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The Gymboree Corporation (NASDAQ:GYMB)

F2Q08 Earnings Call

August 20, 2008 4:30 pm ET

Executives

Jeffrey P. Harris - Vice President, Finance

Matthew K. McCauley - Chairman of the Board & Chief Executive Officer

Kip M. Garcia – President

Blair W. Lambert - Chief Financial Officer, Chief Operating Officer and Director

Analysts

Betty Chen – Wedbush Morgan

Dana Telsey – Telsey Advisory Group

Margaret Whitfield – Stern Agee

Brian Tunick – J.P. Morgan

Jody Yen – Buckingham Research

Linda Tsai – MKM Partners

John Morris – Wachovia Securities

Lorraine Maikis – Merrill Lynch

Thomas Filandro – Susquehanna Financial Group, LLLP

Adrienne Tennant – Friedman, Billings, Ramsey

Janet Kloppenburg - JJK Research

Steve Kernkraut – Berman Capital

Operator

Welcome everyone to The Gymboree Corporation second quarter earnings conference call. (Operator Instructions) Mr. Harris you may begin your conference.

Jeffrey P. Harris

Welcome everyone to The Gymboree Corporation’s second quarter 2008 earnings call. I’m Jeff Harris, Vice President of Finance for Gymboree. On the call with me today are Matthew McCauley, Chairman and CEO; Kip Garcia, President; and Blair Lambert, COO and CFO. Blair will first make a few comments about our second quarter financial performance and plans for the remainder of 2008. Kip will discuss product performance during the quarter and update you on our merchandising initiatives. Matt will then provide some additional background and update you on our strategic plans for the remainder of 2008 and beyond.

After our presentation is finished we will all be happy to take your questions. Before we get started I want to point out that our presentation today contains forward-looking statements including statements about trends and operations, future sales, expectations and future financial performance. Actual results could differ materially from those forecast as a result of a number of factors including those set forth in our annual report on Form 10-K filed for the year ended February 2, 2008 with the SEC.

I would also like to point out that we intend to continue to comply with the SEC regulation FD. As such we will not be providing guidance or projections outside of public forums. You should also be aware that your participation in the Q&A session constitutes your permission to transcribe and re-broadcast any comments that you may make.

Now here is Blair Lambert.

Blair W. Lambert

As reported in our press release net sales for the 13 weeks ended August 2, 2008 were $202.8 million a 13% increase over the $179.9 million in net sales from retail operations reported for the 13 week fiscal quarter last year. Other revenue for the quarter attributable to our Play and Music operations was $2.9 million compared to $2.5 million in the prior year. In total net sales for the quarter were $205.7 million versus $182.4 million for the prior year an increase of 13%. As previously reported comparable store sales for the second quarter increased 1%. During the quarter we saw an increase in the total number of transactions and decreases in the average unit retail and units per transaction. The total number of stores open at the end of the quarter was 835 including 577 Gymboree stores in the US, 29 Gymboree stores in Canada, 104 Gymboree Outlet stores, 101 Janie and Jack shops and 24 Crazy 8 stores.

During the quarter we opened 26 new stores consisting of four new Gymboree and eight new Gymboree Outlet stores. We also opened six Janie and Jack shops and eight new Crazy 8 stores. Total square footage under management at the end of the quarter was 1,623,000 square feet with an average store size at rough 1,945 square feet.

Turning now to gross margin and gross profit, gross profit for the second quarter of fiscal 2008 increased 170 basis points to 45.7% compared to 44% for the same quarter of the prior year. The improvement was the result of the company’s continuing product cost reduction strategies and leveraging of buying costs partially offset by increased occupancy costs and lower average unit retails. While average unit retails were down over the prior year our markdown management efforts allowed us to generate higher AURs than were anticipated at the beginning of the quarter which increased our gross margin rate.

Looking at SG&A expense in the second quarter, SG&A as a percentage of sales was 39.4% of sales versus 39.3% in the prior year. The increase is primarily driven by higher stock-based and incentive compensation offset by reductions in professional fees, communications, marketing and travel costs. Notably excluding non-cash stock-based compensation expense SG&A fell by 70 basis points versus the second quarter of the prior year.

For the quarter operating income jumped 52% to $12.9 million versus $8.5 million in the second quarter of the prior year. As a percent of sales operating income also showed a terrific 160 basis point increase to 6.3% of sales. The tax rate for the second quarter was 39.7% versus 36.3% in the prior year. Net income increased 38% to $8 million versus $5.8 million last year. Earnings per diluted share increased 42% to $0.27 for diluted share compared to $0.19 in the prior year. These earnings include a loss of roughly $0.05 per diluted share associated with Crazy 8.

Let me now move to the balance sheet. Cash, cash equivalents and investments at the end of the quarter were roughly $44 million with no short or long term borrowings outstanding. Inventories at the end of the quarter increased to $129.1 million versus $115.7 million in the prior year. On a per square foot basis inventories decreased 2% over the prior year. Capital expenditures for the quarter were $15.9 million, depreciation expense for the quarter was $8.6 million.

Let me now turn to our plans for the remainder of fiscal 2008. As noted in our press release for fiscal 2008 we are planning for diluted per share earnings in the range of $3.15 to $3.20 on 29.4 million diluted shares outstanding. These earnings targets anticipate a full year net loss from Crazy 8 of roughly $0.10 per diluted share. You will also note that we have not increased full year earnings guidance to reflect the $0.02 of upside we experienced in Q2. This is because one of the factories we contract with in Indonesia experienced a buyer two weeks ago. As a result we’re in the process of placing goods in other factories owned by this manufacturer or placing the goods with new factories. While we anticipate receiving the goods on time we will experience some downward pressure on gross margin in the range of $0.02 to $0.04 during the fourth quarter due to higher freight costs arising from air shipments of the goods. The third quarter earnings will not be impacted by the buyer.

