Millard Drexler – CEO & Chairman
Jim Scully – Chief Administrative Officer & CFO
J. Crew (JCG) Q3 2010 Earnings Call November 23, 2010 11:00 AM ET
Thank you and good morning. I'd like to welcome you to our listen-only conference call to review third quarter results and the transaction we announced this morning. I would like to begin by reminding you of the company's Safe Harbor language, which I am sure you are familiar with.
The statements contained in this conference call, which are not historical fact, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results might differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC.
And now I would like to turn over the call to our chairman and CEO, Millard Drexler.
Good morning. Before we review our third quarter results, I want to spend a few minutes talking about today's announcement that J. Crew has agreed to be acquired by two private investment firms, TPG Capital and Leonard Green & Partners.
As you probably saw in this morning's release, under the terms of the agreement, holders of the outstanding common shares of J. Crew will receive $43.50 per share in cash, or a total of approximately $3 billion. Our board concluded, at the recommendation of a special committee formed to evaluate the proposal, that this was a highly compelling offer that will provide J. Crew's shareholders with substantial and immediate value for their shares.
As part of this transaction, I will continue as chairman and CEO of J. Crew, and will remain a significant shareholder. I'm looking forward to partnering with TPG Capital and Leonard Green &Partners. This transaction is a clear endorsement of J. Crew and the hard work and dedication of all of our associates.
In a few minutes, Jim will provide some more specifics on the transaction, but first I'd like to provide a high-level review of our third quarter results. In the third quarter, our revenues increased 4% with our comp sales down 1% and direct sales increasing 12%. Our operating income totaled $64 million, a 15% decline versus last year.
Needless to say, we are disappointed with our third quarter results and our fourth quarter outlook. While we are seeing strength from our men's, crewcuts, accessories, Factory and Madewell businesses, the softness has been primarily isolated to our women's retail and direct business. In the short-term, we are taking aggressive actions to move through our inventory as efficiently as possible, which is reflected in our updated outlook.
While we work through the short-term hurdles - and we believe it is short-term - we remain focused on our long-term strategy and will not compromise the integrity of our products or our customer service. We continue to see opportunity to capitalize on all the hard work and investment we have made in our quality, style, and design across all of our businesses.
In our J. Crew store business, we have seen momentum in key businesses that hold large potential for further square footage growth. These include our men's business. We had a strong quarter with the opening at 1040 Madison in late August, and Copley Place in late September. Across the company, our men's business is gaining momentum with our customers.
Our wedding and collections store at 769 Madison has been a great showcase for the category, and we are learning, changing, creating every day, and see this as a long-term rollout opportunity in key markets. We're also seeing really healthy growth in our crewcuts business, both in stores and online. Our customer file is growing dramatically, and we still see a lot of opportunity in key markets to open additional standalone stores.
On the direct side, we launched Factory.com in September, weekends only. And while we are still in the testing phase, we are pleased with the performance. As you know, we also launched Madewell.com in late May. We have expanded our online assortment, and it's exciting to see the impact the website is having on our store business.
We are on track with international online, to add selected key countries in the first half of next year, which will include enhanced capabilities to offer shipping and an improved customer experience. Our factory store business continues to be highly productive for us, and we have plans to accelerate our growth through a combination of new units, both J. Crew and crewcuts factory and expansion in the existing centers.
Our Madewell store openings keep getting stronger. We opened our 20th store last week in Georgetown, and opened in eastern Ohio in late October. We continue to actively pursue new store opportunities in key markets, and we will add 10-15 Madewell units next year.
While we have taken the necessary steps to address our short-term hurdles, the team is focused and moving forward in doing what we do every day - focusing on our products, our style, design, and quality.
With that, I'll turn it over to Jim to provide more information on our third quarter results and on the transaction we announced this morning.
Thanks Mickey. To continue on with the quarter in more detail, total revenues increased 4% in the third quarter to $429 million. Our store sales increased 1% to $303 million. This was driven by a 2% increase in net square footage, partially offset by a 1% decline in comp store sales. In addition, direct sales increased 12%, which includes both our J. Crew and Madewell direct businesses.
Gross profit for the third quarter was $187 million, with our gross profit margin declining 490 basis points to 43.5%. The decline in gross profit margin reflected 440 basis points in merchandise margin deterioration, coupled with 50 basis points of buying and occupancy deleverage.
The merchandise margin deterioration was greater than expected, resulting from entering the third quarter with inventory up 12% over last year, which included approximately 2-3 points due to an acceleration of our initial fall deliveries. And what was not anticipated was our more aggressive promotional posture as a result of the customer response to our women's assortment, as Mickey discussed.
SG&A expenses for the third quarter decreased 2% to $123 million, resulting in 170 basis points of leverage with the rate declining to 28.5%. The third quarter included a decrease of approximately $10 million related to share-based and incentive compensation expense compared to the third quarter of last year. If you were to exclude share base and incentive compensation from both this year and last year, we experienced 80 basis points of deleverage.
Operating income decreased to $64 million, from $75 million last year. Our gross margin decline, partially offset by our SG&A leverage, drove our operating margin to 14.9% The third quarter includes approximately $1 million in losses associated with our Madewell business, versus approximately $3 million in losses last year.
