American Eagle Outfitters CEO Discusses Q3 2010 - Earnings Call Transcript

Nov.18.10 | About: American Eagle (AEO)

American Eagle Outfitters, Inc. (NYSE:AEO)

Q3 2010 Earnings Call

November 18, 2010 10:00 am ET

Executives

James O’Donnell – Chief Executive Officer

Joan Hilson – Executive Vice President, Chief Financial Officer

Roger Markfield – Vice Chairman of the Board, Executive Creative Director

Judy Meehan – Vice President, Investor Relations

Analysts

Jeff Klinefelter – Piper Jaffray

Brian Tunick – JP Morgan Chase

Kimberly Greenberger – Morgan Stanley

Christine Chen – Needham & Company

Jennifer Black – Jennifer Black & Associates

Paul Lejeuz – Nomura Securities

Janet Kloppenberg – Jacobs Jenner & Kent

Lorraine Hutchinson – Bank of America

Dorothy Lakner – Caris & Company

Liz Dunn – FBR Capital Markets

Randy Konik – Jefferies

Roxanne Meyer – UBS

Michelle Tan – Goldman Sachs

John Morris – Bank of Montreal

Richard Jaffe – Stifel Nicolaus

Marni Shapiro – The Retail Tracker

Jeff Van Sinderen – B. Riley & Company

David Glick – Buckingham Research Group

Operator

Greetings and welcome to the American Eagle Third Quarter 2010 Earnings conference call. At this time all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star, zero on your telephone keypad. As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Judy Meehan, Vice President of Investor Relations. Thank you, Ms. Meehan. You may now begin.

Judy Meehan

Good morning everyone. Joining me today in Pittsburgh are Jim O’Donnell, Chief Executive Officer, and Joan Hilson, Executive Vice President and Chief Financial Officer. Roger Markfield, Vice Chairman and Executive Creative Director joins us by phone from our New York design center.

If you need a copy of our third quarter press release, it is available on our website, ae.com. As discussed in our press release beginning with the new fiscal year, we will discontinue the practice of reporting monthly sales. Beginning with the first quarter of 2011, we will report sales and earnings together in the quarterly earnings announcement.

Today we will review third quarter adjusted results from continuing operations which excludes the impact of the ARS liquidation this year and a tax benefit last year.

Before we begin today’s call, I need to remind everyone that during this conference call, members of management will make certain forward-looking statements based upon information which represents the Company’s current expectations or beliefs. The results actually realized may differ materially from those expectations or beliefs based on risk factors included in our quarterly and annual reports filed with the SEC.

And now I’d like to turn the call over to Jim.

James O’Donnell

Thanks, Judy. Good morning and thanks for joining us. The third quarter demonstrated progress towards driving our brand forward while enhancing overall profitability. We experienced growth in both sales and operating income during the quarter. The increase in our adjusted EPS reflects the positive impact of recent actions to drive higher sales and expand our profit margins.

It is very gratifying to see the AE brand show recovery in important categories and gain momentum with our customers. I’m encouraged that we are on the right track and excited about the opportunities ahead.

Now I will take you some of the initiatives which drove the third quarter profit improvement. I will also address our longer term plans regarding growth. Starting out with merchandise, we delivered high quality trend right fashions. In fact, the third quarter customer conversion rate was up over last year. We are winning where our merchandise is elevated, special and differentiated. We will not compete on price alone.

A clear example is demonstrated by the strength of AE’s denim and sweaters. These products lines represent the best quality and fashion across several compelling price points. Overall, we were less reliant on promotional activities to drive business which is further evidence of our progress. In the third quarter, lower markdowns delivered an improved merchandise margin. Our inventory is balanced and on plan, and enhanced tools continue to drive more precise buying and allocation to stores and contribute to lower markdowns.

We’ve been successful with reducing inventory overall. Turns are faster. We are flowing goods into the stores more frequently, and with improved capabilities in production and design we’re also leaving more open to buy, enabling us to chase strong categories. In fact, we did this for holiday.

Now regarding product cost, there are clearly pressures in the marketplace with sharp increases primarily in cotton and, to a lesser degree, labor. For the second half of 2010 and spring 2011, costs were held flat; however, we expect modest pressure for summer product. Beyond June, it is still too early to forecast. Importantly, we are doing everything possible to minimize the impact. For example, we are consolidating vendors and fabric purchases and leveraging our volume to negotiate better costs. Additionally, we continue to move production to the western hemisphere which has been advantageous to cost, transportation, and increased efficiencies. What we absolutely will not do is lower the quality or fashion content.

