Abercrombie & Fitch Co. (ANF) Q1 2012 Earnings Report, Transcript and Summary

Good day, everyone, and welcome to the Abercrombie & Fitch First Quarter Earnings Results Conference Call. Today's conference is being recorded. [Operator Instructions] At this time, I would like to turn the conference over to Mr. Eric Cerny. Mr. Cerny, please go ahead, sir.

Thank you, good morning, and welcome to our first quarter earnings call. Earlier today, we released our first quarter sales and earnings, income statement, balance sheet, store opening and closing summary and an updated financial history. Please feel free to reference these materials available on our website. Also available on our website is an investor presentation, which we will be referring to in our comments during this call. This call is being recorded, and the replay may be accessed through the Internet at abercrombie.com under the Investor Relations section. Before we begin, I remind you that any forward-looking statements we may make today are subject to the Safe Harbor statement found in our SEC filings. Today's earnings call will be limited to one hour. Joining me today on the call are Mike Jeffries and Jonathan Ramsden. We'll begin the call with a few brief remarks from Mike, followed by a review of the financial performance for the quarter from Jonathan. After our prepared comments, we'll be available to take your questions as long as time permits. Now, to Mike.

Good morning, everyone. Thank you for joining us today. While we are disappointed that European sales trends remained challenging in a very difficult macroeconomic environment, we are largely satisfied with our overall performance for the quarter in that context. Our U.S. business, including direct-to-consumer, increased 4% on a comparable basis on top of a strong performance last year. Our international business comped negatively, but the economics remain strong and we delivered overall international sales growth of 42%, including a strong performance in direct-to-consumer. With cotton cost issues now largely behind us, we look forward to strong year-over-year earnings growth in the back half of the year. In that context, I would like to spend a few minutes reviewing some highlights for the quarter. Starting with international. We opened 7 new Hollister stores during the quarter, including our third store in China. China remains a major priority for us this year with another 2 or 3 Hollister openings anticipated. In addition, we expect our Hong Kong A&F flagship opening in August to play a key role in raising awareness of our brands in Mainland China. Moving back to Europe. At the very end of the quarter, we opened our Hamburg A&F flagship in the iconic Alte Post building. We look forward to opening our third German A&F store in Munich later in the year. Subsequent to quarter end, we made a big splash in London with the opening of a combined Hollister and Gilly Hicks store on Regent Street and 3 new Gilly Hicks mall stores around London. These stores all opened on Saturday and are a big statement about our intentions for the Gilly Hicks brand. We had a lot of fun with the openings, and I encourage all of you to check out the pictures and videos available on our Facebook pages that captured the energy and excitement of the day. Turning to direct-to-consumer. We are pleased with our continued strong growth of 40% for the quarter, which was on top of 32% growth in the comparable period last year. We are even more pleased that our international business grew faster than the overall rate of growth. This quarter marks the ninth consecutive quarter of increases in direct-to-consumer of greater than 25%. Our margins in the direct-to-consumer channel remain strong and we expect to continue driving strong growth, both through growing awareness of our brands internationally and through multiple investments we are making in the channel. As I mentioned a moment ago, our overall U.S. retail segment comps were up 4% on top of strong growth last year. We were able to do this, while getting our AU up -- AUR up slightly. Continuing to make progress on AUR is an important goal for us going forward. With regard to our stores and the assortment, we are very happy with our spring merchandise. As many of you have noted in your store checks, we feel very much like spring with bright colors throughout the assortments. While it will not fully manifest itself until later in the year, we are also very pleased with the progress we have made on sourcing costs, which will give us a strong tailwind starting in the middle of Q2. This has been a major area of focus over the past 6 months and our merchant sourcing and planning teams have done a great job. This benefit is giving us significant insulation against the impact of macro-driven top line trends for the remainder of the year. Coming back to our international stores. We spent a lot of time analyzing and understanding the trends in these stores and making sure we have incorporated the appropriate takeaways in our longer-term strategy. We are committed to remaining disciplined in our approach to this strategy and opening stores that meet our margin criteria based on conservative volume assumptions. We believe that the macro environment in Europe has been a significant factor in the recent trends we have seen. Cannibalization has also been a factor. However, it is important to note that given the extraordinarily strong start we made in Europe and putting aside the current cyclical macroeconomic factors at play, we have long been prepared for a period of negative same-store sales. When we look at the current trends in Europe, the questions we ask ourselves are: first, are our stores continuing to stand out from the mall in terms of excitement and energy and in terms of traffic and productivity; second, are the new store volumes consistent with the volumes at which we approved the deals; third, are we achieving our annualized targets 30% 4-wall margins at the current trend and after cannibalization; last, is our international direct-to-consumer business continuing to grow at a healthy rate. Despite the downtrend we’ve experienced, at this point, the answer to all of those questions is yes in aggregate and yes, individually, for the majority of our European stores. Based on that, while we will continue to review trends closely and be very disciplined in how we approach new store openings, we believe the current economics of our business in Europe strongly affirm our long-term strategy. We also believe that the other key components of our strategy are on track. These include: one, continuing to provide high-quality, trend-right merchandise in a compelling and differentiated store experience; 2, continuing to close underperforming U.S. chain stores; 3, investing in our DTC business, particularly the international business; and 4, continuing to seek ways to operate more efficiently and reduce expenses. There are things that are not under our control, most notably the macro environment. But we believe we are doing the right things where we do have control. And we look forward to moving into a period of sustained year-over-year EPS growth even in a challenged environment. With that, I'll hand you over to Jonathan, but will be available to answer your questions in a few minutes.

