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Tailored Brands, Inc. (TLRD) CEO Dinesh Lathi on Q2 2019 Results - Earnings Call Transcript

About: Tailored Brands, Inc. (TLRD)
by: SA Transcripts
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Earning Call Audio

Tailored Brands, Inc. (NYSE:TLRD) Q2 2019 Earnings Conference Call September 11, 2019 5:00 PM ET

Company Participants

Julie MacMedan - VP, IR

Dinesh Lathi - CEO

Jack Calandra - EVP, CFO & Treasurer

Conference Call Participants

Luke Hatton - B. Riley FBR

Paul Trussell - Deutsche Bank

Carla Casella - JPMorgan

Janet Kloppenburg - JJK Research


Greetings, and welcome to the Tailored Brands Q2 2019 Results Conference Call.

At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note this conference is being recorded.

I'd now turn the conference over to your host, Julie MacMedan, Vice President, Investor Relations. Miss. MacMedan, you may begin.

Julie MacMedan

Thank you and good afternoon everyone. Welcome to Tailored Brands second quarter 2019 results conference call. This call is being webcast and a replay will be available on the company's Investor Relations website, Please note that comments made during the conference call contain forward-looking statements within the meaning of the United States federal securities laws. These statements are subject to significant business, economic and competitive risks, uncertainties and contingencies, many of which are beyond our control. Any forward-looking statements are not guarantees of future performance, and actual results may differ materially from those in such forward looking statements. Please refer to today's earnings release, our annual report on Form 10-k and quarterly reports on Form 10-Q to understand these risks and uncertainties. You could access all of these reports on the Tailored Brands IR website.

In addition, the information on this call speaks only as of today September 11, 2019. And we assume no obligation to publicly update or revise our forward looking statements. Throughout this conference call, management will be discussing results on an adjusted basis. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures, and our explanation of why the non-GAAP financial measures may be useful are discussed in today's earnings release.

With me today are our president and CEO, Dinesh Lathi and our CFO, Jack Calandra. I would now like to turn the call over to Dinesh.

Dinesh Lathi

Thank you Julie, and good afternoon everyone. Earlier today, we released our results for the second quarter of 2019. And I'm pleased to report that our earnings per share of $0.82 exceeded the high end of the guidance range we provided in June of $0.65 to $0.70. As Jack will describe in greater detail, our outperformance on the bottom-line was the result of topline sales that were in-line with guidance, coupled with expense favorability, primarily in lower marketing spend and lower incentive compensation costs.

While delivering at or above guidance on the top and bottom line is important, and reflects the substantial and collective effort of our nearly 20000 colleagues, no one at Tailored Brands will be satisfied until we have transformed our customer facing experience to one that can generate sustainable bottom and topline growth.

Back in March, I indicated that we had work ahead of us to transform our customer facing experience and that the transformation would take time. Our Q2 comps and our outlook for Q3 reflect the facts that we are in the midst of a transformation, that transformations take time, and that we are executing our transformation in a challenging retail environment. Despite these challenges, we are confident in and excited about our business because of the way the customer is responding to our initiatives.

To that end, before turning it over to Jack who will cover the financials in more detail, I want to update you on our progress on transforming the customer experience. Roughly six months ago, we identified three areas that we believed were going to be critical to transforming the customer experience. They are personalized products and services, inspiring and seamless experiences in and across every channel, and brands that stand for something more than just price.

Personalized products and services are a priority because the customer is not only demanding personalization in his online experiences, but is increasingly demanding it offline as well. In our transformation journey, the early stages of delivering personalization have been focused around two things.

The first is custom clothing and the second is merchandising that better reflects how he dresses for work and special occasions today. Our custom business continues to grow at healthy double-digit rates at the multi $100 million scale. In Q2, we averaged over 6 million a week in custom suiting, up from over 4 million a week in Q2 2018.

We are leaning into the positive response to custom by continuing to push innovation in this category. In July, we introduced the opportunity for customers to choose from a set of fun, non-traditional linings featuring icons, florals, and tropical patterns for their custom garments. We've seen a strong response since the launch of the program, and the good news is that these digitally printed linings have a short lead time allowing us to test into new designs without needing to acquire significant inventory upfront.

The positive customer response to statement lining led us to consider other jacket mining innovations, and last week we announced that we had entered into a multi-year licensing agreement with the National Football League. This agreement enables us to offer sports fans the ability to customize their suits and sport coats with linings depicting most of their favorite NFL teams.

