American Eagle Outfitters, Inc. (AEO) Q1 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to the American Eagle Outfitters' First Quarter 2015 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Judy Meehan, Vice President of Investor Relations. Thank you. You may begin.

Good morning, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Interim Chief Executive Officer; Chad Kessler, Global Brand President of the AE brand; Jen Foyle, Global Brand President of aerie; and Mary Boland, Chief Financial and Administrative Officer. Also, joining us for Q&A today are Roger Markfield, our Chief Creative Director; Michael Rempell, Chief Operating Officer; and Simon Nankervis, EVP of Global Commercial Operations. 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. We have also posted a financial supplement with additional financial details on our website. And now, I'd like to turn the call over to Jay.

Okay, thank you, Judy, and good morning, everyone. I'd like to start today by congratulating the team for outstanding execution. Both AE and aerie performed remarkably well, achieving higher sales and margins, and proving, again, that we can win today's competitive environment. The team has done a great job building on the business momentum we saw in the latter part of 2014, and we're pleased to see momentum continue into the current period. When I reflect on what has changed since early 2014, we now have a greater focus on our customers and we're delivering a better overall experience. Our merchandise assortments are more innovative, on-trend and better quality, while also offering outstanding value. Marketing messages have been clearer with less focus on promotions and more emphasis on merchandise, outfitting and a more compelling brand experience. And we are thrilled that our customers have taken notice and are responding. Now let me review some of the highlights of the first quarter. Net revenue rose 8% and comparable sales increased 7%. EPS of $0.15 was up significantly from $0.02 last year. This was also above our guidance of $0.09 to $0.12. We had a higher penetration of full-price sales and lower-promotional activity. This led to significantly higher merchandise margins. There was much greater consistency across our business, with positive results in AE men's, women's and aerie. SG&A expense was well controlled, enabling us to deliver stronger sales leverage. Inventories are in good shape and the team managed well through the port slowdown. An upgraded digital experience and new flexible fulfillment capabilities also contributed to stronger results, while raising customer satisfaction. We ended the period in excellent financial position with $327 million in cash and no debt. The quarter represented the third quarter in a row of year-over-year earnings growth. We feel great about this progress, yet, our focus is growing on the future and building on our recent success. Over the past few years, we made significant investments and we're now in a position to reap the benefits of this work. For example, this quarter, our digital business accelerated a double-digit growth due to improved merchandise and customer experience, better site functionality, upgraded imagery and marketing. We are pleased with Buy Online Ship from Store and look forward to launching Reserve Online shortly. These new capabilities, combined with our new state-of-the-art fulfillment center, are providing efficiencies. We're able to rationalize inventory investments, reduce markdowns and our customer delivery times are 25% to 30% faster. The closing of our [indiscernible] DC this summer will yield fulfillment cost savings. With the interest -- infrastructure and capabilities now in place, we are focused on optimizing the benefits to our business and financial returns over the course of this year and into next. Global expansion continues with the recent addition of new license partners in Chile, Peru, South Korea, Greece and Singapore. And we are pleased by the progress being made in company-owned markets, specifically, China and Mexico. Our company is well positioned for the future. The leadership team is doing an outstanding job executing improvements across the organization. As Jen and Chad continue to take the lead as Global Brand Presidents, we are fortunate to have Roger engage with the business to ensure a smooth transition. As we move forward, we are in a unique position to capitalize on opportunities in the marketplace. And now, I'll hand the call over to Chad.

