American Eagle Outfitters' (AEO) CEO Jay Schottenstein on Q2 2014 Results - Earnings Call Transcript

| About: American Eagle (AEO)

American Eagle Outfitters, Inc. (NYSE:AEO)

Q2 2014 Results Earnings Conference Call

August 20, 2014, 11:00 AM ET

Executives

Judy Meehan - Investor Relations

Jay Schottenstein - Executive Chairman and Interim CEO

Roger Markfield - Vice Chairman of the Board and Executive Creative Director

Mary Boland - EVP, CFO and Administrative Officer

Simon Nankervis - EVP, Global Stores

Michael Rempell - COO

Jen Foyle - EVP and CMO of Aerie

Analysts

Simeon Siegel - Nomura Securities

Susan Anderson – FBR Capital Markets

Paul Lejuez - Wells Fargo

Randal Konik - Jefferies

Stephanie Wissink – Piper Jaffray

Thomas Filandro - SIG

Adrienne Tennant - Janney Capital Markets

Brian Tunick - JPMorgan

Anna Andreeva - Oppenheimer

Richard Jaffe - Stifel Nicolaus

Jennifer Davis - Buckingham Research

Dorothy Lakner - Topeka Capital Markets

Oliver Chen - Citi

John Morris - BMO Capital Markets

Jennifer Black - Jennifer Black & Associates

Janet Kloppenburg - JJK Research

Betty Chen - Mizuho Securities

Jeff Van Sinderen - B. Riley

Operator

Greetings, and welcome to the American Eagle Outfitters Second Quarter 2014 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host Judy Meehan, Vice President of Investor Relations for American Eagle. Thank you, Ms. Meehan, you may begin.

Judy Meehan

Good morning, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Interim Chief Executive; Roger Markfield, Chief Creative Director, and Mary Boland, Chief Financial and Administrative Officer. Also joining us for Q&A today are Simon Nankervis, EVP of Global Stores, Michael Rempell, Chief Operating Officer, and Jen Foyle, EVP and CMO of Aerie.

Before we begin today's call, I need to remind you that we will make certain forward-looking statements. These statements are based upon information that represents the company's current expectations or beliefs. The results realized may differ materially from those expectations based on our risk factors included in our SEC filings. We have also posted a financial supplement on our website which Mary will refer to.

And Now I'll turn the call over to Jay.

Jay Schottenstein

Okay. Good morning everyone, and thanks for joining us. Although the second quarter was clearly not to our satisfaction, the results were slightly ahead of our expectations. In light of the challenges, the team managed the business well, accomplishing our goal of clearing through spring and summer inventories, while delivering a stable merchandise margin.

Second quarter revenues declined 2% and EPS of $0.03 was well below last year. Despite a really tough first half, we remain in solid financial condition ending the quarter with $263 million in cash and no long-term debt.

During the quarter we made good progress on our priorities to strengthen the business. Now let me provide a brief update and review of some highlights.

It starts with delivering great merchandise assortments and an outstanding customer experience. The upcoming fall and holiday product lines are more consistent with what our customers expect from our brands. The team has done a nice job refining the line, injecting better quality and injecting the merchandise presentation. Gradual improvement should continue as we approach the holiday season and continue into spring.

Inventory levels were down from last year. Goal, plan conservatively in shapes where we see demand while ultimately reducing our reliance on promotions. As Roger will discuss, we become more nimble and typing up our design and production process.

Looking ahead our priorities also includes strengthening customer engagement, customer service and operational efficiencies. Over the past year, we made significant investments in a number of these areas and are beginning to see the benefits and expect to see returns to the business over the next several years.

First, our new state-of-the-art fulfillment center in Hazleton, Pennsylvania is up and running right on schedule. The facility has added needed capacity to our online business and supports an Omni-channel capability.

We’re able to see significantly speed up delivery times now reaching over 90% of our customers in two days or less. Next year we will add served distributions in the facility and over time we expect unit prices and cost to decline by at least 10%.

Our buy online ship from store capability is now in 255 stores. We’re wrapping up further by holiday. BOSS is exceeding our expectations, delivering incremental sales. Over time, we also expect to benefit from lower store markdowns and see improved inventory utilization.

Next, we’ve been making ongoing enhancements to our digital site include the new Denim shop, more on body display and a 360 degree product views. Additionally, we are about to re-launch our mobile app enabling a significantly faster and better shopping experience.

We're investing international marketing campaign aimed at strengthening brand awareness and driving customer engagement with increased digital marketing. And lastly, we've begun piloting a new point of sale system that would be rolled out in 2015 for value improved speed integration with our eCommerce business and upgrade mobile check-out capabilities.

With the completion of number of these products, next year we’ll see capital spending will come down to roughly $150 million or approximately $230 million this year. We also remain focused on our expense reduction efforts.

