Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Abercrombie & Fitch (NYSE:ANF)

Q1 2014 Results Earnings Conference Call

May 29, 2014, 8:30 a.m. ET

Executives

Brian Logan - VP, IR and Controller

Michael Jeffries - CEO

Jonathan Ramsden - CFO and COO

Analysts

Anna Andreeva - Oppenheimer & Company

Matt McClintock - Barclays

Janet Kloppenburg - JJK Research

Betty Chen - Mizuho Securities

Jennifer Black - Jennifer Black & Associates

Adrienne Tennant - Janney Capital Markets

Barbara Wyckoff - CLSA

Simeon Siegel - Nomura Securities

Randy Konik - Jefferies

Paul Lejuez - Wells Fargo

Oliver Chen - Citigroup

John Morris - BMO Capital Markets

Susan Anderson - FBR Capital Markets

Kimberly Greenberger - Morgan Stanley

Dana Telsey - Telsey Advisory Group

Omar Saad - ISI Group

Operator

Good day and welcome to the Abercrombie & Fitch first quarter 2014 earnings results call. [Operator Instructions]. At this time, I would like to turn the conference over to Brian Logan. Mr. Logan, please go ahead.

Brian Logan

Good morning, everyone, and welcome to our first quarter earnings call. Earlier today, we released our first quarter sales and earnings, income statement, balance sheet, store opening and closing summary, and an updated financial history. Please feel free to reference these materials available on our website. Also available on our website is an investor presentation, which we will be referring to in our comments during this call.

Today's earnings call is being recorded, and the replay may be accessed through the internet at abercrombie.com under the Investors section. The call is scheduled for one hour. Joining me today are Mike Jeffries and Jonathan Ramsden.

Before we begin, I remind you that any forward-looking statements we may make today are subject to the Safe Harbor statement found in our SEC filings. After our prepared comments this morning, we will be available to take your questions for as long as time permits.

With that, I will hand it over to Mike for some opening remarks.

Michael Jeffries

Good morning, everyone, and thanks for joining us. In what remains a difficult teen retail environment, we are pleased that earnings for the quarter were in line with our expectations. Overall sales for the quarter decreased 2%, which included strong growth in our direct to consumer business, and comparable sales continued to head in the right direction.

We saw significant sequential improvement in our female business, which comped in line with the male business for the first time in many quarters, and in our Abercrombie & Fitch brand, which comped down only slightly for the quarter.

We continue to be pleased by the results from our recent expansion efforts in Asia. Our Hollister stores in China continue to comp positively and our new A&F flagship store in Shanghai opened in April to huge crowds and strong sales, which exceeded forecast.

The flagship opening generated 500 million social media impressions and added over 30,000 new Weibo followers and we believe will continue to support our growing brand awareness in China. For 2014, we plan to open four additional stores in China, including a mall-based A&F store in Chengdu and are preparing for an accelerated rollout for both brands in 2015.

In addition, our direct-to-consumer business in China has been growing at a very fast rate and will be further boosted when we introduce a local website and local fulfilment in the fall. This is a further example of the significant investments we are making to build our international DTC business, a critical component of our long term strategy.

In Japan, our two Hollister stores are still producing volumes significantly ahead of initial forecasts. For 2014, we plan to open two additional Hollister stores in Japan, one at LaLaport Tokyo Bay and the other in Kobe. And we see significant growth opportunity given our early success.

Our Dubai Hollister store, our first in the Middle East, has been the highest volume Hollister globally since its opening in the fourth quarter of last year. We look forward to additional openings in the Middle East in 2014, including our second store in Dubai and another in Abu Dhabi.

Store comps in Europe continued to show modest improvement and total comps were close to flat in several countries, including Germany, our second largest European market. The general economic outlook in Europe still remains uncertain. However, our overall productivity in Europe remains strong.

In Canada, we moved back into positive comps for the quarter, with particularly strong growth in DTC.

From a merchandise standpoint, we performed well during the quarter in dresses, outerwear, and jeans, all of which has positive comps.

As we look forward, our focus remains on executing the various components of our long range plan. First, we continue to make good progress in evolving our assortment, improving our test and reaction capabilities, and increasing style differentiation.

As you know, we are now testing close to 100% of our assortment. Chase now represents a significant component of our fashion business, and we have reduced lead times for Chase to between 45 and 75 days, which includes the benefit of new fabric platforming processes.

We see opportunity as we expand fabric platforming to additional fabrics and categories. With improved test and react capabilities, we believe we will be more fashion-right, which should lead to higher productivity and margins.

Second, we are increasing brand engagement through enhanced marketing initiatives and campaigns. Earlier this month, we announced the opening of Hollister House, a key part of our new Hollister marketing campaign. Hollister House is a beach house in Southern California that will be open through early August and will support a major digital marketing campaign across multiple platforms, including YouTube, Instagram, Hulu, Twitter, Facebook, Spotify, Pandora, and our recently launched Hollister Snapchat.

The house represents the iconic, laid back SoCal attitude of the brand, delivered in a fresh, new, and relevant way. The house will be used as a vehicle to create social media content, including music performances from Billboard-charting acts, guest celebrities, and stylist videos. It will also be supported by our new blog, “This is SoCal.”