Thanks, Mike, and good morning, everyone. I'll start with a short summary of our results for the quarter and then give an update on our outlook for the full year. For the quarter, the company's net sales increased 10% to $921 million, while comp store sales were down 5% to last year with men's and women's performing comparably. Comp sales were up slightly in U.S. chain stores, but significantly down across international and U.S. tourist stores in a tough macroeconomic environment in Europe and as we lacked strong sales to year ago. Cannibalization also had a meaningful impact on international comp store sales. Total U.S. sales, including DTC, were up 1% with the effect of store closures offsetting most of the comp store sales growth of 4% -- comp sales growth of 4%. International sales for the quarter, including DTC, were up 42% and total DTC sales were up 40%. International sales, as a share of our overall business, reached 30% for the first time. Foreign currency changes for the quarter were insignificant to sales on a year-over-year basis. Despite lower than planned -- despite lower sales than planned, gross margin erosion of 240 basis points was less than expected at the beginning of the quarter due to modest growth in AUR in a somewhat less promotional environment and a lower quarter-end markdown reserve than anticipated. A summary of our fiscal quarter operating expenses can be found on Page 6 of the Investor Presentation. MG&A for the quarter was $116.9 million and up approximately 9% compared to last year. The increase in MG&A for the quarter was due to increases in marketing expense, equity comp and other expense. Stores and distribution expense for the quarter was $455.7 million and up approximately 14% compared to last year. Store occupancy costs were approximately $179 million and all other stores and distribution costs represented 30% of sales, 230 basis points above the percentage of sales they represented last year, including the effect of higher direct-to-consumer expense, store payroll and store management expense. Stores and distribution expense for the quarter included approximately $2 million of accelerated depreciation from our DC consolidation, lower than previously anticipated due to an extension in the expected service life of our second DC. Operating income for the quarter was $6.3 million versus $38.7 million a year ago. Operating margin fell 390 basis points with expense deleverage of 160 basis points adding to the gross margin erosion. The tax rate for the quarter was 43%, and diluted EPS for the quarter was $0.03 versus $0.28 for the prior-year quarter. Turning to the balance sheet. We ended the quarter with total inventory of costs up 44% versus a year ago. This was higher than planned due to a lower sales trend. However, we continue to expect a significantly moderated rate of growth at the end of the spring season and have adjusted our receipts for the balance of the year to reflect the current sales trend. During the quarter, we repurchased approximately 3.3 million shares at an average cost of around $49 per share, bringing our total repurchases to 8.4 million shares in the past 2 years. We ended the quarter with $321.6 million in cash and equivalents and $37.9 million of current marketable securities. In addition, we have available $349 million under our revolving credit facility and $300 million under our term loan facility. During the quarter, we liquidated $62.4 million of our auction rate securities. At our board meeting yesterday, the board approved the addition of 10 million shares to our share repurchase authorization, bringing our total outstanding authorization to 12.9 million shares. As Mike mentioned, we opened one flagship and 7 international Hollister stores during the quarter. Details of Hollister openings for the quarter are included on Page 10 of the Investor Presentation. In the U.S., we closed 5 stores during the quarter. With a regard to our expectations for the fiscal year, based on the first quarter trend, we are now planning for mid-single-digit negative likes for the full year comprising of modestly positive same-store sales for U.S. chain stores and mid-teen negative likes for international and U.S. tourist stores. This projection is based on the trend over the last quarter and does not include any further slowing from that trend. However, it also does not include any benefit from lapping of more favorable compares later in the year. We have revised our non-comp store sales projections consistent with the lower trend for comp stores and now anticipate the sales growth contribution for the year from new stores to be around $500 million. Our lower sales projection is partially offset by a higher projected gross margin rate and lower expenses. The higher gross margin rate reflects continued progress on AUC reductions and the fact that a much higher percentage of our commitments is now locked in. The lower operating income projection for the year is offset by a lower share count at the end of the first quarter. As a result of which, we are leaving our EPS guidance, a full year diluted EPS in the range of $3.50 to $3.75 unchanged. The greatest sensitivity in this projection remains the sales trend. With regard to the second quarter, we expect the gross margin rate to be slightly down versus last year. We expect modest expense deleverage based on our current sales projection. Again, this is based on the sales trend for the past quarter. We will report second quarter sales and earnings on Wednesday, August 15, 2012. This concludes our prepared comments section of the call, and we are now available to take your questions. Thank you.

