Carter's (CRI) Michael Dennis Casey on Q2 2016 Results - Earnings Call Transcript

| About: Carter's, Inc. (CRI)

Carter's, Inc. (NYSE:CRI)

Q2 2016 Earnings Call

July 27, 2016 8:30 am ET

Executives

Michael Dennis Casey - Chairman & Chief Executive Officer

Richard F. Westenberger - Chief Financial Officer & Executive Vice President

Brian J. Lynch - President

Analysts

Ike Boruchow - Wells Fargo Securities LLC

Susan K. Anderson - FBR Capital Markets & Co.

Daniel Ryan O'Hare - Bank of America Merrill Lynch

Anna Andreeva - Oppenheimer & Co., Inc. (Broker)

Kate McShane - Citigroup Global Markets, Inc. (Broker)

Stephanie Schiller Wissink - Piper Jaffray & Co. (Broker)

Jim A. Chartier - Monness, Crespi, Hardt & Co., Inc.

John Kernan - Cowen & Co. LLC

Janet J. Kloppenburg - JJK Research

Operator

Ladies and gentlemen, please standby. We are about to begin. Welcome to Carter's Second Quarter 2016 Earnings Conference Call. On the call today are Michael Casey, Chairman and Chief Executive Officer; Richard Westenberger, Executive Vice President and Chief Financial Officer; Brian Lynch, President; and Sean McHugh, Vice President and Treasurer. After today's prepared remarks, we will take questions as time allows.

Carter's issued its second quarter 2016 earnings press release earlier this morning. A copy of the release and presentation materials for today's call have been posted on the Investor Relations section of the company's website at www.carters.com.

Before we begin, let me remind you that statements made on this conference call and in the company's presentation materials about the company's outlook, plans, and future performance are forward-looking statements and actual results may differ materially from those projected. For a discussion of factors that could cause actual results to vary from those contained in the forward-looking statements, please refer to the company's most recent Annual Report filed with the Securities and Exchange Commission and the presentation materials posted on the company's website.

On this call, the company will reference various non-GAAP financial measurements. A reconciliation of these non-GAAP financial measurements to the GAAP financial measurements are provided in the company's earnings release and presentation materials. Also, today's call is being recorded.

And now, I would like to turn the call over to Mr. Casey. Please go ahead, sir.

Michael Dennis Casey - Chairman & Chief Executive Officer

Thanks very much. Good morning, everyone. Thanks for joining us on the call. Before we walk you through the presentation on our website, I'd like to share some thoughts on our business with you.

We saw strong demand for our brands in our Retail and International businesses in the second quarter. We achieved our first positive comp in two years at our Carter's stores and had strong demand online for both Carter's and OshKosh B'gosh.

Demand from domestic consumers was particularly good. Thankfully, we're seeing some moderation in the negative effects of the stronger dollar and some signs that international customers are coming back and shopping with us again in the United States.

Higher demand for our brands in Canada and China drove the growth in our international sales in the second quarter, and domestic wholesale sales were lower than last year, but in line with our plan.

In the second quarter, we continued to improve price realization. That improvement, together with lower product costs, drove a higher gross profit margin and funded greater investments in store expansion, technology, marketing and China start-up costs. And we're reporting good cash flow for the first half, which has enabled us to meaningfully increase the return of capital to our shareholders. All-in-all, it was a good first half.

With nearly seven months into the year, we have better visibility to the second half. We've adjusted our annual sales and earnings plans to reflect our latest outlook on Spring 2017 bookings and international demand for our brands. Understandably, some of our wholesale customers are being more conservative with their inventory commitments given trends in their businesses. That said, we're expecting good growth for our company this year. Our longer term outlook has not changed. We believe that our multi-brand, multi-channel business model will enable us to achieve $4 billion in sales by 2020.

With respect to business trends, sales ramped up in line with our plan as we moved through the second quarter. If you recall, we saw our retail trends improve following the Easter holiday with positive year-to-date comps through the end of April. Through yesterday, our year-to-date comps have improved on that level of performance. We're expecting positive comps for the third quarter and second half as we lap up against the volatility in exchange rates and drop in tourism last year.

Our supply chain performance was exceptionally good in the second quarter in terms of on-time deliveries and distribution center efficiencies. And inventories are in good shape as we head into the balance of the year.

The stronger dollar continues to weigh on our results, though less so than the previous three quarters. As you may recall, we began to see the dollar strengthen meaningfully in the second half of last year. As the dollar strengthened, we saw lower contribution from our Canadian operations and a significant decline in international customers shopping with us in the United States.

On a comparable basis, domestic demand in our U.S. Retail business grew over 8% in the second quarter. By comparison, international demand declined about 18% for a net comp increase of 3%. We've seen the biggest impact from lower international traffic in the Southeast, in some of our largest most productive stores in Florida. These have historically been our best performing outlet stores that have benefited from international tourism.

Sales to international tourists dropped from 20% of our retail sales in the first half of 2015 to 15% in the first half of this year. This decrease impacted retail comps by about 3 percentage points. As the volatility in exchange rates has begun to moderate, we're seeing a positive correlation in retail sales. There are reasons to be hopeful that these trends may continue. That said, we are also cautious knowing that they may not.

To achieve our growth objectives this year, we have initiatives focused on providing the best value and experience in young children's apparel, extending the reach of our brands and improving profitability.

We believe one of our most impactful initiatives is our strategy to make shopping for our brands more convenient for consumers. We plan to open 130 beautiful stores in North America this year; most of these stores are located in high-value, non-mall shopping centers.

Our best performing stores this year are located outside of outlet centers, closer to the consumer. Our best performing stores are the co-branded side-by-side stores providing the best assortment of our Carter's and OshKosh B'gosh brands in one convenient location.

