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Abercrombie & Fitch (NYSE:ANF)

Q2 2011 Earnings Call

August 17, 2011 8:30 am ET

Executives

Eric Cerny - Manager of Investor Relations

Michael Jeffries - Chairman, Chief Executive Officer and Member of Executive Committee

Jonathan Ramsden - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Barbara Wyckoff - Credit Agricole Securities (NYSE:USA) Inc.

Carla White

Dorothy Lakner - Caris & Company

Linda Tsai - MKM Partners

Jeff Black - Citigroup Inc

Randal Konik - Jefferies & Company, Inc.

Christine Chen - Needham & Company, LLC

Adrienne Tennant - Janney Montgomery Scott LLC

Eric Beder - Brean Murray, Carret & Co., LLC

Paul Lejuez - Nomura Securities Co. Ltd.

Michelle Tan - Goldman Sachs Group Inc.

John Kernan - Cowen and Company, LLC

Brian Tunick - JP Morgan Chase & Co

Pamela Quintiliano - Oppenheimer & Co. Inc.

Omar Saad - ISI Group Inc.

John Morris - BMO Capital Markets U.S.

Marni Shapiro - The Retail Tracker

Jeffrey Klinefelter - Piper Jaffray Companies

David Weiner - Deutsche Bank AG

Erika Maschmeyer - Robert W. Baird & Co. Incorporated

Robin Murchison - SunTrust Robinson Humphrey, Inc.

Evren Kopelman - Wells Fargo Securities, LLC

Kimberly Greenberger - Morgan Stanley

Unknown Analyst -

Janet Kloppenburg - JJK Research

Lorraine Hutchinson - BofA Merrill Lynch

Operator

Good day, and welcome to the Abercrombie & Fitch Second Quarter Earnings Results Conference Call. Today's conference is being recorded. [Operator Instructions] At this time, I would like to turn the conference over to Mr. Eric Cerny. Mr. Cerny, please go ahead.

Eric Cerny

Thank you. Good morning, and welcome to our second quarter earnings call. Earlier today, we released our second quarter sales and earnings, income statement, balance sheet, store opening and closing summary, and an updated financial history. Please feel free to reference these materials available on our website.

Also available on our website is an investor presentation, which we will be referring to in our comments during this call. This call is being recorded, and the replay may be accessed through the Internet at abercrombie.com under the Investors section.

Before we begin, I remind you that any forward-looking statements we may make today are subject to the Safe Harbor statement found in our SEC filings. Today's earnings call will be limited to one hour.

Joining me today on the call are Mike Jeffries and Jonathan Ramsden. We will begin the call with a few brief remarks from Mike, followed by a review of the financial performance for the quarter from Jonathan. After our prepared comments, we will be available to take your questions for as long as time permits. Now to Mike.

Michael Jeffries

Good morning, everyone. Thank you for joining us today. We are pleased that our results for the quarter continued to reflect strong momentum, both in the U.S. and Europe. For the third consecutive quarter, our sales were up more than 20%. This included a strong performance from new stores, particularly the Paris flagship, but also the 19 new Hollister stores we have opened in Europe in the last 12 months. In addition, our U.S. chain store business performed well for the quarter, particularly Hollister, fueled by what we believe is a compelling assortment and supported by effective pricing and promotional strategies.

We had long anticipated that the second quarter would be challenging from an operating income standpoint, considering the effects of investments we are making for future growth. In that context, we are pleased that our top line performance enabled us to significantly beat our internal goal for the quarter and achieve a 71% year-over-year increase in operating income.

Our second quarter results marked the midpoint of the 3-year roadmap we laid out at the beginning of last year. Our focus remains very much on execution against our strategy and the key roadmap objectives, while always maintaining a long-term view. We believe maintaining that long-term approach is even more critical today, given the uncertainty in the macroeconomic environment. I will come back to that in a moment.

First, I want to take a few minutes to review our performance to date against our roadmap goals. Starting with U.S. store productivity, we have clearly delivered on the objectives we laid out in February of last year, and we believe we are on course to sustain meaningful improvements and drive back toward peak productivity levels.

These improvements have been driven by several factors. First and foremost, by having the right merchandise and maintaining a compelling and differentiated store experience. In addition, our pricing and promotional strategies have played a role in the productivity improvements we have seen, and we have improved our execution of these strategies. However, no one should conclude that even in the U.S. chain business, this is a purely price-driven business. Even in an environment where price is increasingly important, you have to be a desirable brand that clearly stands for something in the eye of the consumer. With regard to marketing and customer engagement, we have made progress, but we still see plenty of opportunity ahead of us.

Turning to international. We expect to hit our goal of close to 40 international Hollister openings and 5 A&F flagship location openings this year. Overall, the international stores we have already opened continue to perform very strongly. Tomorrow marks the opening of our first Hollister store in Asia at the Festival Walk mall in Hong Kong. This is a significant milestone for us, and we look forward to our first openings in Mainland China later in the year. In Europe, the performance of our Hollister business continues to be very strong, and our new store openings for the quarter are significantly exceeding plan in aggregate. As I mentioned a moment ago, we are also very pleased with our Paris flagship opening. And while it is still early on, we continue to expect its volume to be in the same range as the London and Milan flagships on a go-forward basis.

