Abercrombie & Fitch Co. (ANF) Q4 2016 Earnings Report, Transcript and Summary

Good day, everyone. Welcome to the Abercrombie & Fitch Fourth Quarter Fiscal Year 2016 Earnings Call. Today's conference is being recorded. [Operator Instructions] At this time, I'd like to turn the conference over to Brian Logan. Mr. Logan, please go ahead.

Thank you. Good morning, and welcome to our fourth quarter earnings call. Earlier this morning, we released our fourth quarter sales and earnings, income statement, balance sheet, store opening and closing summary and updated financial history. Please feel free to reference these materials, which are 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. Joining me today are Arthur Martinez, Executive Chairman; Fran Horowitz, Chief Executive Officer; and Joanne Crevoiserat, Chief Operating Officer and Chief Financial Officer. 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. In addition, we will be referring to certain adjusted non-GAAP financial measures during the call. Additional details and a reconciliation of GAAP to non-GAAP financial measures are included in the release issued earlier this morning. With that, I hand the call over to Arthur for some opening remarks.

Thanks, Brian, and good morning, everyone. And as always, thank you for being with us. Our results for the quarter fell short of our expectations in what was and continues to be a challenging environment. Overall, however, we continue to make solid progress on our strategic initiatives. Hollister, our largest brand, continues to perform and the Abercrombie brand renewal process continues. I'm confident we have the right people, the right talent and the right plan in place to drive future growth. To that end, last month, it was announced that Fran Horowitz was named Chief Executive Officer and Joanne Crevoiserat was named Chief Operating Officer while continuing in her role as Chief Financial Officer. Both Fran and Joanne are highly regarded leaders and talent developers and have made significant contributions to our efforts to position the company for future success. Fran's appointment as CEO reflects the confidence we have that she is the right person to lead the business forward. Having filled out her team with the addition of 2 great brand presidents who joined us last summer and a new chief marketing officer who joined us last month, this is the right time for Fran to formally take on the new responsibility of leading Abercrombie & Fitch. Following Fran's appointment as CEO, our office of the Chairman structure is no longer needed. I look forward to continuing to work with Fran, Joanne and the rest of the team at A&F in my role as Executive Chairman. Now Fran will provide perspective around our current performance and our strategic initiatives.

