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DSW Inc. (NYSE:DSW)

Q4 2011 Earnings Call

March 20, 2012 8:30 am ET

Executives

Michael MacDonald – President, Chief Executive Officer

Douglas Probst – Executive Vice President, Chief Financial Officer

Analysts

Steve Marotta – CL King & Associates

David Mann – Johnson Rice

Scott Krasik – BB&T Capital

Mark Montagna – Avondale Partners

Chris Svezia – Susquehanna Financial

Jeff VanSinderen – B. Riley & Co.

Jeff Black - Citigroup

Claire Gallacher – Auriga

Patrick McKeever – MKM Partners

Operator

Good morning and welcome to the DSW Fourth Quarter and Fiscal Year 2011 Financial Results conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today’s presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your touchtone phone. To withdraw your question, please press star then two.

Please note that various remarks made about the future expectations, plans and prospects of the Company constitute forward-looking statements. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those listed in today’s press release and in DSW’s public filings with the SEC. This event is being recorded.

I would now like to turn the conference over to Mr. Doug Probst, CFO of DSW. Please go ahead, sir.

Douglas Probst

Thank you and good morning. Welcome to DSW’s fourth quarter earnings conference call. With me today in Columbus is Mike MacDonald, our CEO. Debbie Ferreé, our Vice Chairperson and Chief Merchandising Officer, is not with us today as she is travelling overseas with members of our supply chain team.

Today I will comment on our results for the fourth quarter and the full year of 2011 and provide our guidance for fiscal 2012; then Mike will provide more detailed comments on our operating performance. As a reminder, earlier this morning we issued a press release detailing the results of operations for the quarter and the year ended January 28, 2012.

Our reported net income for the fourth quarter was $19.4 million, which included a net $3.7 million charge in items related to our merger with Retail Ventures, which was completed earlier in 2011. You can find these items detailed in the condensed consolidated statements of operations and reconciliation of adjusted results attached to our press release. As we’ve done in prior quarters, we’ll first walk you through the details of the cost and benefits associated with the merger and related items and the specifics of where they are reflected on our P&L so that you have a clear comparison of our operating performance to last year.

The $3.7 million in RVI, merger and related items in the fourth quarter breaks down to the following major components: first, $700,000 in costs included in SG&A primarily related to RVI operating expenses such as pension and legal costs; second, $3 million in non-cash benefits related to the change in fair value of the warrant; third, $900,000 in non-cash income tax expense due to merger-related tax items; and fourth, a $5 million after-tax charge related to the guarantees of two leases that DSW inherited in the merger with RVI.

For the fiscal year, our reported net income was $174.8 million, which included $38.6 million in net benefits related to the RVI merger. For the full year, the impact of the merger is due to the following items: first, $17.3 million in net costs included in SG&A related to the merger transaction and other RVI operating expenses; second, $53.9 million in non-cash expense related to the change in fair value of the PIEs and warrants; third, $10.5 million in interest expense related to interest on the PIEs and deferred financing fees on other RVI debt; fourth, $145.9 million in non-cash income tax benefit due to the reversal of the valuation allowance on NOLs and other merger-related tax items; fifth, a net $4.9 million charge related to two lease guarantees previously mentioned, and finally a net $20.7 million charge related to RVI’s non-controlling interest in DSW prior to the merger date.

Now that we have reviewed these items, the remainder of our discussion will refer to our adjusted results which reflect the performance of our DSW operations. We achieved very good results in the fourth quarter, capping off a strong year overall. Sales for the quarter were $513.7 million and comparable sales grew 5.6% on top of a 14.9% comp increase last year. This represents a two-year comp of 20.5%. By segment, our comps for our DSW business, which includes DSW.com, were up 5.9% and our comps for the lease business division were up 1.4%.

Our total company merchandise margin rate was 41.7% for the quarter. Given the cost pressures in the market, we were pleased to limit the reduction to 15 basis points. We also ended the fourth quarter in good shape with respect to inventory levels and merchandise mix.

On a total company basis, we achieved occupancy leverage of 50 basis points for an 11% occupancy rate for the quarter, primarily due to the increased sales. This was slightly offset by 30 basis points of deleverage in our distribution and fulfillment centers to support continued investments in our size replenishment initiatives and DSW.com business. Combined with the change in merchandise margin, gross profit was virtually flat to last year.

Our adjusted SG&A rate as a percentage of sales decreased 70 basis points to 21.1% due to leverage in store, marketing and IT expenses. This was partially offset by additional spending on preopening expense to support some of our larger new stores opening in the first half of 2012. Our strong sales growth combined with SG&A leverage resulted in a 20% increase in adjusted operating profit to $37.6 million or 7.3% of sales of the fourth quarter.

On an adjusted basis, fourth quarter 2011 net income increased 25% to $23.1 million or $0.51 per diluted share compared to adjusted net income of $18.5 million or $0.41 per diluted share in the fourth quarter of 2010. For the full year 2011, sales increased 11.1% which led to DSW reaching a milestone of $2 billion in annual sales. Comparable sales grew 8.3% on top of 13.2% comp increase in 2010, which represents a two-year comp of 21.5% and increased our top line by over $200 million for the second year in a row.

