Welcome to the third quarter 2014 Crocs earnings conference call. My name is Jeanette, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Please note that this conference is being recorded. Later, we will have a question and answer session. I will now turn the call over to Brendon Frey. Mr. Frey, you may begin.
Thank you. Thank you everyone for joining us today for our third quarter 2014 earnings conference call. After the close of the market, we announced our third quarter 2014 financial results. A copy of the press release can be found on our website at crocs.com. We would like to remind everyone that some information provided in this call will be forward-looking and accordingly are subject to Safe Harbor provisions of the Federal Securities law. These statements include, but are not limited to, statements regarding future revenue and earnings, backlog and future orders, prospects, and product pipeline. We caution you that these statements are subject to a number of risks and uncertainties described in the risk factors section of the company's 2013 report on Form 10-K, filed on February 25th, 2014, with the Securities and Exchange Commission. All actual results could differ materially from those described on this call.
Those listening to the call are advised to refer to Crocs' annual report on Form 10-K, as well as other documents filed with the SEC for additional discussions of these risk factors. Crocs is not obligated to update these forward-looking statements to reflect the impact of future events. The company may refer to certain non-GAAP metrics on this call. Explanation of these metrics can be found on the earnings release filed earlier today and on our investor website, once again, at crocs.com. Joining us on the call today are Andrew Rees, President, and Jeff Lasher, Senior Vice President and Chief Financial Officer. I'll now turn the call over to Andrew.
Thank you, operator. Good afternoon, and thank you for joining us today. We are committed to an ongoing and open dialogue with investors about our company's performance. We're glad for the opportunity to share this update and take your questions. Today, we're sharing our third quarter financial results. We're in the early stages of implementing a series of strategic initiatives that we are confident will drive improved growth and profitability. Our third quarter revenue increased by $14 million, or 5%, to $302 million. Income from operations for the quarter on a non-GAAP basis, excluding non-recurring and special items, was $18.6 million, compared with $21 million in the third quarter of 2013. Our top-line results were in line with the forecast we shared with you in July as we continue to achieve modest top-line growth globally.
That said, our business faced various challenges during the quarter, which represented the continuation of trends seen earlier in the year. Notably, weaker results in our China wholesale and retail business, which impacted our performance in Asia. This was offset by strong sales growth in Europe and improvements globally in our internet and wholesale channels. Jeff will share details in a moment. I want to give you an update on our four key strategic initiatives for the company that we outlined in July, where we are making meaningful progress on all fronts. To remind you, these four initiatives include, one, rationalizing our product line and merchandising approach. Two, focusing our global efforts and investments on six key countries that deliver 75% of our revenues. Three, getting the right people in key roles as we simplify our organizational structure. Four, making significant changes in the way we distribute our product.
Let's take these one at a time. First, we've been rationalizing our product line so that we can focus on our core molded product while developing more compelling casual footwear platforms. We need the right products to drive growth while eliminating SKU proliferation and non-core product development activities and investments. Since early this year, we have discontinued the Crocs Golf business, closed Ocean Minded as an independent brand, and consolidated its key products into the core Crocs line. We've eliminated 30% of our style color combinations from the fall Holiday 15 line while in development. Michelle Poole, who joined the company in July, is leading this effort.
Our current focus for fall Holiday 2015 is developing powerful product stories, including Fuzz Luxe, a collection of clogs, boots, and flats, which our customers know and love; Fast Forward, a product story inspired by active casual products; and Flat-Out Fun, a range of fashion flats that combine great style and comfort for our female consumer. Second, we're well underway in sharpening our focus on key countries that are important drivers of Crocs' future growth. As you know, we've seen tremendous growth in China in recent years, and it remains an important market that holds great potential for our brand. As we indicated during the quarter, we began to see a deceleration in our China business that impacted performance and results. Our retail comps were down double digits, and our wholesale partners were under similar pressure.
Jeff will share the details, including a reserve for doubtful accounts during this quarter. As part of our comprehensive business review, we installed new leadership in China with the appointment of Scott Yuan, General Manager for Greater China. In keeping with our overall aim of prioritizing sustainable profitability over near-term revenue growth, our intent in China is to drive a strategic shift from opening partner doors to focus instead on our current locations and wholesale partner sell-through. This has impacted our results in Q3. We are addressing these issues and expect to right-size our inventory and channel over the next six months. In Europe, we are cautiously optimistic that the business improvements we made will continue to bear fruit. As we note in the release, our Europe revenues were up 13% during the quarter, driven by solid wholesale growth.
