American Eagle Outfitters' CEO Discusses Q2 2011 Results - Earnings Call Transcript

Aug.24.11 | About: American Eagle (AEO)

American Eagle Outfitters (NYSE:AEO)

Q2 2011 Earnings Call

August 24, 2011 9:00 am ET

Executives

Joan Hilson - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Judy Meehan - IR

James O'Donnell - Chief Executive Officer, President and Executive Director

Roger Markfield - Vice Chairman, Chief Design Officer, Executive Creative Director, Vice Chairman of the American Eagle Division and Interim President of Martin + Osa Brand

Analysts

Dorothy Lakner - Caris & Company

Dana Telsey - Telsey Advisory Group

Stacy Pak - Barclays Capital

Jeff Black - Citigroup Inc

Christine Chen - Needham & Company, LLC

Betty Chen - Wedbush Securities Inc.

Michelle Tan - Goldman Sachs Group Inc.

Paul Lejuez - Nomura Securities Co. Ltd.

Adrienne Tennant - Janney Montgomery Scott LLC

Brian Tunick - JP Morgan Chase & Co

Jennifer Davis - Lazard Capital Markets LLC

Jennifer Black - Jennifer Black & Associates

Jeffrey Van Sinderen - B. Riley & Co., LLC

Samantha Panella - Raymond James & Associates, Inc.

Kimberly Greenberger - Morgan Stanley

Janet Kloppenburg - JJK Research

Lorraine Hutchinson - BofA Merrill Lynch

Operator

Greetings, and welcome to the American Eagle Second Quarter 2011 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Judy Meehan, Vice President of Investor Relations. Thank you, Ms. Meehan, you may begin.

Judy Meehan

Good morning, everyone. Jim O'Donnell, Chief Executive Officer, is joining us by phone today. Here in Pittsburgh, we have Roger Markfield, Vice Chairman and Executive Creative Director; and Joan Hilson, Executive Vice President and Chief Financial Officer. If you need a copy of our second quarter press release, it is available on our website, ae.com.

Before we begin today's call, I need to remind you that during this conference call, we will make certain forward-looking statements based upon information which represent the company's current expectations or beliefs. The results actually realized may differ materially from those expectations or beliefs based on risk factors included in our quarterly and annual reports filed with the SEC. And now I'd like to turn the call over to Jim.

James O'Donnell

Thanks, Judy. Good morning, everyone. I will begin with an overview of our second quarter performance, which will include an update on each of the brands, as well as AEO Direct. Next, I will turn it over to Roger to share his perspective on design and merchandising. And then we'll conclude with a financial review and an outlook from Joan.

As we all know, the lack of economic recovery has created a persistently challenging retail environment. That said, we managed our business prudently and made progress on our longer-term initiatives. I'm pleased to report our second quarter sales increased 4%, demonstrating improvement from the first quarter, and our EPS of $0.10 was within the range of our expectations.

During the second quarter, we began our strategy to maximize our key item businesses, like denim and shorts, with stronger and more impactful promotions. This strategy, combined with ongoing merchandise improvements is driving improved results. Although comparable store sales were flat, they were consistently and certainly stronger than the previous few quarters. Performance was fairly consistent within the AE brand, both men's and women's comps were flat, which is a positive sign for women's business.

Overall highlights for the quarter include AEO Direct, which increased 16%, and aerie stand-alone stores demonstrated stronger margin results. Overall, though, our promotional activity was planned and well controlled. However, as expected, higher cotton prices pressured margins and will continue to do so in the second half of the year. There are several indications that the cost of cotton is stabilizing. If that's the case, there is opportunity to recoup a good portion of the margin that we lost and will recover in 2012.

Expense management efforts continued to pay off with SG&A leveraging in the quarter. As Joan will review in greater detail, we are moving into a second phase of our profit improvement initiative, which also includes a deeper dive into our real estate initiatives, as well as other ongoing expense savings. Our balance sheet remains exceptionally strong with more than $500 million in cash and investments at the end of the quarter, and we continue to use our cash to invest in the business.

This brings me to growth. There's no doubt we are focused on managing expenses, but at the same time, we still have our sights set on growth. Early this year, we laid out a series of key initiatives to move us towards that goal.

Here is a brief update. Within the American Eagle brand, we are capitalizing on the strength of the brand and our continued dominance in key categories, as I mentioned earlier, such as denim. Beginning with back-to-school, we have made bolder investments designed to win back market share. This customer is still highly focused on price, and yet we are delivered in our promotional activity. By investing in proven businesses, offering powerful everyday value and creating excitement with compelling promotions, we believe we will continue to drive strong top line.

