Good day, everyone. Welcome to the Abercrombie & Fitch Second 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. Brian Logan. Mr. Logan, please go ahead.

Good morning, and welcome to our second quarter earnings call. Earlier today, we released our second 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 Investors 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 is scheduled for 1 hour. Joining me today on the call are Mike Jeffries and Jonathan Ramsden. We will begin the call with a few remarks from Mike; followed by a review of the financial performance for the quarter from Jonathan and me; followed by an update on our strategic plans. After our prepared comments, we will be available to take your questions for as long as time permits. Now to Mike.

Good morning, everyone. Thank you for joining us today. The second quarter results we are reporting today are disappointing and below our expectations coming into the quarter. In particular, we saw a further deceleration in the sales trend of our international stores, while our U.S. chain stores also comped negatively for the quarter for the first time since 2009. Our direct-to-consumer business remained a bright spot, posting its 10th successive quarter with year-over-year sales growth of 25% or better. As we have discussed in the past, we continue to believe that the macroeconomic environment is a primary driver of the negative comp sales we have seen in our international stores, particularly in Europe. The situation in Europe has continued to become more difficult since we first spoke of our concerns a year ago. In addition, cannibalization has clearly been a factor, as our brands have become more widely available in Europe. With NMR [ph] down 26 comp for international stores for the quarter, we can specifically identify 5 percentage points of this trend as being attributable to store-on-store cannibalization. The overall effect is likely somewhat greater taking into account potential transfer to our rapidly growing direct-to-consumer business. However, it is important to note that significant cannibalization effects are limited to only a portion of our international stores, principally flagships with large tourist components and local catchments where we have multiple stores. It is also important to note that even with the cannibalization we have seen, the great majority of these stores still meet our margin hurdle criteria. Beyond the macroeconomic and cannibalization effects in Europe, we have also given back some share in the U.S., and it is reasonable to assume that some of the factors that have affected our U.S. business have also affected the trend in Europe. Many…

Thanks, Mike, and good morning, everyone. I'll start with a short summary of our results for the quarter and outlook for the full year, and then Brian will go into some additional details. For the quarter, the company's net sales increased 4% to $951 million. Total U.S. sales, including DTC, were down 5%. International sales, including DTC, were up 31%. And total DTC sales, including shipping and handling, were up 25%. Comp store sales were down 10% to last year. Comp sales were down 5% in U.S. stores and were down 26% in international stores. On a weighted average basis, the dollar strengthened approximately 3% versus the prior quarter and approximately 7% versus last year. Foreign currency changes for the quarter affected sales growth adversely by approximately 160 basis points versus a year ago. Gross margin erosion for the quarter of 110 basis points was modestly greater than anticipated, reflecting the lower sales trend. Overall, expenses for the second quarter came in significantly below projection. The main drivers of the expense reduction were lower contingent rent, lower incentive compensation, reductions in travel, marketing and other home office expenses. Operating income for the quarter was $27 million versus $47.2 million a year ago. Operating margin fell 230 basis points, with expense deleverage of 120 basis points adding to the operating margin erosion. The tax rate for the quarter was 38.9% and diluted earnings per share for the quarter were $0.19 versus $0.35 for the prior year quarter. Turning to the balance sheet. We ended the quarter with total inventory cost up 20% versus a year ago. Based on our current sales plan, we expect inventory cost to be approximately flat year-over-year at the end of Q3 and down at the end of Q4. We ended the quarter with $312 million in…

