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Executives

Andrea Shaw Resnick - SVP, IR

Lew Frankfort - Chairman and CEO

Michael F. Devine - CFO and EVP

Michael Tucci - President, North American Retail

Analysts

Robert Drbul - Lehman Brothers

Michelle Clark – Morgan Stanley

Kimberly Greenberger - Citigroup

Jeffrey Edelman – UBS Securities LLC

David Schick - Stifel Nicolaus & Company

Liz Dunn - Thomas Weisel Partners

Christine Chen - Needham & Company, LLC

Erwan Rambourg - HSBC

Dana Telsey - Telsey Advisory Group

Coach, Inc. (COH) F2Q08 Earnings Call January 23, 2008 8:30 AM ET

Operator

Good morning, and welcome to the Coach conference call. Today's call is being recorded.

At this time, for opening remarks and introductions, I'd like to turn the call over to Senior Vice President of Investor Relations at Coach, Ms. Andrea Shaw Resnick. You may begin.

Andrea Shaw Resnick - SVP, IR

Thank you. Good morning and thank you for joining us. With me today to discuss our quarterly results are Lew Frankfort, Coach's Chairman and CEO, and Mike Devine, Coach's CFO. Mike Tucci, President of North American Retail will be joining us.

Before we begin, we must point out that this conference call will involve certain forward-looking statements, including projections for our business in the current or future quarters or fiscal years.

These statements are based upon a number of continuing assumptions. Future results may differ materially from our current expectations based upon risks and uncertainties such as expected economic trends or our ability to anticipate consumer preferences. Please refer to our latest annual report on Form 10-K for a complete list of these risk factors. Also, please note that historical growth trends may not be indicative of future growth.

We presently expect to update our estimates each quarter only, however the failure to update this information should not be taken as Coach's acceptance of these estimates on a continuing basis. Coach may also choose to discontinue presenting future estimates at any time.

Now let me outline the speakers and topics for this conference call.

Lew Frankfort will provide an overall summary of our second fiscal quarter 2008 results, and will also discuss our strategies going forward. Mike Tucci will review the holiday season from a U.S. retail perspective and discuss key initiatives for the spring season ahead. Mike Devine will conclude with details, financial and operational highlights for the quarter, as well as our outlook for the second half and full fiscal year 2008.

Following that, we will hold a question-and-answer session that will end by 9:30 a.m.

I'd now like to introduce Lew Frankfort, Coach's Chairman and CEO.

Lew Frankfort - Chairman and CEO

Thanks, Andrea, and good morning, everyone.

As you know, we've announced strong top line and bottom line growth of 21% respectively for the quarter just completed, a bit ahead of our expectations. We were pleased with our performance, especially in light of the weakening retail climate in the U.S. We were also encouraged with the continued strength of new stores, which are coming online well ahead of expectations.

Some highlights of our second fiscal quarter were:

First, earnings per share rose 21 - I'm sorry, excuse me. Excuse me. Overall, Coach's holiday performance reflected the strength of the Coach franchise, our position as a gift authority, and the continued strength of the U.S. handbag and accessory category.

However, this quarter demonstrated for the first time in our public history that we are not immune to a slowing consumer environment. At the same time, it's important to underscore our continuing positive outlook, including the delivery of at least a 17% revenue gain for the balance of the fiscal year, driven, as always, by both distribution growth and productivity gains.

We're well positioned for the spring season and expect that our diversified model will continue to mitigate the impact of the consumer malaise in the U.S.

Given the vitality of the Coach brand, category strength and our diversified business model, we're confident that the earnings per share guidance for the year originally provided in July and reiterated in October can still be achieved.

In addition, our ability to act quickly and nimbly secure spending during a period of uncertain sales trends as demonstrated in our holiday quarter will ensure continued expense leverage.

While I will get into further detail about current conditions and the outlook for the category in our business shortly, I did want to take the time to review our quarter first.

As you know, Coach announced a sales increase of 21%, a 21% increase in earnings per share for the quarter just completed. It's worth noting that Coach's achieved double-digit sales growth since 2001 in each holiday quarter for a fiveyear CAGR of 27%, including a 30% increase in the year-ago quarter.

Again, some highlights of our second fiscal quarter were:

First, earnings per share rose 21% to $0.69 as compared to $0.57 in the prior year, while net income rose to $252 million from $214 million.

Second, net sales totalled $978 million versus $806 million a year ago, a gain of 21%.

Third, direct-to-consumer sales rose 18% to $799 million from $675 million in the prior year.

Fourth, U.S. same-store sales for the quarter rose 7%, with retail stores down 1.1% versus a gain of nearly 21% last year, while factory store sales were up 17.7%.

Finally, sales in Japan rose 17% in constant currency and 21% in dollars, driven by distribution growth and mid single-digit overall comps as we continue to grow our market share.

During the quarter, Coach opened 10 North American retail stores, including two new markets for Coach - Allentown, Pennsylvania and Anchorage, Alaska - and expanded five others. We also opened three factory stores during the second quarter. At the end of the period, there were 282 full-price and 99 factory stores in operation in North America.