This is the second consecutive quarter of double-digit sales growth in Europe, and we're pleased with the progress made by Vince Gunn and his team. Next, I want to share an organizational update. I'm delighted that Michelle Poole has been named Senior Vice President of Global Product Creation and Merchandising, adding to her merchandising role, global responsibility for product design and development. Michelle joined Crocs in August. After five successful years in senior product leadership roles at Sperry Top-Sider, she also brings great product experience from Converse and Timberland. Michelle is an enthusiastic, high-energy executive with strong leadership abilities, and we are very pleased to have her on our team. Her initial focus has been transforming Crocs to a merchant-led culture with tighter product and marketing stories.
While she's already making great strides in improving our product organization and process, her real impact on our global product strategy will be seen at the beginning of 2016. I want to welcome Bob Munroe as the new General Manager of the Americas region, the largest of our four regions and one where we have significant opportunities for improvement. Like Michelle, Bob is an experienced footwear executive. He has 11 years at Reebok in a variety of leadership roles, including Senior Vice President and General Manager for North America, and most recently, President of the Reebok brand. He brings strong leadership and a keen focus on optimizing performance in North American wholesale accounts. The fourth and final area I want to touch on briefly is improving performance and reducing costs in our distribution channels.
We said in July that we intended to close 75 to 100 Crocs branded retail stores around the world. We are on target to meet that goal. We closed 31 during the quarter, bringing our total to 78 year to date. We plan to close 25 to 30 in Q4. In addition, our near-term closure of nine international e-commerce sites in smaller markets will be completed by the end of the year. Jeff will share details on store closures and anticipated short-term impact on revenue growth. As we constructed future plans, we're very focused on growing our top six markets, including the U.S., Japan, China, South Korea, Germany, and the U.K., which account for 75% of our revenues.
Given the timing of our quarter end relative to the market-based booking windows, we have determined that backlog information we have historically provided does not consistently provide an effective measure of the future trajectory of our business. Therefore, we plan to discontinue the reporting of this measure. However, I would like to give you visibility into what we are seeing for our spring/summer 2015 season on a region-by-region basis. First, in the Americas wholesale, spring/summer bookings are meeting our expectations in the U.S. We project that our wholesale volume next season will be essentially flat to our realized volume in 2014. Second, at present, our Europe bookings in total are up mid-single digits with strong performance relative to the marketplace. This gives us confidence that the Europe season will be up mid to high single digits.
Third, in Japan, on a local currency basis, we anticipate flat sales for the season. Finally, Asia, excluding China, is up single digits across the region. Our China bookings are down year-over-year by roughly $20 million for spring/summer, and we believe that in aggregate, that shortfall results in Asia volume being down mid-single digits for spring. We expect our performance in China to improve in the second half of 2015. I'd like to turn the call over to Jeff to share details of our Q3 financial results and provide top-line guidance for Q4. I'll return to touch on a few challenges and opportunities we see ahead.
Thank you, Andrew. Good afternoon. Thank you for joining us today to review our third quarter 2014 financial results. I will go over the third quarter financial results of operations and projections for fourth quarter 2014 revenue. In total, third quarter revenues increased $14 million, or 5%, to $302 million compared with 2013. Looking at each region, in the Americas, performance in the U.S. wholesale market exceeded our expectation in the quarter, driving Americas wholesale growth quarter-over-quarter by 18%. We saw strong internet sales results, overall revenue was impacted by negative 3% retail comp store sales in the quarter and weaker Latin America volumes. Asia Pacific revenue was down 1.4%. Our performance excluding China was up mid-teens. Our China revenues were impacted by a high level of existing inventory in our partner store network in Q3.
This was the result of aggressive assumptions on same-store sales for the spring/summer season that influenced the amount of product ordered in the first half. As a result, our third quarter China wholesale volume declined 35% from last year. We recorded a reserve for doubtful accounts of approximately $5 million in the Asia region, primarily due to delayed payments from our partner stores in China. We have a comprehensive plan to address this. In Europe, despite the macroeconomic backdrop and challenging currency exchange, revenue was up 12.5% on a U.S. dollar basis, driven by a 23% increase in wholesale. Our business in Japan was down 5% on a constant currency basis, primarily caused by weak same-store sales and lower at-once demand in wholesale.
The decline of the Japanese yen has adversely impacted year-over-year results in 2014 and has put pressure on our overall global gross margins by about 50 basis points. Looking at our global direct channel, global retail sales grew 1% in the quarter as same-store sales were down 4.5% globally. Comps in Europe were slightly positive for the quarter, while all other regions were down. Americas was down 3%, mostly influenced by a poor July comp performance. Japan was down 8% in the quarter. The Asia Pacific region had a drop in the same-store sales in the quarter of 9%, influenced primarily by declines in China, Korea, and Hong Kong. Global internet sales in the quarter were up 9%, driven by a strong performance in the U.S. market. We closed 31 stores in the quarter. We did open 12 stores in the quarter, half of which were outlet or shop-in-shops.
