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Saks Incorporated (NYSE:SKS)

Q1 2008 Earnings Call

May 20, 2008 10:00 am ET

Executives

Steve Sadove – Chairman, Chief Executive Officer

Kevin Wills – Chief Financial Officer

Ron Frasch – President, Chief Merchandising Officer

Analysts

Emily Shanks – Lehman Brothers

Deborah Weinswig – Citi Investments

Christine Augustine – Bear Stearns

Todd Slater – Lazard Capital Markets

Karru Martinson – Deutsche Bank

Dana Cohen – Banc of American Securities

Bob Drbul – Lehman Brothers

Dana Telsey – Telsey Advisory Group

John Lahman – KDP Investments

Michael Exstein – Credit Suisse

Brian Geiger – Merrill Lynch

Analyst for Michelle Clark – Morgan Stanley

Analyst for Carla Casella – J.P. Morgan

Vanessa O’Connell – Wall Street Journal

[Jack Trapecks – Holden Asset Manaegement]

Operator

Good morning, my name is Miranda and I will be your conference operator today. At this time I would like to welcome everyone to the Saks Incorporated first quarter earnings conference call. (Operator instructions) I would now like to turn the call over to our Chairman and CEO, Steve Sadove.

Steve Sadove

Good morning, this is Steve Sadove, Chairman and CEO of Saks Incorporated. I’m joined today by Ron Frasch, our President and Chief Merchandising Officer, Kevin Wills, our CFO and Julia Bentley, Senior VP of IR. I’d like to thank each of you for taking the time to join us.

Today we’ll discuss the financial results for the first quarter ended May 3, 2008, our outlook for the balance of the year and update you on several other matters. At the end of the call we’ll be glad to respond to your questions.

Let me note that some of the comments on the call today, as well as some of the information presented in our earnings release related to future results or expectations are considered forward-looking information within the definition of the Federal securities laws.

The forward-looking information is premised on many factors and actual consolidated results might differ materially from projected information if there are any material changes in our assumptions. For a description of the meaningful risks and assumptions related to these projections please refer to the release and our most recent filings with the SEC, including our most recent form 10-K.

I’ll ask Kevin to briefly comment on the first quarter results and the balance sheet.

Kevin Wills

Thanks Steve and good morning everyone. Net income for the first quarter totaled $18.3 million or $0.13 per share. This compared to last year’s first quarter net income of $11 million or $0.07 per share. The prior year first quarter included after tax charges related to certain items totaling $17.6 million or $0.12 per share.

Note that our first quarter diluted share count was lower than last year reflecting the fact that our convertible indenture was not convertible at quarter end and therefore no share equivalents for this instrument were added to the share count. Quarter end inventories totaled approximately $841 million an approximate 3.6% increase from the prior year on both a total and comparable stores basis.

As you recall, we began the fiscal year with a 9% comp store inventory increase. Our customers responded to our merchandise offerings and promotional efforts during the quarter and consequently, inventories are now more in line with our future sales expectations.

We ended the quarter with approximately $124.5 million of cash on hand and no direct outstanding borrowings on our $500 million revolving credit facility. Funded debt, including cap leases totaled approximately $571 million and debt to capitalization was 32.6%, down from 33.9% one year ago and this is without given effect to cash on hand.

During the quarter we repurchased approximately 1.2 million shares of common stock at an average price of $11.96. We have approximately 34.4 million shares remaining availability under our existing repurchase authorization programs. Steve.

Steve Sadove

Thanks Kevin. Overall I’m pleased with our first quarter performance in light of the ongoing challenging macroeconomic and increasingly competitive retail environment. Operating income totaled $40.1 million, down about 30% from $57.2 million in the first quarter last year, excluding prior year certain items.

The decline in operating margin resulted from gross margin deterioration which I’ll discuss more in a minute. Our first quarter comp store sales increase of 8.4% was among the best in the industry as many retailers posted negative comparable store sales for the period.

Our sales performance indications, were, our continuing to gain market share and improve the productivity of our store base. Importantly we made great progress in reducing and better positioning our inventory levels during the quarter.

Customers responded to our merchandise assortments and incremental promotion which included a more extensive friends and family event and the acceleration of the spring season clearance event into the end of the first quarter this year from the beginning of the second quarter last year.

Excluding these promotional changes, our underlying first quarter comp store sales trend was healthy, increasing by mid single digits. Some of the strongest merchandise categories for Saks Fifth Avenue during the quarter included handbags, shoes, jewelry and men’s apparel shoes and accessories.

The New York City flagship store continued to outperform the company average and several of the company’s newly renovated stores such as Balm Beach Gardens, Beverly Hills and South Coast Plaza in LA posted outsized revenues.

In the aggregate, the number of transactions increased for the quarter while the average dollars per transaction decreased slightly. The increased promotional activity negatively impacted our first quarter gross margin rate by 320 basis points. We estimate that approximately 175 basis points of the deterioration related to clearance markdowns accelerated in the first quarter this year from the second quarter last year.

The incremental promotions and accelerated markdowns were successful as our inventories are now better positioned and we expect to return to gross margin rate expansion for the balance of the year. As we head toward fall, it is imperative that we maintain a new fresh [globe] goods in order to drive sales.

