We will then open the call for questions. Ken Hicks, President and Chief Merchandising Officer is visiting our sourcing offices in Asia and will not be joining us on today's call. Bob Cavanaugh will begin.

Bob Cavanaugh

Thanks, Bob and good morning, everyone. We were obviously pleased with our results as we reported record third quarter earnings from continuing operations of $1.26 per share. We ended the quarter with operating profit of $504 million, an improvement of nearly $100 million above last year, or an increase of 24%. As percent of sales, operating profit was 10.5%, improving 140 basis points from last year's 9.1%.

Our third quarter results reflect a good balance between continued improvement in sales, gross margin and SG&A leverage. In department stores, total sales increased 7% for the quarter, and comparable department store sales increased 5.2% which follows a 2.5% increase last year, better than original expectations.

Third quarter results reflect strength across all merchandise divisions and all regions of the country. This was our sixth consecutive successful back-to-school period and we are very pleased with our customers' response to the fall merchandise assortments. While all categories improved throughout the quarter, the strongest divisional performances came from children's and men's apparel, as well as family shoes. Overall, sales for the quarter were driven primarily by increased traffic with positive trends in both units per transaction and average unit retail.

Moving on to direct. JCP.com continues to be our fastest-growing channel, increasing 27% for the quarter. This was on top of the 26% increase last year. In total, direct sales for the quarter increased 5.3% and were led by women's apparel, Our Home and family shoes.

Turning now to operating profit, gross margin was up 80 basis points from last year, ending at 42.6% of sales. Gross margin continues to show strength and is benefiting from strong performance of our private brands and from the effectiveness of our planning and allocation capabilities which are driving better product flow and a more disciplined clearance process, as we entered the quarter with lower clearance levels, which may have slightly impacted sales in the August period, but gross margin was enhanced by more regular priced selling of seasonal merchandise.

SG&A expenses were leveraged 60 basis points, ending at 32.3% of sales and reflect leverage of salary cost and efficiencies in our direct channel. SG&A dollars increased in line with plan and include approximately $14 million in pre-opening expenses for new stores. Please note that beginning with the third quarter, real estate and other is being reported as a component of operating profit to better align our reporting with industry practice.

For the quarter, real estate and other contributed pre-tax income of $8 million this year, primarily from ongoing real estate operations compared to $5 million of income last year. Net interest expense in the quarter was $36 million and the tax rate was 38.9%. So with 228 million average diluted shares, earnings from continuing operations for the quarter were $1.26 per share, up 34% from last year's $0.94 per share.

Moving on to our financial condition. As of October 28, the company had cash investments of approximately $2 billion. We ended the quarter with long-term debt of $3.5 billion. As most of you are aware, Fitch ratings recently upgraded our long-term debt to BBB, which is the second level of investment grade and they rated our outlook as stable, reflecting our strong financial position and consistent operating improvement as well as our ability to fund our growth initiatives. Our next scheduled debt maturities are in 2007 and total approximately $425 million.

Capital expenditures year to date are $560 million which is line with plan and compares with $395 million last year. As we reviewed at our April analyst meeting, our full year capital plan is nearly $300 million higher than last year primarily in support of our new store growth initiatives. We opened 25 new stores in the third quarter so CapEx has accelerated in the back half of the year. For the full year, we continue to plan capital expenditures to be in the area of $800 million.

Also in the quarter, we completed our $750 million share repurchase authorization with the repurchase of $220 million of our common stock. We repurchased 3.3 million shares in the quarter and 11.3 million shares this year under the entire authorization. These share repurchases are partially offset by the exercise of employee stock options for diluted share calculation purposes.

Cash flows from operating, investing and financing activities were in line with expectations for the first nine months of the year and we continue on plan for the full year. As we previously announced, cash flows for the year include a provision for a discretionary $300 million pension fund contribution in the fourth quarter. Maintaining a well-funded pension plan continues to provide financial flexibility relative to both future cash flows and financial accounting expense. This is especially true, given the Company's decision to restructure its current retirement plans as disclosed in previous SEC filings, substituting a new savings plan for pension benefits for all new hires effective January 2007. As we have noted, our pension plan continues to be in the top 10% of all S&P 500 companies with respect to funded status, and recent pension legislation enables companies with well-funded plans to have more flexibility in making additional contributions, better matching assets and liabilities over time.

On this same topic, the FASB recently concluded the first phase of the review of pension accounting rules. FAS 158 requires the recognition of the funded status of defined benefit plans and other post-retirement plans to be reflected directly on the balance sheet. What is important to note about FAS 158 is that this will have no impact on our earnings per share or cash flow as it is a non-cash item. While FAS 158 will not be effective until year end, we currently estimate the impact to be a decrease in our shareholder's equity net of tax of approximately $250 million. Other companies will be taking similar actions during this and the next earnings period.

