Kate Spade & Co. (KATE) Craig A. Leavitt on Q2 2016 Results - Earnings Call Transcript

| About: Kate Spade (KATE)

Kate Spade & Co. (NYSE:KATE)

Q2 2016 Earnings Call

August 03, 2016 8:30 am ET

Executives

Craig A. Leavitt - Chief Executive Officer & Director

George M. Carrara - President & Chief Operating Officer

Analysts

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

Simeon A. Siegel - Nomura Securities International, Inc.

Heather N. Balsky - Bank of America Merrill Lynch

Ike Boruchow - Wells Fargo Securities LLC

Scott D. Krasik - The Buckingham Research Group, Inc.

Dana L. Telsey - Telsey Advisory Group LLC

Adrienne Yih-Tennant - Wolfe Research LLC

Oliver Chen - Cowen & Co. LLC

Operator

Good morning, everyone and welcome to the Kate Spade & Company second quarter 2016 conference call hosted by Chief Executive Officer Craig Leavitt. After the opening remarks, we will be taking questions. This call is being recorded and is copyrighted material. Therefore, please note that it cannot be recorded, transcribed or rebroadcasted without Kate Spade & Company's permission. Your participation implies compliance with these requirements. If you do not agree, simply drop off the line. The earnings release can be accessed at www.katespadeandcompany.com in the Investor Relations section.

Please note that statements made during this call that relate to the company's future performance and future events are forward-looking statements within the Private Securities Litigation Reform Act. These forward-looking statements are based on current expectations and are subject to the qualifications and cautionary statements set out in this morning's press release, including those under the caption "Cautionary Statement Regarding Forward-Looking Statements," as well as in the company's most recent Annual Report on Form 10-K filed with the SEC on March 1, 2016, and any subsequent quarterly reports on Form 10-Q filed with the SEC under the captions "Item 1A – Risk Factors" and "Statement Regarding Forward-Looking Statements."

The company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. Also, please note that during this call and in the accompanying press release, net sales, gross profit, gross margin, SG&A, SG&A margin, operating income, loss, other expense, net income loss before provision for income taxes, provision for income taxes, income loss from continuing operations and EPS are presented on both a GAAP and a non-GAAP adjusted basis.

In addition, adjusted EBITDA is a non-GAAP measure that is also presented in the press release. The company presents these adjusted measures because the company believes that these measures represent a more meaningful presentation of the company's historical operations and projected financial performance as these measures provide period-to-period comparisons that are consistent and more easily understood. The company considers these measures as important supplemental measures of its performance and believes that they are frequently used by securities analysts, investors and other interested parties in the evaluation of companies in its industry.

The company presents historical 2015 adjusted results excluding wind-down operations and adjusted EBITDA excluding wind-down operations. The company believes these measures provide a meaningful presentation of its historical 2015 results on a comparable basis to its 2016 results. References to amounts on a comparable basis mean that those amounts exclude the impact of wind-down operations. Reconciliations of adjusted results to the GAAP results are available in the tables attached to the earnings release captioned "Reconciliation of Non-GAAP Financial Information," which is posted to the company's website, at www.katespadeandcompany.com in the Investor Relations section.

The company evaluates comparable sales productivity based on comparable net sales per average square foot. The company's policy regarding its calculation of comparable direct-to-consumer net sales is discussed in the MD&A section of its Annual Report on Form 10-K. The company presents these key operating metrics because it considers them important supplemental measures of its performance.

Now, I would like to turn the call over to your host, Mr. Leavitt. Please go ahead, sir.

Craig A. Leavitt - Chief Executive Officer & Director

Good morning. Thank you all for joining our call as we report earnings results for the second quarter of 2016. Also joining me is George Carrara, Kate Spade & Company's President and Chief operating Officer.

On the call today, I will review company financial highlights, discuss our North America and International reporting segments, and provide an update on our performance, along with some industry perspective. And following my remarks, George will provide a summary of our financials and then we'll take a few questions.

Although the current retail landscape is challenging, we continue to focus on the key factors that differentiate Kate Spade and Company. We are managing our business for sustainable, long-term growth while executing our strategy as we continue to grow as a global multi-channel lifestyle brand. That said, our second quarter results fell short of our expectations for several reasons, which I will outline in a moment.

We remain confident in our strategy as we build our diverse and differentiated model, and move toward becoming a $4 billion business at retail. As a management team, we are relentlessly focused on adjusting our business appropriately to respond to what we view as short-term challenges. We are a nimble organization, able to respond and react to changing dynamics with new tactics and immediate actions. And let me be clear, our overall strategy and our confidence in achieving our long-term $4 billion target remains unchanged.

The first factor that had an effect on our performance was tourism. We continue to be impacted in our bricks and mortar channels, where we saw lower traffic and transaction size in our tourist-dependent stores versus the first quarter, given the continuing FX headwinds.

Additionally our international tourist transactions saw a double-digit drop in ADT. Importantly, we maintained our disciplined approach to quality of sale initiatives and did not conduct increased store-wide sale activity in our full-price channel.

Second, in our core handbag business, we tested our new Saffiano Leather Handbag Group, Cameron Street, earlier this year and customers responded positively. As such, we plan to transition away from our established Cedar Street Handbag Group in favor of Cameron Street. While we are pleased with Cameron Street's better than expected performance this quarter, the customer transition to these newer styles was faster than we anticipated, and we did not have appropriate inventory levels of this new group to meet shifting demand. As a result, while we saw increased traffic in our specialty stores and eCommerce site, we missed some opportunity and experienced a decrease in conversion in the second quarter. We have course corrected and plan to complete this transition in the second half of 2016.