As a percent of sales, first quarter year over year SG&A expense excluding certain items essentially was flat. Last year’s first quarter SG&A still included some transition service agreement or TSA revenues related to the divestiture of our department store businesses which reduced SG&A.

Excluding this TSA revenue impact, we would have achieved modest SG&A leverage in the quarter. Last year’s first quarter was the final quarter were TSA revenue was a factor. In order to drive comparable store sales growth we continued to make targeted investments in areas such as selling, Saks direct and marketing, but we remain very focused on our expense structure and will continue to seek operating efficiencies while also investing for the long term.

We achieved 60 basis points of leverage on other operating expenses, depreciation, rents and taxes other than income taxes for the period. Both Saks Direct and Off Fifth posted outsized sales growth for the quarter. The Saks Direct customer is continuing to respond to our constantly expanding designer merchandise offerings, a myriad of innovative and interactive features on the site and service enhancements.

The Direct business also benefitted from the increased promotional activities. Revenues grew by approximately 40% for the first quarter on top of last year’s 50% first quarter growth. The Off Fifth business continued to perform well as we are improving our merchandise selections with more direct purchases from core vendors and additional Saks Fifth Avenue label product.

Our strategic capital improvements are underway. Our estimated capital spending plan for 2008 is approximately $125 million with about 70% allocated to stores and a significant portion of the balance allocated to continued technology investments associated with our merchandising and clienteling initiatives.

Similar to 2007, we’re focused our capital spend on highly productive stores and categories, opening or remodeling over 100 vendor shops and focusing on several major store projects. We’re finishing up the expansions of our Naples, Florida and Boston stores and completing the remodel of our South Coast Plaza store in La.

We have begun renovation and expansion of our key main floor business in our Bal Harbour and Miami stores in Florida and in our Houston flagship. These remodels are largely targeted towards our highly productive handbags, footwear and fine jewelry businesses.

A very exciting aspect of our 2008 capital program is the expansion of certain key elements from our 10022-SHOE concept in our New York City flagship into several additional markets. After seeing the success in New York, we’ve determined that parts of this model are portable and can resonate in other large markets.

By the end of 2008 we expect to expand this concept into our Beverly Hills, Houston, Phoenix, South Coast Plaza and San Francisco locations with 10022-SHOE Beverly Hills, 10022-SHOE Houston, etc.

We’ll continue to make investments in our highly productive New York store. During 2008 and into 2009 we’ll touch six of the ten floors by adding select vendors, expanding existing highly productive businesses like handbags and men’s and introducing several new concepts and resources in our cosmetic and fragrance area.

The most exciting New York City project is the complete renovation of our third floor women’s designer area. This will allow us to add key designers such as Chanel and expand the presence of other important resources. The first phase of this renovation will be complete this September and the project which will showcase over 35 designers will be finished in 2009.

We opened our prototype Off Fifth store in Orlando in April which has been extremely well received by our customers. We have tentative plans to open three new Off Fifth stores in the fall modeled after this prototype store. Let me ask Ron to make a few comments about our ongoing initiatives for 2008.

Ron Frasch

Thanks Steve and good morning. I want to spend a few minutes updating you on some of our operating initiatives for 2008. I’d like to take you back two and a half years ago to when we began our focus on localizing our business. In its infancy, we were principally focusing on our vendor matrix and assortments at the individual store levels.

It was that new focus that brought on our parallel planning and 9-box grid initiative. We spent the fall season of 2006 and all of 2007 working with our stores on an individual basis developing market appropriate assortments. While our initial read on this process was certainly positive, it highlighted the fact that we needed to better maximize these new assortments with a strengthened selling focus and more effective marketing.

We view our business as a three-legged stool where we need the product, the people and the marketing to make it stand on its own. So we’re working with Kurt Salmon and Associates, we are changing our structure and the roles and responsibilities of our merchants, merchandise planning and store associates.

And we have incremental investments in technology in both merchandising and store POS systems. These changes and investments have and continue to strengthen two of the three legs. In 2008 our renewed focus for the organization will be on driving the business at the local level or what we refer to as the third leg.

Let me give you an update on some details of these merchandising, service and marketing initiatives. We remain on schedule with making enhancements to our merchandise assortment and allocation processes. As you recall, we implemented these process changes in our men’s and accessories division in 2007 which represented about 40% of our volume.

The men’s area made their first buys under the new system and processes for spring 08 and the accessories team is making their first buys this spring for fall 08. We plan to continue to complete the rollout of women’s ready to wear, another 40% of our volume in the first half of this year.

We have our first read that the improvements made in the men’s area are working. We continue to gain market share in men’s as evidenced by our strong comp store sales growth in this area in the first quarter and the margin performance in men’s is expected to be better than the company average.

We believe these assortment and allocation process changes will lead to gross margin expansion over time. While we continue to shore up our merchandising through continued emphasis on the 9-box grid and our improved planning and allocation initiative, a key new focus for 08 and 09 is the reinvention of our women’s bridge business.

Women’s bridge which is our good range remains in a fourth element of our balance assortment. This area has been challenging for Saks as well as our peers for some time. Some of this weakness is certainly related to the economy but I think the primary problem has arisen from a lack of fashion and newness.

Since we launched our reinvention initiative earlier this year, we’ve made some very good progress. We are in the final stages of developing the new vendor matrix and a marketing handle for the category. We are aiming to make the shopping experience of this customer more analogous to our designer business.

