Abercrombie & Fitch Co. (ANF) Q2 2013 Earnings Report, Transcript and Summary

Good day, and welcome to the Abercrombie & Fitch Second Quarter 2013 Earnings Results Conference Call. Today's call is being recorded. [Operator Instructions] At this time, I would like to turn the conference over to 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. Today's earnings call is being recorded, and the replay may be accessed through the Internet at abercrombie.com under the Investors section. The call is scheduled for 1 hour. Joining me today are Mike Jeffries and Jonathan Ramsden. Before we begin, I'll remind you that any forward-looking statements we may make today are subject to the Safe Harbor statement found in our SEC filings. In addition, due to the 53rd week in the fiscal 2012 retail year, second quarter comparable sales are compared to the 13-week period ended August 4, 2012. Also as a reminder, the company changed its method of accounting for inventory to the cost method, effective February 2, 2013. As a result, prior year figures have been restated to reflect the change in accounting method. We will now begin the call with a few remarks from Mike, followed by a review of the financial performance for the quarter from Jonathan and me. After our prepared comments, we will be available to take your questions for as long as time permits. With that, I will turn the call over to Mike.

Good morning, everyone. The second quarter proved to be more difficult than expected, due to weaker traffic, particularly in July, and continued softness in the female business. The reasons for the weak traffic we've seen in the U.S. are not entirely clear. Our best theory is that while consumers in general are feeling better about the overall economic environment, it is less the case for the young consumer. In addition, we believe youth spending has likely diverted to other categories. We assume that these effects will abate at some point, but until we have seen clear evidence of that, we are planning sales, inventory and expense levels on a conservative basis. Despite the challenging environment, we were very pleased by strong growth in our direct-to-consumer business for the quarter, which was up in all regions, with particularly strong growth in Asia. We now have a big, fast-growing and highly profitable international direct-to-consumer business, reflecting the benefits of investments we have made over the past few years. We are also pleased by our continued strong comp store sales growth in China, up around 60% for the quarter. We now have 6 Hollister stores in mainland China running at an annualized volume of around $40 million. From a margin standpoint, we generated healthy year-over-year gross margin rate improvement despite a very promotional environment, and we ended the quarter with inventory in good shape. While we believe that much of the weakness during the second quarter was due to macro conditions, we are not satisfied with our results and are working hard to improve the trend for the third quarter and beyond. As a part of this, we have expanded our assortment in accessories, where we are starting to get good traction, and we continue to look for new opportunities to expand our assortment, both owned and through third-party collaboration. For example, we recently announced a partnership with Keds and began offering an exclusive line that features Keds' iconic sneakers with signature Hollister patterns. While only available online, fans can check out the display inside our Hollister stores. Also, in late July, we tested a select assortment of Gilly Hicks intimates in about 225 Hollister stores, both U.S. and international. We are pleased with the results of this test and believe that sales were largely incremental. From a marketing standpoint, we are working on some new programs that we expect to begin testing in the next few months. We are also excited to be able to use our A&F store windows to help support traffic-driving marketing initiatives once we've completed the removal of the louvers from our U.S. chain stores. We remain very encouraged by our profit-improvement initiative. As a reminder, this initiative is focused on profit improvement through a detailed review of our existing operational processes and is primarily focused on areas covering general non-merchandise expense, marketing, supply chain, store operations and home office. We made excellent progress during the quarter, and we now expect savings from this initiative to exceed $100 million on an annualized basis. We will be conducting some significant pilot studies in our stores over the next few months, which will give us insight into whether there is further opportunity beyond that. We expect the overall implementation phase to take another 6 to 9 months to complete, with the majority of the expected benefit to be realized in 2014. We are working hard to be able to realize a portion of the benefit in the latter part of this year. We are also nearing completion of our long-term strategic review. Based on extensive work over the past few months, the plan emerging from this review will map out clear strategies covering our assortment, our real estate plans, direct-to-consumer, omni channel, technology, marketing and CRM and sourcing. We are confident that these plans will give us a clear roadmap for sustainable growth in sales, profitability and return on invested capital. The next key milestone would be a review with our board in mid-September, and we will look to share more details in the future. Before handing over to Jonathan, I would like to say a word about our team. We operate in a business that has ups and downs, and we have certainly seen both over the years. But it is an incredible feeling to come to work every day with a team that always has an optimistic, can-do approach and is constantly focused on the opportunities we see ahead of us, both near term and long term. I would like to say a very big "thank you" to everyone on the A&F team for their hard work and dedication. With that, I'll hand the call over to Jonathan, but will be available to take your questions later in the call.