Looking at inventory entering the fourth quarter, total inventories are up about 1% to last year. On a comp store basis, inventory levels are favorable to plan and down slightly. During the quarter, we saw improvement in inventory turnover. This improvement is in line with our expectations and a result of our goals to improve in-stock and inventory flow, both of which we outlined last April at our analyst meeting.

As we enter the fourth quarter, inventories are well balanced between basics and fashion merchandise and we are ready for holiday. The store set date for holiday merchandise was late October, basically the same timing as last year. And inventories support our gift strategy for the important holiday season.

Looking ahead to the fourth quarter, we expect total department store sales to increase mid single-digits with about $150 million in sales related to the 53rd week in this fiscal year. We expect comparable department store sales to increase low single-digits. We expect direct sales to increase mid single-digits, including approximately $50 million in sales from the 53rd week.

JCP.com sales should continue to grow in line with year-to-date trends in the fourth quarter. We anticipate moderate improvement over last year in the fourth quarter operating profit rate, primarily as a result of gross margin improvement. The 53rd week adds about $65 million in expenses to the quarter but has no significant impact on earnings.

Net interest expense is now expected to be about $32 million in the quarter versus previous guidance of about $40 million. We are forecasting a tax rate of about 38.5% for the fourth quarter. This reflects the 35% federal rate plus state taxes. We expect a full year 2006 tax rate of about 37.2%.

We expect to have approximately 229 million average diluted shares in the fourth quarter, and we now expect to have 232 million average diluted shares for the full year. All of this share count guidance includes about 3 million common stock equivalents.

For the fourth quarter we now expect earnings to be approximately $1.94 per share. This represents an improvement of $0.10 per share from our previous guidance and an improvement of $0.23 per share compared to last year, excluding the impacts of one-time tax credits that contributed $0.21 per share to last year's fourth quarter. Rolling this new guidance into the full year provides for earnings of approximately $4.82 per share.

Before I conclude, as planned, we accelerated our new store growth by opening 25 new stores in the third quarter with 22 of these stores in our successful off-mall format. This brings the total count of new stores open for the year to 28. All of our new stores reflect upgraded features throughout the store intended to make JCPenney an easy and exciting place to shop. These include visually detailed displays to showcase our merchandise as well as coordinated signage and appearance elements that highlight specific brands and looks, allowing customers to easily bring pieces together in a fashionable way. We are extremely pleased with the performance of this group of new stores which are exceeding expectations. Looking ahead as we previously announced, we will open 50 new stores per year in 2007, 2008 and 2009 with the majority in our off-mall format.

In summary, our team delivered a terrific third quarter. We continue to see consistent improvement in the fundamentals of our business with improvement in sales, gross margin and SG&A leverage. We are in the initial stages of accelerated growth. As we look to the holiday season in fourth quarter, our management team is focused on executing our operating plan, which recognizes the macro-economic and competitive retail environments. We believe our business is well positioned to continue to produce solid sales and earnings growth through the remainder of the year and going forward.

Now, I will turn the call over to Mike Ullman.

Mike Ullman

Thanks, Bob. Good morning. We were obviously very gratified with our results on a year-to-date basis and especially for third quarter. As Bob said, our team executed well with strong sales growth across all merchandise categories, all geographic regions and across all our channels: stores, catalog and internet.

Our financial results reflect the excellent progress we made on our growth initiatives as outlined in our 2005 and 2009 long-range plans announced just 18 months ago. The 17 initiatives in that plan all led to our sales growth and results are reflected in our gross margin improvement of 70 basis points, our SG&A leverage of 60 basis points and the improvement in our inventory turnover. The result is earnings per share of $1.26, up 34% from last year. As well our company's sound financial condition is once again recognized with a further credit rating upgrade.

Some of our performance highlights include the performance of our private brands, particularly the new introductions. Our customers acceptance of our new private brand introductions including a.n.a., new women's casual sports wear brand for the modern lifestyle. This is alongside St. John's Bay, which has become a billion dollar brand in traditional lifestyle. a.n.a. is off to a very strong start and will easily see $200 million in its first full year.

The second major introduction was East Fifth. This is a new women's career sportswear brand for customers that are more traditional than represented in our modern lifestyle brand of Worthington. It’s off to another strong start and will contribute greatly to our career assortments.

The third I would like to highlight is Studio which a position within our JCPenney Home Collection and it's doing very, very well addressing the opportunity that our customers said that we had in our updated home merchandise assortments.

These new introductions join our $3 billion- private label brands Arizona, St. John's Bay and JCPenney Home Collection. All of our private brands are growing faster than the overall store is growing. We believe that former May Company customers are finding the styling and quality they found at May Company at smart prices at JCPenney. We think that led to some of our comp store growth during the quarter.

Some other growth initiatives I would like to highlight are, as Bob mentioned, our first prototype Sephora stores inside JCPenney in five locations. There is definitely a newness and excitement to the stores and the early days are very promising based on our customer's reactions.

