At this time, I'd like to turn the conference over to Mr.
Brian Logan. Mr. Logan, please go
ahead. Good morning and welcome to our Q2 earnings call. Earlier today, we released our Q2 sales and earnings, income statement, balance sheet, store opening and closing summary and an updated financial history. Please feel free to reference these materials available on our website. Also available on our website is an investor presentation, which we will be referring to in our comments during this call.
This call is being recorded and a replay may be accessed through the Internet at abercrombie.com under the Investors section. Before we begin, I remind you that any forward looking statements we may make today are subject to the Safe Harbor statements found in our SEC filings. Today's earnings call is scheduled for 1 hour. Joining me today on the call are Mike Jeffries and Jonathan Ramston. We will begin the call with a few remarks from Mike, followed by a review of the financial performance for the quarter from Jonathan and me, followed by an update on our strategic plans.
After our prepared comments, we will be available to take your questions for as long as time permits. Now to Mike.
Good morning, everyone. Thank you for joining us today. The 2nd quarter results we are reporting today are disappointing and below our expectations coming into the quarter. In particular, we saw a further deceleration in the sales trend of our international stores, while our U. S.
Chain stores also comped negatively for the quarter for the first time since 2,009. Our direct to consumer business remained a bright spot, posting its 10th successive quarter with year over year sales growth of 25% or better. As we have discussed in the past, we continue to believe that the macroeconomic environment is a primary driver of the negative comp sales we have seen in our international stores, particularly in Europe. The situation in Europe has continued to become more difficult since we first spoke of our concerns a year ago. In addition, cannibalization has clearly been a factor as our brands have become more widely available in Europe.
Within our down 26 comp for international stores for the quarter, we can specifically identify 5 percentage points of this trend as being attributable to store on store cannibalization. The overall effect is likely somewhat greater taking into account potential transfer to our rapidly growing direct to consumer business. However, it is important to note that significant cannibalization effects are limited to only a portion of our international stores, principally flagships with large tourist components and local catchments where we have multiple stores. It is also important to note that even with the effects in Europe, we have also given back some share in the U. S, and it is reasonable to assume that some of the factors that have affected our U.
S. Business have also affected the trend in Europe. Many of you observed the lack of newness in our stores through May June and the stepped up promotional activity that was necessary as we began clearing through our spring inventory overhang. As we look back on the quarter, and in fact, all the way back to last Christmas, it is clear that the significant slowing in the European business that began in the fall of last year, coupled with a difficult Q4 in the U. S, has continued to have repercussions.
Most notably, it has put us in a position of playing defense to work down our inventory levels rather than being on offense and chasing into trends in which we believe. Through long experience with this company, I know that we are much better when we are playing offense than when we are playing defense. Having said that, our inventory position has improved considerably at the end of the second quarter, and we are expecting further significant inventory level improvement in the Q3 as Jonathan will speak to in a moment. In addition, we are working to keep our committed inventories leaner going forward so that we have more room to chase and react. We'll come back to that in a moment.
Beyond all these factors, one question we continue to ask ourselves as a inflicted? The answer is not wholly clear. However, our entire organization is completely focused on improving the trends we have seen. There are factors beyond our control, but as a team, we believe there are opportunities to do better. We will talk in a few minutes about the various initiatives we have in place to improve productivity and profitability in our U.
S. Stores and to help stabilize trends internationally. In that context, I'd like to make a few more comments on our international business. During the quarter, we opened a combined Hollister and Gilly Hicks chain stores. We are pleased with the brand awareness and excitement that these openings have created.
Our 4 wall operating income from international stores was down slightly to a year ago with contributions from new stores being more than offset by declines in existing stores, most notably flagships. This brings us to one of the paradoxes of our business today, best illustrated by the performance of our A and F flagship store in London. The store was our first international flagship and quickly became a shopping destination for Europeans. The store's performance, however, has been significantly affected as we opened other A and F stores throughout Europe and probably by the growing penetration of Hollister in Europe. Even with the impact of cannibalization, the store has had approximately $64,000,000 of sales over the past 12 months and has generated a 4 wall EBITDA of approximately $33,000,000 By the way, these numbers for London are all included in a slide, which Jonathan will discuss later as part of our strategic update presentation.
Despite the fact that sales volume is well below the store's peak from a couple of years ago and contribution is down even more, the store still achieved a 4 wall margin of approximately 50% over the past 12 months, well above our target rate. Taking into account an initial investment of nearly $30,000,000 in CapEx and other investments, the store's contribution translates into an annual store level ROI of approximately 80% after factoring in incremental non 4 wall costs. And clearly, the cumulative return is much greater than that. Picture is similar from Alain and some of our earliest Hollister stores, which despite significant declines in volume and profitability, continue to deliver very strong results and returns on an absolute basis. As we discussed on our last earnings call, when we look at the current trends in Europe, there are 4 key questions we ask ourselves.
1st, are our stores continuing to stand out from the mall in terms of excitement and energy and in terms of traffic and productivity? 2nd, are the new store volumes consistent with the volumes at which we've proved the deals? 3rd, are we achieving our annualized target 30% 4 wall margins at the current trend and after cannibalization? Last, is our international direct to consumer business continuing to grow at a healthy rate? We continue to believe the answer to all of these questions is yes.
