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Executives

Richard Brooks – President & CEO

Trevor Lang – CFO

Analysts

John Morris – Wachovia

Brad Stephens - Morgan Keegan

Jim Duffy – Thomas Weisel Partners

Sharon Zackfia – William Blair & Company

Mitch Kummetz – Robert W. Baird & Co.

Stephanie Wissink - Piper Jaffray

Betty Chen – Wedbush Morgan Securities

Crystal Kallik – DA Davidson

Unspecified Analyst

Jeff Van Sinderen – B. Riley & Company

Maurice Stein – Janel Management

Zumiez, Inc. (ZUMZ) Q2 2008 Earnings Call August 21, 2008 5:00 PM ET

Operator

Good afternoon ladies and gentlemen and welcome to the Zumiez Incorporated second quarter fiscal 2008 earnings conference call. (Operator Instructions) The following discussions may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Please note that actual financial results of the company for the periods being discussed may differ materially from the financial results projected or implied in the forward-looking statements.

Additional information concerning factors that could cause actual financial results to differ materially from projected results is contained in the company’s Annual Report on Form 10-K and other documents filed by the company with the Securities and Exchange Commission. The company disclaims any intent or obligation to update forward-looking statements.

No reporting or broadcast of this call is permitted without the company’s express written permission.

Now, I’d like to turn the call over to Richard Brooks, Zumiez President and CEO.

Richard Brooks

Good afternoon and thanks for joining us to discuss the Zumiez second quarter fiscal 2008 results. Joining me today is Trevor Lang, our Chief Financial Officer. Following my opening remarks, Trevor will review our financial and operating highlights and then I will provide closing comments before we turn the call over to the operator to conduct the question-and-answer portion of the call.

We were pleased that we once again exceed our earnings projections for the quarter primarily driven by our ongoing focus on cost controls and affective inventory management. We started the second quarter off with a positive comp in May and our comps were up 2.5% at the time we reiterated our guidance towards the end of May.

So at the time of our first quarter earnings release we felt very comfortable guiding comps down in the low single-digit range for the second quarter based upon the early read we had for the summer season. Our skate hard goods and footwear businesses, two departments where we have a significant competitive advantage, remains strong.

However as the quarter progressed the competitive environment became very promotional with a number of teen retailers significantly discounting their spring and summer apparel. This had a negative impact on our June and July apparel comps which were in the negative high single-digits.

As we look to the rest of the year we do not expect any improvement in the macroeconomic conditions or the promotional environment that began in the summer and has remained weak through back to school.

Therefore the original assumptions we shared with you in March and again in May that Zumiez can produce a low single-digit same store sales increase in the back half of the year needs to be adjusted.

I’ve been with Zumiez for 15 years now and this is the most difficult retail climate I have seen. We remain keenly focused on providing our customer with the unique Zumiez experience regardless of the economic conditions.

While the short-term may be challenging, I am very optimistic about our long-term future. We believe that our peers are becoming more and more homogenous and by simply staying true to who we are Zumiez is becoming even more unique in the mall and our shopping experience is becoming even more compelling to our customers.

We believe the true long-term value to the action sports consumer is in presenting the lifestyle which includes broad core brand diversity and broad category diversity. As just defined we are the largest national action sports lifestyle retailer and we believe our strategy will continue to further distance us from other mall retailers.

We have a strong balance sheet and our business model has produced strong cash flow. We have almost $70 million in cash and marketable securities and no debt and we will continue to invest in our infrastructure, technology, and most importantly our people.

We believe the competitive advantages I just mentioned will deliver long-term sustainable shareholder value.

Now I want to turn the call to Trevor to discuss the financials in more detail.

Trevor Lang

Thanks Richard, good afternoon everyone. For the second quarter net sales totaled $92,300,000, and increase of $10,300,000 or 12.5% compared to $82 million in last year’s second quarter. The increase in net sales reflected the opening of 58 new stores since the second quarter of last year, offset by a decline in our same store sales of 1.7% compared to an increase of 11.6% last year.

Our second quarter comps were inline with guidance we gave you in May and we’re driven by negative transactions, somewhat offset by higher average unit retail. From a product perspective our footwear comps led the way followed by our skate hard goods, our accessories and our apparel departments comped negative.

We opened 39 stores since the end of fiscal 2007 and are on plan to open 57 new stores this fiscal year. As we’ve discussed for a few calls now our stores in California, Arizona, Florida, and Nevada continue to be particularly challenging for both new and comping stores. However other markets such as Texas, and Illinois and Wisconsin to mention a few performed nicely for us. Gross profit for the second quarter increased $1,900,000 or 6.8% to $30,100,000 or 32.6% of net sales compared to gross profit of $28,200,000 or 34.4% of net sales in the second quarter last year.

This decrease in gross profit margin was driven by an increase in store occupancy cost as a percent to sales and to a lesser extent lower product margins. Moving to expenses, in total SG&A expenses increased $2.7 million or 11.5% to $26,200,000 or 28.4% of net sales compared to $23,500,000 or 28.7% of net sales in the second quarter last year.