Finally, I want to spend some time discussing our quality of sale efforts. We have maintained our disciplined approach in full-price channels and we are winning with full-price customers. In fact, the penetration of our full-price business in this channel continues to grow. The challenge in this channel is the sale-oriented customer, heightened by the increasingly promotional environment. Key sale events fell short of our expectations, as customers looked for deeper discounts, a trend which negatively impacted both total sales and comps this quarter. It is important to note that as part of our strategy, we did not buy comps in our full-price channel, which resulted in an increase of our full-price product penetration and solid gross margin dollar expansion.

The outlet environment has become even more promotional than anticipated, creating margin pressure in the overall channel. In addition, the quality of outlet traffic, measured in average spend per transaction, continues to diminish in our tourist-dependent locations. Given this behavior, we have increased our promotions in this channel, as we work to maintain market share. We are also testing optimal product mix, and improving product flow to drive sales in this channel and are optimistic about a new core floor set that we delivered in July.

We estimate that the factors that I just described, including tourist headwinds and also consumer spending patterns in Japan, sale event performance and the product performance and transition timing impacted our comps for the quarter in excess of 700 basis points. While we have implemented specific changes to help mitigate some of these challenges, at this point, it is prudent for us to provide you with updated guidance for the year.

The company now expects sales to fall within a range of $1.37 billion to $1.4 billion and comp sales in a range of high-single digit to low double-digit growth with an adjusted EBITDA of $242 million to $260 million. This range represents a meaningful expansion of EBITDA margin of between 100 basis points to 200 basis points, and we expect to achieve further expansion beyond 2016. We remain focused on key initiatives, including supply chain improvements, increased licensing penetration, and SG&A leverage.

There are several factors that we anticipate will lead to stronger performance in the second half of the year and beyond. I will add further color as we discuss the quarter. But, in summary, in our full-price channel, our product mix improvements include applying learnings from our micro-assorting efforts and introducing new exclusive product into certain of these lifestyle clusters to drive demand. We will also launch robust handbag-focused digital marketing efforts this fall, to highlight our expanded inventory position and diversified Cameron Street Group offering. In our off-price channel, we will continue to test and present the optimal product mix and improve product flow, while carefully adding promotions in select events to remain competitive.

We are also working to expand our number of cross category shoppers by building on the new customer relationships we have acquired as a result of our product category expansion.

And finally, with regard to SG&A, we plan to achieve additional leverage through scale and are carefully managing our expense growth in light of the current environment.

While we were not immune to macroeconomic factors, we continue to build on our strategic foundation, maintaining the discipline of our differentiated business model. We are working relentlessly to drive our business forward and grow both our top and bottom line in the second half of the year and beyond.

Now, I would like to discuss financial highlights. We reported net sales of $320 million for the quarter, an increase of 17%, excluding wind-down operations from 2015. Our gross margin decreased to 59.7% versus 61.6% last year on the same basis. It was impacted by the factors I just reviewed.

In North America, we reported net sales of $271 million for the quarter, an increase of 17%, excluding wind-down operations of 2015. Although we face challenges, it is important to note the successes we are seeing with key initiatives. Our micro-assorting efforts, using our stores as laboratories, and our improved ability to chase into product are gaining traction and will help us to deliver the right product to our customers at the right time.

Beginning with our micro-assorting strategy, this approach aligns assortments according to lifestyle and market taste across a range of our product categories. We are seeing the greatest initial success with these efforts in our lower volume doors where the need for door right assortments is particularly important to maximize sales on more narrow offerings. As a result of this initiative, in these doors, we saw a double digit improvement in our ready-to-wear trend.

As we are focused on full-price selling, the role of newness in our full-price offerings is increasingly important. We leverage our stores as laboratories to test certain new styles to better anticipate trends and gauge customer reaction.

In handbags, our wear-to-work assortment included a range of new open-top tote silhouettes. Based on customer feedback about the open design, combined with challenged performance of this group, we responded and added zippers and other closures to the assortment for the back half of the year. Importantly, we have reduced our turnaround time to test key styles and appropriately react to impact future buys.

Turning to eCommerce, while traffic to the site increased this quarter, we saw a sequentially lower conversion rates and average order values. We attribute this result to increased competition for sale consumer dollars, the performance of key sale events, as well as the Saffiano Group transition I described. We should note that the conversion rate, while lower than trend, is relatively consistent to last year.

To further improve the customer experience, we are adding important new omni initiatives such as automating and expanding our same-day delivery option. We also continue to see that our local stores have a positive impact on our eCommerce business with additional online sales growth in new areas where we have recently opened stores.

Our novelty brings emotional connection to our brands and helps drive traffic and conversion. On our flagship eCommerce site, novelty is particularly important to building sales and conversion. While our early deliveries this quarter were strong and sales continued to grow, our June novelty delivery did not resonate with our customer, impacting overall results for the quarter.

Novelty remains a key differentiator for our brand and we will continue to leverage this assortment to build strong customer engagement and customers have responded positively to the July delivery and we are getting strong reads on items across categories and expect to return to strong response to our assortments as we diversify and offer a new take on some previously popular novelty themes.

In addition, we continue to strategically balance the shoulders of our brand, offering both accessible and aspirational price points. On the aspirational shoulder, we are seeing our splurge customer respond positively to our $350 plus handbag offering. As a result, we are growing our handbag assortment featuring higher average price points and offering these elevated groups in more doors in the back half of the year. In addition, our Madison Avenue label continues to grow, and while it represents a small portion of our total business, this quarter had double-digit comps across categories.

Turning to our wholesale channel, we saw an expansion of penetration for the quarter primarily as a result of timing. We continue our industry-leading efforts to significantly reduce our promotional days, and according to our retail partners, continue to outperform the floor. Since we had not yet anniversaried, this pullback in promotional events, as anticipated, we saw an impact in our performance compared to last year. As we carefully add new wholesale distribution, we are building a full-price business from the outset and in these doors, sales increased year-over-year.

And now moving to our International segment, where net sales for the second quarter of 2016 were $43 million, an increase of $7 million or 20% compared to the second quarter of 2015, excluding wind-down operations.

