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Urban Outfitters (NASDAQ:URBN)

Q2 2015 Results Earnings Conference Call

August 18, 2014, 5:00 p.m. ET

Executives

Oona McCullough - Director, Investor Relations

Francis Conforti - Chief Financial Officer

David McCreight - Chief Executive Officer, Anthropologie Group

Richard Hayne - Chairman, President and Chief Executive Officer

Tedford Marlow - Chief Executive Officer, Urban Outfitters Group

Margaret Hayne - President, Free People Brand and Chief Creative Officer, URBN

David Hayne - Chief Operating Officer, Free People Brand

Analysts

Kimberly Greenberger - Morgan Stanley

Dana Telsey - Telsey Advisory Group

Neely Tamminga - Piper Jaffray

Marni Shapiro - The Retail Tracker

Paul Lejuez - Wells Fargo

Lorraine Hutchinson - Bank of America

Janet Kloppenburg - JJK Research

Brian Tunick - JPMorgan

Adrienne Tennant - Janney Capital Markets

Barbara Wyckoff - CLSA

Simeon Siegel - Nomura Securities

Oliver Chen - Citigroup

Anna Andreeva - Oppenheimer & Company

Betty Chen - Mizuho Securities

Matt McClintock - Barclays

Sharon Zackfia - William Blair

Ike Boruchow - Sterne Agee

Liz Dunn - Macquarie

Richard Jaffe - Stifel

Roxanne Meyer - UBS

Laura Champine - Canaccord

Susan Anderson - FBR Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the Urban Outfitters Incorporated second quarter fiscal 2015 earnings conference call. [Operator instructions.] I would now like to introduce Oona McCullough, Director of Investor Relations. Ms. McCullough, you may begin.

Oona McCullough

Good afternoon, and welcome to the URBN second quarter fiscal 2015 conference call. Earlier this afternoon, the company issued a press release outlining the financial and operating result for the three and six month period ending July 31, 2014.

The following discussions may include forward-looking statements. Please note that actual results may differ materially from those statements. Additional information concerning factors that could cause actual results to differ materially from projected results is contained in the company's filings with the Securities and Exchange Commission.

We will begin today's call with Frank Conforti, our chief financial officer, who will provide financial highlights for the second quarter. Dave Hayne, chief operating officer for the Free People brand, will provide a brief update on the Free People Brand. Richard Hayne, our chief financial officer, will then comment on our broader strategic initiatives. Following that, we will be pleased to address your questions.

As usual, the text of today's conference call, along with detailed management commentary, will be posted to our corporate website at www.urbanoutfittersinc.com.

I'll now turn the call over to Frank.

Frank Conforti

Thank you, Oona, and good afternoon everyone. I will start my prepared commentary discussing our fiscal year 2015 second quarter results versus the prior comparable quarter. Then, I will share our thoughts concerning the remainder of the year.

Total company sales for the quarter increased by 7% to a second quarter record of $811 million. This increase was driven by a $39 million increase in noncomparable store sales, opening nine new stores, and a 36% jump in wholesale segment sales. Our retail segment comp rate was flat for the quarter.

Within our retail segment comps, the direct-to-consumer channel continued to outperform stores, posting positive gains, driven by increases in average order value and web and mobile site visitors. Negative comp store sales resulted from decreased transactions, partially offset by higher average unit selling prices, while units per transaction were flat.

By brand, our retail segment comp rate increased by 21% and 6%, at Free People and Anthropologie Group respectively, and declined 10% at Urban Outfitters. Free People wholesale delivered another strong quarter as sales surged 36% to $59 million. These results came from double digit sales growth at department stores and specialty stores domestically and strong international growth.

Gross profit for the quarter increased 2% as compared to the prior comparable quarter, to $303 million. Gross profit rate declined by 194 basis points to 37.4%. The decline in gross profit rate was primarily driven by underperformance at the Urban Outfitters brand, resulting in lower merchandise margin related to poor performing product and store occupancy deleverage resulting from negative store comps at the brand.

Total SG&A expenses for the quarter increased by 11% to $198 million. Total SG&A as a percentage of sales deleveraged by 83 basis points to 24.4%. The SG&A deleverage was primarily due to increased marketing and technology expenses, which drove higher direct-to-consumer traffic.

Operating income for the quarter decreased by 12% to $105 million, with operating profit margin deleveraging by 277 basis points to 13%. Net income was $68 million or $0.49 per diluted share.

Turning to the balance sheet, inventory increased by 4% to $362 million. The growth in inventory was primarily related to the acquisition of inventory to stock new and noncomp stores. Comparable retail segment inventory increased by 1% at cost while decreasing 8% in units.

We ended the quarter with $409 million in cash and marketable securities. During the quarter, the company repurchased and retired 3.7 million common shares for approximately $126 million. We have 6.3 million shares remaining on our May 27, 2014 Board of Directors authorization to repurchase 10 million shares.

As we look forward to the remainder of fiscal year 2015, it may be helpful for you to consider the following. We are planning to open approximately 35 to 40 new stores during the year. By brand, we are planning approximately 11 new Urban Outfitters stores globally, including 3 new European stores, 15 new Anthropologie stores globally, including 3 new European stores, and 12 new Free People stores in North America.