By segment, our comps for our DSW business, which includes DSW.com, were up 8.6% and our comps for the lease business division were up 5.1%. Our gross profit rate increased 130 basis points to 32.3%. We leveraged SG&A to 21.3% and our operating margin increased 150 basis points to 11%. The net result was a 25% increase in EPS to $3.00 per diluted share.

The adjusted tax rate for the full year was 39.2%. As we’ve said before, one of the benefits of the merger with RVI is that we have the ability to utilize the NOLs assumed in the merger. This cash benefit, which will be realized over the next two to three years, was recognized for P&L purposes as a one-time item in Q2.

We ended 2011 with a strong balance sheet and cash and investments totaling $430 million compared to $391 million last year, even as we returned approximately $100 million in cash to shareholders in the form of special and regular dividends and continued to invest for growth.

At year-end, inventory for DSW stores increased 2% on a cost-per-square-foot basis. We remain very pleased with the composition and level of our inventory as we begin 2012.

Capital expenditures for the fourth quarter were $21.7 million, reflecting the opening of one new store, the completion of 13 remodeled stores, and IT projects. For the year, capital expenditures totaled $76.9 million as we opened a total of 17 stores, relocated three stores, and completed the remodel of 59 stores.

Now turning to our guidance – as we did in 2011, we will continue to present our guidance on an adjusted basis. The impact of the mark to market adjustment on the warrants and one-time items will continue to be excluded from adjusted earnings; however, the minimal ongoing RVI operating expenses are included in the 2012 guidance. It is also important to note that our fiscal year 2012 retail calendar includes a 53rd week in January compared to a 52-week fiscal year for 2011.

Including this extra week for fiscal 2012, we expect annual adjusted diluted earnings per share of between $3.20 to $3.35. The midpoint of this range represents a 9% increase over our 2011 earnings of $3.00. We expect comparable sales to increase between 2% and 4% for the fiscal year. As we’d previously reported, we plan to open 35 to 40 stores in 2012. Mike will discuss our accelerated new store opening plan shortly.

While our practice has been to focus on annual guidance, we have given input on significant changes to our operating model. To that end, the following items need to be considered as you begin to model your 2012 expectations by quarter. First, we expect our comparable sales increase to be fairly consistent on a quarterly basis throughout the year. Second, we expect to incur approximately $16 million in preopening expenses in SG&A related to our accelerated store opening program. This represents an incremental investment of $10 million from 2011. Due to the anticipated timing of these openings, the increase will be incurred in the first three quarters. Third, we expect gross profit to remain very strong yet modestly lower than last year, reflecting the continuation of cost pressures that we started to experience toward the end of 2011.

As a result of these three factors and the impact of the 53rd week, we expect a majority of our earnings increase relative to 2011 to be generated in the fourth quarter. We expect capital expenditures to be approximately $120 million in 2012, related primarily to new store openings during the year. As you would expect, the acceleration in our store base this year will make a solid contribution to sales and profitability in 2013.

And with that, I’ll turn the call over to Mike.

Michael MacDonald

Thanks Doug. Good morning everyone. We posted another strong quarter at DSW, concluding an equally strong year of growth and accomplishments towards our long-term goals. Looking at the fourth quarter in particular, we increased overall sales by 10% and achieved a 5.6% comp sales increase. This was a very solid comp gain but it looks even better when you consider that it came on top of a 15% comp increase in Q4 of 2010 and a 13% increase in Q4 of 2009. Our comparable sales increase was driven by growth in both traffic count and units per transaction.

Of course, the real key to our statistical performance is the DSW formula that provides customers with a huge assortment of brands and styles, compelling values on an everyday basis, and the convenience of an assisted self-select shopping environment. With respect to category performance in the DSW segment, our comp sales performance was positive for all major categories with strongest growth in accessories and men’s footwear. Our largest category, women’s footwear, grew by 5.1% led by contemporary, evening and plain pumps. Despite unseasonably warm weather throughout much of the country, overall boot sales actually increased by 6%. Men’s, which is a strategic growth area, recorded a comp increase of 7.5%. Sales of men’s dress shoes and boots were strong. For the year, our men’s penetration grew by 70 basis points.

Athletic footwear had a 1.8% increase in the quarter led by technical and lightweight running. We were pleased with this performance considering that the toning category declined by $20 million year-over-year, or nearly 75%. Accessories, which includes handbags, small leather goods, casual hosiery and fashion accessories, grew by 16.6%. The big driver of that increase continues to be casual hosiery which includes tights, leggings, boot liners, and other fashionable leg wear. Accessories now represents 7% of our total business.

In terms of geographic performance, we continue to see relatively balanced sales growth across all regions with comps ranging from plus-4 to plus-6% in the fourth quarter. The 17 new stores we opened in 2011 are all performing quite well and most are exceeding their initial sales forecasts by a wide margin. We are pleased with the performance of the two small market stores we opened in 2011.

As announced in January, in 2012 we plan to accelerate our new store opening plan to open between 35 and 40 new stores, which compares to our long-term goal of 15 to 20 new stores per year. As we mentioned previously, this decision was really driven by opportunity. Sixteen of the incremental stores are former Borders locations which represent high-quality real estate in markets previously targeted for growth. We will also be opening or relocating stores in several high profile locations, including two in Manhattan, one in downtown Chicago, and one in San Francisco at Union Square. We are also excited to announce that we will open our first store in Puerto Rico this fall. About a quarter of our new stores will open in the first half of the year and three-quarters will open in the back half.