We managed the growth in SG&A to 11.5% on a 23% increase in square footage growth. We de-leveraged in store labor and other store operating expenses due to the negative comp and our focus of trying to make the customer experience a good one, but we leveraged or home office expenses particularly in things like stock based compensation.

Operating income was $3,900,000 or 4.2% of net sales compared to $4,700,000 or 5.7% of net sales in last year’s second quarter. Net income for the second quarter was $2,700,000 or $0.09 per diluted share compared to $3,100,000 or $0.11 per diluted share in last year’s second quarter.

Turning to our first half 2008 financial results, for the six months ended August 2, 2008 the company reported net sales of $171 million, an increase of 13.4% over the $150,800,000 in sales for the first six months of 2007. Comp store sales for the first six months of 2008 decreased 1.3% compared to an increase of 11.4% in the first six months of fiscal 2007.

Gross profit increased $4,800,000 to $54,700,000 or 32% of net sales from $49,900,000 or 33.1% of net sales in the first six months of fiscal 2007. The decrease in gross profit margin was driven by an increase in store occupancy costs as a percentage of sales due to the negative comp of 1.3% and the 58 new stores added since the second quarter of last year.

SG&A expenses increased $6,100,000 or 14.2% to $49,100,000 or 28.7% of net sales compared to $43 million or 28.5% of net sales in the second quarter of last year. The slight increase in SG&A as percent of sales was due to store operating costs de-leveraging on a negative comp, somewhat offset by lower home office costs.

Operating income totaled $5,500,000 or 3.2% of sales compared to $6,900,000 or 4.6% of sales in the first six months of fiscal 2007 and net income was $4,100,000 or $0.14 per diluted share compared to $4,700,000 and $0.16 per diluted share in the first six months of fiscal 2007.

Turning to key balance sheet highlights, on August 2, 2008 cash and marketable securities increased to $68,400,000 from $33,400,000 at August 4, 2007 an increase of over 100%. Inventory was $72,100,000 at August 2, 2008 versus $61,800,000 at August 4, 2007.

Average inventory during the quarter on a comp store basis was flat to last year. As Richard mentioned our team did a good job of managing inventory during the quarter and we ended the second quarter with 6% less inventory on a per square foot basis relative to last year at the same time.

Also at August 2, 2008 the company had no long-term debt including no outstanding balances on its revolving credit facility. Now to our guidance, due to the challenging macro environment and promotional activity in teen retailing, we believe it’s prudent to adopt a more conservative outlook for the back half of the year.

For fiscal 2008 we are lowering our previous sales guidance of $430 million to $445 million to $418 million to $425 million. This is based on our target of adding 20% square footage growth and opening 57 new stores. Our current expectation is that third quarter comps will be in the negative mid single-digit range and fourth quarter comps will be in the negative low single-digit range.

We now expected diluted earnings per share of approximately $0.80 to $0.82 for fiscal 2008 compared to our previous expectation for diluted earnings per share of approximately $0.90 to $0.93. This revised guidance assumes that fiscal 2008 operating margins will be in the mid 8% range driven primarily by lower gross margins due to higher occupancy costs as a percentage of sales and lower product margins.

Our current expectation is that SG&A as a percent of sales will be about flat to last year. Weighted average diluted shares for fiscal 2008 are expected to be approximately 29,600,000. And now I’d like to turn the call back over to Richard.

Richard Brooks

Thank you Trevor, before I open the call to questions, I just want to reiterate a few key points that highlight our competitive advantages.

First, we continue to offer consumers the best brands. No where in the mall will you find such a diverse selection of branded merchandise relevant to today’s action sports lifestyle. This not only includes national and global brands, but brands specific to the particular regions and locales.

Second, we continue to attract and retain the best talent in the industry. Our people are central to our success. And third we’ll continue to open new stores and still have significant growth potential ahead.

Given our historical new store unit economics and associated returns, we believe opening new stores continues to be the best use of cash in order to return long-term value to our shareholders despite the current environment.

And now I’d like to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Morris – Wachovia

John Morris – Wachovia

You talked about managing inventories better can you break it out a little bit about how you’re managing apparel relative to the hard goods which are doing better and where you see that going for the balance of the year given the environment and how you’re planning to it?

Richard Brooks

There’s no secret to this which is again our business model has the strength of being a branded business model so we work very closely with our brands at managing inventory positions. I think we demonstrated that we’ve done a pretty good job of that through the first six months of this year.

So its about a brand partnership for us and that means we work very closely with them to work on based on what’s selling, what’s not selling, switching things out, moving things around, pushing orders out, pulling orders up. It’s a very dynamic process that our buyers are working on every day as we balance out the best of what’s working with the stuff that’s not working in our system.

And that’s fundamentally what we do. It’s dynamic and ongoing.

Trevor Lang

On the projections and again this is where the merchandising team I think has done a really good job for a long period of time. As you know the company was double-digit comping for most of the last five years until we got to the fourth quarter of last year. They had been able to do that on moderate and sometimes less inventory per square foot and they’ve been able to react very quickly as business has gotten tougher in this macroeconomic environment. Our inventory per square foot was down about 8% on a per square foot basis at the end of the first quarter, down 6% at the second quarter.

