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Guess? Inc. (NYSE:GES)

F2Q2012 Earnings Call

August 24, 2011 4:30 pm ET

Executives

Paul Marciano – CEI and Vice Chairman

Dennis Secor – CFO, SVP, Principal Financial and Accounting Officer

Russell Bowers – COO, North America Retail

Michael Prince – COO

Analysts

Jeff Klinefelter – Piper Jaffray

Christine Chen – Needham & Company

Randy Konik – Jefferies

Dana Telsey – Telsey Advisory Group

Jeff Black – Citigroup

Betty Chen – Wedbush

Omar Saad – ISI Group

Diana Katz – Lazard Capital Markets

Eric Beder – Brean Murray

Margaret Whitfield – Sterne, Agee

Susan Sansbury – Miller Tabak

John Kernan – Cowen

Operator

Good day, everyone, and welcome to the Guess? second quarter fiscal 2012 earnings conference call. On the call are Paul Marciano, Chief Executive Officer; Maurice Marciano, Chairman of the Board; Michael Prince, Chief Operating Officer; and Dennis Secor, Chief Financial Officer.

During today’s call, the company will be making forward-looking statements, including comments regarding future plans and financial outlook. The company’s actual results may differ materially from current expectations based on the risk factors included in the company’s quarterly and annual report filed with the SEC.

Now I would like to turn the call over to Paul Marciano.

Paul Marciano

Thank you. Good afternoon and thank you for joining us. We are very pleased with our second quarter performance. We executed well with each of our business, delivering earnings at or beyond the level we had anticipated three months ago. Overall, we generated record second quarter revenues and delivered adjusted earnings that exceeded our guidance.

During the quarter, we increased our revenue by over 17% to $677 million and delivered top-line growth in all the regions. International remained a biggest growth driver, with Europe and Asia combining to represent nearly 80% of our sales growth. We also executed well in our strategy to support and elevate our brand, focusing on inventory control and markdown management, which resulted in overall product margin increase and adjusted operating margin that exceeded our expectation.

For the quarter, excluding the settlement charge that Dennis would describe, we delivered adjusted earnings per share of $0.84, a 17% increase over last year’s second quarter. Overall, the result demonstrates the continued strength and momentum of our brand and the ability of our management team to deliver solid results in this economy.

In North America Retail, we increased our profitability by focusing on full price selling, reducing our markdown, and driving faster sales through. We generated a significant improvement in our product margin. Also with good expense control, we substantially improved retail profitability 170 basis points better than the Q2 of last year. While sales have been impacted by significantly less markdown, we feel we have made strong progress towards elevating the brand even in the current environment.

Low inventories coupled with new visual merchandise initiatives have resulted in a shopping environment that is much more attractive. This is our lowest second quarter markdown rate since 2003 and this is very important to us. Overall, we are seeing great response to our basic denim, which has been a top priority for us, and our accessory business continued to grow. Our success with this initiative has brought substantial increase in our average unit retail price during the quarter.

In Europe, where our business continued to expand even as the economy there had shown some recent sign of slowing, in the second quarter, we increased our revenue by 30% in US dollar. We have also made progress on three very important initiatives but also long-term expansion opportunities. First, we continued to expand our owned retail stores presence. We have opened 28 stores so far this year, and we now operate 165 of our own retail stores of the 443 total stores in Europe.

Extending outside of Italy has been another priority, and retail development is a key factor of our strategy. As I said previously, we are underpenetrated in certain countries in Europe where we enjoy a strong brand awareness that have under-developed distribution. At the end of 2008, we operated only 24 stores outside Italy. Today we have quadrupled that number, leveraging our retail capability to expand our business in important markets like France, Spain, UK and Holland.

We also see Russia as significant growth opportunity where our business has doubled within the last 12 months. We operate directly in 10 different countries in Europe today. Our business continues to expand, but we now enjoy a much more balanced and diversified European business.

Next is Asia where South Korea and China both delivered strong results with overall revenue increasing 31% in the quarter. In Q2, we achieved an important milestone in South Korea with the launch of G by GUESS. So far, we have opened four locations in South Korea, and the business is off to a great start. We believe that this concept represents great opportunity for our business.

By the end of the year, we expect to open a total of 40 G by GUESS locations in South Korea. In China, we continued to work with strategic partners to open stores in secondary cities and have increased our presence by over 40%. We currently have 113 locations in China and well on track to open another 40 for the remainder of the year. We continued to of course to see this region as one of the greatest opportunities ever for our company. Our goal is to have 500 stores and concession in China in the next five years.

Our overall performance this quarter is a testament to the strength and vitality of the Guess? brand. Recently, however, we have seen increased volatility and uncertainty in financial markets around the world and the global economy. As we know from the past, volatility can significantly impact consumer confidence. It remains to be seen how customers would respond that we believe we are well positioned to continue our long history of solid financial performance. For that we have a strong management team with significant experience.

We also have a strong balance sheet and ample access to capital. But above all, we have the Guess? brand. Our number one priority is to support the presence of our iconic brand in every market we enter. We remain committed to our key expansion initiatives in Europe, Asia, and opportunities in new markets like India, Latin America and specifically Brazil. The brand has such a great potential worldwide, and we want to take advantage of that in very strategic and disciplined way.