Also in the quarter, we finalized the installation of the 35,000 new POS terminals in our stores. These are all dot-com ready and our sales associates have become experts on how to connect directly to the Internet to solve customer needs. They can complete a transaction in the store by having access to the biggest inventory of all, that inventory accessible through dot-com.

Our merchandise allocation teams have been very successful during the quarter in improving merchandise flow, frequency of fashion deliveries and improving our price management. We have had excellent success in performance in children's, for example, during back-to-school where we operate on less inventory with more frequent deliveries and ended up with the best increase in all of the back-to-school categories. We obviously will extend this to other categories as well going forward.

In our new store opening program, we will have open 28 new stores this year, most in our off mall free standing format. As Bob mentioned, 25 of which were in the third quarter and 20 in the same week early October. This new prototype reflects customer suggestions, improved merchandising presentations especially in intimate apparel, kids and home; and lifestyle imaging and way-finding signs throughout the store. At maturity, these 100,000 square foot format stores will do $250 gross per square foot.

We believe that JCPenney has a unique balance and important mall presence, which is the key destination of weekend and holiday shopping periods, and a large and growing presence in off mall locations. Please keep in mind, JCPenney himself opened the first off-mall store almost 105 years ago, so we aren't new to the off-mall store business.

As for holiday we believe we are a very exciting destination for our customers. We have special red box gift presentations located near our home goods, in stores catalog and on dot-com. We also have fashion right gifts throughout the store at very smart prices. As always, we planned these promotions ahead of time in a cadence that customers understand and appreciate so we feel we were well positioned for the holiday season and it's validating our customers' trust in us as well as motivating new customers to come try JCPenney.

Looking ahead, our long-range growth target for 2009 is $5.10 a share. As many of you know, we're predicting we will exceed that target in 2007, two years earlier than our plan. We will be putting together a new plan in the spring for 2007 and 2011, particularly in our growth leadership objectives going forward.

As I said, we are continuing to pursue growth in all aspects of our business. Some introductions in 2007 include our new brand offering recently announced, Ambrielle Intimate Apparel, which promises to be the largest private brand launch in the Company's history. The introduction of Liz and Co. for women's and Claiborne in men's will debut in the spring.

The expansion of support in the new stores and remodels in 2007 and further acceleration of openings in 2008. We will begin to open 50 stores per year beginning in 2007 and remodel 70 stores next year. We also expect to see the early impact of our cycle time reduction initiative and continue to see flow improvements on frequency of delivery with fashion right merchandise. We also believe that we are making continual improvements in the functionality and integration of JCPenney.com as the largest general merchandise site on the web as noted with 26% growth just last month. We were continuing as a growth leader in this category.

In our marketing and messaging our new relationship with Saatchi & Saatchi, will help us articulate our desire to make that emotional connection with our customer.

In summary, our talented team is performing well and we appreciate that they are the key to our long term success and growth. It's their commitment and hard work that's paying off. So now we'd be pleased to take your questions.

Bob Johnson

We are now ready to go to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Deborah Weinswig - Citigroup.

Deborah Weinswig - Citigroup

Congratulations on a great quarter. Mike you mentioned what you have seen in children's and in back-to-school season, I was just wondering if this is basically representative of what we will see with the cycle time reduction initiatives? Also if you can give us an update in terms of where we are with that initiative and what we should expect to see in 2007?

Mike Ullman

Yes, I do think it's indicative of what you will see with those improvements. Not just cycle time reduction, it is also the frequency of delivery and it's better planning and allocation performance in terms of flow. While cycle time is a key element, getting it faster obviously there is a better chance to make it fashion right; but actually the merchandise flow has helped us remain current and reduce the markdown percentage. We believe by operating with less merchandise and better flow that will give us better profitability and that's what's encouraging to us.

Deborah Weinswig - Citigroup

I think originally that you were looking at being around 40 weeks in terms of concept to shelf by spring of '07. Is that still the current timeframe?

Mike Ullman

That's the objective.

Deborah Weinswig - Citigroup

Sephora, can you talk about some of your initial insights and maybe some surprises that you have seen thus far?

Mike Ullman

I won't talk specifically because I think it is too early, but we were quite gratified with the average basket which is right at where we believed it would be, the acceptance by customers of all ages, which also pretty much was our assumption. I think we have done exceedingly well in the new store format where it's positioned right in front of the store. In the other stores obviously which were remodels, it's located in the accessories core. Because we had a new store and all new customers at the same time we obviously had great success in introducing Sephora in that store where other stores, obviously the customer discovers it as she comes to shop on a regular basis. So we will need to see through the holiday season really what the pattern is. But we were certainly encouraged by the early results and I believe Sephora is very encouraged as well.

Deborah Weinswig - Citigroup

Thanks so much, and congratulations, again.