Our merchandise investments include a strong focus on AE jeans as denim is obviously a critical driver for the back-to-school business and fall. We've increased inventory to support demand, particularly in styles that carry through holiday and as well into the spring season. We've also made an important investment in accessories, where we see significant future opportunity. The response has been encouraging, particularly in women's, and we are excited about its potential.

At quarter end, we had 250 accessory shops within the American Eagle stores, and we expect to have 400 of these shops by holiday. Also new for AE this holiday, we plan to launch a comprehensive American Eagle personal care line for both men and women.

As I mentioned earlier, AEO Direct had a very strong quarter. We continue to build this business and see it as a great growth vehicle. During the quarter, ae.com was updated with a fresh look and functional upgrades to enhance the shopping experience. Improved navigation features and new filter options made it easier to shop the category level, and we made key upgrades to the search function as well. As a result, we' re seeing increases to our already strong conversion rate.

Now for a few details on our portfolio of brands, beginning with aerie. As you know, we've been expanding this business into a more complete lifestyle brand. While it's still early in the process, I'm pleased to see the second quarter margins show further improvement. Additionally, the initial response to aerie’s fall line has been quite positive. We're seeing increased traffic, as well as a positive customer response to the merchandising.

Aerie's intimate apparel offerings continue to build on its success with additional bra launches in the fall. We are also focused on increasing overall brand awareness, with a comprehensive advertising campaign that includes television, print and mall advertising as well as an innovative social media program.

Turning to kids. This brand continues to gain momentum with a growing customer base and a higher awareness overall. During the quarter, we opened 6 stores, bringing the total to 21 77kids locations. This included the launch of 77kids in our Times Square flagship location. 77kids continues to show its significant potential. The brand is led by a dynamic and highly-creative team, with a true passion for delivering the best shopping experience not only for mom, but for the most discerning customers, the kids themselves.

On the international front, we are growing the American Eagle Outfitters presence in several markets. Following our entrance into Hong Kong early this year, we have opened 4 new franchise stores in Kuwait, Dubai, China and Russia. We are planning to have a total of 21 international stores opened by year end, including new locations in Dubai, in Lebanon, Saudi Arabia, Morocco, Jordan and Egypt. We are also driving our global growth in AEO Direct by adding local currency options, as well as customized language features.

In closing, we are making significant progress in a number of important areas. However, given the continued uncertainty around the macro environment, we have tempered our outlook for the second half of the year. While back-to-school has gotten off to a terrific start, we're facing lower customer confidence in spending, especially during nonpeak selling periods. With this in mind, we're being aggressive and highly targeted on pricing and promotional activities and merchandising. The American Eagle brand has a loyal and large base. We are focused on maximizing our share of their wallet, as well as expanding our reach to new customers in the mall, as well as the Web.

And now I’ll turn it over to Roger. Thank you.

Roger Markfield

Thanks, Jim, and good morning, everyone. There is no doubt we would have liked to have achieved stronger financial results, but we held our own in a highly competitive and promotional environment. I was pleased to see second quarter sales improve nicely from the first quarter as we began to transition toward a more comprehensive key item strategy and stronger fashion content. Supported by investments in core AE categories, we can accelerate our business through strategic and targeted promotions. In other words, we now have the flexibility to go on offense. With the more balanced inventory position, we are seeing a positive change in our business. We are the main highway for the 15- to 25-year-olds and we strive to be top of mind every day. We are 100% focused on providing the right styles, great quality at the right price, and also having the best overall customer experience, both in stores and online.

Across the AE brand, we continue to have terrific success in denim, where we are the #1 with our customer base. We are now in a much better position to support replenishment and satisfy demand. This is especially true in core denim styles which have greater longevity. Essentially, to drive denim 12 months a year, we are positioning core styles to live through the spring season with fashion styles flowing more frequently. This change has had a positive impact with denim continuing to perform well during the back-to-school season.

This summer, we saw a strength in shorts and pants and continued to be a strong bottoms brand for our demographic. In tops, we are focused on getting the right mix of core items in fashion. We are seeing nice progress this back-to-school season, which we expect to continue into fall and holiday. Women's fashion knits and accessories, together with men’s knits, are building momentum, and I believe we are driving the appropriate mix within the sportswear business. Another second quarter highlight, as Jim noted, was the expansion of accessories. We've seen a positive response on the women's side, where we are driving newness and innovation within our offerings. This is an exciting new business which is ripe for an ongoing expansion, particularly during the holiday fast-turning season.

Our high-margin direct business was extremely strong, with growth in both traffic and conversion leading to the double digit sales increase. Other highlights include the performance of our Manhattan stores which are gaining momentum, and our international performance has been extremely robust, as Jim mentioned. Global demand for the AE brand has proven to be strong, providing support as we strategize future growth.

