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Executives

Jane Thorne-Lison - Integrated Corporate Relations

Millard S. Drexler - Chairman of the Board, Chief Executive Officer

James Scully - Chief Financial Officer, Executive Vice President

Analysts

Paul Lejuez - Credit Suisse

Jeff Black - Lehman Brothers

John Morris - Wachovia

Brian Tunick - J.P. Morgan

Kimberly Greenberger - Citigroup

Michelle Tan - Goldman Sachs

Dana Cohen - Banc of America Securities

Richard Jaffe - Stifel Nicolaus

Barbara Wyckoff - Buckingham Research

Samantha Panella - Raymond James

J. Crew Group, Inc. (JCG) F2Q08 Earnings Call August 26, 2008 4:30 PM ET

Operator

Greetings, ladies and gentlemen, and welcome to the J. Crew Incorporated second quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Ms. [Jane Thorne-Lison] of Integrated Corporate Relations. Thank you. You may begin.

Jane Thorne-Lison

Thank you and good afternoon. Before we get started, I would like to remind you of the company’s Safe Harbor language, which I’m sure you are all familiar with. The statements contained in this conference call which are not historical facts may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results might differ materially from those projected in such statements, due to a number of risks and uncertainties, all of which are described in the company’s filings with the SEC.

And now I would like to turn the call over to J. Crew's Chairman and CEO, Millard Drexler.

Millard S. Drexler

Hi, everyone. Good afternoon and thanks for joining us. Jim Scully, our CFO, is here, along with our other senior partners at the company. I’ll being with a review of our second quarter, then Jim will cover our financials in more detail and update our outlook for the balance of the year. We will then open the call up to your questions.

For the second quarter, revenues increased 10% to $336 million, with comp sales slightly negative to last year and direct sales increasing 12%. Operating income totaled $32 million, or 9.4% of revenues versus 12.2% last year. We continue to be confident in our strategies, our fundamentals, and the businesses we are in despite the uncertainty of the macro environment. We achieved double-digit sales growth in the second quarter despite the economic environment and the challenges related to our systems upgrades.

That said, we were disappointed by the impact that the transition to our new systems had on our business and also, of course, on our customers. We view this as a short-term and temporary issue and a completely necessary step to build for our long-term success and quite frankly, catch up from some under-investment in the past.

Before going further, I would like to discuss the investments we made in our website, call center, and distribution center. The upgrades we have launched provide us important capabilities to grow our direct business to new levels, as well as give us much needed additional capacity. The way we see it, our online business will continue to get bigger as our customers are shopping this format more often and the world as we know it continues to change.

The growth we have experienced over the last five years, combined with the growth we see in the future, required us to make these investments. This was absolutely not an optional issue. It was mandatory that we do it. Additionally, these upgrades provide the ability to operate separate websites for new concepts such as Made Well and Crew Cuts. This was not possible under our old system.

We’ve also added new functionality, such as enhanced search, to allow customers to more quickly and easily locate items and image zoom that provides up close views of our products.

Having said all this, we did and still are encountering some challenges, more than expected, that are impacting our ability to capture, process, ship, and service customer orders. It is also taking longer than originally planned and as a result, the costs are higher than expected.

In hindsight, we should have been more conservative in our plans regarding the length and extent of the disruption caused by these upgrades. Jim will elaborate on the financial implications of these challenges in his remarks in a moment.

We are looking forward to the benefits of the new systems provide and we are confident the challenges I mentioned are temporary and will not impact the strength of our business fundamentals, the appeal of the merchandise, or obsessive focus on satisfying all of our customers.

Turning to the highlights for the second quarter, our direct business, which includes our catalog and online, achieved a 12% sales increase in the second quarter on top of a 19% increase last year despite the issues with our direct systems upgrade.

Our customers have responded very well to the enormous improvements we have made in the washes, details, fabrications, and frankly the overall styling, design, and uniqueness of our online and catalog assortments. The direct customers are responding well to the quality and style in our key catalog categories and emerging categories, such as wedding, newly launched suiting, and our accessories collection, shoes, jewelry, and handbags.

Our store expansion remained on track and we are pleased with our new store performance. During the quarter, we opened nine new stores, four retail, three factory, and two made well. We plan to open a total of 42 stores in 2008.

We increased our store productivity with sales per square foot increasing 4% to $574 a square foot from $550 last year, while our square footage has increased 11% over the last 12 months.

From a merchandise standpoint, we continue to seek out new and exciting opportunities across all of J. Crew Group. We just opened our first men’s only store in Tribeca and I think you ought to run, not walk, to go and see it. The exciting thing here is that with the opening of this store, which by the way has been very well-received, we have the opportunity to reposition, reinvent our men’s business and do something that we don’t see being done by other retailers in our industry -- that is men’s.

We also continue to grow our collection business and are excited to open our first dedicated collection store on Madison and 79th in the third quarter. This is all part of our strategy to communicate to our customers what we have been doing the last several years, raising the bar on the quality of our mills, our design, and our fabrications. And of course our customers continue to come to us for our franchise businesses, our day-in and day-out businesses which include our handmade jewelry, ballet flats, our famous cashmere sweaters, and a very strongly growing pant business.

