American Eagle Outfitters, Inc. (AEO) Q2 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to the American Eagle Outfitters, Inc. Second Quarter 2015 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, 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, Chief Creative Director; Michael Rempell, Chief Operating Officer; and Simon Nankervis, Chief Commercial Officer. 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've also posted a financial supplement with additional financial materials on the website. And now I'd like to turn the call over to Jay.

Okay, thanks, Judy. I'm pleased to report another strong quarter. Congratulations to the team for delivering an exceptional first half and building on the recovery that began late last year. When I took the helm in early 2014, I knew we had the potential for a successful quick recovery. Our collective efforts over the past 18 months have proven this. In the second quarter, we reached record sales and delivered the fourth consecutive quarter of year-over-year earnings growth. In a tough retail environment, both American Eagle and aerie achieved significant sales and earning growth, and we see momentum continuing into the third quarter. Our efforts to create a better overall customer experience, strengthen our process and gain efficiencies have created the underlying foundation for improved results. In the second quarter, net revenue increased 12% on a comp increase of 11%. EPS of $0.17 was well above $0.03 earned last year and above our guidance of $0.11 to $0.14. Customers responded favorably to merchandise improvements, greater innovation, on-trend style and outstanding value. As a result, we had more full-price selling and lower markdowns. Strength in our business was broad-based, across geographics, brands and channels. Stores comp positively and our digital business was very strong as we attracted more customers. Inventories and expenses were well managed during the period, contributing to our profit improvement. We ended the quarter in excellent financial positions with no debt and a cash balance of $327 million, $64 million higher than this time last year. We are pleased by our progress over the past year, yet we still have tremendous opportunity for growth and stronger profitability. With the American Eagle brand, we have an opportunity to seize market share and be the #1 casual American lifestyle brand across the globe. Despite a high level of competition, we are performing well. Our well-curated added [ph] assortments, strong point of view and leading bottoms businesses are important competitive advantages. Chad Kessler and team have done a great job and will continue to raise the bar and strive for consistency over the longer term. Next, aerie presents an incredible growth and opportunity, which I believe can double in size over the next several years. Under Jen Foyle's leadership, the brand has gained very good traction. We're enthusiastic about the intimates market and believe aerie is unique, differentiated and perfect for today's young women. aerie is poised for growth much like American Eagle felt early in its history. Our digital business is strong with mobile sales accelerating at a rapid pace. Recent investments are delivering nice returns. Our upgraded new app, better technology and omni-channel tools are driving incremental sales and providing the platform for future growth. Digital is a growth lever as we pursue expanded product lines and open our U.K. sites this quarter, the first step in a broader plan for global expansion. Regarding international. Improvements to our brand and merchandise assortments are fueling good momentum. In company-owned markets, including Mexico, China and the U.K., we have well-paced expansion plans underway. The licensed store portfolio continues to grow, providing accretive expansion with a low-cost capital investment. With additional stores and digital expansion, our international growth will accelerate over the next several years. On operational front, the team is currently working on additional expense reductions and implementing a program of continuous improvement. The transition to our new omni-channel distribution center is complete, providing inventory efficiencies, improved processing and faster delivery times. To conclude, we made a great stride in a short period of time and are extremely optimistic on our future. We have 2 of the best-positioned brands in the marketplace today. We have vast opportunities to expand the reach of our brands and grow through global and digital expansion. Our top priority is to stay focused on delivering future -- on further improvements and returns to our shareholders. Now I'll turn it over to Jen.

Thanks, Jay, and good morning, everyone. I'm so pleased to be here this morning to review another strong quarter for aerie. Before I get started, I'd like to thank and congratulate my team for delivering strong results. We have an incredibly talented team. I'm very proud of the work they've done and their continued drive and passion. The second quarter exceeded our expectations. Comparable store sales increased 18%. We saw positive growth across all store formats, and our digital business was especially strong. The average unit retail price, units per transaction and average dollar sale all increased. aerie was also -- aerie traffic was also nicely positive, clearly above the mall traffic as we continue to gain new customers. Merchandise margins expanded with less markdowns, and we continue to strengthen the bottom line, delivering higher profitability. We were pleased with the strength across the business. The best categories included bras, undies, swim and soft dressing. We delivered newness, innovation, better quality and improved value. For example, our new bra collections and the swim line have provided incremental growth this spring. We are building on categories like accessories and beauty, and we are exploring additional ways to surprise and delight our customer. Our aerie Real campaign has been extremely well received by our customers and is truly a point of differentiation. We are excited to relaunch the campaign this month featuring Emma Roberts as our first real celebrity. Emma was a natural choice for aerie. She has a confident, independent spirit like the aerie girl. On the storefront, we're growing our side-by-side store count where we continue to see strong results in both aerie and the adjacent AE store. Our new modern store formats are performing extremely well. As Jay mentioned, I want to reiterate the tremendous growth and opportunity for aerie, and I look forward to continuing current momentum. Thanks. I'll now turn it over to Chad.