Thank you, Arthur, and good morning, everyone. First of all, it is an honor to lead the company's effort to revise the A&F brand and reignite growth across our business. I am confident in our strategic direction and in our ability to execute on our plan to create more customer-centric brands with clear identities that resonate with consumers and to generate sustainable growth and profit for our shareholders. As Arthur mentioned, our results for the quarter reflect an environment that was and remains challenging and highly promotional. In spite of that environment, Hollister achieved positive comp sales during the quarter and international markets improved measurably from last quarter. But we did not make as much progress at A&F as we wanted, we have made important changes under the new brand President's leadership to enhance the performance of the brand. We continue to listen to our customers as we refine and promote our brand positioning, and we are confident in the team and the plan for the brand's revitalization. Overall, we have made significant progress on our strategic initiatives across both brands that have proven to increase customer engagement and provide a better customer experience. This includes the development of new store prototypes and loyalty programs, as well as the continued rollout of our omnichannel capabilities. Starting into the fourth quarter performance by brand. Hollister continued to perform despite the strong headwinds in the markets. Calling out a few key items of note, in Hollister guys, we saw continued strength in categories where we've added innovation and stretch. We have strong performance in denims, key item knit tops and outerwear, partially offset by underperformance in fleece bottoms. On the Hollister growth side, cozy fabrics and trend details on top fashion and innovation denim performed well. Our emerging Internet category highlighted by the reintroduction of the Gilly Hicks brand did well, partially offsetting overall underperformance in woven and basic jeans. Going to the Abercrombie brand, the challenging external environment, coupled with several specific issues we identified during the quarter contributed to the slower-than-expected progress in our brand revitalization plan. Our flagship and tourist stores continue to weigh particularly heavily on results and traffic remains a headwind despite an improvement from last quarter. In addition, notwithstanding strength in categories where we introduced newness and innovation, it is fair to say we did not achieve the expected improvement in the more seasonally appropriate assortment particularly in outerwear, which lack the signature A&F details necessary to create differentiation. Our designers are now aligned on a singular brand esthetic and attuned to differentiation we need to engage and inspire our Abercrombie customers. In addition, our overall assortment architecture lacks size and color depth in key items, such as fleece, to support the top line and ended this season 2 [ph] in certain brand out categories. This is a function of staffing and process issues we identified during the quarter. The teams have been strengthened with new senior talent in both planning and merchandising. They've worked quickly to improve processes and make the necessary adjustments to the assortment going forward, such as increased depth of buy in top 30 items and reducing number of SKUs to get assortment more focus. There is always a time lag required to work through this type of issue and we expect the impact to continue into the first quarter of 2017, however, this will not happen again. During the quarter, we began to communicate and evolve identity to the A&F brand in conjunction with a major marketing campaign. While the campaign generated over 1 billion media impressions, it did not convey separate brand identity to our customer who did not make meaningful impact. Based on our learnings, we understand that we need to sharpen the brand identity, create invitational message and involve the creative. To be clear though, the brand positioning we shared previously remains the same. The Abercrombie & Fitch brand embodies American casual luxury with an updated attitude that reflects the character, charisma and confidence of today's 20-something consumer. We know and understand that customer and third-party research confirms that more than 80% of U.S. sales come from customers over the age of 18. However, we do need to sharpen how we communicate and express that brand identity. As such, we have engaged an external creative agency and hired a new Chief Marketing Officer, Will Smith, who will help us enhance the power and clarity of our brand identity and strengthen the connections we have with our customers. We continue to acquire success and learnings from our experience with Hollister to the A&F brand, and we are confident that with the right people and processes now in place, we will see greater traction on our revitalization plan for the brand. Despite disappointment with the overall results, as we've mentioned, 2016 was a year of significant progress on our strategic priority. We converted 65 additional Hollister stores to the new prototype format during the year and we've been pleased with the positive feedback we consistently received from customers following each and every new store rollout. Based on our learnings in these prototypes, extensive research and conversations with more than 1.5 million customers, we developed a new prototype concept store for A&F, the first in 15 years and the first of which was unveiled last month. We have been pleased with the initial customer reaction. Also, after a successful rollout of the Hollister Club Cali loyalty program in the U.S., which now have 5 million members, we are on track to launch the A&F club loyalty program next week. In addition to providing valuable, timely insights into our customer's preferences, at Hollister, we saw a direct correlation between program membership and stronger customer engagement as evidenced by increased spend per transaction. We are excited to roll out and replicate the success of this program at Abercrombie this year. We continue to enhance our robust omnichannel capabilities, which our customers are increasingly utilizing. Our POPIN, which our purchase online and pickup in-store, has rolled out across stores in the U.S. and Canada following a successful rollout in the U.K. It accounts for 7% of total DTC orders in a combined markets to which it is available. As we had anticipated, this also drives attachment purchases from picking up in the store. We've also made it possible for customers to cross navigate and transact