For A&F, we expect to launch a new marketing campaign later in the year and look forward to sharing the details of that on a future call.

Beyond marketing campaigns, we will increase brand engagement through investments in our stores and in our online experience. As you know, we have been running a Hollister store remodel test over the past few months, which features the redesigned storefront we previewed in our investor event last November.

As Jonathan will describe further in a moment, the test stores have performed strongly, and as a result, we now plan to expand the rollout of this new design in 75 to 100 stores, including a small number of Canadian stores, by year-end. And with regard to online, we plan to launch a redesigned Hollister website this fall.

We continue to explore third-party channel opportunities, and now expect to begin selling A&F merchandise through ASOS for Christmas. Given ASOS’s strong and growing traffic, this partnership will enable us to increase brand consideration and engagement with an attractive margin structure.

Third, our profit improvement initiative is on track. In fact, savings in the first quarter were somewhat ahead of what we anticipated. As we mentioned in our last call, we believe the next big area of opportunity lies in lowering our merchandise average unit cost. Our average unit cost is expected to be down in the back half of the year, and we see additional opportunity as we move forward, particularly for Hollister.

Fourth, we are making good progress in ensuring we are properly organized to execute our strategic plan. We’ve completed the vertical organization structure by brand for most of our cast in design, merchandising, and planning, in anticipation of the hiring of the brand presidents.

We believe these actions will support a number of key objectives, including increased brand differentiation and accountability. We’re also excited to be adding strong retail experience to our board of directors through new additions.

Finally, turning to omnichannel, we have made solid progress on several core initiatives since last fall. After successfully piloting order in store, we now plan to roll this feature out to all U.S. stores during the third quarter.

In addition, we plan to pilot ship from store during the third quarter, with a broader rollout planned for approximately half of the U.S. fleet in the fourth quarter. Beyond this, we are working to develop other omnichannel capabilities including reserve in store and in-store pickup.

Our sector faces challenges, as highlighted by the spate of recent negative reports. We are fully cognizant of those challenges, and know that we need to be focused, disciplined, and at the top of our game to navigate through this environment. We are more than ready for that. We remain highly focused on returning to growth and believe we are taking the right steps and are on course to accomplish that goal.

Longer term, we are confident that the strategic choices we are making, investing in key international growth markets, investing in our international DTC business, restructuring and repositioning our U.S. store fleet, restructuring our cost base, and making key organizational changes will position us to drive significant improvement in our results and increase shareholder value.

Before handing over to Jonathan, I would like to take a moment to say a word about someone who has been an incredible partner to me for over 20 years. Tomorrow marks Leslie [Harrow’s] last day as a full-time associate at A&F.

Everyone who has worked at A&F knows the role that Leslie has played in our company and its culture. She has exemplified everything we stand for and believe in as a company, caring obsessively about our brands and each other, being collaborative and team-oriented, being positive and optimistic, and not taking ourselves too seriously.

On behalf of everyone at A&F, I want to say a big thank you to Leslie for everything she has done for this company. Jonathan?

Jonathan Ramsden

Thanks, Mike, and good morning everyone. I want to start this morning by saying a welcome to A&F to Joanne Crevoiserat. Joanne joined us earlier this month, and we are thrilled to have her onboard. Joanne will be joining our next earnings call in August.

I’m going to start with a short recap of the quarter, and then talk about our outlook for the range of 2014. For the quarter, net sales were $822 million, down 2% to last year, including direct-to-consumer total comparable sales were down 4%. Total U.S. sales are down 6%, while international sales were up 5%.

Sales for the quarter were slightly lower than expected. Within the quarter, comparable sales were weaker in February versus the combined March and April period. The gross margin rate for the quarter was down 370 basis points, reflecting a higher mix of full merchandise clearance selling versus last year and an increase in promotional activity, including shipping promotions and the direct-to-consumer business.

Promotional activity was somewhat greater than we anticipated, leading to modestly higher gross margin rate erosion than anticipated. We expect gross margin rate erosion to continue into the second quarter, primarily from AUR pressure, with gross margin rate improvement in the back half of the year as we begin to benefit from lower AUCs and go up against more favorable AUR comparisons.

Excluding pretax charges of $16 million, which are detailed on page four of our investor presentation, adjusted non-GAAP operating expense for the quarter was $531 million, down $37 million from last year, representing 310 basis points of leverage.

These savings are net of incremental investments in marketing initiatives and DTC. Savings were greater than anticipated due to continued tight expense management and the earlier realization of profit improvement initiative benefits. We have made good progress in executing our profit improvement initiatives and continue to expect at least $175 million of annual savings.

In addition, we continue to expect to increase 2014 marketing expenditures by approximately $30 million or greater, compared to 2013, with a greater portion of the increase now coming in the second quarter related to the new Hollister campaign.

On a sequential basis, we expect a lower year over year decline in operating expense for the second quarter, due to the cadence of expense savings and offsetting marketing investments, which we now expect to be significantly greater on a year over year basis in Q2.

Other operating income for the quarter was $4 million, which included insurance recoveries of $3 million compared to $1 million in other operating income last year. On an adjusted non-GAAP basis, the operating loss for the quarter was $16 million versus $14 million a year ago.

