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Executives

Millard S. Drexler – Chairman of the Board & Chief Executive Officer

James Scully – Chief Financial Officer & Executive Vice President

Analysts

Paul Lejuez – Credit Suisse

Dana Cohen – Banc of America Securities, LLC

Margaret Mager - Goldman Sachs & Company

Roxanne Meyer – CIBC World Markets

John Morris - Wachovia Securities

Kimberly Greenberger, CFA – Citigroup

Jeff Black – Lehman Brothers, Inc.

Evren Dogan Kopelman – JP Morgan

Randy Konik - Bear, Stearns & Co., Inc.

Dana Telsey - Telsey Advisory Group

J. Crew, Inc. (JCG) Q3 2007 Earnings Call November 29, 2007 4:30 PM ET

Operator

Good afternoon. My name is Mary and I will be your conference operator today. At this time I would like to welcome everyone to the J. Crew Third Quarter and First Nine Months Earnings Conference Call. (Operator Instructions) It is now my pleasure to turn the floor over to your host Ms. Allison Malkin of ICR. Ma’am you may begin

Allison Malkin - ICR

Thank you and good afternoon. Before we get started I would like to remind you of the company’s safe harbor language which I’m sure you’re all familiar with. The statements contained in this conference call which are not historical facts may be deemed to constitute forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company’s filings with the SEC. With respect to each reference we make on this call to adjusted net income a reconciliation of net income on a GAAP basis to adjust the net income has been provided in Exhibit 3 in today’s Earnings Release and in Exhibit 3 of our Earnings Release issued on November 21, 2006 which are available on our website. And now, I’d like to turn the call over to J. Crew’s Chairman and CEO Millard Drexler.

Millard S. Drexler

Thank you. Hi everyone and thanks for joining us to talk about our third quarter and nine months results. Jim Scully our CFO is with me along with other senior partners at our company and following my remarks, I’ll turn the call over to Jim to review financial highlights and update our outlook and then, of course, we’ll do questions.

We continue to experience strong performance in the third quarter driven by our commitment to quality, style and design of our goods and to satisfying our customers. We remain focused and always will be focused on driving long term quality earnings growth through efficiency in the way we invest both our money and our time in the right product and in the right people. In the third quarter revenues increased 21% to $333 Million with a 5% increase in comp store sales on a real line basis and a 36% direct sales increase. This strong revenue increase coupled with SG&A leverage drove a 44% increase in operating income to $48 Million with our operating margin increasing over 2 points to 14.3%. As we said on our call a year ago we wanted to be the best, not the biggest. We started out, we strategically decided by raising the bar by investing in quality style and design and we’re seeing nice returns from these investments. We have said and continue to believe strongly that the only way to rise above the crowd and build a powerful franchise for the future is to continue to stand for the quality business we are in.

We continue to push the productivity in our stores with sales per square foot increasing 10% to $561 a square foot from last years $510. We’re constantly asking ourselves what we can do better to drive out productivity and maximize every square inch in our stores. During the quarter we opened 18 new stores, nine retail, seven factor, one Crewcuts and one Madewell. As I said before, we want to be the best and not the biggest and the way we tailor each of our new stores in both size an offering to each market speaks to this. We expect to open a total of seven stores in the fourth quarter and close one which will achieve our goal of 34 net new stores and square footage growth of 10%.

Our direct business continued to exceed our expectations with a 36% sales increase in the third quarter. Our founding DNA is, in fact, the catalog and direct business with, of course, online coming on board when the online business started. You can not separate online and store businesses today. More and more people are comfortable shopping online, we manage the entire business as one seamless business as far as our customers are concerned. We have strategically invested in this online business and catalog business. We’ve invested in maximizing our customer file, we’re adding and testing new products always with about 1/3 of our product assortment unique to our direct business and upgrading our website with more to come.

We continue to be pleased with our Crewcuts’ business. Our customer love our mini J. Crew assortment in the same great style, quality and design. We operate four stand alone locations and 41 shopping shops as well as our online Crewcuts business. During the third quarter we opened one Madewell location in Natick Mall Massachusetts. We’re very excited to have opened a temporary store in Manhattan early this month, last Tuesday to be exact, while we are building our permanent store to open up at the end of January. Madewell remains R&D and the team continues to fine tune the business and please, if you get a chance, visit our temporary store at 532 Broadway and let us know what you think. I want to turn the call over to Jim now to review the third quarter financials and the outlook in more detail.

James Scully

Thanks Mickey. Turning to the details. Total revenues increased 21% in the third quarter to $333 Million. Our stores sales which include our factory, retail, Crewcut and Madewell stores increased 16% to $234 Million driven by a 5% increase in comp stores sales on a reline basis and a 6% increase in net square footage. Sales in our direct business continue to exceed our expectations increasing 36% to $90 Million. Internet sales represented 79% of our direct business versus 71% last year reflecting the ongoing shift of orders to the Internet from the phone. As we previously discussed, our direct business continues to experience lower return rates. The components of our direct business increase included 25% increase in gross sales as compared to last year and 11% increase due to lower return rates which is a result of two factors: the actual return rate in the third quarter declined 150 basis points as compared to the prior year which is a result of improvements in fit and quality as well as an increase in the penetration of lower returning categories. In addition, net sales in the third quarter of last year included an estimated amount of returns based on historical rates in excess of our actual returns of approximately $4.5 Million. The net impact of this excess amount was included in gross profit.

