American Eagle Outfitters Q1 2010 Earnings Call Transcript

| About: American Eagle (AEO)

American Eagle Outfitters (NYSE:AEO)

Q1 2010 Earnings Call

May 26, 2010 9:00 am ET

Executives

Judy Meehan - IR

James O'Donnell - Chief Executive Officer, President and Executive Director

Joan Hilson - Chief Financial Officer and Executive Vice President

Analysts

Linda Tsai - MKM Partners

Stacy Pak - Prudential

Dorothy Lakner - Caris & Company

Christine Chen - Needham & Company, LLC

Richard Jaffe - Stifel, Nicolaus & Co., Inc.

Robin Murchison - SunTrust Robinson Humphrey Capital Markets

Michelle Tan - UBS

Kimberly Greenberger - Citigroup Inc

Jeff Black - Barclays Capital

Lizabeth Dunn - Thomas Weisel Partners Equity Research

Anna Andreeva - JP Morgan Chase & Co

Janet Kloppenburg - JJK Research

Todd Slater - Lazard Capital Markets LLC

Dana Telsey - Telsey Advisory Group

Jennifer Black - Jennifer Black & Associates

Operator

Greetings, and welcome to the American Eagle Outfitters First Quarter 2010 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce your host, Judy Meehan, Vice President of Investor Relations. Thank you, Ms. Meehan. You may begin.

Judy Meehan

Good morning, everyone. Joining me today are Jim O'Donnell, Chief Executive Officer; and Joan Hilson, Executive Vice President, Chief Financial Officer. If you need a copy of our first quarter press release, it is available on our website, www.ae.com. Before we begin, I need to remind everyone that during this conference call, members of management will make certain forward-looking statements based upon information which represents the company's current expectations or beliefs. The results actually realized may differ materially from those expectations or beliefs based on risk factors included in our quarterly and annual reports filed with the SEC.

And now I'll turn the call over to Jim.

James O'Donnell

Thanks, Judy. Good morning, everyone. The first quarter demonstrated real progress towards our goals. We achieved higher sales and stronger profitability. This was the second consecutive quarter of positive comps, and we achieved a 55% increase in earnings per share, excluding M+O. The AE brand continued to gain momentum with both Womens and Mens posting positive comp store sales. Further, we effectively capitalized from store traffic delivering a near record high conversion rate in the first quarter. Both of these metrics speak to the overall consumer appeal of the AE brand, the strength of the assortments, as well as our value pricing. Aerie also produced strong positive comps in the first quarter and improved its bottom line results as well. While profitability is not yet where we want it to be, we have implemented targeted initiatives, which will put us on a path to deliver improved second-half results and ultimately lead to a target mid-teen operating margin in 2011.

First, we are well into the process of winding down MARTIN+OSA operations, which is within our estimates. The decision to close the brand, while certainly difficult, enabled us to focus talent and resources towards our most attractive opportunities, which are the AE brand, aerie and 77kids.

We are continuing to streamline our entire organization from top to bottom to be faster, more efficient and more productive. We have made pivotal hires in design and merchandising for each of the brands and have forged essential alignment across creative functions. Additionally, we are looking at each aspect of the business for opportunities to reduce costs and improve processes. Our mantra is to work smart, combine a small company entrepreneurial spirit with a big company power and discipline. Specifically, we have made changes within our buying and allocation process. We have positioned more sourcing in the Western hemisphere for both cost opportunities and shorter lead times. We are leveraging our buying power in fabrics and expanding the vendor base where we see opportunities.

In the area of store allocation, we've enhanced our process to be more precise and fluid, which will enable faster turns. The net result of these initiatives will lower inventory levels in the second half of the year. As the assortment plans are reengineered, we also expect to achieve AURs that are more appropriate for our brand positioning in the marketplace.

The AE brand is right on target and is extremely relevant to today's customers as confirmed by our annual research as well as external sources. We continue to be top in line with our 15- to 25-year old customers. We remain dominant in denim and we made appropriate investments to support this brand-defining business, which is a strong contributor to both sales and margins. With our denim as our foundation, we are focused on building our tops business, as well as accessories.

