Tilly's (TLYS) CEO Ed Thomas on Q3 2016 Results - Earnings Call Transcript

| About: Tilly's, Inc. (TLYS)

Tilly's, Inc. (NYSE:TLYS)

Q3 2016 Earnings Conference Call

November 30, 2016, 04:30 PM ET

Executives

Gar Jackson - Investor Relations

Ed Thomas - President and Chief Executive Officer

Michael Henry - Chief Financial Officer

Analysts

Jeff Van Sinderen - B. Riley

Janet Kloppenburg - JJK Research

Neely Tamminga - Piper Jaffray

Pam Quintiliano - SunTrust

Richard Jaffe - Stifel

Betty Chen - Mizuho Securities

Dave King - Roth Capital Partners

Operator

Greetings, and welcome to Tilly's Third Quarter Fiscal 2016 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Mr. Gar Jackson. Thank you, sir. You may begin.

Gar Jackson

Thank you, Operator. Good afternoon everyone, and welcome to Tilly's third quarter fiscal 2016 earnings call. Ed Thomas, President and CEO; and Michael Henry, CFO, will discuss the company's results and then host the Q&A session. For a copy of Tilly's earnings press release please visit the Investor Relations section of the company's website at tillys.com, where you will also be able to find a recorded replay of this call for the next 30 days shortly after the conclusion of the call.

Certain forward-looking statements will be made during this call that reflect Tilly's judgment and analysis only as of today, November 30, 2016, and actual results may differ materially from current expectations based on a number of factors affecting Tilly's business. Accordingly, you should not place undue reliance on these forward-looking statements.

For a more thorough discussion of the risks and uncertainties associated with any forward-looking statements please see the disclaimer regarding forward-looking statements that is included in our third quarter fiscal 2016 earnings release, which was furnished to the SEC today on Form 8-K, as well as our filings with the SEC referenced in that disclaimer.

Today's call will be limited to one hour. When we get to the Q&A session please limit yourself to one question at a time to give others the opportunity to ask questions.

With that, I now turn the call over to Ed Thomas, Tilly's President and Chief Executive Officer.

Ed Thomas

Thanks Gar. Good afternoon everyone, and thanks for joining us today. I will provide an overview of our fiscal 2016 third quarter results before updating you on the progress of our fiscal 2016 initiative. Mike will then review our third quarter results in detail and introduce our fourth quarter outlook.

Our fiscal 2016 third quarter comp sales, operating income, and EPS all exceeded our outlook ranges. Comp sales, including e-com increased 4.4% for the quarter on top of last year’s 3.9% increase. Store comps were positive for the first time since last year’s third quarter and our online business continued to grow at a double-digit rate. After a soft start to the third quarter during the peak of the back-to-school season, store traffic turned positive on a weekly basis throughout September and October marking our first months of store traffic growth in quite some time.

On a total company basis, all departments comped positive for the quarter with the exception of women's, which was down in the low-single digit, but improved as the quarter progressed. We generated meaningful SG&A leverage due to the tighter expense management coupled with our positive comp results.

Third quarter operating income of $10.7 million nearly doubled compared to last year’s $5.4 million and earnings per share of $0.22 more than doubled compared to last year’s $0.10. We ended the quarter with inventory down 9.2% per square foot, cash and marketable securities totaling $105 million, and no debt. As we noted during our last earnings call, we anticipated some merchandizing newness, including a strengthening athletic trend, denim and jackets to drive our business during the back-to-school season.

What we did not anticipate was significant improvement in store traffic I noted earlier. We believe this merchandise newness and our repurposed more localized marketing efforts had a positive impact on both traffic and conversion for the quarter. We continue to see improved comp results in certain underperforming stores that we believe are due to the assortment adjustment initiatives launched late last year.

As you may recall, we started this effort with a small group of stores during the fourth quarter of last year. Our goal was to improve sales results in certain locations where we firmly believe that we should have stronger sales based on the quality of the locations involved. In March, we added a second group of stores and both groups have consistently outperformed the chain in terms of comps.