both the Abercrombie adult and kids brands through a single website. Following initial success at Hollister, we've added ratings and reviews in social content to all our website resulting in closer customer engagement and valuable feedback. We've also augmented our fulfillment capabilities to the West Coast, we upgraded our apps for loyalty and omnichannel integration for mobile devices, which now accounts for over 40% of online sales. A common theme here is ensuring that we meet our customers’ needs regardless of when, where or how they are looking to purchase. We further added to our payment capabilities with Recheck pay and Apple Pay and are now leveraging Facebook Messenger as another point of communication with our customer. We continue to work with our key social media partners to help drive innovative customer engagement and ensure we are at the forefront of exploring new ways in which our customers may want to engage with our brand. Hollister was the first retailer to have a sponsored Snapchat lens and both our brands are among a select group to be part of Instagram test of a new e-commerce feature. In addition, we continue to find new ways to expand our reach in wholesale, franchise and licensing. This year, we doubled our hotel business with the addition of our newest partner, Zalando. And we see further opportunity for future growth, both with existing and new partners. We entered into a franchise partnership in the Middle East but we expect to open 4 stores in each of Qatar and Saudi Arabia in 2017. And our fragrance licensing partner, Inter Parfums, developed and launched 2 new fragrances. First, Instinct by A&F; and Wave by Hollister, which have performed well and are additive to our already successful fragrance business. We talked about having made progress on our key strategic initiatives in maintaining our focus on executing against them. As we move forward, our success comes down to 3 simple but critical points of focus. First, we must consistently inspire our customers by creating emotional connections through rich brand experiences. We must intimately understand our customers to create these brand experiences wherever, whenever and however they choose to shop and to deliver trend-right, brand right products that never compromises on superior quality, fit or softness. In order to inspire our customer, we have to know them and there's no substitute for being in stores, in their environment and engaging with them and that's what we have done and continue to do. We know who they are, what they value and aspire to, how they shop and behave and how they feel about the brand. We'll also continue to improve our research in CRM capabilities, as well as leverage our voice on the customer data, which allows us to continuously receive and respond to customer feedback and measure our performance. This type of insight and feedback is helping us adapt and execute better and faster be it in product design, associate training or store layout. Second, we must innovate relentlessly. This means we challenge ourselves to improve every day from our style, to our stores, with new retail experiences, to our systems and omnichannel expansion. This year, we are introducing innovative styles in existing categories. For example, after seeing a strong customer response to the addition of stretch in key Hollister guys’ categories, we recently introduced a new line of advanced stretch jeans for both guys and girls that integrates performance fibers for added comfort. In addition, we are expanding emerging categories, such as swim and Gilly Hicks. Gilly Hicks was recently relaunched in Hollister stores and online around the world and includes bras, bralettes, swim, lounge and sleepwear. The initial decisions on swimwear and the reintroduction of the Gilly Hicks brands were in direct response to customer insight gleaned from conversations with and the closest to our customer that we value as customer-centric brands. As I mentioned earlier, we have rolled out our successful new store prototype. This is another example of our focus on innovation, coupled with our focus on inspiring our customers through rich brand experiences. Our new A&F store prototype here in Columbus at Polaris Fashion Place was imagined with the best customer experience in mind, and formed by research and customer interaction. We put particular emphasis on technology and a sitting room experience with each fitting room suite having thoughtful amenities, such as control over lighting and music. This is the first of 7 new prototypes that we will open this year and we are excited about what this new customer experience will bring to the brand. While the store has only been open a few weeks, we have been encouraged and excited by its early progress. Lastly, we must develop leaders. Inspiration and innovation require us to attract, retain and develop the best talent. We require leaders that are committed to our vision for the business and can inspire their teams to deliver on that vision with a singular focus and flawless execution. We have such a team in place now. We also continued to invest in our teams through training and development programs to elevate our service and attract the types of leaders who will thrive in this new environment and have a desire to succeed and realize our objective. That investment in training is working and in addition to the inherent cost and morale benefit and the lower associate turnover we are experiencing at all levels of our sales organization, it has had a direct and measurable impact on customer engagement and the overall customer experience. We've seen this clearly in our voice of customer data and customer Net Promoter Scores. On the home office front, we've seen similar improvements in associate engagement and morale. In addition, our new brand Presidents, Stacia Andersen and Kristin Scott, have made significant changes to their teams with additions in key areas, such as merchandising and planning. We now have the right people in the right places and every one aligned on vision and execution. We believe we have the right foundations in place to continue to drive forward the Abercrombie brand revitalization and to accelerate our progress with Hollister. As we look ahead the rest of 2017, it is likely to remain a challenging environment but we are confident that we have taken the right steps to support a strong, standout portfolio of differentiated, aspirational brands and sustainable long-term growth. I would like to thank all our teams for their continued energy, passion and dedication to moving our brands forward in the coming year. And with that, I will hand it over to Joanne.

