Logan, please go ahead.
Good morning and welcome to our Q3 earnings call. Earlier today, we released our Q3 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 this morning. Today's earnings call is being recorded and a 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 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, 3rd quarter comparable sales are compared to the 13 week period ended November 3, 2012. Also as a reminder, the company changed the 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 Q4 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.
Our results for the Q3 were disappointing, driven by continued weakness in top line performance. The weak sales trend that began in July continued through the quarter. While the sales trend improved in October, this was largely related to a step up in promotional activity and the anniversarying of certain events such as Sandy. We are feeling the effects of a number of broad trends, but we can and need to do better in driving the top line of the business. In the near term, we are prepared for conditions to remain difficult in the Q4 and intend to manage the business accordingly.
Despite the challenging retail environment for young apparel, we are pleased by the continued growth of our direct to consumer business, which was up in all regions in the Q3 with particularly strong growth in Asia. Our fast growing and highly profitable international direct to consumer business is demonstrating the benefits of investments we have made over the past few years. We are also pleased by the progress we are making on the ground in Asia. Our 6 Hollister stores in Mainland China are now generating 4 wall margins similar to that of our European stores. Comp store sales growth in China is up around 40% year to date and our newest store in San Le Toun opened strongly and continues to perform well.
In addition, we had a robust response to the opening of our first Hollister store in Japan at La La Porte, Yokohama. It was one of our best performing Hollister store opening weekends in our brand's history. Since its opening in September, this store's volume is tracking to be a top ten Hollister store. With this momentum, we are excited to open our 2nd Hollister store next month at La La Porte Shinmisado in Tokyo. From a merchandise standpoint, we're also pleased with our performance during the quarter in outerwear, which comped up around 10% across genders and brands.
We continue to see high potential in this category. Our underwear and intimates business also did well for the quarter, including the successful test of selling Gilly Hicks product within Hollister stores. And our denim business for the quarter was solid, particularly on the male side. However, our female top business remained weak. We see this as an extremely important area of opportunity to turn around our overall sales performance.
Coming back to our long range strategic review. In our analyst meeting earlier this month, we outlined initiatives that we will undertake in the coming months. Coming out of the meeting, I know that many of you wanted to know more about how we are prioritizing these initiatives and other actions and what will have the most impact in driving improvement and top line growth. From my perspective, our priorities lie in the following four areas. 1st, making female tops better.
Many of the initiatives we spoke to will help with this, but I believe that our evolution to testing close to 100% of our assortment, shortening our lead times and increased style differentiation will be the most significant. 2nd, increasing brand engagement through enhanced marketing initiatives and campaigns. In our analyst meeting, we spoke about having national campaigns in place for back to school next year, building on smaller scale initiatives we will be doing in the meantime. 3rd, completing the restructuring of our cost base. Prior to our next earnings call in February, we expect to have reached final conclusions on the scale of remaining opportunities beyond what we have already announced.
4th, ensuring we are properly organized to execute against our strategic plan. We continue to work on this and expect to reach a conclusion in the near future. I am confident that we will make progress on each of these priorities in the coming quarters and establish a firm foundation for improving our operating performance. We have iconic brands with global appeal and a clearly defined aesthetic. Our brands have a strong reputation for quality, heritage and timeless fashion and we believe the best path to growth and shareholder value creation is to leverage those strengths.
With this in mind, it is of course necessary for us to adapt to changing markets and consumer dynamics and we intend to do so while staying true to our brand heritage. With that, I'll hand the call over to Jonathan, but we'll 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 $1,033,000,000 down 12% to last year. Total U. S. Sales, including DTC, were down 18%, international sales, including DTC, were up 2% and total DTC sales including shipping and handling were up 10%.
Including direct to consumer, comp sales were down 14% with the U. S. Down 14% and international down 15%. Within the quarter comparable sales were weakest in the months of August September. The gross margin rate for the quarter was 130 basis points lower than last year.
This included a calendar shift benefit, which was largely offset by $5,300,000 of inventory write downs related to Gilly Hicks. The lower than anticipated gross margin rate was primarily the result of a step up in promotional activity, mainly in October. On an adjusted non GAAP basis, operating expense for the quarter was $591,000,000 versus $619,000,000 last year. This excludes pretax charges of $96,000,000 which are detailed on page 3 of our investor presentation. Other operating income for the quarter included a $6,000,000 benefit associated with insurance recoveries.
