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Ann Inc. (NYSE:ANN)

Q1 2014 Earnings Conference Call

May 30, 2014 08:30 AM ET

Executives

Judy Lord - VP, IR

Kay Krill - President and CEO

Mike Nicholson - EVP, CFO and COO

Analysts

Betty Chen - Mizuho Securities

Lorraine Hutchinson - Bank of America

Neely Tamminga - Piper Jaffray

Kimberly Greenberger - Morgan Stanley

Randy Konik - Jefferies

Roxanne Meyer - UBS

Richard Jaffe - Stifel Nicolaus

Marni Shapiro - Retail Tracker

Kate Fitzsimons - JPMorgan

Janet Kloppenburg - JJK Research

Operator

Good morning, ladies and gentlemen, and welcome to ANN INC.'s First Quarter 2014 Earnings Conference Call. At the request of the Company, today's conference call is being recorded. If you have any objections, you may disconnect at this time. Following the prepared remarks by the Company, you will have the opportunity to ask questions.

I would now like to turn the call over to Judy Lord, Vice President, Investor Relations. Please go ahead.

Judy Lord

Thank you, Wendy, and good morning, everyone. Thanks for joining us this morning. I'm here with Kay Krill, ANN INC.'s President and CEO; and Mike Nicholson, our Chief Operating Officer and CFO.

Kay will lead off with an overview of the first quarter performance and provide a brief update on our 2014 strategic growth initiatives, followed by Mike who will then review our financial results in more detail and provide our outlook for the fiscal second quarter and full year 2014. After that, we'll open it up for your questions.

Before turning it over to Kay, we would like to remind you that our discussion this morning includes forward-looking statements, which are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect the Company's current expectations as of May 30, 2014, concerning future events and are subject to a number of factors and uncertainties that could cause actual results to differ materially.

With that, let me hand it over to Kay.

Kay Krill

Good morning, everyone. Thank you for joining us to review our results for the first quarter as well as our outlook and strategic growth initiatives for the year. I am pleased that we delivered first-quarter results that met our bottom-line expectations, given the challenging environment in the first two months. As you know, retailers faced significant headwinds in February and March with the continuation of severe winter weather and soft traffic resulting in a higher than anticipated promotional environment.

On the bright side, our expectation was that business would pick up with the onset of warmer weather and the arrival of Easter, and it did. However we were not able to make up for the top line shortfall we experienced earlier in the quarter. In addition, our strategy to clear product negatively impacted our gross margin rate. However, our team did a great job managing the business and our expenses in order to deliver our bottom-line results.

To recap, total sales for the first quarter reached more than $590 million, up from $575 million last year, with comparable sales down 2%. Gross margin rate was 53.4%. SG&A for the quarter totaled $289 million, reflected continued, disciplined expense management. On the bottom-line, diluted EPS was $0.33, excluding restructuring charge. Looking ahead, we are off to a great start in May, and positive comping quarter-to-date. We’re planning for a stronger year-over-year performance in each quarter for the balance of the year. Overall we remain highly focused on our objective to deliver a third consecutive year of record EPS in 2014.

Let’s turn now to the brands. First, Ann Taylor, comp sales for the overall brand were down 2%. Comps at Ann Taylor were flat and declined 7% at factory. Overall Ann Taylor’s product offering was well received, especially in April. Full price sell through was significantly higher, driving improved AURs, and DPTs and contributing to an improved margin rate. The topline however felt the impact of soft traffic, particularly early in the quarter. In terms of the product Ann Taylor continues to achieve great success with its fashion and novelty offerings. Our client is definitely responding to newness and purchasing items not already in her closet.

By category, results were strongest in skirts, pants, jackets, woven tops, accessories, shoes and outerwear. Handbags and shoes were definitely standouts, especially in fashion silhouettes. Dresses, while soft early on; picked up significantly in May in advance of the Easter holiday and have accelerated into May.

Ann Taylor’s color, print and pattern offering worked very well; navy, ivory black, anchored with the assortment of shades of blues and blush. Prints and novelty also performed well including stripes and geometric prints as well as laced details.

In terms of marketing, Ann Taylor continues to make great progress on its overarching objective of one, strengthening its connection to its core clients, and two, attracting the next generation of Ann Taylor clients. The brand is utilizing multiple touch points to engage her and is increasingly personalizing its outreach to maximize its investment.

Turning now to factory. Performance at Ann Taylor factory reflected continued softness in traffic and a highly promotional environment across the channel. In addition, basic knit tops and key item [ph] sweaters were soft early in the quarter but improved in April and into May. In fact, the overall channel has achieved stronger performance in May versus first quarter. Importantly, the factory channel continues to be very profitable.