Thanks, Mike, and good morning, everyone. For the quarter, the company's net sales were $946 million, down 1% to last year. Total U.S. sales, including DTC, were down 8%. International sales, including DTC, were up 15%. And total DTC sales were up 21%. Including direct-to-consumer, comp sales were down 10%, with the U.S. down 11% and international down 7%. Within the quarter, comparable sales were weakest in July. Second quarter sales were below expectations due to weaker traffic, principally in July, and continued softness in the female business. As Mike said a moment ago, until we've seen clear evidence that the traffic environment has improved, we are planning for a continuation of this trend. Gross margin for the quarter improved 160 basis points year-over-year. Operating expense for the second quarter was $585 million versus $567 million last year. Operating expense for the second quarter included $2.6 million in charges related to the implementation of the profit-improvement initiative. Overall expenses for the second quarter came in significantly below forecast, as we flexed down expense in reaction to the lower sales trend. Excluding the profit-improvement initiative charges, operating income for the quarter was $22 million versus $25 million a year ago. Operating margin, excluding charges, decreased 30 basis points, as gross margin expansion was slightly more than offset by expense deleverage. The tax rate for the quarter was 34.7%. On a full year basis, we expect the tax rate to be in the mid-30s. For the quarter, the company reported diluted earnings per share of $0.14 versus $0.20 last year. Diluted earnings per share for the quarter included $0.02 in charges related to the implementation of the profit-improvement initiative. Turning to the balance sheet. We ended the quarter with total inventory down 9% versus a year ago. We have forecast inventory down by a greater percentage. We ended the quarter with approximately $335 million in cash and cash equivalents and borrowings under the term loan of approximately $143 million. During the quarter, we repurchased approximately 2 million shares at an average cost of approximately $49 per share. With regard to our outlook for 2013, specifically the third quarter, based on the assumption that comparable sales for the quarter will be down slightly more than the second quarter, we are now projecting third quarter diluted EPS in the range of $0.40 to $0.45. Due to the lack of visibility given the recent traffic trends, we are not providing further guidance beyond the third quarter. This projection does not include the impact of potential impairment and store closure charges or additional charges related to the implementation of our profit-improvement initiative. Also, due to the calendar shift in the 53rd week in fiscal 2012, the prior year comparable 13-week period ended November 3, 2012, had approximately $22 million less in sales versus the reported 13-week period ended October 27, 2012, which adversely affects third quarter year-over-year sales and earnings. In addition, we expect to get a lower non-comp sales benefit in the third quarter as compared to the second quarter, due to timing of new store openings. We continue to expect capital expenditures of around $200 million for the year and preopening costs of around $30 million. With regard to real estate plans for the year, we continue to expect we'll open an A&F flagship store in Seoul, as well as approximately 20 international Hollister chain stores throughout the year. In addition, we will open a small number of international and U.S. outlet stores during the year. We continue to expect to close approximately 40 to 50 stores in the U.S. in 2013 through natural lease expirations, primarily at the end of the year. The planned opening of an A&F flagship store in Shanghai is now expected in the spring of 2014. As Mike mentioned a moment ago, we now expect savings from our profit-improvement initiative to exceed $100 million. Most of these savings will be recognized through expense, with a smaller element flowing through gross margin. We expect to incur some 2013 charges to achieve those savings that are not reflected in our outlook. These include fees paid to the consultants we have partnered with on this project and other charges which we will call out in our quarterly results as we incur them. The next significant step in this project is to complete the store pilot projects to test some additional savings opportunities. Since we don't expect these projects to be completed until close to year end, our next substantive update on this project will likely be in our year-end earnings call. Finally, I would like to echo Mike's comments that we remain optimistic with regard to our profit-improvement initiative, and we expect that this, along with our long-term strategic update, will lead to sustainable and meaningful improvements in our operating margin and return on invested capital. We will continue to talk more on this -- more about this on our next earnings call. With that, I'm going to hand over to Brian to provide some more details on our results for the quarter.