We plan on closing 25-30 stores in Q4, bringing the total gross closures in 2014 to 105-110. As discussed at the end of the second quarter, we expect store closings will reduce annualized revenue by approximately $35 million-$50 million and reduce SG&A expense by approximately $20 million-$30 million with an insignificant impact on net income. The acceleration of store closures is impacting our projections for revenue growth in Q4, as we are forecasting flat overall retail revenue in Q4. With regards to units and ASP, unit volume increased 11% to just under 13.3 million pairs in the quarter. Global average selling price decreased by $1 per pair from $23.11 to $22.09. This was driven by a planned reduction in boot volume from 7.3% of revenue to under 5% as a result of product eliminations.
Clog volume in the quarter was up from 45% last year to 48% of volume in 2014. This was also influenced by declines in markets such as China and other Asian markets that have relatively lower volume of clogs. Gross margins were down 190 basis points from 53.2%-51.3% compared with the same period in 2013. This was primarily the result of currency-related decline in gross margin in Japan, lower margins on new product introductions in 2014 compared to 2013 launches, and the decline in China revenue in other Asia markets, as the average margins in those markets are higher than the global average. Sustained weakness in the JPY, EUR, and other currencies compared to prior year will further affect our global margins in Q4 and 2015 as our cost of product is tied to the U.S. dollar. Excluding one-time items, our core SG&A expenses declined.
This reported SG&A includes bad debt reserves of $5 million and SAP expenses of $4.1 million. In addition, we experienced several charges, including restructuring charges as a result of transition activities and accelerated depreciation of assets for retail stores that are part of closure plans. We expect future corrective actions to result in additional restructuring charges as we start executing on a profitable revenue growth strategy. Operating income on a GAAP basis was $1.1 million in the quarter, excluding cash expense of $12.5 million, primarily related to restructuring, ERP implementation, and non-cash charges of $4.9 million, primarily related to store closure costs and accelerated depreciation. Our non-GAAP operating income was $18.5 million compared to $21 million in 2013. The difference on a year-over-year basis can be explained by the increase in allowance for doubtful accounts in Asia that exceeded $5 million.
Our press release filed today provides a complete reconciliation of all special items. For the quarter, we booked an income tax credit of $15.7 million. Recently, we concluded an audit of the historical USA income tax filings. The result of this audit was an elimination of a reserve for uncertain tax positions, commonly referred to as FIN 48 reserves, of $10.5 million. The balance of the credit reflects our change in income year to date. Our normal tax rate has been and continues to be impacted by the deductibility and timing of SAP expenses, restructuring, and asset impairment charges. Earnings per share in the quarter were $0.12 on a GAAP basis and $0.30 on a non-GAAP, fully diluted basis.
On a year-over-year comparable basis, excluding the overall impact of the preferred share issuance in January, non-GAAP EPS is $0.39 per share compared to $0.18 per share last year. It is important to understand the pieces that make up the GAAP EPS calculation, including the impact of preferred stock investment in January of this year. GAAP net income for the quarter was $15.8 million. Dividends and dividend equivalents of $3.8 million related to the Series A preferred stock were deducted from this amount, leaving GAAP net income for common shareholders of $12 million. An additional $1.7 million was deducted from the $12 million as undistributed earnings related to the preferred stock, leaving $10.3 million for common shareholders. Common stock weighted average shares used in EPS calculations was 85.4 million shares.
Finally, we repurchased approximately 2.9 million shares at an average price of $14.74 for an aggregate investment of approximately $43 million, excluding related commission charges. Year-to-date, we have repurchased approximately $90 million worth of common stock. This reduced our outstanding common share count to 84 million shares at the end of the quarter. We will continue to be patient, methodical, and opportunistic in the execution of this buyback plan. We ended the quarter with $350 million of cash on the balance sheet. Our increase in inventory and accounts receivable are directly correlated with the business conditions in China. We remain in the testing and development phase of our ERP system implementation. We went live with SAP in Australia on April 1st without significant issues. On July 1st, we went live in Japan, again, without significant issues. Both locations successfully closed the quarter without concern.
A successful global ERP system implementation is our top short-term operational priority, as we will launch SAP in the remaining markets during Q1 of 2015. We expect GAAP revenue of approximately $200 million-$210 million in the fourth quarter of 2014 as we address the issues in China, close retail stores, focus sales activities on key product stories, and anticipate flat same-store sales in the U.S. and Europe. In addition, as mentioned, the above revenue includes the effect of stronger U.S. dollars, which will impact our revenue by 3% in Q4. Specifically, currency rates assumed in our projections are $1.28 to the euro and JPY 107 to the dollar. I will now hand the call back to Andrew for some closing comments before we take questions.