As a result, in October we again doubled the number of stores included in this effort to over 40 total locations. Our results thus far continue to support our thinking and we remain encouraged by the sales improvements that we’ve seen from these efforts.

Turning to our online and marketing efforts, our new Chief Digital Officer is off to a great start and we believe he will meaningfully improve the profitability and efficiency of our online mobile and social media effort. We continue to test our new Buy Online and Pickup in Store program to ensure it functions as intended before rolling it out to all stores.

We’re enthusiastic about the opportunity this program has to drive additional traffic to our stores, and we intend to follow this up with the Ship to Store program offering after the holiday season. These initiatives will complement our already successful Ship from Store program that we've had in place for a couple of years.

We are excited about the opportunity to drive additional traffic and sales by improving customer engagement and satisfaction through technology. We also continue to see positive responses and consistent signups to our rebranded loyalty program that was launched in mid-June. Regarding inventory management, as we have demonstrated in the recent quarters, we are managing inventories tighter than we have in the past and we are reacting faster to slower selling styles.

We believe that this more disciplined approach results in faster inventory turns and allows us to accelerate the introduction of newness for our customers. As expected, our product margins declined modestly in the third quarter, but they remain very healthy overall. We ended the quarter with inventory per square foot down 9.2%, relative to our comp store sales growth of 4.4% and with inventory ageing improved to last year. We still have more room to improve and this will remain a primary focus for us.

Turning to real estate, we remain focused on improving the performance of our existing stores for the time being, rather than opening a significant number of new stores. As I noted earlier, we are seeing positive results from our adjusted merchandising strategies in some of our stores that weren’t delivering the kind of top line results that we believe they should.

Additionally, we continue to work with our landlords to restructure existing store leases when natural lease expirations or kick-ups are available to us. There are nearly 60 total stores to address in the coming year representing just over 25% of our existing store base. While we will remain optimistic about new stores where we believe the location and economics are appropriate, our primary focus will be on improving the productivity of our existing fleet in order to drive increased profitability for our company overall.

In closing, our Q3 results are encouraging and I’m proud of our team's effort over the past year. The fourth quarter is off to a decent start with a low-single digit positive comp due to a strong Black Friday and Cyber Monday. We still have a lot of work to do to further improve this business and get back to our high-single-digit annual operating margin, which remains our objective.

Now, I’ll turn the call over to Mike to provide more details on our third quarter operating performance and to introduce our fourth quarter earnings outlook. Mike?

Michael Henry

Thanks Ed and good afternoon everyone. I’m pleased to share our third quarter operating results for fiscal 2016 compared to fiscal 2015 as follows. Net sales of $152.1 million were up 7.3% compared to last year's $141.7 million. Total comparable store sales including e-commerce increased 4.4% on top of last year's 3.9% increase. Store comps were up low-single digits and e-commerce continued to grow at a double-digit rate.

Our comps were driven by an improved store traffic trend and stronger conversion. We ended the quarter with 225 stores, a 2% increase from 220 stores a year ago. Gross profit of $48 million increased $3.3 million or 7.5% from $44.6 million last year. Gross margin was flat at 31.5%, a 110 basis point improvement in buying distribution and occupancy cost, offset a 110 basis point decline in product margins.

Buying, distribution, and occupancy costs increased $0.8 million compared to last year, but these increases were leveraged effectively on higher total sales. Product margins declined due to increased markdowns as it has been the case all year due to our acting faster on slower sellers, but product margins remained very healthy overall.

SG&A expenses were $37.3 million compared to $39.3 million last year, a decrease of $2 million. As a percentage of net sales, total SG&A was 24.5% compared to 27.7% last year, an improvement of 320 basis points. More efficient marketing spend, lower non-cash impairment charges, corporate payroll savings, and several other smaller expense reductions accounted for 240 basis points of this improvement, resulting in our ability to leverage a smaller total expense base on increased sales.