We’ve done a good job slightly in expense growth, but this is not enough and we continue to go after deeper reductions. As we rationalize our store fleet, we are evaluating our corporate expense structure. In fact across our strategic plan initiatives, we are reevaluating in some cases replacement projects and ensuring we are distributing capital to deliver the highest potential returns.

Our international business performed well in the second quarter. We continue to see a strong global appetite for our brands. In November we will enter the United Kingdom opening company-owned and operated stores in three of the most popular shopping destinations in England. We believe our presence in these centers will provide good returns and a great foundation for further growth.

Before I turn it over to Roger, let me comment that our CEO search is underway and we remain committed to finding a strong successor to enhance performance and capitalizing on opportunities.

In the meantime, we have a very strong and talented team in place and continue to focus on executing our goals.

With that, I’ll turn the call over to Roger.

Roger Markfield

Thanks Jay. Good morning, everyone. Second quarter results reflected ongoing headwinds within our sector of retail. Also as we indicated earlier our AE spring and summer assortments were not our best and inventory was planned ahead of demand.

With that said, our performance was slightly better than we expected and we accomplished our goal of clearing through excess spring and summer inventory. We saw favorability in our product course, markdown stabilized and we delivered a higher merchandise margin in the quarter.

Over the past several months, we made progress laying the foundation for the future. Before I comment further, I’d like to make the following points.

First, all the markdowns were still at unsatisfactory levels, we have reduced our reliance on broad wide promotions. This is a significant opportunity for margin improvement as we move forward.

Next, inventories are in good shape and plan down in the back half. We are keeping more open to buy and using our fast track capability to chase the band. And third, we’ve realigned the design and merchandising teams to ensure we have the right talent in the right jobs and supported by the right process.

We made critical changes over the past several months and I am confident we are now in a much better place. We’ve made some progress on the back-to-school floor set and expect to see improvements ramp up through holiday and into the spring season.

We are telling the lifestyle story better and our stores reflect the stronger point of view with key categories front and center.

New trends and bottoms play to the strength of the American Eagle brand. New styles and rises are combined with updated fabrics on our tried and true fits. We’ve also introduced great variety and newness with joggers, leggings, soft pants and twills.

To address the change with new trends, our denim business was planned down for last year and that’s how it's trending. However, we are maintaining a less promotional stance.

Denim is holding up well in a highly competitive landscape and remains a healthy and profitable business. While, challenges still exist in the macro and competitive landscape we’ve seen incremental improvements from the first half and are somewhat encouraged by early selling especially in the women's business. We plan to build on this success throughout the season and into spring.

Last week we launched our new national marketing campaign on Perfect, a diverse 360 degree customer outreach across social media, in-store, digital, magazines, online video and TV.

It’s critical that we continue to build brand awareness and strive for greater customer engagement. While we are confident we are also realistic about the environment. Our plans provide greater flexibility to read and react to trends. Our merchandise planning and sourcing teams have done a great job tightening up production schedules, reducing lead times and leaving more open to buy.

Now on the Aerie brand, I must congratulate the teams for delivering a strong quarter. Aerie achieved positive comps and higher margins in the second quarter. Across merchandising, marketing and customer engagement, the teams executed extremely well. We leveraged Aerie's most popular bra fits into a successful swim business and we are driving newness with exciting soft dressing trends.

Bras and undies remain solid as well. We’re pleased to see how Aerie customers are responding as we position the brand in proximity to the AE store delivering a true shopping destination for our customers.

The new Aerie side-by-side store design is exceeding expectations and driving improved overall productivity and profitability. The runway for Aerie is long, and we are very excited about the future opportunity.

Looking ahead, our focus for both AE and Aerie is on continuous improvements across all areas. In addition to merchandising, we’re working on customer engagement, customer service and operational efficiencies.

Investments in infrastructure, technology and digital as Jay reviewed will begin to deliver results and pave the way for improved performance.

Overall I’m extremely pleased with the team's performance. Working through a challenging and dynamic business environment is never easy. Yet I’m proud of how everyone has pulled together and make quick adjustments to our process and plans.

I’m certain that as we prioritize merchandize improvements and strengthen the customer experience, we will achieve the results we expect. With ongoing improvements domestically, strong acceptance and growth internationally and the potential for Aerie we are well positioned for bottom line growth.

Thanks, and I’ll turn the call over to Mary.

Mary Boland

Thanks Roger. Good morning, everyone. Despite ongoing pressure in our sector, our second quarter performance came in slightly ahead of our expectations. Topline weakness caused the deleveraging of fixed expense. Compared to last year, markdowns improved as the quarter progressed, reflecting an improvement in our inventory position for the back-to-school season.

Now, looking at the details for the quarter, total revenue declined 2% to $711 million compared to $727 million last year. Revenue from new store growth primarily factory and international nearly offset the negative comp.

