Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)

American Eagle Outfitters (NYSE:AEO)

Q1 2008 Earnings Call

May 28, 2008 9:00 am ET

Executives

James V. O’Donnell – Chief Executive Officer

Susan P. McGalla – President, Chief Merchandising Officer

Joan Holstein Hilson – Executive Vice President, Chief Financial Officer – AE Brand

Judy Meehan – Vice President – Investor Relations

Analysts

Kimberly Greenberger – Citigroup

Lauren Cooks Levitan – Cowen and Company, LLC

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

Todd Slater – Lazard Capital Markets

Jeff Black – Lehman Brothers

Lorraine Maikis – Merrill Lynch

Richard Jaffe – Stifel Nicolaus and Company

Dana Telsey – Telsey Advisory Group

John Morris – Wachovia Securities

Janet Kloppenburg – JJK Research

Stephanie Wissink – Piper Jaffray & Co.

Tracy Kogan – Credit Suisse

Michelle Tan – Goldman Sachs

Operator

Greetings and welcome to the American Eagle Outfitters first quarter earnings conference call. At this time all participants are in a listen-only mode. A question and answer session will follow the formal presentation. (Operator Instructions).

It is now my pleasure to introduce your host Judy Meehan, Vice President of Investor Relations. Thank you, Ms. Meehan. You may begin.

Judy Meehan

Good morning, everyone. Joining me today are Jim O’Donnell, Chief Executive Officer, Susan McGalla, President and Chief Merchandising Officer, and Joan Holstein, Executive Vice President and Chief Financial Officer, AE Brand.

If you need a copy of our first quarter press release it is available on our website, ae.com.

Before we begin I need to remind everyone that during this conference call, members of management will make certain forward-looking statements based upon information which represents the company’s current expectations or beliefs. The results actually realized may differ materially from those expectations or beliefs based on risk factors included in our quarterly and annual reports filed with the SEC.

Now I will turn the call over to Jim.

James V. O’Donnell

Thanks, Judy. Good morning. In the first quarter we faced a number of challenges, both internal and external. I’m not pleased with our first quarter results. However, we’re moving quickly to strengthen the business. I am pleased with the progress we’re making, which we’re going to address today.

First I’ll review the results for the quarter. Our sales were up 5%; comparable store sales declined 6%. This was well below our original plan. The weakness area was AE Girls, resulting in significant markdowns and impacting profitability. Net income declined 44% and EPS was down 40%.

These results aside, there were a number of positives in the quarter that I would like to mention.

Our guys business continued to perform well producing a comp increase. We made progress in key girl categories and we successfully cleared through our denim line.

We saw strong performance from our new eight stores. They continue to generate a year one ROI of over 65%. As I look ahead I see the potential of approximately 100 additional AE stores in North America.

Our direct business continues to demonstrate excellent growth and performance. First quarter sales were up 29% with a strong profit contribution.

We see increasing growth and great potential for our aerie brand and we’re moving full speed ahead with 80 new stand-alone stores opening this year. We’re getting prime locations and attractive rents combined with tenant allowances. The new stand-alone stores buy in is entirely incremental. For example, we downsize aerie merchandise in the AE store when we opened a stand-alone store in the same mall. We successfully replace that volume with our standing girls’ apparel. We see no deceleration in the AE stores comp performance.

Looking ahead, we entered the second quarter in a better position for the current economic environment and our internal challenges. For example, we reduced our inventories for the second quarter and the duration of the year and we made comprehensive reductions in our operating expenses. Further, we have a strong plan and have laid the groundwork for improvements to our flagship AE brand, which Susan will review in detail.

Now a word on MARTIN + OSA. We’re pleased by our recent performance. Of the 22 stores now operating seven locations have been operating for more than a year. In the first quarter, same store sales for the seven stores increased by more than 50% against modest sales levels from last year. Merchandise improvements and accessible price points are driving the sales gain.

We’ve experienced increases in traffic and higher conversion rates. These results are encouraging and we see a meaningful market opportunity for MARTIN + OSA. Our goal is to achieve a four wall break even for the fourth quarter.

We will continue to closely monitor the performance of this business. However, given the current economic environment we are proceeding cautiously.

Lastly, we continue to make progress on 77kids. This new concept is being built to leverage our organization and the power of the AE brand. This October we will launch the e-commerce site. This will enable us to gain insight into our brand positioning and our target customers so we can fine tune our brand offerings before we invest in brick and mortar.

And in summary, we’re responding to the challenges and making the necessary improvements to our business. I have confidence in our plans, which I believe will position us to deliver long-term profitable growth.

Now here’s Susan.

Susan P. McGalla

Good morning, everyone. Thanks for joining us. I’ll start with a brief recap of the first quarter. It was a good quarter for AE guys, but a tough one for our girls business.

Our guys business achieved a 3% comp increase. We saw strength across Miss categories, including denim, fleece, woven shirts, and graphics. However, our AE girls business was challenging in first quarter with an 11% comp decline.

Accessories and bottoms, including pants, shorts, and denims, were the most difficult areas. The shorts business got off to a very late start this spring. We believe our styles are on trend, but the timing of spring breaks combined with cool weather contributed to inconsistent results to date.

Now let’s look at denims. As we typically do, we were exiting our denim assortment in the first quarter to make way for our new collection. A few of the new styles arrived in stores last week, with the majority of the new collection hitting in early July with our Back to School floor sets. However, this year the significant change in the denim fashion cycle made this transition a bit more difficult. This contributed to the high level of markdowns taken in this category. With that said we successfully cleared through and entered the second quarter with our denim inventory on plan.