In Japan, one new department store location was opened along with one new factory store, while one department store location was closed and four locations were expanded. At quarter end, there were 147 total locations in Japan, with 23 full-price stores including 8 flagships, 104 shop-and-shops, 15 factory stores, and 5 distributor-operated locations.

Indirect sales increased 37% to $179 million from $130 million in the same period last year. During the quarter, POS sales at U.S. department stores grew over 10%, while international POS sales grew by more than 25%.

We estimate that premium and U.S. handbag and accessory category sales grew by about 10% during the holiday quarter. At the same time, Coach's handbag sales rose 15% across all channels in North America over the like period.

As mentioned, we were pleased with our overall performance in North America this quarter against very difficult comparisons across all channels. Our total revenues in North America were up 20%, with our directly operated stores generating a 19% gain driven by both distribution and the overall high single-digit comp.

North America retail stores posted an 11% gain despite a 1% comp decline which, as you know, was slightly below our low single-digit guidance. Two of three comp metrics - traffic and conversion - met our expectations, while our average ticket posted a modest decline reflecting the fact that some of our consumers traded down to lower price point items, which Mike Tucci will discuss in more detail in just a minute.

Results in our full-price businesses both in North America and internationally continue to be driven by the monthly flow of new products. Our U.S. factory store business remained remarkably strong throughout the quarter given the vibrancy of the Coach brand, the strength of our proposition, and continued sales growth in premium factory malls.

Finally, Coach sales on the Internet rose 15% in total this holiday, with the majority of the growth driven by the introduction of Coach to the Dillard's and Nordstrom's web sites.

I also want to highlight another excellent quarter for Coach women's footwear. Our business in department stores where we are now sold through about 800 locations rose about 65% at POS for the quarter.

We were also very pleased with the performance at Coach Japan this quarter, where sales rose 17% in yen and 21% in dollars. Growth in Japan was fuelled primarily by distribution through both new stores and expansions, augmented by mid single-digit comparable location sales as our market share continued to expand against a weak category backdrop.

While Mike Devine will get into more detail on our financials in general and these metrics in specific, I wanted to give you this recap of Coach's second quarter performance.

I will now turn it over to Mike Tucci to discuss our North American retail holiday sales performance and our spring initiatives.

Mike?

Michael Tucci - President, North American Retail

Thanks, Lew, and good morning.

Lew has just given you a recap of the quarter, which was challenging in many respects. While we essentially met our guidance of our high single-digit combined full-price and factory store comp, we were surprised by the slight comp decline in our retail stores, where our traffic challenges continued through the quarter.

The good news was that against the lower traffic, we actually converted at a much higher rate, although at a lower average transaction size or ticket than we saw last year as some consumers were definitely trading down to lower-priced items.

As mentioned in our release, our holiday offerings were generally well received across categories in collections. Our key item strategy was successful this season, which featured groups and item concepts generating about 50% of our holiday sales.

Bleecker, our newest lifestyle platform which was inspired by our classic Heritage, was the most important initiative during the quarter. It was well received by consumers, notably at higher price points. In fact, the $400 and up handbag offering represented about 22% of handbag sales this year versus 13% last year.

At the other end of the spectrum, new items such as our $98 capacity wristlet were top sellers, while new categories such as jewellery and fragrance were great giftables at sharp prices.

The strong performance of these categories speaks to the vibrancy of the brand as we gave consumers new ways to participate in Coach this holiday season.

Overall on a comp basis, we did see handbag penetration in our retail stores decline slightly in favor of these lower price point items. This suggests an opportunity in smaller bags at sharper prices which will be reflected in our assortments going forward.

Before moving on to spring, I'd like to touch on some of the key points from our Coach Service initiative during holiday.

Coach Service is an initiative we implemented three years ago to enhance our consumers' shopping experience and ultimately drive conversion. For FY08, the program evolved, providing enhanced leadership skills to our store managers, enabling them to develop their teams more effectively. Our focus for holiday was on technology initiatives.

First, time and attendance. A new time and attendance system was implemented in advance of holiday. The system gives store leadership visibility to individual service leader productivity. Specifically, it allows us to be more targeted in scheduling our most effective service leaders during peak times and then measuring their effectiveness.

Second, E-Runner. Our enhanced line management and checkout process was rolled out to an additional 75 high-volume stores, taking us to 98 stores for the holiday season. The system reduced transaction time and improved throughput.

Third, web store pick up. This service enhancement benefited consumers by allowing them to pre-order online for in-store pickup.

In summary, these initiatives allowed us to leverage our store labor costs while at the same time delivering a superior in-store experience to our shoppers.

I also wanted to briefly touch on the performance of our new stores, which has been well ahead of our internal projections.

During our analyst day presentation in September, we talked about the outperformance of stores opened in fiscal year 2007. This positive trend has continued, and the 21 stores opened in the first four months of FY08 are running about 24% ahead of pro forma, with an average first year annual volume of $2 million.

Turning to spring, we're enthusiastic about our transitional and seasonal offerings. As part of this transition, we recently introduced the New Slim Carly, offered in leather and signature across multiple silhouettes with iconic elements such as harness detailing and turn locks.

In addition, we updated our Hamptons Collection with a fresh color palette and silhouette, including the popular Madeline Tote and introduced new spring accessories.