The tax rate for the quarter, excluding the effective charges, was 27.5%, lower than our full year projected rate, due to the impact of discrete period items on a low pretax figure. For the quarter, the company reported an adjusted non-GAAP loss per basic and diluted share of $0.17, in line with expectations coming into the quarter.

Turning to the balance sheet, we ended the quarter with $357 million in cash and cash equivalents, and borrowings under the current loan of $131 million. During the quarter, we repurchased 3.8 million shares at an aggregate cost of $150 million through our announced accelerated share repurchase. We anticipate additional share repurchases over the course of the year, utilizing free cash flow generated from operations and existing or additional credit facilities.

We ended the quarter with total inventory at cost up 6% versus a year ago. We expect inventory at cost on a year over year basis to be down at the end of the second quarter. During the quarter, we substantially completed the closure of our standalone Gilly Hicks stores and incurred charges of approximately $6 million, primarily related to lease exit costs.

We now expect total capital expenditures for 2014 to be approximately $210 million to $220 million. This now includes additional capital expenditure related to an expanded rollout of a new Hollister storefront that the company has been testing since January of this year.

We now anticipate that this new storefront will be rolled out to between 75 and 100 stores by the end of the year. As Mike mentioned, we are very pleased with the results of the test, which, on average, has resulted in a double digit percentage increase in sales and a substantially greater increase in traffic versus the control group.

For the extended rollout, we are modeling a more conservative ongoing sales lift, but still expect the cash on cash ROI to exceed our 30% hurdle rate. We will also be testing a lower-cost version of the remodeled storefront as we look to extend this rollout across the fleet. As a result of the rollout, we also expect to incur a $3.5 million charge related to the writeoff of existing store assets.

2014 capital expenditures continue to be prioritized toward DTC and IT investments to support growth initiatives, and capex related to new international store openings is prioritized toward the key growth markets of Japan, China, and the Middle East.

During 2014, we expect to open 15 full priced international stores, including a small number of A&F mall-based stores. We also now plan to open 8 to 10 international and U.S. outlet stores during the year.

We continue to expect to close between 60 and 70 stores in the U.S. during the fiscal year through natural lease expirations. Beyond 2014, the actions we have taken in the past few years give us significant flexibility as we think about the optimal size of our U.S. bricks and mortar footprint. In total, about 500 of our 840 U.S. leases are up for renewal between now and the end of 2016.

DTC growth, especially internationally, is a key priority for us. We are off to a good start in 2014, and expect to achieve another year of strong growth with the segment margin remaining in the mid-30s on a full year basis. We plan to continue to invest in DTC, including increasing our assortment of web exclusive styles, advancing mobile capabilities, and expanding international language and payment options.

As Mike mentioned, we will also be introducing a local website and local fulfillment for our DTC business in China. This is another significant step for us as we continue to build on our leading international ecommerce position.

Moving on to our earnings outlook for the rest of 2014, we are maintaining our guidance of full year diluted earnings per share in the range of $2.15 to $2.35. This now includes the effect of the first quarter accelerated share repurchase, which offset the assumption of a somewhat more difficult operating environment.

The guidance is based on the assumption that full year total comparable sales will be in the range of down 3% to down 4%. The guidance assumes a gross margin rate for the full year that is down slightly compared to fiscal 2013. We expect average unit retail pressure and lower shipping and handling revenues to offset average unit cost improvement and a benefit from the company’s profit improvement initiative.

We expect the gross margin rate for the second quarter to be lower than the full year rate, with the third and fourth quarters getting a benefit of year over year AUC reduction. The above guidance does not include charges related to the Gilly Hicks restructuring, the company’s profit improvement initiative, certain corporate governance matters, or other potential impairment and store closure charges.

In addition, the guidance assumes a weighted average share count of approximately 74.5 million shares, which does not include the effect of additional share repurchases over the course of the year, and a full year tax rate of approximately 35%. The tax rate remains sensitive to the mix between international and domestic income.

With that, I’m going to hand it over to Brian to provide some more details on our results for the quarter.

Brian Logan

Thanks, Jonathan. As reported, first quarter comp sales were down 4%. By brand, comp sales, including direct-to-consumer, were down 1% for Abercrombie & Fitch, down 6% for Abercrombie Kids, and down 7% for Hollister. Across the brand, male and female performed comparably.

Changes in foreign currency exchange rates versus a year ago benefited sales by approximately $12 million. The gross profit rate for the first quarter was 62.2%, 270 basis points lower than last year’s first quarter gross profit rate, reflecting the entire mix of fall merchandise clearance selling versus last year and an increase in promotional activity.

Stores and distribution expense for the first quarter was $418 million, down from $449 million last year. The store and distribution expense rate for the quarter was 50.8% of net sales, down 270 basis points from last year driven primarily by savings in store payroll, partially offset by higher direct-to-consumer expense and $800,000 of charges related to the profit improvement initiatives.

Marketing, general and administrative expense for the first quarter was $124 million, a 4% increase compared to $119 million last year. MG&A expense for the quarter included $2 million of charges related to the profit improvement initiatives and $7 million of charges related to certain corporate governance matters.