Now regarding accessories. We were most disappointed with our handbag assortment and down trending flip-flop business.

On the positive side in women’s, we are continuing to see stronger performance in graphics, bearnet (sic), sweaters, fleece, and dresses. That’s a result of our focus on girls’ tops in on trend execution.

We’re implementing our plan to improve the performance of the AE brand, specifically in girls, by focusing on a strong value message and trend point of view. We’re determined to maintain and build on the strength of the AE brand with our target customer. To that end, we embarked on our national research initiative which gave us in-depth, real time intelligence on the mindset of our customer today.

Our customers confirmed that value is an important component of the AE brand. We are re-inventing the way we offer value based on changes in what’s important to our customers. In the past we focused primarily in delivering value in essentials. Going forward, we’re expanding value offerings to include fashion items as well. To be clear, we’re not changing what’s working in value, rather we’re adjusting to meet our customers’ evolving needs. It’s important to note that this is not about the lowest price for AE; it’s about the strong price to quality equation that delivers value at our ticket prices.

We also see an opportunity to become a 24-hour brand offering greater versatility and outfitting that takes our customers from day to night. As we look ahead to Back to School and Fall, we’re encouraged by emerging new trends and how we’re interpreting them for the AE brand. For example, there are new trends incorporating long and lean silhouettes. They’re conducive to layering and they lend themselves to easy outfitting. At the same time, the trends are both fresh and inspirational, giving customers a new reason to buy.

In our new Back to School denim line four of the six fits for girls are new. In guys, two of the four fits are new. There’s a wide range of washes, new silhouettes, and fashion details. I’m confident in this collection, which is a strong representation of fashion newness that has tested well with our customers.

I mentioned the 24-hour customer lifestyle. That brings me to aerie. Aerie essentially picked up where AE leaves off with our girls. In aerie, bras and undies are volume destination categories and we are pleased with these businesses. For Back to School we will launch an incentive program designed to build customer loyalty and create repetitive store business. For the balance of this year in preparation for the future we continue to focus on product innovation and category development as we aggressively build the aerie brand.

Finally, a brief update on marketing which reflects our customer focus and commitment to relevancy. Beginning with Back to School, you’ll see intensified marketing support of our product and value message. This will be prominent from the lease line to in store to on line.

We’ve refreshed our creative point of view and set a graphic style. While still very much in line with the AE heritage, the new creative direction is distinctive and fresh. To support denim we’ve created a major in-store marketing event planned to highlight our new AE jeans collection.

In closing, while the first quarter was difficult we are well under way in executing our plans. We look forward to seeing the benefits of our progress in the back half of this year.

Now I’ll turn the call over to Joan.

Joan Holstein Hilson

Thanks, Susan. As Jim indicated, this was a tough quarter. Sales were well below our plan. And that, along with higher markdowns, pressured earnings.

First quarter comparable store sales declined 6%. That compared to a 6% increase for the same period last year.

Total sales were up 5%. However, we experienced a decline in traffic and lower transactions per store. The average unit retail price was down as a result of higher markdowns.

Turning to gross margin, our rate of 41.2% was a decline of 750 basis points compared to last year. The primary cause: an increase in markdowns. Those markdowns were caused by two things: lower than expected sales and clearance in gross denim as we transitioned to a new assortment this Back to School.

Also within gross margin there was a modest increase in INU (sic). This reflected lower first costs and a reduction in shipment by air versus ocean.

Rent deleveraged 140 basis points. This was due to new store openings and the first quarter comp decline.

And finally, fuel surcharges resulted in higher delivery costs.

SG&A as a rate to sales was 26.5%. That compared to 25.6% in the first quarter last year. The higher rate is primarily due to the negative comp in the first quarter. We deleveraged direct compensation and benefits, services purchased, travel, and communications. However, incentive compensation, advertising, and supplies improved as a rate to sales.

The operating margin declined 880 basis points to a rate of 10.1%. Other income decreased to $6.5 million. This is a result of lower investment balances and investment rates.

EPS decreased 40% to $0.21. That compares to $0.35 last year. That diluted share count decreased by 17 million due to our repurchases made in fiscal 2007.

Now let’s look at the balance sheet. We ended the quarter with a total cash and investment balance of $705 million, including $368 million in auction rate securities. Subsequent to the quarter end, $14 million were called at par. That leaves us with a current position of $354 million. Given our strong cash flow we expect to fully fund ongoing operations, as well as capital plans related to our growth initiative.

Now inventory, excluding the direct business, decreased 17% on a cost-per-square-foot basis at the end of the quarter. Clearest inventories were down entering a second quarter and our total in-store inventory is consistent with our plan. Based on sales trends we’ve tightened our inventory investments and we will use our flow strategy for outside opportunities. Until we see a change in business trends we will continue with this approach. We expected second quarter ending inventory to be down in the low double digits at cost per foot.

Capital expenditures in the first quarter totalled $74 million. They were related to store growth and renovations, headquarters, and distribution centres. In 2008 we expect to spend $250 million to $275 million. After this year the majority of our capital spending will relate to store growth and remodels. The infrastructure projects will largely be completed.

We’re highly focused on improving top line performance and, importantly, we’re taking a disciplined approach on inventory investments. Controlling expense is another critical ongoing initiative. We’re addressing all operating costs through a comprehensive cost-reduction initiative which should enable us to leverage at a minimum of a flat comp for this year.

Based on our current view that the second quarter will remain challenging, our earnings expectation is $0.28 to $0.30 compared to $0.37 last year.

