Dec 4, 2014
Executives
Judy Meehan - Investor Relations Jay L. Schottenstein - Executive Chairman and Interim CEO Roger S.
Markfield - Vice Chairman of the Board and Executive Creative Director Mary M. Boland - EVP, CFO and Administrative Officer Simon Nankervis - EVP, Americas & Global Country Licensing Michael R.
Rempell - COO Jennifer Foyle - EVP and CMO of Aerie
Analysts
Simeon Siegel - Nomura Securities Mark McClintock - Barclays Thomas Filandro - Susquehanna Financial Adrienne Tennant - Janney Capital Markets Randal Konik - Jefferies & Co. Lindsay Drucker Mann - Goldman Sachs Susan Anderson - FBR Capital Markets Anna Andreeva - Oppenheimer Paul Lejuez - Wells Fargo Dana Telsey - Telsey Advisory Group Rick Patel - Stephens Inc.
John Morris - BMO Capital Markets Neely Tamminga - Piper Jaffray Kimberly Greenberger - Morgan Stanley Jennifer Davis - Buckingham Research Rebecca Duval - BlueFin Research Jennifer Black - Jennifer Black & Associates Lorraine Hutchinson - Bank of America Merrill Lynch Marni Shapiro - The Retail Tracker
Operator
Greetings, and welcome to the American Eagle Outfitters Third Quarter 2014 Earnings Call. At this time all participants are in a listen-only mode.
A question-and-answer session will follow the formal presentation. [Operator Instructions].
As a reminder this conference is being recorded. I would now like to turn the conference over to Ms.
Judy Meehan, Vice President of Investor Relations. Thank you, Ms.
Meehan, you may begin.
Judy Meehan
Good afternoon, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Interim Chief Executive; Roger Markfield, Chief Creative Director; and Mary Boland, Chief Financial and Administrative Officer.
Also joining us for Q&A today are Simon Nankervis, EVP of Global Stores; Michael Rempell, Chief Operating Officer; and Jen Foyle, EVP and CMO of Aerie. Before we begin today’s call I need to remind you that we will make certain forward-looking statements.
These statements are based upon information that represents the company’s current expectations or beliefs. The results actually realized may differ materially based on risk factors included in our SEC filings.
Our comments today include non-GAAP adjustments. Please refer to the tables attached to the press release.
We have also posted a financial supplement on our website. Now I’d like to turn the call over to Jay.
Jay L. Schottenstein
Okay, thank you. Good afternoon.
In what continues to be a tough retail environment we delivered higher margins and earnings growth compared to last year, ahead of our expectations. Our results reflect the progress on the work that began earlier this year to strengthen our assortment and drive better efficiencies across the business.
In the third quarter we achieved 16% adjusted earnings growth. By managing the business better we were able to reduce markdown rates and control expenses.
We ended the quarter in good financial condition with a cash balance of $280 million and no long-term debt. The period overall marked a step forward.
Yet we have significant opportunity to further strengthen our business. To that end during the quarter we took restructuring charges aimed at improving the store portfolio and increasing efficiencies at our corporate office.
We will continue to close less productive brick-and-mortar stores as our leases expire while selectively pursuing new openings. We are reducing corporate overhead expense, eliminate redundancies at the home office and we are in the process of consolidating office space.
The work will continue. It’s aimed at making us more profitable, more efficient and will enable us to invest in areas that will fuel future business.
As I said at the beginning of this year we need to bring fun and innovation back to our company. I think we made headway on this front.
Our marketing events and lease volumes are more compelling; our stores both AE and Aerie reflect higher energy, stronger outfitting ideas and improved color pallet and overall better merchandising. This is an ongoing effort as we strive to continuously stay connected to our customers and build a better brand experience.
We have a solid foundation on which to build. Our brands are well positioned in today’s marketplace.
We will stay true to the AE heritage lifestyle while continuing to increase our speed to market and improve the customer shopping experience across stores and digital channels. Aerie has been a standout performer.
They have achieved positive comps and stronger profitability which has continued into the holiday season. We have a highly capable team led by Jen Foyle.
Now we need to keep the momentum going as we evolve the assortments and further expand the Aerie brand. On the technology front we continue to drive advancement in Omni-channel.
Approximately 15% of digital sales are fulfilled through our ship from store capability which is now in about 530 stores. We’ve seen faster merchandise shipping times and better inventory utilization.
BOSS will expand to all stores next year. We also look forward to launching reserve online, pickup-in-store, providing additional shopping alternatives for our customers.
We’re also seeing benefits from our new distribution center which is cutting our average delivery time in half. We continued our global expansion strategy.
In November we opened three new stores in London to an encouraging customer response. We will selectively pursue new growth opportunities while staying focused on strengthening our brand domestically.
I am pleased with how the teams are executing our vision and managing the day-to-day business overall. We’ve done a good job at operational challenges.