Operator

Your next question is coming from Charles Grom - JP Morgan.

Charles Grom - JP Morgan

Good morning, thanks. You cited private label as one of the two key drivers for the margin gain. Can you update us on the mix there? Where are you in the process of sourcing directly with factories? Where you are with your brand portfolio and where you think additional opportunities exist.

Mike Ullman

Well, as many of you know, we are among the leaders in doing consumer research. Not only does that research benefit us from understanding where we might have voids in our assortment, but it also gives us an indication of what's working and what's not in terms of our private labels that we are currently have in the assortment. So these new introductions, a.n.a. and East Fifth, I think are reflections of opportunities that customers told us we had in lifestyle preferences in women's apparel.

We continue to see private label grow at a faster rate than the rest of the store. We don't have to set a target, but we allow it to reach its own level and it's growing quite nicely. In terms of other targets of opportunity, we just keep evaluating by lifestyle preference, where the customers seem to be responding and where we may be underperforming. But right now we are very encouraged by our mix of the most desired national brand merchandise that customers seek when they come to JCPenney and their acceptance of our private label as being the proper style and great quality and smart price.

Charles Grom - JP Morgan

Okay, that's helpful. Another question on margins. If my math is correct it looks like gross profits will be close to 40% this year which is your 2009 goal. Can you share with us your thoughts here on what your revised target may be?

Mike Ullman

Well, we will share the revised target next April. We continue to be encouraged by the effectiveness of our planning and allocation people and our systems investment there. We believe as they get better at understanding how to use these very sophisticated tools and all their expertise, we think it will help merchandise flow, which obviously helps in our price management and also keeps the floors easier to read by the customer with less upfront loading of inventory. So we were encouraged by our gross profit progress.

We recognize that having a smart price is very, very important for our customers so we are not intentionally pushing the price side of that. We are hoping to make it work through the technology that we have, and frankly we think we are in a unique position to localize assortments because of the technological advantage and the expertise of our people.

Charles Grom - JP Morgan

A last one is on Sephora, is there an opportunity to add more than 50 venues next year and could you share with us what you have learned in the month or so that you had the five opened?

Mike Ullman

Well, there may be an opportunity to do more next year. It's all focused on two issues. One is how quickly the suppliers can ramp up our volume, because in many cases the most popular suppliers in Sephora are not large conglomerates. They are innovative entrepreneurs.

The second is, we do intensive and extensive training of our Sephora sales associates and it's very similar to the training they do for Sephora and their specialty stores. We want to make sure we don't water down the training by moving too quickly to open new stores. Those are the two gating factors, and nothing else. We are looking at that now and we agreed with Sephora that we will make a call in early January on what we felt comfortable we could open at a level of expertise and performance that we will be proud of.

Operator

Thank you. Your next question is coming from Jeff Klinefelter - Piper Jaffray.

Jeff Klinefelter - Piper Jaffray

Just a couple of quick questions. One would be in the home category. You talked earlier in the year about during times when there may have been a slight slowdown in consumer traffic or consumer spending. Some of the higher ticket home items might have slowed a bit, that was the extent of your visibility into the consumer behavior shift. Are you seeing that swing back again? Are you seeing a more buoyant consumer response across the higher ticket home products?

Then the second question is on the productivity of your remodels. Can you share with us looking back on a trailing 12-month basis what generally is a parameter for the delta improvement in recently remodeled stores versus your average old prototype?

Mike Ullman

On the first comment, I would say we are doing exceedingly well throughout the store and that includes the home store. So when I say that the hard goods in home continue to be somewhat softer, it's softer from a much more aggressive performance by the rest of the categories so it is by no means dragging us down. I would say furniture and window covering are still the weakest of the home categories which is not surprising given the slow down in the home sector.

But we more than made up for that in soft home as well as throughout the stores. As to the remodels, many of our remodels include the repositioning of fine jewelry. As you may know, our fine jewelry business is exceedingly strong and that is a big ticket purchase for many people. So it's not just the ticket issue; it is quite the opposite. It is a function of the home sector.

The remodels are doing well. I don't really have a number that will be all that helpful to you to generalize across the remodels because many remodels are done for maintenance and improving lighting and some of the soft side of the store which we don't attribute a great difference in sale productivity. Others are done for merchandising opportunities. But the fact we are committing to nearly 70 stores next year for major remodels gives you an idea we believe they pay off and that improves our productivity.

Our productivity overall, you may note, for the last six years is number one improvement in sales productivity in the mall of all anchors and the only ones that have increased every year for the last six years. We are feeling pretty good about earning productivity the old-fashioned way by having customers prefer us versus the competition.

Jeff Klinefelter - Piper Jaffray

Great. Thank you, Mike. Congratulations.

Mike Ullman

Thanks a lot.

Operator

Thank you. Your next question is coming from Michelle Clark from Morgan Stanley.