During the quarter, we made progress on streamlining and reducing expense. Essentially, we are transforming the business to shed complexities and unnecessary layers in process and structure. We continue to identify opportunities across the organization. A few of the primary initiatives are centered on supply chain, production, and non-merchandise procurement. We are strengthening our time and action calendar which we believe will yield both savings and efficiencies improvements. Additionally, we are consolidating purchase and reviewing all outside vendor contracts. These opportunities combined with product enhancement put us on a path for further operating margin improvement next year.

Our overall financial strength is clearly reflected in our balance sheet. We are committed to putting our financial resources to work to enhance shareholder value.

Now a few notes on our future growth opportunities, which include Aerie, AE Direct, and international expansion. First, Aerie. It is a critical growth driver with the potential of reaching 350 to 400 stores versus 147 stores currently open. Beginning this holiday, we are repositioning Aerie into a complete lifestyle brand with a meaningful addition of apparel to compliment the intimates business. We expect Aerie stores to be accretive next year. I believe with the team we’ve assembled and the assortment they’re delivering, Aerie could be one of the most exciting new brands in the mall today.

Secondly, AEO Direct will leverage website upgrades and exclusive online products as well as brand and international expansion. We will invest in relevant marketing such as social media outreach and mobile to develop incremental businesses. We will continue to drive the highly profitable direct-to-consumer business with a goal of achieving sales of 500 million.

The third growth vehicle, international expansion, where we will cultivate a global appetite for the AE brand. Our first franchise stores in the Middle East are exceeding expectations; and in 2011, we will open additional franchise stores in Dubai and Kuwait as well as launch flagship locations in Moscow, Shanghai, Beijing, and Hong Kong.

A word on 77kids – 77kids online has proved to be a great catalyst for the new brick and mortar stores and the early success we are seeing. We are encouraged about its long-term prospects.

In conclusion, we are making significant strides and are optimistic that our momentum will continue in the fourth quarter and into 2011. We expect the environment to remain competitive; however, our formula for quality, on-trend fashion at compelling price points will enable us to gain market share and increase our customer base and deliver profitable growth.

Now I’ll turn the call over to Roger.

Roger Markfield

Thanks, Jim. Good morning everyone. As I said on the last conference call, I am very confident that we are moving in the right direction and now we are beginning to see it in our results. No question, the third quarter was driven by more desirable product and improvements in merchandising. We experienced strength in denim, women’s sweaters, and accessories as well as men shorts and knit tops. Across categories, we have strengthened the fashion component and how we interpret trends for the AE brand. Our back-to-school and fall lines featured exciting new trends including modern military and bohemian-inspired styles. We took a step forward in both fashion and quality and we are emphasizing details such as elevated fabrics, washes and embellishments.

Positive sales metrics, including increased conversions and lower markdowns, underscore the customers’ acceptance. Our holiday line extends our expression of style and emerging trends across sweaters and outerwear, as well as accessories and great gift items. If you haven’t yet, I encourage you to visit our new Soho store, the AE brand’s most iconic, hip and current venue, perhaps the best store in the country.

I believe it now more than ever we are clearly different from our direct competition. We are staying true to our 20-year-old college age customer. As a result, the assortments in the stores come together with the right looks, the right energy, and the right mix of categories. Customers are responding to truly compelling and fresh merchandise with little price resistance. As an example, we are seeing average unit increases in many of our areas including sweaters, accessories, and outerwear.

Recent external research has underscored the powerful presence and growing momentum of the AE brand in the marketplace today. According to market research including Piper Jaffray, AE took top position as a favored brand. Additionally, MPD research as of the end of September indicated that we further extended our market share in denim. In fact, we had an increase to 15% total market share of the 15 to 25-year-old customer and rank as the number one specialty store denim brand. We are extremely proud of this and our denim teams for maintaining strong performance year in and year out. Our creative teams, both design and merchandising, have been strengthened across all categories which I believe will lead to a greater broad-based consistency.

Now on to Aerie. As I briefly indicated on the last call, Aerie is being repositioned as a more complete lifestyle brand with a strong point of view. With intimates as the big inspiration, we’re expanding the apparel categories to supplement the strength in bras and undies. The core of the Aerie’s DNA is beautiful, feminine, soft, sensuous yet comfortable, simple and stylist apparel that is made to live in and wear out. It’s a lifestyle brand for a modern 21-year-old girl. Our holiday line is the very first beginnings of this expression. We are very excited about this opportunity and believe it will help drive Aerie productivity and profitability. We continue to view the brand as an additional platform for future growth.

In summary, I am pleased with the momentum we are beginning to see in our business. Our teams are energized and looking forward to the opportunities ahead.

And now over to Joan.