Thanks, Jen, and good morning. Congratulations to you and the entire aerie team for delivering outstanding results this quarter and for the past several quarters. I'd like to underscore that aerie is an exciting growth opportunity and a great complement to our business. Now on to American Eagle. We had a pretty fantastic second quarter led by improved merchandise and a positive customer response. Our continued focus on having the right people, product, process and presentation led to another strong quarter. American Eagle comp sales increased 10%, a nice acceleration from the first quarter. Our business reflected strong execution and was much healthier overall. Customers recognized improvement, and we saw a double-digit increase in the average unit retail price, consolidated traffic growth with particular strength online due in part to an increase in digital marketing and more customers shopping the brand. Store traffic outpaced mall traffic, a trend we began to see at the beginning of the year. We are pleased with this, especially given the significant reduction in store-wide sale events and fewer clearance units compared to last year. The net result of all of this was significant expansion to the merchandise margin. Turning now to product. We saw positive results in men's led by strength in pants, denim, woven shirts and knit tops, with polos and graphics underperforming. In women's, we saw exceptional growth driven equally by tops and bottoms. This is the best women's business we've seen in many years. We saw strong comp growth in woven and knit tops, dresses and sweaters. The Soft & Sexy line has been terrific, which has now expanded across the knit top assortment. We are especially pleased to see a broad-based resurgence in tops presenting an exciting opportunity for growth and margin recovery. In addition to a terrific shorts business this spring, I'd highlight the innovation we delivered in Denim X, which expanded across classifications and fit. As we are now in the midst of back-to-school and entered the fall season, we are pleased to see positive trends continue. In men's, Flex/Denim is adding innovation and newness. In women's, we've launched updated denim styles and emerging silhouettes. A new denim cycle falls right into our strength. Clearly, Roger was absolutely right years ago when he said I have to create a leading jeans wear collection. Today, AE denim and bottoms are a major competitive advantage. It's where we have strong brand loyalty and have had the most consistent performance. It's also now a significant opportunity as we expand globally. As I look forward, I'm optimistic. While we made some improvements last year, we have plenty of room for further progress. We are running the business better, and our process is working. Marketing efforts will be focused on connecting emotionally with our customers and building a stronger reputation for product leadership and quality. Our brand position is absolutely right for today's consumer, and we are well poised to capitalize on the disruption in our industry. We will remain focused and disciplined while delivering exceptional product innovation, quality and value. Lastly, as we seek to expand our business by bringing newness and interest to our customers, we are pursuing new ideas like our Don't Ask Why fashion council. This could include collaborations or other creative ideas that we can incubate and learn from as they provide incremental business. Congratulations, and thanks to my team for delivering a great season. Now I'll turn it over to Mary.

