Aug 19, 2015
Executives
Judy Meehan - Vice President, Investor Relations Jay Schottenstein - Interim Chief Executive Officer Chad Kessler - Global Brand President, AE Brands Jen Foyle - Global Brand President, Aerie Mary Boland - Chief Financial and Administrative Officer Roger Markfield - Chief Creative Director Michael Rempell - Chief Operating Officer Simon Nankervis - Chief Commercial Officer
Analysts
Oliver Chen - Cowen and Company Adrienne Yih - Wolfe Research Brian Tunick - RBC Capital Markets Tom Filandro - Susquehanna Financial Group Simeon Siegel - Nomura Securities Dana Telsey - Telsey Advisory Group Matthew Boss - JP Morgan Tom Filandro - Susquehanna Financial Group Kimberley Greenberger - Morgan Stanley Anna Andreeva - Oppenheimer Randy Konik - Jefferies Paul Alexander - BB&T Capital Markets Janet Kloppenburg - JJK research Lindsay Drucker Mann - Goldman Sachs Richard Jaffe - Stifel Rick Patel - Stephens Inc. John Morris - BMO Capital Rebecca Duval - BlueFin Research Partners Pam Quintiliano - SunTrust
Operator
Greetings. And welcome to the American Eagle Outfitters, Inc.
Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode.
A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.
It is now my pleasure to introduce your host, Judy Meehan, Vice President of Investor Relations. Thank you.
You may begin.
Judy Meehan
Good morning, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Interim Chief Executive Officer; Chad Kessler, Global Brand President of the AE Brands; Jen Foyle, Global Brand President of Aerie; and Mary Boland, Chief Financial and Administrative Officer.
Also joining us for Q&A today are Roger Markfield, Chief Creative Director; Michael Rempell, Chief Operating Officer; and Simon Nankervis, Chief Commercial Officer. 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.
We have also posted a financial supplement with additional financial materials on the website. And now, I’d like to turn the call over to Jay.
Jay Schottenstein
Okay. Thanks, Judy.
I am pleased to like report another strong quarter. Congratulations to the team for delivering an exceptional first half and building on the recovery that begin late last year.
When I took the helm in early 2014, I knew we had the potential for successful quick recovery. Our collective efforts over the past 18 months have proven this.
In the second quarter we’ve reached record sales and delivered the fourth consecutive quarter of year-over-year earnings growth. In a tough retail environment, both American Eagle and Aerie achieved significant sales and earnings growth, and we see momentum continuing into the third quarter.
Our efforts to create a better overall customer experience, strengthen our process and gain efficiencies have created the underlying foundation for improved results. In the second quarter, net revenues increased 12% on a comp increase of 11%.
EPS of $0.17 was well above $0.03 during last year and above our guidance of $0.11 to $0.14. Customers responded favorably to merchandise improvements, greater innovation, on trend style and outstanding value, as a result we had more full price selling and lower markdowns.
Strength in our business was broad based across geographics, brands and channels. Stores comp positively and our digital business was very strong, as we attracted more customers.
Inventories and expenses were well-managed during the period contributing to our profit improvement. We ended the quarter in excellent financial positions with no debt and a cash balance of $327 million, $64 million higher than this time last year.
We are pleased by our progress over the past year. Yeah, we still have tremendous opportunity for growth and stronger profitability.
With the American Eagle brand, we have an opportunity to cease market share and be the number one casual American lifestyle brand across the globe. Despite a high level of competition we are performing well.
Our well curetted edited assortments, strong point of view and leading bars businesses are important competitive advantages. Chad Kessler and team have done a great job and we will continue to raise the bar and strive for consistency over the longer term.
Next Aerie presents an incredible growth and opportunity, which I believe can double in size over the next several years. Under Jen Foyle’s leadership the brand has gain very good traction.
We are enthusiastic about the intimates market and believe Aerie is unique, differentiated and perfect for today’s young woman. Aerie is poised for growth much like American Eagle felt early in its history.