Thanks, Jonathan. As reported, second quarter comp sales were down 10%. By brand, comp sales, including direct-to-consumer, were down 6% for Abercrombie & Fitch; down 3% for abercrombie kids; and down 13% for Hollister. Across the brands, male performed better than female. Changes in foreign currency exchange rates versus a year ago benefited sales by approximately $3 million. Also, due to the calendar shift from the 53rd week in fiscal 2012, the prior year comparable 13-week period ended August 4, 2012, had approximately $44 million of additional sales versus the reported 13-week period ended July 28, 2012, which provided a benefit to second quarter year-over-year sales and earnings. The gross profit rate for the second quarter was 63.9%, 160 basis points better than last year's second quarter gross profit rate. Stores and distribution expense for the quarter was $472 million or 49.9% as a percentage of net sales, compared to $458 million or 48.1% as a percent of net sales last year. Expense savings in store payroll, store management and support and other store and distribution expense were more than offset by the deleverage effect of negative comparable sales. MG&A for the quarter was $118 million, versus $111 million last year. The increase was primarily driven by consulting and other services, including $2.6 million in charges related to the implementation of the profit-improvement initiative. Details of international Hollister store openings for the quarter are included on the slide on Page 9 of the investor presentation. At the end of the quarter, we operated 285 Abercrombie & Fitch stores, 150 abercrombie kids stores, 594 Hollister stores and 28 Gilly Hicks stores. This concludes our prepared comments. We are now available to take your questions. Thank you.

[Operator Instructions] Our first question today will come from Liz Dunn, Macquarie.

I guess, do you think that inventory at all constrained your comp? Was there any impact from the inventory? And then also, if you could just clarify what guys comped, since you're really calling out the female business as being the weaker part of the business.

Let me answer the first part of the question. I don't believe that inventory constrained the comp. We're happy with the inventory levels. You have to remember that last year we were over-inventoried. What guides comp?

I think the question was about guys comp.

Oh, guys comp, what are the guys comp. The male comps were positive until July. We had an ongoing weakness in female comps, and the primary problem there was in knit tops.

We'll take a question from Dana Telsey with Telsey Advisory Group.

Mike, as you think about the changes that's happening in the teen market now -- in the market now, have you seen this before? And as you think about the product assortment going forward, what should we be looking for, either to reenergize the teen to -- the customer to come in or what you're doing in your stores to drive them back in? And then on the expense-reduction program, how -- in total, could it be $200 million now or just more than $100 million? What should we be seeing?

I think there are always new entries in the teen market, Dana. Either to -- I think that from the top, there is a weakness in young teen business, and I think the weakness is stronger in young teens. As the age matures, the business is stronger. The contemporary business is stronger than the junior business. I'd say, in terms of our assortments, are there things we could have done better? Of course. There always are and that's how we build the business. But I've read quite a few research reports this past quarter talking about how good our stores look, and I think they're right. When times are difficult, it's easy to start throwing this group or that group under the bus for having executed poorly. I don't think that's the right thing to do from a cultural point of view, but more importantly, I don't believe it. I've been around this business, as you know, long enough to know that sometimes, however good a job you're doing, there are factors beyond your control. Sometimes they're in your favor and sometimes they're against you, and they tend to even out over time. The second part of the question is about driving customers into the store, and we're working on a number of marketing initiatives to do that, to build traffic, some online, some offline. But we are very, very dedicated to driving traffic. Thank you.

Dana, I think the other part of your question was about expense saves. Yes, at this point, we're comfortable the figure is going to exceed $100 million. The greatest area of incremental opportunity would be in the store operations area, and we referenced in the script that we're doing some significant pilot tests there that we're not going to have a good read on until the end of the year. So there is, certainly, potentially more opportunity there, but until we've completed those tests and determined whether those changes are sustainable and don't have an adverse impact, either from a volume standpoint or a brand standpoint, we're not ready to put a number out there for those changes.

Our next question will come from Paul Alexander, Bank of America.

Could you talk a little bit more about the cadence of what you saw through the quarter by month? It seems like July really decelerated a lot. So with third quarter guidance slightly worse than the 2Q run rate, does that imply an acceleration from July? Is that what you're seeing in stores right now? Or if it's not based on what you're seeing right now, because you want to wait for a more conclusive sales trend, could you let us know how back-to-school is shaping out?

Paul, so we saw through the first quarter, as we referenced back in May, that there was a sequential improvement by month as we went through the quarter and then that continued into the second quarter. And then, clearly, things stepped down pretty significantly in July. That was much more the case in the U.S. than international, by the way. International, there wasn't a huge delta between June and July. It was fairly modest. So clearly, there was something going on this back-to-school season that had a big impact on July, and I think everyone else has talked about that. So yes, our guidance bakes in what we currently project for the quarter. We typically don't comment on current quarter business. But the guidance we're giving today reflects the trend projection we have for the full quarter based on our usual model for determining that.

Next, we'll hear from Anna Andreeva, Oppenheimer -- and it is not Anna Andreeva. It's Jennifer Black, Jennifer Black & Associates.

This is actually Carla White for Jennifer Black. Mike, I was just wondering if you could talk to us about how your denim is doing at both Abercrombie and Hollister and how you feel about the denim war that's going on domestically. And then just the follow-up is, could you talk about your loyalty program in each division and how many members you currently have? It seems like a big opportunity for you.

