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Executives

Stuart Haselden -

Libby Wadle - Executive Vice President of Retail & Factory

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

Analysts

Grant Jordan - Wells Fargo Securities, LLC, Research Division

Carla Casella - JP Morgan Chase & Co, Research Division

Emily E. Shanks - Barclays Capital, Research Division

Karen Eltrich - Goldman Sachs Group Inc., Research Division

J. Crew Group (JCG) Q3 2011 Earnings Call December 1, 2011 11:00 AM ET

Operator

Greetings, and welcome to the J. Crew Third Quarter 2011 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Stuart Haselden, Treasurer. Thank you. Mr. Haselden, you may begin.

Stuart Haselden

Thank you for joining us to review our third quarter 2011 results. With me today are Jim Scully, Chief Administrative Officer and Chief Financial Officer; Jenna Lyons, President and Executive Creative Director; 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 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 third quarter of fiscal 2011.

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

James S. Scully

Thanks, Stuart, and good morning. I will start today with a brief overview of our third quarter results followed by 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 to your questions.

For the third quarter, total revenues increased 12%, with our comparable company sales increasing 5%. Our comp store sales increased 2%, and direct sales increased 18%. Our adjusted EBITDA totaled $84 million, or 17.5% of revenues, in the third quarter versus $78 million, or 18.2%, last year.

We are pleased with the sequential improvement in our top line trend and the response to our fall assortment. We saw improved results from our Women's business, while we continued to experience strong performance in Men's and Accessories. As always, our #1 focus remains our products. We work every day to offer the quality, style and design that our customers have come to expect. We were excited to have our first-ever presentation during fashion week in New York City in September and could not have been more pleased with the response as well as the domestic and international press coverage.

We also made exciting progress on some of our key initiatives in the third quarter, which include strong growth across both retail and factory, the continued growth in our direct and Madewell businesses, our international expansion efforts and building the infrastructure to support the execution of these initiatives. We saw a solid growth in the third quarter from both our store and direct businesses.

On the retail store side, our long-term goal continued to be to grow our North American square footage in the low- to mid-single-digit range annually over the next 3 to 5 years. In the third quarter, we opened 6 new retail stores, including our first store outside of the United States at the Yorkdale Centre in Toronto in August. We also opened our newest men's-only store at Columbus Circle in early November, which was our ninth and final retail store opening this year. We are actively pursuing a number of opportunities in Canada and the U.S. that will support our future growth plans.

Our factory store strategy remains to grow our square footage by approximately 10% a year over the next 3 to 5 years through a combination of new units and expansions in existing centers where we see potential upside. We opened 4 new factory stores in the third quarter and 2 stores in November, including one factory crewcuts location. We have opened a total of 11 factory stores in 2011, which includes 2 crewcuts locations. We have also expanded our factory crewcuts business significantly in 2011 and now operate 4 standalone locations and 59 shop-in-shops in our factory stores.

Our plans for our direct business calls for outsized growth over the next 3 to 5 years, driven by several key initiatives, including our online international expansion, continued growth from our madewell.com and factory.com businesses as well as focused customer acquisition and marketing efforts in our core J. Crew business. Direct sales in the third quarter increased 18% versus last year, with our penetration to total company revenues increasing to 30% from 28% on an LTM basis. Additionally, on the direct side, in the third quarter, we moved to a flat rate shipping structure, and customers are responding positively.

Our Madewell store business continues to gain traction, and we have plans to expand our footprint at an accelerated rate. We opened 7 new Madewell locations in the third quarter, which included the Westchester in New York, Garden State Plaza in New Jersey and Old Orchard in Chicago. More recently, we also opened Madewell stores at Kenwood Towne Centre in Cincinnati and at Bellevue Square in Seattle in November.

We've also made some exciting progress on our international expansion efforts in the third quarter. We continue to be very pleased with the results in customer feedback from our Yorkdale Centre store in Toronto, and we are now completing plans to open additional stores in Canada next year. And we also expanded our direct reach in the third quarter, launching international shipping to the U.K. in August, followed by France, Italy and Germany in mid-November.