Turning to Japan. Our business there remains challenged with Ginza comping negatively through the quarter. We remain cautious on Japan, while we work to identify and address the underlying issues. Our Canadian business is also not where we would like it to be, although it continues to operate at a healthy profit level, and we believe the sales trend in Canada is more readily addressable.

Our direct-to-consumer business again posted strong growth of 28% for the quarter, as we work toward our $1 billion goal. This business remains a major strategic priority and source of investment. As for Gilly Hicks, we continue to work on our roadmap objectives and remain very excited about the long-term prospects for the brand.

Last, we continue to focus very closely on expenses and challenge ourselves in each area of our business to find additional efficiencies in our model. This is all the more important in an uncertain macroeconomic environment.

Overall, we are pleased with our performance against our roadmap goals. As we look to the back half of the year and into 2012, it is clear that we are entering a period of greater uncertainty. As we have discussed in the past, costing issues will certainly impact us more significantly in the back half of the year and the consumer response to price increases remains unclear. In addition, the global macroeconomic picture and possible exchange rate volatility add to this uncertainty, especially, given the increasing shares of our business represented by Europe.

However, our strong top line momentum and overall performance for the past several quarters gives us confidence that we are well positioned to navigate through this environment. And while external risks have increased, we remain comfortable with our objectives for next year.

With that, I'll turn the call over to Jonathan, but we'll be happy to take your questions later in the call.

Jonathan Ramsden

Thanks, Mike, and good morning, everyone. As Mike said, the story of the quarter was essentially that the strong top line performance mitigated the deleveraging issues we have faced coming into the quarter and enabled us to deliver meaningful growth and operating income and EPS. Sales for the quarter increased 23% to $917 million. Total Domestics sales including DTC were up 12%. Total international sales were up 74%. Within international, Hollister Europe was particularly strong, both the comp and non-comp stores. Overall DTC sales including shipping and handling were up 28%.

As reflected on Page 6 of our presentation, foreign currency changes accounted for approximately 160 basis points for the sales increase based on converting prior year sales at current year rates. The impact of foreign currency changes on our results is likely to increase going forward as international operations account for a greater part of the mix.

Gross margin for the quarter was 63.6%, down 150 basis points from last year, putting our gross margin for the first half of the year up 40 basis points. Gross margin dollars for the second quarter increased 20% versus last year. Decrease in the gross profit rate was driven primarily by an increase in average unit cost, partially offset by a higher AUR and an international mix benefit. AUR was up mid-single-digit for the quarter with increases in both U.S. and international AURs.

Across all brands, men's and women's comps were similar. Men's stronger performing categories were knit tops and fleece, while graphic tees were weaker. Women's stronger performing categories were woven shirts and sweaters, while graphic tees were weaker.

Turning to operating expenses in Page 7 of the Investor Presentation, stores and distribution expense for the quarter included store occupancy costs of $173.6 million, in line with our guidance. All other stores and distribution costs represented 27.5% of sales. Due to the strong sales performance, we saw less deleverage on this line than we had anticipated. As a reminder, these expenses also include $4 million of additional depreciation related to our DC consolidation.

MG&A for the quarter increased 16%, in line with our mid-teen guidance, driven by increases in compensation, including incentive and equity compensation, marketing and other expenses, net of favorable prior year legal settlements. MG&A for the quarter included equity and incentive comp of $18.4 million versus $11.7 million last year. For the quarter, and excluding the effect of prior year store closure costs, we achieved approximately 300 basis points of expense leverage. Overall, operating income was up 71% for the quarter.

The tax rate for the quarter was 30.7% and benefited from a strong performance of international operations with a lower effective tax rate. On a full year basis, we now expect that the tax rate will be somewhat below 35%, although this remains sensitive to mix shifts between domestic and international taxable income, including the effect of currency movements. Diluted EPS for the quarter was $0.35, $0.13 above last year, which included the $0.02 loss last year from store closure charges. Year-to-date EPS diluted is up $0.54 versus last year.

Turning to the balance sheet. We ended the quarter with total inventory of cost, up 7.5% versus year ago or up 3.5%, excluding in-transit. Coming into the back half of the year, we believe we are appropriately positioned with fall and basic inventory, although our spring carryover inventory is somewhat lighter than we would have liked, reflecting the strong first half performance.

During the quarter, we repurchased approximately 950,000 shares at an aggregate cost of $64.4 million, bringing our total repurchases over the past 12 months to approximately 3 million shares at an average cost of approximately $56 per share. We ended the quarter with approximately $540 million in cash and cash equivalents compared to $596 million in cash and equivalents at a comparable point last year. This number reflects buybacks and dividends of approximately $225 million in the past 12 months and a paydown of $53 million in revolver debt. In addition to which, we have eliminated substantially all outstanding letters of credit.