With that, we are committed to focus on improving productivity and long-term profitability in all the markets we operate. But of course, as always, we will navigate short-term with a prudent approach, with our eyes focused on the long-term.

With that, I’ll pass to Dennis.

Dennis Secor

Thank you, Paul. And good afternoon. Let me start with the settlement charge. In late July, we experienced a temporary disruption with one of our logistics service providers in Italy and subsequently off to settle that relationship and transition to a new provider. That transition is ongoing, and we expect it to be completed over the next several months.

Based on the settlement, we’ve recorded a charge that negatively impacted second quarter operating earnings by $19 million. Including the related income tax effect, the impact on second quarter earnings per share was $0.19. This charge has been included in our GAAP diluted earnings per share of $0.65 for the second quarter.

In our press release, I have isolated the settlement charge in our income statement and have also provided disclosure, which reconciles our GAAP results to adjusted results excluding the charge. During this conference call, all our comments and analyses for both the second quarter and the full fiscal year are on an adjusted basis excluding the settlement charge to provide relevant period-to-period comparisons for better operational visibility to the business.

Moving then to the business overall in the second quarter, we increased adjusted net earnings by 17% to $78 million and increased adjusted diluted earnings per share by 17% to $0.84 from $0.72 in last year’s second quarter. Second quarter revenues increased 17%, reaching $677 million, ahead of expectation. Constant dollar revenue growth was 9%.

Total company gross profit increased 19% to $300 million, and gross margin increased 60 basis points to 44.3%. Our overall product margin increased in the quarter, driven by lower North American Retail markdowns and the favorable impact of retail mix and currencies in Europe. These were partially offset by a higher occupancy rate given the retail comps and our continued retail expansion.

Our total adjusted SG&A expenses increased 20% to $187 million, which included a significant unfavorable currency translation impact. The increase supported our store and sales growth, including higher variable selling costs, store selling expenses, and increased distribution costs. General and administrative costs increased to reflect the additional infrastructure investments we made in Europe throughout last year and as we develop our organization in Asia. Our adjusted SG&A rate increased 60 basis points to 27.6%.

For the period, adjusted operating profit increased 17%, totaling $113 million, which includes a $9 million favorable currency translation impact. Adjusted operating margin was flat at 16.7%. For the second quarter, we reported other net income of $3 million. This amount includes $4 million or $0.03 per share in net unrealized revaluation gains on foreign currency contracts and balances, partially offset by net unrealized losses on non-operating assets.

Our adjusted effective second quarter tax rate was 31.4% compared to 30.1% in the prior year. The increase mainly reflects a higher anticipated full year adjusted effective income tax rate due to the effect of currencies on our projected tax liabilities and a different distribution of earnings among tax jurisdictions.

Now I’ll review our segments, starting with North America Retail. In North America Retail, second quarter revenues increased 8% to $261 million. Consistent with our expectations, same store sales declined 1.9% in US dollars and 3.4% in local currency. Operating income increased 25% to $33 million, and operating margin expanded 170 basis points to 12.6%. This operating margin increase reflects significant product margin expansion due to our success in reducing markdowns, lower relative store selling expenses, and leverage over our G&A structure. These were partially offset by a higher occupancy rate due to the negative comp.

During the quarter, we opened nine new stores and closed three, ending the period with 490 stores in the US and Canada. European sales increased 30% in the quarter, reaching $289 million. In local currency, the increase was 14%. Our owned retail stores drove the largest part of the revenue growth despite a decline in comp store sales.

In European wholesale, our apparel business performed strongest, fueled by healthy reorders, while we experienced some decline in handbags and jewelry. Adjusted operating income increased 26% to $64 million and increased 12% in local currency. Adjusted operating margin declined 60 basis points to 22%. The decline resulted from product margin expansion, given the impact of the relatively stronger euro as well as the higher mix of retail stores. This was more than offset by a higher occupancy rate, higher distribution costs, as well as the infrastructure investments that we made during the latter part of last year.

In Asia, revenues for the second quarter increased by 31% to $55 million as we continue to expand our distribution in both South Korea and China. Both of these markets posted positive comps and double-digit revenue increases. Operating profit decreased 15% to $5 million, and operating margin declined 470 basis points to 8.8%. The operating margin decline was due to lower gross margins mainly due to channel mix in our Korean business and a higher SG&A rate, given our planned infrastructure investments to support our growing business.

In North America Wholesale, revenues decreased 1% to $44 million. Operating profit and margin were both roughly flat at $11 million and 24% respectively. In our Licensing segment, revenues increased 6% to $28 million and operating profit increased 6% to $25 million.

Now turning our attention to the balance sheet, we ended the quarter with cash and equivalents of $430 million. Operating cash flows for the first six months of fiscal 2012 were $88 million, down 15% from the prior year period due to the timing of tax payments and the funding of working capital needs to support the business.

Accounts receivable increased 30% over last year to $391 million. In constant dollars, the increase was 20%. Overall, DSOs were higher compared to last year mainly due to the unfavorable timing of the earlier month-end fiscal close this year. At the end of the quarter, about 52% of our receivables were supported by insurance coverage, bank guarantees and letters of credit.

We ended the quarter with inventory levels at $343 million, about 12% higher than a year ago. Half of this increase resulted from currency translation. The vast majority of our inventory growth supports our international businesses, primarily Europe, but Asia as well. When measured in terms of finished goods units, inventory volumes are up about 3% compared to the same period a year ago. Overall, we feel we are well positioned with our inventory, with strong positions in trending categories to support our business for the back half and the holiday season.

