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Executives

Allison C. Malkin - Senior Managing Director

James S. Scully - Chief Administration Officer and Executive Vice President

Stuart Haselden - Chief Financial Officer

Libby Wadle - Executive Vice President of Retail & Factory

Analysts

William M. Reuter - BofA Merrill Lynch, Research Division

Jordan Hughes - Goldman Sachs Group Inc., Research Division

Carla Casella - JP Morgan Chase & Co, Research Division

Grant Jordan - Wells Fargo Securities, LLC, Research Division

Karru Martinson - Deutsche Bank AG, Research Division

Emily E. Shanks - Barclays Capital, Research Division

Karen Eltrich - Goldman Sachs Group Inc., Research Division

J. Crew Group (JCG) Q1 2012 Earnings Call May 31, 2012 11:00 AM ET

Operator

Greetings, welcome to the J. Crew Inc. First Quarter Fiscal 2012 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Allison Malkin of ICR. Thank you, Ms. Malkin, you may begin.

Allison C. Malkin

Good morning. Thank you for joining us to review our first quarter 2012 results. With me today are Jim Scully, Chief Administrative Officer; Libby Wadle, Head of our J. Crew brand; Stuart Haselden, Chief Financial Officer; and other members of our management team.

Before we begin, I'd like to remind you of the company's Safe Harbor language, which I'm sure you're all familiar with. The statements contained in this conference call, which are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC and in the press release issued in connection with today's call.

As a result of the acquisition on March 7, 2011, by TPG Capital and Leonard Green & Partners, the company prepared financial statements last year for the predecessor period from January 30, 2011, through March 7, 2011, and the successor period from March 8, 2011 through April 30, 2011.

Additionally, we have prepared a pro forma statement of operations for the first quarter of 2011, giving effect to the acquisition as if it occurred on the first day of this fiscal year and eliminating all transaction-related nonrecurring expense, which can be found in Exhibit 2 of our press release. We refer you to the supplemental MD&A and other disclosures in our Form 10-Q for the first quarter of fiscal 2012.

During this call, we will refer to adjusted EBITDA, which adjusts for items such as noncash share-based compensation as well as the impact of purchase accounting resulting from the acquisition. You will find a reconciliation of adjusted EBITDA in Exhibit 4 of our press release.

With that, I would now like to turn the call over to Jim Scully.

James S. Scully

Thanks, Allison, and good morning. I will provide a brief overview of our first quarter results, and then Stuart will walk you through our financials in more detail. After which, we will open up the call to your questions.

For the first quarter, total revenues increased 23% with comparable company sales increasing 16% and direct sales increasing 19%. Our gross margin increased 290 basis points to 47.6%, driven by 150 basis points of merchandise margin expansion and 140 basis points of buying and occupancy leverage. Our adjusted EBITDA totaled $102 million or 20.2% of revenues in the first quarter versus $75 million or 18.3% of revenues last year.

We are very pleased with our first quarter results. Our customers responded very well to our spring product flows, and we saw a continued sequential improvement in our top line trend, particularly in our Women's business. Our Women's performance was driven by our strategy to narrow our assortments and invest behind our big ideas.

Before I turn the call over to Stuart, I'd like to take a moment to acknowledge and congratulate him on his appointment to CFO earlier this month. Stuart has been with J. Crew since 2006 and has been an integral part of driving our finance function and the growth of J. Crew.

With that, I would now like to turn the call over to Stuart to review our financial results in more detail and provide the outlook for CapEx for the year.

Stuart Haselden

Thanks, Jim. Turning into the details for the first quarter. Total revenues increased 23% to $504 million. Total comparable company sales, which include comp store sales, direct sales and shipping and handling revenues, increased 16%. Our store sales increased 26% to $354 million with net square footage growing 7% in the first quarter with 10 new store openings during the quarter.

Direct sales increased 19%, which includes our J. Crew factory and Madewell direct businesses. Gross profit for the first quarter was $240 million. Gross profit margin increased 290 basis points to 47.6%, driven by 150 basis points of merchandise margin expansion, coupled with 140 basis points of buying and occupancy leverage. Our merchandise margin improvement resulted from higher full price sell-throughs, driving lower markdowns versus last year.