Looking ahead, Ann Taylor is well positioned for the season and focused on continuing to drive high full price sell through and increased productivity and profitability. The summer assortment offers great fashion and novelty items, complemented by a strong selection of polished and relax go to work essentials for summer.

The color palette is anchored in white, ivory, black and navy with accents of pinks, blues and red. In May, we’ve seen a strong response across the assortment with virtually every category positive camping. In fact suits, skirts, jackets, hand bags and shoes are all up double digits. Our Print & Pattern offering is also selling well, especially geometrics, stripes and dots. Overall the Ann Taylor brand is off to a great start in May and its positive comping quarter to-date.

Turning now to LOFT, comparable sales for the brand decline by approximately 2%, this reflected a comp sales decrease of 2% at LOFT and flat comps that LOFT outlets. Soft traffic across the sector negatively impacted the top-line at LOFT, especially in the first two months of the quarter with business picking up in April. In a highly promotional environment, LOFT took action to be competitive, which pressured the brand’s gross margin rate.

From our product perspective, LOFT generated a strong response to its fashion offering, highlighted by woven tops, pants, denims, shorts, novelty skirts, accessories and Lou & Grey. Dresses picked up significantly at LOFT in April, with strength continuing in May. However, knit tops were softer than expected for the quarter.

Clients responded well to LOFT print and novelty offering, especially spring tweeds, lace and eyelets, as well as stripes, geometric prints and textured sweaters. And from a color perspective, indigo, chambray, pale green, blush tones, navy and white, all sold well.

With respect to marketing, we are pleased with LOFT’s continued progress in expanding its client base with the brand’s active client file continuing to grow at a double digit rate. As a brand that works everywhere, LOFT has significant potential to further broaden its active client following and we are definitely focused on this opportunity.

Turning now to LOFT outlets, total sales for the first quarter increased 13% and despite soft traffic levels at outlet centers, comp sales were flat with last year. However, sales and traffic have both improved in May and we are encouraged by the momentum in this channel quarter to-date. LOFT outlet remains highly profitable and a key contributor to the bottom line.

Looking ahead, we feel good about LOFT summer assortment. In May we have seen strong performance in dresses, skirts, jackets, white denim, shorts and Lou & Grey, while knit tops have continued to be soft. In addition, we have been extremely pleased with the performance of our swim, peach and maternity offerings online. Overall, the LOFT brand is off to a good start in May and is delivering positive comps quarter-to-date.

On our last call, we spent some time outlining our strategic growth initiatives for 2014. Let me now provide a brief update on where we stand on this initiatives, which lay a foundation for Ann Inc.’s continued long term growth.

First, the strategic realignment. I am very pleased to report that the transition to support and integrate its stores and E-com structure had been seamless. We are operating very effectively with this evolved structure. While it’s early days, I feel our team is better aligned to optimize overall brand growth and even more focus on servicing our client, wherever and whenever she chooses to shop.

Second, omni-channel. A key focus of our team is on enhancing the e-commerce experience for our client and we have a number of key initiatives underway. Some of these will go live in 2014, while others in process this year will be rolled out in 2015, but all of these initiatives will help us to complete more effectively in an omni-channel world.

This year’s initiatives include further enhancements to our web platform, which are focused on improving site speed, functionality and our clients buying experience. In addition, we are developing an improved mobile capability across both brands. With approximately a third of our traffic driven by mobile, even a small improvement in conversion can be very meaningful to our bottom line.

Finally, we continue to prepare for Phase 2 of our omni-channel strategy which will give our client access to our online product from the store environment. Ultimately, this will include both endless aisle and advanced client telling capabilities, in order to fully satisfy her wardrobing needs. We are excited about the many opportunities in this area, all of which continue to position us for long term growth.

Third, real estate. As you know, we are being very mindful in how we are growing our store fleet. As Mike will touch on, our activity is primarily focused on the expansion of LOFT footprint in small and mid-tier markets as well as the outlet channel.

Fourth, international. We are on track to continue to expand the presence of both Ann Taylor and LOFT in Canada in 2014 by adding a handful of new locations. We are also on track to bring LOFT to Mexico in the second half of the year. We think this market is a natural for LOFT and offers significant opportunity to reach a new client base and broaden our geographic reach.

Finally, Lou & Grey, we are thrilled with the initial success that are achieving. The product has received a fantastic reception from our existing clients but is also attracting a new client, who is responding to the casual effortless aesthetic. Lou & Grey combines comfort with style in a way that resonates with how women are dressing today.

As of the first quarter, we are offering an edited assortment of Lou & Grey in all LOFT stores. We have launched a dedicated microsite to better showcase the brand and we have opened our first shop-in-shop in Westport Connecticut, which is off to a great start.

Looking ahead we are planning to open a handful of free standing store locations in the fall. We see significant potential with Lou & Grey as a new offering in an attractive market and as an extension of our full product line.

