Macy's Management Discusses Q2 2012 Results - Earnings Call Transcript

Aug. 8.12 | About: Macy's Inc. (M)

Macy's (NYSE:M)

Q2 2012 Earnings Call

August 08, 2012 10:30 am ET

Executives

Karen M. Hoguet - Chief Financial Officer

Analysts

Anne E. McCormick - JP Morgan Chase & Co, Research Division

Michael Binetti - UBS Investment Bank, Research Division

Jeffrey S. Stein - Northcoast Research

Joan Payson - Barclays Capital, Research Division

David J. Glick - The Buckingham Research Group Incorporated

Paul Swinand - Morningstar Inc., Research Division

Paul Lejuez - Nomura Securities Co. Ltd., Research Division

Charles X. Grom - Deutsche Bank AG, Research Division

Bernard Sosnick - Gilford Securities Inc., Research Division

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Deborah L. Weinswig - Citigroup Inc, Research Division

Kimberly C. Greenberger - Morgan Stanley, Research Division

Lizabeth Dunn - Macquarie Research

Wayne L. Hood - BMO Capital Markets U.S.

Dana Lauren Telsey - Telsey Advisory Group LLC

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

Operator

Good morning, and welcome to the Macy's, Inc. Second Quarter Earnings Release Conference Call. At this time, I would like to turn the conference over to your host, Ms. Karen Hoguet. Please go ahead, ma'am.

Karen M. Hoguet

Thank you. Good morning, and welcome to the Macy's Conference Call. I am Karen Hoguet, CFO of the company. Any transcription or other reproduction of the statements made in this call without our consent is prohibited. A replay of the call will be available on our website, www.macysinc.com, beginning approximately 2 hours after the call concludes. Please refer to the Investor Relations section of our website for discussion and reconciliations of any non-GAAP financial measures discussed this morning.

Keep in mind that all forward-looking statements are subject to risks and uncertainties that could cause the company's actual results to differ materially from the expectations and assumptions mentioned today due to a variety of factors that affect the company, including the risks specified in the company's most recently filed Form 10-K.

We are pleased with our second quarter results. While our sales trend was challenging in June, our business rebounded in July, and our profitability for the quarter was strong. As we head into the important back half of the year, we feel great about our merchandise and marketing strategy, our store execution and our increased omnichannel capability. We are positioned very well to continue to grow our market share while improving profitability.

Our second quarter sales were $6.1 billion, up 3% over last year on a comp basis. While below the first quarter trend, the trend in the 2 quarters was almost identical on a 2-year basis. And for the spring season in total, our comp store sales were up 3.7%, slightly above our original guidance of 3.5%. Our sales in the second quarter were very strong in watches, handbags, cosmetics, textile, furniture and mattresses. Men's in general had a tougher second quarter than first but was still very strong on a 2-year basis. Women's apparel was weaker overall in the second quarter, although we were happy to see some positive momentum in the juniors business. We hope this bodes well for our Millennial strategy.

Geographically, our business in the second quarter was generally stronger in the south than in the north. But in addition to southern markets like Florida, Hawaii and Houston, we saw good sales performance in non-southern markets as well, like Oregon, Cleveland and Colorado.

As we had anticipated, Herald Square was a drag on our sales growth because of the disruption from the remodeling work. Part of the new shoe floor is expected to open up this weekend, with the entire shoe floor plus a few key areas of the main floor, including fine jewelry, to open in stages over the next 90 days. It really looks spectacular and it's going to do so much to take the store and the whole Macy's brand to a whole new level. Our team, which includes our merchants, our store associates and our design and construction organization, is doing an absolutely fabulous job managing this very large and complicated project.

Bloomingdale's had a tougher second quarter than first quarter, but as with Macy's, July was stronger than June. Both macys.com and bloomingdales.com had great quarters, and we continue to be very excited about all the omnichannel initiatives. Through technology and the Internet, we have opportunities to accelerate our growth by linking all the various places and ways customers can shop today. This enables us to deepen our relationship with our customers, which is key for building loyalty.

Macy's currently have 280 stores fulfilling orders, either from other stores and/or from macys.com. We will be at 290 stores by the end of the month, and that's where we will stay for the remainder of the year. This 292 though compares to just 23 locations at this time last year.