Turning to SG&A expenses. SG&A increased 25% to $164 million. This represented a 60 basis point increase to last year on a rate basis at 32.6% of revenues. The first quarter includes a $6.7 million increase in share-based and incentive compensation. Adjusted EBITDA, as outlined in Exhibit 4 of our press release, for the quarter was $102 million as compared to $75 million last year with EBITDA rate increasing to 20.2% of revenues versus 18.3% last year. Net interest expense for the first quarter totaled $25 million, which compares to $26 million last year and is reflective of the debt incurred in connection with the acquisition.

Turning to key balance sheet highlights. Cash and cash equivalents were $216 million at the end of the first quarter. Total debt was $1.6 billion at the end of the first quarter, consistent with last year. Our inventory balance was $251 million at the end of the quarter compared to $266 million at the end of the first quarter last year. Inventory last year included a purchase accounting step-up adjustment and higher in-transit inventories compared to this year. Inventory adjusted for purchase accounting and in-transit last year increased 14% or 6% per square foot, on a per square foot basis.

Capital expenditures for the first quarter were $37 million. We expect capital expenditures to total approximately $125 million to $135 million for the full year 2012, reflecting investments to support our growth initiatives with key expenditures for 42 new stores, supply chain infrastructure and corporate office expansion, as well as information technology enhancements and store renovations.

We've made significant progress in the first quarter on several of our key strategic initiatives, including accelerated growth in Madewell, continued development of our direct to customer programs and our expansion into international markets.

Momentarily, we will open the call to take your questions and hope these discussions will provide added detail regarding our financial results to help you form your investment opinion of our company. For competitive reasons, we will not provide insight into our merchandise direction and ask that you limit your questions to our first quarter performance and strategic growth initiatives.

With that, I will turn the call over to the operator to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of William Reuter of Bank of America Merrill Lynch.

William M. Reuter - BofA Merrill Lynch, Research Division

In terms of the better gross margins due to lower markdowns, I'm curious whether you think how much of this was attributable to the better fashion? And how much might have been attributable to better weather as you are probably selling spring merchandise early in the quarter pretty well?

Libby Wadle

This is Libby. We really -- we don't assign much in terms of relevance to weather. So we saw great response to our product within the quarter irregardless of weather, I would say.

William M. Reuter - BofA Merrill Lynch, Research Division

Okay. I guess was there a material change in the cadence of your sales throughout the quarter, either a trend was getting worse or better, that we saw?

Libby Wadle

No.

James S. Scully

Pretty consistent throughout the quarter.

Libby Wadle

Yes.

William M. Reuter - BofA Merrill Lynch, Research Division

Okay. And then lastly, the increase in advertising cost of $6 million in the quarter, does this -- is this kind of representative of the strategy that you guys have going forward? Or was there any change in timing of when you guys are going to be spending advertising this year?

Stuart Haselden

Well, Bill, there's a couple of things that drove the increase. We certainly had -- we launched the new program related to new brand marketing initiatives, and you may have seen some of those in publications like The New York Times, The Economist, Vogue. So that was new this quarter. We also had some very specific catalog prospecting that we also engaged in over the course of the quarter, targeted at lapsed customers and new potential customers.

Operator

Our next question is coming from the line of Jordan Hughes of Goldman Sachs.

Jordan Hughes - Goldman Sachs Group Inc., Research Division

I was wondering how you feel with regard to inventories kind of relative to demand. Do you think that any categories you're kind of chasing sales in those areas?

Stuart Haselden

Well, I'd say in general, we're pleased with how our inventory came in at the end of the quarter at 14% versus our top line trend at 23%, and we think we're well positioned as we head into the second quarter versus our top line trend. And as we look at sort of the composition -- and maybe this will help your question, and we can certainly kind of redirect if we don't hit it square. But as we look at units at the end of Q1, units were up mid-single digit, our AUC was up high single-digit. And so as we think about the balance of the year, that's probably a trend we would expect to see continue. And the commodity pressures that we're seeing in cotton are beginning to ease. We had mentioned in previous calls, that's being offset by some increases in other categories such as wool. And a bigger -- a separate issue that has certainly become part of the story in terms of our inventory cost for the second quarter and second half of the year will be how we're mixing our assortment. We are mixing into higher cost categories and where we do that, we do not expect to see merch margin pressure, because those will be areas that will sell at higher AURs. So that will influence the AUC that we'll experience in the second half as well as the second quarter. So that's taking more of an angle of the composition of the inventory from a commodity standpoint. Is that getting at your question there, Jordan?