Joan Hilson

Thank you, Roger, and good morning everyone. Our third quarter financial performance represents tangible progress on both top and bottom line results. Turning first to the top line, sales for the quarter increased 2% to 752 million. Comparable store sales rose 1%. By brand, AE increased slightly and Aerie increased 11%. Up against a 9% increase last year due to heavy clearance levels, sales for AE Direct decreased 2%. Despite lower sales this year, direct-to-consumer margins and profitability were higher.

AE brand sales were driven by positive comp performance during the peak back-to-school selling period. Improved assortments translated to higher transactions and an increase in our transaction value. This was due to increases in both the average unit retail price and unit sales. Women’s comps were up in the low single digits and men’s declined in the low single digits.

Now moving on to margin. The merchandise margin improved by 90 basis points driven by lower markdowns. As a result, the gross margin increased 30 basis points to 41.6%. Due to the timing of new store openings including our new Soho flagship, buying, occupancy and warehousing increased 50 basis points as relates to sales.

Now looking at operating expense. Demonstrating continued focus on expense reductions, SG&A dollars declined excluding 2.5 million of severance and related charges. SG&A leveraged by 50 basis points on a 1% comp. We achieved cost improvements in virtually all operating areas with the exception of advertising. We invested in mall and outdoor advertising to support our AE denim assortment during this fall season. For the fourth quarter, we expect SG&A dollars to be down and approximately flat for the year, excluding severance and related charges.

Importantly, our third quarter operating margin increased 70 basis points to 12.2%. This increase was driven by improved sales, lower markdowns, and the impact of our expense initiatives. Adjusted earnings from continuing operations increased 16% to $0.29 per share, which also reflects the benefit from a lower share count resulting from share buyback activity.

Now turning to the balance sheet. Third quarter ending inventory was down 4% and cost per foot was down 2%. Our average weekly inventory was on plan and ending clearance levels were well below last year. Looking ahead, fourth quarter average weekly inventory per foot is planned down in the high single digits.

Consistent with our commitment to control costs, certain capital projects were eliminated while others are coming in on the low end of budget. Therefore, we are narrowing our 2010 CAPEX guidance to 90 to 100 million.

We ended the third quarter with a strong cash position of 631 million, including the liquidation of 150 million of auction-rate securities.

Now in terms of our fourth quarter outlook, due to the importance of Thanksgiving weekend as a gauge to holiday selling, we will provide fourth quarter earnings guidance on Thursday, December 2, along with the November sales results.

Now a word on our profit initiative. Our plan is aimed at improving efficiencies and changing the way we work. In the initial phase, we have identified 20 to 30 million of sustainable cost reductions which will be implemented over the course of the next 12 to 24 months. We have addressed operating structure and completed organizational changes. Other savings relate to stores, procurement, and supply chain. It is important to keep in mind that these savings will be captured in gross margin or SG&A.

We will continue to target additional savings through the later phases of our initiative. As we move through the program, we will update you on the progress and additional savings.

In closing, we are pleased with the turn in our business in the third quarter. We are regaining momentum on the top line and demonstrating improvement in the operating margin. We continue to pursue inventory efficiencies and are pleased with the success in the initial phase of our cost reduction program. This is leading to meaningful progress on the bottom line which we expect to continue as we move forward.

And now I’ll turn the call back over to Judy.

Judy Meehan

Thanks, Joan. And now we’ll move on to Q&A. So that more participants can ask a question, please limit yourself to one question. If we have time, we’ll take follow-ups.

Okay Rob, we’re ready.

Question and Answer Session

Operator

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star, one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star, two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions.

Thank you. Our first question is from the line of Jeff Klinefelter of Piper Jaffray. Please state your question.

Jeff Klinefelter – Piper Jaffray

Thank you. My question is really around the international expansion. Jim, you mentioned opening up flagship stores in, I believe, Moscow and then Shanghai, Beijing, Hong Kong. Just remind me again the timing of that – are you doing it alone or with joint venture partners? How do you anticipate the follow-through in terms of mall opportunities; and just along with that, I was wondering if any domestic right-sizing or closures would be on deck for the next couple years. Thank you.

James O’Donnell

Sure, Jeff. The Moscow, Shanghai, Beijing, Hong Kong flagships are all franchise operations. The Moscow operation is a continuing growth with our Kuwait partner, and the Chinese venture is with a Chinese organization based in Hong Kong. As we move forward, we see tremendous opportunities and we are pursuing cautiously, but we are moving forward with other initiatives with other partners around the world, and you’ll be hearing more about that in the ensuing calls as we begin to complete the contracts and the transaction details.

As far as the domestic front, we will close over the next two to three years somewhere between 50 to 100 stores, and next year we’ll probably close somewhere in the vicinity of about 25 to 30 stores.

Jeff Klinefelter – Piper Jaffray

What is the timing of those franchise stores?

