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Carter’s, Inc. (NYSE:CRI)

Q4 2007 Earnings Call

February 27, 2008 10:00 am ET

Executives

Frederick J. Rowan, II – Chairman of the Board & Chief Executive Officer

Joseph Pacifico – President

Michael D. Casey – Chief Financial Officer & Executive Vice President

Analysts

Brad Stephens – Morgan Keegan

Robert Ohmes – Banc of America Securities

Margaret Whitfield – Sterne Agee

R. J. Hottovy – Next Generation Equity Research

Brian McGough – Morgan Stanley

Jim Chartier – Monness, Crespi, Hardt & Co.

[Forest St. Clair – Skystone]

Wayne Archambo – BlackRock

Operator

Welcome to Carter’s fourth quarter earnings conference call. On the call today are Fred Rowan, Chief Executive Officer, Joe Pacifico, President and Mike Casey, Chief Financial Officer. After today’s prepared remarks we will take questions as time allows. If you have any follow up questions after today’s call please direct them to Eric Martin, Vice President of Investor Relations. Mr. Martin’s direct telephone number is 404-745-2889.

Carter’s issued its fourth quarter earnings press release yesterday after the market closed. The text of the release appears at Carter’s website at www.Carters.com under the press release section. Before we begin let me remind you that statements made on this conference call and in the company’s press release other than those concerning historical information should be considered forward-looking statements and actual results may differ materially. For a detailed discussion of factors that could cause actual results to vary from those contained in the forward-looking statements please refer to the company’s most recent annual report filed with the Securities & Exchange Commission. Also, on this call the company will reference various non-GAAP financial measures. A reconciliation of these non-GAAP financial measures to the GAAP financial measurements is provided in the company’s earnings release.

Now, I’d like to turn the call over to Mr. Rowan. Please go ahead sir.

Frederick J. Rowan, II

Good morning. I don’t think it’s a surprise to anyone these are difficult market conditions with the likelihood it will persist. Consumer sentiment deteriorated a lot during December and more so in January. All of our customers are guiding lower for this year. As a result, our fourth quarter results were negatively affected. We experienced some customer cancellations, higher cost for inventory disposal and higher costs for margin support for our wholesale customers. We also had some push back on fall 08 product orders. We must also be cautious. While we are less affected by economic downturns, it is simply just a very tough environment.

While we are approaching this year very conservatively, we will not alter our strategic platform nor fail to invest for short and long term growth. In fact, we did elevate our investments in 2007 prime examples were investments in talent, product and systems. We are extremely focused and we’re equipped to be a better competitor. We do feel we have long term organic growth in all channels, all brands and our sub brand. I’ll speak to our strategic initiatives which we firmly believe will both lead to a recovery and continuation of quality growth.

The first is to upgrade and fill the talent voids to execute both the turnaround and to assure continuity and growth. Secondly, to materially improve the important product benefits for all brands and sub brands. Thirdly, to launch a far more competitive economic model for our wholesale customers. Fourth, to fix the organizational issues, operational issues with Carter’s retail, get much closer to the consumer and the customer, meet or exceed their expectations. Substantially reduce our costs and fix the OshKosh product contingent.

With that I’ll turn it over to Joe Pacifico.

Joseph Pacifico

In the difficult fourth quarter retail environment five of our six businesses achieved positive sales growth which leads to growth of plus four on a consolidated basis. For the full year 2007 we are satisfied with our results in the Carter’s brand business across wholesale, retail and the mass channel. Our OshKosh brand did not perform well during 2007. During the second half of 2007 we identified the need to be more aggressive in positioning our brands for success. As a result we move to lower costs to the consumer through both Carter’s and OshKosh in 2008, providing our wholesale customers with higher natural margins by lowering costs to them and we’ve accomplished this through greater sourcing leverage and by lowering nine critical expenses in 2008. We are increasing our investments in floor presentation, inventory systems at retail and talent across the company. We are investing in more impactful and a comprehensive marketing message to consumers through our retail division. Based on these initiatives we feel we are well positioned in 2008.

I will now walk you through the performance of each of our businesses on a standalone basis covering quarter four, annual performance and our outlook for 2008. To start with Carter’s Wholesale, they had a challenging quarter at Carter’s brand wholesale. Our shipments were slightly positive last year but our net sales were down 6% or down 4% excluding off price. This is seven points lower than our guidance or roughly $9 billion. The decline from our guidance was due to three factors: higher customer cancellations, increased margin support and lower basis replenishments than we had planned. Based on the positive product performance we’ve had in our own retail stores which I’ll discuss later, I believe the decline can be attributed primarily to macroeconomic factors. In looking at the year we are satisfied with our overall revenue growth of plus 6% excluding off price. Including off price, our sales grew 4%. This is our eight straight year of positive growth in this channel.