From a merchandising position, aerie continues to make very solid progress, not only in the foundations categories, but also in apparel. It's an exciting market opportunity with plenty of white space, and we are very pleased with the performance so far this fall. With the right team in place developing great products, and importantly, advertising to drive brand awareness, we have the tools for successful growth.

We have no control over the macro environment, and I recognize that it is very early in the fall season. With that said, I am encouraged by our progress and the impact our strategies are having on our business. The AE brand is enduring and perfectly positioned. We are real, with a broad and diverse customer base, which we embrace with passion. I want to take this opportunity to thank our teams for their dedication, passion and hard work. These have not been the easiest of times, but I know, with the talent and commitment we have across our organization, our progress will continue and lead to future growth and success.

Let me turn the call over to Joan.

Joan Hilson

Thank you, Roger, and good morning, everyone. Our second quarter can be summed up with the following. The top line demonstrated improvement, reflecting a stronger assortment and value offering. Although increased product cost pressured our margins, we delivered higher merchandise profit dollars. The gross margin declined due to the deleverage of brands. Expenses were well controlled, and our balance sheet remains strong.

Now looking at the details. Total second quarter sales of $676 million increased 4% from the second quarter last year, and comparable store sales were flat. Reflecting an improvement from recent periods, AE brand comps were flat and aerie declined 1%. Including the direct business, which had a 16% sales increase, consolidated comps increased 1%. AE Direct sales were driven by new fall merchandise and upgrades to our website, which drove increased traffic and conversion.

Looking at second quarter metrics, a high-single digit increase in the average transaction value fully offset the decline in the number of transactions.

Now moving onto margin. Gross margin decreased 250 basis points to 34.3%. While merchandise profit dollars increased slightly due to lower markdowns, increased product costs pressured the merchandise rate, which decreased 150 basis points compared to last year. BOW increased 100 basis points as a rate to sales due to ramp related to new store openings, lease renewals and flat comparable store sales.

Turning now to operating expense. Even though comps were flat, SG&A leveraged 70 basis points. Controlling expense remains a top priority as we continue with our corporate profit initiative. As previously discussed, we are reinvesting a portion of our savings into planned advertising designed to generate greater brand awareness, including aerie. One example of our ongoing opportunity for savings is the evaluation of long-term contracts upon expiration. For both the third quarter and the year, we continue to expect SG&A dollars to increase in the low-single digits.

Net income for the quarter was $20 million compared to net income from continuing operations of $26 million last year.

Turning to the balance sheet. As we indicated last quarter, we are investing in year-round key item strategy to expand market share and underscore our strong value offering. The quarter-end inventory position supports that initiative. Ending inventory at cost per foot increased 30%, with half related to higher product costs. In addition to our investments in year-round key items, inventory is positioned to support our planned accessory expansion to 400 unique shop-in-shop formats during the second half of this year. Units per foot increased 15%, including the accessory expansion.

Looking ahead, third quarter average weekly inventory will continue to support the key item strategy and accessory expansion, resulting in inventory similar to the end of the second quarter.

CapEx for the second quarter totaled $28 million compared to $20 million last year. The increase reflects store remodeling activity in the second quarter. For the year, we continue to expect CapEx in the range of $90 million to $100 million, with a little over half related to new and remodeled stores. We ended the second quarter with cash and investments of $515 million.

Now looking forward, while we have tempered our outlook for the remainder of the year, particularly during non-peak shopping periods, we expect to see a sales improvement from the first half, driven by the initiatives we discussed today. The back-to-school trend is positive and promotional activity is consistent with our plan. At this time, we expect third quarter EPS to be in a range of $0.22 to $0.27, which compares to adjusted EPS of $0.29 last year. Our guidance assumes margin pressure related to higher cotton costs and our planned promotional strategy. SG&A dollars are expected to increase in the low-single digits.

For the year, we expect EPS to be in the range of $0.85 to $0.95 compared to adjusted EPS of $1.02 last year. Now I'll turn the call back to Judy.

Judy Meehan

Thanks, Joan, and now we'll move on to Q&A. [Operator Instructions] I'll now turn it back to Rob.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question this morning is from the line of Adrienne Tennant with Janney Montgomery Scott.

Adrienne Tennant - Janney Montgomery Scott LLC

I guess this is for Roger. Can you talk about the accessories? It really looks good in the stores. It’s bringing traffic into the stores. I was just wondering how much of the square footage should be -- you expect to dedicate to that percent of the floor or percent of the floor set, however you want to define that. And then can you talk about the margin implications, how much higher the margins are on that piece of the business and how we can expect that mix to flow in?

Roger Markfield

Well, this expansion for us, obviously, is a new venture and the IMUs are certainly higher. Where the business will end up, we'll see as we move through the holiday season, but we really – the space wise, it varies by store based on store type, but it averages about 400 feet and at this point, we're really pleased with a lot of categories on the women's side of the business.