Thanks, Fran, and good morning, everyone. As Fran mentioned, we have a laser focus on driving progress on our strategic initiatives as we continue to tightly manage the business in a difficult environment. We remain committed to being as efficient as possible with our resources to drive both bottom line improvements and fund top line growth initiatives in the future. I'll be taking you through the details of our fourth quarter and full year results and will also provide our outlook for fiscal 2017. Starting with the fourth quarter. Net sales were $1 billion, down 7% from last year with foreign currency adversely impacting sales by approximately $16 million or approximately 150 basis points. Comp sales were down 5% for the quarter, representing a slight improvement from last quarter. Traffic continued to be a headwind but conversion trends overall remain positive. As shown on Page 6 of the investor presentation, by brand, comp sales for the quarter were down 13% for Abercrombie and up 1% for Hollister. By geography, comp sales for the quarter were down 6% in the U.S. and down 4% in international markets. We saw meaningful comp sales improvement from last quarter broadly across international markets in both brands, with the strongest improvement in Europe. However, flagship and tourist stores, although slightly improved from last quarter, continue to be a significant contributor to Abercrombie's negative comp sales performance. Despite these challenges, flagship and tourist stores remain profitable in the aggregate and serve as an important gateway to the brands for our customers. We continue to take aggressive actions through investments in the store experience, in product and in our talents to improve their overall performance. The direct-to-consumer business delivered another quarter of growth across both the U.S. and International markets, fueled by our investments in mobile, omnichannel and fulfillment. On a total company basis, the direct-to-consumer business for the quarter grew to approximately 31% of total sales compared to 28% of total sales last year. Gross margin for the quarter was 59.3%, 90 basis points lower than last year on a constant currency basis as the reduction in average unit cost was more than offset by lower average unit retail. Gross margin was pressured as we took actions to address the assortment issues Fran mentioned, and the competitive environment resulted in more promotional activity and lower AUR than planned. Moving to operating expense. We continue to take an energetic, disciplined approach to cost management. During the quarter, we tightly managed operations and took actions that will improve our efficiency going forward, while also providing the resources needed to support our strategic initiatives. For the fourth quarter, stores and distribution expense increased $9 million from last year and included $16 million in lease termination charges related to the A&F flagship store in Hong Kong as discussed on last quarter's call. In addition, higher direct-to-consumer expenses were more than offset by a benefits from foreign currency exchange rates, the savings achieved on lower sales and through expense reduction efforts. Marketing, general and administrative expense included $4 million of severance charges and decreased $4 million from last year as a reduction in incentive compensation and expense savings efforts were partially offset by increased investments in marketing. Operating income was $61 million compared to $120 million last year and included the adverse year-over-year effects from FX of approximately $6 million. The effective tax rate for the quarter was 11%, reflecting an adjustment from last quarter's estimated full year tax rate and a benefit of approximately $4.5 million related to the realization of foreign currency losses. Also reflected in the rate was a discrete benefit of $2.4 million related to a tax regulatory change. Net income per diluted share was $0.71 compared to $0.85 last year and included the adverse year-over-year effect from FX of approximately $0.05. Recapping our full year results. Net sales were $3.3 billion, down 5% from last year and included an adverse year-over-year effect from FX of approximately $32 million contributing 1% to the decline. Adjusted non-GAAP operating income for the full year was $3 million compared to adjusted non-GAAP operating income of $136 million last year and included adverse year-over-year effects from FX and hedging of approximately $27 million. Turning to the balance sheet. We ended the year with $547 million in cash compared to $589 million last year. During the quarter, we repaid $25 million of term loan debt, bringing our gross borrowings outstanding at the end of the fiscal year to $268 million compared to $293 million last year. We also ended the quarter with total inventory down 8% compared to last year, reflecting our ongoing discipline in this area. Moving forward, we expect to continue to drive incremental improvement in inventory productivity. Details of our store openings and closings for the quarter are included on Pages 10 and 11 of the Investor Presentation. At the end of the quarter, we operated 709 stores in the U.S. and 189 stores across Canada, Europe, Asia and the Middle East. With regards to our outlook for fiscal 2017, we expect comp sales improvement for the full year as our strategic initiatives take hold in A&F, and we gain further traction in Hollister, with improvement building in the back half of the year. Based on forecasted exchange rates for 2017, we expect FX to adversely impact sales by approximately $55 million and operating income by approximately $25 million or approximately $0.25 per diluted share. In addition, we expect the gross margin rate for the full year to be flat to the fiscal 2016 adjusted non-GAAP rate of 61%, but to be up on a constant currency basis driven primarily by lower average unit cost. However, we expect gross margin rate pressure in the first quarter as we contend with steeper traffic headwinds in a continuing promotional environment. As I mentioned earlier, we continue to aggressively pursue operating efficiencies in our model. We took actions during the fourth quarter that will reduce operating expense by approximately $100 million in 2017. While we plan to allocate a portion of those savings to support investments and revenue-driving activities, we expect to see net savings of approximately 3% from the fiscal 2016 adjusted non-GAAP operating expense of $2 billion. We have a long record of success in identifying and realizing savings and continue to focus on this area. Last year, we implemented a continuous profit improvement program across the entire organization and this program was a meaningful contributor to our tight discipline on managing the business. We will continue to pursue additional expense savings opportunities throughout 2017. We expect the core tax rate, excluding discrete items, to be in the mid-30s and to remain highly sensitive to jurisdictional mix, particularly at lower pretax earnings levels. In addition, as a result of the change in share-based compensation accounting standards, we expect to incur a discreet noncash income tax charge of approximately $9 million in the first quarter of fiscal 2017. With respect to capital allocation. We are sharpening our focus on CapEx investments towards projects that align with our strategic initiatives and provide the highest return. For 2017, we expect capital expenditures of approximately $100 million compared to $140 million in 2016, with increased investments to deliver an improved store experience through new prototype expansion in both brands. In 2017, we plan to complete 7 new A&F prototype stores and approximately 40 Hollister remodels. Our investments in IT, DTC and omnichannel extend the solid foundation we have built on these platforms. Our priorities include continued rollout of omnichannel and CRM capabilities around the world, building on the successes that we have seen in the U.S. and U.K. In 2017, we also plan to open 6 full-price stores, including 4 in the U.S. and 2 in International markets and to open 2 new outlet stores. Fran referenced our ongoing program of optimizing the store fleet and this is a continuing and important aspect of balancing our channels in response to evolving customer preferences as well as improving overall store productivity. For 2017, we expect to close approximately 60 stores in the U.S. through natural lease expirations. In addition, with about 50% of our U.S. leases expiring by the end of fiscal 2018, we continue to have significant lease flexibility to strike the right channel balance and drive efficiency by remodeling our or resizing our stores, renegotiating leases or closing. The dividend also remains an important element of our capital allocation philosophy. Last month, we announced that our Board of Directors approved the $0.20 quarterly dividend. In 2016, operating cash flows of approximately $180 million contributed to our CapEx investments, debt reductions and the dividend while maintaining targeted liquidity levels. With a strong balance sheet and a disciplined approach to managing capital and operating expense, we expect to continue to generate the cash necessary to invest in the business, meet our debt obligations and maintain the dividends. This outlook positions the right resources behind our strategic priorities and underscores our focus on inspiring our customers, driving innovation and efficiency and leveraging our team to improve results and realize the full potential of our brand. Now I'll hand the call back over to Fran for some closing remarks.

