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J.C. Penney Company, Inc. (NYSE:JCP)

Q1 2014 Earnings Conference Call

May 15, 2014 4:30 p.m. ET

Executives

Kristin Hays - SVP of Investor Relations

Mike Ullman - CEO

Ed Record - CFO

Analysts

Neely Tamminga - Piper Jaffray

Matthew Boss - JPMorgan

Will Frohnhoefer - BTIG

Oliver Chen - Citi

Bob Drbul - Nomura

Bernard Sosnick - Gilford Securities

David Glick - Buckingham

Steve Strycula - UBS

Rupesh Parikh - Oppenheimer

Paul Lejuez - Wells Fargo

Chris Michael - Goldman Sachs

Mary Gilbert - Imperial Capital

Walter Loeb - Loeb Associates

Charles Grom - Sterne Agee

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter 2014 J.C. Penney Incorporated Earnings Conference Call. My name is Esteban, and I'll be your operator for today. At this time, all participants are in listen-only mode. Later, we'll conduct a question-and-answer session. (Operator Instructions) As a remainder, this conference is being recorded for replay purposes.

I'd now like to turn the conference over to your host for today, Kristin Hays, Senior Vice President of Investor Relation.

Kristin Hays

Thank you. Good afternoon, everyone. As a reminder, the presentation this afternoon includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which reflects the company's current view of future events and financial performance.

The words expect, plan, anticipate, believe, and similar expressions identify forward-looking statements. Any such forward-looking statements are subject to risks and uncertainties, and the company's future results of operations could differ materially from historical results or current expectations. For more details on these risks, please refer to the company's Form 10-K and other SEC filings.

Also, please note that no portion of this presentation may be rebroadcast in any form without the prior written consent of J.C. Penney. For those listening after May 15, 2014 please note that this presentation will not be updated and it is possible that the information discussed will no longer be current.

With that, I will now turn the call over to our CEO, Mike Ullman.

Mike Ullman

Good afternoon and thank you all for joining us on the call today. I'm here with our Chief Financial Officer, Ed Record who joined the company in March. I'm glad to be with you and to take you through the first quarter results and update you on the progress of J.C. Penney's turnaround. We'll also be discussing some of our expectations for the coming quarter and the remainder of the year. And following that, Ed and I'll look forward to answering your questions.

As I mentioned during the last quarterly call, the turnaround of J.C. Penney is taking place in three stages. First, the stabilization phase which we initiated immediately after I returned last April. That was followed by the phase of rebuilding in the third and fourth quarters of last year. And now we're in the third and final stage which we call the go-forward phase during which we're positioning J.C. Penney for long-term profitable growth.

We completed the first two phases of our turnaround by strengthening our team, stabilizing the company operationally and financially, and by rebuilding parts of the business that were key to our long-term success.

This year, we began progressing through the go-forward base, and I'm pleased to report we're making excellent progress. And I believe the results we announce today demonstrate the case. During this phase we're focused on refining our merchandizing and marketing strategies and are to steadily grow sales and significantly improve gross margins while continuing to tighten and manage our expenses, all with an eye toward returning to profitable growth.

Our first quarter results were positive step in that direction. Despite the unusually challenging, if not, unprecedented weather conditions in February and March we're gratified to have exceeded our sales guidance and deliver 6.2% same store sales growth for the quarter or 7.4% growth under the new sales reporting methodology.

In addition, sales improved sequentially in each month of the quarter. Our strongest performance was in April, especially during the Easter holiday period which helped to produce our better and expected results. The customer came back to J.C. Penney in the first quarter, and based on our favorable conversion trends she likes what she saw.

We also delivered gross margin improvement over the first quarter of last year and sequential improvement on the fourth quarter of 2013. Gross margin improved 230 basis points to 33.1% of sales when compared to the same quarter last year. While we're pleased with our gross margin progress this quarter, we recognize there is still lot of room for improvement. Looking ahead, we anticipate further gross margin expansion in the second quarter.

Expenses were well managed during the quarter with SG&A coming in below last year's levels and better than we planned. We'll continue to tightly manage costs as we institute important disciplines and processes across the stores in the home office.

Overall, our first quarter performance was in line with our plans to grow the business and take back market share from our competitors. Now I want to personally thank our 117,000 dedicated associates throughout the organization, who delivered these exceptional results and give great customer service everyday.

With that, I'd like to provide an update on the continued progress of our turnaround. On our fourth quarter call I told you we were focusing on several key priorities including merchandising our stores and dotcom in a way that better engages the customer, and it's easy and inviting to shop, improving our marketing to reconnect with customers and further enhancing our seamless on the channel customer experience across all channels and devices.

First, our merchandizing assortments; for the quarter, women's and men's apparel, home and fine jewelry were the company's best performing merchandise divisions. In women's apparel, casual and career dressing performed especially well, which shows our updated merchandise assortments are really resonating with our core customer. We've made great strides ensuring that customer find what the fits and styles she wants from J.C. Penney, including key private and national brands as well as exclusive brands like Liz Claiborne and Modern Bride.

Private brands such as St. John's Bay, Worthington, Stafford, J. Ferrar and Xersion are outperforming. We have a distinct competitive advantage with our in-house design teams. We truly understand each private brand, its target customer, lifestyle and price point. This is where our customers are very loyal to these brands. They trust them and will consistently deliver quality, fit and exceptional value for which they stand.

Private brands are also important to us, because they've delivered gross margins. They were several hundred basis points higher than national brands. Just as importantly, however, we're proud to be the best moderate department store to buy key national brands that resonate with our customers.