Jordan Hughes - Goldman Sachs Group Inc., Research Division

Yes, that's very helpful. And then in first promotional activities, it seems like there was full price selling was very strong in this quarter. How are you feeling about that currently? Is it -- how do you feel about the kind of the promotional environment right now?

Stuart Haselden

Well, we don't really comment on current business. We can't say we feel good about the business. Some of the things you've heard from some other companies -- we did not pull inventory into Q1, and so we feel good about how the inventory is positioned. We feel we have adequate inventory to support the sales trend. So that's probably the best answer we can offer.

Operator

Our next question is from Carla Casella of JPMorgan.

Carla Casella - JP Morgan Chase & Co, Research Division

A couple of questions. One, on -- I'm hearing and seeing more about stockouts online. And I'm wondering if you've changed your strategy or channeling more of the inventory to stores, if you're seeing a change? And is it customers or is it something that you're driving?

Libby Wadle

Well we're not -- you mean out-of-stock situations?

Carla Casella - JP Morgan Chase & Co, Research Division

No, I guess, how much of your inventory is kind of comingled, where it can go either to online or in-stores? Is it that there's -- I've been hearing a lot about stockouts online for a while now. And I'm wondering if you're just holding less inventory for the online business?

Libby Wadle

No, that's not been our strategy. We do use sort of a seamless inventory strategy, where we do share inventory, but we do buy a separate inventory pool for our direct business and our retail business and then manage in between as the business demands. So I haven't -- I don't think we measure our -- what we call our sell rate online, and we haven't seen any major changes or differences than sort of how we've averaged in the past.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. Are you -- you're okay with your inventory levels for online or do you think you are missing sale, too much sales that you need to add back?

James S. Scully

Definitely. I think given the top line trend, I don't think we've planned at a 23% increase in sales. So I think that obviously, we wish in our other categories we had more inventory. But I think we also feel good about the full price selling and the margin impact. So I think we're comfortable as we go into Q2 that we are invested appropriately in the categories that are doing well.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. That's great. And then on the Men's business, the -- can you talk about how the separation of the men's store is going in New York? And how many other markets do you think that makes sense to have separate men's and women's stores?

Libby Wadle

Well, we're pleased with that we've seen so far within our Men's businesses and our men's stand-alone shops, as well as the shops that we've created in our larger square footage stores. And as real estate becomes available within each market, we're looking seriously at our opportunities for the Men's business, honestly, and for the Women's business where it makes sense.

Carla Casella - JP Morgan Chase & Co, Research Division

How many are stand-alone men's at this point?

James S. Scully

I think it's 8 at this point.

Stuart Haselden

Yes.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. One then just one last question on the strength in the quarter, was -- do you see a lot of pull forward in certain items like bathing suits or key summer warm weather items in the quarter?

Libby Wadle

No, as Stuart mentioned, we really did not have a lot of pull forward within the quarter.

Operator

Our next question is from Grant Jordan of Wells Fargo.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

On the direct, how much of that was driven by your expansion into international?

James S. Scully

We don't break out the components of the direct gross spend, but I would say it was not significant.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

Okay. Second question, just a follow-up on the inventory discussion. I was thinking that whenever you back up and step up inventory was up only like 6% year-over-year, but I guess you're saying that the in-transit accounted for a decent amount of inventory last year?

Stuart Haselden

That's right. The inventory step up from the purchase accounting was definitely larger, a larger factor, but the difference, yes, is the in-transit.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

And why was the in-transit higher last year?

Stuart Haselden

Just timing.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

Okay. Do you know if there's any of those issues in the next couple of quarters as we think about inventory?

James S. Scully

Yes. Don't expect that, that will be an issue.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

Okay. And then my last question, on the last call, you talked about some pressure you felt to offer free shipping in the promotional fourth quarter. Do you feel like that abated as we moved into this year?