Turning to the third quarter and back half of the year. We continue to expect gross margin erosion. However, our visibility on the magnitude of this erosion is less clear than in the first half of the year due to the uncertainties Mike spoke to earlier.

Some more specific items on third quarter expenses is included on Page 11 of our Investor Presentation. This expense guidance excludes the impact of any potential impairment charges, resulting from our annual review of long-lived assets. Store occupancy costs for the third quarter are expected to be in the low- to mid-$180 millions. All other stores and distribution costs are expected to modestly delever compared to last year's rate of 24.8%, including the effect of preopening costs, DTC investments and additional depreciation due to the DC consolidation.

MG&A for the third quarter is expected to increase by a low double-digit percentage, with the primary components of the increase being equity compensation and marketing costs.

Going forward, as we have spoken to in the past, equity compensation charges may escalate significantly. This is a function both of potential increases in the stock price but also of a shorter amortization period for future awards. As a result of the approval of our amended long-term incentive plan, we no longer anticipate that we will need to adopt liability accounting for equity-based awards. Our plans for store openings for the year remain in line with prior guidance. We now expect to close approximately 60 to 65 U.S. stores during the fiscal year, significantly all through natural lease expirations. Based on current new store plans and other planned expenditures, the company continues to expect the total capital expenditures for 2011 to be approximately $350 million.

This concludes our prepared comments section of the call. We are now available to take your questions. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Lorraine Hutchinson with Bank of America.

Lorraine Hutchinson - BofA Merrill Lynch

I just wanted to follow up on the gross margin commentary. I know that the visibility is pretty unclear at this point, but if you could just provide us with any commentary on how initial price increases have gone? What the consumer acceptance has been? What types of cost increases you're seeing? Just any guidelines you could give us to help us try to model this line item.

Jonathan Ramsden

Lorraine, I don't think there's a whole lot of additional color we can really add. I mean, I think, we've long said that we were talking about double-digit cost increases in the back half of the year, and actually, starting late in the second quarter. As Mike said earlier, the reaction to price increases, which for us have not yet fully gone into effect, remains unclear, and it's certainly too early for us to add a lot of color to that. So I'm not sure beyond what we've already said that there's really a whole lot of additional color we can provide at this point. Clearly, as we go through this quarter, in particular, we'll have a greater sense of that.

Operator

We'll go to our next question. Christine Chen with Needham & Company.

Christine Chen - Needham & Company, LLC

I wanted to ask about the price increases. I mean, as I walked the stores, I do feel like there have been at least a mix shift towards higher price point items, particularly, on the fashion side and maybe even on the denim side. How are you thinking about those price increases, is it across the board? Is it skewing the mix? And is it more in fashion versus basics?

Jonathan Ramsden

Christine, I mean, I think we've always said that it wasn't going to be uniform, that it would be based on what we thought was appropriate, category-by-category and item-by-item. I'm not sure, again, there's a whole lot of color we can really add on that.

Michael Jeffries

I think -- let me just pipe in. There clearly is a mix of influence happening in our inventories because our inventories are shifting to a greater percentage fashion, which is what you observed in the stores.

Christine Chen - Needham & Company, LLC

And then for the fashion penetration, I mean, can you maybe shed some light on how much that's gone up? I had to ask.

Michael Jeffries

Good question. I think you see it in the stores.

Operator

And we'll go to our next question, Randy Konik with Jefferies.

Randal Konik - Jefferies & Company, Inc.

Just quick question. I guess, near term and long term. I guess, Mike, first. The comment in the press release about the strong top line momentum, how should we be thinking that -- is that momentum continuing to the back-to-school period thus far? How should we be thinking about -- how are you thinking about the back-to-school season from your perspective? And then, I guess, Jonathan, can you give us any type of updated commentary after the Analyst Meeting on that 475 number for next year? How are you feeling about that?

Michael Jeffries

Okay, let me comment. First question. We've never given guidance on sales during a quarter, and we're not going to now. So I cannot and will not comment on August. What I can tell you, and I think this is the important point, Randy, is that our business has always been built and managed with a long-term orientation. And that applies to protecting the quality of our merchandise and store experience. It applies to our long-term relationships with our vendors, many of whom have been with us for many years. It applies to our people, for whom we want to create long-term rewarding careers. And it also applies to our stockholders, where we are fortunate to have some long-term supportive stockholders who understand our strategy and what we are trying to accomplish. And I'd like this to be my biggest message this morning.

Jonathan Ramsden

Randy, just covering the second part. We remain comfortable with the 475 for next year. The things that are under our control, we feel good about. We've been ahead of our objectives year-to-date. So that's a positive factor, and I think weighing in the opposite direction is clearly the macroeconomic uncertainty. So net-net of those 2 things, I think our outlook is essentially neutral to where it was when we published that number at the Investor Day back in April.

Operator

[Operator Instructions] And we'll go next to Brian Tunick with JPMorgan.