I'll be very brief, and then I'll turn it over to Jonathan. Our denim business is outperforming our total business at this point. Now we go to Jonathan.

On the loyalty program/CRM part of the question, Jennifer (sic) [Carla] , if you look at it, there are really 3 prongs to what we're trying to accomplish. We're trying to increase the number of people who are in the programs, and that entails having enticing reasons for them to join the program. The second piece is we want to increase the percentage of our transactions that are attributable to club members, and that number is steadily growing over time. And then, thirdly, we want to make sure the value attached to those customers who are in the program is performing under the -- at a level greater than non-club participants. So we're tracking each of those metrics, they're all progressing positively. I would say that we're encouraged by that, but we're not yet at the sort of critical tipping point when, for example, we could start to significantly pull back on in-store promotions. But that's the ultimate objective, or a big part of the ultimate objective of this, as well as creating a level of customer engagement that is exciting from a customer standpoint.

Next, we'll hear from Omar Saad, ISI Group.

As you guys drive kind of higher cost savings and you go through these processes of review and you're finding these incremental areas, how do you think about reinvesting some of those savings or balancing the need to kind of reduce your cost structure and make it more efficient, but also the need to maybe invest in certain areas of your business? I've heard you mention marketing a couple of times and maybe training. Could you help us understand your thought process, at least philosophically, around balancing those 2?

Yes. Omar, I think the one area that does come up is marketing, and outside of that, we don't see a lot of areas where we would think that -- there would be an argument that we could be under-invested. There's certainly a question mark there. Having said that, we think there's some opportunity in our existing marketing expense that we can take out. But that's a question we've got an open mind on, and we continue to look at it. And Mike referenced earlier that we're doing some marketing tests through the back half of the year, and how they perform and the return on investment from those tests will be a big factor on that. We're certainly willing to invest if we think it's going to help drive traffic and expand the base.

Our next question will come from Edward Yruma, KeyBanc.

Mike, I think, on the last call, you talked about your under-inventory position, and I know that you don't believe it affected 2Q sales. But I guess, how do you feel about the level of inbound inventory? I believe you said it will kind of continue to ramp up through the year. And I guess given the current trend, how can you make kind of adjustments on the fly to make sure that you aren't over-inventoried?

We are working very hard on that, Ed, because we're very committed to conservative inventory against the sales number. We've had open dollars because we have reacted as late as possible to Christmas. We're doing quite a bit of adjusting to make sure that we're going to be on track for Christmas sales. Jonathan could say...

I'd just add a little more. We're planning to exit the end of the year certainly very clean and in a very comfortable position. At the end of Q3, inventory levels may -- by the way, that would mean, at the end of Q4, that we would likely see inventory levels up year-over-year, partly because we were very significantly under-inventoried and had some timing issues coming into the first quarter of this year. So we expect inventory to be up at the end of the year. Third quarter, there are a couple of other timing effects coming into play. The calendar shift has a slight impact in terms of the inventory position year-over-year being effectively a week later. And then the in-transit, you may recall, a year ago, was very low. It was down significantly. We expect that to be a more normalized figure this year. And then, thirdly, as we've taken our receipts, we've been reacting more to later in the season, so the third quarter figure is likely to be up more than the figure at the end of the year. But we are certainly planning working towards being in a healthy position coming out of the year.

Paul Lejuez with Wells Fargo is next.

I'm just wondering what the reason was for the delay in the Shanghai opening. And also, if you can give any update on CapEx expectations for next year. But also, thinking longer term, what's the right level of CapEx to run with in the business?

Paul, the Shanghai opening, it's part of a big project that's going on there. And it's the timing of the whole project that has slipped so that just pushed back our opening date. It's not something that's unique to us or something that we drove specifically. The CapEx 2013 and beyond is going to be something that will emerge from completion of our strategic review. So when we've wrapped that up in the next few weeks, we'll be in a better position to speak to that. I guess, at this point, I would say that we wouldn't expect it to be materially higher than where we've been this year and maybe it will be lower.

Our next question will come from Kimberly Greenberger, Morgan Stanley.

Mike, I'm wondering, I know that at -- even in times when comps are negative for the business, you're seeing some encouraging traction in different new ideas that you have. And I don't know what you can or can't say on a call like this, given the public nature of it, but maybe you could just, in general, talk about are you seeing some of those sort of reads in your business that give you direction over the next 3, 6, 9 and 12 months? And then just stepping back from the current tone of business, I'm wondering if you could just help us understand, longer term, how you're thinking about international expansion and if there has been any changes in your thinking over the last sort of 6 to 12 months?