Overall expenses for the quarter came in significantly below forecast as we flexed down expenses in reaction to the lower sales trend. In addition, we were able to realize a small amount of savings related to the profit improvement initiative during the quarter. On an adjusted non GAAP basis, operating income for the quarter was $60,000,000 versus $133,000,000 a year ago. Operating margin on an adjusted basis decreased 5.50 basis points resulting from gross margin erosion coupled with expense deleverage. The tax rate for the quarter excluding the effect of charges was 31.1% and included a benefit of $4,900,000 related to certain discrete tax items.
On a full year basis, we expect the tax rate to be in the mid-30s on an adjusted non GAAP basis. For the quarter, the company reported adjusted non GAAP earnings per diluted share of $0.52 versus $1.02 last year. Results for the quarter included $0.06 of tax benefits related to the discrete tax matters I just referenced. Turning to the balance sheet, we ended the quarter with approximately $258,000,000 in cash and equivalents and borrowings under the term loan of approximately $139,000,000 Cash was below our target minimum holding of $350,000,000 but we expect to be back well above that level by year end. We ended the quarter with total inventory at cost up 22% versus a year ago with in transit contributing to the increase.
While overall inventory is expected to be up at the end of the year, we expect to end with appropriate levels of full carryover inventory versus the low levels last year. 2 weeks ago, we announced that we have decided to focus the future development of Gilly Hicks through Hollister stores and direct to consumer channels And we will be closing our standalone Gilly Hicks stores. Excluding charges associated with restructuring, we incurred an operating loss of $12,000,000 related to Gilly Hicks operations in the 3rd quarter. The operating loss included $5,300,000 in inventory write down charges that I mentioned earlier. With regard to our outlook for the full year, based on a projected low double digit decrease in comparable sales for the 4th quarter, we are projecting full year adjusted non GAAP diluted EPS to be in the range of $1.40 to $1.50 This projection also assumes significant gross margin rate erosion in the 4th quarter, including an unfavorable effect from the calendar shift.
We expect gross margin rate for the full year to be approximately flat to last year. The projection for the full year does not include charges related to our restructuring actions for Gilly Hicks, other impairment and store closure charges, charges related to the implementation of our profit improvement initiative or the effect of any additional share repurchases. Also due to the extra week in last year's fiscal calendar and the resulting calendar shift, the prior year comparable 13 week period ended February 2, 2013 would have had approximately $82,000,000 less in sales versus the actual reported 14 week period ended February 2, 2013. This will adversely affect 4th quarter sales and earnings on a relative basis. We continue to expect capital expenditures of around $200,000,000 for the year and pre opening costs of around $25,000,000 With regard to the rest of our real estate plans for 2013, we intend to open approximately 20 international wholesale chain stores in total for the year as well as a small number of international and U.
S. Outlet stores. To date in 2013, we have opened 13 international Hollister chain store locations. We continue to expect to close approximately 50 stores in the U. S.
In 2013 through natural lease expirations, primarily at the end of the year. During the quarter, we opened an A and F flagship store in Seoul. The planned opening of an A and F flagship store in Shanghai is expected in the spring of 2014. With regard to the ongoing profit improvement initiative, we expect to realize a somewhat greater amount of savings during the Q4 than the small amount we recognized during the Q3. As we stated during our analyst meeting 2 weeks ago, we expect to realize net incremental annual savings of at least $100,000,000 beyond what is realized this year and have a close to final figure of expected cost savings by our February earnings call.
For incremental savings, we identified beyond the $100,000,000 continue to expect to reinvest a portion of those savings into funding marketing efforts tied to our strategic plan. Going forward, our financial focus remains on driving operating margin improvement through execution of our strategic plan and maintaining a disciplined approach to capital allocation. With that, I'm going to hand
it over to Brian to provide some more details on our results for the quarter. Thanks, Jonathan. As reported, 3rd quarter comp sales were down 14 percent. By brand comp sales including direct to consumer were down 13% for Abercrombie and Fitch, down 4% for Abercrombie Kids and down 16% for Hollister. Across the brand, female performance was weaker than male.