Thanks, Chad. Good morning, everyone. Our customers continue to respond well to our product and brand initiative, leading to significant earnings growth and a beat to our guidance. The second quarter profit improvement was a result of a positive double-digit top line and higher merchandise margins from lower promotional activity. We also benefited from our expense-reduction initiatives and store fleet repositioning. Now looking at the details of the quarter. Total net revenue increased 12% to $797 million from $711 million last year. Consolidated comparable sales increased 11%. By brand, AE comps were up 10%, and aerie increased 18%. We are pleased that consolidated traffic increased in the quarter. The average transaction value increased in the mid-teens, driven by a mid-teen increase in AUR. The strength in our AUR was driven by a combination of more full price sales and fewer promotion. Additional sales information can be found on Page 6 of the presentation. Total gross profit increased 20% to $285 million and as a rate to revenue, rose 230 basis points to 35.7%. BOW leveraged 130 basis points. This was due to higher sales and rent leverage driven by our fleet rationalization. Reduced markdowns drove another 100 basis points of margin expansion as we continue to successfully reduce promotional activity. SG&A expense remains well controlled, enabling us to leverage by 220 basis points to a rate of 24.5%. Expense dollars increased 3% to $196 million. The increase was due to higher incentives and variable selling expenses driven by strong sales results. Our expense-reduction efforts resulted in a low single-digit decline in fixed expense. This was partially offset by an increase in incentive and variable selling expense driven by the strong sales performance. Depreciation and amortization increased to $36 million and decreased 50 basis points to 4.5% as a rate to revenue. Operating income grew to $53 million from $12 million last year, and the operating margin expanded 500 basis points to 6.7% as a rate to revenue. Within other income, we had a loss of approximately $2.2 million, which was primarily due to currency losses related to cash held in Canadian dollars. The tax rate of 34.7% includes a benefit of approximately $2.5 million due to an income tax settlement. EPS of $0.17 increased from $0.03 last year. Now turning to the balance sheet. Starting with the inventory, which can be found on Page 7 of the presentation, we ended the quarter with inventory up 4% and at cost per foot up 5%. This was in line with our guidance and below sales growth. The composition of our inventory is very healthy with very limited clearance. We expect third quarter ending inventory at cost to be approximately flat. We remain disciplined on our inventory investments and are using our omni-channel tools to gain efficiencies across channels. We are committed to inventory -- to growing inventory lower than sales. Cash and investments increased to $327 million at quarter end compared to $263 million last year. Capital expenditures totaled $37 million for the quarter, bringing us to $79 million year-to-date. We continue to expect CapEx to be approximately $150 million for the year. I'd like to take a moment here to commend the team for a seamless transition to our new distribution facility in Hazleton, Pennsylvania. The teams did a great job with no major disruption to our business. This is our first true omni-channel DC with shared inventory across digital and stores. There are numerous efficiencies to be gained, including greater customer satisfaction through faster delivery and higher in stocks as well as inventory optimization and processing efficiencies. Now regarding our third quarter outlook, based on a mid-single digit increase in comparable sales, we expect third quarter EPS of $0.28 to $0.31 per share. The guidance compares to adjusted EPS of $0.22 last year and excludes potential impairment and restructuring charges. As Jay said, across the organization, we are intensely focused on maintaining our momentum, capitalizing on our opportunities within the marketplace and continuing to build a global presence. Thanks. And now we'll take your questions.

[Operator Instructions] Our first question comes from the line of Oliver Chen with Cowen and Company.

Just regarding your comp guidance for mid-single digits. Is that a function of the more difficult comparisons? I'm just curious about that in light of some of the shifts that have been happening with the holidays as well as the later Labor Day. And Mary, also, could you just update us on how the merch margin comparisons look ahead and how that may trend given the progress you've had?

Yes. The mid-single digit comp guidance is really as a result of the improvement of our business at the end of last year. So it is due to more difficult compares. But I think what's most important here is the profitability of the business and the strength of the business continues here. Great results in Q2. We'll see it here in Q3 as well based on our guidance. Expect to see merch margin continue to grow here in Q3 and Q4 as our product resonates with our customer.

Okay, Mary. And regarding that comp, is that going to follow kind of generally a similar trend with the ADS being the bigger driver in terms of where you're getting the comp points?

Yes, that's correct.

Our next question comes from the line of Adrienne Yih with Wolfe Research.

A question on the percentage of newness that is in bottoms, if you can address that. And then secondarily, really, this just goes back to kind of the inventory productivity. You entered the quarter 2Q with an up 1% total inventory comps. Obviously, you came in at 11%, entering the next quarter with 4% total inventory up. I guess, is there a strategy that you would sort of go contain promotions to generate really healthy margin sales? It's kind of a follow-on from the earlier question just about it would imply that the productivity of the inventory is not as strong as it was in 2Q. So just a question on that.

I think, first, in terms of the bottoms, we did we deliver -- our back-to-school bottoms assortment, we delivered more newness than we've, I think, than we've ever delivered, than we definitely have delivered in the past few years. We've really tried to drive bottoms business through the innovation in: a, Flex/Denim for men's; and then the Denim X, Sateen X and X4 for women's and the expansion there. So between fits and fabric and choices, we definitely have more newness there, and we're seeing nice results. I don't think we're expecting any less productivity out of the assortment for Q3 than we've seen in Q1 and Q2. We continue to try to drive the business through stronger assortment and better customer value and innovation. We're seeing great results, as you can see, from ADS and AUR improvements, and we expect that to continue through the fall.

