J. Crew Group F4Q07 (Qtr End 2/2/08) Earnings Call Transcript

Mar.11.08 | About: J CREW (JCG)

J. Crew Group, Inc. (JCG) F4Q07 Earnings Call March 11, 2008 4:30 PM ET

Executives

Allison Malkin - Integrated Corporate Relations

Millard S. Drexler - Chairman of the Board, Chief Executive Officer

James Scully - Chief Financial Officer, Executive Vice President

Analysts

John Morris - Wachovia

Paul Lejuez - Credit Suisse

Jeff Black - Lehman Brothers

Roxanne Meyer - Oppenheimer

Brian Tunick - J.P. Morgan

Randy Konik - Bear Stearns

Kimberly Greenberger - Citigroup

Barbara Wyckoff - Buckingham Research

Samantha Panella - Raymond James

Michelle Tan - UBS

Operator

Greetings and welcome to the J. Crew Incorporated fourth quarter and fiscal 2007 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Allison Malkin of Integrated Corporate Relations. Thank you, Ms. Malkin, you may begin.

Allison Malkin

Thank you. Good afternoon. Before we get started, I would like to remind you of the company’s Safe Harbor language, which I’m sure you are 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 might differ materially from those projected in such statements, due to a number of risks and uncertainties, all of which are described in the company’s filings with the SEC.

With respect to each reference we make on this call to adjust net income or another adjusted financial number, the reconciliation of net income on a GAAP basis to adjusted net income or of a GAAP financial number to the adjusted financial number has been provided in exhibit 3 and 4 of today’s earnings release and in exhibit 3 of our earnings release issued on March 13, 2007, which are available on our website.

And now I’d like to turn the call over to J. Crew's Chairman and CEO, Millard Drexler.

Millard S. Drexler

Thank you and hello, everyone and thanks for joining us to discuss our fourth quarter and fiscal 2007 annual results. I am joined today by Jim Scully and our other senior partners in the company. Following my opening remarks, I’ll turn the call over to Jim to review our financial highlights and update our outlook. We will then open up the call to questions.

We finished fiscal 2007 with strong revenue and earnings growth. On a 52-week basis, revenues increased 17% to $1.3 billion, with comp sales increasing 6% and direct sales increasing 24%. Adjusted operating income increased 39% to $175 million, or 13.1% of revenues versus 10.9% last year. This 220 basis point improvement came on top of a 260 basis point improvement last year.

During the year, we obsessively focused on our customers, as we always are. For us, this means focusing on our product, on the stitching, the buttons, the details, the colors. We come to work every single day to figure out where we’ve been and where we are going relative to the products for J. Crew, Crewcuts, and Madewell. If we do that right, source it right, invest in it right, communicate it right, and service it right, all else falls into place.

Increased store productivity with sales per square foot increasing 8% to $569 from $526 last year through maximizing every square inch in both our existing and new stores. We capitalized on our ability to reach our customers across all four of our channels. Whether customers come to us in our stores, online, or through catalog, as long as we are satisfying their needs both practically or emotionally, that’s what’s important.

We drove a 24% sales increase in our direct business through unique product quality and design and innovation on our website and in our catalog. We opened 22 new Crew Cut shops in shops and two freestanding Crew Cut stores. We also opened four new Madewell stores in 2007. We executed our store expansion strategy, opening a total of 37 new stores for the year with a 9% increase in square footage.

As I have said before and before, our focus is on driving long-term quality earnings growth through planning our revenues and inventory conservatively while continuing to offer our customers the best quality, style, and design.

In the fourth quarter on a 13-week basis, revenues increased 13% to $400 million, with a 4% increase in comp store sales on a realigned basis and a 15% direct sales increase. The strong revenue increase, coupled with gross margin expansion and SG&A leverage drove a 22% increase in adjusted operating income to $46 million, with our operating margin increasing 120 basis points to 11.4%. We manage the entire J. Crew business between our stores and online as a seamless business and we proactively manage our inventory as one to be more efficient.

Our direct business continues to exceed our expectations as our customers become more and more comfortable shopping online, particularly during the holiday season. Our customers continued to react to what is new and unique. We had a positive response to our gift-giving assortments in both our stores, online and catalog, which we will expand next year.

During the quarter, we opened six new stores, five retail and one factory, as well as operating a temporary Madewell store in Manhattan. We continue to grow our Crewcuts business. We currently operate four freestanding locations and 34 shop in shops as well as our online business, and we’ll soon have a catalog.

Our customers continue to connect to our unique assortment with the same great quality, style, and design as J. Crew. As I mentioned, during the fourth quarter we operated a temporary Madewell store in Manhattan and opened our permanent Manhattan store at 486 Broadway and Broom on February 20th. We are very pleased with the customer reaction and the results so far and the store’s proximity to our 770 office allow our team day-to-day access to our customer.

While Madewell remains R&D, we are enthusiastic about the customer response. Also, please if you get a chance, visit the store at Broadway and Broom downtown.

In 2008, we plan on continuing to execute our strategy, opening a total of 43 new stores, continuing to tailor each store to the market. We remain comfortable with our long-range goal of expanding square footage by 7% to 9% annually and anticipate square footage growth of approximately 11% in 2008.