The remaining 80 basis points of improvement was attributable to severance obligations of $1.1 million recorded in last year's result. Operating income of $10.7 million, nearly doubled compared to last year's $5.4 million. Income tax expense was $4.4 million or 40.4% of pre-tax income, compared to $2.6 million or 48% of pre-tax income last year. Net income of $6.4 million or $0.22 per diluted share more than doubled compared to $2.8 million or $0.10 per diluted share last year. Weighted average shares for the quarter were $28.5 million.

Turning to the balance sheet, we ended the quarter with cash and marketable securities totaling $105 million, a 38% increase compared to $76 million at this time last year. We have no debt under our credit facility. Inventory decreased 9.2% on a per square foot basis compared to our comp sales increase of 4.4% and our inventory ageing was improved versus last year.

Year-to-date capital expenditures were approximately $14.8 million this year compared to $17.5 million last year. Capital expenditures have primarily been for remodeled stores, three new stores, and IT investments. Total CapEx for fiscal 2016 is not expected to exceed $20 million.

Turning to our outlook for the fourth quarter of fiscal 2016, through November 28, quarter to date comps are up low single digits. Our strong Black Friday and Cyber Monday more than offset a weak start to November in our heritage market markets of California, Arizona, and Nevada where a 120 of our 225 stores reside. We believe this weak start was largely attributable to unseasonably hot weather in the West, as we saw heritage market comps bounce back well for the Thanksgiving week.

We expect store traffic patterns to remain erratic with peaks and valleys throughout the remainder of the fourth quarter. For the quarter as a whole, we expect fourth quarter comparable store sales to be in the range of flat to up 2%, operating income to be in the range of $7.5 million to $9.5 million and earnings per share to be in the range of $0.15 to $0.20, compared to last year's $0.10.

We expect our fourth quarter tax rate to be approximately 40% and diluted shares to be approximately $28.7 million. We expect inventories per square foot to remain below LY levels and to end the year with 223 total stores as a result of two store closures late in the quarter.

Operator, we’ll now take questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from Jeff Van Sinderen of B. Riley.

Jeff Van Sinderen

First let me say congratulations on the really substantial improvement in Q3.

Ed Thomas

Thanks Jeff.

Jeff Van Sinderen

So just in thinking about your guidance for Q4, maybe you can just give us a little more color on what you saw around Black Friday weekend in terms of the traffic and transaction trend? I know you said Cyber Monday was good, seems like your e-com business is really strong, but sort of wondering more about that compared to last year? And then, maybe you could just touch on how that plays into your guidance of the flat to up 2% comp? And I guess how we should think about that versus what’s a relatively easier compare in Q4 this year.

Ed Thomas

First of all, our Black Friday was pretty solid and we saw pretty good traffic on Black Friday. I think the guidance really reflects what we expect to be continued volatility in the traffic patterns in both mall and off mall. We didn't see a material difference really between off mall and mall and traffic. So, it is still really difficult to forecast consistently up traffic and our guidance really pretty much reflects that.

Michael Henry

Yeah Jeff, and I’d just add that when you look back at Q3, how we ended up doing so much better than our guidance was the fact that our store traffic suddenly turned positive. We haven't had positive traffic in a long time and as that began to happen, we're looking at each other and saying well how long is this going to last. And as soon as we flip the calendar to November, we saw store traffic drop for the next three weeks. And then even during Black Friday weekend, we had a great Thursday, Friday, but then Saturday fell off. Than Sunday bounced back the other way and early this week it’s fallen off again. So, it’s going back and forth as we said in our commentary, we're seeing some erratic behavior from traffic and we think that’s going to continue, so we’re taking a cautious outlook on what the fourth quarter might bring.