Brian Tunick - JP Morgan Chase & Co

So I guess, question is on the gross margin side again. Just trying to understand sort of your commentary on the back half. Is the concern about more on the AUC side? And what do your lead times look like? When do we start to feel the benefit of what's happened to cotton? Or is it more on the competitive landscape, particularly seeing where Hollister denim might be going out the door now versus some of your competitors?

Jonathan Ramsden

Brian, let me go through some of the components of gross margin, which I think illustrate why we're saying there's less visibility in the back half than in the -- than we had in the front half year. First of all, you've got the average unit costs at stake, which we obviously know. For this point, for the back of the year, and I'll come back to forward expectations on that in a second. We've got price increases in the mix, which we clearly said it's too early for us to say what the reaction to that is going to be. We've got a possibility of slowing economy, a potential double-dip recession, which obviously, could impact our business. And again, I think it's too early to say on that yet, but clearly, that has increased in terms of the likelihood over the last couple of months. I think -- another big factor you have to also throw into the mix is we've got a very significant number of new stores opening internationally in the back half of the year, far more so than in the first half of the year. And the volumes we have attached to those stores could have a significant impact on where we end the year from a gross margin standpoint. So there are a lot of different variables in the mix. Currency on top of that is another one, given increasing proportion of our business in the Eurozone, in particular. So I think, just given all those variables, unlike our feeling 6 months ago when we were pretty comfortable saying approximately flat gross margin for the spring season, we're not comfortable being that specific in the back half of the year, but we do certainly expect there to be erosion in the gross margin rate. Going forward, in terms of costing, we'll have a relatively tough comparison in the first quarter of '12 because as you probably recall, we got very good costing in the first quarter of '11. We should start to see some year-over-year favorability with regard to cotton partway through the second quarter of next year. Although, I think it's also clear that the non-cotton components of costs are continuing to inflate, particularly labor costs. But the cotton, based on where it stands today would start to turn more favorable for us on a year-over-year basis in the middle of the second quarter of next year.

Operator

And we'll take our next question from Dorothy Lakner with Caris & Company.

Dorothy Lakner - Caris & Company

Just wondered if you could provide a little bit more color on the Paris opening. Obviously, that was a pretty big one for you. How that was perhaps different from the London opening or the Milan opening, and what kinds of things you are learning about that? And then, just a corollary to that, what you're seeing in terms of foreign tourist business here in the U.S..

Michael Jeffries

Okay, let me talk a little bit about the Paris opening. It was an opening that was very much like the London opening and the Milan opening. We had lines and excited customers. I think what we're learning about the flagships is that we have a chain in the flagships. We're running a chain of flagships. So we opened each of those stores exactly the same way, and it's interesting that we're getting the same response. And it leads to the point that we operate our stores the same wherever they are in the world, so from a customer's perspective, we are one experience. And that's being born out in the flagships. So exciting opening, exciting business continuing, and we look forward to more in the future. Foreign tourist business, I think, in the U.S., I guess I can comment on last quarter, it continues to be good.

Operator

Our next question comes from Janet Kloppenburg with JJK Research.

Janet Kloppenburg - JJK Research

Mike, I was wondering if you could talk a little bit about your level of happiness with the new denim introduction. I thought it was really well done, and I love a lot of the new fits and washes. I wondered if you could talk a little bit about how important that is to your business going forward. I was also wondering if you could talk a little bit about what -- how you view the discounting environment in the U.S. and if you think it's something that we're just going to have to get used to, or if you see some evolution unfolding where you may be able to be less promotional. And Jonathan, just for you and your outlook for fiscal '12 on the -- my question is when you think about the 475, have you thought at all about the FX benefit you've been incurring, and what might happen? Is there any assumption there for softening of the euro, I think is my most direct question?

Michael Jeffries

Okay, first, Janet, denim, I think that the new denim fits and washes are very important to us. I think this organization did a really good job in reengineering our denim. And I think it's interesting that we're getting real credit for that. Promotional outlook, I don't have a crystal ball. I really don't. We will see what happens in the U.S. Clearly, it's a U.S. issue for us, not an issue in the rest of the world. We are very optimistic about our offerings, and we would hope that over time, the U.S. could become less promotional, that's our intention. Let's see what happens.

Jonathan Ramsden

Janet, on the second part of the question. We certainly do look at the sensitivities of all the critical components of getting to our 475, and FX is definitely one of the more sensitive components of that. Relative to when we put that objective out there, the euro has strengthened -- or certainly, it had with regard to our second quarter results. So we haven't specifically factored in a cushion for that, but we look at the potential sensitivity of exchange rates relative to the other sensitivities in the model around domestic, same-store sales, around international store openings. And then we weigh reasonable outcomes or reasonably likely outcomes in each of those components. And based on all that, we continue to think at this point the 475 is realistic. I think it is. Having said that, clearly when we put that objective out there, we weren't modeling in a double-dip recession in the U.S. or a major decline in the euro. But absent either of those things happening, we remain comfortable with that objective.

Michael Jeffries

Janet, one more point about the denim. I think it's clear that everyone should understand that our back-to-school strategy was to get our new fits on as many new customers or old customers as possible.