For February, we will be launching Heritage Stripe, a group of coated canvas totes and bags representing a new concept, broadening our scope of attitudes, as well as a new collection of signature stripe handbags and accessories at great price points.

For March, we will be introducing a new silhouette, the Francine Satchel, while updating the Hamptons Weekend Collection.

April will mark the re-launch of Soho in drapier, feminine shapes, and we're very excited about pleated Ergo coming in for Mother's Day.

In summary, we're confident in our spring opportunities, both in product flow and our continued focus on Coach Service.

With that, I will return the discussion to Lew to continue with our overarching strategy.

Lew Frankfort - Chairman and CEO

Thanks, Mike.

I think it's important to note that this challenging climate has only served to reinforce our longstanding practice of evolution and continuous improvement. We are embarking on a comprehensive review of all ways in which the brand touches the consumer. These initiatives will be evident as we move into full year 2009, most notably in our product and in our store environments.

We plan to leverage for the early successes we have seen with our Pinnacle offering, creating a broader assortment of more sophisticated and elevated product which will create a halo for the entire brand, heightening Coach's aspirational appeal.

We will also at the same time maintain the balance that is key to our franchise, capitalizing on our leadership position with our loyal core consumer and with the aspirational consumer who is often trading up to Coach.

It is for these reasons that we're now realigning our product development structure to create separate cross-functional design and sourcing teams dedicated to meeting the varying consumer requirements across attitudes and price points.

We will also be enhancing our in-store experience notably through the environment, creating a more residential and intimate feel, with more proprietary elements capturing the attitude we have achieved in our legacy concept store here in Manhattan.

We continue to believe that our opportunities, both in our home market and internationally are abundant. For perspective, we estimate the addressable handbag and accessory market in North America reached over $8 billion in calendar 2007 and is continuing to demonstrate growth despite the weaker economy.

Thus, with the Coach brand so strong and the market expanding, the potential for Coach remains significant.

As most of you know, we have two primary sales drivers; each plan to achieve about 10 points of growth.

First is distribution as we expand our global network of store locations with an emphasis on North America, Japan and Greater China.

And second is productivity, which we drive across all geographies through the introduction of innovative, relevant product offering excellent value.

We have been implementing four key strategies that focus on sustaining growth within our global framework. Clearly, our largest opportunity during our planning horizon continues to be in North America.

First most generally, we're building market share in a growing North American women's accessories market by leveraging our leadership position as a topofmind and preferred brand for self-purchase and gifts.

As part of this strategy, we've been emphasizing new usage occasions within our handbag offering and developing new flanker categories such as jewellery and fragrance.

There is also a continuing opportunity as I mentioned to elevate our handbag offering. As we have seen, the so-called white space between our price points and those of the European luxury brands continue to widen.

Our first legacy boutique which opened on Bleecker Street here in New York in October features a more elevated product assortment, including an exclusive group of handbags and accessories. This store, which allows us to test merchandising, service, and product initiatives, has been performing extremely well.

Our second strategy is the continued rapid growth in North American retail. We plan to add about 40 retail stores in North America in each of the next several years. Based on the performance of our new stores and the greater numbers of new consumers we are attracting, we believe that North America in total can easily support about 500 retail stores, including up to 20 in Canada.

This roadmap for expansion is based upon a build up of individual malls and locations that meet our demographic requirements and economic hurdles. Specifically, during FY08 we expect to open about 40 new North American retail stores, including the 23 already opened in the first half.

The new openings will include 13 completely new markets, and we expect to open a few more factory stores in addition to the six opened in the first half. Also, we will be expanding nearly 20 retail stores and several factory stores.

Taken together, we expect total square footage to grow at about 20% this year, a bit above last year.

And third, outside the U.S. we're continuing to increase market share with the Japanese consumer driving growth in Japan primarily by opening new retail locations and by expanding existing ones. For FY08, we plan to open about 10 net new retail locations as well as a few factory outlets as this channel becomes more important to Japanese consumers.

We will also continue to expand key locations. Overall, we expect to increase our square footage in Japan at a slightly lower rate in FY08 than we did last year.

In addition, we're continuing to target overall constant currency sales growth of between 10% and 15% for the balance of the year in Japan, driven primarily by distribution growth.

Our fourth strategy is to raise brand awareness in emerging markets to build a foundation for substantial sales in the future. Specifically, Greater China, Korea, and other such geographies are increasing in importance as the category is growing rapidly and Coach is taking hold.

During the first half, we opened a net of 15 new international locations outside of Japan, including six in Greater China. In FY08, in total we will open through distributors about 30 net new locations focused on Greater China, Southeast Asia and the Middle East.

A few highlights of our upcoming international openings are worth mentioning.

First, as noted in our press release, given the rapid growth we're experiencing in East Asia and Greater China, we are particularly pleased to announce the opening of a global flagship store on Queen's Road Central in Hong Kong scheduled for early summer 2008. This flagship will significantly enhance the Coach brand and is consistent with our strategy of raising awareness and aggressively growing market share with the Chinese luxury consumer. Clearly, Greater China has the potential during the next few years to become the third major market for Coach following North America and Japan.