Consolidated comparable sales declined 7%, following a 7% decrease last year. By brand, AE comps were down 8% and Aerie increased 9%. On a consolidated basis, transactions and the average transaction value declined. The average year retail was down in the mid single-digits, largely driven by spring and summer clearance. Additional sales information can be found on Page five of the presentation.

The gross margin of 33.4% declined 40 basis points. The comp decline caused buying, occupancy, and warehousing costs to increase 180 basis points as a rate to revenue. This was largely offset by favorability in merchandise and design costs as well as a slight improvement in the markdown rate.

SG&A expense of $190 million increased 2% from last year. As relate to revenue SG&A increased 110 basis points to 26.7%. Investments in advertising, international growth, new factory stores, and Omni-channel initiative draw the increase and were partially offset by reductions in overhead and variable expense growth.

As Jay mentioned, we continued to work hard on further expense reduction, which we expect to ramp up as we progress through the year. Depreciation and amortization increased to $35 million deleveraging 90 basis points driven by Omni-channel and technology investments, new factory and international stores and the new fulfillment center.

Operating income for the quarter was $12 million, compared to $29 million last year, and EPS of $0.03 decreased 70% from EPS of $0.10 last year.

Turning to the balance sheet, starting with inventory, which can be found on Page six of the presentation, we ended the quarter with inventory at cost per foot down 18%, following a 1% decline last year. The year-over-year decline includes a change in the timing of inventory ownership.

As a reminder, late last year we began taking ownership at the receiving port rather than the port of departure, creating working capital efficiencies. Without this change, inventory at cost per foot decreased in the mid-single digits.

We were able to effectively clear through excess spring and summer sale merchandise during the quarter and as a result, we ended the period with clearance units well below last year and overall inventory levels on plan. We expect third quarter ending inventory across per foot to decline in the low double-digit with the change in ownership or a mid single-digit decline excluding the ownership change.

We ended the second quarter with $263 million in cash and investments. Capital expenditures totaled $74 million for the quarter and we continue to expect to spend approximately $230 million this year. As Jim mentioned we expect CapEx to drop off to approximately $150 million in 2015.

During the quarter, we opened 20 stores, including five new North American mainline stores, opened in underpenetrated markets such as Las Vegas and Quebec City. We opened 10 factory stores, three stores in Mexico, and two stores in China.

We closed five stores, including three AE Mainline and two Aerie standalone locations. Additionally, we opened seven international licensed stores ending the quarter with 84 stores across 13 countries. Additional store information can be found on Pages 9 through 11.

Now, regarding the outlook for the third quarter; based on a slight decline in revenue, and a mid single-digit decline in comparable sales, we expect third quarter EPS of $0.17 to $0.19. Our guidance compares to adjusted earnings of $0.19 per diluted share last year and excludes potential impairment and restructuring charges.

We expect third quarter markdowns to decline and SG&A is expected to increase in the mid single-digit. It's important to note that this follows a 13 million or 6% SG&A reduction in the third quarter last year due in part to an incentive adjustment. Excluding this adjustment SG&A is expected to increase this year in the low single-digit. As Jay said we are targeting further reductions.

Now I’d like to provide more details on our fleet repositioning. The majority of our AE store fleet is healthy and generated for well profitability on a trailing 12 months basis. For the American Eagle stores, the average sales productivity of the fleet is over $400 per growth square foot with double digit per growth profitability.

That said, we continue to look at the entire strong portfolio evaluating sales trends to identify potential closures. Last quarter we outlined our plans to close 100 AE and 50 Aerie stores over the next three years.

These stores underperformed the fleet with average sales productivity of $250 per square foot. Of the closures most are in B and C (ph) modes and geographically dispersed throughout North America.

Our investments in factory in Aerie side by side stores are generating more return. Factory store productivity is over $600 a foot and four-wall profitability is over 25% well above the chain average.

As you know, part of our strategy for Aerie's has been to close unprofitable standalone and reposition the fleet as side by side locations next to our AE stores. In 2014, we plan to close 27 standalone stores and open 29 side by side locations.

Our early results have been very favorable with new side by side locations more profitable and nearly 30% more productive than Aerie's standalone stores. Additionally, the majority have also produced a list to comp in adjacent mainline stores.

With our fleet we are highly focused on deeper expense reduction to fill stronger margins and enable us to fund strategic investment necessary for our long term success.

Thanks for listening and now we’ll take your questions.

Question-and-Answer Session

Operator

Thank you (Operator Instructions) Our first question today is coming from Matthew McClintock from Barclays. Please proceed with your question.

Unidentified Analyst

Hi, good morning everyone. This is [Greg Bagley] (ph) on for Matt.

Just wondering if you could talk about in the earlier REITs from back-to-school seems like most retailers are pretty positive to date. Just any major categorical outs and any difference in your strategy this year versus last? And I have just one follow up after that? Thanks.

Judy Meehan

Roger will take that.