We also made important investments in our infrastructure in the third quarter, and these included the opening of our new call center in San Antonio, Texas, providing an important additional capacity and operational flexibility; the continued expansion of our Lynchburg distribution center; and we're also building out the team in key areas, such as international and marketing, to support our growth initiatives. We are proud of the milestones we reached in the third quarter and thank our team for all their hard work, continuing to drive the business forward.

And with that, I'll turn the call back over to Stuart to review our third quarter financials in more detail and provide an update on CapEx for the year.

Stuart Haselden

Thanks, Jim. Turning to the details for the third quarter. Total revenues increased 12% to $480 million. Total company comparable sales, which include comp store sales, direct sales and shipping and handling revenues, increased 5%. Our store sales increased 10% to $334 million. This was driven by a 2% increase in comp store sales coupled with a 7% increase in net square footage. Direct sales increased 18%, which includes our J. Crew, factory and Madewell direct businesses.

Gross profit excluding the impact of purchase accounting of approximately $7 million for the third quarter was $209 million, with our gross profit margin flat to last year at 43.5%. This was driven by 40 basis points of merchandise margin expansion, offset by 40 basis points of deleverage in buying and occupancy.

There are a couple of items influencing our gross margin results that I would like to highlight. Our merch margin was negatively impacted by a $2.8 million reduction in shipping revenues versus last year. If you were to exclude shipping revenues from both this year and last year, we would have experienced an 80-basis-point improvement in merchandise margin. Also, buying and occupancy includes a $2.3 million increase in occupancy year-over-year due to acquisition accounting. Excluding the noncomparability from both periods would result in 20 basis points of buying and occupancy leverage.

SG&A expenses, excluding the impact of purchase accounting and related costs of approximately $4 million for the third quarter, increased 14% to $140 million and were 70 basis points above last year on a rate basis at 29.2% of revenues. The third quarter SG&A includes a $3.8 million year-over-year increase in share-based and incentive compensation due primarily to last year's reversal of a significant portion of the fiscal year 2010 bonus accrual in the third quarter. If we exclude share-based and incentive compensation from both this year and last year, we would have experienced 30 basis points of leverage in SG&A expense. Excluding share-based and incentive compensation, SG&A per square foot increased 5% in the third quarter.

Adjusted EBITDA, as outlined in Exhibit 3 of our press release for the quarter, was $84 million as compared to $78 million last year, with EBITDA rate declining to 17.5% of revenues versus 18.2% last year. Net interest expense for the third quarter totaled $25 million, which compares to $2 million last year and is reflective of the debt incurred in connection with the acquisition. As we discussed at the end of the second quarter, we collected federal tax refunds totaling $64 million from the third quarter resulting from losses incurred in connection with the acquisition.

Turning to the key balance sheet highlights. Cash and cash equivalents were $143 million at the end of the third quarter. Total debt was $1.6 billion at the end of the third quarter, which compares to 0 debt at the end of the third quarter last year. Excluding the purchase accounting inventory step-up, our inventory balance increased 11% versus last year at the end of the third quarter. This represented an increase of 4% on a per-square-foot basis. We are pleased with the composition of our inventory at the end of the third quarter as well as our levels relative to our sales trend. We expect inventory increases to remain in line with our sales trend through the fourth quarter.

Capital expenditures for the third quarter were $25 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 facilities improvements.

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is coming from Karen Eltrich of Goldman Sachs.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

With regards to the international expansion, I guess what other countries are in the pipeline? And if you look at the response, particularly in the U.K., where, I guess, you've had the longest amount of time, do you think there is potential for retail expansion?

James S. Scully

It's Jim. So in terms of where next for us internationally, I think, as we mentioned in our prepared remarks, Canada is really kind of the focus in terms of the most aggressive growth, both online and also direct. And then when we think about expanding online, I think we look at additional countries in Europe first, and then we're evaluating even more countries beyond that for next year. And then for bricks and mortar, I do think the U.K. does come to the top of the list as well as, potentially, Hong Kong and China.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

Great. And with regards to online, we noticed that you did separate J. Crew and factory in terms of websites. Are you finding that, that has been beneficial in terms of addressing cannibalization?