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

I guess question on the denim strength and the silhouette change that we're seeing in the marketplace. Can you maybe talk about what that could mean to your tops-to-bottoms ratio? And then the second question is really on aerie. I think you said you think that business can double over the next couple of years. Does that include an increase in square footage, new stores? Or is that mostly going to come through the DTC channel?

I think in terms of denim, we are definitely seeing a positive response to our back-to-school denim assortments. I think we're seeing -- we have the broadest assortment in the marketplace, and we are seeing some silhouette shifts, but I think that I don't see that necessarily -- we're not seeing huge shifts in terms of the silhouettes and denim. In terms of driving tops, I think that having healthy bottoms business is a great opportunity for our tops business. We did see in Q2 the women's tops business actually slightly outpace the growth in bottoms. Both businesses were exceptional, but it's the first time in that quite a while. And I think that driving -- the bottoms business drives a lot of customer loyalty and a lot of traffic. And when we can get the tops business right and have the right outfit, if the tops go back to the bottom, it just shows -- this quarter shows that we can drive great results that way.

And Brian, regarding aerie, we really believe in all the store formats based on smaller square footage, but we believe in net [ph] growth. And certainly, really leaning on the direct channel as sort of our gateway to the introduction of the brand to the customer. So we've seen nice acceleration on the direct side, so we certainly will continue to leverage that via through the AE customer base and then introductions to new customers and certainly then growing the smaller square footages.

Our next question comes from the line of Tom Filandro with Susquehanna Financial Group.

A Jen-Mary question, just to extend on the longer-term view that Jay said about doubling the business. Can you guys help frame how we should think about the margin profile of the aerie business maybe currently? And as the -- as you grow that business, can you -- do you think it'll be accretive, in line or dilutive to the overall mix? And then I have a factory question. It looks like comps improved a little bit from the first quarter to the second quarter, although down. Curious what drove that improvement, and any view on the long-term merchandising strategy of the factory business would be helpful.

Tom, as I look at the aerie business and our growth opportunity, the aerie business today is accretive to our bottom line, and I expect that to continue. And probably, honestly, grow over time. I think the work that Jen and her team have done on focusing the assortment, getting the fleet, the store fleet rationalized is deploying the side-by-side strategy. All of those would tell me that there is growth, profitability growth for the aerie brand.

I think in terms of the factory channel, we've started to see -- we really focus on trying to make sure that the assortment in the factory channel is more reflective of the, I guess, same -- similar improvements we're seeing in the mainline AE business. So the factory customers are really driven by value and also a differentiation from mainline. We don't have necessarily set targets about how much made-for-factory specifically we will have in that channel, but what we are committed to is providing the customer the absolute best value we can in our factory channel and also providing the best product that we're equally proud of in factory as we are in our mainline and our online business.

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

Really strong AUR increases. How much of that is like-for-like versus the function of mix and cost? And then any thoughts on how much more room you have for increasing AUR? Just given the shift in the back half, do you expect to get an uptick in transactions in the third quarter?

Yes. It -- most of it is driven by like-for-like. As you think about the broad-based reduction and promotional activity, it's really across the board on all our product. I think as I look at AUR here in the back half, we still have opportunity for AUR growth. It will abate a little bit versus the pacing of the first 2 quarters of the year but still opportunity to pull back on promotions in the back half of the year. And honestly, we're seeing great strength of our product and more full-price selling, so would -- it's very encouraging that we'll continue to see some nice AUR growth.

Our next question comes from the line of Dana Telsey with Telsey Advisory Group.

Can you talk a little bit about merchandise margins, level of merchandise margins, where are we relative to peak and what opportunities do you see to move a bit higher?

We see continued improvement in our merchandise margin; expect to see that continue here into Q3 and Q4. We still do have room for improvement beyond the levels where we're posting today. And I think the work that Chad and Jen have done on product and assortment and driving higher AURs, the metrics across the board are really strong. I see that continuing as they continue to deliver great products.

Michael, do you want to talk about AUC opportunities?