While we are encouraged by the Urban Outfitters brand beginning to show signs of improvement, we believe it is still possible that gross profit margin for the third quarter could continue to deleverage on a year over year basis. This deleverage could be due to lower merchandise margins and store occupancy expense deleverage and could occur despite continued sales and profitability momentum at the Anthropologie and Free People brands.

We believe SG&A could grow at a low double-digit rate for the year. This increase would be driven by increases related to direct and selling support expenses to support our new store growth and continued investment in technology and marketing expenditures to further customer acquisition and retention efforts.

Capital expenditures for fiscal year 2015 are planned at approximately $215 million to $235 million, driven primarily by a new fulfillment center in Gap, Pennsylvania, the expansion of our home office, and new stores.

Finally, our fiscal year 2015 annual effective tax rate is planned to be approximately 35%. Please note that this annual rate includes a favorable nonrecurring federal rehabilitation credit related to our home office expansion at the Philadelphia Navy Yard. We believe we could receive this credit in the third quarter of the current fiscal year.

As a reminder, the foregoing does constitute a forecast, but is simply a reflection of our current views. The company disclaims any obligation to update forward looking statements. Now, it is my pleasure to pass the call over to our Free People brand's chief operating officer, Dave Haynes.

Dave Haynes

Thank you, Frank. Good afternoon everyone. I’m excited to share with you some of the achievements and positive momentum we’re experiencing at the Free People brand. When I talked to you in August of last year, we had just completed a record second quarter, and I’m happy to report the same again today.

We set second quarter revenue and operating income records across all three channels of our business, and collectively, the brand achieved the single best quarter in our history. Moreover, the consolidated brand delivered over 30% revenue growth against similar growth the previous year. In fact, the second quarter marks the ninth consecutive quarter in which we’ve exceeded 25% revenue growth at Free People, an accomplishment that our 1,600 brand associates and URBN shared service partners can be proud of.

These results would obviously not be possible without product the customer finds attractive. Meg Hayne, our brand president, and Sheila Harrington, our chief merchandising officer, and the design and merchant teams they lead have consistently delivered compelling and differentiated fashion assortments that have continued to catch the customer’s eye and heart. And Q2 was no different, with retail segment, full price comps exceeding total comps across all major product divisions.

The merchant and design teams have been hard at work on one of the company’s strategic initiatives, product expansion. Customer response to our intimates offer in the second quarter exceeded expectations, and that category continues to be a standout in the assortment.

In May, we relaunched our FP Movement activewear assortment, which offers owned brand designed apparel for yoga, dance, and surf activities. The customer’s reaction has been very enthusiastic, and we’re excited that Movement has the potential to expand into new categories and channels.

And in another new category, footwear, in the past few weeks, we released our owned brand Free People shoe assortment, with early, but very encouraging response on our websites, in our larger format stores, and via a select set of wholesale doors. We look forward to developing these concepts further, and Sheila and her teams are hard at work on these, and more.

Turning to wholesale, July was the single strongest sales month in our history, and the team enters the back half with future bookings on pace with the current trend. The wholesale team has been supporting strong growth in our department store, brick and mortar, and ecommerce channels, with 13 current department store shop in shops and an additional 3 expected by year’s end.

With our specialty store partners, a large portion of Q2 growth was attributable to our shoe launch, further emphasizing the impact that new concepts can have on top line growth. We believe we have more opportunity to grow the domestic wholesale business by expanding our core collection and introducing product extensions to existing accounts, as well as onboarding new accounts.

The wholesale team has been particularly busy on the international front, doubling non-U.S. revenue over the same quarter last year. In Europe, our London showroom team grew their account base nicely and doubled their revenue, yet we feel we are just beginning to scratch the surface here, with much room to grow.

In Japan, our distribution partner opened an additional two shops, bringing the total to nine, with another three to five planned in the back half. These shops, coupled with over 100 specialty doors in Japan, leave us very pleased with the progress of this partnership.

In China, an expanded relationship with the IT Group of Hong Kong will launch five new shop in shops in Shanghai Beijing, and three other top IT locations this fall. And a new relationship with Myer Department Stores, in Australia, will see eight shop in shops operating by year’s end.

All told, Q2 revenue in Asia more than tripled over the same period last year, and the wholesale team, led by Krissy Meehan Mashinsky, deserves credit for delivering a fantastic overall quarter.

Turning to retail, our North American team drove record Q2 sales and successfully opened five new stores, bringing the current count to 97. By year’s end, we anticipate having 102 stores in operation, with total gross square footage growth of approximately 16%.

The five new stores opened in Q2 averaged 3,000 gross square feet, considerably more than our average, and they reflect our previously stated commitment to larger format stores to showcase our widening product assortment. As a brand, we continue to be encouraged by our customer’s reaction to Free People in larger spaces, and we plan to test increasingly larger formats in the future.

Not to be outdone by stores and wholesale, the direct-to-consumer channel also posted record Q2 results, and enjoyed two-year comps well into the triple digits. Direct grew its total customer base 30% year over year, and our customer retention has been robust.

Technology investments are paying dividends. Our iOS app drove 10% of sales for the channel, as mobile sales grew sharply, and the FP Me program continues to drive community engagement, both in stores and online via style pick uploads, local store events, and customer communication.