During the quarter, we invested $29 million in net capital expenditures, mainly to support retail store expansions and remodels. We are now planning full year CapEx to be around $135 million. Our Board of Directors has approved a quarterly cash dividend of $0.20 per share on the company’s common stock. The dividend will be payable on September 23, 2011 to shareholders of record at the close of business on September 7, 2011.

We now will move into our recent business trends and our outlook for both the third quarter and full fiscal year 2012. In North America Retail, so far in the third quarter, comps are down in the low-single digits, as we continued to reduce our emphasis on promotional events. We expect this general trend to continue throughout the quarter, as our lean inventory position should enable us to continue to reduce our markdown sales in a profitable manner.

Overall, we are planning third quarter comps to be down in the low-single digits and for total revenues to increase in the mid-to-high single digits. For the full year, we are now assuming comps will be down in the low-single digits. This reflects a more cautious outlook for the economic and competitive environment in the back half of the year. We now expect to open 38 new stores during fiscal 2012 and expect full year revenues to increase in the mid-to-high single digits.

In Europe, most of our third quarter revenues relate to initial wholesale deliveries of the fall/winter collection, and we expect that our revenue growth will be driven by our owned retail stores. In our Accessories business, we expect to ship less product than previously planned in order to reduce the distribution and protect the brand’s position and integrity. This should affect the quarter-over-quarter EPS comparison by about $0.08 per share.

We expect that European third quarter revenues will increase in the low-single digits in local currency and in the mid-to-high single-digit in US dollars, given our assumption of a modest strengthening of the US dollar. For the full year, we now expect total European revenues will increase from 10% to the low-teens in euros and in the mid-to-high teens in US dollars.

In Asia, we continue to be very pleased with the momentum of our brand and we expect our sequential growth trend to continue. We expect that our growth will continue to be driven by new door expansion in both South Korea and China as well as by positive comps. For the third quarter as well as the year, we expect revenues to increase in the mid-to-high 20% range.

In our North America Wholesale business, our customers have continued to buy tighter to reduce their inventories and improve their turns. Wholesale backlog is currently flat, and we expect third quarter revenues to decline in the mid-single digits. For the full year, we expect wholesale revenues to be flat to slightly down. In global licensing, we expect third quarter revenues to increase in the mid-single digits and for full year revenues to now also increase in the mid-single digits.

Turning to gross margins, we now have good visibility on product costs for the remainder of this year, and inflationary pressures are consistent with what we described a quarter ago. While there has been some recent easing of cotton prices, we do not anticipate that this will impact our business this fiscal year. Our strategies to offset product cost inflation remain intact. We have implemented strategic price increases, which we believe should offset more than half of these cost increases.

In addition, we expect that our continued focus on full price selling should lead to a year-over-year improvement in markdown. And we continue to expect a favorable currency impact on second half margins. Overall, we are planning a slight improvement in gross margins for both the third quarter and the full year, with product margin expansion being nearly absorbed by a higher occupancy rate, given our comp assumptions and the overall retail mix.

We expect our SG&A rate will increase slightly in the third quarter, as the impact of the lower European accessory revenues will more than offset anticipated North American leverage. For the full year, we expect our adjusted SG&A rate will be flat to slightly down.

With respect to taxes, we are now planning our full year adjusted effective tax rate at 30.75%. So this rate could be impacted further by fluctuations in currencies, especially the Swiss franc and the euro. This adjusted rate excludes the impact of the settlement charge. With respect to currencies, we are planning assuming that the euro declines modestly against the US dollar from its current levels. Assuming this, we would expect a small net marked-to-market gains related to currencies in the third quarter.

Given all these factors, for the full year, we now expect revenues to range between $2,740,000 and $2,780,000; adjusted operating margin between 16.0% and 16.5%; and we now expect full year adjusted EPS in the range between $3.25 and $3.35 per share. Including the settlement charge, full year EPS would be in the range between $3.06 and $3.16 per share. For the third quarter, we expect revenues in the range between $650 million and $665 million. We are planning an operating margin of around 15% and for EPS in the range between $0.71 and $0.74 per share.

With that, I will conclude the company’s remarks and open the call up for your questions. Before doing so, let me remind everyone to please limit themselves to one single-part question. If time permits, we will allow people to ask a follow-up question. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Jeff Klinefelter with Piper Jaffray. Please proceed.

Jeff Klinefelter – Piper Jaffray

Yes. Thank you, everyone, for the detail today. Dennis and Paul, could we just follow up on Europe in a little bit more detail? Obviously a lot of discussion on what’s happening, particularly in Southern Europe. Could you give some color on trends between southern markets like Italy and Spain versus northern markets in Q2 and what you’ve seen so far in Q3 and what’s incorporated into that new guidance going into the second half? Thank you.

Dennis Secor

Yes. So far, in Europe, last quarter we said that as we move from spring/summer ’11 to fall/winter ’11, we saw a slower growth rate in the business overall for Europe. And Italy was part of that. It was still growing at a modest cliff. So far with the spring/summer orders – I'm talking about the wholesale business right now. The spring/summer, we’re about three-quarters of the way through that market. We’re seeing a fairly similar trend, both for the European business and Italy. Italy is up slightly in the order book.