Thanks, Jay, and good morning. I'd like to begin by underscoring something that Roger said last quarter, that our vision and priorities over the past 15 months have been the absolute right areas of focus. These are people, product, process and presentation. Our strategies to strengthen our business and customer offering includes: People. I believe that we have the right team in place committed to developing the best American Eagle assortment globally and across channel. Product, first, we have turned up our focus on merchandise innovation. Denim X and Soft & Sexy tops are a few examples. Second, we've improved product quality and we're getting paid for that quality, while continuing to offer outstanding value to our customers. Third, we're delivering strong seasonal concepts that are well curated and edited to be consistent with our brand's heritage, yet, highly relevant to the latest trends and styles. Our current Beach Whites and Indigo Blues are good examples. Process. We are committed to lean inventories that will grow at a slower rate than sales. We will test and react into trends to be more accurate in our buys each season. Presentation. We are focused on clear and engaging in-store and online presentations as well as a more fun, customer-centric shopping experience. Although there are still work to do and much opportunity ahead of us, we are extremely pleased to see a positive response and strong demand from our customers. The American Eagle brand's 7%, comparable sales increase and merchandise margin expansion for the result of a much healthier and significantly less promotional business throughout the quarter. This was aided by our marketing efforts that led with product first, rather than a singular focus on price. We delivered a higher average unit retail and average transaction value. Traffic and conversion also improved from recent quarters, and we were extremely pleased that we outpaced mall traffic consistently throughout the quarter. Our inventories were well positioned, enabling us to read and react to product trends more effectively and chase strong selling categories. I'd like to underscore our commitment to tightly managing inventories, targeting sales above inventory growth. Now looking at merchandise performance. I am pleased that we achieved consistent results across men's, women's and accessories. AE bottoms performed well in the quarter, driven by shorts, pants and women's denim. We've seen significant improvement in women's tops, both wovens and knits, which also contributed nicely to the margin gains. This has been a category of intense focus by the teams, so it's especially gratifying to see our customers responding so well. We also experienced strong results in dresses, soft accessories as well as men's knit tops and woven shirts. With that said, we see plenty of opportunity for additional improvement, and we need to keep delivering. For back-to-school in the fall, we have been busy testing new merchandise lines and have the benefit of reacting to strong current trends. We will continue to focus on providing great value, and importantly, building customer loyalty and a better reputation for quality. I'm also excited about strengthening the shopping experience through projects like our new mobile app and further omni-channel development. Before I turn it over to Jen, I'd like to thank our teams for their drive and commitment. I'm extremely fortunate to be surrounded by outstanding, creative talent at all levels. You can be assured, we're energized to continue to build on our early success this spring. Now I'll turn the call over to Jen.

Thanks, Chad, and good morning. I'm pleased to be here this morning to review aerie's recent accomplishments. Over the past few years, we've been highly focused on building our brand and gaining further customer awareness and loyalty. In the first quarter, comparable sales increased 12%, and we continue to increase our profitability. Like AE, our average unit retails increased and markdowns declined. Aerie's traffic was nicely positive as we made good progress gaining new customers. Now a few highlights and opportunities. We've had greater consistency in our core bra and undies businesses. Our design and merchant teams have done a great job raising the bar and delivering more newness and innovation, including the trend-right Bralette assortment as well as new layering and sports bras. Product expansions and new categories such as swim, accessories and soft dressing are producing strong results. For example, swim has grew nearly 20% of sales in a short period of time and is now a core aerie category. We see tremendous opportunity for further product extensions, particularly within our digital business. Brand marketing, such as aerie real and our selfie beach party this spring have begun to distinguish our brand and create positive buzz. Most customer outreach and engagement is a major, major priority as we move the brand forward. We continue to explore ideas like our collaboration with Yellowberry to create excitement and to broaden the scope of our customer base. The aerie digital business has been extremely strong, and we're also seeing good improvements from our store repositioning efforts. We've been closing unproductive standalone stores and relocating close to AE stores. Essentially, we've seen higher sales, productivity and profitability. Our new 4 head stores, which are brighter, more open, modern and easier to shop are performing very well. Before I turn it over to Mary, I would like to congratulate the aerie team on a great quarter. I'm really proud of the work the team has done. We have tremendous runway ahead, and I look forward to continuing the momentum. And now, I'll turn it over to Mary.