Adrienne Tennant - Janney Montgomery Scott LLC

Okay. Any comments on the extent of the difference in margin, accessories versus apparel?

Roger Markfield

Not at this point.

Adrienne Tennant - Janney Montgomery Scott LLC

Okay. And then, Joan, just to follow up on the comps, so the -- or can you just give us a little bit of color on August month-to-date and/or July when you guys set your floor set in early July, did you see a pretty immediate response in turning to the positive comps and was there any slowness at the end of July similar to some other comments? So if you could just tell us when you sort of saw that inflection point, and is the guidance, are you sort of guiding implicitly for maybe a positive low- to mid-single digit comp for the fall season?

Joan Hilson

Sure, Adrienne. As I mentioned, our comp is positive, and we see that happening as we started our back-to-school promotional activity was when we really saw the positive trend kick in. We did get a nice response to the denim line as it landed in June actually and in the month of July, and we did see a positive response to the key items selling in our core categories, in knit tees, in graphics and so forth. So we did see a nice product response. The positive comp came as we went full bore into our back-to-school promotional strategy. And we'll really wait to see here to comment on what actual comps are as we get through the rest of the quarter. As you know, it's very early in the third quarter.

Operator

Our next question is from the line of Christine Chen of Needham & Company.

Christine Chen - Needham & Company, LLC

Just to sort of continue on the back-to-school commentary, denim clearly and the key items, what else seems to be trending well, and what is a little more challenging? And then with respect to aerie, can you maybe update on the progress of that? Is that expected to break even this year still?

Roger Markfield

On back-to-school categories, we're doing well pretty much across the board right now. But the strength, the beauty of the denim business for us, on the women's side, in view of all of the competition and all of the pricing that's out there, our denim business on the women's side continues to be very strong. But what's really nice is that the tops business now, the knit business for women's, which we've been redoing and redoing. We really have it on the right mark now, and that's doing pretty terrific for us right now, and obviously, the pants business in both men's and women's, which is the non-denim part of the business. And we made an investment for all the warm weather stores in the short business because it's much more wear now than it's ever been and that's paying off for us as well.

Joan Hilson

And with respect to aerie, aerie is progressing very nicely. Jim mentioned in his remarks that we saw a margin improvement in the second quarter. And let me remind you that aerie, as a brand, all channels, is a profitable brand for us. As we look forward into the back half of this year, we're excited about what happened with our Drew launch here in August and the marketing campaign that supported that. And into the fourth quarter, I would expect to see 4-wall profitability for the aerie stores to happen. So we'll see 4-wall profitability in the fourth quarter.

Operator

Our next question is from Jeff Black with Citigroup.

Jeff Black - Citigroup Inc

Joan, on the inventory I thought we were guiding for a low-double digit rise and units down, and we're coming in significantly higher on both of those counts. Accessories, I get it, that accounts for some of it, but when was the denim strategy contemplated? Is that what is driving the units? And what kind of confidence do we have that the merchandise margins aren't going to be under some more pressure given where the inventories are?

Joan Hilson

The average inventory guidance that we gave, in fact, Jeff, was low-double digit, and that's where our average quarter came in for the second quarter. And as we look to -- and as we said on the call, we were supporting the key item strategy, making strategic investments in a year-round key item strategy, which to your point, includes denim as well as some of our basic top categories. So the increase, as you talked about for the end of the quarter at 30%, half of that relates to product cost increases. The other half fully supports this investment in key strategy as well as the accessory expansion. And our view of inventory and the promotional strategy that Jim and both Roger mentioned are all factored into our view of guidance for the third quarter and into our output for the year.

Operator

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

Lorraine Hutchinson - BofA Merrill Lynch

Can you share with us the results of any price increase tests that you've begun for the early back-to-school season?

Roger Markfield

I'll take that question. We're very selective where we try to raise prices. Remember, we're a big brand, we have a strong customer base, and our customer base doesn't have a lot of money. We have to be very careful that we don't raise prices and lose our following. Value pricing for us is critically important, and the cost of cotton increase is a short-term phenomena, which will go away, it looks like, for next year. So we've been very careful in raising prices. We've only done it where we think we can benefit and there we have.

Operator

Our next question is from the line of Stacy Pak with Barclays Capital.

Stacy Pak - Barclays Capital

Just a couple of follow-ups and then one question. One is, what is the AUC [average unit cost] expected up in Q3 and Q4? What’s inventories, just on accessories or just in apparel, however you want to answer it. And then I guess fundamentally, it looks to me like comps are up because inventories are up so high, and where are you, Roger, on sort of improving tops and when do you think you will have the assortment that's going to sort of enable Eagle to gain back some positioning? Because margin's down 10 points from the good old days, so I'm just kind of trying to figure out is there some time period we should be looking at where you feel a lot better about tops or sort of where are we in the continuum?