Excluding those charges, MG&A expense was $114 million, down 4%. A decrease in compensation expense was partially offset by an increase in marketing expense. At the end of the quarter, we operated 842 stores in the U.S. and 157 stores in Canada, Europe, Asia, and Australia.

This now concludes our prepared comments. We will take your questions. Thank you very much.

Question-and-Answer Session

Operator

[Operator instructions.] We have Anna Andreeva of Oppenheimer.

Anna Andreeva - Oppenheimer & Company

I was hoping you could talk about the timing of the brand presidents hires. Maybe talk about some of the qualifications that you guys are looking for, and then secondly, maybe some color on the early learnings from the testing that you guys have been implementing. Obviously your women’s business saw some nice significant improvement during the quarter.

Michael Jeffries

The brand president search is underway. We’re making progress. We’re looking at people who have strong merchandising backgrounds, but also strong administration and operational backgrounds. But the primary qualification is merchant. We are making progress. We’re not ready to talk about anything yet.

The early learnings from product testing, I think you can see the learnings in the fact that our female business sequentially improved month by month. The testing process is taking hold, and we should start to see more impact of that as we navigate through the rest of the year.

Operator

Next we’ll hear from Matt McClintock of Barclays.

Matt McClintock - Barclays

I was just wondering if Jonathan, you could talk real fast about the commentary that you said on the guidance. You said you were taking a view of a somewhat more difficult operating environment. How has your view changed, especially given the improved cadence of sales into March and April?

Jonathan Ramsden

I think it’s not a dramatic change. We’ve slightly taken down our sales outlook for the year, and slightly taken down our gross margin rate projection. I think we were saying flat to slightly down back in February. When I was saying slightly down, we do expect it to be down on a full year basis.

So we’ve taken both those assumptions down a bit based on what we’ve seen through the first quarter, where there was certainly some greater AUR pressure than we anticipated coming into the year. So there are the changes. They’re relatively minor in the scheme of things. And as we said in the overall guidance, they also have the impact of the additional share repurchase we did in Q1.

Matt McClintock - Barclays

On the accounts payable, is that related to some of the supply chain initiatives that you’ve outlined? It seems like you’ve had two consecutive quarters of pretty good accounts payable results. Is that tied to the Chase, the 45 to 75 days Chase initiative?

Jonathan Ramsden

We’re not going to go into detail there, but we are certainly trying to manage our working capital efficiently and effectively, and I think you’re seeing some of that benefit show up in [unintelligible].

Operator

We have Janet Kloppenburg of JJK Research.

Janet Kloppenburg - JJK Research

Mike, if you could discuss the execution of the store-wide sale events. I know that you’re trying to bring people back to the brand. I’m wondering if you could share with us your strategy here, and if this is something we should expect going forward or if it may moderate.

And Jonathan, I was wondering if you could talk a little bit about the expense savings initiatives. I think you said that we should now expect a lower level of expense savings in the second quarter. I thought the second and third quarter would have the greatest impact. And also, some of the learnings from your payroll reduction in store, i.e. is there more opportunity for that?

Michael Jeffries

Let me start and say, I would love to answer your question, but I really can’t.

Janet Kloppenburg - JJK Research

Okay, can you talk about your promotional strategy, and whether or not you think that there will be modifications to it going forward?

Michael Jeffries

Again, I really don’t want to discuss that for competitive reasons.

Jonathan Ramsden

So let me try to break the expense into three pieces that I think will help clarify that. In terms of the profit improvement initiative, we had originally, although it would build from Q1 into Q2 and Q3, just as we rotated into all of the programs, in the event we were ultimately able to activate both of those programs for Q1, so in terms of the gross savings from the profit improvement initiative, it’s relatively consistent between Q1 and Q2.

The net year over year improvement in operating expenses is affected by two other factors. One is the greater marketing expense investment we’re making in Q2. So marketing expense was up in Q1, but it’s going to be up more significantly in Q2. So that’s one of the factors.

And then the other factor is that in Q1, we were able to affect some other expense reduction levers that we don’t expect to be available to us in Q2 and going forward, in part because we were already starting to impact them last year. They’re above and beyond the scope of the profit improvement initiatives.

So it’s really the net effect of those three things, resulting in - certainly we’re still going to see a significant benefit in Q2 and we’re realizing the fully expected profit improvement initiative benefit, but it’s being offset by those two other factors in terms of other net through to the overall operating expense for the quarter.

Operator

We have Betty Chen of Mizuho Securities.

Betty Chen - Mizuho Securities

I was wondering if Mike, you could talk a little bit about the women’s knit top business. We’re starting to see definitely much more trend-right fashionable items in the stores and we’re wondering how you feel about that in the second quarter, going into back to school. And related to the AUC benefits, is there any way you can quantify what’s the reduction that you saw in the first quarter, will see in Q2, in the back half of the year?

Michael Jeffries

The women’s business has obviously improved. The knit tops business has improved. The encouraging thing about the women’s top business is that it is improving with a planned marked decrease in logo wear. So that’s very encouraging to us. We think that the improvement will continue, we think that the assortments look better.