Roger Markfield

We don’t want to give too much color. It's still in the early part of back-to-school and certainly on a competitive spirit, I’d like not to give too much information but we’re relatively pleased with the way the business is trending. It’s on our plan and overall the women’s business really is picking up extremely better than what we would have thought.

Unidentified Analyst

Okay, great. And then just on the international, China you’ve been there for about a year now and your opening stores and you eluded to moving into the U.K. Just wondering what gives you confidence with the consumers in those regions and your strategy any high level stuff would be great.

Judy Meehan

Simon, that’s for you.

Simon Nankervis

Great, I think in relation to greater China it's probably little early to talk about the possibility of the market. We’re annualizing the acquisition of that business in October. And we're seeing some good improvement and early indications from that digital channel there has been good and helping us refine the assortment.

I think in relation to general customer demand and the appreciation from the customers we’ve had an international business since 2010. We're seeing good demand and we’re seeing strengthening in their international locations both the ones that we own ourselves and also the ones that were operated by our license partners.

So the early indications and based on the run rate we still feel incredibly confident about our ability to execute for customer engagement and acceptance of the brand.

Operator

Thank you. Our next question is coming from Simeon Siegel from Nomura Securities. Please proceed with your question.

Simeon Siegel - Nomura Securities

Thanks. Good morning, guys. So you mentioned opening the mainline stores in the underpenetrated markets and I think you updated FY '14 opening plans. Can you speak to that opportunity and then Mary, can you just quickly talk to the gross margins implied within the 2Q guidance given clean inventories and the fact that you're lapping meaningful erosion in the back half? Thanks.

Simon Nankervis

Hi Simeon, this is Simon. Look on the underpenetrated mainline stores, as part of our fleet rationalization we’ve looked broadly across all the geographies. We identified certain markets as we sit in Q1 where the brands still had opportunity because we didn’t have sufficient store concentration nor are we seeing an ability to draw significant opportunities through -- across shopping at various channels.

A great example is Las Vegas where we knew that we we're underpenetrated so we’ve identified those locations. We continue to look for opportunities but the overriding thing is really to look at getting the North American fleet in total back to profitability and part of that will be the continued focus on the rationalization, which will include remodel still movements, but predominantly store closures over the next 12 month.

Mary Boland

And then on gross margin for Q2 it deleveraging about 40 basis points, that was driven by our deleveraging of BOW, which was you know almost offset by some favorability in our mark downs and our product cost; so fairly close to being flat versus LY.

As I look forward to the back half the year, not giving specific guidance on gross margin, but what expect for our gross margin rate to reach up something closer to the 37%, 38% range in the back half of the year.

Judy Meehan

We will take the next question.

Operator

Our next question is coming from the Susan Anderson from FBR Capital Markets. Please proceed with your question.

Susan Anderson – FBR Capital Markets

Good morning and thanks for taking my question. I was wondering if you could give some more color on the product cost efficiency in the second quarter mainly the merchandize and design savings. Exactly what was that and do you expect this to continue to flow through, through the rest of the year and then also was this is bigger impact than the better mark down? Thanks.

Mary Boland

Yes, for the second quarter, the savings was really driven great work by our sourcing team, just driving for efficiency. There wasn’t anything specific there, but more across-the-Broad efficiency work.

For the balance of the year while the team continues to strive for efficiencies, what it looks like as we are basically flat for the back half of the year. So wouldn’t expect to see any average unit cost impact in the back half of the year one way or another.

Operator

Thank you. Our next question is coming from Paul Lejuez from Wells Fargo. Please proceed with your questions.

Paul Lejuez - Wells Fargo

Hi. Thanks guys. Can you talk about the performances that you had at e-com and also if you could by ABCD and outlet malls where you saw the strongest performance and then just secondly I know you talked about some cutting expenses, I am wondering if as you guys have had deeper dive into the business if there are any areas you feel that you under-spend or underinvested just like I am trying to figure out how to think about SG&A growth longer term? Thanks.

Judy Meehan

Okay. It's Michael Rempell on eCommerce.

Michael Rempell

Hi Paul. It's Michael. About eCommerce we are not braking out eCommerce count separately, but what I would tell you is we are pleased in the improvement in the run rate we say between Q1 and Q2 in eCommerce.

Some of the initiatives that we put in place redesigning the site contributed to a lift in conversion and we are expecting continuing improvement going forward. I guess that we were pleased, we are completely satisfied and we recognized there is a lot more opportunity. So we are focused on mobile expansion, international expansion, and the flexible fulfillment project shipped from store that Jay talked about earlier.

Employee relation to the performance of the various brick and motor channels, really we didn’t see a dramatic difference between actual date, pretty much the comps were flat across the chain. As Mary said earlier, it was sort of same in that $400 gross per square foot and factory still managed to maintain average sales around $600 gross per square foot?

Mary Boland

And then in terms of SG&A growth longer term, as I mentioned we are looking for SG&A to continue to increase on a consistent basis here in the low single digits. Having said that we are aggressively pursuing further cost reduction here in the company, which you will start to see some of that impact later this year into the first of next year.