This includes enhancements to visual presentation, merchandise adjacencies and customer service. Another element of the bridge reinvention will be the reintroduction of real clothes, one of our very popular and successful private brands that was discontinued several years ago.

When we last spoke, I introduced our comprehensive project geared towards increasing our selling focus in the stores which entailed modifying several processes both in store and in our support organization. We continue to believe that as the strength in our by store merchandise assortments through our parallel planning efforts, driving a full price selling focus in the stores is a critical component to exploiting our efforts.

At the end of 07, we finalized our pilot program and rolled it out in four stores. Armed with the learning from the pilot, we have expanded the pilot to seven additional stores since the beginning of 08 and expect to complete the rollout to the entire store base in the first half of 09.

We are seeing early benefits in the first wave of pilot stores as our associates seem more engaged, our product is moving through the pipeline at a faster pace and our stores are better prepared to execute. Additionally the rollout of our web base for the sale clienteling system to the balance of our store base is nearly complete.

As associates become more adept at using this system, we expect strength in customer relationships and improved sales trends. We are finding the associates have mastered the mechanics and the basic tasks very well. However, it will take more time and training to maximize the clienteling aspects of the system.

Over time I believe the potential for cultivating relationships and driving sales through the system are extraordinary. We have previously discussed our increased focus on local marketing initiatives and we continue to make meaningful progress in this area. Additionally, we are renewing our efforts to develop by store business plans to ensure that we fully exploit and integrate benefits from our merchandising, selling and marketing initiatives already underway. Steve.

Steve Sadove

Thanks Ron. I remain optimistic about the longer term outlook for the luxury channels and for Saks Fifth Avenue in particular. We’ve made an enormous amount of progress over the last two years, improving the competitive positioning of the business and we’re staying the course with our merchandising, marketing and service strategies and initiatives.

We continue to believe that the execution of these plans will deliver an 8% operating margin over time. However we believe the challenging macroeconomic and promotional environment will continue for the balance of 2008 and consequently, we’re taking a more conservative approach this year.

Our expectation is that our 2008 operating margin excluding certain items will remain relatively flat with 2007. Our financial expectations for the balance of 2008 are built on the assumptions outline in more detail in this morning’s earnings release. Let me highlight a few of these key assumptions.

We expect comp store sales growth of mid single digits for the year with low single digit comp store sales growth in the second quarter and mid single digit comp store sales growth in the second half of the year. Our assumption is that comp store sales for much of the store base will be flat in the aggregate with somewhat higher growth expected from New York, cap aided Saks Fifth Avenue locations, Saks direct and Off Fifth.

Our objective is for inventory levels to remain generally in line with company sales growth expectations throughout the balance of the year. We also anticipate a modest decrease in year over year gross margin rate for the full year with modestly improved gross margin rates in the second, third and fourth quarters, partially offsetting the gross margin decline realized in the first quarter.

We believe we can achieve modest SG&A expense leverage for the full year, excluding the impact of certain items, with more leverage expected in the second half of the year. While 2008 continues to present a challenging environment, I think we’re well positioned to weather the storm. We have an exceptional brand, an extraordinarily loyal customer base, great real estate, a strong balance sheet, a seasoned and talented team and the right strategies in place to deliver for the long term.

At this time, we’d be pleased to entertain your questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Emily Shanks – Lehman Brothers.

Emily Shanks – Lehman Brothers

I wanted to ask in reference to your guidance around comps you had indicated that capital aided Saks Fifth Avenue stores, you had differentiated them, I just wanted to understand how are you defining capital aided and what percent of your footprint or how many stores does this add up to?

Steve Sadove

The way that we’ve looked at the capital aided stores is and we’ve tried to separate out because the growth in aggregate we’d look at as the mid single digit growth. If you were to look at the capital aided stores that we did last year, for example we added 30,000 feet to our Palm Beach Gardens store and we’re seeing very outsized growth in Palm Beach Gardens. We added capital to our South Coast Plaza store in LA, we added capital to our Boston store and have seen improvements.

So there were a number of initiatives, there was the 10022-SHOE implementation in the New York store and then we also called out that we had outsized growth in New York in general. So these are the stores and you can see them from prior releases, which stores they were that were getting the capital investments from last year and that will continue to benefit this year.

Emily Shanks – Lehman Brothers

Okay so is it about 25% of the existing store base or 50%?

Steve Sadove

No, it would be much smaller than that. I mean New York alone you’ve got to look at because New York represents a little bit more than 20% of the store base, so you’re getting, but the shoe piece of the New York which is the capital aided is a much smaller piece of that. The stores that we’re talking about would be substantially lower than 25% of the total store base.

Emily Shanks – Lehman Brothers

Specific to the flagship store, how do you look at or do you have an estimate of how much sales were boosted as a result of international tourism here in New York?

Steve Sadove

I don’t have a specific number that we’re breaking it out, it’s clearly affected, if we were to look at 2007 in aggregate, the company grew about 11.7% comp store sales growth, we would attribute a couple of points of that to the international tourism. Within New York we would probably attribute 5-6% points of the growth that we saw in New York which was quite outsized to the total growth. So while a material number, it’s not a substantial portion of the growth of the company.

Emily Shanks – Lehman Brothers

As you think about the consumer and you had clearly stated that you expect the challenging environment to continue through 2008, what are some of the factors that you at Saks are looking for to turnaround that you view as an indicator that the consumer will start to feel better?