Let me touch briefly on the progress we continue to make on our key initiatives. First, I want to talk about sales productivity, the key driver of store profitability. For the full year, our sales per square foot totaled $243 which compares to just $196 per foot in fiscal 2008, representing a 24% increase. Many of the enhancements we’re making to our assortments, our precision marketing and our supply chain are designed to further improve our sales per square foot, and we continue to believe there is room for improvement here.

Second, we continue to drive store and online traffic with high impact marketing. We kicked the holiday season with special offers, featured items, and GWPs in both our stores and dot-com channels on Black Friday going through Cyber Monday. Simultaneously, we launched our annual gift card promotion on Black Friday and that ran through Christmas Eve. In addition, we continued our precision direct mail and email marketing to our 18 million loyalty member base. Electively, these efforts led to increased sales at higher margins. We also increased awareness of the DSW brand and increased customer satisfaction scores.

Third, we advanced our systems initiatives in 2011. In February 2011, we implemented our Shoephoria stock locator system that allows in-store customers to shop and buy products from DSW.com when it’s not available in their store. In June, we introduced our mobile website which makes it easier for customers to shop, check rewards balances, and find nearby stores from their Smartphones or tablets. Mobile devices now account for 7% of DSW.com demand. At the beginning of the fall season, we introduced kids’ shoes onDSW.com.

Fourth, we significantly expanded our private brand penetration. In 2011, private brands represented 10% of total sales, up from 7% in 2010. Fifth, we continued to upgrade the physical appearance of our stores through remodels, refreshes, and clearance wall removals. In 2011, we touched a total of 59 existing stores and we relocated another three stores.

Turning to our ecommerce business, we achieved solid results in the fourth quarter. Our cyber weekend promotion served to spread sales over multiple days at an improved profitability at the same time. I was pleased with the performance of our systems and our service to the customer over that important weekend.

Our lease business division recorded a 1.4% comp increase in the fourth quarter. I should mention that none of the Filene’s Basement liquidation sales were included in these comp results. This represents the ninth consecutive quarter of positive comps for the lease division.

Finally on February 29, our Board approved the Company’s third quarterly dividend of $0.15 a share. We’re pleased to be able to return value to our shareholders.

This concludes a very strong year for our company in which we grew our sales by 11%. Our adjusted operating income rate grew to 11% of sales and our adjusted EPS grew by 25%. We also enhanced shareholder value through the completion of our merger with RVI. Our business generated strong cash flow and we returned cash to our shareholders in the form of both a special dividend and regular quarterly dividends.

As we begin 2012, we’ve identified a number of important objectives we’ve set for ourselves that we expect will enhance our performance in 2012 and beyond. Here’s a few of those objectives: first, successfully opening 35 to 40 new stores, including eight small market stores; second, implementing our size optimization system in Q2 which will help us to allocate footwear by size by store more effectively, thus helping us to increase conversion and drive incremental sales; third, increasing the capacity of our distribution and fulfillment centers and improving efficiency; fourth, implementing a drop-ship capability for our DSW.com channel to allow us to extend our assortment without increasing our inventory investment; fifth, automating our CRM processes for customer selection based on behaviors, which we expect will further enhance customer loyalty and store and online visits. And as you can imagine, we have a number of additional objectives.

We have accomplished a lot but much more lies ahead. We look forward to another year of profitable growth in 2012.

With that, I’ll turn the call back over to the Operator to open the lines for questions.

Question and Answer Session

Operator

Thank you, Mr. MacDonald. We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster.

And our first question will come from Steve Marotta of CL King & Associates. Please go ahead.

Steve Marotta – CL King & Associates

Good morning, guys. Congratulations on a great quarter. Couple of quick questions – as it relates specifically to the Borders stores, is there economic benefit that’s above and beyond normal; in other words, are there rents per square foot that are a little bit lower, are the build-out costs a little bit lower? Can you talk a little bit about any economic benefit above and beyond?

Michael MacDonald

Sure, it kind of varies on a by-location basis. What I’d say is some rents are high, but we’re think they’re justified on the basis on projected sales productivity such that the real estate cost as a percentage of sales is probably in line with our average today. What I can also tell you is we subjected these stores to the same financial return requirements as any other location, so I would not characterize them as being—on the basis of real estate, being either exceptionally good or exceptionally weak. They are in line with our store return requirements.

Steve Marotta – CL King & Associates

Terrific. And Doug, on the COGS line as it relates to the distribution center, when will that act as a tailwind? Is there an inflection point this year where, again, leverage from a basis point becomes a tailwind as opposed to a headwind?

Douglas Probst

Yeah, I think we’re reaching the top of that plateau. Again, a lot depends on the growth rate of the dot-com business, but certainly the investments that we’re making in that fulfillment center, 2011 into 2012, that will start to bring it down in future years. But I think we wouldn’t see it getting back too much farther, but I would say it would be a contributor to our operating income rate moving forward into 2013.