Our digital business is strong with mobile sales accelerating at a rapid pace. Recent investments are delivering nice returns.
Our upgraded new app, better technology and omni-channel tools are driving incremental sales and providing the platform for future growth. Digital is a growth lever as we pursue expanded product lines and open our U.K.
sites this quarter, the first step in the broader plan for global expansion. Regarding international improvements to our brand and merchandise assortments are fueling good momentum.
In company-owned markets including Mexico, China and the U.K. we have well paced expansion plans underway.
The licensed store portfolio continues to grow, providing accretive expansion with a low cost capital investment. With additional stores and digital expansion, our international growth will accelerate over the next several years.
On operational front, the team is currently working on additional expense reductions and implementing a program of continuous improvement. The transition to our new omni-channel distribution center is complete, providing inventory efficiencies, improved processing and faster delivery times.
To conclude, we have made great strides in a short period of time and extremely optimistic on our future. We have two of the best positioned brands in the marketplace today.
We have vast opportunities to expand the reach of our brands and grow through global and digital expansion. Our top priority is to stay focus on delivering future -- on further improvements and returns to shareholders.
Now I will turn it over to Jen.
Jen Foyle
Thanks, Jay, and good morning, everyone. I am so pleased to be here this morning to review another strong quarter for Aerie.
Before I get started, I would like to thank and congratulate my team for delivering strong results. We have an incredibly talented team.
I am very proud of the work they have done and their continued drive and passion. The second quarter exceeded our expectations.
Comparable store sales increased 18%. We saw positive growth across all store formats and our digital business was especially strong.
The average unit retail price unit per transaction and average dollar sales all increased. Aerie was also -- Aeries traffic was also nicely positive clearly about the mall traffic as we continue to gain new customers.
Merchandise margins expanded with less markdowns and we continue to strengthen the bottomline delivering higher profitability. We were pleased with the strength across the business.
The best categories included bras, undies, swim, and soft dressing. We delivered newness, innovation, better quality and improved value.
For example, our new bar collections in the swim line have provided incremental growth this spring. We are building on categories like accessories and beauty, and we are exploring additional ways to surprise and delight our customer.
Our Aerie Real campaign has been extremely well received by our customers and it’s truly a point of differentiation. We are excited to re-launch the campaign this month, featuring Emma Roberts as our first Real celebrity.
Emma was a natural choice for Aerie. She is a confident, independent spirit like the Aerie Girl.
On the store front, we are growing our side-by-side store counts, where we continue to see strong results in both Aerie and adjacent AE store. Our new modern store formats are performing extremely well.
As Jay mentioned, I want to reiterate the tremendous growth and opportunity for Aerie and I look forward to continuing current momentum. Thanks.
I will now turn it over the Chad.
Chad Kessler
Thanks, Jen, and good morning. Congratulations to you and entire Aerie team for delivering outstanding results this quarter and for the past several quarters.
I’d like to underscore that Aerie is an exciting growth opportunity and a great complement to our business. Now on to the American Eagle.
We had a pretty fantastic second quarter, led by improved merchandise and a positive customer response. Our continued focus on having the right people, product, process and presentation led to another strong quarter.
American Eagle comp sales increased 10%, a nice acceleration from the first quarter. Our business reflected strong product execution and was much healthier overall.
Customers recognized improvements and we saw double-digit increase in the average unit retail price. Consolidated traffic rose with particular strength online, due in part to increase in digital marketing and more customers shopping the brand.
Store traffic outpaced small traffic, a trend we began to see at the beginning of the year. We are pleased with this, especially given the significant reduction in the store-wide sale event and fewer clearance units compared to last year.
The net result of all of this was significant expansion to the merchandise margin. Turning now to product, we saw positive results in men’s led by strength in pants, denim, woven shirts and knit tops, with polos and graphics underperforming.
In women’s we saw exceptional growth, driven equally by tops and bottoms. This is the best women’s business we’ve seen in many years.