There was no AUC benefit reduction in Q1, nor will there be in Q2. The AUC reduction will take place solely at the back half of the year.

Jonathan Ramsden

The only thing we could add is that on a full year basis, you’ll see we’ll be down, so the reductions in the back half of the year will outweigh the increases in the front half of the year.

Betty Chen - Mizuho Securities

And is that in Hollister, or is it in all the brands too?

Jonathan Ramsden

It’s not all brands, but it certainly skews to Hollister.

Operator

We have Jennifer Black of Jennifer Black & Associates.

Jennifer Black - Jennifer Black & Associates

I wondered if you could talk a little bit about your online exclusive. I know you said that it’s doing well and it was growing, but I wondered how much growth you expected to see. Could you double it? What percent of sales would you see it being over the longer term? And then also, I wondered if you had any comments on accessories, which look really good.

Jonathan Ramsden

On the online exclusive merchandise, I think it’s hard to say where it’s going to end up. We’re obviously looking at the incrementality of that as we add it. And it’s been increasing over time. So I don’t think we’re ready at this point to say where it goes to over the long haul, but we’ve certainly seen very good results from it so far. I just think it’s too early to say where that ends up.

Michael Jeffries

Accessories, we’re making a Herculean effort there. I can’t tell you that we have any huge successes. We’re doing volume, but we’re not taking the volume to the bottom line. We’ll continue to push. I think that the new branded organization is going to help that business enormously, because I think they’ll be much better thought out in relation to each of the brands. We continue to think there’s a huge opportunity. We’ll get there.

Operator

Next is Adrienne Tennant of Janney Capital Markets.

Adrienne Tennant - Janney Capital Markets

Mike, is improving in the female business across all divisions? And then specifically, can you talk about the improvement at Abercrombie adult, the negative 1% there, and kind of what you think is driving that? And why should we not think that comps get better across the year? So the negative 3% to 4% for the full year, I’m assuming implies negative comps for the remainder of the year, all three brands. If you can talk to that, that would be great.

Michael Jeffries

The improvement in female was across all three brands. The improvement was greatest in A&F adult, and greatest in A&F female. But there was improvement in all three brands. Difference between A&F and Hollister was driven by the female business. Jonathan, why should we not think about comps getting better?

Jonathan Ramsden

Yeah, I think that’s what we’re currently projecting, based on our model. If you look at Q1 and, say, compare with slightly more favorable than Q2, perhaps, given the lack of inventory we had in Q1 of 2013. But I think as we look at the net effect of that and the overall trend, we’re seeing it play out in that down 3% to 4% range for the year, based on our usual trend model that we use for the purposes of the forecasts.

Operator

Our next question will come from Barbara Wyckoff with CLSA.

Barbara Wyckoff - CLSA

Can you talk about the difference in sales performance in the U.S. kind of buckets of stores, the tourist stores versus the sort of A top stores and the rest of the fleet? And then secondly, related to that, the 60 to 70 store closings, could it be more? And they’re all in the U.S., correct? Or will there be select closings internationally?

Jonathan Ramsden

I guess just starting with the last part of the question, the closings could potentially be more. This is what we currently see today. And this time we’ve anticipated that rate remaining probably in that range for the next couple of years.

But typically, we’re not making the decision until a little later in the year. And obviously, one of the factors we take into account is the performance of the stores and whether we see an improvement in the trend, and whether that would lead us to conclude a store should stay open or potentially close if we’re seeing it moving in the other direction.

The closures this year all but one are in the U.S. There’s one international store we are planning to close, which we talked about in the past as being an outlier in terms of its performance. Going back to the sales performance in the U.S., I think overall, there weren’t major differences between the trend relative to the preceding quarters. The improvements we saw sequentially from Q4 into Q1 were broadly consistent across different buckets of stores.

Barbara Wyckoff - CLSA

And one more follow up. Your thoughts on carrying inventory in the store on items like Keds?

Michael Jeffries

Let me respond to that. As you know, we have the partnership with Keds and SeaVees, and that’s been very successful. And we do have a long list of additional collaborations across footwear, apparel, and accessories, which we’re excited to launch in the coming months. We know our customer values these sorts of relationships, and we believe they can improve our brand positioning while giving us some [unintelligible] sales and margin. So we’re at the beginning of it, but we like where this is going.

Operator

Next we have Simeon Siegel with Nomura Securities.

Simeon Siegel - Nomura Securities

I wanted to ask you guys if you could talk about the right way to think about the capital structure and buybacks. I believe you said you continue to anticipate share repurchases from here, from free cash flow, from existing maybe additional credit facilities, so any thoughts around that?

Jonathan Ramsden

We still have 12.5 million shares authorized for repurchase. That came down during the quarter because of the ASR we did in Q1. And we said back in February that we anticipated utilizing a substantial component of that open authorization over the course of the year with free cash flow and potentially use of credit facilities, either new or existing ones, being deployed to accomplish that.

We typically execute our share repurchases on a quarter by quarter basis as we go through the year. So I think at this point, we certainly have a point of view as to where we’re going for the year, but that’s something we will determine as we continue to go forward quarter by quarter. But again, I think if you go back to the 16 million or so shares we had outstanding at the beginning of the year, we expect to work through certainly a substantial portion of that over the course of the year.