Okay. Let me take the first part of the question. There are always areas in the business that give us direction. And I think you know we spend a lot of time looking at what's happening now and what we think that can mean for the future. So that's a given here. We are very, very reactive. I hope we've been able to react, in fact, for Christmas, based upon initial fall selling. Beyond that, I can't tell you what those things are, but they exist. Let's talk about international expansion. Jonathan?

Sure, Kimberly. Yes, again, that's -- there are a lot of questions related to that, that are part of this strategic review so they include which countries we're going to be prioritizing going forward; the optimal mix between direct and bricks-and-mortar; the potential for doing something other than company-owned stores, which you know has been generally our model in the past, the potential for outlets. All those questions are part of the strategic review, and we're pretty close to coming to some conclusions on that. And once we've been through all of that, we'll look forward to sharing more of that, hopefully pretty soon.

Next, we'll hear from Matt McClintock, Barclays.

I was wondering if we could focus on the strength in the direct-to-consumer channel and -- which I think really stands out as a positive for the quarter. And I'm just wondering if you could maybe comment on the potential for maybe non-traditional competition within the teen space potentially driving some of the weakness that you're seeing across the entire industry from you and some of your competitors. Is there perhaps a structural change that's occurred? And is that what we're seeing within the teen category?

Two questions.

Matt, so I'll take the first part of the question on strength in the DTC channel. Yes, we are extremely pleased by what's going on in the international direct business. And again, coming back to our strategic review, what we're seeing is certainly contributing to our thinking on that. I think some of the key drivers of that have been, when we started to fulfill within Europe, we made some significant investments behind that. The language and translation, local currency sites, have all been significant, but I think they are all obviously building off a pretty healthy level of brand awareness we have and a very healthy gross margin structure we start with, which makes the economics of that business very attractive. So yes, we're very encouraged by it.

The second part of your question, I think you're right on in terms of the potential for non-traditional competition. It's happening and we're -- we want to be in the forefront of that. I think what we own is very powerful brands. And owning those brands, we think we're going to be able to be in the forefront of the non-traditional brick-and-mortar part of the business. Good question.

Our next question will come from Anna Andreeva, Oppenheimer.

This is Dan filling in for Anna. So just a quick question on -- I guess, can you talk a little bit more about the EBIT margins by segment? It looks like maybe there was a step down, both international and domestic. We are looking at the presentation you provided. Any color there would be great.

Sure, Dan. Yes, I guess what you're seeing, clearly, is that international margins stepped down more for international stores. That's partly a function of the fact that our labor model in Europe in particular is a little less flexible than the U.S. We can react to that over time, but short term, it's not as flexible as it is in the U.S. That's certainly a component. There's a little bit of a gross margin mix effect there as well relative to the U.S. stores. Obviously, we're very pleased with the direct-to-consumer margin, which was up for the quarter.

Our next question will come from Janet Kloppenburg, JJK Research.

Mike, I was wondering if you could talk a little bit about the exposure to knits. I think that's been the big culprit on the women's side. And I know you'd talked about it on the first quarter and said that you felt better about your knit assortment in the back half, particularly in the fourth quarter. I'm wondering if you have had an ability to make some adjustments in that category and if you, overall, have been able to modify your fourth quarter receipts at all in light of what you learned to the response from the back-to-school assortment? And Jonathan, I was wondering if you could talk about the international comp, it was, store comp was a little better than expected. Maybe you could talk about the regions. I know China was very good. But -- and I'm also wondering, just based off your last response, if you could, if you will be able to flex on payroll there in the back half of the year?

To answer the first part of your question, Janet, we absolutely have been able to adjust fourth quarter based upon what's happening. And I think it's -- in response to Kimberly's question, it's the same thing. In this business, even if you're -- I think, you're over the top in terms of inventory, you've got to find space for things that are trendsetting [ph] and that's what we've been working very hard to do. So the knit assortment clearly has been adjusted for Christmas. Having said that, the bigger categories for Christmas are not really knit-dependent, unless you describe fleece as knit. The bigger businesses for Christmas are knits and sweaters -- I'm sorry fleece and sweaters, as you know.