In addition, we have long said that we achieve our if we achieve our operating hurdles, return on investment metrics are also very strong. However, given the declines we have seen and the impact of cannibalization, we believe that it is appropriate to add a further question, specifically, whether the return on invested capital we have generated from our international expansion is superior to any alternative deployment of capital over that period. We are very confident that is the case as Jonathan will review in more details in a few minutes. However, given a period of declining returns, we believe it is appropriate to review our future plans in that light and make sure that we remain highly disciplined in only committing to new stores or other capital projects where we are confident that based on conservative assumptions, the answer to all five questions remain yes.
Overall,
will remain yes. Overall, setting aside our future store opening plans, we are very focused on improving the performance of our existing stores. We remain very cautious about the macroeconomic environment, but we are hopeful that with our comp sales for the past few weeks running a little above our 2nd quarter trend, we are beginning to see at least a stabilization in the trend. With that, I will hand over to Jonathan, but we'll come back to make some additional comments in a few minutes.
Thanks, Mike, and good morning, everyone. I'll start with a short summary of our results for the quarter and outlook for the full year and then Brian will go into some additional details. For the quarter, the company's net sales increased 4% to $951,000,000 Total U. S. Sales including DTC were down 5 percent.
International sales including DTC were up 31% and total DTC sales including shipping and handling were up 25%. Com store sales were down 10% last year. Com sales were down 5% in U. S. Stores and were down 26% in international stores.
On a weighted average basis, the dollar strengthened approximately 3% versus the prior quarter and approximately 7% versus last year. Foreign currency changes for the quarter affected sales growth adversely by approximately 160 basis points versus a year ago. Gross margin erosion for the quarter of 110 basis points was modestly greater than anticipated, reflecting the lower sales trend. Overall, expenses for the 2nd quarter came in significantly below projection. The main drivers of the expense reduction were lower contingent rent, lower incentive compensation, reductions in travel, marketing and other home office expenses.
Operating income for the quarter was $27,000,000 versus $47,200,000 a year ago. Operating margin fell 2 30 basis points with expense deleverage of 120 basis points adding to the operating margin erosion. The tax rate for the quarter was 38.9% and diluted earnings per share for the quarter were $0.19 versus $0.35 for the prior year quarter. Turning to the balance sheet. We ended the quarter with total inventory cost up 20% versus a year ago.
Based on our current sales plan, we expect inventory cost to be approximately flat year over year at the end of Q3 and down at the end of Q4. We ended the quarter with $312,000,000 in cash and cash equivalents and $20,000,000 of current marketable securities. During the quarter, we drew down $75,000,000 from our revolving credit facility to provide us with additional liquidity through the trough point in our cash cycle. We have $274,000,000 remaining available under our revolving credit facility and $300,000,000 under our term loan facility. During the Q2, we liquidated $18,000,000 of our auction rate securities.
We did not repurchase any shares during the quarter. In order to maintain our cash cushion, any such repurchases would have entailed further drawing down on credit facilities, which we were not comfortable doing in the absence of clear stabilization in trends. At our Board meeting yesterday, the Board approved an additional 10,000,000 shares to our share repurchase authorization, bringing our total outstanding authorization to 22,900,000 shares. We will come back to this in a moment. With regard to our expectations for the fiscal year, based on the Q2 trend, we are now planning for down 10 comps for the full year with U.
S. And international trends consistent with Q2. Overall, based on the lower sales trend, we are now projecting diluted earnings per share for the year of $2.50 to 2.7 $5 Consistent with past practice, our guidance does not assume any further share buybacks. With that, I will hand over to Brian to add some more details on our operating results for the quarter and outlook for the year.
Thanks, Jonathan. As reported, comp store sales were down 10% for the quarter. U. S. Comp store sales were down 5% versus down 1% in Q1, with chain stores performing slightly better, although comping negative for the quarter for the first time since 2,009.
International comp store sales were down 26% versus down 22 percent in Q1, with Hollister European stores performing somewhat better. By brand, comp store sales were down 11% for Abercrombie and Fitch, 10% for Abercrombie Kids and 10% for Hollister. Within the brands, male and female performed comparably. The gross profit rate for the 2nd quarter was 62.5%, 110 basis points lower than last year's 2nd quarter gross profit rate. The decrease in rate was driven by an increase in average unit costs and the adverse effects of exchange rates, partially offset by an international mix benefit.
A summary of our 2nd quarter operating expense can be found on the slide on page 5 of the investor presentation. Stores and distribution expense for the quarter was $458,000,000 or 48 point 1% as a percentage of net sales. Store occupancy costs were approximately $185,000,000 and all other stores and distribution costs represented 28.7 percent of net sales, 120 basis points above the percentage of net sales they represented last year. The increase in the stores and distribution expense rate was primarily the result of deleveraging on negative comp store sales. Stores and distribution expense the quarter included approximately $700,000 of accelerated depreciation from our DC consolidation, lower than previously anticipated due to an extension in the expected service life of our second PC.
MG and A for the quarter was $111,000,000 versus $110,000,000 last year. The increase in MG and A for the quarter was due to an increase in marketing, IT, travel and other expenses, largely offset by a decrease in incentive compensation expense. The tax rate for the quarter was 38 0.9% compared to 30.7% for the prior year. The increase in rate was primarily the result of a reduced benefit related to international operations, which are taxed at a lower rate. As Jonathan mentioned, we ended the quarter with total inventory cost up 20% versus the Q2 last year.
Spring season inventory continues to be up disproportionately, which is reflected in the higher markdown reserve at the end of the quarter when compared to last year. During the quarter, we opened a combined Hollister and Gilly Hicks store in London on Regent Street, 7 international Hallie Hicks chain stores and 3 international Gilly Hicks chain stores. Details of international stores opening for the quarter are included on the slide on Page 9 of the investor presentation. In the U. S, we closed 6 stores during the quarter.