On that front, we're very encouraged to see continued increases in some of our largest national brands in the first quarter such as Levi's, Nike, Carter's, IZOD and Van Heusen. We attribute this to the strength of our assortments in the appealing shopping environments we created around these brands.

During the quarter we successfully re-launched our new home store, and it's called Home Collections of J.C Penney. As part of the re-launch we re-merchandized the floor to make better use of the space and to confirm the way the customer wants to shop. We also placed a renewed focus on bedding and bath small electrics as well as decorative accessories. We now offer a range of home merchandise that better fits our customer's budget and lifestyle.

Finally, we opened 30 new Sephora Inside J.C. Penney locations bringing the total to 476. We also expanded eight existing stores of our strongest performing support locations this quarter to increase their footprint inside the store. Our Sephora stores continue to perform exceedingly well.

I'd like to thank our merchant of planning allocation teams led by our Chief Merchant, Liz Sweney and our Head of Planning and Allocation, Frank Lucania. Under their leadership the teams have helped to deliver this very successful quarter.

Turning to the marketing front, we feel we have turned an important corner. The When it Fits You Feel It brand positioning which launched in the first quarter has been well received and it's been effective in differentiating us from our peers. Along with compelling promotions around big weekend events and holiday weekends such as Easter and Valentine's Day, our messaging was crucial in bringing customers back to J.C. Penney in the first quarter. It's a matter of fact in the month of April we had the first positive traffic in the last 30 months.

We'll continue to build on and refine our messaging in the second quarter as we fight for customers' attention with marketing that continues to re-establish our unique value proposition and leaves an enduring impression that we'll meet the customers' needs and wants by fitting her size, her wallet, her occasions and her lifestyle.

Deb Berman and her teams are already working on back-to-school and holiday marketing campaigns for this year. And we're confident in our go-forward marketing strategy.

Finally, we're focused on being a leader on the channel of retailing. Jcp.com which is the cornerstone of that strategy continued to perform very well in the first quarter as it has throughout the turnaround. Total online sales rose 25.7% in the quarter. Our associates at stores continue to do a great job helping our customers find additional sizes, styles and colors that she needs online at jcpenney.com. We can complete their online order right at the point of sales and ship the goods to their home or back to their favorite J.C. Penney store for free.

For the first quarter, Find More Referrals were up double-digits over last year. The recruitment of Mike Rogers as the leader of our omnichannel strategy and execution is already making a big difference. Mike and his team are helping us to further integrate digital capabilities and marketing, by doing stores and online.

In the end, the customer experience from marketing to browsing to checkout has to be seamless across all channels and mobile devices, and that's what we're working toward. On the financing front, we also announced today that the company proactively obtained a fully committed underwritten 2.35 billion senior secured ABL credit facility to replace the company's existing bank line.

Now with that, I'll turn it over to Ed for additional detail on our Q1 performance, and I look forward to what we're expecting for Q2 in the balance of the year.

Ed Record

Thank you, Mike, and good afternoon everyone. I'm very pleased to be with you today for my first earnings call since joining J.C. Penney as CFO in late March. I've gotten to know many of you during my 20 plus years in retail industry and I'm looking forward to working with all of you as part of the J.C. Penney team.

It's been a busy and rewarding first month and a half on the job. As Mike mentioned, our business continues to show improvement. We were particularly pleased to have exceeded our comp guidance in the first quarter in spite of what is still a very challenging retail environment. We feel very good about our first quarter results. However, we know that there is still a lot of work to be done to get J.C. Penney to where it needs to be.

With that, let me walk through the results. Comparable store sales increased 6.2% for the quarter or 7.4% under the new comparable stores sales calculation. As we said in the press release we're simplifying our calculations to better reflect year-over-year comparability by removing items such as sales return estimates and liquidation sales.

Our sales growth was achieved despite a difficult weather conditions in February and March, and indicates market share gains relative to our competitors' performance. Of note, sales improved sequentially each month of the quarter and our total brick and mortar merchandise sales were up 6.5%, demonstrating the progress and success for merchandising and marketing initiatives.

In total, sales increased 6.3% to 2,801 million for the quarter company to 2,635 million in the same quarter last year. Total online sales through jcp.com continue to show significant growth this quarter, increasing 25.7% year-over-year under our new methodology.

While still negative for the quarter, store traffic improved sequentially versus the fourth quarter of last year, and was positive during the month of April, as well as during key promotional and holiday periods. April represents the first time in over 30 months our store traffic was positive.

Our store conversion average transaction size and units per transaction for the quarter were all up significantly versus last year. In addition, our average unit retail was up low single-digits. This is attributable in large part to our increased private brand penetration, fully stock basics and the return of key promotional marketing events. And as Mike mentioned, we also continues to see great performance from a number of national brands.

For the first quarter, gross margin was 33.1% of sales compared to 30.8% in the same period last year, representing a year-over-year improvement of 230 basis points. Gross margin was negatively impacted by increased clearance sales as a percent of total in February-March as well as negative clearance margins on those clearance sales.

We're pleased with the progress we've made with our gross margin this quarter and continued improvement as the top priority. As we look forward, we're continuing to build a compelling mix of private exclusive and national brand merchandise that will result in higher sell-throughs and better clearance margins.

As a result we expect our gross margin in the second quarter 2014 to continue to improve sequentially when compared to the first quarter of 2014.