We are very excited to continue to develop this NFL offering as part of our goal to deliver the ultimate personalized experience for our customers. We are also working to innovate the process of buying a custom garment. Last quarter, we shared with you that we were in beta on Custom Builder, a tablet-based app designed to assist our wardrobe consultants and customers with the in-store custom buying experience.

Since then, we have rolled out the app across our entire Men's Wearhouse fleet and the majority of our Joseph A. Bank slate. Feedback from our wardrobe consultants has been incredibly positive, and we are already seeing an improved customer experience and gains in consultant efficiency due to a more engaging and quicker sales process.

For example, stored customer profiles and new features allow consultants to seamlessly duplicate a customer's specific measurements and choices in a second or third fabric for a multiple unit purchase, saving substantial time for both the consultant and the customer. Later this month, we will launch Custom Builder to the balance of Joseph A. Bank stores and across all more stores in Canada.

In addition to custom clothing, we've also talked about the opportunity to present the customer an assortment which better reflects the way he is dressing today for work and special occasions. Despite challenging traffic trends in our polished casual categories, we saw sequential improvement at Men's Wearhouse, and we were pleased with the performance of sportswear and dress shirts at Joseph A. Bank.

Polished casual strength was driven in part by new product introductions such as dinner jackets, seasonal red and aubergine sport coats, short sleeve and full transitional long sleeve sport shirts, and shoes led by new, more casual and comfortable styles. The one exception was sport coats to Joseph A. Bank which were so popular that unfortunately we could not keep up with demand.

The good news is that we have our new fall sport coats in stores as well as new alternative completer pieces for a business casual outfit that includes cardigan and zip sweaters, knit bomber and trucker jackets and less structured sport coats.

The second strategic initiative we discussed was creating inspiring and seamless omni-channel experiences. On our store experience, we're making progress on several fronts. Last quarter we shared that we were running tests to measure the impact of enhanced fixtures, in-store graphics, and product presentation. The results came in during Q2 and we learned which types of stores responded highly to each aspect of the investment.

We are in the process of rolling out those elements of the design to the stores in the fleet that match the winning profile. We've also been experimenting with labor in our stores. We believe that helping them look and feel their best for the moments that matter requires a personal touch. So, we experimented with additional labor on the weekends.

That experiment was a winner. We saw a meaningful lift in sales with the test stores that more than paid for the additional labor, and we are in the process of scaling this new labor model more broadly. On the e-commerce front, we continue to be pleased with the pace at which our e-commerce teams are improving the online experience for our customers. Our e-commerce sales penetration is much lower than our retail peers, and I am really excited about the potential to close this gap.

Over the past six months, we have focused on elevating our e-commerce experience to achieve our goal of delivering an inspiring and seamless omni-channel experience. We believe successful execution of this strategy presents a large unlock for our business on both the top and bottom line. Last quarter, we talked about how we had implemented agile software development methods to dramatically increase the number of tests we are running. Whereas Q1 was very much about implementing these new working methods, Q2 was where we started to see dramatic business impact.

The change in trajectory of our e-commerce business since the beginning of the summer has been fantastic and is due in part to both the growth in traffic associated with our increased investment in digital marketing and a robust test roadmap that has yielded substantial conversion rate enhancements versus the control experience.

An example of one of the features that we've scaled based on test results is serving customers with weather based product recommendations. Based on what we can discern about a customer's location, they will see a message above the top navigation, customize to the weather in their location, such as, dress for 62 degrees, shop now. Once they click on that message, we take them directly to weather appropriate products like a quarter zip pullover.

We are also focused on streamlining the design on both mobile and desktop to give products and call to action more prominence. This means adjusting navigation, product imagery, spacing and font sizes to help the shopper quickly find what they are looking for. Getting customers to products faster is driving higher conversion.

E-com is an area where we continue to be really excited about and the results we are seeing are strong confirmation that we are starting to deliver what our customer wants. The third strategic initiative we discussed was evolving our brands to stand for something more than just price.

The focus of this initiative is twofold. First, to engage our customers in the media channels they frequent, and second, to tell the stories of our brands so that customers better understand what they are getting for their dollar. On the channel shift, we've made significant progress. Our marketing spend in digital channels is up 31% compared to Q2 of last year.

Based on the foundational work and testing we conducted through Q1, we are confident in our ability to put dollars to work in digital channels at greater efficiency than we are achieving in broadcast channels. We are pleased to report that by increasing our digital marketing efforts, we have seen increases in purchase intent for suits and business casual at both brands, particularly among millennials. And we plan to step up our digital spend in Q3 relative to Q2.