Thanks, Jen. Good morning, everyone. We are very pleased with our strong first quarter results as better merchandise and strong customer response led to better than expected sales, a higher AUR and a lower markdown rate. We also effectively controlled costs and saw the benefits of our expense-reduction initiatives as we leveraged SG&A. All of this led to significant earnings growth from last year and a beat to our initial first quarter guidance. Now looking at the details of the quarter. Total net revenue increased 8% to $700 million from $646 million last year. Consolidated comparable sales increased 7%. By brand, AE comps were up 7% and aerie increased 12%. Traffic was flat in the quarter, which was particularly gratifying after many consecutive quarters of traffic declines. The average transaction value increased in the low double digits, driven by a low double-digit increase in AUR. The strength in our AUR was driven by a combination of more full-price sales and less promotions based on a positive response from our customers to our product investments. Additional sales information can be found on Page 5 of the presentation. Total gross profit increased 16% to $262 million. And as a rate to revenue rose 260 basis points to 37.5%. A reduction in the markdown rate led to approximately 290 basis points of merchandise margin expansion. This was partially offset by 30 basis points of BOW deleverage, due primarily to higher delivery costs from an increase in direct orders, including orders filled through Buy Online Ship from Store. We're seeing clear benefits from our Buy Online Ship Shift from Store capability, which is driving incremental sales, higher customer satisfaction and reduced markdowns. Yet, we are still refining the algorithms to better balance the benefits with the increased delivery costs of split shipments. However, within BOW, it is important to note that rents slightly leveraged for the quarter. SG&A expense was well controlled in the quarter. Expense dollars were flat to last year at $185 million. Our expense-reduction efforts offset an increase in incentive and variable selling expense, driven by the strong sales performance. We're pleased to see that SG&A leveraged 210 basis points to 26.5% as the rate to revenue compared to 28.6% last year. Depreciation and amortization increased to $35 million and remained flat at a 5% as a rate to revenue. The increase was due to the new fulfillment center, omni-channel projects and IT investments. Operating income grew to $42 million from $8 million last year and operating margin expanded 470 basis points to 6% as a rate to revenue. As we mentioned last quarter, the port slowdown cost approximately $0.02 in EPS in the first quarter, largely due to increased freight. Additionally, we had a gain of approximately $0.02 or $6 million within other income, which was primarily due to currency gains related to cash held in Canadian dollars. EPS of $0.15 increased significantly from $0.02 reported last year. Turning to the balance sheet. Starting with inventory, which can be found on Page 6 of the presentation, we ended the quarter with inventory at cost per foot flat to last year. We expect second quarter ending inventory to be up in the mid-single digits following a decline last year. Inventory is well positioned and can support increased demand as we utilize our chase capabilities as well as our flexible fulfillment tools. We ended the first quarter with $327 million in cash and investments compared to $328 million last year. Capital expenditures totaled $42 million for the quarter, and we continue to expect CapEx to be approximately $150 million for the year. This includes the chain-wide rollout of the point-of-sale system and supporting technologies, the completion of our new fulfillment center and new and remodeled store investments. During the quarter, we opened 4 factory stores and closed 6 stores, including 3 AE mainline and 3 aerie standalone locations. Additionally, there were 10 international licensed stores openings, and we ended the quarter with 109 licensed stores across 17 countries. Additional store information can be found on Page 9 through 11. Now regarding the second quarter outlook. Based on an expected high single-digit increase in comparable sales, we expect second quarter EPS of $0.11 to $0.14. The guidance compares to EPS of $0.03 last year, and excludes potential impairment and restructuring charges. In the second quarter, we expect continued gross margin expansion, due primarily to reduced markdowns and higher full-price selling. Total SG&A dollars are expected to increase slightly based on variable selling expense and related incentive costs. We are targeting SG&A leverage as we drive lower fixed SG&A expense dollars. As Jay said, across the organization, we are intensely focused on executing our priorities to continue our momentum and capitalize on the opportunities within the marketplace. Thanks, and now we'll take your questions.

[Operator Instructions] Our first question is coming from the line of Adrienne Yih with Janney Capital Markets.

So Roger or Chad, can you talk about the notion of this knit top cycle? How long do they typically last? Clearly, it's coming through for you, probably driving ATV, so can you give us some kind of visibility into kind of the back half and typically how long these types of cycles can last for you?

Hi, it's Chad. Thank you for your comments about the quarter. In terms of knit, I don't personally have the years of experience that Roger does here at American Eagle, but in terms of my experience in the sector generally, I think it's a trend that can last years. I think we're really at the beginning of a strong knit cycle. I think with our test process and the fabric innovations we're bringing -- I think we really see runway ahead of us in terms of continuing to leverage the knits business and see some strong gross margin improvement there.

Our next question is coming from the line of Oliver Chen with Cowen and Company.

I had a question on your speech regarding the balance of quality versus value versus the promotional atmosphere. What are the main drivers in terms of your thinking about that? And does the AUC give you some flexibility in investing? And then, on the denim side, we've been very impressed with your innovation and kind of leading the curve in the bottoms business as well. What would you point out as distinguished -- distinguishing a year ahead of the curve execution on the bottoms? And what attributes of that, would be great.

