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DSW Inc. (NYSE:DSW)

Q2 2012 Earnings Call

August 21, 2012 8:30 am ET

Executives

Michael MacDonald – President, Chief Executive Officer

Douglas Probst – Chief Financial Officer

Christina Cheng – Director, Investor Relations

Analysts

Steve Marotta – CL King & Associates

Mark Montagna – Avondale Partners

Chris Svezia – Susquehanna Financial Group

Camilo Lyon – Canaccord Genuity

Scott Krasik – BB&T Capital Markets

Jane Thorn Leeson – Keybanc

Jeff VanSinderen – B. Riley & Co.

David Mann – Johnson Rice

Patrick McKeever – MKM Partners

Danielle McCoy – Brean Murray

Operator

Good day and welcome to the DSW Incorporated Second Quarter Fiscal 2012 Earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today’s presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your touchtone phone. To withdraw your question, please press star then two. Please note this event is being recorded.

I would now like to turn the conference over to Ms. Christina Cheng, Director of Investor Relations. Ms. Cheng, the floor is yours, ma’am.

Christina Cheng

Thank you. Good morning and welcome to DSW’s second quarter conference call. Please note that the various remarks made about the future expectations, plans and prospects of the Company constitute forward-looking statements. Actual results may differ materially from those indicated by those forward-looking statements as a result of various important factors, including those listed in today’s press release and in DSW’s public filings with the SEC.

Joining us today are Mike McDonald, President and CEO, and Doug Probst, Chief Financial Officer. Debbie Ferrée, our Vice Chairman and Chief Merchandising Officer is attending the MAGIC trade show in Las Vegas today and won’t be here with us. Doug will start our prepared remarks with a short discussion of our reported results and then highlight the details of DSW’s adjusted results for the second quarter. He will also provide some color on our outlook for the back half of the year. Mike will then elaborate on our ongoing strategic initiatives. After our prepared remarks, we will open the call for Q&A.

With that, I turn the floor over to Doug.

Douglas Probst

Thanks Christina and good morning everyone. Our reported net income for the second quarter was $29.3 million, which included a net $700,000 charge for items related to our merger with RVI in 2011. This net charge was primarily due to a non-cash expense related to our fair value of RVI-related warrants. Please note these warrants were fully exercised in the second quarter and as a result they will no longer be the source of mark-to-market adjustments going forward. Including this charge, our earnings per share was $0.65 compared to last year’s $3.96. As you recall, last year’s Q2 reported EPS included a $106 million net benefit due mainly to the reversal of evaluation allowance and other merger-related items. Excluding these RVI-related items for both years, adjusted EPS was $0.66 per share compared to last year’s $0.74 per share. You can find these items detailed in the condensed consolidated statements of operations and reconciliation of adjusted results attached to our press release.

Now that we have reviewed the reported results, we will focus our comments on the adjusted results for the second quarter which reflect the performance of our DSW operation. Sales for the second quarter increased by 7.5% to $512.2 million as comparable sales grew 4.2% on top of a 12.3% growth last year. This represents a two-year comp of 16.5%. By segment, comps for our DSW business, which includes DSW.com, were up 4.3% on top of 13% growth last year. Our DSW comps were driven by an increase in traffic and conversion while average unit retail and units per transaction were relatively flat to last year.

Although we typically open our new stores in the higher volume periods of the first and third quarters, we opened two larger than average downtown stores in the second quarter. We also relocated two stores, bringing our total new store activity to 12 new stores and four relocations for the first six months of the year.

Comps for the lease business division were up 3.5% after growing by 3.7% last year. This is the 11th straight quarter of positive comps for the lease business. We also opened two new locations for our lease business for a total of 343 departments at the end of the period.

Gross profit was 31.3% for the quarter. While this is a good rate by historical standards, it compares unfavorably to the recent high rates of the first quarter this year and the second quarter last year. Our merchandise margin rate declined 120 basis points to 44.5% versus 45.7% last year as we normalized our clearance mix to historical levels and took additional clearance action in early June. These additional markdowns were partially offset by favorable shrink results recorded as part of our annual physical inventory process. Total occupancy leveraged 10 basis points to last year and our distribution and fulfillment rate increased by 20 basis points as a result of the increasing mix of the DSW.com sales.

As expected and previously communicated, our SG&A rate as a percentage of sales increased by 80 basis points to 21.9% due to costs related to new stores and a shift in marketing expenses. As a result of the changes of margin and expense rates, our operating income for the quarter was 9.4% compared to 11.6% last year. Please note that our effective tax rate for the quarter dropped to 38.1% and we expect our tax rate to be slightly below 39% on an annual basis. The end result was an adjusted net income of $30.1 million or, as we mentioned earlier, $0.66 per share for the second quarter. This compares to the adjusted net income for the same period last year of $33.7 million or $0.74 per share and was slightly above our second quarter guidance of $0.60 to $0.64.

At the end of Q2, total inventories increased by 15.4% to $367 million, in line with expectations as we start to receive products for the 27 new stores we plan to open in the next 90 days. On a cost per square foot basis, inventories in DSW stores increased by 6.5% at the end of the quarter. Adjusting for our new store openings and the later arrival of last year’s receipts, inventories per square foot are relatively flat to last year.