Jeff Van Sinderen

Okay that's really helpful. And then if I could just squeeze in one more on the women's business trend, it seems like there is certainly some fashion newness out there and it seems like there is maybe a shift in terms of the overall fashion trend that maybe underway, just wondering if you can speak a little bit more to the women's business what you see is kind of the path to getting that business positive.

Ed Thomas

Well I think really, we’re seeing enough newness in women's going into spring, and so I’m not going to get into specifics in terms of what we're seeing, but part of the women's business I would say a substantial part of the decline in the women's business was primarily attributable to cold weather product. And as soon as we saw the weather turn, we started to see an improvement in most of those categories. So that’s kind of where we are at Jeff right now.

Jeff Van Sinderen

Okay. Thanks very much, and best of luck for the rest of holiday.

Michael Henry

Thank you.

Ed Thomas

Thank you.

Operator

Our next question comes from Janet Kloppenburg of JJK Research.

Janet Kloppenburg

Hi Ed. Hi Mike, congratulations. Really very nice results.

Michael Henry

Thank you.

Ed Thomas

Thank you, Janet.

Janet Kloppenburg

Couple of questions Ed on the women's business, just couple of things did it -- you said the women's business improved as the quarter went along, I mean could it have been positive in October, but there’s something I’m wondering about and also just wanted to talk a little bit more about the mark down pressure, the timing of markdowns impacting the gross margin, should we look to that trend to potentially impact gross margins for the next few quarters, and then also on the store, the opportunity for store closings, did you say that 50 stores have lease expirations in the next 12 months and maybe if you could just blush out how you are thinking about that?

Ed Thomas

Okay. So, let me start with the women's, again Janet the women's business was primarily impacted by warm weather, it was still warm, specifically in our heritage markets, and I don't expect that to continue and as the lease started to see colder weather, particularly in California, Arizona, and Nevada, we started to see improvement in that business. So, I don't see, again I don't think there was anything unusual there. In terms of markdowns, we’re not really…

Janet Kloppenburg

Can you comment on whether the women's business did get in positive territory later in the quarter?

Michael Henry

We don’t …

Ed Thomas

We are not going to comment on those.

Michael Henry

Yeah, we don't comment on individual months or individually.

Janet Kloppenburg

Alright. I'm sorry. I'm sorry.

Ed Thomas

That's okay. That’s alright.

Michael Henry

It was about markdowns and …

Ed Thomas

In terms of gross margin and markdowns, first of all, we started this several months ago as we just -- we're taking markdowns on a more timely basis internally, and so it’s not driven by anything unusual, and you know the thing that I’m most excited about is that our Black Friday, we saw pretty healthy traffic without giving the start away like a lot of our competitors did. So, we then have to get unusual. I think but us getting more disciplined in terms of the inventory management processes has helped minimize any kind of major markdown exposure, and our merchandise margins have been consistently very good over the last several years, nothing has changed related to that. Okay.

Janet Kloppenburg

Okay. And just on the lease expiration.

Ed Thomas

Yes, you want to talk about lease?

Michael Henry

Sure. Yeah, there is almost 60 total stores that will be actionable this year. Some of those are lease expirations, some of those are kick outs that are available to us, some of them are kick outs that we addressed this past year that we may be agreed to a one-year push of the kick out to reevaluate again this year. So, the combination of all those things has blended together a group of roughly a quarter of our total store base that we’re going to be able to address one way or another this coming year.

Janet Kloppenburg

Okay. And you will talk more about that with us at - on the year end call?

Michael Henry

Well as we start to see results we will talk more about that potentially. It’s difficult to say what the impact is going to be, it gets into location by location, landlord by landlord discussions and one answer isn't going to be the case across the board, it’s going to be on a case-by-case basis, there might be some things that actually increase and other things that go down. So, where that actually lands out we’ll have to wait and see.

Ed Thomas

And I would perhaps say it’s a good position to be in when you got that many stores that you can take some kind of action in. It is a good position for us to be in, in terms of negotiation going forward.