Thank you, Jeff. In July, we laid out a clear, action-orientated plan for driving improved performance at Crocs, focused on products, prioritizing our most important geographic markets, people, and points of distribution around the world. Over the past 90 days, we have made significant progress in each of these areas. Obviously, we have much work to do in order to unlock the power of the Crocs brand and deliver consistently better results to our shareholders. We'll be finalizing the location for our new global commercial center in the Boston area. We'll keep working to focus our product line on core molded products and casual footwear, creating powerful product stories. We anticipate exciting news related to marketing strategy for 2015 and beyond. Now we look forward to taking your questions. Operator, please open the line.
Thank you. We will now begin the question-and-answer session. If you have a question, please press star then one on your touch tone phone. If you wish to be removed from the queue, please press the pound sign or the hash key. If you're using a speakerphone, you may need to pick up the handset first before pressing the numbers. Once again, if you have a question, please press star then one on your touch tone phone. Our first question comes from Erinn Murphy of Piper Jaffray. Please go ahead.
Great. Thank you. Good afternoon. I guess first I wanted to focus a little bit on the Asia Pac region and just dig into a little bit more on the pressure that you guys have been seeing in China. Could you just talk about when you started to see the inventory build and how long you think it's going to take to kind of work through some of the inventory there, particularly given that you've just made a management change on the ground there?
Thanks, Erin. Appreciate your question. We first started to see our business in China, from a takeaway perspective, softening in the early part of this year. We saw it within our own retail stores, also within our partners. I think the issues built up because neither our partners nor ourselves anticipated that slowdown. When we ordered the spring inventory, we anticipated significant growth. With a growth in merchandise receipts and a slowdown in takeaway, we saw a buildup in inventory, which accumulated through the spring-summer season, and you can start to see it in our inventory levels at the end of Q2. In terms of addressing it, we have slowed down dramatically sell-in to our partner store operators, to our distributors. Already, we're continuing to work with them to work through their inventory in the fourth quarter of this year.
As you're aware, that's a smaller quarter for us in the China market. We think that'll continue through the first two quarters of 2015.
Okay. Maybe along that line, I think, Jeff, you had mentioned just before, as you wrapped up your comments, that the comp assumption for fourth quarter for both U.S. and Europe was flat. Could you just add a little bit of context for how you're thinking about the comp assumption in the Asia Pac region as well as Japan in the fourth quarter?
We think the influence of Japan and the Asia region will bring our overall comp performance to about -2% for the quarter. That's what we're forecasting internally right now.
Okay. That's helpful. Thank you. Just bigger picture, as we start to just refine our models for next year, understanding that the gross margin in particular came in lighter in the third quarter, just help us think about some of those drivers for the gross margin, both from a headwind as well as tailwind perspective, given that we've kind of got a confluence of both.
Yeah. Thanks, Erinn. I think if you look at our headwinds associated with gross margin, obviously, the global currency markets continue to put pressure on us as we buy in U.S. dollars and we sell in local currency. That's a significant influence on some margin pressure for us. We, as well as other players within our space, will be impacted by cost changes within China and additional social insurance issues that we're seeing in our factory cost. Overall, we think our supply chain can run more efficiently next year as we decrease the number of product styles that we're carrying and really focus our attention on the core molded heritage line that we have. That'll help us in the other cost of goods sold, providing some tailwinds, going into 2015.
Should we anticipate any of the SKU rationalization progress that you've made as it relates to the fall 2015 line to be as a tailwind for the second half, or how do we think about that component?
Yeah, it'll be a slight tailwind for the second half of 2014. Obviously, of both 2014 and 2015. The currency market's also, you've got to consider into fall holiday for next year as well.
Okay. I guess just the last kind of bigger picture question as we think about the margin. I guess first, Andrew, for you, should we still be thinking about a 12% kind of intermediate goal from an operating margin perspective? Just from the SG&A component of the former question, just how do we think about some of those headwinds and tailwinds for SG&A as we build towards that, in theory, that 12%?
Yeah. Thanks, Erinn. Very much, we think we're still on track for a 12% operating contribution in the intermediate future. As we think about the restructuring plan that we've laid out, I think we're very much on track with SG&A reductions, with putting the right people in place and focusing on the team, as well as driving strategic focus around the business. As we look forward to 2015, even with flat revenues or a modest increase in revenues, some stabilization of margins, with the reduced SG&A, reduced working capital, we see strong performance in terms of cash from operations returning to our historic levels. We think that positions us well for some significant growth in 2016 and beyond, which will, as we laid out before, drive to our 12% contribution.
Great. That's helpful. I'll let someone else jump in the queue. Thank you both.
Thanks, Erinn.
Our next question comes from Jim Duffy of Stifel. Please go ahead.
Thanks. Good afternoon. Couple more questions around China. Inclusive of the partner doors, guys, how many points of distribution do you currently have in China? What's your visibility to inventory with those distribution partners?