Thanks, and I will throw the call back to Jim.

James V. O’Donnell

Thanks, Joan. I think it’s important to emphasize the following: In the first quarter we faced stiff challenges and we took strong decisive actions in response. First and foremost we’re moving quickly to bolster the top line with a greater emphasis on value and strengthening our overall girls business.

To improve profitability we’re reducing inventories and expenses.

We’re taking a prudent, measured approach to the growth of MARTIN + OSA and 77kids.

We are committed to our growth of aerie where we see a strong brand potential and a meaningful market opportunity.

And in summary, I remain confident in our long term growth plans.

We will now take your questions.

Question-and-Answer Session

Operator

Thank you. We will now be conducting a question and answer session. (Operator Instructions).

Our first question comes from Janet Kloppenburg with JJK Research. Please state your question.

Janet Kloppenburg – JJK Research

Good morning, everyone. I wondered if Susan could talk about the new fit in the denim line on the girls’ side and, Susan, if there’s been any testing of this product and how optimistic you are for it.

And Jim, if you could talk a little bit more about MARTIN + OSA, it’s loss level in the quarter, and if you expect that loss level – I know you expect to break even in the fourth, but if you expect the loss over to mitigate as the year goes long or if you feel that you’ll have to wait until the fourth quarter for things to get better on the earnings front for that business.

Susan P. McGalla

Okay. Janet, I’ll address the denim. First of all, we do see some fashion changes in denim that we’re very encouraged by. They’re changes in five pocket around rise and leg openings, as well as newness and wash-in fashion details in the denim. We’re very disciplined and strategic on our approach with denim and the majority of the Back to School assortment has been tested with both our girls and our guys and met with very nice success. I’m very encouraged to get that new assortment in denim collection on the floor.

Janet Kloppenburg – JJK Research

And that will be in June we’ll start to see it come in?

Susan P. McGalla

Janet, we had a few styles, four in women and two in men, hit last week. And the balance of the collection will hit with our Back to School floor set at the beginning of July.

Janet Kloppenburg – JJK Research

And pricing, will some of this value pricing work into this assortment as well, Susan?

Susan P. McGalla

That’s a good question, actually. We feel that our value pricing absolutely resonates in denim. As you know, we have very much protected our opening price point of $29.50 and at each tier above $29.50 we believe that the value we offer in fit and wash is the best denim value out there in the landscape and that will continue.

Janet Kloppenburg – JJK Research

Okay. Great. Good luck, Susan.

Susan P. McGalla

Thank you, Janet.

James V. O’Donnell

As it relates to MARTIN + OSA, Janet, we don’t comment on EPS by the quarter by brand. But I can tell you that we have definitive measurement criteria established for each month from now until the end of the year that has to be met by MARTIN + OSA. Primarily it centers around sales per square foot. As I mentioned in the presentation, we do expect in the fourth quarter to break even four wall profit production.

Right now, do we have to wait until the end of the year? Probably. Do we expect to lose less than last year? Hopefully.

Janet Kloppenburg – JJK Research

Do you see progress on the top line there? Do you see productivity improving in the stores, Jim?

James V. O’Donnell

Yes. We see conversion is up about 5 points from last year, although on an unacceptable base, but it’s still a dramatic improvement. Also we see traffic increasing in the stores. And except in women’s, overall product has really been quite good. Men’s has been a bit of a disappointment, although Susan and (inaudible) have made great progress in getting men’s and women’s aligned. We’re starting to see some balance in the business, but I expect that Fall and Holiday we should see a tremendous balance between women’s and men’s, with women’s being about 65% of the business and women’s being about 35% of the business.

I’m very encouraged. I think Susan and Laura and that team, under some pretty adverse circumstances and some pressure points, have responded very nicely.

Janet Kloppenburg – JJK Research

Okay. Great. Lots of luck.

Operator

Our next question comes from Lauren Levitan with Cowan and Company. Please state your question.

Lauren Cooks Levitan – Cowan and Company

Thanks. Susan, if you could give us some more comments about how pricing strategies relate to your heightened focus on value. How should we think about any changes in price points versus promotions? Is there a role for communicating value through the All-Access Pass?

And then I had a question for Joan related to the remaining $354 million in auction rate securities. Can you give us a sense of the composition of that in your expectations for what may occur with that remaining balance?

Susan P. McGalla

Okay. Lauren, we’re very comfortable with our pricing strategy in terms of how we address value at opening price point and then at each tier above. The big thing that changed when we go out to our customer, and particularly focusing on our 20-year-old girl, is what she expects from value has a lot more fashion expectations around it as well. We’re very nimble and we will be adjusting to that. The prices and the way that we approach pricing we’re very comfortable with, and we’ve seen success, but we’re changing and being flexible about what types of items are being offered at some of these value prices.

And as it relates to value for the All-Access Pass, the one thing I want to say is All-Access continues to perform very nicely. It’s a big percentage of our business. It is absolutely on plan in terms of our expectations, of who qualifies, and what type of response rate we get. That program is right on target.

Lauren Cooks Levitan – Cowen and Company, LLC

The changes to the value orientation, will we see those fully in place for Back to School?

Susan P. McGalla

Yes.

Lauren Cooks Levitan – Cowen and Company, LLC

Okay. Thank you.