For example we successfully managed through the West Coast port slowdown with no major disruption to our holiday flow or cost increases. Although we’ve made progress this year we continue to face weak traffic in a highly promotional sector.
In addition as we cycle against our own of history of heavy promotions it’s been difficult to achieve consistent sale performance. Our strategy has been to maintain price integrity by reducing promotional activity.
We strongly believe this is the right approach. We’ve seen some success yet have plenty of room for improvement.
It goes without saying that this is made possible only with great merchandise, the right balance of quality and value, strong inventory controls and engaging customer experience, all major priorities as we move forward. We must continue to challenge ourselves in all fronts.
At the same time we need to continue to bring operating expenses down, deliver stronger profitability. Thanks and now I will turn the call over to Roger.
Roger S. Markfield
Thanks Jay. Good afternoon to all.
This season marks good progress, although we continue to face significant headwinds. As Jay said we’ve been focused on improving the customer experience in elevating our merchandise assortments.
For today’s consumer we are executing an updated lifestyle brand experience that is true to the heritage of American Eagle Outfitters. To be clear this is finding the right balance between new fashion and updated key heritage looks.
We are uniquely positioned as the casual youthfully optimistic American inspired lifestyle brand, which ranks high among our customer base. The emphasis we place on being true our brand image is a very important distinction from how we have operated in the recent past.
And in my view it's the change that when executed well will successfully lead us into the future. Now let me take a step back and review the third quarter.
Although sales declined slightly in a really tough retail environment we saw improvement from the first half. As we said on the second quarter conference call lowering promotion activity was a major priority.
We delivered on this priority and saw our merchandise margins rise over 300 basis points. This was driven by better merchandise, stronger inventory controls and more strategic marketing events.
Consistent with our strategy we did not anniversary 20 days [ph] of 40% off the box promotions hold last year. While mall traffic continued to be a challenge our more disciplined pricing strategies helped spur earnings increase and the average transaction value, driven by a higher average unit retail price and strong units per transaction.
To underscore what Jay said our greatest opportunity is to curb promotional activity while delivering sales improvements. On the last call we also talked about supply chain efficiencies, fast tracking and planning our inventories conservatively.
This was achieved with quarter ending inventories in good shape and below last year. We continue to drive inventory productivity and improved inventory churn from last year.
During the quarter we chased the strong sellers much more effectively, including sweaters, joggers and denim. We made a strategic decision to improve product quality through the use of better fabrics and incorporating new washes and treatments.
Essentially we've added more of the special details we were missing in recent seasons. Our recent launch of AEO Denim X is a great example of innovation in a key heritage category.
The response has been very positive and is an example of how we need to deliver newness across the business. We've seen strength in women's sweaters and men's and women's bottoms.
Some of the more challenging categories include men's and women's tee shirts and pleats. As a category overall, denim held up extremely well, exceeding our plans and delivering higher margins.
Newness in non-denim bottoms such as joggers and jeggings and leggings achieved strong double digit comps and mostly offset the slight declines we experienced in denim. We continue to work on broadening our offerings, putting more emphasis on accessories, greater gift giving and unique opportunities like American Eagle Outfitters, an example of fun and innovation.
Aerie has continued to deliver strong results with positive comp sales and a significant increase in profitability. I'm extremely pleased with the direction of Aerie.
Strong performance has continued in this business and the team has done a nice job expanding categories, strengthening assortments and leveraging our AE customers. This holiday season the stores look great with an emphasis on gifting, strong colors and exciting new trends in soft dressing.
I congratulate the team and look forward to continued success and further expansion of the business. Although we've made good progress against our priorities our margin rates are still well below our goals.
As we continue to strengthen the assortments and drive innovation across product, marketing and customer engagement we expect to see continuous improvement. I'd like to thank the teams for their hard work.
Wish you all happy holiday, and I now I turn the call over to Mary.
Mary M. Boland
Thanks Roger. Good afternoon everyone.
Despite ongoing macro pressures and weak mall traffic our third quarter performance exceeded our expectations. While sales were essentially as expected we effectively reduced markdowns and controlled expenses compared to last year.
This led to adjusted year-over-year earnings growth of 16%. Now looking at the details of the quarter, total revenue declined slightly to $854 million from $857 million last year.
Consolidated comparable sales declined 5%. By brand, AE comps were down 6% and Aerie increased 3%.
On a consolidated basis the number of transactions decreased due to declines in traffic. However as a result of reduced markdowns and a change in promotional strategies the average transaction value increased in the high single-digit driven by mid-single digit increases in both average unit retail and units per transaction.
Additional sales information can be found on page eight of the presentation. Total gross profit increased 17% and as a rate of revenue rose 200 basis points to 36.9%.