We saw strong comp growth in woven and knit tops, dresses and sweaters. The Soft & Sexy line has been terrific, which is now expanded across the knit top assortment.
We are especially pleased to see a broad-based resurgence in tops presenting an exciting opportunity for growth and margin recovery. In addition to a terrific shorts business this spring, I would highlight the innovation we delivered in Denim X, which expanded across classifications and fit.
As we are now in the midst of back-to-school and enter the fall season, we are pleased to see positive trends continue. In men’s, flex denim is adding innovation and newness.
In women’s, we launched updated denim styles and emerging silhouettes. A new denim cycle falls right into our strength.
Clearly, Roger was absolutely right years ago when he set out to create a leading jeanswear collection. Today, AE denim and bottoms are major competitive advantage.
It’s where we have strong brand loyalty and have had the most consistent performance. It’s also now a significant opportunity as we expand globally.
As I look forward, I’m optimistic. While we made some improvements last year, we have plenty of room for further progress.
We are running the business better and our process is working. Marketing efforts will be focused on connecting emotionally with our customers and building a stronger reputation for product leadership and quality.
Our brand position is absolutely right for today’s consumer and we are well poised to capitalize on the disruption in our industry. We will remain focused and disciplined while delivering exceptional product innovation, quality and value.
Lastly as we seek to expand our business by bringing newness and interest to our customers, we are pursuing new ideas like our Don’t Ask Why fashion capsule. This could include collaborations or other creative ideas that we can incubate and learn from as they provide incremental business.
Congratulations and thanks to my team for delivering a great season. Now I turn it over to Mary.
Mary Boland
Thanks, Chad. Good morning, everyone.
Our customers continue to respond well to our product and brand initiatives leading to significant earnings growth and be to our guidance. The second quarter profit improvement was the result of a positive double-digit topline and higher merchandise margins from lower promotional activity.
We also benefited from our expense reduction initiatives and store fleet repositioning. Looking at the details of the quarter.
Total net revenue increased 12% to $797 million from $711 million last year. Consolidated comparable sales increased 11%.
By brand, AE comps were up 10% and Aerie increased 18%. We are pleased that consolidated traffic increased in the quarter.
The average transaction value increased in the mid-teens, driven by a mid-teen increase in AUR. The strength in our AUR was driven by a combination of more full-price sales and fewer promotions.
Additional sales information can be found on page six of the presentation. Total gross profit increased 20% to $285 million and as a rate to revenue rose 230 basis points to 35.7%.
BOW leveraged 130 basis points. This was due to higher sales and rent leverage driven by our fleet rationalization.
Reduced markdowns drove another 100 basis points of margin expansion as we continued to successfully reduce promotional activity. SG&A expense remains well-controlled enabling us to leverage by 220 basis points to a rate of 24.5%.
Expense dollars increased 3% to $196 million. The increase was due to higher incentive and variable selling expenses driven by strong sales results.
Our expense reduction efforts resulted in a low single-digit decline in fixed expense. This was partially offset by an increase in incentives and variable selling expense driven by the strong sales performance.
Depreciation and amortization increased to $36 million and decreased 50 basis points to 4.5% as a rate to revenue. Operating income grew to $53 million from $12 million last year and the operating margin expanded 500 basis points to 6.7% as a rate to revenue.
Within other income, we had a loss of approximately $2.2 million, which was primarily due to currency loss related to cash held in Canadian dollars. The tax rate of 34.7% includes a benefit of approximately $2.5 million due to an income tax settlement.
EPS of $0.17 increased from $0.03 last year. Now turning to the balance sheet.
Starting with inventory, which can be found on page seven of the presentation, we ended the quarter with inventory of 4% and at cost per foot of 5%. This was in line with our guidance and below sales growth.
The composition of our inventory is very healthy with very limited clearance. We expect third quarter ending inventory at cost to be approximately flat.
We remain disciplined on our inventory investments and are using our omni-channel tools to gain efficiencies across channels. We are committed to growing inventory lower than sale.
