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DSW, Inc. (NYSE:DSW)

Q3 2007 Earnings Call

December 5, 2007, 8:00 am ET

Executives

Leslie Neville – Director, Investor Relations

Debbie Ferree – Vice Chairman and Chief Merchandising Officer

Peter Horvath – President

Doug Probst – CFO

Analysts

Christopher –Susquehanna International Group

David Mann – Johnson Rice

Jeff Black – Lehman Brothers

Roxanne Meyer – CIBC

Heather Boksen – Sidoti & Company

John Zolidis – Buckingham Research

R.J. Hottovy – Next Generation Equity Research

Jay [Inaudible] – Morgan Stanley

Brad Leonard – B&L Capital

Operator

Welcome to the third quarter 2007 DSW, Inc. earnings conference call. [Operator Instructions] I would now like to turn the call over to Ms. Leslie Neville, Director, Investor Relations.

Leslie Neville

Good morning, with me today in Columbus today are Debbie Ferree our Vice Chairman and Chief Merchandising Officer, Peter Horvath our President and Doug Probst our CFO.

Earlier today we issued a press release detailing the results of operations for the quarter ended November 3, 2007. Before we proceed please note that various remarks we make about the future expectations, plans and prospects of the company constitute forward looking statements. The 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 our public filings with the SEC.

With that I will turn it over to Doug.

Doug Probst

Good morning everyone. Today I will provide detail on some of the significant factors that impacted our financial performance in the third quarter of fiscal 2007 and review our targets for the remainder of the year. As previously released, net sales for the quarter increased 11% to $367 million. Same store sales decreased 3% for the comparable thirteen week period versus an increase of 2.6% last year. Same store sales for the year to date period decreased 0.5% compared to an increase of 3% last year. Our average unit retails increased due mainly to our clean inventory position entering the quarter. However, like many retailers we experienced a significant decrease of traffic, particularly in the month of September.

Gross profit rate for the quarter decreased 70 basis point to 29.0%, however, as expected the merchandise margin rate, which is margin excluding occupancy and warehouse expenses, increased 30 basis points. The decrease in gross profit was due equally to increased occupancy expense associated with the 102 additional Stein Mart stores added in January and the de leverage of DSW occupancy resulting from the negative comp store sales in the quarter.

Selling general and administrative costs or SG&A decreased 250 basis points during the quarter to 19.6% of sales, due in part to the re-launch of our loyalty program last year and a reduction of our 2007 bonus accrual. These gains offset a 40 basis point de-leverage for the development of our e-commerce channel. The net impact of gross margin and SG&A performance was 190 basis point increase in our operating income rate for the quarter to 9.5% of sales. Overall, net income for the quarter was $22.4 million compared with net income of $16 million for last year. Diluted earnings per share were $.51 compared with $.36 a year ago, a 40% increase over third quarter last year.

To support our long term growth we invested $30 million in capital expenditures during the third quarter, approximately half was for new and remodeled stores with the balance primarily for IT infrastructure and our e-commerce business. Our cash and short term investment balance at the end of the quarter was $141 million. Before looking forward to the balance of the year we believe it’s important to briefly revisit last years results.

The fourth quarter of 2006 benefited from two significant items. The addition of a 53rd week, and the reduction of the DSW awards accrual. The fourth quarter of 2007 is negatively impacted by the calendar shift of volume that benefited the third quarter. That said based on current trends we are estimating diluted annual earnings per share to be in the range of $1.24 to $1.29 and annual comps of flat to down 1%. The 2007 estimate includes $8.5 million of expense related to the development of e-commerce channel which equates to approximately $.13 per share.

While we will not provide earnings guidance for next year at this time, we can say that we are appropriately cautious on our outlook. However, even in a challenging environment we expect to open at least 30 stores, launch our e-commerce channel, continue our investment into our systems infrastructure and deliver earnings growth in 2008.

Now I will turn it over to Debbie for her comments on the merchandise results.

Debbie Ferree

Third quarter comps were below expectations with the miss being driven primarily by weather sensitive businesses, soft traffic in the month of September and a weakening of demand in the men’s area and in women’s junior casuals. However, tight inventory management control allowed us to deliver improved growth margin rates.

Our promotional cadence in Q2 brought us into Q3 with clean inventories and clearance levels at historical lows. Our Boots & More traffic driving event in October exceeded our regular price selling expectations, thus increasing overall margin performance. These strategies have put us in a good inventory position as we head into Q4 and the winter sale to be held at the end of December. We expect that we will end the season clean and be in a good position to start spring of 08’.