We ended the quarter with cash and investments of $485 million. We did not repurchase any shares this quarter under our $100 million opportunistic share repurchase authorization announced in June. Capital expenditures for the second quarter were $22.1 million, of which 12 million was for new stores and relocations and $9 million for the expansion of our fulfillment and distribution centers.

Before we comment on our guidance for 2012, it is important to review our year-to-date results because in hindsight we clearly shifted some sales and earnings into the first quarter. Sales for the spring season were up 9% to nearly $1.1 billion on comps of 6%, which equates to 17.5% comp on a two-year basis. Adjusted net income was $74.2 million versus $73.3 million last year. As we stated back in March, we expect most of our earnings increase to be generated in the fourth quarter due to the timing of preopening expenses, easier margin rate comparison, and 53rd fiscal week. We still believe that to be true.

With that said, we are reiterating our full year adjusted EPS guidance of $3.25 to $3.40 on mid-single digit comps and the opening of 39 new stores. Please note that our guidance does not assume any share buyback activity during the year.

With that, I’ll turn the call over to Mike.

Michael McDonald

Thanks Doug and good morning everyone. First half earnings were up slightly over the prior year, which was consistent with the expectations we shared with you at the outset of the 2012 fiscal year. To remind you, we expected very little earnings growth until the fourth quarter for two primary reasons: first, higher preopening expenses associated with our more aggressive new store opening plan for 2012; and second, the expectation that we would be hard-pressed to duplicate last year’s record merchandise margin performance. With 20/20 hindsight, we can state with certainty that that’s exactly what happened in the first half of 2012.

Having said that, we also readily admit that our first half performance fell much differently by quarter than we had expected. We did better than expected in Q1 and poorer than expected in Q2. Let me spend a couple of minutes discussing the reasons for that performance shift so you can make a better assessment of our prospects for fall.

Our comp sales growth slowed from 7.6% in Q1 to 4.2% in Q2. Approximately 95% of that slowdown was due to the women’s sandal category that grew by 12% in Q1 but recorded a flat comp sales performance in Q2. For the season as a whole, the sandal category recorded a very respectable 5.5% comp, but the unseasonably warm weather in March and April shifted selling in this weather-sensitive category out of Q2 and into Q1.

In terms of merchandise margin, we had flat margins in Q1 which was exceptionally good performance because it duplicated our highest ever Q1 margins of 2011. Conversely, merchandise margins contracted by 120 basis points in Q2 which was a greater decline than we had originally anticipated. As Doug mentioned, this contraction was caused by higher markdowns needed to stimulate selling of clearance goods that started to back up on us in Q2 primarily because of slower sales of sandals. The markdown action was painful to the gross margin, merchandise margin line, but it did work. We ended the season with total inventories in line with our forward sales plans. We also ended the season with clearance units up only slightly from the prior year. And finally, we ended the season with our weighted average discount in clearance goods slightly deeper than a year ago.

Hopefully that explanation provides you with a clearer understanding of our first half performance by quarter but also gives you confidence in our positioning as we enter the back half of 2012. As I have mentioned to many of you before, DSW is not immune from making missteps in forecasting business trends; however, our detailed analytical approach to the business creates an agility that allows us to correct those missteps quickly. I believe we’ve demonstrated that nimbleness in Q2.

As to the performance of other merchandise categories in Q2, men’s footwear was up 95, handbags and accessories was up 8%, and athletic footwear was up 4%. Taken together, the performance of these businesses in Q2 was generally consistent with their comp increases in Q1. For the spring season, comp sales increases ranged from a low of 5% in women’s footwear to a high of 8% in men’s footwear, so you can see across this longer time frame our business was quite balanced.

And finally, our private brand business continued to grow in the first half. For the spring, private brand sales are 11% of the total business, up from 10% in the first half of 2011. As you know, we ultimately intend to grow private brand to a 15% penetration.

As previously noted, we opened 12 new stores in the first half of 2012. As a group, these stores are comfortably exceeding their sales plans. The two new stores opened in the second quarter around State Street in downtown Chicago and at 79th and Broadway in Manhattan. These two stores are of particular interest because they are projected to be among our top 15 stores in the chain. Although it’s very early, so far we are pleased with the performance of both of these stores. And by the way, for those of you who are based in New York City, I would like to personally invite you to stop by our 79th and Broadway store this coming Thursday evening. We’ll be having a fall fashion party from 6:30 to 9 pm for some of our closest friends.

We now expect to open 39 new stores during fiscal 2012. We will open 26 new stores in Q3 and one more in Q4. These stores cover all major geographic regions with a moderate concentration in the northeast. Seven stores are in new markets while 20 stores are in existing markets. We expect modest transference of sales from existing stores to these new stores, but that transference is already incorporated into our full year comp sales guidance.

Let me now update you on our strategies and systems initiatives. In July, we fully implemented our size optimization system that will facilitate the creation of store size packs that conform to customer size profiles by location. The benefits of this capability consists of fewer missed sales and reduced markdowns due to reduction of size imbalances by store. We expect to see benefits from this new system capability in 2013.

Also in July, we implemented a new automated recruiting management and candidate assessment tool that we call RMCA. RMCA automated the associate application process and uses our own historical intelligence to prioritize candidates based on their likely success in the DSW environment. It will also reduce administrative time expended by our store managers in the hiring process. Our managers will consider fewer but better qualified candidates for associate positions. As importantly, we believe this process will help us find associates who share the values that represent DSW’s unique culture.