Janet, just to add a bit of color on the international comp. First of all, as we said, DTC comps were up in every region, particularly strong in Asia, but also very strong in Europe. Looking at stores, as we discussed in the past, you tend to see pretty different dynamics even within Europe, for example. So for the quarter, we were very strong in Scandinavia, and we saw that also in our flagship stores in terms of the credit card data we track in those stores. Our store in the Gallerian mall in Sweden is now one of our top Hollister stores across the chain. Spain comped positively for the quarter. And then, obviously, we had a number of countries, including some of our more significant countries in Europe, like the U.K. and Germany, that remained down on a store-comp basis. So it's a mixed picture. I think, overall, we're hopeful that we're making some progress there. And then, I guess, your second part of the question was can we flex payroll in the fall. I think there's 2 components to that. One is, as part of the profit-improvement initiative, there are programmatic changes that we're looking at, which will have some bearing on that. And then secondly, we are working hard to react to the sales trend, as we did in the first and second quarters, to be, on a short-term basis, taking out expense where we see an opportunity to do that.

Randy Konik with Jefferies is next.

Just a couple of things. Just first, when I look at the income statement and the stores and distribution expense and MG&A, you have a total of around $2.5 billion. When you give us a figure of $100 million, it's about 4%. Is -- I mean, wouldn't it make sense that there's just even got to be more opportunity than just 4% of that expense base? And then with regards to the strategic review, you guys have mentioned, what -- it sounds like there's some sort of potential big shift in the business model that could be that you guys are looking into or not looking into. What would we expect that won't change in this company's business model going forward? Because, I guess, you're not going to tell us what is going to change. But what absolutely will not change going forward? And then lastly, regarding the international piece of your business, is the London store still becoming -- is it still the big, big driver of the comp direction in the company? And if so, when do you think that London store starts to get towards a flattish comp?

So Randy, on the first part, yes, to be clear, what we're saying is the $100 million or in excess of $100 million, is what we're comfortable with at this point based on decisions that we've made and programmatic changes we've made and other pieces that feed into that. We're certainly saying there is potential beyond that. We need to work through the store pilots to determine what that is and to the point earlier, to make sure that any changes we would make will not have an adverse impact either on sales or on the brand. But we're not saying we're done at $100 million. We're saying that's what we're comfortable committing to at this point, as being something we feel very confident is going to be achievable.

And we would...

Sorry, there are a couple of other points to Randy's question. Maybe just on London, yes, we have seen London improve, and it's been sort of comping in the flattish area recently. So that is, I think, a positive development.

It thrills us.

And then the question about what we would not expect to change in the business model going forward, I think, is the core aesthetic and what the brands stand for.

I was just given a note. London is better than trend, and it's been helping since May. Hooray.

[Operator Instructions] Next, we'll hear from Marni Shapiro, The Retail Tracker.

Could you give me a little bit of an update here? You said traffic has been, obviously, a big part of the issue. Can you talk a little bit about conversion at the stores? Once she's in, is she buying? And then, if you could also touch on, Mike, specifically, as we get to the back half of the year, it seems like we might be in for a sweater year, which has historically been really good for you guys. So I was wondering with knits under pressure there...

Oh, I hope you're right, Marni.

I think I am right about this.

Okay, the answer...

And your Lara sweater looks greater, and we purchased it. But I'm curious, have you been able to at least shift some of the dollars for the back half of the year, whether it's out of fleece or knits into some sweaters? Because that's historically been a very good space for you guys.

We're hoping for a good sweater business. We're well inventoried in sweaters. The answer to the first part of your question, the problem is really traffic. Our conversions are pretty flat.

Next, we'll hear from Barbara Wyckoff, CLSA.

Mike, could you talk about the changes you've made in the chase initiatives after first quarter? How are you using this process? How are you using testing for future ideas? And then could you talk also about the accessory business? What penetration is it now? Where do you think it could go?

Okay. The speed to market we're continuing to work on that. As we talked in the first quarter, shortening the development cycle has helped us, and that's largely complete. I also mentioned increasing vendor collaboration, increasing sourcing in the Americas. The chase component, which is what you're describing, I think we have -- we're doing it better than we did for first quarter because, as you remember, we got into some trouble with deliveries with first quarter chase. I think we have a better handle on chase. It's not perfect, but we're getting better. There's also the conversation about increasing positioning in core fabrics, which we are doing and is helping us in terms of speed to market. Accessories, I can't tell you, I don't want to tell you the accessory penetration, but I will tell you that we're getting traction, as I said in the beginning, in accessories. And I think it's not only exciting for the potential of the business, I think it's exciting for the look of the stores.

Next, we'll hear from Oliver Chen, Citigroup.

This is Nancy Hilliker filling in for Oliver Chen. I was wondering if you could tell us a little bit on your view of the nature of volatility in the back half and how you're planning AUR. And also just any comments you have around the new marketing campaigns you have going on now and if that's -- if you're seeing any positive signs, just with the different promotions going on now?