We are also now utilizing the fulfillment logic, which is directing our orders more intelligently. The logic is based primarily on filling orders from stores or warehouses with the lowest sell-through of a particular item, as well as the distance to the customer's home.

Gross margin rate in the second quarter was 41.9%, up 10 basis points over last year. Our merchandise margin was up a bit more than that, but the impact of more delivery expense with the omnichannel growth, as you know, is negatively impacting our gross margin. We ended the quarter with inventory up 1.8%, although on a comp basis, it was up 3.6%.

SG&A in the quarter was just over $2 billion, up 1.7% versus last year. As a percent of sales, SG&A was 32.8%, down 50 basis points versus last year. We benefited in the quarter from $16 million increased income from credit, $11 million in lower stock-based compensation cost and $11 million lower depreciation and amortization relative to a year ago. These positive variances were offset by $19 million higher pension expense as well as the continued investment in our Internet growth and omnichannel capabilities.

Operating income in the quarter was $554 million, up 9.5% over last year. And as a percent of sales, operating income increased 60 basis points. Interest expense in the quarter was $105 million, and book taxes were $170 million or approximately 38%. For the first half of the year, the tax rate was approximately 37%, which is consistent with our annual guidance. Net income was $279 million, up 16% over last year.

During the quarter, we utilized $374 million in excess cash to buy back 10.6 million shares. This resulted in an average diluted share count in the quarter of 470 million shares. Year-to-date, we've utilized $588 million to buy back approximately 16 million shares.

EPS on a diluted basis in the second quarter was $0.67, up 22% over last year. Cash flow from operating, net of investing activities, was $245 million, which is $120 million lower than last year. On the positive side, we produced higher net income, lower inventory net of payables and last year, we had made a pension contribution. Those positives though were more than offset by $167 million higher CapEx, which was driven in large part by the purchase in the first quarter of the portion of our Union Square flagship store in San Francisco, as well as higher cash taxes due in part to our increased profitability.

In the first half of the year, we also utilized close to $1.5 billion of our excess cash in large part to the stock buybacks that I already mentioned, $797 million for debt repayment and $165 million in dividend. At the end of the quarter though, we still have $1.6 billion of cash and cash equivalent, which is $109 million more than we did a year ago.

As I said earlier, we feel very good about our performance over the past 6 months, and we are as ready as ever for the fall season. We are expecting comp sales to increase by about the same amount in the fall season as it did in the first half of the year, approximately 3.7%. Given the Christmas calendar, which has 2 extra days relative to last year between Thanksgiving and Christmas, combined with our optimism and our fourth quarter strategy, we are assuming a higher comp increase in the fourth quarter than in the third quarter. This guidance of 3.7% comp store sales for the full year hasn't changed since our last conference call in May. However, as you saw this morning, we did increase our earnings per share guidance for the year to $3.30 to $3.35. Part of that increase in guidance is due to stronger credit performance. And remember that consistent with prior years, our guidance excludes any costs associated with the miscellaneous store closings that could happen at year end. Remember, these costs are primarily noncash.

Now as you are modeling the third and the fourth quarters, please do remember 2 items in addition to our assumptions for the lower sales growth in the third quarter relative to the fourth. The first relates to credit. Remember that last year in the third quarter, we had a $108 million increase in credit income over 2010. This related to the true-up in our profit share formula. However, this year, we are anticipating credit income to be roughly $35 million to $40 million below last year in the third quarter. We do expect the credit income in the fourth quarter to exceed last year. But for the fall season in total, we are expecting credit to be a drag. For the year end total, however, we expect credit income to exceed last year by more than the $15 million to $20 million increase that we had projected earlier in the year. The second factor to keep in mind is tax rate. Last year, you'll recall that our tax rate in the third quarter was 24% due to favorable tax settlement that happened to occurred during the quarter. We do not expect to have settlement anywhere close to that magnitude this year in the third quarter. And keep in mind that our annual guidance for the effective tax rate remains at 37%. However, because of these factors, we believe we are likely to have a third quarter that is down relative to last year in earnings per share, but this is expected to be more than made up in the fourth quarter.

We are expecting a flattish growth margin rate in the back half of the year. Although with the growth in our omnichannel business and the free delivery, it may be down slightly. We expect SG&A as a percent of sales to decline in the fall. But in dollars, the percent increase is expected to be higher than it was in the spring. Part of this relates to credit, which I've just talked about, and part also relates to the 53rd week this year. We are expecting depreciation and amortization to be approximately $542 million this fall or $1,055,000,000 for the full year. We are still expecting CapEx of approximately $950 million this year.