Within the last two weeks, we’ve made modifications to DSW.com to create specialized tabs that specifically highlight our athletic footwear and a seasonal selection that will highlight boots in fall and sandals in spring. Concurrently, we implemented an enhanced product search tool that delivers faster results with more relevancy.

As for big systems initiatives currently underway, in this current quarter we will begin preliminary work on the assortment planning system that will allow us to build assortments on a bottoms-up basis by store based on each store’s customer preferences. This is a very large effort that is expected to take two years to complete.

Another major initiative we have underway is an enhanced point-of-sale system. This system will improve the customer experience in a variety of ways and will also reduce fraudulent returns. As a part of that initiative, we will also make strides on the omni-channel front. Today, in-store customers can buy from our stores, ecommerce stores can buy from dot-com, and through our Shoephoria system in-store customers can draw on our dot-com fulfillment center to find wanted styles or sizes. By the end of next year, we will give in-store customers the ability to also draw from available inventory in other stores. Once we’ve proved that we can do this proficiently, we will open up in-store inventories to dot-com customers as well.

So that gives you a brief update on how we executed in the first half of 2012, how we are positioned for the back half of 2012, and how we are attacking the initiatives that will allow us to continue our performance momentum in the future years. To sum up, we recognize that this is a unique year given the RVI merger adjustments, the expenses associated with our aggressive new store openings, and the quarterly variation in our performance. However, I hope you’ll come away with three important messages – first, we’re well positioned for a successful fall season; second, we’re on track to have another successful year of growth in both sales and earnings; and third, in 2012 we’re sowing the seeds that will allow us to maintain or accelerate future growth.

And with that, I will turn it back over to the operator to open it up for questions.

Question and Answer Session

Operator

Thank you, sir. We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you’re using a speakerphone, please pick up the handset before pressing the keys. If at any time your question has been addressed and you’d like to withdraw your question, please press star then two. Again, if you would like to ask a question, please press star then one. At this time, we will pause momentarily to assemble our roster.

The first question we have comes from Steve Marotta of CL King & Associates. Please go ahead.

Steve Marotta – CL King & Associates

Hey everybody. Congratulations on a terrific first half. I have a question on merchandise margins in the back half. Doug, the merchandise margins came in higher than at least my expectations in the second quarter. I know that you’re lapping relatively strong merchandise margins in the back half, but it would seem to me, given the inventory positions you have going in and the fact that, again, it was a little bit better, I think, in first half of this year than original expectations, can you give a little bit of color on merchandise margins in the third quarter and the back half?

Douglas Probst

Sure, and thanks, Steve. I guess I would break down your perspectives—and I don’t know what your initial expectations were for the second quarter, but having the next two quarters in front of us, looking at last year, we had a 46.4 merchandise margin rate in the third quarter last year. That is a very high number, and that’s why we think that comparison is relatively tough. The 41.7 we achieved in the fourth quarter of last year, though, is a little bit more manageable as a comparison standpoint, so I think it’s going to be the tale of two quarters as we look at the fall season, with an easier comparison in the fourth quarter.

Steve Marotta – CL King & Associates

That’s very helpful, thanks. And Doug, could you also remind us of the preopening expenses, the actuals in the first and second quarter of this year, what your expectations are for third, and compare those on a year-over-year basis as well?

Douglas Probst

Sure. The annual perspective was that we were going to have about a $10 million increase to last year in preopening expenses, 16 million in 2012 versus 6 million in 2011. That increase by quarter was pretty much evenly split between the first three quarters; in other words, about 3 or $4 million incremental spend in the first three quarters, and that’s still how we’re trending based on how the store opening costs are coming in.

Steve Marotta – CL King & Associates

Great, that’s awesome. Thank you. Congrats again.

Operator

Next we have Mark Montagna, Avondale Partners.

Mark Montagna – Avondale Partners

Hi. Just a question on the boots – I’m wondering, is the average unit price on the boots prior to any promotions for this fall going to be higher than last year?

Michael MacDonald

It’s going to be slightly higher, yes.

Mark Montagna – Avondale Partners

Okay, and if so, why is that? Is it going to be because higher profile boots, or is it the fabric, or you’re just able to pass some costs along?

Michael MacDonald

Yeah, we continue to see cost increases in materials and labor and even transportation, for that matter. So we do think we have pricing flexibility, particularly in the fashion boot category, and that’s really why we feel we can increase retails in the boot category.

Mark Montagna – Avondale Partners

Then what about the initial markup – is that expected to be higher? And then are you skewing towards a greater percentage of the inventory being fashion this year versus last year?

Michael MacDonald

I think our markups in Q3 will be relatively flat to the prior year, and we’re only partially placed for Q4 so I really can’t comment on Q4. In terms of fashion versus basic, I think our mix will be relatively consistent with the prior year in terms of the boot category.

Mark Montagna – Avondale Partners

Okay. And then you were going to target some of the back-to-school customers this year. I’m wondering how that went, and just some thoughts on that.

Michael MacDonald

Yeah, well I really don’t want to comment on any sales trends into the third quarter.