Thank you, Jim. We have about 50 of our own doors, there are about 700-750 partner doors, so about 800 points of distribution in total. I'd say we have increasing visibility to the inventories in our partners. One of the things we've been focusing on very strongly as we've been helping them deal with their inventory levels is getting a much better visibility to their inventory. We're more able to focus in on a distributor-by-distributor basis. Most of our distributors are regional in nature. They have the right to distribute in a given province or part of a given province and cities. So we've been really working hard with them to understand their inventory levels and put in place the right incentives to work them down.
The slowdown and takeaway, as you characterized it, is that concentrated in any particular product categories or styles? I guess a key question from where we sit is how do we know this isn't a Crocs brand issue rather than some temporary inventory imbalance?
We see the majority of the impact, Jim, to be broad-based in terms of across the merchandise that we're carrying in those stores. We attribute a lot of it to the slowdown in the Chinese consumer. We've looked at it geographically. We cannot see significant patterns across the country. We've looked at it across our different distributors. We see it really as fairly broad based. I'd say there are one or two styles that are weaker than others. We've put in place programs to try and address that. The majority of it is really broad based.
Okay. Thank you. Jeff, can you provide the regional split of operating income for the quarter, or will we need to wait for the Q on that?
Just give me a minute, I'll pull it up. When we look at, well, we gave you the channel revenues on an overall basis, right? You just want to get the operating margin on an overall basis?
By region, actually, yes.
Right. Well, we're going to have the queue come out tomorrow, that will have all in there. On a basis for the Americas operating in total, we had about a 9.7% increase in revenue. You'll see the operating income tomorrow, Jim. I don't want to read these figures off, but we'll get those out to you tomorrow.
Fair enough. Last question is on the SG&A, just looking at it on a year-to-year basis, even adjusted still up year-to-year. With the restructuring, I guess it's my expectation we'll start to see some progress there. Are we near to the point where we'll see adjusted SG&A down on a year-to-year basis?
As we think about next year and going into next year, we'll have some headwinds and some tailwinds associated with SG&A. When we look at next year, we're going to be focusing our attention on marketing as a company and increasing our marketing cost about 1% of sales overall as we go into 2015. On the other side, as far as tailwinds that we think about for next year, we see some improved SG&A expenses associated with the restructuring efforts that we've taken place all year long, the elimination of products, the focus around our distribution channels that make sense, and the geographies concentrating in the five geographic markets that we compete in most effectively and really tightening our resources around that. As far as other kind of headwinds for next year, we do have some variable compensation headwinds going into next year.
In total, we're heavily focused on our SG&A line.
Okay, thanks.
If you, Jim, if you back out the bad debt that we highlighted, I think our run rate in the Q3 period was actually down last year.
Okay. Thanks.
Go ahead.
Our next question comes from Scott Krasik of Buckingham Research. Please go ahead.
Yeah. Hey, everyone. Thanks for taking my question. Just a couple questions here. In terms of the Americas wholesale growth this quarter, did you have any type of new channel distribution that may have impacted? Because your gross margins, even with some of the currency stuff, was below our expectation. What's your outlook for the next couple of quarters on gross margin?
Scott, thanks for your question. With regard to the U.S. wholesale business, obviously, we experienced some significant growth there. No significant new accounts or new channels. Although within that number, we were dealing with the closure of both our golf business and the shuttering of Ocean Minded as a distinct brand. We had some inventory that we had to deal within that number. That accounts for some portion of the margin impact in North America. I'll let Jeff take the broader question around what do we see for gross margins in the future.
Thanks.
Thanks, Scott. I think, again, when we look at our headwinds, tailwinds associated with gross margins, our pricing models did assume a more favorable currency exchange. That's an important thing to remember. We will see a little bit of liquidation activities in Q4 associated with some styles and brands we'll be getting out of, namely Ocean Minded Golf and some other things we talked about on the call today. There'll be some downward pressure on our gross margins overall. As we look into 2015 with our tighter focus around product styles that make sense for us, both from a profitability as far as individual styles as well as revenue growth opportunities, we think we'll have some tailwinds as we go into the later parts of 2015 from our focus in the merchandising group.
Just going back to Jim's question about brand stability. What are you seeing, or how do you feel about Europe in particular? You've sold in a lot of products. Your comps aren't that strong. You're assuming they're going to be flat this quarter. I think it was pretty warm in September in Europe. How do you feel about the brand in Europe? Could we be heading towards a China situation next year?
Scott. Good question. The way we think about it, yes, our comps haven't been that strong in our own stores. In terms of the size of our overall business in Europe, even with a weaker macroeconomic environment in Europe, we have a significant amount of penetration opportunity. The majority of our sales are traditional wholesale sales, so they're into large and medium-sized, well-established European retailers. Our biggest countries are Germany, the U.K., followed by France. We're not selling into a partner door type operation that we have in China. We're selling into traditional retailers that have sophisticated operations around the amount of inventory they buy, how they monitor those inventory levels, and sell through that inventory. We have no indication that our business is slowing down.