Thanks, Jonathan. As reported, comp store sales were down 10% for the quarter. U.S. comp store sales were down 5% versus down 1% in Q1, with chain stores performing slightly better, although comping negative for the quarter for the first time since 2009. International comp store sales were down 26% versus down 22% in Q1, with Hollister European stores performing somewhat better. By brand, comp store sales were down 11% for Abercrombie & Fitch, 10% for abercrombie kids and 10% for Hollister. Within the brands, male and female performed comparably. The gross profit rate for the second quarter was 62.5%, 110 basis points lower than last year's second quarter gross profit rate. The decrease in rate was driven by an increase in average unit cost and the adverse effects of exchange rates, partially offset by an international mix benefit. A summary of our second quarter operating expense can be found on the slide on Page 5 of the investor presentation. Stores and distribution expense for the quarter was $458 million or 48.1% as a percentage of net sales. Store occupancy costs were approximately $185 million, and all other stores and distribution cost represented 28.7% of net sales, 120 basis points above the percentage of net sales they represented last year. The increase in the stores and distribution expense rate was primarily the result of deleveraging on the negative comp store sales. Stores and distribution expense for the quarter included approximately $700,000 of accelerated depreciation from our DC consolidation, lower than previously anticipated due to an extension in the expected service life of our second DC. MG&A for the quarter was $111 million versus $110 million last year. The increase in MG&A for the quarter was due to an increase in marketing, IT, travel and other expenses, largely offset by a…

Thanks, Brian. As we indicated in our prerelease 2 weeks ago, we want to spend some time this morning to give an update on various aspects of our forward-looking plans. And in connection with that, I would like to refer you to the Strategic Update section of our investor presentation. First of all, as Mike alluded to a few minutes ago, we are confident that the return on investment from our international rollout to date has been superior to any alternative use of capital over that period, including stock buybacks. Going forward, our philosophy remains to be disciplined in allocating capital to where it will derive the greatest return on a risk-adjusted basis. Turning to the performance of our international operations to date. As we have stated in the past, we think it is helpful to break out the business between Hollister Europe, A&F flagships and other investments. Starting with Hollister Europe. As we have discussed in the past, we believe that Hollister international store openings represent a low-risk, high-return use of capital. To illustrate how we think about this, the slide on Page 14 shows the anticipated sales contribution, EBITDA and operating income for a recent Hollister store we opened -- or we approved rather in France. We referenced this example in some recent conference presentations and think it is a good example of a fairly average European Hollister store. In addition to our expected or approved case, as reflected on the slide, we also show a downside scenario where the store achieves only 75% of its expected volume and a low-end scenario where the store only achieves 50% of its expected volume. In terms of return on capital, we define store level ROI as four-wall EBITDA less estimated incremental non-four-wall costs such as DC, regional management and an…

Thanks, Jonathan. As I referenced a few moments ago, our entire organization is focused on improving the trend of our business. And before closing, I want to review some of the initiatives we are pursuing to accomplish this. This is not an area of significant capital investment, but we believe there is significant potential to improve our overall returns to shareholders through gains in the productivity and profitability of our domestic fleet. First, with regard to merchandising. We have a number of initiatives that will improve our ability to react and to chase. These include implementing more conservative merchandise plans, a shortening of our product development calendar and increasing the chase component of our open-to-buy. In addition, we are increasing local sourcing within the U.S. and Central America to further shorten lead times and increase flexibility. Second, in terms of inventory productivity, we are committed to growing inventory at a slower pace than the rate of sales growth. This will be supported by investments we have made in new merchandising, planning and allocation systems, which are now live for the spring season of 2013. Among other things, these new systems will greatly enhance the efficiencies in building plans and give us much better visibility on margin and inventory plans by selling channel. In addition, these systems will shift our focus to selling margin rather than IMU, which is a significant improvement given the evolution and complexity of our business today. A third key area of focus is insight and intelligence, particularly with regard to our international operations. We are building the team to help us better understand macro, competitor and customer dynamics in our key markets. Ultimately, we believe this improved understanding will help us make better business decisions. This intelligence will include both primary and secondary research, as well…

[Operator Instructions] We will take our first question from Dana Telsey with the Telsey Advisory Group.

Mike, can you -- given the new world that we're in, how are you thinking about the merchandise assortment, basic versus fashion, pricing globally? And you mentioned the changes in the supply chain, which should be very helpful. How do you see that and timing of that of adding to enhancing inventory, enhancing turn and margins?

I think we're thinking the same thoughts. Clearly, we have room for more fashion, more trend turning faster, which will clearly be facilitated by shortening the cycle. In terms of international pricing, I'll turn that over to Jonathan.