Michelle Clark - Morgan Stanley

Good morning, guys and congratulations. You had guided for the fourth quarter to gross margin improvement as the bigger driver of the operating margin expansion relative to expense leverage. It sounds like this is a change in your language or change in your guidance relative to previous quarters. It seems like in the fourth quarter which is typically very promotional that's a little counterintuitive. Can you explain that?

Mike Ullman

First of all, unlike some of our competitors, we don't really react in a short term, interval basis to promotional activity. We have a very methodical, well thought and well planned promotional schedule so we are able to anticipate probably better what our gross margins will be and we believe that much of our gross margin improvement is because of the systems investment and expertise of our people and planning allocation in our merchants. So we may have a little bit more confidence in the gross margin improvement because it isn't quite as dependant on sales leverage for the improvement.

Whereas on the expense side, obviously performing above plan that's why you get the SG&A leverage. I don't think it reflects a major change except recent experience, if you look, it's pretty balanced between improvement in the margin and improvement in expense.

Michelle Clark - Morgan Stanley

A second question is, you had updated obviously your EPS guidance for fiscal year '06 by $0.10. Any updates to your operating margin target of 8.8% for the fiscal year?

Bob Cavanaugh

Not really.

Michelle Clark - Morgan Stanley

Okay.

Bob Cavanaugh

I mean obviously the EPS comes from somewhere. We said we would have moderate improvement in the margin consistent with the $1.94.

Michelle Clark - Morgan Stanley

Thank you.

Operator

Your next question is coming from Stacy Turnof from Merrill Lynch.

Stacy Turnof - Merrill Lynch

Good morning. Now that you have had this POS rollout in all of your registers and it's been a quarter, quarter-and-a-half, can you update us on how that's helping your direct business and how that's driving some of your online business within your stores?

Mike Ullman

We measure very regularly what we call our certification of sales associates that know how to use the register properly to conclude a transaction on dot-com. We set a target of 68% of all associates in stores having successfully executed a transaction, using it to help customers. We see the most improvement in what may be obvious, but in places where the customer wants to complete a transaction like window coverings, in shoes, intimate apparel where sizing and so forth allows even the smallest store to have access to our entire assortment. We are quite encouraged that this is a significant opportunity for dot-com. Our dot-com continues to grow at quite impressive levels off a very large base and we think that can only get better going forward by keeping the store channel and catalog channel and the internet channel connected.

Stacy Turnof - Merrill Lynch

Great. My second question going back to the gross margin improvement. Would you say that the majority of that has to relate to execution related to merchandise flow? Or is it primarily because it's better sourcing deals in Asia?

Mike Ullman

I would say better flow. Obviously we have been doing business in Asia for 50 years and we are constantly looking for opportunities. But we were using the opportunity to upgrade the quality of our merchandise as we have been able to source better. I think the fact that we are growing helps us have a little bit of leverage in the conversation with our partners there and the fact that Kent is over there should give you indication that he is hands on in terms of our cycle time and frequency delivery issue which we believe is one of our key strategies.

Stacy Turnof - Merrill Lynch

Great. Thanks. Great quarter.

Mike Ullman

Thanks a lot.

Operator

Your next question is coming from Adrianne Shapira - Goldman Sachs.

Adrianne Shapira - Goldman Sachs

Mike, you had mentioned that a big driver of comps is the traffic driver and you mentioned that former customers are finding value in your private brands. Can you give us a sense across the chain, are you seeing a wide disparity in traffic lifts especially as you go up against closed May doors?

Mike Ullman

I think we saw more differences by location prior to their launch. I think what's happened with their launch has brought a lot of people to the mall. Frankly our business has been good across all of our mall locations. We think that they're going through some difficulties with their integration, but we want them to be healthy. It helps us when the mall is a destination. I don't have their figures by week, but I have ours by week and we did very, very well during their launch.

Adrianne Shapira - Goldman Sachs

Great. As far as your thoughts on marketing heading into the holiday season, give us a sense of the balance between brands versus price?

Mike Ullman

Well, our promotional cadence is aggressive because that's what the customer responds to and respects and she understands exactly how we run the business and she likes it. Having said that, we continue to move sale and promotion dollars into marketing. You will see a television program this season that we think brings people back to the holidays and Christmas and we think positions us well in terms of having been around 100 years and you can trust us and we have what you want for your family. As we continue to move forward with the emotional connection topic as I mentioned, you will see us evolve going forward with positioning the company to get a better balance between brand marketing and sales promotion.

Adrianne Shapira - Goldman Sachs

Now that you have completed the repurchase authorization, thoughts of a new authorization?

Bob Cavanaugh

What we would do is normally, as we announced last year at the April meeting, Adrianne, is that we would look at our results for this year and review that with the Board after our fourth quarter and full year results and make a judgment at that point in time, just prior to the April meeting.

Adrianne Shapira - Goldman Sachs

Thank you.