Cash and investments increased to $327 million at quarter end compared to $253 million last year. Capital expenditures totaled $37 million for the quarter bringing us to $79 million year-to-date.
We continue to expect CapEx to be approximately $150 million for the year. I would like to take a moment here to commend the team for a seamless transition to our new distribution facility in Hazleton, Pennsylvania.
The teams did a great job with no major disruption to our business. This is our first true omni-channel DC with shared inventory across digital and stores.
There are numerous efficiencies to be gained, including greater customer satisfaction to faster delivery and higher in-stocks, as well as inventory optimization and processing efficiency. Now regarding our third quarter outlook.
Based on the mid single-digit increase in comparable sales, we expect third quarter EPS of $0.28 to $0.31 per share. The guidance compares to adjusted EPS of $0.22 last year and excludes potential impairment and structuring charges.
As Jay said, across the organization, we are intensely focused on maintaining our momentum, capitalizing on our opportunities within the marketplace and continuing to build a global presence. Thanks.
And now, we’ll take your questions.
Operator
[Operator Instructions] Our first question comes from the line of Oliver Chen with Cowen and Company. Please go ahead with your question.
Oliver Chen
Hi. Congrats on really solid results and what we are seeing with the product and in-store execution.
Just regarding your comp guidance for mid single digits, is that a function of the more difficult comparisons? I’m just curios about that in light of some of the shifts that have been happening with the holidays as well as the later Labor Day.
And Mary, also, could you just update us on how the merch margin comparisons look ahead and how that may trend given the progress you’ve had? Thanks.
Mary Boland
The mid single digit comp guidance is really as a result of the improvement of our business at the end of last year. So it is due to more difficult compares.
But I think what’s most important here is the profitability of the business and the strength of the business continues here. Great results in Q2, we will see it here in Q3 as well based on our guidance.
Expect to see merch margin continue to grow here in Q3 and Q4 as product resonates with our customer.
Oliver Chen
Okay. Mary, and regarding that comp, is it going to follow, kind of generally a similar trend, with the ADS being the bigger driver in terms of where you’re getting the comp points?
Mary Boland
Yes. That’s correct.
Oliver Chen
Okay.
Operator
Thank you. Our next question comes from the line of Adrienne Yih with Wolfe Research.
Please go ahead with your question.
Adrienne Yih
Good morning. Let me add my congratulations as well.
Can you hear me?
Jay Schottenstein
Yes. Thank you, Adrienne.
Adrienne Yih
Okay. Great.
The stores look great. A question on the percentage of newness that has been bottoms, if you can address that and then secondarily, really this is good advantage kind of the inventory productivity.
You entered the quarter 2Q with an up 1% on total inventory. Comps obviously came in at 11%, entering the next quarter with 4% total inventory.
I guess is there a strategy that you would sort of go contain promotions to generate really healthy margins now? It’s kind of a follow-on from the earlier question just about -- it would imply that the productivity of the inventory is not as strong as it was in 2Q, so just question on that.
Jay Schottenstein
I think first in terms of the bottoms, we did deliver -- back to school bottoms assortment, we did delivered more units than we -- I think that we’ve ever delivered then we’ve definitely delivered in the past two years. We are really trying to drive bottoms business through the innovation in AEO Flex/Denim for men’s and then the Denim X, Sateen X and X4 for women and the expansion there.
So between fits and fabric and choices, we definitely have more units there and we are seeing nice results. I don’t think we are expecting any less productivity out of the assortment for Q3 than we’ve seen in Q1 and Q2.
We continue to try to drive the business through stronger assortments and better customer value and innovation. We are seeing great results as you can see from ADS and AUR improvements and we expect that to continue through the fall.
Operator
Thank you. Our next question comes from the line of Brian Tunick with RBC Capital Markets.
Pleased go ahead with your question.
Brian Tunick
Hi. Good morning.
Thanks. I will add my congrats.