Dana, I think we've said we are planning for international AURs to be down in the back half of the year, particularly in flagships and to a lesser degree, in the Hollister chain stores on a year-over-year basis.

And I think, Dana, the most important part of trend and increasing our fashion component is, as I said in the overview, being on the offense. Chasing is key to improving that part of our business.

And next we'll go to Randy Konik with Jefferies.

So I guess, obviously, so I think what the market wants to hear is the word discipline and so forth around the capital allocation. So if I look at Slide 21 in the packet, there's a quote that says normalized CapEx of $200 million and normalized free cash flow of $300 million. Is there some sort of like a line in the sand we can be thinking about as -- or the shareholders or investors, potential investors can be thinking about in the sense that either you're going to hold the line at around $200 million in CapEx going forward over the next few years? Or x that, would you be able -- be committing to generating a normalized free cash flow minimum or baseline of about $300 million per year, assuming that if the operations get better, the CapEx could go up a little bit? So just trying to get some clarity there. And then on the share buyback, you made a comment, Jonathan, about buying back when the stock is attractive. Obviously, it's pretty attractive down here, at least from our perspective. I guess the pause, was that due to the cash generation cycle at this point in the year and we could expect that to -- the buyback spigot to turn back on in the back half of the year and into early part of next year? How should we be thinking about the timing of the buyback?

Sure. I mean to take the first part first then, Randy. I mean, we're obviously hopeful that operating cash flow we're going to generate this year is going to be growing going forward. I mean, frankly, if it didn't grow, then I think the likelihood that CapEx would grow would be very unlikely because that would suggest that the dynamics going on wouldn't support accelerating, again, the store openings. So we are hopeful that the normalized free cash flow of $300 million will grow, even if CapEx were to start growing again at some point. But we're going to remain very disciplined about how we're going to look at it on the basis of store-by-store. Is the return we can generate from any given store the best use of capital relative to buybacks or any other use as we commit to each of those stores? So we would certainly hope that, that normalized free cash flow should be growing going forward from what has obviously been a challenging year in 2012. And then on the second piece, there are 2 principal gates we have to get through to do the buybacks: the first one is valuation and the second one is liquidity. The comments we made in the script were that because we would have had to go into the term loan to be buying back shares during the quarter, we weren't comfortable doing that given the trends in the business. And as we’ve just said in the script, once we feel that those trends have stabilized then we would expect to pull down on that facility and use it towards buybacks. And we obviously can't be more specific on the timing around that. But it was really a liquidity-driven issue in the second quarter that prevented us from going forward.

So I just want to make it clear. So should the market be thinking about $300 million as a baseline of free cash flow for this company in its ability to generate that number going forward, over not just the next 12 months but if we're thinking about potential investments -- investors thinking about next 2, 3, 4, 5 years? Is that how we should be thinking about this business?

We're obviously not giving a forecast for the business, but we would be disappointed if we weren't able to generate more free cash flow than that beyond 2012. Does that answer the question?

Yes.

And next we'll go to Steph Wissink with Piper Jaffray.

Just wanted to follow up on Randy's regarding discipline. You added a tremendous amount of discipline around your store operating model. I'm just curious how you thinking about the overall health of your stores based in the U.S. More so, what is right store base size for each of your core concepts?

Yes, Steph, I think that we've said for Hollister, we don't anticipate the store footprint contracting significantly. There are some stores that will probably close, which are not doing particularly well, and there's no new news there. But most of the closures are oriented towards a&f kids and getting the a&f kids brands focused on those stronger performing stores. And as we've said many times in the past, if you look at the sort of upper tier of A&F and kids stores, the economics of those stores are, frankly, comparable to our international stores so there is a segment of those stores that we would like to reposition the fleet towards. We've talked about another 180 closures between now and 2015. Again, most of that would be oriented towards A&F and kids, as it has been for the 135 stores we closed in 2010 and '11.

And next we'll go to Janet Kloppenburg with JJK Research.

