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rue21, inc. (NASDAQ:RUE)

Q2 2011 Earnings Call

August 24, 2011 4:30 PM ET

Executives

Joseph Teklits – Senior Managing Director, ICR Inc.

Robert Fisch – President, CEO and Chairman

Kim Reynolds – SVP and General Merchandise Manager

Keith McDonough – SVP and CFO

Analysts

Paul Alexander – Bank of America Merrill Lynch

Michelle Tan – Goldman Sachs

Ian Murphy – Piper Jaffray

Brian Tunick – J.P. Morgan

Adrienne Tennant – Janney Capital Markets

Paul Lejuez – Nomura Securities

Stacy Pak – Barclays Capital

Operator

Good day and welcome to the Rue21 Second Quarter 2011 Earnings Results Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Mr. Joe Teklits, please go ahead.

Joseph Teklits

Great. Thanks, good afternoon everybody. Thanks for joining us for rue21’s Second Quarter 2011 Conference Call. Joining us today is Bob Fisch, company’s President and CEO; Keith McDonough, the company’s Chief Financial Officer; and Kim Reynolds, SVP and General Merchandize Manager.

Before we begin, the remarks made by management during this call will contain forward-looking statements about the company’s future financial performance and plans. There are risks and uncertainties that could cause the actual results and implementation of the company’s plans to vary materially from those in the forward-looking statements. These risks are referenced in today’s press release, as well as the company’s fiscal 2010 Form 10-K which can be found in the Investor Relations section on the company’s website at rue21.com. All information discussed on the call is as of today, August 24, 2011. Rue21 undertakes no duty to update this information to reflect future events or circumstances.

And with that, we’ll turn the call over to Bob.

Robert Fisch

Thank you, Joe and good afternoon everyone. We were very pleased with our second quarter overall results, with net sales up 21% and net income increasing by 20%. We achieved another record second-quarter merchandise margin driven by our ability to control product loss and optimize inventory and promotions.

This drove our first half performance to 23% top line growth and 42% net income growth and we are maintaining our outlook for the full 2011 fiscal year. We are proud that we’ve been able to deliver consistent top and bottom line growth each quarter regardless of the strength of the economy. We give our customers value for their dollar as that is a proposition that works in all markets in any economy. In fact, historically some of our best quarters have occurred during recessionary periods when the value we offer to our customers for the items they love really differentiate us from our competition.

The primary pattern that we have seen recently is that anything with fashion element is selling very well. Fashion knit tops and dresses have been great and price continues to not be an issue when you deliver quality and fashion merchandise at a great value. But better jeans are turning faster than our basic jeans and our AUR in the second quarter was up by almost 9% not because we are raising prices, but rather because our customers are buying our fashion items at full price rather than waiting for a promotion and as a result we are selling less items at markdown.

Footwear, jewelry and other accessories and our et cetera business also continues to be strong. In a few minutes I will turn the call over to Kim Reynolds to give you some additional color and how we are approaching the fall season. We were able to produce consistent sales growth in the second quarter even with flat comps. We believe sales were affected this year as they have in the past for us in the second quarter but the fact that we buy for a short summer selling season slowing the back-to-school merchandise to our stores as early as July. But the trend we see happening around the country is that customers are buying for back-to-school later into the season and even as late as August or September and we are actually could have used more summer merchandise in July.

We can bring more depth to several items such as sandals, shorts, Capri and dresses in the July especially where we have more than half of our stores in strip center and it was 100 degrees warmer or hotter in much of the country.

We began August with approximately 20% less summer apparel inventory than the prior year which shows that we lack summer merchandize to promote deeper through the end of the quarter and similar to last year, we refused to promote new fall merchandize in July. It isn’t right for the long-term of our business.

Next year we will reconsider our approach and purchase more summer transition value merchandize as it is evident that back to school shopping continues to start later and later every year. So a better balance later in the second quarter next year will benefit us.

In fact what it shows me is that we discussed in core earlier in the first quarter about our Denim shorts for example where we sold at extremely well at regular price and we were able to stabilize and maintain a regular price later than we ever did before and Kim and her team took advantage of Denim shorts with great pricing of lowering costs for purchases for July and August that when we did promote we are having tremendous sales through, that’s something that we look at and instead of just having lower price clearance, we see that is an opportunity for next year that we will reconsider so that we have also looked to have strengthening of our comps in addition to our margins and profits.