When we also look at our retail business, meaning the owned stores that we have there, the comps were down, as we’ve said, overall in Europe. And it was a very similar profile in Italy and the southern parts of Europe. So, so far, Italy is obviously our most penetrated region. So you would naturally expect that it would grow at a different rate than the rest of the business. But so far, Italy has been performing roughly in line with what you would expect given the way the rest of Europe is performing.

Jeff Klinefelter – Piper Jaffray

Dennis, have you made any changes to how you are protecting your margins in Europe? You mentioned that your receivables are insured. I think it’s slightly over 50%. Are you doing anything else with your credit lines to protect your margins in the back half?

Dennis Secor

Nothing different from the main process that we always follow. We manage through a combination of insurance, letters of credit, as we also put our customers through scrutiny before, and in some cases, we collect payments upfront or put companies on payment plan. So nothing really is different now from before.

Jeff Klinefelter – Piper Jaffray

Okay. Thank you.

Dennis Secor

Thank you.

Operator

Your next question comes from the line of Christine Chen with Needham & Company. Please proceed.

Christine Chen – Needham & Company

Thank you. And congrats on a good quarter.

Paul Marciano

Thank you.

Dennis Secor

Thank you.

Christine Chen – Needham & Company

I wanted to ask, can you talk a little bit about the performance in the US, maybe share some detail, how did trends progress throughout the quarter? Did you see a slowdown in the end of July like a lot of retailers did? And thus far in the beginning of August, I know you said that month-to-date things are down, negative low-single digits. But just wondering about that trend, and then wondering if you saw any regional differences and difference in performance across the concepts. Thank you.

Russell Bowers

Yes. Hi, Christine. This is Russell Bowers. In regards to the trends throughout the quarter, it was fairly consistent. During the quarter though, comps did get better each month as we progressed. July was the best month for us, both in terms of comp and in terms of product margin improvements. In August, the trend has been similar to Q2. Through the first two weeks, we were running with our comps flat, but then we ran into a big promotion that we did last year that we really deemphasize. So the end result is our comps are down at low-single digits, again with markdown improvements.

Regionally, the best regions were the West and the Southwest. The toughest areas were Canada and – Mid-Atlantic was tough. A good news for us is the Northeast started to improve. It was tough for us in Q4 and again in Q1. So we’re getting better there. Concepts, the best concept for us has been G by GUESS, which continues to be on a roll. They were up almost 10% during the quarter, again with markdown improvements in that concept. And the Guess brand is where we’ve really gone through the big changes of inventory and promotional decreases. So that’s been a little bit tougher.

Christine Chen – Needham & Company

Great. Thank you, and good luck.

Paul Marciano

Thank you, Christine.

Operator

Your next question comes from the line of Randy Konik with Jefferies. Please proceed.

Randy Konik – Jefferies

Hey, how are you? Dennis, can you just re-clarify the impact of the cautious decision to pull back on accessories distribution? I guess you said that’s solely impacting Europe. Could you give us the – I think the EPS impact is $0.08, but just re-clarify that. And then what’s the revenue impact? And then second piece of the puzzle is it looks like you guys have done a good job taking control of the inventory and that’s leading to improved US margins. I think we’re starting to go up against some easier margin compares later in the year in Europe and so forth. When could we start to see the Europe margins start to base out here? Just curious. Thanks.

Dennis Secor

With respect to the impact in the third quarter, yes, you’re right. We did say it was $0.08, as we – the brand is very strong. There’s a lot of demand, and in some parts of the business, we’re a bit overexposed. So we’ve taken this as the opportunity to take control over the distribution and protect the brand. So $0.08 in the third quarter, that’s the quarter in which I expect the biggest impact. We didn’t specifically quantify the revenue impact. But if you look sort of sequentially as well, you will see that in the second quarter we came out of the most favorable currency environment. So if you are looking sequentially, the trending in Europe is going to be impacted both by that top line and by now with a tighter currency lift for the third quarter. And then what – the rest of your question, the inventory –

Randy Konik – Jefferies

You’re starting to see the fruits of your labor of pulling back on the inventory on the US side of the business where the gross margins are now coming back up. And it looks like – I think the Europe margins were down in the quarter on a year-over-year basis. When can we start to see that type, that geography start to show a stabilization in the operating margins for that region?

Dennis Secor

Yes. I mean, if you are thinking about the European business, the margins – we expect currencies to be favorable for us as we continue through the rest of the year. And then once we get toward the very end of the fourth quarter, we start anniversarying some of the investments that we made in Europe last year. And we’ve also been successful in taking some of the costs that we incurred in the fourth quarter out of the model. So we expect to see some of that improvement starting to hit in the fourth quarter.

Randy Konik – Jefferies

Okay. And then just lastly, just to re-clarify the comment on Italy is that it's not that bad, it’s in line with the rest of what you’re seeing in Europe? Is that the case?

Dennis Secor

That’s a fair characterization, yes.

Randy Konik – Jefferies

All right. Thank you.

Operator

Your next question comes from the line of Dana Telsey with Telsey Advisory Group. Please proceed.

Dana Telsey – Telsey Advisory Group

Good afternoon, everyone. Can you talk a little bit on the product side, what is happening with pricing? We heard last time that dresses and denim the prices being accepted. Is it spreading to other categories now? And how you – can you give us a little bit of the complexion of gross margin, the IMU versus the markdown rate in what you are seeing? Thank you.