The idea is to complete the lifestyle experience for our customers through trend-right fashion and outfitting. We will continue to deliver the core essentials that AE is known for, but additionally, you'll see the assortments peppered with more fashion forward key items that elevate the entire brand experience.

We are being widely recognized for our unique position in the marketplace by customers and influences alike. In fact, ABC's Nightline and the editor of People StyleWatch Magazine just featured American Eagle as a brand of choice for great fashion at affordable prices.

Moving to aerie, this is a brand with tremendous promise. We demonstrated success with our distinct brand position, and we placed a powerful stake in the ground for our bra and undie business. The next frontier, though, is expanding aerie to become a full lifestyle brand, building on the early success of aerie f.i.t., accessories, personal care and loungewear.

A word on 77kids. 77kids is gaining traction and steadily building brand awareness as an online business. The first seven brick-and-mortar stores are slated to open this year beginning in July. The retail stores will continue to raise the brand profile overall and familiarize a broader base of customers with the 77kids product. We're excited about the launch of Little 77 for infants and babies, 0 to 18 months. And you can look for it in our stores and online in July.

International expansion is another important strategy for the company. And I'd like to emphasize, again, that our approach to International is one of minimal cash outlay with nearly immediate financial upside. We're extremely pleased with our first stores in Dubai and Kuwait and are proceeding with plans for additional stores in the Middle East working with our partner, the Alshaya Group. We're also evaluating similar opportunities in various locations throughout Asia.

Looking at the year ahead, we are most optimistic about the third and fourth quarters, as our strategic initiatives will have an opportunity to take a firm hold and deliver improvement to both top and bottom line. While we made progress to date, we need to stay focused and disciplined. And in closing, I hope you share my excitement and enthusiasm for the opportunity in front of us.

I look forward to discussing additional progress with you next quarter.

Thank you, and I'll now turn the call over to Joan.

Joan Hilson

Thanks, Jim, and good morning, everyone. First, I'll provide a few details regarding our improvement in the operating margin. I will then review our outlook. My comments will focus on results, excluding MARTIN+OSA. And please refer to the adjusted earnings statements accompanying the press release.

We are pleased to see a continuation of the sales strength that began late last year. Total sales increased 8% and comp store sales rose 5%. Aerie comps were up 23% and direct sales increased 2% in the quarter. Store traffic levels remained inconsistent, especially during non-peak selling periods. However, strong on-trend assortments drove a higher conversion rate and an increase in the average dollar sale. The first quarter AUR declined due to a promotional mix strategy and an increase in accessories as a percent of the mix.

Now let me turn your attention to gross margins. I'd like to talk about two major spring merchandising strategies, denim and knit tops. As you know, this spring, we made a deliberate investment in denim to support strong customer demand. This strategy was highly successful, delivering growth in both margin dollars and rates. With the knit tops, we entered the spring season with a unit driven, planned promotional strategy designed to send a clear message of value and gain market share. This strategy did not deliver the planned margin. Beginning with the third quarter, we have adjusted our assortment plans, providing for a better balance between pricing and units, enabling us to capture a higher margin.

With that said, our first quarter merchandise margin still strengthened by 210 basis points, driven by lower markdowns. We leveraged positive comp store sales nicely, leading to a rent decline of 40 basis points which delivered a gross margin rate improvement of 250 basis points.

Moving on to operating expense. SG&A increased 11% due to higher compensation costs, including the timing of executive equity grants. Looking ahead, we expect SG&A dollars to be in the range of up low single digit to down low single digit depending on the level of sales. As we've indicated, we are driving forward with aggressive initiatives to reduce cost and simplify our processes. We'll keep you updated as we lock down our savings.

Now turning to the balance sheet. First quarter ending inventory increased 15% at cost per foot, following a 4% decline last year. Our inventory position supports a year-round in-stock denim strategy, which we begin to anniversary in the third quarter. We believe this is absolutely the right strategy entering back-to-school. And as we initiate the changes in our buying and allocation process, second-half inventories are planned down.

In keeping with our conservative spending plan, we now see CapEx of $90 million to $110 million for this year. This is down $10 million from our prior guidance. We ended the first quarter with cash and investments of $732 million. This is after share repurchases of $72 million and a $13 million payment on our demand line.