We’ll continue to expand our Crewcuts distribution with approximately 10 new shop in shops and one to two freestanding stores planned in 2008 and continued growth in both our online and catalog business. Based on the positive response in Crewcuts and the fact that we see an opportunity in factory outlet centers, we will expand our Crewcuts offering to our factory division with plans to open up approximately 10 shop in shops in fall of 2008 and one freestanding factory store.

We plan to open a total of five new Madewell stores in 2008, ending the year with 11 locations. Very importantly, we will launch an e-commerce site for Madewell during this coming summer.

In the first half of 2008, we plan to open up a very small men’s shop in Tribeca to carry a highly edited assortment that will help us continue and evolve our men’s business. We will also importantly be opening a women’s collection only store in Manhattan at 79th Street and Madison Avenue. We’re very excited to showcase our exciting assortment that meets the needs of our best J. Crew Collection customers.

With that, I’ll turn the call over to Jim to review our fourth quarter and fiscal 2007 results and outlook in more detail.

James Scully

Thanks, Mickey. Turning to the details for the fourth quarter, total revenues increased 9% in the fourth quarter to $400 million, or 13% on a 13-week basis. As indicated in our press release, last year’s fourth quarter included 14 weeks versus 13 weeks this year. The extra week in the fourth quarter last year added approximately $13 million to fourth quarter 2006 revenues.

Our store sales, which include our retail, factory, Crewcuts, and Madewell stores, increased 8% to $261 million, or 12% on a 13-week basis. This increase was driven by a 4% increase in comp store sales on a realigned basis and a 9% increase in net square footage.

Our direct business experienced an 11% increase to $126 million, or 15% on a 13-week basis. Internet sales represented 78% of our direct business versus 74% last year, reflecting the ongoing shift of orders to the Internet from the phone.

As discussed during our third quarter earnings call, in the third quarter last year net sales included estimated returns based upon historical rates which exceeded actual returns by approximately $4.5 million. Net sales in the fourth quarter last year included the reversal of this excess amount. Excluding this amount from last year’s sales would have resulted in a direct sales increase of 20% on a 13-week basis.

Gross margin for the fourth quarter increased 10% to $165 million, with gross margin expanding 50 basis points to 41.3% on top of 400 basis points of expansion last year. The 50 basis point expansion was driven by 70 basis points of merchandise margin expansion partially offset by 20 basis points in buying and occupancy deleverage. As I just mentioned, the net impact of the $4.5 million of estimated returns in excess of actual returns recorded in the third quarter and reversed in the fourth quarter had no effect on gross profit but did impact gross margin rate.

On a comparable basis, assuming that last year’s fourth quarter sales did not include the $4.5 million reversal, this year’s merchandise margin was 10 basis points better than last year and gross margin was 10 basis points under last year as a result of the 20 basis points deleverage in buying and occupancy.

Adjusted SG&A expenses for the fourth quarter were $119 million, or 29.8% of revenues versus 30.7 last year. We achieved this leverage while absorbing higher costs associated with funding Madewell and Crewcuts, as well as opening 33 net new stores for the year.

Top line growth coupled with gross margin expansion and SG&A leverage led to a 22% increase in adjusted operating income to $46 million and 120 basis points of operating margin expansion. We were able to achieve this operating margin expansion while absorbing approximately $3 million in operating losses related to Madewell.

Net interest expense for the fourth quarter totaled $2 million compared to a net interest expense of $4 million in the fourth quarter last year. The decline in interest expense reflects lower average outstanding debt and increased interest income due to higher cash balances.

Income before income taxes increased 31% on an adjusted basis to $44 million compared to $33 million last year. This increase was driven primarily by our growth in operating income.

Adjusted net income was $26 million, or $0.41 per diluted share, compared to adjusted net income of $20 million or $0.33 per diluted share in the fourth quarter last year.

For fiscal 2007, total revenues increased 17% on a 52-week basis to $1.3 billion on top of a 20% increase last year.

Store sales increased 14% on a 52-week basis to $915 million, driven by a 6% comp store sales increase on top of a 13% comp store sales gain last year, coupled with 9% net square footage growth.

Direct sales increased 24% on a 52-week basis to $377 million on top of a 20% increase last year. Our strong top line sales growth, coupled with 70 basis points of gross margin expansion and 150 basis points of adjusted SG&A leverage, drove a 39% increase in adjusted operating income and a 220 basis point improvement in operating margin to 13.1% on top of the 260 basis points last year. We achieved this operating margin expansion while absorbing approximately $10 million in losses associated with our investment in Madewell.

Adjusted net income for fiscal 2007 was $98 million, or $1.54 per diluted share. This compares to adjusted net income of $65 million, or $1.05 per diluted share in fiscal 2006.

Turning to the key balance sheet highlights, we ended the year with cash and cash equivalents totaling $132 million. Inventory at the end of the year was $159 million, an increase of 13% over the prior year end and an increase of 3% on a per square foot basis. We remain pleased with the level and composition of our inventory as we enter fiscal 2008. We reduced our debt by $75 million during the year, ending the year at $125 million as compared to $200 million at the end of fiscal 2006.