Operator

Our next question comes from Stacy Pak with Barclays Capital.

Unknown Analyst -

This is Ed actually, standing in for Stacy. I just had a quick 2 questions. One is, I know you don't want to comment on August month to date, but we just wanted to know how are the trends looking? And the second question is, could you comment on whether you still intend to increase prices in September? And what comps for the business looks like when you remove the promotional spend in the U.S.?

Jonathan Ramsden

Yes, I think we already said that we're not going to – we've never commented on intra-quarter, intra-month sales.

Michael Jeffries

And would you pass the message to Stacy, nice try.

Jonathan Ramsden

So I know that we could see. So I think with regard to prices, I think we've already covered that. And then the question on what would comps look like without promo in U.S., I don't think we would even know how to go about quantifying what that would be.

Operator

Our next question comes from Jeff Klinefelter with Piper Jaffray.

Jeffrey Klinefelter - Piper Jaffray Companies

So just a couple quick questions. In terms of the Hollister openings for the back half, you've got many of those scheduled now to hit in the next 2 quarters. Jonathan, could you give a little bit more color on how you expect those to hit between Q3 and Q4? And are they continuing to track at a certain multiple of the average U.S. volume or U.S. productivity? And I think, just to clarify, haven't you guys been giving sort of a general comp outlook for the total enterprise on kind of either quarterly or second-half basis, I'm not sure if I missed that regarding your Q3 expense guidance?

Jonathan Ramsden

Jeff, I guess with regard to the Hollister openings in the back of the year, they are roughly even between the third and fourth quarter in broad terms. In terms of the productivity of the stores we have opened, as Mike said earlier, the stores we opened during the quarter in aggregate exceeded plan. Hollister Europe business remains very strong, both comp and non-comp. They're really -- it's really pretty consistently good across the board for Hollister in Europe. So we're hopeful that those stores we're going to open in the back half of the year will sustain the trend. And we don't see any reason why that wouldn't be the case. The second part of the question was -- what was it, Jeff? Oh, yes, well, I think with regard to the comp outlook. We've spoken going back to the Investor Day in April, Jeff, about what we were targeting. And that would be, clearly, what we've come to share today. It is consistent or better than that. And to be on track with our objectives, we're looking to sustain meaningful improvements in comp store sales going forward. I think at this point, for all the reasons we've alluded to, we're not going to be more specific than that. But relative to our objective, both for this quarter and beyond, we're certainly targeting sustaining those improvements that we've seen.

Operator

Our next question comes from Michelle Tan with Goldman Sachs.

Michelle Tan - Goldman Sachs Group Inc.

So we know you guys had a great July and start to back-to-school. I'm just curious to clarify, with all the commentary on uncertainty that's come up in the macro environment over the last 3 months. Are you guys are really talking about being concerned about things that can have a future impact on your business that you're seeing externally? Or is there some sign of increased uncertainty as you look at whether it's day-to-day volatility in the business, or whatever that you see in your trends today?

Jonathan Ramsden

Was that a question about August sales?

Michelle Tan - Goldman Sachs Group Inc.

Volatility, not absolute number.

Jonathan Ramsden

Well, I think we're not doing anything different than anybody else, which is when there is a significant -- a greater degree of uncertainty out there, you naturally kind of think about what impact that could have and you want to be prepared if that becomes more significant. But I don't think we're seeing anything more than that at this point, Michelle.

Operator

Our next question comes from Kimberly Greenberger with Morgan Stanley.

Kimberly Greenberger - Morgan Stanley

I guess, I won't ask about August. I was actually curious about inventory. I was impressed in the first quarter you were able to drive such strong revenue growth with much slower growth in inventory, and I have to imagine what the increase in your cost that your unit inventories are even well below the 7.5% increase in dollars. So Mike, I'm wondering if you can just talk about how you're feeling about inventory, the way they're positioned in the back half. And do you feel like you've got the inventory you need to do the volume you'd like to do?

Michael Jeffries

I will let Jonathan answer that question. I think the answer is yes, but I'll let him talk about it a little.

Jonathan Ramsden

Kimberly, yes, I think, as we said, we feel we're appropriately positioned with fall and basic inventory. We were a lighter in spring carryover than we would ideally have been just because of the strong first half performance in the year. But we're comfortable with where we are for fall and basic inventory. I think a caveat is also that the quarter end is a point in time, so it's difficult to read too much into that. But overall, we're comfortable.

Operator

Our next question is Marni Shapiro with The Retail Tracker.

Marni Shapiro - The Retail Tracker

I'm taking 7 girls to the mall later, you might want to watch your comps in the tri-state area. I have a quick marketing question. You talked a little bit about marketing in your opening comments. Are you changing something on the marketing side, or is it increased to support some of your international flagship openings? Any kind of color around that will be great.

Jonathan Ramsden

Marni, I guess it's not really oriented to international. I mean, we typically have a steady low-key approach to international openings. So it's more -- we talked in the past about some of the things we're doing in social media and interactive marketing. I think you will probably recall the presentation at the Investor Day on that. So it's all those types of things that we're talking about where we are making progress, but we still think there's plenty more we can do to help drive the business going forward.