Great. So I think in terms of value, value is a critical part of the American Eagle brand. And we, in terms of the quality and value and that whole balance, we are looking to offer the customer as much value as possible. We really believe that with what we put into the product, our items are a better value than the competitors in the mall. I think, when we look at prior years when we haven't seen the success we saw this quarter, we've been trying to compete more on price, on ticket price and on promotional price and less on offering the best product for the best value to the customer. I think we've seen through the results this quarter that the customer recognizes the quality we've invested and recognizes the value they get at American Eagle, and we're able to be less promotional because of that and sell closer to the ticket price. In terms of the AUC, we definitely are able to leverage some of the raw material savings that we're seeing and use that to invest back into the product, further enhancing the value that we're able to provide to the customer. In terms of denim innovation, I think, we really have built a denim center of excellence here and denim is really the foundation of our bottoms business, that drives so much of our customer loyalty. And so we're constantly looking for innovation. We've partnered with our mills, our designers are out all over the world looking for what's happening in terms of denim trends, both in fabric, fit, wash, all of it. And we really have -- as we said, we have a team here that's dedicated solely to making sure that our denim is one step ahead of everybody else's. And even just as importantly, it falls into that same value -- quality and value equation as we look at the whole brand.

Our next question is coming from the line of Anna Andreeva with Oppenheimer.

I guess, the question to Chad, your traffic improved nicely. Just how should we think about the AUR versus transaction dynamic as we look into the back half? In other words, should we think traffic is an opportunity as you lap the big declines from last year? And to Mary, I guess, with $2 in cash per share and CapEx coming down and steady improvement in the business, any updated thoughts on special dividend or buybacks?

I think, I can -- maybe Chad take both questions. So as I look at our AUR for the balance of the year, we continue to see opportunity there for growth as the team puts forward an amazing assortment that our customer is responding to. I do think, leveraging traffic, while we did leverage traffic in Q1, that continues to be an opportunity. And I would say traffic, in general, as that's starting to improve here, should also be an opportunity as we move through the year. Regarding our cash and how we're thinking about our cash? Look, it's always about having the right balance here. Our first priority is to invest in our business, and we return to our shareholders through a pretty robust dividend. And we'll just continue to manage -- or monitor the cash balance. Do need to put lots of quarters back-to-back here of great improvement, and we hope to see that trend continue.

Our next question is coming from the line of Paul Alexander with BB&T Capital Markets.

Guys, can you talk about the trajectory of the comp trend through the quarter? Was April one of the weaker months in the quarter or the weakest, given the earlier Easter and spring break. And if so, what gives you the confidence that you can accelerate from that weaker trend to drive a higher 2Q comp than first quarter?

We aren't going to break our comps by month, Paul. But definitely, with Easter happening -- the Easter peak definitely shifted towards March, but coming out the end of the quarter, we're very happy with the results we saw as the quarter finished up and happy with the results we're seeing as we begin the second quarter, and that's where we're getting the confidence around the comp.

Our next question is coming from the line of Randy Konik with Jefferies.

I guess, first, Mary, when you spoke about the deleverage from buying in [indiscernible] and warehousing deleverage, it says in the press release. You made it sound like look, we got leverage on our rent, but we had this more ship from store impact our costs on that. So can you give us some perspective on, is that something that's more temporary in nature or something that's going to be impacting the long-term trajectory of the gross margin line? And then -- so that's, that question. And I guess, for Chad and Jen, you spoke about different areas where you're either focused on with the business, in particular, process. Where are you on the process side from, I guess, a test to react standpoint? And how much of that, I guess, helped you drive better results in the quarter and just try to think about the sustainability of an improving trajectory on the process improvement, helping drive more stable results in the next 2 to 4 to 8 quarters?

Randy, regarding the BOW leverage question. So as I said, rent did slightly leverage here in Q1, and it was offset by the incremental costs related to split shipments. We piloted Buy Online Ship from Store last year and have rolled that out as the year went on. And we've learned a lot, and we continue to adjust the algorithms to better balance fulfilling customer demand and the higher cost to split shipments. So we continue to refine those adjustments, so I don't think it's an ongoing issue as we look throughout the rest of the year. As I look forward to Q2, expect to see more leverage in BOW as we continue to see the benefit of store closures and fine-tune those B.O.S.S. algorithms that we have. All right. Jess [ph], we're going to answer the rest of that question.

I think in terms of the process, I think, it's important to note that really, for us, we see that the process is back in place and what we really try to do is make sure we're focused first on inventory control and making sure we have enough, leaving open to buy in order to chase within the existing quarters. Part of that is really a focus on the existing business, knowing really what's selling, what to react to and how to chase through our supply chain. And then the second key thing is really making sure that we are continuing to test and react to each upcoming season. So we just finished a back-to-school test that we'll be responding to for July and August, and we do that for every season, making sure that we are getting out ahead of where customer demand will be, and now we have open inventory and open receipts and that we can [indiscernible] our inventories to match demand.