However, our gross margin was very strong this quarter and we are pleased with our results and how we are positioning going forward in terms of inventory. And inventory discipline and control is very important to us as is increasing our margins. We opened 73 stores in this first half of the year versus our planned of 65, 38 malls and 35 in strip centers and we ended the quarter with 710 stores.

We continue to work very hard with the developers on real estate to make sure we are getting the best locations and the best deals possible as one of the few major retail growth stores in the country. The new stores are performing well and continue to drive predictable profit growth. That’s very important to the success of our company. We’ve also converted 26 stores to our et cetera concept so far this year and one store that we just converted was in Monroeville, Pennsylvania which had an expanded area for shoes, our tarea brand of bras, undies, and active wear and a new location for our carbon elements brands of men’s accessory.

It is amazing store that has generated a lot of local attention and having a store like Monroeville so close to our headquarters really gives our management team the ability to test new ideas and understand customer reactions to new merchandise lines, fixtures, store design elements before rolling these innovations to the entire chain.

In the first four weeks for example shoes was approximately 10% of our sales which demonstrates to us the wide space opportunity we have across all of our et cetera store for the future.

Looking specifically at back-to-school sales we’ve had success during past three days where we’ve had 383 stores participate in tax-free events that helped us drive sales around the country in the past few weeks. In Texas alone, 80 stores or 11% of our chain were tax free last weekend and we performed well in comp against the same event last year which is very encouraging.

Overall our back-to-school business has been solid and consistent with our plans and we are feeling very good about our merchandise and how we are positioned with our fashion at everyday great value. Even in malls with some of our competitors are very promotional. Our business has been performing in line or even better in the overall chain. Our product cost continued to be contained, thanks to Kim and her team and we believe our gross margin will increase again in the third quarter.

Another strength we see carrying into the back half of the year is Rue’s ability to control prices that continues to offer value with many of our competitors have stated they anticipate raising their price points. As we stated on last quarter’s call, we do not see material product cost increases impacting us in the back half of the year. The flexibility of our sourcing model allows us to purchase the styles we see trending today and will also take advantage of falling cotton prices. We have not yet placed all of our holiday commitments and we have built a wide vendor base and strong collaborative partnerships with these domestic importers who are able to mitigate increases and are motivated to strengthen their relationship with Rue21 as we gain in purchasing power.

As you move through the second half, we believe this flexibility in sourcing will be a competitive advantage against retailer whose models required them to buy for holiday when cotton costs were at their peak.

In closing we had another solid second quarter and strong first half of the year and we are confident about how we are positioned ourselves for the second half of 2011. Our ability to offer great fashion at everyday value continues to provide us with many short and long-term growth opportunity in any economy and our management team is experienced and very well equipped to foster this growth.

We have a strong, yet simple plan in place, open stores in markets where the customers strive for fashion; continued to update our offering of new and expanded product categories in converted stores; leverage our unique sourcing model to keep cost controlled and implement new tools in planning and allocation in other areas so that we are always improving our operation. This plan is what is provided for our growth so far and this plan is what we will be providing for our growth now and for the future.

I want to say thank you to the team for all of its hard work at the half way point of 2011 and now I would like to turn this over to Kim Reynolds to provide an update on our merchandise performance in the quarter as well as how she and her team are approaching the fall season. Kim?

Kim Reynolds

Thanks Bob and good afternoon everyone. As Bob mentioned our pricing and promotional strategy delivered solid results for the first half of the year and led us to achieve strong margin gain as well as profit growth. Our continuing good, better and best programs highlights our opportunity of growing our retail through strong sourcing combined with great fashion and competitive retail. Fashion range during the second quarter where basic businesses were less compelling to our fashion forward customer.

The key trend for the quarter was to have inspiration and our bestsellers were the higher price points within the dress, footwear and fashion top areas as well as our high margin jewelry and accessory area. Selling through trend-right merchandise at these higher retails meant that we sold less clearance merchandise than in the past which allowed our average unit retail to increase by almost 9%.

We are committed to continuing to raise the bar in fashion and price points through our good, better, best strategy on assortments through the balance of the year and were repeatedly shown that when we offer great fashion, great value and compelling price points we do not need to overly promote to bring customers into our stores and drive volume.

As we said previously, we also continue to increase market share in accessories which now represents more than 25% of our business. There is a huge potential in this area for Rue21 and we’ve added some great trend-right merchandise to our back-to-schools assortments to represent the latest trend including Western inspired boots and handbags, feathers in virtually all categories of jewelry and tooled leather belts. We own this leather accessory business.