We are realizing the investments made in our Crew Cuts business. By the way, our Crew Cuts customers are loving the product, quality, and detail, as well as our service. We are also excited about our recent introduction of the concept of Crew Cuts in our factory division.

We launched Crew Cuts in nine factory stores in July and our customers are responding well, especially to our t-shirts, cardigans, and cords. We also launched our first standalone factory Crew Cuts store in Destin, Florida on August 12th, which is performing ahead of our expectations.

We are also very pleased with our Made Well business, which is really gaining momentum nicely. Our customers love the attitude, the fit, the detail, and the overall vibe and it’s been very exciting.

As I mentioned, we opened two Made Well stores in the second quarter in Annapolis and Lennox Square in Atlanta, both of which are doing real well. We also just opened Tyson’s Corner this quarter on August 5th, bringing the total store count to 10.

Regarding madewell.com, we’ve decided as a result of the challenges related to our direct systems upgrade, we will delay the launch of the e-commerce website to early next year. While this may sound disappointing, the good news for us is that there’s a need for the merchandise that we allocated to the website, there’s a need for that in our stores so frankly it’s a bit of a silver lining.

Our revised annual outlook, which Jim will review in more detail, incorporates our first half performance and commensurate expectations for the balance of the year. While we are comfortable with our plans for the year, we expect the macro environment will continue to be a major challenge for the near-term.

With that, I’ll turn the call over to Jim who will review our second quarter results and outlook in more detail.

James Scully

Thanks, Mickey. While we are clearly disappointed with the impact that our direct systems upgrades had on our customers and our business, we view this disruption as short-term in nature and remain pleased and confident with the fundamentals of our business model.

Having said this, the direct system upgrades did impact our second quarter results more than we had anticipated and will also impact our third quarter and fiscal year results, which I will discuss more later.

With respect to the second quarter, the trend in our direct business prior to the upgrades was very consistent with the trends we had been experiencing in our direct business over the last several quarters. However, following the conversion, we experienced a significant decline to the previous direct sales trend.

We are comfortable that we would have met or exceeded our previous expectations if it had not been for the disruption caused by the direct system upgrades. In addition, based on the recent trend in the direct business and our ability to service our customers, we are beginning to return to more normalized levels.

Before we get into the financial details, we thought it would be important to provide a brief overview of what happened, what the current status is, and when we expect resolution.

As we have previously discussed, we have been planning and are in various stages of implementing three major technology initiatives -- the direct system upgrades, a new store warehouse management system, and a new allocation and distribution tool.

Since the recent disruption was related to the direct system upgrades, I will focus my comments on these initiatives.

In order to properly support our multi-channel, multi-brand strategy, we were required to make some significant investments in the direct business. These includes the following: a new platform for our website to allow for multiple brands, enhanced functionality, and increased growth capacity; a new order management system to improve the overall customer experience in our call center and drive future efficiencies; and a new direct warehouse management system to support our multi-branch strategy.

On the weekend of June 28th, after taking our website down for 24 hours, we cut over to the new systems. Over the next several weeks, we experienced issues related to the site performance, order fulfillment, and call center performance. We had worked diligently since the conversion to address these issues and have made significant progress.

Based upon our current assessment, we expect to have our direct systems and operations stabilized over the course of the third quarter.

As I mentioned, the conversion had an impact on our direct sales trend for the quarter, as well as our gross margin. The second quarter also included approximately $3 million of unanticipated costs related to the conversion. This amount does not attempt to quantify the lost sales and related gross margin impact experienced in the second quarter due to the disruption.

We expect an ongoing financial impact into the third quarter, which we will cover in our revised earnings guidance.

The system upgrades have also caused us to delay the launch of other infrastructure projects, including madewell.com, as Mickey mentioned.

Turning to the second quarter financials, total revenues increased 10% in the second quarter to $336 million. Our store sales, which include our retail, factory, Crew Cuts and Made Well stores, increased 10% to $242 million. This increase was driven by an 11% increase in net square footage growth, with comp stores being down slightly at a negative 0.4%.

Our direct business experienced a 12% increase to $83 million on top of a 19% increase last year. Internet sales represented 85% of our direct business versus 77% last year, reflecting the ongoing shift of orders to the Internet from the phone.

Gross profit dollars for the second quarter increased to $138 million from $133 million last year. However, gross profit margin declined 270 basis points to 41% and was driven by a 150-basis point decline in merchandise margin and a 120-basis point decline in buying and occupancy leverage. The merchandise margin deterioration resulted from un planned customer accommodations related to the direct system initiatives in the form of free and upgraded shipping, increased markdown activity as a result of our inability to transfer store markdowns to the direct channel, and increased freight expenses as a result of transferring inventory between stores combined with an overall increase in freight transportation costs.