Capital expenditures for the fourth quarter were $22 million or $81 million for fiscal 2007, slightly higher than our previous estimate. The increase to our prior estimate was driven by a change in the timing and scope of infrastructure enhancements related to our supply chain, inventory management, and website re-platform.

As we have previously mentioned, we intend to roll out three significant IT projects during 2008, including a new warehouse management system, and new planning and allocation system, and a re-platform of our direct business. We anticipate rolling these out during the second and third quarters.

Turning to the outlook, on an annual basis we continue to expect comp store sales growth in the mid-single-digit range, direct sales growth in the high-single-digits, net square footage expansion in the 7% to 9% range, and diluted EPS growth in excess of 20%.

In addition, we are introducing guidance for fiscal year 2008 and for the first quarter based on our current business trend and the current external environment. We expect diluted earnings per share for fiscal year 2008 in the range of $1.85 to $1.87, which compares to $1.54 for fiscal 2007 on an adjusted basis.

Our annual earnings guidance reflects 43 new store openings and one closure, an effective tax rate of 39.8%, approximately 66 million shares outstanding, capital expenditures of approximately $80 million, and approximately $15 million in losses associated with our investment in Madewell, which includes expenses related to the launch of the e-commerce site.

For the first quarter, we expect diluted earnings per share in the range of $0.46 to $0.47, which compares to $0.39 in the first quarter of fiscal 2007.

Now I’ll turn the call back to Mickey.

Millard S. Drexler

Thanks, Jim. As we begin 2008, we remain committed to our strategy of conservative investment while continuing to push our quality, style, and design. We challenge ourselves every day to learn from our customer and drive for future results and now we are ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from John Morris with Wachovia. Please proceed with your question.

John Morris - Wachovia

Congratulations on a great performance in a really tough environment. First question is Mickey, if you can talk a little bit about the -- you know, in terms of merchandising at J. Crew, where you see the opportunity in the Spring season compared to last year. And maybe if you can shed a little bit of light for us in terms of how the reporting of business has changed with Jeff’s departure and your thoughts on that. Thanks.

Millard S. Drexler

First, in terms of the recording -- what was that, the reporting of the business?

John Morris - Wachovia

Yeah, just you know, with Jeff’s departure, what changes in terms of reporting lines and how does it affect the day-to-day business with what you are going?

Millard S. Drexler

Really, actually nothing much has changed. Jenna Lyons has been creative director. We have one Margot Fooshee reports into me and Todd, head of men’s design, reports to Jenna. Catalog reports directly to Jenna and John, head of presentation, reports to Jenna. So it’s been very seamless. It kind of creates one less layer of management, so that’s really all there is to say about that.

Regarding Spring, and really regarding longer term, always women’s and men’s pants. And as you’ll look at our stores, you’ll start to see much more definition on that. We were in our Garden State store today, which everyone -- a lot of people know is our set-up store, and we’ll continue to reinforce dominant categories that J. Crew wants to be authoritative and the best in.

Now of course, part of that is forecasting what’s moving upward and what’s moving outward, so to speak. Jewelry you’ll see as a major impact beginning in the stores and that’s again -- and I don’t like to talk only about Spring. The thing we look at in any business is can it present a long-term annuity in our company? Can it continue to dominate and force others to shop in our stores, let’s say our competitors’ customers, and continue to improve the quality and design and detail of our clothes and continue to improve the service but always protecting opening price points.

So if you look at this spring and you look at the stores, which we just looked at the three-week set-up today, you’ll see that we are continuing to impact that. The women’s suiting business, we’ve had -- we’ve set them up differently right now in the stores. We’ve had a very quick training program on that to intensify the knowledge of suits, and also remember it’s a higher price point on average so it’s something that will help us.

Men’s business is much more classified. We’ve eliminated lots of excess assortments. Guys like to buy simple, they buy easy, and we’re focusing on the best 15 or 20 men’s items in those categories and then we continue to expand and build on cashmere.

Now that’s a quick answer to this Spring. Wedding online continues to build and build and build, and Crewcuts is building nicely. Shoes online continues to build, so we really want to be the dominant player in key categories where we differentiate from our competition.

So I can’t just mention categories but again, design and make and quality become incredibly important differences between us and our competitors in terms of where we go.

John Morris - Wachovia

Terrific. Thank you.

Operator

Thank you. Our next question comes from Paul Lejuez with Credit Suisse. Please proceed with your question.

Paul Lejuez - Credit Suisse

Mickey, can you share with us the way that you are planning to drive incremental sales on the direct side of the business, whether that be through new catalogs, which I think you mentioned, or just circulation, how you are planning on changing that business, if at all, in ’08.

And then Jim, you’re in a cash position, net cash position for the first time. I’m assuming you’re forecasting strong free cash flow in ’08. I’m just wondering what the plans are for the cash. Thanks, guys.

James Scully

Why don’t I take the cash first? First, we are sitting with about -- you know, at the year-end we had $132 million in cash. One thing we are doing is we are being a little bit prudent, given the current capital markets environment out there. I will say we do not -- we are invested 100% in U.S. treasury and money market funds -- no auction rate securities for us. But we are being a little bit prudent in terms of our pay-down schedule since we are paying down a term loan which we cannot re-borrow, and I think everybody reads the same papers and sees what’s going on in the capital markets, so we are sitting on a little bit more cash than we have historically.