James S. Scully

Well, I think the free shipping -- I guess to give a more holistic answer, we'll continue to see pressure throughout the year from free shipping [indiscernible] to last year. It'll be more pronounced in the first that until we lap the point last year in August, when we introduced the flat rate shipping strategy. We'll continue to be opportunistic. It's a great tool, it's a great lever we have to drive traffic. And so based on the trend of the business, we'll have that as a lever to pull. In terms of the level of promotion versus Q4 last year, at this point, wouldn't expect it to be significantly higher, but it'll depend on where we are when we get to that point in the year.

Grant Jordan - Wells Fargo Securities, LLC, Research Division

And I would assume from your trends that you didn't really thought you had to pull that lever during that first quarter?

James S. Scully

Not as much as we have in the past.

Operator

The next question is from Karru Martinson of Deutsche Bank.

Karru Martinson - Deutsche Bank AG, Research Division

When you guys talk about the accelerated growth of the international expansion, I was wondering could you provide some more color here in terms of how many markets have you reached? Do you have any data on that? I mean, where do you want to be, let's say, probably a year out from now?

James S. Scully

So I mean, I think you've seen that we're now shipping to 106 countries, and obviously, that is giving us a lot of information in terms of where the demand is coming from and taking a lot of what we -- previously was anecdotal information and turning it into good analytical information. We've also said publicly before that what we're looking at is a location in London and also a location in Hong Kong to be kind of the beachheads for both Europe and Asia. And we're currently very active with landlords in those 2 markets, looking to secure real estate, and from those stores launching, that will help inform where we move both in Europe and in Asia after those openings.

Karru Martinson - Deutsche Bank AG, Research Division

Okay. And then when we look at the kind of the CapEx spend, the kind of $25 million for warehousing, $35 million for IT, I mean, is that being spent here kind of in prep for the international expansion or is this more to kind of continue to support the growth rate that you're experiencing right now?

James S. Scully

That's a good question. It's really both. So from a infrastructure on the supply chain side in terms of the DC, that is our direct DC, which needed additional capacity. On top of that, we are investing in some IT systems to help enable international shipping in the future. So I would say -- and also on the IT spend, that is related to some of the activities to enable the site to be able to ship internationally. So it's a combination of the strong growth that we have domestically as well as enabling us to expand internationally.

Karru Martinson - Deutsche Bank AG, Research Division

Okay. I know you guys opened 7 Madewell stores in the quarter and we're going to see a few more of those. Any color you can provide on how that chain is performing?

Stuart Haselden

So -- this is Stuart. We've been very pleased with the recent store openings at Madewell. I guess the biggest indicator we can point to, to indicate how we're viewing the business is just the pace of new store openings that we're pursuing. So we'll open an additional 8 stores in the balance of this year and would expect to continue that sort of an annual pace going forward.

Karru Martinson - Deutsche Bank AG, Research Division

Okay. And this is, I think, just to follow up on Carla's question, when you look at the stand-alone stores, I mean, what's kind of the pace that you would think of following there for new openings going forward?

Stuart Haselden

So we're going to -- we're planning to open 15 this year and so would expect to potentially increase that in subsequent years based on just what we're seeing in the marketplace. So 15 to 20 would not be out of the question.

Karru Martinson - Deutsche Bank AG, Research Division

For Madewell?

Stuart Haselden

For Madewell. Your question was specific to Madewell, right?

Karru Martinson - Deutsche Bank AG, Research Division

Well it was a combination of Madewell, but then also just in terms of when you look at things like the Ludlow, the liquor store and others, are there more plans to kind of accelerate that side of the equation as well?

James S. Scully

Right. So I think you would expect a mid-single-digit growth rate for the J. Crew brand, both retail and factory. I'm sorry, mid-single-digit square footage growth is what I meant.

Operator

Our next question is from Emily Shanks of Barclays Capital.

Emily E. Shanks - Barclays Capital, Research Division

My question is in regards to -- I'm just curious around comp trends by geography. Was there anything notable during the quarter?

James S. Scully

It was consistent by geography and by month throughout the country, so we didn't see any notable differences through geographies.