Michael, congratulations on an outstanding opening in Hong Kong. That's very exciting. A couple of questions. At the end of the first quarter or maybe fiscal year '11, you had said that you expected to recapture a great portion or almost all of the gross margin that you lost in 2011 attributable to higher raw material cost. Can you just give us an update on that outlook right now? Secondly, I know there'll be increased M&A pressure -- MG&A expense pressure in the quarter due to the CRM and China marketing costs, should we expect that again in the fourth quarter? And just lastly, Mike, how soon can your merchandising and sourcing -- your shortened lead time initiatives affect the merchandise in the stores?

Okay. Jonathan, do you want to take the first part?

Sure. In terms of gross margin rate, Janet, what we said is that we anticipate a substantial recovery of the erosion we had last year so well towards -- well back towards the 2010 gross margin rate. And as Brian said in his comments, that's primarily driven by the average unit cost benefit, with some international mix coming into play. On the marketing piece, there is a -- there will be some ongoing costs of operating the CRM programs and there'll be some ongoing Hong Kong and China marketing, where there is a disproportionate effect in this quarter, particularly around the Hong Kong opening, where we did fairly extensive marketing around that on that expense, as well as some of the initial content creation for the club programs is disproportionately impacting Q3. So it should certainly abate beyond Q3.

Janet, I'm going to give you a long answer to work our way into your question. And I'd like everyone to know that I think that we have to start by going back to this time last year. Our international business had been very strong through the first 6 months of the year. And I think Hollister comped around 20% for the second quarter of last year. Our U.S. business was also strong. Since that time, we've had obviously very significant reductions in sales volumes, and we've had to make material changes to our merchandise plans in response to that. So we have been in the mode for most of that time in trying to get out of inventory receipts and work down inventory levels, as opposed to chasing the business, which is what we've proven ourselves to be rather good at doing. And that's a tough place. Did we miss business over the past 2 quarters because our assortment was too narrow and because we are late on some trends? I believe so. But what we have been working toward is what I've stated, to put ourselves in a position where we can be back on the offensive. This is an important point that I keep making. And that means conservative merchandise plans, more open-to-buy, more chase. And the answer to your question is that I think we'll be there as we progress through Christmas in terms of what you see in the stores and certainly, for spring. In our financial plans though, we're not counting on any improvement in the trends from this, but we're hopeful that we'll see some.

And next we'll go to Adrienne Tennant with Janney Capital Markets.

My question is on the international lease structure, and I was wondering, it sounds like Hollister is quite similar to the U.S. mall structure, 10-year leases with kick-outs. I was wondering on the flagships, if you can help us. Are they longer leases? Are they -- can you work with landlords in terms of adjusting them as we go? And is that different in Asia versus Europe?

With regard to Hollister, by the way, it's probably worth noting that the structure of the leases in a number of countries in Europe actually gives us more flexibility than we have in the U.S. Somewhere like France or Belgium, they -- there are kick-outs that kick in after various periods of time, pretty much automatically in the structure of the leases in those countries. So we do also have a couple of those kick-out type provisions in some of the smaller flagship stores. We don't have them in the bigger flagship stores in Europe. But frankly, the scenario in which could see ever wanting to exercise a kick-out in those flagship stores is so remote as to make it essentially kind of a moot question. In Asia, it's still early days over there. The leases typically in China tend to be a little bit shorter than they are in Europe or the U.S. I think with regard to new flagships and lease flexibility, based on our current plans as we said, we're not anticipating, at this point, adding to the commitments we have out there other than Shanghai. So again, it's somewhat moot at this point. But I think in terms of general duration of the leases in somewhere like China, where it is, in any case, shorter than the U.S. and given the relatively small number of leases we have, we haven't really got into this point of discussion about kick-out provisions in those leases.

Okay. And any update on Singapore?

Yes, it's doing solidly.

Solid business, yes.

Great. And Mike, I just wanted to say, once again your eye for color is fantastic for the fall season.

Thank you. That's very kind.

And next we'll go to Evren Kopelman with Wells Fargo.

It's Maren Kasper in for Evren. So the four-wall margins are still really strong in Europe, but the non-store expenses are what are weighing on the operating margin. Is that just a factor of scale? Or is there an opportunity to reduce some of those non-store expenses?