Steve Marotta – CL King & Associates

Terrific. One last question – I know you guys are normally reticent to speak about quarter-to-date, but in the totality of your product mix, I have to imagine that the unseasonably warm weather is more helpful to first quarter than less.

Michael MacDonald

Well, you kind of teed up our answer for us in the beginning of your question, but to your point of warm weather, we’ve said before and we’ve always said we look at the whole March-April period combined, but certainly warmer weather early gives us good checkouts in all areas of the country, and that helps us make inventory adjustments as necessary. But again, we have to get through the whole March-April period before we extrapolate anything.

Steve Marotta – CL King & Associates

Excellent. Thank you again.

Operator

Our next question will come from David Mann of Johnson Rice. Please go ahead.

David Mann – Johnson Rice

Yes, good morning. Congratulations on a great year. Can you talk a little bit more about the cost pressures that you saw in the fourth quarter, what you’re seeing in the first quarter, and what perhaps you’re seeing on product that you’re buying now as it pertains to later in the year?

Michael MacDonald

Sure. In the fourth quarter, we experienced cost inflation overall of about 5%, and if you look at our on-order position for spring right now, it’s pretty much in line with that 5%. We really have not placed significant orders beyond first half of the year, and I’d be hesitant to quote anything in the way of inflation and on cost in the back half. Like you, we’ve heard that cost pressure will begin to soften as we move through the fall season, but we don’t really have any empirical data to confirm that right now. So right now, we’re looking at about 5%.

David Mann – Johnson Rice

And I think on the last call, you talked about both private label and perhaps taking some price where you could as options to mitigating some of these pressures. Can you just give us your post mortem on how that worked for you?

Michael MacDonald

Well, private brand was a big help. We obviously almost increased our penetration by 50% from 7 to 10% in 2011, so that was a big deal because of course it carries several hundred basis points of margin advantage with it – private brand, that is. We continue to work very closely with our branded partners and also with our direct factory partners to make certain that they have as much knowledge about our buying and our production needs as they have, because when they have that forward knowledge they can schedule production at times that are opportunistic for them and therefore can pass along better savings to us.

So all of the things—and I guess I should say that all of our systems initiatives, in one way or another, served to offset cost pressures because the systems are about getting the right product in the right location at the right time, which helps us avoid missed sales but also avoid inventory imbalances which can lead to markdowns. That is always an underlying mitigator to cost pressures, so all of the same things that we have been relying on to help us offset cost pressures will continue to be at play as we move out of ’11 into ’12.

David Mann – Johnson Rice

Great, thank you.

Operator

Our next question will come from Scott Krasik of BB&T Capital. Please go ahead, sir.

Scott Krasik – BB&T Capital

Hi, thanks, and congratulations as well. Doug, can you break down that merch margin a little bit more? I think last quarter, the 130 basis point gross margin, you actually quantified the benefit from private label and some of the other moving parts.

Douglas Probst

I don’t believe we necessarily broke that out. I think Mike did a nice job summarizing the offsetting benefits to those cost increases, but I don’t know whether breaking it down, we have that capability of knowing exactly how much was contributed by size replenishment or effective marketing—precision marketing, or things like that. So I think the biggest contributor perhaps to mitigating that downside from the cost pressures was the private brand penetration. It was three percentage points for the year, and that was certainly seen in the fourth quarter as well, and the mix of that private brand being more of our in-house brands also helped us as well. But as far as a specific basis point breakdown, I don’t have that available.

Scott Krasik – BB&T Capital

Well I guess, then, if you looked at the third quarter, I think you had low single digit cost pressure but you were still able to grow merch margins 130 BPs. So with slightly greater cost pressure, what was the biggest – was it promotions? Did you have to clear more boots because of the warm weather? What was the big driver of down 15 versus up 130 when the cost pressures were similar?

Douglas Probst

Well, the cost pressures – I like to characterize them really started affecting us in the last fourth months of the year, so I think the cost pressures were a lot different between the third quarter and the fourth quarter, and then you really have to go back another year to the comparisons of what we did in the third quarter of 2010 to really get a perspective of that performance. So we are not disappointed with our fourth quarter merchandise margin rate; in fact, we’re pleased with it, particularly with the timing of those cost increases. So we think it was a good performance.

Scott Krasik – BB&T Capital

Okay. And then just as we think about your comment that expect gross margins to be down slightly in 2012, maybe just help us understand the components of that a little. You said distribution costs would start to flatten out, but--?

Douglas Probst

Yeah, I think it’s helpful to remember that in 2010, we had a 31% gross profit rate. In 2011, that jumped 130 basis points to 32.3. That’s beyond even our expectations for 2015 in our long-range model, so it was a very high gross profit rate in 2011 and have a little bit of contraction on that – you know, it’s probably going to stay closer to that 32. That’s a pretty good gross profit rate for this business. The components in 2012 will have leverage in occupancy. We can leverage occupancy at those comp expectations, but we have to be realistic about our merchandise margin rate because those cost pressures will be with us for a full year versus just four months in 2011.

Scott Krasik – BB&T Capital

Okay, that’s fair. And then just lastly, you’re opening some expensive stores in 2012 between the New York stores and Chicago and Union Square in San Francisco. In 2013, have you contemplated any big-city stores, or will the stores more look like the average store base?