Turning now to earnings for the third quarter of fiscal 2008 we are planning third quarter earnings to be in the range of $1.02 to $1.04 per diluted share on 29.4 million diluted shares outstanding. This earnings estimate includes the loss of $0.01 per diluted share related to Crazy 8. In terms of real estate we plan to open 43 new stores during the third quarter consisting of nine new Gymboree stores, 12 new Gymboree Outlets, 8 new Janie and Jack shops and 14 new Crazy 8 stores. We also plan to remodel, expand or relocate nine Gymboree stores. In planning the income statement for the third quarter we’re looking for increased gross margin and operating income rates on flat to slightly negative same store sales. We expect third quarter year-over-year gross margins to increase versus prior year due to lower products costs, higher average unit retails and buying cost leverage. These drivers of gross margin improvement will be partially offset by negative occupancy expense leverage as experienced in Q2 and increased Crazy 8 volume at relatively lower gross margin rates.

Looking at SG&A net of the impact of stock-based compensation we expect slight SG&A leverage. On balance operating margins are expected to be higher than those experienced in the prior year.

Now I’d like to turn it over to Kip for discussion of our merchandising activities.

Kip M.Garcia

Overall we are pleased. In a tough economic environment we posted a positive comp for the quarter. I’d like to walk you through each of the brands and discuss the successes and the opportunities identified during the quarter.

Starting with Gymboree at the department level Boy posted the strongest comp followed by Newborn. Starting with Boys as has been our trend and resulting from our execution of our strategies to gain market share in Boy we continue to see growth in this category. Top performing classes in Q2 for Boy were polos, fashion woven shorts and active tops or hoodies. Fashion shorts for Boy were planned as a key trend for the season and plaid, print and patchwork shorts consistently were our top performers across all lines. We also launched our new Boys Will Be Boys marketing strategy which included a [Magdalon] press kit featuring the authentic styling, details, fabrics and treatments that we’re offering for Boys. We followed the press kit mailing with an elevated exposure of our Boy product on our website and gave Boy featured presentation in our stores.

Next, Newborn has also been identified as a key opportunity for increased market share. We launched our brand new Baby collection in the first quarter with our Baby Event and this category continues to perform over plan and was the major regular price contributor to our Newborn comp this quarter. For Q2 we launched a new whimsical monkey-themed concept for this category which has resonated with our customer. We were thrilled that our monkey concept product was featured in Minnie Driver’s baby shower which had great media coverage and we highlighted it on our website as the perfect gift collection for baby showers.

At the category level for the quarter shorts and tanks were strong summer drivers across all of our Boy and Girl departments. Sales for this category were driven by our successful [Cat Fields] event which featured $6 and $8 price points during the highly competitive May and June selling season. We also featured [Tread Rite] most wanted fashion plaid and novelty shorts at higher price points during the summer season across all departments and those categories were strong performers as well.

Early back-to-school sales in July were primarily driven by back-to-school essentials. We expanded our assortment of uniforms and backpacks this year and both strategies performed above plan and posted solid comps. On the other hand our early back-to-school fashion lines for Girls were slow to start. Our traditional Apple themed collection was disappointing. However our fashion collection for the second phase of back-to-school which is in right now, Classroom Kitty, had it set in late July was and continues to be especially strong across both Girls apparel and Girls accessories. Our customers are positively responding to fashion styling, the hot pink and gray color palette, the cute kitty icon, plaids and fashion shoes.

Now turning to Janie and Jack, for Girl our strongest performing line was our On Safari collection which featured bold, brown giraffe skin prints, hand crocheted details, orange pop colors and giraffe icons. For Boys our customers loved our Ocean Blue collection which featured shark icons, white on white pass works, blue linens and mixed blue hued madras plaid shorts. Our Special Occasion collection which features elevated top of the line dressy dresses and accessories for Girls and suits, dress shirts and ties for Boys continues to perform over plan. April and May have been our strongest selling months supporting our strategy to capture the demand for dressy alternatives for Boys, Girls and Newborns to wear to graduations and weddings. Based upon the success of Special Occasion we plan to expand this collection from 11 to 30 stores going forward and this is in addition to our web.

Now turning to Outlet accessories led our comps at the department level. Accessories has been underdeveloped in Outlet due to minimum purchase requirements. However now that we have buying leverage with more units we have been able to grow this category primarily in shoes. Going forward we have growth opportunity in sleep, hair accessories, bags and underwear as well and as in Gymboree Boy was also a positive comp department for Q2. Our strongest line was Summer Rodeo which featured fashion plaid shorts and western graphic tees plus opening price point tanks and shorts at $6.99. On the other hand we were disappointed in our growth performance for the quarter particularly from our early back-to-school line which set in July. Our strongest comp for Girl in the quarter came from swim and our summer two line which was Strawberry Farm. It featured strawberry artwork, gingham checks and opening price point tanks and shorts at $6.99. Going forward we feel that we have an opportunity to drive early back-to-school sales in Outlet by putting more emphasis on back-to-school staples such as backpacks, uniforms and denim particularly Boy denim.

Now turning to Crazy 8, we continue to be pleased with our Boy, Baby Boy and Baby Girl department performance. We feel that pushed fashion a little too hard in Girl and Girl active wear has been very disappointing. We have adjusted our styling for Girl going forward and have right sized Girl active wear based upon sales trends and productivity. We have kicked off back-to-school with a very successful denim and graphic tee event and feel that there is even more opportunity going forward as we fine tune our washes and fits in denim and focus our assortments to expand our best selling graphic tee themes for both Boys and Girls. We also feel that we have a great opportunity for backpacks and uniforms next year based upon our success with Gymboree and we’ll have more buying power to expand these categories with our increased store count.

Finally looking forward for third quarter and the balance of the year we’re really excited about our product offering and are working diligently to ensure that we rise above our competition buy staying focused on our brand strategy to be best in class by offering our customers the fashion, mix and match outfitting, detail and quality that they expect from our brand while continuing to be competitive in this tough economic environment.

Now I would like to turn it over to Matt.