Gross profit dollars for the third quarter increased 19% to $152 Million. Gross margin for the quarter was 45.6% down 80 basis points from the reported third quarter last year. The 80 basis points decline in gross margin was driven by a 90 basis point decline in merchandise margin, partially offset by a 10 basis points in buying occupancy leverage. As I had just mentioned the net impact of $4.5 Million in estimated returns in excess of actual returns was included in last year’s gross profit. However, in this year’s third quarter net sales actually reflect actual returns. On a comparable basis, assuming that last year’s third quarter direct net sales were adjusted for actual returns, this year’s gross margin was relatively flat. This is calculated by increasing last year’s sales with no impact to gross profit dollars thus, reducing last year’s gross margin.

SG&A expenses for the third quarter were $104 Million or 31.3% of total revenues versus 34.4% last year. We are pleased to generate 310 basis points improvement in SG&A driven in large part by higher than anticipated direct sales while absorbing higher costs associated with funding Crewcuts and Madewell, as well as opening 29 net new stores. Strong top line growth coupled with solid SG&A leverage lead to a 44 point increase in operating income to $48 Million and 230 basis points of operating margin expansion. We were able to achieve this increase while absorbing approximately $3 Million in operating losses related to Madewell. We now anticipate the full year impact of Madwell’s loss at approximately $10 Million which includes the expenses associated with opening a New York temporary store in time for the holiday season.

Net interest expense for the third quarter total $3 Million and compares to net interest expense of $5 Million in the third quarter of last year. The decline in interest expense reflects our lower average outstanding debt. Income before income taxes for the third quarter increased 59% to $45 Million as compared to $28 Million in the third quarter last year. This increase was driven by our growth in operating income and reduction in interest expense. The resulting net income available to common stock holders was $27 Million or $0.42 per share as compared to $26 Million or $0.40 per diluted share in the third quarter last year. Note that the current year period reflects an effective tax rate of 39.8% as comparison effective tax rate of 7.1% in the third quarter last year. On an adjusted basis assuming the IPO occurred at the beginning of fiscal 2006 and an effective tax rate of 38.6 net income in the third quarter of last year totaled $17 Million or $0.27 per share.

For the first nine months total revenues increased 19% to $935 Million with comparable store sales on a realigned basis increasing 6% and direct sales increasing 29%. Gross profit margin increased 70 basis points to 45.3%. We experienced 190 basis points in SG&A leverage driving a 46% increase in operating income and a 260 basis point increase in operating margins to 13.8%.

Turning to the key balance sheet highlights, we ended the quarter with cash and cash equivalents totaling approximately $64 Million. In addition, we reduced our debt by an additional $50 Million in September, ending the third quarter with total debt of $125 Million down from $250 Million at the end of the third quarter last year.

Inventory at quarter end was $211 Million an increase of 21% over the prior year and represents a 13% increase on a per square foot basis. As we previously discussed the 53 week in fiscal 2006 causes each quarter in 2007 to begin and end one week later resulting in non comparable point-in-time inventory increase. We estimate approximately $15 Million of our third quarter ending inventory is a result of this shift. Excluding this $15 Million our ending inventory increased 12% over last year and 5% on a per square foot basis. Even with the non comparable point-in-time inventory, at the end of both the second and third quarter our average inventory for the third quarter increased 19% to last year versus our 21% revenue increase. We remain pleased with the level and the composition of our inventory as we enter the fourth quarter. Capital expenditures for the third quarter were $27 Million. For the year we now expect capital expenditures to be approximately $75.

Turning to the outlook. On an annual basis we continue to expect comp stores sales growth in the mid single digit range, direct sales growth in the high single digits, net square footage expansion in the 7-9% range and diluted EPS growth in excess of 20%. Based on our better than expected third quarter results we are increasing our full year earnings guidance range to a $1.50-$1.52 per share from our previous guidance of $1.42-$1.46. Our annual earnings guidance continues to reflect 38 new store openings, an effective tax rate of 39.8% and approximately 64 Million shares outstanding for the full year.

For the fourth quarter we are introducing earnings guidance of $0.37-$0.39 per share which is modestly higher than the implied fourth quarter guidance of $0.36-$0.38 given during our second quarter earnings call and compares to adjusted earnings per share of $0.33 in last year’s fourth quarter.