Second, we are also pleased to announce plans to enter the Russian market through an arrangement with JamilCo, a local distributor with significant luxury brand experience. Together, we expect to open at least 15 Coach locations in Russia over the next five years, initially concentrating development in Moscow and St. Petersburg.

In summary, we're well positioned to continue to capitalize on the many opportunities available to us and have the strategies in place to realize our long-term growth plan irrespective of the near-term environment.

At this time, I'd like to turn it over to Mike Devine, our CFO, for further detail on our financials.

Mike?

Michael F. Devine - CFO and EVP

Thank you, Lew.

Lew and Mike have just taken you through the highlights and strategies. Let me now take you through some of the important financial details of our second quarter results.

As mentioned, our quarterly revenues increased 21%, with direct-to-consumer up 18% and indirect up 37%.

Earnings per share for the quarter increased 21% to $0.69 a share as compared to $0.57 in the year ago period as net income rose to $252 million from $214 million.

Our operating income rose 18% to $403 million in the second quarter versus $341 million in the same period last year.

Operating margin in the quarter was 41.2% compared to 42.3% in the year ago quarter.

In the second quarter, gross profit rose 19% to $737 million, up from $621 million a year ago.

Gross margin rate was 75.4% versus 77.1% last year, impacted by the promotional environment in North America as well as currency fluctuations.

SG&A expenses as a percentage of net sales were below prior year levels in the quarter and represented 34.2% of sales versus 34.8% last year.

We achieved leverage on our retail P&L despite its lower level of comp, while we also saw leverage on what we refer to as our semi-fixed corporate functions.

Moving to the balance sheet, inventory levels at quarter end were $301 million, about 20% above prior year levels and slightly below our sales increase, leaving us well positioned with clean inventories as we enter the spring season. This inventory increase allows us to support 54 net new U.S. stores, 15 net new locations in Japan, and substantially increase sales levels.

Accounts receivable balances rose only 14%.

Cash and short-term investments stood at $891 million as compared with $820 million a year ago, despite the repurchase of $839 million worth of our stock in the interim 12 months.

Net cash from operating activities in the second quarter was $393 million compared to $345 million last year during Q2.

Free cash flow in the second quarter was an inflow of $345 million versus $307 million in the same period last year, mainly due to higher net income.

Our Capex spending, primarily for new stores and renovations, was $48 million versus $37 million in the same quarter a year ago.

As noted in our press release, during the second quarter we repurchased and retired 20.5 million shares of common stock at an average cost of $34.51, spending a total of $707 million or an additional 9.9 million shares at $34.24 per share since our November 9th announcement of the new $1 billion authorization.

As of the end of Q2, $661 million was still available under the company's most current repurchase authorization, which was put in place on November 9th.

Now I'd to provide you with some of our updated goals for fiscal 2008.

For the second half of 08, we're targeting net sales of at least $1.5 billion representing a year-on-year increase of at least 17%, operating income up about 16%, reflecting an operating margin of about 36.5%, and earnings per share of $0.97, an increase of 20%.

As noted, we are not providing comparable store sales guidance due to the lack of visibility given the macro backdrop.

Additionally, it should be noted that going forward we will be reporting only total sales growth in Japan consistent with the practice of our peers.

Our current goals for the full fiscal year are net sales growth of at least 20% to at least $3.15 billion, and we're targeting an operating margin of 37.7%, which assumes further SG&A leverage over the balance of the year while gross margin is expected to decline about 100 basis points; operating income dollar growth of about 20% above FY07 levels; interest income of about $40 million, which is significantly lower than included in our prior guidance due to the cash used on buyback activity as well as lower interest rates. This interest income will add the pretax income while net income will be somewhat offset by a higher tax rate this year at about 39% due to the fact that incremental taxable income is being taxed at higher rates.

Including these factors, we anticipate generating EPS growth of 22% which will produce earnings per share of $2.06, consistent with our prior guidance.

For FY08, we are still planning to spend about $200 million on Capex, primarily for new stores and expansions both here and in Japan, as discussed.

In addition, as mentioned in our last call, we are expanding our distribution center in Jacksonville, Florida by about 50% to support Coach's projected sales growth for the next few years. While we upgraded the technology at this facility a year ago, a physical expansion is now necessary to accommodate the expected growth of our business. This expansion will require Capex of about $12 to $15 million in FY08.

While these are our current goals, our actual results may vary from these targets based upon a number of risk factors, including those discussed under the Business of Coach, Inc. and Risk Factors in our annual report on Form 10-K. Coach also does not assume any obligation to update these targets as the year progresses.

In summary, we're confident that our growth strategies will enable us to continue to gain share in the large and growing global market for fine accessories and gifts.

Thank you for your attention, and now Lew, Mike, Andrea and I will be happy to take questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions)

Our first question comes from Robert Drbul with Lehman Brothers. You may ask your question.

Robert Drbul - Lehman Brothers

Good morning.

Lew Frankfort - Chairman and CEO

Good morning, Bob.

Andrea Shaw Resnick - SVP, IR

Morning, Bob.