I think we are trying to balance a lot of things here, the need to continue to invest in advertising behind our brand to support in the market and also trying to balance the short-term with the long-term.

So we are looking at areas of business that are attached to the declining part of the business, which is brick and mortar and trying to continue to rationalize that cost base, but we still need to invest for the long-term here because that’s what this is about. So trying to balance all of that together and we will continue to stay focused on expense and production and keep you posted.

Operator

Thank you. Our next question is coming from Randal Konik from Jefferies. Please proceed with our question.

Randal Konik - Jefferies

Thanks a lot. So in the presentation you said that the transaction counts were down slightly. Is there any color if the transaction counts turned positive in the last month in the quarter and then with regards to the merchandize margins, I think you said they were up?

Is that really a function of better planning our inventory or you are seeing a better self through rate on the product and then lastly on the CapEx guidance you gave CapEx guidance of $150 million for next year. Is that a number that can come down further in a year after that just trying to think about what is maintenance type CapEx levels? Thanks.

Mary Boland

Okay the CapEx, historically the company has found around $100 million to $200 million depending on the year. We are planning as we stated about $150.

I think as we look at our business and our growth potential we will need to continue to invest outside the U.S., I think a $150 is probably at this point in time about the best planning number to use going forward.

Your question on merchant margin, the merge dollars were pretty flat here for Q2, but we did improve the rate here pretty significantly. There -- lots of things drove that and as I look forward at our merchant margin, we got product improvement that the team have been working on. We are focused on marketing.

We do continue to focus on inventory and you know big component of this and to help drive down our mark-down rate and we will see that mark-down rate continue to decline as the year goes on. So it's not really any more single item. It's a combination of a lot of effort across the company.

Operator

Thank you. Our next question today is coming from Stephanie Wissink from Piper Jaffray. Please proceed with our question.

Stephanie Wissink – Piper Jaffray

Hi. Good morning everyone. Thanks for taking our questions. I just over a quick clarification I think in respect to Paul’s earlier question on the expense reduction. Mary could you give us a sense on the balance between kind of headquarter level expenses and what you expect to be looking forward at the store level in terms of draw backs?

And then Roger, if I can pull in front of you as well as on the Aerie business, could you talk a little bit about the mix of that business relative to what it's been historically between intimates, lounge and into the activewear category? Thank you.

Mary Boland

Regarding the expense reduction, what's most important here for us is that we maintain our great customer experience that is critical to our brand. So we are all very careful about how we will get expense reduction in our stores.

Having said that there is efficiencies to be found everywhere including our stores. So Simon and team continue to focus on that and drive efficiency. I would say a lot of the focus here though does need to be on the overhead side, the corporate overhead side as the company’s revenue has been relatively flat. We need to continue to drive fractural reductions there and that's what we are working on.

Roger Markfield

Stephanie, I am fortunate to have Jennifer Foyle here with me who is leading at Aerie fleet business, so I’ll let her give you her comments.

Jen Foyle

Hi. Stephanie. How are you? We are excited about the focus on the intimate apparel portion of the business in Aerie. We've penetrated that business and we are winning there because of really investing in bras and undies. That penetration is about 65% of the total and the balance resides in nearing categories such as swim and lounge, which is really the balance of the assortment.

Stephanie Wissink – Piper Jaffray

Thank you.

Operator

Thank you. Our next question today is coming from Thomas Filandro from SIG. Please proceed with your question.

Thomas Filandro - SIG

Hi. Thanks and I would like to offer some congratulations on a well-managed quarter in a tough environment.

Hi Roger can you please discuss maybe some of your forward merchandizing views of the business for fall in holiday. Where do you see kind of the greatest opportunities?

And in terms of the current season as well as holiday can you tell us if there has been any changes in skew count and how you are viewing AUR and just quickly kudos to Jen and the team for the Aerie performance. Can you guys remind us may be the size and profit profile of that business? Thank you very much.

Roger Markfield

Tom. Thanks for your note. At the same time I don’t really expect that you expect that I’ll give much detail on what you asked for, but I’ll tell you that I definitely expect the average unit retail to continue to increase.

Jen Foyle

Yeah, so the Aerie overall profitability is accretive to our bottom-line and as the team has gone through and assorted or changed the assortment here over time, and as we’re moving out of the standard prominence of the side-by-side, we’re seeing further improvement in profitability and a great improvement in overall productivity, so continue to see great improvement in the Aerie profitability and we expect that trend to continue.

Operator

Thank you. Our next question today comes from Adrienne Tennant from Janney Capital Markets. Please proceed with your question.