Having said that, if you look at our forecast for the year, our guidance for the year including the $80 million in capital expenditures, we would anticipate seeing cash, free cash flow similar to last year in the $120 million range. Typically as you know that’s weighted to the back half of the year, so I think we’ll wait to see how things unfold for the year and then make a pay-down decision a little bit later in the year.

Millard S. Drexler

In terms of the direct business, well first I think it’s from our perspective, there is and continues to be a migration from retail to online and catalog. So as we look at that, we don’t care essentially where they buy as long as they buy and as long as they like our goods. So I think that’s a very overall arching issue in the world today and I think it seems like a lot of retails are reporting that.

Very importantly, we are building our 12-month file. As I said in the last year, we brought in a very experienced professional team and we are finding that our regular customers are coming back more and more and the file which was declining for a number of years is growing again and that’s critically important.

The other thing we’ve done -- and I don’t know if we were late or not on it, but the search, search business through Google, Yahoo!, whomever, has been growing dramatically and we keep investing more in that. Crew Cut mailings we’re investing more in. Our dress business and shoe business and frankly, they are very nice online and catalog businesses, hate to be inventorying all our stores with lots of shoes but one inventory is a huge benefit in terms of the direct and online business. Cashmere, more styles, more assortment; jewelry is growing online and I say it’s seamless but about one-third of our direct and online business is unique to that area, so it keeps driving traffic.

And then we have shops, we’re building out key item impacts in online. Plus the other thing that is kind of appealing to our customers, we hear, is as we dramatically change the nature of our catalogs and online, i.e. videos with the -- videos of our shoots in certain locales, much more interesting geographic elements brought into our catalogs that make them I think a lot more interesting to read is what our customers say. You know, the Kaufman house this year where we shot is actually a very famous house in America that again drives interest.

So we are trying to emotionally and intellectually connect to customers. We are trying to show people that where we go is not just pretty blue water and a beach, because that could be anywhere. But it’s a town, it’s a village, it’s something with history and that’s been part of our strategy and our team has been driving that.

So all that I think drives more loyalty, drives more people to the site, and actually creates a lot more excitement. Plus Crewcuts is still a pretty unknown new business and we continue to make that more and more aware to our customers to go online, since we don’t have that many stores.

Paul Lejuez - Credit Suisse

That’s very helpful. Thanks and good luck.

Operator

Thank you. Our next question comes from Jeff Black with Lehman Brothers. Please proceed with your question.

Jeff Black - Lehman Brothers

Thanks. I guess a couple of questions for Jim; first, can you shed some light on what your 1Q guidance is predicated on from a comp perspective and from a margin perspective? It would seem -- you know, you’ve talked for the year about 11% square footage growth, which is higher than that 7 to 9 long-term range. What’s that say about the comp expectations for I guess both Q1 and the year?

And second, on the expense side, given that we had a little more headwind from Madewell, it sounds like, how should we look at that in terms of just growing? Should we look at that as a 12, 13, given that square footage? Any of that would be helpful. Thanks.

James Scully

Sure, Jeff. So first, in terms of -- let me address the square footage growth first. What we said is the long-term net square footage growth will be 7% to 9% over three to five years, higher in the front-end, lower in the back-end -- it’s just the laws of numbers, grow on the back-end, so the 11% is consistent with that.

If you look at the guidance of $0.46 to $0.47 for Q1, that is predicated on the same long-term or annual guidance that we’ve given, which is mid-single-digit comps for our retail and factory, it’s high-single-digit for our direct business, and it’s 100 basis points in EBIT expansion, with the EBIT expansion coming from the same places we’ve said in the past, which is a third from gross margin and then two-thirds from SG&A.

Madewell, as I said, it’s going to be $15 million this year versus 10 this year -- $15 million next year, and that’s split evenly pretty much throughout the course of the year. A third of it is related, the increase is related to launching the new website, a third of it is related to some targeted investments in the infrastructure for that business, and a third of it is related to some of the new stores coming online.

Jeff Black - Lehman Brothers

So correct to look at SG&A in terms of just growth, would you say north of 12% is a good number?

James Scully

I’d sit there and say on a year-over-year basis, we’re looking for a 100 basis point improvement, so I would back into the growth necessary to get the leverage.

Jeff Black - Lehman Brothers

Okay, fair enough. As always, good luck, guys.

Operator

Thank you. Our next question comes from Roxanne Meyer with Oppenheimer. Please proceed with your question.

Roxanne Meyer - Oppenheimer

Thank you and let me add my congratulations. My first question is on Madewell. I guess, Mickey, in your perspective, how has Madewell evolved already since its -- already just short inception? Do you believe that the merchandise in the stores now, it will look the same in about a year from now as it does right now?

And I guess it seems like you are a little bit more excited about it. You are obviously opening more stores. Is it part of your growth or at this point is it still in test mode?

Millard S. Drexler

Well, I don’t want to sound more excited -- I’ve never been a good poker player but I’m kind of thinking it’s a nice business. We have a -- from a year ago to today, it’s pretty much night and day on assortment and night and day on the team, by the way. We have a new leadership, we have new design, we have new marketing. We have kind of a -- you know, a renewed energy about making it work and I can’t emphasize the importance of having a store about 10 blocks away from our office here. We hang out there. We’re there. We’ve hired one of the world editors of a fashion magazine here is now assigned to be the Madewell editor and marketer working with Margo.