Fringe and color are key axons that our customer uses to complement her fashion wardrobe. In beauty, we’re launching our new limited time only pop up fragrance and this September and a new guys fragrance in October to add to our growing line of fragrances, cosmetics and beauty products. To further support this growing business, we’ve strengthened our accessory planning and allocation teams and are focused on leading the value retail industry and accessories.

The guys performance was a little softer in the quarter than we would have like to see. Our shorts and tees for summer didn’t perform well as in the girls side of the business where we draw through some great fashion trends and denim stores and fashion tops. However, we continue to be focused on new trends and guides for the second half of the year and see lot of potential sales opportunity in the varsity and club trends where we also offer coordinating accessories like skate shoes, belts and guy’s jewelry that we sell under our CARBON ELEMNETS brand. We think guys accessories will be a huge win for us going forward.

We are also introducing more fitted styles and boots and nets that better reflect the young attitude of our guy customers. We just returned from a magic show in Las Vegas and are thrilled to see more fashion trends for the first time in several years. A lot of newness in guys and some exciting new vendor partners that will contribute to trend right product at great value in our guys area.

In terms of sourcing, we continue to leverage our strong vendor relationship and flexible sourcing model and we are not experiencing the cost increases that are plugging many of our peers. We view this is a real advantage going into holiday as we are still placing orders for October and November and unlike many of our competitors, we feel confident that we’re not compelled to raise prices in our stores to achieve margin growth.

We will raise retails as fashion commands a higher price not because of costing pressure. We also anticipate that we will see the beneficial effects of some of our new planning and allocation initiatives that will allow us to better control inventory by store for holiday. So again we are really excited about the opportunities we see for the second half of the year.

With that, I will turn the call over to Keith to go through the financial performance for the quarter and the first of the year.

Keith McDonough

Thank you, Kim. I will review the second quarter and first half financials and then provide an update to our outlook for the remainder of the fiscal 2011 year. Net sales for the quarter were 172.8 million up 21% from 143 million in the second quarter of 2010. The increase was driven all by non comparable store sales as comp sales were basically flat in the quarter. Sales growth metrics for this quarter included transaction growth of 14%, an AUR growth of 9% as Kim stated.

The AUR increase we attribute primarily to less reduced price merchandise on hand and more initial price selling achieved through stronger inventory management. We are also seeing impact from continued opportunistic up selling related to our good, better and best merchandising strategy.

We have 34 stores, converted 14 and closed one in the quarter which is well ahead of our plan and compared to 31 openings, 9 conversions and one closure last year in the second quarter. We are operating 710 stores at the end of the quarter, up 19% from last year consisting of 556, comp stores and 154 non-comp or about 22% of the total. Last year’s total calendar quarter of the Q2 and was 595 consisting of 469 comparable stores and 126 non-comparable stores are about 21% of the total.

Gross profit for the quarter increased by 24% to $67.6 million, our gross margin expanded to 39.1% up from 38.2% last year. This 90 basis point increase comes on top of 220 basis points margin increase achieved in the second quarter of 2010. The gross margin expansion for this quarter was driven completely by merchandising margin which grew enough to offset a 10 basis points deleveraging in fixed expenses and cost of sales.

Merchandised margin improvement was driven by a lower mark down rate performance which repeats the directional performance of the first quarter while IMU was equal to the second quarter last year. This relative IMU performance we are especially pleased with given the macroeconomic inflationary pressures we often hear about in our retail peer group but have yet to experience. As I will go into further during my balance sheet commentary, we also coupled a strong margin performance in the quarter with an excellent inventory performance ending down by 0.7% on a square footage basis.

As a footnote to this strong margin and inventory performance I’m able to report our advanced allocation system implementation has been piloted very successfully today and we are on budget and on plan to go live in September. Our next challenge is advance planning system and we are scheduled for a meeting with our chosen vendor for that system tomorrow.

Selling, general and administrative expenses increased by 26% to $48.9 million and expense ratio moved up a 120 basis points. Our expense dollars increased above our plans primarily due to some eight typical causality insurance claims in the quarter, as well as an accelerated growth in store expenses caused in part by opening and converting stores well ahead of our plan.