Well, the non-store expenses are a combination of a few different things. If you're looking at the segment chart in the investor presentation, you've got DC costs, which are largely a function of sales over time, as a fixed component. And we've always said that DC costs in Europe will progressively reduce, as a percentage of sales, as we have more volume going through those facilities. Regional management is a function of store count for the most part. Typically, there's a span of control for the regional district managers that isn't really directly correlated with volumes, so there is a little bit of deleveraging to that effect when you have negative same-store sales. They are a couple of the bigger buckets, the bigger pieces that go into that. Then obviously, we have pre-opening costs, which is outside of that. I think reading that out of other expense line quarter-to-quarter is a little challenging. I think it's more meaningful on a sort of full year basis, but what we've generally said is we would expect that to remain, on a full year basis, relatively flattish as a percentage of sales. We don't expect either significant leverage or deleverage on an ongoing basis.

Okay, great. That's helpful. And then secondly, when do you think you guys have potential to begin to leverage occupancy expenses again?

I mean, that’s really driven by comps, frankly. I mean, if we're in a positive comp environment, obviously, you can leverage occupancy. And if you're negative same-store sales, clearly it's going to be the opposite. We do have a 80 percentage rent component to our occupancy cost. But most of our occupancy cost is made up of fixed rent and fixed depreciation, so it’s clearly a function of the sales trend.

[Operator Instructions] We'll next go to Lorraine Hutchinson with Bank of America.

Just a quick follow-up. When you talk about comp trends stabilizing in order for you to draw down on the revolver, does that mean turn positive or just not getting worse?

I think it's a belief that -- we don't want to over-parse this, but I think it's a belief that things aren't getting worse primarily and therefore that -- and that we have a comfort factor that the trend stabilization that we're looking at when we make that decision is one that we think is sustainable. And that entails obviously not just seeing a few weeks, but seeing somewhat longer period of stabilization or improvement.

Okay. And then my question revolved around the cannibalization analysis that you did when you were originally rolling the stores out. Where do you think it went wrong in trying to predict the cannibalization? And do you feel like you have a good enough handle on it now to be opening 30 more Hollisters internationally over the next year or so?

Well, first of all, I think the premise of the first part of the question that we went wrong is not one we would agree with. I think we've -- it's obviously hard, to begin with, to project those things. When we opened a store in Oberhausen, it was tough for us to know whether people were driving 100 miles or 50 miles to come to the store because the brand was so appealing so it was tough to gauge. And I think there was probably some opening surge, in any case, around those stores. But more importantly, when we've gone back and looked at all the stores that have been cannibalized and looked at whether we -- in hindsight, we would still have opened them, there was probably 1 or maybe 2 that we might not have opened because they wouldn't have met our overall returns. So it's not as if in retrospect it led us down a path that we wouldn't have gone down. Going forward, we are able now, based on the patterns we've seen in certain discrete catchments like in, for example, the Frankfurt area or obviously, around London or even in somewhere like Manchester, where we have 2 stores that are pretty close together, in the U.K. We now have a pretty good read on that and then every store we approve. Today, we put in a specific assumption of the cannibalization of existing stores and looking at the incremental return that store generates both in terms of the four-wall margin but also, in terms of the overall store level ROI that we talked about earlier. So I think to some degree it's natural. When the brand first got to Europe, it was very hot. People were probably going out of their way to get to the store to find it or having a friend go there. Over time, as it becomes more available than some of the existing stores probably that had some cannibalization, there's no great surprise about that. But fundamentally it doesn't, I think, change the economics of what we have been through.

And let me add to this. Our discipline is really strong. To look at Hong Kong, where we just stated what the flagship is doing, we also have an immensely successful store in Festival Walk. It's one of the highest volume Hollister stores in the fleet. We are not -- we're going to open one more store in Hong Kong, and that's this month in Causeway Bay. But that will be it in Hong Kong. So with the size of that business and enthusiasm for our brands, we're very disciplined about calling it a day at this point.

And next we'll go to Kimberly Greenberger with Morgan Stanley.