Now transitioning to our forward view. We are initiating second quarter adjusted earnings guidance of $0.12 to $0.16 per share, which reflects margin pressure related to weaker business trends early in the quarter. This guidance excludes estimated closing charges and an operating loss related to MARTIN+OSA of $0.13. It also excludes potential investment security charges.

Our clear priority is to quickly return to earnings growth. With the improvements in the areas of product -- or production and allocation, we have reduced our inventory for the second half of the year. A more balanced price and unit strategy will allow us to recapture margin. And our expense initiatives will enable us to drive leverage and strengthen profitability.

Thanks, and now I'd like to open the call up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is coming from the line of Christine Chen with Needham & Company.

Christine Chen - Needham & Company, LLC

I was wondering, what -- can you just talk to us a little bit in more detail about what changes you're making in planning out an allocation so that you'll be able to get your inventories down in the second half? And then wanted to ask about aerie. I think you're only opening nine locations for the year, and I think previously you had said 20. What's the reason for the change?

Joan Hilson

The changes in the planning and allocation really relate to further differentiating our store allocation by volume levels. We see that we have an opportunity to turn our inventories faster than we have done in our lower-volume stores and truly leverage a program that we have that we call Store-to-Door, which enables our customers to get sizes or choices from our web that they can't necessarily find in those lower-volume stores. So that's number one, and it's very important. Secondly, we're leveraging, and continue to leverage, fabric platforming as well as just looking at the production improvement related to some of our top strategies that we, now seeing what we see in the first quarter, have the confidence to really turn those inventories faster and bring the inventory in [indiscernible] (21:48). And the third point on that is that our denim strategy is one that we anniversary in the third quarter. It's one that we began last year third quarter. So that's the reasons why we believe we can really turn those inventories faster. With respect to aerie, we've shifted stores into 2011, and really feeling very good about the aerie brand. We've seen nice improvement in the first quarter. And we'll continue to evolve the lifestyle. I'm going to let Jim add a few comments related to that.

James O'Donnell

Basically, just to put a little more color around Joan's comments on aerie, we looked at where we're successful, in what type of markets and what type of locations within shopping centers. And so we've taken a look at where we want to place, physically place, the aerie stores. And so in doing that, we decided to slow down 2010 in order to position very strongly in 2011 and '12 going forward in markets and centers that we deem to be appropriate based on data that we currently have where we're successful.

Operator

Our next question is coming from the line of Jeff Klinefelter with Piper Jaffray.

Unidentified Analyst

It's Stephanie for Jeff Klinefelter. I have two questions this morning. The first is, Joan, if you could just give us some further detail on your knit tops initiative? I think you mentioned that Q3 you'd be realigned in your sourcing structure there. But what kind of effect can that category, changes in that category, have on your merchandise margin as we look at the model for Q3 and Q4? And then second question, just following up on your second-half inventory plans, now having inventory planned down, if you could just give us some sense on what you're planning then for comp rate, knowing that your inventory was up in the first half and you delivered a nice comp in Q1? How should we be thinking about the sales growth in locations on a down inventory plan in the second half?

Joan Hilson

With respect to the unit strategy that we went out with in the first half of the year, we really were going after a unit value strategy. We have a firm understanding, we believe, of rate of sale relative to those price points. And in addition to that -- And we were able now to plan that properly within the back half of the year. So that's one. The other side of that is we're able to turn those inventories and really leverage from production improvements that enable us to bring those inventories in, our knit tops in closer to need. So that's really why we can rebalance and certainly see that there is merch margin opportunity in the third quarter and in the back half itself. What this means to us, Stephanie, is that this is a higher AUR that we can drive to in the third quarter because of this better balance and because of our ability not to take the higher level of markdowns that we've chosen to do in the first half of the year here to set ourselves up clean for the third quarter. With respect to the second half in terms of comp guidance, what I would tell you there is that, clearly, we're planning our inventories down, really leveraging the ability to turn faster, and we are remaining conservative in our approach to the year.

Operator

The next question is coming from the line of Jeff Black with Barclays Capital.