Dennis Secor

Okay. Hi, Dana. As far as pricing, the targeted price increases are in effect in our stores now. What we’ve seen so far, if she likes it, there has been very little resistant to the changes. Great examples are strong denim results, dresses that we spoke about earlier, and the overall AUR increase that we’re seeing as a category of all of our best selling items. As far as the IMU, we did see some pressure a little bit on the IMU starting in the second quarter. And we overcame that with an excellent markdown rate and ended up with product margin expansion.

Dana Telsey – Telsey Advisory Group

And then as you just think of the upcoming holiday season and what you’re seeing on the accessory side and any of the license products, anything changing there? Pricing or inventory levels? Thank you.

Dennis Secor

Yes. We’ve – the inventory levels are pretty consistent with last year in our accessory categories. The pricing is up a little bit, but not as up as much as they are in the apparel categories. And we’re not pressured in IMU at all in the accessories.

Dana Telsey – Telsey Advisory Group

Thank you.

Dennis Secor

Yes.

Paul Marciano

Thank you, Dana.

Operator

Your next question comes from the line of Jeff Black with Citigroup. Please proceed.

Jeff Black – Citigroup

Yes. Dennis, moving to Europe again and staying on that, what’s behind the accessories weakness? It sounds like – you know, you mentioned in your comments accessories is weak. Is that some of your accounts over there are experiencing weakness and you are pairing those and again the exposure to some of those accounts on the wholesales side, or is it an issue with product and we’re just not comfortable with this product we have out there now and we’re pulling back a little bit? Any clarity on that would be helpful. Thanks.

Paul Marciano

This is Paul. I think it’s a mixture of – I go there basically every four weeks. And when you walk the streets of every capital in Europe, clearly we always have in mind what we talk constantly about, which is brand integrity. And we feel that we are somehow in certain cities more overexposed. Across the board, we will give direction – being the handbags or watches or eyewear or shoes or any category, we will give direction immediately to correct that. The demand in Europe is bigger than what we ever expected when we start to operate directly five years ago. We will reach $1 billion this year. And that came in five, six years. And to certain degrees, we are looking to spread out that business rather than to be concentrated on only three or four countries. So you have that one factor.

The other factor, of course, is the success of Guess accessories, especially in shoes and handbag and watches, has absolutely stimulated the competition. And of course, you will have some competition come with a product that could be similar or close to what we do. And that’s what we deal with. We continue to drive our business with discipline. And what is key for us and to don’t overly expose, over-sell in our different categories, and that’s what we have. So we don’t look at what’s going to happen next Christmas. We look at what happen in the next five years, the next seven years. And whatever it takes, we are going in that direction.

Jeff Black – Citigroup

It sounds like it’s just a proactive move rather than reactive just on big slump in accessory trends.

Paul Marciano

Absolute. And we will continue to meeting what we have called one world, one brand. We have all our partners, licenses and distributors around the world in spring 2012, and our message has been the same consistent after 30 years. We are looking how we are going to celebrate the 40 years, not how we’re going to celebrate 31 years. So it’s not a product issue. It’s a product of strategy that the north of Europe and Eastern Europe has not been addressed properly by us when we exploded in all the southern Europe. I mean, if you visit Europe, it’s easy to find out how popular the Guess brand is in such a short time. So I think if you travel there, you will understand.

Jeff Black – Citigroup

Great. Thank you.

Paul Marciano

Thank you.

Operator

Your next question comes from the line of Betty Chen with Wedbush. Please proceed.

Betty Chen – Wedbush

Thank you. Good afternoon, everyone. I was wondering if you can give us a little bit more color around South Korea and China. Very nice double-digit sales growth in that region, at least in those two countries. Give us a little flavor if you could on products are resonating with that customer and also whether we should expect investments in that region to also impact operating margin in the third quarter. And then just as a follow-up to the earlier question, given that some of the accessories business in Europe is part of your initiative to control the brand integrity, can you also just give us some color around North America accessories? I know traditionally it’s been very strong in the past. Anything that you saw in the second quarter, early Q3 would be helpful. Thank you.

Paul Marciano

I think you covered the world. I think you went from Asia to Europe to North America.

Betty Chen – Wedbush

I’m trying.

Paul Marciano

We would try to address all that. South Korea and China, basically I think that, as we mentioned, again it’s a major factor of our future investments. Whatever it takes, whatever we will have to do, what we did right in Europe, we would try to do right in Asia. So the $0.5 billion business mark is definitely visible. The $1 billion business in Asia will be in our target. And whatever it takes the time, it doesn’t matter to us. What matter to us is that we have a strong team there. We have a (inaudible) of the brand different concepts to be in place there. I’m reaching there again in four weeks. I was there eight weeks ago. I continued to go constantly in these countries. South Korea is beyond what we ever expected to have as a business, and we are the number-one brand internationally there today.

We think that – and don’t forget we don’t have any business in Japan, zero. We have left that country alone for few years to clear the market until we re-enter that market in the next future in a direct or joint venture. So China is clearly – I mean, we’ve now our new President, Kitty Yung. We are making a very, very strong progress, and we are having a presence well, well in place on every key city. Any mall that you will visit of the meaningful malls, you will find a GUESS store. And we continue to be present on every plan of expansion of any new developments. So that’s that.