Matthew K. McCauley

As a management team we are focused on driving consistent, long term earnings growth. In the second quarter we faced a challenging environment and still delivered a positive comp and although we have higher expectations for comp store sales growth we are happy to report operating income is up over 50%. Operating margins expanded 170 basis points and EPS growth is up 42% bringing our year-to-date earnings per share to a positive 32%. Although we believe kids retail is somewhat insulated from these macro economic pressures like most retailers we have certainly felt the impact of the current pull back in spending. That said we are confident our strategies will deliver meaningful earnings growth in the current year and into the future.

I’d like to take just a couple of minutes to discuss some of our key longer term growth strategies starting first with top line sales then moving on to our operational strategies. Top line sales growth will come from new stores in Outlet, Janie and Jack and Crazy 8 as well as Boy market share in Gymboree. Operating margin expansion will come from store payroll efficiencies and cost of goods reductions in all brands. Starting with our store growth we currently operate 835 stores. The majority of the store growth in 2009 will com from Outlet and Janie and Jack giving Crazy 8 time to reach a meaningful four wall contribution. There will also be a small amount of store growth in Gymboree US and Canada during 2009. Beyond 09 we anticipate the majority of the store growth to come from Crazy 8. We continue to feel that Crazy 8 could be at least as many stores as Gymboree.

Now for Boy market share, we continue to see significant opportunities to gain Boy market share. This is still one of the largest sales growth areas for Gymboree. We have substantially more market share in Girl than we do in Boy yet the industry spend on Boy is closer to 50/50. We have moved the needle with the increased focus on Boy and it has led the way in comp store sales growth for the past three years. We are on the right track with Boy and see sales growth for the next several years.

Moving onto store efficiencies, last year we started rolling out a new payroll tool for stores. This tool better aligns sales staff and transaction patterns and more accurately allocates hours for tasks and events. As a result we are seeing improvements in our already stellar customer feedback scores and decrease in overall hours used to operate stores. We saw a slight leverage in store payroll during the first half of this year. As we continue to refine our payroll model and better manage our average hourly rates and improve our store task efficiencies we anticipate more significant leverage in the future.

Looking now at cost of goods reductions, for the flagship Gymboree brand cost of goods reductions will continue into 2009 but at more modest rate. While more significant reductions will continue in Outlet, Janie and Jack and obviously Crazy 8. Year-to-date we have increased gross margins 160 basis points due primarily to cost of goods reductions. The improvements in cost of goods is coming from increased quantities in the newer divisions and for Gymboree the reductions are coming from continued sourcing improvements as well as strong factoring agent partnerships.

Turning now to Crazy 8, clearly we see both top line sales growth as well as operational efficiencies in our newest concept. Crazy 8 is targeting moms that want cool, wholesome kids’ clothes at a price. Crazy 8 is meeting our sales expectations and we’re constantly identifying opportunities for growth. The Newborn department needs to deliver more fashion more frequently. The Kid Girl product needs to be younger, sweeter and more outfit driven. The Kid Boy department can build on its strong sales by reducing the basic active wear and increasing true All American fashion. We will expand the accessories business as the order sizes increase and we will compete more effectively in seasonal sales as the IMU increases.

On the operational side, we expect to get the same sales out of 2,000 square foot that we are getting and can get out of 2,500 square feet. We can significantly reduce proprietary expenses with increased order sizes and with the growing store count and our payroll efficiencies rolling out in other brands will greatly improve our payroll leverage in Crazy 8. We’re confident in our ability to execute these improvements and plan to open approximately 25 stores next year bringing the total store count to 65 by the end of 09.

Other long term initiatives include elevating the customer experience at Gymboree Retail and Play and Music. After spending a lot of time with our customers and listening to the things they love about our stores and the things they would like to see improved, we are launching a new store design. The focus is on increasing stroller space, elevating the look and feel of the store and offering dressing rooms where possible. Some of our stores will be completely remodeled while others will receive a facelift or light version of the remodel. It is imperative that we offer a shopping experience that is consistent with the quality of our products. In terms of a roll out this year we will do four full remodels. The remodels will be in Stonestown San Francisco, South Shore Plaza in Boston, Burlington Mall in Boston and Cherry Hill in South New Jersey. We will also do one light remodel in Hillsdale Mall in San Mateo, California. Please note that the cost of these remodels will not have a material impact on earnings or our capital plans in the current fiscal year. We will monitor customer reactions and prepare for a potentially more significant roll out in 2009.

Now with regards to Play and Music, as you know Play and Music is the leader in early childhood development. We operate almost 600 sites in 30 countries around the world. Over the last year we have focused on acquiring new customers for Play and Music and enhancing their experience through concise communications, incentives at retail and tangible benefits for being a part of the Gymboree family. During the second quarter we launched a redesign of our Play and Music website. Since its launch last month we have seen a significant increase in traffic and enrollments and we are very pleased with the results in customer feedback. Launching this new website is one piece of a larger strategy that will not only enhance the customer experience but also us to increase our overall customer base across all brands.

While we confident the strategies outline above will drive meaningful and sustainable earnings growth for the long term, I want to speak briefly to our short term outlook. Looking specifically at Q3 comp and earnings guidance, last year we were more promotional resulting in higher comps. We also recognize the macro environment has not improved. In light of this we feel it prudent to forecast a conservative comp and allow ourselves to focus on maximizing our profitability. Our approach for the last three years has been to focus on a broad range of strategies that drive earnings growth and to be prepared. Our strategies have been outlined in this call and past calls. Being prepared for the difficult economy is a constant focus. We run extremely tight expense control yet we are investing in the things that matter most like customer experience and the customer acquisition.

In summary we are continuing our focus on long term growth while managing through the current challenging retail landscape. With a multi-brand strategy focused on reaching every mom in America significant store growth in current proven concepts and major market share opportunities, we’re on track for solid growth for the next several years. We look forward to sharing our progress with you in the future and now we’re happy to answer any questions you have.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question comes from Betty Chen – Wedbush Morgan.