SG&A expenses for the second quarter increased 11% to $106 million, or 31.6% of revenues versus 31.5% of revenues last year. The deleverage in SG&A expenses was a result of unanticipated costs related to the direct system upgrades. We continue to absorb incremental costs associated with our new stores and new concepts.

Operating income totaled $31.5 million, which compares to $37.1 million last year, with the operating margin deteriorating 280 basis points to 9.4%. Operating income was negatively impacted by $3 million in unanticipated costs related to the direct system upgrades. This does not include an estimate for the lost sales and related gross profit.

Net interest expense for the second quarter totaled $1 million, compared to net interest expense of $3 million in the second quarter of last year. The decline in interest expense primarily reflects our lower average outstanding debt balance.

Income before income taxes decreased 12% to $30 million compared to $34 million last year. Net income was $18 million, or $0.28 per diluted share compared to net income of $21 million, or $0.32 per diluted share in the second quarter last year.

Turning to the key balance sheet highlights, cash and cash equivalents were $113 million at the end of the second quarter and include the impact of income taxes paid of $61 million and voluntary principal payments of debt of $75 million during the last 12 months.

Inventories at the end of the second quarter were $198 million, reflecting the impact of 38 net new stores opened since the second quarter of fiscal 2007. The end-of-quarter inventories also included approximately $15 million in inventory above our anticipated end-of-quarter levels. This resulted from the issues related to the direct systems upgrade, as well as the softness in our store business. The gross margin impact associated with clearing this additional inventory will extend into the third quarter.

Capital expenditures for the second quarter were $19 million. Our full-year forecast for capital expenditures remains at approximately $80 million.

Turning to our outlook, our long-term goals remain comp store sales growth in the mid-single-digit range, direct sales growth in the high-single-digits, net square footage expansion in the 7% to 9% range, diluted EPS growth in excess of 20%. However, given our first half results, disruption to our direct business resulting from the direct system upgrades, as well as the continued softness in our store business due to the economic environment, we are revising our outlook for the second half of 2008 and the fiscal year.

We now expect diluted earnings per share for the fiscal year 2008 in the range of $1.44 to $1.54, as compared to our previous guidance range of $1.70 to $1.75, and fiscal 2007 diluted earnings per share of $1.52, which did include the impact of a severance charge of $0.02.

Our revised fiscal 2008 earnings guidance reflects: comp store sales approximately flat to slightly negative for the second half; direct sales growth in the high-single-digits; net square footage expansion of approximately 10% to 11%; operating margin deterioration of approximately 200 basis points, with gross margin deterioration of approximately 150 basis points and SG&A deterioration of approximately 50 basis points; SG&A includes approximately $6 million in costs associated with the direct system enhancement in the second half of the year; an effective tax rate of 39.8%, approximately 65 million diluted shares outstanding; capital expenditures of approximately $80 million; and approximately $13 million in losses associated with Made Well.

For the third quarter of fiscal 2008, we are introducing guidance for diluted earnings per share in the range of $0.28 to $0.33, which compares to $0.42 in the third quarter of fiscal 2007.

Our third quarter outlook reflects approximately flat to slightly negative comp store sales and direct sales growth in the high-single-digits. We expect approximately 300 basis points in gross margin deterioration and 150 basis points in SG&A deleverage to produce 450 basis points of operating margin deterioration to last year. The projected pressure on our gross margin is primarily related to the impact of clearing the inventory we are carrying into Q3. In addition, we will continue to experience pressure on [B&O] as a result of the softness in our store business. The pressure on our SG&A rate in the third quarter is primarily related to the costs associated with the system upgrade.

As I mentioned, we expected to have the direct systems and operations stabilized over the course of Q3. That said, we have assumed a continued modest impact in the fourth quarter in order to be conservative.

And now I’ll turn the call back to Mickey.

Millard S. Drexler

Thanks, Jim. As we move into the back half of the year, we will continue to remain focused on doing the best we can do for our customers, quality, style, design, and service. We are in this for the long-term. As I have said before, we do not sleep at night until every customer is satisfied, and now we’re ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Paul Lejuez from Credit Suisse.

Paul Lejuez - Credit Suisse

Thanks, guys. Jim, just one clarification -- when you say the direct business returned to more normal levels, did that mean in line with your guidance of up high singles or did that mean consistent with what you were seeing prior to the systems issues?

And then a question on the comps -- did you see any change? You provided some color on the monthly change on direct. Can you provide the same on the comps? Thanks.

James Scully

Paul, my reference in terms of beginning to return to more normalized levels was reflective of our guidance in the high-single-digits, and I think you know, as the quarterly issuer of comps, we don’t comment in intra-quarter in terms of as it relates to comp. But I would say that we do not see a material impact throughout the quarter by month.

Paul Lejuez - Credit Suisse

Okay, and then also, can you provide shipping costs, what they were this year versus last year? That’s kind of tied up in the gross margin line, just to help us understand magnitude?

James Scully

I can help you and say that, as I mentioned, that we had approximately $3 million of unanticipated costs in operating income. It was split about 50-50 between merchandise margins, as it relates to some of the shipping costs, and the other half was in SG&A, due to some expenses.