For Korea, the G by GUESS has entered just now and by the end of the year we’ll have another 40 locations. As you know, the format in Korea, it’s not shopping centers. There are no shopping centers there. It’s the same as Japan. There’s many department stores business, that large shopping shop almost the size of a store. And we will plan to have another 40 stores there. We are doing directly also underwear line in Korea. So we have a big plan of expansion also in Korea. If you talk about the CapEx, for example, for Korea, it will be much less than what we do in US because we don’t have this big cost of store development like we do in US. It has many department stores.

So the product assortment, we have adjusted a lot of seats for the Asia customers, and we also have very good partnership with some franchisee partners who have expertise in their region. If you are familiar with China, some partners, franchisees can have 100, 150, 200 stores and are expert in the region with management, with training, with everything. This is where we have been focusing there. The big cities are controlled by us, and the secondary cities have many partners. And this is a clear strategy that we intend to continue. We have no intention to operate entirely China stores at all.

Russell Bowers

I think, Betty, you asked about the accessories in the US. We’ve been really successful in our watches. They are doing great for us. Eyewear is performing very well as is jewelry. Jewelry has been held by the introduction of the European line here to a lot of our stores and so that said, it’s an incremental business for us.

Betty Chen – Wedbush

Thanks, Russ. Dennis, just a follow-up to Asia. Should we expect margins to also be down like in Q2 due to new investments in that region?

Dennis Secor

Yes. I think in the second quarter you certainly will see impact on the SG&A lines. The second quarter was a little bit more impacted because it’s the timing of when we make some shipments in South Korea in the outlet channels. So I think the second quarter probably, you would expect to see – this quarter has kind of the most severe change quarter-over-quarter and it should be a little more muted, but we still expect margins to be down because of the investments for the year.

Betty Chen – Wedbush

Great. Thank you so much and best of luck.

Dennis Secor

Thank you.

Operator

Your next question comes from the line of Omar Saad with ISI Group. Please proceed.

Omar Saad – ISI Group

Thanks. Good afternoon. I was a little bit surprised to hear that in Europe, the slowdown you are seeing in Italy is about the same as the rest of Europe given the fact that you still saw underpenetrated in the rest of Europe. Has your views changed there in terms of – are you seeing anything in those markets there that are affecting how you are planning the expansion into those markets outside of Italy? And then broader picture, Paul, given your experience and success in the European market play as well as your personal background there, any thoughts you have on the big macro situation in Europe with the sovereign debt issues, any insight you have there would be greatly appreciated. Thanks.

Paul Marciano

Yes, Omar. I think that – I think you’ve visited Italy few times, and you’re right that that question is a little bit strange to say why Europe is suffering now but Italy less than the rest. And we have been implanted in Italy for many years. So the brand acceptance and recognition in Italy is extremely strong and for many reasons. One is, when we started in Europe as a direct operation in 1994 – ‘95 I think, we were based in France, Italy and we still have a strong base office, like 300 people in the office in France. So we have been really implanting the brand for over almost 15 years. So we – let’s put it that way. We are part of the landscape today. We are not the newcomer like we are a newcomer in Spain, we’re newcomer in UK, or newcomer in Germany.

So when you have a slowdown somewhere, like if you take UK, the first thing will be affected, these are brands that are not really well recognized or well present or well spread out for the country. And we don’t have as many stores there or not a big presence in department stores. We are just barely beginning the last three years. That’s what I call barely beginning, four years. So, now for the micro economic, honestly, everyday you open the TV, you have no clue if things are going to be up or no clue if things are going to be down. I mean, nobody has been able to predict anything.

And we try to manage to see how the consumer – we look at the simple basic factor, is the traffic. We look at the traffic. People are shopping. And people are shopping where? And are they looking at more products? Are they looking at more prices? Are they looking at – this is where we navigate rather than to try to figure out what the government of Germany and France are going to do about euro and what’s going to happen to euro itself. Is it going to explode? Yes/no, we have no clue. At our level, we have no clue. So we try to see what is our strategy and towards your feedback.

France is continuing to expand. Spain, with this crisis, we are showing strong count across the year. And when the country has 22% unemployment, so everything is different in each country. Germany is one of the toughest markets, and yet for the small business we are doing in handbag, shoes, and denim, all the numbers are positive comp for us, because our base is small and because we are newcomer like doing a business company to Italy. Italy, we have a very strong presence in a world map of all the stores in every city. So that’s why our business is as strong there. Thank you.

Omar Saad – ISI Group

Thank you, Paul. Good luck.

Dennis Secor

Thank you.

Operator

Your next question comes from the line of Diana Katz with Lazard Capital Markets. Please proceed.

Diana Katz – Lazard Capital Markets

Hi, thank you for taking my question and all this great color. Speaking of traffic, can you break out traffic versus conversion within your own stores domestically and then how your tops versus bottoms performed?

Dennis Secor

Yes. As far as traffic goes, our traffic has been down consistently, where conversion is down also, but a lot of that has to do with doing less markdowns because we made a lot of progress with our AUR. Tops versus bottoms, bottoms overall are performing much better than tops.

Diana Katz – Lazard Capital Markets

And do you see the new tops that are coming in starting in September? Do you see any initial reads on those and if you think that could change your top comp performance?