As noted by our assumed 3.7% comp sales and our increase in the earnings guidance, we are confident in our strategy and, as importantly, in our team's ability to execute them. Clearly, we are not operating in an ideal macroeconomic environment. Issues like unemployment and housing prices continue to be on the minds of our customers. But we believe that Macy's and Bloomingdale's still have the opportunity to grow sales and earnings by listening closely to our customer and delivering exactly what they need, when and where they need it. That is the underlying principle behind our core strategy.

There are some things we cannot control but many that we can, and that is where we are concentrating our energy and resources. So through the back of this -- back half of this year, you will hear us talk about the fresh and unique merchandise we have to offer, the great value we are delivering to customers, the fun and creative marketing that will drive interest and traffic, the skill of our associates in engaging shoppers and the cross-channel initiatives that will help us to grow sales and improve the turn in our inventories. These are the factors that give us confidence in our business and that we believe will help us to continue to capture market share. As you know, we had terrific success in sales and earnings growth in both 2010 and 2011. We think we are on track for significant incremental improvement again in 2012 as well as in the years ahead.

Thank you as always for your interest in Macy's. And now, what questions do you have?

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Matt Boss from JPMorgan.

Anne E. McCormick - JP Morgan Chase & Co, Research Division

It's Anne McCormick on for Matt Boss. I just have a quick question about the online opportunity from omnichannel. You said that you're going to be in 290 doors in the fall versus 23 last year. Can you see just some changes we'll see on the website and what categories will see the largest increase in SKUs?

Karen M. Hoguet

Well, I think what's going to happen is the online assortment will just be available in more places. And what we've learned is that in many situations, our inventories were too tight on the dot-com -- in the dot-com buys. So we're able to satisfy more demand.

Anne E. McCormick - JP Morgan Chase & Co, Research Division

Okay, great. And then just one other question. On the juniors business, you saw some improvement in July. Are there any initiatives in place there? Are there -- is there anything that we should be watching for in that category?

Karen M. Hoguet

Well, as you know, we've put in place a new Millennial organization, as well as the beginnings of Millennial strategy that are focused, first and foremost, on improving the product offering, both in juniors as well as in Impulse. I mean, as you know, the juniors had been an underperforming category for a while. It's still not one of the best performing category. But during the second quarter, we did begin to see some improvement. So we're hoping that that's a positive momentum particularly as we go to back-to-school.

Operator

We'll take our next question from Michael Binetti with UBS.

Michael Binetti - UBS Investment Bank, Research Division

So just one quick question. Merchandise margins seemed like -- from your comments, like they're up nicely. But I'm guessing you still had some cotton pressure running through the P&L, those kind of things, on the private brand side. Could you call out any puts and takes on the merchandise margin for us in the quarter? And then I have a quick follow-up.

Karen M. Hoguet

No. We really don't give any detail on the merchandise margin.

Michael Binetti - UBS Investment Bank, Research Division

Okay. So if I assume that it was pretty good just based on your comments there, if I -- and I look at your guidance for slightly negative gross margins in the back half, it sounds like, adding up again, part of this from pretty aggressive focus on e-com and the free shipping mix there. But again, the merchandise margin looked pretty good. Inventories are pretty clean. You should have some input cost rolling off. And then the incremental pressure from -- I'm guessing store-to-door with the 290 store shipping is a lower margin sale than shipping from a distribution center. It seems like there should be from upward pressure on the gross margin. Could you maybe help me straighten that out a little bit for the model for the back half?

Karen M. Hoguet

I think all I can tell you is that our guidance, as best we can tell you, is flattish with the possibility of some downward pressure. Beyond that, unfortunately, Michael, you're on your own.

Operator

Our next question comes from Jeff Stein with Northcoast Research.

Jeffrey S. Stein - Northcoast Research

Karen, I'm just wondering if you could maybe discuss some of fulfillment issues, if any, or glitches that you might be seeing as you begin to fill orders from the stores for your online customers.