Operator

Thank you. Your next question is coming from Dana Cohen from Banc of America.

Dana Cohen - Banc of America

Just looking at the Q3 gross margin improvement, is there any way to give us a sense of how much of it is coming from the improved flow, how much is coming from incremental penetration of private brand, just any help on that, particularly since it seems like the gross margin is the biggest delta in guidance for Q4?

Mike Ullman

Well, I think it's really all the topics you mentioned. The biggest opportunity is in price management, honestly. The way you improve price management is by having the right inventory at the right place, at the right time. Obviously the less we front load the inventory and the more we deliver it when the customer is ready to buy it, more often she buys it at an earlier price rather than at a clearance price. I would say that's the biggest driver and that is reflected essentially in the combination of markup and markdowns.

Dana Cohen - Banc of America

How important do you think is the fact that the private brands continue to outperform?

Bob Cavanaugh

It's already very high levels incrementally, it's probably not a big factor; it clearly contributes. I mean, interestingly in the most recent customer research that we have done looking at seven competitors, the store that comes out responding the best to having the brands I'm looking for is JCPenney. So we don't think the private brands are anything that we are embarrassed about. The fact that we didn't have a lot of national brands traditionally allowed us to gain a lot of expertise and understand what customer valued. That's paying off well for us.

Dana Cohen - Banc of America

Just getting back to one other question that was asked earlier about the competitive landscape. I want to confirm that you were saying that before there was more of a discrepancy in the store base between stores that were up against the store closures versus today.

Bob Cavanaugh

Well, I think it's normal when a store closes in a mall, there is a jump in activity in the competitive stores. So it was more pronounced at the beginning. As people sought a new place to shop, whether it was in the new Macy's or other anchors, it started to level out. The point I was making is that a Macy's store or a May Company store is virtually in every single one of the mall locations we are in and as they promoted incrementally a lot of television in early September, that benefited us.

Dana Cohen - Banc of America

Okay, great. Thank you so much.

Operator

Thank you. Your next question is coming from Christine Augustine - Bear Stearns.

Christine Augustine - Bear Stearns

Mike, could you update us on your new brand management function and how that has been integrated into the organization, maybe any benefits you are seeing or what you would expect to see over the next 12 to 18 months?

Would you have any interest in the Gottschalks locations since they put themselves up for sale? Thank you.

Mike Ullman

First on brand management, as many of you know we formed a brand management and marketing function within marketing and their prime responsibility is to own the integrity of each of the private brands, at least the seven most important private brands. We think that's been a very healthy relationship between the sourcing organization, the merchant and the brand management people. We think part of our improvement and the delineation of lifestyle within our brands has been the brand management group deciding what the guardrail should be for each brand, what the brand definition should be in what the integrity of each brand should be. We would like to move more and more of our private brands and we think that Ambrielle is probably going to be the most notable expression of that at its launch. Because over 50 people were involved within the organization over a year coordinated by the brand management group and making sure we had every single part of the brand expression, whether it be how it's produced, how it's marketed, how it's displayed. The flow of the merchandise, assortments and so forth is probably the best indication of how we plan to go forward in terms of managing our brands.

With 50 different brands, each had a CEO and to a certain extent that CEO made sure there was brand integrity and brand cooperation across all elements and that's essentially the same kind of function that we put in the organization here.

As to the Gottschalks, we wouldn't comment on their portfolio except to say we are in a number of locations where they already have real estate. And so in any case, it wouldn't be a major thrust for us.

Christine Augustine - Bear Stearns

Thank you.

Operator

Your next question is coming from Hillary Morrison - Lehman Brothers.

Hillary Morrison - Lehman Brothers

I was wondering if you could talk a little bit about new store productivity of your off-mall versus on the mall stores? What are the biggest difference you are seeing or biggest drivers?

Mike Ullman

The format lends itself to higher productivity on one level so we don't have the second level or third level difference in productivity. We believe that the layout is very convenient for the customer and lends itself to high productivity. So we are probably running somewhere between $50 a-square-foot higher in our off-mall format than we do in a typical mall store. We are exceeding our expectations for productivity in the early years. We have 38 off-mall 100,000 square foot stores open at this point, and as mentioned, we will open about 50 a year, at least for the next three years if not more.

Hillary Morrison - Lehman Brothers

Thank you.

Operator

Your next question comes from Bernard Sosnick - Oppenheimer.

Bernard Sosnick - Oppenheimer

Thank you for providing the ammunition to get the stock to a new all-time high. I have a question regarding Penney as a gift store for the holiday season. It never really was very much of that until you began an effort about two years ago or so. I'm wondering what your consumer research shows with respect to the receptivity of Penney as a holiday gift source, especially as you make that a central part of your advertising marketing program for the holiday season?

