Deckers Outdoor Corporation Q2 2010 Earnings Call Transcript

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 |  About: Deckers Outdoor Corporation (DECK)
by: SA Transcripts

Operator

Good afternoon ladies and gentlemen, and thank you for standing by. Welcome to the Deckers Outdoor Corporation's second quarter fiscal 2010 earnings conference call. At this time all participants are in a listen-only mode. Following the presentation we will conduct a question-and-answer session. (Operator instructions) I would like to remind everyone this conference call is being recorded.

Before we begin, I would also like to remind everyone of the company's Safe Harbor language. Please note that some of the information provided in this call will be forward-looking statements within the meaning of the securities laws. These statements concern Deckers plans, expectations and objectives for future operations. The company cautions you that a number of risks and uncertainties, some of which maybe beyond its control, could cause Deckers actual results to differ materially from those described in this call.

Deckers has explained some of these risks and uncertainties in its earnings press release and in its SEC filings, including the Risk Factors section of its annual report on Form 10-K and its other documents filed with the SEC. Among these risks is the fact that the company's sales are highly sensitive to consumer preference, to general economic conditions, the weather and the choice of its retailers to carry and promote its products.

Deckers intends that all of its forward-looking statements in this call will be protected by the Safe Harbor provisions of the Securities Exchange Act of 1934, as amended and the Securities Act of 1933 as amended. Deckers is not obligated to update its forward-looking statements to reflect the impact of future events.

I would now turn this conference over to the President, Chairman and Chief Executive Officer, Mr. Angel Martinez. Please go ahead, sir.

Angel Martinez

Thank you operator and welcome to everyone joining us on the call today and listening via web cast. With me are Zohar Ziv, Chief Operating Officer; and Tom George, our Chief Financial Officer.

We reported another great quarter with financial results that once again exceeded our projections. I'm going through the numbers in a moment. But before that, let me highlight a few key themes. As you know several years ago, we detailed our long-term sales goals for the company and since that time we've been executing growth strategies that have us moving towards successfully achieving those objectives.

If you look at the evolution of our business, I think it's clear that our sustained efforts to build a balance business in terms of seasonality, distribution channels, geographies and brands are working.

First seasonality, with the growth of the UGG spring line and thus launch in 2005 combined with the resurgence of the Teva brand, we now have a much more meaningful business in the first half of the year. Sales of our products have achieved the compound annual growth rate of approximately 20% for the last five years and represent roughly 30 of our total revenues, which is close to our goal of having our spring season make up roughly 35% of the business in the next few years.

Second, looking at sales by channel. We have become much more diverse in terms of wholesale, retail and eCommerce. Wholesale, our largest channel has continued to grow steadily and was up in the first half of the year driven by strong sell in and sell through for both our UGG and Teva spring lines.

For the UGG brand this was true across our account base, of better department stores, specialty chains and key independents, all of which carried a much broader assortment of spring product this year.

Similarly, Teva brand sales were consistently higher at key retailers such as REI, Dicks, EMS and Sports Tula (ph). While at the same time, the brand has generated renewed interest from some non-traditional accounts such as Nordstrom, Dillard's, Von Maur and Zappos, as we have broaden the product line.

Entering the back half of the year, we're well positioned to capitalize on this momentum with 140 additional UGG brand Shop-in-Shops for a total of approximately 290 worldwide and much more complete offering of fall product from the Teva brand. Our retail business has been performing exceptionally well. Same store sales were up 19.2% in the second quarter and have increased 25.6% year-to-date over last year, this combined with the five new stores we opened last year, fueled strong double digit growth for our retail segment during the first half of 2010.

We're very excited about these results, particularly if we prepare for our most aggressive period of expansion by opening nine stores this year. After opening our store in Shenyang, China in late June, we will open eight additional stores over the next five months. Six of the eight new stores will be in the U.S. with locations in Miami, Washington D.C., Los Angeles, Las Vegas and Orlando. We'll be opening our third New York City store, which would be located on Madison Avenue at 58th Street and finally, the remaining two stores will be in Shanghai, China. All stores except for Orlando will be full price retail stores.

Finally, with our eCommerce business UGG brand sales were up double digit in the second quarter driven by heightened demand for the spring line. However, this was offset by lower sales from our other brands, which were up against difficult comparisons because of high close out level in the prior year, which we didn't have this year.

Third, let's talk about geographies. The spread between our domestic and international sales has also become more balance in recent years and we're tracking to achieve our goal for 2012 of having approximately 30% of our annual sales come from outside the United States.

In the second quarter, international sales were up 55% and rose 41% for the first half of the year, due to a number of growth drivers. First, we're seeing more distributors achieving success with a greater selection of product from the spring and fall lines. As retailers in our foreign markets are seeing the benefit of supporting broader width of collections rather than relying on a small number of (inaudible).

Now, this has allowed us to gain valuable shell space and increase our retail presence in several key countries such as the U.K., the Benelux region, Italy, Germany, Korea and Canada. We're continuing to evaluate the new markets and we're working with our partners to secure the right distribution, establish a (inaudible) of lifestyle position and attract our target consumers.

For example in Russia, our partners are taking off the brand by opening an UGG Australia store in one of the most notable locations in Moscow, Red Square. We believe the Russian market, with its long winters and quality and fashion conscious consumers present a great opportunity for the UGG brand. And we're also benefiting from our decision to convert from a distributor to a wholesale business model, the UGG brand in Japan at the start of 2009 and a Teva brand in the Benelux region earlier this year.

Japan is a large market for luxury goods and presents another great growth opportunity that wasn't fully realized by our previous distribution partner. Under our storage ship, the UGG brand has added key points of distribution within the country's retail network, increase shell space in the country's finest department stores and begun delivering a consistent, cohesive brand message to the consumers.