Karen M. Hoguet

Well, there is always going to be examples of individual customer orders where a mistake happened. But by and large, our fulfillment rates coming out of the stores are getting very close to the same accuracy and on-time rate as that in the distribution center. So again, I can't tell you that one of you didn't have a bad experience or somebody didn't. But in total, we are doing a spectacular job in fulfilling the orders out of the stores, frankly better than I thought we could do. So it's really quite encouraging.

Jeffrey S. Stein - Northcoast Research

Good. And one follow-up question. I'm wondering if you could just talk a little bit about your inventory plan for the back half of the year and maybe tie that into where you ended at Q2 and reconcile the difference between comp inventory and total inventory, which was a bit lower.

Karen M. Hoguet

Yes, I mean, total inventory includes merchandise in transit. Many of you will remember we talked a lot about that last year. And in the month of July, it was actually below a year ago. So that's really the biggest difference there. And so as we go through the fall, I think we may end up being able to improve our inventory turn this fall, but I am not going to forecast exactly where we will be at the end of the year.

Jeffrey S. Stein - Northcoast Research

Okay. But it would sound to me like if that is your goal, then your inventory should probably end up being in the mid-3% or lower range above your goal levels if you're able to achieve your goal. Would that be fair?

Karen M. Hoguet

I mean, yes, that's in the ballpark.

Operator

Our next question comes from Bob Drbul with Barclays.

Joan Payson - Barclays Capital, Research Division

It's Joan Payson on for Bob. I guess first off, maybe if you could talk about what you've seen so far in terms of early reads on back-to-school or if you have initiatives in place around that on top of what you're doing with the Millennials program?

Karen M. Hoguet

We'll talk about August when we get through the month. Obviously, juniors doing a little bit better in the second quarter may be a positive sign. So we feel good about our strategy. But again, no comment until we get through the month.

Joan Payson - Barclays Capital, Research Division

Okay. And then in terms of what you've said on the tourist traffic, could you just give some additional color on what that looks like at Macy's versus Bloomingdale's and if there are any categories that have been more impacted than others?

Karen M. Hoguet

Yes. I mean, I think the tourist business is still helping the company overall but perhaps not by as much as it did earlier in the year. So again, we still are doing better in the tourist market than the non but, again, without as much benefit as we saw earlier in the year.

Operator

Our next question comes from David Glick with Buckingham Research Group.

David J. Glick - The Buckingham Research Group Incorporated

Karen, I'm just wondering if -- since you have started to roll out these doors on the store-to-door initiative, I'm wondering what kind of benefit you're seeing in your e-commerce business to date, whether that helped drive the improvement in July.

Karen M. Hoguet

Well, remember that we just -- there are 2 pieces with the fulfillment door. The lion's share of what they're fulfilling are orders from other stores, not from dot-com. But starting in the spring, we did begin to expand out the categories on the website that, in essence, would be backup inventory in the stores and that has been growing. But most of the growth is coming out of the dot-com inventories themselves.

David J. Glick - The Buckingham Research Group Incorporated

Okay. And then just a follow-up, Karen, on Bloomingdale’s. I'm just wondering if there are certain categories that drove the slowdown in Q2. And what do you attribute the improvement you saw on July? Is that something we should fill optimistic about continuing into the second half?

Karen M. Hoguet

On one hand, I'd say that's probably the challenge of discussing sales monthly. I'd rather focus more on the quarter than what happened in July. And we'll see if the categories at Bloomingdale's are really similar stories to Macy's in terms of where the strengths and weaknesses have been.

Operator

Our next question comes from Paul Swinand with Morningstar Inc.

Paul Swinand - Morningstar Inc., Research Division

Quick follow-up questions here. On the tourist spending, could you comment, perhaps, whether there is any difference between Asia, South America and Europe? Is the decline driven by Europe?

Karen M. Hoguet

I think we would all assume that it's driven by Europe, but I don't have any statistics in front of me to tell you that's definitively the case.

Paul Swinand - Morningstar Inc., Research Division

Okay. And then just again following up on the inventory. On a unit basis, is your inventory actually down since prices and input costs have been up? And should that rectify itself as we move to the back half of the year next year with prices starting to normalize?

Karen M. Hoguet

I don't have the unit inventory in front of me. So I don't know how to answer that question.