Simeon Siegel - Nomura Securities

And quick follow up, if you don’t mind. On the merchandise you’re going to be selling through ASOS, is that just Abercrombie & Fitch concept, or is that going to be companywide?

Jonathan Ramsden

It’s A&F at this point. We may expand it to Hollister, but A&F is confirmed at this point. We’re moving forward on that and Hollister we’re continuing to discuss.

Operator

Randy Konik with Jefferies is next.

Randy Konik - Jefferies

I guess a couple of things. First, in terms of thinking about optimizing the store fleet in the USA, is there any kind of color you can give us between what’s currently the margin differential between the three businesses, i.e. is the Abercrombie Kids business lagging much greater than the Hollister division or vice versa, where it’s driving what types of stores are closing between the businesses?

And then I guess you gave us some color on Germany being almost flat, I believe you said in the prepared remarks. Can you give us some more color on the U.K. part of the business? And then on marketing, you’re upping the marketing spend. Are you assuming a sales lift from that marketing spend, or are you seeing any results of the increased marketing spend yet?

And then finally, is there some sort of free cash flow baseline number that we should be thinking about your company being able to generate on a go forward basis annually?

Jonathan Ramsden

In terms of the performance of the brands, and how we think about that from a store closure standpoint, historically, the A&F same-store margins have been somewhat north of the other brands. That partly reflects the higher AUR and the efficiency that gives us further down the P&L. But it’s obviously a continuum for each of the brands.

We have a decision tree we go through as we think about each potential store closure, which is driven primarily by a financial evaluation, but also includes a brand positioning component. And obviously it reflects an assumption about where we think those particular malls are going to trend over time. And it works through the various questions we address before determining whether or not that store should stay open or closed at the end of its lease term.

But there is a continuum of margins across the fleet for each of the brands, from a few that are still negative in each brand to others that are obviously at or above our overall target benchmark of a 30% formal margin.

Michael Jeffries

The Kids conversation is interesting. We’re running a test on carveouts for the Kids stores in existing stores, which could help us from a profitability [unintelligible].

Jonathan Ramsden

On the same period of your quarter, on the U.K. business, it was still negative on a total comp basis, but did show improvement from Q4. So we are seeing improvement there, as we are in other markets. But the U.K. is still in negative territory from an overall comp standpoint.

From a marketing spend standpoint, we don’t believe yet that the initiatives we’ve undertaken have driven a significant impact on the top line. It’s still very early days on that. We have a much more significant investment rolling in in Q2, as I alluded to earlier.

And I think even beyond that, the important point here is this isn’t a one-time event. This is something we’re going to have to sustain and invest in over a long period of time to really drive that ongoing brand engagement. But we certainly hope to start seeing some tangible benefits in the next couple of quarters, particularly given what we’re putting behind this for Q2 and Q3.

Free cash flow baseline minimum, obviously that’s primarily going to be a function of earnings and we certainly believe we’re going to be able to make progress from an earnings standpoint over the next few years. From a working capital standpoint, we expect to continue to be more efficient, but I don’t think we can answer that with a precise dollar figure, because it’s clearly going to be a function of the overall trajectory of the business over the next few years.

Randy Konik - Jefferies

Can I just ask one little follow up? Do you think that the capex number, let’s say it’s up slightly from the original guidance of like 210 and 220, whatever you said, is that 200-ish type of number a number that we should be thinking about on an annual basis for the next few years? Is that kind of a number we can be thinking about from a capital expenditure standpoint?

Jonathan Ramsden

I’m glad you asked that question on first part, because just as a reminder, we said previously that capex would be $200 million or a bit higher, partly due to the fact that capex came in quite a bit lower than $200 million at the end of 2013, when there was some timing rollovers, which is part of the reason it’s running a little higher this year.

But having said that, as we look to the results of this Hollister storefront test, we felt that the ROI from rolling that out to [unintelligible] of the fleet was certainly justified from an ROI standpoint. And essentially, our capital allocation philosophy will continue to be that we’re going to allocate capital to whatever investments, whether it’s share repurchases or internal investments we think are going to generate the greatest risk-adjusted returns.

As of today, I think we still believe that $200 million is a reasonable benchmark rate for where we would expect to be, but we will continue to evaluate internal and external uses of that capital and focus on where we think we’re going to get the greatest risk-adjusted return over the long haul.

Operator

Paul Lejuez of Wells Fargo has a question.

Paul Lejuez - Wells Fargo

Just looking at the direct to consumer segment, it looks like sales increased almost $40 million, but operating income in the segment stayed the same. So just wondering if that was more of a gross margin issue in the direct-to-consumer channel, or was it higher expenses? If you could break that out.

And then just a quick follow up there, also just wondering about the gross margin performance in the U.S. versus international, how much was each down?

Jonathan Ramsden

On the first part of the question, there were three drivers of the lower DTC margin rate in the quarter. First, the merchandise margin was lower year over year, and that was because back in the first quarter of 2013, when we had kind of an abnormally high margin in DTC, we had minimal clearance inventory in the DTC channel. So margin was way up, comps were not very good in the first quarter of 2013. So that year over year is part of the effect.