If you think about it, Ann Inc. has a unique and powerful position in the marketplace. The past five years have been driven by our mission to inspire and connect with women, to put their best selves forward every day. And what began 60 years ago as a singular women’s sportswear brand has dramatically evolved, grown and diversified into a multi-brand full spectrum offering, focused on women. Today we meet all of our wardrobe needs with quality, style and value, from the day to day to the special moments account, from head to toe and to every dimension of her life. This ability to address the full spectrum of her wardrobe needs has afforded Ann Inc. a strong and differentiated competitive position, and we look forward to further building upon this strength as a go to wardrobing destination for women with style.

Let me now turn it over to Mike.

Mike Nicholson

Well, thanks Kay and good morning everyone. Today I’ll start with a summary of results for the first quarter 2014 and then I’ll provide you some perspective on our outlook for the second quarter and full year fiscal 2014.

Beginning with net sales, net sales for the first quarter were $590.6 million, an increase of approximately 2.8% versus the $574.5 million in net sales reported in the first quarter of 2013. By brand, net sales across all channels of the Ann Taylor brand were $219.9 million, up 0.3% from the $219.3 million reported last year. At the LOFT brand net sales were $370.6 million, up 4.3% versus $355.2 million reported last year.

Moving on to comps; total company comparable sales for the quarter decreased 1.8%. At the Ann Taylor brand, total brand comps decreased 2.3% reflecting flat comps at Ann Taylor and a 7.1% decrease at Ann Taylor Factory. At the LOFT brand, total brand comps for the first quarter declined 1.6%, reflecting decreases of 1.8% at LOFT and 0.2% at LOFT outlet.

Turning to gross margin, we reported a first quarter gross margins rate of 53.4% versus last year’s rate of 55.8%, primarily reflecting a higher than anticipated level of promotional activity. From a merchandise margin perspective, while the total company was down year-on-year, Ann Taylor delivered a stronger merch margin versus the first quarter of 2013, which was offset by margin pressure at LOFT and in our factory outlet channels.

Turning now to SG&A. SG&A expenses in the first quarter were $289 million, compared with $287 million reported in the first quarter of 2013. As a percentage of net sales, selling, general and administrative expenses were 48.9%, a 100 basis point improvement when compared with 49.9% in the first quarter of 2013. This improvement reflected a decrease in performance-based compensation, as well as the benefit of ongoing disciplined expense management, partially offset by increases in other expenses to support the expansion of our business.

Moving down the P&L, during the first quarter of 2014 we recorded a pre-tax restructuring charge of $17.3 million in connection with a strategic realignment we announced in March. There was no restructuring charge in the comparable period in 2013. Operating income on a GAAP basis was $9.2 million in the first quarter. Excluding the $17.3 million restructuring charge, operating income for the first quarter of 2014 was $26.5 million, compared with operating income of $33.9 million in the first quarter of 2013.

Net income for the first quarter of 2014 was $5.2 million or $0.11 per diluted share, which reflects the impact of the $10.2 million or $0.22 per diluted share after-tax restructuring charge. And excluding the impact of the restructuring charge, net income was $15.4 million or $0.33 per diluted share, compared with net income of $20.9 million or $0.44 per share in the first quarter of 2013.

Weighted average diluted shares outstanding for the quarter decreased 1% to 46 million shares versus 46.5 million shares in 2013. Our effective tax rate for the quarter was 41%, versus 39% in the first quarter of 2013. Depreciation and amortization in the first quarter totaled approximately $28.6 million, compared with $25.3 million reported in the first quarter of 2013. And finally capital expenditures in the first quarter totaled $26.3 million, compared with $29.3 million in the first quarter of 2013.

Moving on now to the details of our quarter-end inventory. We ended the first quarter of 2014 with total inventory per square foot for the company of 2.7% compared with last year, which reflected increases of 14.7% at Ann Taylor, and 7.8% in the factory outlet channel, partially offset by a decline of 5.6% at LOFT. The dollars per square foot increase at Ann Taylor was a direct result of our previously articulated strategy to buy into more fashion and novelty products at higher initial ticket versus last year.

In fact, on a unit basis Ann Taylor’s inventory per square foot was down slightly. Inventory at our factory outlet channel also reflected a shift in mix as well, as slightly higher unit inventory compared to last year. At LOFT, the decrease in inventory per square foot was due to the successful clearance of early spring product, as well as an overall decrease in units versus the first quarter of 2013. And finally, I am pleased to report that we entered the second quarter with 90% of our inventory representing fresh summer products.