Michael MacDonald

They’re going to look more like the average store base in 2013.

Scott Krasik – BB&T Capital

Okay. All right, great. Thanks. Congratulations.

Operator

Our next question will come from Mark Montagna of Avondale Partners. Please go ahead.

Mark Montagna – Avondale Partners

Hi, good morning. A couple questions just looking out further to the fall – you know, for spring there is obviously a huge emphasis on color. I’m wondering if you’re expecting a similar emphasis for the fall on color but obviously not quite as bright.

Michael MacDonald

I’m not sure I can comment on color for fall. What I can comment on is the boot classification appears to have a lot of newness to it, based on preliminary looks from our merchants; and there is also some silhouettes within the boot category that appear to be becoming more important. The one that comes to mind is Western. So boots is a big driver of our total women’s category in fall, and it’s always a function of newness as to how robust that category can grow. I am encouraged by the merchants who come back from market and say there does appear to be a lot of newness, which gives our customers a reason to buy.

Mark Montagna – Avondale Partners

Okay. And then what about private brand penetration for this year – do you have a targeted range, like 12%, or can you just kind of talk about that?

Michael MacDonald

Sure. I think our long-range target for private brand is 15%. We’re currently at 10. It’s probably going to take us three or four years to get there, which says about a point a year. So if you were modeling, I’d model it at 11%.

Mark Montagna – Avondale Partners

Okay. And then talking about the new stores, you gave us some good direction on somewhat of the flow of the new stores; but can you be more specific and guide us as to how many new stores each of the first three quarters, or even the fourth quarter if you happened to open one in the fourth quarter?

Michael MacDonald

Well, it’s like I said. It’s almost exactly 25% in the first half, and 75% in the second half. You know, they fall into the March-April time period almost exclusively, and then into the August-September time period in fall.

Douglas Probst

We don’t expect—a couple stores could slide into the fourth quarter, but as of now we’re not expecting to open any in the fourth quarter this year. We like to see openings in the first and third quarters when we can. That’s the window we’ve created, but a couple times we make exceptions. But there’s none planned for Q4.

Mark Montagna – Avondale Partners

Okay. So with that, when we look at the preopening expenses hitting SG&A, would the majority of the third quarter store openings with those preopening expenses, would the majority fall into the second quarter or into the third quarter?

Douglas Probst

I think some into the second and some into the third, and I would say that increase is pretty evenly split between the first three quarters. That incremental 10 million is probably evenly split into the first three quarters.

Mark Montagna – Avondale Partners

Okay, that sounds great. Thank you.

Operator

Our next question will come from Chris Svezia of Susquehanna Financial. Please go ahead.

Chris Svezia – Susquehanna Financial

Good morning everyone. Question for you, Mike, on size optimization. I think previously you were talking about that opening up towards the end of the first quarter. Now it looks like second quarter. Any thoughts as to how you’re thinking about that and the impact for 2012 to either comp margin, or is that really more of a 2013 potential benefit to comp and margin for DSW?

Michael MacDonald

Yeah, it’s a good question, Chris. The system is actually up and working right now. What it’s doing, though, is it’s essentially accumulating data on size demand by location. We won’t begin to actually place orders utilizing that knowledge until Q2, and really most of those orders won’t start to hit until Q4. So the benefit is really going to be Q4 only in 2012, and as you say, most of it happening in the following year. But we’re beginning to accumulate the knowledge right now, and I won’t say there’s no benefit before Q4 because goods that are in the distribution center awaiting allocation in Q2 and Q3, some of those we can be more precise about how we allocate that product by size, by store. But for modeling purposes, I’d assume most of the benefit begins in Q4.

Chris Svezia – Susquehanna Financial

Okay, helpful. Thank you. And then on the athletic business, when do you guys—I know you’re making a big push on the technical athletic piece of the business, higher price points. When do you start to lap the headwind in toning – is it fair to say in Q1 for the most part, toning doesn’t have that much of an impact, if at all, from a comparison perspective? Just maybe talk about that.

Michael MacDonald

Yeah, I think in 2010, toning represented about 13 or 14% of our total athletic business. In 2011, it still represented a little over 3% of our business, so there is a continuing ongoing toning business but—and I don’t know what it is, whether it’s call it 1 or 2% of our total athletic right now. I think that’s probably fair, so you might over the course of the year be dropping 1 or 2% in terms of penetration to total year-over-year.

Chris Svezia – Susquehanna Financial

Okay, but as the athletic business—as you start to move to more technical, higher price point product, that should help drive comp because the toning is lower price points and becoming a smaller piece of the business. Is that—so the comp sequentially improved Q3, Q4 in that category. I’m just trying to get a sense—you seem to be rounding the corner in that category. Does that logically make sense?

Michael MacDonald

Yeah, it does. Remember when we were in 2010, the toning AURs were higher than average, and then gradually as we went through ’11, the AURs came down; and as we converted it to clearance, they became lower than average. So that’s the historical AUR story. In terms of technical, it’s been almost the exact opposite and that’s why it’s been nice to see the comps come back. I mean, I think technical, which we define as being $75 or more compare at price, I think it went from 18% of athletic in 2010 to 25% in 2011, and we fully expect it to be 30% in 2012. So as that ramps up and the negative impact of toning declines, yeah, I think it’s fair that the comps should accelerate.