Roger Markfield

Well, on tops, on the men's side, they're doing extremely well. The knit business for us in men's is very strong. In women's, we started with the back-to-school set. The knit business is very strong. We have, as I said on the last call and the call before, we were redoing the teams, the teams are in place, and I really feel very comfortable with where we are in terms of the knit business at this point. I was in the mall 2 days ago, I visited all of the stores. I think we're very focused. We are tight, and we have the right looks, and it's doing well for us and our customer’s responding.

Joan Hilson

And with respect to the average unit cost, Stacy, it's up midteens, average, the product cost up midteen and the view of inventories, apparel versus accessory, the apparel unit increase is roughly 10% and the accessory is about 5 points, bringing it to the full 15%.

Operator

Our next question is from Sam Panella of Raymond James.

Samantha Panella - Raymond James & Associates, Inc.

I guess with respect to your direct business, up nicely 16%, but being down last year, I guess is there anything constraining stronger growth at that business?

Roger Markfield

Well, as you know, it's a terrific business for us. The site has been improved. It's about 12% of our business, which is a pretty good sized business for a business that wasn't structured as a catalog business. And it's growing. It's a nice double-digit growth right now. We're really happy with it.

Operator

Our next question is from Janet Kloppenburg with JJK Research.

Janet Kloppenburg - JJK Research

A couple of questions. Joan, units per foot are up 15% with accessories. I assume that's a higher investment in accessories. So are you saying units per foot are up the high-single digits that you had guided for earlier? And also, I wanted to know, Joan, at what comp can you leverage occupancy, please? And also on inventories, should we expect year-end inventories to be up this much as well?

Joan Hilson

Okay, Janet. With the units per foot, as I said, 10% relates to apparel, 5% relates to accessories. The guidance that we give doesn't include quarter-end point of view due to in-transit. So the guidance I gave at a low-double digit increase includes an average weekly view of inventories, and we were in line with that throughout the quarter. The comp leverage point for occupancy is low- to mid-single digit. And the question on inventory, we would expect the fourth quarter to be similar to the third quarter, with an ease of that inventory into the first half of the year.

Janet Kloppenburg - JJK Research

Okay. And for Roger, Roger, can you talk about the level of success of your marketing program and your positioning, which I think has moved more Bohemian even a slash surf skate feel in the TV advertising in particular. And if you could comment on the success of the women's fashion top business in the second quarter as well?

Roger Markfield

Well, in the second quarter, the women's tops were not where we wanted it to be yet, and as I indicated on the last call, we're working strongly on it for back-to-school, and it's working. So fortunately, what we thought would happen is happening. As it relates to the marketing, we're really pleased, the aerie marketing, we're hearing great responses on, and it's really driving increased traffic into the stores and the conversion is terrific. In the Eagle as well, our advertising for the most part is really about denim. The denim business, especially on the women's side, is strong for us where it's a more fashionable business, and everyone has loved what we've done from the marketing perspective. And in light of all of the competition out there at price points that are just amazing to me, it's not having much of an impact that we can see. But obviously, I guess we would be doing that much better if those price points were not out there.

Operator

Our next question is from Brian Tunick with JPMorgan Chase.

Brian Tunick - JP Morgan Chase & Co

I guess for Joan, maybe on the balance sheet, it looks like now that you've had that big inventory build, when does returning cash to shareholders sort of move up from a priority perspective? And if someone could update us on the CEO search, we'd be curious about that. And maybe just finally for Roger, just on the denim price points, it looks like a couple of times, you've gone all denim below $30, but some of your main competitors are still a lot lower than that. Just curious if you're looking at that, thinking about reacting to that or does the fashion, especially on the women's side, give you the ability to keep your price points above them?

Roger Markfield

I'll start on the denim. I don't want to sound too proud, but if you walk any street anywhere in the country, they're all wearing the backside of the American Eagle. They love our fit, they love our jeans. And as long as we're priced at a reasonable price, they'll buy our jeans over anybody else's. And I'm real proud of it, and the organization has done one great job in accomplishing that. Now with that being said, we didn't own the inventory to replenish. Remember, when we talk about inventory, we're a bottoms-based business in American Eagle. We dominate in the bottoms business. The number of SKUs that's necessary in order to be able to replenish with the assortment that we carry in the bottoms business is quite sizable, and for us, it turns pretty well and it's pretty risk-free. So when you look at the base of the total inventories, it's very important to understand how much inventory we invest in the bottoms business and what we've done for this particular season. With that being said, our turn is still, the turnover is still pretty fast for a bottoms-based business.