Yes. I think the broad answer to the question, Nancy, is that, as we said earlier, we're planning conservatively for sales, expense and inventory levels, and I think that would also include AUR. We're certainly striving to do better on each of those, certainly on the sales and AUR component. But we -- at this point, we're planning based on a fairly low sales comp number, as we talked about earlier. And then your second part of the question was new marketing campaign in place now and if we're seeing positive signs from that.

To make a comment on that, the "Everyone Wins" sweepstakes, we think that it -- believe it or not, it has had some positive increased traffic result. It was really a similar program to last year. But there is some increased traffic that we're seeing from it. And the other positive is that it allows us to collect customer contact information. But as we said in the beginning, we're really focusing on this traffic conversation.

Our next question will come from John Kernan with Cowen.

Just going back to the expense-reduction plan, can you give us a little bit better guidance in terms of when we can start modeling MG&A dollars down year-over-year? Is that something in the first half of 2014? Or could you see any of that in the fourth quarter of 2013? But when can we actually start to see MG&A dollars decline year-over-year? We did see that a little bit in the first quarter and then saw it tick back up again this quarter.

Yes. Well, first of all, John, what you saw in the first quarter had nothing to do with the ongoing profit-improvement project. That was more tactical things that we did, which we also did in the second quarter. The visibility on those may just be a little bit lower. As we said in the script, we are planning to recognize -- or realize most of that $100 million figure in 2014. We may begin to, or should begin to see some of it in the later part of this year, as Mike said in the prepared comments early on, and maybe a little bit of it coming into Q3. But we haven't included anything for that at this point.

Our next question will come from Stephanie Wissink with Piper Jaffray.

Mike, a question for you. I'm just curious how the current experience around back-to-school and the traffic volatility, how that's shaping your thoughts around the store-level cost takeouts. Are you thinking differently than maybe where you were even 6 months ago, just given that this volatility seems to be the new normal? And Jonathan, if you could just give us some insight into the pilots at the store level that you've referenced a couple of times, that would be helpful.

I'll let Jonathan answer this.

I mean, I think the program we have in place is something that is going to yield significant savings in our base model. In terms of the flexibility of our model, our model is pretty flexible in the U.S. from a cost standpoint. Obviously, there's a significant more fixed component, particularly on the occupancy side. In terms of the pilots, the sort of -- frankly, there isn't a whole lot of additional color we can give you at this point. The nature of these projects is, frankly, that if we implement these changes they, hopefully, won't be visible from a customer standpoint, but they would entail some fairly significant operational changes in how we run the stores. And we may end up implementing some of them and not others, and that will be determined as we work through the pilots.

Our next question will come from Betty Chen with Wedbush.

I was wondering if you can talk a little bit, Jonathan, perhaps about input costs into the back half. Gross margin grew again in the second quarter after the first. I think part of it was driven by input costs. How should we look about that element into the back half? And any sort of color you can share with us regarding early '14 will be helpful as well. And then, specifically for Q3, how should we think about gross margin specifically? And what are the opportunities there for the quarter?

Yes, Betty. Yes, we -- second quarter gross margin was approximately in line with where we were in Q1, and we're looking to hold in around about that level on a full year basis. So that's probably the most color I can give you on that at this point. And that would be applicable to Q3, as well as the outlook for the full year.

At this time, we have a question from Lindsay Drucker Mann with Goldman Sachs.

Just a few questions for me. First, Jonathan, I was just hoping to go back to the international operating margin question. I know that you got -- you talked about less flexibility on the labor side. But your comp, actually, the rate of decline got a little better, and yet the margin pressure got a little worse. So I was hoping maybe you could square those things. And then secondly, I'm sorry if I missed it, but did you talk about what AURs in the U.S. were in the quarter and what you're expecting, even if on a relative basis, sequentially for them to do in the third quarter in the U.S.?

Sure, Lindsay. Yes, on the -- when you look at the segment analysis, that is international stores only, the comp figure we give for international is stores plus DTC, we saw a very strong sequential improvement in international DTC between Q1 and Q2, which I think is probably a pretty big part of that effect that you're seeing, and that, in part, went back to the inventory shortage issue we had in Q1. AUR for the quarter was flattish to slightly down in aggregate. Again, as we've said in the past, we have a lot of different moving parts in our AUR, so it's hard, I think, to interpret, read too much into that global AUR figure. And what we're expecting in Q3, again, we have built into our assumptions for Q3 something that we believe is conservative AUR.

Our next question will come from John Morris with BMO.