Thanks, Joanne. While we are not happy with our results, we are pleased with the progress we continue to make against our key strategic initiatives. Hollister, our largest brand, is stabilized and continues to perform. Despite the headwinds in Q4, our performance of Hollister demonstrates the potential for our brand, when brand voice, products and brand experience are aligned are attuned to our customers. A&F revitalization continues with many of the lessons learned from Hollister being applied. We've made significant organizational changes, improved operating efficiency and investment in stores and leadership talent to position us for future growth. We remain committed to being efficient with our resources to drive both bottom line improvement and fund top line growth initiatives. In 2017, I am confident we will build on the progress we've made over the past year, growing our Hollister brand as we continue to execute on our plan to revitalize the Abercrombie brand. Now, I will hand it back to Brian.

Thanks, Fran. That concludes our prepared remarks. At this time, will be happy to take your questions. [Operator Instructions] Thank you.

[Operator Instructions] We'll first go to Stephen Albert with Bank of America Merrill Lynch.

I just wanted -- first question was on the clarifying the comp guidance for the year. You're calling for comparable store sales to improve. Does that mean positive or just less negative?

Stephen, thanks for the question. We do expect improvement. We haven't provided specific points in terms of improvement to point you to. We expect the first half to remain challenging particularly in the first quarter as we work through the carryover assortment issues, and we deal with traffic headwinds that we have seen and as others have reported in the industry. But we do expect to build momentum in the back half of the year as our strategic initiatives gain traction. Hollister continues to perform. We expect to continue that momentum and expect to build improvement in A&F as our strategic initiatives gain traction through the year.

Okay. And just a quick follow-up on the CapEx guide for the year. You're calling for a cut but it's coming from omnichannel and DTC investments by more than 2/3. Just curious the rational around that with the customer continuing to shift more towards online?

Yes, we've been very successful in capturing that business and we have invested in that space very successfully and are very pleased with the returns we're seeing. Our penetration to the total business in Q4 was 31%. I think, it's an evidence that we are putting our money behind the right things. Where we have invested historically, has been more in the foundational and building of those capabilities, which is -- requires a little bit more capital. Our focus is to continue to invest behind those priorities. We're now in more of a rollout phase on those, so the specific priorities in 2017 -- I’m sorry, are to continue to roll out our loyalty program to international markets and roll it out globally. And also to extend our omni capabilities particularly to the EU. And what you see in terms of the investment is a reflection of the difference in building versus rolling.

We'll next go to Susan Anderson with FBR Capital Markets.

I was wondering if you can maybe give us an update on the dual A&F and A&F kids’ stores. I guess I haven't heard you guys talk about the combination for a while and just how they're testing, and if that's going to be a format that you will continue to roll out?

Yes, this is Joanne. I'll jump in on that, we have in some locations added the A&F kids product to our adult A&F stores. We do that opportunistically where we had an opportunity to showcase the kids product either in a location or a mall, where we don't have a presence for kids and where we have an opportunity to improve the productivity of the adults store. We have many stories in A&F, frankly, that are larger than we would like, and we're -- we have added the kids product to those locations to drive productivity in the box. We have seen a nice return on those investments in terms of driving productivity and margin in those boxes. It is not a strategic decision. It is an opportunistic decision that allows us to extend the kids brand.

And next will go to Tiffany Kanaga with Deutsche Bank.

Would you discuss what you're seeing for quarter-to-date trends by brand and geography. And I know you touched on flagship and tourism traffic, but would you talk about your expectations for a time line for potential improvement and provide an update as to how you're thinking about your flagship real estate portfolio?

Hi, Tiffany, it's Fran. Q4 did -- was a challenging quarter for our segment of the business. We did see some headwinds from a traffic perspective. Some of that has continued into the first quarter but much beyond that, we don't normally comment on our current in-quarter business. Regarding the flagships, they are a really important gateway for the brand. They remain profitable in the aggregate, and we are aggressively have steps to improve their performance. As you know, last year, we closed 2 of them, as well as negotiated some lease reductions. We are working diligently on our assortments, on our customer experience and finally, towards the back half of the year, we'll be rolling out in international loyalty programs to help our customer engagement in those stores.

Yes, I'll just jump in quickly, Tiffany. We are investing behind those improvements in the customer experience in those markets. We've added and made changes to make the shopping experience in those flagship locations easier and more convenient for customers. We're focused on improving conversion of the traffic that we do have. And as Fran said, working towards the end of the year to roll out a loyalty program to engage more local customers.

I have 1 follow-up question. Would you dig into which categories you're finding fat to cut on the SG&A line? And in what inning you believe you're in, in terms of identifying and achieving expense reduction?