Our SG&A was 1 billion 9 million for the first quarter. That's down 69 million or 6.4% from the same period last year. These savings were primarily driven by lower corporate support and advertising costs and improved credit income. The team continues to manage expenses throughout the business by delivering excellent service every day to our customers.

Embedded in our real estate and other bucket are $12 million in net gains on the sale of 20 acres of fringe land surrounding our home office and four tire battery and auto locations. Overall, total operating expenses were down $125 million or 9.6% versus last year, representing a 740 basis point improvement.

Our operating profit improved 50% for the quarter through a loss of 247 million compared to a loss of 486 million last year. When compared to last year's first quarter, our net income was negatively impacted by 207 million or $0.68 due to the change in reported taxes. Our first quarter earnings per share is a loss of $1.15.

Now moving on to the balance sheet, cash and cash equivalents at the end of the first quarter of 2014 were 1,170 million. Inventory was 2,835 million, an increase of 1.3% over the same period of last year. We ended the first quarter with inventory under plan and we feel very good about the currency and composition of our inventory position heading into the second quarter.

We continue to expect working capital to be a source of fund this year. Property and equipment was 5,510 million down from 5,690 million in the first quarter a year ago.

Our suppliers' payables at quarter end were $841 million compared to $1,248 million last year. This large decrease year-over-year is driven predominantly by last year's ramp up of receipt as we work to get back into a more typical stock position coming out of 2012. This reduction is in no way indicative of any changes in payment terms to our vendors. Our vendors continue to be very supportive of our turn around efforts. We expect our ratio tables to inventories to normalize throughout the year.

Other accounts payables and accrued interests were 1,167 million compared to 1,524 million last year. This reduction is primarily driven by accrued and non-pay capital expenditures in the first quarter of 2013. Short-term borrowings are 650 million representing the outstanding borrowings on our existing ABL facility.

We are pleased to announce the refinancing of our existing credit facility with a new 2.35 billion ABL credit facility that will have two components, a revolving credit portion and a smaller term loan. The facility is being underwritten by lead arrangers, Wells Fargo and Bank of America Merrill Lynch, as well as J.P. Morgan, Barclays and Goldman Sachs. Wells Fargo is a lead arranger for the revolver, and Bank of America Merrill lynch is a lead arranger on the term loan.

We decided to pursue this new facility proactively to extend the maturity several years and enhance our liquidity position particularly during periods of peak working capital needs. With improving trends in or business as well as favorable market conditions, we expect to receive better pricing relative to our old facility. We've also maximized the inventory advance rate to 90% from 85% to better utilize the inventory supporting new facility.

Our key banking partners have great confidence in our ability to complete the turn around. As evidenced by their commitment for the entire 2,350 million facility size. Proceeds from the term loan will be used to pay down the cash borrowings on the existing facility. This transaction will be debt neutral from a balance sheet perspective.

Moving on to cash flow, our operating cash flow for the first quarter was a use of 271 million compared to 752 million last year. Our capital expenditures totaled $80 million for the quarter offset by the proceeds from sale of non-core assets of $15 million. Cash flow from financing activities was a use of $11 million. Overall our cash and cash equivalents decreased $345 million in the quarter. As we said in our release we expect to be free cash flow neutral this year.

In addition the previously announced fully committed underwritten 2.35 billion senior secured ABL credit facility is expected to add $500 million of incremental liquidity due on peak seasonal periods. This is additive to our previous comments and maintaining trough liquidity in excess of $1 billion. So we now expect trough liquidity to be in excess of $1.5 billion. Please note, however, the incremental 500 million is constrained by our borrowing base. So during non-peak periods when our inventories are at their lowest and our cash balances are at their highest such as yearend, this facility will increase the company's liquidity by approximately 100 million.

With that I'll turn it back over to Mike.

Mike Ullman

Thank you, Ed. In summary, during the balance of the year we will be executing a plan that's designed to improve gross margins and steadily grow sales. We will continue to tightly manage and ultimately leverage our expenses. With this strategy we see a path back to generating positive free cash flow this year as Ed mentioned.

We are making solid progress to our strategic focus on merchandising, marketing in omnichannel, there is so work to be done. The goal is to deliver consistently improved financial results and to reestablish J.C. Penney as the leading moderate department store in America.

I'd also like to remind you that we plan to hold an Analyst Investor Day in New York in October. Details will be forthcoming and it will include two of our new Brooklyn gateway store. We hope you all plan to attend. And now, Ed and I will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Neely Tamminga with Piper Jaffray.

Neely Tamminga - Piper Jaffray

Great. Good afternoon. Congratulations on the progress that you are making, Mike, and welcome, Ed, we are glad you are here.

Ed Record

Thank you.

Neely Tamminga - Piper Jaffray

Yeah. Can we talk a little bit about home and then product categories overall? So the home inventory to us, Mike, seem actually pretty light in our most recent others' Mother's Day weekend that we were around the stores. Are you thinking about flows, new flows coming into home and what would that look like and due to the business considering you are pretty dark in that category a year ago? And then, similarly, what product categories from your vantage point in Q2 present some of the better gross margin opportunity? And I have a follow-up.

Mike Ullman

Okay. Well, first about the home store. As you are probably aware, we increased the footprint size of home during the major remodel a year ago and much of our activity of the last eight or nine months has been re-assorting the merchandise in such a way that it relates better to the way customer shop. So for example, pulling together classifications, so bath and bed and various categories are usually shopped.