In Japan, we saw a slight increase in net sales versus last year, although a deceleration from last quarter, as the overall market remains challenged due to the decrease in consumer spending and the inbound tourist transaction size. Despite these headwinds, we are particularly pleased with our solid growth in eCommerce, our ready-to-wear performance, and building overall transaction size to help mitigate the reduction in traffic and transactions in department store concessions, and the inbound tourist patterns.

In Europe, we are increasing brand awareness and strategically identifying new locations as we build our network of stores. In London, our new location on Regent Street continues to reach locals and tourists and build brand equity, while improving on KPI's including conversion. In addition, we are seeing a sequential lift in overall sales at stores in the UK since this store opened.

We also look forward to further expansion in retail and wholesale channels in France, Italy, Germany and other key markets within Continental Europe in the months ahead. In addition, our European eCommerce business continues to grow as a percentage of our total business.

In China, we continue to work with our JV partner on generating awareness and strengthening our brand position. We are building out our network strategy in Tier 1 cities and are particularly pleased with productivity improvements in newly renovated doors and the performance of newly opened doors, where we applied our micro-assorting approach. The Hong Kong and Macau markets remain challenging due to the continued decrease in Chinese tourists and average transaction size, as well as the impact of the local currency peg to the US dollar.

We are increasing our door assorting and marketing efforts, particularly through the digital channel, as well as implementing a substantial in-store customer experience effort in order to appropriately reach and engage local customers. Our travel retail business continues to grow, and we continue to open new doors and diversify our network. The overall network grew double digits compared to last year with strong growth in cruise ship retail.

Moving now to our product category axis of growth. Within our women's pillar, we are seeing meaningful growth in our two relatively new handbag groups, Cameron Street, which I mentioned earlier, and Orchard Street. We are also enhancing personalization efforts for our overall handbag assortment including an expanded monogram program and interchangeable straps. As we continue to thoughtfully introduce new product categories, we have seen success as we increase our casual offerings, our Broome Street Collection is in its early stages and penetration continues to grow. Not only is it attracting new customers to our brand, we are also seeing existing customers making their first ready-to-wear purchase from this label. This is a prime example of our efforts to attract cross category shoppers.

We also continue to expand our activewear collaboration with Beyond Yoga, introducing new colorways and silhouettes. We are adding exclusive items to our specialty assortment, as well as introducing the collection in the UK market.

Our elastic categories build brand awareness and offer thoughtful, strategic access to our brands. Our tech accessories continue to gain popularity in the U.S. and in addition to remaining the number one fashion brand, our ranking moved up into the overall top 10 tech brands, indicating strong customer preference for our assortment.

We also are looking forward to the launch of our connected wearables with Fossil Group this fall in time for the holiday shopping season. Our home category pillar is an important part of our lifestyle vision and we plan to expand into additional premier furniture galleries, including ABC Carpet & Home, John Lewis in the UK, and Bloomingdales, Dubai this year. Of note, our kate spade new york kitchen collection continues to show quarter-over-quarter growth and outperform the market across classifications.

Finally, our children's pillar continues to attract an increasing percentage of new customers to the brand and we are seeing these customers go on to make purchases in other categories.

Our brand is grounded in storytelling and our marketing efforts help drive awareness and establish an emotional connection with our customers. Increasingly, our focus is on bringing these stories to our customers on the social media platforms where she is spending her time. As a result, we are seeing increased engagement and customer acquisition success.

And now, I'd like to turn the call over to George.

George M. Carrara - President & Chief Operating Officer

Thanks, Craig, and good morning, everyone. I will now take you through a review of our second quarter financial results, which are on a comparable basis relative to last year, and exclude wind down operations in 2015.

During the second quarter, our results were impacted primarily by the factors Craig referenced. These included: first, lower spend by foreign tourists, which impacted both the outlet and specialty channels to a much greater extent than what we had experienced during first quarter. Second, a slower product transition ramp within our Saffiano Leather Group where we underestimated shifting demand. Third, others in the retail industry being increasingly more promotional during sale periods, which depressed the impact of our own sale events. And lastly, overall weaker consumer spending in Japan.

To mitigate these headwinds, as Craig discussed, we have a number of concrete actions already in place, which we expect will improve our performance in the back half.

Now turning to the details of the quarter. We generated top-line growth of 17%, to $320 million, which was relatively consistent, both on a reported and constant currency basis for the total company as the recent strengthening of the yen was offset by the weakening of currencies in other regions where we operate, specifically Canada.

You'll recall that the second quarter of last year was negatively impacted by the timing of wholesale shipments, which resulted in a temporary increase in the penetration of wholesale sales during this quarter. This was coupled with the timing of normal off-price shipments compared to last year, which further increased our wholesale penetration year-over-year for the second quarter. We expect this to normalize in the back half, such that the penetration for full year is relatively consistent versus LY.

Our sales growth included comps of 4% in total and 1% excluding eCommerce. We estimate that these four factors, which I just discussed, impacted our total comps by in excess of 700 basis points. Within our bricks and mortar stores, results were impacted by a similar amount.

With respect to eCommerce, our global eCommerce business, again, generated double-digit growth and continues to outperform relative to bricks and mortar, albeit at a lower rate than we had been expecting, and sequentially decelerated from Q1, as Craig discussed earlier.

In our North America segment, net sales increased 17% to $271 million, aided by the wholesale timing shift I just explained. On a constant currency basis, sales increased 18%, as sales were impacted by the weakening of the Canadian dollar.

We opened four stores during the quarter, on both a gross and net basis, including three specialty stores and one outlet store. Average retail square footage increased by 9% year-over-year to 391,000 square feet. Sales productivity in our kate spade new york brand across the North American retail fleet decreased 1% to LY on a constant currency basis, driven by the factors we just discussed.