To encourage more frequent online shopping and store visits, we have recently rolled out technology that enables consumers to shop online and pick up their purchases in our stores. With more of our stores located closer to the consumer, we believe this option for free shipping has become more attractive. Since launching this initiative, about 10% of consumers choose to have the product shipped to our stores. And when they pick up their order, we have seen additional purchases made in the store.

We continue to see good performance from other initiatives this year, which include our new loyalty program, extended sizes for both brands and expanded shoe offerings.

Our rewards program was launched in October last year. Prior to its launch, our loyalty program was not available to our e-commerce shoppers. The consumers' response to this initiative has exceeded our expectations. Nearly 90% of transactions in our stores and online are with customers who have enrolled in the rewards program. This program captures important consumer information, which enables us to engage them more effectively. We're seeing higher redemption rates and higher spending upon redemption. We're also seeing higher sales per customer and more frequent visits.

We believe we've improved the scope of our product offerings this year. In addition to Little Baby Basics launched in May, we now have extended sizes for both brands. If you recall, we launched size 8 for Carter's last year and sold out earlier than expected. We've sourced more product for this fall and are seeing a nice lift in sales.

This fall, we've also launched size 14 for OshKosh B'gosh. It's early, but we believe this initiative will enable us to outfit more children for a longer period of time. We've also expanded our shoe offering this year. Like apparel, we believe consumers want high quality, high value footwear for their children from brands that they trust.

We're also reaching more consumers internationally through our global distribution capabilities. We saw strong demand in international sales, which grew 8% in the second quarter, up 12% in constant currency and up 16% year-to-date. Our business in Canada continued to strengthen its number one market share position in young children's apparel. We now own over 16% share of the Canadian young children's apparel market, double the share of the next largest specialty retailer.

The next largest component of our international business is supported by retailers, representing our brands in over 60 countries. Despite the turmoil in the world and effects of currency devaluation, we're expecting this part of our business to produce over $100 million in sales this year, which is comparable to last year.

China is the next largest international opportunity for us. The number of annual births is four times that of the United States. We continue to believe China sales could exceed $100 million by 2020.

With respect to improving profitability, we are focused on increasing our direct sourcing capabilities, improving distribution center efficiencies, strengthening inventory management capabilities, and improving OshKosh profitability. Collectively, our profit improvement initiatives should enable us to achieve a 14% operating margin by 2018.

In summary, we made good progress improving our business in the first half of this year. Given the strength of our brands in the marketplace and multi-channel model, we believe we're on track to have another good year of growth in sales and earnings.

Looking beyond 2016, we're encouraged by reports indicating an improved trend in the U.S. birth rate for moms who are 25 years and older. Recent reports also suggest that the job market and the housing market are improving. And the Presidential Election will be behind us, and some of the uncertainties that weigh on consumer behavior may moderate.

I want to thank our employees throughout the company who helped us achieve the results we're reporting this morning. I'm grateful for their passion for our brands and their commitment to help us execute our growth plans.

Richard will now walk you through the presentation on our website.

Richard F. Westenberger - Chief Financial Officer & Executive Vice President

Thank you, Mike. Good morning, everyone. We have a good quarter to tell you about today, and I'll begin my comments on page two with some overall highlights.

Consolidated net sales grew 4%, which was at the high end of our prior guidance. Growth was driven by our U.S. Retail and International businesses. Adjusted operating income was roughly comparable to last year at $64 million. Adjusted operating margin declined by 70 basis points, reflecting gross margin improvement offset by increased investments to support our growth agenda.

Adjusted earnings per share were also about comparable to last year at $0.72, which was better than our previous expectation, largely due to lower than planned spending in the quarter. Some portion of this spending favorability, we believe, is due to timing and does not represent upside for our full year earnings outlook.

Negative movements in foreign exchange continued to be a headwind in the second quarter, including continued lower demand from international consumers shopping in our U.S. stores and on our website. We've estimated that the various effects of foreign exchange throughout the P&L cost us approximately $14 million in top line revenue and approximately $0.15 to $0.20 in earnings in the second quarter.

Moving to page three with details of our sales performance in the second quarter. Our Carter's business in the U.S. grew 5%, driven by strong growth of 11% in our Carter's Retail segment. Carter's Retail achieved a comp of plus 4% with both stores and e-commerce contributing to the positive comp. Our OshKosh business in the U.S. grew 1% with the OshKosh Retail segment contributing nearly $6 million to our sales growth.

International delivered another solid quarter, growing 8% compared to last year, with growth of 12% on a constant currency basis. Our Canadian Retail business and new e-commerce business in China drove the growth in this segment. I'll cover our business segment results in more detail in a moment.

Turning to our second quarter P&L on page four. Consolidated gross margin improved by 120 basis points to 44.1%. This performance reflects a modest improvement in average unit pricing, largely due to a higher mix of retail sales and lower product costs.

Adjusted SG&A grew 11% in the second quarter. Consistent with recent quarters, the expense increase and higher SG&A rate were driven by growth in our Retail businesses in the U.S. and Canada, as well as investments in our e-commerce business in China. To a lesser degree, investments in marketing and higher technology spending also contributed to the increase.

As I noted a moment ago, second quarter SG&A was lower than forecasted. Some portion of this upside relates to the timing of spend in such areas as consulting, HR and marketing. We expect we'll now incur these costs in the second half of the year.

Continuing down below operating income, the interest and other line reflects a $300,000 loss in the quarter related to unfavorable settlements and reevaluation of foreign currency forward contracts. This loss compares to a gain of nearly $2 million in last year's second quarter. Interest expense was comparable year-over-year.

Our effective tax rate was 35.5%, down somewhat compared to last year, primarily due to increased contributions from our International businesses. For the full year, we're forecasting an effective tax rate of approximately 35.5%, consistent with 2015.

Our weighted average share count declined approximately 4% versus last year, reflecting our share repurchase activity. The results of all those items was bottom line adjusted earnings per share of $0.72 compared to $0.73 in last year's second quarter.