James O’Donnell

The franchise stores that I mentioned, the Moscow, Beijing, Shanghai, Hong Kong are all slated for 2011 with Moscow and Hong Kong and Shanghai for early to late spring, and for Beijing for what we would call back-to-school.

Jeff Klinefelter – Piper Jaffray

Great, thank you.

Operator

Thank you. Our next question is coming from the line of Brian Tunick with JP Morgan Chase. Please state your question.

Brian Tunick – JP Morgan Chase

Thanks. Good morning and congrats on the improvement. Question, I guess, is the sense of where the markdown rate stands today, sort of where it’s been the last couple of years. And given what Roger is saying about his inventory plans and also what you’re seeing in the competitive pricing landscape, what is a realistic improvement on that markdown rate to expect over the next year or two?

Joan Hilson

Thanks, Brian, for the comments. The markdown rate for the third quarter was significantly improved from the prior year; however, we still have opportunity to improve the markdown rate certainly next year in the third quarter; and as we look forward to fourth, again, we expect significant improvement in markdown. As we look forward into 2011, certainly the front half of the year we would expect even more significant improvement in markdown rate given the promotional activity that we saw last year—or excuse me, in 2010.

Judy Meehan

Okay, next question, Rob?

Operator

Thank you. Our next question is coming from the line of Kimberly Greenberger of Morgan Stanley. Please state your question.

Kimberly Greenberger – Morgan Stanley

Great, thank you. Good morning.

James O’Donnell

Good morning.

Kimberly Greenberger – Morgan Stanley

I’m wondering if you can talk about your longer term financial goals. You’ve express a target of getting back to a mid-teens operating margin, and can you just help us understand the pieces of how you get there? Is there a specific recovery in your store productivity that you’re looking for, and how does Aerie fit into that financial picture? Thanks.

Joan Hilson

Thanks, Kimberly. Clearly mid-teen is an operating goal for us. Now, as it relates to 2011, as Jim stated in his remarks, there is pressure that we’re all aware of related to cotton and costs of labor, particularly in the back half of next year, and the magnitude of that we’re working through and it’s too soon to tell what that will be. But clearly we’re working aggressively towards solutions to mitigate those pressures. Some of the things we are doing is keeping our inventories conservative, as Brian mentioned earlier. We continue to have the opportunity to drive to a lower markdown rate through conservative inventories, faster turns, flowing of product more frequently, and more precise allocation. All of those will contribute to the lower inventories, as well as just buying less and pitching our plans closer to trend and chasing into inventories. Importantly, our cost initiatives will also help us drive towards that operating margin goal. We delivered savings in our first phase. As I said, it was 20 to $30 million and that’s expected over the next 12 to 24 months.

So these are the efforts that we have in place to drive towards this goal, a possibility for 2011 and more likely for 2012.

Kimberly Greenberger – Morgan Stanley

Thanks, Joan.

Operator

Thank you. Our next question is from the line of Christine Chen of Needham & Company. Please state your question.

Christine Chen – Needham & Company

Congratulations on the improvement.

Joan Hilson

Thank you.

Christine Chen – Needham & Company

I wanted to ask about Aerie. So you threw out numbers of 350 to 400. I seem to recall at some point you had said maybe that Aerie could get up to 500. Wondering what has changed – is it a type of mall that you’re considering entering? It makes it seem like maybe you want to focus on A-malls, and I’m wondering if there’s a difference in performance of Aerie across different mall types? Thank you.

James O’Donnell

That’s a very good question, Christine. We actually did one time feel that 500 was the magic number of stores. I haven’t ruled that out. The 350 to 400 would be domestic. We still think there is a place—we definitely think there is place for Aerie internationally, but what we are finding is in the mall comparisons is that the brand seems to perform at a much higher level in what we would call the strong A and B-plus shopping centers. It’s not that we don’t have success in some of the smaller markets but it’s clearly less than, so what we’re focusing now on is trying to place the brand in more of the A and B-plus shopping centers with hopefully very, very good locations. But that’s an indicator as of this point.

Christine Chen – Needham & Company

And just as a follow-up to that, long-term do you expect Aerie to be as productive as your AE stores from a sales and operating margin contribution perspective?

James O’Donnell

No. They’re not planned at this particular time to run at the level. I think they can get close but right now we don’t have enough information—or I don’t feel confident enough that I can make that statement that it will. But I do think that if the plan follows the vision of Roger and the merchant team, and we can deliver the right balance of real estate, it will be a very profitable brand and a brand that we’ll be very proud of. And I think it will add a whole new dimension into the shopping center environment. It’s a brand right now that’s very desirable by the shopping center developers. We’ve actually slowed it down a little bit just to kind of get our second wind, and also get this repositioning in a much more formidable state where we feel pretty good about it, and I think holiday will be some of the first indications of this acceptance, but clearly first quarter of ’11 is really where we’ve pitched both the product and the marketing and all the messaging that surrounds the repositioning of the brand that we would like to think we would see a very substantial lift in top line and hopefully convert that into bottom line earnings.