Turning to our International segment, net sales increased 20% to $43 million on a reported basis, and 9% on a constant currency basis, principally impacted by the strengthening of the Japanese yen. During the quarter in Japan, our sales were impacted by the overall market softness, which weakened versus Q1 trends, and this was underscored by the Japanese government's recent decision to delay the consumption tax hike.

We opened three owned International stores on both a gross and net basis, including one specialty and two concessions during the quarter. Our average retail square footage increased 22% year-over-year to 87,000 square feet. International kate spade new york retail fleet sales productivity decreased 13% on a constant currency basis versus LY, driven primarily by the global economic pressures impacting consumer spending that I just mentioned in Japan.

Moving down the P&L. Our gross margin rate for the quarter was 59.7% versus 61.6% last year. This was primarily driven by the greater than anticipated promotional pressures, principally in the outlet channel, and increased wholesale penetration. Had it not been for these two factors, our gross margins would have increased on a year-over-year basis. In our full-price business, where we continue to protect our quality of sale, we saw an expansion in gross margins and full-price selling penetration. We also continued to benefit from the increased licensing penetration and supply chain initiatives.

Turning to SG&A. As a percentage of sales, SG&A was 49% for the quarter versus 52.3% last year, as we benefited in part from decreases in employee-related costs and the outsized penetration of our wholesale business in the quarter relative to last year. Adjusted EBITDA for the quarter was $54 million or 16.8% of sales, an increase of 30% year-over-year and up 170 basis points versus LY. The adjusted EBITDA margin rate in our North America segment increased 90 basis points year-over-year to 17.5%.

For the International segment, adjusted EBITDA margins increased to 9.3% for the quarter, up 280 basis points year-over-year. You'll note that the sequential decline in International margins relative to Q1 was consistent with last year's cadence, and we continue to expect meaningful expansion in each of these segments for the full year.

The environment in the Hong Kong and Macau territories remains challenging, offsetting improvements we are seeing in the PRC territory and pressuring profitability related to our Greater China joint venture. As a result of these headwinds, we are now projecting a loss relative to the JV in the range of $7 million to $8 million for the full year. As a reminder, this flows through as an expense in the other income and expense line item in our P&L, and is a deduction included in adjusted EBITDA.

Diluted earnings per share, reflecting a normalized tax rate of 40%, were $0.11 for the quarter, up 38% versus $0.08 in the quarter last year.

With respect to the balance sheet, our overall financial position remains strong. We ended the quarter with over $300 million in cash. In fact, on an LTM basis we generated triple-digit free cash flow, resulting in net debt of less than $90 million and continue to project triple-digit free cash flow for the full year.

Our inventory levels ended the quarter up 15% versus LY, relatively consistent with our reported sales growth. We continue to monitor our inventory levels against our sales plans and intend to manage them accordingly. For the first half, we spent $26 million on capital expenditures versus $30 million last year, and continue to project CapEx spend of $65 million to $70 million for the full year.

Operating initiatives and platform enhancements. Starting with supply chain, we're pleased with the performance of the various initiatives we've put in place in this regard, including the in-sourcing of our accessories business, speed-to-market and leveraging our scale to reduce input costs.

On the technology side, we continue to build upon our eCommerce success and have recently piloted an expansion of our ship-from-store program, which enables us to cover a greater breadth of both our door base and assortment.

Additionally, in early 2017, we expect to pilot an enhanced product life cycle management system, which will improve our design development and merchandising processes, and finally, we intend to launch buy online, pickup in-store during the first half of 2017.

Now turning to our updated guidance. We remain confident in our long-term strategic growth initiatives and margin expansion opportunities. However, in light of our second quarter performance and the current retail landscape, we are updating our expectations for the remainder of the year. Accordingly, we have adjusted our full year sales and earnings guidance. We now expect total sales in the range of $1.37 to $1.40 billion representing meaningful growth of 13% to 15% on a year-over-year basis.

The FX assumptions in our updated guidance for the balance of the year assume no material fluctuations from current rates. Our revised guidance now assumes comps in the high-single to low-double digits for the full year. To help you with your modeling, our comp guidance assumes a comp consistent with Q2 in the back half that will be supplemented by the product initiatives Craig described, in addition to the cadence of our flash sale events, which occur more towards the back half of the year relative to LY. I would note that our total number of flash sale events for the year will be a bit higher than 2015, although still approximately one-third below our peak. We expect the combined effect of these factors will create a 300 basis point to 700 basis point sequential improvement in our H2 comps versus Q2.

Given first half gross margin trends of approximately down 100 basis points versus LY, we now expect the back half and full year to be down against LY by a relatively similar amount. We expect a similar level of promotional activity relative to Q2, which will offset the benefits we are realizing from sourcing and supply chain initiatives. Year-to-date, we have and will continue to benefit from internal initiatives, including our supply chain successes, and in the back half, we expect to realize at least a $5 million benefit in this regard. As you know, the benefits of these initiatives will be realized as we sell through the related inventory.

With respect to SG&A, we continue to expect to see meaningful expense leverage for the full year of at least 200 basis points. In light of the sales and gross margin headwinds, we have taken action and embarked on a company-wide initiative to strategically curtail expense growth. In this regard, we expect to moderate SG&A dollar growth from a low double-digit rate we reported for the first half to a full year growth rate in the mid-to-high single digits. Importantly, however, we will continue to invest in brand building initiatives.

With respect to our bottom line, we expect adjusted EBITDA in the range of $242 million to $260 million and EPS in the range of $0.63 to $0.70, which reflects a normalized tax rate. This yields adjusted EBITDA margins in the range of 17.7% to 18.6%, demonstrating significant expansion of 100 basis points to nearly 200 basis points and EPS growth of 26% to 40%. A full walk from adjusted EBITDA to EPS is included in our press release.