Paul Swinand - Morningstar Inc., Research Division

Okay. I'll have to ask a more innocuous question. How about on -- in the beginning of the year, we talked about some of the initiatives and they're ongoing. And you said you had a lot of other levers to pull in 2012 for whether it's training or My Macy's merchandising strategies. Could you just give us an overview of what has worked? And then looking ahead, are there new things that you found out that you will pull in the future, that you could give us some color on?

Karen M. Hoguet

It's a hard question to answer quickly. But if you think about our 3 key strategies, My Macy's, M.A.G.I.C. and omnichannel, we've made improvements on all 3. If I think about My Macy's, as I've talked about in the past, we've been working on a major initiative for the last 9 months or so, called My Macy's 2.0. Some of the things that we've done has been improve the processes to both increase speed and reduce complexity. We've been working on talent development for some of the positions that were created through My Macy's, and we've done some work specifically to improve the merchandise assortment at the small store that have been very successful. In terms of MAGIC Selling, we've been working on building coaching skills and ramping up our efforts vis-à-vis fast feedback especially on the very busy days that we have, like one-day sale, and that seems to be paying off because our Net Promoter Score has gone up 4 points over spring of 2011. So that seems to be working. And in omnichannel, we've been talking about some of the changes in terms of getting -- making sure that a customer has availability of inventory across the company, whether she be shopping online or in-store. So there's a lot going on there. So again, we've been talking about that all morning.

Operator

Our next question comes from Paul Lejuez with Nomura.

Paul Lejuez - Nomura Securities Co. Ltd., Research Division

What kind of CapEx is required at the store level to allow a store to become part of the store-to-door a program? And also, I'm thinking -- just wondering what you're thinking is in terms of the right number of stores to be included in this program?

Karen M. Hoguet

Are you talking about store fulfillment?

Paul Lejuez - Nomura Securities Co. Ltd., Research Division

Yes.

Karen M. Hoguet

It's a small amount of capital and it is more expense, obviously, to have these people available to fulfill throughout the store. So the capital is relatively small. And we frankly don't know what the right number is. We think that 292 may end up being close to the right number, but we'll know a lot more once we get through Christmas.

Paul Lejuez - Nomura Securities Co. Ltd., Research Division

And what kind of expense increase occurs at that store level?

Karen M. Hoguet

Again, I don't have the specific number, but that's all factored into our projections for the fall.

Paul Lejuez - Nomura Securities Co. Ltd., Research Division

Yes. Just lastly, can you just quantify the disruption from Herald Square and also talk about the volume lift that you're expecting once everything is complete?

Karen M. Hoguet

We really haven't quantified the disruption only because you'd have to make a prediction on what the store would have done have you not remodeled. But the Herald Square has clearly been a slight drag on Macy's, Inc. sales this spring, particularly in the second quarter and, as we go through the fall, expect it to be less of a drag although it still will be somewhat so.

Operator

Our next question comes from Charles Grom with Deutsche Bank.

Charles X. Grom - Deutsche Bank AG, Research Division

Could you talk to when the fulfillment logic actually went into place and how much do you think that helped your merchandise margin performance in the second quarter?

Karen M. Hoguet

We started testing it earlier in the second quarter. So it's fairly recent. So at this point, it's way too early to be able to give you any sense of what it's going to do for the margin. It remains to be seen.

Charles X. Grom - Deutsche Bank AG, Research Division

Okay. And you said the combination of both lower sell-through and distribution benefits, right?

Karen M. Hoguet

Yes. But the biggest factor is the sell-through.

Charles X. Grom - Deutsche Bank AG, Research Division

All right, okay, great. And then when you take a step back and look at the second quarter and sort of the horse-shaped -- horseshoe-shaped performance on comps, with June being so soft, I mean, what do you think kind of happened in the June period, which obviously had a better start and a better finish?

Karen M. Hoguet

Yes, honestly, I don't know. It may be that we misplanned June, particularly vis-à-vis the July 4 holiday. I honestly don't know. I mean, it just looks to us like the customer hiccupped, because July sells a lot better, but we'll see. And clearly, as we've said, we had some concerns about the environment.

Operator

Our next question comes from Bernard Sosnick with Gilford Securities.

Bernard Sosnick - Gilford Securities Inc., Research Division

With regard to omnichannel efforts, it's an attempt to coincide your efforts with how consumers wish to shop and the changing shopping methodologies. Could you give us some indication of how omnichannel interlinks with your loyalty programs and efforts there?