Paul Lejuez - Credit Suisse

Thanks.

Operator

Our next question comes from the line of John Morris, Wachovia. I’m sorry, we seem to have just lost Mr. Morris’ line. (Operator Instructions) Our next question comes from Jeff Black with Lehman Brothers.

Jeff Black - Lehman Brothers

Thanks. Could we just get a breakdown on the comp in terms of AUR and traffic? And Mickey, could you talk about two things? I mean, do we think we are pushing the envelope too much on price here and that we have reached limits in this environment? And secondly, do you think we’re back to having enough specialty to the products? I think you harped on that a lot on the 2Q call. Do you think we move into fall with some better product and when do we see it? Thanks.

Millard S. Drexler

Regarding AUR and traffic, there’s a very big headline in the world today of retail and that’s traffic. And then the next headline is traffic and the third headline is traffic. If you look at the numbers, that’s really a pretty big impact on our business, so that’s really our big -- I think that’s the big concern, that’s the big issue.

In terms of skewing pricing, absolutely a non-issue. I don’t think we give out the actual numbers but we are actually at last year’s level. And one of the things I debated about with some of the words is I don’t want anyone taking out of context the fact that less than 5% of our business comprises kind of a lot of the impact of what people in the marketplace hear, so I think it’s a really good question, I’m glad you asked it -- no. If you look at the [inaudible] store, which I think is incredibly important to us in terms of its strategic long-term opportunity it presents as to where we take the men’s business and what direction, I think that yes, it is higher priced. It’s only 1,000 -- I guess they report a as 1,000 square feet, the store. It’s about 1200 square feet and it’s an extraordinary R&D investment that we opened to pencil out also. But it is absolutely not raising price. In fact, if you look at what we are doing, we are very religious about opening price points because the last thing we want to do is let any of competitors slip in and try to take over a business we are building now. So the answer is -- but it’s a good question, the answer is no.

And then there was a last part of the question I think, or -- was that it, Jeff?

Jeff Black - Lehman Brothers

In terms of specialty to the product. You mentioned you got a little bit too basic you thought last quarter. Do you think you’ve addressed --

Millard S. Drexler

No, I -- when did I -- oh, you mean shorts and tees at the last call? No, I think we -- you know, the tendency for a merchant is to kind of over-buy what looks easy and simple. The world is moving so rapidly now that no, I think actually we fixed that. We corrected that and we keep moving forward on product. If you look at the assortment today, yes, we have our famous Jackie cardigans but we also have a very new famous ruffled cardigan. We have new famous checked glass cardigans.

But I think to get people to shop today, you can’t rely on the same old, add-on basic. But we are not forgetting that we have a huge franchise business in shorts and t-shirts but frankly, we kind of overdid it a little last season. But you know, that we cleaned up but clearly we evolve product and nothing really is too revolutionary in terms of what we are doing here, so I’m not worried about that.

Jeff Black - Lehman Brothers

Great. Good luck.

Operator

Our next question comes from the line of John Morris of Wachovia.

John Morris - Wachovia

If I missed it, and I may have in that moment I was off, but Mickey, if you could talk a little bit more about Made Well. We are hearing very good things about it through the channels. I know you all are talking about I guess -- let me just clarify, delaying the start-up on the Internet business there but any impact to your growth plans for stores next year? And then a little bit more color on the progress you seem to be making there.

Millard S. Drexler

I said we are very pleased. You know, in calls like this, you’d say pleased or very pleased, so we’re very pleased. And you know, we’ve done some dramatic changes throughout the last year and the stores are -- well, first of all, the good news is it’s a very interesting position for us and I think we are targeting 15 stores next year and we are looking where we can see opportunity.

I think it’s kind of taken a nice hold now. It’s only 10 stores so I don’t want to get excited or -- you know, it’s 10 stores. But the fact of the matter is that it’s 10 stores that are really getting tremendous customer feedback and the positioning of that business where we have it today is kind of exactly where we want it to be. It took us a year. The company is two years old this month since we opened our first store and there’s a huge learning that we go through but we are finding the jeans assortment -- I don’t want to say anything but if you look at the comment boards, you can see comments on our stores that I’m giving up my fill-in-the-blanks on the competitive jeans, but we have worked so hard at putting together a very exciting jeans assortment at the $98.50 to $125, $135 range, and our rail straight, our garment dyed jeans, our skinny lows, we are putting into the marketplace undersigned pockets, simple jeans. And frankly, you know, if you do the taste test on the jeans, we are after the better I call it high-priced -- I don’t want to say over-priced but sometimes I think they are over-priced -- jeans market that’s very small, scarce, and they sell a number of clients. But we see a pretty important opportunity that we don’t think has been taken advantage of out there in the market. It’s $100 to $150.

We’re raising the bar in some of the jeans and we’ve seen dramatic improvement on the jeans, percent to total, and the reason we started that business and the reason it’s been a mission for us is to really get into that market because the supply at those price points, and not just price, it’s really fashion and it’s always reinvention because you can just do price and it doesn’t move unless it’s something special. That plus the rest of the assortment -- the t-shirt assortment, the boot assortment is almost a wait-listed business for us, our Italian boots.