The freepeople.co.uk business exploded with triple digit growth in the second quarter as our PR and customer engagement efforts begin to take hold. And this progress has our store team exploring the U.K. for opportunities.

Also in early July, the ecommerce team successfully launched freepeople.cn, our localized China website. The translated website accepts Alipay payments, sells our full global assortment, and offers convenient shipping and return options, all in an effort to reduce the friction of cross-border ecommerce. Although still very early, we are excited for the launch and our ability to foster relationships with new customers in this dynamic market.

This commentary would be incomplete without acknowledging the contributions of our marketing and creative teams. Their success in elevating the Free People brand image can be seen everywhere the brand is experienced: viewed in the creative imagery of our web photography, look books, and catalogs; watched in our FP Presents video series; read daily on our Bldg 25 lifestyle blog; listened to at an FP Me dinner and backyard concert event in Nashville; or felt in the rich physical experiences created by our store display artists.

Wherever it be, every environment touched by these teams exudes the brand’s spirit, and their ability to elevate the Free People brand experience is a significant contributor to our ongoing success.

Our goal is, and has always been, to create differentiated product that our customer will appreciate and to create lifestyle experiences she enjoys being part of. I’d like to thank and congratulate the entire Free People family for accomplishing these goals in spades this past quarter, and I’m eager to see where our talented team will take the brand in the future.

Thank you very much for your time. I will now turn the call over to our CEO, Dick Hayne.

Richard Hayne

Thank you, Dave. Congratulations to you and the entire Free People team. What a great story. Delivering double digit comp sales increases in this environment is difficult enough, but what makes your feat so remarkable is the fact that the brand has produced second quarter double digit comps for three straight years now.

Indeed, this is the ninth consecutive quarter of double digit positive comparable sales. The Free People team has earned a well-deserved thank you for an extraordinary performance.

Like Free People, Anthropologie executed at an exceptionally high level during the quarter. Both brands are setting new industry standards for delivering a strong brand experience and powerful customer engagement.

For the quarter, Anthropologie delivered record sales, near-record merchandise margins, and record operating profits. The penetration of regular price sales continued to grow, and total comp sales increased by 6% on top of the strong 9% comp recorded in the second quarter of last year. David and his team built upon their prior successes, and delivered the highest quarterly operating profit in Anthropologie history.

Again, like Free People, the Anthropologie brand had continued success in Q2, with their expansion categories. The Bhldn wedding product is now offered online, in two standalone stores, and inside five Anthropologie stores. Bhldn experienced extremely strong double digit comp sales growth during the quarter, and total Bhldn sales almost doubled versus the second quarter of last year.

The Anthropologie petites assortment is now offered online and in 21 stores. Sales of that product more than tripled in the second quarter over the same period last year. The success that Anthropologie has experienced launching these categories has encouraged David to begin expanding into other categories.

They are currently working on a larger concept store and will unveil it at our upcoming investor day this September. This prototype store will highlight additional expanded and new categories tailored specifically for the Anthropologie customer.

Turning your attention to the Urban Outfitters brand, their second quarter performance was as we expected it would be when we last spoke on our May conference call. Total retail segment comps for the Urban brand decreased by 10% in the quarter. Initial margins lagged the prior year, and promotional activity increased as we cleared through slower-moving spring merchandise.

As you may recall, we said all teams, and especially the product and creative teams, were focused on getting the back to school product assortments right, reinvigorating the brand experience, and reengaging the core 18 to 28 year old customer.

To do this, we outlined three major initiatives. First, elevate the product by offering better, more fashionable designs; improving product quality by using better fabrics and finishes, and gently raising our average retail prices. Second, heighten the customer experience by improving the visual merchandising through better, more cohesive storytelling, and by creating more sophisticated and compelling imagery online and in stores.

The final initiative was to back away from what had become incessant promotional activity and stand for brand integrity and authenticity. I believe that Ted and Meg and their teams have executed upon all of these initiatives, and the progress is starting to be seen in the assortments and experience as we speak.

I invite you all to visit our new Harold Square or Space 98 stores in New York. I think you’ll agree with me that these stores have a distinct Urban Outfitters personality, with fresh, exciting product and an experience that resonates with the 18 to 28 year old urban-dwelling customer.

The progress is even more apparent in the direct-to-consumer channel, where the impact from improved creative imagery, better storytelling and new product is greater than in the store. The online customer is responding nicely, and regular price comps have been running positive for five out of the last six weeks. At the same time, we are starting to see our retail store customers responding to the new product assortments as well.

Now, given the difficult women’s apparel and accessory businesses at the Urban brand over the past nine months, those teams were rightfully very conservative when ordering initial back to school inventory. Lean buys, combined with strong sell throughs on a number of items have created more out of stock situations than normal.

The merchants are now in chase mode, so further comp sales improvement will be a gradual process, but the Urban group is encouraged by good early reads. Keep in mind the near term goal is to drive regular price traffic and business. As the cadence of promotional activity is reduced, we will use regular price comp sales as a measure of progress. This is similar to what the Anthropologie brand did two years ago.

Typically, at this point in the call, I would provide an update on our long term strategic growth initiatives, but I will reserve that for our September 23 investor day. You will have the opportunity to hear from each of the brand leaders and their teams in more detail, either in person hear it or at our Philadelphia Navy Yard offices or via live webcast.