Mike Ullman

I think you quite right; that probably wasn't one of our strengths. As we listened to customers, they were shopping with us throughout the year but felt from time to time they didn't find the gifts they wanted during the holiday. So we have been very conscientious about making sure we have a gift merchandise in men's which are appropriate obviously for men's gift giving and throughout the women's apparel areas. We are specifically highlighting the red box gifts this year as a special statement across four major categories.

One is what we call home and cozy. Another is electronics and innovation. Third is jewelry and watches and the fourth is our toy area. One unique aspect of this is that we have these gifts represented not only in the store, but we have a guide or catalog guide that has the UPC codes on the catalog. If you see something you like in the store and they haven’t got it, they can scan the UPC and it takes them directly to the page on dot-com to fulfill their requirements.

We are trying to make it easy. We know that the gifts are vastly improved than we have offered in the past. Cashmere sweater in Worthington with a scarf for $89.99 is a great aspirational product. Cashmere sweater in men's for $59.99, again a great aspirational product. A lot of clever things for kids. Electronic gadgets that are very giftable at this time of year and we were not strong in those areas in the past.

We see it as an upside. As we win the customer over, we need to take care of her all year long. Not just for career sportswear.

Bernard Sosnick - Oppenheimer

There are two aspects to the gift giving, one is having the right gifts which you just described and the other is the customer's view, vision, of the store as the right place to give a gift from. This ties in with the emotional connection. What is your research showing in that regard?

Mike Ullman

You are quite right. People want to be proud of where they shop for a gift. I think our red box packaging, I think all the collateral materials, the marketing that you will see on television and in print will all reinforce what we want to be evident to our customers and the gift receiver is that Penney's has changed. We are desirable place to shop and desirable place to get a gift from. The fact that our fine jewelry business is probably now the strongest fine jewelry business in department style retailing says that people are willing to see us in a different light and give us a chance. We are being rewarded and they are very happy. We think it's a process, not a project and as we continue to implement our 17 initiatives and long range plan it works together. It's not just doing better advertising or screaming louder. We have to have the right merchandise.

In our red box gift program, we have a red box gift sales associate with a red apron in the department that can help people check out with a separate register. I mean, the whole easy and exciting, getting the merchandise right, taking care of the customer and helping them have a great experience that leads them to want to shop with us again. We are taking this seriously. Our associates are excited about it. I was in the store last night watching it be executed and early indications are that it is very well received.

Bernard Sosnick - Oppenheimer

Well, best wishes on a successful holiday season. Looks like you are ready for it.

Mike Ullman

Thanks a lot.

Operator

Thank you. Your next question is coming from Liz Dunn - Prudential.

Liz Dunn - Prudential

Good morning. Congratulations. Can you discuss, as you have shifted your focus from having a bunch of private labels to more of an emphasis on brands that you really think make an impact, can you discuss how big do you think of an opportunity, if you're going to introduce the new brand like East Fifth or does the opportunity have to be a certain size to justify going into it with a new brand? Can you provide us some quantification?

My second question is, I know it's early on Sephora, but is there anything anecdotally that your sales associates shared with you about how the customer is maybe shopping other areas of the store as are attracted by Sephora, and then maybe find their way into other areas of the store? Thank you.

Mike Ullman

On the first question, I don't believe we would undertake a private brand either investment or initiative, for something that would be less than $100 million. We're a $20 billion retailer, we need to focus on the big opportunities. We now have six or seven brands that are $300 million plus in volume. We are going to do the most amount of investment in enhancing those brands. We also are mindful of the exclusive brands, not just private brands but we were working with a nationally recognized designer. Those are opportunities that we are going after, Chris Madden being the best example. It's now over $700 million and we are just finishing our second year. I think our initial goal was $100 million.

So when we do it right and when we invest properly in terms of marriage that is a two-way marriage where we communicate well and where we share a lot of the same integrity of how the brand should be presented to customer, we do very well. We just don't jump at a celebrity or brand name for the sake of having a PR announcement. What really pays off is if you have multiple years of success and big brands that customers start to recognize.

As to the Sephora experience throughout the store, obviously its early days. We have them in five different stores, five very different stores. Ventura in South Miami, Glendale in the middle of Los Angeles, Queens -- 37 languages are spoken in that store --in Sacramento, obviously more of a middle market. In Fort Worth which is an off-mall. All of the locations are in the middle of the stores in accessories.

We will have the best indication after Christmas, that's the most important accessory time of the year. We will see some kind of difference in terms of what we experience in those stores versus the prototype where we paired them up with a similar store to find out if we can measure the differences. Suffice it to say we are very happy with the customer's reaction and the excitement of our associates is probably the best indication of our enthusiasm for it. Usually when the associates are excited about something, it's because they like it and they think their customers are going to like it. It's probably the most exciting thing they have had come along for many years.

Liz Dunn - Prudential

Great, thank you.

Operator

Thank you your next question is coming from David Glick - Buckingham Research.