So I think the assortments look a lot better. New businesses, as you all know, I’m not saying anything no one doesn’t see in our industry, are really hard to start. They only work if there’s a strong long-term vision and a tremendous passion and a point of view that’s focused about the product and the consumer.

I would say a year ago -- look, if you’re in our business and you start a new business, the glass is always usually half full, not half empty. I would say I’m really pleased with the progress. We are not opening a lot of stores relative to what -- I can only compare to our other players in our industry who seem to be opening more stores on new concepts. We are very conservative. We’re not counting this in any long-term plan whatsoever, but I can also say we live and breath to make it as successful as we can, and then the rest is really up to the customers to vote or not vote.

We did say we had a few -- I would call them real estate -- you know, they shouldn’t have been the first round. They could have been the third or fourth round, which is a nice way of saying I’m sorry we opened them the first year, but we did unfortunately. You know, when you are up against the business the first year, usually doing a little better the second or third year, and when you open up a new center with a new concept, where I might add we have spent no money advertising for purposes that we don’t want to over-promise and under-deliver.

We opened Manhattan about three weeks ago, February 20th and it’s here and if you haven’t seen it, I suggest you look at it. And I always say whatever customers think, it is. So I kind of -- we’re absorbing the feedback. We’re in there every day looking at it and we are living and breathing it. I like the location. I think it’s created kind of a cool, interesting corner there. Top Shop is coming next November from London. We’re really excited about that so I guess, Roxanne, it’s not in the growth numbers. We’re committed to make it successful. It’s not an ego trip and we’re still calling it officially here R&D.

Roxanne Meyer - Oppenheimer

Okay, great. Thanks. That’s certainly very helpful. And then second, I just was wondering -- I know you had mentioned it at ICR, talking about perhaps that you were a bit over-assorted in hindsight in the back half of last year. And I’m wondering if you could talk about the opportunity to maybe pare down on some of the SKUs, some of the colors, some of the more basic offerings, some of the more basic sweaters, and talk about how sizable that opportunity could be.

Millard S. Drexler

Well, first of all, there’s no merchant I know who will not say we’re over-assorted about their own business because a lot of over-assortment comes from hindsight. If you go to Garden State today, I think you’ll be really pleased with -- as we are -- with the general assortment feel.

Now, that being said, the job of any merchandiser is to continue to weed out a marginal or not great investment in apparel or accessories, so I think we’ve made a lot of good progress. I think what we are finding is you don’t buy 10 of a key item in all 12 colors. That we undid three or four or five months ago. We had a little of that left over for fourth quarter but as we see opportunity to reinvest our dollars, there’s two issues going here.

One is the productivity in our stores is growing and it’s our responsibility to continue to increase productivity in X amount of square feet. There’s a few ways you do that. It is not by buying more units at lower prices. It’s hopefully by buying maybe sometimes lesser units at higher prices. For example, a suit business at a $300 to $500 average retail, you sell a heck of a lot less of them than you have to sell a tank top, which we sell zillions of.

But you know, it’s the balance between quality investment, protecting opening price points that will in fact continue to drive the assortments there. But I think we’ve made really nice progress. In men’s, we’ve gone to a complete category impact presentation the way men like to shop. So if you go into -- and I say Garden State today, I hope it’s 200 stores -- you’re going to see by category the men’s assortment that we never categorized that before. Plus frankly, we took out a lot of choice. Now, none of this happens easily but it happens with again a fierce devotion to investing in the best, and of course having exciting news every day. In goods, we have a Sutherland trench in men’s that’s I think $298. That’s a new best-seller winner for us.

So men’s is always a little slower and more challenging to build but the building process is constantly evolving in men’s, women’s and now in Crewcuts and accessories. You know, if you looked at our jewelry business a year ago, it’s nothing like it looks today. So we are always heading down the road. We are always moving towards the future and our mission always is to provide best quality design aesthetic and service and understanding that the prices in America today, around America, European goods, designer goods are so expensive that it gives us we think an enormous opportunity because we are sourcing goods in Italy and wherever else.

Cashmere, our shoes are made in Italy -- compare our quality and our goods and our aesthetic to what’s going on in the marketplace, not to what’s going on in the high-end fashion magazines. To what the customers are buying and that’s the mission and we want them to keep knowing what we do in terms of the caring of the product and the quality. And by the way, it’s why each and every one of us in this company is available to all our customers 24/7.

Roxanne Meyer - Oppenheimer

Terrific. Thanks so much for that insight and best of luck.

Operator

Thank you. Our next question comes from Brian Tunick with J.P. Morgan. Please proceed with your question.

Brian Tunick - J.P. Morgan

Congrats, guys and nice article, Mickey in the New York Times. I guess our question was -- I know you are not going to give us obviously comp breakdown between factory and the full price business, but I guess we were trying to understand maybe directionally what’s happening in the margins? I know there was a couple hundred basis point difference between retail and factory margins over the past couple of years. Could you just maybe walk us through where are we now, where is there opportunity to sort of get those margins closer to each other?