Changes in foreign currency exchange rates versus a year ago benefited sales by approximately $7,000,000 Also due to the calendar shift from the 53rd week in fiscal 2012, the prior year comparable 13 week period ended November 3, 2012 had approximately $23,000,000 less in sales versus the reported 13 week period ended October 27, 2012, which adversely affected Q3 year over year sales and earnings. The gross profit rate for the Q3 was 63.0 percent, 130 basis points lower than last year's Q3 gross profit rate, primarily driven by lower average unit retail. Stores and distribution expense for the quarter was $565,000,000 up from $497,000,000 last year. Stores and distribution expense for the quarter included $84,000,000 of charges related to the restructuring of Gilly Hicks, other store impairments and the profit improvement initiative. Excluding these charges, the stores and distribution expense rate for the quarter was 46.5 percent of sales compared to 42.5 percent of 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 and higher direct to consumer expense. MG and A expense for the quarter was $131,000,000 versus $123,000,000 last year. MG and A expense for the quarter included $12,000,000 of charges related to the profit improvement initiative and the restructuring of Gilly Hicks. Excluding these charges, MG and A expense for the quarter was $120,000,000 a decrease of 3% versus last year. 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 287 Abercrombie and Fitch stores, 151 Abercrombie Kids stores, 597 Hollister stores and 28 Kelly Hicks stores. This concludes our prepared comments. We will now take your questions. Thank you.
Thank you very much.
Our first question today will come from Kimberly Greenberger, Morgan Stanley.
Thank you so much, Mike.
Good morning.
Sorry about that. We're seeing new flows of fashion, particularly in the Abercrombie and Fitch brand that looked pretty encouraging. And we're seeing 30% off, at least we were seeing 30% off even in new fashion in the month of October. So I'm wondering, do you think how long or what is the strategy to sort of gradually wean the customer off of promotions as you start
to deliver more new fashion?
I think that's a very good question, Kimberly, and thank you for noticing that there's encouraging fashion because we believe that's the case. We are doing this on kind of a week by week basis. Obviously as we start to get better traction, we're going to be able to raise our retails. I think we are in an intensely promotional time today. And I would love to say that this is going to happen in the next few weeks.
The interesting thing is that we run the business on a week by week basis. So as we see traction, we're going to be able to do this. I believe the fashion is getting better and better as do you. Thank you.
Our next question will come from Marni Shapiro, The Retail Tracker.
Good morning. If I don't remember, best of luck for holidays.
Hi, Marni. Thank you for your suggestion.
I'm waiting for it. And I saw the mannequin yesterday and it looked great.
Okay. You're going to get a response.
I have 2 quick one housekeeping question. If you could just clarify you said 50 stores to close by year end that's excluding Gilly Hicks. And is it still more heavily weighted to the Abercrombie brand? And then Mike, if you could just look forward, be it a year, 18 months and the balance of fashion is better in the store, I'm assuming there'll still be a good percentage of logo merchandise in the store. Should we start to think of that as more of I don't want to say a promotional vehicle, but we know the customer is always looking for promotion.
So should we start to think of the balance in that way that fashion would be the full size vehicle and the logos would be the promotional vehicle?
Let me just deal with the first two points, Mani. Yes, the 50 stores by year end includes the stores we've closed year to date, but doesn't include any of the Gilly Hicks stores that would be over and above that. In terms of the mix, we are anticipating that it is going to shift a little more to Hollister over time given the number of closures that have already occurred. So yes, a higher proportion of Hollister stores than we've seen today.
In relation to your question about logo wear, I think that's very smart that there's a logo business that is ongoing. Our mission in logo is to make that category cooler. And by doing so, I don't think we have to relegate that to a promotional business only. Thanks, Martin.
Our next question will come from Liz Dunn with Macquarie.
Hi, good morning. My question was about the international business. You've obviously called out some strength there in certain stores, but broadly the business is weak. Are the areas of weakness fashion wise similar to what you're experiencing domestically? Are the same categories not working?
Just a little bit more detail there. Thanks.
I'd answer that question. So yes, it's generally the same.
Our next question will come from Barbara Wyckoff, CLSA.
Hey, good morning. Hi, Barbara.
Hi. On the stores that are closing, should we assume that most of them are domestic or any of
They're all domestic Barbara, yes. Other than the Gilly Hicks stores again that we're opening that we're planning to close in the Q1 of 2014, the other closures this year are all domestic.