Betty Chen – Wedbush Morgan

Is it fair to assume then in terms of looking at your Q3 outlook that your turning to like you said, Matt, focus more on margins and earnings or should be view your comp store sales commentary and your reflection of the early August business? Then I have a follow up if I could.

Matthew K. McCauley

It’s exactly what we said, we really want to make sure that we’re not putting ourselves in a position where we’re forcing to try to hit certain comp numbers and we really want to focus on managing the bottom line consistent with what we’ve been doing over the last three years and we feel like that guidance allows us to focus on what’s most important.

Betty Chen – Wedbush Morgan

Looking forward in terms of Blair’s remark about the factory in Indonesia, when we think about the fourth quarter I think you said it’s going to be roughly $0.02 to $0.04 impact to the fourth quarter, Blair?

Blair W. Lambert

Correct.

Betty Chen – Wedbush Morgan

Lastly for Kip, could you talk a little bit about the growth category? It seems like the business in that category has been a little more erratic. Obvious the Boy has done very well. Is there anything on a macro level that’s going on or do you think really just on a merchandising level that you want to continue to focus on the design?

Kip M.Garcia

I think a little bit of both. We actually had a really good summer in Girl and what happened to us is we had a rough transition going into back-to-school so our early transition line which was the Paris line which is very traditional and it was based in navy which we normally do really well with and then our really traditional Apple line which also was based in navy and very traditional which we normally do well with, honestly I think the customer is really waiting. Because as we’re seeing our Apple line, it’s actually picking up as we’re getting closer into August towards back-to-school. When that Kitty line and it was fashion forward and great colors and new and different, the customers responded immediately. So that’s where I think the design and merchandising elements come into play because we know that when we have a great line and it hits, the customer responds immediately.

Betty Chen – Wedbush Morgan

One last question, it currently sounds like inventory levels are pretty clean coming out of the second quarter down a couple percent per square foot, could you remind us what is your plan for the third quarter and the back half?

Matthew K. McCauley

We plan on ending the quarter up slightly so it could be in the low single digits is what we’re expecting but keep in mind that’s kind of a snapshot in time, but that’s our expectation right now.

Betty Chen – Wedbush Morgan

I guess I’m curious, it seems like that might be slightly above the current outlook for sales? Is that in anticipation for the holiday?

Matthew K. McCauley

Obviously we’re investing in holiday. If you go back even a couple of years ago, we said that the two biggest areas that we wanted to buy into in and invest was back-to-school and holiday, those were two areas that we felt we hadn’t really maximized in our seasonality and last year we bought up quite aggressively for back-to-school and not quite as aggressively going into the fourth quarter. This year it’s offset a little bit, we’re down slightly coming into third and up a little bit more in the fourth. It’s really part of our bigger strategy of going after these two times of year that we felt like we were under potentialized in our seasonality.

Operator

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

Dana Telsey – Telsey Advisory Group

As you think about the outlook for the back half of the year, you’ve always had those mission impossible, the defense and the offense, what are you changing that may have been different than at the beginning of the year and as you plan for 2009, both on the product side and the growth side, how are you evaluating your investment opportunities?

Matthew K. McCauley

That really speaks to our philosophy of dividing the teams into offense and defense and some of the changes that we’ve made going forward obviously to be honest it doesn’t feel that much different for us. We’ve been operating under the assumption that we’ve been under a recession for the last three years. Our approach of being prepared has always been to not get aggressive and get ahead of our sales on the sales plans and budget accordingly, so the changes that we’ve made in terms of customer acquisition on the offense side, I’ll speak to that a little bit, we’ve reallocated some of our dollars where we pushed really, really hard on direct mail. We’re seeing great returns more in magazines and reallocating dollars a little bit from direct mail and a little bit more to magazines. Promotional and events, promotions that we’re running, one of our strategies is sometimes we’ll run them a little bit longer but not in marks quite as deep and we’re able to drive a lot more traffic with the event and noise in the front of the store and with the windows without actually having to take as deep a margin hit. Those are a couple of things that we’re doing around driving more traffic and more customers in on the offense side and that seems to be really paying off.

On the defense side, really it’s moving forward on strategies that we had already put in place and rolling out really around the store efficiencies, making sure that we’re really cutting down on the time that it takes for us to do tasks, spend more time with the customer and make sure that we manage our average hourly rates appropriately so we can leverage payroll more efficiently than we have in the past. Hopefully that answers your questions.

Operator

Your next question comes from Margaret Whitfield – Stern Agee.

Margaret Whitfield – Stern Agee

I wondered if it would be fair to conclude that your strategy for being less promotional in Q3 than you were a year ago would also apply to the fourth quarter so that we perhaps should not assume positive low singles in that quarter as well?

Matthew K. McCauley

We’ll talk about fourth quarter when we get a little bit closer to it, but let me just make sure I’m clear when I’m talking about being less promotional we’re talking about trying to market deep. We may actually run events longer, we may create more noise in the windows to drive more traffic, we may as I said run the events longer but the intent is not to market deep so that we make a little bit more money on each sale and run higher margins. I just want to make sure we’re clear on that. It’s pretty consistent with what we did in the second quarter so we’ve already been doing that for the last three months.

Margaret Whitfield – Stern Agee

Will there be any lingering affect of this fire in early fiscal 09?

Matthew K. McCauley

At this point it doesn’t look like it should be significant. Obviously whatever we carry over that we brought into the fourth quarter it’ll impact, but we’re anticipating that it should be much less material there.

Margaret Whitfield – Stern Agee

Over to Crazy 8, I think you said you’d lose $0.10 this year, was that correct?

Matthew K. McCauley

That’s right.

Margaret Whitfield – Stern Agee

Any thoughts on what the loss might be next year? I assume it won’t be profitable yet for another two years or so.

Matthew K. McCauley

We’ll talk a little bit more about that when we put 09 guidance out there, but certainly making a lot of changes around the operational efficiencies there.

Margaret Whitfield – Stern Agee

You said you had increased the transactions in Q2, could you give us that number? And declines in AUR and UPGs, could you give us the metrics?