Janet Kloppenburg

Absolutely. And just one last question Ed when you look across your major categories of men's, accessories, footwear, women's is there one plan prevailing trend that’s driving this improved traffic and conversion or is there a multitude of smaller trends?

Ed Thomas

I think it’s a multitude. You know we saw pretty good performance across a lot of categories in a lot of different brands, so there was no single dominant thing in the men's category shoes or anything that really we believe drove traffic. We think part of our traffic improvement was really somewhat related not only to merchandise because we always felt that overall the merchandise assortment was good, but also some of the marketing initiatives that we thought we did during the quarter and some of the - addressing the underperforming stores and the things we did in terms of micro merchandising those stores, it was really a combination of a lot of different things. Nothing stood out in terms of being a dominant trend.

Janet Kloppenburg

Okay. All right great. Lots of luck for this season, we'll talk to you later.

Ed Thomas

Thank you.

Michael Henry

Thank you.

Operator

Our next question comes from Neely Tamminga of Piper Jaffray.

Neely Tamminga

Great, good afternoon. Let me add my congratulations to you and the team. So, could you talk a little bit more about the your third-party brands, as well as your private label brands, kind of the national brands versus private label and maybe give an assessment of how private label is performing for you guys and if there is opportunities as we look into 2017? And then I guess related to that, and how you’re feeling about the content kind of the up-and-coming brands, so it’s a landscape that has been evolving a little bit on the lifestyle that your brands kind of purchase. So can you share us your thoughts there? And then also we've been hearing a little bit more about kind of tactical shift towards improving flows or going forward flows to keep the stores very interesting around holidays, how are you guys planning to flow some of your merchandise this year versus last year. Thank you.

Ed Thomas

Okay. So, in terms of our proprietary brands versus the - what I’ll call nationally recognized brands, we’re happy with both and I would not expect us to make a material change to that, the strategy that has been in place for a long time. What we try to do is again our stores as you know carry a lot more brands than what our perceived direct competition is. And we're not just about actions foot. So, it gives us a lot of flexibility in terms of what we can do in merchandise mix and so on and so forth and the biggest thing we are trying to do is shorten the life-cycle of a time - the time it takes, the lead times it takes to get some of our merchandise in that will give us more flexibility for adjusting to any potential trend that we missed or anything like that.

So, those are the major initiatives, I think the buying team has adjusted to a little bit different change in philosophy and they've adjusted well. So, we will continue to work on that, you know some brands, the bigger brands we're not going to be able to change lead times that easily. So, it’s really an evolutionary process that will take to get faster, but certainly we have speed in mind of getting more newness to the stores more frequently.

Neely Tamminga

And I guess related to that, are you planning then flowing a little bit differently this holiday versus last year or how should be thinking about your flows on a year-over-year basis?

Ed Thomas

Yes, I don't think, it’s not going to be materially different from what we’ve historically done. I mean starting the quarter while being down on a comp inventory basis of 9.2%. That was the biggest objective we wanted to accomplish because we felt the inventories generally were too high. So, we have consistently managed the inventories down and that will continue to work away of that, but in terms of flow, I think the only thing I would say is we're trying to get better of adjusting to some climatic differences where I think we are okay, we weren’t great, we are probably making more adjustments along that line of having more timely - we are now merchandising certain markets.

Neely Tamminga

Okay great. Best wishes and have a wonderful holiday.

Michael Henry

Thank you.

Ed Thomas

Thank you. Same to you.

Operator

Our next question comes from Pam Quintiliano of SunTrust.

Pam Quintiliano

Hi congratulations guys, really phenomenal. The quarter especially in this environment where a lot of people are very challenged, so I just had a few questions for you. First off, regarding the assortment initiative that you have in place, is there any level of detail you can give us on how the comps in those 40 stores have been doing relative to the rest of the base, so just how performance has been? And also plans for next year and beyond, and how quickly you can introduce more stores into that program?