And you know, we are living a mission at Made Well and I’d say it’s at J. Crew too that I don’t understand why prices have to be what they are in this day and age in the marketplace. And you want to know -- a customer knows and they are smart and we mentioned last time the ubiquity of the business of designers and logos frankly to us is a huge positive for us because we don’t identify the clothes. We identify through our design, style, and incredible make. We identify our shoes or our boots made in Italy, so we are very much on a mission to have the best quality, style, and design and Made Well in fact, for us, as we look at the price points there and we look at the equivalent price points at -- you name the higher-end boutiques and specialty shops around America and the expensive wholesale lines really I think compares so favorably. We have arguably the best cardigan assortment in America. I’d say J. Crew is pretty much there too, with a different style group. Italian boots, but the jeans are the big story and very exciting. Our new handbag collections, so a long answer, John but yes, it’s R&D still but now we are committed to 15 stores for 2009. We just took a store in Greenwich, Connecticut. We took one on Newberry Street in Boston and our New York store, we couldn’t be more delighted and pleased, Annapolis -- and so it’s going real nice.

John Morris - Wachovia

Great. Thanks.

Operator

Our next question comes from the line of Brian Tunick with J.P. Morgan.

Brian Tunick - J.P. Morgan

Thanks. I guess, Jim, your gross margin guidance for the third quarter, that assumes what kind of inventory that you plan to end third quarter with? And I guess do you plan to be more value-focused or promotional on the fall goods, not just the summer clearance? And then maybe can you talk about the factory versus the full-price stores? Was there a difference worth calling out here in the quarter relative to the slowing traffic you are talking about?

James Scully

Sure. I think I’ve got most of those. I think first with respect to the guidance and the inventory levels that we have coming in, the back half guidance obviously gets us to where we feel comfortable at the end of Q4 that we will be -- have inventories balanced to the sales trend at that point. The largest impact is obviously in Q3 as we clear through the additional inventory from Q2 as we come into Q3. It doesn’t mean we will be more promotional in Q3. It means we will clear the -- what I call the excess inventory that we brought in. But the cadence for promotional activity in Q3 is currently planned consistent with last year.

And then in terms of retail and factory, I think last quarter we mentioned that they performed relatively consistently and I would say that held true in Q2 as well.

Millard S. Drexler

But to answer your question about traffic, it is definitely down more in retail than it is in factory. I would say it’s much more so there. But --

Brian Tunick - J.P. Morgan

And then if I can --

Millard S. Drexler

Go ahead. I’m sorry, you were saying?

Brian Tunick - J.P. Morgan

Sorry, Mickey. You are always very helpful -- is there anyone out there right now or is there any item or classification you think you guys are missing that you see out there in the market right now?

Millard S. Drexler

You know, this is a -- you know, we’re not happy with the quarter. On the other hand, we’re really happy with the assortments and if you look at the business, we are very well-balanced in pants, jackets, shirts, our graphic tees, our accessories, jewelry, and it’s not really a matter of the item business. The women’s cashmere, which we’re really pleased with, has been fantastic, pants, the matchstick pants, our wool trousers, jewelry, necklace, cardigans, graphic tees. In men’s, we’re committed to a new business, so an upgrade [with offers] of chino, suitings, denim in men’s.

You know, it’s not really that and by the way, on promotional things, the one thing that is really important to us long-term is you don’t see more markdowns in our stores right now than you would have seen a year ago, let’s say. Because we know at the end of the day, there’s a big sale customer out there and there’s a big regular priced customer so we’re balancing that with maintaining integrity through this period and we are moving markdowns, we try to do it online and selectively because that’s one thing we want to maintain, is the integrity of our product.

Brian Tunick - J.P. Morgan

All right. Good luck.

Operator

Our next question comes from the line of Kimberly Greenberger from Citigroup.

Kimberly Greenberger - Citigroup

Great, thanks. Good evening. I’m just wondering, as I look at your sales results here for the second quarter, you’ve got direct sales up 12%, which is a really solid result. Comps were flat or I guess just down a fraction, which is certainly not terrible in this environment, and it doesn’t appear that the 10% sales growth is out of whack with your longer term goals, which sort of begs the question, I’m sure that you consider your financial results from an EPS point of view not where you’d ideally like them to be, so is it that inventory wasn’t planned for the 10% sales growth? Is it that the expense budget wasn’t planned at this level? I’m just trying to reconcile what looks to be not a terrible top line with EPS that I know you view as disappointing.

James Scully

I think I’ll take this. I think as we talked previously, we came into the year with comp expectations of mid-single-digits and when we gave guidance, when we knew we would have pressure on gross margin with respect to our inventory positioning that we are hoping to get realigned by Q4, so I’ll come back to that. The second piece is we did have $3 million of unanticipated costs in Q2 as a result of the direct system upgrades.