Situation with the Teva brand is different in the Benelux region. As this market for many years has been one of Teva's strongest markets. That said, in addition to the incremental sales and margins that Going Direct brings with it. We're finding opportunities to expand that business within the region and next door in France especially as we develop more year round product lines.

The next six months will be a very busy period in our international division as we continue to assemble the personnel and build out an infrastructure to support wholesale distribution for UGG, Teva and Simple brands in the U.K. and get ready to add the UGG and Simple brands for our current wholesale platform in the Benelux region. These regions represent our two largest markets behind the United States.

Domestically, sales are up 15% year-to-date, driven by demands in the UGG and Teva brands in the wholesale channel as well as the rapid growth experience in our U.S. retail stores.

While we expect the international markets will grow at a faster pace in the coming years, we still see a lot of opportunity here in the U.S. based on recent studies that indicate that the UGG brand is still under penetrated from a demographic standpoint as well as from a geographic standpoint most notably in the Southeast region. At the same time, we continue to evolve the Teva product line to include more multifunctional footwear. We're confident we can capture an important share of this much larger segment of the outdoor market.

The Teva brand has one of its best spring season's ever. As our efforts to develop a more comprehensive line of open and closed toe footwear is resonating with consumers. The 2010 product line included some of our most innovative and commercially appealing styles including the Sunkosi 2, the Itunda, the Tirra, the Tanza (ph) and the lighted flip-flop, the Illum. We've taken our technical expertise and leadership position in sports (inaudible) and are successfully establishing the Teva brand within the broader outdoor performance oriented category. As a result, we're much less dependent on whether than we were just a few years ago and we're now closer to having more meaningful year round presence at retail.

The UGG brand also had a very strong first half, highlighted by sales surpassing a $100 million for the first time in both Q1 and Q2. This was achieved by a very positive reaction to our spring line, which featured expanded assortment of sandals, casuals, spring boots and a sneaker collection and all of which performed very well. Growth of our spring business is evidence that the retailers are comfortable with the UGG brand as a year round brand and we're confident that consumers demand for the spring line (inaudible) greater interest in our expanded fall assortments as well.

We're seeing a much greater diversity in the ordering patterns for our wholesale accounts with the majority taking a much wider selection of boots across our multiple collections, classic knit, casual fashion and cold weather, in addition to more slippers and sneakers for fall 2010.

So, as you can see our UGG business is about so much more than one category, one season or one market. With the turnaround of the Teva business, we're about more than just one brand. As we get into the fall season and move in to 2011, we expect this growth trends to continue and our business to become even more diversified. This diversity along with the expansion of our consumer direct division, plus the upcoming conversion to a wholesale model in the U.K. and Benelux region should put us in a better position to address rising manufacturing and materials cost, which for 2011 appear to be in the 5 to 10% range consistent with others in the footwear industry.

Tom will now go through the financials in more detail, Tom?

Tom George

Thanks, Angel. For the second quarter of 2010 net sales increased 33.7% to $137.1 million versus $102.5 million for the second quarter of last year. Net sales of UGG products from the worldwide wholesale division as well as the distributor retail and eCommerce increased 34.6% to $100 million versus $74.4 million for the second quarter last year.

Net sales of Teva products increased 38.4% to $31.2 million in the second quarter compared to $22.6 million in the same period of 2009.

Combined net sales of the company's other brands were $5.6 million for the second quarter of 2010 flat with the year ago period.

Included in these numbers are global retail store sales of $10 million up 63.1% from $6.1 million in the second quarter of 2009, driven by five new stores and the same-stores sales increase of 19.2%.

Sales of our eCommerce business, which are included in the brand sales numbers, were $5.2 million for the second quarter flat with the same period a year ago. The eCommerce business face difficult comparisons to 2009 as prior to your sales included larger close outs for the other brands. The UGG brand eCommerce sales increase 19% for the quarter.

Also included in the brand sales numbers, domestic sales for all brands increased 16.2% to $65.2 million compared to $56.1 million in the second quarter of last year and international sales increased 54.8% to $71.8 million compared to $46.4 million in Q2 2009. International sales were 52.4% of total sales up from 45.3% last year.

Gross margin for the current quarter improved 450 basis points to 44.3% compared to 39.8% in the second quarter of last year. This increase was driven by improve margins for Teva and the other brands and lower close outs and some write downs for the other brands. We also experienced gross margin improvement from Teva, being a direct subsidiary in the Benelux. In addition, we received $3.1 million in duty refunds during the second of 2010, which we don't expect to recur at these levels in the future.

Total SG&A expenses for the quarter was $47.5 million or 34.7% of net sales compared to $36.6 million or 35.7% of net sales a year ago. We had planned SG&A to increase in absolute dollars due to several factors including cost associated with five new retail stores that were not open the full second quarter of last year. Operating expenses for our direct Teva operation in the Benelux, international distribution started up expenses, increase payroll, and variable expenses for the increase sales.

Operating income for the quarter was $13.2 million or 9.6% of sales compared to operating income of $3.3 million or 3.1% of sales last year. The improved operating income was attributable to the aforementioned increases in sales and gross margins.

Net income for the second quarter of 2010 increased 156.2% to $9 million from non-GAAP net income at $3.5 million, and second quarter diluted EPS increased 155.6% to $0.23 from non-GAAP diluted earnings per share of $0.09 in the second of last year.

Please note that all share and diluted earnings per share, amounts discussed in this call, including the amounts for the second quarter of 2010 and 2009 take in account the three-for-one stock split in the form of a stock dividend, which took effect in July 2010.

Now, turning to the balance sheet, at June 30, 2010, our overall inventories decreased 17.3% to a $120.5 million versus $145.6 million a year ago.