Robert Drbul - Lehman Brothers

Lew, I guess the question that I have this morning for you is given the uncertainty out there in the environment, I mean, how can you be confident in the guidance that you're giving us for the second half of 2006 of the year?

Lew Frankfort - Chairman and CEO

Bob, as you know, we have a diversified business model. We're not overly dependent on any single channel.

We do have two levers for growth. The first is distribution, which will represent slightly more than half of our planned growth in the second half of 2006 and that we have great visibility to.

We also look to improve worldwide productivity, and we have excellent visibility in that arena as well.

So we have built a range of assumptions that lead us to confidently project growth of at least 17%.

Robert Drbul - Lehman Brothers

Okay. And then just another question real quickly would be: When you talk about the consumer trading down specifically within your stores, have you seen higher levels of cross-shopping between, you know, full-price stores, shopping in the outlets or, you know, any other trends you guys usually analyze.

Lew Frankfort - Chairman and CEO

No. The short answer is no.

What we have found both in our factory stores and in our full-price stores is substantially higher conversion levels. So once the consumer is in our full-price store or our factory store, she's converting at higher levels.

But we don't see consumers trading down from full price to factory.

Robert Drbul - Lehman Brothers

Great. Thank you very much.

Lew Frankfort - Chairman and CEO

You're welcome.

Operator

Your next question comes from Michelle Clark with Morgan Stanley. You may ask your question.

Michelle Clark - Morgan Stanley

Great, thanks. And good morning, everyone.

Lew Frankfort - Chairman and CEO

Good morning.

Michelle Clark - Morgan Stanley

First in terms of traffic trends, can you give us any more color, any notable cause in terms of one geography, and then if you're seeing any notable differences in terms of your on-mall locations versus your standalone locations?

Michael Tucci - President, North American Retail

Sure. We actually saw traffic patterns through the quarter that were very consistent from the start of the quarter right through and frankly, very consistent across geographies, so no major differences to call out around traffic.

Obviously, we're fighting that headwind and trying to convert the people who are coming into our stores, which we're doing at a much higher rate.

Michelle Clark - Morgan Stanley

All right. Thanks.

And Mike, any notable differences in your on-mall locations versus your off-mall locations in terms of traffic?

Michael Tucci - President, North American Retail

A very slight difference in terms of malls suffering a little bit more and our street locations and what you might call lifestyle centers or hybrids a little bit more healthy.

Of course, that's a much smaller piece of our portfolio.

Michelle Clark - Morgan Stanley

Right. And then, second question, Lew, your thoughts on announcing a new share buyback plan in the second half of '08?

Lew Frankfort - Chairman and CEO

We actually have an existing stock authorization program, and as Mike Devine indicated, I believe there's over $660 million still available.

Michelle Clark - Morgan Stanley

Right. But anything in addition to that if you can get through it in the third quarter?

Lew Frankfort - Chairman and CEO

Well, we can deal with that at that time.

Michelle Clark - Morgan Stanley

Okay, great. Thanks and best of luck.

Operator

Thank you. Our next question comes from Kimberly Greenberger with Citi. You may ask your question.

Kimberly Greenberger - Citigroup

Great, thank you. Good morning.

Lew Frankfort - Chairman and CEO

Good morning, Kimberly.

Kimberly Greenberger - Citigroup

The SG&A rates or the SG&A growth rate was very nice this quarter and actually lower than we were expecting. Is this a sustainable level of SG&A growth rate, and if you could just talk about some of the levers that you're pulling in a little more detail, that would be helpful.

Michael F. Devine - CFO and EVP

Sure, Kimberly, I'll take that.

We were pleased with where SG&A landed for the quarter. As you pointed out, it was - we got about 60 BPS of leverage from SG&A. We actually saw leverage on Mike Tucci's P&L at about a 7 comp. We were able to pull that off in Q2 when volumes were high, and I think it does speak to the levers and the manoeuvrability we have within spending and how nimble we are.

You know, I've called them out before but I'm happy to talk about them again, particularly in our direct businesses. A lot of our spending is variable. We are in percentage rent in the majority of our stores. That is true in Coach Japan as well, where their occupancy is largely variable.

Also, Mike talked about some of the technology enhancements that we've put into the store environment to make our associates more productive, most notably those around time and attendance and smart scheduling allows us to ideally match staffing levels with anticipated traffic and control store wages that way.

We've also put on hold certain longer payback spending initiatives.

Also I will tell you that, as we've shared with the Street community over the years, our internal goals are always stretch versus those expectations we set with the Street, so we also have a variable component of our SG&A in terms of management bonuses.

So all of those things taken together give us a lot of confidence that on a mid-teen type of top-line growth, we can continue to deliver SG&A leverage.

Kimberly Greenberger - Citigroup

Great. That's very helpful.

And just one last question on your gross margin guidance for the fiscal '08 year, I think you said down 100 basis points for the year, which would imply, you know, obviously some slight pressure on Q3 and Q4, but not to the extent that we saw in Q2.

Please talk about how it is that you're getting there, and what gives you the confidence that the promotional environment that we saw here in the holiday period doesn't continue into Q3 and Q4?

Michael F. Devine - CFO and EVP

Yeah, actually, Kimberly, you're right in calling out that it is down year-over-year in the second half; that continues.