Matthew K. McCauley

We don’t really break it out on the specifics, but I think what it really speaks to us for us is we’re happy with the strategies that we’re driving around getting new customers and more customers in the stores. The fact that the average unit retailer and the average trend is down a little bit speaks to the customer spending less from everything that we can gather. Fortunately the strategies are working, we’re driving more customers and more transactions and at a time that seems to be in some pretty significant headwinds.

Margaret Whitfield – Stern Agee

I guess the mall traffic trends in early August have gotten worse from July, any comment on the current environment? You seem to be bucking the trends quite well but the trends are getting worse.

Matthew K. McCauley

The trends are tough and they continue to be tough. Fortunately we’ve seen an increase in our number of transactions across all brands and we’re feeling it as I said earlier. I think where we’re feeling it most is the fact that people are spending less and our strategies have really been about customer acquisition and those are paying off and I think that’s offsetting some of the things that are happening in the mall traffic. We’re just gaining a little bit more market share. The challenge is just getting them to spend more.

Operator

Your next question comes from Brian Tunick – J.P. Morgan.

Brian Tunick – J.P. Morgan

Further color I was looking for maybe on the customer acquisition/marketing side, maybe talk about either dollars or percentage of sales, maybe what you guys are doing there for the back half and then also I guess on the real estate side you haven’t really given us the 09 real estate except for Crazy 8 and with these new bankruptcy and store closing announcements every day, would you consider accelerating maybe your plans?

Matthew K. McCauley

Around the marketing strategies, our promotions are going to be pretty similar to what we did last year. As I mentioned earlier we may run them a little bit longer, we may be a little louder about the events particularly in the malls, in the windows, to drive more traffic. Pretty much what we did in the second quarter so that’ll be pretty consistent. And then the only other changes you’ll see a shift a little bit less on the direct mail, a little bit more in the magazine because we’re seeing really nice returns there, reaching a broad group of customers and it’s less per customer and getting great results there. So those are the changes that you’ll see. We haven’t broken out our real estate for 09, felt like it was important to give a little color around Crazy 8 since there are a lot of questions around that. As we get closer to 09 we’ll share the numbers on each of the other brands.

Jeffrey P. Harris

I think it’s important though, Brian, that we did leverage in Q2 on marketing and anticipate that that will continue.

Brian Tunick – J.P. Morgan

Is the thinking still that a Crazy 8 can be break even next year?

Jeffrey P. Harris

We actually haven’t put a number out there. We said that it took us a little over three years in Janie and Jack to break even, we’re hoping to be ahead of that. When we get closer to 09 we’ll put a number out there.

Operator

Your next question comes from John Zolidis – Buckingham Research.

Jody Yen – Buckingham Research

This is Jody Yen on behalf of John Zolidis. Question for you, how much longer can you keep up the same growth margin performance with slightly negative comps going forward?

Matthew K. McCauley

Looking at our guidance as I talked about for the long term plans, we see opportunities to expand our margins in a couple of ways around our operating margins improvement really around operational efficiencies in stores in addition to cost of goods reductions. What we’ve spoken to so far is the impact of cost of goods reductions for Gymboree all the way through 2009 and then throughout the next several years in the other brands as we increase store base. Our expectation is that we’re never done, we’re always looking to improve our margins and at this point we’ve said that we expect them to continue to grow throughout this year and next year.

Jody Yen – Buckingham Research

You think you can do that even with a slightly negative comp?

Matthew K. McCauley

Yes, actually we’re forecasting that in the third quarter and feel very, very good about that and at this point we feel like the negative comps aren’t going to dramatically change that strategy. At this point we’re guiding flat to slightly negative.

Operator

Your next question comes from Linda Tsai – MKM Partners.

Linda Tsai – MKM Partners

Is there any way to quantify the benefit of the new payroll systems in the quarter and what it might look like going forward?

Matthew K. McCauley

There is and we’ve done it, we’re just not sharing it quite yet. We feel good about it, and feel like it’s material enough to help us feel really good about this year and next year. It’s also kind of a work in process. We’re rolling it out, we’ve been tweaking it, fine tuning it and there is still lots of opportunities to improve it. What I did say is that we saw slight leverage in the first half, so it should be more significant going forward.

Linda Tsai – MKM Partners

Is it in all your stores already?

Matthew K. McCauley

It’s not actually, it’s really in Gymboree right now and the opportunities to roll it out into the other brands, a lot to look forward to and as I said before what we’ve seen is an improvement in the hours at this stage. What we need to do now is manage our average hourly rate so that we see the real savings flow through.

Linda Tsai – MKM Partners

What led to your decision to remodel some of the Gymboree stores? Is this due to customer feedback or are you trying to position the brand differently in the marketplace?

Matthew K. McCauley

Actually what really led to it is we feel like our stores really need to be consistent with the quality of the product that we offer. If you talk to our customers they’ll tell you that we’ve got the cutest clothes in the mall and it’s the best quality and our stores don’t always reflect that. So over time we want to be able to elevate the experience of the store, make it consistent with the quality of the product. We feel like that’s the right direction and we have a lot of stores to remodel over time and feel like we need to make sure that we’ve got our best foot forward.

Linda Tsai – MKM Partners

Does this also include expanding the square footage?

Matthew K. McCauley

No, we’re looking for ways to improve our productivity through fixture optimization, things that work a little bit harder, create more space on the floor and just make sure that we’re using the space as efficiently as possible.

Operator

Your next question comes from John Morris – Wachovia Securities.

John Morris – Wachovia Securities

Two separate questions, first of all the gross margin increase that you were able to achieve on the quarter, you briefly talked about some of the components. Can you give us a little bit more color on the components contribution to the year-over-year increase in basis points?

Matthew K. McCauley

Just a couple things, Blair can break out how they were all weighted, but coming from buying occupancy and product costs, obviously we reduced our cost of goods and we talked a little bit around our promotional strategies where we didn’t have to go as deep as we anticipated and flowed through more of that initial mark up all the way through, but obviously we had some leverage in buying and a little bit offset by occupancy.