The margin improvement was driven by reduced markdowns and was partially offset by 120 basis points of buying, occupancy, and warehousing deleverage. SG&A expense of $205 million declined 1% from $206 million last year.
As a rate of revenue SG&A held flat to last year at 24% despite negative comps. We were pleased with good expense management driven by reduced overhead and variable expense, partially offset by continued investments in new stores and international expansion as well increased incentive expense accruals.
Depreciation and amortization increased to $37 million deleveraging 40 basis points, due to Omni-channel and IT investments, new factory and international stores and the new fulfillment center. On a non-GAAP basis our tax rate was 42.4% in the quarter reflecting reserves against international start up.
Adjusted operating income grew 22% to $74 million and the operating margin expanded 160 basis points to 8.7% as a rate of revenue. Adjusted EPS of $0.22 increased 16% from adjusted EPS of $0.19 last year.
Now turning to the balance sheet, starting with inventory, which can be found on page nine of the presentation, we ended the quarter with inventory at cost per foot down 14%. The year-over-year decline includes a change in the timing of inventory ownership.
As a reminder late last year we began taking ownership at the receiving port rather than the port of departure, creating working capital efficiencies. Without this change inventory at cost per foot decreased 3%.
We expect fourth quarter ending inventory at cost per foot to be up slightly following a mid-teen decline last year. Fourth quarter ending inventories reflect an acceleration of spring receipts due to the West Coast port slowdown.
Following holiday, end of season inventories are expected to be down approximately low double-digits. We ended the second quarter with $280 million in cash and in investments.
On December 2, we closed on a new $400 million asset-based credit facility replacing the existing $150 million revolver. The new credit facility, which carries a five year term remains undrawn and provides increased financial flexibility, liquidity and takes advantage of a favorable credit environment.
Capital expenditures totaled $64 million for the quarter. We continue to expect CapEx to be approximately $230 million this year falling to $150 million in 2015.
During the quarter we opened 23 stores including five North American mainline stores, ten factory stores, five stores in Mexico and three in Asia. We closed three stores, including two Aerie standalone locations.
Additionally we opened ten international license stores ending the quarter with 94 licensed stores across 14 countries. We are on track to close over 70 stores by year end with over 40 closing in January.
Additional store information can be found on pages 12 through 14. Now I would like to review the restructuring charges incurred during the quarter.
Third quarter GAAP results included approximately $51 million or $0.17 per share of charges related to our profit improvement initiative. This includes roughly $33 million of non-cash store and asset impairment charges.
As a result of our store fleet review and challenging performance this year 48 AE and 31 Aerie stores were impaired. Third quarter GAAP results also include $18 million in restructuring charges related to corporate overhead reductions, including severance and related items and office space consolidation.
Regarding the outlook for the fourth quarter, we continue to operate in a volatile and highly competitive environment. As we see it currently we expect a slight decline in revenue and a mid-single digit decline in comparable sales.
For the fourth quarter we are expecting EPS to increase over last year to $0.30 to $0.33. Our guidance compares to adjusted earnings of $0.27 per diluted share last year and excludes potential impairment and restructuring charges.
We expect fourth quarter markdowns to decline. As we anniversary a $37 million or 15% decline in SG&A last year due to incentive reversals and lower advertising expense we currently expect operating expense to increase in the high single-digits in the fourth quarter.
In addition to the impact of incentives the balance of the increase is due to advertising and new store openings. Now looking forward to 2015 the results of the restructuring will drive gross savings of approximately $27 million across gross margin, SG&A and D&A.
These reductions will be largely offset by inflationary costs and strategic investments including Omni-channel projects, customer facing activities and continued global expansion. As a result SG&A dollars are currently expected to be in the range of flat to down slightly in 2015.
We continue to strive towards gross margins in the high 30s which we expect to come primarily from continued reductions in markdowns. BOW is expected to increase in the low single-digits in 2015.
Our plans to close 150 stores over the next three years remain on track and we continue to assess the fleet for additional closures. In 2015 we will open about 20 to 25 stores, primarily factory and international locations.
We will close approximately 70 stores, including 20 Aerie standalone stores and most of the closures will occur upon lease expiration in January of 2016. While new stores continue to deliver higher returns and have higher sales per foot than the stores we are closing the new stores also carry higher rents leading to the increase in BOW.
We remain committed to executing on our priorities to reduce promotional activity, improving assortments and control inventory while continuing to bring down expenses to strengthen our profitability. Thanks for listening and now we’ll take your questions.
Operator
Thank you. We will now be conducting a question-and-answer session.
[Operator Instructions]. And the first question is from Simeon Siegel of Nomura Securities.
Please go ahead.
Simeon Siegel
Thanks, good afternoon guys. Can you talk about your view to the long-term store targets, maybe between full price, factory domestic and international?