Operator

Our next question comes from Paul Lejuez with Nomura Securities.

Paul Lejuez - Nomura Securities Co. Ltd.

Just a follow-up on Kimberly's question. What should we expect from you guys in terms of inventory at the end of the third quarter? I'm also wondering why the current inventory position wouldn't be somewhat of a tailwind to your gross margins, how we should think about that? And then, just a little bit more long term in nature, wondering about Gilly Hicks international opportunity. Is that something that can be a 2012 story, or you're still uncertain about the international opportunity there?

Jonathan Ramsden

I guess, on the first one on inventory, Paul, we would expect it to be a greater increase at the end of the third and fourth quarters, but a significant piece of that is all the international store openings that we have coming into play, for which we obviously have to buy inventory to support that. I think we can't really add much more color in terms of the gross margin than we've already said, and I think there are a lot of uncertainties to that. With regard to Gilly, we have a very specific roadmap on Gilly. We're making good progress against that. I think at this point, we're not ready to give specifics on when we would start increasing the store count in a more significant way.

Operator

Our next question comes from Erika Maschmeyer with Robert W. Baird.

Erika Maschmeyer - Robert W. Baird & Co. Incorporated

Could you talk a little bit more about your ability to chase into products in the fall, winter and the actions that you're taking to chase to a greater degree than you had been? And then, just a quick follow-up on the increase in your number of store closures. I guess, kind of what were the factors around that? And are you still -- are the stores that you're closing still on average about $1 million of volume and kind of breaking even?

Michael Jeffries

Let me respond to the first part of the question. This organization is very good at chasing product. It has always been. I don't think we have chased enough in the past. We have a concerted effort now to do more chasing. We're reserving more dollars for what we're calling chase, and it's working out very well.

Jonathan Ramsden

With regard to store closures, obviously, it's a fairly modest increase from where we've previously been, and it just reflects our continual -- or continued sifting through all those lease expirations at the end of this year. It skews heavily towards A&F and kids. Again, in terms of volume, that $1 million average store volume for those stores is probably still a reasonable estimate.

Operator

We'll move to our next question, Evren Kopelman with Wells Fargo.

Evren Kopelman - Wells Fargo Securities, LLC

In the second quarter, the 150 basis points in gross margin, can you quantify the basis points of benefit from the international mix and if you think that would be higher in the back half at all? And also, if you expect more gross margin pressure in the third quarter compared to the fourth because the pricing doesn't really start as much in August?

Jonathan Ramsden

Evren, we haven't broken out that gross margin effect from international versus domestic. I mean, certainly, one of the things that we're looking at as we've spoken to in the past, how we give metrics that enabled people to model the different components of the business, but to this point, we have not done that. I don't think we can break out Q3 and Q4 at this point. Our outlook was for the season. As you know, things at the markdown reserve at end of the quarter within the season can have an effect on the gross margin rate for the 2 quarters within the season. With regard to whether the international effect is going to be higher in the back half of the year, it should be because, obviously, we have more stores opening in the back half of the year, but I don't think I can give you any more specifics on that.

Operator

Our next question comes from Jennifer Black with Jennifer Black & Associates.

Carla White

This is Carla White, I'm standing in for Jennifer Black. I just wanted to talk about your new denim launch. It appears to us that you are taking a huge market share, and that the denim launch was very successful. Can you talk about any planned promotions on denim that you'd have for the balance of the year? And then also, can you talk to how your yoga line is doing? And could we expect to see any line extensions off of that?

Michael Jeffries

We can't comment on what we're going to be doing promotionally. I can't even comment on the denim promotion. I cannot tell you that it's successful or not. We'll see when the quarter is over. Yoga, I can't comment on that either. I'm sorry, Carla, but thank you for the questions.

Operator

Our next question comes from Jeff Black with Citi.

Jeff Black - Citigroup Inc

So Mike, you opened with comments on Europe that the business in aggregate is doing good, which would imply some better, some worse. What's really happening across the region? I mean, are there real differences in Italy, London, Germany that you can glean? And in terms of Hollister and what you've opened there, any learnings on what works better or what doesn't work as well?

Michael Jeffries

I think the answer is that Hollister is working every place that we've opened it. And we do not have an unsuccessful store. I believe we said in aggregate across Europe, it's beating plan. But I don't -- I'm trying to think of a store that's under plan, but I don't want to be held to that. They are all very successful. And I think the point of Hollister is that we think it is a brand that operates well in a mall environment in many countries. That's what's being proven. We know that in Europe. We don't know that in Asia, that's why opening in Hong Kong is going to be interesting for us and China.

Operator

Our next question comes from Eric Beder with Brean Murray.

Eric Beder - Brean Murray, Carret & Co., LLC

Let's talk a little bit longer term with international. You're at almost 25% of your sales are international, where do you see that going in the next 2 to 3 years in terms of percentages? And could you talk a little bit about the U.S. tourist-driven stores? How is their performance different from the rest of the U.S. stores?