Will, I guess, I could characterize it as a very long game because we have been on this path for quite a while in terms of finding expense savings, and we had a lot of success over the years in terms of finding efficiencies in our model. In terms of where we're finding efficiencies, I characterized our process or our program as an energetic, disciplined approach to cost management, and we have a lot of energy behind finding efficiencies in the organization. Last year, we rolled out a continuous profit improvement program, and we have tremendous contributions across the company. Just to give you sort of an idea of how pervasive it is, I think there were almost 900 individual ideas that were implemented in 2016 to help drive these changes. So the cost savings are coming very broadly across our organization and we're pleased with our progress but we're clearly not done.

And I just want to underscore, it is a critical initiative on by both Joanne and myself and it's an ongoing process working with each and every cross-functional team member and leadership team member to make sure that we are finding all of our opportunities. That is a continuous ongoing process.

Next will go to Matthew Boss with JPMorgan.

This is Steve Zaccone for Matt today. We were curious looking over the next 1 or 2 years, what do you view as the target margin profile for this business once the top line stabilizes? Is it best to think about gross margin as flat on a go-forward basis? And does that also flat operating margin?

Yes, we have not provided a longer-term operating margin metrics. However, the way we think about the business is certainly very sensitive to top line growth. We are investing in the things that we think are most important to drive that top line growth, including and probably our biggest priority is engaging our customers in new and different ways. So as we think about how that impacts the total business in terms of overall margin performance, we expect to continue to deliver better product, continue to manage inventory well. We have had a very disciplined approach to inventory management. And as we see more customer acceptance of our products, we continue to manage our inventories well and improve our processes behind how we buy and the depth of our buys and the breadth of our assortment. We expect to see improvement in AUC, to see improvement in AUR from having to discount less, which are the benefits we see from improving those processes. And I think we've touched on our operating model is one we're we expect to continue to drive efficiency. So we expect the operating margin to improve over time and it's not applied to just one line on the P&L.

Next will go to Simeon Siegel with Instinet.

This is Gene Vladimirov on for Simeon. So with the DTC business up nicely driving a higher distribution expense, I'm just wondering as we move through 2017 and presumably the channel -- the trends in the channel continue, what sort of actions can you take to mitigate the impacts of the potentially growing expense?

Yes, the DTC channel is actually a very profitable channel for us. It does have a high degree of variable expense with it. Our efforts are focused on making sure we're delivering the right customer experience and the right interactions with our customer to make sure we can capture the market share that frankly is moving very quickly in that direction. We're adding capabilities around the world. As we scale, we scale our fixed cost investments in that space. So we feel good about that. And our actions are to manage our brick-and-mortar expense, if you will, and our store occupancy and store productivity in conjunction with that, which is why we play such a high importance on having the flexibility with our leases that we do.

Got it. That's great. And then one quick follow-up, could you give us any color on when the 53rd week will add?

Yes, the 53rd week we think is probably $40 million in sales and maybe about $0.02 to our EPS for the year.

Now we go to Betty Chen with Mizuho Securities.

I was wondering, Fran, if you can talk a little bit more about swim and Gilly Hicks, any more color you can give us on whether you think that's been driving some incremental sales? Any quantification there? And then also what you think that longer-term opportunity could be? Secondly, was wondering in terms of the leases, I think, Joanne you mentioned about half of the U.S. leases have some kind of action available soon. Can you just walk us through kind of what's the philosophy as you evaluate those opportunities? Is it rent reduction of a certain level? Is it renewal terms? What are you looking for? And then also what do you think eventually should be the right store size for the 2 brands?

Hey, Betty, it's Fran. I'll take the first part of this question. So Gilly Hicks and swim specifically, as you know, Hollister has really continued to perform. In this brand particularly, both of these extensions and opportunities were results of customer request and our response to really listening and understanding what our consumer is looking for. We've had a nice response to both categories, both swim, as well as Gilly. We see an opportunity to continue to drive those businesses throughout this year. We launched Gilly through both our website and all of our stores around the world and swim as well. You're also going to see an increased swim presence in the Abercrombie brand because we believe that swim really does drive traffic to our stores.

And I'll pick up the lease conversation. I think you hit on many of the decisions that we have available to us. We evaluate the opportunities on a store-by-store basis. We do look at the economics of each location, understanding both current traffic trends and future. We have, I would say, tremendous partnerships with our landlords. Fran and I have spent a lot of time working and talking with our landlords as we move our strategies forward. We do work with them for rent reductions on renewals. In some cases, we also have the opportunity to remodel or resize our stores, which is an important aspect of driving store productivity in the future. Or we make decisions to close stores, and we haven't been shy about that. In terms of stores, how many stores we're going to have as we move into the future or what we see in the future? That's really still unfolding and depends a lot on customer preferences and how we see these traffic patterns unfold, where they choose to shop and how we expect to continue to capture that market share. We do believe stores are a very important part of the story. Customers like to interact both with our brick-and-mortar stores and online. Our omnichannel initiatives really underscore that point. We've seen a tremendous response from customers on those omnichannel initiatives where they'll buy online and come to our stores and interact with us in-store.