At the end of the quarter, we operated 293 Abercrombie and Fitch stores, 159 Abercrombie Kids stores, 578 Hollister Stores and 25 Kelly Hicks Stores. With regard to our expectations for the fiscal year, in addition to the down 10 comps for the fall season, we anticipate for the full year that stores opened in 2011 will contribute approximately $250,000,000 to sales growth, while stores opened in 2012 are expected to contribute approximately $200,000,000 Including excuse me, excluding charges, we anticipate a substantial recovery of our 2011 gross margin rate erosion to be largely offset by expense deleverage. The gross margin rate recovery is expected to be primarily the result of lower average unit cost due to the abatement of cotton prices. During the fall season, U. S.
Chain AURs are expected to be flat to slightly down to last year, while international AURs are expected to be down to last year. In addition, as a reminder, our 4th quarter gross margin rate for last year was estimated to be adversely impacted by about 200 basis points as a result of markdowns on higher carryover inventory. We expect the fiscal year tax rate to be in the high 30s and capital expenditures to be approximately $360,000,000 With regard to Q3, we expect gross margin rate improvement to be more than offset by expense deleveraging on negative comp store sales. For the Q3, we expect an increase in MG and A expense versus Q2 due to higher marketing expenses related to the introduction of our CRM programs and brand awareness initiatives in China, including those around the Hong Kong flagship opening. We will report 3rd quarter sales and earnings results on Wednesday, November 14.
With that, I will turn the call back to Jonathan.
Thanks, Brian. As we indicated in our pre release 2 weeks ago, we want to spend some time this morning to give an update on various aspects of our forward looking plans. And in connection with that, I would like to refer you to the strategic update section of our investor presentation. First of all, as Mike alluded to a few minutes ago, we are confident that the return on investment from our international rollout to date has been superior to any alternative use of capital over that period, including stock buybacks. Going forward, our philosophy remains to be disciplined in allocating capital to where it will derive the greatest return on a risk adjusted basis.
Turning to the performance of our international operations to date. As we have stated in the past, we think it is helpful to break out the business between Hollister Europe, A and F Flagships and other investments. Starting with Hollister Europe, as we have discussed in the past, we believe that Hollister International store openings represent a low risk, high return use of capital. To illustrate how we think about this, the slide on page 14 shows the anticipated sales, contribution, EBITDA and operating income for a recent Hollister store we opened or we approved rather in France. We referenced this example in some recent conference presentations and think it is a good example of a fairly average European Hollister store.
In addition to our expected or approved case as reflected on the slide, we also show a downside scenario where the store achieves only 75% of its expected volume and a low end scenario where the store only achieves 50% of its expected volume. In terms of return on capital, we define store level ROI as 4 wall EBITDA less estimated incremental non 4 wall costs such as DC, regional management and an allocation of country specific costs divided by a total investment calculated as our original net CapEx plus other investments comprised primarily of preopening costs, lease deposits where applicable and store working capital. Using this store level ROI analysis, this example shows that the return on the approved scenario is 62%, the return is 41% in the downside scenario and is still above 20% in the low end scenario, a scenario we regard as very unlikely. This particular store does not have any significant in France runs higher than our average across Europe. On a trailing 12 month basis, approximately 90% of our Hollister European stores exceeded a 30% 4 wall margin.
In addition, on average, the stores are exceeding their approved sales volumes by approximately 20% with the result of the overall store level ROI for Hollister Europe is well above the example we just reviewed. It is also important to note that our downside risk on Hollister chain stores is also protected by lease exit clauses that exist in many of our leases. 90% of our Hollister European stores have lease exit clauses either unconditional or based on sales. Turning to A and F Flagships. The slide on page 16 provides an illustration of the performance of our A and F London flagship over the past 12 months.
As Mike stated, we believe that the London flagship is a good example to discuss as no other store has been more adversely affected by the macroeconomic and cannibalization trends. Despite a material decline in London's volume over the past year, the store continues to operate well ahead of its original approved volume and well ahead of our 30% contribution margin hurdle rate. In addition, the store level ROI has also remained strong and the store has generated cumulative returns, which are a multiple of our initial investment. Using a comparable measure, our overall store level ROI on a trailing 12 months basis for our European A and F flagships exceeds 35% with all of our European flagships other than Copenhagen and Dusseldorf operating at 4 low margins above 25%. As a last point on Europe, the returns referenced above do not include the benefit our increased store presence has had on our international DTC growth, which we believe is significant.
With regard to other international operations, our store level ROI for our Canadian operations is comparable to Europe, although at this point we are not planning any further investment in Canada. With regard to Asia, our rollout is still at an early stage and we will continue to take a test and learn approach to new opportunities, limiting our invested capital until the opportunity is proven. Turning to what this means for our future opening plans. The slide on page 18 shows the A and F international store plans we have today. We have added no new commitments since our prior update in May, although we continue to move forward on Shanghai location that we would expect to open in the fall of 2013.
In addition, we have scaled back Dublin and Seoul from full flagships to smaller Tier 1 formats with meaningful reductions in associated capital expenditures. We are not able to confirm an opening date for London kids at this time. With regard to Shanghai, we do not expect Distort to achieve our 30% forward margin hurdle rate. However, we believe that a Shanghai flagship is important in supporting our broader rollout in China, which in addition to Hollister may potentially include some A and F chain stores. Beyond Shanghai, we are pausing all other flagship commitments, but we'll keep this under review as we go forward.