David Glick - Buckingham Research

As you look at your sales by store and market for Q3, can you quantify for us what those market share gains from the former May stores mean to you on a consolidated comp store basis? I know it's not an exact science, but is it 50 basis points? 100? 200? Just a rough idea.

Following up on that, are there certain geographic markets that have stood out or business categories that have stood out as where your business has accelerated from competitive market share gains? For example, Federated called out the home business as being particularly weak in the former May stores.

Mike Ullman

Well I won't comment on Federated's business, but their home business was weak before they had the May consolidation so I don't know if that would impact us in any way. Our business in home has been excellent before the consolidation and since.

In terms of geography, we stated that our strongest markets in the third quarter saw a good rebound in Southern California after the fuel price abated somewhat. Our business in the Southeast has been strong all year. We have seen resurgence business in the Northeast. Probably where we had less robust growth has been in the central part of the country and I think that would be the same for our key competitors; although it got cold early this year, so we had good rebound growth in the apparel categories. But in terms of the underlying business trends, those tend to be on the coast where the customers respond the best.

I am not just saying this to avoid your question, we literally have not calculated what we think the May Company impact is by market. We did trace it for a while when the 85 stores closed, but at this point our business is growing on a balanced basis across all categories in all region so it wasn't required. We were focused on fueling the growth.

We are optimistic that their national brands that they dropped that May Company customers were loyal to that we either added or already had in our stores and we are getting a certain amount of business out of that. Frankly we think it's the growth in our private brands.

Operator

Your next question is coming from Michelle Tan - UBS.

Michelle Tan - UBS

Thanks. I had a quick question on the direct business. You mentioned the leverage there on the SG&A side. I was just curious as you migrate away from the big book and towards more specialty catalogs and obviously the online business is growing at a very healthy rate, are you seeing an acceleration in the leverage that you are getting from the growth in that business? I'm assuming it's also a more leveragable business than the retail stores. So could you comment on that as well? Thank you.

Mike Ullman

The dot-com business as you point out, can be leveraged quite effectively because the paper and postage that is required to increase the distribution of catalogs is not part of that equation. Having said that, the big book catalogs have been big contributors for us in the direct business over the years because we have a longstanding relationship with our customers and we basically are the only ones that do it well, at this point. So we are not necessarily concerned about big book, in terms of profitability. It will decline over time because of the increase in postage and increase in paper costs and we believe we are transitioning that customer to dot-com and to specialty catalogs.

The underlying profit improvement is frankly the old-fashioned way. Making sure that what we have to sell gets better sell-through so we get less clearance, and less clearance means that your margins are going to be better. We have been able to anticipate demand better in terms of the way we run the business. We have done a great job over the last four or five years of building a business that can stand on its own and actually hold its own in profitability versus the rest of the company and contribute.

So we’re optimistic that the dot-com is the underlying foundation of our whole business going forward. Catalogs will contribute and stores are obviously the most visible presentation of who we are.

Michelle Tan - UBS

Is there any reason that it was particularly called out this quarter on the expense side? Or was that just continuing in terms of its contribution to leverage?

Mike Ullman

No, I think it's what I said. They had great sell through. We had less clearance and less clearance led to margin improvement as well as expense leverage.

Operator

We have time for one last question which is coming from Dana Telsey - Telsey Advisory Group.

Dana Telsey- Telsey Advisory Group

Can you talk a little bit about the overlap of the off-mall format to others such as Kohl's. It seems like it's reasonably high. Is there any difference in performance from time of opening and are your brands giving you a competitive advantage? Thank you.

Mike Ullman

I guess retailing lore is you tend to do better when you are closer to other stores. We do very well across the street from Kohl's and I suspect they would say the same thing, that they do well when they are near us. It's a concentration of customers in a particular shopping area. What we have learned, which I'm sure they have known for some period of time, is because it is a neighborhood store it tends to be on a free standing basis in the neighborhood they can be more closely located to one another. In other words, if it's a 15-mile radius that's the optimal regional mall distance between your stores, it is maybe half that amount when it's in an off-mall format.

That is one of the reasons we are so optimistic about the number of opportunities is while we are well represented in malls, regional malls stopped the rapid expansion in the early 90s, we have a lot of opportunities where we didn't build stores because there were no malls in the neighborhood and we weren't doing particularly well during that time.

We believe there is a lot of opportunity where people will welcome a JCPenney store, more and more if it's a department store. We have staffed departments with knowledgeable sales associates in shoes and intimate apparel and window coverings, in fine jewelry, in men's clothing. So we believe that in many ways we complement each other in some categories and we are very competitive in others. Competition is a good thing and the customer is the winner.

Operator

Thank you. I will now turn the floor back to management for any closing remarks.

Mike Ullman

Thank you all for joining us on today's call.

Operator

Thank you. Ladies and gentlemen this does conclude today's teleconference.

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