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Executives

James Scully - Chief Administration Officer, Chief Financial Officer and Principal Accounting Officer

Stuart Haselden -

Libby Wadle - Executive Vice President of Retail & Factory

Analysts

Karru Martinson - Deutsche Bank AG

Spenser Samms - BofA Merrill Lynch

Emily Shanks - Lehman Brothers

Karen Eltrich - Goldman Sachs Group Inc.

Carla Casella - JP Morgan Chase & Co

J. Crew Group (JCG) Q2 2011 Earnings Call September 1, 2011 4:30 PM ET

Operator

Greetings, and welcome to the J. Crew Second Quarter 2011 Results Conference Call. [Operator Instructions] It is now my pleasure to introduce your host, Stuart Haselden, Treasurer of J. Crew. Thank you, Mr. Haselden, you may now begin.

Stuart Haselden

Thank you for joining us to review our second quarter 2011 results. With me today are Jim Scully, Chief Administrative Officer and Chief Financial Officer; Libby Wadle, Head of our J. Crew brand; and other members of our management team.

Before we begin, I would like to remind you of the company's Safe Harbor language, with which I am sure you are familiar. The statements contained in this conference call, which are not historical fact, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results might differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC and in the press release issued in connection with today's call.

During this call, we will refer to adjusted EBITDA, which adjusts for items such as noncash share-based compensation, transaction-related litigation, as well as the impact of purchase accounting resulting from the acquisition. You can find a reconciliation of the adjusted EBITDA in Exhibit 3 of our press release, as well as additional information in the MD&A section of our Form 10-Q for the second quarter of fiscal 2011.

With that, I would now like to turn the call over to Jim Scully.

James Scully

Thanks, Stuart. I will start with an overview of our second quarter results and an update on some of our key strategic initiatives. Stuart will then walk you through our financials in more detail, after which we will open up the call for your questions.

For the second quarter, total revenues increased 7%, with our comparable company sales increasing 3%. Our comp store sales increased 1% and direct sales increased 13%. Our adjusted EBITDA totaled $64 million or 14.8% of revenues in the second quarter versus $70 million or 17.1% last year.

While we are never happy with the year-over-year decline in earnings, our results did represent a sequential improvement in our top line trend, driven by an improving trend in our Women's business while we continue to see strong performance from Men's, Crewcuts and Accessories. As we mentioned at the end of the first quarter, we were able to make more significant adjustments to our Women's second quarter assortment as well as the back half of this year, and we are beginning to see the benefit of those adjustments.

Our top priorities as always remain our focus on our product and our customers. We are also moving forward on a number of key strategic initiatives and will continue to keep you posted on some of these as part of our quarterly calls. They include international expansion, our direct business, store growth across retail and factory, our Madewell business, and building the infrastructure to support the execution of these initiatives.

We celebrate some exciting milestones regarding these initiatives over the last 2 weeks, and I'll mention a few of these today. On our international expansion effort, we opened our first store outside of the United States with a women's only store at the Yorkdale Centre in Toronto opening on August 18. We are really pleased with the results and customer feedback so far. We also successfully launched international shipping to the U.K. on August 18. Additionally on the direct side, we moved to a flat rate shipping structure online, and although early, customers are responding positively.

Turning to store growth. We plan to open additional stores in Canada in support of our plan to grow our retail square footage in the low to single-digit range annually over the next 3 to 5 years. We are planning to open a total of 9 new retail stores in 2011, including one Crewcut store. This also includes our next Men's only store opening at Columbus Circle in the fourth quarter.

In our factory channel, we opened 4 new stores in the second quarter, including one factory Crewcuts location. So far in the third quarter, we have opened an additional 3 stores and plan to open a total of 11 new factory stores in fiscal 2011. Our long-term plans remain to grow our factory square footage by approximately 10% a year over a 3- to 5-year horizon through a combination of new units and expansions in existing centers where we see potential upside. We've expanded our factory Crewcuts business significantly year-to-date and now operate 3 standalone locations and 58 shop-'n-shops in our factory stores.