As we look into 08 we are taking a conservative approach in planning our business. We expect to finish 2008 with long single digit growth which will come in the second half. The first half is coming in lower than we had previously guided based on spring line cancellations and reducing our basic replenishment assumptions. We are also being affected negatively due to the less fall orders falling in our last week in June due to large part in the shift in our customer’s calendar. For Carter’s fall 08 we have put together a powerful and comprehensive business model for our consumers and customers. For the consumer better product and we validated this through consumer testing and pre-lining with our top accounts, lower prices to the consumer, a much stronger value message to the consumer through the implementation through the everyday low pricing strategy and we’re funding a better store presentation. We are expanding on the zero to 24 concept that we implemented in spring 08 and took it a step further at Kohls where we’ll actually be putting in 250 shops in the third quarter. We are also increasing the servicing of the floor at our top doors. Our customers will also benefit from these initiatives through increased revenue and sell throughs as well as increased margins due to lower wholesale costs.

OshKosh Wholesale; in [inaudible] off price, OshKosh Wholesale sales were up three in the quarter including off price sales were up 8%. For the year OshKosh Wholesale finished down 10% in line with our guidance. We have discussed the poor product performance on every call this year as well as improvements we have made to the 2008 lines. Much of the improvements are product specific however we have also implemented a new model that should greatly benefit both the retailer and us. The improvements we made to the 08 line are the key item focus with clear merchandising statements, younger more understandable art and color, lower prices over 10% to both the retailer and the end consumer, improved customer margins. We are also investing in better branding at the floor. We have reduced the complexity in our style colors by more than 20%. At the same time we have lowered costs which should lead to better margins. For spring 2008 we are seeing better early sell throughs this year than we did last year at our major accounts however, March is the largest volume month of the quarter so we’ll need to see those results before drawing any conclusions.

We have received fall orders and while we are disappointed with the way they came in, the decline was to be expected. This is a much improved line and yet our retailers are remaining cautious until we prove ourselves again with stronger consumer selling. Because of these fall orders we are projecting the year now to be down double digits. We have a new OshKosh brand leader in place at the AVP level, Suzanne [Cawkins], Suzanne is a proven Carter’s executive with 18 years of multiple leadership roles within the company. We have also brought on a new chief merchant to drive design and merchandising in our Shoo design studio.

In regards to the mass channel, our mass channel business beat guidance in the fourth quarter providing sales growth of plus 12% on a consolidated basis. This resulted in a very positive year with growth plus 10. Our Just One Year business at Target performed very well providing sales growth of plus 20% in the quarter which brings us to plus 13% for the year. Child of Mine sales at Wal-Mart were plus four in the quarter and finished the year at plus nine. Our Child of Mine results in quarter four were in line with our expectations. We had outlined on the last call that business had become difficult for the following reasons: the macro environment, our product performance issues and tighter inventory initiatives and we do see this continuing through the first half of 2008. For fall we are aggressively addressing these issues by elevating product benefit with no increases in price and in some cases offering lower prices, improving turn through improved sell throughs lower our average weeks of supply and execution of our top door allocation strategy.

In look at the full year 2008, we project Child of Mine revenue to come in relatively flat through 07, weaker than we had previously expected. The joint business looks strong and should provide double digit growth. In total we are planning the mass channel to be down in the first half and up low single digits for the year.

Carter’s retail; turning to our retail business I’ll begin by discussing quarter four performance for the Carter’s brand side of the business followed by OshKosh and then an outlook on 08 for both brands. We had a great fourth quarter at Carter’s retail beating our previous guidance with revenue at plus 13.8% and a comp increase of 8.9%. This brings us to plus 10% revenue growth for the year and a plus 4.1 comp. Carter’s retail has now delivered positive comps eight straight months. We finished the quarter especially strong with the combined November/December comp of plus 13%. In addition to top line revenue growth we also saw margin quality improve in the overall business. Much of these improvements can be attributed to product performance and our inventory management versus last year.

At OshKosh retail we had another challenging quarter. Total revenue for the quarter was up 3.9 and comps were down 3%. For the year we had total revenue growth of plus two on a negative 4.3 comp. In the later part of the quarter we did see a slowdown in demand for our fall holiday product. As a result we had significant fall holiday carryover in quarter one. Our objective is to aggressively move through this inventory and be out of it by the end of quarter one. However, this will have an effect on selling of our spring products as well as on our overall product margins. In addition to the product value strategies I mentioned in the wholesale discussion, we have also allocated approximately 15% of our spring mix to our new incremental opening price point categories making us more competitive and providing more products to the value conscientious consumer. This mix will increase to 25% with the shipping of the summer line. We have also added new product categories to the line such as layette and girl’s basic denim and will begin to see those results in March.

I feel good about our overall retail business as we move into the first half of 08. [Chip Petty] has put together a good team and I am pleased with the plans that each functional leader has presented to me for 2008. Our spring floor sets for both brands look good, product is improved, more color and art and from a value equation perspective, we’ve got a much better shopping environment with many more lifestyle product presentations, we’ve add an average of about 30 plus body forms per store this year. Much stronger consumer value message throughout the store with an improvement in price clarity driving a lot more price points versus percentage off as well as a new sign package for both brands and we are building a much more comprehensive marketing package. We are beginning to build a powerful database of customers greatly expanding our list of names. Weekly impressions or direct emails to customers let 26 million impressions in quarter one 08 versus 6 million in quarter one of 07. Based on our team and initiatives I’m confident you’ll see good improvement in retail sales and margins in 2008. On the Carter’s side business in the first two months of 08 has actually been stronger than the performance we saw in quarter four.