And our own anticipations are that we're going to need to continue the promotional activities that we employed in our direct businesses, particularly in North America, in the second half.

These intensified promotional activities are really going to be required for Coach to adapt to the difficult consumer environment, and so that is assumed in the gross margin guidance that we've laid out there for the balance of the fiscal year.

Kimberly Greenberger - Citigroup

Great. Thanks, and good luck here in the second half.

Lew Frankfort - Chairman and CEO

Thank you.

Operator

Thank you. (Operator instructions) Our next question comes from Jeff Edelman with UBS. You may ask your question.

Jeffrey Edelman - UBS Securities LLC

Thank you. Good morning.

Lew Frankfort - Chairman and CEO

Good morning, Jeff.

Jeffrey Edelman - UBS Securities LLC

On the promotional side, this is the first time you've had to step it up to create incremental purchases. As you analyze your customer base, are we seeing any shift in less positive response to new line offerings or are would you attribute it to overall slower store traffic or price points?

Lew Frankfort - Chairman and CEO

Overall, the significant majority of our sales in Q2 were made at full price, so we continue to be primarily a full-price proposition.

So what we're talking about, Jeff, is on the margins, we intensified our preferred customer events in order to offset some of the reductions that we were experiencing in traffic and to be responsive to the challenging retail environment.

Our brand is as resilient as it has been. Based on the research we did as recently as last month and into the first part of this month, Coach consumers intend to continue to spend on bags as much or more in the future than they did in the past, even though their overall purchasing spend is expected to be less.

So we don't see this as germane to anything related to our franchise.

Jeffrey Edelman - UBS Securities LLC

Okay. Lew, in the past you've always maintained a very strong full-price proposition and the consumers have responded to that. As you increase your friends and family coupon or whatever, what's the fear that you have that you would create the let's wait and see what the next promotion is before I come into the store?

Lew Frankfort - Chairman and CEO

It's a very good question, Jeffrey.

What I should have mentioned earlier perhaps is that the intensification primarily came from a new program that we just introduced to our exclusive factory store consumers where we offered our best factory store consumers the opportunity to buy at a discount in full price for a limited period of time. That initiative was extremely successful.

So this is a situation where we're looking to migrate factory consumers who are unique factory consumers or what we call exclusive factory store consumers to full price. It's been very successful.

So that's been the vast majority of the intensification. And again, the vast majority of our sales continue to be at full price.

The other thing that was interesting to us, notwithstanding the very strong response we got from our best customers who we invited - best factory customers who we invited to our full-price events, there was no fall off in our factory business during or subsequent to that event.

Jeffrey Edelman - UBS Securities LLC

Okay. And the same question as far as the full-price stores are concerned?

Lew Frankfort - Chairman and CEO

The only thing that happened was our business increased during the period in full price.

Michael Tucci - President, North American Retail

Jeff, what Lew was explaining is that the exclusive factory store customer invites were the invites for those consumers that shop in the full-price stores.

Andrea Shaw Resnick - SVP, IR

And that was the incrementality year-over-year.

Jeffrey Edelman - UBS Securities LLC

Okay.

Andrea Shaw Resnick - SVP, IR

That new set.

Jeffrey Edelman - UBS Securities LLC

Okay. But the fact that you've stepped up the friends and family or coupon to the existing full-price store customers, if you fall back on that -

Lew Frankfort - Chairman and CEO

Year-on-year, it's heavily the same on full price.

Jeffrey Edelman - UBS Securities LLC

Okay. Okay, thank you.

Lew Frankfort - Chairman and CEO

There was one event this quarter, there was one event last quarter; the numbers are relatively similar.

The difference is that we did a very substantial event inviting, again, unique factory store consumers to shop at full price. We obviously will be measuring the long-term impact to see whether all of the spend is incremental, whether we're also able to convert some of them to buy in full price at full price.

Jeffrey Edelman - UBS Securities LLC

Okay. Okay, great. Thank you.

Lew Frankfort - Chairman and CEO

You're welcome.

Operator

Thank you. Our next question is from David Schick with Stifel Nicolaus. You may ask your question.

David Schick - Stifel Nicolaus & Company

Hi. Good morning.

Lew Frankfort - Chairman and CEO

Good morning, David.

David Schick - Stifel Nicolaus & Company

The question is really if you could talk about your online business and your communication with your customers through email, what they're looking at, what they're opening in terms of spring. Is there anything that leads you to any conclusions on attitudes or appetite from that line of communication? Thanks.

Michael Tucci - President, North American Retail

Sure. In terms of our online activity, we had a very strong quarter online. We introduced a number of features online, like the - what we're calling web store pick up.

Interestingly, our traffic patterns online have remained very healthy. We have not significantly increased our email activity. We're very disciplined around email activity, and our thought process there is that we're going to send emails to those people who are most interested in receiving them and have the highest propensity to open them.

Our email and promotional activity online is really focused on newness, so what we're using online as a vehicle for is an introduction to the brand.

Our business online equals on an annual basis all of our visits in store. It's an enormous number of people.