[Operator Instructions] And for our first question, we go to Jeff Klinefelter with Piper Jaffray.

Two questions this morning. One, on Europe, Mike and Jonathan, I'm wondering if you could just give a little bit more color on what you're experiencing recognizing the headwinds, the economic headwinds. Kind of on a sequential basis, between Hollister and your flags, particularly the key London, Milan and any updates on Asia or Tokyo? And then with respect to Hollister, specifically, it seems like that's really where more of the sequential deterioration has come from. Could you talk about that? And then how you're viewing traffic trends into the second half of the year for those businesses? And then just a couple housekeeping issues, Jonathan, tax rate. Are you forecasting the tax rate from Q1 through the balance of the year in your guidance? And then also inventory units versus dollars.

Jonathan?

Maybe I'll start with the last. Yes, the tax rate guidance will be the same as we've given out in February, which was slightly below 35% for the full year. The Q1 rate is just distorted because of the low absolute level of operating income and some of the discrete period items, so that isn't reflective of what we would anticipate for the full year. I think just going back to your question on trends, clearly the overall environment in Europe and the trend of our business was tougher in this quarter than it was in the fourth quarter. Hollister did move from having comped positively to comping negatively. Having said that, we were up against very strong comps in the first couple of quarters of last year. I think 20%-plus for Hollister Europe although relatively few stores in the comp base, so we were fighting against that. As we said in the guidance for the year, we're basically assuming the run rate for the trend in Q1 continues on a full-year basis, so we're projecting down mid-single-digit comps for the full year. As we said, that doesn't allow for any potential further deterioration of the trend, but it also doesn't allow any benefit for lapping of the sequentially easier compares as we get into the latter part of the year.

I guess I'm curious about the -- any changes that you're observing in terms of overall competitive promotional cadence. You mentioned cannibalization in terms of impacting your comps. Although you also said that you've been factoring in a lot of these trends in your modeling for new stores, I think that's probably the greatest concern that people would have is what is factored in, in terms of top line tolerance in stress testing these new stores? So I was just wondering if you could share a little bit about the environment that you're observing and then also what kind of downside protection you have in your model?

I think the key point, Jeff, is, as Mike said in his comments, when we open new stores, we want to be confident that we can hit that 30% 4-wall margin even after allowing for the effective cannibalization of other stores. So we take that into account when we look at those stores. And we put a conservative volume on it or one that we believe is conservative. And as of today, as we're opening new stores, we're looking at volumes based on the current trend of the business. So the key point remains that we want to be opening stores that incrementally are delivering a 30% margin on a conservative volume figure. And as Mike said, if you look at the great majority of our stores, or certainly if you look at our stores in aggregate in the majority of our stores, today they are operating above that 30% 4-wall margin.

We are finding, Jeff, that we are probably our biggest competitor internally in Europe.

And we go next to Dana Telsey with the Telsey Advisory Group.

By the way, I was in the Paris store on Saturday and looks terrific. And want to just get some more color. As you think about Europe, macro versus cannibalization, how do you think about the slicing and dicing of the environment and just the cannibalization? And then also as you think about inventory levels, how do you see inventories progressing? And is the inventory, is it more U.S. or international? And just lastly, on prices. I think you were going to adjust prices in Europe. Have they been adjusted or what do you see there?

Okay, macro versus cannibalization. I think the biggest factor in the downtrend in Europe is clearly macro. Cannibalization would come second, and then I think the third issue is the incredible opening rate and the fact that it was -- some of these rates weren't sustainable. We are, as Jonathan said, planning cannibalization into our future model, and it is a factor. We are planning the macro environment to stay the way it is. We're not planning for it to get worse. But our assumption is that it's going to stay the same for the rest of the year. You want to talk about inventory levels?

Sure. In terms of inventory, Dana, we do expect the rate of growth to moderate significantly at the end of Q2. Part of what you’re seeing at the end of Q1 is essentially a timing effect. We have a lot of the spring goods sitting there today. And as we look to the balance of the year, we are planning based on that negative mid-single-digit likes assumption in terms of how we're planning inventory through the end of the year. So we -- on that basis, we have reduced receipts over the last couple of months on a full-year basis although that had limited impact on where we were at the end of Q1.

The last part of the question, pricing. In Europe, we are slightly above last year for the spring season. We'll be slightly below for the fall season.

We go next to Lorraine Hutchinson with Bank of America.