Our margin expense was also impacted by flat comps, which was below our low single-digit plan. Our administrative expense ratio excluding stock comp expense leveraged by 50 basis points. Stock comp expenses offset much of the admin expense ratio gain growing by 40 basis points. Overall SG&A expense deleveraged by 80 basis points excluding stock comp expense, but we anticipate this will normalize with insurance casualty claims cost along with the return to low single-digit comp sales in the future.

Depreciation and amortization totaled $6.4 million increasing 20% from last year, this expense represented 3.7% of sales both this year and last. We are planning 2011 CapEx to continue to be roughly $39 million net, which includes a 115 store openings, 35 conversions, store maintenance and fixture CapEx and our continuing IT support center and supply chain investments. Operating income for the fourth quarter grew by 18% to $12.4 million from $10.5 million a year ago.

The quarter’s effective tax rate was 38% versus 38.7% for the same period a year ago. The lower effective tax rate last year was a result of discreet tax event in the quarter including the state tax credits and a disqualifying disposition stock options. We do anticipate seeing the start of a general long-term improvement in this area due to various initiatives we have underway or are planned.

Finally, net income increased by 20% to $7.7 million for the quarter, up from €6.4 million a year ago. Fully diluted earnings per share were $0.31 versus $0.26 a year ago and approximately the same diluted outstanding share count of $25.1 million of shares. For the first half, moving to the first half, sales growth now stands at 23% after an increase of 20% in first half of 2010 and comp sales growth at 2.4% is on top of increase of 2.8% in the first half of last year.

Gross margin is expanded by 100 basis points and operating margin expanded by 90 basis points growing by 38% to $28.1 million for the half. Net income year-to-date at $17.3 million is up 42% on top of 47% growth rate last year and margin has expanded to 5.0% from 4.3% last year.

Our balance sheet at the end of the quarter was strong, cash and cash equivalents at the end of the quarter were $43.4 million compared to $16.7 million at the end of the second quarter 2010. As I said earlier, inventory levels at the end of the quarter are down 0.7% on a square footage basis and are in good position for the back-to-school season. We have no longer debt on the balance sheet and our revolver facility is $85 million plus another $15 million equity and future option. We did not borrow at all during the quarter and have no plans to borrow throughout 2011.

Now, turning to outlook. We now plan to open a 115 stores in 2011 and have achieved 73 openings in the first half. Conversion should reach 35 for the year. We also plan to close a handful of stores late in the year all of which that have leases are expiring. As a side note, on that average Rue21 has closed two stores per year over the last five years.

For the third quarter of 2011, we expect diluted earnings per share in the range of $0.32 to $0.34. This guidance assumes low single-digit same-store sales increases and total sales growth of about 20%. For the full year 2011, we continue to expect sales growth to be at least in the high teens and net income to grow from 24% to 28% year-over-year. EPS guidance for the year we are reaffirming at a range of $1.50 to a $1.54 on a fully diluted share count of 25.2 million shares.

As a reminder, our long-term forecast for annual cycles include square footage growth in the high teens, low single-digit comp growth and annual net income growth of at least 20%. That completes my prepared remarks and now Bob, Kim and I are prepared to answer any questions you may have.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Lorraine Hutchinson with Bank of America Merrill Lynch.

Paul Alexander – Bank of America Merrill Lynch

Hey guys, it’s Paul Alexander for Lorraine. What gives you guys confidence that the comp trend is going to accelerate here from 2Q? And just as a follow-up, inventory seems to be managed pretty lean right here, do you have enough inventory to drive that comp? Thanks.

Robert Fisch

I’ll answer that Paul. Nice to speak to you. I’m just thinking our average comp over the past 10 quarters has been around 4.5% and low single-digit feels like a consistently natural comp for a business. And more important based on our August selling so far, we don’t see any reason why that to change in the third quarter.

Inventory wise, to me I think being lean is very important and I think that what happens is by being lean and with having good sales we’ll have better flow of new merchandize coming in. And I think that’s what’s important. And I have seen quarters in this company when we picked up very strong comps in total growth and being lean inventory did not disappoint us. And I think that Kim has the ability also to react very quickly if there is ever a time where we need more merchandize.

Paul Alexander – Bank of America Merrill Lynch

Great. Thanks.

Robert Fisch

Thank you, Paul.

Operator

And the next question comes from Michelle Tan with Goldman Sachs.

Michelle Tan – Goldman Sachs

Great, thanks. Hey guys.

Robert Fisch

Hey Michelle.