By division, UGG inventory decreased 20.3% to $103.9 million, Teva inventory increased 42.7% to $11.2 million, and the other brand inventory decreased by $2.1 million. In addition, at June 30, 2010, we had cash and cash equivalents totaling $333.7 million, up 90.4% compared to cash, cash equivalents and short-term investments of a $175.3 million at June 30, 2009.

Accounts receivable at June 30, 2010 were $81.6 million, compared to $61.2 million at June 30, 2009. During the quarter, we repurchase a split adjusted 61,000 shares for an average price of $43 per share. We have $27.4 million remaining in our current share repurchase program.

Now, moving to our guidance, based on our better than expected second quarter results coupled with an improved outlook, including increased sales projections for the UGG and Teva brands, we are raising our 2010 guidance. We now expect 2010 revenues to increase approximately 14% over 2009 levels, up from our previous guidance of approximately 13% growth. For the full year, we now expect UGG brand sales to increase by approximately 13%, up from our previous expectation of 11%, and Teva brand sales to increase in the high-20% level, up from our previous expectation for growth in the mid-20% range. Our other brands combined are now expected to increase approximately 15% down from previous guidance of 20%.

We currently expect diluted earnings per share to increase approximately 16% over a split '09 diluted earnings per share at $2.98 per share, which excluded a non-cash impairment on intangible assets of $1 million, as discussed in our associated earnings release. This is up from our previous guidance of approximately 11% growth.

Our forecast is based on a full year gross margin of approximately 49% and SG&A as a percentage of sales of approximately 26%.

As a reminder, in preparation for assuming distribution control of the UGG, Teva and Simple brands in the U.K. and the UGG and Simple brands in the Benelux region in 2011, as well as Teva Benelux in France transition this year, we will incur additional expenses in 2010 for the new initiatives to establish the infrastructure necessary to support broader wholesale operations beginning in 2011.

Also because of the transition, sales of approximately $10 million will shift to 2011 under our wholesale model that would have been recognized as international sales in November and December of 2010 under the former distributor model. Total these incremental expenses and profit shift of $8 million will have an estimated diluted earnings per share impact of $0.13 of which approximately 65% is a one-time impact. Excluding its cost, we're guiding diluted earnings per share growth to 20%.

Furthermore, due to the impact on our international pre-tax income from the aforementioned expenses in 2010, our effective tax rate is expected to increase slightly to 36.5% from 36.2% in 2009.

Our capital expenditures for 2010 are expected to total approximately $25 million to $30 million, a $10 to 15 million increase from our 2009 level of $15 million, driven mainly by the build out of new retail stores as well as the new eCommerce platform and PLM software.

For the third quarter of 2010, we currently expect revenues to increase approximately 15% diluted earnings per share to increase approximately 4% compared to the third quarter 2009.

Third quarter guidance includes approximately $1 million or $0.02 per diluted share of incremental investments associated with the distribution transition, as well as startup cost and higher levels of fixed overhead for the new retail stores, international infrastructure and other general and administrative costs.

For the fourth quarter of 2010, we currently expect revenues to increase approximately 8% in diluted earnings per share to increase approximately 8% compared to the fourth quarter of '09. Fourth quarter guidance includes approximately $5 million or $0.08 per diluted share of incremental investments associated with the distribution transitions as well as the aforementioned higher levels of fix overhead.

Operator, we're now ready to take questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, we will now be conducting a question and answer session. (Operator instructions) Our first question is from the line of Todd Slater with Lazard Capital. Please go ahead.

Todd Slater – Lazard Capital Markets

Thanks very much and congratulations to everyone.

Angel Martinez

Thank you, Todd.

Tom George

Thank you.

Todd Slater – Lazard Capital Markets

I was wondering if you guys could comment a little bit on your strategy to offset the 5 to 10% cost increases on the easy coming down the road, if there are – I would think some margin mix benefits from the retail expansion, the distribution, aversion internationally. I'm wondering what you're also thinking in terms of ASPs. And then secondly just curious about what you're thinking at all is change on your own direct to consumer, the retail stores, given the success there, if you might be thinking longer term about what that footprint might look like globally, has that change? And I guess I'll just stop there with those questions.

Angel Martinez

Okay, Todd. To the first question, in terms of our strategy, you really hit on a lot of the major levers so to speak on what we have to work with. I mean we're addressing global pricing, we're addressing the fact that we're direct now in the U.K. and there's been a luck spur for UGG that that will provide an opportunity as well to improve our margin as well as the reevaluate our strategy in terms of the pace and amount of our retail store expansion. So, those are all the things that we're addressing. In this point in time, it's still in process. It's still early in our 2011 planning process, so that's about all I can talk about now relative to that until we get further along that process and see the impact.

Zohar Ziv

Todd, this is Zohar. Also in addition to that we are looking in our – we're sourcing is coming from. Until now the majority of our sourcing comes from Southern China. Next year, we'll start a sourcing some from Vietnam and we expect that next year, less than 50% of our products are going to come from Southern China. Our factories are moving more to Central China, some of them already have done so and by doing that they're offsetting some of the cost pressure that it's mainly in Southern China.

Angel Martinez

Let me add to that, we have been sourcing Vietnam for several years now, obviously, to some pretty spectacular results in terms of product quality and delivery. So, it's an ongoing evolution. I would strategically add that over the next few years you'll see a diversity of manufacturing across the globe as facilities become available in addition from a design and development point of view will be developing products that offer a better opportunity to diversify manufacturing, in many cases more simplified constructions, product innovation and design innovation are going to become very important in assuring that we're still able to hit the price lines better appropriate for the consumers.

Todd Slater – Lazard Capital Markets

Should we be thinking about 2011 as a year in which we begin to leverage some of the infrastructure investments that are being made in 2010 or should we think of it as another year in which as you take over more of the distribution, there is still the potential for de-leveraging.