And then just quick follow-up, Mary so clearly markdown factors could skew this but historically it looks like the Q4 gross margin rate has been below the Q3 gross margin rate on a seasonal basis. Any reason that shouldn’t be the case this quarter and I guess what you embedded in there what are you expecting within your guidance for Q4 gross margins?
Thanks.
Simon Nankervis
Hi, Simeon, it's Simon. I will take the first part of the question and pass it off to Mary for the second part.
So in relation to the blended mix between factory and mainline it’s part of our continuing strategy to assess where the main line fleet looks in the U.S. in particular.
As we’ve said on earlier earnings calls we look at the way that our customer’s currently shopping between the various channels and we use that as a leading indicator to tell us how many stores we should have in each of the various channels and where there’s been movement between our shop in the factory and mainland channel. And then overlying that is the digital strategy we have to have flexible fulfillment opportunities with final launching [ph] from store and the other opportunities that we're working towards for 2015.
In relation with international we've really just commenced that journey from owned and operator perspective. We continue to develop the license business relatively aggressively at the moment.
It's a low capital investment initiative for us with high return on investment. And from an owned and operator perspective we're going evaluate the way that those stores continue to perform and as the stores perform and we see the return on that investment we'll continue to expand accordingly.
Mary M. Boland
And then regarding gross margin for the fourth quarter, expecting it to be probably in the mid-30% range which is slightly down from Q3 but pretty consistent with Q1 and Q2. I think more importantly that gross margin in the mid-30s will be a significant improvement over last year, could be pretty close to 300 basis points improvement.
So seeing that good trend continue into Q4.
Simeon Siegel
Perfect. Thanks a lot.
Good luck for the holidays.
Mary M. Boland
Thanks.
Operator
Next question comes from Mark McClintock of Barclays. Please go ahead.
Mark McClintock
Hi, yes. Good afternoon everyone.
Really impressive job of reducing the box wide [ph] promotions this quarter. And now that we're into the holiday season I was just wondering if we get maybe your updated thoughts on, given the environment itself are you more or less optimistic that the promotional intensity or in the strategy to be able to reduce those box wide [ph] promotions, given where the promotional intensity as of the industry.
And then also as a second question I was wondering if you could update us on the franchise stores internationally, haven’t heard much on the performance of those. You’re opening number of those this quarter.
Maybe just update on where those stores stand relative to maybe the performance the last time you updated us on that thanks.
Jay L. Schottenstein
Right. Our pricing strategy obviously is contingent on having a stronger better compelling product than the marketplace and that which we had last year.
So with that ability, we believe we have it we have the strategy in place and we want to be consistent with that. So at this point in time yes the promotional activity in the malls is greater than ever.
It's deeper than ever. So at this point we stand pretty consistent to vision.
Simon Nankervis
Mark, in relation to the franchise business we opened two additional markets in Q4 in Thailand and Indonesia. We’re seeing continued expansion with our existing licensees.
We've been really happy with the performance of those businesses and I think the growth that you're seen in the store count is reflective of the why that those markets have performed. In relation to the earnings that we’re seeing coming out of that we've been really positive.
We are seeing positive improvement in that and we’re continuing to see additional opportunities with new partners coming on into next year.
Operator
Thank you. The next question is from Thomas Filandro of Susquehanna.
Please go ahead.
Thomas Filandro
Hi, thanks and first happy holidays to all and again my congratulations for delivering solid execution in a tough environment. So Jay question for you it's kind of a broader question I was curious can you kind a just tell us what gives you confidence in the viability of the business model because some have questioned the viability of the business model as well as the brand direction and leadership.
And then second part of that or third part of that, long-term do you see -- where do you see the balance between brick-and-mortar and DTC. Thank you.
Jay L. Schottenstein
You asked three questions here, Tom.
Thomas Filandro
I just -- I cheated Jay sorry.
Jay L. Schottenstein
It gives me confidence on the new product that we introduced we see a very good reception on it right away with the customer. So my feeling is that, look it's a combination, number one we have to get the right product, the right quality and that's where we put our emphasis this past nine to ten months on is really getting the product right.
And we made a lot of progress. I would say the last nine months this quarter the quality of the product is much improved than it was nine months ago.
So from that direction everything’s going the right way. The second thing is you’re never completed, and I feel that there is a still a tremendous opportunity out there to create more excitement within the store.
Roger and I and the team we have worked on it and we feel there is a lot of opportunities for the next 12 months coming up. And as soon as we get through the holiday season, we will start working on that.
So I’m very optimistic about the brand. We see the way, where the customer response between the -- on the brick and mortar and also we see the response of our website, that where the customer is responding.
It’s very positive that we didn’t go to the 50 off discounts on our site, we went to 40% but yet we got very good results at 40%. I think we did better at 40% than the team was anticipating.
So, that is positive. And I feel that in this type of environment as long as we stay true to our beliefs and stay true to the heritage to the company I think we will be in very good shape.