Yes. And I would just add, Dana, we see sourcing environments changed, as we've talked about in previous calls, quite a bit over the last year. And we do see an opportunity that we'll start to feel at the end of Q3 and certainly have some nice tailwinds in Q4. In terms of like-for-like costs, we're seeing lower costs, so we're able to take some of that in margin, and we're able to invest more into the product and drive some of the innovation and newness that Chad and Jen have been talking about.

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

So as we think about the larger-picture gross margin opportunity and to tie into your last comments there in the continued merchandise margin opportunity, as we think more holistically, is -- if 2012's 40% gross margin level, I mean, is that a realistic goal over the next couple of years? And on the expense side, just the best way to think about SG&A dollar growth versus top line growth on a go-forward basis.

Yes, I think from a gross margin perspective, being in the high 30s, somewhere or somewhere around that high 30s, 40% is certainly a target that we continue to strive for here in the company. And I think that the improvements that we've seen across the board on a multitude of our metrics would give me confidence that, in the very short term, we could drive ourselves to that high 30%. As I look at SG&A expense, our goal here is to continue to keep what I would call our fixed expense flat to declining as obviously as revenue grows and continues to grow at the rate we're growing, our SG&A dollars will increase due to the variable expense related to selling and incentive. So again, hope to continue to leverage SG&A is what that means at the end of the day, and the team continues to stay rigorously focused on expense.

Our next question comes from the line of Tom Filandro with Susquehanna Financial Group.

I got in for another one. I actually have a quick question for Jay.

How did that happen?

I don't know. I'm caught off guard. But I actually had a quick question for Jay. I'll take it. Jay, I mean, you've obviously proven a lot of people wrong and done a great job guiding the ship. You guys are back on course. I'm just curious, where are you currently now spending the bulk of your time, in what areas of the business?

Well, I spend a lot of time, like in the merchandising side with Chad and with Jen and also with Simon, with the whole team there. We have a strategy session that we have all the time. We have goals we set for ourselves, and we have immediate goals we've set, and then we have long-term strategies, too. So we just keep -- we keep guiding the ship.

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

I wanted to hear a little bit more about the international growth, if you can talk about that, and maybe just help us think about monitoring the progress internationally along the way and what you ultimately think the top line and bottom line impact might be. And I just had one clarification, if I could squeeze it in. I'm not sure how to bridge the difference between the mid-teens increase in the average value of a transaction and the 11% comp. What is the -- what are the sort of 3 or 4 offsetting percentage points in there?

Thanks, Kimberly, it's Simon. I'll just -- I'll cover up the international piece and then hand it back to Mary. As I think about international, we were pretty clear 1.5 years ago that we were focused on consolidating the business and growing our license franchise business. We're at 114 stores and in 19 countries at the end of the quarter. By the end of this year, we'll be at -- we'll be in 141 stores in 22 countries. We recently opened in Singapore and Korea. So we've got a continued focus on driving the license business as it's relatively low-capital intensity for ourselves, and we've got a really good business model for running that operation. In relation to the owned and operated, we set back at the end of last year and said that this year was a year of consolidation. We wanted to set ourselves up for the future. We wanted to make sure that we -- we're pacing that investment aligned with the return that we were seeing, and we feel confident that all of the initiatives we've put in place at the end of the -- of last year are now currently paying off. And to that regard, we've -- we have a vision for the next 3 years around growing our business in greater Asia, growing our business in the United Kingdom, Western Europe and consolidating our position in the Americas with really the completion of our strategy in Mexico, so.

And to answer your question, our -- the number of transactions are down, and our conversion is slightly down as well, too. That's really driven, Kimberly, by lower promotions. And I think as we look at our business in Q2 and in Q3, the business is so much healthier from a profitability perspective as we pull back on promotion and have driven higher [ph] AURs. Obviously, you can drive higher transactions through high promotions, but that's not the choice we've made.

[Operator Instructions] Our next question comes from the line of Anna Andreeva with Oppenheimer.

I was hoping to follow up on the comp guidance. What are you guys seeing so far in the early back-to-school markets? And Mary, you're guiding comp about in line with The Street, but EPS range a little bit higher. Can you maybe talk about how we should think about SG&A versus gross margins components as part of that guide for 3Q?