The level of inventory we think is appropriate. There maybe more space than we're used to just because of the size of the footprint. We think as the business grows we will obviously increase the inventory accordingly. We feel good about our home performance. We call it department now, home collections, and we've had great customer feedback. Our business with Home Online has also bounced back a significant piece of our online business. So, we feel good about the re-merchandising and I think that you will see us continue to innovate in the home area as we get through back-to-school into the holiday.

In terms of other gross margin opportunities you may remember we messaged in the past that we made a shift in the opening of our store where we moved Joe Fresh into a shop environment and moved a.n.a to the door that was significant gross margin improvement. Selling more merchandise at the promotional price and less at the clearance price, now that we've edited out the unproductive brands that was accretive to our gross margin. We expect to continue to improve gross margins by managing clearance in a more effective way. Our private brands are now fully in stock.

The discontinued brands are out of the store and the private brands as you know operate 400 or 500 basis points higher than our national brand margin. So we are very optimistic about continued improvement in gross margin. We recognize this as a process, not a project. And we didn't expect to recover it all in the first quarter, but we think we feel very positive about the rest of the year.

Neely Tamminga - Piper Jaffray

That's great. If I may just one housekeeping item here on the guidance; trying to reconcile maybe you are just being conservative, but it sounded like your April was stronger than the reported comps. So I am going to assume at least maybe high single digits. Assuming that you like others have continued to put that sort of trajectory in trend in May is the mid-single digit comp guidance been in queue to factoring something about a shift in a promotion activity or something to that effect? Or is it just sheer conservatism based on …

Mike Ullman

Well, I wouldn't assume that April was consistent with the average for the quarter. April was very, very strong because of the shift in the Easter holiday. We had very tough business in February, like March like everyone else; we were down something like $40 million to plan at one point just from weather. So we had a great recovery in April. I think what you are seeing in the guidance for the second quarter really is the re-opening of the home store in early June last year. So some of the comparables are obviously different than it would have been in the first quarter, but we continue to see the business environment pretty tough and very promotional. So we are not going to bet the ranch on some hockey stick comp improvement.

Neely Tamminga - Piper Jaffray

Understood. Best of luck out there. Thank you.

Mike Ullman

Thank you.

Ed Record

Thanks.

Operator

Our next question comes from Matthew Boss with JPMorgan.

Matthew Boss – JPMorgan

Good afternoon. Clearly you saw some improvement with the traffic in April. My question would be we obviously had an Easter shift and some things in your favor. Have you seen some of the positive traffic continue into May? And what's the best -- what would be the best way to give us increased comfort around lapping some of the tougher comparisons in the back half of the year? I guess the question really being momentum in the business versus math in the model.

Mike Ullman

Yeah. I'd say that one of the reasons we are quite positive about the momentum is that we recognize that we did not get back into business very quickly last spring. If you think about we had to add $400 million inventory at cost that probably arrived in April that feathered in. So we didn't have a terrific Father's Day. We were not totally buttoned up in terms of promotion of pricing as we change back to the strategy. We also didn't feel like we had a fabulous back to school. We feel much better about Men's. Man's was our lead category for the first quarter.

Kids is being completely rebuilt in terms of the re-assorting the brands that we are most resonating with the customer. So we know we have to run the business day by day, but frankly we feel like we didn't have a strong beginning of fall season; September and October not great. We thought we executed holiday much better than the first part of the year. So I would say that the guidance is appropriate for what we see, and we obviously hope to be that.

Matthew Boss – JPMorgan

Great. And then Mike, with top line and margins moving in the right direction here, liquidity enhanced with the ABL today. Can you just talk a little bit about your plans and the currency your search underway, and also any additional management bench opportunities, any homes that you are still looking to sell?

Mike Ullman

I would say first of all the team is -- we are fully staffed at the senior level. With Ed's arrival with Deb Berman in marketing, with Mike Rogers in Omnichannel, three terrific adds to the team. As for succession we've made it clear that the 2014 is the go-forward phase of our strategy, we are all together with this. And the team is very aligned at executing that strategy. So there is pretty -- no major changes on the horizon.

Matthew Boss – JPMorgan

Great. Thanks a lot.

Mike Ullman

Thank you.

Operator

Our next question comes from Will Frohnhoefer with BTIG.

Will Frohnhoefer – BTIG

Hello. Thanks for taking my call. Just a question for Ed, so you guys replaced the ABL rather than simply just expand through the accordion. I am wondering if there is any kind of significant structural difference in the new ABL change in baskets, significant change and in pricing etcetera. And if you could just kind of speak to the structure of the new ABL.

Ed Record

Sure, as we said the new ABL will consist of a revolver and a term loan portion. Currently we have about 650 million outstanding today on our existing ABL. We expect the term loan portion to be plus or minus that number, the rest will be revolver and it should be roughly give or take the same size that we are dealing with today. As we mentioned earlier on my script that we expect the pricing to be better and we also increase the advance rate from 85 to 90.

Will Frohnhoefer – BTIG

Yeah.

Ed Record

Part of the reason we undertook is now as that we did -- there was an opportunity to go on and get better rates. And we also felt that this was an opportune time to the right and get the additional liquidity. So we feel good about the bank deal and how our banks really support us in stepping up to be fully committed at this point.

Will Frohnhoefer – BTIG

Yeah, excellent, and I assume no change in the lean package here with new deal either way.

Ed Record

I am sorry, with what?

Will Frohnhoefer – BTIG

The lean package.

Ed Record

The lean pack, no. No change.

Will Frohnhoefer – BTIG

Okay. And then just lastly looking at your position now you are pretty good working capital situation, I am wondering a lot of the question that have risen over this past couple of quarters for you guys regarding your vendors, has that improved? I mean I noticed that we saw improvement in credit income and then there is also the question over whether or not you feel you have a stronger hand with your lessors as well and if you have any more rationalizations plan?