Chris Svezia – Susquehanna Financial

Okay. And Doug, a question for you – when you talk about the majority of your earnings growth is towards the second half, and particularly towards that fourth quarter, is there any particular quarter where you would expect earnings to decline? I know you don’t want to give specific guidance on a quarter, but any thoughts to that, if you can answer it?

Douglas Probst

We’re very uncomfortable with having any quarter be less than last year, but fair question. I think the highest pressure would be in the second quarter, given that it’s a lower volume period, we have preopening expenses, those kind of things. That would be the one pressure that we’d have the most pressure to that challenge; but again, that wouldn’t be acceptable for us.

Chris Svezia – Susquehanna Financial

Okay. And the last question I have is just on the kids’ business – any update how you like it, what’s been going on, what you’ve learned? Any thoughts about that on dot-com?

Michael MacDonald

Sure. Well, we were pleased with the first season’s performance of kids on dot-com. It represented about 1.4% of our sales on dot-com in the fall season with some ramp-up period. We’re planning it to increase to 2% of dot-com in 2012, and one of the things that I think will accelerate that business is just understanding who’s buying it, and developing a customer base to whom we can market. We really haven’t had that kind of database yet, just because it takes time to learn how is buying your kids’ shoes. So as we move closer to Easter, we’ll be contacting those customers more directly and I think our history proves that the sales respond pretty directly.

Chris Svezia – Susquehanna Financial

Okay. Well, thank you very much and all the best. Congratulations.

Operator

Our next question will come from Jeff VanSinderen of B. Riley. Please go ahead.

Jeff VanSinderen – B. Riley & Co.

Good morning. I’ll add my congratulations. Any regional differences to note in terms of your spring business so far?

Michael MacDonald

We don’t comment intra-quarter on business at all, so I’m sorry; but as I mentioned, the business in Q4 and really for the year was pretty even across the country. I think the low was 4% comps and the high was 6 and change, so it’s a pretty tight range. I would expect that going forward, but I can’t comment specifically on how it’s moving right now.

Jeff VanSinderen – B. Riley & Co.

Okay. And then I know it’s really early, but relevant to the boot business and looking out to second half, could colder weather be an opportunity in boots in second half for you this year? Let’s just say it is more normal, seasonable weather – do you see that as an opportunity, or do you feel like you’re just more in fashion boots and that’s not so much of an opportunity?

Michael MacDonald

Well let me just comment on what happened in the fourth quarter, because it was really interesting. I think our women’s business in total was up about 5% in Q4, and our total women’s boot business was up about 6% in the fourth quarter. So we actually—in warm weather, some of the warmest weather we’ve ever seen, we actually had an increase in our penetration of the boot business to total women’s. Having said that, the mix within the boot category changed very dramatically. In Q4, we were down something like 27 or 28% in the cold weather category, and it was really offset by more fashion boot business. So—and the other thing you need to remember, Jeff, is that our cold weather boots only represent about 15% of our total boot business in Q4. So I guess what I’d say is that we’ve proven an ability to withstand pretty dramatic weather changes and to offset large declines in weather sensitive categories with more robust gains in fashion-related items. So even if we were to have a return to normal cold weather in the back half of 2012, my sense is we’d have softer comps in fashion boots and have stronger comps in cold weather boots – kind of the converse of what we experienced in Q4 of 2011.

Jeff VanSinderen – B. Riley & Co.

Got it, okay. And then just a question on how you’re looking at cost increases. It seems like your guidance doesn’t really include any major cost pressure relief for second half, and I’m just wondering—I know it’s still early, but given what we know today or what we’re all hearing today, as you look at it on a year-over-year comparison basis, just wondering why we might not see some cost pressure relief in second half.

Michael MacDonald

Well I guess what I’d say is—I mean, in fourth quarter we had inflation on our costs, not all of which we passed along to the consumer because we’re looking at it on a style-by-style basis, and where we think we can pass it along and not injure the business, we’ll do that. Or where there is leadership exhibited by others or direction from the resources, we’ll do that. But in those situations where we think that there is some price elasticity on the item, then we want to make certain that we maintain our value proposition since it’s such a critical element of who we are as a company. It’s part of our DNA. In those cases, we’ll give up some margin in order to protect the volume, or perhaps even increase market share if others maintain their mark-up and go ahead and increase the prices. So we’re going to continue to utilize that same philosophy, that same pricing philosophy in 2012, and as I mentioned before, we’re going to continue to pursue all of the other initiatives, whether it’s systems or it’s private brand or it’s resource relationships, or it’s just the mix of product we’re selling in order to offset those modest declines in IMU that otherwise might fall to the gross margin line. Hopefully, we can come out with a flattish margin performance, as Doug said; but that’s how we’re approaching it and that’s as clear as I can be.

Jeff VanSinderen – B. Riley & Co.

Okay, fair enough. Thanks very much and good luck this quarter.

Operator

Thank you. Our next question will come from Jeff Black of Citigroup. Please go ahead.