At the department level, we had a miss in men’s and women’s, while athletic and accessories had positive comps. Across the departments we are seeing a shift toward more classic, cleaned up looks. This resulted in some of the softness we saw in the young attitude areas. We are positioning inventories to take advantage of this trend going forward. Unseasonably warm weather softened demand and higher AUR categories such as boots while we saw double digit positive comps in casual sandals and positive performance in athletic once again driven by the fashion component.

Our strategy to support casual sandals with fresh receipts in the appropriate market exceeded both our sales and margin expectations. We are pleased with what we have seen in the boot category in Q4, the AUR is more than $3.50 higher than last year and we expect to end the season in a clean inventory position. The women’s casual area had strong comps in comfort and missy flats, however, total casual comps did not meet expectations as demand softened in the junior area, specifically in flats and balkanized.

We have taken steps to address underperforming categories here and expect inventory to be on target for Spring.

While the total women’s dress area had negative comps in Q3, we saw positive comps in the young attitude area driven by round toes and Mary Jane’s. The classic dress area delivered flat comps for the quarter with trend toward cleaned up classic looks we feel strongly about this area as we head into Spring. In the men’s area we were pleased with double digit comps in traditional core men’s dress and casual and will continue to fund these businesses. However we experienced a lack of demand in young men’s product and have reduced inventories here through the remainder of the season. While men’s boots did not meet expectations being a weather sensitive business, we tightly managed the inventory and are in a good position going forward.

The highlight in the women’s accessories area was the strong double digit comp performance in small leather goods and fashion hats. The cold weather goods got off to a slower start but we have seen it pick up in the recent weeks and will manage inventories through the Fall as needed.

Collectively, our leased division had flat comps increased promotional activities by our leased partners contributed to an increase in mark downs for the third quarter. Inventories are in line here for the remainder of the season.

As we head into Spring we feel good about our balanced assortment offering of fashion versus core and our position to maximize opportunity. Early indications are that this will be a strong season for dress shoes and color will be important.

Now, I’d like to turn it over to Peter.

Peter Horvath

Based on our forecast for fiscal 2007 DSW will not achieve full year earnings growth over the prior year. This is a first for us as a public company and we are disappointed with this outcome. While we continue to see significant improvement in execution in many areas across the business in aggregate our execution fell short during a particularly difficult retail environment.

Like other retailers our team gathers each week to review the prior week results, make adjustments and improve our understanding of the customer. Consistent with prior seasons we don’t allow the discussion to be dominated by external factors such as weather or retail the environment. While we are very aware of the external factors, our focus continues to be on controlling the controllables.

By holding ourselves accountable for the factors within our control we continue to learn from both our successes and disappointments. I’d like to share with you some of our key learning’s which appropriately align with elements of our growth strategy.

1- Lower targeted clearance inventory levels did not hurt sales and they improved gross margin during the third quarter. The semi-annual sales event helped us to manage to targeted clearance levels. By entering seasons with inventories positioned flat or down faster expected turns and content mixed more toward current fashion than clearance we consistently positioned the business for up side while mitigating down side risk. This can be seen in the third quarter, despite running negative comps and missing our original third quarter plan, we delivered good margins, and entered fourth quarter the inventories basically flat to last year. This refinement will continue in the fourth quarter with our Winter sale event. Our outlook incorporates a realistic view of sales trends and the markdowns required to ensure the best possible inventory position entering 2008. Like the beginning of third quarter 2007, we are targeting a reduction in inventory over last year. Inventory levels will be appropriate providing a reasonable level of protection against continued comp store weakness.

2- The power of our loyalty program. By every measure our loyalty program continues to strengthen and improve. We are growing the DSW Rewards Program faster than our store growth in rolling 40,000 – 50,000 new members each week. Improved retention rates and increased enrollments are driving member growth. Reactivation, new member welcome, gift with purchase, bonus point promotions and member e-mail contacts generated significant incremental sales that contributed to our third quarter sales total.

3- Better new store staging and planning. New real estate development is dominated by the Lifestyle Center format. We are pleased that we have become a tenant of choice for these Lifestyle Centers with our new store design and smaller footprint. Like many other retailers, we are experiencing initial sales shortfalls to plan in some of these new centers. In many circumstances we are among the first tenants to open with as much as 70% of the remaining tenants under construction for several months. While this does not impact our comp store performance, it does contribute to our short fall to plan. We have addressed this in our new store process and plan go forward. The overall real estate strategy continues to perform as expected, new stores are training to superior sales per foot to the chain average and delivering the desired profitability rate.