We also have a lot of excitement going on in our Madewell business. On the store side, we opened 2 new locations in the second quarter at San Francisco Center and Lincoln Road, Miami. More recently, we also opened Madewell stores in Corte Madera, California, and Towson Center in Maryland earlier this week. We currently operate 26 stores and have plans to open 6 additional net new stores by the end of this year. We remain pleased with how our Madewell stores are performing and are pursuing opportunities to expand our footprint at a higher rate than previously.

We've also mailed our first ever Madewell catalog on Saturday to both our existing Madewell customers as well as some potential new customers, reflecting a new strategy to build brand awareness and drive traffic to our madewell.com website as well as our stores, and we are excited about the launch of our Alexa Chung for Madewell assortment that will be in stores on September 22, which has been getting some good press.

And finally, to support the growth of our business, ensure a high level of service for every one of our customers, we opened a new call center in San Antonio, Texas, in the second quarter. We are pleased with the progress we are making on our growth opportunities and feel we are well positioned from an assortment standpoint as we move into the back half of the year.

With that, I will turn the call back to Stuart to review our second quarter financials in more detail and provide an update on CapEx for the year.

Stuart Haselden

Thanks, Jim. Turning to the details for the second quarter. Total revenues increased 7% to $435 million. Total company comparable sales, which include comp store sales, direct sales and shipping and handling revenues, increased 3%. Our store sales increased 5% to $311 million. This was driven by a 1% increase in comp store sales, coupled with a 4% increase in net square footage. Direct sales increased 13%, which includes our J. Crew factory and Madewell direct businesses.

Gross profit excluding the impact of purchase accounting of approximately $23 million for the second quarter was $182 million, with our gross profit margin declining 280 basis points to 41.8%. The decline in gross profit margin reflected 180 basis points in merchandise margin decline, coupled with 100 basis points of buying and occupancy deleverage. The merchandise margin deterioration resulted primarily from increased markdown activity versus last year due to our spring/summer inventory position relative to our top line trend, primarily related to our Women's business, although, as Jim mentioned, we did see a sequential improvement in our Women's business during the first -- I'm sorry, during the second quarter as compared to the first quarter of this year.

SG&A expenses, excluding the impact of purchase accounting and related costs of approximately $14 million for the second quarter, increased 8% to $132 million and with 30 basis points above last year on a rate basis at 30.4% of revenues. The second quarter includes $3.6 million reduction in share-based and incentive compensation year-over-year. Excluding share-based and incentive compensation, SG&A per square foot was up 8% year-over-year. The year-over-year increase reflects increases in variable expenses and investments in the strategic initiatives Jim mentioned.

Adjusted EBITDA as outlined in Exhibit 3 of our press release for the quarter was $64 million as compared to $70 million last year, with EBITDA rate declining to 14.8% of revenues versus 17.1% last year. Net interest expense for the second quarter totaled $26 million as compared to $600,000 last year and is reflective of the debt incurred in connection with the acquisition.

We also wanted to update you on taxes. Subsequent to Q1, we decided to pursue a federal tax refund of $64 million resulting from losses incurred as part of the transaction instead of using these tax benefits to offset future estimated tax payments. We collected the refund in August.

Turning to key balance sheet highlights. Cash and cash equivalents were $88 million at the end of the second quarter. Total debt was $1.6 billion at the end of the second quarter, which compares to $49 million at the end of the second quarter of last year. Excluding the purchase accounting inventory step-up, our inventory balance increased 15% versus last year at the end of the second quarter, which includes approximately 5% related to an early factory delivery. This represented an increase of 11% on a per square foot basis. We are pleased with the composition of our inventory at the end of the second quarter. Our inventories are coming in line with our sales trend as we move into the back half of the year, as evidenced by the sequential decline in year-over-year increase in inventories at the end of the second quarter versus the first quarter of this year.

Capital expenditures for the second quarter were $28 million, and we continue to expect capital expenditures to total approximately $95 million to $100 million for the full year, reflecting our increased store opening plans, information technology enhancements, warehouse and call center expansions, store renovations and corporate facility improvements.

Operator, we would now like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Karen Eltrich from Goldman Sachs.

Karen Eltrich - Goldman Sachs Group Inc.

If you look at the inventory balance, how is that relative to your expectations? What portion of the increase is due to inflation, and are you clean yet from summer merchandise?