Before I open the line to your questions, I would like to formally welcome Trish Donnelly to the URBN family. Trish recently joined the executive team as president of the Urban Outfitters brand in North America. She is already making significant contributions, and I have no doubt that she will play an instructional role in the Urban brand’s ongoing growth story. Thank you, Trish, and welcome.

Finally, in closing, I think our 22,000 associates worldwide for their amazing dedication, drive, and creativity. I also recognize and thank our many partners around the world. And finally, I thank our shareholders for their continued support.

That concludes my prepared remarks. I will now turn the call over to your questions.

Question-and-Answer Session

Operator

[Operator instructions.] And our first question comes from Kimberly Greenberger of Morgan Stanley.

Kimberly Greenberger - Morgan Stanley

My question today is actually for Frank. Frank, I think you said during your prepared remarks that your gross margin outlook for the third quarter could continue to deleverage. I’m wondering if you could just give us a little bit of color behind that. Is it that it’s possible that either Anthro or Free People doesn’t anniversary the near record gross margins they had last year? Is it, to Dick’s point, that the inventory buys at Urban are still so lean that that division is likely to negative comp, and therefore you’re baking in the probability of some B&O deleverage? Or do you think, even with the encouraging signs that you’ve got here at the Urban Outfitters brand, that the merchandise margin at the Urban division might be down in the third quarter?

Francis Conforti

You’re right, I did say in the prepared commentary that we believe it still is possible that Q3 margin could deleverage on a year over year basis. Please keep in mind, Q1 and Q2 margin declined about 200 basis points on a year over year basis. We do think it’s possible that we can improve upon that, but we do think there is risk that we could have deleverage in Q3.

The drivers of that deleverage could be still driven by the Urban Outfitters brand store comp performance. The brand appropriately bought inventory very lean coming into the quarter based off of where they were in the first half of the year. They’ve begun now to get some strong reads from the direct-to-consumer business, and some strong sell throughs within the store business. We’ll now be in a transition period where we are going to be in chase mode, chasing into those reads and distorting the inventory in order to help improve our comp performance.

If the store comps are negative in the third quarter, that would drive property deleverage. In addition to that, we believe some of that distortion could result in markdowns as we’re transitioning the inventory to the products that are working well online.

Operator

Our next question comes from Dana Telsey with Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group

On the Anthropologie business, and Free People, where the regular price selling has been going so well, any more commentary on how merchandise margins are there. And when you think about -- and the peak quarterly operating profit that you reached for the Anthropologie division, is there more upside opportunity there? And just lastly, on the Urban division, how are the expenses being managed at the Urban division, and if we see some improvement, will there be some leverage?

David McCreight

Regarding Anthropologie’s Q2 results, as Dick and Frank both pointed out, Anthropologie did see margin expansion and near-record levels with the merchandise margin. And we saw tremendous profitability and continue to feel good about our right priced comps for the quarter. The team executed very well, and we’re always looking for improved opportunity to be more fashion right for our customers.

Tedford Marlow

In regard to the expenses at Urban, on a cash basis in the quarter obviously we were pretty tight-fisted on our expenditure. And cash basis was well below where we budgeted, but of course sales were below where we budgeted as well. So we did experience deleverage. We have identified expense savings. We did that actually coming through first quarter for the balance of the year, and we intend to be pretty tight on the expense of the equation. The store property line, however, is a number which is difficult to deal with in that regard, but other than that number, we’re being quite tight on the expense side.

Operator

Our next question comes from Neely Tamminga with Piper Jaffray.

Neely Tamminga - Piper Jaffray

David, could you speak a little bit more about the pace of expansion of the petites as well as some of athletic gear that you guys have had out there at Anthropologie? What could we see in terms of maybe percentage of penetration of the overall assortment this fall versus where we were a year ago?

David McCreight

As we discussed earlier, we’re looking for ways to create shop in shops and to tailor our offerings to our customers. Direct-to-consumer provides really unlimited opportunity for category expansion. We have rolled out this year a very aggressive number of shop in shops. They’re performing strongly, and we’re going to continue to look for opportunities to see what’s smarter, whether we’re going to bring the petite shops specifically to markets across America.

To date, we’ve focused on the top 20 metropolitan areas, and we’ll examine them sort of metro area by metro area, with the hope being that we can hit more markets in the U.S. over time, whether it’s our current format stores or larger format stores, as Dick alluded to.

She’s a passionate customer who has been underserved, the petite customer, and we’re seeing wonderful response, and so we’re going to continue to look for expansion there.

Operator

Our next question comes from Marni Shapiro from The Retail Tracker.

Marni Shapiro - The Retail Tracker

Can you just talk a little bit about what you’re seeing online? Any price resistance at Urban Outfitters with the new pricing? It doesn’t look like you’re seeing that, but I just want to confirm it. And also, at Free People, it sounds like the DTC is very strong, but is that true in the U.S. as well as globally?

Richard Hayne

I think both online and in stores, we’re seeing no price resistance, as long as it’s the item that she wants. So fashion issue, not a price issue.

David Hayne

And online, at Free People, we are enjoying growth right now in the direct channel, and the international volume is penetrating right now, quicker than domestic. So, it’s something that we’re trying to support with rollouts of new sites like the U.K. and the China site.

Operator

Our next question comes from Paul Lejuez of Wells Fargo.