Mark Montagna – Avondale Partners

Okay, okay. I thought you were trying to do some of that toward the end of July, but if you’d rather hold off, that’s fine.

Michael MacDonald

Yeah.

Mark Montagna – Avondale Partners

Okay. Then just lastly, you were going to emphasize the wedding category. I think that started in the second quarter. Can you maybe touch on progress with that?

Michael MacDonald

Yeah, it actually started in Q1 and I think, if my memory serves me, the penetration was about 8% of our total evening business, and it accelerated to 12% of total evening in Q2.

Mark Montagna – Avondale Partners

Okay, thank you.

Operator

Next we have Chris Svezia, Susquehanna Financial Group.

Chris Svezia – Susquehanna Financial Group

Good morning everyone. Congratulations. I’m glad Debbie got to sleep in this morning – lucky her! Quick question – so, I’m just curious, we look at your first half and you’re kind of—from an EPS perspective, I think you kind of beat—or not beat, you’re up around $0.03, I think, year-over-year for the first half. You’re still talking about the first three quarters generally flat in aggregate from an earnings perspective, just so I got this right, and then the majority of earnings growth in that fourth quarter. Is that still a fair observation/

Douglas Probst

Yes.

Chris Svezia – Susquehanna Financial Group

Okay. How much—did you guys ever break out how much the 53rd week impacts your fourth quarter, or no?

Douglas Probst

We didn’t really. There’s so many different ways we’ve noticed that people calculate it, so we’ll kind of leave that up to you and guide you to the fact that we made $0.51 a share over 13 weeks last year, and so now we have 14 weeks. The other point to consider is that that incremental week, like a lot of retailers, is the lower sales and margin weeks of the year.

Chris Svezia – Susquehanna Financial Group

Okay, I got you. And then when you guys throw out the 12—I think you commented on how your sandals comp was 12 Q1 and then flat in the second quarter. Is that what you were talking about – did you guys actually break out what the women’s category was from a comp perspective?

Michael MacDonald

I did say 12 up in Q1 and flat in Q2 for women’s sandals.

Chris Svezia – Susquehanna Financial Group

Can you talk about the women’s category overall, because you mentioned handbags, athletics, and men’s. I was just curious what the overall men’s—what the women’s category did in Q2.

Michael MacDonald

Yeah, I think women’s was up about 4 in Q2, Chris.

Chris Svezia – Susquehanna Financial Group

Okay, all right. And just on the inventory, just so I have this right, I think last year there was a comment that you missed some sales opportunity as you went through early third quarter because of timing of some receipts. Going back to the question I was asking earlier, I’m not asking so much about your performance. I’m just asking about—could you just maybe walk through some of the nuances on the inventory, just so we understand this? I think there was some product that came in later last year. You were tighter on inventories when you went into the quarter. Could you maybe just talk about some of these nuances just so we have a sense, and maybe throw on how you feel about your sandal inventory too as you came out of the second quarter?

Michael MacDonald

Okay. Well, last year we did have some shift of receipts. I think it was due to a tightening of the ship window that, in retrospect, we wished we hadn’t done and we ultimately reversed ourselves on that. But my recollection, Chris, is we shifted about $25 million of retail receipts out of July and they trickled in over the month of August, and there may even have been some spillover into September, as I recall, for us to fully catch up. So that’s the receipt issue, and there was also some delay in the movement of accessories to the stores in early Q3. So those are the two receipt nuances that we had last year, and that was really the basis for Doug’s comment that when you adjust for those receipt changes and the new store inventory for this year, our cost per square foot, our inventory per square foot is pretty flat.

In terms of our clearance position as we move out of Q2 into Q3, I think—was that your question, Chris?

Chris Svezia – Susquehanna Financial Group

Yeah, I mean, you mentioned the clearance inventory a little bit, but I’m also just curious in general, just the category of sandals or how you ended the quarter – just where you stood there.

Michael MacDonald

Yeah, I think our total units per average store, which is how we keep track of it, in clearance at the end of Q2 was up about 3% to last year in total. That’s inclusive of both footwear and accessories, and the sandal category itself was up more than that. You know, that’s why we took the early rotation in June, and you may have noticed we also took a rotation last week. So we accelerated the June rotation by 10 days and we accelerated our August rotation by 10 days as well.

So we feel like that’s going to probably do it for us and we’ll be fine the rest of the way; but yeah, the sandal category per se is up more than the total in terms of clearance units per average store.

Chris Svezia – Susquehanna Financial Group

Okay. And the last question I have is you didn’t buy back any stock. Just your thoughts there, if at all.

Douglas Probst

No further comment, other than the fact that it’s an opportunistic buyback program.

Chris Svezia – Susquehanna Financial Group

Okay. All right, fair enough. Thanks guys. Talk to you soon.

Operator

The next question we have comes from Camilo Lyon from Canaccord Genuity.

Camilo Lyon – Canaccord Genuity

Thanks and good morning everyone. Just following up on the last question about the accelerated rotation of the promotional cadence in sandals. I’m wondering – in second quarter, it seems like the accelerated promotions did not really deliver the sell-through that you had expected. Is that a fair statement to make from that?

Michael MacDonald

Is your question that the accelerated rotation from June did not work?

Camilo Lyon – Canaccord Genuity

Well, basically.