We continue to expect to open approximately 40 to 45 net owned and partner operated stores, consisting of approximately 15 owned stores on a net basis. In the second quarter, we opened 16 net stores, including 9 partnered and JV stores and 7 owned stores. Year-to-date, we have opened 30 net stores, including 18 partnered and JV stores and 12 owned stores. EPS guidance continues to assume a modest headwind from FX versus LY as a result of our hedging of the US dollar inventory purchases for our Japan business. And, as a reminder, our EPS guidance reflects a normalized tax rate of 40% in spite of our $739 million NOL position as of yearend 2015, which will result in minimal taxes for 2016, both on a cash and P&L basis. Finally, we continue to expect to generate triple-digit free cash flow.

In spite of the headwinds for the current year, we expect to continue to see expansion in our adjusted EBITDA margins in 2016, where we are forecasting at least 100 basis points of expansion. We also remain confident in our ability to generate margin gains on a sustained long-term basis driven by the following: our double-digit sales growth, which will allow us to leverage our fixed costs, including corporate costs; the continued expansion of licensing and partnerships; meaningful leverage as we scale our foundation in existing markets and continue to expand into new markets; and lastly, supply chain enhancements.

In closing, while we have taken a prudent approach in adjusting our expectations for the remainder of the year, we remain confident in our future growth trajectory toward our long-term $4 billion retail footprint target and the initiatives we are implementing to drive performance in the second half of 2016, and beyond.

Now, I will hand the call back to Craig.

Craig A. Leavitt - Chief Executive Officer & Director

Thank you, George. As I said at the beginning of this call, we are intently focused on appropriately adjusting our business to help mitigate the short-term challenges we've discussed. As such, we have implemented specific changes that we anticipate will lead to stronger performance in the second half of the year, and beyond.

As we execute our strategy, we are building a diverse and differentiated business model, and are highly confident that we will continue to see meaningful growth and margin expansion. Well managed brands endure. We are relentlessly focused on growing our business and strengthening our solid foundation. We remain as confident in our long-term growth trajectory and our ability to become a $4 billion business at retail, as we were when we announced first quarter earnings. And we look forward to updating you further, when we report third quarter results on Wednesday, November 2.

And now, we'll open it up for a few questions.

Question-and-Answer Session

Operator

The floor is now open for your questions. Your first question comes from Kate McShane of Citi Research.

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

Hi. Thanks for taking my question. I guess, if we could just focus on the flash sale commentary. I know it's a little granular but it just caught my attention that the flash sales are going to be up relative to last year. Is that on outlet product or full-priced product? And is that a way to work down current inventory or a way to be more competitive in the second half?

George M. Carrara - President & Chief Operating Officer

Yes. So, hi, Kate, I will take that question. So our flash sales in the aggregate in 2016 will be up a bit to LY but let me remind everybody they will still be down one-third versus our peak. So very important to note. In planning the year, 2016, we, of course, looked at our flash sale plan, and we had a plan in place but we maintained flexibility to comp it to LY, give or take 1% or 2% and effectively in the back half, you will see a bit of an increase relative to LY that will account for additional upside. It's principally as it continues to be DFO product. So made specifically for the eCommerce channel and I think that's all we need to say on that one.

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

Okay. Thank you.

Operator

Your next question comes from Simeon Siegel of Nomura.

Simeon A. Siegel - Nomura Securities International, Inc.

Great, thanks. Good morning, guys. George, can you just help us understand the comments about quality of sale not promoting to drive comp versus maybe the gross margin rate decline. So, to your comments, how much of that gross margin decline was driven by the increased wholesale penetration, maybe how much came from FX? And then, with wholesale penetration normalizing, what would you expect that back half gross margin to be based on the current trends? Thanks.

George M. Carrara - President & Chief Operating Officer

Sure. Sure. So on gross margin during the second quarter we experienced a 200 basis point decline. If you – Simeon, if you exclude the increased penetration in the timing of off price shipments in wholesale, coupled with the increased promotional environment in outlet, our gross margin rate would have actually expanded for the quarter, driven by our quality of sale efforts and disciplined in managing that within our full-price channel. So, we remain very committed to that. Our view is that's the way to maintain our long-term growth and keep our brand sustainable. So, that's critical.

And, also I will remind you that we have low, very low industry-leading low crossover between our off price and full-price channel. FX did have an impact, of course. But in the aggregate, it was probably about 50 basis points or so.

Craig A. Leavitt - Chief Executive Officer & Director

And I think to underscore what George was saying where we really won for the quarter was with our full-price customers. That's where we saw gross margin dollars, solid expansion, a higher penetration of full-price sales in our full-price channels and we've seen in previous quarters this was really in the full-price channel. The challenge, as I mentioned in my prepared remarks, was really on that sale-oriented customer. And capturing the sales from that particular consumer who is inundated with a promotional landscape, in general, was an additional learning that we had during this quarter. And where we saw the challenges in our full-price business were actually during the key sale periods and the most important of which, the largest of which, was actually at the very end of the quarter for our semi-annual sale.

George M. Carrara - President & Chief Operating Officer

And so when thinking about the second half, specifically the low end of the range, which we have extreme confidence in achieving, Simeon, we took our 200 basis points drop, which, again was inflated by both the increased promotional activity in outlet, coupled with the temporary increase in the timing of off-price shipments in our wholesale channel. We took that, offset it by what we mentioned in our prepared remarks will be at least $5 million of sourcing benefits on the supply chain side. We built that into our second half. So that will give us the ability to absorb some further decline in the in-trend, if we had happened to experience it.

Simeon A. Siegel - Nomura Securities International, Inc.

Great, thanks. And then, Craig, just to your points, is there anything with the flash sale commentary and the environment and the global conversation, has anything changed on the more higher level on the outlet channel longer term? And then do you guys know offhand what percent of your business is done in outlets?

Craig A. Leavitt - Chief Executive Officer & Director

So as it relates to the changes, I think one, I outlined a second ago, that was in the full-price channel where the competition for that sale customer, which for us as we have seen in our consumer data is largely differentiated from our full-price buyer was certainly more competitive.

