American Eagle Outfitters, Inc. (AEO) Q3 2014 Earnings Report, Transcript and Summary

Greetings, and welcome to the American Eagle Outfitters' Third Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Ms. Judy Meehan, Vice President of Investor Relations. Thank you, Ms. Meehan. You may begin.

Good afternoon, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Interim Chief Executive Officer; Roger Markfield, Chief Creative Director; and Mary Boland, Chief Financial and Administrative Officer. Also joining us for Q&A today are Simon Nankervis, EVP of Global Stores; Michael Rempell, Chief Operating Officer; and Jen Foyle, EVP and Chief Merchandising Officer of aerie. Before we begin today's call, I need to remind you that we will make certain forward-looking statements. These statements are based upon information that represents the company's current expectations or beliefs. The results actually realized may differ materially based on risk factors included in our SEC filings. Our comments today include non-GAAP adjustments. Please refer to the tables attached to the press release. We have also posted a financial supplement on our website. Now I'd like to turn the call over to Jay.

Okay. Thank you. Good afternoon. In what continues to be a tough retail environment, we delivered higher margins and earning growth compared to last year ahead of our expectations. Our results reflect the progress on the work that began earlier this year to strengthen our assortment and drive better efficiencies across the business. In the third quarter, we achieved 16% adjusted earnings growth. By managing the business better, we were able to reduce markdown rates and controlled expenses. We ended the quarter in good financial condition, with a cash balance of $280 million and no long-term debt. The period overall marked a step forward, yet we have significant opportunity to further strengthen our business. To that end, during the quarter, we took restructuring charges aimed at improving the store portfolio and increasing efficiencies at our corporate office. We will continue to close less productive brick-and-mortar stores as our leases expire while selectively pursuing new openings. We are reducing corporate overhead expense to eliminate redundancies at the home office. And we are in the process of consolidating office space. The work will continue and is aimed at making us more profitable, more efficient and will enable us to invest in areas that will fuel future business. As I said at the beginning of this year, we need to bring fun and innovation back to our company. I think we made good headway on this front. Our marketing events and lease lines are more compelling. Our stores, both AE and aerie, reflect higher energy, stronger outfitting ideas, an improved color pallet and overall better merchandising. This is an ongoing effort as we strive to continuously stay connected to our customers and build a better brand experience. We have a solid foundation on which to build. Our brands are well positioned in today's marketplace. We will stay true to the AE heritage lifestyle while continuing to increase our speed-to-market and improve the customer shopping experience across stores and digital channels. aerie has been a standout performer. They have achieved positive comps and stronger profitability which has continued into the holiday season. We have a highly capable team led by Jen Foyle. Now we need to keep the momentum going as we evolve the assortments and further expand the aerie brand. On the technology front, we continue to drive advancement in omni-channel. Approximately 15% of digital sales were fulfilled through our ship-from-store capability, which is now in about 530 stores. We've seen faster merchandise shipping times and better inventory utilization. B.O.S.S. will expand to all stores next year. We also look forward to launching reserve online, pickup in store, providing additional shopping alternatives for our customers. We're also seeing benefits from our new distribution center, which is cutting our average delivery time in half. We continued our global expansion strategy. In November, we opened 3 new stores in London to an encouraging customer response. We will selectively pursue new growth opportunities while staying focused on strengthening our brand domestically. I'm pleased with how the teams are executing our vision and managing the day-to-day business overall. We've done a good job anticipating operational challenges. For example, we successfully managed the West Coast port slowdown with no major disruption to our holiday flow or cost increases. Although we made progress this year, we continue to face weak traffic in a highly promotional sector. In addition, as we cycle against our own history of heavy promotions, it's been difficult to achieve consistent sale performance. Our strategy has been to maintain price integrity by reducing promotional activity. We strongly believe this is the right approach. We've seen some success yet have plenty of room for improvement. It goes without saying that this is made possible only with great merchandise. The right balance of quality and value, strong inventory controls and engaging customer experience, all major priorities as we move forward. We must continue to challenge ourselves in all fronts. At the same time, we need to continue to bring operating expenses down to deliver stronger profitability. Thanks. And now I'll turn the call over to Roger.