Keith McDonough

Hi Michelle.

Michelle Tan – Goldman Sachs

So I guess, just a couple of questions. One was when you look at your consumer, have you seen any changes in behavior or volatility and traffic or anything like that as we’ve seen some of the broader confidence measures weaken over the last several weeks?

Robert Fisch

No, if anything we’ve seen a little strengthening in the last couple of weeks in business and traffic and I think that has a lot to do with the reason that back-to-school is now starting to come on strong. And I think we’re well positioned merchandise wise for the back-to-school season. So I’m not seeing, I’m not seeing something that is any extraordinary changes, no.

Michelle Tan – Goldman Sachs

Okay, great. And then, I was wondering, I think you gave the AUR up 9%, sorry, if I miss this, but I think you gave the other metrics on a total company basis the transactions and what not. What was the offset on a same-store basis to that AUR being up 9%? Was it number of transactions or are you selling less clearance units per transaction, which helps margin, but hurt the comp, what was the kind of composition of the same-store sales versus total sales?

Keith McDonough

Yeah, it was transaction. They were down just under 6% Michelle.

Robert Fisch

But its unit per transactions which had a lot to do when we really looked at that Michelle.

Michelle Tan – Goldman Sachs

Yeah.

Robert Fisch

It’s what you just said, it has a lot to do with selling less clearance and selling less clearance at much lower price point clearance. It’s not that we don’t have clearance, we just didn’t have the clearance at the lower price point range as we sold down in that and it was really not with the prevalent to our business.

So to me would that have affected our comps, it’s possible. But I think that it showed – we did not just increase gross margin percent, we could increase the gross margin dollars. And only thing that I mentioned is earlier we are going to take a look at things, because I think that we always should look at correctable in our business. And I think that we do believe it – perhaps a very important.

So we don’t want to think that top line growth alone is the only answer. But so I think when I mentioned about Denim and Kim mentioned about Dresses and sandals and being at position not to have more clearance reduced, but it might be with summer being the way it is, and when it’s a 100 or 90 degree, it’s going to be hot. I think that that can help drive that business and not hurt our margins. But overall, we were very happy with the performance that we had in those stores.

Michelle Tan – Goldman Sachs

Yeah. That makes sense. And then just finalize on that point, I know you called out some of these challenges in July like not having clearance and the back-to-school start maybe being a little delayed and what not, can you give us the sense of how much of a drag July was on your comps for the quarter?

Robert Fisch

We don’t really get into by the months, but what I will say is obviously it was very hard at the end of July and we did see in effect a little greater the last couple of weeks of July and that has a lot to do, but I think of the summer product not being in depth. And I said I’m not sure that that would have made for more profits if we had more or necessarily a much bigger comp. But to me, it was the right decision to make and not to promote all back-to-school merchandise early, because that is what – it’s not that much different in last year, it’s in the factor that if you – we all think back to last year at this time we did hold the line on selling of early promotional merchandize.

And when we did we ended up doing very well in the third and the fourth quarter by positioning ourselves right not only in merchandize, but as you know how many retailers today are promoting so deep early that I believe that we are every day great competitive value business and that would hurt us for the third quarter and the fourth quarter if we did that. And I believe that that will help us and we are confident with the guidance we just gave.

Michelle Tan – Goldman Sachs

Okay, great. Thanks so much guys and I will see you soon.

Keith McDonough

Thanks Michelle.

Robert Fisch

Thank you Michelle.

Operator

Our next question comes from Jeff Klinefelter with Piper Jaffray.

Ian Murphy – Piper Jaffray

Great. Thanks. This is actually Ian Murphy for Jeff. I just had a quick follow-up on that comp in the second quarter. Could you just then speak to potentially the difference between men’s and women’s I’m assuming women’s has been positive and strong throughout the quarter and what men’s are seeing a little bit weaker?

And then I had a question for Kim on the fashion trends in the quarter and then for Bob for Magic. With respect to denim with – the better the more fashionable keeps us trending and turning faster. Are you seeing still that’s outperforming others and then some of – with respect to Magic are you seeing any trend for spring 2012 that you will be looking to achieve? Thank you.

Kim Reynolds

Well, two questions, first of all in denim we are seeing a higher price point denim and the more fashionable denim turning more quick even our basic denim. The key to that continues to be scaling for us both in growth as well as in guide and one of the takeaways from Magic was an enormous color direction that are going forward to the first half of next year.