Adrienne Tennant - Janney Capital Markets

Let me add the nice progress on the inventory management. Roger, I wanted to talk to you about -- you had made some comments about lowering your inventory or down inventory investment in the denim category. What percentage is that kind of back-to-school fall sales and earlier in the year, you had came to investing one commodities or I should say basic fashion basis and I am just wondering if you can talk about that mix shift for the fall season as well. Thank you.

Roger Markfield

I think I can give you a little color without giving you percentages.

Adrienne Tennant - Janney Capital Markets

Okay.

Roger Markfield

Certainly, we have a very healthy and profitable denim business and as you know our market share is well over 30% in the teen space, which is quite frankly a huge market share. I believe we’re maintaining that level of market share and probably growing as -- our denim assortment is quite selectively better than it’s ever been before.

As relates to fashion mix, we have core. We have core fashion than we have fashion and the way we’re having the mix with tighter inventories and the way we’re chasing, especially on the women’s top business is really working nicely for us.

Adrienne Tennant - Janney Capital Markets

Okay. Thank you very much.

Operator

Thank you. Our next question today is coming from Brian Tunick with JPMorgan. Please proceed with your question.

Brian Tunick – JPMorgan

Thanks. Good morning. Hoping to get maybe a couple of quick liners on the factory comp decline in the quarter. Also your view on the men’s business that’s been decelerating and then just maybe any comments on the port strike and any impact that could have on product flows or ship versus boat costs. Thanks very much.

Jay Schottenstein

I will talk to you Brian quickly about the factory comp decline. What we saw is in the last year if you recall we opened a lot of factory stores and what we think we’ve seen in Q2 is the hangover from those initial openings and the enthusiasm of the number of new models, I think plus the rapid expansion that we had into that and what we’re seeing now is a settling down of the run rate into more normalized levels of the chain historically.

Roger Markfield

On the men’s business, yes, you recognize that men’s is a bit more of a commodity driven business than the women’s business, which is more fashion oriented and the price pressure in the malls is quite dramatic and we choose not to meet those prices.

Our quality of our products I believe is that much better, but for holiday, it is significantly better and I think we’ll start to see a change in trend as we move men’s in for holiday.

Mary Boland

Michael?

Michael Rempell

Right and on the port strike, it’s obviously something that we’re watching very carefully. The team does have contingencies in place should a strike occur. As of now it’s kind of a wait and see game and hopefully we’ll get through holiday without an impact.

Operator

Thank you. Our next question today is coming from Anna Andreeva from Oppenheimer. Please proceed with your question.

Anna Andreeva – Oppenheimer

Great. Thanks so much for taking my question.

Great to hear about improvements in the business for back-to-school, I guess the question -- are you guys running in line with negative mid-single-digit comp guidance or do you need a business to accelerate to get there and maybe remind us of how your comparisons shook out in September and October versus August?

And a question to Mary, with CapEx levels coming down next year, just maybe remind us how much cash cushion you guys need on the balance sheet and any updated thoughts on the share buyback. Thanks. It’s a lot of questions.

Mary Boland

Yeah. So we’re -- our guidance for -- on comps was down mid-single digits. That’s how we think the third quarter will play out. We’re not looking for any huge fund over the coming months. We don’t give monthly comp guidance so obviously I’ll just leave it there at the quarter.

In terms of the cash cushion, we have always on a annual basis we need somewhere around $200 million to $250 million cushion to make sure we have enough cash to weather anything that comes our way and we’re in great shape here and in the quarter with $253 million of cash and we feel good about that.

In terms of share buybacks and shareholder returns, again our focus continues to be investing in our business and investing for long term growth. We provide shareholder return though outstanding dividend and we continue to evaluate the possibility of share buybacks.

Operator

Thank you. Our next question today is coming from Richard Jaffe from Stifel. Please proceed with your question.

Richard Jaffe - Stifel Nicolaus

Thanks very much. Just a working model question and then a follow-up to the margin question. First the tax rate for the second half, where do you think that will end up?

And then a bigger question, gross margins of 37% to 38% in the second half have been really terrific and wondering if that’s as much a factor of much leaner inventories and a much more disciplined approach to markdown as it is to full price selling. So wondering how you’re seeing one factor versus the other impact the numbers and let us say what you’re basing the margin outlook on?

Mary Boland

Yeah. So the tax rate for the year was expected to kind of settle in here at about 44% or somewhere in that ballpark. So obviously will come down here in Q3 and Q4 up from where we’ve been pacing the first half of the year.

As I look at gross margin in the back half for the year, it is really about more effectively managing our inventory and investing the inventory, pacing inventory with -- on product lines that are really working versus getting out of balance with the total trend.

Leaner inventories mean less markdowns and as we said earlier, we saw our markdown rates are to improve as we’ve gone away from as many backstop promotions versus last year and we expect to see that continue. We’re seeing that in August as well, so I feel pretty good about the combination of products, the combination of focus marketing, continued focus on inventory here, all of that should result in a lower markdown rate and help drive our gross margin up.