Christine Chen – Needham & Company

Great. Thank you and good luck for the holiday.

James O’Donnell

Thank you.

Operator

Thank you. Our next question is from the line of Jennifer Black of Jennifer Black & Associates. Please state your question.

Jennifer Black – Jennifer Black & Associates

Hi. Let me add my congratulations. My question is on Aerie. Because now it’s a lifestyle brand, I wondered how much crossover we’ll see in merchandise between Aerie and American Eagle going forward. Thank you.

James O’Donnell

Very little, Jennifer.

Jennifer Black – Jennifer Black & Associates

Perfect. Thank you.

Operator

Thank you. Our next question is coming from the line of Paul Lejeuz of Nomura Securities. Please state your question.

Paul Lejeuz – Nomura Securities

Hey, thanks guys. A question on the direct business. Just wondering if you can maybe share with us how big the kids business is as a percent of total, and how should we think about growth in that channel overall in 4Q? Should it still underperform the stores? Thanks.

Joan Hilson

Paul, sure. On the direct business, the kids piece of that is small and it’s basically immaterial to the bottom line performance of that channel. In terms of fourth quarter, we would expect direct to post up some modest growth at the top line, but I just need to reemphasize that the clearance inventory volume from last year, which was heavy in the third quarter, is really what contributed to the down comp, if you will, in that channel. The business remains very profitable and in the growth mode.

Paul Lejeuz – Nomura Securities

Got you, and just one follow up. Do you plan to open Aerie stores next year?

Joan Hilson

Yes, we have a few stores that we plan to open to fill out some markets.

Paul Lejeuz – Nomura Securities

Thanks.

Operator

Thank you. Our next question is from the line of Janet Kloppenberg of Jacobs Jenner & Kent. Please state your question.

Janet Kloppenberg – Jacobs Jenner & Kent

Hi everybody. Congratulations.

Joan Hilson

Hi Janet.

Janet Kloppenberg – Jacobs Jenner & Kent

Hi. I was wondering if Roger could talk a little bit about maybe what he might have done differently in the third quarter business; and maybe if you could talk a little bit, Roger, about the men’s business and if you’re happy with the performance there and if in the fourth quarter you’ve capitalized on some opportunities that could perhaps help comps to accelerate. And I know you’re not giving guidance; I’m just talking about opportunities. Thanks so much.

Roger Markfield

Right, well Janet, third quarter—and you saw the stores and commented that we were really pleased with how we put the assortments together, and the customer responds to the right product. And as you know, we’re really—in terms of the destination for back-to-school, we’re the leading brand and denim is the most important singular category for back-to-school, and our denim assortment, not by—you know, I don’t want to be the one to measure it, but obviously from all of the research, it is stronger than ever. And I’m in the streets of New York every day and it’s just amazing how any street I walk on, I’m always looking at the backsides of people and there’s always an American Eagle jean on someone. So denim really helps us in that particular type of period.

As relates to the men’s business, the average unit retails in most of the categories was up. We’re running very tight and conservative inventories. The denim business was very strong, and overall I would have liked to have seen a little bit more impetus in terms of the volume level, but I think the assortment as you go into the store now for fourth quarter looks right on. We’re the dominant brand in men’s. We’re the number one brand in men’s in the 15 to 25-year-old category, and our share of market has not gone down at all so I feel pretty good.

Janet Kloppenberg – Jacobs Jenner & Kent

Okay, well lots of luck. I hope this is a great season for you guys.

Roger Markfield

Right, and visit that Soho store. It’s quite something.

Janet Kloppenberg – Jacobs Jenner & Kent

Thanks.

Operator

Thank you. Our next question is from the line of Lorraine Hutchinson of Bank of America. Please state your question.

Lorraine Hutchinson – Bank of America

Thank you. Good morning. You had some B&O pressure this quarter from the Soho flagship and other items, and I was just wondering what you expect for the fourth quarter and beyond, and where you think your leverage point will be on that line item?

Joan Hilson

Lorraine, the leverage point is a mid-single digit comp. When we look forward to fourth quarter, I wouldn’t expect to see the same pressure on that line item, and as we move forward into 2011, we see that leverage point come down slightly.

Lorraine Hutchinson – Bank of America

Thank you.

Operator

Thank you. Our next question is from Dorothy Lakner of Caris & Company. Please state your question.