Thanks, Jay. Good afternoon to all. This season marks good progress, though we continue to face significant headwinds. As Jay said, we've been focused on improving the customer experience and elevating our merchandise assortments. For today's consumer, we are executing an updated lifestyle brand experience that is true to the heritage of American Eagle Outfitters. To be clear, this is finding the right balance between new fashion and updated key heritage looks. We are uniquely positioned as the casual, youthfully optimistic American-inspired lifestyle brand, which ranks high among our customer base. The emphasis we placed on being true to our brand DNA is a very important distinction from how we have operated in the recent past. And in my view, it's the change that when executed well, will successfully lead us into the future. Now let me take a step back and review the third quarter. Although sales declined slightly in a really tough retail environment, we saw improvement from the first half. As we said on the second quarter conference call, lowering promotional activity was a major priority. We delivered on this priority and saw our merchandise margins rise over 300 basis points. This was driven by better merchandise, stronger inventory controls and more strategic marketing events. Consistent with our strategy, we did not anniversary 20 days of 40% off-the-box promotions hold last year. While mall traffic continue to be a challenge, our more disciplined pricing strategies helps in spur an increase in the average transaction value, driven by a higher average unit retail price and strong units per transaction. To underscore what Jay said, our greatest opportunity is to curb promotional activity while delivering sales improvements. On the last call, we also talked about supply chain efficiencies. Fast-tracking and planning our inventories conservatively, this was achieved with quarter-ending inventories in good shape and below last year. We continue to drive inventory productivity and improved inventory turn from last year. During the quarter, we chased into strong sellers much more effectively, including sweaters, joggers and denim. We made a strategic decision to improve product quality through the use of better fabrics and incorporating new washes and treatments. Essentially, we've added more of the special details we were missing in recent seasons. Our recent launch of AEO Denim X is a great example of innovation in a key heritage category. The response has been very positive and is an example of how we need to deliver newness across the business. We've seen strength in women's sweaters and men's and women's bottoms. Some of the more challenging categories include men's and women's T-shirts and fleece. As a category overall, denim hold up extremely well, exceeding our plans and delivering higher margins. Newness in non-denim bottoms such as joggers and jeggings and leggings achieved strong double-digit comps and mostly offset the slight declines we experienced in denim. We continue to work on broadening our offering, putting more emphasis on accessories, creative gift-giving and unique opportunities like American Eagle Outfitters, an example of fun and innovation. aerie has continued to deliver strong results, with positive comp sales and a significant increase in profitability. I'm extremely pleased with the direction of aerie. Strong performance has continued in the bra and undies business, and the team has done a nice job expanding categories, strengthening assortments and leveraging our AE customers. This holiday season, the stores look great, with an emphasis on gifting, strong colors and exciting new trends and soft dressing. I congratulate the team and look forward to continued success and further expansion of the business. Although we've made good progress against our priorities, our margin rates are still well below our goals. And as we continue to strengthen the assortments and drive innovation across product, marketing and customer engagement, we expect to see continuous improvement. I'd like to thank the teams for their hard work. I wish you all a happy holiday. And now I turn the call over to Mary.