Our current expectation as we look out to the third quarter is that total growth in inventory will be in the mid teen range but with a 21% increase in square footage growth you would expect that inventory per square foot would be down similar to where we were in the second quarter which again was about 6%.

As we look out to the end of the year when we get to January, we are currently showing just a modest amount of inventory per square foot declining and the reason for that is there are certain parts of our business where we think we can do a better job of providing for our customers. We know there’s some transitional product between winter and spring that we could do a better job of based on our results last year and things we tried. We also know there are some warmer weather doors that we have opportunities to do things down there as well.

Pretty consistent, hopefully at the end of the third quarter relative to the second quarter and as we get to the end of the year there probably will be a very modest decline in inventory per square foot but not the mid single-digit to high single-digits that you’ve seen for the last two quarters.

Operator

Your next question comes from the line of Brad Stephens - Morgan Keegan

Brad Stephens - Morgan Keegan

But given the reduction of guidance can you talk about what we’ve seen so far in August?

Richard Brooks

We typically don’t do that but what I say at this point is the guidance for the third quarter is in the mid single-digit range and here today we’re doing significantly better then that but we believe that this environment that its important to be conservative in that this is the peak period and we think it could get tougher as we move into the off peak periods in this environment. So this is prudent for us to take a conservative position.

Brad Stephens - Morgan Keegan

When I look at this, your SG&A controls are pretty amazing given the square footage growth what steps are you taking to make sure that you’re not starving the business in order to try to put up a number to try to appease Wall Street that may compromise the future growth of the company?

Trevor Lang

Let me start with the things that we have not cut back on and then I’ll talk about the areas where we have made reductions, we are still investing heavily in our information technology organization. We’re growing that at a much faster rate then sales because we think there’s some strategic investments we need to make in that organization.

We are leveraging things like new credit card contracts with our vendors. We are doing a better job at operational expense controls at the store levels for things like cash over/short and things of that kind of nature. We are de-leveraging at the store payroll level actually. We are investing in our store payroll at a faster rate then we’re growing our sales because again we think that would negate the customer experience.

The biggest place where we are getting leverage from an SG&A perspective is here at the home office. And if you look at our SG&A structure, we spend about 80% of our SG&A at the store level with about just over 20% of our SG&A spent at the home office level. And we are going to get some level of improvement at the home office level. Unfortunately instead of compensation is one of those areas that will be lower this year relative to last year as you might imagine with our current projection that earnings would be down.

We’ve also spoken for a couple of quarters about stock based compensation and the way we’ve structured the programs, how they differ with more restricted stock and less stock options. So the vast majority of our leverage that came in the first half of the year as well as the leverage we expect to come in the back half of the year is not coming out of the 80% of the field where we spend our money, its coming really here in Everett, Washington in our home office.

So we feel pretty decent. That’s obviously the piece of the business that’s a little easier to predict then revenue and margin and we have not cut back on the areas that we think are important to continue to grow again IT and marketing and store labor and things like that. But there are other areas that we put the brakes on things here that we think are important to do so in the difficult environment but again we don’t think we’ve cut anything so severely that its going to mitigate our impact, our ability to continue to open stores in the future.

Brad Stephens - Morgan Keegan

Can you talk about the snow business and how you’re approaching that going into Q4?

Richard Brooks

Again, from a strategy point of view we’re going to, we’ve been doing this a long time the snow business. As you know the snow business is a risky part of the business from an inventory position because you buy it and you own it. So we have over the last number of years we have taken the strategy that we always buy snow well below what we expect the sales projection to be because as I said many times, it always doesn’t snow somewhere. So the goal of snow, of our product strategy is to chase the weather. So where it snows is where the product gets moved to.

The other thing we have done this year from a strategic direction is that we have based upon the results last year, is we’ve taken a two prong strategy to position our inventory. We’re going after the, at the high end, we’re going after the technology driven products for our kid who really wants the latest and greatest in technology and pro model boards, and at the other end, we’ve gone after and we’ve shifted the mix of our hard goods product to more of a price point driven business.

We’re working with our brands on doing that so that we can provide packages to our consumer as we get into the season and where we have, we can move on some of the price issues.

Trevor Lang

Certainly the snow business is very important for us, really starting in about October, is when that business becomes more important for us and so the way we define the snow business is the hard goods component as well as things like snow boards, snow pants for both the men’s and the junior side of the business and so in October that piece is about 11% of our sales and as you get into the fourth quarter those categories represent about 18% of our sales.

So I just want to make sure you understand that snow is important, it’s very relevant to the action sports consumer but it doesn’t get above 20% of our sales at really any point throughout the fourth quarter.

Operator

Your next question comes from the line of Jim Duffy – Thomas Weisel Partners

Jim Duffy – Thomas Weisel Partners

On the snow, you had a tough year in snow last year, are you going to de-emphasize it from a merchandising standpoint at all, make use of the space in other categories?