Pages five through seven summarize our year-to-date performance. In the first half of the year, we've delivered good top line growth of 5%, expanded gross margin and we've grown earnings. As expected, sales and margins in the first half were weighed down by lower sales to international consumers shopping in the U.S. Our spending is higher, although less than we had planned, as we've continued to invest in our Retail businesses and in critical infrastructure and omni-channel initiatives.

Now turning to page eight with a few balance sheet and cash flow highlights. Our liquidity at quarter-end remained solid with a cash position of over $200 million and available capacity under our credit facility of over $300 million.

Quarter-end inventories increased 8% versus last year, principally due to business growth. We believe our inventory quality was very good as we exited the second quarter. Operating cash flow for the first half of the year was $86 million, near a record high for us, compared to $27 million last year. Favorable movements in net working capital and higher earnings drove the improvement over last year.

First half capital expenditures were comparable to last year at $50 million. Significant areas of investment this year include new stores in the U.S. and Canada as well as various information technology projects.

Free cash flow in the first half improved to $36 million driven by strong operating cash flow. We've made good progress in returning capital to our shareholders and have now returned three times as much as we had at this time last year. Through the first two quarters of 2016, we repurchased $180 million of our stock and paid $34 million in dividends for a total return to shareholders of $214 million.

With respect to our capital structure, we have concluded for now that we're comfortable with our current leverage profile. Our adjusted leverage is about 2.3 times, which we think is reasonable and consistent with our peer group. This leverage level, along with our substantial borrowing capacity, provides us with significant financial flexibility and strength.

We hope to continue to return excess capital to shareholders. This is a priority for us. Should we require liquidity to support this initiative or the business, we have substantial capacity under our existing credit facility. We think this is a better approach at this time than pursuing more structured longer-term financing. Our review of our capital structure is an ongoing exercise for us and something which we discuss with our board regularly.

Page 10 summarizes our business segment results in the second quarter. Consolidated adjusted operating income was roughly comparable to the prior year at $64 million and adjusted operating margin was 10% compared to 10.7% last year.

Our U.S. Wholesale, OshKosh Retail and International businesses delivered stronger operating margins, while our Carter's retail segment margin declined. Corporate expenses deleveraged 20 basis points compared to last year, principally due to spending on the upgrade of our core financial systems.

Moving to our individual business segments in more detail, beginning with Carter's Wholesale on page 11. As planned, net sales for Carter's Wholesale in the second quarter declined year-over-year. Net sales were affected by the timing of customer demand, both earlier demand from some customers which fell into the first quarter as well as some Fall product shipments planned for the third quarter as opposed to second quarter last year.

On a first half basis, net sales in our Carter's Wholesale business grew 1%, which was consistent with our plan. Net sales in this part of the business are now planned to be comparable to last year for the full year. Carter's Wholesale segment operating profit was comparable to last year at $40 million. Segment margin improved by 40 basis points to 19.4%, reflecting favorable product mix and lower product costs.

As Mike mentioned, we've moderated somewhat our sales forecast in our Wholesale segment, consistent with the challenges which many of our wholesale customers, particularly those with a high concentration of stores in traditional shopping malls, have articulated regarding their businesses.

Page 12 shows a recent Carter's floor set at Babies "R" Us, one of our important wholesale partners. One of our key strategic priorities is to provide the best value and experience in young children's apparel. Wherever mom is shopping, including in the wholesale channel, it's important to us that she finds our brands in a way that emphasizes the strength of our value proposition and the beauty and quality of our products. This is a good example of where we have partnered with a significant wholesale customer to elevate the signage, fixturing and branding surrounding the Carter's assortment carried at Babies "R" Us.

Turning to page 13, and the Carter's Retail segment. Total Carter's U.S. Retail segment sales increased 11% versus last year. Carter's Retail segment same-store sales grew 4% over last year, with store comps up 1% and e-commerce comp sales growing 17%.

We're pleased with our retail performance in light of such soft consumer traffic trends in the marketplace. Our analysis indicates our Carter's retail stores fairly significantly exceeded industry traffic benchmarks in the second quarter. In Q2, we opened 15 new stores and closed one. Over the last year, we've added 62 net new Carter's stores in the U.S. New stores are delivering good returns with average after-tax return on investment in excess of 20%.

Carter's Retail segment profits in the second quarter were comparable to last year at $38 million. Segment operating margin declined by 150 basis points, principally driven by store expense deleverage, mostly from new store expenses, higher promotional activity due to lower international consumer demand and increased marketing spend and investments in technology.

On page 14, we've updated the analysis we've shared previously, which estimates the meaningful effects, we believe, of lower international traffic on our U.S. Retail businesses in the second quarter.

Consistent with the last few quarters, we've seen good demand from domestic consumers but a significant decline in demand from international consumers shopping in our U.S. stores and on carters.com.

Our forecast assumes that the declines in demand from international consumers will be less significant in the second half than what we've seen over the past several quarters. We've already seen some meaningful improvements in international demand in e-commerce. The stores however continue to be under pressure. If the decline in U.S. retail store sales to international consumers were to continue to decline at roughly the same year-over-year pace that we've been experiencing, it would represent an estimated additional $10 million in sales and profit risk to our current forecast.

Pages 15 and 16 contain portions of the latest Carter's direct mail piece. These pages showcase our latest take on our iconic Carter's bodysuit, a must-have in every baby's wardrobe as well as our updated sets which provide easy dressing options for parents all at great prices.

Now moving to page 17 and OshKosh Retail results. OshKosh total retail segment net sales grew 5%, driven by new store openings and growth in e-commerce. OshKosh's retail comp declined approximately 1% comprised of e-commerce comp growth of 18% and a store comp decline of 6%.

We believe lower demand from international consumers disproportionately affected the OshKosh store comp performance given the concentration of international tourist outlets in the OshKosh brand's store portfolio. Nearly two-thirds of OshKosh stores are in outlet centers compared to only one-third for Carter's. Non-outlet OshKosh stores, principally side-by-side stores, comped positively in the second quarter. In Q2, we opened 12 new stores and closed one. Over the past 12 months, we've opened 41 net new OshKosh stores.