And the same for aerie, we platform our fabrics early on in the season either on a 6-month base or 12-month base, and then we move from there. And also, just to add on, we have a pretty unbelievable focus group called Eagle's Eye, and we literally go to our customers and listen to them and what they want. So it's not just about testing and reacting, it's about really supporting what the customer wants.

Our next question is coming from the line of Matthew Boss with JPMorgan.

It's Christina Brathwaite on for Matt. Just on the store count, given the guidance for 180 store closures through fiscal '16, you'll be running up against that target by the end of fiscal '15 based on your guidance. Just how should we be thinking about yearly prunings beyond this year and an ideal store count between full-price, factory, and domestic and international? And then, on your comps at the factory channel, so really -- obviously, really impressive comps at the full price, but factory keeps underperforming. Can you just walk us through the drivers that of that underperformance and any initiatives to improve things there?

Thanks, Christina, it's Simon. Just to talk to you about store count, you're right. By the end of this year, we'll have basically got to the number that we forecast 12 months ago regarding store closures. I think, from our perspective, we have a highly profitable fleet. The majority of our stores remain four-wall profitable in every channel, including the factory channel. And to be honest, we continually review. We review what's happening with the malls. We review what's happening with traffic. And we look to opportunities to continue to evaluate the fleet, and also see where customer demand is coming from. We -- as we move towards our omni-channel initiatives, and Mary spoke earlier about our Buy Online Ship from Store capabilities, we are able to fulfill demand from a number of different distribution centers across the country. So I think, we'll continue to evaluate the fleet. We don't have a number in mind. I think, everyone gets fixated on what that number should be. We really will continue to evaluate the fleet and its performance. And just look in relation to factory, whilst we have seen a sales comp that didn't perform against the chain. You also need to remember the profile of our malls. The majority of our factory, our outlet fleet is -- are in exterior malls that are highly exposed to the weather. We did see decline in traffic comps in that channel, as well, over the last quarter against last year, which was significantly below the balance of chain. And as we think about going forward, we've seen the improvement in traffic and an improvement in the comps over the last quarter as the weather's got better and better. None of us ever want to talk about that, but that's been a reality. And Chad and his team continued to work on improving our merchandise assortment as we reflect the change in assortment that we've done in the main line as well.

Our next question is coming from the line of John Morris with BMO Capital Markets.

Really, really great job on the execution. Chad and Jen, question for Chad first. The spring trends, the strength that you're seeing there, how well do they translate to the fall? Clearly, on track, and I'm just wondering if you can give us a little bit more color on that, especially with an eye towards denim against last year. What are you particularly excited about as you approach fall? And Jen, with aerie, really impressed with the strength in swim. Maybe if you can highlight other new initiatives that both helped in the quarter? And what new initiatives you have planned that we can look forward to?

Thanks for your comments and questions, John. I think, a lot of the macro trends we're seeing in the business around women's tops, knits and wovens, we didn't mention it earlier, but sweaters and then in men's with knits and wovens there as well, I think we should -- we're confident that we should see those trends continue going into Q3 and Q4 in terms of improved product, and that the styles and the fashion itself does translate from a warmer weather season into a colder weather season. We are still working on our back half assortments. We feel very good about what we're seeing and what's coming. In terms of your specific question to back-to-school, we're still too far out in terms of, I don't want to tell you what our secret sauce is for back-to-school. We don't want people chasing what we have coming, but we have -- we talked about the process earlier, we have focus grouped, we have tested multiple times. Some of the innovation that we have coming in men's and women's denim for back-to-school, and we are very excited. We can't wait to have that product hit stores in July.

And the same here, I'm not going to share all our top secret information, but we are really excited for back-to-school. I mentioned this in a prior call, but what we do love about the intimates business is, it is seasonless, so bras and undies, we will continue to dominate in that category. We look forward to some new launches. We always launch new ideas every quarter, and we'll have some newness. And then it's really about just product extensions and really going after it and distorting those categories. So what we've done in swim, you'll see coming up in the future. Soft dressing is a big win for us, and we'll continue to address that whole casual lifestyle, what the girls doing today. And as we head into holiday, gifting is really a focus for us.

Our next question is coming from the line of Dorothy Lakner with Topeka Capital Markets.