Blair W. Lambert

The key items are really product cost reduction is really the driver of the savings. The buying cost leverage was really offset by the negative leverage in occupancy that we’ve been talking about. It really came from product cost reductions, that was the key for driving the gross margin.

John Morris – Wachovia Securities

On Crazy 8 with respect to the store openings and what you’ve learned in terms of geography or real estate store by store, I know you’ve had learnings in the past in terms of where some of these units operate, can you give us an update there? What kind of new insights have you had in terms of where you want to locate the stores go forward?

Matthew K. McCauley

Seeing a lot of strength where we already have Gymboree stores so we’re happy to see that. Seeing that you can make some money in some of those less expensive locations that are not in the malls, we’re happy to see that. At this point really learning that 2,000 square feet versus 2,500 square feet, we’ve got some 2,000 square foot stores that are equally as productive if not more and we’re excited about that. Size of store can come down a little bit and in terms of location, it’s really all about finding great locations with great traffic, that’s important but we’ve also seen that we can make some of these off-mall locations very, very productive as well, not as much pressure on the sales because the expenses are so much less.

John Morris – Wachovia Securities

Are most of the openings that you’re looking at for 09 in those locations near Gymboree stores?

Matthew K. McCauley

It’s going to be a mix but you’ll see a pretty large percentage of them in malls where Gymboree already exists pretty much because those are great malls.

Operator

Your next question comes from Lorraine Maikis – Merrill Lynch.

Lorraine Maikis – Merrill Lynch

This is Rick Bethel calling in for Lorraine. In terms of your future cost savings opportunities you highlight a couple different areas where you can save, but can you just give us some more color which area you think has the biggest potential for future savings?

Matthew K. McCauley

It’s really both around the cost of goods is certainly big and certainly store payroll is huge. One of your largest investments is store payroll in retail so if you can leverage that a little bit more, those are big dollars. The color is that we’ve got both of them ahead of us and obviously in the cost of goods reductions you’re going to see more modest reductions in Gymboree but we’ve still got three other concepts that have store growth that’s going to be able to get IMUs up, cost of goods down at the same time that the stores are growing. We also have opportunities to leverage corporate payroll as well.

Jeffrey P. Harris

Let me just throw out a couple other quick areas, one we just finished the roll out of the new POS system, it’s now in all stores. As a result we’re seeing some reductions in our repair and maintenance costs. We’ve also at the same time have been changing the way we communicate with the store, we’ve got a significant reduction in communications cost back and forth to the stores and one of our mission impossibles this year was to get our professional fees down and we have seen a terrific reduction in professional fees throughout the organization and we think those will continue as we go into the second half of this year.

Lorraine Maikis – Merrill Lynch

Is it possible to update us on a margin goal that you may be working towards?

Matthew K. McCauley

We’ll do that when we get a little closer to 09 but definitely going up.

Lorraine Maikis – Merrill Lynch

Just separately, I know you’ve purchased most of your product through this year, but as you look to 2009 orders are you seeing any type of inflationary pressures coming out of your vendors?

Matthew K. McCauley

We’re experiencing the same pressures that everybody has. We talked about at the last couple of calls where you’ve got pressure on cost of labor going up, fuel charges going up. Fortunately we’re offsetting that in a couple of ways. We’re sourcing in new countries that are new to us that may not be new to a lot of other retailers out there and we’re still growing in those countries, that’s offsetting some of the increases in cost of labor that you see more in China and at the same time, we’re seeing an opportunity for us to see the IMUs go up with growing store counts. We’re in a good position where we’re actually opening stores. A lot of factories are excited to work with us because they see growth rather than retraction.

Operator

Your next question comes from Thomas Filandro – Susquehanna Financial Group, LLLP.

Thomas Filandro – Susquehanna Financial Group, LLLP

Quickly on this fire, what percent of the buy are we talking about and I wasn’t really certain I understood what flow are we talking about in relation to the fire?

Matthew K. McCauley

We’ve got a couple of deliveries that were impacted primarily knits really impacting in November, some early part of December and it’s mostly the knits and some wovens because we actually had some of our fabric that was being stored there to be cut. The good news is we’re going to get the product here, it’ll be here on time. It’s less than 10% but it’s very expensive to air goods.

Thomas Filandro – Susquehanna Financial Group, LLLP

I have a question on Crazy 8 and I’m not really sure exactly how to ask it so I’ll try my best here, as you build this brand out, I know when you use the bag stuffers through the Play and Music you’re clearly sending a message that you have this family of brands, but are you at all utilizing Gymboree as the anchor to launch the brand in any kind of marketing meaning whether you’re doing bag stuffers in stores, in the same mall? Are you trying to distinctly have two separate brands?

Matthew K. McCauley

Actually we’re leveraging it more. When we launched Janie and Jack we were very separate. But what we know about our Gymboree customer is that they shop pretty much everybody that’s in the mall and we want them to continue shopping Gymboree for the reasons that they do but because they’re also shopping other places that are in the mall that are at a price, we want to be able to take away every reason to shop the competition at a price and shop us. To answer your question directly yes we have done direct mails when we launched the store that tell them that it’s Gymboree’s newest concept. We have gone to the Gymboree email list when we launched to those zip codes to tell them that we’re opening there and it’s proving to be very, very successful for us to do that, to link the two together and we’re no seeing cannibalization beyond what we had forecasted so that’s the most important thing for us. Last year we did for example Santa lines and handed out coupons to anybody who got their photo with Santa. You’ll see that family of brands approach there as well. We feel great about communicating that it is Gymboree’s concept.

Thomas Filandro – Susquehanna Financial Group, LLLP

I think you mentioned lower UPTs and maybe this just, Matt, ties into what you said, that it’s just tougher to get customers to shop, they’re much more price conscious today and just shopping less. Is there any reason why UPTs are down that you can point to or is this is a trend or what can you tell us on UPTs?