We now anticipate around 30 Hollister openings this year in addition to the 4 international Geely Hicks stores we have already opened. For 2013, we are planning for approximately 20 international Hollister chain store openings. This includes close to 10 existing commitments. Overall, these openings will be focused on under penetrated markets where we expect minimal cannibalization. They will include our 1st stores in Australia and likely in the Middle East.
On the latter point, we are finalizing the agreement to establish a joint venture with a Middle East based partner that will provide us with operational support while enabling us to operate our stores consistently with our fully company owned stores. As we have done in the past, we will continue to review all store openings on a case by case basis. We now expect capital expenditures in 2012 to be around $360,000,000 and 13 capital expenditures to be around $200,000,000 Our modified store opening plans will also result in significantly lower pre opening costs, which should now come in around $50,000,000 this year and reduce to approximately $30,000,000 next year. Coming back to our capital allocation strategy as reflected on slide 19, our share repurchase philosophy is as follows. After allocating capital to new stores and other internal projects such as DTC investments that provide superior returns, we would expect to return excess cash to shareholders through dividends and share repurchases.
We define excess cash as being cash above a $350,000,000 base requirement at all times. We believe this amount is appropriate to protect the company from the short term effects of external factors. In addition to cash from operations, we will continue to review the appropriateness of adjusting our capital structure through the use of the term loan facility or other instruments over time. This evaluation takes into account the inherent leverage already in our business model as well as our outlook on the business in general. Given business trends during the Q2, we chose not to draw down on the term loan, but would expect to use this facility once we are confident the business trends have stabilized.
Lastly, we will execute buybacks when we believe the stock is attractive attractively priced on a long term basis. In the on a long term basis. In the above context, the slide on page 20 of the presentation illustrates our capital allocation over the past 6 quarters and shows that over that period we have spent approximately $360,000,000 on new store openings, approximately $358,000,000 on stock buybacks, approximately $155,000,000 on other CapEx projects, including maintenance type projects and approximately $90,000,000 on dividends. Regarding our share buyback potential, the slide on page 21 shows a projected normalized free cash flow for 2012 of around $300,000,000 with a normalized lower run rate CapEx. Assuming that our underlying results improve going forward, the free cash flow generated should increase accordingly.
In addition, having been in a position where inventory has been a use of cash over the past 12 months, we expect inventory to be a source of cash over the next 12 months. Beyond that, we are committed to growing inventory at less than the rate of sales. Based on this, we anticipate that we will have substantial free cash flow from operations over the next 18 months to support continued capital return to shareholders. In addition, we have the term loan facility of $300,000,000 to supplement that. Based on these projections, our Board yesterday authorized an additional $10,000,000 share increase in our share repurchase authorization, bringing the total authorization to 22,900,000 shares.
With that, I will hand back to Mike.
Thanks, Jonathan. As I referenced a few moments ago, our entire organization is focused on improving the trend of our business. And before closing, I want to review some of the initiatives we are pursuing to accomplish this. This is not an area of significant capital investment, but we believe there is significant potential to improve our overall returns to shareholders through gains and the productivity and profitability of our domestic fleet. 1st, with regard to merchandising, we have a number of initiatives that will improve our ability to react and chase.
These include implementing more conservative merchandise plans, a shortening of our product development calendar and increasing the chase component of our open to buy. In addition, we are increasing local sourcing within the U. S. And Central America to further shorten lead times and increase flexibility. 2nd, in terms of inventory productivity, we are committed to growing inventory at a slower pace than the rate of sales growth.
This will be supported by investments we have made in new merchandising, planning and allocation systems, which are now live for the spring season of 2013. Among other things, these new systems will greatly enhance the efficiencies in building plans and give us much better visibility on margin and inventory plans by selling channel. In addition, these systems will shift our focus to selling margin rather than IMU, which is a significant improvement given the evolution and complexity of our business today. A third key area of focus is insight and intelligence, particularly with regard to our international operations. We are building a team to help us better understand macro competitor customer dynamics in our key markets.
Ultimately, we believe this improved understanding will help us make better business decisions. This intelligence will include both primary and secondary research as well as leveraging our associates to gather and synthesize intelligence they come across. 4th, with regard to customer engagement, we are excited about the launch of our new club programs for A and F and Hollister. Yesterday marked the official launch date of our new A and F club program and for our new Hollister Club Cali in the U. S.
Our CRM programs are something that we have been working hard on for nearly 2 years. They will enable us to have a single view of the customer across channels, to target both product and promotional messages to customers on a segmented or ultimately individualized basis and to engage with our customers in new ways and through unique content via mobile, social and cross channels. We believe that these programs will also allow us to gain insight into the the behaviors of both new and returning customers. Prior to launch, we had 150,000 pre registrations for the clubs, and we expect this to grow significantly in the coming weeks months and become a meaningful part of our model. 5th, with regard to expense and AUC, we will continue to focus on finding efficiencies and taking costs out of our model as we have done successfully over the past year, and we will continue that process going forward.
Although the complexity of running our business has increased with our international expansion, our head at the home office remains lower than it was 4 years ago. This further reinforces the leverage benefit of our profitable international store openings. We have also analyzed and adapted our international operating margin model, resulting in reductions in our selling payroll and other expenses such as repairs and maintenance. The progress we've made on AUC for the fall season is also a good example of how effective our teams can be when they are aligned around specific measurable
goals.
Last, store closures will also remain an important part of our long term plan to improve both the overall profitability and the brand profile of our U. S. Stores. We continue to expect closures primarily through natural lease expirations to be modestly accretive to EPS on a year over year basis. We believe all these efforts can be meaningful in terms of improving the trajectory of our domestic business, and many of them will also benefit our international business and our DTC business.