Second, we did invest more in shipping promotions this quarter year over year, and we found that to be effective in driving the top line. So that was part of the erosion. And then third, further down the P&L, there are marketing investments we’re making, including expanding digital marketing efforts into Europe in particular, and to some degree into Asia, that [unintelligible] on the quarter, but which to some degree will benefit us in the second quarter and beyond.

I think the important point is that as we look at it on a full year basis, we do expect the margin to remain in the mid-30s. So we certainly expect to see incremental operating income from the channel on a full year basis.

The second part of your question was about gross margin performance in the U.S. versus international, how much was each down. I think we typically haven’t gone into that in any detail, so [unintelligible].

Operator

Next we’ll hear from Oliver Chen with Citigroup.

Oliver Chen - Citigroup

I’m wondering if you could talk a little bit about the similarity of merchandise that’s regular price merchandise versus clearance, and how you see that changing throughout the year, and whether the fast track is improving that differentiation between the two.

Michael Jeffries

We think that we’re making progress there, and it’s a key part of our strategy that we differentiate the styles, that there be more differentiation, and it’s very much part of our strategy to increase AURs. We think we’re making progress there, and there will continue to be more differentiation.

Oliver Chen - Citigroup

And can you just touch upon the traffic versus conversion metrics this quarter?

Jonathan Ramsden

I think that’s something we historically haven’t gone into, Nancy.

Operator

Next is John Morris of BMO.

John Morris - BMO Capital Markets

I guess for Jonathan, just talking a little bit more about the AUC improvements that you see coming, and give us a little bit more color on the genesis of that, where that’s coming from, if it’s product reengineering, or if you’re working with different vendors now, etc.

And then secondly, could you comment a little bit about the composite of the inventory levels that you have on hand? Real nice improvement there, but just curious to know how clean you are and the complexion of carryover versus full price at this juncture.

Jonathan Ramsden

I’m not sure there’s a whole lot we could add on the AUC improvement. It’s going to be in the back half of the year. It’s going to be down on a full year basis with the back half reduction offsetting an increase in the front half. It’s skewed to Hollister, but again, it’s across all brands that we’re focusing on it, but with a greater emphasis on Hollister.

I think it’s coming, as Mike said on the call back in February, from things that we don’t think you or the customer will see in terms of the product, but is a way of reducing the individual unit product cost. So it’s more in that category, I think, than the other [unintelligible].

Michael Jeffries

And new vendors don’t really play a role in this. We’re dealing with our large vendor partners, and they’re playing a key role in helping us make this happen.

John Morris - BMO Capital Markets

Yeah, I just wanted to get a sense that it wasn’t coming out of quality in terms of the product.

Michael Jeffries

You will never see that, John.

John Morris - BMO Capital Markets

And the inventory, Jonathan?

Jonathan Ramsden

So your question was about fall/spring basic mix at the end of Q1? Fall is a bit up relative to where we were a year ago. I think that’s a carryover effect that as you’ll recall we came into 2013 with exceedingly low fall inventory carryover levels. So year over year, in dollar terms, it is up, but we’re comfortable with where we are, both in fall and in overall inventory levels. And again, we expect to be down in inventory at the end of Q2, and then through the balance of the year.

Operator

Our next question will come from Susan Anderson with FBR Capital Markets.

Susan Anderson - FBR Capital Markets

I was wondering if maybe you could give a little bit more color on the better-than-expected comps in the quarter. Definitely, I think the product looks much improved out there, particularly on the women’s side, but also do you think just kind of the higher promotions that you’re utilizing is kind of driving the team [to buy] since the price point’s much more attractive now? And if that’s the case, do you expect this to kind of be the new norm?

Jonathan Ramsden

Just on the first part of the question, the comps actually were slightly lower than we thought coming into the quarter. We said that in the prepared remarks. I’m not sure I understand the question.

Susan Anderson - FBR Capital Markets

I guess better versus where the Street was, what we were expecting.

Jonathan Ramsden

It was a little below what we expected, and I think clearly it was a tough environment for the quarter, and the challenges that we faced across the sector have been well documented. So I think in that context, we certainly felt comfortable where we came out for the quarter. The DTC business was particularly strong as we’ve said, and we continue to be believers that that’s going to be a major growth channel, both in the short term and on longer terms.

Susan Anderson - FBR Capital Markets

And then one quick question too on the DTC. It sounds like it really accelerated versus last year, and you gave a little bit of color on what’s driving that. But is there anything else you’re doing from an omnichannel perspective that’s driving increased traffic and sales to the site?

Jonathan Ramsden

I think there’s a lot of things we’re doing. The benefit is primarily coming from conversion in DTC at this point, and I think that is a reflection of a lot of the investments we’ve been making. We are activating fulfilment, for example, in China. We talked about that in the prepared remarks. When we activated fulfilment within Europe, two and a half or so years ago, we certainly saw a very significant pickup in the business after that as lead times shortened and shipping and handling costs came down.

So we’re frankly seeing very strong growth rates in our Chinese and Asian business generally already, but as we move to more localized fulfilment, more localized websites, we’d expect to see that continuing.