Paul Lejuez - Wells Fargo

As the wholesale business continues to grow as fast as it is, I’m just wondering what’s happening to the margins in that channel. Are they improving? Or is there some investment happening in that business that’s keeping margin growth in check?

Francis Conforti

We are happy with the margin growth in the wholesale channel. The main focus for us has been expanding the core collection, and working with existing accounts to expand the collection. Expanding the categories that we’re selling through wholesale, and trying to grow internationally. But from a margin perspective, we are pleased.

Operator

Our next question comes from Lorraine Hutchinson of Bank of America.

Lorraine Hutchinson - Bank of America

Just wanted to follow up on the Urban brand. How quickly can you chase product when you see it working? And are there categories that you can chase faster than others to get the product in stores that’s working?

Tedford Marlow

As far as the chase times, we’ve been pressuring the business over the last few years in regard to our own proprietary product and tightening our lead times, but you know, we work in fairly traditional time bands, depending on the product category. If it is cut and sew knit items, which those have been performing well for us, that is a product that can be chased a little quicker than longer lead time items such as sweaters and knitwear.

As well, in regard to some of the branded product in the mix, that does become difficult on replan. So there’s really no new answers in regard to how quickly. We’re pretty aggressive on a week in, week out basis, following up on what we’re reading in the business, with reorder where it makes sense. And that has been the case as we’ve come through the month of July, and kicking off August.

Operator

Our next question comes from Janet Kloppenburg of JJK Research.

Janet Kloppenburg - JJK Research

I had a question on Urban Outfitters. I know you said you’ve had positive comps in the direct channel. It sounds like perhaps not in the stores channel. I was wondering if you could perhaps describe whether or not you’ve had some improvement in the stores, and if the trend is moving in the right direction. And then in terms of the sell outs of the product, are you able to shift that inventory from the stores to the direct channel, and will you be back in stock for those items for the fourth quarter.

Tedford Marlow

In regard to the performance of the direct business, as we came through the second quarter, we did experience positive regular price comps in direct at retail, indirect regular price for the quarter. The store side was more challenging, but as that product as well has come into the mix, coming through the month of July and into the back to school season here in August, there are a number of categories where we’re experiencing strong double digit sell throughs.

That is product where it makes sense to chase for future business as we go forward through the balance of the season, we are doing so. And in regard to the question about fulfilling through the stores, we are able to fulfil direct orders through the inventory in the stores. And no doubt that, to some degree, has helped support the comp growth in the direct to consumer side, coming through the quarter.

The quarter was up against regular price performance last year, indirect was up against a pretty strong double digit performance. So we like what we’ve seen there in regard to the performance of the business, with the elevated imagery and the experience that we’re offering the customer through direct.

Operator

Our next question comes from Brian Tunick with JPMorgan.

Brian Tunick - JPMorgan

I guess maybe Frank, just again, on the gross margin commentary, any update on the full year views? And what kind of store comp do you need to hold the occupancy level flat? And maybe Dick could talk about the DTC, you’ve talked about that goal to get it to 50% of sales longer term. I’m sure you’ll update us at the analyst day, but can you talk about some of the near term omnichannel wins, what you’re doing in single SKU initiatives, the WebEx product, loyalty rollout, just anything would be helpful.

Francis Conforti

Related to the full year on gross profit margin, we’re certainly going to be in a transition and chase mode here in Q3, which is significantly going to affect how the year lands. So we don’t have a strong point of view that I would want to give you there just yet. It’s going to depend on if and how well we can kind of improve the business here in the third quarter.

We typically, or we haven’t for a long time now, given out what store comps needed to be in order to leverage property with the direct-to-consumer business continuing to increase from a penetration standpoint. That statistic would only be good for that point in time that we gave it out. It continues to evolve as the business continues to grow, so we’ve held out on doing that for some time now.

Richard Hayne

I think I’ll hold off on some of this until September, and our investor day. But I do want to pass along one thing that we’ve, I guess, relearned, or have had impressed upon us again, and that is the power of imagery in the web area. Free People had a couple of styles that came in during the quarter, and they performed less well than the folks at Free People thought they should. And they went back and reshot those images and saw a fairly substantial lift in the selling.

So again, it brought home to us how important the imagery is when we’re talking about web. And we’ve also had that same experience in stores with imagery. So I think that’s one of our big learnings. Again, we’ll go over a lot more of this in September.

Operator

Our next question comes from Adrienne Tennant of Janney Capital Markets.

Adrienne Tennant - Janney Capital Markets

My question is actually Ted, for the UO product, are there any commonalities? I know you guys tend to look at attributes and the types of things that you could reorder into to give you more confidence that things are working. So any commonalities in terms of the merchandise at regular price that is comping online?

And then, secondarily, Dick, can you give us any update on your tuck-in acquisition strategy? Any thoughts there?

Margaret Hayne

The categories and items that we felt strongest about are really working. We have a lot of strong indicators of what to do with this product, and how to move forward going into the spring season. So we’re really excited about the hits that we’re getting, and learning a lot about future business.

Richard Hayne

As far as acquisition strategy is concerned, we have had many, many discussions with a number of parties. We’re not in any rush to do this. I would characterize it as the market is a bit frothy right now in terms of valuations. And I guess as an old Scotsman, I don’t like to pay what I think is too much. So we have had discussions. We keep having those discussions, and I think at some point, hopefully still this year, we may have something to report.