Joan Holstein Hilson

But Lauren, with respect to the auction rate securities, just under 60% relate to student loans and about 30% are in the municipal bonds. The balance is in DRDs or the dividend received auction rate preferred securities. We have just about $20 million that’s been called and it’s sitting in our short-term investments. The balance is we’re waiting for that to basically loosen up as we head into the back to school college environment. We’re optimistic about that, but we’re in a holding pattern.

Lauren Cooks Levitan – Cowen and Company, LLC

Any implications for your thoughts on share repurchase relative to those (inaudible) securities? Does that have any implications for how much true cash you want to keep on the balance sheet?

Joan Holstein Hilson

Well, certainly it limits the flexibility that we have to be as aggressive as we have been in the past, Lauren.

Lauren Cooks Levitan – Cowen and Company, LLC

Thanks very much and good luck.

Operator

Our next question comes from Adrienne Tennant with FBR. Please state your question.

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

Hi. My first question is, can you give me, with only a few days left in the month, can you give any comment on the May month-to-date trends?

And then secondly, can you talk about the sales productivity at the new area stores? I know they were at $450 where there’s trending now at the newer ones, as well as MARTIN + OSA. Thanks.

Susan P. McGalla

In terms of May, Adrienne, that’s not something that we can comment on at this time, but our sales release will be coming out, as you know.

In terms of the sales productivity for the aerie stores, the existing stores that we have are comping nicely. We’ve started off on a run rate that is annualizing nicely for the 2006 to 2007 class of stores. From an animalization perspective we’re a little lower and from that $450 per square foot, but we’re encouraged by is the assortments that we’re seeing in the third and fourth quarter, which is very critical to the annualized run rates. So we’ve been very busy building the dorm assortment; very pleased with bras and panties. So we’re optimistic about where that can land for the third and fourth quarter.

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

And how is the seasonality at aerie? How does it differ from the core business?

Susan P. McGalla

Well, we see the seasonality occurring in Back to School, as you can imagine, in the bras and undies business. Then as you move into the fourth quarter you see those businesses continue and you see a lift in gift giving which tends to be geared towards some of the dorm wear categories.

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

And then for MARTIN + OSA, the sales productivity comments there.

James V. O’Donnell

Yeah. I’ll take that on. Right now we’ve established a minimum run rate for this year of $350, which we hope to achieve a $375 per square foot run rate for MARTIN + OSA. Currently we are on track to meet somewhere in the middle between the low and the high. So we’re encouraged. But right now it’s a month-by-month built as we get to Fall and we get to Holiday.

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

And Susan, what are the biggest changes that you’ve made at MARTIN + OSA that you’ve seen impact the improvement here?

Susan P. McGalla

Okay. There are a couple of things. First of all, as it relates to really meeting the lifestyle needs of the 30 to 40 year old customer, the biggest change is that, while I think we all believe in the original positioning of the brand it would vary the focus and the ability to outfit yourself was too narrow. It was really heavy on the active side. We use to say we would have the best dressed women going to their kids’ soccer games, but it didn’t allow them to go later into the day and be able to dress up and dress down outfits. So that positioning on the men’s and women’s side is a much more well rounded, versatile assortment. That’s number one.

The second thing is accessibility at key price points. Even though MARTIN + OSA is positioned at a higher average unit retail as American Eagle, it’s still very important that there’s accessibility in the knit categories, in the sweater categories in order to build key item growth within that business. I think that on the Fall and through the Holiday collections I really believe that some of the opening price points will surprise and delight this inspirational 30 to 40 year old customer. And then we certainly build luxury in at the higher price points as well. So this is the two biggest changes to the MARTIN + OSA collection.

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

Great. Thank you very much. Good luck.

Operator

Our next question comes from Stephanie Wissink with Piper Jaffray. Please state your question.

Stephanie Wissink – Piper Jaffray & Co.

Thank you. Jim and Susan, can you just walk us through the decisions you’re making around inventory balances? Are the reductions in line with your sales outlooks or are you in a position to chase into comp sales in the Back to School season?

Susan P. McGalla

Okay. All right, Stephanie, we’re certainly on a bit of a diet, I think, as Joan stated in her comments. We are being very prudent and tight in terms of our inventory investment. This company has always remained very flexible, though. We will be continuing to have key trigger dates for the business so that we can invest. Joan and I worked very closely with the teams on our destination categories and some of our key item categories. We have key trigger dates built in so that as we see either the business open up or certain categories open up we want to remain flexible to invest in these businesses in a very smart way.

Stephanie Wissink – Piper Jaffray & Co.

Okay. My second one. Joan, could you just walk us through some of the cost reductions that are lowering your leverage ratio? I think it primarily or previously was in mid-single-digit comp, now it’s closer to flat.

Joan Holstein Hilson

Yeah. It’s at a minimum of flat now, Stephanie. What we’ve really been encouraged at, how the team has rallied around this, one is there’s non-merchandise procurement type items like packaging and some of our procurement contracts that we have in place. We’ve been able to work with each functional area of our business and affect renegotiations and just have smarter ways of doing business in terms of those types of outside purchases.

Secondly, we are very focused on the efficiency of our operations and the source and the store operations team has done a terrific job in working with our visual teams to find more efficient ways of setting floor sets, as an example. We’re looking throughout our expense lines and really understanding, is this something we truly need to do or is this something that, as Jim likes to say, is nice to have. In this environment we’re very focused on being prudent on our spending and really driving profit through to the bottom line.

Stephanie Wissink – Piper Jaffray & Co.

Just a follow up to that, Joan. I think you mentioned in your prepared remarks that advertising was one of the cost reductions in the quarter. Is that something that we’re going to see going forward? Advertising being cut back to spare some of that expense?