In fact, we've probably got modest indications that it's picking up and we're getting incremental traction with key wholesale partners.
Okay, that's good. Just your comment that sales would be at mid to high single digits in spring 2015 in Europe. Was that on a constant currency basis?
Yes.
Okay. Thanks, guys.
Our next question comes from Sam Poser of Sterne Agee. Please go ahead.
Thank you for taking my questions. I guess the first question I have is, were there pull-forward orders for, I guess, probably the U.S. and Europe in Q3?
No, Sam. We haven't consciously pulled forward sales in either Europe or the U.S. in Q3 from Q4.
I would assume you're not expecting the wholesale business in the fourth quarter for either to be as strong as they were in Q3. Is that a fair statement?
I think when we look into Q4 for 2014, Sam, we've got a number of headwinds I'll go through. One is, that our China business on a year-over-year basis will be down about $11 million. That represents about half of our forecasted decline on a year-over-year basis. As we talked about earlier in the year, and then throughout the year, in conversations with the analyst community, we've been very open about the South America challenges that we've seen. Obviously, as they come up upon their summer period, in South America, that's a revenue impact, and that's about a quarter of our overall decline on a year-over-year basis. Then, finally, I sound like a broken record today around currency, but that's impacting our fourth quarter revenue projections as well.
That's pretty much the three components that go into the fourth quarter revenue projections.
Thank you. Just to go back to gross margin. Last fourth quarter, you were down 240 basis points. Given all of the moving pieces, do you expect to be down as much as you were in Q3 in the fourth quarter or slightly less just because the comparison is much worse in a sense?
Well, as you know, our gross margins are very seasonal in nature as we come up into the higher cost, fourth quarter with a lower level of revenue to cover our cost of goods sold outside of the product cost period. That'll be a headwind as well into our gross margins overall. As I mentioned when we were talking about gross margins earlier, we'll have some impact in the fourth quarter associated with currency and the liquidation of styles that we're no longer carrying into 2015. Those are really the three kind of components as you think about our fourth quarter gross margins.
Would you expect it to be down 150 basis points again? Would it be in that range, higher or lower?
I think there'll be pressure downward.
You don't want to answer the question.
Well
We're trying to figure this out. We want to be able to model this properly. The comparisons are all different. They're moving pieces all over the place. Can you give us more direction than that, or you're going to get people on every different planet on the numbers here?
Sam, I think when you look at overall, the headwinds that we're going to deal with, the currency alone is probably going to be about 50 basis points-100 basis points of negative drag on us. As we look at the style liquidation, there'll be a component to that. Your particular viewpoints at 150 basis points, is probably in that kind of range. We didn't come here today to give particular guidance around gross margins going into fourth quarter.
Okay. Thank you. How much of the inventory increase is China-based? Is the majority of that problem in China right now of the 15% increase?
We think about a third of the problem is in China. We know about a third of the problem is in China from an inventory basis. There are a couple of other important elements, Sam. One was coming into this year, as a business, we felt like we were light in our core basics, increased the inventory levels in our core basics in our stores. Secondly, our internal projections around the U.S. business being stronger than it ended up being in the spring-summer season had us ordering more inventory than we've been able to sell through. About a third is in China, about a third is in North America, we've got some other impacts.
I think it's important to say we fully recognize the degree to which our inventory is higher than it should be, we have a very coherent plan to work it down this quarter, the first two quarters of next year.
Just to follow up, how should we think about that? When do you think your sales and your inventory will get in line with one another? How do you foresee that?
We are in no rush to burn off this inventory, Sam. The vast majority of the inventory that we have in excess is our core basic styles, which as you know, will sell this year as well as they'll sell next year. There's no point in us liquidating that unnecessarily. That would be counterproductive. We see the two being in line by the end of Q2 2015.
Okay. Just the 12% EBIT margin. You're going to need the revenue really to get going to get there. You're really expecting that, I guess beginning in spring of 2016, once the work of all of the new initiatives really get going. All through next year it's sort of going to be transition?
We have the most confidence around projecting revenue growth when we have the product line and the marketing to back it up, Sam, which we think will be spring/summer of 2016. We're going to make progress next year, one of the challenges with the timing of this turnaround is obviously our fall holiday season is significantly smaller than our spring/summer season. Next year, we'll make impacts in the back end of the year, but the size of those impacts were muted by the relative size of the seasons.
Okay. Thank you very much. Good luck.
Thank you.
Our next question comes from Mike Schwartz of SunTrust. Please go ahead.
Hey, good afternoon, guys. I just wanted to talk about gross margin. I know we've kind of beaten this horse dead, but just looking at maybe over the longer term, how you think about gross margin vis-a-vis the product mix, the evolution therein, and also just with the changing of your distribution model as you continue to close stores. I guess, how should we think about it? Is kind of the mid-50s the right level? Is that how you plan for the business to look in a couple of years, or is it another level altogether?