The stores have been looking terrific. I just wanted to follow up a question on the international side of the business, what you're seeing there. Are you seeing the same successes across categories, men's and women's, et cetera? And then, secondly, are you seeing any -- will there be any residual impact from the port situation into the second quarter or is that behind us now?

So in relation to the international side of the business, Dorothy, I think that, basically, we see that the brand resonates the same as it resonates in the U.S. We do see significant traction in the categories that Chad talked about in his opening remarks and that he's talked to here. In relation to the men's versus women's, it really does depend on the market and the country. And I think, if you think about the Middle East, we have a much stronger men's business than we do women's business. But if you think about Europe and Asia, we have a business that's much more reflective of the proportions that we see in North America. So all in all, we generally see the same trends, although the blends do move a little bit within the categories, but overall, the performance by gender and by department and category within the brand is very similar to the U.S. business.

And regarding residual impact of the port slowdown, there is a little bit in Q2 related to freight, but it's really not material. I do want to acknowledge the team and the great work they all did to help this company manage through a very long port slowdown and deliver the kind of business results that we've seen. So kudos to the entire team here.

Our next question is coming from the line of Kimberly Greenberger with Morgan Stanley.

Mary, I'm looking at the inventory balance here, and I think you mentioned on the last call that you expected some average unit cost savings here for the year. But it looks like the AUC and the inventory is actually higher, so I'm wondering if you can help us understand what's driving that. And then, as you go into the back half of the year, with the mid-single digit increase in your inventory buy, if the sales trends don't sort of deliver where you think they will, is there an opportunity to sort of trim back on that inventory buy in season without hurting the gross margin?

Yes. If I look to answer your first question on AUC, yes, it's up a bit, really mostly driven by mix, but also by the product investment that Chad articulated earlier. And if you think about our increase in Q1, for example, in AUC compared to our increase in AUR, a resounding response from our customer around the product investments that we're making, so great.

Yes. I'd like to add a comment there. Our average transactional value was, by far, the highest in the history of the company. So we're more than getting paid for that additional average unit cost. And as we look forward, the sourcing machine is going to have better average unit costs.

Our next question is coming from the line of Brian Tunick with RBC Capital Markets.

I guess, understanding you don't have a new CEO announcement yet, but as we try to balance store closures, the omni-channel shifts, the factory and international, I think, you used to target, I think a 14% to 16% operating margin. So just wondering, as we think about the changing dynamics of the business, what would be an updated target you would feel comfortable talking about? And then the second question is on traffic. I guess, it was flat, it was nicely above the mall, but what could be some efforts regarding either marketing spend, or I think you've mentioned a new loyalty program? What are some other things you guys look at last year that didn't work so well and could be doing differently in the back half this year to drive traffic?

Well, I'll start off. Look, we do have a CEO sitting here at the table today. And he's been instrumental in helping the leadership team drive the kind of results that we've seen, and we expect that to continue as we move forward. I think your basic question about operating margin, which is a great question, can we get back to double digits, which has been our historical kind of performance. We're delivering great top line and margin performance right now, but having said that, I still do see opportunity across pretty much all elements of the P&L to drive that margin back to double digits. Still opportunity here on top line. I see further opportunity for margin expansion, keeping control of BOW and still managing through the store closures, which we still have more to do. And then the team has done a great job of staying focused on our expenses, and I expect that to continue as we move forward. So if you think about the combination of all of that, should drive us over time here back to a double-digit operating margin.

And Brian, just in relation to your question around initiatives and opportunities to drive traffic. I'll throw to Michael to talk about our omni-channel initiatives. But ultimately, we monitor the malls, we monitor what our teams are doing. We look to what the mall owners are doing. We have a substantial investment on an annual basis in what the malls are doing regarding their marketing, as all of us do who at least [ph] have a substantial real estate portfolio. We do believe that there is opportunities to continue to drive customers to malls and a large part of that will come down to our digital strategy and our potentially use the omni-channel network to fulfill both customer demand, plus also establish a marketing cadence that is appropriate.

Yes. Still, I would just add to what Simon said. I think in addition to, obviously, the product and marketing and more compelling store experience driving traffic, above what's happening in the malls, to our stores. We are seeing that our increase in digital capabilities and spend is having an overall halo effect on the business. So digital performance marketing, we increased our investment. We're seeing a nice return on that investment. And as Jay mentioned earlier, we're launching additional initiatives, like reserve in-store that we feel very confident are going to drive qualified traffic into our stores in the second half.