Just wanted to follow up on the gross margin. It was significantly better than your plan. I'm just wondering if you could give us a little bit more information, how much of that was the competitive environment was better? How much of that was AURs sticking? And what we should expect going forward?

Lorraine, I think as we said, when we came into the quarter, we were counting on that sort of aggressive environment we saw in the fourth quarter continuing. And our AUR assumption was based on that. In reality, as it turned out, we were able to do better than that on AUR and get our AUR up in the U.S. business up a little bit, so that helped. And then, in terms of the impact on the quarter-end markdown reserve, that effect kind of flowed through into that. And I think, clearly, given everything we'd seen in the fourth quarter, we had a fairly conservative mindset coming into the season about AUR and gross margin.

For our next question, we go to Randy Konik with Jefferies.

This is Amanda Sigouin on for Randy. Just a question to follow up on that. Given the less promotional environment you saw in the first quarter, does that change your thinking for the promotional cadence for the balance of this year? And then just a question on the share repurchases that was stepped up nicely in the quarter and obviously you increased the authorization. Is there any further buyback baked into the outlook now for the $3.50 to $3.75?

I'll take the first part of the question. We are hoping and pushing to raise the AUR for the balance of the year.

On the second part, Amanda, we don’t count in any further buybacks relative to where we ended in Q1 in terms of what's baked into the guidance.

For our next question, we go to Brian Tunick with JPMorgan.

One for Jon and one for Mike. I guess, Jon, it sounds like at the beginning of the year, we thought you guys cut your guidance from $4.75 down to that $3.50, $3.70 level because of the taking comp guidance down to flat. And now it sounds like you're taking comps down again, but keeping that $3.50 to $3.75. So just hoping to get a little more color on what the offsets there and is it mostly gross margins? And then if Mike could just comment sort of on how you’re viewing, I guess, China differently from Japan and what sort of market research you guys have done and sort of what you think will be different from the outcome there.

Brian, on the first part, gross margin is a significant driver of the offset to the lower sales trend. A big piece of that is that we now have a much higher confidence level in our AUC reductions for the full year. We were feeling fairly positive about that back in February, but now much of the commitment is locked in and we have continued to make progress in terms of the reductions we're seeing there. So we feel very good about AUC and now that is substantially locked in for the year at this point. There's still some open for Christmas. So that was one piece of it. Expenses also came down obviously in part as an offset to sales. And then the share count is lower by several million shares than we'd assumed back at the time of the guidance in February. So they're really the 3 principal drivers and then the other piece that's having a little bit of an impact is a slightly higher AUR assumption that we had back in February just based on what we've seen in the first quarter.

Let me comment on the second question, Brian. First, let me give you a little more color on Japan. We are doing a lot of business in our Ginza flagship. Our problem in that flagship is that we made, in an effort to get into Japan quickly, we made a deal that was not very economic. In a rational economic deal in that site, we'd be making a lot of money. We understand more about Japan than we have in the past. There will be Hollister mall stores in Japan. China is a very huge focus of ours. And we have been looking at it extensively. We're off to, we think, a very good start. We're, as a company, really engaged and we've engaged many, many people in China to figure this market out. We -- as I said this morning, we think opening the Hong Kong flagship will be very meaningful to China and we are negotiating for a flagship in China for next year. We're taking this very seriously. We think there's a lot of business to be done in China.

And for our next question, we go to Robin Murchison with SunTrust.

Two questions. Can you parse out the U.K. from Continental Europe if there is a difference in performance? And secondly, regarding cannibalization, does that suggest anything for forward unit growth in Europe?

I don't know that we want to comment on country-by-country performance, Jonathan, what do you think?

I mean, I think we haven't seen some of the big discrepancies you've heard other people talking about. I mean we haven't seen that necessarily same divide between Northern and Southern Europe. We could probably say that, but I’m not sure there's much else we can add on that.

The unit growth?

I'm not sure I really understood the question, Robin, on the cannibalization and on unit growth.

Yes, sorry. The question gets to if there's cannibalization, does that change your thinking at all in terms of unit growth in Europe?

Okay. Well, again it all comes back to that 30% 4-wall margin. And if we could open a store and then net of the effect of cannibalization, it could deliver that 30% on a conservative volume assumption, we would continue to go ahead. Based on if you're looking at what's in the plan today, we don't foresee the Hollister that having any significant impact on the store count plans. Most of those stores, even after cannibalization, are comfortably beating the hurdle rate even with the negative likes we've seen over the past quarter for Hollister. For A&F, we have pulled back in a couple of instances where weren't satisfied that we were going to meet the hurdle rate. So a little bit of an adjustment there, but overall not a major adjustment to the plan.

But we're looking at it. At this point, we're looking at it very hard in a very disciplined way.

We go next to Janet Kloppenburg with JJK Research.