Next we have Janet Kloppenburg, JJK Research.
Hi, everybody. Hi, Mike.
Good morning, Janet.
Hi. Couple of questions. For Jonathan, you talked about I think you said that you expected greater expense savings on the store and distribution level and perhaps the MG and A level in the Q4. Maybe you could give us a little more detail there where it's coming from the magnitude of the change? And also if we should expect incrementally lower store and distribution and MG and A as we go forward quarter by quarter next year?
And Mike, I wondered, if the testing process had been conducted on the spring on the women's spring top assortments and how confident you are in the performance of that category in the spring season? Thank you.
Good morning, Janet. On the first part of the question, the reference wasn't really to the split between MG and A and stores and distribution. What we were saying is that in the Q3, we have started to realize some savings across both line items relative to the profit improvement initiative. We anticipate there's going to be a somewhat greater amount of savings in Q4. But regardless of that, we anticipate there will be at least $100,000,000 of incremental savings going forward beyond that, most of which we'd recognize in fiscal 2014.
And that excludes any potential additional savings that we're able to finalize between now and the end of the year that Mike referenced in his comments
earlier on. Janet in relation to the testing, the answer is we improve as a percent tested as we move through spring season. While the initial spring set is tested, the percentage isn't 100%. We're really getting better at this on an ongoing basis. And I would say, we're really going to be harvesting the major percentage of this improvement for back to school.
And just Janet coming back to your point about progression during the year, there will be some degree of progression in terms of the realization of the savings as various initiatives get put into effect. But we do anticipate again that we will recognize most of that $100,000,000 incremental in $14,000,000 And then to the extent that there are additional savings coming from the store pilots or other areas, we should be able to affect those pretty quickly in 2014 as well.
Paul DeJuez with Wells Fargo has our next question. Thanks guys.
Good morning Paul.
Hey. We've seen negative comps in the international business for 2 years. Can you maybe talk about where you feel comfortable that you've seen a bottom from a sales productivity perspective? And what particular markets or flagship stores do you feel like you've kind of bottomed out so that we can at least start thinking about the productivity not falling further? Thanks.
Yeah. I can give a little bit of color on that Paul. I mean obviously we are comping negatively across the great majority of the countries that we're in. There are a couple of places where that's not the case. You talked about Sweden in the past.
Obviously, China, we're doing much better than that. Actually Japan has turned from a comp standpoint the stores we have in the base over there. But most of our countries in Europe Hollister and ANF are comping negatively at this point. So I don't think we're ready to say that we've we're necessarily at the bottom of the cycle. What we can say is if we look at the what's baked into the guidance for this year in terms of international, our Hollister European stores will still be very close to 30% on a 4 wall basis.
I think 29% right around there. ANF is the range of performance in ANF is a little broader, but the overall 4 wall for ANF the year over the year will be a couple of points below that, but still in the mid-20s for the year despite that 2 years of negative comp. And then as we said at the Investor Day a couple of weeks ago, Hollister stores in Europe are still running 30% north of mall productivity on average. So short answer is, yes, we don't know. I don't think we're ready to say that the comp trend has bottomed out.
We haven't seen that yet. But the overall economics today remain very profitable, very cash generative.
Our next question will come from Brian Tuncay, JPMorgan.
Thanks. Good morning, guys.
Good morning, Brian. Hey, Brian.
Hey, guys. So two questions. Just I guess as we look ahead, Jonathan, the puts and takes on gross margin for this company next year and the year beyond. I guess you came into 2013. I think you were under inventoried and that obviously helped gross margins.
And then we're trying to think about your view on international margins. It's hard for us obviously to see the promotional activity over there. But do you think you'll be able to maintain the premium pricing abroad, especially if comps remain down double digits? And then second question, I guess, is on the buyback. Obviously, there was nothing this quarter.
As you move through the next quarter or 2 and you get to this cash balance, can we expect you to be back in the market? Thanks very much.
Hey, Brian. So a couple of things there. With regard to maintaining premium pricing abroad, yes, we do. We've had to be a little more promotional and participate in some of these sort of seasonal events that other retailers do. And bear in mind that it's a highly promotional environment in much of Europe as well.