Thanks, Roger. Good afternoon, everyone. Despite ongoing macro pressures and weak mall traffic, our third quarter performance exceeded our expectations. While sales were essentially as expected, we effectively reduced markdowns and controlled expenses compared to last year. This led to adjusted year-over-year earnings growth of 16%. Now looking at the details of the quarter. Total revenue declined slightly to $854 million from $857 million last year. Consolidated comparable sales declined 5%. By brand, AE comps were down 6%, and aerie increased 3%. On a consolidated basis, the number of transactions decreased due to declines in traffic. However, as a result of reduced markdowns and a change in promotional strategies, the average transaction value increased in the high single digits, driven by mid-single-digit increases in both the average unit retail and units per transaction. Additional sales information can be found on Page 8 of the presentation. Total gross profit increased $17 million and as a rate to revenue, rose 200 basis points to 36.9%. The margin improvement was driven by reduced markdowns and was partially offset by 120 basis points of buying, occupancy and warehousing deleverage. SG&A expense of $205 million declined 1% from $206 million last year. As a rate to revenue, SG&A held flat to last year at 24% despite negative comps. We were pleased with good expense management, driven by reduced overhead and variable expense, partially offset by continued investments in new stores and international expansion as well as increased incentive expense accruals. Depreciation and amortization increased to $37 million, deleveraging 40 basis points due to omni-channel and IT investments, new factory and international stores and a new fulfillment center. On a non-GAAP basis, our tax rate was 42.4% in the quarter, reflecting reserves against international startups. Adjusted operating income grew 22% to $74 million, and the operating margin expanded 160 basis points to 8.7% as a rate to revenue. Adjusted EPS of $0.22 increased 16% from an adjusted EPS of $0.19 last year. Now turning to the balance sheet. Starting with inventory, which can be found on Page 9 of the presentation, we ended the quarter with inventory at cost per foot down 14%. The year-over-year decline includes a change in the timing of inventory ownership. As a reminder, late last year, we began taking ownership at the receiving port rather than the port of departure, creating working capital efficiencies. Without this change, inventory at cost per foot decreased 3%. We expect fourth quarter ending inventory at cost per foot to be up slightly, following a mid-teen decline last year. Fourth quarter ending inventories reflect an acceleration of spring receipts due to the West Coast port slowdown. Following holiday, end-of-season inventories are expected to be down approximately low double digits. We ended the second quarter with $280 million in cash and in investments. On December 2, we closed on a new $400 million asset-based credit facility, replacing the existing $150 million revolver. The new credit facility, which carries a 5-year term, remains undrawn and provides increased financial flexibility, liquidity and takes advantage of a favorable credit environment. Capital expenditures totaled $64 million for the quarter. We continue to expect CapEx to be approximately $230 million this year, falling to $150 million in 2015. During the quarter, we opened 23 stores, including 5 North American mainline stores, 10 factory stores, 5 stores in Mexico and 3 in Asia. We closed 3 stores, including 2 aerie standalone locations. Additionally, we opened 10 international-licensed stores, ending the quarter with 94 licensed stores across 14 countries. We are on track to close over 70 stores by year-end, with over 40 closing in January. Additional store information can be found on Pages 12 through 14. Now I'd like to review the restructuring charges incurred during the quarter. Third quarter GAAP results included approximately $51 million or $0.17 per share of charges related to our profit improvement initiative. This includes roughly $33 million of noncash store and asset impairment charges. As a result of our store fleet review and challenging performance this year, 48 AE and 31 aerie stores were impaired. Third quarter GAAP results also include $18 million in restructuring charges related to corporate overhead reductions, including severance and related items and office space consolidation. Regarding the outlook for the fourth quarter. We continue to operate in a volatile and highly competitive environment. As we see it currently, we expect a slight decline in revenue and a mid-single-digit decline in comparable sales. For the fourth quarter, we are expecting EPS to increase over last year to $0.30 to $0.33. Our guidance compares to adjusted earnings of $0.27 per diluted share last year and excludes potential impairment and restructuring charges. We expect fourth quarter markdowns to decline. As we anniversary a $37 million or 15% decline in SG&A last year due to incentive reversals and lower advertising expense, we currently expect operating expense to increase in the high single digits in the fourth quarter. In addition to the impact of incentives, the balance of the increase is due to advertising and new store openings. Now looking forward to 2015. The results of the restructuring will drive gross savings of approximately $27 million across gross margin, SG&A and D&A. These reductions will be largely offset by inflationary costs and strategic investments, including omni-channel projects, customer-facing activities and continued global expansion. As a result, SG&A dollars are currently expected to be in the range of flat to down slightly in 2015. We continue to strive towards gross margin in the high 30s, which we expect to come primarily from continued reductions in markdowns. BOW is expected to increase in the low single digits in 2015. Our plans to close 150 stores over the next 3 years remain on track, and we continue to assess the fleet for additional closures. In 2015, we will open about 20 to 25 stores, primarily factory and international locations. We will close approximately 70 stores, including 20 aerie standalone stores, and most of the closures will occur upon lease expiration in January of 2016. While new stores continue to deliver higher returns and have higher sales per foot than the stores we are closing, the new stores also carry higher rents, leading to the increase in BOW. We remain committed to executing on our priorities to reduce promotional activity, improve assortments and control inventory while continuing to bring down expenses to strengthen our profitability. Thanks for listening. And now we'll take your questions.