Yes. In terms of our comp guidance for the quarter, that reflects the business that we expect to see here in Q3. Look, back-to-school is just starting, so way too early to call any season here. As I look at our margin and expense, I see continued expansion in our gross margin as we look forward, again, driven by the reduction in promotions and higher AUR, obviously. SG&A, we'll target to continue to leverage SG&A here in Q3. I think in Q4, as sales are driven in Q4 just due to the higher volume and incentive comp, not sure we'll leverage, but that's our goal to continue to try and leverage.

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

So Mary, I just want to follow up on the commentary around the gross margin. You're talking about, I guess, goal towards 40%. Can you guys just talk about what are the factors that could drive the duration of time to get to that potentially 40%? And if you had to kind of handicap the different buckets of aerie contributing to IMU, DC improvements, leverage on the business and markdown rate improvement, how do you handicap the different buckets of what could be most impactful for you to getting to that 40% potential target?

Yes. I would say that the list of everything you talked about is correct. It is a combination of a multitude of things that will help drive our gross margin up higher. I mean, obviously, top line growth is important here. We do see the opportunity for further margin expansion. We still have opportunities on our -- in the promotional space to improve there. There's always opportunity on the assortment to expand our assortment and drive innovation in our product. Control our BOW is another big area. As we continue on the path of our fleet rationalization, we'll continue to see BOW improve and leverage. And the team continues to stay very focused on expense controls. So it is really all about managing every line of the P&L as there's opportunity pretty much across the board, and the team continues to focus on it.

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

Could you talk about the knit tops business a little bit and any thoughts on how that tailwind in business might change at all as we move into fall holiday and as the seasonality of mix changes? And would you include sweaters in that discussion of the knits category?

Paul, I think we have -- we're very optimistic about the knits business. We had a great knit and sweater business in -- on the spring side. A lot of the comp incentive [ph] is obviously driven by our Soft & Sexy fabric and then sweaters. We had a great knit business and some great second layers. We're seeing continued strength heading into Q3. I think going into the fall and colder weather, from some of the testing we've done and have in place, we are anticipating that we'll still have a strong knits business going forward. And as you know, that's a terrific margin business, but we have -- we're evolving and innovating Soft & Sexy in ways that will make it more seasonless or more for cold-weather appropriate, so we're excited about that. And then we are also -- we continue to be bullish on the assortment business as well.

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

Just a couple of quick questions. Chad, if you could elaborate a little bit on the Flex/Denim assortment and the response to that and if you think that, that category could -- or that sub-brand could help the men's comp to accelerate here in the third quarter. And Mary, I'm just a little confused on the gross margin opportunity for the third quarter. Is it as great as it was in the first half? Or should we expect it to moderate? And I'm wondering also in the inventory, what your clearance levels are like year-over-year at this time.

Janet, so in terms of the Flex/Denim, we are seeing strong response so far in back-to-school to Flex. We have it represented in multiple levels within the assortment. But also, we really work to put it through all of the different fit architecture that we have, and we're definitely seeing the customers respond to it and is making a significant contribution to the men's denim business. We saw last year Denim X as -- for women's as an inflection point in the women's business, and we believe that Flex/Denim can provide that sort of -- the innovation Flex/Denim can provide that sort of inflection point for men's as well. So we are very excited about the response so far from the customer.

And regarding Q3 gross margin opportunity, we'll see nice improvement in our gross margin in Q3. It will -- the rate of improvement will moderate slightly as we come up against the improving business last year. Clearance, we're in great shape on clearance. So no clearance hangover at all, and inventories are in great shape.

Our next question comes from the line of Lindsay Drucker Mann with Goldman Sachs.

I was hoping you could give some perspective on your AUR sitting very, very strong in the quarter and year-to-date. And as we think about the potential for AUR going forward, can you sort of break down how you're thinking about the opportunity for AUR from fewer markdowns year-over-year from increasing IMU or sort of ticket price? So maybe just the prospect for further AUR and what the big drivers are. And then also sorry if you mentioned this, but can you help us understand the cadence of comp by month across the quarter?

Well, we don't provide comp guidance by month. Again, we're guiding to mid-single-digit comps for the quarter.

I meant for 2Q. What happened for in 2Q? Sorry.