Emily E. Shanks - Barclays Capital, Research Division

Okay. Great. And then just moving to real estate, I'm just curious how you're characterizing the current cost environment from your perspective as you're looking at rolling out these new stores? And then secondarily, if you could just comment on what was driving that decrease in the buying and occupancy costs this quarter, if that should mean that we should expect to continue please?

Stuart Haselden

So, Emily, it's Stuart. I'll speak to the second question first. So the buying and occupancy did increase 10% on the quarter, and the leverage was just a function of where the top line came in at the top of the business. It was -- the buying occupancy was a little better than our expectations but not significant. That was just -- it's just a function of the top line average. And then with respect to real estate costs, it's probably the same story you've been hearing from everybody is that in the A locations, rents have remained pretty stable to slightly increasing. And then at the other end of the spectrum, obviously, you're seeing a lot of opportunities to get cheap deals. But from our perspective, we don't pursue the B- to C locations. We focus our attention on the A markets, and there is pricing power that the landlords have in those key A locations that we're interested in.

Operator

Our next question is from Jordan Hughes of Goldman Sachs.

Jordan Hughes - Goldman Sachs Group Inc., Research Division

I was hoping you could just give us a sense for how much of the growth in the quarter may have been driven by kind of the vibrant or neon colors in some of your stores and if you think you did experience just a onetime benefit from that in the quarter?

Stuart Haselden

Well I think as we mentioned earlier, we have a lot of -- you know there's a lot of competitors listening to these types of calls. We didn't want to look into the details surrounding kind of our merchandise strategy. I don't think -- I think obviously, color is important, but when it comes to product and apparel, it's kind of our balanced approach to it. And I think when you look into the stores just more than color, it's also the categories. It's also how we're investing in those categories. So I don't think you can hang it out on one thing. I think that's probably the most want to say about it.

Operator

Our next question is from Karen Eltrich of Goldman Sachs.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

How today do the economics compare for a Madewell new store versus a J. Crew new store?

James S. Scully

I don't know if that's necessarily a fair comparison just given the maturation curve of the business. We've tracked the Madewell openings versus the J. Crew openings. And we have a lot of locations, the same sister locations we call them, where Madewell is in the same mall as a J. Crew location. And typically, we look at a 3-year maturation curve to see that it gets to the same operating performance as a J. Crew. What I would tell you is that over the last 3 years, we've seen that 3-year maturation curve and the comps required in those 3 years shrink over time, just given the launch of the website, the marketing behind Madewell and just the overall brand awareness of Madewell. So that's one of the things that gives us confidence to get behind the stores, opening more stores this year and opening potentially even more stores in the hungry years.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

Great. Is there any potential for Madewell overseas? We're obviously shipping overseas for J. Crew. Are you shipping overseas for Madewell yet? And is there any thought to that?

James S. Scully

We're shipping in 2 countries right now -- but we weren't into, [ph] and now it's Canada and in Japan. And right now, we have so much domestic opportunities for Madewell. I think we're going to cut our teeth internationally first with J. Crew. But as we build the infrastructure for J. Crew internationally, we're obviously building with the flexibility to take Madewell right behind us.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

Great. On that same vein, again, as you're shipping as I think you said 102 countries, are there any countries to that surprised you in terms of having stronger receptivity than you would have expected or maybe a bricks and mortar strategy will follow?

Stuart Haselden

You know, it is going to be a less-than-satisfying answer, unfortunately, Karen. The answer is yes. I just can't tell you the countries. So we would -- there were countries that surprise us on both ends of the spectrum, where we didn't see the demand. But what's interesting is the outcome with added complexity when it comes to retail, outside of those 2 core markets that we talked about. So it's interesting that it informs us, it may move them up in the prioritization, but it doesn't -- nothing that we've learned has knocked either the U.K. or Hong Kong out of the first 2 spots to open bricks and mortar up in the North America.

Karen Eltrich - Goldman Sachs Group Inc., Research Division

Very good. Very fair. And how are you finding in terms of shipping fulfillment, are you meeting your own service standards?

Stuart Haselden

Yes, we're actually very pleased.

Operator

At this time for closing remarks, I'll turn the floor back to management.

Stuart Haselden

Well, Jim, so thank you very much for joining us today and we look forward to speaking with you when we're -- for our second quarter results at the end of August. Thanks.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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