James Scully

I’ll take a shot at this. First, if you look at the channels or if you look at the businesses, as we’ve said, direct is by far our most profitable channel, followed by factory and then retail behind that, with the biggest difference being between direct and the bricks and mortar businesses.

I mean, going forward in terms of getting to our guidance, it comes from all the different channels in terms of the leverage we get in SG&A. I will tell you that when we look at gross margin opportunity going forward, we have seen a benefit in gross margin. As we become more sophisticated and more efficient with one inventory across the channels and as we move faster from retail over to either factory but most importantly to direct and sell earlier in the cycle, we are seeing higher gross margin opportunity in the direct business which helps on a consolidated basis.

Brian Tunick - J.P. Morgan

Okay, but how about between the two retail channels?

James Scully

Well, it’s -- going forward, I don’t see one outpacing the other in terms of margin expansion. I would say that the gap between the two would stay constant over the period.

Brian Tunick - J.P. Morgan

Okay, and then finally, Jim, your comment to someone else about 100 basis points -- was that operating margin expansion for 2008 or was that SG&A opportunity?

James Scully

That was EBIT margin expansion for 2008.

Brian Tunick - J.P. Morgan

Okay, terrific. Good luck, guys.

Operator

Thank you. Our next question comes from Randy Konik with Bear Stearns. Please proceed with your question.

Randy Konik - Bear Stearns

Thanks a lot. First, a question for Mickey and then Jim; Mickey, just want to get your thoughts on your real estate strategy. You talked a lot in the last couple of conference calls on opening some stores in the city locations. Do you see any change in the way you are thinking about store locations from a suburban versus urban strategy, mall versus non-mall strategy? Just get your thoughts there.

And then Jim, with your stores or planned opening stores in the malls with all the recent closures of stores that are happening out there, can you just give us an update of what you are seeing with recent deals with your landlords and in rent expense rates? And then, what is your current comp point that you need to get leverage on your B&O and can that move lower over time?

Millard S. Drexler

In terms of real estate, I think it continues where we’ve been very cautious, conservative. No deal gets done in this company that does not pencil out with relatively conservative estimates, so we are not in the “we’ll spend it on marketing business” at all.

Now, that being said, city versus suburban, we go where the money is. We go where the right [demographic] is. We go where people who like fashion are and that could be differences in location but I don’t think it will ever get down to particularly suburban versus city versus lifestyle.

It really gets down to the community, the neighborhood and what’s important to people who live or shop in those neighborhoods. And I think every deal we do is really driven by that.

The stores in Manhattan are interesting. The men’s stores, really it’s a very short-term lease. It gives us a chance with very little investment or risk and more upside in terms of our reputation to fool around and play with the men’s store. Now, it’s going to be so small that it’s not even worth talking about probably after this call, although we are working on one or two freestanding men’s stores as we speak because we have a problem of do we have enough room for women’s, do we have enough room to expand certain categories in women that are more important or not?

Madison Avenue and 79th Street is actually for us a very -- you know, again it’s not a huge store. In the total scheme of numbers, it’s just one store out of the many hundreds that we have in the entire company but it’s a store that will be a collection store. We have a lot of demand for better goods in our catalog and if you look at it, the collection goods are growing in terms of its reputation. I would -- and I’m not that objective on this but I try to be always -- I compare them in quality and style and design, pretty much anything that’s out there and frankly I think they are a lot more wearable than runway clothes you see in the magazines, that plus they are made in a lot of the same factories, the same piece goods and fabric.

We need it -- very importantly, a store to highlight and showcase that, that we would hopefully make money in so again, we’re not paying the rents you read about $1,000 or $2,000 on Madison. We don’t go in there thinking that it’s going to cost us money but we think it’s going to be women’s only store, edited and we’ll communicate in one of the wealthier neighborhoods in the world what in fact a J. Crew looks like that it didn’t look like three or four or five years ago. The great exciting opportunity here is that there are still a lot of people who actually, and something personally I don’t love hearing it but if I -- in fact, that newspaper article brought us tons of letters and e-mails that people think that a label denotes quality, style, and design when in fact frankly it doesn’t always. In a lot of case, it doesn’t. It’s about the quality day-in, day-out and the commitment to a business.

So our real estate strategy I think is probably getting maybe a little shrewder in terms of more testing, let’s say, or more communicating opportunity. East Hampton, we’re expanding there this summer. We’re expanding in other places where there’s a very special unique customer who lives there and goes there, so -- otherwise they all must pencil out and it’s not so important whether it’s defined as a mall or city. It’s more about who the customer is and what they like and that’s where we are chasing real estate.

James Scully

Randy, in terms of what we are seeing on the real estate side from an expense perspective, I think just given our size with our retail stores is about 190 units, you know, we’re still targeting a large percentage of A and high B quality center, so we’re not seeing right now as much as you would expect in terms of softness in those locations. We are seeing a little bit more in terms of landlord contribution and also in terms of site selection opportunities.

But I think where a lot of people are seeing some softness in the market is quite frankly in projects where we’re not interested.