Okay. It was all positive. I mean, every month was positive for Q2, and so far, that trend is continuing. AUR, going forward, we do expect to see continued improvement in AUR. Obviously, as we start to lap the end of Q3 and Q4 next year, the improvement in AUR will abate a little bit, but we still do see room for improvement. I do think as we move forward into Q4, as Michael mentioned earlier when he was talking about [indiscernible], we do see some opportunity there to drive improvement.

Chad, I don't know if you wanted to talk a little bit about the product improvement.

Yes, I think that for the most part, the AUR improvement we've seen has been based on reductions in the markdowns. We are -- we're trying to make sure we are committed to delivering the best value for the customer possible and the most innovation and quality we can in the assortment. And so as Michael mentioned, like-for-like, we're seeing cost improvement. Some of that we reinvest into the product, and some of that we do take as higher IMU. But for the most part, we aren't looking to artificially inflate tickets. That's not how we're getting our AUR. We're really getting our AUR by having -- by getting stronger customer response to the product that we have out there and selling closer to ticket than we have historically. Some -- there are some items, if you're doing store checks, there are some items where ticket prices are up to last year. But if that is the case, it's because there's something better, there's more quality and more innovation in that product than there was a year ago. Customer response has been strong where that's been the case. But for the most part, we're looking at ticket prices holding steady like-for-like and selling closer to the actual ticket price.

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

And I guess a real estate question, 2 parts. One is the fleet rationalization effort, I'm wondering how you see that unfold in the following year and then the opportunity for bricks and mortar internationally versus the franchise of relationships that you've had in the past.

Thanks, Richard. Fleet rationalization was something that we started in early 2014. We went out in 2014 and said we closed 150 stores over 3 years. We're well in the midst of that at the moment. I think the theme that has become a critical focus for us is really the productivity of each of these stores that we have. We have a substantial fleet. The majority of that fleet remains profitable. Just to give you an idea. We've only got 23 American Eagle stores that aren't forward [ph] profitable. So the fleet itself is incredibly solid. So I think we'll continue the course. We review every lease. We've just come through straight -- [ph] fleet review and just finished reviewing everything. And ultimately, the stores will stay open that weren't staying open as the customers' requires [ph] demand. I think thinking about international and brick-and-mortar opportunities, we've got a very clear strategic path around the opening of stores. If you think about what we're doing in the back half of, hopefully, in the next -- by the end of this quarter, we'll open that digital site in the United Kingdom. And that's really a way for us to identify the opportunities for expanded bricks and mortar but also for us to leverage the technologies and opportunities we have currently in our U.S. business and to develop the global footprint through all of the various channels that our customers shops.

Our next question comes from the line of Rick Patel with Stephens Inc.

Just a quick question on your denim business. So Denim X has been great, but some of your peers are getting into the stretchable denim category in a bigger way this year. So given the heightened competition, how do you stand out and maintain your leadership position? And then also a question on sourcing. Do you see the recent pullback in the Chinese yuan as an opportunity to reduce sourcing cost further? And if so, when should we start to see the impact of that?

I think in terms of denim, and we have, I think, the most experience in the jeans business of our competitors. And it's not just about the fabric. I can promise you that our Denim X fabric and our AEO Flex fabric is better than any of our competitors' fabric. We got all -- we work very closely with all of our mills to develop these fabrics even down to the yarn suppliers as to where we're putting in the fabrics, and we definitely have the best fabrics in the industry. And it takes a lot more -- I think the other critical thing is it takes a lot more than just having a seriously stretchy jean to be in the denim business. It's all about fit, fabric, wash. Every single fit, every single wash, every single CC is individually fit by our tech team. And we're in the factories constantly making sure that they're maintaining the quality and the specs that we're requesting. So I know that some people are trying to chase us in terms of stretch. Some people are trying to chase us by even the using the term flex. But I'm confident that our jeans are superior, and I know that our customer recognizes that.

Right. And on the sourcing side, yes, sure, we do expect the Chinese currency to help. As I was saying before, we -- we're going to see a significant IMU improvement in the fourth quarter this year, and we expect that -- we already had expected that to continue through the first half of next year, and the currency really gives us incremental opportunity on top of that.

Our next question comes from the line of John Morris with BMO Capital.

My question for Chad -- and I guess, Chad and Jen. Chad, you've talked to this a little bit in terms of the opportunity as you get into the back half, but -- and Jen love to hear from you as well from a product perspective, where else do you see opportunity, particularly for holiday versus last year? Because last year, I think it was really kind of the time when you were beginning to have some noticeable impact on the assortments, so I'm thinking year-over-year, besides what you've already touched on, maybe give us a little bit more flavor of where that opportunity is.