We see a lot of -- we see Aerie. Aerie had good results.
They haven’t done steep discounting. We see big opportunity there.
The international business has been strong. We see an opportunity coming up very shortly expanding our e-Tail business overseas.
There is a lot of real positive things going on. It’s just a lot of work to do but everyone is up to the task.
Roger S. Markfield
Obviously Jay I talk every day and we in sync on all of the things that he just talked about. Look when people challenge the liability of the lifestyle brand equity, if you take a look at all of the research, not the ones that we have done but your due diligence throughout the industry has done, American Eagle is by far the strongest brand.
Our brand equity scores higher -- other than Nike we are the second strongest brand in apparel retailing in this demographic. We have a very powerful brand.
Our share of market in bottoms is dramatic and our power as a destination store in denim is unequal. We have so many parts of the lifestyle brand that work for us, that the customer comes to us for as the destination store and not [ph] by putting the right product in, in a complete lifestyle way with the right finishes, and washes and details it is resonating with the customer as you can see our results vis-à-vis the competition at this point in time.
I feel optimistic of the positioning of a lifestyle brand versus fast fashion as I have ever been.
Operator
Thank you. The next question is from Adrienne Tennant of Janney Capital.
Please go ahead.
Adrienne Tennant
Good afternoon everybody. My question is more sort of on a philosophical level, yeah, there is a trade-off as you pull back on the promotions between sort of the gross margin rate and then gross margin dollars and I am wondering as you are less promotional than others, some of your competition, are you concerned that in the near term you may lose some share but you are well doing the right things at the company longer term and then just update on the CEO search would be wonderful.
Thank you very much.
Roger S. Markfield
Of those two questions, I will Jay answer the CEO search.
Jay L. Schottenstein
Well, the process is underway. We are committed to find a strong successor and as soon as we do we will let everybody know.
Roger S. Markfield
As relates to share of market in our competitive land escape, obviously we are gaining share of market and I will leave it at that.
Operator
Thank you. The next question is from Randy Konik of Jefferies.
Please go ahead.
Randal Konik
Hey, guys. I just -- your thoughts on the environment.
Do we expect seeing [indiscernible] kind of stabilize at all and Mary on the CapEx is everything -- according you can do in the CapEx or how should the CapEx look maybe two years out from now? Thanks.
Mary M. Boland
You know if I look at AUR, I will answer both questions, as I look at kind of AUR expect to see a continued improvement in our AUR as we pace through the fourth quarter here and probably a bit into next year. I mean and that again is really driven by the reduction in markdowns as the product is improved and we backed off the strong promotion.
From a capital perspective as I said earlier we will spend about $230 million this year. As I look into ’15 and ’16 we are probably back to what I would call more normalized rate of something like a $150 million.
We had a lot of catch up to do here this last couple of years around infrastructure and some digital spend and that will moderate back to about $150 million.
Judy Meehan
Next question.
Operator
Thank you. The next question’s from Lindsay Drucker Mann of Goldman Sachs.
Please go ahead.
Lindsay Drucker Mann
Thanks, hi everyone. I was hoping, number one, can you give us any color on how your performance has been quarter-to-date and just any color on Black Friday?
And then secondly Mary, it was great to hear some of that -- those preliminary thoughts on 2015, the high 30s gross margin goal, is that something that you can -- do you have a certain timeline to that and I'm guessing you hope -- you’re looking for some gross margin improvement just based on the pace of what we've seen in the back-half of this year, and also any early thoughts on where the tax rate might shake out next year.
Jay L. Schottenstein
Lindsay, we don't report on monthly information or really report on quarterly, but just to give you a sense, let's say that the month of November is trending pretty similar to how the third quarter was doing where we were quite pleased with. Obviously we were not nearly as promotional as we were last year for the Black Friday weekend and certainly our margins in average unit retail were considerably higher.
Mary M. Boland
I think for gross margin Lindsay, as I look into next year, every quarter is a little bit different depending on our product mix et cetera and cadence of store opening. I think for the year I feel pretty good about the high 30 rate that we'll be able to achieve, may not do it every quarter but I think we will for the year.
Tax rate expect that to fall back to something historical levels right, around 40% as we get into next year.
Operator
Thank you. [Operator Instructions].
The next question is from Susan Anderson of FBR Capital. Please go ahead.
Susan Anderson
Hi, thanks for taking my question. I was wondering if I could just get your thoughts on if we look out a year a two from now, the competitive environment just seems like things aren't letting up.
I know a lot of the team [ph] are rationalizing stores, that then we still are getting a lot of the international players coming into the market. So maybe just your thoughts on that and how you think about getting comps back to positive.
Jay L. Schottenstein
On the competitive landscape and of the international players coming into the market, this is good. When you're in this business you kind of thrive on great competition.