But going back to the gross margin for a second, so I think we were originally anticipating or hoping to come in at relatively flat on merchandise margin in Q2 as a result of this slowing trend in our store business. The disruption created by the system upgrades did put additional pressure because of some of the customer accommodations, which is about a third of the 150 basis points in merchandise margin deterioration. In addition, because of our inability to transfer merchandise from our store business to the direct channel, which is where we have historically done very successfully, we did have to take deeper markdowns in place which did put merchandise margin pressure on the Q2.

Millard S. Drexler

You know, I want to add, I think there was something really important that we didn’t mention and we didn’t passively watch what was happening to the direct online business. We took purposeful steps to slow the direct sales since we were having problems through the system. So we stopped our outgoing e-mail marketing, et cetera. So I want you to know that part of the breaks put on were intended because we were answering customer comments 24/7 and we didn’t want to disappoint our customers and we felt frankly that we’d rather cut back and we did it probably the second week into the transition.

So I don’t want you to think it was like oh, gee, this is it and we’re just going to watch it, the business evaporate. No, we cut back the business because we said longer term -- look, here’s how we look at it, this is a short-term issue. It took us a little by surprise as the severity of it but then we decided look, we’d rather not alienate. We drive the business everyday through e-mails, marketing, special events, free shipping. We just dramatically pulled back. We turned it off and the risk, of course, was obviously a little less sales but less pissed off customers; the risk was having a little more inventory but for us, more importantly, we wanted to make up to any customers and we didn’t want to just piss off more people. That being said, we actually converted a lot of people because a lot of us were on the phones in the DCs taking care of customers and I’d like to say to all the customers we spoke to who were pissed off, when they got calls from any of us and e-mails and a quick response, we at least converted a lot of upset people. I just wanted to clarify that we throttled back.

Kimberly Greenberger - Citigroup

That’s helpful. Thanks, Mickey. So if you could go back to December of 2007 when you internally declared a recession at J. Crew and change any of your actions, would it be just to assume a weaker comp result here in 2008 and order less inventory or would there be other adjustments you would make?

James Scully

I’ll take this and see if Mickey wants to add some color. I think first, potentially maybe had planned a little bit more conservatively for the store business, obviously, given where the trend is today versus where the original plan was. But I think more importantly, we would have been more conservative in our internal planning in terms of the potential disruption related to the direct business, which would have led us to be more conservative in setting expectations externally with our customers and our other constituents.

Millard S. Drexler

You know, actually it’s a good question. We said it in January. What’s happened unfortunately has happened plus. I think -- I’ll get back to it -- I think the real big issue we are facing -- well, first of all, I am really pleased with the direction of the business. You know, I think the assortment, the businesses, Crew Cuts, et cetera, I am really pleased and our customers are, forgetting what I feel, but I think the real big issue is traffic. We have seen a consistent decline over the last -- I think, Jim, it’s since the beginning of the year and it’s been very consistent.

Now, it’s also -- things are slow in happening but I wouldn’t -- there’s not too much I’d second-guess us on, other than maybe having less t-shirts and shorts but that was for the summer season.

Kimberly Greenberger - Citigroup

Great. Thanks and good luck here in the second half.

Operator

Our next question comes from the line of Michelle Tan with Goldman Sachs.

Michelle Tan - Goldman Sachs

Great, thanks. I guess my question is probably for Jim -- what exactly is it that gives you comfort that the direct platform issues are going to be fixed in the third quarter? And importantly, I guess, where could you be wrong on that assumption?

James Scully

Michelle, I think the most important thing is this is a day-by-day thing. I mean, we are meeting on a daily basis, looking at metrics across the board. And what I would say is that when we look at the website and the call center, we know we have some fine-tuning to do, that we still have issues that arise, but I think -- and even with the DC, I think we feel that we have identified and contained some of the major issues that we experienced in the beginning. So I think first, when your issues list does not grow on a daily basis, that is a good thing and we have contained it at this point and we obviously are working through it.

So in terms of confidence level, I mean, it’s based upon what we know today and we have a plan that gets us there by the end of the third quarter and we manage it at a high level internally using experts from our third-party vendors as well as independent experts as well. But the focus is on the capacity in the DC. It’s our highest priority right now operationally for the company and we are focused on it and we monitor it and we have the metrics so we know the glide path we need to be on to get back to pre-conversion capacity, and that what gives us comfort today.

But obviously new things arise and we address them as they come up and we continue to work on it. The most important thing is it’s day to day.

Michelle Tan - Goldman Sachs

Okay, that makes sense. I guess my other question, kind of follow-up, would be as you look at the better sales trend that you’ve started to see in the direct business once you came out with some of these accommodations and what not, has that been at all driven by better functionality or was it really more an issue of giving some of the discounts and kind of the make-up stuff with the customers?