Richard Brooks

The simple answer is no we’re not. Snow is really a central part of the action sports lifestyle so we don’t anticipate de-emphasizing it. We’re going to continue to provide the training to our team. We’re not going to cut back on investing in the product knowledge for any of our sales people. We’re going to try to push that business as it makes sense, and again, to the let the product chase the weather conditions. No, I think it would be counter productive to what the Zumiez brand is about to de-emphasize it.

Jim Duffy – Thomas Weisel Partners

With regards to some of the promotional activity you’re seeing from your competition can you talk about Zumiez strategy to address that and maybe counter some of that and then if so does that have any impact on the margin outlook?

Richard Brooks

I’d like to start off by just reminding everyone that on a, as painful as this environment is on a relative basis we think that we’re doing a pretty good job relative to our competitive set and that’s particularly true from a comp store basis where we have the toughest comp store sales of just about anyone.

Let me tell you what we’re going to do and how we view our strategy here both from a strategic perspective and attachable perspective. The first strategically for us is that we really want to focus on maintaining the integrity of the Zumiez brand experience and I’ll just highlight a couple of things. You’ve heard us say it a number of times, we want to partner with the best brands. We want to be there with the best core brands in the industry. We want to provide a true lifestyle experience in the sense that we have all the right core brands and a broad diversity of them and we have a broad category diversity representing everything in the lifestyle.

And then we have to have great people. We have to make that investment on people and training them on the product knowledge to sell technical snow products. Obviously this is a very promotional environment and there are some things in the environment that go beyond our ability to control, the first obviously is the macroeconomic set. Its tough and again the guys who put out there assumes it doesn’t get any better here in the back half of the year.

And clearly that’s making it a much more price point promotional environment and again, while I’m not going to comment on specific brand performance I do want to make a couple of comments about how we see this from a brand perspective. The first is that those brands that we’re carrying that are focused on distribution in core shops like Zumiez are generally doing really well in our environment. We’re having a good experience with those brands and we’re working really hard from our perspective to help those brands build their brand integrity including maintaining the price integrity of their brand strategy.

Now on the other hand there are brands that have broader distribution in the mall outside of the core retailers and generally those are the brands where we’re finding that its really price promotional driven and unfortunately we’re being forced in those situations to be price promotional by the competition with those same brands. So as we look at where we’re being price promotional on a brand perspective it’s where we cross over with the non-core retailers in the mall environment.

So to summarize strategically it’s really important for everyone to hear us say that we’re going to stay true to who we are and we’re going to stay true to the Zumiez brand experience while tactically we’re going to do what we’ve done here in the first six months. We’re going to focus on managing inventories very carefully and trying to again, shift and move product to the best brands that are working for us and then we’re also going to tactically focus on controlling our costs and managing our expenses.

Trevor Lang

If you look at the guidance that is implicit that we’ve given for the back half of the year, it intimates when you go through and do your modeling that we’re going to have some portion of about 170 basis points of de-leveraging at the operating margin. All of that is going to come from gross margin and when you break into the details of gross margin the vast majority of that and I would expect gross margin to be down about 200 basis points for the back part of the year as the vast majority of that is going to come from occupancy cost de-leveraging on a negative comp.

But we are also assuming that our product margins will be down somewhere between 50 to 100 basis points. As you know as you read through our 10-K and summary of significant accounting policies there’s a lot of other things in our gross margin other than product [calls] but I’d summarize it that the operating margin degradation in the back half of the year of 170 basis points probably at least 200 basis points of that is going to come through gross margin, the vast majority of that coming through occupancy de-leveraging and then again product margins 50 to 100 basis points and then we’re going to have just a modest amount of leverage on SG&A which gets you down to the 170 basis points reduction in operating margins.

Jim Duffy – Thomas Weisel Partners

If I look at your expense structure and some of the savings you’ve been able to deliver on SG&A does that imply a different comp hurdle to lever expenses then maybe you had talked about at the outset of the year as we look out to 2009 what type of comp numbers should we be thinking about that you would need to lever expenses?

Trevor Lang

I wouldn’t change the 3% to 5% which is what we’ve historically given. You’re right; we have done better this year. I think the store team and the home office group have done a really good job of reining in expenses but there are things like incentive compensation and other areas that we need to fund next year and so as business gets better you’re going to have to add more of that expense to the bottom line which will impact the flow through. We have done a better job on the expenses then the way we’ve planned the business but I would not lower that 3% to 5% comp under the auspice that we’re going to continue to have 20% square footage growth.

Operator

Your next question comes from the line of Sharon Zackfia – William Blair & Company

Sharon Zackfia – William Blair & Company

On your thoughts on the cadence of growth for 2009 at this point, I know you’ve stuck with the 20% expansion now and just curious as to whether that’s been rethought internally?

Richard Brooks

Well as I said a number of times and over the last year is we reevaluate that as part of our planning process which is in the beginning phase now so at this stage I’m not ready to comment on what our plans are so we’ll get back to you more later in the year.