In the off-price channel, we, again, saw continued challenges with the foreign tourists, and the quality of the foreign tourists measured in average spend per transaction. So that's something that trend worsened in Q2 versus Q1. And, remember, because we have a relatively small number of outlet stores, we are really over-indexing in the A and A-plus centers and those centers happen to have a higher penetration of foreign tourists. So, it exacerbates the problem or that headwind for us.

Simeon A. Siegel - Nomura Securities International, Inc.

Okay. All right. Thanks, guys. Best of luck for the rest of the year.

George M. Carrara - President & Chief Operating Officer

Thank you.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks, Simeon.

Operator

Your next question comes from Heather Balsky of Bank of America.

Heather N. Balsky - Bank of America Merrill Lynch

Hi, thank you for taking my question. Can you just clarify as you look to the back half of the year, how you are thinking about the promotional environment, especially that sales customer, and what you think you can do to get her to spend more or are you thinking that you would prefer to focus on that full-price customer?

Craig A. Leavitt - Chief Executive Officer & Director

So, as a general statement, we want to focus on the full-price customer. So our strategy of building that full-priced customer base, creating that sense of urgency for her to purchase our product at full-price, that certainly remains unchanged. And as I said, we are actually seeing positive results in that regard, even in this tough quarter, where we saw that penetration of full-price product increase over previous quarters. So we are going to continue to merchandise our markdowns, focus on these key sale periods that we are maintaining, not adding additional store-wide sale events, but merchandising our markdowns and focusing our efforts to capture those off-price sales in that channel during those key events.

And so if that means taking deeper discounts during that finite period, we're going to do that, but this continues to be about managing our inventory through markdowns and not getting into these store-wide events. So we will work during these periods to make sure our inventory is turning, but we are going to focus it on aging or challenged inventory.

George M. Carrara - President & Chief Operating Officer

And within the outlet channel, we delivered in July a new core floor set which we are very optimistic about. So we believe that will have an impact. Additionally, we are adjusting our product flow as we learn about the micro-assorting environment within the outlet channel. And lastly, expanding ship-from-store to include a breadth of that product.

Heather N. Balsky - Bank of America Merrill Lynch

Okay. Thank you.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks, Heather.

Operator

Your next question comes from Ike Boruchow of Wells Fargo.

Ike Boruchow - Wells Fargo Securities LLC

Hey, everyone, good morning. Thanks for taking my question. George, I think you mentioned off-price sales a few times. I'm just kind of curious as we think about our model, can you maybe tell us how much that piece of the business was up either in dollars or percentage in Q2, and how you plan that in the back half of the year?

George M. Carrara - President & Chief Operating Officer

Sure. So, for the full year, thinking about wholesale in the aggregate, which, of course, wholesale off price is a component of, we will maintain a relatively flat penetration versus LY. When you run your model, you'll observe for the first half the penetration of total wholesale was up a couple hundred basis points and that was principally driven by normal timing of off-price shipments. So really nothing out of the ordinary there. The off-price, there's not a cadence to the off-price channel as there is in the full-price channel, where we deliver newness every month. So, again, the full year penetration within wholesale will be relatively flat to LY.

Ike Boruchow - Wells Fargo Securities LLC

Got it. And then just a quick follow-up, I guess, for Craig. You guys have done a good job with the full-price side, keeping margins flat to slightly up. I guess my question is: what would you need to see within the full-price channel, if anything, that would maybe have you change your outlook there and maybe have to participate a little bit more with some of these promotions and sales that are going on in the industry?

Craig A. Leavitt - Chief Executive Officer & Director

Well, Ike, as I said, this continues to be about two things. One is continuing to win with the full-price customers. That is such an important part of our strategy and we are seeing strong results in that regard. So making sure that she is engaged, that she has that sense of urgency. And, again, the results reflect that that strategy is working. And we balance that by merchandising our markdowns to make sure that we are focusing our markdown dollars on aging or challenging product and focusing our efforts during those key sale periods.

Now, as those sale events have become more competitive for that differentiated consumer, we have seen a trend of needing to potentially go deeper. And so, that's where if we need to have any additional promotional efforts in the full-price channel, they will be focused during those periods. And that's a matter of depth of markdown, not a matter of changing strategies in terms of adding store-wide sale events, where, as I've said before, we wind up skimming the cream off the top, selling our best product at discount, and not merchandising our markdowns. So, this strategy is working and we will continue to maintain that thought process.

Ike Boruchow - Wells Fargo Securities LLC

Got it. Thanks, guys.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks, Ike.

Operator

Your next question comes from Scott Krasik of Buckingham Research Group.

Scott D. Krasik - The Buckingham Research Group, Inc.

Yeah. Hi, thanks. Can you just give me a little more color on Japan specifically, what you are embedding in the guidance for International going forward, and International wholesale opportunities as well, outside of Japan. Thanks.

Craig A. Leavitt - Chief Executive Officer & Director

Sure. So I will kick it off. A couple of things to say about Japan. Certainly, the overall consumer sentiment continues to be challenging, in fact, worsening. I think this kind of thing is underscored by the government decision to delay their consumption tax hike. So that's obviously something that's in the macro environment there.

There's also continuing and strengthening headwinds from the reduced inbound tourists from places like PRC. So, just like it is in other markets, this continues to be about building strong relationships with the customers, the local consumer base, and also building relationships with consumers around the world. That's our focus on consumer origins, so that no matter where she's engaging with us, we have that relationship.

We are also seeing some strengthening in terms of how the brand is perceived in Japan, witnessed by, as an example, improving performance and a broadening penetration of our aspirational side of our line architecture in handbags. We are seeing an expansion of ready-to-wear. And while the traffic, particularly in the concessed department store environment continues to be a challenge, we are seeing actually an increase in transaction size there based on driving higher AURs. So, as traffic returns over time, and we are seeing this growth in AUR, and acceptance of that more aspirational product from us, we think that actually bodes well for our future in that strong market for us.