It's not dramatically off. The way we think about it in the long run, it's a good question. The way we think about it in the long run is, as you said, you've got a number of those factors. You've got channel mix changing, which has a dramatic impact because obviously if we're selling in retail at a double margin versus wholesale. We see a lot of our growth coming out of wholesale. It's much more capital efficient. It's much more profitable in terms of return on the assets that we invest. On the flip side, I think a much stronger focus around the product range, innovation, both in our molded products, which are very profitable, to drive growth in that arena, as well as growth in our cut & sew or non-molded products.
We are planning and thinking around gross margin, a longer run being in the sort of 51%-52% range.
Okay, that's very helpful. Thank you. Then, I guess we look at the tax benefit you had in the quarter. Is there a way to look at what EPS would've been excluding that kind of tax benefit? Should we see something similar in the fourth quarter?
It was all booked in the third quarter, Mike. There won't be any benefit in Q4 associated with the USA tax audit settlement. That was $10 million, so it would've been about $0.11 per share benefit associated with that tax credit.
Okay, thanks a lot. I appreciate it.
Our next question comes from Steve Marotta of C.L. King & Associates.
Good evening, everybody. I just have two quick questions. We talked a lot about the costing pressures going into 2015. Are there any opportunities whatsoever to get a tailwind to ASPs, either from new product that's being launched that's slightly higher on price point or very small incremental price increases anywhere that would be able to offset some of the costing pressures on the unit side?
Yes. We will certainly be looking very hard at pricing our products to the value that they deliver to consumers. There will be some opportunities for price increases as we look across the range. In terms of the mix, I think largely that's gonna work against us in terms of the shift from retail to wholesale. As we continue to focus and develop our product range, we're really looking very hard at what our weighted average gross margin is and planning that on a very coherent basis. We do have some products within our range that are extraordinarily profitable, and product ranges are extraordinarily profitable. If we can drive significant sell-in and take away for those products, it can have a material impact on gross margin.
Thank you. The other question I had is, you had previously mentioned in public forums that you believed after the strategic realignment, and without major sales increase, you'd be at roughly a 10% operating margin rate, and that run rate could be hit by the end of next year. Is that still in the gun sights?
I think when you look at our operating margin, in the near term, obviously we're being influenced by the events internationally, just like everybody else. That's a near-term pressure point on us. As we get out into call it TTM spring/summer 2016, we'll start to substantially improve our trailing 12 months operating margins. As we think about the business model going forward, we are really focused in 2015 on cash from operations and improving our overall cash flow as an organization. We think primarily we can improve our cash from operations by addressing our working capital needs, and a more rational approach to our inventory and accounts receivables going forward, which will reduce our need for working capital on that front in 2015. A year, in 2015, without restructuring charges, we'll return our cash from operations back to historical levels that you saw in 2013.
That's really our kind of near-term focus. In 2016, we're really focused on improving our operating margin.
One more question on the share repurchase. I believe it was the beginning of the year that there was an intimation that it would be done in a relatively quick period of time, within a couple of quarters. Is there any set deadline to exhaust the share repurchase? I know you mentioned flow improved and you'd be opportunistic, but is it opportunistic within the next two quarters, or the next three quarters, or the next four quarters? Can you put any parameters around it whatsoever?
I think when we think about the share repurchase, first of all, we almost bought 3 million shares last quarter. That was a pretty healthy pace of share purchases. As we look out into the future quarters, we continue to be methodical and patient and opportunistic in our purchasing of shares, and do it in a very patient manner to get the best possible flow of our cash back to our shareholders through the form of stock repurchases.
That's kind of how we think about it. We're not putting a specific deadline to this share repurchase program. Okay. Thank you.
Our next question comes from Danielle McCoy of Wunderlich Securities. Please go ahead.
Hi. Thank you for taking my question. I was wondering if you could just talk about some of the progress that you're having with shifting to more of a distributor model in some of the smaller international markets.
Thanks, Danielle. Thanks for joining us today. I think last quarter, we talked about the progress that we're making both in Taiwan and in Brazil. I'd say our progress in Taiwan is substantially advanced. We've moved the vast majority of our business to distributors, including passing a number of our company-owned stores or selling a number of our company-owned stores to some of our key distributors. We're still actively working on our Brazil situation. I'd say there are probably two additional countries where we're looking at a potential transition to a distributor, but obviously, these are fairly complex discussions and negotiations, and we wouldn't like to prejudice them by talking about them in a public forum at this stage.
Okay. Can you just talk about some of the strength that you're seeing in the Americas in the wholesale channel? Is it any increased shelf space at some places or new style SKUs? Talk about that a little bit.