I guess question on the denim strengths and the silhouette change that we are seeing in the marketplace. So can you maybe talk about what that could mean to your top to bottoms ratio?
And then the second question is really on aerie. I think you said, you think that business can double over the next couple years.
Does that include any increase in square footage, new stores or is that mostly going to come through the DTC channel? Thanks very much.
Jay Schottenstein
I think in terms of denim, we are definitely seeing a positive response to our back-to-school assortment. I think we are seeing -- we have the broadest assortment in the marketplace and we are seeing some silhouette shifts, but I don’t see that necessarily -- we are not seeing huge shifts in terms of the silhouettes in denim.
In terms of driving tops, I think that having a healthy bottoms business is a great opportunity for our tops business. We did see in Q2, the women’s tops business actually suddenly outpaced the growth in bottoms, both businesses were exceptional.
It’s the first time for quite a while. And I think that driving -- the bottoms business drives a lot of customer loyalty and a lot of traffic and when we can get the tops business right and have the right outfits, so the tops can go back to the bottom.
It just shows -- this quarter shows that we can drive great results that way.
Mary Boland
And Brian, regarding aerie, we really believe in all the store formats based on smaller square footage but we believe in that growth and certainly really leaning on the direct channel as sort of our gateway to the introduction of the brand to the customer. So, we’ve seen nice acceleration on the direct side.
So, we certainly will continue to leverage that via through the AE customer base and then introductions to new customers and certainly then growing the smaller square footages.
Operator
Our next question comes from the line of Tom Filandro with Susquehanna Financial Group. Please go ahead.
Tom Filandro
Hi. Let me add my congratulations.
It’s great performance across the board. A Jen, Mary question, just to extend on the longer-term view that Jay said about doubling the business.
Can you guys help frame how we should think about the margin profile of the aerie business may be currently and as you grow that business, do you think it will be accretive in line or dilutive to the overall mix and then I have a factory question? Looks like comps improved a little bit from the first quarter to the second quarter although down.
Curios what drove that improvement and any view on the long-term merchandising strategy of the factory business would be helpful? Thank you.
Mary Boland
Tom, as I look at the aerie business and our growth opportunity, the aerie business today is accretive to our bottom line and I expect that to continue. And probably if we grow over time, I think the work that Jen and her team have done on focusing the assortment, getting the fleet, the store fleet rationalize, deploying the side by side strategy.
All of those would tell me that there’s growth, profitability growth for the aerie brand.
Jay Schottenstein
I think in terms of the factory channel, we have started to see -- we are really focused on trying to make sure that the assortment and the factory channel is more reflective of the, I guess similar improvements we are seeing in the mainline AE business. So the factory customers really driven by value and all those differentiation from mainline.
We don’t have necessarily set targets about how much made for factory specifically we will have in that channel. But what we are committed to is providing the customer the absolute best value we can in our factory channel and also providing the best product, product that we are equally proud of and factors beyond our mainline and our online business.
Operator
Our next question comes from the line of Simeon Siegel with Nomura Securities. Please go ahead.
Simeon Siegel
Thanks. Good morning, guys.
Really strong AUR increases, how much of that is like-for-like versus the function of mix and costs and then any thoughts on how much more will you have for increased AUR, just given the shift to the back half, do you expect to get an uptick in transactions in the third quarter? Thanks.
Mary Boland
Yeah. Most of it’s driven by like-to-like.
As you think about the broad-based reduction and promotional activity, it’s really across the board on all our products. I think as I look at AUR here in the back half, we still have opportunity for AUR growth.
It will abate a little bit versus the pacing of the first two quarters of the year but still opportunity to pullback on promotions in the back half of the year. And honestly, we are seeing great strength of our product and more full price selling.
So it’s very encouraging and we will continue to see some nice AUR growth.
Operator
Our next question comes from the line of Dana Telsey with Telsey Advisory Group. Please go ahead with your question.