Mike, I wondered if you could talk a little bit about any progress you're seeing at the European flagship since you've adjusted the AUCs. I know you just said that you expect some progress as the year goes by, but I was wondering if you could talk a little bit about that mix shift and price points there? And you also said that you felt good about China, but given that there's some Hollister stores that have been open for a while, I wondered if you could talk a little bit about the performance there vis-a-vis how the initial stores opened in Europe. That would be an interesting analysis if we could learn more about how they're ramping. And Jonathan, I don't know if you answered Jeff's question about tax rate, but maybe you could help us with the tax rate number. And at the expense line, can you maybe help me understand on both the store and operating and the MG&A line whether the rate of increase in expenses will continue to be the same or if it should moderate as we go through the year? And I had one more question, just about the operating margin rate of the direct business, which seems to be coming down.

Okay, let's go through the list. It's okay. Pricing in the flagships. We have adjusted that mix and it's very difficult to tell what that result is, candidly. We think it's the right thing to do in terms of positioning the stores. But looking at the reductions and the mix, it's very difficult to have a direct correlation. But we think we're doing the right things. China, we're pleased with how we’ve started in China. I think what we're learning in China is from a real estate perspective, we have to treat China the same way we did Europe, which is to be in the best centers. We opened in -- the first China store is in Shanghai. It is a good store. It's gaining momentum. It would be ranked as a good Hollister store anywhere in the world. We opened in Shenzhen, which is the secondary city and we're meeting our plan, which wasn't as aggressive as Shanghai. And we opened our first store in Beijing in a mall where we shouldn't have opened. And our lesson there is that our first store in Beijing should not have been in a kind of a third rate mall. So we're optimistic about China. We're optimistic about all of the brands there. And I think that's all I have to say about China.

Janet on the other part, the tax rate we're saying still slightly below. We didn't update the guidance we gave you in February, which was slightly below 35% for the full year. On expense, what we're saying in the presentation is modest deleverage in Q2 and modest deleverage for the full year, so better than what we saw in Q1 but still some deleverage now on a full year basis. And then in terms of the operating margin on direct, I think we'd said on the last earnings call that we anticipate a mid-40s would be a reasonable run rate going forward. What you have baked into that margin and for the other channels, too, is still that significant year-over-year costing impact in Q1, which will turn around nicely over the next couple of quarters. But we still think that mid-40s run rate for direct-to-consumer is about the right ballpark going forward.

So we should look for it to be maintained here, right, Jonathan, around this level?

Yes, I think we've said -- we'd say that being in the mid-40s on a go-forward basis. And obviously, on a full-year basis, there are some quarterly swings in all of the channels. And what you're seeing for international stores clearly they were below 30% for Q1, but adjusting for the costing effect and the sort of seasonalization, that would still put us above 30% on a full year basis.

I think I have one more store for you, that's our Hollister store in Hong Kong in Festival Walk is a phenomenal store. It would be rated up the -- somewhere on the top of our store list.

And we go next to Evren Kopelman with Wells Fargo.

It's Maren in for Evren. Just quickly, when we look at the U.S. stores, in terms of the significant comp decline in the tourist stores, do you think that's because there's fewer tourists or do you think it's more of a brand issue?

A, fewer tourists.

And for our next question, we go to Omar Saad with the ISI Group.

Wanted to ask you guys, as you're looking at the European stores and some of the tourist stores in the U.S., what kind of information are you seeing and patterns are you seeing with the consumers? Are you seeing a lot of repeat customers and they're buying less or are you seeing less repeat customers? We can still see that there's lines out in front of a lot these stores, so there’s still clearly a lot of demand, but what is on the margin causing that negative like-for-like in the store? How much of it is traffic and how much of is losing customers? Have you done that kind of level of analysis with the consumers that are flowing through there?

It's very -- we do not have that level of detail. We hope to develop that capability. And measuring traffic in our flagship stores is really impossible because of the level of traffic. But we see that traffic is down in those stores and that's what is driving the volume. We clearly see that in the U.S. tourist stores.

We go next to Liz Dunn with Macquarie.

Just a point of clarification on the comp guidance for international of mid-teens decline going forward. Is that a constant-currency comp? Or because just when we do the math, it looks like the comp decline in the first quarter in the international stores was a bit sharper than that. And then my second question relates to real estate decisions. You talked about some missed steps in Japan and in China. How are you changing your real estate decision-making process or the team? How are you adjusting so that some of these missed steps don’t happen in the future?

Liz, just on the first one, we report comps on a constant-currency basis and that applies both to what we reported for Q1 and what we're projecting for the full year. I'm looking to Brian to confirm that?

That's correct.

So I think that answers the first part.

Yes, but can you break out what the currency hit to the sales or to the comp was?

Yes, I mean the currency hit is shown. If you look at -- if you go to Page 5 of our investor presentation, the foreign exchange impact was less than 1% year-over-year in the first quarter, so it wasn't negative. And then we -- but we separate that out from the impact of comp store sales. We should then state it on a constant-currency basis.