So there is a need to some degree to compete with that. And I think that's partly what you saw in the Q3. But also keep in mind that strategically our footprint in Europe puts us in a much better position to protect that premium pricing than in the U. S. We've constrained store count.
We're only in the best possible malls. And again, we are continuing to run well ahead of the mall in terms of productivity. With regard to gross margin for 20.40, it's a little early at this point for us to really get into any details of that. I think at this point, we would be disappointed if we couldn't at least maintain our 2013 full year gross margin, but we'll give more color on that coming into the year and the various puts and takes that will go into that. With regard to buybacks, we typically don't give specific forward looking guidance quarter by quarter.
Our overall philosophy is what it's been for a long time, which is we want to protect to a minimum cash amount of $350,000,000 at the trough point in the cycle. Beyond that, we would expect to be deploying free cash flow towards buybacks, if we believe the stock is attractively priced on a long term basis. So that philosophy hasn't changed. We bought back significant amounts of stock over the past couple of years under that philosophy. We used the term loan proceeds to augment that.
And in broad terms, we would certainly expect to be in the market going forward buying back stock. And as we said at the Investor Day that we believe is going to be a significant component of how we drive long term shareholder value.
Next we will hear from Dana Telsey, Telsey Advisory Group.
Can you talk
a little bit about on the U. S. Store side where the operating margin declined pretty significantly this quarter? As you think about what you think about next year after the cost cutting is done, what should a steady state operating margin rate be? And how do you bucket that between gross margin and SG and A?
Thank you.
Hey, Dana. I think that kind of goes into the same bucket of it's a little early for us to start giving specifics on questions like that given we haven't come out with guidance for 2014 and the cost saving process is not yet complete nor is our budget for 2014. So I think we'll be able to give a lot more color on that by the end of the year, but it's a little early to start breaking that out at this point. As we said a minute ago, we'd be disappointed overall if we couldn't at least maintain our gross margin rate on a full year basis in 2014. And then to the extent we're getting traction beyond that with our strategic initiatives we've said we our objective is to get AURs up over time which hopefully would enable us to achieve some improvement in gross margin rate.
Dana, that's the first time you've ever only asked one question.
Next is Lindsay Drucker Manns, Goldman Sachs.
Hi, good morning, everyone.
Hi, Lindsay.
I have two quick questions. First, Jonathan, on the SG and A savings, the update that you hope to give us before the next earnings call, The buckets, can you just identify the buckets of areas you think you may be able to identify savings from? You talked about the store prototypes, but I was hoping you could detail any other areas we should consider in that sort of list of items? And then secondly, your gross margin guidance for the full year for flattish implies pretty sharp deterioration versus the Q3 run rate even though comps are seems like your comp guidance is for similarly poor performance. I was wondering if you could break down the buckets of that.
So how much of it is 53rd week if any? How much of it is specific inventory write downs that might be lumping excess charges into the Q4 versus other quarters? Maybe just help me understand the drivers there. Thank you.
Sure. I mean with regard to SG and A savings for 20.40, the biggest area of potential additional opportunities in the store operations area, Lindsay, that comes back to it's not really the store prototypes, which when we refer to that, we're talking about a new model for the physical layout of the stores, the store pile up project that we've been doing and that Brian went into some detail on in the analyst event. So that's clearly the greatest area of additional opportunity, although we continue to scour all other areas of expense for potential opportunities as we come towards closing our budget for 2014. With regards to the gross margin rate in 4th quarter, we have baked into that the assumption that we're going to need to be incrementally more promotional than we were in the Q3. Certainly some of our competitors were more promotional in the Q3 took rate down and were able to achieve somewhat better comps as a result of that.
We're assuming that the overall environment as Mike said earlier is going to remain very difficult and that we're going to need to take our AURs down to be competitive and that's what is primarily driving the gross margin rate erosion that's baked into the guidance.
Our next question will come from Steph Wissink, Piper Jaffray.
Hi, good morning everyone. I want to just follow-up with an earlier question regarding the comp. Mike, if you could take us through the rebuilding of the comp rate from this double digit level now to more of a flat level. I think you mentioned markdowns were a piece of it, declines in pricing and then the women's tops business. Could you just again help us kind of step function the relative degrees of impacts from those areas?
Thank you.