James Scully

No, when I talk about -- when we say that the trend is normalizing, as Mickey mentioned, we constrain demand. So when I talk about normalizing, I talk about our ability to meet customer expectations operationally because we know how to throttle demand and so it’s more that we are making sure that operationally, we are on track to meet that demand in terms of when I say getting back to more normalized levels, because we intentionally constrained the volume. So pretty much I don’t want to say at will but we can drive volume through the system at will and then it’s up to us operationally to fulfill that, so we are managing both pieces right now.

Michelle Tan - Goldman Sachs

I got it. Perfect. And then Mickey, just a quick question on categories, you know, we know you’ve had great success in Crew Cuts and costume jewelry -- one of the categories that you’ve talked about investing in the past was suits. What has been the progress there and any changes to the plans to that business?

Millard S. Drexler

Well, we are running slightly up. I would say that I would like to see some more suit business. I kind of think it might be early and there’s regional differences on traffic lately. You know, the regional differences are quite dramatic from one region to another but you know, suits are -- how do I say? It’s kind of long-term but in the short-term here, I’d rather suits were up another 5 or whatever then they are up right now but I’m not concerned because one of the things we did in our suit business is not design an obsolete kind of line. Most of the business we missed in suitings was a woman coming in and wanting that black suit, the grey suit, whatever, in a particular fit and a size and one that doesn’t get marked down. So we have a little more but I’m not too concerned. It’s really now a year-round business, so we adjust inventories going forward.

Michelle Tan - Goldman Sachs

That’s perfect. Thank you very much for the help.

Operator

Our next question comes from the line of Dana Cohen with Banc of America Securities.

Dana Cohen - Banc of America Securities

Just going back on the inventories, I understand that you came into the year with plans up higher than what you guided to most recently with the second quarter, but how much of the overage of the $15 million is -- you know, like how much higher are you now than where you thought you would be a quarter ago, or is this where you thought you would be in terms of inventory?

James Scully

I think the way we look at it is the 15 at the end of Q2 is the 15 -- that is the excess above where we thought we would end at the end of Q2, so I think you need to take that off the top and then you would see what our expectation was for how we would end Q2 without the disruption.

Dana Cohen - Banc of America Securities

So is the $15 million entirely from the disruption then? Because I guess what I’m trying to understand is the sales for the second quarter didn’t come in materially different than where you guided to for the second quarter, so why is the overage there?

James Scully

I think first of all, if you think about the $15 million, let’s first say that half of that is related to the direct business and the other half is related to the store business, in terms of our inability to transfer and clear in the direct channel. And the other half is related to the disruption in the direct.

I think everybody knows that our direct channel has been running significantly higher than the high-single-digits and during the course of Q1, we had a 17% increase on top of -- in excess of 30% last year, and I think most people know that we plan the business on the half and obviously because of the way, the rhythm of the direct business, it’s a little bit more front-loaded, which gives us the ability to chase trend throughout the first half. And I would say that given the performance in the first quarter, plus what we were seeing pre-conversion, we were driving to a higher number, obviously, than the 12% and with the disruption that we experienced in the last month, coupled with the first in August and pulling it back, it did leave excess inventory because it came in lower than anticipated. And we fund the business to a higher number because of the trend that we were experiencing.

Dana Cohen - Banc of America Securities

So basically the internal plan and the inventory plan were higher than the external and the financial plan?

James Scully

Well, I would say that the trend -- we have plan and then we have actuals and performance, and we drive the business to what we see by every book and everything that we see and demand in the direct business, so yes, I think there’s a difference because the plan is nine months old and then we can chase business and have a little bit of flexibility even more so in the direct business.

Dana Cohen - Banc of America Securities

And just strategically, why [inaudible] -- I mean, what was the strategy behind not maybe just taking it in Q2 and carrying over the excess inventory into Q3 sort of strategically?

James Scully

Well, I think -- I mean, things developed very quickly from --

Millard S. Drexler

Time out -- I’ll give you an answer. Whatever we are doing is June 28th, we’re going to figure out the maximum value to our bottom line as best as we can. If we planned it -- look, the real hindsight here is we didn’t plan the disruption very accurately. But June 28th is -- you know, you could have gotten rid of all of it but at what price and what margin? It’s not like the goods aren’t saleable but because the quarter ends, we’re not going to determine that we are going to take a hit. We don’t run the business quarter to quarter but we report the results. But on June 28th, and then before you know it, it’s July 1st, July 2nd, and you know, there’s also integrity issue in the business and we couldn’t ship it that easily. So we decided look, it’s -- we decided that we’ll take it and this too will pass, but we’d rather have taken it into August, if you will, and into September.

Dana Cohen - Banc of America Securities

Great. Thank you.

Operator

Our next question comes from the line of Richard Jaffe with Stifel Nicolaus.

Richard Jaffe - Stifel Nicolaus

Thanks very much. Just a quick follow-on with the idea of holding back the direct business a little bit -- could you comment on circulation, whether you will be cutting that going into the second half? If so, how much? And what impact do you think that might have in terms of driving foot traffic to stores?