Turning now to store openings and closures, during the first quarter of 2014, we opened a total of 13 stores, comprised of three Ann Taylor factory stores, seven LOFT stores and three LOFT Outlet stores. We also opened our first Lou & Grey shop-in-shop in an existing LOFT store in Westport, Connecticut. We closed a total of six stores during the quarter, comprised of four Ann Taylor stores and two LOFT stores.

The total store count at the end of the first quarter was 1,032 stores, comprised of 264 Ann Taylor stores, 111 Ann Taylor Factory stores, 544 LOFT stores and 113 LOFT Outlet stores. Our store square footage at the end of the first quarter totaled approximately 5.9 million square feet, a 4% net increase from the total square footage reported at the end of first quarter 2013. Overall, we expect to open approximately 50 new stores in fiscal 2014.

In terms of the timing we opened 13 new stores during the first quarter and anticipate approximately 15 openings in the second quarter of 2014 with the remainder scheduled to open in the second half of the year. Regarding our store closure plans, we closed six stores in the first quarter and expect to close an additional 24 stores during the fiscal year with a majority of these closures slated to occur at the very end of the fiscal year. By brand, we expect to open approximately five Ann Taylor stores and 10 Ann Taylor Factory stores. At the LOFT brand, we expect to open approximately 20 LOFT stores with the vast majority of these openings in small and mid-markets where we have been very successful to-date and 15 LOFT outlet stores.

And finally as always, we will continue to manage our real estate portfolio at both brands to maximize profitability and ensure brand presence in key regions and markets. In terms of our strong balance sheet, we ended the quarter with approximately $128 million in cash and no bank debt. We remain committed to using our strong balance sheet, free cash flow and availability under our 250 million share repurchase authorization to further enhance shareholder value as we move through the year.

Before I turn to our outlook, I’d like to update you on the progress of our strategic realignment which we announced in March. As Kay mentioned, the transition to a more streamlined and integrated structure has gone very smoothly and in fact is slightly ahead of schedule.

As mentioned earlier, the first quarter pre-tax restructuring charge was $17.3 million. In terms of savings, we now expect to generate approximately $20 million of the anticipated $25 million in ongoing annual savings in fiscal 2014.

In addition to the financial benefits of the realignment, we have streamlined operations and as part of the restructuring Ann Inc.’s sourcing function now reports to me. So I’d like to take a moment to share my early observations as well as some of the strategic initiatives underway this year in our supply chain.

As always, we will continue to focus on cost containment across the supply chain as we have done with great success for many years. In addition to this ongoing effort, we have identified opportunities for the supply chain to even better support our strategic growth plan namely faster speed to market, enhanced flexibility, as well as efficient logistics and distribution capabilities to better meet the distinctive needs of our differentiated brands.

The first two objectives, speed to market and flexibility go hand in hand. Our ability to move in lock step with our client and a dynamic macro environment is critical to our overall business performance. Our goal is to optimize lead times and flexibility across our supply chain to facilitate merchandising decisions closer to market.

To achieve this, we expect to further consolidate our apparel production among our premier supply chain partners which will benefit speed to market as well as consistency of fabrication and fit. In addition, by further leveraging scale we become even more important to these providers giving us greater flexibility and the ability to contain costs. We have also identified certain product categories where it makes sense for us to expand the use of third party partnerships to facilitate even faster turns and we will be expanding our near shoring program which has been very effective in moving fast moving product categories. Finally we have identified some near term efficiency opportunities around process and technology.

Moving on to our third area of focus, enhancing logistics and distribution, the team has already begun to identify and implement measures designed to improve speed and efficiency from the factory to our stores. Overall, we’re putting even more emphasis on supply chains’ role in translating the distinctive look and feel of each brand. Importantly, with the transition to our integrated structure, we are better positioned to leverage and share corporate resources and best practices across the Company.

Now turning to our outlook for the second quarter and full year of 2014. For the second quarter of 2014 we expect total net sales to be $670 million, reflecting a total company comparable sales increase in the low single digits. Our gross margin rate performance is expected to be 53.5% and selling, general and administrative expenses are estimated to be $295 million.

In terms of the full year, our outlook is as follows. We expect fiscal 2014 total net sales to be $2.610 billion, reflecting a total company comparable sales increase in the low single digits. Our gross margin rate performance is expected to be 53.2%.

Total SG&A expenses in fiscal 2014 excluding the first quarter pre-tax restructuring charge of approximately $17 million are expected to be $1.2 billion compared to SG&A expenses of approximately $1.173 billion in fiscal 2013. The overall increase primarily reflects support for the company’s 2014 strategic growth initiatives including our 2014 new store growth plans.

Our 2014 effective tax rate is expected to be 40%. Capital expenditures are expected to be approximately $120 million. This reflects the following investments. First, $40 million in support of approximately 50 stores for both brands; second, $20 million to support approximately 20 downsizes and remodels; third, $30 million for store renovation and refurbishment programs; and finally, $30 million to support continued investment in information technology, including investments to support our omni-channel capabilities.