Karen M. Hoguet

I'm hesitating. The loyalty program that we have is at Macy's -- not at Bloomingdale's but at Macy's. It's based on our proprietary credit card and so, obviously, have somebody shop regardless of the channel will help in terms of status on the loyalty program. With Bloomingdale's, they've integrated it more with the bloomingdales.com shopping with their new Loyallist program. And that one is tender-neutral. So again, you can be a part of the loyalty program not solely by using the Bloomingdale's card, and they've been very thoughtful in how they've integrated bloomingdales.com both in terms of earning points but also in terms of the delivery of those rewards.

Bernard Sosnick - Gilford Securities Inc., Research Division

What are your plans with regard to rollout of handhelds?

Karen M. Hoguet

Handheld devices to do what? I want to make sure I'll answer it properly.

Bernard Sosnick - Gilford Securities Inc., Research Division

Well, Nordstrom is rolling out handheld devices to ease the shopping and provide inventory information to sales associates on the store, enable credit cards to be used by the handheld devices to check out.

Karen M. Hoguet

Yes. Okay, no, no. I want to make sure you were talking about that vis-à-vis iPad, which we're using in a different way. Of course, we are experimenting with the handheld devices. And in fact, an important part of the shoe floor at Herald Square is going to be the use of a new device that should greatly enhance customer service on the shoe floor. But again, I think it's that kind of test that you're talking about, also looking at iPads in many stores to help enhance the assortment. So for example, in a smaller store, even some of our bigger store, say, in fine jewelry, where we don't -- we may have a necklace but don't have the earrings to match, can show it to the customer on an iPad. So again, that's not quite a handheld but it is a mobile device.

Bernard Sosnick - Gilford Securities Inc., Research Division

Is there anything that would make coupons incompatible with handheld devices?

Karen M. Hoguet

No, it's just -- no, it will depend on the device.

Bernard Sosnick - Gilford Securities Inc., Research Division

Okay. Because one of your competitors said that they couldn't -- handhelds couldn't handle coupons. I just wanted to be certain.

Karen M. Hoguet

Well, I maybe wrong but I believe it has to do with what you have to do with the handheld. So it may require a more complicated handheld.

Operator

Our next question comes from Lorraine Hutchinson with Bank of America Merrill Lynch.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

You're beginning to lapse some big AUR increases for the fall. So what are your plans for pricing in the second half? And should we expect most of the second half comp to come from unit growth?

Karen M. Hoguet

The truth is you all need to remember that AUR is not necessarily related just to price. We get AUR increases very often with changes in the mix, whether it be categories or vendors. Also, as we roll out higher price point initiatives, things like the Impulse strategy, and also frankly with more regular price selling, we get an increase in AUR. So I want to make sure that we don't equate increases in AUR to price increases. As you know, this spring, we've had about an 8% increase in AUR. We think the fall AUR will be up but not by as much as it's been in the spring.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Okay. And then last quarter, you mentioned women's classic as showing some signs of life. I didn't hear any mention this quarter. Can you just talk about what's happening in that business?

Karen M. Hoguet

Yes -- no. I was, I guess, over generalizing about the women's apparel business in general. We've had a very good spring season with some of the classic businesses, most notably private brands like Charter Club and Karen Scott, but the strength there wasn't enough to pull up the whole category to make it strong.

Operator

Our next question comes from Deborah Weinswig with Citi.

Deborah L. Weinswig - Citigroup Inc, Research Division

Actually, following up on Lorraine's question, would you say that private label on exclusive outperformed national brands, overall?

Karen M. Hoguet

Private brands and exclusives had a good quarter and a goof half of the year. It's a very important part of what we're doing, as you know.

Deborah L. Weinswig - Citigroup Inc, Research Division

Absolutely. And then with strong online sales, how have you found that, that has impacted store traffic, if it has all? Or has that actually driven more store traffic as consumers have looked online and then that's driven them into the store?

Karen M. Hoguet

Yes. Interestingly, what we're finding is that omnichannel or the online shopping is having a bigger influence on store sales and more and more people are browsing online and coming in store. Others are doing the opposite. So we don't actually track traffic, but we are tracking how customers are behaving that buy. And we are finding that this omnichannel shopping behavior is terrific for store sales, as well as online sales.