We ended the second quarter with a 119 side-by-side format stores, which now represent 45% of the OshKosh store portfolio. These new stores are delivering good returns with an average after-tax return on investment in excess of 15%.

OshKosh Retail segment income in the second quarter improved by about $300,000. Segment operating margin improved by 60 basis points, reflecting distribution efficiencies and lower product costs. These benefits were somewhat offset by store expense deleverage, increased marketing and investments in technology.

Pages 18 and 19 feature selections from our recent OshKosh direct mail piece. These pages convey the value, quality and relevance of the OshKosh brand as we enter the important back-to-school shopping season.

Page 20 is a photo of one of our newest side-by-side stores in the Minneapolis, St. Paul market. In this particular location, we had an opportunity to add a new OshKosh store to an existing successful Carter's store in order to establish a side-by-side location and meaningfully increase the selection of our brands and products available to the consumer.

Moving to our International segment on page 21. Our International segment achieved very solid growth again this quarter. Second quarter reported net sales increased 8% and grew 12% on a constant currency basis.

Our Canadian store and e-commerce businesses continue to perform very well. Canada retail comps increased 8% with solid comps in both stores and e-commerce. Our International e-commerce business more than doubled in the second quarter with net sales growing to $7 million compared to approximately $3 million last year. Our China Tmall business, launched at the end of Q2 last year, drove most of this growth.

Net sales in the wholesale component of our International segment were $22 million compared to $26 million in last year's second quarter, largely reflecting lower shipments to Mexico. On a full year basis, we're forecasting 2016 net sales in this component of international to be comparable to 2015.

International segment adjusted operating income in the second quarter grew by 19% to $9 million. Segment operating margin improved by approximately 120 basis points to 12.7%, principally driven by the strong comp sales and improved profit contribution from Canada, partially offset by unfavorable foreign exchange effects.

Page 22 includes a photo of one of our newest stores in Canada. This Toronto area location opened in May and represents our second mall location in Canada. Results to date have been very encouraging.

Now turning to page 23 for our outlook for the third quarter and fiscal 2016. For the third quarter, we expect net sales to grow approximately 6% to 7%, principally driven by growth in our U.S. Retail and International businesses. We anticipate modest growth in our Carter's Wholesale segment.

We're forecasting third quarter adjusted diluted earnings per share to grow approximately 6% to 10% compared to an adjusted EPS of $1.52 in the third quarter of 2015. This earnings forecast contemplates gross margin improvement on a year-over-year basis and SG&A deleverage, in part due to planned spending that has shifted from the second quarter to the third quarter.

For full year 2016, we now expect net sales to grow approximately 5% to 6%, driven by our U.S. Retail and International businesses. This compares to our prior outlook of growth of 6% to 7%. As mentioned, this revised sales outlook reflects, in part, more modest expectations for wholesale and international demand in the second half.

We continue to forecast good growth in profitability in 2016. We now expect adjusted EPS to grow approximately 10% compared to 2015's adjusted $4.61 per share.

Risks that we're monitoring include inconsistent trends in consumer demand and store traffic both in our Retail business and with our wholesale customers, foreign exchange rates, the level of promotional activity in the marketplace, and consumer sentiment in light of the ongoing Presidential Election cycle and the overall macroeconomic environment.

With these comments, we're ready to take your questions.

Question-and-Answer Session

Operator

Thank you, sir. And for our first question, we go to Ike Boruchow with Wells Fargo.

Ike Boruchow - Wells Fargo Securities LLC

Hey. Good morning, everyone. Thanks for taking my question.

Michael Dennis Casey - Chairman & Chief Executive Officer

Good morning.

Ike Boruchow - Wells Fargo Securities LLC

So, I think, just about every vendor that's reported so far has talked about weaker Q3 orders. So it makes some sense what you're seeing in wholesale. I guess, my question is, is that due to a particular channel? Whether it be mid-tier department stores or the mass channel? And then, how are your sell-throughs at POS within the wholesale channel, any change there relative to the first half?

Brian J. Lynch - President

Yeah. I'd say a couple of things. We've got good initiatives out there in wholesale, but the retail environment does continue to be challenging, especially we're finding the brick-and-mortar and mall-based department stores. Our online business is very good and growing rapidly at virtually all the accounts. So, our latest view with our sales this year in wholesale as, I guess, Richard said are going to be comparable to the last year.

As far as spring 2017, just to give you a little color on that, the bookings process is still ongoing. But at this point, we do believe that they will come in lower than last year, and that's primarily softness we're seeing in that mall-based department store bookings segment of the business. They're going to be down, but they do represent a much smaller portion of our Wholesale segment at this point. It's about 15% of our segment is the mall-based department store business.

So we're continuing to invest with our partners in presentation and driving sales to their websites and continue to support them in their efforts to drive the business. You asked about selling, I would say, spring overall as we finished up, I'd say, we had a really good playwear season. Sell-throughs were good. I would say, in some of the other categories, the sell-throughs were not quite as high as we'd hoped the inventories are up just a little bit more than we would probably have anticipated in some of the accounts. But we think that's going to normalize quickly if you remember the fall bookings were comparable to last year.

So, overall, the channel, we think, this year we can finish up comparable to last year, maybe up slightly. We feel good about that. We still have the spring bookings underway. We've got a lot of good initiatives out there. We're driving online businesses, driving the playwear business. Presentation, I think, we've spoken about the Coles (28:39) playwear strategy, which were coming up on comping that from last year. And they continue to see very good results with the expansion of our playwear business with that account as well.

Ike Boruchow - Wells Fargo Securities LLC

Got it. And it sounds like there shouldn't be much variability, Q3 and Q4, on your wholesale performance. Is that fair?