[Operator Instructions] And the first question is from Simeon Siegel of Nomura Securities.

Can you talk about your -- just a view to the long-term store targets, maybe between full price, factory, domestic and international. And then just a quick follow-up, Mary. There are clearly markdown factors that could skew this, but historically, it looks the Q4 gross margin rate has been below the Q3 gross margin rate on a seasonal basis. Any reason that shouldn't be the case this quarter? And I guess, what are you -- embedded in there, what are you expecting within your guidance for Q4 gross margins?

Simeon, it's Simon. I'll take the first part of the question and pass it off to Mary for the second part. So in relation to the blended mix between factory and mainline, it's part of our continuing strategy to assess where the mainline fleet looks in the U.S. in particular. As we've said on earlier earnings calls, we look at the way that our customer is currently shopping between the various channels and we use that as a leading indicator to tell us how many stores we should have in each of the various channels and where there's been movement between our shopper in the factory and mainline channel. And then overlaying that is the digital strategy we have through our flexible fulfillment opportunities with buy online, ship from store and the other opportunities that we're working towards for 2015. In relation to international, we've really just commenced that journey from an owned-and-operated perspective. We continue to develop the license business relatively aggressively at the moment. It's a low capital investment initiative for us with high return on investment. And from an owned-and-operated perspective, we're going to evaluate the way that those stores continue to perform, and as the stores perform and we see the return on that investment, we'll continue to expand accordingly.

Okay. And then regarding gross margin for the fourth quarter, expecting it to be probably in the mid-30% range, which is slightly down from Q3 but pretty consistent with Q1 and Q2. I think more importantly, that gross margin in the mid-30s will be a significant improvement over last year. It could be pretty close to a 300 basis point improvement. So we're seeing that good trend continue into Q4.

The next question is from Matt McClintock of Barclays.

Really impressive job of reducing the box-wide promotions this quarter. And now that we're into the holiday season, I was just wondering if we could get maybe your updated thoughts on given the environment itself, are you more or less optimistic that the promotional intensity or your -- and the strategy to be able to reduce those box-wide promotions, given where the promotional intensity is of the industry. And then also as a second question, I was wondering if you could update us on the franchise stores internationally, haven't heard much on the performance of those. You're opening a good number of those this quarter. Maybe just update us on where those stores stand relative to maybe the performance the last time you updated us on that.

Sure. Now our pricing strategy obviously is contingent on having a stronger, better compelling product than the marketplace than that which we had last year. So with that ability, if we believe we have it, we have a strategy in place, and we want to be consistent with that. So at this point in time, yes, the promotional activity in the malls is greater than ever, it's deeper than ever. So at this point, we're staying pretty consistent to our vision.

In relation, Mark, in relation to the franchise business, we opened 2 additional markets in Q4, being Thailand and Indonesia. We've seen continued expansion with our existing licensees. We've been really happy with the performance of those businesses, and I think the growth that you've seen in the store counts is reflective of the way that those markets have performed. In relation to the earnings that we've seen coming out of that, we've been really positive -- we've seen positive improvement in that and we're continuing to see additional opportunities with new partners coming on into next year.

The next question is from Thomas Filandro of Susquehanna.

So Jay, a question for you. It's kind of a broader question, I was curious, can you kind of just tell us what gives you confidence in the viability of the business model? Because some have questioned the viability of the business model as well as the brand direction and leadership. And then the second part of that or third part of that, long term, do you see -- what do you see the balance between brick-and-mortar and DTC?