I’ll now turn it over to Mike.

Michael D. Casey

Good morning everybody. Last night we reported our fourth quarter results so this morning what I’d like to do is walk you through the results and then I’ll comment on our outlook for 2008. With respect to our performance in 2007 there are three items which impacted our earnings which should be considered when reviewing our results. The first is the OshKosh impairment which was reported in the second quarter. The second relates to the cost to close an OshKosh distribution center, most of those charges were also taken in the second quarter. The third item impacting our results was the benefit from reversing provisions for center performance equity incentives which we recorded in the fourth quarter. Because these items impact comparability, I’ll comment on our results and our outlook excluding these items which we’ve outlined in our press release.

With respect to our fourth quarter results our adjusted earnings for the quarter were $0.45 per share, flat to last year and $0.05 lower than the guidance we shared with you on the last call. Most of that shortfall relates to a decline in our gross margin which was 140 basis points lower than we expected. This margin shortfall equates to approximately $5.5 million or $0.06. In the fourth quarter our markdown support to our wholesale customers was $4 million higher than we planned. We also had off price losses and inventory provisions which were $3 million higher than we expected due to order cancellations and the changes in the 2008 forecast. We were able to partially offset these charges with better product costs and better margins in our retail segment. With respect to sales in the fourth quarter total sales were up $16 million or 4% last year. That growth largely came from Carter’s retail stores where sales grew $14 million or 14%.

With respect to profitability, our gross margin in the fourth quarter was 34.5%, that’s down 150 basis points to last year due to the lower margins earned in our OshKosh segments and higher provisions for excess inventory. With respect to spending in the fourth quarter, on an adjusted basis SG&A was 24.3% of sales, that’s 50 basis points better than last year due to lower provisions for incentive compensation and progress with our cost reduction initiatives. Our royalties from licensing activities in the fourth quarter were $7.8 million up 4% to last year. Carter’s royalties were down 2% due to the shift of our Joy brand launch from December to January. OshKosh royalties in the quarter were up 9% driving by the growth in our domestic licensing business.

On a consolidated and adjusted basis, our operating margin in the fourth quarter was 12.2%, down 100 basis points to last year. That margin erosion equates to approximately $4 million all of which is due to the decline is OshKosh profitability. Interest expense in the fourth quarter was down 14% driven by a $49 million or 12% reduction in average borrowings and a lower effective interest rate. With respect to taxes, our effective tax rate in the fourth quarter was 36.6% comparable to our fourth quarter last year.

Just to recap our performance for the year, we had total sales growth of $69 million up 5%. All of that growth came from our Carter’s segments. At Carter’s sales were up $74 million or 7% including 10% growth in the retail and mass channel segments. Carter’s Wholesale sales increased 4% last year, lower than we had planned due to the weakness in that channel in the fourth quarter when our wholesale sales decreased 6%. At OshKosh sales for the year were down $5 million or 2% driven by a 10% decrease in wholesale sales.

On an adjusted basis our operating margin for 2007 was 10.9% down 140 basis points to last year due primarily to the performance of our OshKosh segments. The operating margin erosion in 2007 equates to approximately $20 million. The margin erosion at OshKosh alone was $24 million.

In terms of liquidity, cash flow from operations in 2007 was $52 million, $36 million lower than last year due to higher inventory levels. Our inventories at the end of the year were $227 million up 17% compared to last year and in line with our guidance. The growth in inventory reflects higher level of inventory per door in our Carter’s and OshKosh retail stores which were under inventoried at the beginning of 2007. Cap ex for the year was $22 million primarily for 19 retail store openings and the integration of our information systems.

That’s a summary view on 2007 and I’ll comment on our latest thoughts on 2008. As we’ve discussed on the call this is an unusually weak environment. Our wholesale and mass channel customers are being very cautious on inventory commitments and as a result it’s very difficult for us to forecast growth with them. Accordingly, we’ve decided to be more directional and less specific with guidance. For 2008 we’re currently projecting low single digit growth in sales and earnings at a level comparable to the earnings we achieved in 2007. Based on our current trends we’re not projecting sales growth in the first quarter and we expect first quarter earnings will be lower than last year due to the continued weakness in OshKosh and higher provisions for customer support. We’ll focus this year on the things we can improve like product competitiveness, cost reduction, inventory management, system upgrades, and other investments we believe will support our growth initiatives.

For example, cap ex is projected to be approximately $50 million this year. Most of that cap ex will be allocated to our retail segment. We’re currently planning to open over 20 Carter’s stores and about five OshKosh stores. We’ll also invest about $15 million in new retail systems, $10 million for a new point of sale system and $5 million for a new planning and allocation system. We’ll fund these investments with operating cash flow which we expect will be meaningfully better than last year. Free cash flow is expected to be about $30 million which is comparable to last year.