I think I don't want to get into specifics about holiday because obviously, it's a few months away. But I think we -- I think last year we did start to see improvement. We started to get the AE brand headed in a better direction. We've seen that momentum increase through the spring season. We've spent -- clearly, holiday is a critical season. The whole team here spent -- has spent a lot of time trying to make sure that our assortment will be the best-curated assortment for the best innovation that we've offered to customer and the best value. We're making sure that our inventory levels are controlled, so that we don't find ourselves pressured from having too much inventory to be promotional. And then another key to it is that we have -- we test the whole assortment. So we haven't -- we've laid out what the holiday assortment is. We haven't set the final assortment yet, and we certainly haven't set the final levels yet. We still have weeks and even a month or so before we have the whole holiday assortment nailed down. So we know how critical the holiday assortment is to our performance for the year, and it's something that we all take very seriously to make sure we get it as accurate as we can in what we'll be providing the customer. But I think that's part of it. I think the second thing that's just as important is making sure that the assortment feels -- that the outputs are terrific, that the assortment feels strong and that it will really emotionally resonate from the customer. And we're pretty excited about holiday.

And in aerie, it is really about bras. It's our biggest category. And we've layered on a whole new business that's actually providing incrementality to the bra assortment. So we will continue to chase and deliver on that business, which is top layers, and it's going extremely well. And then similar to what happened in the first half, swim is really an extension business but again, providing incrementality. As we look forward into fall and holiday, we have a fairly penetrated business in sleep and again, some of those at-leisure businesses that we're already getting strong results are. So again, we'll continue to look forward into that business into Q4.

Our next question comes from the line of Rebecca Duval with BlueFin Research Partners.

Just a quick question for Chad. It seems that we're seeing kind of an older customer shopping to stores now more often. And I'm just wondering if you are also noticing changes to your customer profile in both the men's and women's business and if you see further opportunity there.

Well, I think there's 2 parts to it. First, I think that there's a lot of disarray happening in mall-based retail today. And I think as one of the retailers who I think, as a true lifestyle brand providing a nice, edited, curated assortment with easy outfits and a terrific bottoms business, I think we really provide the customer an easy place to shop. We're very focused on adding -- on curating to the 20-year-old customer, that college-age customer. But we believe that with the strength of our bottoms business and both men's and women's and with the democratic assortments we have that we do appeal to a broader customer base than just the 20-year-old. And I think we do have an opportunity to see that even expand going forward.

Our final question comes from the line of Pam Quintiliano with SunTrust.

So actually, just 2 quick ones. You mentioned new aerie customer. Can you just tell us who she is? And can you convert her to an Eagle customer? Or is she already shopping at Eagle now just with the side-by-side, making her way over to aerie with a new product there? And then you had also mentioned that the traffic was higher at the mall -- than the mall average of both divisions. Obviously, product improvement is contributing to that. But can you talk about response to recent marketing and social media campaigns and just how we think about your approach to that for the back half of the year?

Yes, sure. In aerie, I guess, first and foremost, on your last question as far as social media, we leaned on that heavily, kicking out in spring one with the selfie event, and that was a great start. So we'll continue to leverage that. We've assembled a whole new social networking team that is highly focused on speaking to the girl in the way that she responds. So regarding that part of the business, it's been highly effective. And then the second -- can you remind me of your first question, please? I'm so excited about the social part of the business. I forgot about your first question.

New aerie customer.

Yes, in the new aerie customer, I said it before. I'll say it again. We continually leverage the AE customer base. They have over 16 million customers, and over 50% of those are women, for sure, so we're speaking to them. We've leveraged them on the digital side. If you go on to website today, you'll see an aerie nav on top of the AE home page, and that certainly is driving direct traffic. So yes, of course, we're leveraging that base, and then we're finding new ways to speak to the customer through those social networks that I just spoke of.

Okay thanks, everyone. That concludes our call. We appreciate your participation today and continued interest in American Eagle Outfitters.

Thank you. Ladies and gentlemen, this does conclude our teleconference for today. You may now disconnect your lines at this time. Thank you for your participation, and have a wonderful day.