Well, you asked 3 questions here, Tom. Well, you know what gives me confidence? On the new product that we introduced, we see a very good reception on it right away with the customer. So my feeling is that it takes a combination. Number one, we have to get the right product, the right quality. And that's where we put our emphasis this past 9, 10 months on, is really getting the product right. And we made a lot of progress. I'd say the last 9 months this quarter on the quality of the product is much improved than it was 9 months ago. So from that direction, everything is going the right way. The second thing is you're never completed. And I feel that there's a -- still a tremendous opportunity out there to create more excitement within the store. Roger and I and the team, we've worked on it and we feel there's a lot of opportunities in the next 12 months coming up. And as soon we get to the holiday season, we'll start working on that. So I'm very optimistic on the brand. We see the way the customer responds between the -- on the brick and the mortar, and also, we see the response of our website that -- the way the customer is responding. It's very positive that we didn't go to this -- to the 50%-off discounts on our site. We went to 40%-off. But yet, we got very good results at 40%-off. I think we did better at the 40%-off than the team was anticipating. So that's positive. And I feel that in this type of environment, as long as we stay true to our beliefs and stay true to the heritage of the company, I think we'll be in very good shape. We see a lot of good -- we see aerie. aerie's had good results. They haven't done any steep discounting. We see big opportunity there. The international business is being strong. We see an opportunity coming up very shortly of expanding our e-tail business overseas. So there's a lot of real positive things going on. It's just a lot of work to do, but everyone is up to the task.

Obviously, Jay and I are -- talk every day, and I'm -- we're in sync on all of the things that he just talked about. When people challenge the viability of the lifestyle brand equity, if you take a look at all of this research, not the ones that we've done, but the -- your due diligence throughout the industry has done, American Eagle is by far the strongest brand. Our brand equity score is higher -- other than Nike, we're the second strongest brand in apparel retailing in this demographic. We're a very powerful brand. Our share of market in bottoms is dramatic, and our power as a destination store in denim is unequaled. We have so many parts of the lifestyle brand that work for us, that the customer comes to us for as the destination store. And now by putting the right product in, in a complete lifestyle way with the right finishes and washes and details, it is resonating with the customer, as you can see our results vis-a-vis the competition at this point in time, Tom. I feel optimistic of the positioning of a lifestyle brand versus fast fashion as I've ever been.

The next question is from Adrienne Tennant of Janney Capital.

My question is more sort of on a philosophical level. There's a trade-off as you pull back on the promotions between sort of the gross margin rate and then gross margin dollars. And I'm wondering as you're less promotional than others, some of your competition, are you concerned that in the near term, you may lose some share, but you're -- while doing the right thing for the company longer term? And then just any update on the CEO search would be wonderful.

Well, that was 2 questions. I'll let Jay answer the CEO search.

Well, the process is underway. We're committed to finding a strong successor, and as soon as we do, we're going to let everybody know.

As it relates to share of market, in our competitive landscape, obviously, we're gaining share of market. And I'll leave it at that.

The next question is from Randy Konik of Jefferies.

I guess, just thoughts on the environment. Do you expect the AURs to kind of stabilize at all? And Mary, on the CapEx, is there going to be more further cutting you can do on the CapEx? Or how's the CapEx look maybe 2 years out from now?

If I look at AUR -- I'll answer both questions. As I look at kind of AUR, expect to see a continued improvement in our AUR as we pace through the fourth quarter here and probably a bit into next year. I mean, and that, again, is really driven by the reduction in markdowns as the product has improved, and we backed off the strong promotions. From a capital perspective, as I said earlier, we'll spend about $230 million this year. As I look into '15 and '16, we're probably back to what I would call a more normalized rate of something like $150 million. We had a lot of catch-up to do here, this last couple of years, around infrastructure and some digital spend, and that'll moderate back to about $150 million.

Next question is from Lindsay Drucker Mann of Goldman Sachs.

I was hoping, number one, can you give us any color on how your performance has been quarter-to-date? And just any color on Black Friday? And then secondly, Mary, it was great to hear some of that -- those preliminary thoughts on 2015. The high 30s gross margin goal, is that something that you can -- do you have a certain time line to that? I'm guessing you're looking for some gross margin improvement just based on the pace of what we've seen in the back half of this year. And also, any early thoughts on where the tax rate might shake out next year?

Lindsay, we don't report on monthly information. We're really quarterly. But just to give you a sense, let's say that the month of November is spending is pretty similar to how third quarter was doing, which we were quite pleased with. Obviously, we were not nearly as promotional as we were last year for the Black Friday weekend, and certainly, our margins and average unit retails were considerably higher.