4- Better management of fashion distortions. While we experienced significant double digit comps in areas of fashion distortions such as flats and balkanized product our inventories are planned for even higher sales. While our Spring plan supports fashion distortions as it should, we have limited distortions to our inventory investment leaving more room to chase trends in season.

5- Customers love the new store design. We will end this year with 35 stores in the new Easton Design format, including five remodels where we are reading sales lift and form our capital planning decisions. Initial indications are good but premature. Customer comments have been incredibly favorable. We will be conducting formal customer research over the next six months to better understand the impact of the new design.

6- Customers are beginning to experience the new service model. This summer we rolled out our new service model and we are beginning to see it deliver with consistency across all stores. This service model is about providing customer engagement that is passionate, friendly, helpful and real, fellow shoe lovers who are enablers for our customers. By focusing on service instead of sales, our associates are viewed as partners, fellow shoe lovers, not just sales people whose motives are tied to personal gain. This behavior shift is no small task when you consider that we are asking almost 9,000 associates to deliver it. We expect to see consistent delivery of the service model in the near future.

7- Market share. Although our comps store result for the first nine months of 2007 have been lack luster we continue to increase market share due to new store growth at DSW and expansion of the Stein Mart lease business. Third quarter to date sales increased $123 million over last year.

Finally, we are on tract to launch e-commerce during the first half of 2008. We understand that multi channel customers represent significant growth potential for DSW and we are excited by the prospect of combining e-commerce with our successful and growing loyalty program. We’ll provide more color on what we are planning and specifics around timing as the launch approaches.

We continue to make significant progress against our long term growth strategy despite short term execution challenges in operating in a more challenging environment. We fully appreciate that strategy without execution has no value. We will continue to proceed cautiously in this uncertain environment while controlling the factors that will strengthen our capability and lead to long term shareholder value.

With that I’ll turn it back to Leslie to introduce Q&A.

Leslie Neville

Could you now please instruct the callers how to indicate a question?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Christopher from Susquehanna International Group, please proceed.

Christopher –Susquehanna International Group

A couple of questions, first Debbie for you. Given the shifts in the merchandise strategy, particularly with the Juniors and balkanized and men’s boots, is that factored into your thought process for the fourth quarter and do you anticipate given the strong performance in Q3 on the merchandise margins, do you anticipate merchandise margins to increase in Q4 given your comfort level with regard to inventory?

Debbie Ferree

Let me just address the first part of your question. First of all, some of the inherent weakness in some of the categories in Q3 I think will continue to see that into Q4, specifically in the casual area around flats. Flats is still comping very positively but let me just clarify that in Q1 and Q2 sales were outpacing inventory significantly in Q3 the inventory started to outpace sales in flats into Q3 and I think will continue into Q4. What we’ve done to offset that in Q4 is there is some other categories that are starting to emerge that are starting to offset that inherent weakness in some of the old flat business and that is more in the comfort flat business. We think that there should be a balance going into Q4 that should be able to offset any inherent weakness in the margin coming out of the casual category. Yes, that has been factored into the thought process for Q4.

Christopher –Susquehanna International Group

In terms of key products as you look to 2008, you kind of threw a lot of things out there in terms of what’s working for you now and obviously flats, as you anniversary the numbers going into next year, any key categories shifting, you mentioned the dress business, is it continuing to shift in that direction or do you anticipate casual being strong components of the business going to Spring 08’.

Debbie Ferree

For Spring 08’ I see a distortion into the dress shoe category but it’s not as significant of a distortion as what we saw this year building the flat category. There will be, I have down trended some of the casual business and have moved that into the dress business. Right now I just have to tell you that I’ve not seen for the Spring season any major items or category that was as strong as what flats was for us this year. I’m hopeful that getting into the marketplace that we’ll be able to recognize a bigger distortion of what I’ve seen so far but right now they are just moderate distortions and flats will continue but we will continue to manage that in a different way. It will go into missy comfort flat flats and we will also make sure that we tighten up the sku offering to the consumer and also make sure that we keep open by liquidity in case we see any further down tick in the flat category.

Christopher –Susquehanna International Group

That’s helpful. The last question is for Doug. In the third quarter, the operating expense line in terms of SG&A was certainly pretty impressive. I was wondering if you can quantify to some degree with the re-launch of the loyalty program and the reduction of bonuses, how much that was in the period just because it looks pretty significant in terms of decline for the third quarter given all the growth initiatives and investments in IT, I just wonder if you can add some clarity to that and maybe how we should look at that for Q4?

Doug Probst

The Q3 items are really kind of one timers as it relates to the third quarter. As we already said in the script the loyalty program launched last year was about $4 million and the reduction of our bonus accrual is an impact comparable to last year of roughly $7 million. Those two items account for the major points of the decrease in SG&A.