Last quarter, we also talked about the launch of new advertising campaigns at both Men's Wearhouse and Joseph A. Bank. And we're pleased to see that these campaigns, which had a brand storytelling orientation, are resonating more with the important millennial segment when compared to more price promotion oriented spots.

We have been leveraging the new brand campaign content through numerous channels such as broadcast, digital, our e-comm sites and our Joseph A. Bank fall catalog. Looking ahead, our goal is to focus in on specific stories we know our customers care about and amplify them across all marketing touch points.

We are also looking forward to leveraging the strong brand recognition that the National Football League brings to us through our new licensing agreement. Finally, in addition to the progress we've made on our customer facing initiatives, we've also made some significant new additions to our senior ranks at the Men's Wearhouse and Moores. These leaders were universally attracted to the opportunity and the challenges of transforming our customer experience and each of them brings a track record of delivering impact and outcomes in their respective domains.

Mary Ann McGrath joins us as SVP and chief marketing officer from Williams-Sonoma Inc. where she led the transformation of multiple brands to a digitally focused, data driven marketing approach and drove significant sales and customer growth. Jerry Brandehoff joins us as SVP and general merchandise manager from PVH Corporation, where he led the North American Calvin Klein jeans and sportswear business after a distinguished career in merchandising at leading specialty retailers.

And finally, Sharmila Sudhakar comes on board as VP of e-commerce from's home decor business, where she drove meaningful topline growth and profitability for the home division. We are delighted to have them onboard and we are already benefiting from their new perspectives and ideas, their execution orientation and their customer obsession.

With that context of progress on our customer facing strategic initiatives, I'll now turn the call over to Jack, who, in addition to discussing the financials for the quarter in more detail, will also cover our updated capital allocation framework, our cost savings initiatives and our guidance for Q3 2019.

Jack Calandra

Thanks Dinesh and good afternoon, everyone. Today, I'll review our updated capital allocation strategy, the expected impact of recently enacted tariffs, second quarter financial results and guidance for the third quarter. I will also share with you the progress we're making on our multi-year cost savings and operational excellence programs.

I'd like to start with the recently completed sale of corporate apparel and the updated capital allocation strategy we announced in today's release. We were pleased to sell the corporate apparel business on August 16th in order to focus on core retail operations in the US and Canada and strengthen the balance sheet. The sale also improves both our pro forma leverage ratio and operating margin.

We expect to present the sale as a discontinued operation beginning in the third quarter. Of the $62 million sale price, we have received approximately $50 million cash after working capital adjustments and will receive an additional $6 million in the first quarter of fiscal 2020. We are reinvesting these proceeds in the business, and this frees up funds previously slated for capital expenditures to pay down debt.

In addition, today we announced the suspension of the $0.18 per share quarterly cash dividend starting in Q4. On an annual basis, this will make available about $36 million to be used for a combination of share buybacks and accelerated debt reduction. This change does not impact the previously approved $0.18 quarterly cash dividend payable on September 27th.

I want to take a moment to explain why we are making this change. Simply put, we strongly believe given the current stock price and dividend yield, that there is a more efficient way to allocate capital and that redeploying cash from the dividend into a combination of share buybacks and debt reduction will enhance long term value creation for all stakeholders. For executing share buybacks, we have $48 million available under an existing repurchase authorization from our board.

I also want to reiterate our unwavering commitment to paying down debt and strengthening the balance sheet. Over the past 2.5 years, we have made significant progress on debt reduction, reducing total debt by over $440 million with a focus on the 7% senior notes that mature in July 2022.

We also extended the maturity on our largest tranche of debt, the $884 million term loan to 2025. Although our debt to EBITDA ratio has increased this year due to business performance, we remain committed to reducing debt to EBITDA to 3 times over the medium term.

Now, I'd like to provide our current assessment of how tariffs on imports from China impact the business. As a reminder, the first three lists of tariffs largely do not impact the goods we source and any financial impact from those tariffs is immaterial. The fourth list to watch a 15% tariff is being applied is comprised of two groupings, the first of which went into effect September 1st and the remainder of which goes into effect December 15th.

Most of our product falls into that first grouping. This has been a somewhat fluid process, but we believe we can absorb the list for tariffs within the existing product cost structure with minimal impact to the bottom-line this year. This is due to both diversifying our sourcing and working with our vendor partners in China to help mitigate the impact of the tariffs. We had already reduced the percent of direct source product from China from approximately 30% in 2017 to 23% last year. For 2019, we expect to lower that further to between 18% and 20%.