Dennis Secor

Yes, we do. And we are starting to get encouraged with what we are seeing with the knit top category, in particular. And the table program that we had out there during the second quarter performed very well. We are going to bring in more woven’s to help build that business back up, and for holiday, we’re really going after again the key item program. So, yes, we’re really encouraged what we are going to see at the back half of the year.

Diana Katz – Lazard Capital Markets

Thank you very much.

Paul Marciano

Thank you.

Operator

Your next question comes from the line of Eric Beder with Brean Murray. Please proceed.

Eric Beder – Brean Murray

Good afternoon.

Dennis Secor

Hi, Eric.

Dennis Secor

Hi, Eric.

Eric Beder – Brean Murray

Could you talk a little bit – I heard you mention Latin America and Brazil. What are you planning to do in those markets? And on a completely unrelated subject, what was the North American inventory increase per square foot and the square footage at the end of the year?

Dennis Secor

Yes. Our square footage is up about 9% year-over-year, and our inventory per square foot is down in dollars and the mid-single digits and close to 10% if you look at on a unit basis.

Paul Marciano

And Eric, this is Paul. About Latin America and Brazil, Latin America, if you take the total business we do there, we don’t count Mexico and all that, we talk Latin America. It’s pretty small even though that we have some distribution for many, many years in all these small countries like Panama and Guatemala, and we started some business in Peru and Chile, but it’s small in a scale of what we do as totally in Latin Americas, all Americas. Brazil is clearly a huge opportunity. But because of tough experience with a licensee there many, many years ago, which was an experience of let them (inaudible) product.

We decided that unless we do control 100% or a joint venture operation, we will not operate in Brazil. So we are in discussion now with three different potential partners, but it will be no question about all majority owned by us or 100% owned by us. So, again, three months, six months, nine months, we are not changing anything on our plan. We want to act with a proper strategy, meaning full control or strong joint venture with complete transparent partners. That’s our goal. That Brazil is – we are frustrated that we are not there, that we prefer to don’t be there than to be with the wrong partners or licensees.

Eric Beder – Brean Murray

Great. Good luck.

Paul Marciano

Thank you.

Dennis Secor

Thank you, Eric.

Operator

Your next question comes from the line of Margaret Whitfield with Sterne, Agee. Please proceed.

Margaret Whitfield – Sterne, Agee

Good afternoon, and congratulations on a good quarter. I wondered if you could comment on the opportunities for G by GUESS outside of North America and South Korea. And in terms of your goal to penetrate other countries in Europe, what do you think Italy might end the year this year as a percent of Europe and how do you see it trending? And what countries do you think would take up the slack? And finally, why do think the accessories issue will be confined to Q3? Thank you.

Paul Marciano

Why don’t we start with G by GUESS. G by GUESS, we started little bit on Korea and obviously having a great success. We did some doors in South Africa in Johannesburg and Cape Town, and obviously for the reason you can understand, because of price points. And also we did some in Philippine, where we have the biggest brand now for the last 20 years in Philippine. So you think of these countries and the common thread you will have somewhere is these aspirational certain young customers who would love to buy Guess? but cannot afford Guess?. And so we are moving slowly on these three different depths in the world, three different region of the world and then see how it’s evolving. And our experience in North America has been very good with G by GUESS. Visit any of the stores and I think you will have some very pleasant surprise. I don’t know which region you are in, but I think you will like it very much, or look at the website. What other question you have?

Dennis Secor

You asked about the penetration of Italy. If you look at the business over the last several years, Italy used to be the majority and it’s been becoming less and less. While it’s been growing, the rest of the business is growing even faster. So we are right now in the sort of the low 40% in terms of the penetration of Italy as to total European business. And then just to clarify, with respect to the adjustment in accessories, what I – the message was that I expect the biggest impact in the third quarter, but we could see some lingering headwinds until we fully anniversary the second quarter next year.

Paul Marciano

Thank you, Margaret.

Margaret Whitfield – Sterne, Agee

Thank you.

Operator

(Operator instructions) Your next question comes from the line of Susan Sansbury with Miller Tabak. Please proceed.

Susan Sansbury – Miller Tabak

Yes, thank you very much. And yes, you did have a great quarter. So, kudos for that.

Paul Marciano

Thank you.

Dennis Secor

Thank you.

Susan Sansbury – Miller Tabak

Could you shed a little bit more light on this service provider that you severed a relationship with? What type of service provider – you know, what type of service and logistic provisions are you talking about? Do you expect any ramifications or start-up problems from the new guy that you’re now using? And then secondly, on the accessories question, I’m still a little confused about whether this is – whether it’s a specific product category within accessories like handbags or whether it’s just across the board?

Michael Prince

Hey, Susan, this is Michael Price. I’ll take the first one. As Dennis mentioned, we had temporary disruption with a logistics provider in Europe in late July and we evaluate the situation and assess the potential volatility. It’s all like it was in the best long-term interest of the company to transition to another provider. And when you look at the long-term benefits, we believe this other provider will provide the platform to really support our growth agenda and Europe for the long-term.

Susan Sansbury – Miller Tabak

Michael, not be stupid, but what do you mean by a service provider? What are we actually talking about here?

Michael Prince

Logistics. So, distribution of product to the consumer or to –

Paul Marciano

Third-party shipping.

Michael Prince

Yes, retail accounts.