That concludes our opening remarks and we’ll open up the call to your questions.

Question-and-Answer Session

Operator

Ladies and gentlemen our question and answer session will be conducted electronically. (Operator Instructions) We will pause just for a moment to assemble the question roster. For our first question we go to Brad Stephens with Morgan Keegan.

Brad Stephens – Morgan Keegan

Where to begin, with OshKosh can you give us maybe some milestones along the way to you guys which proves it’s a viable brand still and how we can monitor the success or the improvement in this brand.

Frederick J. Rowan, II

I’ll give you overview and how we feel there. We feel committed to OshKosh, we’ve revisited the consumer, you know and the consumer sentiment type brand is high, we know our customers still want the brand to do well. If I felt that was not the case there’s no question we’d shut this business down. I’ve said 100 times and I’ll say it 101, we believe most of the OshKosh problems by far were our own miskeeps and we think we’ve identified them, we’ve repositioned that brand to be more core key items, it’s more competitively priced. The product is going to be far superior. The milestones will be spring 08 is not [inaudible], we’ve said that all along. We started improving the product for the spring launch, we’re seeing some bright spots there. Summer, we’ve validated all this with our customers and the consumer, we’re using consumer panels for all our product development. Consumers see the summer even better than spring. We particularly struggled in girl’s consumer segment and particularly in color since we really acquired the business. The consumer likes the summer girl’s colors. We’ve done the same with fall. Actually, our customers are seeing product improvement but it’s a phasing issue here with us. It should improve as the year moves on. We’re very focused on that. We have better talent, there’s no question. The sentiment inside is that we’ve got a very talented group at Shoo now that are really fixed on the brand product and doing a good job.

Brad Stephens – Morgan Keegan

It sounds like you’re committed there at least for the near term. Moving on to Carter’s Wholesale business, can you give us some more color on that maybe one as it pertains to the higher vendor allowances. Was that something you realized throughout the fourth quarter or was this something that the retailers came back to you more recently and they’re really starting to clamp down on the vendors in general? Then, if you can talk about your order book looking forward, why is it weaker? Is it a case of the product slowdown? Is it a case of you’ve seen traffic slowdown at the retailers? If you could maybe delineate between the different baby, sleepwear and playwear, is it EDI? Is it fashion? What is it that’s causing the slowdown here at wholesale?

Frederick J. Rowan, II

I think Brad you have to go to the fact that this is an unusually weak market. I mean when you have our best retailers in the country have all gotten down we definitely would see less strength in our order base. So, that’s a macro issue. This is a tougher market than I remember and it’s a $101 per barrel of oil and the mortgage rates are very difficult and it’s an election year. So you have to start with that and everybody’s going to watch the inventory and watch their expenses.

Joseph Pacifico

Brad, as far as the accommodations, really it heats up in the month of January. Our year ends December they’re year end is January or actually February, I think the first week in February this year. We look at it monthly but really business got very tough, November was actually a decent month because the calendar – December got bad and then the requests we started handling from the middle of January to the end. So, it caught us, we knew things weren’t good and we know they always ask but it was more aggressive than we thought. As we look at 08, we’re planning conservatively as Brad said and as are our accountants. I think the first quarter and maybe the first half will be affected by 2007 performance of our customers, they’re going to be carrying over additional inventory into the first half of the year. I think retailers will be managing their inventory investments. When times get tough, cut expenses, watch your inventories. I think our spring product in our stores are performing well although we don’t want to be confident based on the month of February, it’s not a big enough month. Fall 08, as far as I’m concerned the best products and total marketing package we’ve had since we’ve been here. We have fall orders in our hands for fall and we are up in all three product markets, we’ve got positive growth baby, playwear and sleepwear in the mid single digits. We’re just looking at the market and guiding conservatively.

Operator

We go next to Robbie Ohmes with Banc of America Securities.

Robert Ohmes – Banc of America Securities

A couple of quick questions, the first is can you give us a sense of what the backlog essentially are for spring and what you’re looking at for fall 08 for Carter’s and OshKosh? Then, the other question is can you guys give us the breakout on the sales and profit margins, or the profit margins, the EBIT margins for Carter’s and OshKosh wholesale and retail so we don’t have to wait for the K to get that?

Frederick J. Rowan, II

I’m not sure I understand your backlog, are you talking about inventories?

Robert Ohmes – Banc of America Securities

Can you actually tell us what the spring 08 and fall 08 backlogs are for Carter’s Wholesale and OshKosh.

Frederick J. Rowan, II

Spring 08 we were positive in baby and playwear, a total of 6%. We were negative in sleepwear which I think we covered on the last call, we eliminated a couple of product categories there that really took away our increase in sleepwear. For fall, this is Carter’s I’m talking about, all three baby, seasonal, fall playwear, fall sleepwear are all mid single digits. OshKosh, spring was actually positive, summer was down which we had thought would have been positive based on good reception of spring we view the summer lines better, actually when it came time to get orders which was after our call, they were worse than we expected and fall is down dramatically as I said. So, that leads us to double digit increases in OshKosh for the year.