Robert Fisch

And then the other part of the question was about strength of businesses. We don’t really get into with different variations, but we will say that we are seeing extremely strong business in accessories business, our accessories business we were pleased with our growth and we set the tone a little in guys, but I think Kim mentioned to you what’s she sees is opportunities for the future and it’s not that the guys business was to dramatically up. So, we don’t really have that huge swing of our businesses and I think that we will see an improvement in guys.

And the other thing that I would like to say about denim is that I think that we are going to be looking more to obviously – you have to promote plans in denim, but we really do want to get away for just the low-priced basic denim that you have to promote all the time because that’s really not what makes us successful.

And even though we are at everyday great value, having price points we are just testing now merchandise of 39.99 in denim that’s having very good sell through. We’ve never had that price point before and that’s turning up fast. And so to me I think you will see us work on our product a little more and marketing of the product more and to make it even more fashionable and maybe convert a little more from the lower price points to our good better best strategy.

Operator

And next question comes from Brian Tunick with J.P. Morgan.

Brian Tunick – J.P. Morgan

Thanks good afternoon guys.

Robert Fisch

Hey Brian.

Kim Reynolds

Hi Brian.

Brian Tunick – J.P. Morgan

Hey guys just trying to get some more granularity on the third quarter guidance. So you missed the SG&A versus our expectations in 2Q.

So wanted to through a little more there to what your view is onetime items and how we should be thinking about that because when we look at the third quarter, we are trying think through you know Bob’s comments about positive gross margin but at the same time like I said you missed our SG&A numbers and then maybe some comments on the real estate side Bob sort of what you are seeing from the mall based openings sort of you are coming into a market where there is a lot more competition you know you sort of have the off mall concept to yourself just maybe tough when how those new stores are opening and what you’re seeing from a price point perspective against those lower-priced competitors?

Robert Fisch

Got it, I think the biggest element that I did not anticipate in the guidance, Brian, was this workman’s compensation casualty claims that we experienced in the second quarter. I have not seen anything like it since I have been here from the right standpoint. Conversely we had an exceptionally good quarter in the second quarter of last year. So the dealt in basis points actually approached 30 basis points in the quarter this year versus last. So that certainly didn’t help us contain costs in the quarter. The other big factor I think was we accelerated, had a great experience with new stores, and opened them. They are well ahead of our plan and that created a lot of energy in the company, it also created a lot of activity and along with that activity came some cost that we consider investments. These costs will pay dividends we believe. The stores are now open and operational and we believe those investments and those start-up expenses will create good profitability and good margin for us going forward into the third and fourth quarter.

Kim Reynolds

And Brian, to your question on real estate side, couple of key points I couldn’t be more excited about the mall opportunity also. Number one, the mall business for us has been our stronger comps. So it’s not that they had the major difference and we are very fortunate that there isn’t a major difference strips, outlets and malls, but malls has continued to show strong results. So we don’t feel that we’re getting, #1 affected because people are that promotional in the business.

And as far as real estate, why we look to open up a little more strip center stores as we move forward over mall stores, the mall store rents are still the ones that are the least expensive, ones we have the best opportunity on and many times even in opening up in our average 5,000 square foot store sometimes we have a little bigger store to experiment in and we still pay the same low rent as a store that’s 4,500 to 5,000 square foot and we are continuing to lock into our rents where we have for the next 10 to 15 years locking in at great rate.

So I do not see a difference. I do not see because there is more competition that there is an issue and I feel as strong as ever in our growth opportunity to continue to be one of the fortunate people to be able to say that we believe we could double our size from 700 stores right now to be 1400-1500 stores in United States alone.

Brian Tunick – J.P. Morgan

Okay. And if I could just my final question, I look at the back half from last year that 1.8 comp in the third quarter I think October was very challenging from a weather perspective, are you guys doing anything different this year as you sort of transition towards holiday and out of back-to-school?

Robert Fisch

Well a couple of things that we’re – that’s very important to us, one I think that Kim mentioned also on the call about launching certain fragrances. Just to let you know, when we launch a fragrance we’re launching a girl’s and a guys fragrance one is a pop-up fragrance that is going to be a limited edition and one is a launch that’s going to be of a guy’s fragrance. That could have very good effects for us in our business in total growth in comps.

And just to let you know, we did launch last year in July a fragrance called 21 Black and that probably did effect our comps a little and you can’t always anniversary things at the same exact time and that was a tremendous launch. It was one of the top one or two we’ve ever had. Do not discount how important fragrance is to our business and I think we see that as an opportunity.