Stuart Haselden

So Karen, as we have described earlier, and this is Stuart by the way, we saw our average unit costs up low single digit in the first half of the year, and the inventory increase, if you take -- if you adjust for the 5% pull-forward from factory, 10% takes to account that average unit cost pressure. So that's kind of, I think, the position on the inventory in terms of how the cost pressure's affecting it in the first half. As we look to the second half, as we had mentioned on the last call as well, we're still seeing unit costs up high single digits, and yes, that's -- that cost pressure we would expect to begin to ease in the second quarter of next year.

Karen Eltrich - Goldman Sachs Group Inc.

Great. And with the flat shipping, I also noted that Nordstrom went to free shipping for all orders. Is that something that you're considering? Do you think the industry's moving that way? And how would you manage the economics?

James Scully

Well, I think -- it's Jim. I think, first of all, I think there's a lot going on in the industry in terms of where people are going with shipping. I think for us going to the tiered approach with free shipping over a threshold and flat rate made the most sense right now from where we were. Obviously, we continue to monitor all aspects of it, whether it's free shipping, markdowns, promotional stands, but I think right now, we feel good about where we are on shipping for our direct business.

Karen Eltrich - Goldman Sachs Group Inc.

Great. And final question, any early read on now the fall merchandise is being received?

Libby Wadle

This is Libby. We're pleased with the performance we're seeing early on in the quarter with the new fall merchandise.

Karen Eltrich - Goldman Sachs Group Inc.

And any -- are you seeing any resistance to price increases? But I have to -- anecdotally, I was in the store this weekend. Obviously, cashmere highlighted and you had said that was one of the areas where you'd be taking pricing, but frankly, I didn't really notice much in terms of, like, price going up.

Libby Wadle

We're seeing cashmere being welcomed with open arms. There's a lot of demand for cashmere out there and they're loving what we have to offer.

Operator

Our next question comes from William Reuter from Bank of America.

Spenser Samms - BofA Merrill Lynch

This is actually Spenser in for Bill. I was just wondering, with all the factory stores that you're opening kind of broadly, what percent of those are in your full-priced stores, and are you seeing like any cannibalization from that?

James Scully

So we don't break out the percentages, but I would tell you this. I would say that -- I would say it's a mix close to our stores. What we've seen historically is that where we have a retail store and we have a factory store we have not seen cannibalization unless it's extremely close, but what we've seen in those markets is actually a net positive from opening that. We think that's largely from brand awareness and hitting 2 different customers. So I'd say recently, we have not seen really any cannibalizations. We've opened the higher volume of factory stores. We've been quite pleased with the factory store openings.

Spenser Samms - BofA Merrill Lynch

Okay. And then I know you guys commented that you were happy with your fall merchandise performance, but have you seen any, just kind of broadly, change in trends with all the recent market volatility?

James Scully

It's interesting. We've heard a lot of conversation on calls and in the press in terms of other retailers speaking in terms of volatility in their business as it relates to the volatility in the market. I mean for us, we really don't see a day-to-day reaction in our business to the market. Obviously, we all know that over a period of time, these market movements will at some point impact consumer confidence, which is not good for anybody, but on a day-to-day basis, we do not see it impact our business.

Operator

Our next question comes from Carla Casella from JPMorgan.

Carla Casella - JP Morgan Chase & Co

I'm wondering on your product shipping rates, costs that you are bringing in, are you seeing any reduction there that might help to bring down your overall cost of sourced good as you go into the back half or even for next year?

James Scully

You mean the cost of transportation or are you saying actually on the finished goods coming in?

Carla Casella - JP Morgan Chase & Co

Yes, the transportation on, I guess, the finished goods coming from overseas.

James Scully

We're constantly renegotiating rates coming in. Obviously, it's a mix between air and sea. I'd say that one of the things that we've seen over the last couple of years is we have grown as a business. We have hit volume hurdles where we've gotten better and more attractive pricing on freight coming in and also as it relates to some of the shipments we have domestically, so I'd say it's not material. I'd say it's, more than anything, it's probably stable.

Stuart Haselden

I would just like to say the freight part of the total sourcing cost is pretty small.

James Scully

Right.

Carla Casella - JP Morgan Chase & Co

Okay great. And then on the inventory side, can you talk about for holiday, how much your -- the unit purchases, how they vary versus last holiday, up, down?