Our next question is coming from the line of Rick Patel with Stephens.

Can you talk about your assumption for how the back half plays out for the teen sector as a whole as lower cotton prices start to flow-through? Are you anticipating pricing pressure on average ticket, do you think companies are going to go after margins? Just some thoughts on what you see as the base-case scenario? And Mary, as you think about AUR continuing to improve, do you see that being driven by the strong momentum, is it fewer promos year-over-year, is it sales mix, just some help behind that assumption.

So I'll talk think about the cost first, I mean, someone referenced cost earlier. I think what we had said in earlier calls was that we expected flattish costs in the first half of the year and improved costs in the second half of the year, and that's certainly, what we're seeing. Like Mary said, mix has an impact on cost on AUC, overall. But we're seeing significant improvement in costs based on lower raw material, weak demand in the market and some of the initiatives our team's undertaken. Roger, I'll let you talk about what you see in the sector.

Well, obviously, the sector is in a bit of disarray and fortunately, for us, these are exciting times. Our brand momentum is as strong as it's ever been. The average unit retail is dramatically higher. The transactional value is dramatically higher. The team we have in place, I think you're listening to Chad and to Jen, are right on the notes, the product offering is stronger than ever. Our presence in terms of denim is huge, and we're the dominant player. That should all play well as we move into the second half of the year. Our women's denim business is terrific right now, and the innovation that we have put into men's and women's for back-to-school is very strong. We're clearly the global brand in this demographic, we are the brand to reckon with. And I would assume that this momentum will continue.

And regarding AUR, look, we expect, as Roger said, the competitive environment to continue. But as I look at our growth opportunity and AUR, fewer promotions, clearly, a driver, mix is also a driver and more full-price selling is also a key driver, but also good inventory management. So it is really the combination of all of the above, not one driving it more than another, and that's why we have the confidence that it will continue as we move through the year.

Our next question is coming from the line of Janet Kloppenburg with JJK Research.

I wanted to ask first, Chad, if you could talk about the progress you've made in the men’s business and what opportunities there are going forward. Also, for Jen, very exciting what's happening with your -- with the aerie brand, and I'm wondering if new store openings or acceleration of new store openings may be in the works? And for Mary, when I look at the second quarter, I know there's a lot of opportunity on the topline, but your margin performance last year in the second quarter was healthier than in the first. So I'm wondering if we should be thinking that the gross margin opportunity could be the same or equal to the first quarter?

Janet, just I'll go first with your question about men's. We're definitely glad that we saw positive comps across both men's and women's in Q1. The bottoms -- the men's bottoms business is still a bit stronger than the tops business. In total, we did see some great traffic or great results in men's knits and in men's woven tops. But in total, we really feel that we still have a great opportunity in men's tops. So that's really what we see, a turnaround in the last year in the women's tops business, and it's a good focus now to make sure we start to see the same improvement in the men's tops area. I also don't want to leave out the bottoms area, just in terms of that business has been stronger than the tops business in men's, but with what we have coming for back-to-school, we are very bullish in men's bottoms as well. But tops will continue to be an area of focus there. And I think part of it is, for us, just looking at, I think, there's a shift in how guys are dressing, a little more -- incorporating more athletic apparel and more, sort of more of a mix between sportswear and athletic wear. And I think that's a place where we need to play a little catch-up, and also move the men's styling forward there. But we feel good about the men’s business, and we are definitely focused on making sure that we get the tops business moving along nicely.

And Janet, in aerie, thank you, again, for your comments by the way. We're really excited about what we're seeing in the -- on smaller formats, so the side-by-side locations where we're really leveraging AE. So nice momentum there, and we love the new store concept. The team did an amazing job, really, upping the ante on all the visuals and just the customer experience has been really well received. That said, we are going to test and scale a smaller standalone box, and we're going to see what it does. We love what we're seeing again in the side-by-side locations, so this will be a test in scale, and we'll go from there.

And Janet, regarding gross margins, just looking at the data here, Q2 gross margin last year was down slightly from Q1 of last year, which I think is our normal historical trend. But I think, more importantly, here for Q2, I would expect to see good improvement year-over-year in our gross margin, like we saw in Q1.

Our next question is coming from the line of Simeon Siegel with Nomura Securities.

So what do you expect the licensing income to be this year? Maybe any thoughts longer term there, given the clear success you're having with those stores and the openings. And then, just Mary, how much of the cash is domestic versus abroad? Do you expect to continue to see the benefit in the other income line in second quarter and in the full year?