Matthew K. McCauley

No, our assessment is that we’re feeling the same pressures that most retailers are, that it’s harder to get people to spend. Fortunately we’re offsetting that by getting more people to spend. Those are the things that we feel like we can control a little bit more within the store. We’re doing everything we can to drive those UPTs, give great customer experience and certainly trying to deliver the best product. At this point we know that we’re up against a little bit of a headwind and we’re choosing to focus most of our energies and efforts on driving more customers in the doors and trying to offset the fact that the customer is probably just going to spend a little less at this time.

Thomas Filandro – Susquehanna Financial Group, LLLP

On the AUR front, just so I’m clear about this, in the second quarter can you tell us what drove the lower AUR? Was it a function of mix? Because I think at the end you also said on the markdown side you achieved better than a beginning of quarter plan for AUR and I thought you said AUR is expected to increase in the third quarter assuming that’s a function of the promotional teams last year. Final AUR question is can you give us a sense of what AUR looks like excluding the Outlet on a year-over-year basis?

Matthew K. McCauley

You saw a combination of things in the second quarter of Outlet growing in addition to the mix of rag and markdown and going forward our goal is to continue to increase the average unit retail and at this point it’s very, very hard to predict which way we’re going to have to go. We’re very reactive and responsive to the customer and certainly have a lot of strategies put in place to be prepared for whichever way that the customer goes and feel like we’ve got enough inventory to support whichever direction they go. But at this point our goal is regardless of Outlet, with Outlet, our averaging at retails would go up, that’s our goal.

Thomas Filandro – Susquehanna Financial Group, LLLP

Question on the tax rate, what should we be thinking about for the back half tax rate and 09 maybe?

Jeffrey P. Harris

40% to 41% is the target.

Operator

Your next question comes from Adrienne Tennant – Friedman, Billings, Ramsey.

Adrienne Tennant – Friedman, Billings, Ramsey

My question is, can you help us out on a relative four wall between the Outlets, core and Janie and Jack? And then when Crazy 8 is at maturity, where will Crazy 8 play into that, the relative four wall?

Matthew K. McCauley

We don’t break them out as specifically, but I’ll give you the breakdown. Outlets is the number one four wall contributor. Obviously great sales there and a little bit less to do business and real estate occupancy and labor, you can leverage little bit more. Gymboree is actually close behind and Janie and Jack a few more points away but climbing and we’ll see that increase as the IMUs go up, as our average cost of goods go down. Where we expect Crazy 8 to be, we’re still assessing where than can land but we have very aggressive goals and high expectations. I think a lot of people thought that it would be impossible to hit the type of four walls we’re seeing in Gymboree today. We aren’t really putting a ceiling on it, but at this point we feel like we’ve got a pretty solid strategy across all fronts on the concept that’ll get it in the mix in terms of our walls.

Adrienne Tennant – Friedman, Billings, Ramsey

So over time, it could actually get toward where Gymboree is running?

Matthew K. McCauley

It’s hard to say that at this stage. One of the advantages you have with Gymboree as well, you’ve got a lot of those stores that have been around for a long time, occupancy is a little easier to leverage. We’ll see, but our goal is to definitely have it in the mix. We don’t want it to drag down our operating margins, that’s not the goal. For us to be able to open as many stores as Gymboree ultimately, we need to have those four walls up there.

Adrienne Tennant – Friedman, Billings, Ramsey

What are you seeing with regard to rent trends? Are you seeing, to the extent that there is more openings.

Matthew K. McCauley

On balance in the better malls, the better malls are always in demand. Occasionally we’re seeing a spot come available where we wanted to get into one of those malls that we may have been unable to get into before. On some of the newer malls we’re starting to see the development start to slow down a little bit there. I think the developers are pulling back a little but on some locations. They may not be getting their openings as rapidly as they had hoped to. They’re delaying some projects in some cases and in those cases, we’re getting some rent benefits if we’re in the mall and it’s not completely filled so we go to an alternate rent during that time. On the high end, not a lot of change. On the low end, probably some opportunities when we’re doing renewals to see whether we can get some benefits there in the renewal process. A lot of the malls, they’re owned by the same people so they tend to try to leverage us, the lower volume store against a higher volume store and so it gets to be a little bit of a challenging environment. I think the biggest opportunity though is in managing where fill rates in the different malls are not up to that 85% rate and we can get some rent breaks, make sure we go through those. Now just to work with the landlords to make sure that we’re taking advantage of the opportunities that are opening up for space to be able to get into some of the malls with newer concepts.

Adrienne Tennant – Friedman, Billings, Ramsey

For Crazy 8 what types of malls have you found that are working best? I know Ted did a couple different things.

Matthew K. McCauley

What we’re seeing is that in terms of revenues obviously the higher traffic malls are very strong for us. Where we’ve got a Gymboree already we’re seeing that those stores are actually performing a little bit better and fortunately we’re not seeing cannibalization beyond what we anticipated but we’re also finding that we can make nice profits on some of those off-mall locations that cost a little bit less to do business there. Sales aren’t quite as high but the pressure is not there because the expenses are lower. We’re finding success in a lot of different areas.

Adrienne Tennant – Friedman, Billings, Ramsey

Birth rates are on the rise and are expected to do so probably over the next 10 years or so, and I know you had the initiative where you’re actually trying to capture the mother at birth pretty much. What else can you do to capture some of that secular of trend in demographics?

Matthew K. McCauley

One of the biggest opportunities is really around Play and Music. We’ve got a very large percentage of kids that are born in America going through Play and Music and we actually have about 70% of those moms are brand new moms. Just by going to our own backyard and integrating the message and the benefits of being part of Play and Music in the Gymboree family is migrating a larger percentage of new customers to us than we had done in the past. What we’re also doing is placing some of our emphasis in marketing around maternity magazines. We’ve supported that with product, with a new emphasis on brand new with our product. So is the marketing is really behind it, driving new customers in to increase the pipeline and really going after customers that we already have in our own backyard with Play and Music.