Michael D. Casey

Robbie, I think your second question relates to profitability?

Robert Ohmes – Banc of America Securities

Yes.

Michael D. Casey

For the year, the operating margin on it will go from around 12.3% down to about 10.9%. If you look at it by segment, Carter’s wholesale what’s interesting is despite the weakness in the fourth quarter, the operating margin for Carter’s wholesale actually improved. Last year it was around 18.8% and in 2007 it will be about 19.2%. So, throughout the year we saw very good product performance and we got caught off guard at the tail end of the year, particularly January when we saw our customer’s performance and the demand they had for markdown support. Carter’s in the mass channel, the operating margin last year was 15.2%, for 2007 it will be 14%. We did have some product performance issues in the second half at Wal-Mart and those are being corrected for fall 2008 which will start to ship in June. At Carter’s retail, the operating margin last year in 2006 was 16.9%, it will be slightly lower, it will be 16.4%. If you remember in the first half in 2007 we were out of balance on inventory. We enter the year with a significant lower inventory position than was appropriate. We spent most of the first half building those inventories, as the inventories built we saw better performance particularly in baby and the fourth quarter margins were stronger year-over-year. So, we’re in good shape as we go into 2008 at Carter’s retail but for the year, the year is being weighted down by the first half performance.

OshKosh performance suffice it to say not good. Last year the OshKosh wholesale margin is 11.6%. It will have a negative margin this year because of the product performance issues and the markdown support. The Genuine Kids component we’ve made about $2.4 million in 06, slightly more in 2007 about $2.7 million. There’s no margin because there’s no sales, it’s a licensing program and we feel good about what’s going on at the Genuine Kids brand. The lack of significant growth there reflects the fact that we were transitioning out of big girl sizes and transitioning in a new toddler denim program. OshKosh retail in 06 had an operating margin of 8.2% and that dropped in 2007 down to 2.8%. It’s all in gross margin, significantly higher markdowns because of the product performance and the product mix.

Robert Ohmes – Banc of America Securities

Just a quick follow up question, on the revenue outlook for the first half of 08 when I’m looking at those backlogs, so it’s primarily mass channel is going to be down pretty significantly offset by positive growth in baby and playwear in Carter’s wholesale? Or, is sleepwear such a big drop that it offsets the positive spring 08 backlogs for baby and playwear? I’m just trying to understand how to get to the down revenues in the first half of 08 off those backlogs?

Joseph Pacifico

Carter’s brand wholesale we think is going to be pretty much flat to down slightly for the first half and that is sleepwear affecting that. Plus, we’ve went back and looked at our basic assumptions based on the environment and we’ve lowered our basis assumptions. If you add that back in we would be at – so, we’re assuming things based on the environment. Mass, you’re correct, Child of Mine will be down in the first half, we’ll be up in the second half, we think we fixed those issues for the second half and Target should have good first half, good second half, good year.

Robert Ohmes – Banc of America Securities

And the retail comp assumption you guys are using in the first half?

Frederick J. Rowan, II

We’ll have the growth at Carter’s retail and I would say its upper single digits and then OshKosh retail will be low single digit growth.

Operator

We go next to Margaret Whitfield with Sterne Agee.

Margaret Whitfield – Sterne Agee

Could you give me some background on what happen in Q4 among the three components of wholesale baby, playwear and sleepwear? And I guess, you’ve given us some outlook for the New Year.

Joseph Pacifico

Directionally, I think of it pretty much in line with – baby and playwear were positive and sleepwear being the negative.

Margaret Whitfield – Sterne Agee

Okay. And, given the performance of retail versus Carter’s wholesale, obviously we have new management, better execution but it’s the same product. Any additional thoughts you can give us on the disparity in performance? It’s a similar customer, I believe.

Joseph Pacifico

Yeah we look back at it Margaret, if you really look at our top customers they had difficult third and fourth quarters, probably negative comps. If you’re talking our two biggest Carter branded and to our knowledge and from the research we have done we’ve performed, and kids usually better than total store, and we performed as good as or in a few cases better than their children’s department. So, we think it’s reflected of their performance in the third and fourth quarters and January which was their fourth quarter.

Margaret Whitfield – Sterne Agee

So there are no competitive issues in the wholesale channel that you can relate this to? It’s a macro issue.

Frederick J. Rowan, II

I think that there’s no question our customers’ private label business has gotten better and with our new economic model that we’re rolling out, in Carter’s particularly as we start the fall launch we close the gap in private label considerably. Our product is better, our prices are more competitive so you have to say that that has been some issue but we feel that there’s no huge issue we can’t deal with.

Margaret Whitfield – Sterne Agee

Okay. The markdown accommodations that were a factor in January, is there a certain timing will there be any issues in Q2 if business conditions remain challenging? Or, is it a yearend situation?

Michael D. Casey

We provide for it throughout the year Margaret and we’ve obviously baked in a level that we think is appropriate given the environment in to our estimates this year.