Dorothy Lakner – Caris & Company

Thanks, and let me add my congratulations. The Soho store does look fantastic, especially compared to the much smaller older one. My question is for Roger, going back to the Aerie assortment because it does look just fantastic in that store. So I’m wondering if you could just talk a little bit more, give us more color on what the differences are that you see between the Aerie assortment and the American Eagle women’s assortment; and then just one other add-on, and that is you’ve seen strength in denim and sweaters. What about the knits category, which was a problem for you last year, or earlier this year, excuse me. So what are you thinking about in terms of that category going forward? Thanks.

Roger Markfield

In both men’s and women’s, Dorothy, the knit category overall is pretty strong for us. We redid the teams both for merchandising and design, and we like what we have. And I think if you look at the assortment in the store, the knits look pretty good right now.

As relates to Aerie, we put together a complete new design team, as you know, and a new leader for the entire brand who is an incredibly capable person and has built brands. That combination is very powerful. And when you visit the store, I think, as you said, you’ll start to see the difference; but keep in mind, it’s an intimate brand. The power will come from panties and bras. The bras to us will be like denim is in the Eagle, but the sportswear that’s being developed will help with the productivity and the average unit retail dramatically. And the team that we have assembled has the capability to do beautiful, soft, sensuous apparel that enhances the intimate lifestyle. I think for us this is a major niche in the market that we really can win on.

Dorothy Lakner – Caris & Company

Great. Thanks and good luck.

Roger Markfield

Thank you.

Operator

Thank you. Our next question is from Liz Dunn with FBR Capital Markets. Please state your question.

Liz Dunn – FBR Capital Markets

Hi, good morning. Let me add my congratulations. I guess—I’m looking at your inventory position and hearing you that you have more open to buy and can chase. But I just sort of wanted to know, do you feel like you have enough inventory to drive a positive comp in the fourth quarter? And then also I was just wondering about uses of cash given that you didn’t buy back stock in the third quarter, and you obviously have a very healthy cash balance. Thanks.

Joan Hilson

Okay, Liz. With respect to the inventory, yes, absolutely. We have enough inventory to drive a positive comp. It’s well balanced. Our clearance inventories are down and we’re positioned against targeted key items on preplanned promotions, so feel very good about inventories position for the fourth quarter.

With respect to share buyback, no, we were not active in the quarter; however, over the course of this year we have repurchased 14 million shares, roughly $192 million. We are a believer in share buybacks as if you look at our history over the last several years, we’ve repurchased 50 million shares, almost $1 billion. So we’re a believer in the program. We also have just raised our dividend in the second quarter with a nice yield on that dividend, so we feel very good about our capital program and we continue to evaluate that on an ongoing basis with our Board.

Liz Dunn – FBR Capital Markets

Great. Thanks.

Operator

Thank you. Our next question is coming from the line of Randy Konik of Jefferies. Please state your question.

Randy Konik – Jefferies

Hey great. Thanks. Question for Joan – Joan, can you just go over again these expense savings, specifically the 20 to 30 million. How much would be from the SG&A line versus the gross margin line? And then you said this is just the first phase. How many more phases can we expect, and could those phases be bigger than the first phase? Thanks.

Joan Hilson

Thanks, Randy. The 20 to 30 million is over the next 12 to 24 months, and it really relates to, one, organizational changes and changing the way we work, which did result in the elimination of positions that affect both SG&A and margin. We also have addressed indirect procurement, very specific spending that more affects the SG&A than the gross margin line. And we’re working through some supply chain initiatives as well in store operating cost, that the supply chain affects gross margin; the store operations, clearly, is in the SG&A line. So at this stage it’s a little early to break it out specifically as we are in the midst of our implementation of those initiatives. So once we can get to the timing of when those costs will actually be seeded in our operating P&L, I’ll be able to be more specific.

With respect to later phases, we are working on an ongoing basis identifying now in our second wave here additional cost savings, and we see it, again, in the way we operate our business across all functions. No function has been excluded. So it’s an ongoing basis, Randy, so there isn’t a stop and start to each phase; and we’ll continue to report our progress on each call.

Randy Konik – Jefferies

So if I just hear this correctly, it could be something where the first phase—the second phase is not announced on completion of the first phase. You could have a second phase layered on top of the first phase? Is that correct?

Joan Hilson

That’s correct. That’s correct, Randy. It’s ongoing.

Judy Meehan

Okay. Rob?

Operator

Okay, our next question is from Roxanne Meyer with UBS. Please state your question.

Roxanne Meyer – UBS

Great, thanks. Good morning.

Joan Hilson

Good morning.

Roxanne Meyer – UBS

My question is on SG&A. I’m just wondering based on your flat SG&A guidance for the full year, that implies something like a 10% reduction in dollars in the fourth quarter. So just wanted a little bit more color on how you see—you know, where the costs are coming down. Thank you.