Dana Telsey
Good morning, everyone and regulations on a terrific result. Can you talk a little bit about merchandise margins, level of merchandise margin, where are we relative to peak and what opportunities do you see to move a bit higher?
Thank you.
Mary Boland
We see continued improvement in our merchandise margin, expect to see that continue here in to Q3 and Q4. We still do have room for improvement beyond the levels where we’re posting today.
And I think the work that Chad and Jen have done on product and assortment and driving higher AURs. The metrics across the board are really strong.
I see that continuing as they continue to deliver great product.
Dana Telsey
Michael, do you want to talk about AEC opportunities?
Michael Rempell
I would just add Dana, we see the sourcing environments changed as we’ve talked about in previous calls, quite a bit over the last year. And we do see an opportunity that we’ll start to feel at the end of Q3 and simply that’s a nice tailwind in Q4 in terms of like-for-like cost.
We’re seeing lower cost. We’re able to take some of that in margin and we’re able to invest more into the product and drive some of the innovation and newness that Chad and Jen have been talking about.
Operator
Our next question comes from the line of Matthew Boss with JP Morgan. Please go ahead.
Matthew Boss
Hi. Good morning and nice result.
So as we think about the larger picture gross margin opportunity and to tie into your last comments there in the continued merchandise margin opportunity. As we think more holistically, is 2012’s 40% gross margin level, I mean, is that a realistic goal over the next couple years?
And on the expense side, just the best way to think about SG&A dollar growth versus topline growth on a go-forward basis?
Mary Boland
Yeah. I think from a gross margin perspective, being in the high 30s, somewhere around that high 30s, 40% is certainly a target that we continued to strive for here in the company.
And I think that the improvements that we’ve seen across the board on a multitude of our metrics would give me confidence that in a very short term, we could drive ourselves to that high 30%. As I look at SG&A expense, our goal here is to continue to keep what I would call our fixed expense flat to declining as obviously is revenue growth and continues to grow at the rate we’re growing.
Our SG&A dollars will increase due to the variable expense related to selling and incentive. So again, hope to continue to leverage SG&A as what that means at the end of the day.
And the team continues to stay rigorously focused on expense.
Operator
Our next question comes from line of Tom Filandro with Susquehanna Financial Group. Please go ahead.
Tom Filandro
Hi. I got in for another one.
I actually have a quick question for Jay. I don’t know.
I’m caught off guard but actually a quick question for Jay. I’ll take it.
Jay, I mean you’ve obviously proven a lot of people wrong and done a great job of guiding the ship. You are guys back on course.
I’m just curious. Where are you currently now spending the bulk of your time and what areas of the business?
Jay Schottenstein
Well, I spend a lot of time on the merchandising side with Chad and with Jen. And I also we’re signed in there with the whole team there.
We have a strategy session that we have all the time. We have goals we set for ourselves.
And we have a media goals we set. And then we have long-term strategies too.
So we just keep -- we keep guiding the ship.
Operator
Our next question comes from the line of Kimberley Greenberger with Morgan Stanley. Please go ahead.
Kimberly Greenberger
Great. Thank you so much.
Very nice results here today. I wanted to hear a little bit more about the international growth if you can talk about that?
And maybe just help us think about monitoring the progress internationally along the way and what you ultimately think the topline and bottom-line impact might be? And I just had one clarification if I could squeeze it in.
I’m not sure how to bridge the difference between the midteens increase in the average value of the transaction and the 11% comp? What is the -- what are the sort of three or four offsetting percentage points in there?
Thanks so much.
Simon Nankervis
Thanks Kimberly. It’s Simon.
I’ll just -- I’ll cover off the international piece and then hand it back to Mary. As I think about international, we were pretty clear at the year and half ago that we were focused on consolidating the business and growing our licensed franchise business.
We had 114 stores in 19 countries at the end of the quarter. By the end of this year, we’ll be 141 stores in 22 countries.
We recently opened in Singapore and Korea. So we’ve got continued focus on driving the license business as it’s relatively low capital intensity for ourselves.