I think for gross margin, Lindsay, as I look into next year, every quarter is a little bit different depending on our product mix, et cetera, and cadence of store openings. I think for the year, I feel pretty good about the high-30 rate that we'll be able to achieve it. I mean, I do it every quarter, but I think we will for the year. Tax rate, expect that to fall back to something, historical levels, right around 40% as we get into next year.

[Operator Instructions] The next question is from Susan Anderson of FBR Capital.

I was wondering if I could just get your thoughts on if we look out a year or 2 from now on the competitive environment, it just seems like things aren't letting up. I know a lot of the teen retailers are rationalizing stores, but then we still are getting a lot of the international players coming into the market. So maybe just your thoughts on that and how you think about getting comps back positive.

On the competitive landscape and of the international players coming into the market, listen, when you're in this business, you kind of thrive on great competition. It makes you perform better. And at this point, all of those coming in are really fast fashion guys, they're not really in the lifestyle business where we put together a, what I call, a Broadway show 10x a year. So our fashion is as updated as anyone else's, and we do it 10x a year with a great floorset. So and they're all fast fashion players, so from my perspective, I don't see it as an issue for us. And the reality is that some of the competition that was in our space, which seems to be changing their strategies, may no longer be in the business at all. So I think we're in a great position at this point in time.

The next question is from Anna Andreeva of Oppenheimer.

I had a question on inventories. I guess what number should we think of ending the fourth quarter, excluding the earlier spring receipts? And also into 2015, I think you guys still have an opportunity for tight management in the spring. And also, maybe just an update on factory. It's been a couple of quarters of declining comps over there. Maybe remind us about the sales productivity and the profitability of that business.

Okay. I'm not sure I got all the questions right here, but on inventory, if you exclude the early spring receipts, we'll likely be down kind of low double digits. So kind of fall holiday, we'll be cleared out, I think, pretty well by the time we get to the end of the quarter.

In relation to the factory business, we're still seeing that business outperform the mainline. It's still a highly profitable business for us. We've continued the expansion of that network of stores as we've seen growth and opportunities. I think part of the impact on comps has been as you grow the footprint and as the number of new factory developments coming on, you're not seeing those significant grand openings that we were seeing historically. So we're still really positive about the space and continuing to focus on development of that strategy.

The next question is from Paul Lejuez of Wells Fargo.

Can you talk about AUC in the fourth quarter and what the outlook is into the first half of '15? And also, curious about e-comm performance versus the stores and if you're seeing any difference in categories, e-comm versus bricks-and-mortar?

Right. Paul, it's Michael Rempell. I'll take your question. First on product costs, product costs continue to be a focus for us and frankly, should be an opportunity heading into the back half of 2015 as we have tailwinds from both currency and cotton. You have to remember that in both the fourth quarter this year and in the first half of next year, we're going to anniversary product that was much less expensive, but our customers clearly didn't feel like it was special or unique enough and really wasn't -- they didn't think it was a great value. So during that time, fourth quarter this year into the first half of next year, we'd expect product cost to be roughly flat as we look to improve the assortment. Our focus as a team is really in the back half of next year, where we see opportunity to continue to improve our quality, differentiate our product, but take some of the tailwinds that we have and reduce cost. And the second part was about performance in DTC in terms of the mix. I would say the selling online is roughly the same as what we see in the stores.

The next question is from Dana Telsey of Telsey Advisory Group.

As you think about the marketing, what's working? How do you see the marketing spend moving forward? And are there any particular categories we should watch for it on? And also, aerie versus American Eagle in terms of what you're seeing there to help drive the sales.

I'll let Jen talk a little bit about aerie since it's such an exciting story, and we're lucky to have her with us right now.

So aerie, we had a really nice quarter. I was really proud of the team. They really delivered on all fronts. And it's really never about one thing as Roger always says. So we had creative marketing. The lease lines were innovative. The product was great. And we have a solid strategy that we're delivering on, which is opening up the new store formats, closing nonproductive stores. And then not to forget about the direct-to-consumer channel, that's been really generating nice traffic. We've been leveraging the AE brand, and it's aiding in brand awareness.