We didn't hear your first question. Could you please repeat it?

Sure. The first was just, what do you expect for licensing income this year, just watching the store openings?

Simeon, yes, we continue to see the licensing income grow. We -- as you can see, we're at 109 stores in 17 countries now with the newly announced deals that we've put together over the last couple of weeks. That will have us in 22 countries by the end of the year with 141 stores. I think, long term, that business is highly profitable to American Eagle. It's definitely accretive to the earnings. But as we've said earlier, we look at our international business in totality, not just the license business. We look at that in light of what we're also doing with the owned and operated business and how those 2 play off each other. But we would continue to see that the licensing income will continue to grow as we grow that store revenue base over the next 5 years or so.

And regarding our cash, the majority of our cash is in the U.S. and U.S. dollar-based. And the Canadian exchange favorability that we saw on other income this time around, we could see some slight favorability as the Canadian dollar continues to strengthen, likely not to the amount you saw hear in Q1.

Our next question is coming from the line of Richard Jaffe with Stifel.

Just a -- more of a question for Mary. Could you just talk about depreciation and amortization for the year? And also, what is included in other income? And obviously, what shows the -- caused the big change versus last year? I just want to know how to think about other income going forward.

Yes. So depreciation and amortization for the year is about $150 million and for Q1, it was about $35 million, so it's fairly evenly split across the quarters. The other income favorability we saw in Q1, again, was related to Canadian dollars that we're holding. As the Canadian dollar appreciated. We saw the favorability of that translation. As we look forward, there may be some further strengthening of the Canadian dollar, but I wouldn't expect of the magnitude we saw in Q1.

The next question is coming from the line of Lorraine Hutchinson with Bank of America Merrill Lynch.

Mary, I just wanted to follow up on your comments around SG&A being only up slightly in the second quarter. Do you expect to be able to control costs in that manner for the rest of the year? And then, when should we see that move to grow more in line with your top line?

Yes, the goal here is to clearly leverage SG&A. And as I look at our expenses, there's a segment of our expenses that are fixed that we continue to focus on, try and continue to decrease or at a minimum, hold flat. Variable expenses related to our top line growth, we may or may not be able to offset those in entirety, it depends on the level of top line growth that we see. But the clear goal here at the end of the day is to leverage. We're seeing that leverage. We expect to see the continued leverage in Q2 and as the year plays out.

Our next question is coming from the line of Susan Anderson with FBR Capital Markets.

I was wondering if maybe you could talk a little bit more about the margin opportunity in the back half of the year. Do you continue to expect to get higher AUR from lower markdowns? Or should we think about this kind of switching over to more of a AUC opportunity with lower cotton costs? And then, maybe too, if you could just talk about a little bit AUC expectation for the back half, if it's still expected to be down 3% to 7%?

Yes. I think, as we look at the back half of the year and our margin opportunity, I see opportunity pretty much across the board. Continue to expect to see great improvement in our AUR that we have seen so far. AUC, I think we'll continue to see opportunity in AUC, although we do continue to invest in our product. Our customer is voting for that investment that we're making. And I think, Chad and Jen are doing a great job of balancing that right value relationship. Also, the team continues to work on controlling expenses, both up in the BOW area as well as SG&A. So really, it's the combination of all of the above that I think will allow for continued margin opportunity. And we have confidence in the product and the assortment that we have coming forward in the back half of the year, which should help drive through most of these metrics as well, too.

Our final question of the day is coming from the line of Dana Telsey with Telsey Advisory Group.

As you think about the in-store environment and obviously, the nice positive reception from the new products, what are we seeing in terms of technology that you think will enhance sell-through, make you smarter about the customers, given technology investment?

Hi Dana, it's Michael, I'll take that. We have a bunch of things under work here that are going to help -- that are going to leverage technology to help our customer shop with us and enjoy that experience more. For -- when we think about, it's really about customers coming into our stores with their own devices, and how do we get them excited about the product, how do we get them information, how do we get them a more personalized experience that really brings to life the changes that Chad and Jen are making to the assortment. So again, when you look at our digital experience, we've moved from a place where we're very focused on in an item and a deal to really making sure that the product is king and that the experience is compelling, and we're continuing to invest in that. And I think, you're going to see some benefits in the back half.

Okay, great. That concludes our call today. Thanks for your participation and continuing to [indiscernible] American Eagle Outfitters. Thank you.

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