We’ve decided to provide fourth quarter revenue guidance for two primary reasons. First, due to the non comparability of this year’s fourth quarter period to last year and secondly, we have noticed that some of the current models appear to be using a realigned comp store sales estimate versus an actual comp to calculate total sales. With respect to non comparability and revenues to last year there are two items to keep in mind. Last year’s fourth quarter included 14 weeks versus 13 weeks this year. The extra week to the fourth quarter last year added approximately $13 Million to the fourth quarter in 2006 and added less than a penny to our adjusted fourth quarter earnings last year. The fourth quarter this year is also impacted by the one week shift in the calendar created by the 53rd week last year. Realigning last year’s calendar to this year would have the affect of reducing last year’s fourth quarter revenues by $11 Million. Assuming a normalized flow through this $11 Million reduction in last year’s fourth quarter sales would have the impact of reducing last year’s fourth quarter earnings per share by $0.03-$0.04.

Our fourth quarter guidance is based on 2007 revenues in the range of $390-$396 Million dollars. This estimated range includes the following assumptions which are consistent with our previous annual guidance. A mid single digit increase in comp stores sales on a realigned basis which compares to a 7% increase last year. A high single digit increase on direct sales on a comparable 13 week basis which compares to a 38% increase for the 13 week period last year and the opening of 34 net new stores since the fourth quarter last year. And now, I’ll turn the call back to Mickey.

Millard S. Drexler

Thanks Jim. As we move in to the key holiday season we’ll continue to push the envelope in terms of our quality, style and design and do the best we can for our customers. In this business, we’re learning from our customers everyday and constantly challenging ourselves to do better for them. And now, we’re ready for questions.

Question-and-Answer Session

Operator

Certainly sir. At this time I’d like to remind everyone if you would like to pose a question, please press star and then the number one on your telephone key pad. And, to allow all parties to ask questions, please limit yourself to one question and one follow up. You will be able to rejoin the queue to ask further questions. We’ll pause for just a moment to compile the Q&A roster. And our first question comes from Paul Lejuez from Credit Suisse. Please go ahead.

Paul Lejuez – Credit Suisse

Hey guys, Paul Lejuez. Really impressive direct growth. I’m just wondering what’s driving that from a category perspective? Has the kid’s business contributed to that strength and given the strengths in direct. I believe that’s your highest margin business. Does it change how you think about how high operating margins can go? Then just second, wondering if you have any reads on the giftable items to what extent that might be driving an incremental customer to the store.

Millard S. Drexler

Well, first of all in terms of what’s driving the online and direct business, I might sound like a broken record but, from the day the holiday season ended last year 2006 holiday season, we critiqued, we went through and we looked at what customers are in fact looking for. Now, this is really third quarter continuing into fourth quarter but, over 1/3 of our product in our catalog and online is not available is in our stores. So, that’s critical to know and it drives a lot more customers there.

Our customer file is growing. As we said, in the past we invested in some experts who understand that business a lot better than we had prior to their joining us and up until a year or two ago our customer file was not growing. So, we’ve been able to invest in new customers, develop more repeat customers and so we’re really pleased about that. Certainly, Crewcuts is adding to that number because it’s a brand new business and growing nicely. But, in terms of the product, it’s pretty much across the board and the things we are pretty well known and famous for, things like lower priced knit shirts might not be the biggest business online but, in fact, the rest of the assortment including our J. Crew Collection has been very, very successful. So, that’s where we are.

Of course, we have a big cashmere business, we have a very healthy sweater business and a better fashion women’s knits business, men’s cashmere, our jacket business. So, generally speaking it is across the board. Most importantly, most importantly as we look at this it is not what’s driving it even in the third quarter, it’s what the overall long term is for our opportunity online and I will also say really other critical differentiation is our catalog because, our catalog, if you’ve noticed, over the last three or four issues is being shot in different places. It’s being shot with much more emotional connection to the places its been shot. We very much are strategically positioning the catalog to connect more and more with a feeling from what our customer’s mindset is.

So, I think it’s a lot of things driving up those and frankly, our strategy to play at a level in America where we think the customer is moving too along with us, quality and style and I repeat, quality and style keeps us, I think, at the forefront. So, that’s where we work very hard to accomplish and I’ve always said, you know, we don’t want to be in the price business and as I look at the world today there are some great price players out there on basics, on commodities and we move away from that, we move into color, detail, style, our kids offerings are very unique and different and that’s really our reason for being. So, that’s kind of a long answer for that but, I think its all of that. Plus, our email strategy, in addition, is working very nicely in terms of communicating and connecting to our customers so, that’s certainly helped our online business also.

Lastly, I forgot to mention, the affiliates Google, etcetera, we’ve stepped up our investment in that because we think the times right for us to be aggressive about, in a reasonably tough competitive environment and tough market for what we’ve seen over the last few weeks, to really step it up and be more out there visa vi where we’ve been before. We have something to talk about. It’s our product, it’s our service, it’s our and we’re really talking more about it through our affiliates also.

Paul Lejuez – Credit Suisse

How does that 1/3 unique product, how has that changed versus last year and where can that go and then again, on the giftable items any read there?