The answer to the second part of your question is that we have essentially a new real estate group. And to be transparent about this, obtaining real estate globally is a different matter from obtaining real estate in malls in the United States. And we had to change our team in terms of levels of experience, and actually, the amount of oversight that we're giving that part of the business today. I feel comfortable that we're making the right decisions.

For our next question, we go to Kimberly Greenberger with MSB.

Great. Morgan Stanley. This morning, I think Jonathan you said that U.S. comps are running up 4, I wasn't -- I think I missed the international comp, if you could just remind me what that was. And my question is on the divisional margins. We saw about a 730 basis point decline in the direct-to-consumer operating income rate. I'm wondering if you can just help us understand the big drivers behind that? And also, I presume that the 580 basis point decline in the international store operating income rate is driven by the negative comp, but if there are other factors in there as well, I would be interested to hear that.

Okay, Kimberly, thanks. On the U.S. comps, what we said was the total retail segment comps, including DTC, were up 4%. Though same-store sales, we were up 1% and then DTC took it up 4%, which we think is the appropriate way to look at it from a U.S. standpoint. The overall comp we gave was down 5%, is purely same-store sales. And we don't include DTC in that partly because we think it's problematic to do that in terms of looking at our global DTC business and including all of that in a comp number as we expand our new stores significantly internationally. But you can kind of do the math and if you added that global DTC growth back to the negative 5% comp, you'd be sort of flattish on an overall comp basis if you did include all of that DTC growth. With regard to the DTC operating income rate, I think we touched on that with the answer to Janet's question. A big piece of it is the sourcing cost impact year-over-year, which is affecting all of the channels. But I think we've also said that the rates we had in 2011 were probably not sustainable anyway and that we anticipate a go-forward rate closer to the mid-40s for direct, particularly given some of the investments we're making in the channel, which are necessary to drive the continued growth. And then the third part of the question, the decline in international, a big piece of that again was the sourcing cost issue year-over-year. That would have been the biggest single component. And then some deleveraging of expenses as a result of the negative comps.

I'm just wondering why there was so little impact in the U.S. store. We saw only about 110 basis points decline in the operating income rate, but I would have thought that you would see a similar kind of sourcing cost inflation within each channel, but the profit rate in U.S. stores was much, much, much closer to last year's. So I'm just trying to understand the disparity of results by channel if there's an easy explanation, that would be great.

Unfortunately, there isn't an easy explanation, Kimberly. It's a little bit complicated by the markdown reserve issue, which is sort of abnormally -- having an abnormal impact on this quarter. So essentially, the markdown reserve we took at the end of fourth quarter disproportionately benefited the U.S. stores in Q1 in terms of how that margin is coming through. I think we've included this analysis and we intend to include it going forward quarter-by-quarter. I think it is a little bit distorted by that effect in this particular quarter, but that effect should go away. Also, it'll be less significant on a full year basis.

We go next to Barbara Wyckoff with CLSA.

Question for Mike. Can you talk about women's bottoms and women's bottoms business, denim versus color, twill, silhouettes? How do you see this going forward? How are shorts performing? Talk about skirts and dresses, please?

Oh, Barbara, I would love to talk to you about this. But I really can't. The women's bottoms business is good. I don't want to give you forward projections. The short business is good. Women's bottoms business is good.

We go next to Paul Lejuez with Nomura.

Just a couple of questions. Just wondering if you could share with us, and sorry if I missed this, the AUR in the U.S. versus the European business. Also was wondering what kind of AUC reductions you're looking for, just ballpark, just wondering if you'll see it down double digits at some point this year. And also trying to understand the view of gross margins getting a little bit better with the inventory levels up where they are. I think you said the markdown reserve was lower at the end of the quarter here. Just wondering what that was, if you can share that with us versus last year.

I guess in terms of the AUR, Paul, we said U.S. AURs were up slightly and then international AURs a little bit more, so the overall AUR was up modestly for the quarter in total. AUC, we'd said on the last earnings call we expect it to be into the double-digit reductions in the back half of the year. And as we said earlier on, we’ve made continued progress on that and that is now substantially locked in, so we feel very good about that. With regard to inventory we’ve -- as we said, we've aligned our receipts for the balance of the year to that negative mid-single-digit trend that we've talked about. So, on a full year basis that’s what we're now buying to. And then in terms of the markdown reserve at the end of Q1, I don't have that number to hand. It was lower than we'd anticipated coming into the quarter, primarily reflecting some of the progress we are making in getting AURs up and continuing to seek to get AURs up, but we'll obviously publish that number as part of the Q.

It was actually down versus last year, the markdown reserve or just relative to your plan?

It was down a little to last year's, as Brian was saying.