Trevor Lang

We have done a very thorough analysis of the stores, of the new store openings over the last four years. We looked at the entire class of 04, 05, 06, and 07 and have evaluated what our all in costs are both from a build out perspective and a working capital investment perspective. We’ve looked at how those stores have trended for the stores that now have four years worth of operating data versus the class of 07 where we don’t even have a full year’s worth of data, and I’ll tell you, its still quite amazing the amount of cash that those stores generate.

So we are being cognizant that the business has gotten tougher for us but we are still generating very nice returns on the stores even when you look at the more recent classes of stores, we’re generating returns that are within the realm that we’ve set out. We did have amazing returns for the class of early 04, 05, and 06. Those returns have moderated a bit when you look at the class of 07 but again, that’s more relative to the macro environment and when you look at those older classes of stores when our comps were up I think 13% and 14% you can imagine that the returns on those stores that we were opening during those years when the comps were up really high.

I just want to be clear that we feel very good about the returns we have on our stores but we are going to be very cognizant of the operating environment that exists today as we look at the deal environment into 2009 and 2010.

Richard Brooks

We continue to feel that opening stores is the best use of our cash resources so as we said, but again its prudent as we evaluate and plan for next year that everything gets on the table and we look at it and evaluate it but again, I believe that it is the best use of our cash.

Sharon Zackfia – William Blair & Company

I know you’re expecting SG&A leverage in the back half of the year are you expecting that in the third quarter as well on the negative mid single-digit?

Trevor Lang

Our current expectation is that all of that that leverage really comes in the fourth quarter. Because we’re doing more like a mid negative single-digit comp for the third quarter, our current expectation is that we would de-leverage some portion of 50 basis points on SG&A in the third quarter but then we would do a lot better in the fourth quarter. So yes, we would have some de-leverage of SG&A in the third quarter but a pretty fair amount of leveraging of SG&A in the fourth quarter.

Operator

Your next question comes from the line of Mitch Kummetz – Robert W. Baird & Co.

Mitch Kummetz – Robert W. Baird & Co.

I was hoping to get more color on your comp outlook over the balance of the year, you obviously split it up between the two quarters and you’ve talked about assuming a prudent stance given the environment, but when you look at how you comped in the second quarter in footwear and hard goods, are you assuming a similar trend over the balance of the year given that, to what you said you’ve got a competitive advantage in footwear and hard goods right now, would you expect those categories to continue to trend positively and the promotional environment on the apparel side to be where the big drag continues to be?

Richard Brooks

Yes, that is what we’ve assumed in putting, in adjusting the model is exactly that.

Trevor Lang

We comped down negative eight-tenths of a percentage point in the first quarter versus a positive 11.3% in the previous year. Here in the second quarter that we just finished we comped down negative one seven against almost a 12% comp last year. Our toughest comp last year was in the third quarter when we comped up 13%, we’re obviously now telling you we think we’re going to comp down in the mid single-digit but as you remember, business started getting tougher for us really in October and that’s where we started comping in the mid single-digit.

So as we get into the fourth quarter we’re certainly not on an even playing field because I think the macro environment is probably even a bit tougher then it was last year but we’re up against much more moderate comps as we come into the fourth quarter and to your point we think the competition in the mall setting is getting more and more different, a little bit more private label focused and price point focused and I think the kids who are into cool unique brands that you can’t elsewhere in the mall will bode well for us.

Mitch Kummetz – Robert W. Baird & Co.

I know part of the drag on the fourth quarter last year was the snow business and it’s at its highest percentage in the fourth quarter, could you tell us what the snow comp was last year in Q4 and I mean all in with hard goods and soft?

Trevor Lang

I think it was in the mid single-digits, negative.

Mitch Kummetz – Robert W. Baird & Co.

And it sounds like you’re going to continue to be invested in that category, you’re assuming a bit of a different approach, a two pronged approach trying to bring in some lower price points and working with some of your vendors, it sounds like part of the expectation with a strong comp in Q4 might be that you would expect better results out of your snow business. On the soft goods side, you made a big push last year into private label there and I that inventory is a little harder to get rid of where you can’t just push it back on your vendors, what’s your approach to the soft goods side of snow this year?

Richard Brooks

In general looking at the season and how we think we’re going to do relative to the comp, you know that when we’re talking about the snow business a couple of things matter, the first is when it snows which it is important in the snow season you get early snow. You want to see it in that November timeframe. Last year it was late in a lot of markets. You have to get snow but it’s also important when you get it. That’s why we try to risk manage our inventory position by the way we buy it, letting the product chase the weather conditions.

As it relates to private label and penetration of our outerwear business we’ve always had a significant penetration. There’s nothing unique or different year to year relative to that expectation.

Mitch Kummetz – Robert W. Baird & Co.

You’ve talked about this, there’s definitely been some weakness in certain markets, California, Arizona, Nevada, Florida, could you talk about the impact from those particular regions was on the second quarter and does the outlook assume a continued drag from those markets? I know the softness begins to be anniversaried I want to say starting October but I guess I’m assuming that you’re not expecting some improvement in those markets, maybe less of a drag?