Millard S. Drexler

Well, the giftable, the 1/3 versus last year and, you know, in this business again, you’re kind of always moving forward sharpening the edge, if you look at that you’ll see a lot more color. The catalog actually, if you compare it, I think, you know, as any typical merchant will say they love the goods but, we look at this year’s catalog visa vi last year and every time we sent one out we said, “Gee, last year’s looked dull.” I don’t know if I’m going to say the same thing next year but, I think the setting, the environment, the styling the catalog, if you notice, there’s a lot of color combinations in there that we think is very exciting and creative and most importantly, again, it’s consistently driving a certain point of view and image and having a woman and a man feel very comfortable about saying, “I could look like that.” And frankly, not having to mortgage their house to buy our clothes. You know, the Euro issue is an interesting one. We buy a lot of fabric in Italy so, we don’t like that but, frankly, we kind of like it because it drives more and more designer customers to our doors, and to our catalog and to online because, at the end of the day we think a lot of people who can afford it don’t want to spend that much money dealing with the currency exchange and paying that much more for designer goods. So, I think it’s all part and parcel. There are so many moving parts here but, I think from an overview strategic point of view that all plays into why our direct business is growing.

Giftable items we’ve segmented now, it’s early for holiday. Rosh Hashanah, wrong holiday, Chanukah this – you know what happens, Chanukah is this coming week and the reason really starts to kick off post Thanksgiving. We’ve sectored and segmented holiday items by price. We have a new gift book. Like I said last year, December 26 we started to critique, “How does the customer shop?” We’ll report more once we’re through the holiday season. We set up in seven stores a gift card kiosk to hopefully speed up the lines and kind of last minute, if you have two minutes to shop, don’t wait on a long line which we hope happens again, good news/bad news, we have kiosks in seven stores we’re testing. This season the stores have a much, I think, more exciting, more colorful assortment of accessories that we’ve ever had and giftable items and we keep working on it and trust me any merchant worth anything is still saying, “You’ve got to keep cutting back assortments.” And, that’s our mission, is to keep culling it out, assorting it and having a stronger focus.

Operator

Our next question comes from Dana Cohen from Banc of America. Please go ahead.

Dana Cohen – Banc of America Securities, LLC

Yeah, hi guys. Just on niche, I think you said earlier that the 53 week was $13 Million and a penny to last year but then it became 11 and 3-4 so I got confused.

James Scully

So Dana, I think we may have had this conversation with you before. What I think I said was the $13 Million was what we reported last year as the impact of the week last year, the additional week last year. Then what I said was, if you compare, if you take the shift this year, compare the shift this year it’s about a $11 Million impact resulting from the shift of starting a week later in the year.

Dana Cohen – Banc of America Securities, LLC

So for modeling purposes the $11 and the 3-4?

James Scully

No, it’s the $24. Oh, you’re saying for comparison or for modeling?

Dana Cohen – Banc of America Securities, LLC

For modeling.

James Scully

It’s $24 Million and it’s 3-4.

Dana Cohen – Banc of America Securities, LLC

Okay. And then, I think you said that you were slightly edging up Q4 and I was just wondering on the, sort of like where should we think the changes?

James Scully

So, well this is the first time we introduced the EPS. We had it implied at the end of Q2 so, I would say that its pretty consistent with our past which is we said mid single digit, high single digit with a 100 basis points [inaudible] split between a 1/3 in gross margins and 2/3 in SG&A and it’s pretty much consistent with that.

Operator

Our next question comes from Margaret Mager from Goldman Sach. Please go ahead.

Margaret Mager - Goldman Sachs & Company

Hey, it’s Margaret. Congratulations on another great quarter and good luck in the holiday season. Hey Jim or Mickey can you just talk about the SG&A growth year-to-date up over 12% but, in the quarter you’re up 9.5% year-over-year. How was that happening? What expenses are curtailed in the quarter versus the year-to-date.

James Scully

Well, that’s a good question Margaret. I think some of the, some of the little bit of decline on that, first of all it has to do with the opening of new stores so there’s a non comp piece that doesn’t necessarily flow evenly throughout the year. The second issue is probably incentive compensation related to not only bonus but also FAS 123 R that has a different year-over-year timing and I would say those would probably be the two areas, it’s not that big of an overall difference but, I would say those are the two biggest areas.

Margaret Mager - Goldman Sachs & Company

Okay. And then, with Madewell how does it at this point factor into the equation? Is it a drag anywhere? Or is it supporting itself at this point? How do you think about that?

James Scully

Well, from the financials, like I said, it cost $3 Million in the quarter. For the year we think it’s about $10 Million, that’s about $1 higher than the range we talked in the past and that’s primarily due to the opening in the temporary store, we wanted to get the store opened before the holiday season. With the financials you were talking about Margaret? You probably got cutoff Margaret. It was $3 Million in Q3 and that had an impact of about 80 basis points on the operating margin as well.

Operator

Our next question comes from Roxanne Meyer from CIBC. Please go ahead.

Roxanne Meyer – CIBC World Markets

Great. Thanks. Let me add my congratulations. Two questions, one I’m just curious what is your investment in your heritage, when you think about your heritage cashmere items this year versus last year, what percentage of the store would you say it is? Has that changed? And also, in light of the difficult environment are you seeing any resistance to price points both for the collection as well as the other items within your assortment that are at that higher price point range? Thanks.