Michael MacDonald

Yeah. We think it worked just about exactly the way we figured it would work, and that’s why we were able to exit Q2 with clearance inventories in good shape. When we do a rotation, we rotate all categories. We don’t rotate by category, if that helps you.

Camilo Lyon – Canaccord Genuity

Got it. No, that’s very helpful. Okay, so I guess I’m just going to the point on the merchandise margins for the second quarter did come in a little bit stronger than expected, and I’m just curious if that was a result of the sandals category not selling through as fast as had been anticipated, and that’s resulting in some incremental inventory that’s seeping into the third quarter here.

Michael MacDonald

Well, as I tried to say in my remarks, our margin performance in Q2 was lower than what we had budgeted at the outset of the year. So the stronger margins are against other people’s expectations, not against our own expectations, and the reason our margins came in lower than we thought is for the reasons I mentioned – there was a shift in the sandal business out of Q2 into Q1. It really helped sales and margin in Q1, as you saw, but it had the reverse impact on both sales and margin in Q2. So that’s how we think about it, and I don’t know if I’ve fully captured all elements of your question but I tried to.

Camilo Lyon – Canaccord Genuity

No, I appreciate it. Maybe if I could just ask—you mentioned the third quarter comparison last year from a merchandise margin perspective is obviously very difficult. I think that’s your best segment, (inaudible) segment merchandise margin on third quarter you’ve ever produced. If you could just talk about the dynamics that happened in that third quarter that makes that a difficult comparison that should not repeat this back half of this third quarter. That would be helpful.

Douglas Probst

Well, to recreate the third quarter, I’m calling on some memory here but basically it was 5.2% comp, which was a nice, strong comp, and we didn’t have the cost increases really creeping into our business at that stage last year, so that also benefited us in that 46.5% margin rate we achieved. So those were probably the two primary categories.

Camilo Lyon – Canaccord Genuity

Okay, great. And then my final question just on how to think about the comp progression into the back half. I mean, you guys did a great job, put up strong high teens, double digit—or high teens two-year comps in the first half of the year. The deceleration on a two-year basis by the implied guidance, how do we rationalize that? How do we think about that being the appropriate way to conceptualize the comp?

Michael MacDonald

Yeah, it’s a really good question. We are crossing over into what amounts to our fourth year of significantly positive comps, we hope, and so with each successive year, it becomes harder to comp on top of comp on top of comp on top of comp. So I would say that’s a headwind. On the other hand, we have some of these receipt issues that may have hurt us a little bit in early Q3. Another factor which I don’t want to overstate but just by way of reminder, we did have Hurricane Irene hit at the end of August and into the first week of September last year. My recollection is that cost us about $1 million in the month of August and might have cost us a few hundred thousand more in September, although the northeast had a really very good overall third quarter last year, so perhaps we didn’t really end up giving up too much. But that’s a possible plus to us.

And then I guess the other countervailing influence is just, as I mentioned in my remarks, some modest transference of sales in markets where we’re opening up additional stores, and how that exactly splits out between new stores and comp store sales, we’ll have to wait until the end of the year to see that. But that’s another factor that could make it tougher to comp up in the back half, but that’s not a huge element.

Camilo Lyon – Canaccord Genuity

Okay. That’s all very helpful. Thanks so much, and keep up the good work. Good luck with the rest of the year.

Operator

Next we have Scott Krasik of BB&T Capital Markets.

Scott Krasik – BB&T Capital Markets

Yeah, hey Mike, hey Doug. How you doing? Morning. Question on traffic – you know, traffic is usually the component of comp that allows you to exceed your long-term guidance. As you look to the third quarter, at least the data points on some of your categories are pretty strong. Athletic is very strong; there have been data points that boots have gotten off to a good, early start. Your men’s business is your strongest comping category. So how do we think about your ability to drive traffic given that you still have very strong trends in some of your categories, although the comparisons are tough?

Douglas Probst

Well, you’ve got to recall, too, that we’re getting better at our marketing programs. Our database continues to grow substantially every week, and we did have a couple headwinds that Mike spoke to last year and the weather wasn’t that favorable as it related to cold weather boots. So we believe the awareness is growing and we’re investing more wisely than we did in previous quarters, so there’s a lot of different elements to help drive that increased traffic.

Scott Krasik – BB&T Capital Markets

Okay, and relative to a year ago, you would say it’s neutral to positive, the opportunities or the trends, however you want to put it?

Michael MacDonald

Scott, it’s Mike. We always think of TV as a driver of increased awareness and traffic into the store, and this will be an interesting year or an interesting back half that we’ll have ringside seats to watch. And what’s happening is because it’s a presidential election year, all of the network TV spots get eaten up or get priced to a level that’s uneconomic for us. So whereas we typically have a mix of national cable and local network targeted, this year we’ll be 100% national cable this fall. Our impressions will be up very substantially, but it will be in the form of cable versus network, so we’ll see what happens.

Scott Krasik – BB&T Capital Markets

Okay, that’s interesting. Thank you.

Michael MacDonald

I don’t know if you saw it, but our ad started running last night.

Scott Krasik – BB&T Capital Markets

Okay, I’m going to look out for that. And then the last question, Doug, is on merch margins – you know, you’ve talked a lot about it, but other than the 10-day earlier rotation on markdowns that will be in the third quarter and tough comparisons, is there anything else that should drive the merch margins lower year-over-year – mix or anything like that?