Turning now to the second quarter results, I'd like to make sure everyone knows that I will be discussing adjusted numbers today, which eliminates certain items that are not indicative of core business results. Please refer to our press release for more details. Total sales for the second quarter were $789 million, down 4.1%. Retail sales were down 4.1%, with comp sales down 3.6%. The non-comp spread of negative 0.5% was largely explained by headwinds of 40 basis points from foreign exchange and was primarily due to the weakening pound and its impact on corporate apparel sales.

Moving to gross margin, consolidated gross margin was $337 million, a decrease of $36 million. As a percent of sales, consolidated gross margin decreased 260 basis points to 42.6%, primarily due to lower retail segment gross margin rate. Retail segment gross margin rate was down 290 basis points to 43.7%.

The decline was primarily due to a 180 basis point decrease in retail clothing gross margin rate driven by increased promotional activity versus last year and a 90 basis point deleveraging of our occupancy costs.

Turning to expenses, advertising expense decreased $5 million and was down 50 basis points as a percent of sales to 4.2%, reflecting a shift from broadcast to online spend as we optimize channel mix as well as a shift of some marketing spending to Q3. SG&A decreased $9 million largely due to lower incentive and share based compensation expense.

As a percent of sales, SG&A was flat at 29.4%. Operating income of $71 million compared to $93 million last year. As a percent of sales, operating income decreased 220 basis points to 9%. Net interest expense was $18 million, down $3 million compared to last year, reflecting a year-over-year reduction in total debt.

The effective tax rate was 21.2% compared to 23.9% last year, and second quarter diluted earnings per share were $0.82 compared to a $1.07 last year. Turning now to the balance sheet and cash flow. We ended the quarter with total liquidity of $421 million, which includes $402 million available on the revolving credit facility and $19 million of cash.

At quarter end, inventories were up $60 million or 8% versus last year. The majority of the increase is from higher levels of raw materials, including fabric. While fabric inventory is higher than planned. It is current and in support of basic replenishment product. Within finished goods, an inventory increase in Men's Wearhouse was largely offset by a decrease at Joseph A. Bank.

The increase at Men's Wearhouse was associated with strategic investments in polished casual categories, including sport coats, sportswear and shoes, a pull forward, of fall receipts and lower sales than planned in the suits division. Importantly, the quality of finished goods inventory as measured by inventory age is significantly improved at both Men's Warehouse and Joseph A. Bank versus last year. Debt at quarter end was approximately $1.2 billion, down $62 million versus a year ago. On a trailing 12 month basis, debt to EBITDA was 3.9 times. As I mentioned previously, paying down debt continues to be a high priority.

Year-to-date cash flow from operations was $33 million compared to $198 million last year. The decrease reflects lower net earnings, an increase in inventories and rental product purchases and changes in accounts payable and accrued expenses, primarily due to timing. First half capital expenditures were $39 million, up $14 million versus last year and consistent with plan.

While we still expect a modest increase in full year CapEx versus last year's $82 million, we will continue to react responsibly to conditions and opportunities in the business. With respect to real estate, during the quarter, we closed a net seven stores consisting of six Joseph A. Bank stores and one Men's Wearhouse and Tux store. The total number of stores at quarter end was 1,455.

Turning now to guidance, as we discussed last quarter, our plan is to continue to provide quarterly guidance for the remainder of this fiscal year. We expect third quarter earnings per share of $0.40 to $0.45, excluding the impact of any share repurchases. Our third quarter guidance assumes the following. For comp sales, we expect Men's Wearhouse down 3% to 5%, Joseph A. Bank down 2% to 4%, K&G down 2% to 4% and Moores down 4% to 6%. We expect rental comp to be down about 6% as we lapped last year's big vanity wedding date in August.

We expect an effective tax rate of 23% to 24%. With respect to real estate, we expect net closures of seven stores across both Men's Wearhouse and Joseph A. Bank. And finally, this outlook excludes expected costs for third party domain experts and other options associated with our cost savings and operational excellence programs.

Before I turn the call back to Dinesh, I want to give an update on where we are in delivering against our multi-year cost savings and operational excellence program.

During the first half of 2019, we leveraged the expertise of a third party to help us analyze large elements of our cost structure and make recommendations for improvement. We've already implemented some of these cost savings measures. That said, the bigger opportunities require thoughtful and rigorous analysis to ensure we continue to deliver a superior customer experience.