Operator

Our next question comes from Barbara Wyckoff with CLSA.

Barbara Wyckoff - CLSA

This is question for Ted. If you could wave a magic wand, would you close some of the stores on college campuses? And are the items that are in that channel selling any differently than mall versus street stores?

Tedford Marlow

That’s as bold a question as I’ve had asked in 13 years of listening to these. And my answer is a very strong no way would I think of closing any of the 33 locations that are adjacent to college campuses. I think that is a real defining piece of real estate for us. I think it challenges us to stay true to our brand’s position. And it still represents enormous opportunity for the business going forward. In fact, I would have interest in finding other locations. There are some locations that we haven’t tapped, college campus related. And we’re interested in finding real estate to tell our story there.

In regard to the difference, yes, there is a definite different, but not just specifically college related to whether it’s a mall community or a metro level store. We slice and dice our store grid a few different ways, and we try our best to merchandise these stores with a sensitivity to what works in each locale, based on attribute and the customer that trades there. So yes, there’s a definite, definite difference in the college community stores versus what we see in our other store groups.

Richard Hayne

Barbara, that was such a provocative question, I feel obliged to second what Ted just said. There is absolutely no way we are thinking of closing college stores. As a matter of fact, to the degree we can, we’re thinking of enlarging and hopefully adding more.

Operator

Our next question comes from Simeon Siegel with Nomura Securities.

Simeon Siegel - Nomura Securities

Frank, can you speak to the difference between inventory cost and units? Is that AUC, is it mixed? Anything there? And then you mentioned the increased marketing in technology for DTC. What’s the right way to think about that line item going forward as DTC continues to grow?

Francis Conforti

Yes, you’re right on the inventory differential between cost and units. That is being driven by the Urban brand product being elevated slightly, as we talked about, where the product has been positioned over the last couple of. We did talk about elevating the product, which is why you’re seeing costs at a plus one and units at a minus eight. That’s the biggest driver, not the only driver. Some of it’s mix, but that’s the biggest driver of that delta there.

As it relates to the marketing and the technology investments, you know, it’s hard to look three, four years down the road, as to where we’ll need to be with these investments. We keep talking about how important mobile is to our business today, and I think four or five years ago, we never would have anticipated the significance or the magnitude.

So we plan on SG&A coming in at the low single digits, and we certainly continue to invest in marketing and technology initiatives. We believe they’re driving very strong results as the direct-to-consumer business, not only on customer acquisition, but as well as on a customer retention.

And just to give you some highlights as to some of the initiatives that we did land in the quarter, as Dave Hayne mentioned earlier in his commentary, we did open up our first China website. FP China is open. We did launch an Urban Outfitters Android app in the quarter. We did launch pick, pack, and ship, which is store fulfilment in Europe. We had it in the U.K., but we didn’t have it in the rest of Europe. That launched in this quarter.

And we also did launch Anthro E.U. mobile. So we continue to land a lot of these planes in these initiatives that we think will continue to help drive very strong direct-to-consumer growth for years to come, hopefully.

Operator

Our next question comes from Oliver Chen with Citigroup.

Oliver Chen - Citigroup

Regarding some of the classifications that you had an opportunity to chase, what was the nature of those? And if there’s some similarities with the pricing tier or the types of items, that would be great. Also, as you do engage in the journey to gently elevate average unit retail, what’s the strategic rationale there, and how should we observe that as we look at your stores?

Tedford Marlow

Just in regard to the categories and the chasing of product, I really want to avoid getting into specifics there. It’s a very competitive playing field that we play in, and we reserve the right to kind of keep that in house. In regard to the strategic rationale on elevating, it’s not so much, I would say, necessarily, that we were going at that to put more expensive product. As a matter of fact, that has really nothing to do with the approach. We were really looking to open up the opportunity to merchandise as a strong product story as possible for the customer that is the core customer of the brand.

And we felt like our costing, combined with our markups that we strive to archive, we really had boxed ourselves into offering a product that was below where we felt like we should be in the market, on our offer. It’s not across the board. There were some very specific areas that we looked at. But as we have moved into a bit more elevated product offer in all areas of the business, we have seen positive response to our offer, if the product is the right product.

Operator

Our next question comes from Anna Andreeva of Oppenheimer.

Anna Andreeva - Oppenheimer & Company

A question on inventories. In great shape coming out of the quarter. Do you think some of that site inventory position potentially kept the upside at Anthropologie? Anything behind the softer accessories performance at this division? And a question to Frank. How should we expect inventories to shake out for the back half, especially given that Urban is in a chase mode?

David McCreight

We have, at Anthropologie, been spending a lot of energy obviously trying to buy what’s right, looking to distort into the right fashion in key items. And certainly, our development of best-in-class technology has allowed us to manage the delicate balance across channels.

We have had six straight quarters of year on year turn improvement, and I think we continue to watch that. We had, thanks to the team and our shared services partners, we did deliver great operating income margin expansion and merchandise margin expansion. That being said, we exited the quarter, or entered the new quarter, lighter than we would have liked. So we’re continuing to look and chase as well.