Deborah L. Weinswig - Citigroup Inc, Research Division

Okay. And then I think your guidance is for flat gross margins. I don't know if you have provided some additional insights in terms of the stronger growth margins. And then speaking with the online topic, I think that the gross margins tend to be lower. How should we think about the EBIT margins for online?

Karen M. Hoguet

Well, at this point, Deborah, it's almost impossible to differentiate online from offline because how do you allocate things like marketing expense? But generally, the online merchandise margins have been higher, which offsets the higher delivery cost. So from a profit perspective, we believe that we're going to continue to be able to grow the omnichannel business and also increase the total profitability as a business at the same time.

Deborah L. Weinswig - Citigroup Inc, Research Division

Great. And then one last quick one. I think that the RFID initiative will be in full swing on the third quarter on the, basically, replenishment goods as you think about 30% of sales. When will that roll out for the fashion items? And how do you expect that to impact the third quarter as well?

Karen M. Hoguet

Well, it's actually later than that in terms of the replenishment goods. It's going to start this fall but really be in full swing next year. And I think we're very optimistic about the replenishment side, and then we'll roll it out from there on the fashion. I don't know the specific timing. By the way, RFID is also going to be an important part of the shoe floor. So interestingly, you would think you would not be testing technology in your biggest store, but we're about to do so.

Operator

Our next question comes from Kimberly Greenberger with Morgan Stanley.

Kimberly C. Greenberger - Morgan Stanley, Research Division

Karen, I'm wondering if can you talk about traffic versus ticket. You mentioned an 8% increase in the average unit retail here for spring. Does that include online? And if you have separate statistics for the stores, that would be helpful as well.

Karen M. Hoguet

I don't have separate statistics because again, more and more online, offline, to us is the same thing. And with the 8% increase in AUR this spring, the unit per transaction has been down about 3% with the transaction down slightly.

Kimberly C. Greenberger - Morgan Stanley, Research Division

And do you track traffic in your stores versus transactions? Or do you use transactions as a proxy for traffic?

Karen M. Hoguet

We use transactions as a proxy for traffic.

Operator

Our next question comes from Liz Dunn with Macquarie Capital.

Lizabeth Dunn - Macquarie Research

I have a question about the omnichannel efforts. Amazon is testing same-day delivery in one market. I wonder if you could think out to the future. Is that something you think you could be poised to do from your own stores particularly since they have to open up a new distribution center to do so whereas you now have 290 stores kind of shipping directly?

Karen M. Hoguet

Yes, absolutely. I mean, in essence, we have warehouses all over the place, which if we decide is an important need for the customer, I think we're going to be very well positioned to do so going forward. At this point, I can't tell you we've concluded it's a good thing to do, but you're absolutely right. We're much better positioned to do so than they will be.

Lizabeth Dunn - Macquarie Research

How many store associates do you need to add to be able to do store-to-door, like for the 290 stores?

Karen M. Hoguet

I don't know how to answer that. The truth is we add hours and it depends on the anticipated volume. So I don't know a specific answer. But again, that's all been factored into our plans for the fall.

Operator

Our next question comes from Wayne Hood with BMO Capital.

Wayne L. Hood - BMO Capital Markets U.S.

I had a couple of questions. One, the industry, as you know, continues to move to free shipping. And do you see yourself kind of sticking to that $99 minimum? And if you do have to follow them down so you don't cede at least some market share, what impact do you think that might have on your gross margin maybe in the back half of the year but even on a longer-term basis?

Karen M. Hoguet

For now, we're comfortable where we are. I can't tell you that we will always be. But interestingly, when we went to $99, we were able to increase the average order size and it helped our business. So we'll see what goes from here.

Wayne L. Hood - BMO Capital Markets U.S.

Is there a hurdle rate where you would, say, below $50, it doesn't make sense to have free shipping? Or what is the...

Karen M. Hoguet

Remember, when you're in a store and we do Search & Send, it is $50.

Wayne L. Hood - BMO Capital Markets U.S.

Okay. And I guess my second question kind of relates to this as well, if you were to look at the best in class and replenishment, those that have a store-based kind of model and you compare your distribution cost or fulfillment cost to that best in class, how much do you think you would have an opportunity to take cost down as you get better at it?

Karen M. Hoguet

I'm not sure who would be best in class, and I'm not even sure it wouldn't be us. And will we be able to do it more efficiently going forward? As you might imagine, we'll try everything we can to do so. But I have no way of projecting for you what that could mean. Remember that we are pretty focused on taking cost out wherever we can. So trust me, if there's an opportunity there, we'll find it.