With regard to DTC, we remain pleased with the progress we are making, particularly internationally, where initiatives such as broadening the payment types we accept and accelerating our fulfillment capabilities are significantly improving conversion. In closing, I want to reiterate our confidence in the global appeal of our iconic brands. This was once again affirmed with a strong response to our Hong Kong flagship on Saturday, and this adds to our cautious optimism about the potential for our brands in Mainland China. Through its first five days, the store has done over $1,000,000 in sales. We remain excited and optimistic about the opportunities ahead of us, disciplined and judicious in our use of shareholders' capital to pursue these opportunities.
Thank you and we'll be happy to take your questions.
Thank you. You. We'll take our first question from Dana Telsey with Telsey Advisory Group.
Good morning, everyone. Good morning, Dana. Hi, Dana. Hi. Given the new world that we're in, how are you thinking about the merchandise assortment, basic versus fashion, pricing globally?
And you mentioned the changes in the supply chain, which should be very helpful. How do you see that and timing of that of adding to enhancing inventory, enhancing turn margins? Thank you.
I think we're thinking the same thoughts. Clearly, we have room for more fashion, more trend turning faster, which will clearly be facilitated by shortening the cycle. In terms of international pricing, I'll turn that over to Jonathan.
Yes. Dan, I think we've said we are planning for international AURs to be down in the back half of the year, particularly in flagships and to a lesser degree in the Hollister chain stores on a year over year basis.
And I think Dana, the most important part of trend and increasing our fashion component is, as I said in the overview, being on the offense, chasing is key to improving that part of our business.
Thank you.
Next we'll go to Randy Konik with Jefferies.
Hey, can you hear me?
Hey, Randy. Hi, Randy.
Hey, guys. How are you? So I guess obviously, so I think what the market wants to hear is the word discipline and so forth around the capital allocation. So if I look at slide 21 in the packet, there's a quote that says normalized CapEx of $200,000,000 and normalized free cash flow $300,000,000 Is there some sort of like line in the sand we can be thinking about as or the shareholders or investors, potential investors can be thinking about in the sense that either you're going to hold the line at around $200,000,000 in CapEx going forward over the next few years or ex that would you be able to be committing to generating
normalized free cash flow
minimum or baseline of about 300,000,000 free cash flow minimum or baseline of about $300,000,000 per year assuming that if the operations get better, the CapEx could go up a little bit. So just trying to get some clarity there. And then on the share buyback, you made a comment, Jonathan, about buying back when the stock is attractive. Obviously, it's pretty attractive down here at least from our perspective. I guess the pause was that due to the cash generation cycle in this point of the year and we could expect that to the buyback spigot to turn back on in the back half of the year and into early part of next year?
How should we be thinking about the timing of the buyback? Thanks.
Sure. To take the first part first then Randy, I mean, we're obviously hopeful that operating cash flow we're going to generate this year is going to be growing going forward. I mean, frankly, if it didn't grow, then I think the likelihood of CapEx would grow would be very unlikely because that would suggest that the dynamics going on wouldn't support accelerating again the store openings. So we're hopeful that the normalized free cash flow of $300,000,000 will grow even if CapEx were to start growing again at some point. But we're going to remain very disciplined about that.
We're going to look at it on the basis of store by store is the return we can generate from any given store the best use of capital relative to buybacks or any other use as we commit to each of those stores. But we would certainly hope that that normalized free cash flow should be growing going forward from what has obviously been a challenging year in 2012. And then on the second piece, there are 2 principal gates we have to get through to do buybacks. The first one is valuation and the second one is liquidity. The comments we made in the script were that because we would have had to go into the term loan to be buying back shares during the quarter, we weren't comfortable doing that given the trends in the business.
And as we just said in the script, once we feel that those trends have stabilized, then we would expect to pull down on that facility and use it towards buybacks. And we obviously can't be more specific on timing around that. But it was really a liquidity driven issue in the second quarter that prevented us from going forward.
So can you hear me? Can you hear me again?
Hey, Randy.
Yes, I'm sorry. So I just want to make clear. So should the market be thinking about $300,000,000 as a baseline of free cash flow for this company and its ability to generate that number going forward over not just next 12 months, but if we're thinking about potential investments investors thinking about next 2, 3, 4, 5 years? Is that how we should be thinking about this business?
We're obviously not giving a forecast for the business, but we would be disappointed if we weren't able to generate more free cash flow than that beyond 2012. Does that answer the question?
Yes. Thanks.
Thanks, Randy.
And next we'll go to Steph Whiskey with Piper Jaffray.
Thanks. Good morning, everyone. Just wanted to follow-up on Randy's question regarding discipline. You added a tremendous amount of discipline around your store operating model. I'm just curious how you think about the overall health of your store base in the U.
S? More so, what is the right store base size for each of your core concepts? Thank you.
Yes. Hi, Steph. I think we've said for Hollister, we don't anticipate the store footprint contracting significantly. There are some stores that will probably close, which are not doing particularly well and there's no new news there. But mostly the closures are oriented towards A and F Kids and getting the A and F Kids brands focused on those stronger performing stores.
And as we've said many times in the past, if you look at the sort of upper tier of A and F and Kids stores, the economics of those stores are frankly comparable to our international stores. So there is a segment of those stores that we would like to reposition the fleet towards. We've talked about another 180 closures between now and 2015. Again, most of that would be oriented towards A and F and Kids as it has been for the 135 stores we closed in 2010 and 2011.