Steve Sadove

The luxury consumer operates somewhat differently I think than the more moderate, lower consumer. I think that our performance is much more tied towards confidence in the markets, in the stock market and stability in the markets, I would tell you that we’re feeling better today in terms of some of the stability that you’ve seen over the last month or month and a half than you did early in the year.

But I think over time it’s going to be, how do the markets perform, does the luxury consumer feel that there’s stability. Longer term I think that you’ll start to see some impact, whether it’s the checks that are going in consumer’s hands, whether or not you’re going to see some stability in the price of oil.

I do believe we’re in a rough economic period right now, the consumer is operating as if we’re in a recession, whether we’re technically in one or not. But if you start to see some stability in the overall economy and the market which tends to be a lead indicator shows some stability or any kind of growth then the luxury consumer is going to respond quite nicely.

Operator

Your next question comes from Deborah Weinswig – Citi Investments.

Deborah Weinswig – Citi Investments

In terms of if we look back at the first quarter which will, obviously look different than the rest of the year with regard to promotion, with the increase in promotions do you think that you were getting a new customer in your store or a greater share from your existing customers?

Steve Sadove

I think you’re probably getting a combination of both. We know that our current customers have responded very well to the promotional activity as well as to the merchandise offerings. If we look at our top tier for example of the customer base, that that top tier is responded very well and we’re seeing higher growth out of the top tier customer than we are in the aggregate.

When we did the family and friends event which we had a very, very good response to, we know that there was a large number of reactivations of customers that were coming back into the franchise that we had not seen. So that was in some ways you would call it whether it’s a bringing back of older customers or new customers, we know that we got a very good response from that.

And we also know that we’re attracting new customers in terms of feeding the funnel on a continuing basis so that we have, as we track the number of new customers coming into the franchise overall. So we actually feel good about the attraction of new customers during the quarter.

Deborah Weinswig – Citi Investments

When you reported fourth quarter you had guided inventory levels to be more in line with the company sales growth kind of beginning in the fiscal third quarter. It seems that you’ve kind of met that plan a quarter early, can you talk about what happened in terms of allowing you to achieve that goal a quarter early?

Steve Sadove

I think that clearly we made a decision that we needed to come out of the season certainly by the end of July with inventories in line. We made a decision that we wanted to be more aggressive in terms of clearing out the inventories, we had come into the beginning of the year at a 9% comp inventory, we wanted to be more aggressive in clearing it down. I’d rather take a first markdown than a second markdown.

We think that our consumers, we know that our luxury consumer when we gave them a bi incentive that they responded exceptionally well to the offering. We were a little bit more aggressive, the friends and family last year had been a 20% discount level it was at a 25% discount level.

The environment was such that we thought that it was the right thing to do to get the inventories in line earlier to free up the cash to be able to go and start flowing in the new fresh fashion earlier and clear out the inventory. It’s going to have to be cleared out at some point and we thought it would be better to clear it out earlier than later.

Operator

Your next question comes from Christine Augustine – Bear Stearns.

Christine Augustine – Bear Stearns

On the inventory could you discuss the units because obviously the dollars are down because you took the permanent markdowns at the end of the quarter but how much of that, how much carryover inventory is there and related to that I’m kind of surprised that you think your gross margin can be up in the second quarter.

Steve Sadove

Let me turn it to Kevin. I think that we feel quite good about the, you know we took the hit in terms of the gross margin, properly valuing the inventory. We cleared out a lot of the goods and we think that obviously there was a margin hit in the first quarter, we estimated 175 points that’ll flow back into the second quarter. So that would have obviously a positive effect in the second quarter. So in terms of the unit, Kevin do you want to talk to it?

Kevin Wills

We don’t report units Christine but in the aggregate I would tell you that our clearance inventory position at the end of the first quarter was generally consistent with where it was a year ago as a percent of sales and would not see a significant deviation year over year in the unit level.

As Steve indicated, we’ve estimated that the impact of the Q1 margin of accelerating the [event on weep] was 175 basis points. We would expect and as you look at the Q2 to have lower markdowns as a result of that, however, given the macroeconomic environment and the promotional positions, we would not anticipate a full recoup of that and as a result I think we gave the guidance that you’d expect modest gross margin expansion in Q2.

Christine Augustine – Bear Stearns

Right but you’re also forecasting a decelerating comp trend because ex the promos in 1Q you were up mid singles and you’re guiding up low singles. Is there another reason for that, are you changing ramp promotions 2Q versus last year?

Kevin Wills

Promotional expectation in the calendar for Q2 this year would be relatively consistent with last year.

Steve Sadove

Remember, by shifting that promotion from the first week of the second quarter into the last week of the first quarter, you could see the impact that you saw in April comps. That’s going to come right out of May comps.

Had we not done that shift, you would have seen a substantially higher second quarter comp rate because that was a pretty big volume shift going into the first quarter and into the April comps. So if you were saying that you’re only looking at low single digit comps now in the second quarter, that primarily is being driven by that shift into the first quarter.

Christine Augustine – Bear Stearns

The underlying trend is up mid singles, it’s just the shift and that’s the reason why you’re only forecasting the up low singles for 2Q?

Steve Sadove

Correct, that’s what we’ve said, we said instead of the eight and change we would have been closer to the mid single had we not had that shift of the promotional event into the last week of the quarter.