Our total weighted average square footage for fiscal 2014 is expected to increase by approximately 3%, and we expect to end the year with approximately 1,045 stores. Regarding our share count, we anticipate that our full year weighted average diluted shares excluding the benefit of potential future share repurchases will be approximately 46.5 million shares in 2014.

For the purposes of modeling EPS in 2014, note that this figure excludes the impact of approximately 1 million participating securities that should be incorporated into your models for a total of approximately 47.5 million shares on a weighted average basis. And finally, we expect to continue to maintain our healthy balance sheet, including a disciplined approach to inventory management throughout the fiscal year.

And with that, I'll turn it back to Kay.

Kay Krill

Thank you, Mike. In conclusion we have entered 2014 with a clear focus on strengthening Ann Inc.’s positions as the go to wardrobing destination for women for every dimensions of their lives; by delivering exceptional products at outstanding value and enhancing our relevance to her. We look forward to continuing to expand our market share, while driving incremental growth through our strategic initiatives. We are very excited about the opportunities ahead for both brands and our company.

With that, let’s open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question today is from Betty Chen from Mizuho Securities.

Betty Chen - Mizuho Securities

Good morning everyone and congratulations on a great performance in a tough environment. I was wondering if you can talk a little bit about the outlet business. It seems like it continues to be impacted a little bit by soft traffic, but if we heard correctly that things have improved, we’re also hearing that additional openings will occur for the balance of the year. Could you remind us on the performance of those stores and the longer term targets and sort of what is the inventory plans for that channel in the back half of the year?

Mike Nicholson

Sure. Betty it is Mike. In terms of outlets, I think it is fair to say that the first quarter, the traffic was tough, traffic was down mid-single digits at both and Ann and LOFT outlets. However, trends did improve as the weather got warmer. The trends improved in April and that clearly has carried forward into May in the second quarter. The traffic has improved pretty materially.

Again, these businesses are valuable contributors to the Company and they enable us to reach clients who wouldn’t otherwise have access to our brands. And we are being very selective in terms of the expansion of our footprint. And we’ve talked previously about longer term targets, Ann Taylor factory call it approaching 125 stores over time, and LOFT outlet approaching 150 stores over time, and we’re really focused on picking right centers, right locations as we fill in within the factory outlet segment.

In terms of inventory, what I’d say is on the last call, I had indicated that we have positioned at the outlet business from an inventory perspective, both Ann and LOFT to deliver low single digit positive comp in the first half of the year. That obviously didn’t happen in the first quarter. We did clear through early spring merchandise and we are well-positioned for the second quarter and summer products, but we are positioned slightly heavier in the second quarter from a unit basis than the underlying trend. So we’re going to work through that over the course of the second quarter and then as we transition into the back half of the year, the inventory at both Ann Taylor factory and LOFT outlet will be positioned even more conservatively.

Betty Chen - Mizuho Securities

Mike, can you just remind us about the profitability of that channel relative to retail?

Mike Nicholson

Yes. What I we’d say is that the overall level of topline productivity is significantly higher than full price brick and mortar. Traditionally, historically the gross margin rate has been healthier as well as we want that channel with a much linear infrastructure. So four-wall flow through it significantly greater.

Operator

Thank you. The next question is from Lorraine Hutchinson with Bank of America.

Lorraine Hutchinson - Bank of America

I just wanted to follow-up on the pricing strategy at Ann Taylor full-line. It times like you’re bringing in some more novel and higher end product. Can you just talk about, if that -- so what categories you are focusing that on, what’s the customers’ reaction to that has been?

Kay Krill

Sure. We definitely, this season, decided to go after fashion and novelty and that absolutely has a higher AUC and higher AIR. And thankfully that strategy was very successful, because that is really what drove the business. All of the fashion and all of the higher ticket items that we invested in Ann Taylor specifically -- because it was specifically Ann Taylor and not LOFT that we did this, was very, very successful. So we are continuing to manage our AUC definitely, but we will continue to focus on the fashion and the novelty component of our assortment. We are very mindful of having the right balance, Lorraine, and managing the AUC. So that’s all at top of mind for us.

Operator

Thank you. The next question is from Neely Tamminga with Piper Jaffray.

Neely Tamminga - Piper Jaffray

Kay and Mike, could we just dig in a little bit more on timing to the mobile update. Just trying to understand when you guys are anticipating on rolling out that optimized site, and more kind of customer friendly mobile optimized site, maybe give us a sense of the complexity behind why it’s taking maybe this long to do it. That would be really helpful.