Jeff Black - Barclays Capital

So can you shed some light on where you're seeing weakness to start the quarter? Is that -- what categories that might be in, et cetera? And Joan, on the kids and aerie businesses, what kind of drag do we see from the combination of those this year?

Joan Hilson

The second quarter is really -- what we need to think about here is that we've initiated guidance on a weak start to the quarter. We need to get through -- Importantly, this is a big week. We've shifted some of our promotional cadence as well, and really need to get some more sales and category selling under our belt before we would really comment on a category basis. So it's an early start to the quarter. It's a quarter that we hope that we can play out here with some of the innovative marketing ideas that we have in our arsenal. And we'll see how the quarter plays out. But that's really -- It's early, and it's premature to really talk category selling. And with respect to the kids and aerie business, aerie is, without really giving specifics on the bottom line impact, aerie is progressing nicely. It is improved from last year. We're in the quarter. We're pleased with that. It is on a store profitability, standalone four wall is doing far better than it did last year. We have much higher merch margins. And so we are encouraged by that. 77kids has a nominal impact to our operating profit rates in dollars, and it's a brand that is truly, no pun intended, in its infancy. We will look to see what retail can bring to us, and we're excited about it in the July back-to-school timeframe. So that truly a stay tuned, Jeff.

Operator

Our next question is coming from the line of Janet Kloppenburg of JJK Research.

Janet Kloppenburg - JJK Research

First, I wondered on the guidance for the second quarter, how much of that down forecast had to do with inventories being too high, Joan, as opposed to the weak business trends that you're seeing right now. And I wondered about the North American sourcing that Jim talked about and how that will help you improve margins, because generally, we think of that as a less competitive pricing market. And lastly, I think Jim mentioned that he was looking for operating margin improvement perhaps in 2011, or moving towards the goal of mid-teen in 2011. So does that suggest that you're not looking for operating margin improvement in fiscal 2010?

Joan Hilson

So I'll take two and then Jim will take the production question. We have absolutely taken the markdowns that are appropriate to take in the first quarter, Janet. So as we look at the second quarter, our second quarter inventories reflect a similar denim position. As I've said, we'll move into the third quarter and anniversary that. Without denim, we are up roughly low single digit, and in terms of the balance of our inventory. So truly what is happening in the second quarter is it's a weak start to the quarter. It's early in the quarter, and we are taking the markdowns, assuming the markdowns in our guidance that we need to take to clear through the excess inventories. With respect to 2010, we clearly expect to get operating improvement in 2010 that leads us to the path to achieve that mid-teen operating margin in 2011.

James O'Donnell

Janet, as it relates to cost competitiveness between the Western Hemisphere and the Far East, actually the Western Hemisphere is actually very competitive in its pricing for the type of product that we're having manufactured there. And also combined with that is that we have the ability to leverage freight. So it's cost less money to get the product here to our distribution centers in the U.S., as well as we're able to be more expeditious in our lead times. And so hopefully that will combine with faster turnover and leaner inventories. So overall, it has all the trappings to be a real margin contributor in the future.

Operator

Our next question is from the line of Brian Tunick of JPMorgan.

Anna Andreeva - JP Morgan Chase & Co

It's Anna Andreeva for Brian. First, Joan, just a follow-up on SG&A. Your comments for SG&A to be up low singles to down low singles, is that for the year or starting with the second quarter?

Joan Hilson

That is for the year.

Anna Andreeva - JP Morgan Chase & Co

And how should we think about SG&A dollar growth in the second quarter?

Joan Hilson

The SG&A, the way we should think about it, it was up the 11% in the first quarter. That is in half or up mid single digit in the second quarter. Again, that relates to timing related to the equity grants. And then as we progress through the year, you should see the back half SG&A down.

Anna Andreeva - JP Morgan Chase & Co

And then just on the balance sheet, you guys bought back about 4 million shares. In April, you have $26 million or so left on the buyback. Just maybe talk about your and the Board's appetite towards buying back stock here in the back half?

Joan Hilson

We will continue to evaluate share repurchase. That $26 million authorization lasts throughout the year, as you mentioned, and it's something that we will review on an ongoing basis.

Operator

Our next question is coming from the line of Michelle Tan with Goldman Sachs.