It makes you perform better. And at this point all of those coming in are really fast fashion guys.
They're not really in the lifestyle business where we put together what I could call a drug [ph] ratio 10 times a year. So our fashion is as updated is as anyone else is, and we do it 10 times a year with the great floor set.
So and they are all fast fashion players. So from my perspective I don't see there is an issue for us and the reality is that some of the competition that was in that space which it seems to be changing their strategies may no longer be in the business at all.
So I think we're in great position at this point in time.
Operator
Thank you. The next question is from Anna Andreeva of Oppenheimer.
Please go ahead.
Anna Andreeva
Great, thanks, good afternoon everyone, and congratulations on managing well in tough environment. I had a question on inventories.
I guess what number should we think of ending the fourth quarter, excluding the earlier spring receipts and also into 2015, I think you guys still have an opportunity for tight management in the spring. And also maybe just an update on factory.
It's been a couple of quarters of declining comps over there. Maybe remind us about the sales productivity and the profitability of that business.
Thanks so much.
Mary M. Boland
Okay. I'm not sure I got all the questions right here.
But on the inventory if you exclude the early spring receipts we’ll likely be down kind a low double digits and the fall holiday we will be cleared out I would say pretty well by the time we get to the end of the quarter.
Simon Nankervis
In relation to the factory business we are still saying that business outperformed the mainland. It’s still a highly profitable business for us.
We've continued with the expansion of that network of stores as we’ve seen growth and opportunities. I think part of the impact on comps has been as you drive the footprint and as the number of new factory developments coming on, you're not seeing those significant grand openings that we were seeing historically.
So we are still really positive about the space and continuing to focus on development of that strategy.
Operator
Thank you. The next question is from Paul Lejuez of Wells Fargo.
Please go ahead.
Paul Lejuez
Hey, thanks. Can you talk about AUC in the fourth quarter and what the outlook is into the first half of ‘15?
And also curious about e-com performance versus the stores and if you seeing any difference in categories e-com versus bricks and mortar? Thanks.
Michael R. Rempell
Hey, Paul it's Michael Rempell. I will take your question.
First on product comps, product comps continue to be a focus for us and frankly should be an opportunity heading into the back half of 2015 as we have tailwinds from both currency and cotton. You have to remember that in both the fourth quarter this year and in the first half of next year we’re going to anniversary product that was much less expensive but our customers clearly didn’t feel like it was specially unique enough and really wasn’t -- didn’t think it was a great value.
So during that time, fourth quarter this year into the first half of next year we expect product cost to be roughly flat as we look to improve the assortment. Our focus as a team is really in the back half of next year where we see opportunity to continue to improve our quality, differentiate our product but take some of the tailwinds that we have and reduce cost.
And the second part was about performance in DTC, in terms of the mix. I would say the selling online is roughly the same as what we see in the stores.
Operator
Thank you. The next question is from Dana Telsey of Telsey Advisory Group.
Please go ahead.
Dana Telsey
Hi, good afternoon everyone. As you think about the marketing, what’s working how do you see the marketing spend moving forward and are there any particular categories we should watch forward on?
And also Aerie versus American Eagle in terms of what you are seeing there to help drive the sales? Thank you.
Jay L. Schottenstein
I will let Jen talk little bit about Aerie since it’s such an exciting story and we are lucky to have here with us right now.
Jennifer Foyle
On Aerie we had a really nice quarter. I am really proud of the team.
They really delivered on all fronts and it’s really never about one thing, as Roger always says. So we had creative marketing, the lead [ph] lines were innovative, the product was great and we have a solid strategy that we’re delivering on which is opening up the new store format, closing non-productive stores and then not to forget about the direct to consumer channel that’s been really generating nice traffic and we’ve been leveraging the AE brand and aiding in brand awareness.
Jay L. Schottenstein
And then as it relates to marketing for both out for the Eagle and Aerie you are a real student of the business. I think you can walk into the malls and look at our [indiscernible] malls windows and I think you will say that the marketing of our stores is quite attractive and it’s compelling and it drives people into our store.
At the same time each time we do a set we’re back to the structure and the decision of doing marketing for each one of those sets, it’s telling a whole new story. That is something that fast fashion players don’t do.
That’s a very important part of being a true lifestyle brand. So when you put together what we are doing on the outside and using our own mobile and web devices to do that and it corresponds to what we are doing in our stores and in our windows the combination of all the efforts being very focused it drives the message that we need to do.
Operator
Thank you. The next question is from Rick Patel of Stephens.
Please go ahead.
Rick Patel
Good afternoon everyone and congrats on the progress you are making. I had a question on fashion products, they seem to be doing pretty well.
Given what you are seeing should we expect that assortment to represent a bigger piece of the pie either for the spring season or back to school and if there are changes that are going to occur what are the implications for margins?