Richard F. Westenberger - Chief Financial Officer & Executive Vice President

So, I think, Brian's comments, Ike, are more directed towards the outlook for spring bookings. There is a portion of the spring shipments that go in the fourth quarter. I think that's the piece that we've moderated our expectations at this point. We're continuing to have a good outlook, I think, for the shipments of our fall products, but we're watching that as well.

Ike Boruchow - Wells Fargo Securities LLC

Got it. Thanks so much.

Michael Dennis Casey - Chairman & Chief Executive Officer

You're welcome.

Operator

And for our next question, we go to Susan Anderson with FBR Capital Markets.

Susan K. Anderson - FBR Capital Markets & Co.

Hi. Good morning, everyone. Thanks for taking my question. I was wondering if I could just dig in a little bit deeper on the wholesale orders for the fall. So it sounds like basically they came back to you guys and brought them down a little bit, because I think they're supposed to be modestly up before.

Brian J. Lynch - President

I think we said before that they were comparable to last year, if not up modestly. So when you put it all together, you got the fall bookings, Susan, and then you've also got spring 2017 bookings. And some component of spring 2017 bookings are pre-ships that go in the back half of this year, late in the fourth quarter. And that's the key reason we're moderating the outlook. Those, we do believe, will be down slightly to last year. So when you put that all together with fall bookings and spring pre-ship bookings, that's how we arrived at that revision.

Susan K. Anderson - FBR Capital Markets & Co.

Got it. Okay, that's helpful. And then, I think you guys also said that you expect international to slow a bit. Maybe if you could just touch on that a little bit, is that still the tourist impact or is that coming from Canada or other parts of the International business?

Michael Dennis Casey - Chairman & Chief Executive Officer

There's a few parts. The spring 2017 bookings from our international customers are also expected to be lower than we previously expected, given issues in their different parts of the world and the continued effects of the stronger dollar. So that's one component. The other component is the ramp-up in our new China e-commerce business. That business will more than double this year, just won't be at the same level of demand that we had previously forecast.

Probably the biggest challenge in our business though, I would say, is the level of international demand from international tourists shopping with us in the United States both in our stores and online. Thankfully, we're starting to see some recovery online. It appears though they're coming back shopping online, even though that business was down in the second quarter. If you'd exclude the big drop in China, online international demand was actually up online in the second quarter.

So we're starting to see some recovery, haven't seen as much recovery yet in our stores. We're starting to see some recovery in some of the larger outlet stores in Florida, but it hasn't been sustained. So, our biggest assumptions in the second half are, as exchange rates start to normalize year-over-year, the international guest is coming back. And so we put reasonable assumptions on both our e-commerce business and the stores. We're seeing recovery online, not so much in the stores yet.

Susan K. Anderson - FBR Capital Markets & Co.

Got it. That's helpful. And then one last question on the OshKosh business. So it seems like after several good quarters of comps it turned negative, is that just as you guys kind of cycle more difficult compares or is there anything else that you're seeing in that business?

Michael Dennis Casey - Chairman & Chief Executive Officer

I'd say, the arrow is pointing up on OshKosh. OshKosh is making good progress, had positive comps in June, expecting positive comps in the second half. You got to keep in mind, two-thirds of OshKosh stores are in outlet centers, and a good chunk of those outlet centers are in tourist locations. So we saw a big drop off in tourist locations for OshKosh and Carter's, but having two-thirds of these stores in outlet centers works against Oshkosh.

Our plan is to, over the next five years, take that mix of outlet stores from what is two-thirds to less than a third. And we're seeing very good performance from our side-by-side stores. The best traffic and the best comps are in our side-by-side stores. That's where you have the best of Carter's and best of OshKosh sitting side-by-side. The feedback from consumers on those stores have been good. The comps have been good. And every store we open going forward for Oshkosh will be in the co-branded format.

Susan K. Anderson - FBR Capital Markets & Co.

Great. That's really helpful. Thanks so much. Good luck to next quarter.

Michael Dennis Casey - Chairman & Chief Executive Officer

Thanks very much.

Operator

For our next question, we go to Robert Ohmes with Bank of America Merrill Lynch.

Daniel Ryan O'Hare - Bank of America Merrill Lynch

Good morning. This is Dan O'Hare on behalf of Robbie Ohmes.

Michael Dennis Casey - Chairman & Chief Executive Officer

Hi, Dan.

Daniel Ryan O'Hare - Bank of America Merrill Lynch

Hey. So how has the Little Baby Basics launch go or, yeah, how has it performed post-launch? And is that primarily a retail or is that wholesale as well? Thanks.

Brian J. Lynch - President

Yeah, the Little Baby Basics launch is all channels. We successfully launched that in May. I think we did a good job with strong marketing and brand presentation across the channels. The product is doing particularly well on line in all channels, I would say, a little less so in the stores. The replenishment trends with our wholesale partners, we've moderated that forecast slightly based on initial out of the gate. There are some products that are doing really well and other ones that we are refreshing. We have about 15% of the business life cycle, and so it's early. But we're monitoring that sell-through as they finish clearing up their old program, and we do have some refreshed creative for key components of that launch, which arrive later in the year to support fall and holiday selling.

Daniel Ryan O'Hare - Bank of America Merrill Lynch

Got it. And then, could you just remind us how many signups that the Rewarding Moments loyalty program has?

Michael Dennis Casey - Chairman & Chief Executive Officer

My understanding, right now, it's over 8 million. So it continues to grow. We're surprised as we dug into what percentage of the transactions, both online and in stores, are tied to the Rewarding Moments program. It's nearly 90%. So it's been a very, very successful program drawing more people back to the stores after their initial purchase. So it's been well received.

Daniel Ryan O'Hare - Bank of America Merrill Lynch

Got it. And then, has there been any increase in the transaction size with the customers that have recently signed up or any...?

Michael Dennis Casey - Chairman & Chief Executive Officer

Yes. Yes.