Trevor Lang

The drag for the quarter, the negative one seven comp we did would be a positive one comp if those markets had just been flat. So those are comping down in the high negative single-digit range. And when you look at our year to date number, our comps of negative 1.3 would have been positive 1.6. Those markets have not changed materially this year. When you start thinking about Q3 and Q4 this year relative to where we were last year, you’re right, most of Q3 those markets were pretty good for us, especially California, Arizona and Nevada. Florida is kind of a new market for us but those markets were pretty good for us, up and then through about September and then we saw a pretty precipitous fall.

When you get into the fourth quarter again those markets continued to be a drag for us but they were not at the level they are now meaning we will not be on an apples to apples comparison when we get into the fourth quarter. Those markets will probably still be some piece of a drag on our business. We’re really hopeful assuming those things don’t continue to get worse, we won’t be at parody until we get to Q1 2009. But it has stabilized this year; it’s been about a 3% drag on our comps.

Operator

Your next question comes from the line of Stephanie Wissink - Piper Jaffray

Stephanie Wissink - Piper Jaffray

On the mix of sales given the strength in hard goods and footwear, can you give us general breakout on an annualized basis of apparel, hard goods, footwear and accessories, the contribution to sales?

Trevor Lang

If you look at our business on an annualized basis for last year, footwear represented about 18% of our sales, accessories another 18% of our sales, hard goods which we define as both skate and snow hard goods represented about 14% of our sales, men’s apparel is about 33% of our sales, junior’s apparel is about 15% of our sales, and the boy’s apparel is about 2%.

Stephanie Wissink - Piper Jaffray

When you’re looking at 2008 thus far even through the back half based on your comp guidance any shift in those percentages?

Trevor Lang

Footwear is going up; we could easily be above 20% in footwear. Hard goods will go up a very modest amount, it might be 15% and those will come mostly at the detriment of apparel.

Stephanie Wissink - Piper Jaffray

Does that change the carriage on inventory balances or the balance in merchandise margins for the back half?

Trevor Lang

We’ve already spoken about the inventory so yes; we’ve taken that into account and the decline in the inventory per square foot that we’re projecting for most of the rest of this year. And it certainly does have an impact on margin. It has a modest amount of de-leveraging on our product margins because the shoe business is just a little bit under margin of the apparel business and the skate hard goods is slightly even below the shoe business.

We’re not talking 1000 basis points in between each one of these; we’re taking increments of 300 to 500 basis points in between each of these so I wouldn’t get overly concerned that there’s going to be a massive impact because the mix of shoes and skate is going up.

Stephanie Wissink - Piper Jaffray

In those housing states, have the declines started to moderate or are you continuing to see acceleration in the declines?

Trevor Lang

It’s been consistent, it’s not gotten a lot worse but it certainly has not gotten any better.

Stephanie Wissink - Piper Jaffray

Looking at the comp guidance for the second half does that assume consistent declines in traffic and improvements in the transaction value or are there different assumptions to what you’ve experienced through the first half of the year?

Trevor Lang

I think that’s right, I think we’ll have an increase in average unit retail more then offset by a decrease in transactions.

Operator

Your next question comes from the line of Betty Chen – Wedbush Morgan Securities

Betty Chen – Wedbush Morgan Securities

I know that a lot of retailers are talking about perhaps getting some better real estate deals could you talk about what you’re seeing out there and I know maybe there’s a difference between A or B level malls and then longer term, how should we think about the ultimate store based opportunity for Zumiez? I think in the past you had talked about an 800 store opportunity.

Richard Brooks

We are continuing to focus on our 800 store target. Its one of those things that our real estate team manually looks at and evaluates and updates in terms of which centers were targeting that make up that pool of stores. So no we are staying focused on the 800 store target. Currently in the real estate market it’s a landlord by landlord specific case as to what we’re seeing in terms of whether or not the deals are getting or not. I would characterize it that those landlords that want to do more deals with us are getting a bigger share of our open to buy market and we are one of the few growing specialty retailers out there today. In fact many people are shrinking.

And not only are we growing but our balance sheet is very healthy so I think we’re a very attractive tenant for the landlords. So we work at this close with the landlords in terms of trying to approach as a partnership and some landlords are more willing to do the kind of deals we think are warranted and those that are, are the landlords we’re focusing and doing more deals with. Because of our size we can do that. We can focus in and target our efforts with the landlords that value the quality of our financial position and our ability to generate sales.

Betty Chen – Wedbush Morgan Securities

As we start to think about next year and I know you work very closely with your branded partners what are you hearing in terms of pricing pressure, as some products costs are rising, how should we think about that in 2009?

Trevor Lang

There’s no doubt product costs in Asia are going up. The cost of fuel, what they’re doing with the Yuan and the cost of debt in Asia is certainly being impacted. So we obviously have pretty good view into how the rest of this year is going to come out. Next year there probably will be cost increases and we’re currently in the process of evaluating what those cost increases mean to our business and our vendors are doing the same. One of the benefits of the Zumiez business model is historically speaking when either cost increases, modest cost increases have come up or features and attributes of the products have been enhanced we’ve been able to raise our prices to reflect that.