Mike Ullman

Maybe I could talk to that. I have spent a lot of time with our suppliers. I think they feel very comfortable that we are a great partner. And I think we put to bed a lot of the previous anxieties and frankly our results will only enhance that we are going forward. We'd not had major issues with our mall landlords or other landlords. I think at this point we are a preferred tenant.

Will Frohnhoefer – BTIG

That's great. I really appreciate the time. Thank you very much.

Mike Ullman

Sure.

Operator

Our next question comes from Oliver Chen with Citi.

Oliver Chen – Citi

Hi, congratulations. Regarding the comp outlook in your guidance, do you anticipate that it will still be split between traffic and average unit retail and is the traffic trend that you have been seeing sustainable just in terms of your view? Also regarding the product outlook, if you could speak a little bit about Kids or whatever you would prioritize most or what's most incremental on a year-over-year basis as we get in the back half; that would be great.

Mike Ullman

Sure. I think one of these we are seeing with returning traffic is partly is additional business by all customers. So that's very encouraging and our conversion rates when they are in the store have been consistently positive for the last two or three months. So we feel that we do have a sustainable trend and we do have a lot of analytics to back it up. We also feel that the message, the fit message is resonating, and that our promotional spending is better aligned with what is most productive.

So we found that we were spending too much in some weeks, and then not spending enough in others. And I think we've optimized Deb and her team worked very hard to make our budget work harder. We didn't do a lot of crazy promotional things just for the sake of trying to drive traffic, in the short-term we are looking it as a year long strategy that speaks to the customer at times when she really expects to be shopping. So we feel good about that.

In terms of the categories, clearly we have a big opportunity in Kids. The Joe Fresh assortments did not resonate as much as we wanted them to. As a result they are being faced out over time. Our key private brands in Kids are coming back very strongly. Okie Dokie total grow, Arizona, these are brands that mom loves because of their great price performance, but they are also style and esthetically appropriate for her kids. We also we are not in basics to the extent we wanted to be a year ago nor we in stock and uniform the level we should have been a year ago. So we are very optimistic about the incremental opportunity for kids.

We still think we have opportunities, for example, the sleepwear business was not that great last year. We are now on a very good trend in sleepwear. We expect that to be accretive to the back half particularly the Christmas bathrobes and sleepwear. We just have a number of categories where we look at 2011 levels and we are still not on trend to the improvement in other categories. So it happens that our strongest categories versus our two year ago, three year ago trend would be women's sportswear which is the biggest portion of our business.

So we are very optimistic about the outlook for growing the business back. But anybody sensible would realize that you don't grow it back all in one season. So we think the reason we call to go-forward period is that we are going forward season by season rebuilding the business brick by brick. We know that we need to do so to be able to leverage the expense structure that we have, and at the same time we are not taking our eye off expense, we are taking decisions where appropriate to keep our expenses down. We were pleased with our expense performance in the first quarter.

Oliver Chen – Citi

Great, congratulations. We like what we are seeing, so best regards.

Mike Ullman

Okay. Thanks a lot.

Operator

Our next question comes from Bob Drbul with Nomura.

Bob Drbul – Nomura

Hi, good afternoon.

Mike Ullman

Hi, Bob.

Bob Drbul – Nomura

Hi guys. I guess I have a couple of questions. The first one is on the gross margin. What was the percentage of clearance sales that you had in the first quarter? Can you show just a gross margin percentage on clearance in the first quarter? And what would you consider normal percentage of clearance sales and clearance gross margin percentage?

Mike Ullman

Well, I think probably what we are going to share since some of it is that kind of competitive information is that traditionally we sell about -- our sales would be 85% at promotional and regular prices and 15% at clearance prices. I would say there were times we will double that proportional clearance, which is obviously not optimal as we are getting out of discontinued brands.

So we expect that to be accretive in the rest of the year, because frankly we are not up against the same level of discontinued brands, and to a certain extent if you think about the discontinued brand clearance was more or less fighting with the normal clearance last year. So we feel we have -- we can earn additional margin by the getting back to the more normalized rate -- portion of promotional versus clearance markdowns.

Bob Drbul – Nomura

Got it. Okay. And at the AP to inventory ratio 30% is like lower than expected, was this timing or this a good level to assume going forward?

Ed Record

It will be lower than clearly last year. Last year it was exaggerated. It should be slightly higher than the 30 though. One is in trends in inventory was down pretty substantially. So that reduced that. In addition to that are receipt towards slightly front loaded. So we don't expect them to be have that same flow in each quarter. So 35 is about a reasonable number for us historically. I would expect to effective by that number.

Bob Drbul – Nomura

Okay. And then the last question I have is, is there any update on asset sales or monetization of cash from the sale of the headquarters win?

Mike Ullman

We have a partnership there that extends over next several years. So we are in the middle of that strategy. So we are pleased with the progress thus far. We have nothing to report until we basically have the whole master plan committed.

Bob Drbul – Nomura

Okay, great. Thank you very much.

Mike Ullman

Thanks, Bob.

Operator

Our next question comes from Bernard Sosnick with Gilford Securities.

Bernard Sosnick - Gilford Securities

Thank you.

Mike Ullman

Hi, Bernie.

Bernard Sosnick - Gilford Securities

Hi. You complemented about planning an allocation, and I am wondering if you can give us a little bit of color about the distortions that existed the year or so ago, and how that's been improved and how that's entering into the improvement in merchandising?