James S. Scully

Well, I don't think we've actually create -- disconnected the sites. You still get through factory.com through the J. Crew site. The marketing may have been more distinguished, but that's in our future plans, to actually take factory.com and have a separate site for factory.com, something that we're evaluating right now, potentially for next year.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

Great. And with the reduction in the shipping expense, was that due to your new shipping policy in terms of the flat rate? And have you gotten a customer reaction in terms of sales to offset that lost volume in your opinion? Or offset that lost income, I should say?

Stuart Haselden

It's Stuart. Just to be clear, it was -- the 2.8 was a reduction in shipping revenue, and it's in connection with, as you've just mentioned, the flat-rate-shipping change, which we've seen good customer response to this point. It's a trend that's affecting every company in the industry, and at this point, we feel like we're positioned appropriately for our customer. That is something we continue to evaluate, and we will make changes as we go.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

On that same note, what are you seeing in terms of promotional environment, particularly as you look at how the Thanksgiving weekend went for you? It seems to me that there was an inordinate amount of friends-and-family coupons going on there. Do you think this holiday season is going to be more promotional? And do you guys think you're well positioned?

Libby Wadle

It's Libby. Yes, we're seeing -- I mean, it's as promotional, if not earlier in terms of promotion timing, than, I'd say, last year was. We didn't participate in that friends and family, but we definitely saw it start around the Veterans Day holiday and really continue through. We do feel like we are well positioned to weather the environment. Yes.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

And how was traffic for you guys on Thanksgiving weekend?

James S. Scully

We actually don't comment on that, Karen.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

Okay, fair enough. Final question, how -- as you look to spring, how do you feel your offerings are shaping up? And what kind of are the big trends that you've identified?

Libby Wadle

Well, we feel good about what we're seeing now in terms of our business, specifically towards our improvements in our Women's business, and as we continue into spring, and the franchise businesses that really are driving that and the brands we've built within our own brand still are very strong and positioned well for us as we enter the first half.

Operator

Our next question is coming from Emily Shanks of Barclays Capital.

Emily E. Shanks - Barclays Capital, Research Division

I have a couple of follow-up questions specifically around the merchandise margin expansion. It definitely exceeded our expectations, and I was looking to see what you would attribute the merchandise margin expansion to and if you can give us any commentary on what your outlook for is on a go-forward basis.

Libby Wadle

Yes. I mean, we attribute, really, the merchandise margin improvement to, again, the uptick in the improvement in our women's business within core J. Crew, both in retail and direct. And really, we saw strong performance in full-price selling this year. As you know, we had a lot to make up for from last year with regard to full-price selling in women's.

Emily E. Shanks - Barclays Capital, Research Division

Okay, great. And then somewhat related to that, what is your outlook for inflationary? Any potential inflationary pressure as we look into the first half of 2012?

Stuart Haselden

So Emily, I think as we had said on our last call, from a cost standpoint, we're expecting or we are seeing cost increases in the high-single-digit range in the back half of this year. We'll expect to see the same levels into first quarter of next year. Although we'll begin to lap the increases in the first quarter of 2010, so it won't be quite as high on a percentage basis. And then we'll -- we expect to see the increases ease in the second quarter of next year. Does that answer your question?

Emily E. Shanks - Barclays Capital, Research Division

Yes, it does, and thank you for affirming your commentary from the prior call. My final question is just around the "inventory per square foot" figure that you gave us. I just wanted to make sure we were clear. Is that specific to selling space? Or does that also include direct and inventory sitting at DC/in-transit?

James S. Scully

It's everything. It's all of our inventory, and it's -- the denominator is gross square footage.

Operator

Our next question is coming from Grant Jordan of Wells Fargo.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

My first question, you talked little bit about the improvement in the Women's business. Maybe give us a little bit more detail in terms of what's driving that in terms of how you repositioned it.