And we’ve got a really good business model for running that operation. In relation to the earned and operated, we set back at the end of last year and said that this year is a year of consolidation.
We wanted to set ourselves up for the future. We want to make sure that we are pacing that investment along with the return that we were seeing.
And we feel confident that all of the initiatives we put in place at the end of the last year are now currently paying off. And to that regard, we have a vision for the next three years around, growing our business in greater Asia, growing our business in the United Kingdom, Western Europe and consolidating our position in the Americas with really the completion of our strategy in Mexico.
Mary Boland
And to answer your question, the number of transaction are down and our conversion is slightly down as well too. That’s really driven Kimberly by lower promotions.
And I think as we look at our business in Q2 and in Q3, the business is so much healthier from a profitability perspective as we pull back on promotions and have driven higher AURs. Obviously, you can drive higher transactions through high promotions but that’s not the choice we made.
Operator
Thank you, ladies and gentlemen. [Operator Instructions] Our next question comes from the line of Anna Andreeva with Oppenheimer.
Please go ahead.
Anna Andreeva
Great. Thanks so much and congratulation for the whole team, really terrific results.
Mary Boland
Thank you.
Jay Schottenstein
Thank you.
Mary Boland
I have two things to follow up on the comp guidance. What are you guys seeing so far in the early back-to-school market?
And Mary, you’re guiding comp about in line with the street but EPS range a little bit higher. Can you maybe talk about how we should think about SG&A versus gross margins component as part of that guide for 3Q?
Mary Boland
Yeah. In terms of our comp guidance for the quarter that reflects the business that we expect to see here in Q3.
Look back-to-school just starting. So way too early to call any season here.
As I look at our margin and expense, I see continued expansion in our gross margin as we look forward, again driven by the reduction of promotions and higher AUR obviously. SG&A drove target to continue to leverage SG&A here in Q3.
I think in Q4 as sales are driven in Q4 just due to the higher volume and incentive comp, natural will leverage but that’s our goal to continue to try and leverage.
Operator
Our next question comes from the line of Randy Konik with Jefferies. Please go ahead with your question.
Randy Konik
Okay. Thanks a lot.
So Mary, I just want to follow up on the commentary around the gross margin you’re talking about, I guess, go towards 40%. Could you guys just talk about what are the factors that could drive the duration of time to get to that potentially 40%.
And if you had that kind of handicap, the different buckets of Aerie contributing IMU, DC improvements leverage on the business and markdown rate improvement? How do you handicap the different buckets of what could be most impactful for you to getting to that 40% potential target?
Thanks.
Jen Foyle
Yeah. I would say the list of everything you talked about is correct.
It is the combination of a multitude of things that will help drive our gross margin up higher. I mean, obviously, topline growth is important here to see the opportunity for further margin expansion.
We still have opportunities on our -- in the promotional phase to improve there. There is always opportunity on the assortment to expand our assortment and to -- drive innovation in our product.
Control our BOW is another big area as we continue along the path of our fleet rationalization. We’ll continue to see BOW improve and leverage, and the team continues to stay very focus on expense control.
So it is really all about managing every line of the P&L as there’s opportunity pretty much across the Board and our team continues to focus on it.
Operator
Our next question comes from the line of Paul Alexander with BB&T Capital Markets. Please go ahead with your question.
Paul Alexander
Thank you. Could you talk about the knit tops business a little bit and any thoughts on how that tailwind and business might change at all as we move into fall holiday and as the seasonality of knits changes and would you include sweaters in that discussion of the knits category?
Jay Schottenstein
Hi, Paul. Yeah.
I think, we have -- we are very optimistic about the knits business. We had a great knit and sweater business on the spring side.
A lot of the cotton and knits obviously driven by our Soft & Sexy fabric and then sweaters, we had a great knit business and some great second layers. We’re seeing continued strength heading into Q3.
I think going into the fall and colder weather, from some of the testing we’ve done and have in placed. We are anticipating that we still have the strong knit business going forward.