Mike Nicholson

Sure, Neely. So first, the desktop version of our sites are optimized to work across all major tablets and smartphones and as Kay mentioned earlier on in the call, that mobile in 2013 accounted for about 40% of our traffic, site visits and more than a quarter of our revenue. The good news is that broadly speaking across the company, we’ve embraced the concept of pursuing the fastest path to value and we’ve identified a third-party strategic partner that will enable us to go live with a mobile site in the back half of this year. So we’re confident that we will be in a much better position to provide our clients with a much improved mobile experience.

Neely Tamminga - Piper Jaffray

And Mike, will that include standalone apps, or is it just going to be focused primarily on the site with a lot of effort just on the site.

Mike Nicholson

At this point, the primary focus is on the site with apps over time.

Operator

Thank you. The next question is from Kimberly Greenberger from Morgan Stanley.

Kimberly Greenberger - Morgan Stanley

I am wondering if you can talk to us about -- just longer term management of inventory and any initiatives you might have within your sourcing supply chain to accelerate deliveries when you are outselling your buy, or how do you adjust, how do you create some flexibility in your inventory flow over time, so that you can adjust up and down with variable sales trends? Do you have any initiatives in place to help with that?

Mike Nicholson

Sure. I would speak -- say globally speaking, we have demonstrated a capability and commitment to managing our inventory and even in tougher times and softer business, we have committed to clear through right our season goods and we typically will enter a subsequent quarter or a new season with minimal carryover and so it’s safe to say that you should expect us to move forward and continue to deliver on that commitment. I did talk about in a very high level, some of the initiatives underway within the supply chain and really our focus is on speed and flexibility and really giving the merchants and the designers more time to better respond to fashion trends and overall client demand.

So whether it’s efforts through near shoring, so identifying suppliers, both within the U.S. on the east and west cost, as well as within Latin America, the concept of test and learn and chase back into product is now beginning to be embraced more broadly across the business and I would say just in terms of our process, so we’re really taking a hard look at our end-to-end process from idea to ultimate store delivery and looking to take weeks out and or put those weeks back to where the value is created in the business and again giving the merchants and designers time to better read and react to trends within the marketplace.

Kimberly Greenberger - Morgan Stanley

That’s terrific. It sounds like there’s a nice sales and margin opportunity, if you have a chance to explore some of these things and actually put them into action?

Mike Nicholson

I think that’s fair Kimberly. At the end of the day what this should result in is faster turns, higher full-price sell through. These strategies should give us better confidence and predictors of future success and all of that should yield to higher gross margin realization, higher levels of top-line productivity and with our commitment to manage our expense base, there’s a significant leverage opportunity overtime for the company.

Operator

Thank you. The next question is from Randy Konik with Jefferies.

Randy Konik - Jefferies

So I just wanted to follow-up, I guess on Kimberly’s question; is there any type of I guess, guidepost you can give us in terms of timing of these streamline processes on when they’ll bear the fruit. And then is there any type of, kind of yardstick you can give on turns or X we think turns can move to Y, open the (indiscernible) 43:45 you know what I mean?

Mike Nicholson

Yes. All fair questions for me and I’d say in the last two months I have been spending more time with the supply chain team. So why don’t you give me a couple of quarters to better define clear milestone and mile posts overtime, but I think it’s safe to say that as we look at our gross margin rate performance today, last year in relation to where we’ve been historically, there’s clearly an opportunity for us to drive and improve gross margin rate realization and it is going to be a critical factors in us getting back to double digit operating margins. It’s productivity, its higher gross margin rate realization and the commitment to manage expenses and leverage that expense base.

Randy Konik - Jefferies

Can I ask a follow up?

Mike Nicholson

Yes, sure. One follow-up.

Randy Konik - Jefferies

How about this question? How about in terms of how -- you gave us the nice breakdown of CapEx. How do we -- how should we be thinking about, because I’m thinking about kind of the free cash flow generation potential of the business. How should we be thinking about those different buckets you broke down of CapEx going forward, which ones would maybe fall off, which ones have to go up, which ones stay the same, something like that? Thanks.

Mike Nicholson

Yes, sure, sure. So timely question. For modeling purposes over the next few years, I’ll call it two to three years, I think a good assumption is in the $100 million range. I think clearly across the retail sector we are all taking a very hard look at the size of our real estate footprint domestically and so we’re -- not that we haven’t been thoughtful. We’ve been very thoughtful in the past. We have pruned our fleet where we needed to, but we will be even more strategic going forward as it relates to incremental investment in new square footage. So I can actually foresee going forward, potentially a greater rebalancing between investment and in square footage to potentially technology that will yield even greater bottom line outcomes as it relates to e-commerce, multi-channel, mobile, planning and allocation as well as in the sourcing area.

Operator

Thank you. The next question is from Roxanne Meyer with UBS.