Jay L. Schottenstein
Our fashion business is doing very well and we have great opportunity, because as you know we are such a dominant bottoms business. I won’t give you our ratio but the opportunity in the ratio for us to drive a lot more tops business with the bottoms business now that we’ve hit the right fabrications and the right filing [ph] and the testing that we are doing with stock in place, I see big opportunity as we move into spring on the tops business and most of that is the fashion.
Operator
Thank you. The next question is from John Morris of BMO Capital Markets.
Please go ahead.
John Morris
Thanks, my congratulations to everybody as well. You talked about the customer interfacing initiatives ahead you plan to invest more for in 2015.
So Jay or Roger, can you talk a little bit more about that, what we expect to see and would we expect to see some of the benefit of that impact in 2015?
Roger S. Markfield
The things you are doing with the…
Jay L. Schottenstein
We will let Michael take that.
Michael R. Rempell
Yeah, so John.
John Morris
Hi, Michael.
Michael R. Rempell
Hey, how are you?
John Morris
Good.
Michael R. Rempell
We are doing quite a bit under the umbrella of our Omni-channel initiatives to try to give our customer better experience and also leverage the capabilities we have with the company. We are thrilled with our ship from store roll out that we have been working on all year.
We are in about 530 stores. We have learned quite a bit about this technology through the year, how to manage the algorithm, how that manage the algorithms to drive profitability and we are very pleased by the volume that’s been generated and the ability to better service our customers.
We now during holiday we have a target on unproductive inventory in lower volume stores that are within two day shipping of our customers and we are seeing great results. We plan to roll that out to the balance of the chain next year.
The team has done a tremendous job, the stores are fulfilling these orders very quickly, training stores very nicely and we think there is a huge benefit there for our customers. We are going to roll out reserve in store next year which we think is going to be a big win.
A part of our customer base doesn’t have credit cards. So, the ability to be on their device, identify something they want to buy, and then go to store pick-it up, pay cash we think it is going to be huge win for us.
We rolled out new digital capabilities, both in improved mobile -- improved website as well as the new mobile app in the last quarter. And why that’s critical John is we updated that approximately eight times in the quarter, okay.
We were able to do that because we it build it in-house and we own that technology. Previously, we were only able to do update about eight times a year.
So as quickly as traffic is driving to mobile we are able to meet and exceed customers’ expectations with that new technology and it’s only at the tip of the iceberg. And just the last thing is we went into pilot in the back half of the year with a new point of sale system.
It’s only in about 10 stores today but we plan to roll it to entire chain next year and there is two key capabilities in that, that Simon and I are -- and the team is very excited about. One, is we are going to mobile check-out in all stores, have the ability to check a customer out through either an iPad or an iPod in the stores.
And the second is the ability to service us [ph] out from the same devices, so and associate with the customer, we don’t have their size in store. They can look up in the iPad see if we have it in another store or in a DC and ship it to our customer’s home.
Operator
Thank you. The next question is from Neely Tamminga of Piper Jaffray.
Please go ahead.
Neely Tamminga
Great, good afternoon. One quick point of clarification on the SG&A, to make sure I heard that correctly.
SG&A dollars rate are both being flat to down slightly for next year, Mary. And then Roger for you we have heard a lot about joggers and jeggings and leggings, I don’t if I can say that again that fast but wondering what are the kids wearing that with?
What are -- what’s going on with tops? What top should they be wearing?
What business should be better in tops?
Roger S. Markfield
If I tell you what they should be wearing with these tops I’d be giving too much information out.
Neely Tamminga
All right. Joggers, jeggings and leggings, all right.
Mary M. Boland
And then SG&A next year flat dollars, flat to slightly down dollars for 2015.
Operator
Thank you. The next question is from Kimberly Greenberger of Morgan Stanley.
Please go ahead.
Kimberly Greenberger
Thank you so much. My question is just on traffic.
Clearly traffic is suffering today because you are pulling back on the promotional activity but you’ll anniversary that in the second quarter next year and beyond Q2 in 2015 how do you expect your traffic trends and your transaction counts in store to trend? Thanks.
Jay L. Schottenstein
Yeah, it’s difficult to forecast that, as you know Kimberly, very difficult. By my sense is that when you take the transactions online and when you take the transactions in the stores and you put it together if we are the compelling lifestyle brand that I think we are at this moment vis-à-vis the competition and how much better we can be when we do it much better as we move forward.
I would think that the combination our traffic should start to trend upward.
Operator
Thank you. The next question is from Jennifer Davis of Buckingham Research.
Please go ahead.
Jennifer Davis
Hey guys, good afternoon. And Jay, I will say, I agree the merchandise is much improved from nine months ago and that Denim X is really great.
Jay L. Schottenstein
Thank you. He won’t beat me up after this call.