This is again a very different economic environment then what we’ve seen for probably at least the last 15 or so years so to be more to come as we do the planning process and we can update you in November. Everything that we’ve seen as we’re dealing with our vendors over there, ourselves, our private label businesses, as well as what we’re hearing from our customers, with the cost of oil and the other inputs into the cost of making products in Asia, there are likely going to be some cost increases coming through.

Richard Brooks

I would also say that again, we’re one of the few growth retailers out there so we’re certainly reminding our vendors that our volumes, potential increase with them too as we evaluate this and their pricing structure with our business. So the other thing is that in some cases we carry many brands, we’re very brand diverse, that you have to come to our shop to buy in the mall setting so there tends to be less price issues from the consumer perspective when the brand is just a great brand a really cool brand and kids want to have it. Those more unique brands are tending to perform very well for us so in those cases it may give us some pricing power relative to those more unique brands.

Betty Chen – Wedbush Morgan Securities

How is the ecommerce business and I think it has a very small percentage but obviously a tremendous amount of opportunity going forward, how has it done so far in the first half and are there any initiatives to accelerate the growth of that channel?

Richard Brooks

Our ecommerce business is very, very strong so we’re doing quite well in that area. You are correct in that it’s still a very small part of our business so we believe and we are working on a detailed business plan that there is a big opportunity to build that business over in the next five years. It is on our key list of things to do. We’re starting to do a number of things along that front and our business is very strong today there although it’s still a small percent of the business.

Betty Chen – Wedbush Morgan Securities

Could you tell us what was the growth in the second quarter?

Trevor Lang

It was 75% growth in the second quarter, 65% year to date.

Operator

Your next question comes from the line of Crystal Kallik – DA Davidson

Crystal Kallik – DA Davidson

Could you talk about the sales per foot target you’re looking at now as we start thinking about the store profitability model, has it changed at all, where do you feel you are right now?

Trevor Lang

Last year our sales per square foot was just under $500 a square foot, our trailing 12 month sales per square foot is about $470 today and so it is down a little bit as we’ve had the negative comps. The other thing that we are cognizant of is we look at total flow through on the business so we will take stores that do over $800 a square foot and expand those stores because we can drive more volume through them. So we spend a fair amount of time discussing this subject and we think sales per square foot is a good indicator but not the indicator because if you can take a store that’s doing for example $1,000 a square foot, you can double the size and get that store to do 50% more volume but you’re going to do less sales per square foot, that makes for a lot more operating profit flow through.

So I think that’s a good metric for people to monitor when they’re looking at our business but it’s not a single metric that we drive. What we focus on is what is the amount of operating profit we can drive through that box and in some cases, some of our highest volume stores in the last three or four years the sales per square foot has come down when we’ve expanded the size of the store. Take a store from 2500 or 3000 square feet to 4000 square feet but it’ll drive much more operating profit when we do so.

Crystal Kallik – DA Davidson

So would you say your focus then would be more on the four wall return or the pay back period of a store versus a sales per square foot?

Trevor Lang

Yes.

Crystal Kallik – DA Davidson

Are you discussing what a goal or what a reasonable target that would be for you when you look at the stores?

Trevor Lang

Renewing deals or new stores?

Crystal Kallik – DA Davidson

Just in general, a lot of retailers will say that they’d like to be around $500 a square foot, but it sounds like you look at it a little bit differently, so what is your business model, what your goal four wall return or pay back period is for your store productivity?

Trevor Lang

We look for a 40% IRR between years two and three and that generally will give us a total cash pay back of everything invested in the store between 12 to 18 months.

Crystal Kallik – DA Davidson

When you look at, no doubt the earnings growth has been phenomenal for many years and when you look at earnings expansion presuming for your business model what are you really planning on, how much of that is California getting going again or just driving the total cumulative comp or business recovery in the men’s area, what’s the big focus for you in really working towards getting earnings expansion beyond the macro piece?

Richard Brooks

I’m not sure we can separate it from the macro piece. I think that is the suppressing factor whether it’s the comp number or the new store number. That is for us the overriding factor. From a product perspective I think we are as diverse as we’ve ever been with unique and really great brands. What we need is the consumer feeling better and I think at that point we see our business getting better.

Operator

Your next question comes from the line of Unspecified Analyst

Unspecified Analyst

In light of the softness in apparel, as you’re moving around your orders and working with your merchandising teams, are there any categories in apparel or specific brands that are performing better then average?

Richard Brooks

Yes there are and there are others that are not. We don’t want to get into that level of detail just because we would spend the entire call, we have an incredible number of categories that again we are very category diverse in men’s, women’s, accessories, and it’s our expectation that categories are always moving up and always moving down. So we don’t want to get into the specifics of it. The issues we’re having with the apparel business at this stage are really price promotional driven from our competitors. The brands that are full price brands for us, those unique brands that are in core distribution channels like our stores are doing quite well. It’s the brands that have broader distribution where we’re really feeling the price pressure from our competitors.

Unspecified Analyst

Could we have an update on shrink initiatives?