Mike Ullman

Well, I would say that the first headline would be we were under stocked in key basics and sizes and they did a terrific job of getting us back into business. I think the fact that our apparel businesses are the best trending businesses we have and they are toughest categories to plan on merchandise men's, women's particularly, I think that bouts well for the future of our planning function and our ability to moderate assortments and tailor them to specific customer use by store. So we think we have a great process and terrific people in that area. They are great partners for our merchants and it's appropriate that we recognize their contribution to our results.

Bernard Sosnick - Gilford Securities

You also mentioned the design team. I know that you are very proud of the design team that you built up earlier and that when you first brought in designers that took a year to maybe three for them to learn of the brand and really get it right. During the period in which Penny had all of the difficulties in turnover, was there turnover in the design staff or are we dealing with people who have been there for years?

Mike Ullman

I'd say about 75% of our 150 designers have been on the team throughout. There is always a little bit of turnover because it's such a important fashion area that we keep ourselves current. And I would say that Liz Claiborne and team which is based in New York has really not changed much at all and they have the terrific trend going. But I would say that when Ken Mangon came back the same week I came back, we reinstituted the disciplines and the quality design that we think is important. We really believe it's a competitive advantage. We don't rely on other people design our goods and the fact it is consistently season by season brings the brand attributes more consistency and so what the customers expect to see by brand. So we feel good about the design team. We are continuing to hire design talent where appropriate.

Bernard Sosnick - Gilford Securities

Congratulations on what you have been accomplishing. Keep it going. Thank you.

Mike Ullman

Thanks, Bernie.

Operator

Our next question comes from David Glick with Buckingham.

David Glick – Buckingham

Thank you. Ed, just a follow-up question; I am not sure if you answered this, forgive me if you did, but in terms of the accounts payable to inventory ratio. Was that the 35% you were referencing? Also what's the minimum cash levels you are looking at operating this year and do you anticipate using your revolver for peak working capital needs in Q3? Thank you.

Ed Record

Sure. Hi, David. Yes, the 35% was the question. I think we are little under 30% or AP to inventory ratio. And the question was what's more normalized. I said looking at history, 35 is more normalized. We expect that to normalize throughout the year. Q2 probably still be a little deficient to last year because last year was not normal. But again we think that the AP to inventory will improve from where it is today in normalized.

Your second question was the minimum cash level.

David Glick – Buckingham

The minimum cash level.

Ed Record

As I said in my script we think are now the new trough liquidity is $1.5 billion. So prior to this ABL refinancing it was $1 billion. We'd not go below $1 billion all year. We do not expect to go below 1.5 billion now all year. We will need to tap the ABL in the third quarter to pay for working capital. But again we will still have liquidity of 1.5 billion at all times.

David Glick – Buckingham

Okay. I was really just referring to the pure cash. Actually your ability to borrow as we model out the cash flows. A number that you really don't like to go below.

Ed Record

I am not sure I understand the question, David.

David Glick – Buckingham

I'll get you offline. Thanks.

Ed Record

Okay.

Operator

Our next question comes from Michael Binetti with UBS.

Steve Strycula – UBS

Yeah. Hi guys. This is actually Steve Strycula filling in for Michael. A quick question, this time last year you quantified the drag from the home section with 19% of your square footage offline. I think you said it was 300 basis points. Could you comment as to what the tailwind was for that this year? And what was the net square footage brought back online this year relative to last year?

Mike Ullman

Well, I would say that we probably had about 10 million square feet of home which maybe 70% of it was out of commission for the period second quarter last year is truly that it represents a pretty big footprint of our store. But right now it's rebuilding back to the former levels in terms of its sales level. So I am not exactly sure what you are looking for. I'd say about half of our comp could be in regard in the first quarter as being less than half probably of our comp in the home category. We will still have that effect in the first portion of the second quarter.

Steve Strycula – UBS

Okay. That's helpful. And then just one follow up was, at the end of the fourth quarter you ended inventories pretty high and it was pretty impressive how much you brought them down the way up 1% year–over-year. Can you comment as to what the dynamics were in place that helped you clear that much inventory from the fourth quarter relative to the first quarter?

Mike Ullman

Yeah. I am very proud of the team as one of the reasons we mentioned applying allocation to merchants. Because frankly having been behind plan during the weather difficulties we could have ended up with a big inventory problem. But I think we worked through it well. We feel very good about the condition of our inventory coming into the second quarter. And we've modeled out the rest of the year such that we believe that we can buy and sell merchandise profitably. We don't really have a big carry over concern. So I think to the extent that we start to trend better than our plan, we will obviously chase goods and that will help us maintain fresh receipts. So we have been very guarded about not getting ahead of ourselves in terms of our commitments.

Steve Strycula – UBS

Great, thank you.

Operator

Our next question comes from Brian Nagel with Oppenheimer.

Rupesh Parikh – Oppenheimer

Hi. This is Rupesh Parikh for Brian Nagel. Thanks for taking our questions. So our first question has to do with marketing and promotion. So, we have seen recently a pickup in what appears to be there frequency of some of your promotions and couponing. Are you starting to see better traction to some of your historical like 10 out of 25 offers and 15 off 15?