Angel Martinez

So, I think – we are continuing to evaluate let other markets we can look at going forward, Todd, from a going direct point of view. I think it's still a little bit early in the process as we walk to some of those levers we talked about earlier relative to the gross margin before we get down that path. That's sort of a little bit early in our process to be sort of a kin to giving some guides for 2011 because we're really not prepared to do that at this point in time.

Tom George

I will add that if you look at, and you ask the other question about retail as you look at the success of our retail operation, we can see that we have successful formula there. We've develop a pretty solid operating capability. We're in a good position as a brand that's in demand around the world and we're able to secure locations and premium locations inside cities, et cetera.

We've still been, I would probably say cautious on the evolution of our retail business justifiably so in this economy but it continues to perform us and with continued performance, you'll see more aggressiveness from us as we move through 2011 on this front.

Todd Slater – Lazard Capital Markets

That's great and well, good luck and all the best.

Zohar Ziv

Thank you.

Angel Martinez

Thank you.

Operator

Our next question is from the line of Mitch Kummetz with Robert W. Baird. Please go ahead.

Mitch Kummetz – Robert W. Baird

Yes, thank you and let me have my congratulations as well.

Angel Martinez

Thank you.

Mitch Kummetz – Robert W. Baird

Few questions on maybe, Tom, on your Q2 gross margin, which was up 450 basis points. It looks like about half of that was due to the 3.1 million in duty refunds. Can you talk about the other half? Could you be maybe quantify the impact of, that Teva going direct and the few are closed outs and were there any other sort of puts and take within that number that are worth calling out maybe quantifying as well.

Tom George

Yes. Those are the bigger items really. They're not that many other puts and takes. Teva being direct, that Teva the second quarter is a lower quarter for Teva so that was, but still roughly 70 to 100 basis points.

Mitch Kummetz – Robert W. Baird

Okay.

Tom George

You hit on the duties that's about the right number there. The closeouts and the markdowns for the other brands that that's about 40 to 50 basis points and just improve wholesale margins at full price for the other brands is about 150 to 200 basis points.

Mitch Kummetz – Robert W. Baird

Okay. With your retail business being up 64 percent in the quarter, I know that's a relatively small quarter for retail, did that have much impact on the gross margin of the quarter?

Tom George

Not as much as you think because we were up a little bit higher relative to expectations but as a percentage of sales compared to a year ago, it's about constant.

Mitch Kummetz – Robert W. Baird

Okay. And then on your SG&A guidance for Q3 and 4, I look at SG&A in dollar terms. I think it was up around 11 million in Q2 year-over-year. Based on your sales and SG&A guidance the percentage of sales, it looks like that's going to ramp up to somewhere in the 21 million range in Q3 before dropping back down to 11 million in Q4. I don't know if I did my math correct or not. But can you talk a little bit of, a bit why the big bump in Q3? I'm assuming that has something to do with your transition in Europe.

Tom George

Some relative to the transition in Europe, but really more there's not just Europe. We've been direct in Japan for awhile. We've got some ramping up in Japan. We've got some expansions and international marketing. The stores, there is five more stores. There is six more stores operating this year relative to year ago, but there's also the startup cost relative to getting eight more stores …

Mitch Kummetz – Robert W. Baird

Yes.

Tom George

To open up in the fourth quarter. And then there's, now that we're direct with Teva and the Benelux, there's some additional cost there. There's also some volume driven cost. Those are the main drivers that are driving that.

Mitch Kummetz – Robert W. Baird

Okay, that's helpful. And then on the UGG business, you mentioned in your comments, 100 million plus in each of the first two quarters that's new for the company. Q2 really stands out for me, I think up 35%. Could you talk a little bit about what really drove that's a pretty big sequential improvement from what you saw in the first quarter.

Tom George

I think a variety of factors. I've always said that's product, product and then followed by product. The sneaker line has been very successful. We continued to achieve great result with not only sandals but wedges and it has I think from a product presentation point of view at retail, we've got a much better and more diverse assortment in just about every single point of distribution and we have a broad cross section of products that are turning and checking (inaudible) very well.

So, I think what you're seeing is a brand that's diversifying in its appeal. Our kid's business remains a real opportunity for us. Our men's business remains a very big opportunity for us as we move in the next couple of years. But the most impressive thing that I've seen is the exciting new product that the UGG team continues to put on the table and the way in which the retailers are responding to it and willing to give us the shelf space and real estate necessary to display it. So, I mean it's a real highlight in the retail environment right now.

Mitch Kummetz – Robert W. Baird

Did you do bunch in a way of reorders in that business in the quarter? Is that still pretty much a pre-book business?

Tom George

It's pretty much a pre-book business with the exception of some very core styles, but generally speaking it's a pre-book business.

Mitch Kummetz – Robert W. Baird

Got it. Okay. Thanks, good luck.

Tom George

Thanks.

Angel Martinez

Thanks.

Operator

Thank you. Our next question from the line of Sam Poser with Sterne, Agee. Please go ahead.

Sam Poser – Sterne, Agee & Leach, Inc

Good afternoon. Thank you for taking my call. A couple of things. Number one, what was the wholesale gross for UGGs in the U.S. and internationally? Can you give it to us?

Tom George

Yes, Sam. Hi. This is Tom. Quickly, the total wholesale growth for domestic and international combined is about 32% for the quarter. The international growth was higher than the domestic growth. So, the domestic growth was more in the mid-single digit kind of domestic growth, loading at single digit.

Sam Poser – Sterne, Agee & Leach, Inc

And then, okay, thank you. And then in the guidance that you gave in regards to the – was that – are you giving us GAAP or non-GAAP guidance?

Tom George

Non-GAAP guidance, but for this year, so far non-GAAP and GAAP are one of the same. But I give you percentage increases over the prior year non-GAAP.