Douglas Probst

No.

Scott Krasik – BB&T Capital Markets

Okay. All right, thanks guys.

Operator

And the next question we have comes from Jane Thorn Leeson of Keybanc.

Jane Thorn Leeson – Keybanc

Thanks. Congratulations on a good quarter. I was wondering if you could talk about if you expect the promotional environment second half of this year to be similar to or less than last year.

Michael MacDonald

Yeah, I don’t think it ever gets easier. So we are laser-focused on the values and on the prices that we’re offering the customer. We monitor our average discount off of our compare at, which is the MSRP price, and we try never to let that average discount off of MSRP shrink. I think it’s an essential part of our value proposition. We’re continuously checking our prices against not just brick and mortar but dot-com and dot-com pure play competitors. So it’s sort of a way of life – I don’t think it’s going to change in the fall materially, but it’s certainly not going to get any easier.

Jane Thorn Leeson – Keybanc

Okay. And did you—can you talk about the selling trend of the clearance merchandise versus regular price, I guess the dynamics between the increased planned clearance in the second half versus regular price.

Michael MacDonald

You talking about mix?

Jane Thorn Leeson – Keybanc

Yes.

Michael MacDonald

Yeah, well I mean, our inventories are relatively flat in total on a cost per square foot basis, and our clearance inventories are up only slightly. So I wouldn’t see that—assuming our sell-through rates of each continue at predictable levels, I wouldn’t think there would be a huge mix change between reg and clearance selling.

Jane Thorn Leeson – Keybanc

Okay, great. And then my last question is on the accessories. Did the average ticket go up slightly given the higher quality, higher priced products that came in during the quarter?

Douglas Probst

I’ll have to pull it up.

Michael MacDonald

Just two seconds on that one. We are kind of excited about our handbag business right now. We think we have a more intelligent, balanced assortment in terms of quality and price points by location that’s better aligned with the footwear assortment in each store. So we are pretty happy about that business right now.

Douglas Probst

The average unit retail for accessories – and this is average unit retail, not necessarily ticket – but the average unit retail is pretty flat to last year.

Jane Thorn Leeson – Keybanc

Okay, great.

Douglas Probst

On a year-to-date basis.

Jane Thorn Leeson – Keybanc

But you expect that to tick up a little bit as you put in more of the—

Douglas Probst

Yeah, I think it could, sure.

Michael MacDonald

Yeah, it was up slightly in Q2. Doug’s talking about first half. It was up slightly in Q2. That should continue.

Jane Thorn Leeson – Keybanc

Thanks. That was very helpful, thanks a lot.

Operator

The next question I have comes from Jeff VanSinderen of B. Riley. Please go ahead.

Jeff VanSinderen – B. Riley & Co.

Good morning. Can you guys talk a little bit more about what you’re seeing in the kids business, also the smaller market stores, and then maybe update us on how you feel about the potential to grow the athletic segment.

Michael MacDonald

Okay, sure. Kids business continued to increase penetration. It’s now up to almost 2% of our dot-com business, so we’re pleased with that, and I think we’ll understand better going forward now that we’ve annualized the opening of that business. We’ll understand better how to effectively promote that and win, so we’re pleased with the progress we’re making in kids.

In small markets, I would say we are thrilled with our small market performance in total, and ecstatic about some of the customer response in certain markets. The ones that come to mind are Fargo, North Dakota and Peoria, Illinois, where in one case we’re almost doubling the sales plan, and in another we’re doing about, seems to me, 70% more than what we’d planned. So that whole strategy is working great.

We just opened up a store in Fort Wayne, Indiana this week and a couple of days does not the full story tell, but we’re very pleased with that. We opened that on Thursday of last week. We’re going to be opening up stores, at least one every Thursday for now through November 1, and on some Thursdays we’re going to be opening up multiple stores so it’s going to be very exciting. Some of those are going to be small market stores.

So now what was the third part of your question?

Jeff VanSinderen – B. Riley & Co.

Actually as a follow-up, I was going to ask you, since we’re talking about the small markets, given the performance there, might you accelerate the openings of small market stores?

Michael MacDonald

Yeah, well let me just say this – we’re just about red-lining this fall season in terms of the number of stores we can open in close proximity, both time and geography. So we’re really testing our ability to open stores this fall season, so I think the chances are that we won’t open more stores in a season than we will this fall season.

Jeff VanSinderen – B. Riley & Co.

Okay, fair enough. The other part of my question was really just to kind of get your latest feeling or latest thoughts about your athletic segment.

Michael MacDonald

Yeah, athletic is strong. We’re pleased with first half performance. It’s being driven by technical, which is good because by definition technical carries a higher ticket. It was also driven by lightweight and it’s continuing to rely more heavily on color. It’s becoming a fashion business, even in the technical category, and of course the whole growth of technical is conscious on our part. It’s not just happening to us; we’re making it happen because we learned from customer research that they really appreciated our fashion or street athletic assortment but they thought we needed to do a better job in the more serious running and cross-training categories. And so we actually beefed up our assortment and our brand representation in those more technical, higher priced categories, and the customer is responding, frankly, faster than I thought they would. So we feel real good about that business right now.