Trevor Lang

We’ve started going on about a year now, one of the biggest things we did on the shrink initiative was to start putting in ink sensor pins in high theft garments. We’ve been doing that now for about a year. We do it in a strategic manner that we only put it on the high theft items and so we think that’s been working pretty well. Our head of stores has done some good things from a training and from a people perspective to help hold people accountable and make sure they understand the areas that cause shrink so we’ve spent a little bit more time on training. If you read our call from the first quarter earnings release, we did pretty well on shrink.

We had a decrease in shrink in the first quarter, we’re about to start up our second large round of physical inventories that we do after the back to school period and before the holiday period and we’ll see how it turns out. But we really do our physical inventories twice a year. We did a lot better in the first quarter relative to the first quarter of 2007 and we can update you on the second round once we get through it in the next few months.

Operator

Your next question comes from the line of Jeff Van Sinderen – B. Riley & Company

Jeff Van Sinderen – B. Riley & Company

I know your apparel business has been running negative on a consolidated basis but if you exclude the bad geographies or bad real estate markets how do your apparel comps look?

Trevor Lang

We’ve not done that analysis but I think it’s been tough all over. If you look at our districts we’ve got about 38 districts where we carve up our 324 stores, about a third of those districts are posting positive comps and about two-thirds of those districts are posting negative comps. So there’s no reason for me to expect when I’ve looked at some of the detail on a by district basis that we’ve seen any material deviation so I don’t think you could assume the apparel in just the tough housing markets is really the drag, I think its pretty consistent across most of the stores.

Richard Brooks

I would that’s the same issue of; we have the same heavily priced promotional competitors across the country that are driving that apparel business down.

Jeff Van Sinderen – B. Riley & Company

As far as hard goods were you more or less promotional in this quarter on hard goods and then also are you planning to be more or less promotional on hard goods in the second half?

Richard Brooks

There is no change to the promotional cadence on hard goods in the first half of the year versus a year ago and we don’t anticipate any going forward in the back of the year at this stage of the game. I might add that we comped up in the first half of the year in hard goods against very tough, tough comparisons from the prior year and we’re still going to comp up I believe in the low single-digits in the first half of this year. So no, we haven’t had to take any different promotional cadence in our hard goods business and at this point we don’t anticipate having to take any.

Operator

Your final question comes from the line of Maurice Stein – Janel Management

Maurice Stein – Janel Management

Broadly speaking, how would you characterize the difference in the back to school merchandise assortment this year versus last year, differences in brands or price points?

Richard Brooks

Broadly speaking from a brand perspective we are again I think very, very diverse. That hasn’t changed from the previous years so there are a number of, now which brands, how brands perform within the mix has changed from a year to year basis so there are a number of brands again that are characterized by the brands that have tighter distribution that are doing very well in our environment today and we think they will continue to do well in our environment and are selling at full price.

And there are those brands that are driven by price competition from our on mall competitors that have broader distribution so it’s a mix there that’s moving all over the board as it relates to brands. From a fashion trend perspective at this point I think we’re covering a lot of ground. You’re definitely seeing a lot of players, you’re seeing a lot of color throughout the store from the footwear wall to both the men’s and women’s apparel and even what we’re doing in accessories, you’ve seen us with a lot of color across the store because that is basically as we view it the trend cycle at this point.

Maurice Stein – Janel Management

And your comment about brands, the more core ones doing better, being less promotional to what extent does that lead you to want to want to tweak your assortment more, shrink your assortment of the cross over brands and try and expand the assortment of core brands?

Richard Brooks

That again is a very natural process here and that is part of what our buyers do on a daily basis managing those brands across our chain and again some of those can be regional, even local based kinds of brands so it’s a very dynamic process again and we certainly do that and we’re certainly having those discussions with the brands that are doing well and the brands that are struggling.

Maurice Stein – Janel Management

Any way to quantify the kind of mix shift that we might be able to see over the next six months?

Richard Brooks

No not really and again I would tell you, you can tell a lot just by being in our store as to which brands are performing and how they’re positioned.

Maurice Stein – Janel Management

If I could just clarify, that the business became more promotional and tougher June, July so a negative high single-digit comp, I heard you say that this trend continued into August. But then I heard your projection for Q3 is down mid single-digit comps, and that currently they’re running a little bit better then that, so I’m confused, because I don’t know if the comp month to date is negative high or better than negative mid, could you clarify for me?

Trevor Lang

What we said was the promotional environment has continued into the second quarter and has continued to impact our apparel comps. What we said was negative high single-digit was our apparel comps. Apparel represents about 50% of our business and so yes, that business continues to be difficult for us but the shoe business and the skate business and to a lesser extent the accessories business is not doing that. Just to be clear, comps, our expectations in the third quarter will be down negative mid single-digits and that we are currently doing a bit better then that.

Richard Brooks

We caution you that this is the peak period. We expect they’ll get off peak when there’s less need for people to shop that those may get worse and that’s why we’re taking a conservative position.

Operator

This concludes today’s conference call.

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Source: Zumiez, Inc. F2Q08 (Qtr End 080208) Earnings Call Transcript
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