So I think you have to look at this market-by-market. In the Greater China region, the strengthening of our business in PRC was obviously offset by Hong Kong and Macau business that continues to be challenging, with continuing reductions in inbound traffic there and quality in terms of transaction size. But in PRC, we are seeing some very strong initiatives in terms of looking at our either newer stores or newly renovated stores. We are seeing actually a strengthening of our comp results there that, again, give us confidence for the importance of that market in the future.

But the core of our International strategy continues to be making sure that we are engaging with that consumer, building that brand equity in all key markets around the world, as we know that that impacts multiple markets around the world.

And I think the last thing to say about this is, remember that most of this International expansion is expansion via partnership. That's one of our points of our differentiated model. So these are capital light, very low investment expansions where we have a significant amount of creative and distribution control, but light investments and that's about growing our brand footprint to build that global engagement.

George M. Carrara - President & Chief Operating Officer

And in terms of half two guidance, Scott...

Scott D. Krasik - The Buckingham Research Group, Inc.

Yes.

George M. Carrara - President & Chief Operating Officer

You could think that there's no anomaly in the International segment worth calling out. So what that means is both the top line and bottom line will grow at rates commensurate with the total company.

Scott D. Krasik - The Buckingham Research Group, Inc.

Okay. So an acceleration from 2Q or...

George M. Carrara - President & Chief Operating Officer

So 2Q saw a double-digit top line and actually a triple digit expansion in the bottom line, International, and you will see similar for the back half of the year.

Scott D. Krasik - The Buckingham Research Group, Inc.

Okay. Thanks. And then, if I could just follow up on the gross margin comment. Just thoughts around when the positive tailwinds from lower leather costs should start to hit the P&L. I assume that's not part of the $5 million supply chain call out.

George M. Carrara - President & Chief Operating Officer

Yeah. So that would be part of the $5 million. So that will start with the full product hitting the floor. So we'll start seeing that in the quarter and as we sell through the related inventory, we'll see it to an increasing degree as we sell out of spring/summer, and sell more of the fall holiday product line. So, you'll see an acceleration of that during the half.

Scott D. Krasik - The Buckingham Research Group, Inc.

Okay, thanks.

Operator

Your next question comes from Dana Telsey of Telsey Advisory Group.

Dana L. Telsey - Telsey Advisory Group LLC

Hi. Good morning, everyone. You mentioned the fact that on the novelty product, the June novelty product didn't resonate. What are the learnings from that and how are you planning novelty products going forward? And then, as you transitioned from Cedar Street to the Cameron Street, when will you have the appropriate inventory levels to meet demand? Thank you.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks, Dana. So, first on novelty. This really was an anomaly. We have had, as you know, a great strength with our novelty product for a very long time. And, as I mentioned in my prepared remarks, we're actually seeing good early results from subsequent deliveries. So, we do really feel that this was an anomaly.

And as we look, going forward, where we continue to be invested in novelty because, again, not only for the sales in the novelty area but we know it drives both traffic and conversion in both our eCommerce and store. So it's very important from that perspective. Obviously, it's a very important part of our storytelling that builds further engagement with the consumer.

Looking forward to the balance of this year in terms of additional novelty deliveries, many of them are reinventions of tested themes that have worked well for us in the past. So, we have a track record that, again, gives us even further confidence in the performance of this segment of product going forward.

And, I've talked a lot about micro-assorting efforts in our stores and obviously one of these clusters that we look at is stores that actually over-indexed in novelty and we feel that we have the appropriate assortments, including some products exclusively for this cluster that will help us drive additional sales across product categories for the balance of the year, including where it's particularly important in the holiday season where we'll have multiple novelty themes that we feel very strongly about. So, we feel that's taken care of and those initiatives are already in place. Product is on the way.

Relative to the second question, on the Saffiano transition, and let me underscore that this is while a challenge for Q2 is really good news because we had planned this transition from these two different groups since we began testing this product, really back in Q4. And we had strong results and therefore planned the transition.

The transition, from the customer perspective, actually happened faster than we expected, which is why we missed some sales in Q2 as a result. But that product is already coming into stores now. And as we move through the next couple of months, we will be at a full inventory level not only on the existing styles, but also with additional silhouettes and additional price points that will resonate with the consumer. So we are well situated for this transition to be complete as we move towards the back of this quarter and certainly for the balance of the year.

George M. Carrara - President & Chief Operating Officer

And I will emphasize we also have incremental marketing against that stock position or the increase in stock position. And specifically, this positions us to deliver upon a comp improvement in the second half of the 300 basis points to 700 basis points. So this is one of several factors that Craig discussed that gives us that ability.

Craig A. Leavitt - Chief Executive Officer & Director

It's also important to note that this new group that we are transitioning to that is resonating so well actually has a higher average unit retail than our Cedar Street Group that we are transitioning out of.

Dana L. Telsey - Telsey Advisory Group LLC

Thank you.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks. Thanks, Dana.

Operator

Your next question comes from Adrienne Yih of Wolfe Research.

Adrienne Yih-Tennant - Wolfe Research LLC

Good morning. Thank you. Craig, my first question is the International AUR increases, are you seeing the same thing happening domestically? And is that from a mix assortment or is that the customer responding to higher AUR categories? And then, George, really quickly, just to clarify, are you saying 300 basis points to 700 basis points above the 4%, the consolidated, inclusive of DTC comp? And then, the gross margin, do we expect the 200 basis point hit to be recovered in the third quarter? Thank you very much.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks. So starting with your AUR question, we are seeing that increase in our AUR in our full-price business. Obviously, that's balanced with the higher markdowns on the markdown product. But focusing on the full-price penetration, yes, we are seeing that and it is actually a mix of both customer reaction to the more aspirational product but also to our line architecture, where we are looking to maintain a relatively stable AUR, which has been our strategy for some time, but we're seeing the success of these aspirational products slowly migrating the customer and the offer higher. So it is a combination of offer and customer response to some of these most important aspirational products.