Millard S. Drexler

Yeah, what Holly said today -- and Holly Cohen runs real estate -- is the really good centers haven’t done much in terms of changing their pricing. The lead time here might be for next year or so. You know, there’s a little waiting game around America now real estate, residential and commercial. We’ll see what happens now. The world is a little unpredictable and that’s why we’re -- every day there’s a little bit of a new surprise coming on, aside from yesterday, but anyway.

Randy Konik - Bear Stearns

Just the -- you’re getting a little bit more on the tenant [allowance] side and just on the comp, what’s the comp you need to get the B&O leverage, just so we know?

James Scully

Sorry, Randy, it’s a mid-single-digits comp and yes, over time you would expect to see that comp down as obviously the comp base grows and you don’t grow the same on B&O.

Randy Konik - Bear Stearns

Thank you.

Operator

Thank you. Our next question comes from Kimberly Greenberger with Citigroup. Please proceed with your question.

Kimberly Greenberger - Citigroup

Thank you. Good evening. Mickey, you said something that was really intriguing back at the ICR conference about declaring a recession internally within J. Crew. I was wondering if you could just expand on what you meant by that and talk to us about how J. Crew is managing its business relative to your view on the external environment? Thanks.

Millard S. Drexler

You know, it’s interesting -- we said that I guess whenever it was in mid-January, early January. There were too many uncertain signals out there in terms of the economy.

Look, it’s really simply -- you know, it’s 11% growth in 2008, real estate we’re looking 7 to 9 long-term on average. Some centers come on earlier, increases it, et cetera. It’s all about inventory today, differentiation, and I believe and we all on the team believe, have to believe, it’s about the quality of the goods and the service and innovation. And by the way, I think it’s always about that.

Now, the reality is that we are playing it as if we’re still a small player. We look at the better market out there and then we look at some of the competition, so we played a little game yesterday. We added up over $20 billion at least in goods at the price levels of ours or over. And then we said we did $1.3 billion this year. And then we say well, why can’t we do better? And not arrogantly, but why can’t we do better?

So I think that if we were owning a very large chunk of the better business or the opening price point, better business, I’d be a little more concerned.

I also like the fact that we are in a game right now of beating the competition or doing better and being more creative. And if you look at successful companies in America, I think that’s been the game. The winners will win not because they are cutting expenses long-term. They are winning because they are innovating in their products. I’ve always said there’s enough stores in America to -- you can get rid of probably one-third of the closing stores and by the way, I assume over half the goods or three-quarters of the goods were sold on sale anyway. So whatever the prices are, a lot of the businesses are sale businesses.

So looking at the recession, I don’t know. We’re worried. Day to day, it changes. I don’t think anyone in the world looks at what happened today and expected it in this world, although if you looked at the housing growth over the last five years, someone logically would have said let’s stop building some houses, just like we said let’s stop buying some of the categories that have peaked.

So I look at it and as long as we don’t live with too much inventory, we’re prepared for downside. We’ll try to do as best as we can do but I will also tell you, all of us own this company and there’s not one customer out there who we don’t want to know, that in fact we listen and we care and you can’t imagine what we’ve learned from that article last week in the Times in terms of feedback and, by the way, how it got us -- now, it wasn’t meant to be an article on suits. It happened to be the mag of the month here was suits, so what happened then is we went out to Garden State, we went to Fifth Avenue, went to Prince and low and behold, we said gee, thanks to our customers with feedback and thanks to what we found out, is we can do a lot more business in categories that we’re dominant enough in, whether it’s presentation or knowledge, and that’s what we are doing.

The recession is here. Someone I think said it again today. It’s silly. The politicians are afraid to say it because they don’t want to get blamed for it, maybe. At the end of the day, when you read what you do in the papers every day, assuming half of it’s true, we’re in a recession. So we’re just dealing with that as it is. We’re not cutting back on anything because we are not doing anything frivolous right now because business has been relatively good over the last few years.

Kimberly Greenberger - Citigroup

Great. Thank you.

Operator

Thank you. Our next question comes from Barbara Wyckoff with Buckingham Research. Please proceed with your question.

Barbara Wyckoff - Buckingham Research

-- performance. Can you talk about the circulation versus last year, prospecting strategies? And then what percentage increase do you need in direct to consumer to cover the fixed expenses?

James Scully

First, Barbara, on the circulation site, last year for ’07 we wound up the year down 1% in circulation. We are anticipating for 2008 that circulation will increase about 5%. It comes from the things that Mickey was talking about in terms of some Crewcuts additions and also some targeted circulation related to some of the categories, and also to growth in the file that Mickey talked about.

But Barbara, I’m not sure I understand the question about the growth in the fixed expenses in the direct business.

Barbara Wyckoff - Buckingham Research

What percentage increase do you need in sales to cover your fixed expenses before it starts dropping to the bottom line?

James Scully

Hold on for one second. We’re just having a little bit of a -- I mean, we have tremendous leverage in the business today so the fixed costs are actually relatively small for the business because if you think the variable is really circulation, which we have control over, so the actual core expenses are relatively small. We have tremendous leverage in it today so it’s a relatively small number to get incremental leverage out of it.

Barbara Wyckoff - Buckingham Research

Okay. Thanks.

Operator

Thank you. Our next question comes from Samantha Panella with Raymond James. Please proceed with your question.