This is Janine Stichter on for John Morris. I was just wondering if you could talk a little bit about U.S. tourism levels. And if you could give us any color on what you're seeing in terms of the U.S. chain stores versus the tourist stores.

In terms of U.S. tourism levels, I think there's a whole lot we could add to that. Clearly, the step down we saw this quarter was the greatest in the U.S. chain stores, particularly from June to July. As we said a minute ago, that change in the international stores and the U.S. tourist stores was less than in the U.S. chain stores, which again, we think comes back to that very specific issue that there is something going on with the younger customer in the U.S. So I think that answers the question.

Our next question will come from Richard Jaffe, Stifel.

Just 2 quick thoughts, one is IMU. Are you seeing any changes in your opportunity to buy product and to do so at lower costs? And then, if you could just add a little color regarding the timing and the potential impact on the marketing, both in stores and online, for the third and fourth quarter, the removal of the shutters, et cetera?

I'll take the first part of the question. The answer to opportunity to buy product at a lower cost is no at this point. Timing and potential impact of marketing in stores, I can't -- and online, I can't really share that with you, Richard. I'd love to, but that's pretty confidential at this point.

And we'll take a question from Pamela Quintiliano with SunTrust.

So others out there have mentioned some price resistance, particularly in the teen space, among more of the basics categories. Just wondering if you were seeing that as well. And also, do you think part of the traffic issue is also that the teen may not be as inspired, perhaps, as last year, just given the strong fashion trends we did have for the back-to-school season?

I'll answer the second part. I don't think so. I think there's plenty of good fashion out there. I think there's something else going on other than that. Price resistance, sure. I'm not sure that it's more of a problem this year than last.

I think the big point of that, Pam, is that we had gross margin rate improvement year-over-year, and we're pretty happy with where our gross margin ended for the quarter.

Yes. And we talked about our denim business, and our denim business is outperforming our total business at an AUR that's roughly flat to last year.

Our next question will come from Jaime Katz with Morningstar.

You guys actually didn't mention very much about Gilly Hicks. And I know it's a small part of the business, but can you kind of give us some insight into what you think you've done well and what you've done poorly there? And maybe how you see the business going forward?

Okay. I can -- I think we remain excited about the potential of both the intimate apparel business for us and the Gilly Hicks brand. And we are focused on how to best drive it forward. The international online business has been strong. As I've mentioned, the expanded Gilly test in Hollister stores has worked well, and we'll clearly expand that further in the spring of '14. I've also said, and I'll repeat, that we had some legacy issue with U.S. stores' square footage, and we still need to figure that out. But overall, we remain very excited about this category. And I think we're getting better and better at it.

Next, we'll hear from Mark Altschwager with Robert W. Baird.

This is Blair Pircon in for Mark. You've hinted in the past that outlets are possibly coming in to play a bigger role in the strategy. First, could you talk a little bit more about the opportunity for outlets? Secondly, just touch on some of the reasons for going there. Ostensibly, suppose it has some better traffic trends than you're seeing in the mall. And then lastly, do you have any insight or data perhaps from your recent customer survey, just to give some comfort around that, the thought that outlets maybe wouldn't impact your brand image in the long run?

Yes. I guess on the outlet question, that's part of the strategic review. And at this point, we're not ready to share the conclusions of that, but we expect to be able to do so pretty soon. But that's certainly been a question that we've been examining as part of that process.

And I have to say that Kimberly really put us on to this, and it's an issue that we are looking at very hard. I spent a Sunday, 2 weeks ago, in the Ashford mall in Kent in the U.K. Very eye opening. We have a lot to learn there.

At this time, we have a question from Brian Tunick with JP Morgan.

Hoping just to get a little more color on the international business. I think you guys, in the past, have talked about whether it's cannibalization or macro or obviously, the last couple of quarters, had been inventory. So just wondering, if you think about the 2 bigger buckets, cannibalization between the concepts and macro, what do you think has been a bigger drag on the business. And then I think, Jonathan, on the last call, you thought, at that point, that 30% four-walls for the international segment would be achievable potentially. So just wondering, do you need to have positive comps in the international business to achieve a 30% four-wall there?

Brian, maybe to start at the last part. Since we're not guiding for the full year, I can't really give you any color on what our four-wall margin for the international component would be for the year. With regard to the components of international business, cannibalization, at this point, is becoming a pretty minimal to insignificant component. We would believe that the macro has been, by far, the biggest component -- or is the biggest component currently. And then as we talked about in the past, the maturity curve in different markets can vary quite a bit.

That does conclude our question-and-answer session. And that will conclude today's conference call. Thank you very much for your participation.

Thank you.

Thank you.