Richard Jaffe - Stifel Nicolaus

And that…

Mary Boland

Yes, I think we lost you. Next question.

Operator

Our next question is coming from Jennifer Davis from Buckingham Research. Please proceed with your question.

Jennifer Davis - Buckingham Research

Hi guys. Sorry. Can you hear me now? Sorry about that. Good morning and let me add my congratulations on a good performance in a really tough environment.

I had a quick clarification on and then I wanted to see Mary if you discuss on AUCs for maybe the first half of next year especially with cotton down at about $0.64. The clarification, how much of the merchandise margin rate I guess it was driven by better cost versus lower markdown so I am just trying to reconcile the decline in AUR because of more spring and summer clearance with the merchandise margin improvement or was that just more spring and summer sales in general in the second quarter versus fall sales.

Mary Boland

Yeah, I’ll just handle the merch margin question and Michael will talk about average unit costs.

So when you look at Q2, we did see some favorability here in our product costing, which did help our merch margin. Our markdowns improved about looks like about 40 basis points in Q2 versus LY, so a fair amount -- that was part of the improvement, but more of it was driven by the product cost side of that.

As we move forward thought what I would say is that the merch margin improvement will flip around and be mostly driven by markdown improvements.

Jennifer Davis - Buckingham Research

Okay.

Michael Rempell

And it’s really too early to give a forward view of what product costs are going to be see for spring and summer as we’re trying to work closer to the season. But what I will tell you is we’re carefully watching cotton prices.

If they stay where they are and go down further, we have a lot of cotton in our product and I’d expect you -- we'd expect we would see some benefit that will flow through the product costing.

Operator

Thank you. Our next question today is coming from Dorothy Lakner from Topeka Capital Markets. Please proceed with your question.

Dorothy Lakner - Topeka Capital Markets

Thanks. Let me add my congratulations on managing through a really tough period and making really good progress here. I had a question for Roger, just if you could give us a little bit more color on where you are in terms of how much open to buy you're keeping and how much of the assortment you're able to fast track at this point? Thanks.

Roger Markfield

Dorothy, we have the prices really tightened up the way we used to run the business and we are keeping the right amount of inventory open to chase. We're now chasing. We set our next set on 9/11, which is the Fall set, and there is probably about 20% of that inventory was chased. We're working on holiday. We have an extraction that will take place in out stores at the end of this month on holiday. And after we read that extraction we'll go into chase mode for holiday.

Dorothy Lakner - Topeka Capital Markets

And the fast tracking?

Roger Markfield

Well, that is fast tracking.

Operator

Our next question is coming from Oliver Chen from Citi Group. Please proceed with your question.

Oliver Chen - Citi

Hi guys. Great job on a tough environment. Regarding your product planning and what you're seeing for the bottoms trends and the softer dressing and the jeggings and leggings, how does that dynamic work with the lower average unit retail versus denim? And will that transaction there will be able to offset a potential AUR mix headwind?

And then, Mary thanks for the details on the gross margin side. So, looking forward, are there certain classifications that you're more enthusiastic about in terms of merchant margin expansion opportunities.

Roger Markfield

So, on the average unit retail question, obviously we follow trend of product and we let the average unit retail come out where it comes out in the mix. But with the reduction of markdowns and the sell-through that we're getting in one of these products I still believe the average unit retail will be rising. But it's very good for us with all of these bottom trends taking place other than denim; we're very well positioned for that trend.

Mary Boland

And then I think in terms of the gross margin, I'm looking forward at our product portfolio here for the back half of the year and seeing the improvements in product that Roger and Jen and the entire team are driving, you know, encouraged by what we're seeing.

But I think, honestly, as we sit here today all I think about planning forward is just keeping inventories in line, making sure we're chasing only what we need to chase, and being able to drive a markdown improvement by not having to go big box promotional. So, you know, I think the product will feature itself once its out and we'll see what kind of results it delivers.

Operator

Thank you. Our next question today comes from John Morris from BMO Capital Markets. Please proceed with your question.

John Morris - BMO Capital Markets

Thanks. Really nice progress to the entire team. Mary, question for you. Roger had very good comments, constructive comments about the start of back-to-school and pleased with where they are in the women's trending banner yet. You are planning negative to mid-single-digit comp for Q3, although we're up against an easier compare on the same inventory lien level. So I'm wondering if there's any consideration there for that I guess the cautious guidance.

Mary Boland

Yeah. I think that you know I wouldn't call it cautious guidance. That's our guidance and when we look at all the variables that we have playing here for Q3 we're -- we feel confidence in that guidance and based on what we're seeing is the only read.

Again, we're really trying to move ourselves away from the box -- the big box also the promotions that we ran last year. We started that journey here in the second quarter and into that journey as we speak. So expect to see the bottom line results improved as we continue on in the quarter.

Operator

Thank you. Our next question today is coming from Janet Kloppenburg from JJK Research. Please proceed with your question. Ms. Kloppenburg, your line is now live. Perhaps your phone is on mute.