Number two, I think last year in October was tougher because the year before was a record cold weather. Now it can happen again, you never know. It could snow 20 inches in Florida in October and that’ll be strange or it could be in New York 80-90°, but I think we’re positioned ourselves better in good wear now merchandise but we will have a good strong assortment of sweaters and outer wear for that timing. In fact our sweaters what we are very confident in is that we’re not looking to – we’re not looking to – we don’t have to raise our retail, we could do the same thing we did with denim shorts and sweaters and positioned ourselves very strong as day in and day out prices in sweaters because we are not raising our cost price. And I think that gives us Rue 21 a very strong competitive advantage in the United States right now.

Operator

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

Adrienne Tennant – Janney Capital Markets

Good afternoon everyone. Hello, my first question is for you just kind of expanding on the comment you made in your quote which talks about you are happy with your March assortments and you are positioned to see margin expansion continue in the second half of the year. I assume that you are talking about the March margin, the gross margin line there. And should we kind of think about this notion of having better margin at mark down flowing through to a very similar type of gross margins were up 98 basis points and kind of having that, that look at the back half of the year? And then if I can – I am sorry, go head.

Robert Fisch

All right. First of all, everybody just – when I read things about Rue and everything going on out there in retailing right now, everybody just assumes because everybody is having a tough time in margin that we are going to have a tough time. I am not going to quote exactly what our margins are going to be and I don’t know exactly what they are going to be. But I am very confident that, yes, I think we are going to keep controlling our inventory which I think disciplined inventory is very important and I think that I do care about comps and we gave a guidance of low single-digit that we certainly look to do that and we believe we will.

But I believe that improvement of gross margins will have going to be important and I am confident and that’s what the key is that we – I think it’s time for everybody to see to believe us that we are not really looking to raise our prices. We do not have to raise our costs. And right now, I think with cotton prices coming down and going from $2.17 a pound to a dollar and of all the big retailers hold off for another three to four weeks you might see it go down lower and that’s the nervous pot of peoples spending in advance or not.

And I see with us that Kim still has the power to go into the market for the fourth quarter and take care of opportunities that other people have already spent their money on. So to me there was no guarantees ever and how high your comps are going to be, but you can control something and that’s what we can control these are costs.

And we believe that we are one of the few retailers that are able to do that. That has a lot to do to Kim and her team and also our sourcing and with our domestic importers Adrienne. So I do see the end of the comps being doing well in the third and fourth quarter. So that’s what we are supposed to do that’s what we have to do to – along with comps to increases to raise our margin and our operating margin.

Adrienne Tennant – Janney Capital Markets

Now that’s very helpful. And that actually segues into some of the questions I had for Kim, which is how much of the open to buy that if you can disclose, how much of the open to buy, do you still have for holiday. And as you go back to market are you actually seeing price reduction, when you go back. Obviously, you didn’t see the price up on the way up so, are people willing to give you the price downs as the cotton is coming down. And then thirdly for Keith, if you can just talk to the inventory plan at the end of the third quarter that would be wonderful. And I do think you guys are doing a fabulous job managing the costs.

Robert Fisch

Thank you very much we appreciate that.

Kim Reynolds

Thank you. To your question about immediate purchases, we never absorb price increases to begin with. So our pricing stay consistent. I think the benefit for us in really key items and things we are placing for fourth quarter into first quarter where the cotton prices are coming down and we are seeing roughly a single-digit reduction to last year’s cost there.

Adrienne Tennant – Janney Capital Markets

Okay, great. Thank you.

Robert Fisch

I want to add one thing to that that it’s kind of our model here, you don’t say no to Kim Reynolds and you don’t say no to RUE in the market. And I know it sounds funny but that’s exactly what happens out there and that’s what we’ll keep delivering.

Kim Reynolds

Inventory planning, Adrienne, would be somewhere in the neighborhood of low single digit cost – inventory per square foot growth. That – I think that’s a conservative number. We certainly can afford that. The great thing about this business model is that Kim can react and that’s exactly what she is going to do within reason.

We are applying that kid of a business model to a new system and new business process with regard to allocation and plan, and so far this year we’ve seen good results from that and I would expect that to continue. Going live in September with our new allocation system I’m excited about it. I think the whole team is excited. I know the allocators want to get to, they all want to begin this new system and that’s fun to watch and I expect good things from that to occur, but I would be prudent to not be real aggressive in terms of market decreases in inventory per square foot in the third quarter.