Roxanne Meyer - UBS

My first question is on LOFT. You called out a host of categories that have been doing really well with softness in knit tops and I’m just wondering how important is that knit top category in the 2Q, how much it could weigh you down. And then from a bigger picture perspective, what is you strategy in 2Q as it relates to going after comp versus margin? Are you planning promotions up at both divisions or do you expect either division to be able to pull it in below that of last year from a promotional perspective. Thanks.

Kay Krill

I will take the knit top Roxanne. Earlier in the quarter we landed a lot of our key items in basic knit tops as well as fashion but a greater percent of basics. That is really the part of knit tops that did not move. So well, what we’re seeing is she really is opting for fashion and novelty knit tops in mixed media, woven to knits, and that’s what working. So we’re working through our basics right now, promoting our way out of them. And we have a greater emphasis and focus on the fashion component for the second quarter. So we do expect it to get better but it was definitely softer in the first quarter and you know it’s a significant part of the LOFT business.

Mike Nicholson

And then just in terms of your question regarding promotional activity across the business, our current plans with respect to the second quarter, I think it’s safe to say that we would expect a similar level of promotional activity in the earlier part of the quarter at LOFT, at Ann Taylor, I would say similar to slightly lighter. I would expect Ann to be able to drive gross margin rate improvement year-on-year in Q2 like they did in Q1 and we will absolutely be promotional in the factory outlet channel in the second quarter as I mentioned, despite the fact that we’re happy with the mix of new versus carry over from Q1 into Q2 in factory, we do need to move through units in the factory outlet channel. So a result, our framework that we provided for the second quarter suggests that overall gross margin rate will be down slightly more than a 100 basis points year on year. And then as we move through the third and fourth quarter we would expect to be able to recapture rate versus last year.

Kay Krill

Roxanne, let me just add to the knit top question that it is a definitely a woven cycle right now, shirts and blouses and that category has taken some of the knit top business for sure in LOFT and all of this is baked into our outlook and all of this is baked into the positive comp performance that we’re seeing so far in May.

Operator

Thank you, the next question is from Richard Jaffe with Stifel.

Richard Jaffe - Stifel

Question about, I guess from Mike about real estate and the opportunities you’re seeing on the outlet side or factory side as you begin to at least by my eye appear to be nearly maximizing those channels, and then perhaps the resistance you’re getting or the reception I should say you’re getting for Ann Taylor in terms of trying to shrink that store base and then the horizon for LOFT and different venues you may be exploring for the LOFT from a real estate standpoint.

Mike Nicholson

Sure thanks Richard, I’ll do my best to answer your three part question, so in terms of Ann Taylor’s right size and remodel strategy, at this point we more than 80%, approaching 90% of the fleet in terms of right size and remodel behind us. The strategy moving forward will really be selective growth in key markets and the landlords are absolutely supportive of the Ann concept and providing us with access to best space and best centers. As it relates to LOFT full price, it’s less about major markets at this point and more about mid and small markets. Typically with these real estate transactions, it’s a situation where we have to willing to give up a little bit on the top line. Overall total box volume is less than chain average but we love the economics in that the landlords participate in a very significant way in terms of cost of build were incredibly important in terms of these centers and strip locations and life style centers in these mid to small markets and so warm reception there.

And in terms of factory, you’re right. In terms of Ann Taylor factory, quite frankly we’re approaching what we had multi, going back a few years I identified as our desired fleet size of 125 stores and again we are being very selective with respects to the centers that we fill into, a bit more room to go in terms of square footage at LOFT outlets and again we play a very important role in the overall center and we are looking at new centers and new markets to continue to grow that LOFT outlet concept.

Operator

Thank you, the next question is from Marni Shapiro with Retail Tracker.

Marni Shapiro - Retail Tracker

Just had a couple of quick traffic questions. If you could give us any color -- we know traffic was down but if you can tell us out a little bit to margin and how you’re feeling about conversion rates at this level and you talked a lot obviously then about traffic being down significantly February-March. So I was curious if you were seeing the same trends online and it is was really just she was not ready at all for spring, whether online or store and if you saw the traffic trends online pick up the same way with weather.

Mike Nicholson

Sure Marni, thanks for the question. Traffic, first quarter was tough across brick and mortar. Full price was high single digits to approaching down 10 and factory was consistent in the mid-single digits in terms of traffic being down mid-single digits. And early on in the first quarter quite frankly traffic online, while still positive was tough. However traffic did improve pretty significantly in April and as we turned the quarter into the second quarter, 3.5 weeks doesn’t necessarily make a trend but it’s fair to say that at full price brick and mortar, traffic that went down tenish in the first quarter was running down low to mid-single digits. So it was a pretty significant improvement in terms of the run rate of traffic, full price brick and mortar and in factory we did see an uptick in May as well.