Christopher –Susquehanna International Group

Something that should be offset going into fourth quarter, work the opposite was in fourth quarter?

Doug Probst

On the rewards accrual yes, we benefited the fourth quarter last year of about $.08 and the reversal of that accrual, but the bonus is already accounted for.

Christopher –Susquehanna International Group

Thank you very much.

Operator

Your next question comes from the line of David Mann from Johnson Rice, please proceed.

David Mann – Johnson Rice

On the lease departments, I know you changed a little bit some of the offerings in the Stein Mart stores can you give an update on how that went for you?

Debbie Ferree

Yes, what we did is we evaluated the brand and price point architecture of the product we were putting into Stein Mart and we actually shifted a little bit out of the core merchandise into fashion merchandise. The customer’s response on that in terms of sell [inaudible] per week was very very favorable. I guess what I would tell you is we moved from being a predominately a core classic middle of the road kind of an offering to a blend between fashion and core and the results were very positive.

David Mann – Johnson Rice

Debbie, on the men’s business it seems to have been tougher for you for a little while now, can you give a sense on what you think you can do to improve that and how committed you are to maintaining the same square footage devoted to that department?

Debbie Ferree

First, I think we should probably, David, back up a couple of quarters and remember that I articulated that the place that we were struggling the most was finding the right inventory levels and sales levels for the traditional dress and casual component of the business. We have steadied that in the water now, it seems that we’ve found our level, the right blend between dress and casual traditional in the inventory levels to support that. The strategy behind that was to reduce sku count and be in stock on core items and key vendors so that the male consumer that was coming in to buy core product would be able to find his size. We’ve been able to do that and in this third quarter earnings release that’s why I reported that the men’s dress and casual we’ve actually had a good double digit comp there and that was because of the strategy that I just explained.

The place that continues to be a challenge for us and we just need to find what the right level is, is in the young men’s piece and that’s the young men’s fashion piece. We continue to revise our sales based on customer response and our inventory levels. I still don’t think that we have found the low there. I think we are close to that, David, but I don’t think we are there yet. Every other category though, was strong for us in men’s and the big drop that we took third quarter was specifically in two areas; young men’s and in the seasonal boot category. I’m feeling very good about where the core of our business is right now that we’ve got that managed, we’ve got the right sku count in inventory levels and we’re just waiting to continue to find out about the young men’s area.

David Mann – Johnson Rice

One last question, regional differences that you are seeing in your business, even including through November or are there big distortions there, especially with the concerns about Florida and California?

Doug Probst

No significant or notable differences David.

David Mann – Johnson Rice

Thank you

Operator

Your next question comes from the line of Jeff Black from Lehman Brothers, please proceed.

Jeff Black – Lehman Brothers

I guess a couple of questions, Peter or Doug or Debbie, whoever wants to take it. On the inventory you outlined in your point’s one and four Peter that you were looking at it from limited distortion and getting more comfortable clearance levels, but there has been a tremendous amount of growth margin risk we think, in 2Q and what’s probably going to be apparent in 4Q. Is there a sense that most of this is fashion misses and just not getting the kind of read that you got last year in some of these categories or alternatively, is there a sense that you guys could do more with lower levels of inventory? When you talk about lower distortion are we really talking about just taking the in store inventory levels down, do we think we need to do that?

Doug Probst

I’ll take a crack at this, I think you hit on it; inventories obviously involve a lot of different things. In terms of what’s happening in the second and fourth quarter of 2007, in terms of the mark downs that we are taking, really what it ends of being is what we’ve determined is that during the peak season, first quarter and third quarter you really need to focus on selling full price. The customer is oriented toward that and we take marks, we have a clearance rotation that’s continuous all the time and the reality is adding to that rotation or taking promotional markdowns the customer doesn’t really bite on that until it’s time to buy sales.

What we’ve done is given our self this weapon, if you will, in a semi-annual sale where we can move through large chunks of inventory, generate significant regular price sales, introduce the customer to the next seasons fashion and we feel that this is really the best way to move through inventory. The result is we are entering seasons cleaner, what you are seeing is the shift versus our history of markdowns probably from third quarter to second quarter from first quarter to fourth as we accelerate clearance through these sale events. We think this is a pretty smart weapon to have whether you are beating your sales plan or missing the sales plan.