Sam Poser – Sterne, Agee & Leach, Inc

Okay. But you had some one-time charge? Did you have some one-time charge? What was the one-time charges in the last quarter? You mentioned that there's going to be $5 million or 5.5 million in Q4.

Tom George

So, that's the international transition.

Sam Poser – Sterne, Agee & Leach, Inc

Right.

Tom George

Reference for making for the fourth quarter or approximately $5 million.

Sam Poser – Sterne, Agee & Leach, Inc

And was there any of that in this quarter or in Q? Is there any of that in this current quarter or in Q3, do you expect?

Tom George

Yes. So, the current quarter was sort of a rounded $1 million roughly and the same for the third quarter, this immediate third quarter coming up.

Sam Poser – Sterne, Agee & Leach, Inc

And that's pre-tax correct?

Tom George

Correct.

Sam Poser – Sterne, Agee & Leach, Inc

Okay, perfect. And then lastly, can you give us – to things. Number one, I mean (inaudible) questions about it because when you're inventories are high, everyone why your inventory is so high. Now, people are going to start asking if you're inventories are very low and arguably very good shape, but what have you done differently to allow yourself to continue the growth momentum with inventories down 17% going into the busiest time of the year?

Tom George

Well, it's a lot of planning and effort related to our product life cycle management initiatives there. IE inventory, want to get it in, you don't want to carry too much of it, you want to get it in closer to when you're going to deliver it to your retailers. So, it's been a lot of efforts by a lot of people within the organization, you time inventory closer to when you shift the retailers. With our growth, you bring in too much inventory too early, you start running in against warehouse capacity constraints, so which can add cost that can cost some leverage issues. So, we've again then really put a lot of effort and to time the inventory better.

Sam Poser – Sterne, Agee & Leach, Inc

And then lastly, can you give us what the operating income is by segment?

Tom George

Yes. I got it right here. So, for the quarter by segment, UGG wholesale was obviously the strongest one at 33.6 million. Teva was close to 7 million. The other brands were just a little bit below zero, good improvement relative to the prior year. eCommerce is relatively flat. Keep in mind, eCommerce and I'm going to give you a retail number as well, assumes that most of the cost is the wholesale cost that does include the vertical margin. The vertical margin was with that UGG wholesale number. So, the eCommerce was relatively breakeven.

The retail store second quarter is the worst quarter for retail stores. On a wholesale basis, it's slightly below breakeven and then we got the other corporate overhead cost or whatnot that you plug in there that takeaway from the rest of the income at operating segments.

Sam Poser – Sterne, Agee & Leach, Inc

Thank you very much and continued success.

Tom George

Thanks.

Operator

Thank you. Our next question is from Chris Svezia with Susquehanna. Please go ahead.

Chris Svezia – Susquehanna Financial Group

Good afternoon, everyone and congratulations. Going off of Sam's question here, as we think about inventory, how should we think about as we go through the balance of the year? Does that start to move up slightly as you start to fill in orders or just kind of how we should think about that as we move through the second half of the year?

Tom George

Yes. Relative to the euro over year comparisons, there shouldn't be as much of a down relative to the prior years of moving to the third quarter and the fourth quarter, this should be. But at the same time, we expect the continued to manage inventories well for the third quarter; it should be down some probably not down as much as it was in the second quarter. And then the fourth quarter, that's all the function and how reorders go and how retail stores go as well. So, that's a tough for one to call.

Chris Svezia – Susquehanna Financial Group

And on Angel for you, I guess what you're sort of view of the sort of consumer environment, what we tell is – they've been telling you is they kind of think about the second half in their commitment to inventory and buys and any, I guess sort of initial blush thought as you think about spring, particularly for the UGG business as you continue to evolve the spring line just in terms of the maybe some color into the commentary you're getting from retailers.

Angel Martinez

Well, I mean I think it's a very interesting environment. It's very segmented in many ways. You have some pockets of the retail environment for example, a footwear, athletic footwear, particularly running is doing well, other specialty (ph) seems to be doing pretty well. I think people are foregoing the extent of vacation, et cetera and they're maybe running some road races on weekend, maybe taking advantage of some car tamping and outdoor activities. On the department store front, we're a major highlight given what's going on, I think the best scenario I could use is cautiously optimistic from some retailers and then just plain cautious and pessimistic from others.

So, the focus on brand that turn and perform and retail is very important, continues to be. There are still somewhat of a consolidation going on. I think peripheral brands are going to have a very hard time. It is a still a nervous environment with a lot of talk about a double dip recession, et cetera. I think brands like us performing and to have a performing as they are in this environment bodes well for the future when we see a better economic upturn.

Chris Svezia – Susquehanna Financial Group

So, it's fair to see you continue to take (inaudible) buy?

Angel Martinez

Yes. I think so.

Chris Svezia – Susquehanna Financial Group

And then the last question, I just want to ask is just of the cash for one second. I know in the past you've talked about looking acquisitions, $100 million to 200 million. Just curious about your updates that I've thought and I guess is there a timing? Do that ceases if you don't find anything whether it for price or it just doesn't come along? Is there a point in what you say, “Okay, that's enough let's move forward and think about something else or just your thoughts there?

Tom George

Yes, Chris. This is Tom. We're still evaluating on acquisition opportunities and being very patient there, so there is directly there's always a time that if something doesn't come along we switch gears. But we're just going to be patient there, we've done – we're doing obviously very well. We get great returns on capital with our current business. So, we're going to be cautious from that point of view.

At some point in time, if something doesn't come along we continue to build the large cash balances that we have and we will have to consider some other uses of that cash that which may include further share repurchases or dividends or some other kind of returns to shareholders.

Chris Svezia – Susquehanna Financial Group

Okay. Thank you very much and good luck.

Tom George

Thanks.