While we still have work to do to assess their impact on our business, we feel good about the progress we are making. We have identified the following major areas of cost savings and efficiencies. First, marketing, we've begun implementing a more effective marketing mix as we shift from broadcast to digital to tell our brand stories which over time we expect will be reflected in reduced spending relative to sales.

Second store footprint. We've previously discussed that we believe we have an opportunity to rethink the number of stores in the fleet and the location of those stores and to do so in an analytically rigorous manner. By the end of this fiscal year, we will complete a comprehensive fleet analysis. Given over 98% of our stores deliver a positive four wall contribution, this is much more complex than just clothes, money, losing stores.

We are working with a third party to build sophisticated models that will help us make decisions that maximize cross brand cross-channel market level profitability. Third, supply chain. In the second quarter, we consolidated our Canadian infrastructure by closing one of our two distribution centers. The closed distribution center is an owned facility and was recently listed for sale, the proceeds from which will be applied to our updated capital allocation framework.

In closing, while there is more work to do, we are making good progress and I'm encouraged by the potential to take significant cost out of the business. In the meantime, we are focused on shareholder value creation through investing in our growth strategies, tightly managing expenses, strengthening our balance sheet and repurchasing stock. Thank you. And now I'll turn the call back to Dinesh to wrap up.

Dinesh Lathi

Thanks, Jack. To wrap up, on our last call, I indicated that we were on a journey to transform our customer facing experience to one that can generate sustainable and profitable growth, and that we would continue to execute and invest in a focused manner with a clear goal of continuing to generate cash while we transform the experience.

Transformations take time. And we have much work ahead of us to reinvigorate our topline performance. However, as you've heard on this call, we are seeing the early signs of customer response to our transformational strategies of providing personalized products and services, inspiring and seamless experiences in and across every channel and brands that stand for more than just price.

We are launching new, personalized and innovative products for fall. We are driving more traffic to enhance e-commerce experience and we continue to shift more advertising spend from broadcast to digital, where we are seeing positive return on investment as we reach customers and more relevant channels. And while we work to scale these and other transformative initiatives into reliable sources of growth and profit, we are delivering on and remain committed to focused investment and execution that generates cash.

Meeting our financial commitments while making healthy progress against our transformation roadmap is the result of our team members recognizing that this is not business as usual and not accepting the status quo. They are changing the way the company executes for the better by being anchored in and obsessed with the customer by investing for long term and sustainable value creation by an analysis to guide decisions and by moving with an urgency that reflects our conviction and confidence in our ability to own the customer's loyalty and advocacy.

I'm incredibly proud of the progress the team has made despite the challenging retail environment and couldn't be more excited about the positive customer response we are seeing and what it means for the journey ahead.

With that, let's open the line for questions.

Question-and-Answer Session


At this time, we will be conducting a question answer session. [Operator Instructions] Our first question is from Susan Anderson, B. Riley FBR. Please proceed with your question.

Luke Hatton

Good afternoon. This is Luke Hatton on for Susan. So you talked about the increased promotional activities in the retail clothing line being one of the main drivers of the gross margin deleverage. I was wondering if you could provide a more detail on was this promotional activity similar across the brands and then sort of how did it track against your expectations coming into the quarter?

Dinesh Lathi

Hi, it's Dinesh, I'll take that one. Yeah as far as the way it tracked across the quarter, you'll remember when we provided the Q2 guidance, a couple of the inputs that we were using to form that guidance were both traffic and what we were seeing in the promotional environment at that time. And as you saw with our results coming in line with guidance that we provided, I characterized the environment as promotional but not out of line with what our expectations were, and that's one of the reasons we were able to deliver within guidance.

As far as within the brand themselves, I wouldn't characterize them as meaningful differences in terms of each brand being more or less promotional than the other. I'd say the promotional activity was similar across both brands and consistent with what we saw last year, although we continue to and will continue to push on testing new handles and new price points, but the frequency was similar to last year.

Luke Hatton

Got it, thank you. And then sort of looking out into the third quarter, I know you don't provide specific gross margin or SG&A guidance, but given the similar level of comp declines, should we be thinking about that, you know sort of tracking the same way for the third quarter here?