Margaret Whitfield – Sterne Agee

You said the first quarter would be down, what would need to change to improve the second quarter results? Or, should we, if we’re conservative assume a down Q2 as well?

Michael D. Casey

Well, the things that are weighing us down will continue to be OshKosh so when we start to see better performance from OshKosh that will make the performance better.

Margaret Whitfield – Sterne Agee

Well, I applaud your investment in retail. I think long term that is the way to go.

Operator

For our next question we go to R. J. Hottovy, Next Generation Equity Research.

R. J. Hottovy – Next Generation Equity Research

Just really one quick question, in regards to the OshKosh wholesale, you’ve given us some feedback from the focus groups and what not in terms of the product for spring and summer. I’m just trying to get a better sense and knowing that some of your wholesale partners have cut back on orders for the year, what are they saying in terms of the product quality though? Is there any feedback you can give us there in terms of has it been well received? Just a little bit more color if you can right there.

Frederick J. Rowan, II

I think they’re saying predominately our color and art is getting far better. Keep in mind far better means as we move through the seasons. The most persuasive feature or attribute for a product in our business is color and art. It’s the emotional connection with the consumer and in OshKosh we were too forward in colors particularly in girls so they see that being corrected as we move through the seasons. Not so much in spring girls but far better in summer and they’ve seen fall and they see not only the color and art but they see our pricing is more competitive and they see we’re matching up to their models. We’re in the midst of our spring 09 now and we can’t report on that but we think the new team that we’ve put in place at Shoo is dramatically changing, even having a big influence on holiday which launches in September. So, we can only tell you the customers like our directions and we validate it with consumer panels. I mean we’re actually showing consumers the color, the art and the style as we develop the line so it’s not focus groups, we don’t put a lot of validity in focus groups. We put it in, would they like it? Would they buy it? I don’t know if that answers your question.

R. J. Hottovy – Next Generation Equity Research

It covers it to an extent.

Frederick J. Rowan, II

And the customer is not negative on the brand, the customer just doesn’t want to stick their neck out and over order. So, when we say falls down significantly that’s a smart thing to do. It’s also not bad for us because we don’t need extra margin support either. It’s better to be more conservative.

R. J. Hottovy – Next Generation Equity Research

So really what it comes down to is you would say it’s more the environment than it is the product?

Frederick J. Rowan, II

No, I’d say OshKosh is mostly self inflicted, us. The environment certainly affected it but the product has been the issue.

R. J. Hottovy – Next Generation Equity Research

But going forward?

Frederick J. Rowan, II

Going forward, yes.

Operator

We go next to Brian McGough with Morgan Stanley.

Brian McGough – Morgan Stanley

Joe, you had noted that when times get tough you should watch inventories and cut costs and that seems like it’s exactly what you’re doing I mean inventories appear to be getting better on the margin, your SG&A was down this quarter on top of fourth quarter last year when I think it also was down but there are a couple of other brands out there who are actually putting up some pretty good numbers in light of the current environment who are really going the other way and they’re investing money back into their model even if it hurts their operating margin for a couple of quarters because it’s really gotten their top line really going again in pretty strong way. I’m wondering in line of where you guys have been over the past say year, when do you think you might get to a point where you have a change in your view, if at all, just about how you approach the model?

Joseph Pacifico

I think we are making investments again in both the wholesale and retail sides of the business. We talked to you about the 250 stores that we’re going to build, 250 shops with Kohls in the fall this year. We’re increasing what we call our retail marketing organization which will start servicing more doors. And, I don’t want to include product investments but those are major and then on the retail side we’ve invested dramatically in talent, fixturing, systems. It think it’s all kind of evolving because we’re doing it and we’re doing a lot of it this year so I don’t want you to think we’re not investing in things that are critical to both the customer and the consumer because we think we are. So, some of our expense controls have been we’ve cut things here to invest but have not cut down total investments.

Brian McGough – Morgan Stanley

Well, what are the other offsets though? Like what categories are down to get what you view as the key real business drivers up?

Michael D. Casey

We’ve been reigning in spending since we started showing weakness in our retail business in the second half of 2006. So, to Joe’s point, our issues have not been for a lack of investment. We got off track because of product positioning at OshKosh and we had leadership and execution issues in our retail business. I would say one of the most significant investments we made last year was in talent. [Jim Petty] he’s got an entirely new team, a new head of store operations, new head of planning and allocation, new head of marketing. So the issues that we’ve had are the areas that we have been investing. As we’ve done for 16 years, we reign in spending where we can. We’ve done a good job, we’ve had a very good track record in terms of watching how we spend our money and spending as we can afford to spend. I wouldn’t say there’s one major area, the thing that we unfortunately had to do in 2007 was eliminate the incentive provision but our style all years has been we want to take care of the shareholder first and if the shareholder has been taken care of then we’re rewarded and given the performance we made a decision to reign in those investments. We will fund incentive comp for 2008 because we think that’s important to do, we’ve got a very talented group of people here at multiple levels and all of our functions and we want to make sure they are incentivized to drive the things that are important to grow this business.