And Dana, as it relates to marketing for both the Eagle and aerie, you're a real student of the business. I think you can walk into the malls and look at our 7.5 miles of windows, and I think you'll say that the marketing of our stores is quite attractive, and it's compelling and it drives people into our store. At the same time, each time we do a set, we're back to the structure, and the precision of doing marketing for each one of those sets, it's telling a whole new story. That is something that fast fashion players don't do. That's a very important part of being a true lifestyle brand. So when you put together what we're doing on the outside and using our own mobile and web devices to do that, and it corresponds to what we're doing in our stores and in our windows, the combination of all the efforts being very focused is it drives the message that we need to do.

The next question is from Rick Patel of Stephens.

I had a question on fashion products. They seem to be doing pretty well. Given what you're seeing, should we expect that assortment to represent a bigger piece of the pie, either for the spring season or for back-to-school? And if there are changes that are going to occur, what are the implications for margins?

Our fashion business is doing very well, and we have great opportunity because as you know, we're such a dominant bottoms business. I won't give you our ratio, but the opportunity and the ratio for us to drive a lot more tops business with the bottoms business, now that we've hit the right fabrications and the right styling and the testing that we're doing is back in place, I see big opportunity as we move into the spring on the tops business, and most of that is the fashion.

The next question is from John Morris of BMO Capital Markets.

You talked about the customer-interfacing initiatives ahead. You plan to invest more for in 2015. So Jay or Roger, can you talk a little bit more about that, what we expect to see, and would we expect to see some of the benefit of that impact in 2015?

The things you're doing with the weather. Let Michael...

Yes. So John, we're doing quite a bit under the umbrella of our omni-channel initiative to try to give our customer better experience and also leverage the capabilities we have as a company. We're thrilled with our ship-from-store rollout that we've been working on all year. We're in about 530 stores. We've learned quite a bit about this technology through the year, how to manage the algorithms to drive profitability, and we're very pleased by the volume that's been generated and the ability to better service our customers. We now -- during holiday, we have it targeted on unproductive inventory and lower-volume stores that are within 2-day shipping of our customers. And we're seeing great results. We plan to roll that out to the balance of the chain next year. The team has done a tremendous job. The stores are fulfilling these orders very quickly, training stores very nicely, and we think there's a huge benefit there for our customers. We're going to roll out reserve in-store next year, which we think is going to be a big win. A big part of our customer base doesn't even have credit cards, so the ability to be on their device, identify something they want to buy and then go to a store, pick it up, pay cash, we think is going to be a huge win for us. We rolled out new digital capabilities, both in improved mobile -- improved website as well as a new mobile app in the last quarter. And why that's critical, John, is we updated that app 8x in the quarter, okay? We were able to do that because we built it in-house and we own that technology. Previously, we were only able to update about 8x a year, okay? So as quickly as traffic's driving to mobile, we're able to meet and exceed customers' expectations with that new technology, and it's only the tip of the iceberg. And just the last thing is we went into pilot in the back half of the year with a new point-of-sale system. It's only in about 10 stores today, but we plan to roll it to the entire chain next year. And there's 2 key capabilities in that, that Simon and I are -- and the team are very excited about. One is we're going to have mobile checkout in all stores, so the ability to check a customer out through either an iPad or an iPod in the stores. And the second is the ability to save a sale from those same devices. So an associate with a customer, we don't have it in their size in store, they can look it up in the iPad, see if we have it in another store or in a DC and ship it to a customer's home.

The next question is from Neely Tamminga of Piper Jaffray.

One quick point of clarification on the SG&A, just to make sure I heard that correctly. SG&A dollars, rate or both for being flat to down slightly for next year, Mary? And then, Roger, for you, we've heard a lot about joggers and jeggings and leggings, I don't know if I could say that again that fast, but wondering, what are the kiddos wearing it with? I mean, why are -- what's going on with tops? What tops should they be wearing? What business should be better?

Well, if I told you what they should be wearing with these tops, I'd be giving too much information out.

All right. Joggers, jeggings and leggings, all right.

That's it.

And then SG&A next year, flat dollars, flat to slightly down dollars for 2015.

The next question is from Kimberly Greenberger of Morgan Stanley.

My question is just on traffic. Clearly, the traffic is suffering today because you're pulling back on the promotional activity. But you'll anniversary that in the second quarter next year, and beyond Q2 in 2015, how do you expect your traffic trends and your transaction counts in-store to trend?