Joan Hilson

Yes, in the fourth quarter we would expect SG&A to be down high single digits, Roxanne, and where the costs are, it’s really across our operating expense lines. Our advertising, however, will be flat we expect in the fourth quarter with savings across all other operating expenses.

Judy Meehan

Thanks. Rob, next question, please?

Operator

Our next question is from Michelle Tan with Goldman Sachs. Please state your question.

Michelle Tan – Goldman Sachs

Great, thanks. I think last year you guys gave us an update on November to date. I was wondering if there’s any sense you can give us on where you guys are tracking; and then also just remind us what the loss is on Aerie roughly for this year and whether you expect it to be accretive on a four-wall or all-in basis for next year. Thanks.

Joan Hilson

So November sales we’ll talk about when we release in the first week of December. With respect to Aerie, we would expect Aerie for next year to be accretive on an all-in basis, so four-wall plus covering of overhead.

Michelle Tan – Goldman Sachs

Great. And what was the loss for this year?

Joan Hilson

We’ve not disclosed the loss; however, I will tell you that it is improved to the prior year and it has been improving each quarter.

Michelle Tan – Goldman Sachs

Okay, perfect. Thanks.

Operator

Thank you. Our next question is coming from John Morris of Bank of Montreal. Please state your question.

John Morris – Bank of Montreal

Thanks. My congratulations to you guys, too, on the progress. Joan, just quickly – you’ve already addressed it quite a bit, but the new store impact on gross margin, can you tell us—you know, nice improvement on gross margin, up 30 basis points. Can you tell us what it would have been ex that impact of just that new store? And then also, Roger, good work on merchandising, etc. The bottoms trends perhaps shifting as we move into next year. Do you use that in terms of maybe moving—broadening out away from denim a little bit more? Clearly, that will continue to be a pretty important category for you. How are you positioned to capital on how those new trends are shaping up? Thanks.

Roger Markfield

Joan, do you want me to take the question on bottoms?

Joan Hilson

Yes, sure.

Roger Markfield

John, yes, obviously denim is forever and we will continue to be dominant. And our inventories are very efficient and we see no slowing of the denim business. With that being said, we’re very clear on the new trends taking place and you will see that impact as we enter into the spring season.

John Morris – Bank of Montreal

Good. We’ve picked up on that, thanks. Joan?

Joan Hilson

Yeah, the deleverage in rent largely relates to the timing of Soho as well as remember that Times Square has not comped yet, so that’s the impact. It largely relates to those two.

John Morris – Bank of Montreal

And are we talking 10 to 20 basis points? What would that have been?

Joan Hilson

Well, we need to leverage rent on a mid-single digit comp, as you’ll recall, and so I would say it’s 20 to 30 basis points related to the stores.

John Morris – Bank of Montreal

Okay, great. Thanks, guys. Good luck for holiday.

Operator

Our next question is from Richard Jaffe of Stifel Nicolaus. Please state your question.

Richard Jaffe – Stifel Nicolaus

Thanks very much, guys, and well done. I guess just a quick follow-on question on expenses. The SG&A savings we’re going to see in the fourth quarter is remarkable. What’s the degree of change, or how do you see that continuing in 2011? I assume the pace will slow throughout the year 2011, and can you perhaps quantify the year-over-year declines? Let’s start there.

Joan Hilson

Richard, the SG&A for next year, we are in the process of finalizing our 2011 operating plan and we plan to talk more about that probably in January at the ICR event. The issue with quantifying at this stage is really getting into the detail of the timing of the savings in our initial phase; so before I can really do that, I need to understand how those will lay into both 2011 and 2012. So it’s really stay tuned on the year-over-year look, but bear in mind we do expect to open net additional stores which will drive some of our operating costs up on a variable basis too.

Richard Jaffe – Stifel Nicolaus

Okay, just a quick question on the kids business – has your passion for that business slackened with Aerie becoming the new darling, if you will, for growth along with e-commerce?

James O’Donnell

No, not at all. We actually have two darlings. We have the twins. We have Aerie and we have 77kids. 77kids, as I stated earlier, we gained a tremendous amount of consumer input from being online for two years. We have translated that into our brick and mortar stores, which we have nine open currently, and I can state that as of this point, we’re pleased with all nine. But we’re going to be very cautious. The motto around here is no more martinosis (sp?). So we’re being very cautious about what we do. Aerie, as Roger stated very aptly, we have 147 stores so we have some critical mass, and so therefore we can expect Aerie to contribute at a much higher rate. The kids business is a few years away but it’s a stepping stone to positives right now, and we’re going to continue on that path.

Richard Jaffe – Stifel Nicolaus

Great. Thanks very much.

Operator

Thank you. Our next question is from Marni Shapiro of The Retail Tracker. Please state your question.