Mike, I'm wondering if you can just talk to us about the international pricing strategy. I know last year you felt like you had potentially overreached on price a little bit, and you've been taking pricing down early this year. Do you feel like you've found the right sort of level on pricing in international stores? And then Jonathan, I'm wondering if you can just help us with U.S. versus international comps by quarter last year. I would assume that the international comparisons get a little bit easier as we progress through the second half of the year. And if you just have the transaction metrics here for the second quarter that you just reported, that would be great.

Let me comment on international pricing and -- first, flagship and then Hollister. What I believe I said was that we felt we might have stretched the flagship prices too high. We have reacted to that and lowered the mix in flagship stores. I can't really tell you, Kimberly, if what I was saying was correct. It's very difficult to track that flagship AUR to the business. I believe that the slowdown in those stores has been really macro-related primarily, they're tourist stores, and some cannibalization. So we've lowered the retails slightly, for go-forward in the flagship stores. I'm really not sure if the result is going to be dramatic. But Hollister AURs are very, very comparable to last year.

Kimberly, on the second part, just to take some of the pieces of that, I think we said on the U.S. that the -- and this is off the top of my head. These numbers may not exactly right. But I think we'd said high single digits for U.S. stores through the first 3 quarters of last year and then approximately flat, I think, in the fourth quarter of last year, I think, is what we've said. With regard to Hollister Europe, we were up in the 20%-plus range through the first 6 months of last year. That then moderated into single digits in the third and fourth quarters of last year and then turned negative in 2012. The flagships’ trend declined a little than Hollister. We started to see the first signs of that in the second quarter, although really predominantly in August. But it didn’t really become clear until the third quarter. And then the flagships went negative from the third quarter onwards in 2011, and then they've been more negative through the first half of 2012 within Hollister.

And Jonathan, just on the transaction metrics in the second quarter?

You're asking for a recap Kimberly or some...

AUR...

Basically, we have a...

Is that in the presentation?

Brian, do you want to take that, on AUR for the second quarter?

Yes. For the second quarter, I think we only gave some information on go-forward on the AUR.

We didn't specifically call that out. But I think again, Brian, correct me if I'm wrong. I think was it roughly flattish to slightly down for the U.S. chain stores in the second quarter.

That's correct.

And next we'll go to David Glick with Buckingham Research Group.

Jonathan, just a question about the tax rate. I mean, clearly, international business is still very profitable, yet the corporate tax rate is back toward more historical levels before you had a more profitable international operation. Can you help us understand why that's the case and how we should think about the tax rate going forward?

Sure, David. There's kind of a 30-second answer to that question, and there's like 2-hour one, so it's a...

I'll take the 30-second.

30 seconds. I mean, essentially, we have the underlying profitability, the economy profitability of the operation, which is obviously still very strong. Then what happens though is a portion of our central overhead, for tax purposes, gets pushed out to the International operations. So our home office cost here -- and that's primarily based on sales, how that gets allocated for tax purposes. So as international's grown as a proportion of the sales, for tax purposes, more of our central overhead, for tax purposes, gets moved to international and that therefore, reduces the taxable profits internationally. It doesn't -- I mean, so there's a somewhat different answer between the economic profits and the taxable profits. So that's the short 30-second version of it.

Okay, moving on. We'll go to Robin Murchison with SunTrust.

Question, what is the approximate number of stores needed to maintain critical mass in the kids division? And then as you look at -- are you looking at any merchant design team changes relative to any or all of the brands?

I guess on the first part, Robin, I mean, it's something that we clearly feel we have critical mass with the store count we have today from a buying standpoint. And certainly, within the plans that we've made for store closures, we don't anticipate changing our position, so we're not going to take the overall store footprint to a level where we would start to lose leverage from an average unit cost standpoint.

Okay. And the merchant design changes, any?

None that we're discussing at this point. We're constantly evolving that step. I think the most important point is we have the -- arguably the strongest merchant and design teams in the business. We're very pleased with them. They continue to perform.

And next we'll go to Liz Dunn with Macquarie Capital.