Okay. I think if I'm understanding your question, I'm understanding your question, we're doing a comp rate from Belgium. Okay. Here is the strategy for getting the comp rate to improve. And I think it's important to list all these factors.
1, reducing redundancy in our assortment through increased differentiation in styles. And that's not only within the current assortment, but also between seasons and deliveries and between the brands. That's 1. 2, increasing the cadence of fashion in the assortment, which is going to make the assortment look fresh and new. 3, utilizing more sophisticated testing.
4, reacting faster and reducing lead times. And that's going to be done. We've talked about this before and we're doing this, but we're doing more of it as we go forward through shorter development cycle, increased fabric platforming, increased vendor collaboration, more sourcing in the Americas and very important, reserving more open to buy for Chase. These are the merchandise initiatives for especially for female tops but for the whole business, which we believe will take us to a better top line, which as you're saying is taking the comps negative to positive. In addition to the merchandise initiatives, I think it's very important to note that we have to combine this with marketing investments.
And we're very excited about this because we have to build traffic as a part of this, which we believe will make our brands stand out and grow. We hope to see the benefits of these initiatives by back to school.
Oliver Chen with Citi has our next question.
Thanks a lot. As you do prioritize fashion tops and women's fashion tops, can you just explain the dynamic in terms of the plans to reduce the number of SKUs simultaneously? Also in your expectation of this happening, should we expect the comps and the gross margin to kind of improve in sync as you realize higher AUR? And Mike, given that you've been really experienced in retail, do you think 30% is the new normal? And how do you think about next year as we have trouble from our perch kind of figuring out how we get out of this intensely promotional type of competitive environment?
Well, let me answer the last part of the question first. I think we get out of it by the total segment becoming healthier. Young apparel is a very challenged business today. I think that that will improve. I think there are pressures on young people today in terms of how they're spending their money, but I think those pressures will abate.
So I think the whole segment will get better. And then I think we'll get better as we improve the operations of the business. And all of the factors I mentioned I just mentioned will result in us running a better regular price business. I think that the conversation of reducing the SKU count is there's been too much made of that. It's an in store SKU count reduction and I couldn't build too much into that guys.
I think maybe too much was made of that in the session. This is an in store SKU count reduction. And in fact our DTC SKU count is being dramatically increased. It gets to the same matters that I just related to in terms of how we're going to drive the business which I think is exclusive of the SKU count conversation.
Our next question comes from Thomas Valandro, Susquehanna Financial Group.
Hi. Thanks for taking my question. Mike, I was wondering how are you doing Jonathan? I was wondering what you guys plan to take a more aggressive stance at merchandising and or marketing the lease line of the stores since you I think you've removed all the louver. So I guess first update us on the lubers removals.
And then if you can update us on when you plan to take a more aggressive stance on merchandising or marketing those windows?
Good question Tom. The lubers have been removed. You will see more aggressive marketing on those windows next week. See you on Thursday.
And we'll have, Tom, some of the new Hollister prototypes with the that we showcased at the analyst event will be up and running in the Q1 which will give us an opportunity to do the same thing in those stores. Great question.
Next is Adrienne Tennant,
surprises coming out of the
study about brand perception? Thank you.
Adrian, we're still sifting through that information. We have quantitative analyses, but we're sifting through the qualitative. I'll be prepared to get into more detail on the next call.
Next is Matt McClintock, Barclays.
Hi. Good morning, Mike, Jonathan, Brian.
Hey, Matt. Hey, Matt.
The question I have, Mike, in your prepared remarks, you outlined 4 priorities. The 4th one was ensuring that you're properly organized to execute on the strategic plan. And I was wondering if you could elaborate more on that specifically. As you think about the longer term, how do you think about the longer term term
challenges
that you're facing?
Thanks.
We have a real commitment here to succession management. And we want to make sure that we're properly organized to achieve our current long term plan, but to look to the future.
We've got
quite a few people from the outside, DTC, marketing, procurement, store design, what else, strategic planning. We have a really strong bench in the merchandise as we're harvesting the result of this aggressive recruitment college recruitment program over the last 15 years. But we need to sit and ask if we're as strong everywhere as we need to be. We are going through that review process right now and would hope to have some more information for you. Probably our next earnings call, part of this organization has to do with giving more bottom line orientation to the people in the business.