Dinesh Lathi

Yeah, I think that's fair. Our guidance for Q3 combines a number of inputs. But one is obviously the traffic trends that we've observed for the start of the quarter. Another is our view of what the promotional environment will be like. And then the third is the timing of certain strategic cost savings and customer facing initiatives reaching scale. As far as the promotional activity and the traffic as I think, those were similar to what we were seeing in Q2.

Luke Hatton

Got it. And if I can just sneak in one quick one. So on real estate initiative that you just spoke on, can you just give us a sense of sort of what the average lease term looks like in the portfolio right now and if you're seeing any sort of rent concessions from landlords in your recent discussions? Thank you.

Jack Calandra

Yeah. Hi, Luke. This is Jack. So, lease terms vary by brand. I would say in our Men's Wearhouse business, those terms tend to be a little bit longer in Joseph A. Bank, probably a little bit shorter where we're doing more short-term renewals. But I would remind you that every year about 15% to 20% of our fleet comes up for lease action. And so, we've got a fairly high degree of flexibility to impact the fleet on a regular basis.

Luke Hatton

Great. Thank you and good luck next quarter.


Our next question is from Paul Trussell, Deutsche Bank. Please proceed with your question.

Paul Trussell

Good afternoon. I wanted to -- just maybe dig a little bit more there on the third quarter guidance. You spoke positively about some green shoots you've seen in regards to some of your initiatives. Just maybe reconcile for us, you know, a very similar cadence of comps across each of the banners as we think about the third quarter.

Dinesh Lathi

Hey Paul, it's Dinesh. Thanks for the question. As you think about the green shoots that we talked about and that comp guidance we gave for Q3, I guess I'd start by reminding you that we are in the midst of a transformation and the transformations take time. We're approaching this with a test and learn mindset.

That means we're running experiments at a small number of stores that won't impact the financial results, whether the test is a winner or loser. The reason we're so excited is because we're starting to see signs of positive customer response to a lot of these tests, whether they be in merchandising stores, e-commerce or marketing.

It's the scaling of these tests that's going to drive the top and bottom-line impact.

And some of them like e-commerce, you'll be able to scale very quickly. And that's one of the reasons we talked about the growth we're seeing in the e-commerce business and what we're so excited about. Others like stores or new merchandise, those are going to take more time given things like production lead times and the nature of physical store rollouts and so that the impact they have will be happening later.

What we did say though also was while the customer facing transformation is taking place, we've also committed to really being focused about our execution and where we're investing with an eye towards generating cash, and that includes things that can have a nearer term impact on the bottom-line, like the cost savings initiatives that Jack discussed as well as continuing to get sharper on our basic business practices, whether that's things like pricing or buying.

And so, the guidance for Q3, particularly at the comp level reflects both of those things, the nature and timeline of transformations and the fact that we continue to get sharper in our execution and we'll continue to keep you posted on our progress.

Paul Trussell

Thank you for that color. And maybe you can just spend a minute giving a bit more detail on the capital allocation decision made here, especially as it relates to the dividend decision and also help us understand what -- the decisions you're going to -- how you're going to decide to when to buy stock versus paying down debt. Thank you.

Jack Calandra

Yeah. Hi, Paul. This is Jack. So as I mentioned in my prepared remarks and given where the stock prices and the dividend yield, we strongly believe that there's a more efficient way of deploying capital then through the dividend. Want to make it clear that funds freed up from the dividend, as you mentioned will be deployed into a mix of share repurchases and accelerated debt reduction, and also just to make clear that the funds that we received from the sale of corporate apparel will be entirely applied to debt reduction.

In terms of how we will toggle between those two opportunities, you know, we'll consider a number of variables in deciding how to allocate funds between the two. I would say given our transformation strategies, the confidence we have in them and our assessment of their risk adjusted outcomes, we do believe that the stock is undervalued based on a DCF methodology, and we will continue to look at where the stock is relative to those to that valuation, as well as where the bonds and the term loan are trading relative to one another to make that decision, and it's a decision that we will obviously be revisiting frequently as we move through the months ahead.

Paul Trussell

Got it. You know, looking at Moores and K&G, you know, those are segments we spent a little bit less time speaking to, maybe just remind us what's the connectivity there between those divisions and MW and Banks? How should we view those businesses in terms of core assets and just kind of looking under the hood, you know, talk about some of the trends and initiatives going on within those businesses.

Jack Calandra

Paul, first, with respect to what you talked about on core businesses and in prior calls as you know we've talked about the fact that we saw synergies associated with operating our Men's Wearhouse, Joseph A. Bank, Moores and K&G consumer retail businesses and that we did not see synergies associated with operating the dry cleaning business or the corporate apparel business.