On the channel, we’re moving forward, as we said in the prepared remarks, on multiple fronts there. We’ll have order in store rolled out in the third quarter. We’ll have ship from store rolled out to a significant number of stores in the fourth quarter. We’re focusing on click and collect, reserve in store, those other initiatives. So I’d say we’re sort of working across the gamut of omnichannel.

I think one of the questions we continually have to work through is where we prioritize our investment between driving the international business, which has particularly high margins in ecom, and where we continue to believe in early mover advantage, versus investing in the core business, where in the U.S., there are investments we need to make to remain competitive going forward.

So we have to continue to balance those two things, but I think we feel very comfortable about the investments we have made in the ecom business, and [unintelligible] we see in particular on the international side over the past few years.

Susan Anderson - FBR Capital Markets

And one last follow up if I could. Not sure if you would be able to comment just on any color second quarter today how things are going. I know some of your competitors out there have said that May is not necessarily off to a great start.

Jonathan Ramsden

We generally don’t do that, as you know. So we’re not going to change that practice.

Operator

We have Kimberly Greenberger of Morgan Stanley.

Kimberly Greenberger - Morgan Stanley

Mike, I’m interested to get your views and how your thinking has evolved since I saw you in November. You talked a little bit about the changing landscape and the way that teens and young adults look at brands and fashion. And you were talking about evolving the Abercrombie and Hollister brands to address the new ethos of that younger consumer. For example, becoming more inclusive rather than exclusive. You know, some of those brand characteristics and the way you were looking to evolve them. Have you done any more research on that demographic? And what kind of work on the long term position of the brand do you expect to engage in here in 2014?

Michael Jeffries

I think I said it in November, and we continue to research this customer. I continue to believe that we are taking the brands to a place that is more relevant. I think you can see that in our marketing efforts, and I think you’ll see more of it. I don’t want to get into more detail, but I think that’s very much a part of our current marketing campaigns.

Kimberly Greenberger - Morgan Stanley

Do you have someone internally who’s actually spearheading this kind of research and these initiatives to help move the brands forward and make them more relevant to today’s teens?

Michael Jeffries

Yes, we do.

Kimberly Greenberger - Morgan Stanley

And are you looking to hire anybody else in those roles as well?

Michael Jeffries

No, I think we’re well served, and it’s really being spearheaded by two people in the company. And I feel that we’re moving in the right direction.

Operator

Next we have Dana Telsey with Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group

You mentioned that you’re going to be wholesaling some of the merchandise through ASOS. Do you see opportunities for third-party selling to other types of companies too? And how does the terms of that work? And is there any exclusive product to that versus your stores? And lastly, as you think about the Hollister business, where do you see the greatest area for improvement there?

Jonathan Ramsden

I’ll start on ASOS. I think it’s too early to say what will happen beyond that. As you know, we like to test pretty much everything we do. So we look at this ASOS venture as being in part a test. And then we’ll go from there in terms of where that could take us with regard to other potential outlets.

Whether Hollister is where we see the most improve, is that a product question?

Dana Telsey - Telsey Advisory Group

Yes, product question. Exactly.

Michael Jeffries

I think that’s an interesting question. I think we’ve seen improvement in the female business. I would imagine that there’s the most room for improvement in Hollister female, in total.

Dana Telsey - Telsey Advisory Group

And Mike, as you see back to school, how do you see back to school different this year from last year, in how you’re planning?

Michael Jeffries

Well, I think our assortments look a lot better. We’re looking for it to be a tough season because of the environment, but I think we’re doing the right things in terms of planning the season. I don’t want to get more specific in terms of details.

Operator

Our final question will come from Omar Saad of ISI Group.

Omar Saad - ISI Group

I wanted to ask a question about the new Hollister storefronts. What you’re seeing there in the test phase that’s really giving you the confidence to expand that to I think you said 75 or 100 this year. How it’s different, and what’s working with it, and how the consumer is relating to it, and how it fits into the Hollister more focused brand positioning for the Hollister brand.

Jonathan Ramsden

We established these test stores back in January, so the test has been running for over three months. And the traffic and sales improvements have been pretty stable for a while now, which is what gives us the confidence that this is a sustainable increase. And again, what we’ve modeled into the assumption to support the capital investment we’re making in rolling this out is well below the rate of increase that we’ve been seeing in the test so far, so it certainly allows for that rate to come down to some degree over time.

I think in terms of why it’s effective, I think if you see the stores, it’s somewhat kind of evident just from looking at them. It’s very fresh and new, you can see into the store. You can see the merchandise, and as we said in the prepared comments earlier, the traffic uptick we’ve seen has been well above the double digit increase in sales we’ve seen. So we’re certainly pulling more customers into the store, which is clearly one of our core objectives over the next few years, to drive greater traffic.

Michael Jeffries

In terms of how it fits into brand positioning, I think looking at Hollister today, we are paying more and more attention to the reference to Southern California beach culture. The front clearly reinforces that.

Operator

That does conclude our question and answer session. And that does conclude today’s conference call. Thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Abercrombie & Fitch's (ANF) CEO Michael Jeffries on Q1 2014 Results - Earnings Call Transcript
This Transcript
All Transcripts