James Scully

We finished the first half of the year essentially flat in circulation and while earlier in the year we had anticipated a little bit more in terms of an increase in the back half of the year, getting to an annual increase of about 5%. Unrelated to the issues in our direct business, we did take the opportunity through further analysis to shrink circulation in the second half, not only from our customer file from less productive customers but also from less productive pages, and right now we anticipate the second half will be flat, consistent with the first half and so the year will therefore be flat.

You will see fluctuations in Q3 with it being up about 10% and Q4 will be down about 10% but that’s primarily related to just the timing of some of the catalogs going out.

Richard Jaffe - Stifel Nicolaus

Is there an opportunity to ratchet that back to try and reduce demand, as you mentioned, deal with fewer e-mails with the catalog before that?

James Scully

No, it’s because -- I mean, I think first of all, we are managing it much more through the e-mail side and as Mickey mentioned, some of the offerings, including free shipping and things that we post on the website, given the fact that the catalog is our primary, only branding vehicle and how critical it is to the overall business, these decisions that we made were more strategic from an efficiency perspective. But I feel good about where we are right now and if you look at the trend over the last two to three years, I feel even better about it.

You have to look at this in light of the fact that the actual active file of our active customers keeps growing, so to the extent that we keep it flat, we are becoming more efficient.

Richard Jaffe - Stifel Nicolaus

Got it -- [a more effective list].

James Scully

Exactly.

Operator

Our next question comes from the line of Barbara Wyckoff with Buckingham Research.

Barbara Wyckoff - Buckingham Research

What is the [attach rate] penetration now, including jewelry, hair, scarves? And where could you build it over time? And then could you talk about the successes in accessories this fall to date? You mentioned jewelry, Mickey, earlier -- what about shoes and boots outside of Made Well, other classifications? And then I have just [inaudible].

James Scully

In terms of penetration, it’s relatively consistent year over year between men’s, women’s, and accessories and I’ll let Mickey comment on shoes.

Millard S. Drexler

We’re really happy. The shoe collection is getting a terrific response. We won’t discuss the numbers but we always tread a little lightly on shoes in the stores because the last thing you ever want is too many odd sizes or too many shoes left over in stores but in direct, it’s really running nicely and in retail it’s running nicely. And I think again, the world -- the positive part about the macro environment in the world right now is there’s such a distortion of price on shoes and other things that we are really taking advantage I think of the customers who have seen what we are doing, they like what we are doing, and by the way, it gets back to the first question about us talking about the better goods because if you speak to the higher end of any audience, a lot of people will follow. But we are really pleased with the shoes.

The jewelry thing has been absolutely extraordinary and that’s been incredibly exciting too, so we’re really happy with that. As long as you don’t over-buy shoes and end up with too many leftover shoes, it could be a pretty good business.

Barbara Wyckoff - Buckingham Research

Okay, great. And then has there been in apparel a stand-out color yet or --

Millard S. Drexler

Stand-out colors? Well, you know, it’s an interesting question. We have so many different colors but in Made Well, gray denim, which has a little sexier name than that -- what do we -- gravel? Gravel, I don’t know how sexy that is but anyway, the gravel color in gray is doing amazing in denim. The neutrals are great. Gray -- it’s a gray world right now, which is interesting. I mean, no pun intended but a lot of grays and a lot of flat grays and neutrals.

But you know, where we put in an interesting pop color, like men’s purple Marinos in men’s, which we love, you know, there’s fun colors but it’s always got to be the right color and we are buying less colors and less styles, so I think we are investing the colors more strategically where we think it works in particular styles but nothing beyond that.

Barbara Wyckoff - Buckingham Research

Okay, thanks. Good luck.

Operator

Our last question comes from the line of Samantha Panella with Raymond James.

Samantha Panella - Raymond James

Good evening. In terms of going back to the upgrade and everything, where do you see it in terms of being able to move merchandise from retail onto the direct channel?

And then a question relative to Made Well -- I believe you said this year looking at a loss of $13 million. I think previously you said $15 million. Is it that you are seeing better sales or is it your cost line that’s coming in better than expected? Thank you.

James Scully

With respect to transferring inventory, the guidance we have given is the expectation is that we will clear the inventory in retail now, just given the fact that we said that we are going to -- our goal is to get stabilization by the end of Q3, we’re going to keep the retail inventory or the store inventory and the store channel and focus on getting direct back to its prior trend without putting an additional burden on that. But that is contemplated in the Q3 guidance and the second half guidance.

With respect to Made Well, you are correct -- we are expecting Made Well now to cost about $13 million on the operating income line. It was previously $15 million. I would say about $1 million of that is related to the fact that we, as Mickey mentioned, we deferred madewell.com into the first half of next year and the other $1 million is because it is performing better than anticipated.

Samantha Panella - Raymond James

Okay, great. Thank you and good luck.

Operator

Thank you. At this time, there are no further questions. Gentlemen, I would like to turn the conference back to you for closing comments.

Millard S. Drexler

Thanks again for joining us all -- look forward to speaking with you when we report our third quarter results in November. Take care.

Operator

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

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Source: J. Crew Group F2Q08 (Qtr End 8/2/08) Earnings Call Transcript
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