Mike Ullman

Yeah. I'd say more than that. We are actually -- obviously those promotions are popular. The customer understands them and they work well for us too because it drives the kind of volume at the margin as we planned. I'd say if you look at the category like fine jewelry, we've returned to promotional activity the customer really valued back in 2011 and before. And those have been very effective. So we are employing promotional techniques that we think the customer really understands. We will try not to have unplanned promotions. Frankly, those are usually pretty unproductive in terms of what they do to the bottom line. So I would give our marketing people a lot of credit for their discipline and the analytical way to looking at the business and our spend.

Rupesh Parikh – Oppenheimer

And then just one quick question on just private label, you mentioned some positive commentary on some of your private label brands. So where are we currently with your private label penetration versus some of your historical levels?

Mike Ullman

Yeah. I probably should have mentioned that in my remarks. We are almost up to 50% which is our goal, so we are fully back in business in St. John's Bay. We have returned Ambrielle to the assortment with great reviews. As I said the kids private brands are going to be brought back to their full levels of inventory in Okie Dokie and Total Girl in Arizona. So we feel very good about the private brands. We are spending additional emphasis on Liz Claiborne and Arizona as we take them more visible to the customer as national brands in a sense, because they are recognized as that. So we believe it is a huge strength and something the customer appreciates.

Rupesh Parikh - Oppenheimer

Thank you. Good luck next quarter.

Mike Ullman

Thanks.

Operator

Our next question comes from Paul Lejuez with Wells Fargo.

Paul Lejuez - Wells Fargo

Hey, thanks guys. We didn't see your gross margins, but I think you have a fixed cost component in that gross margin line that you leverage with better sales. So wondering what merchandise margins were specifically and how much were they up? And was that just a mix shift as opposed to seeing better margins within private and exclusive as opposed to national brands? So I guess I am wondering on an apples-to-apples basis what were the merch margins and private exclusive versus the same category last year. Thanks.

Mike Ullman

I think the margin improvement was totally based on the percentage of business that was done in private brands versus national brands and exclusive. We wouldn't disclose what the other components are. That's competitive information.

Paul Lejuez - Wells Fargo

So you think it was a mix shift is what drove the merch margins higher, correct?

Mike Ullman

Plus buying and selling merchandise for each of those three categories are better, but it's also the mix improved for private brand. That's where we have the big opportunity. We had dropped from 50% prior [branch] (ph) to 30 a year ago. So restarting that extra incremental 20% of our total business is the most material improvement in the margins.

Paul Lejuez - Wells Fargo

Yes, got you. And then I guess I am just wondering if excluding the Easter shift if you saw any improvement in traffic, and can you tell if any of your former lapsed customers are actually coming back to the stores? Thanks.

Mike Ullman

Yes, we're tracking that, and we've been very pleased with the return of lapsed customers. And as a matter of fact we have attracted a lot of new customers to our home store which is quite gratifying. So we still think we have lots of room to grow the business with our existing customers and also as they discovered that we're back in business and we're doing things the way they expect them to be done. We'll attract lapsed customers as well as new customers.

Paul Lejuez - Wells Fargo

So, just last, how do we tie that together with traffic being down still for the quarter?

Mike Ullman

As we mentioned, traffic was up in April.

Paul Lejuez - Wells Fargo

Yeah. Okay, thanks.

Operator

Our next question comes from Chris Michael with Goldman Sachs.

Chris Michael - Goldman Sachs

Hi, thanks for taking question. Can you give us any details around maybe the comp differential if any between A, B, and C malls? And then any differences by geography? Obviously weather had an impact probably and the Northeast and Midwest, but have you seen these regions bounce back as weather normalized? Thank you.

Mike Ullman

I'll answer the last part of the question first. Yes, we have seen a bounce back for all four of our regions. The strongest regions have been during the winter. Obviously the weather was more favorable like the west and the southeast. So the bottom part of the country, so to speak were more favorable in terms of comps than the Midwest or the up -- in northeast.

In terms of mall, grades of mall and more or less the mall footprint, I don't notice any major differences between the malls. They obviously differ by parts of the country and by different developers and so forth, but it's not something we track specifically. We look at our business by geography primarily.

Chris Michael - Goldman Sachs

Great, thank you.

Operator

Our next question comes from Mary Gilbert with Imperial Capital.

Mary Gilbert - Imperial Capital

Yes. Given the improvement and the favorable momentum that you are seeing and the favorable response by your shares, would you take advantage of the opportunity to raise another offering of stock to reduce debt for the long term, improving your capital structure?

Mike Ullman

Well, obviously we have an ABL that had put out in detail and we're in the process of finishing that, so …

Mary Gilbert - Imperial Capital

Yeah, but what about after that and given the strong momentum for this year?

Mike Ullman

I think that's our focus at the moment.

Mary Gilbert - Imperial Capital

Okay. And then with regard to new customers versus some of the core customers whether it is the lapsed customers coming back, are you able to give us a profile on what that composition is? Like what percent of your customers represent, let's say, your core older customer and then what percentage are new customers and how you see that evolving?

Mike Ullman

Well, we've done a lot of work in segmentation, which has been very useful to us understanding the -- by customer segment, what they react well to and what resonates with them. So it's a little bit complicated to kind of go through the 10 or 12 segments that we look at, but obviously the ones we think are the most likely to get additional business, additional spend is now we direct our marketing to those segments.

Some other segments maybe less attracted to our offer, but we still obviously attract cross shopping from a variety of retailers. So, obviously the fact that we're growing our business against our competitors, we believe we're gaining share.

Mary Gilbert - Imperial Capital

Okay. And then what about localization, are you able to start the localization back again, because last year you were sort of an emergency mode? So, now are you able to get assortments going forward more locally-oriented?