I also mentioned in my remarks that we're seeing very strong reaction to our Madison Avenue Collection which, of course, is at our highest AURs. And, again, it's still a relatively small but growing part of our business and those have significantly higher AURs that are help driving this result as well.

George M. Carrara - President & Chief Operating Officer

Hi, Adrienne. So our second half top line assumes comp improvement from the second quarter of 300 basis points to 700 basis points and that's total comp. So let me just be clear on that one. 300 basis points to 700 basis points assumed in our second half guidance. And, again, that's on the total comp line.

With respect to your gross margin question, the 200 basis points of erosion that we experienced in Q2, we have that planned into the second half. That will be offset by at least $5 million of supply chain benefit, and additionally could be further offset by the benefit of mix.

In the second quarter, the impact of increases in the timing of off-price shipments expanded that deterioration a bit. So, again, that will normalize a bit in the second half. So we should see some offsets.

Adrienne Yih-Tennant - Wolfe Research LLC

Great. Thank you very much. Best of luck.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks, Adrienne.

Operator

We have time for one more question. Your final question comes from Oliver Chen of Cowen & Company.

Oliver Chen - Cowen & Co. LLC

Hi. Thanks for the details. On the factor about the customers looking for deeper discounts, is your sense here from your consumer research that it was other handbag competitors or the department store channel at large? And, as you think about that factor, it feels somewhat out of your control. So, how can we have confidence that your comp guidance is achievable? Do you feel like your comp guidance for the back half is in the optimal place relative to different factors which will depend on how competitors behave and the environment of the consumer and also supply and demand feels distorted a little built right now. Thank you.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks, Oliver. So, a couple of things. First, as it relates to this phenomenon of that sale customer, I would say that it is relative to the industry, in general, the retail landscape, not specific to competitors or specific brands. This is really the department store environment continuing to drive a lot of this discounting. And, again, for that differentiated consumer, certainly for us, as we look at our research, that's a differentiated consumer and she is driven primarily by price. And so that has to be the story that we tell her, which is why we are focusing our markdowns during those periods where she is active and shopping, and the balance of the year, we are focusing on continuing to build that strong relationship with that full-price customer with whom we are winning.

And so, to the second part of your question, if you look at the performance this quarter, it is a balance of factors, some of which are macro factors, some of which are things within our control. And when you look at this, it was the confluence of all of those factors that came together to produce a challenging result.

We're focused on the things that we can control and that, of course, starts with product. And when you look at what we have already in action, so the actions that we have already taken for balance of the year, we have a very strong confidence in the guidance that we provided you related to our comps.

So, just a very quick recap. We have talked about the transition in our Saffiano Groups. That is underway. So there's – actions have already been taken and it will influence as early as third quarter and certainly fourth quarter as well. Novelty, I outlined a few minutes ago, in terms of the actions that we have taken there; focusing on diversity of assortment and our shoulder pricing approach, which continues to resonate, making sure that we are having those aspirational price points along with those entry price points; we feel very good about the gifting product that we have coming in in the back half of this year; the micro-assorting efforts where we have seen early wins. Again, we've only had that effort in place since February, so this is about learn and apply, and we are already, again, have actions in place with product coming in in the back half, including exclusive product to some of these lifestyle clusters that we think will drive product.

Some of the things that we didn't talk about, a focus on cross category shoppers. That's an important part of our overall effort as a lifestyle brand. You've heard us talk about how that has been an important part of customer acquisition and we are continuing to see greater numbers of those consumers who are coming into some of these newer product categories, coming back to buy some of our core categories. And our efforts from a marketing perspective, we're going to continue to focus on those consumers to grow sales in the back half as well. So high level confidence in what we outlined.

Oliver Chen - Cowen & Co. LLC

Craig, the details are really helpful. Just so we understand this and I understand this, when you do post gain, the customer transition issue and the novelty issue, what would you have done differently, if anything, in terms of how would you have planned or processes as you think about that? And just so we can understand it, with Cedar Street, the customer response to Cedar Street sounds like it tapered off a little faster than you thought it would.

Craig A. Leavitt - Chief Executive Officer & Director

So it's really understanding how quickly the consumer was shifting, and I think the learning is that when you start to guide her, the consumer shifts even faster than we anticipated. And, again, the good news is that she's responding to exactly what we wanted her to. We planned this transition to this new group, and the fact that through our marketing efforts, we were able – and our visual merchandising, she responded more quickly is certainly bad news for the quarter but good news for the future and that's what we have to focus on.

As it relates to novelty, that is something that we – we deliver newness every single month. We are focused on product that's really engaging and that's really differentiated and that does carry risk. We have won in that segment of our assortment really from the start of our entry into novelty. This is one month of miss, and as I said, we are already seeing signs of that improvement with the newer deliveries. So we believe that's an anomaly. And particularly when we look at the go forward using more of our tested themes, and let's call that another learning, to your question, some of those tested themes as we start to deliver product in the back half of the year.

So I think the two things that I would say directly to what we would do differently are the fact that we, as we leave the customer, we need even greater confidence in bringing her with us more quickly. And secondly, more test and apply, and we are certainly set up to do that.

So this, in the end, is about balancing short-term challenges, these anomalies of the second quarter that we have described in great detail, with the long-term opportunities that we know continue to exist for our brand, and particularly with the confidence that the consumer is showing in purchasing our product at full-price and that's what gives us the basis for the confidence that we have in the balance of the year and the go-forward.

Oliver Chen - Cowen & Co. LLC

Okay. Thank you so much. Thank you.

Craig A. Leavitt - Chief Executive Officer & Director

Thanks, Oliver.

Operator

Ladies and gentlemen, that does conclude today's conference call for today. Thank you for your participation. You may now disconnect.

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