Joanne, if I could follow-up real quick on that. As those leases coming due, can you give us a sense how that split on A, B or any C mall locations? And then when you do close a store, do you see any sort of recapture either online or at nearby store location?

Yes, in terms of what's coming to by mall grade, is really I wouldn't say there is a preponderance of one side or the other. I would tell you by brand, we're in Abercrombie in more A's and B's. We're not in a lot of C malls and actually the same with Hollister. In terms of sales recapture, it depends on the proximity of another store as to whether we recapture. But overall, we don't recapture a lot of the brick-and-mortars sales. We do see a little bit of recapture to the online business. But that is something we are focused on and trying to improve particularly with our expanded CRM capabilities in terms of driving a stronger engagement with our customers, and in locations where we need to close from an economic perspective, we're focused on trying to retain that customer through our relationship online and through our CRM capabilities.

Our next question comes from Janet Kloppenburg from JJK Research.

I was wondering, Joanne, if you could talk a little bit about your AUC benefit. Do you see that for the whole year? And do you think that the impact of that will be muted in the first half given the promotional environment that Fran is referring to? And Fran, on the comp front, you sound like you expect Hollister to be better this year but I'm unsure of the signals you're trying to give us on the first half. Has is started out more challenging than expected and maybe we should not expect an improvement -- sequential improvement versus the fourth quarter at Hollister? Maybe if you could help us define that? And just lastly, on this new marketing initiative at A&F that you're working with the creative agency. When will we see that? And how will you test that to make sure that it will resonate better than the prior campaigns?

So I'll start ticking through this, Janet. On the AUC benefits, we do expect to see AUC benefits throughout the year. A lot of changes that we put in place include process changes that help us unlock some cost savings in our sourcing and supply chain, including improving the depth of our buys and reducing our SKU count. In terms of first half versus back half, we do expect AUR pressure, both from FX during the year sort of offsetting the AUC benefits we expect. But also see expect pressure in the first quarter related to persistent traffic headwinds that we're seeing and increasingly and promotional environment where we're positioned to compete. I'll pick up the comp conversation. The comp cadence, we expect improvement through the year. We have said that we expect the first half to remain challenging, partly from some of the issues that I just mentioned. We need to work through some carryover issues in Abercrombie that Fran talked about. We're working very quickly to address those issues in the assortment, and we're dealing with traffic headwinds in the first half. However, Hollister has been performing. It's proven sustainable. We have a number of things in that business that are gaining traction, including the swim and Gilly Hicks business. So we expect that to continue perform during the year. And Abercrombie, with the many changes we're making there, we expect to see improvement as we move through into the back half of the year.

On the marketing piece, so I want to clarify. It was not quite the impact that we had anticipated but it really was the beginning of our conversations with that consumer. So it's essentially a sharpening of our focus as we move forward, and we believe that the addition of Will, who had joined us about a month ago, as well as this creative agency, will help us understand how to sharpen that focus. But we've had some positive signs as well through this program, and we're going to continue down this path.

[Operator Instructions] Will next go to Brian Tunick with Royal Bank of Canada.

This is Kate Fitzsimons on for Bryan. I guess I just wanted to dig into the sequential improvement that you saw in international traffic in the quarter. What did you see is driving that? And any particular markets that you would call out? And then secondly, if you could provide any update on what you're seeing in terms of U.S. and International four-walls in the quarter there?

Hi, Kate, it's Joanne. I'll take that one. We did see improvement in the international business. In the third quarter, I think we mentioned that it was unseasonably warm and one of the biggest points of difference in -- between the 2 quarters was the performance of our seasonal business. So I expect that some of the traffic improvement is related to do just more seasonal temperatures as we move through the quarter. We did see that improvement broadly across our International markets. So it wasn't just in one specific spot. And the biggest improvement was through Europe, which was really nice to see. In terms of U.S. versus International four-wall, our International four-wall margins continue to be strong and higher than our domestic four-wall margins. In both regions we're continuing to focus on driving the things that will keep those moving in the right direction, including rolling out all of our omnichannel capabilities. I would add that we've been pleased with our ability to drive improvement in growth in our digital business. Our digital business internationally in terms of penetration, only lags our U.S. business slightly and has been growing nicely as well.

I just want to underscore, Kate, too as far as the International flagship, Joanne mentioned that the assortments were seasonally more appropriate. The team is also working on specialized assortments for those locations in addition to shoring up our talent and our customer experience to help our customer experience in those stores. And that's an ongoing process, we've seen stronger customer engagement as well.