We are going to be introducing new product into the stores on Friday of this week, which will be a lifestyle platform called Heritage Stripe. We'll use online as a way to introduce that in terms of a product refresh online as well as email.

Sequentially, on the 15th of February we will introduce a major platform of Signature Stripe. We'll also refresh our web site in conjunction with our store refresh, use email to communicate that.

And that's essentially how we do it. We see the online experience as a direct link to our store experience, and very recent data that we've looked at suggests that more and more, the store experience is being pre-shopped by our consumer online. They're going online to basically interact with the brand, scout for newness, scout for information, and then they're visiting the stores off of that experience.

So we feel very good about what we're doing with our online consumer.

David Schick - Stifel Nicolaus & Company

And is there anything, you know, in the last month or two months in terms of what people are looking at price point wise or anything that you can track there that would lead you to other conclusions about price point going forward other than what you've already shared?

Michael Tucci - President, North American Retail

It's very funny. It's such a mirror image, what the consumer buys online and how she behaves online. We merchandise our web site as a flagship, so it's a very broad offering.

I would take the opportunity to maybe bridge to the subject of assortment and what we believe very strongly in is continuing to focus on this elevated product assortment and going after the white space.

I will say that there is an opportunity offsetting that to make sure we have proper balance across price spans at lower prices in the handbag spectrum, and as I said earlier in my prepared remarks, that's something that we're addressing.

I think with the next two deliveries, in fact - Heritage Stripe and Signature Stripe  you're going to see a very broad offering from a price standpoint, including some very sharp price points in smaller bags, and that'll round out the assortment.

And you'll see that online and in store.

David Schick - Stifel Nicolaus & Company

Great. Thanks.

Operator

Thank you. Our next question comes from Liz Dunn with Thomas Weisel Partners. You may ask your question.

Liz Dunn - Thomas Weisel Partners

Hi. Good morning.

Lew Frankfort - Chairman and CEO

Good morning.

Andrea Shaw Resnick - SVP, IR

Hi.

Liz Dunn - Thomas Weisel Partners

Can you discuss the price adjustments that occurred during the quarter? How was that accounted for? My understanding is that it was accounted for as a price adjustment, not a markdown.

And over time, what's your ability to sort of hit those lower price points while maintaining your exceptional growth margins?

Also related to gross margin, what's the cost environment like? We're hearing a lot of talk about cost pressure coming out of China. What are you experiencing?

Lew Frankfort - Chairman and CEO

Okay. Well first, with regard to the repricing, the catalyst for the repricing was to provide price comparability with department stores whose inventories were larger than they would have liked going into the week before Christmas. And their interest was to cleanse their inventories, and we followed up to provide consumers with comparability.

What you need to appreciate is that it was less than 5% of our sales. It wasn't undertaken to lower price points. It was really undertaken to give consumers an equal value.

It was an exceptional event. We did it because wanted our department store inventories to be clean for the spring, which they are, and we think we're better off for it. It was de minimus to our overall results.

With regard to the cost environment, you're correct. Costs are going up in China. At the same time, we are beginning to migrate some of our production to lower-cost neighbouring countries such Vietnam and India, which of course is not that close. But we are looking at other geographies. We're also, within China, moving to lower-cost areas in the northern part of China.

So we have a very flexible constellation of independent factories that work in partnership with us in order to preserve high quality and at the same time enable us to maintain or reduce costs.

Mike, you want to -

Michael F. Devine - CFO and EVP

Yeah, just to drill down and a little nearer term in around the cost pressures, they have existed and continue to exist. We've seen some easing of leather prices, but there are also offsets.

The sourcing organization has done a marvellous job. In the second quarter alone, while we talked about gross margin being impacted by some promotional pressures in our direct business, we actually saw gross margins expand in our indirect business.

And so again, the sourcing organization, merchandising and our wholesale sales divisions really did a terrific job in actually delivering year-over-year margin growth in the indirect business.

So we have been able to offset those cost increases in what I'll call our organic gross margin rate product price versus cost ratios.

Liz Dunn - Thomas Weisel Partners

And do you think your gross margins are sustainable in sort of a mid-70s range over the long term?

Michael F. Devine - CFO and EVP

Yeah, we feel very strongly that way.

Liz Dunn - Thomas Weisel Partners

Great. Thanks.

Michael F. Devine - CFO and EVP

You're welcome.

Operator

Thank you. Our next question comes from Christine Chen with Needham & Company. You may ask your question.

Christine Chen - Needham & Company, LLC

Thank you. I was just wondering, for the gross margin decline in the quarter, can you help us quantify what part of it might have been due to the channel shift, you know, given the outperformance of factory and how much of it was due to the promotional environment?

And then can you also talk a little bit about your relationship with department stores, like for the bags that did get marked down in the department stores, is that markdown money that they have to bear or is that on your end?

Thank you.

Michael F. Devine - CFO and EVP

I'll take that one. I'll answer the last part of the question first.

In terms of relationship with the wholesale partners, the markdown money is something that's been accounted for both in our actual margins through Q2 that we published today and in our guidance and thinking going forward, so it's in there, if you will.

And I'm sorry, the second part of the question?

Andrea Shaw Resnick - SVP, IR

Breakdown gross margin.