It's difficult to forecast out, as you know, Kimberly, very difficult. But my sense is that when you take the transactions online and you take the transactions in the stores and you put it together, if we're the compelling lifestyle brand that I think we are at this moment vis-a-vis the competition and how much better we can be when we do much better as we move forward, I would think that the combination, our traffic should start to turn upward.

The next question is from Jennifer Davis of Buckingham Research.

And Jay, I will say, I agree, the merchandise is much improved from 9 months ago, and that Denim X is really great.

Thank you. He won't beat me up after this call.

All right. Yes, that's the softest denim I felt. Anyway, the...

Wait until you see 4X.

Okay. A quick clarification on merchandise margins, if you could. How much of the merchandise margin increase was based on a reduction in markdowns and how much on AUCs?

For Q3, it was mostly markdowns, almost entirely markdown-driven.

Right. As Michael said, the -- we really improved the fabrics, the washes, the quality of the make. So we were able to hold our cost pretty flat, which is terrific. But going forward, Michael is going to have great improvement with the currency and cotton changes.

Okay. So you've actually increased the quality but held the cost current or...

That's correct.

The next question is from Rebecca Duval of BlueFin Research.

Roger, my question is for you, and I know you don't like to give too much away, but we saw a lot of success for some of these capsules that you were bringing into the stores with the Artisan De Luxe, the 40 West [ph], Don't Ask. And it seemed like you were able to get away with some premium retail. And my question is can we expect to see more of that go forward? And is there plans to be rolling that out to more doors as well?

We're very happy with what it does and we -- actually, Jay and I just went through our concept for holiday for next year. And the collaboration and those capsules are better than ever. But they always will only be a small part of the business. But when it inspires the inspirational part of the store and it gives us that sizzle that we absolutely need to have, and we need to have more of it, we certainly are going to continue it, but it will be contained. And it's great information, not as exciting for the customer, but it's great information for us.

The next question is from Jennifer Black of Jennifer Black & Associates.

We're seeing a bigger assortment of accessories, and I wondered what percent of their -- of your business accessories represent now and where could we see that go? And then I just have a follow-up on what kind of a comp do you need to get leverage in 2015.

The comp leverage is probably low single digits, and then I would ask Roger...

And accessories will continue to grow.

And you're not going to say what percent they are now?

No.

Well, do you have substantial room for growth?

Yes, we do.

The next question is from Lorraine Hutchinson of Bank of America.

Mary, with CapEx coming down next year, can you review your view on priorities for free cash flow?

I think it's again about our product, our assortment, making sure our stores reflect a great customer experience, continuing to invest in the company, open stores, et cetera. I think, as I look at kind of our plan for next year and where we're investing, it is really around those priorities plus in the digital space where, as Michael articulated earlier on the call, lots of great investments that we have going forward that are needed for the company to get competitive and hopefully, gain a competitive advantage. So I think it's all about investing in the company and in investing in areas that will help drive profitable growth for the company as we look forward.

The next question is from Marni Shapiro of The Retail Tracker.

Could you just talk a little bit more, you mentioned that some T-shirts and knits and fleece have been a tougher part of the business, but how much of the softness in that space is due to headwinds from the trending-down logo business? And how much less logo business do you have in the stores today, even versus last year where you were kind of blowing out some of it at decent prices?

Right. The logo business is such, for us, has never been a huge part of the business. It was not how we wanted to build the business. I never believed in taking the eagle and spraying it across the chest other than in graphics with tees and fleece. So at this point, it represents under 10% of our business. And obviously, the trends are a bit less, but our eagle is a very powerful icon on a global stage. And we -- I believe in the eagle very strongly. You would never see Ralph take his polo player off, and I don't think you should expect to see the American Eagle take the eagle off of its garments. But as it relates to the whole graphic, that is something we've never really been in a big way. I don't believe in that.

And that was all the time we have for questions. I would like to turn the floor back over to management for any additional or closing remarks.

Okay. Thank you for your time today. We look forward to delivering improved profitability and stronger shareholder returns. We wish you all a happy holiday season. Thank you.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.