Our next question today is coming Jennifer Black from Jennifer Black & Associates. Please proceed with your question.

Jennifer Black - Jennifer Black & Associates

Good morning and congrats. Your side-by-side looks amazing. I wondered if you could talk a little bit about your rewards program, and what type of changes we could expect to see in the back half of the year. And I wondered how many active members you have? That's the question.

Roger Markfield

We're sitting right now with close to 30 million rewards customers, loyalty customers, and that's up double-digits. So I really feel good when I see that with the strength of the brand. And we're in the midst of reworking in the whole loyalty program even though it's successful. So when we complete our analysis on what we're going to do I'll let you know.

Jennifer Black - Jennifer Black & Associates

Okay. Do you have any comments about your marketing for the back half for holiday season?

Roger Markfield

We're in conversation right now, and Mary and Jay, myself and the team we all believe in marketing the brand. It's a very powerful brand. We like where we are with the campaign that we have in place now, my imperfections which was resonating and we'll continue to do something for the holiday season.

Operator

Thank you. Our next question today is coming from Janet Kloppenburg from JJK Research. Please proceed with your question.

Janet Kloppenburg - JJK Research

Can you hear me?

Mary Boland

Yes, Janet.

Roger Markfield

Yes Janet.

Janet Kloppenburg - JJK Research

Okay. Thank you and congratulations on the progress. Just a couple of quick questions. Roger, you talked about the down trending denim cycle. I wonder if you thought that would continue into the spring.

And secondly, I wondered if your investment in the alternative bottom was appropriate now or if that will be building. It looks a little light to me in the stores. I don't know if I have the direct channel.

And Mary, I know you didn't want to talk about current comp trends, but I was wondering if your encouragement on the business for the back half might be related to business trends improving slightly as the back-to-school product arrive in mid-July. Thank you.

Roger Markfield

Well, I never have a crystal ball, but my sense is that the denim cycle will continue to be a bit soft. Its still, as I said before, a dominant business, very healthy and very profitable.

The other categories, the legging business, the jeggings business, the soft dressing businesses will continue, and obviously into Spring and we're obviously in chase mode. And that will -- you will see that in our next set, in our next set of windows. So I feel pretty good about where we're moving to and how we are positioned.

Mary Boland

And regarding the comp trend, the Q3 guidance is down mid-single-digits. As we look to Q4 we'd expect to see some improvement versus LY. We had a really tough Q4 last year, so expecting to see some improvement versus LY.

Operator

Thank you. Our next question today is coming from Betty Chen from Mizuho Securities. Please proceed with your question.

Betty Chen - Mizuho Securities

Good morning, everyone, and my congratulations as well. I was wondering; Mary, if you can clarify in terms of the inventory at the end of Q3. Total cost will be down, how should we think about unit changes year-over-year?

And then also in terms of the comp lift you're seeing is adjacent American Eagle stores next to the Aerie side-by-side. What sort of conflicts are you seeing? And then lastly for Roger, are you also seeing some success with the tops business as you see the better sell-through in the bottoms. And how are you feeling about some of the new fashion trends, if any, as we go from holiday into the Spring season? Thanks.

Mary Boland

In terms of the unit inventory we're down in Q2 looks like about 13% roughly and we'd expect to see something similar to that in Q3 versus LY. Regarding the comp lift between the AE box with Aerie side-by-side, you know, look it's early to declare a number or declare a success I would say early read we're seeing a bit. And we'll just keep you posted as we get more experience under our belt.

Roger Markfield

And the women's top business is strong and we're in real speed sourcing chase at this point in time. The swing from where we were in first and second quarter to where we are in third quarter is quite dramatic.

Mary Boland

Kevin, we'll take one more question.

Operator

Thank you. Our next question is coming from Jeff Van Sinderen from B. Riley. Please proceed with your question.

Jeff Van Sinderen - B. Riley

All right. Thanks. Just to clarify Mary, I think you said improvement versus last year for Q4, just wanted to clarify on that. you mean positive comps correct?

Mary Boland

No, no. We're giving guidance here for Q4. I think what I was trying to articulate is that we expect to see improvement -- a bit of an improvement in our trend based on the strength of all the work the team has done here on the product.

Jeff Van Sinderen - B. Riley

And then any update you can give us on the longer term outlook for real estate? Are you leaning more towards closing more than the 100 stores? I think you’ve talked about for the next few years or would you be leaning toward just keeping it at that at this point?

Simon Nankervis

So look Jeff, its Simon. Where we are at the moment is we've got a 100 stores to 150 stores including Aerie that we've identified through closure. We've got another 200 stores that have leases expiring over the next three years.

As we're moving for the businesses, as we're seeing the customers traffic patents change between the digital channel and the brick and mortar channel, we will change our focus and update the strategy accordingly.

Operator

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day. We have you for your participation today.

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