Our next question comes from John Morris with BMO Capital Markets.

It's Trevor Lamb on for John Morris. So given your commentary about a pressured AUR, do you guys expect to see any other drivers of comp improvement, whether it be units per transaction or conversion?

Yes, our focus has been and continues to be on driving conversion. We have an opportunity to make more of the traffic that's out there in our stores. We're doing that on a number of fronts, all of our investments are focused on improving that experience and making it easier for the customer to transact with us. When we talk about our OpEx investments, we're talking about investing in the store to help our associates better engage with customers to drive improvement in conversion. So most of the improvement we're looking for would be in conversion. The AUR pressure really stems from FX. We continue to expect to step away from promotional activity as we see more acceptance from our customers of our product assortments. And as we do that, that should be part of an offset to the AUR pressure.

Trevor, throughout 2016, it's been exciting to see the conversion improvement in Hollister. What it has shown us is that we get the product, the voice and the experience correct for our consumer. They really respond. And as we are applying those learnings to Abercrombie, we expect to see the improvement in conversion as well through '17.

And I want to add, Trevor, that we're not accepting the traffic trends as they are. We are investing behind points of engagement with our customer, both our marketing message, as well as our CRM capabilities to try and move the needle on that as well.

Next we'll go to Oliver Chen with Cowen and Company.

Regarding the denim assortment, it looked attractive to us. So what happened with the basic versus novelty? And are there learnings for how you want to navigate that store or the assortment and timing for how that may be edited? And as you do focus your marketing message in terms of sharpening your marketing message, what are -- what do you think will happen to traffic? Or what should happen to traffic? Or what's the interplay between traffic opportunity versus sharpening marketing just because we do see it as this radical journey but a good one in terms of building authenticity in the A&F banner?

So the first question regarding the denim, we have seen a significant shift out of our basic inventory from our consumer into our novelty due to the ability of our pretty flexible supply chain. We've been able to shift our assortment, and we've seen success to your point on all of the destroyed -- [ph] Denim has been very good. All of the innovation that we put into the denim from the stretch perspective has also been very strong. So we are moving very quickly to make sure that our assortments reflect all of those changes. Second question was marketing, sorry. As regarding to marketing piece...

Yes, I can jump in. The sharpening of the message, we think is an opportunity for us to start the conversation with our customers, particularly in A&F. We haven't historically done a lot of -- spent a lot of-- or invest a lot of money in marketing and it's a great opportunity for us to start that conversation. We expect over time that, that will have an impact on traffic. We talked about the fourth quarter not delivering the impact that we wanted but it is the beginning and was the beginning of a longer conversation that we expect to have with our customers.

So I just think from a traffic specific perspective, we obviously can't control the traffic but we can control all the other things involved in our business, such as how we speak to, when and to our consumer. We've had tremendous success for the digital front speaking to our consumer. For fun little fact, we have the takeover on Snapchat for National Pizza Day and had 6 million views from our consumer. So we're pretty in tuned to speaking with our consumers where they are, and we will continue to do that and drive the traffic through our omni capabilities.

Will let us go to Anna Andreeva with Oppenheimer.

Two quick one. First, a follow-up on gross margins. As we think about the pressure here in 1Q, should it be similar magnitude as in the fourth quarter? Inventories looked tightly manage. How do we think about inventories ending 1Q and as we go through the year? And then secondly, this Q cut at A&F, what's the magnitude of that and when does it start? Any specific categories you guys are tweaking down?

You want to start?

Yes, I want to pick up the first part of this. The gross margin pressure in Q1, as I mentioned earlier, we expect AUC benefit in Q1 and that will flow through the year, offset by FX pressure so that's a real pressure point on our gross margin and AUR. The other pressure in Q1, however, is persistent traffic headwinds in a competitive environment, and we expect to compete in that environment further pressuring AUR. In terms of the SKU count -- inventory ending Q1. So we do feel good about our inventory position coming out of Q4. The AUR pressure in Q1 is really related to the competitive environment. We're keeping an eye on what our customers are expecting. We're keeping an eye on what are the competitors are doing to make sure that we can compete. We expect inventory ending Q1 and during the year to -- we expect to improving the inventory productivity, which would have us managing inventory below our sales.

Also Anna, for this SKU reductions, we have a little bit of a tail coming out of the fourth quarter but we have a -- we will see sequential improvement as far as the focus on our assortment goes throughout 2017.

And I'll jump in here and thank everyone for all your questions. Before we conclude though, Fran would like to make some closing remarks.

Thanks, Brian. So 2017, I am confident we will build on the progress we've made over the past year, growing our Hollister brand as we continue to execute on our plan to revitalize the Abercrombie brand. I want to thank you all for your time this morning and we look forward to updating you on our progress next quarter.

And that does conclude today's conference. We thank everyone for their participation.