Jeff Black – Citigroup

Thanks and congrats on a transformative year, guys. Looking out, I guess either Doug or Mike, a few years, what does the model really look like here? On the revenue line, it sounds like store growth goes back to a high single digit penetration, but what about ecommerce? Does that start getting more meaningful in your thinking? And what about an acquisition? I know you’ve talked about that in the past. Does that play out in the next couple of years? And then on the op margin, given all the stuff you’ve put in place and continue to put in place – you know, we’re at 11, I guess we’re looking at flattish this year given your guidance. But what do you think is possible as we look ’13, ’14, for the business in general? Thanks.

Michael MacDonald

Okay Jeff, I’ll take the first part of that and let Doug comment on the operating margin. You’re right- store square footage growth has spiked this year and will return to a more normal level next year. I think you’re seeing our comp sales moderate from the two consecutive years of strong double-digit growth to a more mid-single digit kind of comp growth. I think our last couple quarters’ performance is probably predictive of future comps. Dot-com continues to be the fastest growing part of our business. We are investing in it from an inventory perspective, from a technology perspective. We are investing in it from an infrastructure perspective. We’re undergoing a physical expansion of our fulfillment center right now to accommodate the growth. The one big thing that could stimulate our growth beyond that is the drop-ship capability, which is a big darn deal but it’s going to take us most of 2012 – probably all of 2012 – to develop that systemic capability and get our first partner up. But if we’re successful in doing that and we think we will, that could stimulate growth, as I say, at an accelerated pace, and the return on investment would be phenomenal because we really wouldn’t be investing in inventory to support that sales and profit growth. So I don’t see why dot-com shouldn’t continue to be a driver of our comps going forward. We continue to market to our customers on a cross-channel basis, and as we’ve said before, those cross-channel customers are worth about 2x what a single channel shopper is worth. We know that that’s the way we want to build this business, so I am very optimistic about our ability to continue to drive comps and to have the dot-com channel, even though we don’t break it out separately, to be a driver of that overall comp.

And I’ll let Doug talk about the margin prospects.

Douglas Probst

Yeah, in 2010, as you recall, we had a 9.5% operating income rate, and we kind of blew by the 10% because we finished 2011 with 11%, so the next horizon is obviously 12. I think as you see the components of that 12% in the next few years, it’s probably going to be mostly SG&A driven. Reaching 32.3% this year was a pretty good number to hit. Our long-range model didn’t anticipate to maintain that kind of margin; in fact, it was closer to 32%. Getting leverage in SG&A as we continue to grow sales, get some of these investments into our business behind us, we could see further expansion into our operating income rate; but again, most of it will come through SG&A leverage. And if some of the cost pressures start to alleviate and start going the other way, we could get some down the road expansion as well on the gross profit, maybe through occupancy or the distribution center, those kind of things. But it’s nice to know that our model doesn’t rely on gross margin or gross profit expansion at this stage of the game. So very confident and optimistic about our ability to expand our operating income rate go forward.

Jeff Black – Citigroup

Got it. And Mike, you’ve mentioned acquisitions in the past as a potential use of cash. What’s your thinking on that in the next year out?

Michael MacDonald

You know, we continue to look. We’re discriminating buyers, Jeff. We want companies that aren’t broken. We want companies that have runway ahead of them, they’re not out of growth. We want companies that aren’t going to distract us from our primary mission, which is driving this business; and we want companies that can be immediately accretive. You put all those things together and it’s a pretty tight sieve we’re putting all of these acquisitions through – I’ll admit that. But that’s what we think is appropriate for DSW right now, and I would say we continue to look.

Jeff Black – Citigroup

Fair enough. Good luck. Thanks guys.

Operator

Thank you. Our next question will come from Claire Gallacher of Auriga. Please go ahead.

Claire Gallacher – Auriga

Great, thank you. Good morning. You mentioned traffic and UPT being up in the quarter. Could you give us the AUR for the fourth quarter and talk about conversion and how that trended during the fourth quarter?

Michael MacDonald

You know, conversion was about flat in the quarter, and our AUR was down about 2%. What I would say about the AUR decline is that it was really more a function of two things, which is the big toning numbers that we were up against in Q4 of 2010, which had high AURs, and then the double-digit growth of our accessories business that has an AUR that’s about a third the size of our footwear AUR. So it was really more mix than anything else.

Claire Gallacher – Auriga

Okay. And then as the toning comparison eases as we head into 2012, would it be fair to think that the AUR could potentially go back to about flat?

Michael MacDonald

Well, it probably ought to go up a little bit in athletic, I would suspect; and beyond that, I think we continue to think accessories can grow faster than footwear, which those tend to offset.

Claire Gallacher – Auriga

Okay.

Michael MacDonald

But yeah, I think given cost pressures and higher retails on some of those items, the footwear AUR, unless we have a slowdown in demand, our AUR should go up.

Claire Gallacher – Auriga

Okay, great. And then touching on your inventory levels, they seem pretty clean here coming out of the quarter. Could you talk about the clearance inventory levels this year versus last year, how that fell out at the end of the quarter?

Michael MacDonald

Yeah, our clearance inventories, we measure it on a units per average store basis, and clearance levels overall were down slightly to the prior year at year-end.