Jennifer Davis
All right, that’s the softest Denim I saw. Anyway…
Jay L. Schottenstein
Wait till you see 4X.
Jennifer Davis
Okay, quick clarification on merchandise margins if you could, how much of the merchandise margin increase was based on reduction in markdowns and how much on AUCs?
Mary M. Boland
For Q3 it was mostly markdowns, almost entirely markdown driven.
Jay L. Schottenstein
As Michael said we’ve really improved the fabric, the washes, the quality of the make. So we were able to hold our costs pretty flat which is terrific.
But going forward Michael is going to have great improvements with the currency and cotton changes.
Jennifer Davis
Okay. So you have actually increased the quality but held the costs current?
Jay L. Schottenstein
That’s correct.
Jennifer Davis
Okay, all right.
Operator
Thank you. The next question is from Rebecca Duval of BlueFin Research.
Please go ahead.
Rebecca Duval
Hi guys. Let me add my congratulations as well for managing through the tough environment.
Roger, my question is for you and I know that you don’t like to give too much away but we saw a lot of success with some of these capitals that you were bringing into the stores with the Artisans Luck [ph], the 40 West, The Don’t Ask and it seemed like you were able to away with some premium retail. So my question is can we expect to see more of that go forward and is there plans to be rolling that out to more doors as well?
Roger S. Markfield
We are very happy with what it does and we actually -- Jay and I just went through our concept for holiday for next year and the collaboration and those capsules are better than ever but they always will only be a small part of the business. But when it inspires the inspirational part of the store and it gives us that sizzle that we absolutely need to have and we need to have more of it, we certainly are going to continue it but it will be contained and it’s great information.
I know this is exciting for the customer but it’s great information for us.
Operator
Thank you. The next question is from Jennifer Black of Jennifer Black & Associates.
Please go ahead.
Jennifer Black
Good afternoon and let me add my congratulations as well. We’re seeing a bigger assortment of accessories and I wondered what percent of your business accessories represent now and where could we see that go?
And then I just have a follow-up on what kind of a comp do you need to get leverage in 2015? Thank you.
Mary M. Boland
The comp leverage is probably low single-digits and…
Roger S. Markfield
And accessories will continue to grow.
Jennifer Black
And you are not going to say what percent they are now? Do you have substantial room for growth?
Roger S. Markfield
Yes, we do.
Operator
Thank you. The next question is from Dorothy Lakner of Topeka Capital Markets.
Please go ahead.
Judy Meehan
Dorothy are you there? All right, we will take the next question, Mannie.
Operator
Certainly the next question is from the line of Lorraine Hutchinson of Bank of America. Please go ahead.
Lorraine Hutchinson
Thank you, good afternoon. Mary with CapEx coming down next year you can you review your view on priorities for free cash flow?
Mary M. Boland
I think it’s again about our product, our assortment making sure our stores reflect a great customer experience, continuing to invest in the company, open stores et cetera. I think as I look at kind of our plan for next year and where we are investing, it is really around those priorities plus in the digital space, where as Michael articulated earlier on the call, lots of great investments that we have going forward, that are needed for the company to get competitive and hopefully gain a competitive advantage.
So I think it’s all about investing in the company and in investing in areas that will help drive profitable growth for the company as we look forward.
Judy Meehan
Mannie we’ll take one more question.
Operator
Certainly. The next question is from Marni Shapiro of The Retail Tracker.
Please go ahead.
Marni Shapiro
Hey, thanks and in case I forget best of luck with the holidays, your stores look great.
Roger S. Markfield
Thank you, Marni.
Marni Shapiro
Could you just talk a little bit more, you mentioned that some tee shirts and knits and pleats have been a tougher part of the business but how much of the softness in that space is due to headwinds from the trending down logo business and how much less logo business you have, sort of say you have even versus last year where you were kind of blowing out some of it at decent prices?
Roger S. Markfield
Right, you know the logo business as such for us has never been a huge part of the business. It was not how we wanted to build the business.
I never believed in taking the Eagle and spring it across the chest other than in graphics with tees and pleats. So at this point it represent under 10% of our business and obviously the trends are a bit less but our Eagle is a very powerful icon on a global stage and I believe in the Eagle very strongly and you would never see Ralph take his Polo player off and I don’t think you should expect to see American Eagle take the Eagle off of its garments.
But as relates to the whole graphic that is something that we have never really been in, in a big way, I don’t believe in that.
Operator
Thank you. And that was all the time we had for questions.
I would like to turn the floor back to management for any additional or closing remarks.
Jay L. Schottenstein
Okay, thank you for your time today. We look forward to delivering improved profitability and stronger shareholder returns.
We wish you all a happy holiday season. Thank you.
Operator
Thank you. Ladies and gentlemen, this does conclude today's teleconference.
You may disconnect your lines at this time and thank you for your participation.