Christine Augustine – Bear Stearns

On the convert, your original guidance was $37 million for interest expense and if you’re now assuming that the convert is not going to be dilutive at all this year then shouldn’t the interest expense be over $40 million, shouldn’t you be adding back the full $4.5 million in the interest expense line?

Kevin Wills

The interest expense is reflected in the P&L as the interest on the convert and you would take that out when you do the diluted share count and as a result of the share price at the end of the quarter, the convert was not convertible, as a result it didn’t get added back in. But whether the convert is convertible or not, it would not impact the expense that shows up in the GAAP income statement.

Christine Augustine – Bear Stearns

But you’re now forecasting 140-145 million diluted shares so you’re basically assuming that there’s no convert, that it’s not going to be converted during the year, correct?

Kevin Wills

Given the current share price it is not convertible, hence the guidance. If the share price moves up like you have seen in prior periods, it would factor in to the diluted share count but if the share price stays where it is today or lower it would not be in the diluted share count.

Operator

Your next question comes from Todd Slater – Lazard Capital Markets.

Todd Slater – Lazard Capital Markets

Steve you said you expect to recoup the 175 basis points in gross margin erosion because of the sale of Full Forward in the second quarter but then Mike you said you expect to get only a part of that and I’m just curious how much of that do you really expect to get back?

Kevin Wills

As we have said our expectation for the second quarter would be modest expansion in the gross margin rate year over year. So we’re anticipating getting back some of that but the reality of it is we are very early into the start of the second quarter and given again the challenging macroeconomic and increasingly competitive position, we would not anticipate a full recoupment of that.

Todd Slater – Lazard Capital Markets

So that, in our estimate comes to about $0.07 so I’m assuming you expect to get probably at least half of that back?

Steve Sadove

I think that what we don’t want to do is give you a specific percentage of how much it’s going to be recovered of that 175. I think what Kevin has said is that we expect modest gross margin improvement for the second quarter.

There are a lot of other variables that are going into the gross margin in terms of what kind of competitive situation, what kind of mark downs you’re going to be required to take during the quarter. But we’re saying is in the aggregate of it all, we would expect to see modest gross margin improvement in the second quarter.

Todd Slater – Lazard Capital Markets

It just seems a little bit conservative but I get it. On the SG&A side, to me the leverage looks kind of light on an 8.4% comp and I’m wondering why you didn’t see better leverage and should we see on a lower comp in the second quarter some greater SG&A challenges there on the rate?

Kevin Wills

As we’ve indicated the last year’s first quarter included the final TSA revenue payment and while we had some expenses to provide those services last year in the first quarter they were fairly nominal. So if you took out the last year TSA revenue, we would have probably had SG&A leverage this quarter in the 40-50 basis point range.

Todd Slater – Lazard Capital Markets

Okay because you said slight, I didn’t realize it was that much, backing that out.

Kevin Wills

So if you compare that to what you’ve seen in the last several quarters it looks in line.

Todd Slater – Lazard Capital Markets

I’m interested in your reintroduction on the real clothes side on the private label and I’m just curious, on the private label I think that the average unit retails are lower that the margins could even be lower than in some of the branded businesses and I wondered if you could just talk to sort of the advantages and the benefits of growing the private label mix and also what is the appropriate mix you feel is appropriate for your business on the private label side?

Ron Frasch

It remains a marginal part of our business. It’s not a major thrust of our business, the private label in its entirety, but it does provide us with some differentiation and it does provide us with an ability to service customers and products that we’re not able to source from our branded resources.

The real clothes initiative is clearly that, it’s a modern casual clothes product concept that will be introduced in August and September of this year. So we feel very good about that. Relative to the margins, every margin depends on how well you can sell it. At the end of the day, the margin is a function of selling. It’s our hope and goal that we source these correctly, that the prices are what the clients want to pay and quite frankly we feel pretty good about this initiative.

Todd Slater – Lazard Capital Markets

Do you feel you can recover some of the customers that may have been lost when you discontinued real clothes?

Ron Frasch

I think so, I think that the issue probably is a lot greater than real clothes, it’s been a whole bridge business issue that we are working diligently as I noted in my opening comments to reinvent. And the real clothes component is important servicing the more casual lifestyle needs. So we hope that our goal is to both service the customers we have an continue to expand our client base for sure.

Operator

Your next question comes from Karru Martinson – Deutsche Bank.

Karru Martinson – Deutsche Bank

In terms of the market share gains that you referenced, where do you feel that that’s coming from and how do you view the sustainability of those gains?

Steve Sadove

It’s a hard question to answer directly. Clearly you can just take a look at our comp performance versus some of the direct competitors and by definition we’re getting more growth than they are.

So you’d say well share is coming from there but the consumer today isn’t just buying in a narrow set of outlets, they’re mixing and matching, they’re buying in the specialty stores, they’re buying in the my brand luxury stores. Some of them are buying frankly in a Target, so I don’t know that you can equate it and say Saks is winning and company X is losing.

I would just look in the aggregate versus whether it’s the apparel universe or the consumer who’s buying luxury goods, we are I think getting a disproportionate share of purchases right now.

Karru Martinson – Deutsche Bank

With the competitive environment you guys pulled some sales and promotions forward, how is your confidence going forward as the others fit their own promotional calendar that you can continue to maintain that gross margin expansion and keep that customer?