Daniel Ryan O'Hare - Bank of America Merrill Lynch

Awesome.

Michael Dennis Casey - Chairman & Chief Executive Officer

We've seen it. Yeah.

Daniel Ryan O'Hare - Bank of America Merrill Lynch

Okay. Thanks so much.

Michael Dennis Casey - Chairman & Chief Executive Officer

You're welcome.

Operator

And we're going next to Anna Andreeva with Oppenheimer.

Anna Andreeva - Oppenheimer & Co., Inc. (Broker)

Hi, great. Thanks. Good morning, guys, and congrats on really strong 2Q results.

Michael Dennis Casey - Chairman & Chief Executive Officer

Thanks, Anna.

Anna Andreeva - Oppenheimer & Co., Inc. (Broker)

I guess I had a couple of questions. First, remind us how much of your business is replenishment in the fourth quarter, and your ability to chase just in case better demand ends up realizing.

Secondly, Richard, gross margins very strong in the second quarter. Maybe talk about the dynamics between AUR and AUC and how should we think about gross margins for the back half? And then finally, you mentioned we should expect positive comps in retail for 3Q and 4Q, what are you guys seeing so far in July? Thanks.

Brian J. Lynch - President

I'll take the replenishment question. Replenishment in our Wholesale business is about 20% to 25% of the business overall in the back half of the year. We position inventory in the shelf here. We give it a quick testing on things like Little Baby Basics in our stores, and we change our forecast based on that to make sure that we try to keep the best articles in stock. So we do go a little bit long on some things. So we do have ability to, I'd say, ratchet that number up if it merits. Significant chase? No, because of lead times, but we do have the ability to service that, I think, at a good level.

Richard F. Westenberger - Chief Financial Officer & Executive Vice President

And on gross margin, for the second quarter, I'd say, there are obviously multiple things at work there. You have the ongoing benefit of lower product costs. We do expect that will continue in the second half of this year. Pricing, a less significant component. We did have a modest improvement in pricing. Some portion of that is mix related both from growing the higher AUR businesses, including retail stores and e-commerce. I think those are the primary effects for the second quarter.

For second half, we have good continued gross margin reflected in our forecast. Actually the basis point expansion year-over-year would be if we're successful with our forecast above what we achieved in the first half. We're hoping that we don't have the same measure of liquidation activity that we had a year ago with all that inventory that we procured for the international consumers. I think we were sharper in how we made our inventory commitments for the second half with the benefit of that analysis. So continuing to forecast the benefit of lower product costs, hopefully with less liquidation activity and continuing growth of our high margin businesses, that's how I would characterize the outlook for margin.

Michael Dennis Casey - Chairman & Chief Executive Officer

You asked about third quarter comps, both brands are comping positively. Third quarter to-date had a strong start to the quarter with good demand for both brands over the 4th of July holiday, saw a similarly good demand over the Memorial Day weekend. But July got off to a strong start. See, the last couple of weeks had been a little under what we had expected, but not materially. So, I'd say, third quarter to-date, we're on track to have positive comps.

Anna Andreeva - Oppenheimer & Co., Inc. (Broker)

Awesome. Thanks, guys. Good luck.

Michael Dennis Casey - Chairman & Chief Executive Officer

Thanks very much.

Operator

And for our next question, we go to Kate McShane with Citi Research.

Kate McShane - Citigroup Global Markets, Inc. (Broker)

Good morning. Thanks for taking my question. Just to drill down again at the wholesale account, could you give us any insight into how promotional those accounts have been especially at the brick-and-mortar department stores and how you see that playing out for the second half with regards to your gross margin guidance?

Brian J. Lynch - President

I think that, overall, the retail environment continues to be promotional, Kate. I don't know that it's backed off at all. Retailers are using different models to drive traffic to their sites as the customer pre-shops, and they want conversion on their sites as well as drive folks in their stores.

So there continues to be, I would say, significant promotional activity, certainly not less. I would say, it's at or above what it was in prior years. We were slightly more promotional in our retail channel, primarily due to our loyalty program, and then the impact of international, but people are trying very different things. As we said, the department stores and the mall-based, I think, it's been well chronicled in the media some of the challenges they're having. So they're trying different things to drive traffic to their stores.

Kate McShane - Citigroup Global Markets, Inc. (Broker)

Okay. Thank you. And my second question is on retail. Can you remind us at what comp you need to leverage both for Carter's and OshKosh? And with OshKosh shifting away from outlet over time, how does that impact some of the occupancy and the rent?

Michael Dennis Casey - Chairman & Chief Executive Officer

Our objective is to achieve a 3% comp – a retail comp for each of the brands at that level. Above that level, we leverage SG&A, below we deleverage. And as we open up these OshKosh stores, keep in mind, once we open up the OshKosh stores they are attached to Carter's. And we're seeing a very good profit contribution from both brands, because there is a sharing of the overhead, sharing of the real estate, build out effort. So that's – the side-by-side model is much more profitable than standalone stores. And so we're seeing good performance with OshKosh seeing good comps. The closer the OshKosh store is to the consumer, the better the performance.

So we had positive comps for OshKosh in the second quarter from the brand stores and the side-by-side stores. And so we're not concerned that by opening up more OshKosh stores it will put more pressure on our goals to achieve that 14% operating margin by 2018, it actually supports it.

Kate McShane - Citigroup Global Markets, Inc. (Broker)

Thank you.

Michael Dennis Casey - Chairman & Chief Executive Officer

You're welcome.

Operator

We go next to Steph Wissink with Piper Jaffray.

Stephanie Schiller Wissink - Piper Jaffray & Co. (Broker)

Thanks. Good morning, everyone. Mike, I wanted to just focus on your longer-term guidance, the $4 billion in revenue and that 14% that you just mentioned. Can you help us understand maybe what the complexion of the business might look like out a few years relative to the segment drivers? It seems like wholesale may be stepping down a little bit, retail stepping up, and then international contributing a bit more. Can you help us appreciate maybe what the puts and takes are as we look forward a few years?