Marni Shapiro – The Retail Tracker

Hi guys. Congratulations everybody and good luck with holiday.

James O’Donnell

Thank you.

Marni Shapiro – The Retail Tracker

Could you just touch a little bit more—and I hate to beat a dead horse here on Aerie, but some of the apparel has looked quite good there, even better than what I’m seeing at the easel stores. So can you talk about just how far down the apparel line you envision this brand? Does it have its own denim assortment? Is that part of the lifestyle? And what happens to fit, personal care – does men’s factor into this—does guys factor into this at all? Just a little bit more color on that.

Roger Markfield

You know, I’ll tell you – I just read a blog on the website Racked, and I think this girl was in our store in Soho and she says it pretty well. She says the lower level features an expanded Aerie collection. It’s just not underwear anymore, folks – the muted colors and cozy textures of the labels, separates and sleepwear, and broad new range of Aerie accessories stand in sharp contrast to the all-American sporty prep feel of the American Eagle main collection and will appeal to fans of dash and dash. This is really an exciting new lifestyle and it has its own sensibility, and we just finished going through—obviously I’ve done the spring lines and I’ve done the summer lines. When you see the spring lines in the store, you will really be excited. It’s all of the beautiful soft apparel that goes with the intimate lifestyle for the girl to be in the dorm or wear outside the dorm. Personal care will become a very big part of it, but not right away. Accessories is a major opportunity for us in this particular business, and the bra and panty business will only grow.

Marni Shapiro – The Retail Tracker

I guess in response to that, the dash and the dash—you know what? I think I’ll take this offline. Good luck for holiday, guys. Thank you so much.

Roger Markfield

Okay. Okay.

Operator

Our next question is coming from the line of Jeff Van Sinderen of B. Riley. Please state your question.

Jeff Van Sinderen – B. Riley & Company

Good morning, and let me add my congratulations as well. Just a broader question for you guys – given the changes in pricing and promotional strategy at some of your competitors like Abercrombie & Fitch, not to single anyone out, but how has that changed how you think about your competitive positioning in terms of price value, if at all? And how do you see that evolving over the next year or so?

Roger Markfield

Jim, would you like me to take that?

James O’Donnell

Sure, Roger.

Roger Markfield

We are our own lifestyle, and as you know, we’re a very value-oriented brand. With that being said, since you mentioned Abercrombie, we have not found that when they promote, it has an impact on us; and we certainly know that their impact of promotion has been quite strong. We run our own business and we are really the main lifestyle. When you think about the size of our brand, the Eagle brand which is a $3 billion brand in the U.S., there’s really—in the 15 to 25-year-old category, we’re the biggest brand. We’re the big highway. So we have to run our business the way we run it, and we have not had difficulty with whoever the competition is, whatever they might be doing; and if you noticed in our metrics, our average unit retail within the AE brand is up with all of that promotion taking place. So we feel very good about where our brand is positioned.

Jeff Van Sinderen – B. Riley & Company

Okay. Great to see. Thanks very much and good luck for holiday.

Judy Meehan

Okay Rob, we have time for one more question.

Operator

Okay, that question is coming from the line of David Glick of Buckingham Research. Please state your question.

David Glick – Buckingham Research Group

Yes, good morning. Just a question on pricing. We recognize the second half of next year is very uncertain. It’s highly fluid and you probably don’t know at this point exactly what your product costs look like; but clearly, as you indicated, they’re likely to be higher. I’m just wondering what your philosophy is as you approach that time frame from a pricing perspective. Do you think you can—and do you plan on passing it through in a competitive environment, and how do you think about that question?

James O’Donnell

Well as I stated earlier, David, there is a number of different initiatives that we have as levers to try to mitigate what looks to be cost increases for the second half of the year. Clearly I think it would be foolish and foolhardy to state, as a value brand, that we were going to arbitrarily take prices up across the board. You know, we look at product all the time, Roger and his team, and where product is of such a—from a factor of differentiation, trend-right and so forth, we can take a look at that type of product and maybe move the prices. But right now what we need to do is get our partners lined up and so that this is sort of an equal sharing of some of the cost increases. So, you know, it’s really too early, as you stated, to actually forecast a definitive action. We have a number of different initiatives that we are that we know will help mitigate some of the increase; we just don’t know how much of it’s going to be able to be mitigated until we actually see what the actual cost is for the raw material and for the finished product. So that’s more to come.

David Glick – Buckingham Research Group

Okay, great. That’s helpful. Thank you very much. Good luck.

James O’Donnell

All right, thank you.

Judy Meehan

All right. I know everybody has a busy day today, so thanks for your participation. Our next announcement will be November sales on Thursday, December 2; and we wish everyone a happy Thanksgiving.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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