Angel Martinez

Thanks.

Operator

Our next question is from the line of Jim Duffy (ph) with Stifel Nicolaus. Please go ahead.

Jim Duffy – Stifel Nicolaus

Thanks. Hello, everyone and nice quarter. Tom, improving the inventory management would focus is really impressive. As you look to the supply chain are there other kinds of standout opportunities for cross savings that you hope to realize in the coming periods?

Tom George

Yes. As part of that overall strategy, we're looking at materials, trying to find common materials we can across all brands and therefore you get better quantities and therefore lower unit cost and we've been constantly looking at ways to control the cost of our distribution space and monitoring how quickly we add distribution space. There's constantly evaluating given our growth, what we're paying for our freight and what not, trying to make sure we're very competitive from that point of view. And then just one other thing is going to drive profits as we work on trying to reduce our cycle times, we'll be able to order products or to close or consume the preferences for models, which that in turn at the end results and lower markdowns, fewer closeouts and higher margins.

Jim Duffy – Stifel Nicolaus

Is it fair to say that for years, you've been focus on managing the growth and maybe there's opportunity to dedicate more management time towards the cost side of the equation, which could benefit the margins on a go forward basis?

Angel Martinez

Let me address that. I think that as (inaudible) really has done part and partial with managing cost as well that's why we've maintained the operating margins at the level we have. I've benefited from having experience in a (inaudible) environment in my previous business career and learn the hard way that you have to pay attention to both at the same time. In this environment, it is very difficult to just drive growth and then expect that you'll e able to go back and fix all of the overlooked problems and overlooked opportunities because your organization at that point and the structure you've built may not even allow you that opportunity by then.

So, you've got to sort of build it. It's a purpose built kind of structure that we have here, where cost is always a consideration and a major factor in how we're driving growth versus just blindly driving growth for growth sake.

Jim Duffy – Stifel Nicolaus

That makes a lot of sense. And then Angel, in the past, you've always highlighted that geographic opportunities within the U.S. for the UGG brand, how are you progressing towards executing on that opportunity? Do you have some proof points that that's working and have you found those marks to be receptive to the brand and embracing it?

Angel Martinez

Yes. Yes, I think a big part of it will have to be with diversity of the product line. We had initially a product that was more heavily perceived as a fall/winter product and (inaudible) so was driven by classic for the most part. We now have a much more diversified product offering. We knew when we had that, that we could diversify the geographic penetration, but we've had retailers across a variety of regions that Dillard's, for example, is one significant presence in the South of Southeast. They've step up with excellent presentation of UGG product and retail. And we've proven that the product sells through year round in those environments.

So, that's been very, very helpful and the more success say at Dillard's has the more that influences the local independent specialty retailer as well as other department store competitor. So, it's been a well-orchestrated expansion geographically combined with very strategic expansion of the product line to facilitate that.

Jim Duffy – Stifel Nicolaus

Great. Thanks very much for taking my questions and best of luck into the second half.

Angel Martinez

Thank you.

Tom George

Thank you.

Operator

Our next question is from the line of Chi Lee with Morgan Stanley. Please go ahead.

Chi Lee – Morgan Stanley

Hi. Good afternoon, guys. Congratulations. Follow-up question on the 5 to 10% sort of cost outlook for the full year, how do you expect the cadence of those cost increases to go presumably right on decent visibility into the first of the year? But should we be expecting those cost increases to decline as we progress to the back half?

Angel Martinez

Yes just relative to that for next year. So just to confirm it for 2010 we're locked in, for spring of 2011 we're further locked in for the most part. For the back half of the year we are – that's the season, so that's where you're looking at some cost increases.

Chi Lee – Morgan Stanley

Okay, specific for the spring 2011 period, are we looking towards the higher end of that 5% to 10% range?

Angel Martinez

That 5% to 10% number was more different models, some higher volume models, but still you have to be determined really as we're finishing our 2011 planning process just what the next would be. So I'd like to sort of stick with the range.

Chi Lee – Morgan Stanley

Just a follow-up question to the tone of customers, are you seeing any differences between the toning of domestic retail partners versus your international distribution partners and domestically what you're seeing from some of the more independent specialty retailers.

Angel Martinez

Yes, from domestic versus international everything that I've read, our domestic retailers are a little more nervous than the international retailer has been. I think that we're starting to see expansion of that sort of nervousness in Europe but a brand like us is considered fairly – it's fairly premium, somewhat exclusive, not a lot of competition for price, it's a very desirable brand for retailers outside the United States. We're following the same method we followed here with selected distribution. So we've worked very hard to try to put a plan together and offer a product line that protects the margins for the retailers who want them to make money obviously.

The other thing is that we're still relatively speaking up very penetrated in Europe and certainly in Japan. So we are something new something very different and there's one thing I hear from every retailer at every level we need new, we need fresh, we got to excite the consumer, you're giving us that and if you're giving us that we'll continue to grow with you and that's really been the exciting story of this spring and we think based on the lead we're getting for our line for the fall, we're going to get the same kind of enthusiasm.

Chi Lee – Morgan Stanley

My last question pertains to just e-commerce. It seems though e-commerce margins have seen about – it seems about five quarters of pressure. If it's about (flattish) profitability I think it's about six quarters. Can you talk about what the underlying drivers are of that pressure and when that could actually start to reverse?

Angel Martinez

Let me address part of it and then Tom can jump in. I think one of the things that we philosophically have always wanted to do with our e-commerce business is first of all provide an opportunity for consumers to educate themselves about the brands, all the brands and all the product lines. We've never looked at our e-commerce business as a vehicle to promote and compete directly with our retailers. Our philosophy was really almost to do e-commerce as a facility for the consumer to access our brands.