Yeah. There's a couple of places where we're very pleased with our progress. There are one or two of the family channel retailers where, particularly Shoe Carnival, where we have a number of shop in shops that we've established over the last year. Those shop in shops have been particularly successful in terms of driving both our sell-in and sell-through. We're very pleased with the strong relationship we have with that account in general. There is also some significant strength at some key department store accounts where we've had some strong sell-in and sell-through, namely, in Dillard's and Belk have been particularly successful for us. Obviously, they're focused towards the southern part of the U.S. and particularly appropriate for our product range. Then I think the third one I'd highlight is Amazon. Amazon is a significant account for us.
They continue to grow significantly, our rate of growth with them significantly outpaces their underlying growth.
Okay, great. I'm not sure if I missed this earlier, tax rate going forward for the fourth quarter, then how should we look at it in 2015?
As we return to profitability across our overall regions and return to historical levels of profitability and then exceed that going forward, we'll return to a tax rate of 22%-25% overall from an effective tax rate perspective. The key for us is more of a balanced operating income around the globe, which really is the most tax efficient for us.
Okay, great. Thank you. Good luck.
Our next question comes from Mitch Kummetz of Robert W. Baird. Please go ahead.
Yeah. Thanks for taking my questions. Jeff, I think you said you expect to close another, was it 25, 30 stores in Q4? If that's the case, where does that put your store count at year-end? I mean, isn't that 575-580 range, or are there new stores also coming online in Q4?
We'll be down below 600. Right around that 590 mark. There's a couple of stores that are opening in Asia, nothing really to write home about. The major initiative that we're under is rationalizing our fleet going forward.
If you're at 590, I think you said that if you close 25 or 30 in the quarter, how many will you have closed since you sort of initiated this plan?
We'll be over our original target, and we'll continue to work on retail stores going forward.
Okay. Yeah, I guess that was my next question because I think the plan was originally 75 to 100 stores initially. How should we be thinking about stores on a go-forward basis, now that you've sort of exceeded the initial stages of the plan? I mean, where does it go from here?
Well, like we said, we continue to look at opportunities for opportunities for outlets and some other key locations where the brand strength really drives the economics for a retail platform. Overall, our initiative is focusing our long-term growth in revenue in the wholesale channel, specifically global family footwear channels and department stores and key independent players. That's our predominant focus. Not on growing retail stores, but we're opportunistic, I guess, on the retail storefront.
Okay. What's the timeline on the SKU count reduction? Not only just in terms of how you're reducing SKUs, but when you would expect to see that positively impacting the business. Andrew, I think you made a comment in your prepared remarks. I mean, there was something about elimination of 30% of something by fall holiday 2015. I thought you said something about just colors, but maybe you could just elaborate on that and talk about kind of where you are in the process of looking to reduce SKUs and when that kind of runs its course and impacts the business positively.
That's a great question. As we dug into and started to work on fall holiday 2015, we were able to reduce about 30% of our SKU style colors in development. The style colors that came out the back end of our development process that were confirmed in the line and that we're going to produce are about 30% less than those that were being worked on. I would say the rough order of magnitude will be about the same in terms of 30% less than the prior season. That's a significant reduction. A lot of that reduction comes from eliminating differences and duplications across the regions. Getting all of the regions on the same fundamental platform, on the same colors, and really driving efficiencies there. That was step one and if you like, the easy work.
The harder work will really take effect in spring summer 2016, which is what is the tight assortment, the line that we think is going to drive growth in revenue, but on a smaller SKU base. If we think historically, we've been around the 1,600, 1,800 range in terms of number of style colors in any given season, we think go forward will be more 1,200 to 1,400, in terms of the style colors that we go to the marketplace with.
Okay. Getting from 1,600 to 1,800 down to 1,200 to 1,400, what do you think that does in terms of margins or operating profit or however you want to look at that?
Well, there's a lot of moving pieces in that. We think it allows us to focus our organization and reduce a lot of development costs, in terms of molds, the way we work with our factories, et cetera, and the way we develop product. We think there's some opportunities for cost of goods savings from that perspective. As I talked about earlier, as you think about the long-term margins, we're really trying to balance mix shifts in terms of our channels, mix shifts in terms of our regions, rising cost of goods, the benefits of SKU focus and SKU reduction. We see as a baseline, the sort of 51%-52% range as kind of a long-term annualized margin rate.
Okay. All right. Thanks. Good luck.
Thank you.
Our last question comes from Corinna Freedman of BB&T. Please go ahead.
Oh, hi. Thank you for taking my question. You did allude to it in the press release, but I was wondering if you could give us a conservative assumption or guideline as to when you think you'll have a CEO, and maybe if you can talk about when it doesn't seem like it might be likely for 2014, but if it's a fiscal 2015 issue, is it first half, second half? Just wanted an update on the timing there. Thank you.
Thank you, Corinna. The board is actively engaged in the CEO search, and that continues. When they have news, they will make an announcement.
Okay. Thank you.