The comment on distortions is really just group learning that we had. Being a fashion business, you have to make distortions if you aren’t making distortions you miss fashion trends. I think the team has been very good at looking around corners and matching these distortions to what customer’s desires are. I think the level of inventory that you put behind distortion is always a gamble. Especially when you are talking about across many categories, in the case of flats, it was across many categories and it was a significant increase to the prior year. Basically, what we are trying to do is be even more deliberate about that process.

Debbie has mentioned that probably the distortions on flats, flats are still selling, obviously we’re running 50-60% comps in flats but we have more inventory than that. There will be more flats in the business obviously for Spring, it won’t be an increase in inventory in Spring, and it will probably be a decrease. The new distortions are more on dress shoes and those distortions we’re saying are going to be a little bit more conservative going into the season and we are positioning the opportunity through back ups and other things to chase the trend should the trend be stronger than our inventory investment.

That might be more detail than what you are looking for but I hope that answered your question.

Jeff Black – Lehman Brothers

No, we always love detail. On the open to buy, how much can we infer that inventory is going to be down at a level lower than sales to end the year and what kind of open to buy are you keeping relative to the past levels, relative to last year and the year prior when we move into next year?

Doug Probst

I’m going to answer the inventory levels. This business, for a shoe business has a very good turn, I think in store we are turning units four times a year. We think this business can turn five, five and a half times a year in store and we’re seeing that with the smaller format stores. If practical reality that if you are going to do the same sales in a 15,000 square foot store that you did in a 25,000 square foot store you are turning faster. What that means is there is not a lot of concern that we enter each season with inventory position flat or down in expectation of mid single digit comps off of that inventory. The way we are doing that, there are a few levels; the first level is we are pulling inventory out of the total system, in other words, inventory that is not in the stores, our distribution center becomes more efficient every year, the flow of product becomes more efficient. I think taking inventory out of the system and managing flow to meet demand is really what we are talking about.

In store capacity, you are not going to see a decrease in the inventory in our stores. We’ve established capacity targets that we think are appropriate for the sales and we’re managing the business to those capacities, we monitor that weekly by store.

I guess I can tell you that going into first quarter our intention is to be flat or down in inventory, our intention in clearance is to be even lighter than last year. What we’ve done is we’ve proven to ourselves that our historical levels of clearance are probably high compared to what they can be and it doesn’t hurt sales. There is always that concern, clearance speaks to our opening price point customer and in effect its our opening price point offering, so its important to always maintain some level of clearance but I think we are discovering is what perhaps the appropriate level is and we are committed to entering first quarter with less than last year.

Jeff Black – Lehman Brothers

Great, good luck guys, thanks a lot.

Operator

Your next question comes from the line of Roxanne Meyer from CIBC, please proceed.

Roxanne Meyer – CIBC

Just a few questions, first a housekeeping question. Can you give us the store count on square footage as of the end of the quarter?

Peter Horvath

The square footage for DSW, 5.99 million square feet.

Roxanne Meyer – CIBC

In terms of some of the merchandise call off, the areas that weren’t as strong, young men’s and young women’s, have you noticed those particular areas as being a challenging spot throughout 07’, and is there something going on there in the competitive landscape that you think makes those categories increasingly tougher or is the weakness there just a reflection of the distortions that you happened to go with this year?

Debbie Ferree

First of all, let’s just look at the junior area in general. The junior category actually was very very strong in Q1 and Q2, going into Q3 is where we started to see a little bit of softening and specifically that was around junior flats and junior balkanized. In all the years in retailing, I’ve never really seen a category start to decelerate in sales as aggressively as it did in the middle of Q3. Q1 and Q2 sales out pacing inventory, Q3 inventory started to outpace sales it was strong in the beginning half of the year and then started to decelerate a little bit toward the third quarter. I think what caused that is that there was so much novelty and fashion in the industry and we weren’t the only one to have it. I think probably every one is going through these discussions today.

The trend, how the customer is shopping and what she is shopping for. Actually we started to see a shift in that in the middle to the end of Q3 that is what I address in the earnings comment on the return to more cleaned up classic styles. I think there is probably so much fashion in the industry and we all reaped the benefits and rewards of that in sales and margin in the first half and that started to change in the middle of the third quarter.

I think we are just going to keep our eye on that, it doesn’t mean that the junior business goes away, it just means that you have to watch it, you have to manage it, tighten up your sku count, tighten up your inventory levels and wait for the next item to emerge from the market, which we’ve not seen that happen yet. We are holding the inventory levels there very very tight.

There is some good news though in terms of how customers are shifting and to what they are buying and that is in to the more cleaned up classic looks. We will take advantage of that Q4 and moving into Spring 2008 in the classic dress area and also in classic missy flats. There is a little bit of good news there to offset what we have just experienced but the thing that is a little challenging to us all right now is there hasn’t been a big category or a big item that has emerged yet that would show that it would drive significant volume for the Spring season. We still have a few more shoe shows to go through so we are hoping to see that.