Michelle Tan - UBS

I was wondering if you could talk a little bit more about the top strategy. Were you happy with the pricing and the initial margin and just bought too many units? Or as you look into the second half, are you think about buying fewer units and also taking the initial margins on the category higher? And any kind of product changes that you're planning to go along with that or is it just really about the pricing?

Joan Hilson

It's twofold, Michelle. The way you think about knits is we went into the first quarter with a position with a unit value strategy. So yes, units were heavy, heavier than needed in the first quarter. The response to the knits was positive from the customer, but not to the level of our unit buy. So from that, we've been able now to evaluate the right rate of sale for that price point and also manage within our mix a bit of a price point change that will allow us in the third quarter to have modestly higher AURs on lower unit buys.

Operator

Our next question is going to be coming from the line of Dorothy Lakner with Caris & Company.

Dorothy Lakner - Caris & Company

Just following up on the tops category again, I guess. Could you talk a little bit more about what worked, what didn't work, how it's going to change in the second half aside from just the unit strategy? And then also just talk a little bit more about the changes that you made to design and merchandise teams to give us some comfort level that the strategy there on the tops can play out in the second half of the year? And then also, just a little bit more color because denim has been such a strong category for you, a little bit more color on what's working there as well, and how many -- what, if any, changes we might see going into back-to-school in second half?

Joan Hilson

With respect to tops, Dorothy, as we look at the assortment, the basic top strategy, which was at a lower price point, again, is more of a unit issue with a nice response from the customer. The fashion side of what we call fashion, the higher price point, had a modest acceptance by our customer, which in some of the higher price points, that was one of the strategies to offset some of the slower selling. So we've been able to make those adjustments into, and build on that, into the third quarter assortment. And also frankly, we don't need as many choices as we were providing the customer in the first half of the year here. So those are the adjustments that we've made in our knit strategy. And with respect to denim, one of an interesting change that is also going to help our merchandise margins as we progress through the year is the idea of how we transition into our back-to-school line. And so we've been able to put forth a strategy that helps us manage newness, and what I'd call our core systems, that allows the right amount of freshness going into the quarter, but also enables us to leverage that in-stock strategy in some core systems. So that's a margin plus for us. And with respect to our talent and the changes in the merchandising and design, we are very pleased with how the teams are working together and really coming together with the unified view under our new leader, our Chief Merchandising Officer for the AE brand and really seeing that come together and really believe we'll start to feel the effects of that in the back half of the year. With respect to aerie, and we have some new design talent there, and one of the things that Jim mentioned is this idea of expanding the aerie branded to be a full-fledged lifestyle brand. And the design team is showing all signs of bringing the right level of talent for us to be able to do that.

Operator

Our next question is coming from the line of Jennifer Black of Jennifer Black & Associates.

Jennifer Black - Jennifer Black & Associates

I wondered how you're positioned in accessories for back-to-school, and what areas you're focused on improving in that category? And then I also wondered how you're positioned for the big khaki trend. And then lastly, you talked on the last call about trademark issues that you were working on, and I wondered where you were there as far as International.

Joan Hilson

With respect to accessories, as we move into back-to-school, we are extremely excited about accessories. And, Jennifer, you may have noticed in the stores, the expanded presentation that we have with our jewelry assortment. And we really feel that, that is a business that we've actually scratched the surface on in our mix, and we're really pushing that category to be at the right price points, the right balance within our overall assortment. So you'll see the expanded presentation. It is serving us well, nice return on that investment. And really continue to push the jewelry button there. With footwear as a smaller part of the assortment, and getting into some of the soft accessories, we think that's important as well for the back-to-school period. So nice investment, nice return thus far. We're going to continue to grow.

James O'Donnell

As it relates to trademark, I recently returned from a trip to Europe, where we were very successful in negotiating and resolving a dispute that we had with someone who controlled trademark in some countries that we deemed to be strategically important to us for International expansion. We resolved the matter in very favorable terms for both parties. And it has opened up the door now for us to enter into agreements with potential partners to expand in other parts of the world that we're very positive that we'll reap some very positive gains in a very short period of time. And you'll be hearing more about that as the year progresses. And we'll try to give you as much color around it as possible. But we are embarking now in a very serious and strategic way to place International on the front burner, on the priority list of things we need to do now and to go forward over the next few years.