Joan Hilson

With respect to the cash. As you know, we have a strong track record of returning cash to shareholders, and we do have $14.5 million or 14.5 million shares currently under authorization, and we'll continue to evaluate share repurchase along with dividends with our Board of Directors.

Judy Meehan

Jim, would you like to address the CEO search question?

James O'Donnell

Well, the search has been activated, and we're moving forward, and that's all we have to say right now.

Operator

Our next question is from Paul Lejuez with Nomura Group.

Paul Lejuez - Nomura Securities Co. Ltd.

When you first started opening aerie stores, what kind of leases were you signing, like what length? And just wondering what you've been doing as these leases come up for renewal, if some of them have. Or if they haven’t, I guess what are your plans as they do? Do you expect to hang on to all those stores or do you expect to get out of some of those leases? And also just wondering on the accessories business, what is that replacing on the floor? I'm just wondering why the investment in accessories accounts for so much of the inventory increase? Doesn't it replace something?

Judy Meehan

Jim, would you like to address the real estate?

James O'Donnell

Sure. All of the aerie mall leases are 10 years in duration, and all the leases have, at a given time period, what is determined a kick-out clause. They usually run somewhere around a window of 3 to 4 years, but 3 being more the rule than not. As we look at some of these leases that are coming up, we make a determination whether we wanted to exercise the kick-out or continue on with the duration of the lease. If these stores are not performing to a level of what we feel is the acceptable expectation, we would look to close those stores. As to date, we have evaluated all of our stores, the Eagle included, under a major portfolio review, and we're in the process now of putting together a comprehensive plan as to what future markets will look like in North America, and that would include aerie. Currently, the aerie stores, we have to give them, as Roger was stating, a little bit of time because the latest collection and the efforts that we put behind this evolving lifestyle business is just starting to get traction, and I wouldn't want to make a foolhardy decision to close a store that eventually we want to have in that particular shopping environment. But there are indications that certain stores are probably not deemed to be appropriate for certain markets, and naturally they’d be targeted to close, and you'd hear more about that in the future.

Roger Markfield

On the accessory expansion, as a company, we have over 1,000-store fleet. And on the selling foot basis, we do over $500 a foot, so one would say where do you find the space? Well, we did our due diligence, and it's amazing how we came up with 400 stores that absolutely had the room to create an accessory shop, either in the back area where it was originally supposed to have been or around the cash and wrap. And quite frankly, we didn't need to do anything else other than carve it out.

Operator

Our next question is from the line of Michelle Tan with Goldman Sachs.

Michelle Tan - Goldman Sachs Group Inc.

Roger, I agree with you. I think that the product’s starting look more on brands. I'm surprised that with better sales against the easy comparisons you have from last year that your markdown rate didn't improve more. I can't help but thinking it's because of the amount of investment you keep putting behind inventory. I guess can you give us any color on where that markdown rate sits now versus where it used to be several years ago? And what levers you’re thinking about to unlock that opportunity? How you think about the balance of inventory, what else can happen going forward?

Roger Markfield

I really like where our inventory is, and I know you guys figure out turnover. If you look at a bottoms-based business, you'll see that this inventory level is about right now, we'll be able to satisfy our customers. We can replenish where we need to, and I'm pretty damn comfortable with where we are in terms of the inventory. In terms of the markdowns, it's a bit higher than I would like it to be. It's still a relatively low number in this business, and it's because of the competitive environment out there. But if you factored the difference in the cost of goods based on cotton, we would be making more money, and that hopefully will come back to us as we move through 2012.

Operator

Our next question is from Betty Chen of Wedbush.

Betty Chen - Wedbush Securities Inc.

I was wondering if you can speak a little bit to the online business. It grew nicely up 16%, and I think you alluded to higher traffic in transactions, conversions as well. What, if any, differences are you seeing in that online customer versus the ones in the stores? Any learnings that you can carry over to the brick-and-mortar part? And then my second question’s around 77kids and aerie. Where do you still see the longer-term store potential, the number of stores for each of the concept? And when should we expect, although quite early, when should we expect 77kids to also potentially reach either breakeven or profitability?

Roger Markfield

The synergy on e-commerce and stores is terrific. The teams that we have in the e-commerce business now are teams that were merchants running the Eagle business, and now with Fred heading up merchandising and e-commerce and Michael Leedy back in marketing, the whole combination is very powerful, and this e-commerce business is really, really, for us, growing. It's really showing the strength of the brand, and we're now using e-commerce strategy to even drive more traffic into our stores. So the whole combination, I'm really happy with right now.

Judy Meehan

Jim, would you like to address the question on store potential for kids?