Steve Sadove

I think that we’re going to be competitive as our competitors take mark downs and go into promotional cadence, we’re going to be doing it as well and we’re very confident that we’re going to be able to continue to hold onto that customer and it’s not just about price, price is a piece of the equation.

It’s about service, it’s about clienteling, it’s about having the right products and I feel very good about where we are in the initiatives we’ve been taking have been playing out. What we did in this quarter was a small piece of, that was a decision in terms of just acceleration of a little bit of the promotion.

What we’ve been doing in terms of over the last year or two, if you looked at the growth last year and the close to 12% comp growth and a doubling of the operating income of the business was largely about whether it’s ideas and thinks like the 10022-SHOE or the merchandise assortment mix of the improved service and clienteling, those are what are going to longer term drive the share performance of the business.

Karru Martinson – Deutsche Bank

In terms of the New York market, it seems that your top tier customers are kind of overwriting the economic pressures that you’re seeing here and I was wondering if you could speak to what you’re seeing in some of your aspirational customers and just the market in general.

Steve Sadove

Well there’s no question that we’re seeing more strength out of the higher end customer. What we call our diamond and platinum customers continue to purchase at a higher rate than the more aspirational entry price point customer.

And you’ve seen, if you looked at it in product categories, the bridge customer which is our good versus the better, best, we’re seeing more pressure at the good price points than we are at the best price points. If I looked at it on a category by category basis, for example, even take a category like jewelry where we point to that as being one of our higher growth categories, we’re seeing much more in the way of accelerated growth at the high end of jewelry than we are the entry price points of jewelry.

So you have a convergence of any number of data points which are saying that that high end customer continues to be healthy and they’re also liking a deal, if they can get one. But the high end customer is healthy and that more aspirational customer is having a little bit of a harder time.

Operator

Your next question comes from Dana Cohen – Banc of American Securities.

Dana Cohen – Banc of American Securities

You gave the category rankings and I was wondering would there be any material difference in those rankings if you sort of promo adjust it?

Steve Sadove

I don’t think that you would see a substantial difference in terms of the differences. The only, if I were to look at the promotion certainly from the first week of the second quarter into the last week of the first quarter you would have seen essentially no swings on that.

The only area that you would have seen a swing of any kind was we saw really good outsized growth in our jewelry business and during the month of April we ran a major purchase account, no interest program on jewelry purchases, no interest for a year. And that proved highly successful, so you probably bumped up your jewelry sales proportionality a bit because of that program. But that would be the only shift I would see.

Dana Cohen – Banc of American Securities

Not even in accessories given that it was 30 off those categories, things that are not usually on sale during that two day event?

Steve Sadove

Not really, not appreciably different, you might have had seen a little bit of a swing but I wouldn’t have told you, if I were to look at the trends of the business going into that event versus after that event, I wouldn’t have said that it was appreciably different. There are a lot of other pieces, there were other promotions that you ran but relative to others, I didn’t see a big difference.

What you did see which is clear is that if I looked at the January, February, March data, you saw a slowdown across the entire company. So that it was still higher, if I were to look at accessories, shoes, handbags, jewelry, they had come down from the well into the double digit growth that we had seen all of last year, but they were still at a higher rate than the rest of the businesses.

Dana Cohen – Banc of American Securities

What should we think inventories will be for the rest of the year?

Steve Sadove

Well we’ve said that they were going to be more in line with sales growth and we’ve guided towards a low single digit in the second quarter, mid single digit in the remainder of the year and I said that we would be in line with that. So I would expect that you shouldn’t see a number higher than those numbers. It might be lower but you shouldn’t expect to see it higher.

Operator

Your next question comes from Bob Drbul – Lehman Brothers.

Bob Drbul – Lehman Brothers

On the Off Fifth business, was there a lot of redirection of inventory during the quarter into the Off Fifth channel and are you tracking if there’s any sort of cross shopping between your core Saks customer and the Off Fifth business?

Steve Sadove

Off Fifth as I said in the remarks, we felt very good about the Off Fifth performance, we’re seeing outsized growth in that business, I couldn’t be more excited by the opening of our Orlando store which is the prototype of the store in terms of how we’re evolving it and we’re seeing very good numbers.

The overlap with our full line stores has traditionally been in the 10% level, so that’s the kind of crossover, so it’s a nominal crossover level. If I talked to some of our competitors and some of the mono brands, that’s a similar type of a level. So we feel that it’s a different customer base between the two. If you looked at the first quarter shift of goods from full line to the Off Fifth business, it would not be a meaningful number by any means.

Bob Drbul – Lehman Brothers

Overall when you look at the competitive environment that you’re facing, do you feel like the inventory levels across the channel in the luxury space are at acceptable levels or do you think that this promotional cadence that you guys picked up on in the first quarter will continue, like what sort of assumptions are you making around that, the competitive response in the second quarter and into the summer?

Steve Sadove

I think you’re going to see, first of all, everybody is going into promotion mode right now. If you looked in today’s New York Times, Nordstrom was breaking their sale tomorrow. So you’re going into a clearance mode, so I think that you’re going to see an environment that is similar across, probably similar to what you saw last year and it’s going to be competitive where everybody’s going to be taking their prices down.