We don't do any kind of promotional calendar on e-commerce. We're not every day with free freight and those are the tools that are conventional e-commerce retailer is getting to utilize every day. I mean free freight is a normal thing now and we don't offer it. So when we don't offer it the consumer educate themselves about our brand on the UGG website and then perhaps goes to zapples.com if they have it in stock and buys it from them.

We've been okay with that. We think that the approach that we've taken has built our business, established a lot of really positive consumer insight about our product line and we don't really have any plan to get any more aggressive than we have been on that front. It's not part of our long term strategy.

Tom George

Just sort of to discuss a little bit more of the metrics and the dynamics, I mean one thing that we have been doing at our website as part of the effort expand awareness of the brand and drive even some business to our wholesale partners is we have been spending some more marketing money on the e-commerce as well as we're working on the backroom infrastructure so to speak in getting prepared to be able to have some higher velocity so to speak with e-commerce. So that is – it's more of an operating expense kind of some additional investments that have been causing it to get more like breakeven on a very low quarter, keep in mind second quarter is a very low quarter.

Angel Martinez

I will also add that if you take a look strategically at what we've been doing, we've been developing capability and capacity to reach our consumer, very important. The e-commerce division via retail, via our wholesale partners and the brand presentation and even shopping shops, that going forward, who knows that – I don't really – I can't predict – I don't crystal ball to know what the world of regular retail is going to do in the coming years. But I will say this that we are stronger than ever at reaching our consumer in every way that we need to and I think it positions us very nicely in that diversified approach. No matter what happens in the marketplace we're going to be able to reach our consumer and we'll be able to reach them in multiple ways and ways in which they want to be doing business with us.

Operator

Your next question is from Scott Krasik with BB&T Capital Markets.

Scott Krasik – BB&T Capital Markets

What's your comp assumption built into your Q3 and Q4 revenue guidance for your own stores?

Angel Martinez

Thanks Scott, good question. We haven't really – we don't give that level of granularity in our guidance but let me tell you last year our comps – our actual comps in the third quarter and fourth quarter I think to be exact the third quarter was like 31% and the fourth quarter was 29%. So we're up against very difficult comps in a very uncertain retail environment. So we're being cautious there but we don't want to – we're not going to give that level of granularity.

Scott Krasik – BB&T Capital Markets

What's the timing in opening the six stores in the US? Will those be early in the Q3 or –?

Angel Martinez

Most of them in Q4. I think there are a couple that sneak in to Q3, at the end of Q3. So Q3 is a quarter that you have a good amount of the employees, you're paying some rent, you're getting some store opening cost, you're getting some grand openings, you're incurring some G&A relative to very little sales contribution of any in the third quarter. So that's why the fourth quarter is bigger. And from a sales point of view historically the fourth quarter sales are at least a third roughly of the annual sales whereas the third quarter still relatively low.

Scott Krasik – BB&T Capital Markets

Have you run into issues with the inventory that your distributor has in the UK or the Benelux and what happens to that inventory over the next six or nine months or the retailer wants to be paid for or the distributor, how does that work?

Zohar Ziv

No and we haven't run into any issues. We had the conversion of the (inaudible) distributor and that hasn't been initiated at all. And the process which we are going through we really are not changing any of the ways how the distributor is buying the inventory. By the way, we are reviewing all the inventory buys that are done by the distributor. So there's really not a change in the methodology.

Scott Krasik – BB&T Capital Markets

So I guess that answers it. You're pleased with what he is selling to the retailers anyways.

Zohar Ziv

Yes, we've blessed it all. We're reviewing it and as Angel was mentioning we are managing the brand on a global basis. So we're making sure that both the distribution and globally is similar to the US both from the level of the quality of the retailers and the diversification of the products.

Scott Krasik – BB&T Capital Markets

The first few days of the Nordstrom Sales is always important. How did you guys do, were you up year-over-year, did it give you good reason on the fall?

Angel Martinez

Yes we are very happy with performance of the brand and the sale this year. I'd say we are not getting very specific as we intend not to do that, it's for Nordstrom to disclose. But I'd say our performance is consistent with where we were last year and we're very happy with that.

Scott Krasik – BB&T Capital Markets

The fashion items, it's a good read for fall.

Angel Martinez

Yes it is.

Operator

Our next question is from Maggie Gilliam with Gilliam & Co.

Maggie Gilliam – Gilliam & Co.

Yes I was wondering if you could elaborate a little bit more on your plans for extending the international distribution and penetration such as e-commerce going into some new places. And also to what extent are you going to have to build inventories in the places for your – switching to a wholesale operation.

Angel Martinez

Well, from an e-commerce perspective our intension long term is to mirror the access consumers have to the brand to what we see in the US most developed market. So, you'll see a combination of retail, you'll see e-commerce, you'll see shop-in-shops and you'll see our wholesale, more broad based wholesale business, and that is facilitated obviously by a subsidiary environment we're operating which allows us to really control how we do that.

From an inventory point of view in some of the markets we're involving and I mentioned Russia; again that's a distributor model there. The distributor plans the development of that brand. We review all of the orders that go into every market. We're satisfied with the rate of growth both spread and assortment of product and the quality of distribution than we have in any of those markets.

So we don't see any deviation from the basic formula that has gotten us here and given us success in the UK for example. We're rolling that same idea out in Japan over the next few quarters we'll be able to give you more feedback on that but we don't see any reason to change our approach.

Maggie Gilliam – Gilliam & Co.

Okay, but I mean is there anything you can comment on as far as timing is concerned?

Angel Martinez

Well, other than what we've already disclosed, no. I'm a big believer in not having too many spinning plates up in the air at the same time like the Ed Sullivan Show, you remember that guy. I don't want to have those plates all come crashing on the floor. So I tend to make sure that we refine that approach in a given market and then move on to the next one. So you're not going to see us do five things all at one time putting at risk the potential for success.