We've obviously sold both the dry cleaning business and the corporate apparel business. But our view with respect to our consumer retail businesses hasn't changed. We continue to see synergies associated with operating the Men's Wearhouse, Joseph A. Bank, Moores and K&G. And so those remain core businesses.

And as far as the initiatives and when we talk about the various e-com initiatives, marketing initiatives, those are things that are being leveraged across the portfolio, merchandising initiatives, and again, that's just a further example of the fact that there are synergies in operating these four different retail businesses.

Paul Trussell

Thank you. And lastly from me, just as we think about SG&A and advertising dollars, down quite a bit in 2Q. Maybe just hold our hand a little bit more as we think about, you wanted to make some maybe strategic investments, but also obviously still looking at different ways to save on costs. How should we think about these line items going forward?

Jack Calandra

Sure Paul. So this is Jack again. As you mentioned, we don't guide on either advertising spend or SG&A. But to be helpful, let me start with advertising. We expect to see this continued mix shift from broadcast to online digital and that obviously provides some efficiencies. But as I mentioned in my comments, some of the Q2 save versus last year was pushed into Q3. So I wouldn't expect as much a leverage in Q3 advertising expense as you saw in Q2.

With regard to SG&A, we'll continue to see dollar savings versus last year from some of those same items like incentive compensation and also, you know, the other cost savings actions that we've taken that are outside of some of these bigger strategic actions, for which we're still doing some work on.

But, in the areas of non merchandise procurement, our international shipping, travel and entertainment, these are all areas that we've attacked this year. Those savings help offset some organic cost increases in the business. But as I look to Q3, I would expect, sort of flattish dollars in SG&A, but deleverage given the lower sales.

Paul Trussell

Thanks for the color. Best of luck.


Our next question is from Carla Casella, JPMorgan. Please proceed with your question.

Carla Casella

Hi. One more question on the capital allocation first on -- did you give an actual leverage target? You mentioned your focus on keeping leverage neutral or bringing it down, but did you give the actual leverage target or timeframe?

Jack Calandra

Yeah. So Carla, this is Jack. Our leverage target of getting to a debt to EBITDA ratio of three times in the medium term is unchanged. That's still our target. As I mentioned, that ratio has creeped up a little bit this year with the softer business performance, but we are still focused on getting to that three times in the medium term.

Carla Casella

Okay. And then on your third quarter guidance, that excludes corporate apparel, correct?

Jack Calandra

The third quarter guidance excludes corporate apparel. Correct.

Carla Casella

Okay. And in my -- if I'm looking at given the EPS guidance you gave that to me looks like it implies EBITDA in the down low $70 millions. Is that accurate?

Jack Calandra

Yeah, we don't guide to EBITDA. But certainly I think given the components that we've shared around EPS and the tax rate and some of the comments I've made around, you know, some of the other items, I think that you can probably model that number.

Carla Casella

Okay. And then you now include rental. I'm assuming that includes both tux and suit. Can you give us some sense for how much of that rental income is suit versus tux at this point? And is there any major difference between those two business in term of economic standpoint?

Jack Calandra

Yeah. I don't have the exact numbers off the top of my head, Carla. But within the rental business, it is still predominantly a tux business, not a suit rental business. And I am not aware that the economics between those -- between renting a suit and renting a tux are very different.

Carla Casella

Okay. And then just one cash flow question. There's a there's a big -- about a $100 million use of cash in you working capital that for other liabilities. What is that related to? I was assuming it has something to do with the lease liability changes, which has another offset in the cash flow statement. But just wondering if there's something else going on there in that other liabilities line items.

Jack Calandra

No, I think you've captured -- it's the implementation of lease accounting and to your point, you should see an offset for that elsewhere in the cash flow statement.

Carla Casella

Okay. And one more debt reduction question. So you mentioned that the $62 million from the corporate apparel will go towards debt reduction. What are your options in terms of reducing debt? Do you have to buy back in the market and what's your thought on term loans versus bonds given where they're trading?

Jack Calandra

Sure. So we have the option of both repurchasing the notes on the open market as well as executing a call, as you know, at a premium of 1.0175. So we have the option of doing either of those in terms of the senior notes. In terms of thinking about the term loan versus the notes, I would say at current prices, the yields on those instruments are pretty comparable. And obviously the notes come due in July 2022, whereas the term loan we've extended to April of 2025. So I think our bias would be given the similar yields, our bias would be on the shorter maturity senior notes.