I think what’s important for us is that what we try to do was get in a mode where we could clear some inventory and we could bring in some fresh goods. So we freed up, if we wanted to get to the kind of the inventory level, you know you can look at an absolute growth in inventory at 3.5-3.6% and then you look at where you want to be at the end of the quarter but you also have to look at the mix of clearance to fresh goods and what we’re focused on is getting rid of some of that at the right value, getting rid of some of the older goods that we can free up for the new goods coming in.

Operator

Your next question comes from Dana Telsey – Telsey Advisory Group.

Dana Telsey – Telsey Advisory Group

Can you talk a little bit about what you’re seeing out there in terms of designer pricing, price points for fall, increases compared to last year and also how you’re planning marketing spend for the balance of the year, especially for the holiday season? And then just lastly I know you tested Off Fifth with the new name Saks Fifth Off Fifth, is that, did it help and do you do that going forward?

Steve Sadove

First of all on Off Fifth, the branding we believe has helped. If you were to go up to Woodbury Commons just north of New York City, we changed and for those of who are this close to it, Saks Fifth Avenue, Off Fifth used to be called Off Fifth with minimal association with Saks Fifth Avenue.

The use of the brand name Saks Fifth Avenue really wasn’t done much in the store at all. The private brand product was either called Folio or other names and there was very little leakage to Saks Fifth Avenue. What Dana is referring to is we’ve started to use the Saks Fifth Avenue brand name more aggressively, we put big signs, for example at Woodbury, instead of just Off Fifth, it’s Saks Fifth Avenue Off Fifth.

We’re using the Sakes Fifth Avenue name on some of the private branding product and we’re seeing very, very good response. We’re seeing more traffic for example in Woodbury as a result of the new signage. And as appropriate, we’re rolling it out. All the new stores have the new signage on it. There’s some cost involved with changing all the signs, so we’re doing this on a gradual basis, but the product in the store is using the Saks Fifth Avenue brand name.

Again, remember, there’s only about a 10% overlap in customer. As it relates to the marketing spend I would say it’s relatively flat to a year ago in terms of our spend to the consumer. We have a bit more of a shift in dollars going from national to local spend so you’re seeing it deployed somewhat differently. But in aggregate I would say that the holiday spend that you’re seeing is not materially different from a year ago.

Ron Frasch

The pricing of the European goods has shown a gradual increase, in fact this spring in many cases it was more than a gradual increase. Much of its based on the Euro but as important as the year over year on the Euro, it’s what our partners in Europe were hedged at. So we actually in some cases are seeing pretty dramatic growth based on a very positive hedging scenario in prior years with some people.

That being said, the vendors have been up until this point, very good in terms of absorbing it, the problem now is they just can’t absorb it as much as they did before. So the increases are being passed along. So to give you some ranges, we’ve probably seen best case in the 6-7% range to worst case in the high teens. We’ve tried to edit our buys accordingly because there is a ceiling that people will pay for product that we have found. So we were pretty cautious about it for fall.

Operator

Your next question comes from John Lahman – KDP Investments.

John Lahman – KDP Investments

I wanted to address in your presentation you had targeted funded debt to EBITDA of less than 2.5%. Just running some quick numbers, it looks like you are probably going to beat that with the 08 bond rolling off. However, you get closer to that target by rolling the 08 into a new bond. Are you anticipating rolling debt or continuing just to pay it off at maturity?

Kevin Wills

You’re correct, we have about an $84 million senior note that’s coming due in November. We have not made a final determination yet but as we said today we would anticipate retiring that security through using their unfunded liquidity under our revolver and or available cash. If you look at our 2.5 times target today, if you look at it on an LTM basis, excluding some certain items, we’re probably about a 2.2 range now.

John Lahman – KDP Investments

That’s correct, so you’re comfortable with the 2.2 or would that give you some I guess room to add a little bit more debt for share repurchase?

Kevin Wills

As indicated we set the target at 2.5 times, we’re currently comfortable with our capital position but we’ve made no comments prospectively relative to share repurchases or aggregate debt levels.

Operator

Your next question comes from Michael Exstein – Credit Suisse.

Michael Exstein – Credit Suisse

Can you talk about profitability of the credit business and what you’re seeing a couple retailers that have sold their businesses have seen some negative impact from that?

Number two, not to beat a dead horse on the subject of inventory but, sort of interested in where you think you are on the quality gap, aging gap of the inventory because generally when you do sort of this blanket type of promotion like you did, you get some adverse selection, you don’t necessarily get everything out that you need to. So can you give us an idea of the quality of what’s left now?

Steve Sadove

If we talk to the credit side first, as you may recall we sold our credit, our receivables to HSBC several years ago, so they own the portfolio, we receive income from that portfolio, it continues to perform quite well and very healthy. I think that if you were to look at that portfolio, it’s probably among the best that you’re going to see in retail.

And probably a little bit of a deterioration in the aging but I would tell you it’s not material and it’s a nominal level. So it’s held up, the conclusion I would look at, when I look at the monthly report on that that it’s held up very well.

Michael Exstein – Credit Suisse

So in terms of your impact on SG&A and also to SG&A that’s not an issue?

Steve Sadove

Not an issue for us. And as it relates to inventory aging, if you were to look at our aging this year versus last year, it’s essentially the same in terms if you look at the end of the quarter and what happened with the promotion and clearing out the goods, our percentage of goods that are zero to 90 days is essentially the same as it was a year ago.