Francis Conforti

The second part of your question, you’re right, the Urban brand is in a bit of a chase mode here, and we do believe at the end of the third quarter, they could end with retail slightly up, with units though still negative on a year over year basis. And as it relates to Anthro and Free People, we expect inventory to basically continue to stay in line with their sales rates.

Operator

Our next question comes from Betty Chen from Mizuho Securities.

Betty Chen - Mizuho Securities

I was wondering, Frank, if I missed it early, could you clarify or give us any direction on the level or the magnitude of gross margin deleverage in the third quarter? That would be really helpful, as you did in the first half. And then in terms of the euro brand, Ted, could you remind us, when you merchandise, how is that as a blend of third-party branded and your exclusively, internally designed. And I think sometimes you also do exclusive with third-party. And how we should also think about the margin profile for each of those product sources.

Francis Conforti

As I said earlier, the first half of the year, we declined about 200 basis points. We believe it is possible we can improve upon that number and have a better year over year number, but it is still possible in the third quarter that we could deleverage on a year over year basis. All of this is going to depend on how well we chase into it, and how well we’re able to distort our inventory in the stores, as well as several other initiatives we’re working on and improving within the brand.

Tedford Marlow

In relation to the branded product piece of the question, the percentages in the mix are pretty much where they have historically been over the last half a dozen years. However, we have seen branded product outperforming expectations, both in North America and Europe, and we’re expressing some interest in building out a bit more branded offer in the overall assortment, both in North America and in Europe.

Operator

Our next question comes from Matt McClintock of Barclays.

Matt McClintock - Barclays

With such strong growth for so long in the wholesale channel, I was just wondering if you could give us your updated thoughts in terms of overall penetration in door count for wholesale domestically. Clearly, there’s a lot of growth internationally. At what point does that switch over from a door growth story to more of a space within existing doors, or just velocity story?

And Frank, I’m sorry if I missed it, but it sounds like a lot of the investments you’re making, or you’re committed to, are longer-term investments. I was just wondering if you could remind us the flexibility you have to manage your expense base, at least over the back half of this year, should varying levels of consumer demand materialize.

David McCreight

We are looking to grow internationally. That is one of our strategies. And the opportunity there is obviously a lot newer, so we are looking to mainly partner and find new doors to enter. The domestic opportunity is clearly one where expanding categories is more of our target. So I think that the opportunity domestically is certainly to open more doors, but also to expand categories.

Francis Conforti

The two main areas that are fairly variable in SG&A are marketing and direct store controllable. And as the marketing initiatives, the thing that I love being of course the finance guy, loving the analytics, is really within two weeks, you get a very good sense whether the initiative is working or it’s not. And I can tell you that myself and the teams have very robust analytics that they look at on a regular basis, and fund initiatives that are giving fruit, and pull back in areas where they’re not seeing the return that they hope. And that’s really truly the case at all of our brands.

The other big area is the direct store controllable, and we guide that from a rate and a dollars perspective as we look at the store comps. And I can tell you, when store comps are negative, we certainly pressure that item pretty heavily. And Ted and team certainly have done that and will continue to do that if the market indicates it’s necessary.

Operator

Our next question comes from Sharon Zackfia of William Blair.

Sharon Zackfia - William Blair

A few more follow up questions on the Urban Outfitters brand. I guess as we looking forward into the fourth quarter, do you expect chase to impact the ability to either get to positive comps at Urban, or to post margin improvement on the gross margin line in that division?

Francis Conforti

I’d tell you, we’ve got a couple of real big weeks ahead of us here, and a big quarter ahead of us here, as we continue to make improvements at the Urban Outfitters brand and continue to transition [into the store] our inventory. I think it’s hard for us right now to have a clear lens into margin and comp improvement in the fourth quarter, and I would really hesitate to give you information that I just don’t feel confident on. So I think let us get through some of the improvements that we’ve got to get through in the third quarter, and then we’ll revisit on the next call.

Margaret Hayne

I would like to say at Urban Outfitters we are a work in progress. As I said earlier, we have identified items that are working, and categories that are working. We’re also building strongly into the talent team and design, and the merchant team. We have a lot to be hopeful for and look forward to going into the fourth quarter and into spring.

Operator

Our next question comes from Ike Boruchow with Sterne Agee.

Ike Boruchow - Sterne Agee

I guess Frank, just a quick one for you on capital allocation. I don’t think anyone’s mentioned it yet. You bought back another decent amount of stock in the quarter. The cash balance is now down a little year over year. Is there a certain level of cash you want to maintain on the balance sheet? And just curious, going forward, your appetite for buyback?

Francis Conforti

I thought I was going to get through a call without a buyback question. As has been the case for the last several quarters, if not years, we’ve got a board meeting coming up next week. We will continue to review our capital allocation. As you saw, we did buy back 3.7 million shares in the quarter, which takes us to just shy of 14 million shares for the year. So we have been opportunistic with our buyback. It will be something that we’ll revisit at our board meeting and see where we feel our levels of cash and buyback are appropriate going forward. So I think you’re going to have to check back with us on that topic.

Operator

Our next question comes from Liz Dunn of Macquarie.

Liz Dunn - Macquarie

I really appreciate a lot of the commentary from Meg regarding Urban Outfitters. I’m just trying to understand where you are with the assortment. And I apologize, I know there have been a lot of questions, but is it that you just approached the season with sort of a very lean approach and a lot of open to buy to sort of see what started to resonate with customers, and then are chasing after that, and so you have less things that aren’t working, because you bought leanly across the board? Or are we really at the point where we’re starting to see a lot more cohesion between the trend team and the merchants?