James O'Donnell

Sure. Ironically, and not necessarily will they both be in the same locations, but the plan is for approximately 350 to 400 stores in North America for both aerie and 77kids. The numbers just happened to work out that way. It's rather obvious, and I think I've stated this a few times in the past, we do not expect either the aerie or 77kids to have the same number of stores that we do have at American Eagle. I think that both the brands are of a nature where want to be strategically located, but we really don't want to be on every street corner in America. So it provides a little bit of a more exclusivity to the brand. Joan and I have run some quick numbers on the profitability for kids. And right now, on its current cadence, I would expect, we both would expect the brand to be profitable in 2013, with major improvement in 2012.

Operator

Our next question is from the line of Dorothy Lakner with Caris & Company.

Dorothy Lakner - Caris & Company

Roger, I wondered if you could just comment a little bit more on denim. I know you love to talk about it. But where the comp actually is tracking since you've had a good track record in the category, and it’s certainly been pretty promotional this season, but you seem to be very positive about it. So where the comp is there. Secondly, on aerie, where the apparel comps are tracking versus the core foundation business? And then lastly for Jim, just how the remodeled stores are continuing to perform for you?

Roger Markfield

Dorothy, I'm not going to give specific numbers out 3 weeks into the back-to-school quadrant but women's denim’s doing very well for us and aerie is doing terrific.

Joan Hilson

Aerie is doing well in both the apparel side of the business, as well as the core foundation side of the business, Dorothy.

Judy Meehan

And then, Jim, did you want to address the remodels?

James O'Donnell

Sure. Dorothy, on the remodels, I think all of you who have followed the company for quite a while know that in the next, actually, this year of '11 and '12 and '13, really, I think will be the largest number of stores that we have the leases coming due because of the growth cycle we had 10 years ago, 11 and 12 years ago, respectively. So we have looked at remodels a little differently currently than we have in the past. In the past, when we had maybe what we would call 25 or 30 remodels we've looked at redoing the store. Now that we have remodels that number well into 130 to 150 locations, we’ve now broken it down into a number of different financial variables as to, and it's by market and by store volume, whereby we will do anything short of just sort of a freshen up and that's paint and lighting to a full-scale remodel, which would be the entire store to be redone. The entire store redos are in limited numbers, so we're keeping our CapEx costs down. But the short answer is that I'm very pleased that -- at the results of our remodel, both on the less expensive version, as well as the more expensive version. So our remodeled stores continue to outperform our stores that have not been remodeled on both a gross sales, as well as a modest single-digit comp store sales.

Operator

The next question is from the line of Dana Telsey of Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group

Can you talk a little bit about the tops business both on the women's side and the men's side? You mentioned the improvement in mix. What are you seeing there, price promotions versus price points? And also on the graphic tee side of the business. And do you expect knits versus denim, how are you thinking about the holiday season?

Roger Markfield

Obviously, Dana, for holiday, we're going to be pretty aggressive on the knit side of the business, which is the holiday giving business. But it's quite amazing that our denim business during the holiday period is almost as strong as it is during the back-to-school period, and we will own the inventory this year to be able to replenish and the assortments that we have and the fashion that we're playing with, we like what we have. So we feel pretty good about that.

Operator

The next question is from the line of Jennifer Davis of Lazard Capital Markets.

Jennifer Davis - Lazard Capital Markets LLC

One, actually 2, clarifications, please. On the apparel units, I think you said that inventory increased 10% and accessory units increased 5%. Could you break that down in dollars? I assume that there's a bigger increase in apparel given the cotton prices. And then also wondering if I could get a little more color on comps, the UPT, AUR traffic and conversion.

Joan Hilson

With respect to the inventory, yes, apparel units were up 10% at quarter end and the accessory is 5 points of the 15%. With respect to costs, Jennifer, 50% of the increase in our ending inventory relates to product cost increase and about 5 points of that, of the balance relates to accessories and the other 5 points relates to key item investment. With respect to the quarter and sales metrics, we had a very nice increase in our AUR in the quarter. Traffic, however, was down, but our conversion remains strong speaking to the points that Roger was making on the strength of the assortment during what we would consider a relatively tough traffic period.

Operator

Our next question is from the line of Jeff Van Sinderen of B. Riley.

Jeffrey Van Sinderen - B. Riley & Co., LLC

I guess this is really a clarification question. In terms of the overall promotional cadence versus last year, are you currently more or less promotional for back-to-school versus last year? And then what is the plan for level of promotional cadence versus last year for the remainder of this quarter?

Roger Markfield

I would say we're a bit more promotional than we were last year in view of the climate out there. The stores in the malls are much more competitive than where they were last year. But we're right on our cadence of what our strategy was. So I feel pretty good that we don't need to go further than our strategy in order of meeting the competition and gaining market share.