Operator

Your next question comes from Brian Geiger – Merrill Lynch.

Brian Geiger – Merrill Lynch

I wanted to know, in the event of a deep and prolonged recession, do you see a risk of your customer base shifting towards lower price competitors or is that not really a concern for you guys?

Steve Sadove

I actually think what happens in a longer term recession is that the high end consumer doesn’t trade down to a lower price competitor, they may instead of buying two Gucci bags, they might buy one, but they’re not going to go down and buy a Coach bag, and I’m just using that as an example, maybe they will.

But I don’t think that it’s going to be a trade down to lower priced goods, they tend to be, what you’ll see is you’ll see more of the aspirational consumer dropping out of the franchise but that core customer is not going to change their purchasing behavior. It’s who they buy from.

Brian Geiger – Merrill Lynch

Right and how big would you, what percentage of your customers would you categorize as aspirational customers who might be at risk?

Steve Sadove

I don’t have a hard and fast number so I think that we’ve talked in terms of it might be in that 15-20% range.

Operator

Your next question comes from Michelle Clark – Morgan Stanley.

Analyst for Michelle Clark – Morgan Stanley

This is actually [Chi Lee] calling. Two quick questions, one, were you guys seeing any differences in the traffic lift from accelerated promotions between the flagship and non-flagship locations? And second, on second quarter SG&A, will there be any expense shifting out of the quarter or is it reasonable to expect some deleverage as a result of the volume loss?

Steve Sadove

As it relates to flagship to non-flagship performance, clearly the flagship performance is impacted by the New York numbers because the New York performance was substantially higher than the aggregate, so that affects the number. If you were to look ex New York, I don’t think you would have seen a material difference between flagship to the non-flagship stores.

Analyst for Michelle Clark – Morgan Stanley

Okay but specific to the actual lift from the promotional events, were they pretty much on plan between the two formats?

Steve Sadove

Yes, I think that we saw a very good lift from the promotion. It did what it was intended to do which was to clear out some of the excess inventory and it did it in both of the flagship and the non-flagship stores.

Kevin Wills

As to the SG&A expense, we had indicated that we would expect modest SG&A leverage for the balance of the year.

Operator

Your next question comes from Carla Casella – J.P. Morgan.

Analyst for Carla Casella – J.P. Morgan

This is actually Gretchen [Hoey] for Carla Casella. I just wanted to ask a couple of quick housekeeping questions. Is there any chance you could provide the stock comp and cap ex for the quarter?

Kevin Wills

We don’t break out stock or equity compensation, you will see the cap ex for the quarter when we do our cash flow statement but we spent approximately $25 million in cap ex for the quarter.

Analyst for Carla Casella – J.P. Morgan

Do you have a date planned for filing your 10-Q?

Kevin Wills

We will file that probably within the next couple of weeks.

Operator

Your next question comes from Vanessa O’Connell – Wall Street Journal.

Vanessa O’Connell – Wall Street Journal

I have a question in the international stores, I’m just wondering how much royalty revenue is Saks getting on the overseas stores and does it have a target for what percentage of overall sales might be comprised by that royalty income in the next five years or something.

Kevin Wills

We don’t break out the international royalty income. I would tell you that in aggregate it’s not a material number at this point. It’s relatively a small number in total and I wouldn’t, assuming on the growth over the longer term, if we expand into a number of countries and we’ve chatted with you in terms of some of the potential in the future, it could become a more meaningful amount of incremental income for the company, again that’s a royalty stream. But right now it’s not a material number.

Vanessa O’Connell – Wall Street Journal

In the economic slowdown, how are those stores performing generally speaking?

Steve Sadove

Internationally if we look at our stores in the Middle East, Dubai and Riyadh, extremely well. Well into the double digit plus growth. Mexico is much, much too early to tell, we just opened the store in November so you really don’t have trends to be able to compare it to.

Operator

Your next question comes from [Jack Trapecks – Holden Asset Manaegement].

[Jack Trapecks – Holden Asset Manaegement]

Can you comment about if you are seeing cost inflation primarily on your private label goods coming over from China?

Ron Frasch

So far it has not been an issue for us, we have a little more elasticity in our pricing model than some of the more significant private label developers would have where their operating margins are a lot thinner than ours. So to date we haven’t seen it and quite frankly we have made a decision when we began private label a couple of years ago that we work with partners here in New York so that we lean on them for production management and sourcing. So it has not had an effect on us at this point.

[Jack Trapecks – Holden Asset Manaegement]

What percent of your apparel business would you say you want private label collections to become?

Ron Frasch

I didn’t mention it because it’s not at this point a material part of our business, it’s in the low single digits and in terms of forecasting into the future it would really depend on how it develops.

Steve Sadove

If you look historically it was in the 6% type of a range, real clothes was a meaningful number, we did about $60 million in revenue on it. Depending upon how it evolves, it could get back to a mid single digit type of number. It’s gone down to almost nothing. So it could increase but it’s not going to be a number that you see at a traditional department store. It’s going to be at best in the mid, perhaps a little bit higher number.

Operator

And you have no further questions at this time.

Steve Sadove

Thank you very much everybody for joining us and we’ll speak with you again next quarter.

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Source: Saks Incorporated Q1 2008 Earnings Call Transcript
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