Thank you.
Thank you. And next we'll go to Janet Kloppenburg with JJK Research.
Good morning, everyone. Michael, congratulations on an outstanding opening in Hong Kong. That's very exciting. A couple of questions. At the end of the Q1 or maybe fiscal year 2011, you had said that you expected to recapture a great portion or almost all of gross margin that you lost in 2011 attributable to higher raw material costs.
Can you just give us an update on that outlook right now? Secondly, I know there'll be increased M and A pressure, MG and A expense pressure in the quarter due to the CRM in China and marketing costs. Should we expect that again in the 4th quarter? And just lastly, Mike, how soon can your merchandising and sourcing your shortened lead time initiatives affect the merchandise in the stores? Thanks so much.
Okay. Jonathan, you want to take the first part? Sure.
In terms of gross margin rate, Jenna, what we said is that we anticipate a substantial recovery of the erosion we had last year, so well towards well back towards the 2010 gross margin rate. And as Brian said in his comments, that's primarily driven by the average unit cost benefit with some international mix coming into play.
Okay. Great. Thank you.
On the marketing piece, there is a there will be some ongoing costs of operating CRM programs and there'll be some ongoing Hong Kong and China marketing. But there is a disproportionate effect in this quarter, particularly around the Hong Kong opening where we did some fairly extensive marketing around that. And that expense as well as some of the initial content creation for the club
programs is disproportionately impacting Q3. So it
should certainly abate beyond Q3. Should certainly abate beyond Q3. Great. I'm going to give you a long answer to work
our way into your question.
Sure. And I'd like everyone to to know that I think that we have to start by going back to this time last year. Our international business had been very strong through the 1st 6 months of the year. And I think Hollister comped around 20% for the Q2 of last year. Our U.
S. Business was also strong. Since that time, we've had obviously very significant reductions in sales volumes, and we've had to make material changes to our merchandise plans in response to that. So we've been in the mode for most of that time in trying to get out of inventory receipts and work down inventory levels as opposed to chasing the business, which is what we've proven ourselves to be rather good at doing. And that's a tough place.
Did we miss business over the past 2 quarters because our assortment was too narrow and because we're late on some trends? I believe so. But what we've been working toward is what I've stated to put ourselves in a position where we can be back on the offensive. This is an important point that I keep making. And that means conservative merchandise plans, more open to buy, more chase.
And the answer to your question is that I think we'll be there as we progress through Christmas in terms of what you see in the stores and certainly for spring. In our financial plans though, we're not counting on any improvement in the trends from this, but we're hopeful that we'll see some.
Great. Lots of luck.
Thanks, Janet. Thanks, Janet.
And next we'll go to Adriana Tennant with Janney Capital Markets.
Good morning. Hi, Adriana. Hi. Is on the international lease structure and I was wondering it sounds like Hollister is quite similar to the U. S.
Mall structure 10 year leases with kick outs. I was wondering on the flagships, if you can help us, are they longer leases? Are they can you work with landlords in terms of adjusting them as we go? And is that different in Asia versus Europe? Thank you very much.
Adrian, with regard to Hollister, by the way, it's probably worth noting that the structure of the leases in a number of countries in Europe actually gives us more flexibility than we have in the U. S. Someone like France or Belgium, there are kick outs that kick in after various periods of time pretty much automatically in the structure of the leases in those countries. So we do also have a couple of those kick out type provisions, some of the smaller flagship stores. We don't have them in the bigger flagship stores in Europe.
But frankly, the scenario in which we could see everyone wanting to exercise a kick out in those flagship stores is so remote just to make it essentially kind of a moot question. In Asia, it's still early days over there. The leases typically in China tend to be a little bit shorter than they are in Europe or the U. S. I think with regard to new flagships and lease flexibility, based on our current plans as we said, we're not anticipating at this point adding to general duration of the leases in somewhere like China, it is in any case shorter than the U.
S. And given the relatively small number of leases we have, we haven't really got into at this point, there's a discussion about kick out provisions in those leases.
Okay. And any update on Singapore?
Yes, it's doing solidly. So in business, yes.
Great. And Mike, I just wanted to say once again, your eye for color is fantastic for the fall season.
Thank you. That's very kind.
And next we'll go to Evelyn Kopelman with Wells Fargo.
Hi. It's Maren Kasper in for Evelyn.
Hi, Maren.
Hi. So floral margins are still really strong in Europe, but the non store expenses are what are weighing on the operating margin. Is that just a factor of scale? Or is there an opportunity to reduce some of those non store expenses?
Well, the non store expenses are a combination of a few different things. If you're looking at the segment chart in the investor presentation, you've got DC costs, which are largely a function of sales over time. There's a fixed component. We've always said that DC costs in Europe will progressively reduce as a percentage of sales as we have more volume going through those facilities. Regional management is a function of store count for the most part.
Typically, there's a span of control for the regional district managers that isn't really directly correlated with volume. So there is a little bit of deleveraging of that effect when you have negative same store sales. There are a couple of the bigger pieces that go into that. Then obviously we have pre opening costs, which is outside of that. I think reading that other expense line quarter to quarter is a little challenging.
I think it's more meaningful on a sort of full year basis. But what we've generally said is we would expect that to remain on a full year basis relatively flattish as a percentage of sales. We don't expect either significant leverage or deleverage on an ongoing basis.
Okay, great. That's helpful. And then secondly, when do you think you guys have potential to begin to leverage occupancy expenses again?