Roxanne Meyer – CIBC

Thanks so much for that color, it was really helpful. Do you feel at this point then going into Spring that the amount of novelty products you have is appropriately downsized or that there still risk there?

Debbie Ferree

No, I feel we have addressed anything that was a risk.

Roxanne Meyer – CIBC

Just a follow up on a prior question regarding 4Q. Can you please provide some additional clarity around your expectations for gross margins, because on one hand it sounds like you are fairly comfortable with your inventory levels going into 4Q, however, your guidance implies a 1% operating margin? I’m having a hard time understanding how to get there?

Doug Probst

Obviously we have some inventory we are going to have to deal with from the shortfall in sales. It should be noted that in the second quarter we ran the sandal sale Sandals and More and the summer sale for the fourth quarter this year we are just anticipating the winter sale and a lot is going to depend on how we liquidate the merchandise throughout the quarter. We are being cautious in the top line volume and again, we know the inventory target we have to get to, we are going to have to be as aggressive as necessary to get to that target.

Peter Horvath

Keep in mind that we’re expecting to miss our internal plan for sales in the fourth quarter so that creates, even though we have been agile at our inventories and deliveries that creates the need to take additional markdowns in the fourth quarter as well. Even if the comp result is equal or better than third quarter, we are still going to miss our plan and there will be inventories to be dealt with. Also, I think I suggested in the discussion earlier, that we are targeting lower levels of clearance entering first quarter than we had last year so that would mean accelerating some markdowns into our sale in fourth quarter. That is part of the story.

Roxanne Meyer – CIBC

Thank you very much, that’s helpful and best of luck.

Doug Probst

I failed to answer the other part of your question; we had 250 stores at the end of the quarter.

Operator

Your next question comes from the line of Heather Boksen from Sidoti & Company, please proceed.

Heather Boksen – Sidoti & Company

You kind of just touched on my question, for some additional clarity, if you could speak to either promotional cadence for fourth quarter. It sounds like aside from the scale of some of the markdowns it shouldn’t differ from what we’ve seen in previous years or with what we saw last year with just the after Christmas sale, is that correct.

Peter Horvath

I want to speak to the promotional cadence. This will be the third semi annual sale event that we will have executed and a year ago the first one was explosive, it had exactly the kind of top line expectation we were hoping for, it met that expectation. However, we lacked in our systems and processed the precision on pricing so quite frankly we gave away more shoes at a lower price than we think we should have had to but it’s what we were capable of then.

The second sale that we did at the end of the Spring was more precise in terms of pricing but I think we had a bigger obstacle to overcome with the shortfalls in sales in the first half of the year. This sale, we have high expectations that like the last two, the first one was very good, the second one was better; we believe this one will be even better. It may culminate more in margin, that we’ve got greater precision in pricing; we’ve got greater execution at the store level in terms of pricing goods. Our expectation is that the event will be successful and will help us move through goods better.

The balance of the promotional cadence for the quarter, again, being footwear we aren’t a gift destination, however, we do feed off the natural traffic that’s out there in the fourth quarter. We’ve experienced some really good success with our loyalty customers by providing them benefits that we promised we would give them when we re-launched the program. Opportunities to earn bonus points, etcetera, since it’s 70% of our sales, that’s where the promotional cadence is really directed and those efforts typically do not generate markdowns, what they generate is accelerated rewards certificates, because they are accumulating points faster and a rewards certificate is relatively inexpensive relative to the average dollar sale that accompanies it and it is sort of a bounce back because it gives people a reason to visit us. So that’s kind of the overview of the promotional strategy. I don’t know if Doug wants to give any color on fourth quarter.

Doug Probst

No, other than what we said before regarding the difference between second quarter and fourth I think we’ve covered it.

Heather Boksen – Sidoti & Company

Thanks guys.

Operator

Your next question comes from the line of John Zolidis from Buckingham Research, please proceed.

John Zolidis – Buckingham Research

If I look back at 2006 and I look at the quarterly variability in earnings per share in earnings growth, it’s fairly consistent throughout the year and then as we move into 2007 there has been enormous volatility in your earnings and in your margins on a year over year basis. What I’m wondering is when we look into 2008, given that 2007 volatility was partially caused by changes related to the 52 week versus 53 week calendar, should we expect that earnings growth and margins should look more consistent or is the business just going to continue to be extremely volatile?