Brian McGough – Morgan Stanley

Mike, just one last point on the balance sheet, I think about half year debt as a floating rate so one is, is that right? And just two, in light of what’s going on out there in the credit markets, how are you managing that in order to ensure that there’s no creep on the debt service side and no risk on refinance side.

Michael D. Casey

We’re in good shape. Our timing was good, I think a year or so ago we restructured the debt to take advantage of what was then a fairly favorable interest rate environment so today our interest rate is LIBOR plus 150 basis points and about 70% of that is protected under interest rate hedges, we have both a collar and another hedge in place so about 70% of that is protected so we’re in good shape. The leverage is less than two times our trailing EBITDA, the debt service is some portion less than $4 million a year so we’re in good shape there, we’re don’t feel as though we’re exposed to interest rate fluctuation, that’s a very manageable component of our balance sheet.

Operator

We go next to Jim Chartier with Monness, Crespi & Hardt.

Jim Chartier – Monness, Crespi, Hardt & Co.

What kind of assumptions are you using for wholesale margins, vendor allowances and such for first half of 08? Is it similar to what you saw in fourth quarter?

Michael D. Casey

We’re assuming that we’re going to have low growth in sales, we’re assuming that the markdowns in the quarter will be comparable to what we saw in the fourth quarter unless we’re proven otherwise and we’re assuming no growth in the margin on those sales. That’s what’s putting the pressure on the first half.

Jim Chartier – Monness, Crespi, Hardt & Co.

Then, you reorganized sleepwear under the baby leadership team, how has that gone? Are you seeing any improvement there?

Joseph Pacifico

Like I said our fall bookings in sleepwear are up, fall 08 versus fall 07, they were negative and that was the real first line that fell under the leadership of [Brian Lynch] for the baby team. So, yes we are seeing good feedback from our accounts and good bookings.

Jim Chartier – Monness, Crespi, Hardt & Co.

Then as far as a rise in cost pressures, labor cost in China, appreciating [inaudible], higher raw material prices, is that going to impact the second half of the year at all?

Michael D. Casey

There’s no question cost are going up in China. Fortunately, the way our group manages the supply chain we have not seen much pressure on our prices, we’ve got visibility out about six months in prices. It’s always been a challenge, there’s nothing new about this environment in terms of managing costs, it’s always been a challenge but we’ve got a number of initiatives that enable us to manage the growth and product costs.

Jim Chartier – Monness, Crespi, Hardt & Co.

What percentage of sourcing do you do in China these days?

Michael D. Casey

A little over 50%.

Jim Chartier – Monness, Crespi, Hardt & Co.

Then when will we start – I guess when will the new POS and planning and allocation system for retail be installed? And, when should you start to see some benefit from that?

Michael D. Casey

The point of sale system is being rolled out currently. It should be in place for all approximately 400 stores by the latter part of the third quarter and planning and allocations, the new leader there is scoping out a number of different products. He’s focused more right now with getting a very good process in place so that we match the right system up with the right process. My guess is that that will launch sometime in the fourth quarter this year and may spill in to the first quarter of next year.

Jim Chartier – Monness, Crespi, Hardt & Co.

Then can you comment on how the loyalty program performed for your fourth quarter and what your plan is for that? Then also, on the direct mailings, I believe you had one for spring, how that’s performing?

Joseph Pacifico

In regards to the loyalty program we have 1.2 million active names. We projected it to be about a 15% to 17% of our current transactions. We believe it has a potential to be over 50%. It is tied, part of the automation is tied to the POS so it will get stronger as we roll out this year. We are seeing increased repeat business and we are seeing an increase customer spend so we do think it’s working but we need to tie it to the POS, get more results as we get further into the year. As far as weekly impressions, what we call impressions are emails, direct marketing mailers to the customers, those are the two things we really call impressions and we’re saying we’re going to have 26 million this year versus 6 million the year before and I think it’s reflective in the Carter retail performance.

Operator

(Operator Instructions) We go next to [Forest St. Clair] with [Skystone].

[Forest St. Clair – Skystone]

Can you give out the OshKosh brand loss for 2007 in absolute dollars and what, implied in your guidance for earnings for 08, what the implied loss is for the brand?

Michael D. Casey

What I can share with you [Forest] is what we’ll report in the 10K in terms of segment profitability. For 2006 OshKosh contributed roughly $32 million of the $165 million we had in operating margin, operating profit. For 2007 it will contribute about $7.9 million so it’s dropped about $24 million but it is still reporting a profit from a segment standpoint. For 2008 we’re assuming negligible growth in that. So we assume it will be flat to up a bit for 2008.

[Forest St. Clair – Skystone]

And in terms of ultimately I mean there’s obviously costs with the debt that was assumed with the acquisition so net-net of the debt on the balance sheet would total purchase price etcetera, how much is that loss? How much is that impacting the numbers?

Michael D. Casey

It’s a non-GAAP measurement that we don’t disclose. But suffice to say if you saw Carter’s performance before the acquisition and the track we were on to repay our debt to your point with the debt service you could make a case that OshKosh is diluted but it’s a non-GAAP measurement and we don’t disclose that.