Mike Ullman

Yes. We believe that the planning and allocation process we use allows us to assort by store on number of attributes. I'll say that when the business is broken, virtually everything is a bit broken, so we're feeling better all the time about size and ethnicity and various components that are very important by store. But as I go to stores I don't hear from associates that we're in misalignment at this point. I think we're back to running the business properly.

Mary Gilbert - Imperial Capital

And then finally with the Home department it sounds like that business is still evolving in terms of getting it exactly where you want it to be. Are you planning to downsize it or you are happy with the size of it? And when do you think you will be at a point where you feel like you are at an optimal level in terms of the assortments that you are offering in the home department to sort of get that business back to where it was?

Mike Ullman

We're long way back. It's a long way from where we were at one point. Home was probably twice as bigger percent of the total business as it is today. So we know we have to earn that back, and it will take several years, but we're comfortable given our price points, the style, the penetration of private brand there and the fact that we reallocated the space to be more aligned with what the customer expects to see in the store. We know that some of the most profitable categories like window and luggage and those categories were downsized for whatever reason. So we are making those adjustments.

We also are going to probably move from disparate categories into some of the home space to make it more productive. So, we are doing the things that you'd expect merchants to do when you trying to build the business. But we're encouraged; in fact we're attracting new customers to home. And I think that our home messaging is starting to resonate, but it was pretty broken for a period of time there, so it's taken us some time.

Mary Gilbert - Imperial Capital

Thank you very much.

Operator

Our next question comes from Walter Loeb with Loeb Associates Inc.

Walter Loeb - Loeb Associates

Congratulations on a great quarter, but I have a question that I need some clarification. Going forward, the company would centralize the comparable store sales calculations, and I don't understand why you have to change comparable store sales calculations since it's all within the four walls?

Ed Record

It's not all within the four walls. There were a bunch of accounting adjustments put into the comp store calculations, which we felt impacted our comparability year-over-year, and so we're taking those out.

Walter Loeb - Loeb Associates

Thank you.

Ed Record

Thanks, Walter.

Operator

Our next question comes from Charles Grom with Sterne Agee.

Charles Grom - Sterne Agee

Hey, Mike, congrats on the progress here, nice to see. Just a follow-up on Paul's earlier question regarding the traffic, I may have missed it; I hopped on a couple of minutes late. But did you break out traffic and ticket for the quarter for the comp?

Mike Ullman

We basically said that we had positive traffic in the month of April for the first time in 30 months, and the ticket and units per transaction and basket and all those things were favorable. So we didn't break them out specifically with numerical stats, but we're going in the right direction in all those metrics.

Charles Grom - Sterne Agee

Okay. So if we could just maybe just to dig into the ticket a little bit, how much of the increase was AUR versus UPT just with your private brands growing from 30% to 50% year-over-year? I am surprised that the AUR would be up so much. So was it UPT that drove it?

Ed Record

It was predominantly. In my script I said AUR was up low single-digits. The rest was obviously average ticket value which was driven by average units.

Charles Grom - Sterne Agee

Okay. And given the strength in the comp, we were a little bit surprised at margins. I mean never good, but I thought that would be up a little bit more particularly considering that clearance was down, I believe, 500, 600 bps year-over-year and then like you said, Mike, private brands were up so much, so I guess my question is how much did the clearance markdowns weigh on the margins in the quarter and would you expect that amount to essentially go away in the upcoming quarter or two?

Mike Ullman

I already mentioned that we felt that we're feathering in improvement as we upgraded the unproductive brands. We also -- everybody else had the same issue which is the season of merchandise in February and March, that selling open-toed sandals in the snowstorm. I think everybody took some margin hit in that area. So we wouldn't expect to repeat that in summer.

So, there are aspects that lead us to believe that much of the margin erosion is not comparable in the upcoming quarters. We still have a lot of work to do to refine the buying and selling merchandise at a profit obviously. But we're much better off. We're much narrower and deeper than we used to be, taking out 15 brands and cleaning up the floor and -- cleaning up the floor. Those are things that will improve our margin.

We're quite pleased with the margins we're getting on private brands. And frankly, our national brand partners are quite happy with our partnerships, and we feel that we're early in the kind of margins we'd expect in those brands.

Charles Grom - Sterne Agee

Okay, and then just to clarify on the guidance for the margins in the second quarter, you are expecting -- do you expect the absolute number to be greater than what you just produced here in the first quarter? Is that how we should interpret the guidance?

Ed Record

From a rate standpoint we expect it to improve from Q1.

Charles Grom - Sterne Agee

Okay. And then from an SG&A perspective, down close to $70 million, $80 million year over year, should we think about that as a good run rate to use over the balance of the year by quarter or do you think it starts to normalize and level out?

Ed Record

It starts to normalize. As you look at our history we were -- I don't know, a billion 78, Q1; a billion 25, Q2 and then a billion 5. So expenses came down on each quarter last year. We expect -- we are basically a billion this year. We expect that to be roughly our run rate. There may actually be a little slight uptick in fall this year as we hopefully will be paying some incentive comp and some other things that were not in the history.

Charles Grom - Sterne Agee

Okay, great. Congrats. Thanks.

Ed Record

Thanks, Charles.

Operator

That concludes our Q&A session. I'd now like to turn the call back over to Mike Ullman for closing comments.

Mike Ullman

Well, thank you for joining the call. As you can tell we're quite enthusiastic about the rest of the year. We as previously mentioned, we intend to complete our turnaround during 2014 and we look forward to seeing you in October at Brooklyn Gateway. Thank you.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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