Got you. And when you say the -- your inventories lined up to down mid-single digit, you're talking inventory dollars, correct?

Yes, in effect. It's what we're buying to and obviously we’re not buying to minus 5 in total because clearly there is new store sales growth and direct-to-consumer growth. But in terms of how we build up the buy, we start from that negative mid-single-digit comp on a dollar basis.

Which means units would be down mid-teens in a comp store basis?

No, I don’t think we're going to get into the AUR assumption baked into that.

Okay. Just, I was talking from a cost prospective, if your cost or AUC is going to be down double digits, wouldn't that imply that units would be down somewhere in the mid-teens?

I'm not sure I'm following your logic.

Your mentioning dollars down mid-single-digits on a comp store basis and your average cost per unit, are they going to be down double digits?

That's what we said for the back half of the year, yes.

So units would have to be down double digits, correct?

Whatever that you see based on the units. I mean I guess what affects the units is the comp trend and the AUR assumption. And what we're saying is the comp trend, we're planning for negative to mid-single digits. And AUR, we just previously said flat for the U.S. chain business. We're hoping to make a bit of progress on that as we did in the first quarter. For international, it's a bit of a different story because we’re up in the first half of the year, year-over-year. But as Mike alluded to earlier, we would expect that to turn slightly negative for the back half of the year. So I hope to get you to see really the bearing on...

Yes, that's right. It could actually be up a bit, now that I'm thinking about it. Sorry, I was just doing the math the wrong way there. Okay, got you.

We go next to Marni Shapiro with The Retail Tracker.

I think the stores look very happy. So I have a couple of quick questions. First, I want you -- how to trend where the fashion has outpaced what I call more of the core business of T-shirts and sweats and you were sort of chasing into that business, I wonder how you feel about your comfort level with keeping up with the fashion there. It does seem to still be outpacing the core on the sales? And if you can talk just a little bit -- and it feels as well, the promotions definitely feel very light this spring compared to what we've seen over the last couple of months and seasons, particularly on the fashion side. And I want to make sure what I'm seeing is right there, particularly at Hollister; it feels even lighter than the other stores, which has been the more promotional. And then just one last question on marketing. If you can just give us an update. Has anything changed on the marketing side or does it remain focused on the direct business in the part of the channel?

Okay, first part of the question. I feel that we continue to make progress in fashion. So if I'm understanding the question correctly, I feel that, that business will continue at a good rate in female.

If you were sort of a chase mode on the fashion because it was selling faster, trying to get the balance a little better. Are you feeling good about that?

Yes, I think, Marni, that we're always in chase mode for fashion. And I think that's a good thing.

Yes, I agree.

The promotions, I think we are less promotional and we anticipate being less. And from a marketing perspective, it is directed to the direct business. It continues to be.

Is that true in Europe and China as well?

Well, we don't really market -- our marketing is done in-store. So we clearly have websites. I'm not sure I understand the question.

Females, for example, are a big marketing part for you guys. Even Facebook here in the United States, I'm constantly seeing updates on Facebook from you guys. Are you doing things like that in Europe and China and Japan?

We're getting started, Marni. I mean we're doing a lot more interactive marketing over here. We are getting started, particularly in China now. But we are a long way away from where we are in the U.S. The other thing we do in China, in particular, is focus on those new store openings. And in Hong Kong we’re making, as we mentioned earlier, a big push around that opening in terms of creating awareness in Mainland China.

And really look at Facebook to see what happened in London last weekend, that's our marketing effort is.

Yes. And on the mobile side, are you guys pushing into the mobile technology at all, particularly in Japan and China? Or you'll get there in time?

Yes is the answer. I mean we're working so that all of our online interaction is sort of mobile enabled. That would apply not just in the U.S., but also internationally. And I think we've said in the past that around 20% of our traffic online is already coming through mobile, so it's clearly happening.

For our next question, we go to Dave Weiner with Deutsche Bank.

So I just wanted to follow-up on a earlier question about pricing. I want to make sure I understood the answer. Basically I was curious, I think you said that pricing, and I don't know whether this was referring globally or to Europe specifically, it was kind of up to modestly in the first half, going to be down modestly in the back half. I guess if you could just confirm that's the case. And within Europe, is there any way you can kind of break that out between Abercrombie and Hollister? Do you kind of need to do that same type of cadence for both brands?

The answer is that we were describing Europe. And I said that we'd be down, up slightly in spring and down slightly in fall. A little more aggressively down in Abercrombie & Fitch than Hollister for the fall season.

Got you. And I guess, I mean the pricing obviously is a -- seems to be a key lever here where you're trying to gauge it in an economy in Europe that's kind of deteriorating, is in a state of flux. So I mean kind of how do you figure out ahead of time how are you trying to kind of analyze what the appropriate pricing level is? I mean it seems that, that's a real challenge especially since your -- many of your brands have relatively short track record versus others there in the malls and whatnot?