Operator

Our next question is from the line of Kimberly Greenberger with Morgan Stanley.

Kimberly Greenberger - Morgan Stanley

Joan, I thought I heard you say, average unit retail was up in the second quarter. I'm wondering if you could help us understand the magnitude of that. And then just looking back in the model, it looks like the last time we saw a 30% spread between total sales growth and total inventory growth was at the end of the second quarter of '05, following which the gross margin rolled over. So I'm just wondering how carrying a heavier level of inventory doesn't result in merchandising margin pressure going forward. If you could just help us understand that, that would be great.

Joan Hilson

Sure. The color on the AURs is up high-single digit and it nicely offset, which drove the average transaction value up, Kimberly, which then nicely offset the decline in transactions related to traffic. With respect to the inventory, the key point to think about is this replenishment thought and the idea that this is year-round inventory that we're holding in stock to replenish and maintain a size integrity to ensure we protect our franchise in the cornerstone of our brands in denim. That's #1. And then this idea on this key item strategy on basics or core items in tees and in graphics, these are styles that can live longer, they can carry over into the spring season, and we can continue to turn those. And so with that in mind, we feel comfortable with the guidance projection or guidance that we have for the third quarter because we have the promotional plans baked in or laid in that Roger mentioned. And we can continue to satisfy our customers and with the hope that we will effectively drive the top line.

Roger Markfield

And keep in mind that half of that cost of goods is in the cost of the cotton.

Operator

That next question will be coming from the line of Jennifer Black with Jennifer Black and Associates.

Jennifer Black - Jennifer Black & Associates

I have a couple of questions. I wondered, Roger, if you see a more preppy cycle coming in. I'm just talking about retail across the board. That's my first question.

Roger Markfield

I hate to talk about fashion, but yes, obviously, we see preppy, but we see preppy obviously with other variations, so it's not the old preppy, but it’s the new preppy.

Jennifer Black - Jennifer Black & Associates

Okay. So you won't be moving away at all from the Bohemian look. Is that correct?

Roger Markfield

I didn't say that.

Jennifer Black - Jennifer Black & Associates

And then I wondered if you could talk about the AE campus stores and the outlet centers? I mean obviously, you get lower rents, but I was curious about the productivity you're seeing versus your mall stores.

Roger Markfield

Jim will take that one. He likes that one.

James O'Donnell

Well, Jennifer, thanks for using the term off-campus. Actually, this whole outlet center phenomenon that's really emerging throughout North America, primarily here in the States is, it used to have a negative connotation, sort of low prices and not exactly a great shopping experience, that whole attitude and perception is now gone and it's really a quite -- they're quite the place to shop because of the mix of retailers that are there. Anyway, that is a backdrop. We are very pleased with our off-campus business. We have developed a model that we think can really survive the test of time. What that means is that the financial goals and objectives that we've set down, although modestly aggressive, we've been meeting and beating those in most every instance. And yes, the overall potential profitability, because of lower rents, and it's also lower overhead because you don't have the common area maintenance and other expenses that are fixed to a mall location, you view the channel to be incredibly profitable. And we're on that path. We're very, very pleased. I have an excellent team in place. The stores are run like an American Eagle store, although the product mix does deviate somewhat for our off-campus stores, but clearly, they run with the same standards of an American Eagle mall store. And the driving force is a combination of the inventory that we put in the stores, but they are, especially in this type of an economy, I think it's rather obvious to all of us, they have the perception and the traffic patterns are incredible in these shopping centers across the North America, primarily here in the States.

Jennifer Black - Jennifer Black & Associates

Do you plan on further, I mean are you going to put your foot on the accelerator with these stores? And then I guess you didn't exactly answer my question. I mean, as far as the productivity versus the mall stores, I mean would it be fair to guess 20% to 30% higher?

James O'Donnell

The quick answer is yes on that. And as far as the strategy for growth, most of our new stores, I would say 90% of our new stores, are planned to be off-campus stores. Right now, we have, I believe around 52 or 53. I think we have the capability over the next few years to have somewhere of 100 stores. But I just want to put a caveat in there. We've done this portfolio review on our entire fleet. And I will not be putting in off-campus stores at the expense of a mall store. So it's a very precise exercise that we go through to ensure that if we layer in an off-campus store that it will not have a negative effect on a mall store or in some cases, the off-campus location would be viable and then we could look at potentially a mall store if it's not as proficient, and at the proper time, we probably would terminate and only have a presence of one mega store in that particular market. But they have been on average about 20% to 30% more profitable than what would be a mall store.

Judy Meehan

Okay, guys. That concludes our call today. Our third quarter announcement is currently scheduled for Tuesday, November 22. So thanks for participating today and have a great day.

Operator

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

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