Millard S. Drexler

By heritage I assume you mean like our classic cashmere?

Margaret Mager - Goldman Sachs & Company

Exactly.

Millard S. Drexler

Yeah, it’s down from LY because, in our business today, customers are so competitive, you’ve got to keep moving forward, new color, new silhouette. We don’t abandon franchise business, we adjust and sharpen the edge every year. So, if you look at the classics, their definitely down from last year but, that’s reinvested in more new styles and more items that we think are new and right. So, that’s pretty much what’s happening there.

Regarding price, you know, again, I think there’s two worlds out there, and there’s obviously more than that, this is kind of not a black and white area but, as we keep reaching into market where we’re not inventing the better affluent consumer market, it’s been around forever. It’s in homes, it’s in cars, it’s in apartments, it’s in special occasion, whatever, it’s in iPods and Nanos and computers, we don’t see any resistance to price and I say that is all relative to our investment in higher priced goods. But, if anything, our strategy is still to chase and to build in to a better market place long term.

You know, it’s much more challenging to go from what we have come from than to take a better business down. You take a better higher quality business down a notch or two, it’s much easier to attract more customers. We have taken our business very strategically up a notch or two every season, so to speak, since we’ve all been running the company and we don’t see that resistance. Number one, we’re not buying that much for it to hurt us at all. Number two, some of its umbrella, others is real business and good margin business. So, you know, the world’s so big and we’re so relatively small that there’s always going to be people who spend money on quality things and if anything, that’s exactly what’s compatible with where we’re going. So, the short answer is no, we’re not seeing any. But, if you look at our prices none of them are, kind of, unreasonable.

We will not buy high style, high fashion trending goods at high prices because that’s, not to say the kiss of death but, it’s not the way that we’re going to make our money and sustain our margins.

Operator

Our next question comes from John Morris from Wachovia. Please go ahead.

John Morris - Wachovia Securities

Thanks. Hey, congratulations on a strong performance in a really tough environment.

Millard S. Drexler

Thank you.

John Morris - Wachovia Securities

I guess this ones for Jim. First of all, Jim, I think the way that you talked about the gross margin as the impact from the returns was flat and I’m wondering on that basis can you give us a little bit of color about IMU and markdowns?

James Scully

Sure. First, I really want to be clear with this that we’re extremely pleased with the gross margin performance being flat on an apples-to-apples basis comparison to last year. We were able to really anniversary that 260 basis point improvement that we had last year, which was really driven by the 19% comp last year. And, most importantly to your point, were able to also match last year’s full price sell through. So, I think all and all we were very happy once you normalize it for the adjustment I discussed.

John Morris - Wachovia Securities

And so, were the IMUs up or down on that adjusted basis? And, were the markdowns up or down?

James Scully

Well, I would say, we haven’t gotten in to much details on that, IMUs were up, I’d say markdowns relatively the same. It’s really not that much of a big enough difference, John.

Operator

Our next question comes from Kimberly Greenberger from Citi. Please go ahead.

Kimberly Greenberger, CFA – Citigroup

Okay. Great. Thank you. Good evening. The SG&A leverage this quarter was very impressive and I was hoping you could speak as to how we should think about the SG&A opportunity going forward. And then, gross margin coming in flat, does it feel to you like the gross margin has reached a level where you’re sort of normalizing and we should really think about flat gross margins going forward? Thank you.

James Scully

Let me go on the SG&A first. We were extremely pleased with the SG&A performance and the expense that we had in Q3. As we’ve said, historically, we expect leverage at the mid single digit comps. We reported a 5% realigned comp but for reported purposes it was actually 8% so that was higher than where we need to leverage. In addition, I think, as we’ve talked about before, is that the direct business is the most profitable piece of our business and when the beat end sales line at 21% on the top line is being fueled by a 36% increase in the most profitable segment we get incredible leverage there. So, in terms of us going forward that is not our expectation, that’s not how we plan the business but, when we overachieve in that segment of the business, it drives substantial leverage on expenses.

And, in terms of peaking on gross margin, again, our expectation is on an annual basis has always been only 30 basis points with half of that really coming from buying and occupancy. So, there’s only about 15 basis points we’ve been looking for in IMU and full price markdowns because the velocity in the business has been so good for so long we’re up against some pretty big numbers.

Margaret Mager - Goldman Sachs & Company

Alright. Thank you. Good luck with holiday.

James Scully

Thanks.

Operator

Our next question comes from Jeff Black with Lehman Brothers. Please go ahead.

Jeff Black – Lehman Brothers, Inc.

Yes, thanks. A couple of questions. One is just on the inventory content, how good do we feel about that and then how good to we feel about the forward looking nature of the inventory at this point? And then secondly, Jim you’ve talked about DC expansion and warehouse management system expansion, planning and allocation tools in 08. How does that all roll out next year, if all of it does roll out next year? Thanks.