Margaret Hayne

There’s definitely a lot more cohesion between the trend team and the merchants. We’re also resonating with the customer more through our imagery and the store experience. So we wanted to take it a little bit easy going into the season, based off of our past history. And as I said earlier, I’m really excited by, the things that we believe are really working. And we see opportunities across the board in apparel and accessories for women.

Operator

Our next question comes from Richard Jaffe of Stifel.

Richard Jaffe - Stifel

A question, Dick. You made a comment that initial margins at Urban have been disappointing. I’m wondering, is that a change in the strategy in your plan to move average retail upwards at Urban? I’m curious about the initial margins shifting around.

Francis Conforti

Sorry if that commentary was confusing. The biggest driver on deleverage in initial margins at the Urban Outfitters brand right now is mix related. With the home business being as strong as it is, and some of our apparel categories still being challenged, you’ve had home increase as a total penetration of our overall sales assortment. And that has a negative effect on our IMU.

Our IMU actually within categories is actually fairly comparable on a year over year basis, and we’re fine with that. So the biggest driver right now in IMU is mix related. It’s not disappointing performance on a year over year basis within category.

Operator

Our next question comes from Roxanne Meyer of UBS.

Roxanne Meyer - UBS

You alluded to, earlier, last year you had a younger customer, a transitional customer, that was coming in your store, and your assortment did skew to a little bit more basic and entry level. And I’m just wondering now, at this point, if you started to see your age appropriate customer return? And where are you, as it relates to mix shift of apparel? Do you feel like you’ve got the right percentage of entry level, more basic product, that could start to build an outfit, like a camisole type of an item? Or is it going to take time to get the mix where you want it to be? And how is that mix shift weighing on your comp performance?

Tedford Marlow

I will take a piece of this, and I would like to have Meg weigh in as well. In regard to the age on the customer, we do survey work a couple of times a year in regard to who’s shopping with us. And that survey work has provided information that the age bands are pretty consistent with where we usually see them in our business. And that is late teen to late 20. We get younger, we get older, but we haven’t necessarily distorted, or changed, we haven’t seen any information that says that we’ve gotten much younger.

What we did see coming through last year was overperformance, and fairly dramatic overperformance, in our mall-based stores. And that, combined with how we were feeling about some of the aesthetics and sensibility in our product offer, and our marketing message, was what we sought to make a change in in the interest of positioning the brand better, to serve the core constituency that we see as a 20-something.

Richard Hayne

There are a number of things that are resonating more effectively with the slightly older customer that we have always sought to have. And that is the imagery, that is being done out of our direct-to-consumer and creative areas. And also, I think if you take a trip out to Brooklyn and look at Space 98, and that store is doing very well. You will notice the customer that we’ve always wanted, and that we’ve always had, in that store and enjoying the product and the atmosphere. And I can guarantee you that there aren’t a lot of young teens in Brooklyn.

So I think that’s a very good indication of us resonating more fully in the product and in the imagery, and in the store environment, with a customer that we’ve wanted.

Margaret Hayne

We’ve spent a lot of time looking at the opening price point in all categories in the women’s business. We took a look at the price, we took a look at the quality and the make, and the fabric, of everything that was considered an opening price point and redefined what opening price point looked like, and what the quality and products should be for our customer. So we feel very satisfied with our opening price point, and that we addressed our customer the way she wants to be addressed.

Operator

Our next question comes from Laura Champine with Canaccord.

Laura Champine - Canaccord

I know you don’t want to get specific about what’s working in Urban Outfitters, but can you comment on men’s versus women’s, or talk about over what time period that product has been working? How long have you been seeing positive signs out of the new product?

Tedford Marlow

I’d say positive signs out of the new product, in the women’s area, really has been coming through second quarter. And as well, I would say that the positive signs on that product have been complemented by continual evolution of the quality of our creative work to support that, and marketing the business, coming through that timeframe.

As far as men’s versus women’s, the strongest categories in the mix right now have been our home business, our women’s apparel and men’s apparel business, in the retail stores, has been challenging for us and has overperformed in direct, direct versus retail.

Operator

Our final question comes from Susan Anderson with FBR Capital Markets.

Susan Anderson - FBR Capital Markets

If you could talk about, if price was the major driver, the regular price comps versus units. And also, if you could maybe give a little bit more color on just the timing of getting some more of that mix in there? And if you can talk about maybe your new outfitting strategy at UO and your read on how it’s working out there?

Francis Conforti

I think that’s a little detailed as far as giving out that specific information. We historically wouldn’t give that out. What we can tell you is we’re not seeing price resistance when product is appropriate. That has been the case for a long time right now, in the Anthropologie and Free People brand. And we have started to execute some better product in the Urban Outfitters brand, and we are not seeing price resistance when the product is appropriate, and we’re seeing quick sell throughs. So I think that’s very important to us.

Richard Hayne

All right, thank you very much for attending the call, and we’ll talk to you in three months.

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Source: Urban Outfitters' (URBN) CEO Richard Hayne On Q2 2015 Results - Earnings Call Transcript
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