Susan Sansbury – Miller Tabak

Okay. And so this – is this provider going to transition to the new provider, or do you expect any issues as this transition –?

Michael Prince

No, we’ve got an agreed upon transition period. So we don’t anticipate any issues.

Susan Sansbury – Miller Tabak

And a transition period is how long?

Michael Prince

It’s over the next several months, as Dennis mentioned earlier.

Paul Marciano

Susan, let me make it clear. The problem came four weeks ago, not four months ago, not four years ago.

Susan Sansbury – Miller Tabak

I know. It was a surprise.

Paul Marciano

So that’s why we act and we act swiftly on any issue come up. We don’t let any problem getting worse. So, in four weeks, what we have done was incredible. And we have not disrupted anything. That is the key. About the accessories, I answered before, I cannot pinpoint. It will be – if you have to extract the two categories where there had been some weakness in general in Europe comparing to the big volume we’re doing accessories in Europe, I would point out more of jewelry, custom jewelry and handbags more than anything of watchers or shoes or eyewear or any of the categories – or belt. It’s really more sensitive in jewelry and handbag.

Susan Sansbury – Miller Tabak

Okay. So this excess inventories, if I can call it that, was situation reflected the former owner of that jewelry business that you just bought a couple of months ago, with the product over distributed, or how did it get over-distributed?

Dennis Secor

No. I mean – no, we don’t – first of all, we carry very, very little jewelry inventory. So the inventory that we have on our balance sheet is largely driven to support our apparel and our handbags and footwear business. That’s where our inventory investment is. What we are saying is that the product has been overexposed. We had a great year coming out of last year and it's over-distributed. We do what’s right for the brand for the long-term, and we’re taking the opportunity to take a little heat off of that business.

Operator

Your next question comes from the line of John Kernan with Cowen. Please proceed.

John Kernan – Cowen

Hi, guys. Thanks for taking my question. Nice performance in Q2, especially on the gross margin line.

Dennis Secor

Thank you.

Paul Marciano

Thank you.

John Kernan – Cowen

I guess in the North American Wholesale business, I know nobody has asked the question on this yet, is there a reason why the revenues are declining in the back half of the year? It was a growth business last year. Do you feel like you are losing floor space in one of your wholesale accounts? Can you talk about what’s going on there in the back half of the year?

Russell Bowers

Yes. This is Russ. It’s down mostly because the department stores are managing their inventories just like we are in our stores. They are buying tightly and they want to have faster turns. Our sell-through in Macy’s and Bloomingdales, our comps are up in the doors that we’re in, and it’s progressing – it’s just pressing very well, especially in YC in women’s. As far as doors, we’re not losing a lot of space though we did shed some doors that were unprofitable earlier in the year.

John Kernan – Cowen

Okay, thanks. And then shifting to Europe, is there any reason to believe your prior peak-type operating margins aren’t sustainable anymore, given you are shifting to more of a directly operative retail? Are those prior historical margins, like the margins you used to put up near 23%, 25%? Can we believe at some point when the environment normalizes there that you could get back to that type of level productivity?

Paul Marciano

This is Paul. Yes. Clearly, you cannot compare what is not comparable. If you look at when we started after we took over our licensees five years ago, exactly in January ‘06, we had like 10 stores, altogether 10 doors. So the 10 doors, 95%, 96% of our business was wholesale and 5% was retail. But today, we operate 165 stores ourselves. We have 3,000 employees in Europe. At that time, we had 70. So you can see the scale. It’s a same story of North America. Our margin, when we were wholesale in 1990s and 1995 up to 2000, has nothing to compare with today when we operate 500 stores and 10,000 people. So, clearly, the 24%, 25% margin that you mentioned about, of course, will be difficult to go back to knowing that we have a clear intent to continue to open stores all over Europe, including North Europe, including south of Europe where we are not completely developed like Spain or France. France, we think, we can double the department [ph] stores and it would be most likely outsourced. So, that answers your question.

John Kernan – Cowen

Yes, thank you. And then one last final question. The backlog in Europe in constant currency, did I miss that? Dennis, did you give that?

Dennis Secor

No. The backlog is – I just need to get my hands on it for one second. The backlog is – right now, it’s roughly flat and that includes the remaining shipments that we have for fall/winter as well as the order book that we have in spring or summer so far. So you get some timing affects with fall/winter. So far, the spring/summer orders are up in the mid-single digits.

Operator

At this time, there are no further questions. I’ll turn the call back to Paul Marciano for closing remarks.

Paul Marciano

Yes, thank you. Basically, we’re going to conclude this. Just we finished last week one of the higher roller coaster week in the stock market all over the world. Statistics show that in four weeks, it was as high of a loss around the world than the worst four weeks of March ‘09. And when you have that across the globe, you have to wonder and sit back and think what impact it has. Consumers day-to-day who are visiting more are visiting stores, I mean, we have to think about that every day. But we know clearly what we know and we are not economists.

We are trying to navigate in this environment and we try to make the best decision every single day. So that’s what we do. And we try to manage also what is manageable for us, which is clearly inventory margin, production costs and try to do the best product. The rest, it’s not in our hands. What the market does, it’s not in our hands. So, that’s it. Thank you very much. And we’ll talk to you next quarter. Thank you.

Operator

Ladies and gentlemen, that concludes today’s presentation. Thank you all for your participation. You may now disconnect. Have a good day.

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