Robert Fisch

And I have something to add to that Adrienne. By controlling our costs there is a lot of people as you know in other retailers where inventory, their units are lower or flat but the dollar retail is higher. We’re able to be in a position where we could have the same or lower units but not seeing higher dollars. And I think that that’s something we continue to work on, and I think that will help us in a long way because dollars is what affects the profits...

Adrienne Tennant – Janney Capital Markets

That’s right. Right. Very nice control of the business and really best of luck in the back half.

Robert Fisch

Thank you very much Adrienne.

Operator

Our next question comes from Janet Kloppenburg with JJK Research. And again Jack, your line is open. Please go ahead with your question. And hearing no response to that line, we will take the next question from Paul Lejuez with Nomura Securities.

Robert Fisch

Hi Paul.

Paul Lejuez – Nomura Securities

Hi guys.

Robert Fisch

Very consistent on your name, that’s all I can tell you.

Paul Lejuez – Nomura Securities

So couple of questions. When should we expect the stock-based compensation no longer to be dragged on the SG&A rate and what’s baked into your second half guidance on that line specifically? And then second on the tax rate, it sounds like you are looking for it to go little bit lower, how low can it go and also again there what’s built into the second half guidance?

Robert Fisch

Actually the comp, the stock comp expenses you and I have talked about Paul is going to be deleveraging for the next probably six quarters. We’ve got – when we went public we put in place a stock compensation plan and in that plan are three year vesting of our issues and stock options. At this point we’re half way to the point where we’re going to see anniversary us a full boat of stock compensation expenses. So the incremental cost of that is somewhere in the neighborhood of 5 to $600,000 per quarter. I don’t have that for next year but I will certainly talk to that at the end of the year. And your other question was?

Paul Lejuez – Nomura Securities

On the tax rate, like how low it can go and what’s built into the second half guidance?

Robert Fisch

Yeah, the tax rates that we have seen thus far contains kind of no permanent structural improvements, those are yet to come that’s the good news that we don’t work after these discrete events, I would kind of soft up is as best we can most of the state tax credits that were part of the decrease in the first part of the year will continue to see discreet stock option events, but we haven’t forecasted that. So to your question, we’re actually moving up in effective tax rate in our guidance.

This year or this quarter we said it was 38%, we’re moving back to in the neighborhood of 39 to 39.5 through the second half. During that period we’re going to start to see some impact, just started to see some impact from some structural changes that we’ll make, that we’ll enjoy next year then we’ve got another initiative that they we’ll hopefully add on to that, that will kick in next year as well.

Paul Lejuez – Nomura Securities

And where are you going to go next year do you think?

Keith McDonough

I think 38 is reasonable, I would hope that we can do a little bit better, if we factor in a few of these discreet events.

Paul Lejuez – Nomura Securities

Got you. Thanks. Good luck guys.

Robert Fisch

Thank you very much Paul.

Operator

And next is Stacy Pak with Barclays Capital.

Stacy Pak – Barclays Capital

Hey guys, this is Ed actually calling in for Stacy. Most of my questions have been answered. I just had a question on the inventory, what was clearance inventory levels versus last year? And if you could talk more about the comp guidance call for +LSD this year, what are you seeing right now that gives you confidence to be able to get back to that plus de-comp in Q3? Thanks.

Keith McDonough

Yeah, I mean as we stated, we are certainly down from a summer merchandise quarter, quarter-to-quarter last year versus this year, we were down somewhere in the neighborhood of 20% in that inventory at the end of the quarter and at the end of the second quarter. The comp guidance is pretty standard for us.

We look forward in their long-term guidance is generally low single-digits. We feel comfortable with that kind of guidance especially Bob’s comments about what we’ve done historically. If you look at us over a public company, we are a little bit above that on an average looking back and that’s – so that’s our guidance going forward both for the rest of the year and long-term.

Stacy Pak – Barclays Capital

Okay. Thanks.

Operator

And that does conclude the question-and-answer session. I will now turn the conference back over to you for any additional remarks.

Robert Fisch

Well, thank you everybody. And I want to thank everyone for being on this call. And we do look forward to speaking to you all again after the third quarter. Thank you very much. Have a good day.

Operator

And that does conclude today’s conference. Thank you for your participation today.

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