Michael Dennis Casey - Chairman & Chief Executive Officer

Sure, your understanding is correct. We're planning low-single-digit growth in our wholesale business, and that currently is under a bit of pressure. We're still hoping that our wholesale sales this year are comparable year-over-year. Some of our wholesale partners are going through some changes in their business. We hope those changes work for them and that we grow off of a different base of business. But we still believe there's some growth possible for wholesale. That was not the lion's share of the growth.

The biggest growth driver in our long-term plan is through the side-by-side stores. Our objective is to open up 250 side-by-side stores. When you open those stores, they contribute some portion of about $2 million in annual sales, it's a wonderful $0.50 billion growth opportunity.

As we open these stores, we're seeing an interesting lift in e-commerce sales, where those stores open up relative to the adjacent trade area. So we're seeing a benefit in e-commerce. We're certainly seeing that on our OshKosh brand. OshKosh e-commerce comps were actually better than Carter's comps in the second quarter, and that's unusual. Usually nothing outperforms Carter's, but OshKosh at least online did in the second quarter.

And then international, we're expecting double-digit growth in international, lots of ways to grow. The two big growth drivers in international will be Canada, because there is more room to grow in Canada and China, but we also have well over 20 partners representing our brands in over 60 countries, good retailers, working hard to grow their businesses and ours. And so, the two big good growth drivers for international will be Canada and China. That's our expectation.

So, this is the way I think of the business. I think of low-single digit growth in wholesale, think of high-single digit growth in store sales, think of double-digit growth in e-commerce and in international sales. Those are our growth objectives.

Stephanie Schiller Wissink - Piper Jaffray & Co. (Broker)

That's really helpful. Thanks. And then, just as a follow-up to that, can you remind us at what level the international or the China business specifically becomes accretive? I think you called it out as a drag in the quarter. So just help us appreciate where that curve starts to bend?

Michael Dennis Casey - Chairman & Chief Executive Officer

Trying to understand your question, say international sales?

Stephanie Schiller Wissink - Piper Jaffray & Co. (Broker)

On the China specifically, I think that was what was called out.

Michael Dennis Casey - Chairman & Chief Executive Officer

Well, China, I believe, made money in the second quarter. It's modest. Again, keep in mind, China e-commerce, some portion of – we hope that some portion of $20 million business this year relative to the $3.2 billion, but China is not a drag on our earnings right now. It's a modest contribution.

Richard F. Westenberger - Chief Financial Officer & Executive Vice President

Steph, we have some other start-up costs as well in China that are coming through the P&L. There's distribution center expenses, building some of the infrastructure capabilities that we're going to need long-term. So, in addition to China e-commerce, Mike's correct, made a small amount of money, it is a smaller margin business today than obviously the other more mature parts of the portfolio. But we're making good progress, but we are making some investments there.

Stephanie Schiller Wissink - Piper Jaffray & Co. (Broker)

All right. Thanks, guys.

Operator

We go next to Jim Chartier with Monness, Crespi & Hardt (sic) [Monness, Crespi, Hardt] (44:09).

Jim A. Chartier - Monness, Crespi, Hardt & Co., Inc.

Good morning. Thanks for taking my questions.

Michael Dennis Casey - Chairman & Chief Executive Officer

Good morning.

Jim A. Chartier - Monness, Crespi, Hardt & Co., Inc.

First, it sounds like the larger size initiative maybe exceeded your expectations last year. Is that opportunity, do you think, bigger now than you originally expected, and do you plan to go into higher sizes for Carter's going forward?

Brian J. Lynch - President

I think we're very pleased with how it's going. We did sell out last year. We sourced a bunch more, as Mike noted, of size 8 this year. I don't know that we're prepared to give an exact number in terms of revenue impact this year, but we've also added size 14 for OshKosh; that is on plan and out of the gate as well. So we'll continue to roll those out. I think we've got an opportunity in our stores and online to grow that. And I'd like to think that that can help us grow the business with our wholesale partners as well. Several of them have taken part in the size 8 in Carter's, some have not based on the way their floors are laid out and organized. So let's hope that that's the case. And again, we started – we think Carter's, we'd like to have the life of the consumer extended with us. So we started with size 8, and we feel good about that. And if that makes sense, maybe we go higher at some point.

Jim A. Chartier - Monness, Crespi, Hardt & Co., Inc.

Great. And then, Richard, just want to get some more specificity on kind of the impact that you're assuming for the international component of your comp sales. Do you expect that to still be down? And a drag on comp sales in the back half of the year, do you expect that to get to flat in the back half? Thanks.

Michael Dennis Casey - Chairman & Chief Executive Officer

Yeah. We do expect that and the stores component in particular will be down in the second half, although at an improved position relative to what we've seen recently, but still pressure in the second half.

Jim A. Chartier - Monness, Crespi, Hardt & Co., Inc.

Great. Thanks and best of luck.

Richard F. Westenberger - Chief Financial Officer & Executive Vice President

You're welcome. Thank you.

Operator

And we go next to John Kernan with Cowen.

John Kernan - Cowen & Co. LLC

Good morning, everyone. Thanks for taking my question. Can you help us understand SG&A dollar growth or SG&A as a percent of sales in the back half? Obviously there's still some square footage growth to come, and it sounds like there's more investments in IT and China as well?

Richard F. Westenberger - Chief Financial Officer & Executive Vice President

Sure, John. Well, we continue to shift the balance of the business to the higher SG&A format businesses that we have retail stores, e-commerce, they're much higher SG&A businesses than wholesale. We've mentioned that we've taken down our forecast for wholesale. So we would expect the SG&A rate will continue to increase. There are some discrete investments that we're making around some IT technology, some infrastructure, and some discrete projects to help the Retail business to build out our omni-channel capabilities.