Just a follow-up to the stores question. A lot of higher-end brands sort of have a kind of 300-store opportunity in the United States that they talk about and somewhere above that, such as Coach. I'm just curious as to your perspective on why the Abercrombie & Fitch brand doesn't have that sort of potential scale and now we need to close stores in that brand. And then, also, I appreciate your careful management of the brand aesthetic over the years, and obviously, that's led to some longevity for the brand. But how do you -- do you think, at all, that, that sometimes constrains your ability to chase emerging trends as quickly as your competitors?

Well I guess on the first part, I mean, I think, obviously, our demographic is somewhat different than someone like a Coach. We obviously can't speak to anybody else's store count plans. We look at it based on the economic performance of those stores we're in today. And the stores that are marginal or we think are declining relative to the chain, in many cases, they're in malls that -- where the malls are declining. So we certainly wouldn't want to keep open a store, if it's not doing well today and the mall itself is declining. We are generally in malls only, which may also account for some of the difference with some of those other brands you're looking at. But I don't think we can really talk about anything beyond how we look at it and the economics of the stores that we're focused on closing versus the ones where we expect to keep open because of their performance.

To answer your question, Liz, about whether our aesthetic prevents us from chasing trends as fast as our competitors, I don't think that's the case. I think that we might -- we have a point of view that we chase trend that is appropriate to our aesthetic. But there is plenty of trend out there that is appropriate to our aesthetic.

And next we'll go to Brian Tunick with JPMorgan.

I guess one question for Mike. If you could just elaborate on your comments about the improved trend you've seen over the past few weeks. Is that both in the U.S. and in Europe? Obviously, there was some noise around the Olympics. And then maybe, Jonathan, some more color on the gross margin expectations for the back half. Just maybe help us feel more comfortable what you've baked in domestically. Again, when we see A&F doing all denim $39 last week; American Eagle is now priced under $30. How much have you assumed that it gets very competitive in the back half? We understand you get the cotton back, but just trying to understand what you've assumed in your guidance for the full year on the gross margins, really more domestically.

Okay. The answer to your question is that comp sales have improved for both U.S. and international. However, it's too early to say this represents a decisive change in the trend. As we found during the second quarter, the comp sales can be volatile. We'll know -- we think we'll know more over the next several weeks. But for now we're not counting on an improved trend, but we remain hopeful.

Brian, on the second part of the question, as Brian, I think, referenced in his comments, we are planning for AURs in U.S. chain stores to be flat to slightly down for the balance of the year, which is a little more conservative than we had -- we've indicated back in May. Obviously, we're up against a very aggressive promotional period, particularly in the fourth quarter. So at this point, we think that's a reasonable assumption. The other key drivers are also the average unit costs. The biggest help to gross margin year-over-year is that reserve effect that Brian alluded to earlier, which is also helping to some degree, and then international mix where we also have lower AURs baked in year-over-year for the international stores.

And we'll take our last question from Anna Andreeva with FBR.

I was hoping you could parse out some of the gross margin decline for the second quarter, down 100 basis points. It’s actually, a little better than what we would have thought given all the promotional activities. So what was AUC versus ForEx? And then, looking into the third quarter, you mentioned bigger expense deleverage. So how should we think about stores and distribution expense? I think it was up about 8% in dollars year-over-year. In the second quarter, should we think about a similar type of increase in 3Q and similarly on MG&A?

Okay, thanks. I guess on AUC, Anna, it was flat to slightly up for the quarter. The turning point was sort of midway through the quarter. So in terms of what we actually sold, it still skewed a little bit up on a year-over-year basis. I don't know if we pulled out the specific FX impact on gross margin. We haven't specifically broken that out. I think one of the reasons it was probably better than you might have anticipated really goes back to that point that we've been focused on trying to work through the inventory, kept it on the floor a little longer. And that probably has, to some degree, impacted the sales trend. But we did focus on trying to hold the gross margin rate as we worked through the season. Brian, do you want to comment on the other pieces? I think the question about increased expense deleverage in Q3. Any additional detail we can give?

I think part of it is some of the incremental expenses that we're going to see around our CRM programs, which will be incremental in the third quarter in addition to some of the marketing initiatives we had discussed as well related to -- primarily related to China.

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