Joan Holstein Hilson

What I tell you is that our advertising return is very much a focus, but is very much consistent with last year on a rate basis. We are very focused on spending advertising dollars in the right way to drive our traffic as well as to continue with brand investment.

Stephanie Wissink – Piper Jaffray & Co.

Okay. Thanks. And my last one, Jim, if you could just expand a bit on your view of the fleet size for the core American Eagle brand. I think you indicated 100 more stores or so. Are those evergreen markets or new emerging markets for you? Could you expand a bit on that? Thanks.

James V. O’Donnell

Sure. Primarily they would be in lifestyle centres. There are very few shopping malls, visual shopping malls that we’re not in. So I expect them to be in lifestyle centres and also there will be a few that are in outlet centres, although we do not run an outlet business. But we do have stores in some of the off-price centres and it has been a very productive initiative, as well as it does not affect any stores within proximity. That’s primarily where they’ll come from.

Stephanie Wissink – Piper Jaffray & Co.

Thanks. Good luck.

Operator

Our next question comes from Paul Lejuez with Credit Suisse. Please state your question.

Tracy Kogan – Credit Suisse

Thanks. It’s Tracy Kogan filling in for Paul.

Two questions. The first, I was wondering if you could tell us what your second quarter EPS guidance, what comp your second quarter EPS guidance is based on.

And secondly, if you could talk more about some of your systems initiatives and when we should be able to see some of the benefits from those. Thanks.

Joan Holstein Hilson

The comps for the second quarter, we truly don’t give comp guidance, but what I’ll share, Tracy, is that we’re assuming similar business trends will be experienced in the second quarter as we saw in the first. So just from a category perspective and so on, as Susan spoke about, we expect similar trends. However, I’d like to re-emphasize that our initial inventory buys are more conservative headed into the second quarter, as well as we’ve been able to implement a piece of our cost reduction program, which is what is also considered in our guidance for the quarter.

James V. O’Donnell

As it relates to systems, the biggest initiative that we’ve got going currently is our new point-of-sale system that should be fully implemented in the United States and, hopefully, most of Canada by Holiday of this year. Through this new point-of-sale system we expect that we will be able to process (inaudible) in a more efficient way, so increasing our productivity and shortening the length of the lines we also will be able to have a direct on-line visibility to our direct business to assist our customers in a more expeditious way to make a sale via our AE Direct. So these are two of the biggest wins we will have out there. Point-of-sale has many other facets, but this is not the forum to go into it.

We also have in place our size profiling, as well as our markdown optimization programs that are in place and producing positive results as it relates to those two initiatives.

Tracy Kogan – Credit Suisse

Thank you.

Operator

Our next question comes from John Morris with Wachovia. Please state your question.

John Morris – Wachovia Securities

Thanks. Joan, just to clarify on the follow up on that on the comp trend, I guess what we heard you say was that Q1 comp trends we would assume those to continue into Q2 and then you were just pointing out that the initial inventory buys were more conservative. Is that correct? Am I understanding you correctly?

Joan Holstein Hilson

Yes, John. The initial buys on the inventory were more conservative heading into the second quarter than they were heading into the first quarter. We’re recognizing the environment that we’re in.

My comments on comp trend was that we believe that the guidance that we have includes similar trends that we saw in the first quarter, recognizing the commentary that Susan gave in terms of denim and style setting for the large part with the Back to School floor set.

John Morris – Wachovia Securities

Okay. Great. Thanks. Susan, we’ve obviously had some discussion about the inventory planning into Q2, the balance of the summer season. For Fall, I know it’s a little premature, but would we be looking at the same kind of tight inventory planning into the back half of the year as well? What’s your initial philosophical take on inventory planning for the back half as you look out?

Joan Holstein Hilson

John, I’ll take that. It’s Joan. As I mentioned, we are maintaining a conservative position heading into the third and fourth quarters as we have headed into the second quarter and until we see the business turn or the environment change we will continue with that approach. But also bear in mind that we have upside and trigger opportunities should we see a turn upward and we can go after some additional business as well. But we feel at this time it’s prudent to remain conservative with our initial inventory buys.

John Morris – Wachovia Securities

And then just lastly, on 77kids, which I guess we haven’t talked about, what are you most excited about there? If at all, how has your thought process evolved here over the course of the last quarter in planning that division?

Susan P. McGalla

John, I think that first of all this is a demographic and a business opportunity that we’re really looking forward to getting into. In terms of how our view has changed or evolved, I would just tell you we continue to be students of that demographic. The biggest difference is that when we’re focused on that demographic it’s the mom and the kids. So in addition to developing product we’re developing our relationship with those two customer bases in terms of learning what they care about, how they view things. We’ve been taking some of our product directly to those groups of moms, toddlers, and graders – as we call them, and then we’re working on developing product that absolutely leverages off of kind of the lifestyle of what the American Eagle brand brings but positioned differently for the two to 10 year olds. We just signed off on the Holiday line, we’re working on spring, and we’re very pleased with how things are looking.

John Morris – Wachovia Securities

Thanks very much.

Operator

Our next question comes from Lorraine Maikis with Merrill Lynch. Please state your question.

Lorraine Maikis – Merrill Lynch

Thank you. Good morning. Just a follow up on the 77kids business. Can you update us on any new thoughts you have on the timing of brick-and-mortar stores and also how we should think about the cost ramp going into your October on-line launch?