Samantha Panella - Raymond James

Good afternoon. I was curious how many stores carry the collection business and what that number was last year, and about how much in terms of a percentage of your direct business, you know, at the end of the fourth quarter versus last year. Thank you.

Millard S. Drexler

It’s all actually very low. In terms of stores, there are select groups of stores, very few stores that carry collection and the -- it’s a small percent and it’s growing. It’s a good margin business and it’s certainly less than 10%, and even much less than 10. I don’t want to give the exact number but it’s an umbrella that we’re building slowly and surely because long-term, without the proprietary ownership of design, style, and quality and consistency, businesses don’t last. And so this one, every year we plan a little more, we design a little more, and I think we do much better and that’s why we are opening up Madison Avenue. And it’s not going to be a pie-in-the-sky expensive store. Remember, there’s one other factor in America that’s going on today and I don’t think people pay that much attention -- it’s prices of apparel at high levels. Prices of designer goods, prices of cashmere, prices of shoes made in Italy -- I am stunned at how high the prices are and, by the way, I think a lot of customers are.

Our aim is to continue to reach into the marketplace and I know we’re not -- well, I think we are but we are not yet perceived the way we would like to be out there among everyone. We have a very strong, growing legion of customers right here in our backyard in Manhattan, all over online and in our catalogs, and a lot of cities in America where they know they come to J. Crew for their cashmere, for their Italian shoes, for their high quality suits with Italian fabrics, and for their special Ratti fabrics, men’s linen -- and you know, that doesn’t happen overnight. It only happens with a really long-term vision and plan to execute net.

So collection’s small and the other thing that’s happened -- this is again just for us a nuance -- as we continue to build, all of J. Crew, unlike the old days, becomes special unique goods. Go into our stores today -- which I don’t want to say they are perfect but they are reasonably good, or our Crewcuts stores, I don’t think you are going to find the same goods in other stores. So that’s the uniqueness and it does not require a mortgage to wardrobe yourself in our stores as it does in certain designer stores and very high-end department stores.

Samantha Panella - Raymond James

Great. Thank you and good luck.

Operator

Thank you. Our final question comes from Michelle Tan with UBS. Please proceed with your question.

Michelle Tan - UBS

Thanks. I had a couple of questions. One was can you give us a sense of where IMU is trending and how you are planning that for next year? And then also, on some of the product line extensions or opportunities you have like jewelry and Crewcuts, can you give us a sense of how big, in particular jewelry? Because it seems like you are just really starting to talk about that more and grow it in the stores, how big that business can be and what it looks like from a margin and productivity standpoint relative to the rest of the store? Thank you.

James Scully

First on the IMU side, what we’ve said historically, I think you know, is that 30 basis points or a third of the overall 100 basis points comes through gross margin. Half of that comes through buying and occupancy, with the other half coming through a combination of markdowns in IMU.

I think the IMU story is about the second half of this year. We are seeing some inflationary pressure in the second half of the year and what we are doing right now is we are going ourselves to be flat in the second half of the year from an IMU perspective and we’re working on leveraging our relationship with our vendors being one of the few companies out there that’s growing as we become more significant with them, and we are also going after costs throughout the entire supply chain, most notably in transportation. So that’s more of the second half story.

And with that --

Millard S. Drexler

Well, the new categories, I think we mentioned we’re dramatically growing costume. Crewcuts we’re growing really nicely. The dress business, the shoe business, Crewcuts in factory gets launched for fall and again, we don’t have any predictors on that. Our pant business in women’s, if you look at it it’s much more strongly defined, will be much more strongly marketed both in our online catalog and in the stores. Easier to shop.

In men’s, we’ve really narrowed down and focused in on the business. We’re going to get more so into the J. Crew style. Our tie business in men’s is phenomenal. It took us a little while to get there. We’re almost out of knit ties right now because we did them right. I think we did them with an attitude and a point of view. And of course in our business, we never want to be all things to all people, but I think we’re taking our shots. And we are very famous for our entire knit business, graphic tee business -- I mean, these are the businesses that we are growing. We are staying away from the commodities. We are staying away from anything that doesn’t provide special appeal or quality or feel or wash or detail to our customers because this is a very challenging environment. It really gets back to whether we’re in a recession or not, even if only 5% of the people in America are more careful purchasing, that’s a big impact on all of us. So that’s really what we’re doing and every day, by the way, there’s always new and meaningful ideas we can plan to.

For example, today we saw an idea for a new catalog in a very dominant category that we are going to devote the entire catalog to it. And that again gets it out there, it builds. Remember, we’re in the business to build long-term annuities on consistent goods with continuing to change and flow in newness -- color, prints, style -- and do better and better as we go forward.

Michelle Tan - UBS

Thank you. And it would seem to me that the margins on some of these categories, what I was saying on something like jewelry, productivity opportunities and margin opportunities are pretty significant considering that something like costume doesn’t take up a lot of square footage on the store.

Millard S. Drexler

Yes.

Michelle Tan - UBS

That’s great. Thanks.

Millard S. Drexler

Yes, jewelry. I think that’s it. Is that it? Okay. Thank you for joining us and we’ll look forward to speaking with you first quarter results when we announce them for the first quarter some time in May. Thanks, everyone. Take care.

Operator

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

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