Libby Wadle

Yes. Well, I touched on really what we're calling our franchise businesses. Really, the businesses, we built brands within Women's. If you know the assortment, you probably know a lot of them, the Minnie pant, the schoolboy blazer, these things just that we're investing in and going after. And they've been performing. And that's really how we're pitching the go-forward seasons as well. And we've had success within our fashion as well as, clearly, we had fashion and that's been working as well, novelty, fashion and prints.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

Okay. And then just looking more on the expense side, you talked a little bit about the increase you saw or the leverage that you got on buying and occupancy and then the SG&A. Given the strong sales increase, I guess, maybe you could have -- I would have expected to see a little bit more. Is that just a result of making investments in all the areas you talked about growth?

Stuart Haselden

I think that's right. This is Stuart. So when you strip out the noncomparability in the bonus and incentive comp, we had 30 basis points of leverage in SG&A. It would have been more, to your point, had we not been pursuing the growth initiatives as aggressively as we are. So that's a big part of the story.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

Okay. And just in terms of trying to think forward, like how long this investment period will be, is this kind of ongoing for the next couple of years in your mind? Or the next couple of quarters?

Stuart Haselden

I think it's -- if you look at the posture we have from a square-footage-growth standpoint and the initiatives we have in our direct business, it's probably, for the near term, a higher investment phase from an expense standpoint. We're not going to put a specific number on how long that's going to last and at what point the dynamic may change, but for the near term, it is in investment mode.

Operator

Our next question is coming from Carla Casella of JPMorgan Chase.

Carla Casella - JP Morgan Chase & Co, Research Division

I'm wondering if you could talk about the performance of the mall versus the online and -- well, online versus the stand-alone stores. Are you seeing much of a difference? And are you -- it sounds like you're trending above mall traffic, it sounds like. So is that a correct assessment in the mall?

James S. Scully

It's -- I don't want to comment on kind of the relative performance on traffic, given -- we know our traffic is -- from our traffic counters, it's hard to look at the mall data. I would say that if you look at the split between our businesses, you can see that we've seen an increase the penetration of our business going to 30% online versus 28%. A lot of that is driven by some of the new initiatives that we have, which include international, factory and the Madewell growth. But as you know, at this time of year and with all the promotional activity that's going on and with our multi-channel platform, direct is very important for us this time of year. And I would say that this has been -- over the last week, we've seen -- or the last of couple weeks -- some strength in that business.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. And then just curious, what percentage of your business today is outerwear and what percentage is shoes? And do you see that changing dramatically as we go forward?

James S. Scully

We don't break it down to that granularity. I think we look at it -- if you see it in the 10-Q that we filed this morning, you'll see it at more aggregate level between men's, women's and accessories. We're just going to leave it at that.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. I think I had just seen an article about a shoe expansion. Is that not something that -- you're just not commenting on yet?

Libby Wadle

Yes, sure. I mean, we've definitely expanded our Accessory business via shoes, really a big emphasis on shoes in the back half, both our ballet flats and our other shoes as well as our handbag business. It's a important initiative for us now and go-forward.

Operator

[Operator Instructions] Our next question is coming from Emily Shanks of Barclays Capital.

Emily E. Shanks - Barclays Capital, Research Division

I just wanted to see if you could give us directional guidance, at the least, in terms of what you expect for CapEx for fiscal year '12 and/or store expansions?

Stuart Haselden

It's Stuart. We'll give a detailed, I guess, outlook for those items as part of our next call in March. I think Jim had kind of given you the directional guidance around the ranges of square footage growth and then with a little more specificity on Madewell. So at this point, that's kind of the story, and we'll have more details for you in March.

Operator

Our next question is coming from Carla Casella of JPMorgan Chase.

Carla Casella - JP Morgan Chase & Co, Research Division

Sorry, I forgot to ask, do you have the restricted payments basket, where that stands today?

Stuart Haselden

So we've made some small investments or the cost to open the stores in Canada are the only items that have hit the RP basket at this point. It's very small.

Operator

That's all the time we have for questions for today. I'd like to hand the floor back over to management for any closing remarks.

James S. Scully

So this is Jim. I want to thank everyone for participating. And we want to wish everyone a happy and healthy holiday season, and we look forward to speaking with you when we report our fourth quarter and fiscal results in March. Thanks.

Operator

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

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