Adrienne Tennant – Friedman, Billings, Ramsey

My final question is the holiday calendar, I guess one less weekend and five fewer days between Black Friday and Christmas, but it seems as though there’s a big fifth week component to holiday sales these days. How are you thinking about that and trying to entice her to shop earlier and not wait as we’ve seen in the past few years?

Matthew K. McCauley

I think that what you’re going to see happening with everybody is everyone is going to more aggressive a lot earlier. No one is going to wait, everyone is going to try to get the sales in earlier. Our expectation is we’re going to have to compete quickly and be aggressive. We’re not going to wait either. But what we’re trying to do is make sure that we manage our margin and our profit by making sure we drive traffic and not necessarily have to go as deep on our prices but maybe we’ll run events a little longer to drive the traffic.

Operator

Your next question comes from Janet Kloppenburg - JJK Research.

Janet Kloppenburg - JJK Research

I just wanted to ask Matt a couple questions about his outlook for margins going forward. I think you expect them to continue to rise, Matt, but it sounds like maybe the gross margin improvements while still available to you may not be as substantial as they have been in the past. Should we start to look for some SG&A leverage as Crazy 8 starts to leverage or how do you want us to think about that?

Matthew K. McCauley

Basically what we said is that the margins will continue to grow and really operational margin and come from two places. One is from the reduction in cost of goods and that’s the one we said is not going to grow at the same rate that you’ve seen in the past but it’s still growth. What offsets that as well or adds to it is the fact that see some pretty significant opportunities to improve our payroll efficiencies and that’ll make a meaningful impact to our margins.

Janet Kloppenburg - JJK Research

Should we expect the rates to continue to be about the same level or how should we think about it going forward?

Matthew K. McCauley

Our goal is to grow it, that’s the expectation and hard to comment on what the expectation is at this point but when we get into 2009 we’ll put a number out there in terms of our guidance for the future. We’re expecting to grow it, that’s the plan.

Jeffrey P. Harris

Janet, from an operating standpoint, if you’re talking operating margin, we’re certainly looking to leverage the corporate structure pretty significantly. We use that shared services approach, the same people manage every piece of product that goes through the distribution center so we become more and more efficient with that structure. We get to leverage that. Everybody in the corporate office that’s in any of those shared service functions, whether they’re real estate, construction, accounting, finance, the whole systems group, throughout the organization we’re really using all of those same systems in each one of the brands so as we add volume, volume is our friend. We love getting that volume and can leverage some of those expenses over a larger sales base.

Matthew K. McCauley

There’s really few areas where you need a separate team.

Janet Kloppenburg - JJK Research

Should we expect in the third quarter given this comp guidance that the stores will be less promotional than last year at this time? I know last year that gross margin slipped a bit, didn’t it?

Matthew K. McCauley

Actually our margin dollars were up significantly, our average unit retail was down. So what we’re really trying to accomplish here is not have to be as deep but we’ll probably run events a little bit longer. That’s our goal, we don’t want to be so aggressive that we’re giving away so many margin dollars to hit a comp number. We really want to try to make sure that we drive as much traffic as we can with the events and not go as deep as we did last year.

Janet Kloppenburg - JJK Research

On this Indonesia fire, I know we’ve talked about it at length here, but you are able to duplicate the product that you wanted to have manufactured and there won’t be any flow disruption?

Matthew K. McCauley

That’s right, we’ll get the products here in time. A large percentage is being done with the same factory owner in other factories that he owns. The balance is going to be reproduced in other factories that we have done business with for years and years and probably already have some of our existing product for the same time period. We’re getting it there on time by flying it, we’re airing it and that’s the impact to our margin there.

Janet Kloppenburg - JJK Research

So you don’t see any interruptions, business interruptions or flow problems relating to this?

Matthew K. McCauley

That’s right and it’s still less than 10% of the goods, it’s just very expensive to get the goods here.

Janet Kloppenburg - JJK Research

Lastly, on the Crazy 8 Girls business, I know you talked about how you’re going to fix the product and improve the assortments, make them sweeter, etc. How long will that take?

Matthew K. McCauley

We’ve been working on it for the last few months as we started to get a read on it and you’ll start to see that happen in the middle of 2009. You’ll start to see improvements flowing through in spring but feeling much, much better about the Girl product really towards the middle of next year.

Janet Kloppenburg - JJK Research

So it’ll be a few months before we see that change?

Matthew K. McCauley

It will. You’ll start to see it in spring but not to the degree that we really want to see it until the middle of next year.

Janet Kloppenburg - JJK Research

But you think you understand the problems and how to fix them?

Matthew K. McCauley

We all feel pretty confident. It’s a hard question to answer, but we all feel pretty confident that we know who the customer is and we know what resonates with this customer and we’re making those changes accordingly. Fortunately we’re seeing the sales where we expected and there’s a lot of other things that we can improve on along the way that it should just progressively get better and better. Over time we’ll see it continue to increase profitability.

Jeffrey P. Harris

Christie, we’ve got time for one more question.

Operator

Your final question comes from Steve Kernkraut – Berman Capital.

Steve Kernkraut – Berman Capital

I’m just a little confused. In terms of the profitability of Crazy 8 on a four wall basis, do you see at maturity it’s going to be comparable to the Gymboree stores or is it just when you take the marginal analysis when you say you’re leveraging all the fixed costs and the shared services it adds to the overall profitability of the enterprise?

Matthew K. McCauley

It’s hard to say at this point it’s so early in its life but we have very high expectations and we expect it to be in the mix, don’t know exactly if it’ll be as high or higher or slightly lower than Gymboree at this stage. But or expectations are very high from what it needs to do because if we’re going to open close to Gymboree number of store count, we need that four wall to be up in the range of where we are with our other concepts.

Jeffrey P. Harris

I want to thank everyone for participating on our call. If you have any further questions you can certainly call us at our Investor Relations hotline, 415-278-7933. Thank you very much.

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Source: The Gymboree Corporation F2Q08 (Qtr End 08/02/08) Earnings Call Transcript
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