Michael Henry

Yes Pam. So as we noted in our prepared remarks, those stores have consistently outperformed the chain since we’ve been doing this. So that’s why we just recently a few weeks ago increased the number of stores to a little over 40 stores now. That first group - actually the first two groups all year long have had better comps as a whole than the chain. So, that’s what’s convinced us that our thinking was spot on in terms of the opportunity that was there and so we've just looked at other locations now from next level down of okay who else do we think has opportunity to grow, and let’s try to adopt some of these things to those additional stores and that’s what we’re doing.

Ed Thomas

Yeah, and just to add to that, as we had mentioned in the past, if we see anything in these stores, these underperforming stores to control group that we think is an opportunity in the rest of the chain, we would implement that immediately, but this is more of adjusting our merchandise mix to a specific store profile in terms of what brands sell and that types of things and that’s really what we’re concentrating on and so far so good. So, we're going to continue it.

Pam Quintiliano

Right. So you won’t quantify for us - the comp differential using with that first store base or is there anything meaningful other than the strengths?

Ed Thomas

No.

Michael Henry

No.

Pam Quintiliano

Can't blame on this front.

Michael Henry

It’s been better every month and that’s as far as we will go.

Pam Quintiliano

Okay. And how about another question for you guys, the localized marketing efforts and you’ve mentioned a few times how that really swung the traffic, so can you give us more detail on exactly what you are doing there and beyond that, just when we think about weather overall in your regional emphasis and then you mentioned how weather wasn’t great in early November and that probably hurt. So, how do we think about weather too helping you guys in 3Q?

Ed Thomas

Sure. The localized marketing efforts is a number of things we've done, we have done in-store events, some of it nationally in all stores, some of it regionally, could be sponsored by a particular brand and we have done quite a few of those type events, which we have found to be pretty successful, particularly in newer markets where they may not know Tilly’s as well, our heritage markets, but certainly generally overall we have done a number of things, we are getting better in terms of social media marketing and localization of that in some cases.

And one of the things we don't talk a lot about, but we still have a catalogue and we use catalogue to drive business and we've gotten better in terms of directing who we mail the catalogues to, particularly in new markets. So, I’d say those are off the top of my head of the biggest things that we’ve done and so far that worked well. And then lastly on Black Friday we ran an opening event that was a combination of, we gave scratches out, and we had a little bit of final set with virtual reality, cash flow customers and we had a gift pack for the first 100 customers and that really helped us in a lot of ways. So, there’s no one particular thing we will continue to be to do a combination of national marketing and some localization.

Pam Quintiliano

And do you think weather helped you go ahead particularly in the West?

Michael Henry

As we got into the Thanksgiving week, yes, I would say so. We really got off to a rough start out here in the West. The first two and half weeks of the month it was in the 80s and 90s almost every single day, so we had a really rough start out here. And then as we got into Thanksgiving week and weather turned more seasonal like you’d expected, we saw traffic and comps bounce back, so that’s why we say we’re pretty convinced that it was a weather phenomenon that impacted us and that does play into our guidance.

So when you think about compares and things like that as Jeff alluded to, one of the things we are looking at is during those weeks whatever sales we thought we are going to get during that time we didn't get there, we missed them. And we’re not counting on getting that missed activity back. We don't think that certainly there is a backlog that were owed, we missed sales during those weeks undeniably and we’re not counting on getting that back.

Pam Quintiliano

On the flipside, do you think in 3Q that having exposure to the West, which was more seasonally appropriate, helped you?

Michael Henry

Well it is tough to say because traffic just wasn’t up here in the West, it was up in all markets and our heritage markets were positive comp as were our new markets, so some of our best comp markets were outside of heritage markets. We were good all across the country and traffic was up all across the country. So, the Q3 performance really wasn’t as regionally based as the early Q4 performance was, you know we do have traffic counters in all of our stores, so we are able to see when there are distinctly different behaviors in particular markets or in a given region, we can see that, and that’s what really happened in the beginning part of November is, it was very distinct. We were doing well outside of our heritage markets with traffic that was flattish-to-up versus out here, we were really getting hammered. And then that changed as we got into Thanksgiving week.