So as they grow, they'll be experienced in handling bottom line responsibility. We think that that should give us a pretty good lift as soon as we get our hands around that organization. So expect more information on the conversation of organization.
Simeon Siegel with Nomura has our next question.
Great. Thanks. Good morning, guys. So Mike, in light of your comments around the promotionally driven top line improvement, I guess, in October, some of your peers mentioned lean inventories. If the promos are helping to drive some improvement, can the units you have actually help drive a better comp over the promotional holiday?
And then, Jonathan, with regard to that inventory, can you just break down the composition of this quarter's increase? And then just lastly to clarify quickly, from beforehand, are there any Gilly inventory write downs embedded in the Q4 gross margin guidance? And can you quantify the calendar shift impact to gross margin that you mentioned? Thanks.
I'll let Jonathan handle both of those questions.
Okay. So let me start with the comments about inventory markdowns in the Q4. No, at this point, we've baked in the lower cost of market inventory write downs for Gilly that we think we need to run out the remaining product obviously beyond the ongoing assortment, which is subject to the ongoing lower cost of market evaluation. So that $5,300,000 hit we took in Q3 is essentially the cleanup of the incremental write downs we need to take because of the restructuring as well as some normal lower cost of market adjustments that occurred in Q3. In terms of the comments about promo in October and if promos are driving improvement, I think the way we look at it again, we're going to need to be pretty promotional we assume in the Q4 to drive even the relatively modest comp improvement that we've baked into our guidance.
We're assuming it's going to be a tough environment. To your point, we do have the inventory to support the promotional strategy we have baked into our plans for the quarter. So we'll obviously see how that plays out as we go through the quarter. Was there another part of the question? Our inventory breakdown for the end of Q3, We did have greater in transit year over year.
That was a component of what was rolling into that overall increase. Again, our primary focus for inventory is that when we exit the year, we're going to have an appropriate level of full carryover inventory and that's what a lot of our AUR and other strategies are directed towards for the quarter and we're comfortable that we're heading towards that. The spring inventory at the end of the year will be higher because of the very low levels we had last year, the very low in transit levels we had as well. So spring inventory will be up fairly significantly, but fall inventory we're working to have in a very healthy position rolling over into Q1. Healthy position, but still a
little heavier than last year, because we had practically no fall, which could give us a Q1 opportunity.
Our next question will come from Paul Alexander, Bank of America Merrill Lynch.
Hi. Thank you. Can you guys tell us a little bit more about the mechanics of the testing program? Where in the life cycle of the product are you going to be testing? Are you going to be testing finished product to get an idea of how much to order or chase?
Or will you be testing product attributes like color and silhouette? And also, getting to 100% of testing, how will you manage all that increased testing? Are you going to have to hire more merchants? Or can you do this with your existing teams? Thank you.
Paul, I'd rather not get into the specifics of the testing program. It's pretty sophisticated. And we're already kind of delighted with what's happening. In terms of workload, it's perhaps a little more intensive for both design and merchandising. But because we're testing at every point of the process from concept to finished product, we're getting some efficiencies.
Next we'll hear from Anna Andreeva, Oppenheimer.
Thanks for taking my question guys. Good to hear that October trends improved for the business although modestly. Was that consistent across brands and also international versus domestic? And your guidance for comps to be down low double digits for the Q4, I guess, embeds some improvement in the trend. Just curious, what are you seeing so far in November?
And then finally, just to follow-up on AURs. What was AUR
first part Anna. The October trend improvement was across brands and there was improvement in international and domestic, but more in domestic. But I also I think as we said earlier, I wouldn't put too much into that. We clearly were more promotional that contributed. Then there were some other factors in terms of what we were lapping year over year in October that helped.
So we think there was a bit of a pickup in the underlying trend. But I wouldn't take that too far at this point. We typically don't comment on current quarter to date business on these calls. Our projection for the quarter is based on our standard model, which is a 13 week trailing trend with greater weighting being given to the most recent weeks that gives us an outlook for the quarter and that's what our guidance is based on and that obviously rolls in the direct to consumer business in that sense. That's part of the comp.
With regard to AUR decline in Q3 and what we expect in Q4, what we're signaling obviously is we're going to have a greater decline in AUR in Q4 certainly adjusted for mix and other factors given the expectation that we will need to be more promotional in Q4 to get to where we need to be at the end of the year.