[Forest St. Clair – Skystone]

And just the reason why I ask is obviously the stock is being penalized right now one for macro reasons but also two due to the dilutive impact there and clearly this has been a focus for people and just trying to help better understand the true underlying value of the Carter’s brand as a standalone. At what point you know whether its 2008 or 2009 do you say we’ve given it our best shot and it’s not going to work?

Frederick J. Rowan, II

With respect to OshKosh we’re not in love with anything but winning and we’re going to do the things that are necessary for that brand. It’s going to take the better part of this year and believe me we don’t like to losing and know you don’t either and I’d be the first to shut it down if I thought we did our best work and it still didn’t work but we’re optimistic. So just follow through the year, don’t panic and just believe that we can fix these things and if we can’t we’ll do something about it.

[Forest St. Clair – Skystone]

And second question as it relates to kind of the first half earnings of 2008, given the significant recovery in improvement in the retail business which is clearly looks like it’s turned the corner there has to be some pretty significant you know margin pressure in the rest of the business in order for the year-over-year earnings to be kind of flat to down. Where is, I think the previous caller asked a question on the wholesale side, what was the wholesale Carter’s margin in the quarter and what was the kind of mass channel margin? And looking over the next couple of quarters I think you said.

Frederick J. Rowan, II

Well in terms of the fourth quarter?

[Forest St. Clair – Skystone]

That’s correct.

Frederick J. Rowan, II

For wholesale the fourth quarter for wholesale was year-over-year comparable. And again, the issue was not so much that the support was significantly higher, we anticipated it would have been better just based on how our business was trending, so the fourth quarter operating margin went for Carter’s wholesale went from 16.7% to16.9%. Your question on the first half again, we’re not assuming much growth in terms of total sales in the first half of this year. In terms of a gross profit margin we’re assuming that down because - and again, it’s largely being weighed down by the issues that we’re having at OshKosh. SG&A will be higher because you’re going to have the full cost of the new retail team, our unit volume is up.

[Forest St. Clair – Skystone]

What is the delta in the SG&A year-over-year?

Frederick J. Rowan, II

In terms of what?

[Forest St. Clair – Skystone]

It looks like if is it about $6 million?

Frederick J. Rowan, II

For what period?

[Forest St. Clair – Skystone]

Kind of like you know the Q4 run rate versus the first half of 07?

Frederick J. Rowan, II

The you should assume that the spending will be higher in the first half, the first half of 08 and for the three things that are driving that is the investment in this new team, the cost of the additional stores, you have higher unit volumes, the distribution and freight costs are going to be higher. We’re making provisions for the risk of the West Coast Dock Strike which may increase our distribution costs. We’re hopeful that’s an upside to the plan and the other thing that was not in the fourth quarter spending that will be in the first half is a higher provision for incentive compensation.

Operator

We go next to Wayne Archambo with BlackRock.

Wayne Archambo – BlackRock

You’ve referenced a few times on this call on the OshKosh business shutting it down, has any thought been given to possibly selling this business?

Frederick J. Rowan, II

The only thought we’ve given to the business is fixing it, we haven’t had discussion about shutting it down. If you’re thinking you’re hearing that, that’s not the message the message is fix it and we believe in it and I don’t want to beat a dead horse here but the issues we think, the problems with OshKosh are fixable. It will take this year to get it down.

Wayne Archambo – BlackRock

So this time next year mark my calendar February 27, 2009 if we’re having this discussion and it’s still not fixed is the line in the sand 12 months from now?

Frederick J. Rowan, II

I didn’t draw a line. We’ll keep you posted. But we’re not going to let it continue to be a drag on shareholder value that’s for certain.

Operator

And with that ladies and gentlemen we have no further question on our roster. Therefore Mr. Rowan I’ll turn the conference back over to you for any closing remarks.

Frederick J. Rowan, II

Just a quick summary I think we all know that market conditions are tough. I described in one word is uncertainty and I don’t think anybody knows the depth of it or the longevity of it. What we’re doing is going about improving our business model. It’s a young children’s market is large, it’s growing, the demographics are favorable, it’s fragmented, there’s plenty of opportunity with share gain. We have a far better competitive model for our customers and we’re about to meet with each one of them, we have the talent to do the job, we’re making the important investments, we’re watching inventory and expense and our job is to stay focused on that. We look forward to our next call. Thank you.

Operator

Ladies and gentlemen this does conclude the Carter’s call for today. If you would like to listen to a replay of this call it will be available beginning at 11:30 am Eastern Standard Time today through midnight Friday March 7th. The dial in number of the replay is 888-203-1112 in the United States and Canada and 719-457-0820 from international locations. The confirmation code to access the replay is 5965436. Again, that’s 888-203-1112 and the continental US and 719-457-0820 internationally. The confirmation code is 5965436. We do appreciate your participation and you may disconnect at this time.

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Source: Carter’s Q4 2007 Earnings Call Transcript
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