James V. O’Donnell

The brick-and-mortar, Lorraine, is planned for 2010. More than likely it will be, that we would term the Back to School time frame. It’s all tentative right now. Things could change. We could accelerate it to earlier 2010, but right now it’s planned for the latter part of 2010. We’re going to stay with our direct business all the way through that time frame and gain as much knowledge and insight into our consumer, as well as into our product and our marketing. There’s much to be learned about a kids business that we’re experiencing today and it’s been very gratifying that we have the ability through the web to be able to connect with our customers without making heavy investments in our stores.

Lorraine Maikis – Merrill Lynch

And then should we expect the cost from 77kids to offset some of the savings that have already been implemented for 2008?

James V. O’Donnell

No. No. The 77kids is very nominal. You won’t see the effect at all.

Lorraine Maikis – Merrill Lynch

Thank you.

Operator

Our next question comes from Kimberly Greenberger with Citigroup. Please state your question.

Kimberly Greenberger – Citigroup

Susan, I was hoping you could talk about denim for a second. I’m not sure that I understand in the first quarter what was different about the annual clearance of this prior denim styles that caused so much pressure on your gross margin this year that was not, I guess, seen in prior years.

Then secondarily, could you just talk about the comp trends in the American Eagle stores that are located in malls where you have had over the past year or two an aerie store open and do they differ from the chain average? Thanks.

Susan P. McGalla

Okay. Let me address, Kimberly, the denim first. First of all, you know, we have gone through and cycled, in the cadence and the way that we run our denim business, we cycle into a very large amount of newness for the Back to School time frame. As you remember, last year for Back to School we had 100% newness. So running things this way and driving into this much newness, it’s something that we’ve done in the past.

What changed for this year, and I think that’s what you’re asking, is that we had some fashion cycle changes that really had a significant impact on the business. Let me talk about this for a minute. We had capris and pedal styles that were seasonal denim businesses that are down trending in denim and non-denim categories alike. That had an impact on the Q1 and Q2 business. In addition to the fact that there are changes in five-pocket jeans and details, and I just believe that the relevancy of the product that we carried over from fourth quarter into first quarter was not as productive as we have had in the past, so as we talked about, we spent a major amount on markdowns. We don’t sit on problems in this company. We protect this category. We are very pleased. While I don’t like at all what happened in the first quarter, because we want to own the denim business 12 months a year, we got through our issues, we’re on our inventory plan, and we’re poised and ready for the Back to School denim selling season.

The second part of your question that you asked about comp in the AE stores where we have an aerie, the AE comp performance when we open up an aerie stand alone has been at or above our overall business comp performance. So we’re very pleased with that number.

Kimberly Greenberger – Citigroup

Thanks, Susan.

Operator

Our next question comes from Jeff Black with Lehman Brothers. Please state your question.

Jeff Black – Lehman Brothers

Okay. Thanks. Just a couple of clarifications. Joan, can you just give us a sense of how to look at rent and what you talked about on the IMU side going forward? I mean, how much of this gross margin, when you break it down, was due to denim? How much was due to the other two things that you called out?

Then on the SG&A side, I’m assuming a healthy portion of that was lower incentive comp this quarter. How much does that play into your overall guidance for flat comp or leverage on flat comp for the year? Are we going to see lower incentive comp through the balance of the year, is what I’m asking.

And then Susan, can you just talk about, you know, if you guys are keeping MARTIN + OSA, you’re ramping up kids, how comfortable are you with the whole design team infrastructure right now? Where are you concentrating your time and do you have enough time to do all these things? Any help on that would be appreciated. Thanks.

Joan Holstein Hilson

Okay. Jeff, I’ll start. In terms of rent, you know, rent deleveraged 140 basis points. A significant portion of that is the number of new stores that we opened in the first quarter compared to last year. A bit of it is the fact that we had a negative comp and we need closer to a mid-single-digit to leverage rent. So I think that addresses your rent question.

And then with respect to the incentive compensation, clearly we’ll have lower incentive comp given the general performance at this time and our incentive program is based on performance targets. As those performance targets are achieved we’ll begin to accrue on incentive compensation.

Susan P. McGalla

All right, Jeff, to answer the questions you sent my way. First of all, as it relates to my time, given the volume of the business and the AE brand, rest assured it’s my number one priority and where an inordinate amount of my time is directed. I am really comfortable with the time allocated with the balance of the brands and we have very strong leadership in both merchandising and design in each of our brands, so I have great partners in the business that very much walk in and know what their jobs are that they need to do each day.

Then to add on to that, you asked about how comfortable I am with design infrastructure as it relates to MARTIN + OSA. We’ve made some changes in MARTIN + OSA design that I think are very positive. First of all, we have a veteran that’s been there since the inception of the MARTIN + OSA brand on the men’s design side and he does a terrific job. And then on the women’s side we brought in some new talent from the outside who, her first collection you’ll see part of the benefits of her talents in the Fall collection and fully into the Holiday collection. I just really think that design team at MARTIN + OSA is coming into their own. They have great teams underneath the two leaders I just mentioned and they’re comfortable.

Joan Holstein Hilson

Jeff, with respect to the IMU, it was a modest increase in the IMU in the first quarter and we basically would not anticipate that in our guidance for the second.

Jeff Black – Lehman Brothers

Great. Thanks for the clarity. Good luck.

Operator

Our next question comes from Dana Telsey with Telsey Advisory Group. Please state your question.

Dana Telsey – Telsey Advisory Group

Good morning, everyone. Could you talk a little bit more about the research and the findings that you completed that track what you’re learning?

And how, as you look forward and think about the Holiday season, how are you planning Holiday different than Back to School?