I mean, I think that's really driven by comps, frankly. I mean, if we're in a positive comp environment, obviously, you can leverage occupancy. And if you've got negative same store sales, clearly, it's going to be the opposite. We do have a percentage rent component to our occupancy cost, but most of our occupancy cost is made up of fixed rent and fixed depreciation. So it's clearly a function of the sales trend.
Okay. And we ask that you do limit yourself to one question. We'll next go to Lorraine Hutchinson with Bank of America.
Thank you. Good morning. Just a quick follow-up. When you talk about comp trends stabilizing in order for you to draw down on the revolver, does that mean turn positive or just not getting worse?
I think it's a belief that I mean, I don't want to overpass this, but I think it's a belief that things aren't getting worse primarily and therefore that and that we have a comfort factor that the trend stabilization that we're looking at when we make that decision is one that we think is sustainable. And that entails obviously not just seeing a few weeks, but seeing somewhat longer period of stabilization or improvement.
Okay. And then my question revolved around the cannibalization analysis that you did when you were originally rolling the stores out. Where do you think it went wrong in trying to predict the cannibalization? And do you feel like you have a good enough handle on it now to be opening 30 more Hollister's internationally over the next year or so?
Well, first of all, I think the premise of the first part of the question that we went wrong is not one we would agree with. I think we've it's obviously hard to begin with to project those things. When we opened a store in Oberhausen, it was tough for us to know whether people were driving 100 miles or 50 miles to come to the store because the brand was so appealing. So it was tough to gauge. And I think there was probably some opening surge in any case around those stores.
But more importantly, when we've gone back and looked at all the stores that been cannibalized and looked at whether within hindsight we would still have opened them, there's probably 1 or maybe 2 that we might not have opened because they wouldn't have met our overall return. So it's not as if in retrospect it led us down a path that we wouldn't have gone down. Going forward, we are able now based on the patterns we've seen in certain discrete catchments like in, for example, the Frankfurt area or obviously around London or even in somewhere like Manchester where we have 2 stores that are pretty close together in the U. K, we now have a pretty good read on that. And in every store we approve today, we put in a specific assumption of the cannibalization of existing stores and looking at the incremental return that store generates both in terms of the 4 wall margin, but also in terms of the overall store level ROI that we talked about earlier.
So I think to some degree it's natural. When the brand first got to Europe, it very hot. People were probably going out of their way to get to the store to find it or I mean, their friend go there over time as it becomes more available than some of those existing stores probably that had some cannibalization. There's no great surprise about that. But fundamentally, it doesn't I think change the economics of what we've been through.
And let me add to this. Our discipline is really strong. To look at Hong Kong, where we just stated what the flagship is doing, we also have an immensely successful store and Festival Walk is one of the highest volume Hollister stores in the fleet. We are not we are going to open one more store in Hong Kong and that's this month in Causeway Bay, but that will be it in Hong Kong. So with the size of that business and enthusiasm for our brands, we're very disappointed about calling it a day at this point.
Okay. And next we'll go to Kimberly Greenberger with Morgan Stanley.
Good morning. Mike, I'm wondering if you can just talk to us about the international pricing strategy. I know last year you felt like you had potentially overreached on price a little bit and you've been taking pricing down early this year. Do you feel like you found the right sort of level on pricing in international stores? And then Jonathan, I'm wondering if you can just help us with U.
S. Versus international comps by quarter last year. I would assume that the international comparisons get a little bit easier as we progress through the second half of the year. And if you just have the transaction metrics here for the Q2 that you just reported that would be great. Thanks so much.
Let me comment on international pricing and first flagship and then Hollister. What I believe I said was that we felt we might have stretched the flagship prices too high. We have reacted to that and lowered the mix in flagship track that flagship AUR to the business. I believe that the slowdown in those stores has been really macro related primarily. They're stores, I'm really not sure that the result is going to be dramatic.
The Hollister AURs are very comparable to last year.
Kimberly, on the second part, just to take some of the pieces of that. I think we said on the U. S. That the and this is off the top of my head that these numbers may not be exactly right, but I think we said high single digits for U. S.
Stores through the 1st 3 quarters of last year and then approximately flat I think in the Q4 of last year I think is what we've said. With regard to Hollister Europe, we were up in the 20% plus range through the 1st 6 months of last year. That then moderated into the single digits in the 3rd 4th quarters of last year and then turned negative in 2012. The flagship's trend declined a little earlier than Hollister. We started to see the first signs of that in the Q2, although really predominantly in August, but it didn't really become clear until the Q3.
And then the factors were negative from the Q3 onwards in 2011. And then they've been more negative through the first half of twenty twelve than Hollister.
And Jonathan, just on the transaction metrics in the second quarter?
You're asking for a recap, Kimberly, or some
AUR Is that in the presentation?
On AUR for the second quarter.
Yes. For the second quarter, I think we only gave some information on the go forward for the AUR.
Yes. We didn't specifically call that out. But I think again, Brian correct me if I'm wrong, I think it was roughly flattish for the slightly down for the U. S. Chain stores in the Q2.
That's correct.
And next we'll go to David Glick with Buckingham Research Group.
Good morning. John, just a question about the tax rate. I mean clearly the international business is still very profitable, yet the corporate tax rate is back toward more historical levels before you had a more profitable international operation. Can you help us understand why that's the case and how we should think about the tax rate going forward?
Sure, David. There's kind of a 32nd answer to that question and then there's like a 2 hour one.
I'll take the 32nd.