Jonathan Ramsden

Eric, on the first one, we said at the Investor Day back in April that we foresaw that international will be roughly half of the business in 2015 based on the plans we talked about for Hollister and A&F international openings. With regard to the U.S. tourist stores, I think Mike said earlier that they continue to perform well. We don't specifically break that out relative to the other U.S. stores, but they have continued to do well.

Operator

Our next question comes from John Morris with Bank of Montréal.

John Morris - BMO Capital Markets U.S.

Most of the questions have been asked, but I think regarding the Canadian comments, I think you said Canada was a little bit weaker. What do you think that is from where you stand now? And I think you said that you had plans to address it, so if you can share some of those thoughts, and just let us know what the mix of business for Canada is now.

Michael Jeffries

Do you want to take that?

Jonathan Ramsden

Well, John, I think, we're digging into Canada. We're not going to be too public about kind of what we think is going on. The exchange rate has probably had some impact in terms of making the differential between the AUR in Canada and the U.S. look greater, and that's probably part of it. As we said, our margins in Canada remain pretty strong, so it's not a profitability issue, but the top line has been under some pressure in Canada. And I don't think we want to go into detail about what we're doing to address it, but we think we have a clear path to getting that fixed.

Operator

Next question comes from Omar Saad with ISI Group.

Omar Saad - ISI Group Inc.

I wanted to follow up on Japan, if you could talk about the negative comps you continue to see there. What you think is going on in that marketplace? And does it color your view on Asia and how the brand should be positioned in other parts of Asia? Or do you really feel that Japan has a unique situation? And any macro versus company-specific issues in Japan too?

Michael Jeffries

First answer is that we don't believe Japan represents Asia. We will find that out because we'll be in other Asian countries very soon. We think it is a Japanese situation. We think, clearly, there are macroeconomic issues and an aging population and a young population that is very infatuated with fast fashion today. We understand that. We cannot run a business in Japan that's appreciably different from the rest of the world, nor will we. But we're looking at the situation in Japan just as hard as we possibly can. But I think the real answer is not to believe that Japan equals Asia. We don't.

Operator

Our next question comes from John Kernan with Cowen and Company.

John Kernan - Cowen and Company, LLC

Quickly on the CapEx guidance, what drove it to the high end of your previous range to $350 million from $300 million, $350 million, you've seen higher store build-out costs, or what changed the thinking there?

Jonathan Ramsden

I think we were at $350 million on the last earnings call, John, was our guidance. We had started the year lower, you're right. FX was part of the increase and then I think just firming up some of the store plans was the other piece of it, some additional IT investments. It was a few different pieces rather than one major piece. But FX was certainly a meaningful piece of it relative to the original figure we gave.

Michael Jeffries

Is no one going to ask about "The Situation"?

Operator

Our next question comes from Pamela Quintiliano with Oppenheimer.

Pamela Quintiliano - Oppenheimer & Co. Inc.

Well, I am going to ask about the [indiscernible] exactly. I'm not going to ask about "The Situation". I'm not going to ask about August, but I'm just trying to figure out, you made a comment about a little bit more heightened concerns about a double-dip recession over the past few months. So clearly, you guys have been the leader, early aggressive about getting out there with then promotions, and I think stealing market share from other guys. But have you been able to adjust your orders and promotions reflecting that heightened concern regarding a double-dip? And when you think about the customer -- the core customer in each of your divisions domestically, do you think they respond to the promotions in the same way currently, or are they sensitive to the Hollister versus Abercrombie?

Michael Jeffries

I really don't want to talk about the promotions in the business. Jonathan?

Jonathan Ramsden

Are you sure you don't want to ask about "The Situation"?

Pamela Quintiliano - Oppenheimer & Co. Inc.

If I get a second question, we'll talk about "The Situation".

Michael Jeffries

I'll let Jonathan comment.

Jonathan Ramsden

I mean, honestly, what we're seeing, I think, about the economy isn't any different to anybody else. It's something that everyone is obviously more mindful of today than they were in the past. I don't think we can really speak to any specific things we're doing differently. And frankly, as we said earlier, we certainly are monitoring the situation, but we remain focused on the long-term execution of our strategy and for all the reasons Mike described earlier, we feel we're well positioned to accomplish that.

Operator

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

Adrienne Tennant - Janney Montgomery Scott LLC

Mike, would you please tell us the back story on the whole situation, that would be my first situation question because I am really curious. And then my second one, really, is for Jonathan. Cotton, obviously, is coming down, and I'm not going to ask you about kind of comp increases, but at the current level of $1, $1.03, at what point would we start to see beneficial tailwind in the financial side, plus 9 months assuming that it crosses sometime in November? So would that put us in the back half, mid to back half of 2012 theoretically?