James Scully

Well, I would say, in general strokes, if you look at it, as Stuart said, costs are up high single digits in the back half, so I would say that units are flat to down in the back half of the year.

Carla Casella - JP Morgan Chase & Co

Okay. And the -- your inventory on the books currently, how much of that is current goods versus clearance from summer?

James Scully

So we don't break it out but I would say is that our, what we would consider our carryover inventory, our spring summer carryover into the back half is, on a dollar basis, very consistent with where we were last year at this time.

Operator

Our next question comes from Karru Martinson from Deutsche Bank.

Karru Martinson - Deutsche Bank AG

Just to be clear on the inventories, if we look out and back out the kind of the pre-buys or inventory at 10% and you're saying cost of low single digits, is that kind of how you're looking at it being in line with sales that were kind of in that high 6%, 7% range?

James Scully

Yes.

Karru Martinson - Deutsche Bank AG

Okay. And now, when we go forward here with the store buildout, how do you feel that inventories will kind of stay at this level, come down materially for third quarter or how should we look at that?

James Scully

So we don't really give -- because we don't give guidance, we don't give forward-looking on inventory. I think, as we look to the back half, I think it just -- what we said it as we cleared -- as we enter into the back half, it's going to align with sales, and you can read into that what you'd like but we can't give any more guidance. If you look at what we talked about on the last call where inventory's set above the sales trend, it's been a big party [ph] for us to realign that so that there's a healthy addition of the inventory versus the sales momentum.

Karru Martinson - Deutsche Bank AG

Okay. And just in terms of the difference here between the stores and the direct, I think the stores were down about 5% on a comp basis a year ago, direct has continued to be very strong. This year, we kind of see that same trend continuing. What is the shift that's going on with your customer here?

James Scully

Well, on a penetration basis, I think the business is actually relatively stable between direct and stores. I think what you see are some comparison differences in trends. I'd say for the -- where we are right now, we've seen the improvement, and I think you'd see it -- actually, as you look in a 2-year, 3-year basis, which I think you have to, versus a one-year comparison, for the direct business, we've seen kind of the same trend as we have in the retail business which is an improving Women's trend and continued strength in our Men's and our Crewcuts and Accessory businesses.

Karru Martinson - Deutsche Bank AG

Okay. And just lastly for housekeeping, what was the thought process behind taking the tax refund kind of upfront in cash rather than the write-down over the course of the deferment?

James Scully

Cash now.

Operator

Our next question comes from Emily Shanks from Barclays Capital.

Emily Shanks - Lehman Brothers

Just one clarifying point on the taxes. Given the receipt of the federal tax refund in August, does that mean that you will be a cash taxpayer going forward?

James Scully

Right. We will pay about $30 million in cash taxes this year, and so you have to look at the 2 pieces to get to the net cash impact for the year.

Emily Shanks - Lehman Brothers

Okay. And then for fiscal year '12, how should we think about cash taxes?

James Scully

We will be a full taxpayer.

Emily Shanks - Lehman Brothers

Okay, thank you. And then my other question is, I know people have been pretty focused on inventory. As I look at accounts payable leverage, it looks like it did contract almost 15 points year-over-year. I was just hoping -- I understand, I think I followed the inventory component of it, but anything in particular going on in the accounts payable side?

James Scully

Yes. I think you have to back out the step-up from the purchase price accounting to get to apples-to-apples, and you won't see as much of a variation at that point.

Emily Shanks - Lehman Brothers

Okay. So nothing unusual going on, on the payable side?

James Scully

No, no.

Emily Shanks - Lehman Brothers

Okay, great. And then my final question is, I was just curious if you could give us any color in terms of how back-to-school has rounded out for you and perhaps any comment you can make around the impact of Hurricane Irene if any at all?

James Scully

Well, I'll touch on Irene for a second. Back-to-school is not as big for us as for other players. With respect to Irene, we had over 100 stores impacted over the period of time, whether that be through full store closures, partial closures or late openings. The impact was small and certainly will not have an impact on the results in Q3.

Operator

[Operator Instructions] I will now turn the call back over to management for any closing comments.

James Scully

Well, thanks for joining us, and we look forward to updating you with our Q3 results. Thanks again.

Operator

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

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