And just lastly, some of the new product lines that you’ve launched in aerie, any updates on those and what the next initiatives are?

Thank you.

Susan P. McGalla

All right. I got two of the three. So if I miss one you’ll remind us.

First of all, Dana, as it relates to research, what we’ve focused on primarily is the girl because with some of the macro external and internal challenges around the women’s business we’ve really focussed on the AE brands girls demographic. Really I think what has changed, first of all, we’re a lifestyle brand that is going to remain casual. That hasn’t changed. What’s changed is what that means to that girl. With some of the fashion cycle changes and how she spends her time, it’s very important to her to have versatile product that she can dress up or dress down. You can say it’s day into night; for us it’s dressing up, dressing down. There’s versatility in terms of the way that fashion and outfitting is being put together. So we absolutely are a brand that will deliver that to her in a way that’s inspiring and compelling to her with key item impacts underneath. So those are some of the changes that we see.

There also is an intense, I think the macro environment is putting an intense amount of pressure on value and they see us as a value brand. That’s the good news. We just have to make sure that we are delivering that in a way from the key item and a fashion standpoint that satisfies their needs. That’s what you are seeing in what we’re pulling into the Back to School and Fall collections going forward.

As it relates to the aerie product, we’re very pleased with the aerie business overall. Particularly that the market share businesses of undies and bras. The amount of progress that we’ve made over the past 12 to 18 months is, quite honestly, at or above our expectations in those key categories. We’re continually investing in how that assortment will expand within those categories and to external categories. Joan talked about the dorm wear business. Quite honestly the boxer business has been down trending, I think not only for us but for some other people, and so what we’re doing is repositioning some things in dorm wear in the back half of the year that we think will really capitalize and round out some categories within the dorm wear side and sort of the wear inside/wear outside type of product that aerie really is a part of what that business is all about.

Anyway, you will continue to see us round out that lifestyle, invest and try new categories, as we move forward into this year and into 2009.

Dana Telsey – Telsey Advisory Group

And just planning Holidays compared to Back to School?

Joan Holstein Hilson

Could you clarify your question there, Dana?

Dana Telsey – Telsey Advisory Group

As you think about Back to School and how you planned it with the newness and all, and you think about how you planned Holiday last year, how is the planning at all different in terms of newness, in terms of product assortment, marketing? How are you thinking about Holiday in 2008?

Joan Holstein Hilson

For the AE brand and aerie? Are you talking about those, Dana?

Dana Telsey – Telsey Advisory Group

Oh, both of them.

Joan Holstein Hilson

Okay. Well, first of all, each of our quarters have, if you look, Q4 to Q3 is over 80% newness. So we will continue to invest in the same amount of newness and freshness to the floors that we have in years past. As it relates to key categories that we’ll be going after, we believe for both of our brands, AE and aerie, in giftability, market share in the sweater and tops categories, and you will continue to see us aggressively own denim into the fourth quarter in the AE brand for guys and girls.

The marketing changes, I would just tell you, are more acutely honed in and we are investing to support our product messages like we never have before. If there’s a nuance there and a change, that’s what it would be from a marketing front.

Dana Telsey – Telsey Advisory Group

Thank you.

Operator

Our next question comes from Michelle Tan with Goldman Sachs. Please state your question.

Michelle Tan – Goldman Sachs

Great. Thanks. I was just wondering if you could give us any indication of whether you’re seeing any newness in the silhouettes for the top business as well. I know you talked about the fashion cycle change in denim. I was wondering if there was anything kind of fresh coming along in women’s tops as well. And then also how things are trending in the accessories business.

Susan P. McGalla

Okay. A couple of things, Michelle. First of all, if it relates to newness in the tops, for competitive reasons I won’t go into a great amount of detail, but certainly some of the volume in the tops, whether it’s baby doll looks or volume of fabric that was occurring in the tops over the last year or so, that wasn’t great for AE and it wasn’t great for the women’s businesses in the macro environment, quite honestly. And we’ve seen that really slim down and go in a different direction. So stay tuned and you will see how we interpret that for our customer. We’re very pleased and we think that’s very good for the AE brand and our lifestyle in terms of the way the fashion is evolving.

What was the other part of your question, Michelle?

Michelle Tan – Goldman Sachs

How the accessory category is doing overall. I know that was struggling for a little while. Are there any changes that you’re starting to see there?

Susan P. McGalla

Yes. We continue to see accessories struggle for us, quite honestly. I’m not pleased with that business and where it stands right now. What we are doing, though, is we’re strategically phasing in key accessories categories and you will see some of those new ideas phase in in the third quarter, fourth quarter, and into 2009. How we’ve made the decision of how we’re phasing in some of those improvements is based on some categories that are trending out there in the external environment. There’s some seasonality issues that lay into how we’re phasing in some of the improvements and newness in accessories, and as well as when we think the product is ready and right to deliver in an impactful way to our customer.

Michelle Tan – Goldman Sachs

Okay. Great. And then one last quick question. The inventory position in units, does it look similar to where you are in dollars or is there any kind of difference to call out there.

Joan Holstein Hilson

No, it’s consistent, Michelle.

Michelle Tan – Goldman Sachs

Great. Thank you very much.

Operator

Our next question comes from Todd Slater with Lazard Capital Markets. Please state your question.

Todd Slater – Lazard Capital Markets

Thanks very much. I just want to get a clarification on IMU. Was it up or down in the quarter? And going forward, could you just talk about the direction of IMU given the gas surcharges you mentioned and the higher sourcing and the like.