32nd. I mean essentially we have the underlying profitability, the economic profitability of the operation which is obviously still very strong. Then what happens though is of our central overhead for tax purposes gets pushed out to the international operations, so our home office cost here. And that's primarily based on sales, how that gets allocated for tax purposes. So as international has grown as a proportion of the sales for tax purposes, more of our central overhead for tax purposes gets moved to international and that therefore Okay.
And moving on, we'll go to Robin Murchison with SunTrust.
Okay. And moving on, we'll go to Robin Murchison with SunTrust.
Hi, good morning. Thank you for the color and visibility. Question, what is the approximate number of stores needed to maintain critical mass in the kids division? And then as you look at are you looking at any merchant design team changes relative to any or all of the brands? Thanks.
Okay. I guess on the first part, Robin, I mean that's something that we clearly feel we have critical mass with the store count we have today from a buying standpoint. And certainly within the plans that we made for store closures, we don't anticipate that changing that position. So we're not going to take the overall store footprint to a level where we would start to lose leverage from an average unit cost standpoint.
Okay. The merchant design changes, any?
None that we're discussing at this point. We're constantly evolving that staff. I think the most important point is we have arguably the strongest merchant and design teams in the business and we're very pleased with them. They continue to perform.
All right. Next we'll go to Liz Dunn with Macquarie Capital.
Hi. Thanks for taking my question. Just a follow-up to the stores question. A lot of higher end brands sort of have a kind of 300 store opportunity in the United States that they talk about and some are above that such as Coach. I'm just curious as to your perspective on why the Abercrombie and Fitch brand doesn't have that sort of potential scale and now we need to close stores in that brand?
And then also I appreciate your careful management of the brand aesthetic over the years and obviously that's led to some longevity for the brand. But how do you do you think at all that that sometimes constrains your ability to chase emerging trends as quickly as your competitors? Thanks.
I guess on the first part, I mean, I think obviously our demographic is somewhat different than someone like a coach. We obviously can't speak to anybody else's store count plans. We look at it based on the economic performance of those stores we're in today. And the stores that are marginal or we think are declining relative to the chain, in many cases they're in malls that where the malls are declining. So we certainly wouldn't want to keep open a store if it's not doing well today and the mall itself is declining.
We are generally in malls only, which may also account for some of the difference with some of those other brands you're looking at. But I don't think we can really talk about anything beyond how we look at it and the economics of the stores that we're focused on closing versus the ones where we expect to keep open because of their performance. To answer your
question, Liz, about whether our aesthetic prevents us from chasing a trend as fast as our competitors, I don't think that's the case. I think we might we have a point of view that we chase trend that is appropriate to our aesthetic, but there is plenty of trend out there that is appropriate to our aesthetic.
And next we'll go to Brian Tunick with JPMorgan.
Thanks. Good morning guys. Good morning. I guess one question for Mike. If you could just elaborate on your comments about the improved trend you've seen over the past few weeks.
Is that both in the U. S. And in Europe? Obviously, there was some noise around the Olympics. And then maybe, Jonathan, some more color on the gross margin expectations for the back half.
Just maybe help us feel more comfortable what you've baked in domestically again when we see A and F doing all denim $39 last week, American Eagle is now priced under $30 How much have you assumed that it gets very competitive in the back half? We understand you get the cotton back, but just trying to understand what you've assumed in your guidance for the full year on the gross margins really more domestically?
Okay, Brian. By the way, I missed June Roosevelt Field a week ago.
I'll see you soon.
Okay. The answer to your question is that comp sales have improved for both U. S. And international. However, it's too early to say this represents a decisive change in the trend.
As we found during the Q2, the comp sales can be volatile. We'll know we think we'll know more over the next several weeks. But for now, we're not counting on an improved trend, but we remain hopeful.
Brian, on the second part of the question, as Brian, I think, referenced in his comments, we are planning for AURs in U. S. Chain stores to be flat to slightly down for the balance of the year, which is a little more conservative than we had indicated back in May. Obviously, we're up against a very aggressive promotional period, particularly in the Q4. So at this point, we think that's a reasonable assumption.
The other key drivers are obviously the average unit cost is the biggest help to gross margin year over year. There's that reserve effect that Brian alluded to earlier, which is also helping to some degree. And then international mix, where we also have lower AURs baked in year over year for the international stores.
Okay. And we'll take our last question from Anna Andreeva with FBR.
Great. Thanks so much. Good morning, guys. I was hoping you could parse out some of the gross margin decline for the Q2 down 100 basis points. It's actually a little better than what we would have thought given all the promotional activity.
So what was AUC versus ForEx? And then looking into the Q3, you mentioned bigger expense deleverage. So how should we think about stores and distribution expense? I think it was up about 8 percent in dollars year over year in the Q2. Should we think about a similar type of increase in 3Q and similarly on MG and A?
Okay. Thanks. I guess on AUC, Anna, it was flat to slightly up for the quarter. The turning point was sort of midway through the quarter. So in terms of what we actually sold, it still skewed a little bit up on a year over year basis.
I don't know if we've called out a specific FX impact on gross margin. We haven't specifically broken that out. I think one of the reasons it was probably better than you might have anticipated really goes back to that point that we've been focused on trying to work through the inventory, kept it on the floor a little longer and that probably has to some degree impacted the sales trend. But we did focus on trying to hold the gross margin rate as we work through the season. Brian, do you want to comment on the other pieces?
And the question was about increased expense to leverage in Q3. Any additional detail we can give?
I think part of it is some of the incremental expenses that we're going to see around our CRM programs, which will be incremental in the Q3 in addition to some of the marketing initiatives we had discussed as well related to primarily related to China.