Operator

Our next question is from the line of Robin Murchison with SunTrust.

Robin Murchison - SunTrust Robinson Humphrey Capital Markets

One, if you could possibly talk about what's your inventory, how you see it at the end of the second quarter, win back-to-school sets? How much of your denim is sort of year-round versus fashion that you bring in by season? And then just to piggyback off of Jennifer Black's question about khaki, if there's anything to say about that? Does it play into back-to-school second half?

Joan Hilson

We haven't given guidance for some time around quarter-end inventories, Robin. And that is because of the timing of accruals at the end of the quarter. So what we're giving is a view of average weekly inventories on a cost-per-foot basis. That said, the inventories in the second quarter total up low double; without denim, up low single. And as I said, in the back half of the year, we're anniversarying that denim strategy and we expect the inventories to be planned down. And I feel very good about the work the teams have done around this inventory strategy and really driving more efficient turns in our inventories at a category level. With respect to khaki, khaki is a part of our assortment and a strategy that you will see from us. And stay tuned on what that looks like.

Operator

Our next question is from the line of Liz Dunn of Thomas Weisel Partners.

Lizabeth Dunn - Thomas Weisel Partners Equity Research

Is there any sort of quantification on the level of carryover inventory right now? Anything you can add to give us some sense of the freshness of your inventory? And then I know that it's early in the quarter, but is there any way you can say whether or not you're running negative comps now? And what's leading to the optimism for the back half? Because if I understood it, you're saying you're more optimistic for the sales outlook for the back half, though comparisons are bit more difficult? So if you could just provide some clarity there.

Joan Hilson

Sure. To clarify the inventories, the weakness in the second quarter relates to summer goods. And what we are -- in terms of -- this isn't about carryover of spring first [ph] (48:13) product, it's about the weakness in trends, and that works [ph] (4:21) in the business performance that we're seeing today. So carryover is not a part of the inventory or margin pressure that we're seeing. With respect to the back half, the optimism that you're hearing is about the management of our inventories and the confidence that we have in our ability to turn our inventories, leveraging those production strategies and the changing the strategy, rebalancing the unit position from the first half strategy. So that's the optimism you're hearing, is around the inventory strategy and what I had mentioned earlier that there is a conservative view of business trends in the back half.

Operator

Our next question is from the line of Todd Slater with Lazard Capital Markets.

Todd Slater - Lazard Capital Markets LLC

I want to start by recognizing that merchants have really done a good job delivering on the fashion products. It sounds like the message is that you're aggressively addressing the inventory issues here. I'm wondering though who is primarily responsible for the inventory decisions, if it's coming out of the financial function or the merchants driving the unit plan? And also with the inventory up 15% in dollars, can you give us a sense of what the inventory is up in units? And then excluding denim up low single digits in dollars, what's the relationship also in terms of units? And how much, can you give us a sense of how much the inventory is up in the denim area specifically, because that sounds like it's a big driver? And then last thing, on the balance sheet, very strong balance sheet. Stocks down a lot. Why is the company, the Board, not really talked about deploying the cash more aggressively?

Joan Hilson

Thanks for your comments, Todd, relative to our fashion. In terms of the inventory position, I'll state that -- and this is the content of our inventory speaks to denim, and that is where the increase is. Our denim strategy is working. We feel very good about it. We hit our sales and margin plans. So the denim position is a strategy that we've employed for the last year. The unit strategy was a strategic move to regain market share in our knit top category. So that's where those decisions are coming together. As it relates to second quarter inventory specifically, up low double without -- on an average weekly basis, without denim up low single. And from a unit perspective, for the second quarter we're seeing it up mid-single on an average basis. So that's the comments related to the second quarter. And with respect to the buyback, or the potential repurchase of shares, we just repurchased $72 million, 4 million shares in the first quarter, and we will continue to evaluate that as we progress through the year.

Operator

Next question is coming from the line of Kimberly Greenberger with Citigroup.