Claire Gallacher – Auriga

Okay. And then just my last question has to do with Shoephoria and the penetration there. I don’t know how you measure it – I’m sure you do in some way – but how did it measure in the fourth quarter maybe versus the third quarter? Are you noticing more and more use of the system?

Michael MacDonald

Yeah, I’ll tell you – I don’t know that I have the penetration in Q4 specifically. I can tell you that it represents about 10% of our total dot-com business, and based on recent anecdotal information it does appear to be building somewhat. We are gaining a better understanding of the kinds of items that are being looked up at store level through the Shoephoria system, and to the extent we build that knowledge, we’re going to go deeper in terms of our on-hand quantities in support of those items. So as we build our inventories in support of items most likely to be interrogated from the Shoephoria system, it will increase our hit rate and at some point, hopefully in the not-too-distant future, our success rate on Shoephoria inquiries is going to be at a level where we can proclaim this system capability to our customers. Today, if you go into our stores, you’ll notice no signing of the Shoephoria system. The only way the customer knows that we can look it up is through our associates who are interacting with those customers and responding to their questions, but we don’t actually market it to the customer yet; and the reason is because our hit rate isn’t at a level where we want to do that just yet. But I think in the not-too-distant future we’ll be at that level and then we can implement some appropriate signing, and I think at that point it could become an even more significant contributor. It’s definitely helping us serve the customer better, that’s for sure.

Claire Gallacher – Auriga

And do you think that it’s possible to have that signage and whatnot in 2012? Do you think it will happen in this next year?

Michael MacDonald

Yes, I do.

Claire Gallacher – Auriga

Okay, great. All right, well thanks and best of luck.

Michael MacDonald

Thank you.

Operator

Thank you. Our final question this morning will come from Patrick McKeever of MKM Partners. Please go ahead.

Patrick McKeever – MKM Partners

Thanks. Good morning everyone. Any update on adding another leased business partner to replace Filene’s Basement? I was just wondering where that ranks in the priority list, and how many logical partners are out there in that area? Where does the leased business model work best, and do you have that same immediately accretive hurdle that you were talking about with any potential acquisition in adding another leased business partner?

Douglas Probst

Sure, good questions. First of all, the closing of Filene’s Basement didn’t accelerate or increase our efforts to try to land a new lease partner. Fortunately, that was one of the smaller businesses and from a profitability standpoint, it was even smaller because of the terms of that arrangement. So that didn’t accelerate our effort. We have been talking to many people. The range of interest is from people that currently have shoe departments and others that don’t, so we’re looking at a lot of different places. Certainly we want to make partnership with people that are genuinely healthy and have an idea that shoes could be a driver of their total business overall. We have a lot of services now. As we get bigger, people recognize that we could help them on a number of fronts, so we’re kind of broadening our tool set for offering to new businesses. And again, we’re hopeful but again our business model doesn’t expect us to have one certainly in 2012, so we’ll keep on with that effort throughout the year.

Michael MacDonald

And in terms of hurdles, it’s pretty simple because the biggest investment you have with a new lease partner is just the inventory.

Patrick McKeever – MKM Partners

Right, okay. And then on DSW.com, you said that’s the fastest growing area of the business right now. How big can that be, do you think, at some point maybe five years down the road in terms of total dollar sales, and just generally speaking what are the economics of ecommerce versus the store level economics? Are they ultimately better, are they comparable, or are they not quite as good? Thanks.

Michael MacDonald

Okay, in terms of penetration, again we’re so paranoid about splitting out dot-com just because the way we approach it is from a multi-channel perspective. That’s how we communicate to our customer. We actually encourage them to buy online and return in the stores, and so there’s a blurring of the lines that separate store business from dot-com business. But I think other brick-and-mortar retailers, you know, 10% penetration is sort of a bright line, but the customer is changing the way they shop and who knows how big it can be? The fact that we just fired up mobile last year and already it’s representing—mobile devices are representing 7% of our demand on dot-com is kind of indicative of just how fast customers are changing their shopping behavior. So 10% may be a low number five years from now – not really sure.

In terms of the operating characteristics – Doug, you want to talk about that?

Douglas Probst

Yeah, we have that discussion quite frequently in here. The incremental sale of an additional pair of shoes would be more profitable coming out of the store because there’s no variable expense. An incremental sale on dot-com comes with it shipping expenses, et cetera. Overall though, it’s a very large contributor to our operating profit and will continue to be as we get more sales to cover some of the fixed expenses and we get more efficient at our fulfillment center. So to Mike’s point, the customer looks at it as one channel and that’s DSW, and you can get that in-store and online; so we really don’t even break it out on a P&L basis, but we certainly know the margin contribution that each channel brings and from an expense basis, we manage that from a total DSW segment. We’re pretty confident both are contributing to our bottom line profitability.

Patrick McKeever – MKM Partners

Great. Thanks, Doug. Thank you, Mike.

Operator

And ladies and gentlemen, that will conclude our question and answer session. I would like to turn the conference back over to management for any closing comments.

Michael MacDonald

Sure. Thanks very much, Operator, and thanks to all of you who have tuned in this morning. We genuinely appreciate your interest, your support, and I believe Doug and Jenny will be available for calls later today. So thanks again. Have a great day.

Operator

Ladies and gentlemen, the conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.

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