We look at sales on a weekly basis and we look at trend. Pricing is an important part of what we do. But it's -- how do I describe this? I suppose the answer to the question is, first, our first driver of business is not price in any place in the world. We drive the business through differentiated store experience, through right -- trend-right product and then price is something that follows. We've never driven the business through price. And we don't in Europe. So pricing is a factor. But as I said to Janet earlier in the session, reducing the AURs in the flagships in terms of mix, we haven't able to really see a result. It's a very complex issue, but it's not the issue that we're obsessing with. We're obsessing with right stores, right product, that’s success.

Right. And so that strategy in Europe would kind of that focus not so much -- that first focus not so much on price, that would apply is much to the Hollister stores in the mall as to the flagships?

Absolutely, absolutely.

We go next to John Kernan with Cowen.

I wondered if you could update us on the cadence of store closures domestically both for Abercrombie and Hollister the remainder of this year?

John, yes. We've said on the last earnings call 180 approximately between now and 2015. We haven't given a specific figure for this year yet and there's a lot of water to go under the bridge on that. We did close 5 stores in the first quarter. We'll be in a better position to give an update on that as we get later into the year when we start engaging directly with the landlords with regard to plans to renew or close stores, but there really isn't anything new relative to what we've said in February at this point.

And then maybe I missed this, but FX guidance related to the euro for the remainder of the year, what's embedded in your assumptions?

We've said in February it was about negative $50 million full year effect. It's a little less than that at this point based on the current rates, but they’re pretty close. So it’s on a full year basis, somewhat below negative $50 million from a dollar sales standpoint.

So the actual euro rate is embedded in your assumption, it's lower?

It's pretty close to the current spot rate.

For our next question, we go to Roxanne Meyer with UBS.

I have a couple of questions for you actually. One, just wanted to know what the sequential progression was in terms of comp performance throughout the quarter. Second, if you could give us a little bit more color about how Hollister performed in the U.S. relative to how it did internationally? And then within the international landscape, any thoughts of separating outperformance of Hollister versus A&F in terms of how they're feeling out the macro weakness and impact? And then last, just on cannibalization. I guess I'm curious to know how you see the endgame for a store like London, which continues to feel the pressure from cannibalization. What is it that's going to get the sales to stabilize and turn it around and maybe even get it to comp positive again at some point?

I guess in terms of the sequential trend during the first quarter, Roxanne, it was complicated by a number of factors including the Easter shift. There were some weather things going on. So I think it's tough for us to really add a lot of color to that. Clearly, we've changed the guidance from flat to down mid-single digits based on what we're seeing during the quarter. And I'm not sure there's a whole lot more detail we can really add. I'm not sure I fully understood the second part of the question. Can you still remember it?

Yes, just looking for any color you can provide as to how Hollister performed in the U.S. versus outside of the U.S.?

I guess in the U.S., A&F versus Hollister, A&F was a little stronger in the first quarter relative to where they've been in, in the fourth quarter than Hollister.

But what about comparing just Hollister to Hollister U.S. versus internationally, and how it's doing?

Well, I'm not sure that's a terribly meaningful comparison. I mean I think you've got to look at what they're trending against from prior periods. We don't really look at it that way. We look at what's going on in each of the geographies rather than comparing them across geographies, and I think it would be tough to draw any conclusions from looking across geographies for any of the brands frankly. Going to the third point, I think the single most important point on London is that it is today still far ahead of the volume we signed up for the store, which is linked to hitting that 30% margin. So even after all of the cannibalization we've seen in London and the negative trend, it's still an extremely healthy and profitable store and I think that's the single most important point about London. And it's true of the other flagships too for the most part.

And for our next question, we go to Erika Maschmeyer with Robert W. Baird.

Blair Minarik for Erika. Just if you could speak about the environment a little bit. Given your comments about pushing for AUR increases in the U.S. for the balance of the year, what do you expect other retailers to do with the cost benefits everyone should be seeing in the second half? And how fast could you react should the environment dictate declines in AUR?

We are anticipating that we can raise our AURs. If we find that the competition is lowering prices aggressively and that is affecting our business, we can respond very quickly.

Okay. And then a follow-up on Gilly Hicks. Is that a sign of acceleration of that strategy and expansion internationally? And then could you talk about those recent store openings?

Yes, I think everyone should take a look at them because they were a lot of fun last Saturday. Gilly performed very well in the first quarter on a comp basis. We are still learning a lot about the brand and the categories. And within the openings in Europe, we have different formats. So I will not say that this is signaling that we are on our rollout mode with Gilly at this point. But we're very happy with the progress and continuing to learn a lot about the business.

And ladies and gentlemen, due to time constraints, this will conclude our question-and-answer session. And this does conclude our conference call. Thank you for your participation. You may now disconnect at this time.