Next we'll hear from Dorothy Lager, Topeka Capital Markets.
Thanks. Good morning everyone.
Good morning, Dorothy.
You gave a lot of helpful information at the meeting regarding your timeline for when we should see certain changes. And I just wondered in terms of the greater differentiation you're looking to do between Hollister and ANF, is that just going to roll in kind of gradually? Should we really look for that to be full impact back to school next year? I'm just wondering if you could speak to that. And then also on the kids business, the kids comps are quite a bit better than the overall business.
I just wondered what's helping you there and what your thoughts are in general on kids?
Okay. Let me take a stab at this. In terms of differentiation between Hollister and A and F, twofold. 1 is product and 2 is marketing. You'll see a continued emphasis on differentiation as we proceed through the year in product.
You'll start to see better differentiation in marketing as of spring, clearly by back to school. We hope that you see an appreciable difference. In terms of the kids business, I really believe that the difference is that the parents are buying the products there.
Our next question will come from Betty Chen, Mizuho Securities.
Good morning, everyone. Good morning, Jonathan. As we get into next year and start to think about the new merchandise that will be hitting around back to school especially, is there any difference in terms of the pricing architecture? I know at the analyst event you mentioned that AUR will be an opportunity because of lower red lines and promotions. But how about in terms of the initial markup?
Are you testing that as part of your testing process on how your pricing is being received by the customer base? And will we see any changes on that front? Thanks.
I don't know how
I think what we've said, I mean, it's really it's about promotions and clearance is what we're thinking Betty is going to help us get the AUR back up. It's not really about ticket strategy as much. So it's being less having a lower proportion of clearance and being less promotional.
Right. And driving that clearance percentage down is critical, which is related primarily to differentiated product. So we're not competing with ourselves in the backroom. Major initiative. And I mentioned that as number 1 in terms of initiative.
Next we will hear from John Morris, BMO Capital Markets.
Thanks. Kind of 2 quick parts here Mike. You've done a great job outlining some of the work that you're doing from the merchandising standpoint and the initiatives. And you have talked a little bit to the marketing. So obviously the product is coming first.
The marketing you said it will be kind of fully evolved by back to school, but some small scale changes in the spring. So wondering what your thoughts are about that and your philosophy, your approach to that in terms of what we might see smaller scale. And then Jonathan just a quick update
on the
London flagship. I think last quarter you said it was flattish comp. And I'm just wondering kind of the trend any quick update there as well? Thanks.
I think John the marketing initiatives are very exciting. Beyond a full blown campaign, we're doing a lot of testing in a lot of different areas. What's going on, I don't need to say to you in terms of newness and the way to deliver messages to our target customers are enormously exciting. So we're fully engaged in new ways of delivering message as well as what the message is. And we're doing an enormous amount of testing there.
Now to go to the
Yes. On the London flagship, John, we did see a step down there consistent with what we saw in the international comp from Q3 to Q2.
Bridget Weshar with Morningstar is next.
Good morning. Thanks for taking my question. I know that you highlighted that women's tops were weak. I'm wondering if women's in general had weaker comps across the board than guys. And so if you could give any detail if it's on traffic or conversion?
And the third piece of the question is, are you can you highlight any ongoing marketing campaigns that are specifically targeting that weakness? Thanks.
Women's had weaker comps than men's. However, the real weakness was in women's comps. Traffic or conversion? Traffic is a total company. So I think it's difficult to talk about traffic in terms of that category.
Although overall traffic is correlated pretty well with comps. So we would assume that it's more traffic than conversion on the female side because of that.
Any particularly market campaign specific to that category? I would rather not talk to that.
Our final question today will come from John Kernan with Cowen.
Hey, guys. Thanks for squeezing me in.
Helpful color on inventory and where you expect to finish it. What are you seeing in terms of unit cost for next year? We've heard some companies talk about unit cost up in the low single digit range. And just wondering how you're factoring in any inflation whether labor or cost into your gross margin next year? Thanks.
Yes. Again, John, it's a little bit early for us to get into a lot of specifics on gross margin for 'forty, but the broad comment we made earlier reflects about being disappointed to not at least hold our 2013 rate would reflect what we're currently seeing in AUC, which broadly based on what you just referenced wouldn't be that different to what you're hearing elsewhere.