We're going to be methodical. We're boringly if there is such a word methodical in that sense and I think it works well right now.

Maggie Gilliam – Gilliam & Co.

Is there anything also to report on the licensing activities going into fall?

Angel Martinez

No, actually I would say it's the one thing we can report and we have been reducing the licenses out there over the last couple of years. The success of our license in cold weather accessories with the (inaudible) company has been extraordinary; they've done a wonderful job. As you know, we've been taking on the development and production of our own outerwear and we're very happy with the progress we've made there and continue to develop that idea and there really aren't any other areas where licensing is going to play a role.

Operator

Our next question is from Howard Tubin with RBC Capital Markets.

Howard Tubin – RBC Capital Markets

Any significant change into your marketing plans for the fall season this year versus for a switch you've done in the past or last fall season?

Angel Martinez

Well, it's a great question. We have a new senior head of marketing in the organization and her name is Jessica Buttimer. She is an exceptionally talented and experienced brand marketer, came to us from Clorox. And so the answer to the question in short is yes, there are going to be new initiatives begun. We have already begun consumer insight initiative worldwide that began actually early in the year. We have extracted, I think it was mentioned on the call, we have extracted a tremendous amount of insight already about our brand in particular and the opportunities we have from a demographic perspective to reach people.

You'll see us get more aggressive about the men's business. We think that's a pretty significant opportunity. I think you'll see the beginning of some of that in the fall. I think you'll see us diversifying the marketing mix. We have a lot of opportunity with – I think it's close to 350,000 of fans on Facebook that have grown organically. We've really not orchestrated that. We don't drive that very well yet. You'll see us make a move in that direction to solidify that opportunity.

So across the board we're just working at getting closer to our consumer and understanding what they want from all of our brands and then make sure that the product that we develop is consistent with those expectations, which – that's the basic blocking and tackling of marketing that I think we've done well so far but now we get to diversify into new markets with new consumer demographic profiles and I think that bodes well. To me that's an exciting part, you build the brand on a foundation and then you get to diversify into new areas; so marketing allows you to do that.

Operator

Our final question comes from Sean Naughton with Piper Jaffray.

Sean Naughton – Piper Jaffray

Clearly you guys have done a great job of getting the brand permission with your core female consumer to expand the UGG brand and new categories. And I think Angel you were just talking about some of the marketing initiatives you're doing to bring new people into the brand and to reconnect with the consumer. Can you talk a little bit about where the biggest opportunities are potentially outside of that in terms of cold weather accessories or in the men's business or are your retailers – retail partners now starting to ask for those types of products to extend into?

Angel Martinez

Well, you hit on two big ones; cold weather is something we've done extremely well with the last few seasons. If you ask any of our retailers, the number one response they'll give you is yes, I loved it, (inaudible) could not get anywhere near enough of it. So our idea is well, let's not just make more of it, anybody can do that; let's make a better product, let's make more compelling products, let's make products that functions better. So you're going to see an evolution of our cold weather product that is pretty exciting. It's still UGG and its core but it's going to be more technical. It's going to have a different level of appeal to a sophisticated consumer relies on that kind of product to be outdoors.

As you can imagine, it's a little stretch of the imagination living in Santa Barbara but I did spend a lot of years in New England, so I have a (inaudible) cold wet feet.

The other aspect on the men's side I think clearly an untapped potential there. Several years ago we started to put rubber bottoms on some of our men's slippers. We found that young men particularly were wearing those as the sort of winter flip-flop if you will and that has a lead us to a relationship with the consumer that is – I find it just tremendous. It's an extraordinary opportunity on the men's front. Men like UGG for different reasons than women do, but in the end they love it just as much.

So we've been digging into the wires of that and we're ready to offer some wonderful product to address that as we move forward in the next few seasons. I got to tell you I get excited about a lot of things but that's one of the things I'm probably most excited about.

Sean Naughton – Piper Jaffray

On the shop-in-shops I don't know if I heard this number correctly, but 140 was that the number that you guys planned on doing this year and if that's true now where can we expect to start to see some of these shop-in-shops start to continue to show up?

Angel Martinez

Yes that was the number and that was both the domestic and an international number, about 290 is where we'll end up for the year.

You'll see them at the better specialty retailers that have traditionally carried (inaudible) UGG, you'll see them at the major department store, leading department stores. You'll see them obviously dealers in Nordstrom in the United States for example, Galeries Lafayette in France and you'll see them all over the world. We have several in London.

Sean Naughton – Piper Jaffray

On the sourcing costs and clearly a hot button for most investors and it seems like management hands as well. How much was the headwind I guess if you could remind us that you are facing this year in the second quarter and then what you're up against for the second half of this year knowing that that product cost is already locked in but what were the increases you were seeing this year?

Zohar Ziv

Well, for this year, if you remember Sean we're locking price a year in advance. So for this year we really haven't seen much of price increases.

Sean Naughton – Piper Jaffray

Okay so that's pretty much flat for the entire year then?

Angel Martinez

Yes, pretty much let me remind you too that we've been anticipating changes in this area for quite a while. As you may recall at the beginning of 2009 we anticipated price increases that did not materialize and we're able to obviously, pocket some of that difference not knowing exactly when and I think the soft economy forestalled some of those price increases. But now with the economic environment proving somewhat and manufacturers certainly having to chase production and the nature of the changing workforce in China, you're going to start to see those increases spread to all brands, everybody producing anything in China.

So this is not new on our radar screen, we've been anticipating this and we've been planning for it for quite a while.

Angel Martinez

Well, thank you all for joining us today. Again, we're really pleased by our recent performance. We are excited to head into our key selling season with a positive momentum that we have across our business. We really look forward to updating you on our progress when we report our third quarter results in late October. So thank you all.

Operator

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

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