Wayne L. Hood - BMO Capital Markets U.S.

Okay. And my last question relates to merchandise margin. You mentioned they were up greater than 10 basis points in the second quarter. So as you think about the fall season, are you expecting it to be up close to 20 or 30? Or just put some color around that, please?

Karen M. Hoguet

Well, I mean, again, what I always said is that we're expecting gross margins to be flattish although with a recognition there might be some risk from the added cost associated with delivery.

Operator

We'll take our next question from Dana Telsey with Telsey Advisory Group.

Dana Lauren Telsey - Telsey Advisory Group LLC

Can you talk a little bit about the Millennial strategy and how you're thinking about it? You had many important strategies, whether it's localization, MACIC Selling. Where does it fit in the strategy framework? And what other changes do you see coming about because of that? And just on the online, optimizing inventory by channel, how do you see inventory growth changing the cost of the channel distribution now?

Karen M. Hoguet

Those are 2 tough questions. On the Millennial strategy, obviously, it cuts across all 3 of the major strategies, My Macy's, M.A.G.I.C and omnichannel. You can't talk about Millennial without talking about omnichannel. A big portion of the strategy relates to engaging better on our selling floor with the customers that come in. So there's a whole store initiative as part of that. But I would say the key part of the Millennial strategy in its first phase -- or the first priority is all around product and developing new brands and finding brands that fit the various customer profiles that the team has developed. So we're very excited about that, very excited about the product that we're producing ourselves like Bar III, for example, which has been doing extraordinary well, but also the products that some of our key vendors will be making for us starting next year. So a lot more to come on that, but we're very excited about it. Your second question relating to optimizing inventory, that's still in front of us. Right now, we've been more focused on satisfying customer demand wherever the customer may be standing. And next on the list, we'll be trying to tackle this very complicated subject of where is the best place to have inventory to satisfy that demand, best for the customer but also with an eye towards profitability.

Operator

[Operator Instructions] We'll take our next question as a follow-up question from Michael Binetti with UBS.

Michael Binetti - UBS Investment Bank, Research Division

I'm just wondering if you could talk a little bit about how you're thinking about your full price selling or the couponing strategy into the key value seasons like back-to-school? Obviously, you've got a big competitor who's sticking by a strategy of not couponing and we've seen recent results deteriorate there. We saw some comments from Coach earlier that said that when they pulled coupons, there was a very clear message from the consumer. So I'm just curious if you could give us kind of your view of how you're approaching the promotional strategy for the fall and into holiday, please?

Karen M. Hoguet

Yes, I mean, if you think about it, our strategy has been working for 3 years. So don't expect any changes from us in terms of the couponing or the level of promotion. We think what we're doing is working, and we're going to stick with it.

Operator

Our next question is from Adrianne Shapira with Goldman Sachs.

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

Karen, just a few follow-ups. I know we talked a little bit about merchandise margins. I'm just wondering if you could give us some color. Is that a function of better markup or markdown?

Karen M. Hoguet

Better -- and you're talking about the second quarter?

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

Yes, what we just saw in terms of the merchandise margin being above the gross margin.

Karen M. Hoguet

Yes. It's a little bit of both.

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

Okay. And then the guidance you had given about comps being better in the fourth quarter versus the third, I'm wondering in light of what you saw in, as you mentioned, maybe the second quarter, that June saw softness, the function of planning, how should we think about the third quarter? And any color you can give us in terms of the cadence and the events in terms of the monthly cadence in the quarter given that it sounds -- it looks as if you're up against tougher comps earlier on the quarter versus late?

Karen M. Hoguet

As we look at the months in the quarter, they're relatively the same for the third quarter. So I don't -- and again, in terms of major changes in holidays or promotions, there is nothing in the third quarter. Fourth quarter, obviously, we have the additional time between Thanksgiving and Christmas, which will help the month of December. But in terms of the third quarter, I really don't see much there.

Operator

It appears we have no further questions in the queue at this time.

Karen M. Hoguet

Great. Well, thank you, all. And if you have other questions, feel free to call me or Matt or Sara. And again, thanks for your interest in Macy's.

Operator

That does conclude today's conference. Thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!