Jeff VanSinderen – B. Riley & Co.

Okay, good. And then as we’re thinking about second half, anything you can add in terms of what your merchants are feeling the most optimistic about in terms of drivers of the business outside of some of the key categories like boots, and you just talked about athletic. Anything that you feel are sort of the standouts, or they feel are the standouts to drive the business in the second half, or maybe offer the most upside potential for second half?

Michael MacDonald

Well, let me say this – I think if you looked at our sales plans, accessories would probably have the highest comp followed by men’s and women’s, and athletic footwear would probably be tied for third place. So that’s how we’re planning the business for fall. You know, boots is going to be important. We’re planning on a comp increase in boots. Western is important. The whole motorcycle influence that is characterized by studs and zippers and buckles, that’s kind of important. In men’s, there’s a whole rugged influence that is expressed in the boot category as well with a lot of distressed leathers, and as I said in athletic it’s about color and technical. I think there’s some new silhouettes on the floor, too. There is a sneaker wedge which is a pretty high fashion look that we think will be good in the fall. The flats will get some newness with the smoking slipper silhouette, and I think in the dress category there’s going to be a lot of special details, sequins and other details that really stand out on the floor. So those are some of the key looks that we’re trying to highlight for the fall.

Jeff VanSinderen – B. Riley & Co.

Okay, that’s helpful. Thanks very much and good luck this quarter.

Operator

Next we have David Mann of Johnson Rice.

David Mann – Johnson Rice

Yes, thank you. Good morning. Mike, I’d like to start with a philosophical question because I think this is the first quarter or year since you joined where the company chased some business that didn’t go the way you planned. So I’m curious – as you look forward this back half and into next year, first of all, how do you assess that opportunity when you’re making the decision to chase business? Is there anything you can do there as you look back on the post mortem on the first half? And then secondly, are you potentially more gun-shy about chasing the business?

Michael MacDonald

Well, I don’t think we’re gun-shy, but at the end of first quarter I can distinctly remember having conversations with the team here, and it was really as the first quarter unfolded, and the question was how should we respond to above expectation sales? Should we say it’s all accelerated business that we’ll give back in the second quarter? Should we say it’s shift-plus business we’re going to bank and our second quarter plans will stay unchanged, or is it a new underlying trend? And we picked door no. 2 – we said it was plus business that we were going to bank, but that it wouldn’t affect our comps in Q2. And in every category except for sandals, which includes both casual and dress, we were right, but we were wrong in dress sandals.

You know, one of the other questioners earlier asked about margin and prospects going forward, and when you’ve been around the business for a while, you realize that the old retail axiom of receipts minus sales equals markdowns, it proves to be true every single time. So when we get out in front on receipts on the comp, our margin performance is tougher; and when we chase business like we did last year in the first half and generated a 10 or 11 comp in Q1 and a 12 or 13 comp in Q2, guess what? We had record high margins. So yeah, I guess we need to re-taught that lesson from time to time, but it holds true almost uniformly, and hopefully we have planned the business in the back half in terms of receipts and inventory levels in a way that will allow us to maintain good margin performance and chase the business as it unfolds.

David Mann – Johnson Rice

Thank you. Doug, a question about the third and fourth quarter breakdown. You know, it seems like for the second quarter we on the street might have had expectations a little bit too high, or maybe didn’t appreciate how it would have played out. So any clarifications you can make about that breakdown, especially given you seem—I think you’ve talked about coming into the third quarter you might have a little higher clearance or markdown activity.

Douglas Probst

Yeah, and maybe to restate your first part assumption of the first half – we didn’t expect that number to come down to the levels, and that’s why we gave that midterm guidance. We had an idea that it was going to be significantly less than the first quarter, but that’s why we came out in the middle of June to kind of restate our expectations for the second quarter specifically.

So as it relates to the back half, I guess I’d like to keep the comments and perspective for the full fall season. We’ve given you some perspective that most of the earnings increase will be in the fourth quarter. Obviously sales and how we’re trending in various categories are going to make a big influence as we get through the September-October period, and we’ll make adjustments. But based on the three things that we talked about – the margin comparisons, the 53rd week, and the preopening expenses – those are the things that we’ll focus on and give us the increase in fourth quarter that we described.

David Mann – Johnson Rice

In terms of the inventory, can you quantify how much in dollars the early receipts were versus last year?

Michael MacDonald

We didn’t have really much in the way of early receipts this year. It was really delayed receipts last year, which of course affects the year-over-year comparison, and we felt like there was a movement out of Q2 into Q3 of about $25 million of retail receipts, so that would equate to about an $11 million worth of cost receipts.

David Mann – Johnson Rice

That’s helpful. In terms of the lease department opportunities, can you just update us where you stand in terms of developing new partners?

Douglas Probst

Unfortunately we have not signed any contracts with anybody, but we’re having a lot of meetings and our historical performance has enabled us to talk to a lot of different people; but we haven’t signed any sort of deal yet, so we are continuing that focus and have, again, many meetings with different retailers of a variety of size and shape and location, but haven’t signed any deal yet.

David Mann – Johnson Rice

And in terms of the dot-com side of the business, can you just give us a sense on the directional trend of that business? Is it steady in terms of its growth rate? Is it accelerating, or is it slowing down at all?