James Scully

Sure. With respect to inventory, as we said at the end of Q2 and we’re saying today, we’re very comfortable as we enter Q4. As we indicated in the press release and in my script, if you take into the account the shift for the 53rd week, which we estimated at $15 Million and then on a square foot basis up 5%. In terms of a composition, we feel very good. I think one thing to point you to, one thing I always look at is the payables leverage on a year-over-year basis and I think if you look to the payables leverage on the balance sheet you’ll see that in improved about 200 basis points which I think speaks to the recently of the inventory from a numeric perspective.

In terms of the roll out, the DC expansion we’ve completed the DC expansion in terms of the physical space and that will be coming online early next year in terms of systems and the sorter equipment. And, the planning and allocation tools are in development and we’re accessing when they will be launched in terms of timing with our windows either next year or early the following year as it relates to just hitting the critical parts of the year when we have an opportunity to implement these systems.

Jeff Black – Lehman Brothers, Inc.

Great. Thanks.

Operator

Our next question comes from Brian Tunick from JP Morgan. Please go ahead.

Evren Dogan Kopelman – JP Morgan

Thanks this is Evren Dogan Kopelman for Brian. I just had a couple of questions. First, just two clarifications, did you say for the fourth quarter you expect the direct business to grow in the high single digits?

James Scully

Yes and that’s consistent with our guidance on an annual basis and what we’ve provided in the past.

Evren Dogan Kopelman – JP Morgan

Right. But, the first nine months of the year is up 29% so I’m just wondering, that sounds a little conservative to us. Are you being more conservative? Do you see something in the business that tells you that business is going to slow down from the first nine months trend?

Millard S. Drexler

Not really. But, you know, what we do is this is a business of a lot of ups and downs in the world, investment wise, merchandise wise, emotions. We have a very singular focused habit and it’s plan conservative because, if we start planning better and promise better it’s going to lead to a less disciplined approach to inventory. And, every day we wake up we figure we’re going to hopefully get our 5 comp, or our 9 comp, or our 8 comp and anything above that is really exciting and nice. I also might add that December is kind of always a treacherous uncomfortable month until the last week. Before December it’s a game of who’s doing what? Who’s liquidating? Who’s not? Who’s chickening out? Who’s doing all this stuff? So, I hope you’re right and I hope we’re wrong but, it’s very hard to forecast a fashion business because, as I look all over the world the last three months, I don’t think anyone four months ago whether it was hot or not in October, and you want to know something, it didn’t matter to us because we were conservative and, I said this on the last call, I say this for how many years, is that you plan conservative inventories, conservative comps and conservative growth in direct and then the rest takes care of itself. Even on the margin issue we’re planning flattish margin. It will be really terrific when we’re really good on goods and when it won’t be terrific is when we have a few more mistakes in the inventory.

What makes us not feel smart is when we shoot for larger increases in sales when in fact, really good merchants know how to turn their goods and be out of goods and bring in new goods. Now, I think the game of stack them high, throw them in, hopefully there’s more people coming in, is not the game that wins today. It’s a very, very tricky, complicated environment. So, yeah, I hope again it’s better and it should be but, we don’t draw a trend line with a good quarter even a good half because, you kind of never know what’s going to happen and not that any of us are economic experts but, I have more people I hear from now in all of our worlds who are really worried about the underpinnings of what’s going on. And, we’re not going to guess on interest rates and who’s lowering them or raising them every day of the week and the month. So, we’re just kind of sticking to the program and long term sticking with our opportunity, continue to build the best we can build and if we give up some by the way, for lack of inventory, which by the way, is the other side of the coin. We don’t want the last pair of pants necessarily sold and then we’re going to have extra inventory. So we get the sales and then it slows down your inventory and so on and so forth. So, yeah I think you’re absolutely right in asking the question.

Evren Dogan Kopelman – JP Morgan

Okay. Then, a follow up, I was about the weather because, a lot of investors over the quarter called us and said, “Hey J. Crew sells a lot of cashmere sweaters and a lot of retailers have been complaining about the weather.” Did you see any slow downs when it was warm in your business?

Millard S. Drexler

Well, the fact of the matter is that no matter what happens, like it was raining yesterday, I was in Madewell store downtown and it rained, I think, I don’t know if it was yesterday or Monday, yes it slows down. The weather clearly slows it down. Men have a built in thermometer, if they feel cold they then walk in the store. So, as far as most guys are concerned October was August and they didn’t shop. Yes, we saw that. But, on the other hand we didn’t buy that much to get hurt and we said last year.

It’s funny because two years ago it was so hot again, we all have short memories and when you ask a merchant to look at the calendar, remember one third of America’s business is kind of in warm weather stores. We all forget that too because we live in New York, most of us do, and they forget the rest of the world is not as cold as New York. The average temperature in the month of September I think was 71 degrees on the east coast which if you said that to a merchant and they’re buying heavy sweaters and coats, they think, “Oh my God. You’re crazy.” But, it’s the facts. Every year, I’m not saying, I’m not a proponent of global warming or not, that’s my private feelings. But, the fact of the matter is we are conservative and that is exactly why we’re building conservative inventories. If we didn’t say the day had got cold the business was not better we wouldn’t be truthful. But, of course that’s the case and if it were a colder October we probably would have done a little better in October.