Peter Horvath

I’d like Doug to take this since he spent a lot of time looking at it, but I wanted to offer this. We give annual guidance and I know that leaves some question around what we’re thinking by quarter. I have to tell you that we expected the first and the third quarters to be the big earnings quarters this year because we understand the underlying details around last year and what our plans are for this year. I’d say internally it doesn’t appear volatile because it’s what we were planning. In terms of missing our expectations on sales, that causes additional markdowns before the end of the season and that accentuates the natural pattern that we understand.

I just wanted to share that with you because the word volatility suggests that, I don’t want anyone to think we are the ones who are surprised, I understand why our investors in the street might be because they are not privy to internal expectations by quarter.

Doug Probst

To add on, John you probably caught on the 53rd week shift benefiting the first and third as we said at the beginning of the year. I think it is also important to remind people on the Q3 and Q4 impact of last year, remember we had the marketing expense associated in the third quarter last year which makes our increase look better in the third quarter this year as well as, remember the rewards reversal in the fourth quarter last year benefited us about $.08 in that fourth quarter. A $.04 expense in the third and $.08 benefit in the fourth so that adds to the volatility as well and then you add to the top line this year where we had negative 3% comps roughly in the first and third quarters. That is going to add to some things that make those comparisons a little difficult. So we understand that it looks up and down but some of that, as Peter already mentioned, was anticipated.

John Zolidis – Buckingham Research

Just trying to get some clarity, I believe that at the beginning of the year you guys talked about the second quarter and the fourth quarter being flattish on a year over year basis due to the 53rd week shift, now we are looking at $.05 to $.10 in the fourth quarter versus $.37 last year. I really would like it if you would answer my question about fiscal 08’ are we going to have this extreme volatility continue in the earnings on a quarterly basis or should the year over year change and should earnings and margins be more consistent?

Doug Probst

We’re not going to give a lot of color on 2008, but you would expect that, as Peter said, that the margin opportunities are going to be in the first and third quarter, taking advantage of the regular price. I think we are going to see maybe if we have better top line performance, better comps in the first and third quarters that would mean higher highs and obviously if we don’t have to liquidate inventory off those first and third the lows won’t be as low. By taking advantage of those first and third margin opportunities you should see some ups and downs but the baseline sales is going to dictate most of it. I hope that gives you some clarity, we’re not trying to evade the question, it’s like predicting the future by quarter and that gets to be a little difficult but hopefully you are understanding the cadence of the business a little bit. We won’t have those calendar shifts and rewards reversals, those kinds of things disrupting the cadence either.

Peter Horvath

I think it’s also worth adding that this year not only did we change the cadence in terms of utilizing sale events we also pulled markdowns, compared to our history, pulled markdowns from trailing quarters into those quarters. We kind of took it on both sides, if you miss your sales plan in first quarter that increases your markdowns in second and if you want to enter third cleaner than you ever had historically you are pulling markdowns from third historically, we are doing the same thing in fourth. I think this is the right direction for the business because getting markdowns behind you quicker is a good thing but it does create the optic that you are observing. I think we are expecting to use your words I think we are expecting less volatility if we hit our plan.

John Zolidis – Buckingham Research

Great, that’s helpful, thank you.

Operator

Your next question comes from the line of R.J. Hottovy from Next Generation Equity Research, please proceed.

R.J. Hottovy – Next Generation Equity Research

Just a couple of quick ones here hopefully. First of all, just in terms of the Winter sale, are you guys looking at any more incremental advertising expenses associated with this sale and correct me if I’m wrong but I though it was about $1 million last year for it, is there anything different we should be looking at in our model?

Peter Horvath

We’ve look at what is most effective and what’s interesting is we did a test with television last year at Christmas and honestly it did not give us the result we are looking for so we are going back to the old faithful, e-mails, direct mail and voice mail actually, which is something that is an emerging thing. Those are showing very good response rates and it is focused on our loyalty customer. So it’s not very expensive to be honest, the other impactful marketing that we are doing is a big red sign in the front of the store that says “Up to 80% Off”. We found that to be very impactful to the non loyalty customers and the natural traffic during the sale period. I wouldn’t expect, I don’t want to speak to an expectation of what marketing costs will be in the fourth quarter but I can tell you that’s what we are doing.

R.J. Hottovy – Next Generation Equity Research

If it’s associated with the sale it’s going to be lower than last year?

Doug Probst

The marketing total will be roughly flat at a rate to sales.

R.J. Hottovy – Next Generation Equity Research

The second question I had to do with the new format stores and if you could give us a little bit more color in terms of the sales per square foot and where that’s tracking in compared to the rest of the store base?