Michael MacDonald

Yeah, I think it’s still very, very strong and we just are in the process of finishing out a fairly significant expansion of our fulfillment center in order to accommodate that growth. You know, that business is going to continue to grow and be the fastest growing part of our business for the foreseeable future, and what we’re trying to do is support that growth. The other thing that we’ve got ahead of us, frankly, is the opportunity to do drop ship, which is a system we’ve talked about before but we have yet to implement it. We hope to implement it in the back half of next year, and essentially that allows us to display on our website product from our suppliers that actually is held in their warehouse such that if a customer buys it, our supplier ships it from their warehouse directly to our customer’s home. And that will be another source of growth without the space requirements to support it, and it would also be a source of growth because it would be differentiated product – product that we wouldn’t otherwise have on our website.

So we’re continuously making improvements to our assortment. We are focusing on the mechanics from a customer point of view as to how to interact with the website. We’re monitoring mobile traffic and trying to react accordingly, so I don’t have anything but good things to say about our dot-com channel.

David Mann – Johnson Rice

Great, thank you. Best of luck in the back half.

Operator

Next we have Patrick McKeever, MKM Partners.

Patrick McKeever – MKM Partners

Thanks. So understanding that you don’t want to get into too much detail about the quarters and the back half of the year, but I think, Doug, you did say that the guidance for the first three quarters of the year more or less would be for—more or less kind of a flat in aggregate EPS number. I think you did $2.50 in the first three quarters of 2011 on an adjusted basis, so that does imply a pretty big—I think as you’ve said, a hockey stick in the fourth quarter, and I think we understand the preopening costs that you won’t have and the cycling of some cost increases last year on the product side and the 53rd week and all. Just maybe you could help us get a little more comfortable just with the implied, pretty sharp increase in operating margin in the fourth quarter by the guidance.

Douglas Probst

Yeah, the only other—you’ve set up the question beautifully because you’ve repeated everything we’ve said, so thank you for listening. The other thing you already referred to is that the comparisons of the margin, but maybe one last thing is the occupancy leverage that comes from an additional week, and we didn’t have that kind of leverage in the second quarter, nor would we expect that in the third quarter. But when you have an extra week, you don’t pay an extra week of rent necessarily, so that may be another component as you’re thinking about your models.

Patrick McKeever – MKM Partners

Okay, great. And then on the buybacks, there too I’m just going to push you a little bit. I understand it being an opportunistic program, but the stock did take a bit of a hit after the update, the full year and second quarter guidance update back in June. So just given the balance sheet, the $485 million in cash and investments, why wouldn’t you have been opportunistic in the quarter? What’s it going to take, I guess is the question, to become more aggressive or to get into that buyback?

Douglas Probst

It’s a good challenge, and I can’t say we had a predisposed target if it hit to there. But we just kind of analyze it, and obviously in perfect hindsight that nice run it had back up after the announcement would suggest we should have. But listen – we have a lot of ideas here. As we’ve said, first and foremost, we’re going to invest in this business and we’re exploring several different things, and our first target is that. But it’s a good challenge on the buyback, and I just have to repeat that we didn’t buy it on an opportunistic basis in the second quarter, but we’ll see what happens in the future.

Patrick McKeever – MKM Partners

Great, thank you.

Operator

The next question we have comes from Danielle McCoy from Brean Murray.

Danielle McCoy

Hi guys. Congrats on a great quarter. I just had one little follow up on the ecommerce business. Have you guys increased any of the web-exclusive product?

Michael MacDonald

No.

Danielle McCoy – Brean Murray

Okay.

Michael MacDonald

In fact, we think there might be an opportunity to rationalize some of the web exclusive product.

Danielle McCoy – Brean Murray

Okay.

Michael MacDonald

We’re trying more and more to run this business as a single business and not a separate channel, so the more different you make the assortment, it really fights against that objective.

Danielle McCoy – Brean Murray

Okay. And just one little last question – the fashion cues that you guys were testing in 34th Street location, I’ve seen them in a few other stores. Have you rolled that out? How many stores have you rolled it out to, and what have you guys seen as the impact?

Michael MacDonald

Well we had some special merchandise for the 34th Street opening, but we tier up our assortment in terms of brands and price points just routinely, so I wouldn’t really characterize the 34th Street layer-on as a test that’s rollout-able to the rest of the chain; rather, it was just we were trying to spice it up for the store opening. You are going to find that our metro stores – the Union Squares, the 34th Streets, the Union Square in San Francisco, the State Street in Chicago, the Bethesda stores that have high volume and high appetite for bigger price points – they’re going to have a different mix of merchandise than is Peoria, Illinois.

Danielle McCoy – Brean Murray

Okay, that’s helpful. Thanks guys. Good luck.

Operator

Well that’s all the time that we have for questions today. We will go ahead and conclude our question and answer session. At this time, I’d like to hand the conference back over to management for any closing remarks.

Michael MacDonald

Okay, thanks very much, Operator, and thanks to all of you who are still on the phone. We appreciate your interest and your support of DSW. We’ll do our best to keep it going. Thank you.

Operator

And we thank you, sir, and to the rest of management for your time. The conference has now concluded. We thank you all for attending today’s presentation. At this time, you may disconnect your lines. Thank you and have a great day.

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