Pam Quintiliano

Okay. And then just if I can ask one last one, regional penetration of online, the strength that you're seeing there, is it mirroring what you're seeing in the stores in brick-and-mortar? So does the store base help the online penetration, or even though you're not necessarily looking to expand aggressively now, are you finding areas of strength that you currently don't have stores in?

Michael Henry

The penetration of sales on e-com mirrors our stores to a large extent. So think of it in those terms.

Pam Quintiliano

Great, thanks so much, best of luck.

Michael Henry

Thank you.

Ed Thomas

Thank you.

Operator

Our next question comes from Richard Jaffe of Stifel.

Richard Jaffe

Thanks very much, guys, and sorry to beat a dead horse about traffic, but wondering if there's differences in mall versus strip stores? And any social media initiatives that you took, that you can point to, as helping wake up your customers, and get them in to take a look at the new product?

Ed Thomas

Well first of all, there was no material difference during the quarter between mall and off-mall traffic. So, we're not seeing anything unusual there in terms of one being better than the other. You know, I think it’s always hard to measure when you are doing a number of things like catalogue, social media where it is always hard to really determine the exact, what’s driving traffic, but certainly I think we got better at everything in terms of catalogue distribution again. I think our social media we have done some localization that we're getting better at it and I still think we have further opportunity to develop that, but right now it’s – what’s happened is and there is market as you well know Richard in fact there’s no one multiple of magic thing to drive traffic and certainly a part of our demographic social media is very important. We continue to place high-value on that.

Richard Jaffe

Okay.

Operator

Our next question comes from Betty Chen of Mizuho Securities.

Betty Chen

Thank you good afternoon and I like to add my congratulations as well.

Michael Henry

Thank you.

Betty Chen

I was wondering, maybe Mike, you can give us a little bit of help? So in the third quarter, it seems like merchandise margin was impacted, since the team is reacting quicker to some of the markdowns. But with inventory so lean going to the fourth quarter, should we expect a similar dynamic in terms of merchandise margin pressure, or actually an opportunity to maybe be up year-over-year, since our note shows us maybe merch margins were down slightly in Q4 a year ago?

Michael Henry

We are going to continue to do whatever is necessary to keep inventories as clean as possible and as we think about the holiday season as we saw in advance of Black Friday and through the Black Friday weekend there were a lot of our competitors that were a much more promotional than we were, and so our guidance is contemplating the potential impact of that, and us leading to respond in certain ways to the promotional environment, but also just continuing to keep inventory as diligently clean as we can.

So embedded in our guidance is an assumption that there will continue to be a certain amount of margin pressure because year-over-year, you know Ed just reached his one year anniversary towards mid-October I thing, so, he was just getting familiar with the business at this time last year and we really just started some of these initiatives during the fourth quarter as he was just getting on board and getting familiar, re-familiarize with the business. So, we still will have this same kind of impact that you saw in each of the first three quarters we had a modest amount of product margin pressure and we are anticipating that in 4Q.

Betty Chen

Okay, okay. And then, kind of curious, in terms of the loyalty program I think, Ed, you mentioned earlier in your remarks that you were pleased with the re-launch. Anything else you can share with us, in terms of how the loyalty customers are behaving, and any learnings you may have on that during the early phases so far?

Ed Thomas

I think it’s too early for us to comment on that, what I will say is that we’re starting to see faster growth of that royalty base and that’s exactly what we intended to do, but we introduced kind of a non-paid time, we have been pleased going to back-to-school and we will continue to market it through holiday and going forward, but I think it’s premature for us to comment I think, as it I will just say so far so good and it’s far good.