Michael Jeffries

Okay, I think I can respond to the first part of your question. And this is how it started. Last Friday morning, I was with a group of people here, and someone came up and said, "Mike, I have terrible, terrible news for you. Last night, on Jersey Shore, "The Situation" had an A&F product on." So we all said, "Oh, that's terrible. What are we going to do about it?" And the group kind of came up with the solution: let's pay them not to wear our product. That's how it happened. That's where we are, and we're having a lot of fun with it. Second part of the question?

Jonathan Ramsden

Yes, Adrienne, on the cotton, I think we spoke to that earlier, we would see cotton, specifically, if things stay kind of where they are today, becoming a tailwind in the sort of middle part of the second quarter of next year, again, we've got some very favorable costing in the first – while not very favorable -- we have favorable costing in the first quarter of this year before the cotton increases had really taken effect, at least for us. And then it started coming much more significantly in the second quarter and through the back half of the year. So if everything stays the same today, then we would expect that to become a tailwind in the middle of the second quarter of next year. But as I said earlier, there are still other inflationary pressures which aren't fading or turning, most notably, labor costs.

Operator

We we'll go to our next question from Linda Tsai with ITG Investment Research.

Linda Tsai - MKM Partners

In the press release, you mentioned a higher AUR on international mix benefit, was the AUR positive for all the brands? And then you also mentioned graphic tees being a little bit weaker across the brand, was this an issue of units or [indiscernible]?

Michael Jeffries

We can barely hear you.

Linda Tsai - MKM Partners

I was saying in your press release, you mentioned a higher AUR in international mix benefit with the AUR positive across the brands, and then you also mentioned graphic tees being a little bit weaker, was that an issue of units or competitive efforts?

Jonathan Ramsden

On the AUR, Linda, what we said was that our AURs were up both domestically and internationally. And then internationally, that's obviously on a constant currency basis. So overall, we were up mid-single-digit for AUR. We don't break that out by brand, and there's not really anything additional I can tell you on that piece.

Michael Jeffries

I think your question about the graphic tees is a good one. We planned decreases in graphic tees because we're consciously trying to push more fashion in the business and less reliance on logo. And that's one of the thrilling things that's happening in the business, it's working.

Operator

And we'll go to our next question, Robin Murchison with SunTrust Robinson Humphrey.

Robin Murchison - SunTrust Robinson Humphrey, Inc.

I wanted to ask about your -- directionally, and I know it's very early, but directionally about CapEx for the out-year. Presumably, haven't you kind of come through a lot of the larger flagship Abercrombie stores, and so the forward stores might be somewhat smaller, a little less costlier, any cash flow info would help.

Jonathan Ramsden

Yes Robin. If you look in terms of total count, we'd spoken in the Investor Day to the fact that our rate of Hollister openings, we would be looking to accelerate that further beyond the 2011 level. And then the level of flagship openings we were targeting for '12 would be higher than '11. So I think taking on those 2 factors, they would drive CapEx up beyond the 2011 level. Other CapEx not related to stores would probably be less significant in terms of the year-over-year change. And to your point, though, it is still very early in the process for 2012 CapEx, and we'll certainly be giving more detail and color on that at the end of the year.

Operator

Our next question comes from Barbara Wyckoff with CLSA.

Barbara Wyckoff - Credit Agricole Securities (USA) Inc.

Two questions. Are there going to be -- of the 34 Hollister stores that opening this fall, are any of those in Asia outside of Festival Walk, that's number one? And then number two, Mike, looking back if you could do over second quarter, could you -- what could you have done better? I know it was a great quarter, but flow, inventory classification, just sort of thinking about how it played out.

Jonathan Ramsden

Barbara, just on the first one, yes, we do have other Hollister store openings in Mainland China, which we spoke to earlier on, which are part of the count that we have close to 40 for the year.

Barbara Wyckoff - Credit Agricole Securities (USA) Inc.

How many?

Jonathan Ramsden

We haven't given that number, but it's a couple.

Operator

Our next question comes from David Weiner with Deutsche Bank.

David Weiner - Deutsche Bank AG

Two quick questions. So number one, on international mall rents, just curious, we've heard that sequentially, over the last couple quarters, the rents are starting to come -- are starting to tick up after being down for a while. If you could just kind of talk about, relative to your 475 plan, if kind of what you're seeing in the mall rent trends into next year, is it internationally is kind of in line with what you thought? That was really my only question.

Jonathan Ramsden

David, I guess with regard to rent, it all comes back to how we look at each of these deals internationally. And ultimately, all comes back to that target fall margin of 30% for Hollister, and typically a little bit higher for A&F that we're shooting for. So if you look at the overall economics of the deal, the CapEx we have to spend to build the store, the rent -- and if we feel we can get that acceptable overall return, then we typically go forward with the store. I can't really speak to what's happening with individual rents, but we're obviously looking out at each deal on a deal-by-deal basis and making sure it meets our criteria.

Michael Jeffries

I would have to add that with our success in Europe, we're a very much in-demand tenant.

Operator

Ladies and gentlemen, that does conclude today's question-and-answer session, and concludes today's conference. Thank you for your participation.

Michael Jeffries

Thank you.

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