Net interest expense for the third quarter totaled $2 million compared to net interest expense of $1 million in the third quarter last year. This year's net interest expense included a $1.4 million non-cash charge for the writeoff of deferred financing costs associated with our voluntary pre-payment of the remaining $49.2 million on our term loan in August.
Our effective tax rate for the third quarter was approximately 39% as compared to 41% in the third quarter last year. The lower tax rate was primarily the result of the resolution of certain discrete tax items.
Net income for the quarter was $38 million, or $0.58 per diluted share, compared to net income of $44 million, or $0.67 per diluted share, in the third quarter last year.
Turning to key balance sheet highlights, cash and cash equivalents were $312 million at the end of the third quarter compared to $247 million at the end of the third quarter last year.
We ended Q3 with no debt. During the last 12 months we paid down approximately $100 million of debt, including the payoff of our remaining term loan in August.
Inventories at the end of the third quarter were $261 million, representing a 17% increase versus last year, and were up 14% on a per square foot basis.
As we mentioned during our second quarter call, we expected our inventory to sit higher than our sales guidance at the end of the third quarter, driven by a shift forward in the timing of our holiday deliveries by approximately one week and our more conservative approach to the back half. The shift forward of holiday, coupled with a ramp up of investment in Factory.com inventory, drove approximately 8% of our inventory increase relative to last year.
We expect total inventory to increase in the mid-teens versus last year at the end of the fourth quarter, and approximately 10% excluding a partial pull forward of our spring deliveries.
Our fourth quarter guidance contemplates fall and holiday inventory levels comparable to our last year by the end of the quarter. We expect inventory to be in line with our expected sales trend at the end of the first quarter.
Capital expenditures for the third quarter were $20 million.
Turning to our outlook, based on our third quarter performance and the trend of our business, we are now lowering our full year outlook.
For fiscal year 2010 we expect diluted earnings per share in the range of $2.08 to $2.13, which compares to $1.91 for fiscal 2009. This annual earnings guidance reflects comp store sales growth in the mid-single digits, direct sales growth in the low- to mid-teens, operating margin approximately flat to 30 basis points of expansion.
We expect SG&A per square foot will increase in the low- to mid-single digits versus 2009, based on our current sales estimates. The full year also reflects an effective tax rate of approximately 40%; approximately 66 million diluted shares outstanding, which compares to 65 million shares in fiscal 2009; capital expenditures of approximately $55 million, which includes 15 new stores with annual net square footage growth of approximately 3%; and approximately $10 million in losses associated with Madewell versus our previous expectations of a loss of $13 million.
For the fourth quarter, we expect diluted earnings per share in the range of $0.30 to $0.35, which compares to $0.61 in the fourth quarter of fiscal 2009. Our fourth quarter outlook reflects comp store sales in the negative low single digits, direct sales growth in the positive high single digits, and a gross margin decrease of approximately 600-700 basis points as compared to the fourth quarter of 2009.
This decline is higher than the decline we experienced in the third quarter, because our sales guidance for the fourth quarter reflects a more conservative top line trend and we anticipate increased promotional activity during the holiday selling period.
The fourth quarter also assumes approximately 66 million average diluted shares outstanding, which compares to 66 million shares in the fourth quarter of 2009.
Finally, we're all hearing a lot about product cost pressures for 2011 and we wanted to give you some more color. We are seeing cost pressure primarily in raw materials and wages. Our number one priority is, as always, to protect the quality of our goods while maximizing our flexibility, ensuring timely delivery, as well as negotiating price.
We are seeing low single-digit cost pressure in the front half of 2011, and we expect mid-single digits in the back half, but we have not completed our fall and holiday 2011 purchases. We have moved quickly wherever possible to work with our vendor partners on pricing and see opportunities in our supply chain to mitigate some of the cost pressure.
That completes my review of the third quarter. However, before we wrap up, I'd like to provide a few more details on the transaction that Mickey outlined for you.
To begin, a few words on process. As we noted in the release, a special committee of the J. Crew board of directors, comprised of four independent directors, negotiated the transaction and recommended it to the full board. The special committee was advised by independent financial and legal advisors. After a thorough assessment, the board concluded that this transaction is the best way to maximize value for shareholders who will receive a significant premium for their shares.
Also, as we announced, the special committee negotiated a robust "go-shop" provision that enables it to solicit review, evaluate, and enter into negotiations with respect to alternative proposals through January 15, 2011. This extends beyond the holiday season, which as you know is a critical time for retailers like J. Crew. And as you know, there is no assurance the "go-shop" provision will result in a higher offer.
With respect to next steps and timing, J. Crew will file a proxy statement with the SEC, which will contain more detailed information about the transaction and the board and special committee process. If no superior proposal is brought to the special committee, the transaction is expected to close in the first half of fiscal 2011, subject to shareholder approval and other closing conditions.
With that, I thank you for your time and interest in J. Crew. I would just note that this recorded call is in lieu of the previously scheduled earnings call that was to take place today at 4:30 Eastern time. Thank you.