But, then again, the online business and the catalog business isn’t really as weather driven which is really interesting for us. And, I think again, long term the online world is a big, big world growing bigger every day. More consumer trust, better players online. I was at a lunch today with our Crewcuts team and, you know, an online only company in a fashion world, someone most of us never heard of came up as a major place they shop for fashion goods, a small little company. But, I think it just changes the entire dynamic. But, the weather doesn’t really affect our online business whatsoever. It does affect store traffic, absolutely.

Evren Dogan Kopelman – JP Morgan

Thanks for the insight.

Operator

Our next question comes from Randy Konik from Bear, Stearns. Please go ahead.

Randy Konik - Bear, Stearns & Co., Inc.

Hey, great. Thanks a lot. So first, two questions. One for Mickey and one for Jim. Mickey, you talked in your response to someone’s question earlier about revising and tooling and redoing and fixing the franchise businesses over time and you said cashmere is a little lighter this year over last year. Can you kind of walk us through going into 08 or a little longer term, how do you see the franchise strategy changing somewhat from a product standpoint? Any new franchises you’re working on? And then Jim, on the sourcing front can you just give us a little color of what you’re working on the sourcing side? Have you been to Asia? We here a lot about the labor increases and transportation cost going up. Can you just talk a little about the opportunities you guys have there?

James Scully

So, sure. I’m going to start with the sourcing side first. Some of the areas that we’re working on are related to more of the logistic side whether it be freight, moving to open accounts, reducing some of the financing costs and some of the friction on the supply chain. I have been in Asia over the last couple of months talking to our vendors with respect to that. In terms of the actual sourcing of the material obviously, everyone’s hearing about potentially higher costs related to raw material costs. One of the benefits that we have is our growth and as we grow with our vendors we are seeing, we are seeing the ability to offset some of the price increases that other people are seeing.

Millard S. Drexler

In terms of franchise items we said in cashmere we, and this is what we do kind of daily, every week of our lives here. We’re just looking at the future, we’re the roads going, where the pucks going, etcetera. Like the say, whoever skates to where the puck is, where the pucks going not to where it is, whoever that hockey guy was, Gretsiky – if you look at the business, and again, it’s part of the complication of America competitive environment and many, many retailers. We’re just trying to figure out where it’s going and we adjust naturally the investments in what looks more tired, what looks more old. We see some of our competitors, they take our color palette and they copy it. Or, they think that they can sell things that we sell. It’s fine, it’s the life that we’re in, in the business. So, we are, a natural tendency of a merchant is to buy more this year of the business they missed last years. It’s one of the big rules, do not fill in this year’s quantity with the want goods last year because the world’s now skated ahead of you so to speak.

So, you know, the challenge that Libby and Tracy and Jeff and we all have is to figure out what’s new? What’s exciting? What’s the newest next? And, color and so, that’s where we’re planning it. I think it’s a dangerous game today to continue to repeat without updating. Now, I say that but, you must remain consistent and true to the perimeters of your style and personality of your company and that’s what we do. We try very hard to do that and the Crewcuts business we’ve seen that we can’t be in the commodity business and sell a solid basic item for $5 more [inaudible] $5 better but, if it has critters, if its patchwork, if it’s cashmere with a critter, that’s what our customer’s want. We do not want to sell all customers, all over the world. So, I think on that piece of it, it is kind of the nuance and how we have to play our investment game and we’re always moving forward, and you know, watching where the customers going.

Randy Konik - Bear, Stearns & Co., Inc.

Would you say there’s any changes on the horizon that you see that you’re getting tired from a fabrication or category?

Millard S. Drexler

Well, you know what we see is the fast fashion and cheap, you know I read yesterday, you know Top Shop is coming, we are thrilled because they are opening next to our new Madewell store. I was in the Top Shop store about a month ago in London and, “Oh my God it’s Christmas everyday.” But, I think when you have Top Shop, H&M, The Basic Company, just stay away from the cheaper fabrics that they do well. We’re looking at some of our fabrications now. The customers know they can buy on sale and I’m not going to mention what they are today but, we’re moving chunks of our investments our of certain lower priced fabrication into a better fabric at a higher price which, of course, means you’ll buy less units. We don’t want to be in the unit velocity game, we want to be in the margin dollar velocity game.

But, I think if you look at the trends now with the foreign players coming in who are really good at the business, a lot of domestic players getting bigger and bigger, we just want to play in that niche which is style and quality and great product design. And, the emphasis is on design and quality and style and I must say color. We have famous colors we have. We repeat them and people can’t do the same colors that we do, the same style. But, it’s kind of an industry now with watch it because someone’s always out to get you. So, we kind of watch it and then keep moving in the direction we want to take the business based on where the team sees it going with great consistency.