Michael F. Devine - CFO and EVP

Oh, the breakdown of gross margin, I'm sorry.

We had roughly an offset. I just spoke about the hard work of the sourcing organization. We actually had the sourcing relationship improvements roughly offset our channel mix. Both were at about $40 BPS in either direction offsetting those.

And so the year-over-year change of about 170 basis points came from about 100 basis points due to increased promotional activities in our direct businesses and about 50% - I'm sorry, 50 basis points - also from a negative impact from currency fluctuations, most notably the yen in Japan.

And so from guidance, where we had guided down about 50 basis points for Q2, the mix was about 120. That same 50 in currency accounts for part of that 120. We didn't anticipate the strengthening of the yen going into the quarter.

And then our promotional activity was about 70 basis points more in our direct channels than we had anticipated when we gave our October guidance.

Christine Chen - Needham & Company, LLC

Got it. And then I guess just to further clarify the relationship with the department stores, some vendors, you know, negotiate a discount upfront and then at the end of the quarter they don't need to argue about markdown dollars. Is that how you do your business, or do you discuss it at the end of every quarter?

Lew Frankfort - Chairman and CEO

We have a longstanding partnership with department stores. They look, as we do, at our business with them on an annual basis, and any markdowns and discounts are a very small part of the total picture, not worth even discussing.

Christine Chen - Needham & Company, LLC

Got it. And then can you talk a little bit about jewellery, how that did during the quarter?

Michael Tucci - President, North American Retail

Sure. We were very, very pleased with jewellery. It is a flanker category. It is a category that we believe has strong relevance in the mix in terms of our brand. We introduced it to all stores in September. We refreshed jewellery in terms of new product going into the quarter.

It performed better than we had planned at slightly better penetration levels in the 3% range overall; higher in our more dominant flagship locations which had a broader assortment of jewellery, including sterling.

And one of the learnings that we got is that we got a very strong reaction to the sterling portion of the jewellery mix, and we are rolling that to several more stores as early as this quarter where we can provide fixturing and add that in terms of an assortment mix.

So we feel very good about the assortment. You'll see a lot of newness in jewellery in the next 60 days in our stores.

Lew Frankfort - Chairman and CEO

Christine?

Christine Chen - Needham & Company, LLC

Yes.

Lew Frankfort - Chairman and CEO

Yeah, just one last thing on department stores. I know you know this, but I'll just say it anyway.

For context, department stores are only about 11% to 12% of our global sales, so it's actually a very small part, unlike the situation with most American brands.

Christine Chen - Needham & Company, LLC

Right. Well, thank you and good luck.

Lew Frankfort - Chairman and CEO

Thank you.

Operator

Thank you.

Our next question comes from Erwan Rambourg with HSBC. You may ask your question.

Erwan Rambourg - HSBC

Hi. Good morning, everyone.

Lew Frankfort - Chairman and CEO

Good morning.

Andrea Shaw Resnick - SVP, IR

Good morning.

Erwan Rambourg - HSBC

I think you've been very clear on the promotional environment in the States. I was just wondering if this was an isolite - an isolated, sorry - phenomenon or if you're also seeing promotional activity going on in Japan? And if that's the case, does that explain the fact that your comps are accelerating in Japan, or is that linked to something else?

Lew Frankfort - Chairman and CEO

Well, first, our comps aren't accelerating. They've been fluctuating between low and high single digits for years now.

Our primary growth is through distribution. The level of promotional activities in Japan are no greater today than they were yesterday. They're consistent.

Erwan Rambourg - HSBC

Okay. And then I was just wondering if you had given further thought to the potential of a dividend given the tough equity markets we're experiencing today?

Lew Frankfort - Chairman and CEO

It's never far from our minds. We talk about it regularly, so the answer is yes, it continues to be under consideration.

Erwan Rambourg - HSBC

Okay, thank you.

Lew Frankfort - Chairman and CEO

You're welcome.

Operator

Thank you. Our next question comes from Dana Telsey with Telsey Advisory Group. You may ask your question.

Dana Telsey - Telsey Advisory Group

Good morning, everyone. Can you talk a little bit about how you're reorganizing the business in terms of by brand or by product category, by usage? How is that going to impact costs or sales or margins or better help you develop product? Thank you.

Lew Frankfort - Chairman and CEO

The intention is really to help us better develop product, and I think the best illustration I can provide is by illustration.

We're creating a group to focus on higher-end product and we're calling that Collection Group. And that group is going to have, within the same entity, designers, sample makers, product development people and sourcing people who will be responsible for the procurement of materials.

And to the extent that we are going to be introducing new collections in this white space, and we are, there's longer lead times that are required for new material development, and by having a dedicated unit from conception to completed production will enable us to be more nimble, enable us to also broaden our development activities.

So that's really taking our category teams to the next level.

Dana Telsey - Telsey Advisory Group

Thank you.

Lew Frankfort - Chairman and CEO

You're welcome.

Andrea Shaw Resnick - SVP, IR

Thank you, everybody, for joining us today. It is now 9:31 per my watch and, of course, I look forward to taking your questions as does Mike Devine throughout the day, but we're going to end this conference call. Have a terrific day. Thanks, everyone.

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