Kimberly Greenberger - Citigroup Inc

You laid out the goal of hitting a 15% operating margin in 2011. I'm wondering if you could help us understand the levers that would help you get there? What sort of sales growth assumption would you need in order to achieve that goal? And what is the contribution from gross margin and SG&A on a relative basis? That would be helpful.

Joan Hilson

Sure, Kimberly. As we look at achieving that mid-teen operating margin, what we need to do is drive top line and get back some of that sales productivity. So that's an important piece. Improving merchandise margin to begin to approach some of our high points or peaks in our history is something that we are driving towards. It would be unrealistic to think that we could actually get to those peaks sitting from this vantage point today. But we believe that a big piece of the improvement needs to come from our merchandise margin, and that's why we're very focused in some of the strategies that Jim mentioned, as well as the strategies that I mentioned around planning and allocation. SG&A is clearly a piece and why we're aggressively going after a savings initiative here and expect to be able to come back to you in the third and fourth quarters with some real savings opportunities, but less so than to the margin opportunities. So it's top line margin. Merch margin is a larger piece than the SG&A.

Operator

Our next question is from the line of Richard Jaffe of Stifel, Nicolaus.

Richard Jaffe - Stifel, Nicolaus & Co., Inc.

You talked about averaging in retail moving up in the second half, and I understand the appeal of that. Is this going to be a shift in your more aggressive promotional pricing? And if so, how are you going to sort of convince the consumer to pay more? What's your visibility on this sort of shift in product that I assume would follow this goal? And if you would talk a little bit more about International and the financing of that business and the potential growth of that business?

Joan Hilson

Richard, with respect to the AUR in the second half, as I mentioned, it's a modest increase. And it's one that it really is a fine tuning, a little bit of rebalancing in that unit value strategy that will drive it. And also remember that accessories is a part of that mix and something that we're growing as well. So that's really -- it's more of a subtle change and an outcome of turning our inventories faster and having a more conservative view in that management.

James O'Donnell

As it relates to International, I believe I stated in my comments that as far as the American Eagle investment, it's minimal. And in our arrangements, our contractual arrangements with our partners and potential partners is, right now, is a licensee arrangements. So the licensee bears the majority of all the financial aspects of the transaction. As we progress forward and we decide on how we want to progress in each of the parts of the world we deem to be appropriate, it can take on a number of different variations as to the transactional arrangement. The licensee is the minimal amount of risk and the minimal amount of investment, but it also captures your overall contribution. We're also looking at joint ventures where we would have the majority share. We have not entered into any. We have researched that, and in some cases we might do a combination of early on licensee arrangements and then eventually would graduate to a joint venture with American Eagle taking over the majority share. And there's a remote possibility in some parts of the world we may go at it ourselves, although we haven't explored that in any great detail at this time. And so I don't see that in the near future. So you'll be hearing more about the International operation and our growth plan and also the financial structure that we're going to pursue on a go-forward basis. But right now, there will be minimal investment on the part of American Eagle and almost zero exposure financially for any downturn.

Operator

Our next question is from the line of Dana Telsey of Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group

Can you talk a little bit about how you're thinking about IMU and the continued opportunity going forward, and the upcoming raw material cost increases and how you're planning for that? And is there any more color on terms of guys and girls, what you're seeing by product category, strength in denim and tops?

Joan Hilson

With respect to IMU, or really the way we talk about it, as you do, is in terms of costing of our product. We're seeing currently that product costs are down in the spring season, and we've been able to pass a portion of that on to our customers. However, as we look forward, we expect to see modest benefits in costing in the third quarter and in the fourth quarter, really expect to see that flatten out. And as far as next year, which is I know on the minds of many people, it's really early. We are working with our vendor partners to optimize as best we can the position that we're seeing occur out in the market with respect to rising cost. So we are diligently working our way through that to mitigate any increases as best we can. With respect to the guys and girls mix and any color on the category selling, really strong obviously in both Mens and Womens denim. We feel very good about that. We see bright spots in our top category across. We have bare knits. We have our fashion knits. The basic knits we've been talking about as well as graphic T-shirts. And we're seeing that there is a nice response to our assortment. And as we navigate away from the unit value strategy and approach the back half of the year, we feel that the assortment we're seeing is we feel good about it. And in the back half of the year, once we move away from that excess inventory, that we will be able to flow through better margin.