That funding will continue to some extent those projects are a little bit behind where we thought they would be from a spending point of view in the first half of the year. So some of that spending shifts forward, and we have a couple discrete consulting engagements that are also running here in the second half of the year. Those will both drive up the dollar amount of SG&A and the rate in the second half.

John Kernan - Cowen & Co. LLC

That's helpful. Thanks. Can you help us also understand the durability of lower product cost as a benefit to your gross margin for what it's worth, we've seen cotton pick-up a little bit in recent weeks?

Michael Dennis Casey - Chairman & Chief Executive Officer

You're right, cotton has gone up at least a dime. And so we're keeping an eye on it. Oil continues to be favorable, freight continues to be favorable. Probably the most single largest impact on our costs going forward will be global capacity, which is abundant given the overall weak demand for apparel globally. We're growing, we're one of the few apparel companies growing.

So we're seeing hungry manufacturers eager to do business with us and working with us to meet our cost objectives. So we have visibility through spring 2017 for product costs, and we're expecting those costs to be down. We'll surely be working on fall 2017. Probably by October, we'll have some indication of how costs are trending in the second half of 2017 where visibility into the first half of 2017 is good. We expect a lower product cost in the first half of next year.

John Kernan - Cowen & Co. LLC

That's helpful. Thanks. And then just one final question. Congrats on the big acceleration in Carter's same-store sales. Can you help us understand the drivers of the operating margin decline on the improved sales?

Michael Dennis Casey - Chairman & Chief Executive Officer

Just, I'd say, the timing of store openings – keep in mind, the second quarter is the lightest quarter of the year. So the store expenses are the same – relatively the same from quarter-to-quarter. You'll start to see improvement in the second half of the year. So the deleverage you see in the second quarter segment profitability for retail, you will see that improve. We expect that that will improve meaningfully in the second half, and still will be a bit of deleverage for the year but not as significant as you're seeing in the second quarter.

John Kernan - Cowen & Co. LLC

Okay. Thank you. Best of luck.

Michael Dennis Casey - Chairman & Chief Executive Officer

Thanks very much.

Operator

And we go next to Janet Kloppenburg with JJK Research.

Janet J. Kloppenburg - JJK Research

Good morning, everyone.

Michael Dennis Casey - Chairman & Chief Executive Officer

Good morning.

Janet J. Kloppenburg - JJK Research

I was wondering if you could talk a little bit about your spring 2017 wholesale outlook. I think you said it may be down year-over-year. And I was wondering if you could help us understand if that's just ongoing conservatism by the mid-tier department stores or something else so perhaps the international wholesale business or if you're seeing increased competition there maybe from owned brands or other new competitors in the marketplace.

Brian J. Lynch - President

Yeah. I think as we said a few minutes ago, we do plan to see the spring 2017 bookings lower than last year. And we've got ways to go. A lot of our mass bookings are not even in yet, they book a little bit later. But that is primarily a mall-based apartment store issue. We're optimistic with the sum total of the account base. The rest of the account base that we continue to have good performance, but this represents somewhere around 15%, 16% of our wholesale business, and we would project that that would be down.

As far as competition, you've got some of these folks and department stores particularly that are trying to make a goal of it and drive traffic and they have strategic shifts and they certainly do lean into private label, they make different decisions on their business and trying to have unique products. So I think in terms of new competitors, we would say no, we don't see new competitors. There are always the ups and downs and shifts of folks growing and right-sizing their private level businesses, and I would say it's fair to say that is going in department stores.

Janet J. Kloppenburg - JJK Research

Okay, great. And just specifically on the outlook stores, I know the domestic – I mean, I know the international oriented traffic stores were down deeply, but are you seeing improvement in outlet store malls where it's primarily a domestic customer.

Michael Dennis Casey - Chairman & Chief Executive Officer

Domestic demand generally has been good. We track credit card data and so we can see the domestic demand for the brand is good, but international is down. As I shared with you online, we're starting to see improvement in the stores, we're starting to see some improvement in some of the larger international tourist locations, and time will tell. We expect it to improve in the second half, the unknown is timing, when will it start to moderate, we're assuming some moderation, more so online than the stores based on our experience to date.

Janet J. Kloppenburg - JJK Research

And just one last question on the wholesale channel, please. If that business continues to be under pressure, should we expect operating profitability in that channel to also be under pressure?

Michael Dennis Casey - Chairman & Chief Executive Officer

It may, it may. Time will tell. We're not forecasting it for the year. We're forecasting margin expansion for wholesale this year, but time will tell, because we don't have all the spring bookings in yet. But in October, we'll have better visibility to it for you.

Janet J. Kloppenburg - JJK Research

Okay. Also, I think, you made some reference to inventories maybe being a little bit high in the channel. And I wondered if you had to have some mark down reconciliation with the stores?

Brian J. Lynch - President

No, we have a different model with our wholesale partners; an upfront discount model. So, the answer to the question is no. To reiterate the inventory, yes, there is some inventory that's elevated some of the product categories. Playwear sold-through the best, some of the other categories did not have the sell-through that the folks planned for many different reasons. So, there are some pockets out there, but we booked flattish to up modestly for fall. So in totality, we're not very concerned about it.

Janet J. Kloppenburg - JJK Research

Okay. Thanks so much for your time.

Brian J. Lynch - President

Our pleasure. Thank you.

Michael Dennis Casey - Chairman & Chief Executive Officer

Welcome.

Operator

And with that, ladies and gentlemen, we have no further questions on our roster. Therefore, Mr. Casey, I will turn the conference back over to you for any closing remarks.

Michael Dennis Casey - Chairman & Chief Executive Officer

Okay. Thanks very much. Thank you all for joining us on the call. We appreciate your interest in our business. We'll update you again on our progress in October. Good bye.

Operator

And ladies and gentlemen, this does conclude today's conference. Thank you for your participation. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!