We upgraded our suit business this year. We said there’s some good better players out there but, the upgrade we continue to look at because people, the funny thing is I don’t think that many people actually around America know the quality of our business yet because, we’re still kind of new at the game. We might not have that, although I thought what Tom Ford said today in an interview about the luxury business becoming more massified which, I think is true. A lot of the luxury players, I think he said in some quote in Moscow, “There’s too much choice out there.” We want to just stick to our knitting in our niche and do what’s right in a J. Crew way. But, we keep our eyes open every day for the trends and we get them as we read our sewing reports every day. And, I might add, just hang out in those stores and talk to those customers every day and watch where those trends are going because, they are going always. In technology, in automobiles and in apparel and accessories.

Randy Konik - Bear, Stearns & Co., Inc.

Thanks a lot.

Operator

Our next question comes from Dana Telsey from Telsey Advisory. Please go ahead.

Dana Telsey - Telsey Advisory Group

Hello?

Millard S. Drexler

Hi there.

Dana Telsey - Telsey Advisory Group

Hi Mickey.

Millard S. Drexler

How are you?

Dana Telsey - Telsey Advisory Group

Good. How are you? I wanted to find out in terms of product and productivity, what do you look at in the store as productivity enhancers. I mean, everything’s doing so nicely. Whether it’s the jewelry and accessories, whether it’s the collection business, how do you look at the next evolution of the store in terms of driving the growth? Thank you.

Millard S. Drexler

You know, that’s a good question. It’s kind of a high class problem we have. We mentioned we are, first of all, what we look at is again, the every square inch and some of the stores I know are getting quite crowded. Again, it’s a nice problem to have but when I visited our stores around the country, you know, things getting out there. But, what we do is we look at the pressure on our space in some very productive stores because you know where our square footage is going. The bar is being raised to a very high degree.

We’re looking to open a couple of men’s stores now because we think we can take some of the pressure on the real estate by rolling out a men’s store or two we think in the market place there’s a really important opportunity which, frankly, you know, we weren’t ready to do. I said, the no’s are as important as the yes’s so, now we are ready. We were not up until this year to do a men’s store because we think, not that there are that many rich men’s companies around but, there are a few. But, we think there’s really an important [inaudible]. As we look at our stores, interesting enough, our stores that have important men’s departments where men can go in and feel like they are not shopping with a lot of women around or vice versa. Well, the women don’t care but, the men do care. We found out our highest productive stores all around America was we happen to have an extra different floor which is really interesting. That plus we look at the categories online and in our catalog. There are clear messages to us that we should be putting some more of those goods in our stores. We have a lot of great feedback and information that comes from our online and direct business. In fact, our best and better goods actually do a heck of a lot better in productivity wise if it’s one inventory online. So, that gives us a message where the futures going.

We’re expanding costume jewelry. We’re looking at, you know, my cry is always, I say it every day, I come to work I say, “We’re over assorted, we’re over assorted, we’re over assorted.” Everyone’s over assorted and so I think that plus the nuance, for example, taking a commodity fabric in men’s that we always end up putting on sale, it’s a low average unit, it sells two weeks in front of Christmas and you sit with slow inventory so we’ve made a decision next year instead of it being a cheap item it’s going to be a better item. We’re going to have less units, more space to shop in. I was in our 5th Avenue store this morning, I think it was 5th, Columbus, I’m sorry Time Warner and Rock Center and it’s crowded. Even in men’s you can’t see some of the beautiful jackets. So, part of the answer to that is strategically filtering out some excess unit low price drivers without given up gross margin dollars and trying to have a little more space in the stores. We are not adding Crewcuts to anymore stores because of space limitations. We’re looking at opening Crewcuts stores as you know. Not being aggressive about it but, we are now negotiating for two men’s stores. Both in the northeast. One here and one in a very affluent town outside of Manhattan and that’s going to be a whole other thing. So, I think that’s an opportunity but, we do have a, and Tracy and Libby and Jeff know in the business we’re looking at the average price point and that’s a very interesting challenge to keep balancing it out so that you’re not alienating customers. But, they’re growing up with us and they’re trading up with us because, you still have these massive competitive cheap players who actually do a great job at taking a little business from everyone around. So, we’re playing that and anything else we can think of doing, we’re doing. If you look at the stores, a lot of those square inches are taken up with goods at this point.

But, we for example, have men’s shoes that are very hot for us right now. It’s not in any of our stores. We don’t want it put in our stores until we have space to do that right. If you sell a men’s shoe at $195, it is much better than selling four t-shirts at $15. So, that is an ongoing process. The key items and tons of colors. I think those days are kind of now here anymore which, a lot of people have grown their business on. It’s much more selective and key in the right colors.

Dana Telsey - Telsey Advisory Group

Congratulations Mickey and have a great holiday.

Millard S. Drexler

You too.

Operator

Ladies and gentlemen this concludes the Q&A session. I would like to turn the floor back over to management for any closing comments.

Millard S. Drexler

Thanks everyone and I also want to wish you all, although Dana said it, happy and healthy holiday and we look forward to speaking with you during our fourth quarter call in March. Thank you very much.

Operator

Thank you everyone. This concludes today’s conference call. You may disconnect your lines at this time.

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Source: J. Crew 3Q 2007 Earnings Call Transcript
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