And to your question about e-commerce, we did see a spike in traffic and I would say a return to more normalized levels during the first 3.5 weeks of the second quarter as well. Your question regarding conversion, my expectation is when the traffic is down, we better see a spike in terms of conversion rate and we absolutely did.

Operator

Thank you. The next question is from Brian Tunick with JPMorgan.

Kate Fitzsimons - JPMorgan

This is Kate Fitzsimons on for Brian. Thank you for taking the question. Just a follow up to the gross margin guidance. I understand that inventory will be coming down in the outlet channel in the back half. But can you speak to what other assumptions are embedded in that guidance for expansion, particularly during holiday, just how should we think about some of the puts and takes related to last year’s shipping and handling drag and benefits of the restructuring and so on?

Mike Nicholson

Yes, so really at the end of the day as I think about our guide for the full year and down 70 basis points, again we realized about 240 basis points of year-on-year compression in Q1. We’re guiding to 120 in Q2. And as I think about the third quarter I think about a performance that is flattish to 10 to 20 basis points with a majority of the benefit coming in the fourth quarter. That really is a result of - we’re going to buy the business much tighter year-on-year as well as we do expect to recapture some portion of the rate erosion that we experienced last year related to shipping and handling.

Kate Fitzsimons - JPMorgan

Okay, great. And then just a quick follow-up. You guys are implementing a variety of new strategy in terms of multi-channel and other supply chain. Can you just speak about long-term low double-digit operating margin goal and maybe now how we should think about some of the letters to get there, just post restructuring? Thank you.

Mike Nicholson

Yes, sure. I mean for me first and foremost it starts with productivity and if I think about all the end levels of productivity, total company level in relation to our total square footage, taking into account e-commerce volume as well, this year our full year guide I believe will net us out and call it a 430 to 440 range and based on this year’s guide, what we would need is productivity levels in the range of call it north of 475. So, without holding me to a specific number, let’s call it a range of 475 to 500. The critical driver to us getting back to double-digit operating margins is top line productivity.

With that said, we do believe that there is opportunity in terms of gross margin rate and I articulated some of the early day strategies that I’m working on with the team in the area of supply chain. And I’m optimistic and hopeful that there will be even more opportunity moving forward.

And then with respect to expenses, not only are we committed to continuing to aggressively managing our expense base but also with respect to any incremental cost that we put back into the business, we are looking for both short, mid and long-term returns. And so with all that said, I would say first and foremost, it’s going to come from top line productivity, some accretion in gross margin rate over time but a commitment to manage expenses that gives the opportunity to significantly leverage SG&A over time.

Operator

Thank you. Our final question today is from Janet Kloppenburg with JJK Research.

Janet Kloppenburg - JJK Research

Thanks. I got in under the wire. Just a question, first of all, Kay, the store look just great. I love the Ann Taylor floorset. On the dress category, it sounds like that might be slowing down or becoming more…

Kay Krill

What did you say, Janet I’m sorry.

Janet Kloppenburg - JJK Research

I said on the dress category, it sounds like after many years of tremendous growth that that category may be slowing down and it looks like maybe the pants and skirt category compensating for that. Can you comment on that trend and what does that mean for margins? And Mike, your expense control has been terrific and I’m wondering if we should think that you have flexibility on the SG&A line going forward for the rest of the year?

Kay Krill

Janet, let me just jump in and say dresses were really soft in February and March. It picked up significantly in both brands in April and that has continued into May. So dresses have been strong pre-Easter through now, in really all shapes and lengths. Maxi dresses are amazing right now in both brands in actually all channels. It was definitely a skirt season and from pencil skirts to fluid skirts to maxi skirts, we are seeing strength across the board in the skirt category. Pants, it’s all about the ankle pant. So we are really seeing strength in the structured areas as well as dresses right now.

Mike Nicholson

And then in terms of expenses, Janet, I appreciate your positive feedback on. Thanks. The team did -- across the company did an outstanding job in the first quarter. Is there flex going forward? Listen I think history suggest if the trend is not there, we are able to muscle our way through and manage expenses. And it’s sort of the day in -- day out ongoing effort inside of the business that just continue to look at, take hard honest look and a self-assessment at where we spend, why we spend and whether we’re getting the payback on the investment and that commitment will continue moving forward.

Janet Kloppenburg - JJK Research

Well, thanks and keep it up. It was great execution.

Kay Krill

Thank you. Okay, thank you everyone. We appreciate your interest in Ann Inc. and look forward to updating you on our continued progress in 2014. Have a great weekend.

Operator

Thank you. That concludes today’s conference call. Thank you for your participation.

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Source: Ann Inc.'s (ANN) CEO Kay Krill on Q1 2014 Results - Earnings Call Transcript
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