Then second, less interested in having you divulge specific proprietary fashion choices. I’m just curious about the bigger picture, Susan. How you think the train got off the fashion tracks and how the product became a little bit predictable. It used to be much more leading edge. Whether it was distraction due to the initiatives that you have or the usual conflict between size and commercial and fashion ubiquity. What your focus group work is telling you and how you get back on track. Outside of the denim issue that you talked about on the rest of the product.

Susan P. McGalla

Okay. I understand, Todd.

Joan Holstein Hilson

Todd, the IMU was up in the first quarter in a modest way and then for the second quarter we’re not expecting that.

Todd Slater – Lazard Capital Markets

You’re expecting that to be down?

Joan Holstein Hilson

We are not expecting an increase at this time in our forecast.

Todd Slater – Lazard Capital Markets

Okay.

Susan P. McGalla

All right. And Todd, as it relates to our interpretation for the AE brand of fashion, now and as we go forward, I think a couple of things. First of all, we are seeing and our customers are seeing improvement in some of the changes that we’ve made in the women’s tops area. The women’s top area is comping positively and we continue to make improvements and I think we’ll see improvements as we move through the back half of this year as well.

However, I do believe that from a fashion standpoint the predictability that you never like to hear in a fashion business I think is that our girl particularly loves us for her fashion essentials. She thinks we’re great for our hoodies and some of the key destination categories we’ve invested. I think that what we would be guilty of is maybe taking a little too narrow of a view of how versatile our fashion needed to go to service our customer. And that is where I believe our merchandising and design teams are excited to embrace versatility and being a little more open minded about how to address day to night product. Again, we will not be a club brand, we will not be a night time brand. This is about versatility in fashion that can be dressed up or dressed down in our girls’ eyes. We’re very in touch with her right now and have some great things in place as we move into the third and fourth quarters of this year.

Todd Slater – Lazard Capital Markets

Is there something structurally you’re doing to allow the merchants to be more creative and assertive and leading?

Susan P. McGalla

One thing we are doing is we have a new trend process that we’re putting place. Myself and Henry’s staff are at the head of the AE brand in merchandising and LeAnn Nealz, our head of design. We’re working through trends a little bit differently. Identifying some things earlier and then periodically through the process and really pulling merchandising and design and getting agreement with the two groups a little differently than we have in the past, which feels very good to us right now. It’s leading the teams and leading fashion into the collections.

Todd Slater – Lazard Capital Markets

And your initiatives on the focus groups, the 160 degree focus groups that you’re doing.

Susan P. McGalla

We’re very pleased with that. Our continuous conversation with our customer is very important to us. I just think we’re being a little bit more open minded about how far AE can go in versatility.

Todd Slater – Lazard Capital Markets

Okay. Best of luck.

Judy Meehan

I have about five to 10:00 here, so we’ll have time for one more call.

Operator

Thank you. Our final question comes from Richard Jaffe with Stifel Nicolaus. Please state your question.

Richard Jaffe – Stifel Nicolaus and Company

Thanks very much. Just a couple of quick questions about the e-commerce business and the marketing efforts, how they might be better synced both to drive e-commerce and the easy commerce to drive marketing.

And then if you could be more specific on the marketing initiatives. You talked about getting more bang for your buck, having more impact, particularly in the denim categories. If you could talk more specifically about some of the initiatives, the channels, and what we should look for in the second half in terms of ad spend.

Susan P. McGalla

All right. A couple of things, Richard. First of all, on how e-commerce marketing and stores support each other. That multichannel customer continues to be an absolute win for us. If you look at the customer that, as we market through e-commerce to our stores and from our stores to e-commerce, that continues to be a growing initiative, a very productive initiative, and absolutely the best AUR customer that we’ve got.

The other thing that I would like to note is we continually will progress in capitalizing on the pre-shopping behaviours of both our kid and the moms as it relates. They go on line. We find that they’re printing things off the website, bringing them into the store. Whether it’s for gifting or just every day shopping, that pre-shopping behaviour continues to be something that we’re really honing in on our customers with. So we’re very pleased how that whole dynamic continues to progress and be productive.

As it relates to the bang for our buck in marketing. There are really two things happening. First of all, I think it’s very important that our marketing is distinctive. What do I mean by that? When you come up onto the lead sign of the American Eagle store it’s very important that our photography, what we do with our windows, and when you enter the front of our store that it feels different than the other brands in the mall. So you will see us doing some things, whether it’s additional outfitting in the Back to School time period, some different photography styles, and things that we want to push our way with any AE heritage away from the crowd a bit and be a more distinctive. So stay tuned for that.

And then the investment of our marketing funds, as Joan said, we will continue to invest in brand recognition and brand equity, but we want those to be initiatives that are productive and give us a return on the business.

Richard Jaffe – Stifel Nicolaus and Company

And so dollars spent should be kept in line with sales? That is to say, the rate won’t change year over year.

Susan P. McGalla

As Joan said, we will keep the rate at or slightly below a year ago.

Richard Jaffe – Stifel Nicolaus and Company

Got it. Thank you.

Judy Meehan

Okay. Thank you. We thank you all for participating today. Look for our next announcement on May sales, which will come out next Thursday, June 5th. Thanks and have a great day.

Operator

Thank you. Ladies and gentlemen, this concludes today’s teleconference. You may disconnect your lines at this time. Thank you all 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!

Source: American Eagle Outfitters Q1 2008 Earnings Call Transcript

Check out Seeking Alpha’s new Earnings Center »

This Transcript
All Transcripts