Operator

Our next question is from the line of Stacy Pak with SP Research.

Stacy Pak - Prudential

I guess I'm still sort of circling back to the $0.12 to $0.16 because it just looks like you kitchen sinked it. So Joan, can you -- I mean, I have a number of questions. I mean, what is May to date? It's almost over. I know this week's important. But if you would tell us that, what are you assuming for the Memorial Day shift? Are you assuming any increase in the June comp? Or what is the Q2 comp assumption? What are you assuming about the summer knits in terms of markdowns, because given your SG&A guidance, it looks like you're basically assuming they're not going to sell much at all. What's the excess inventory in knits? And then for the second half, I think what people are asking, aren't we going to feel the impact of the new knits designer from Splendid? Or should we not get more excited about the knit assortment, how the product looks for the second half? And do you expect the gross margin to be up in the second half?

Joan Hilson

Let's answer this way, Stacy. Our practice is not to give comp guidance. And appreciate the interest. It is a really -- We have a big weekend, or big week that we're in now and some shifts in our own promotional cadence. So we need to get through this and we'll bring you sales results for May next week. And we will talk about -- We won't talk about quarterly comp guidance, but our view of that obviously is reflected in the margin pressure and the guidance we're seeing for the second quarter. With respect to the knits and the back half, clearly, we believe that we will have with better managed inventories in terms of this unit strategy and the quick turn leveraging the production cycles and bringing closer to need, we will be able to improve our merch margin in the back half of the year. That is our goal, that's our target, and what we're working towards. We feel that the knit strategy is improving. I believe that in the third quarter, we are offering a better balance of choice, meaning we do not have to bring at any one given time the breadth of assortment that we saw in the first half of the year. And we also have gotten good feedback in what's selling and what the customer is responding to. And that's the comment we'll have on knits.

James O'Donnell

Allow me to weigh in here because I think maybe we painted a picture that you're all deeming to be much more dramatic and drastic than it really is. The knit program that was initiated for the first quarter of this year, actually some of it is in the fourth quarter of last year, but how many for first quarter this year was not a disaster. We actually -- Lessons learned we've had some phenomenal selling in some graphics, non-branded and in branded on our graphic T-shirt line. Some of our styles in Womens in what we would call the on-trend product was well received. We've actually lessons learned that we were able to get some higher price points on product that we probably could have, hindsight being 20/20, could have bought a little heavier, but we didn't. We've actually -- The problem with the knit assortment is that we might have been a little too enthusiastic, and the assortment was a bit broad. And probably we could have been a little more strategic in how, not only how we purchase it, but how we brought it in and landed it in quantities. So all of these lessons learned, they're being course corrected during the second quarter with the markdown strategies to eliminate some of the summer styles, as well as bring in some, what we think, are some new and exciting styles for third quarter. And we're very excited about holiday. The knit team that we have, primarily in Womens, is a quite talented team. And I have all the faith that they're going to deliver some on-trend product that's going to be well received. Combining all of that, you're going to see that the AUR can go up somewhat in that category, whereas we were in a very much in the unit velocity mode early in the season. And bottom line is it didn't work. And when something -- you have to try something before you know, and there are some things that we did learn that we'll take advantage of as we move into the third and fourth quarter. Second quarter will be what it's going to be. And it has to be -- we've been in this business for a while, and we're just going to do what we have to do in order to have clean inventories going into the two most important quarters of the year, and that's the third and fourth quarter.

Operator

That question will be coming from the line of Linda Tsai with MKM partners.

Linda Tsai - MKM Partners

Given the inconsistent traffic trends, are there any marketing initiatives or promotions that have been successful for you that could help smooth the volatility of customer traffic?

Joan Hilson

Linda, we are, as I mentioned earlier, working on some innovative marketing ideas. And clearly, we're on it. And we'll be bringing that to you in the back half of the year, as well as late into the second quarter.

Judy Meehan

All right, everyone. That concludes the First Quarter Conference Call. As you know, our next announcement will be May sales, which we will report next Thursday, June 3. So thanks for your participation today, and everyone have a great weekend.

Operator

You may now disconnect your lines at this time. Thank you for your participation.

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