Betty Chen

And then, Ed, also I think earlier Janet had asked about whether it is a collection of trends, that's sort of driving this strength in the business. And it sounds like you said, it is a multitude of brands. How, I guess, as you look forward, do you - are you encouraged by the fact that may be the momentum behind some of these brands can continue into 2017? Or perhaps you even see some new emerging brands that could continue to propel the momentum next year?

Ed Thomas

Again I don't think there is any one single brand or category that I’m expecting to be the same here for a while. We saw performance in a number of our brands in our proprietary merchandise and I would expect that to continue. There’s nothing that sticks out that says to me, all of a sudden this brand is going to become hard. We are always bringing in new brands, so there is always something new that will add to the merchandise mix and so again, I think it helps us with the size of our store, and the fact that we’ve been doing this for many years that it’s not a learning curve for us and we can manage it properly. So, there is nothing that I can tell you that really is different than what I already said.

Betty Chen

Okay. Well, the stores really did look terrific over the Thanksgiving weekend. So, really best of luck for the balance of the holiday.

Ed Thomas

Thank you.

Michael Henry

Thank you so much. Thank you.

Operator

Our next question comes from Dave King of Roth Capital Partners.

Dave King

Thanks, nice quarter, guys.

Ed Thomas

Thank you.

Dave King

I guess, on the guidance, maybe taking Betty's question a step further, it looks like Mike, you might be guiding operating margins down a little bit year-on-year. I guess, can you talk about the components of that, between product margin, BDO to leverage, and SG&A on the comp obviously, that you're guiding to, understanding that. But then, particularly as we think about some of the more efficient marketing spend, and then some of the payroll savings you've had, and then how should be thinking about those continuing?

Michael Henry

Sure. So, product margin pressures as I noted, we are anticipating some of that due to the promotional nature of the holiday season and again doing whatever we have to do to keep inventory as clean as possible, so we are contemplating some product margin pressure year-over-year on SG&A yes we have made some structural decisions over this past year about marketing and other areas where we've cut certain things, scaled back on others or repurpose dollars here and there.

So, on either end of our comp guidance actually we would expect to get a modest amount of SG&A leverage even on flat sales at the bottom end of our guidance range, we might have a little bit of SG&A leverage. So just to make that point pretty clear, on Q3 we had 240 basis points of leverage outside of some LY severance impact, we wouldn't expect that kind of SG&A leverage in Q4 based on our flat to plus 2 comp, but I will just tell you that we can generate a modest amount of leverage even on the flat side.

Dave King

Okay, that’s helpful color.

Michael Henry

Is that helpful?

Dave King

Yes, that's great. And then maybe switching gears, Ed, cash was up another 9% sequentially. I guess, can you talk about how you're thinking about future investments between adding stores, further digital initiatives? And then, given your view that cash is king, should we continue to expect that balance to build? And does that change at all, or does your view on that change at all, if the environment is improving, as it looks like it might be perhaps?

Ed Thomas

I would say the single biggest, we are going to invest more on technology - on the technology side and continue to invest in our e-commerce business for sure. And then as far as new store growth, we have a lot of deals on the negotiation now, but still need to wait we are waiting to see how it all plays out. We still don't know where some of these major store closing is going to take place after a holiday and we want to see how the environment ends up being after Christmas. So, we’re prepared for pretty much any kind of options and there’s no, it is something as I had mentioned in the past, our board discusses quite frequently, and that’s pretty much where we are at right now.

Dave King

Fantastic. All right, thanks for the color, and good luck for the rest of the holiday.

Michael Henry

Thank you.

Ed Thomas

All right, thank you.

Operator

Ladies and gentlemen we have reached the end of a question-and-answer session. I would like to turn the call back to Mr. Ed Thomas for closing remarks.

Ed Thomas

Thanks again for joining us. We look forward to discussing our fourth quarter results with you in mid-March. Have a good evening everyone.

Operator

This concludes today's conference, thank you for your participation. You may disconnect your lines at this time.

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