Carla Casella

Okay. Great. Thank you.

Jack Calandra

Thank you.


Our next question is from Janet Kloppenburg, JJK Research. Please proceed with your question.

Janet Kloppenburg

Hi, everybody. Just a couple of questions on the suit business. Sounds like custom is really strong. Is the promotional activity you're talking about in the off the rack suit business? And Dinesh, do you think that's coming more from the lack of demand for suits because of the casualisation trend or because department stores or off price retailers are trying to gain share and using price as a mechanism. And then I had a follow-on.

Dinesh Lathi

Yeah, I'll take the second one, Janet. Then you're going to have to remind me of the first one, what you're asking about on custom. But as far as the promotional activity, yeah, we are seeing heavy promotional activity in suits. And that is something that we saw in Q2.

That's something that informed our Q2 guide and it's something that we actually saw materialize through the quarter, and it's also influencing our Q3 guide. That is -- it's going to be driven in part by traffic, which we've talked about is it remains challenged I'd say for first retail as a whole. And then also you've met -- you referenced correctly this trend of casualisation which is obviously -- it works against off the rack suits.

I would mention, though, that there is also a trend towards personalization. And given that we're playing in custom suits, that's actually a trend that helps us and it's one of the drivers behind the healthy growth. We continue to see in our custom suiting business, even while that business is tracking at a multi $100 million scale.

Janet Kloppenburg

Okay. And then in terms of the inventory, it sounds like it's a little heavy at the Men's Warehouse, maybe the content is skewed more to suits Jack, I think that's the way you said it in some finished goods as well. How do you see that working out, getting in line with where it should be? And should we assume that the gross margin -- retail segment gross margin compression we saw in the second quarter is likely to continue for the remainder of the year?

Dinesh Lathi

I get it. I'll pick the first part of that as far as inventory is impacting the gross margin. As Jack indicated in his prepared remarks, the inventories, while higher than last year, are also of a higher quality as measured by ageing. And he also indicated a meaningful portion of those were associated, a meaningful portion of the increase I should say is associated with raw materials for basic replenishment program.

So because of the nature of that inventory, we haven't modeled in any extraordinary promotional activity in Q3, meaning our promotional efforts in Q3 will continue to be guided by the competitive environment we need to participate in and not by the current state and levels of our inventory.

Jack Calandra

Yeah. And Janet, this is Jack. I would just add to that. So just look looking forward, as you know, we don't guide to inventory, but to be helpful, I would say we expect some improvement in the third quarter -- in the end of third quarter inventories. So we'll expect -- I would expect that increase versus last year to come down and therefore for the spread between inventory and sales to improve and then to expect more significant improvement by the end of the fourth quarter.

Janet Kloppenburg

And do you see this gross margin pressure moderating as your inventory content skews more to the sport coats and the just casual, which I think you're expecting to really be impactful on the spring season?

Dinesh Lathi

Yeah, the gross margins are obviously lower in our polished casual segments than they are in our suit segments. And so obviously as the mix shifts and that'll impact gross margin. The offset to that, though, Janet, is the frequency associated with polished casual purchases is obviously much faster and much higher than that associated with foods. And so even as you might see an impact on gross margin, we think there's an opportunity for SG&A leverage associated with higher transaction velocity in polished casual.

Janet Kloppenburg

So, should we expect gross margins to continue to be under pressure for the next couple of quarters? And am I right that you inventory content will be where you want it to be in the spring season?

Jack Calandra

Yes, so with regard Janet to gross margin, I would expect many of the gross margin headwinds that we experienced in the second quarter will continue into the third quarter. Dinesh talked about some of these just in terms of the level of promotional intensity and competitiveness out in the market, and we expect that to continue with the increased penetration of custom, as you remember that's a lower gross margin rate at higher gross margin dollars.

And obviously with the comps that we've guided to, there will be some occupancy deleverage. So I would expect that the gross margin headwinds that we saw in Q2 to largely carry into Q3 and that's been contemplated in our guidance.

Janet Kloppenburg

Okay. Thank you so much.

Jack Calandra

Thank you.


We have reached the end of the question and answer session. And I will now turn the call back over to Dinesh Lathi, President and CEO for closing remarks.

Dinesh Lathi

Thank you everyone for joining us today. We appreciate your ongoing interest in and support for the important work of transforming our business. We look forward to sharing our continued progress with you next quarter. Thank you.


This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.