Peter Horvath

I’m probably going to sound like I’m repeating stuff we’ve said in the past, because the story hasn’t changed much. With the chain at about $215 to $217 a foot in that range, the first year a store opens historically it would be at 80% of that number which would put it at about $170 a foot. Our new stores are opening north of that company average number so that is a significant number. If you just do the math that sure feels like 30 to 40% better sales productivity.

That story continues, we’ve looked at the last 54 stores that we opened, which include 2006 and we kind of chunked it up to how many of these store are hitting the ball out of the park, how many are maybe soft but we can explain why they are going to get better such as the comment earlier on Lifestyle Centers and being the first guy open in a Lifestyle Center and putting shoes on all the feet of the construction workers, which is something we’re not going allow to happen in the future.

I think we are very satisfied that the majority of our stores are meeting our expectation. The productivity numbers and the four wall profits are right on track.

R.J. Hottovy – Next Generation Equity Research

That was helpful. My final question, can you give us any sense as to how long the e-commerce development costs are going to last into 08’, just a sense of how long that is going to continue to drag on the SG&A line?

Doug Probst

As we mentioned in the call the e-commerce channel should be up in the first half of the year so the development costs will basically be extinct so to speak because we will have volume to offset those. I would say, end of the first half of the year where there will be no sales but just expenses for the people that we’ve got on board to open it up and then hopefully have some top line volume to offset those and certainly decrease the impact on the bottom line.

R.J. Hottovy – Next Generation Equity Research

Okay, good luck with everything.

Operator

Your next question comes from the line of Jay [Inaudible] from Morgan Stanley, please proceed.

Jay [Inaudible] – Morgan Stanley

I just had a question on gross margin. You guys have been really helpful giving great color on the detail within SG&A; I just wanted to hopefully understand a little bit more about what might be going on in 4Q for gross margin. Let’s just say for conversation sake it decelerates by 400 basis points, what part of that would be from occupancy and what part would be from inventory?

Doug Probst

Some of the call broke up a little bit, you made an assumption and I didn’t catch the number, I’m sorry.

Jay [Inaudible] – Morgan Stanley

I was saying just for conversation sake let’s say gross margin decelerates by 400 basis point in 4Q, so that was the number that is used.

Doug Probst

So you are making that assumption well, the occupancy is going to have some significant de-leverage this quarter because we had 14 weeks versus 13. So, in your example of 400, at least half of that would be using your example, would be occupancy de-leverage because we have less sales. I hope that helps a little bit.

Jay [Inaudible] – Morgan Stanley

That does help, I appreciate it. My follow up question is, is it mostly just from not having the extra week or is there because the Lifestyle Centers are what I assume higher occupancy rate is there any extra de-leveraging factor going on from the fact that you are moving into more expensive real estate?

Doug Probst

Primarily the extra week.

Jay [Inaudible] – Morgan Stanley

Primarily the extra week. One more question if that’s okay. With the inventory was there any change to the inventory reserves in third quarter and do you expect any in fourth quarter?

Doug Probst

There are changes every quarter to the inventory reserves but that reserve number is really just an identification of the clearance balance from quarter to quarter. We can talk to you about that offline as far as the accounting support on that but not really noteworthy as far as this audience.

Jay [Inaudible] – Morgan Stanley

Thanks so much for your help.

Operator

Your next question comes from the line of Brad Leonard from B&L Capital, please proceed.

Brad Leonard – B&L Capital

Thanks for taking my call. Quick housekeeping question, the e-commerce, did you guys take $8.5 million expenses for the year?

Doug Probst

Yes

Brad Leonard – B&L Capital

How much of that has been expense year to date?

Doug Probst

All but about $3.5 million, so $5 million to date and another $3.5 million we expect in the fourth quarter.

Brad Leonard – B&L Capital

When I look at Q4 to talk about a 1% or 2% operating margin that is the worst Q4 you guys have had in a long long time and to help me understand this from last call when things were still, you were pretty adamant about sticking to your guns and the $1.60 something a share and inventories are clean going into Q3. Is this basically sales were below planned, instead of comping zero to three up you are going to comping slightly down and you had to blow through a bunch of merchandise and the gross margins are going to take a hit in Q2 and Q4, is that to sum it up reasonably?

Doug Probst

Absolutely.

Operator

There are not further questions at this time. I’d like to turn the call back over to Ms. Leslie Neville for closing remarks.

Leslie Neville

Thank you for joining us this morning, as always if you have follow up questions feel free to give us a call her at our home offices. Thank you.

Operator

Thank you for your participation in today’s conference, this concludes the presentation.

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