I mean, as you know that’s a terrific margin business. But we’re evolving and innovating Soft & Sexy in ways that we’ll make it more seasonal or more to cold weather appropriate.
So we’re excited about that. And then we are also -- we continue to be bullish on the sweater business as well.
Operator
Our next question comes from the line of Janet Kloppenburg with JJK research. Please go ahead.
Janet Kloppenburg
Good morning -- good morning, everyone, and congratulations on a great quarter. Just a couple of quick questions, Chad, if you could elaborate a little bit on the Flex Denim assortment and the response to that and if you think that category could or that sub-brand could help the men’s comp to accelerate here in the third quarter?
And Mary, I’m just a little confused on the gross margin opportunity for the third quarter? Is it as great as it was in the first half or should we expect it to moderate and I’m wondering also in the inventory, what your clearance levels are like year-over-year at this time?
Thank you.
Chad Kessler
Hi, Janet.
Janet Kloppenburg
Hi.
Chad Kessler
So in terms of the Flex Denim, we’re seeing strong response so far in back-to-school to Flex. We have it represented multiple levels with any assortment, but also we’ve really worked to put it through all of the different fit architecture that we have and we’re definitely seeing the customer respond to it and its making a significant contribution to the men’s denim business.
We saw last year, Denim X for women’s as an inflection point in the women’s business. And we believe that Flex Denim can provide that sort of -- the innovation Flex Denim can provide that sort of inflection point for men’s as well.
So we are very excited about the response so far from the customer.
Mary Boland
And regarding Q3 gross margin opportunity, we’ll see nice improvement in our gross margin in Q3. It will -- the rate of improvement will moderate slightly as we come up against the improving business last year.
Clearance, we’re in great shape on clearance, so no clearance hangover at all and inventories are in great shape.
Operator
Our next question comes from the line of Lindsay Drucker Mann with Goldman Sachs. Please go ahead.
Lindsay Drucker Mann
Thanks. Hi, everyone.
I was hoping you could give some perspective on your AURs have been very, very strong in the quarter and year-to-date and as we think about the potential for AUR going forward? Can you sort of breakdown how you’re thinking about the opportunity for AUR from fewer markdowns year-over-year, from increasing IMU or sort of ticket price, so maybe just the prospect for further AUR and what the big drivers are?
And then also, sorry, if you mentioned this, but can you help us understand the cadence of comp by month across the quarter? Thanks.
Mary Boland
We don’t provide comp guidance by month. Again, we’re guiding to mid single-digit comps for the quarter.
Lindsay Drucker Mann
I meant for 2Q, what happened in 2Q? Sorry.
Mary Boland
Okay. It was all positive.
I mean, every month was positive for Q2 and so far that trends continuing. AUR going forward, we do expect to see continued improvement in AUR.
Obviously, as we start to lap at the end of Q3 and Q4 next year, the improvement in AUR will abate a little bit but we still do see room for improvement. I do think as we move forward into Q4, as Michael mentioned earlier when he was talking about IMU, we do see some opportunity there to drive improvement.
Jen Foyle
Yeah. I don’t know if you wanted to talk a little bit about the product improvement.
Jay Schottenstein
Yeah. I think that for the most part, AUR improvement, we’ve seen has been based on our reduction and markdown.
We’re trying to make sure we are committed to delivering the best value for the customer possible and the most innovation and quality we can in the assortment. And so as Michael mentioned, like-for-like we’re seeing cost improvements.
Some of that we reinvest into the product. And some of that we do take at higher IMU but for the most part, we aren’t looking to artificially inflate tickets.
That’s not how we’re getting our AUR. We’re really getting AUR by having, by getting stronger customer response to the product that we have out there and selling closer to ticket than we have historically.
In our some items, if you’re doing store checks, there are some items where ticket prices are up to last year and if that is the case it’s because there is something better. There is more quality and more innovation in that product than it was a year ago.
Customer response has been strong where that’s been the case. But for the most part, we’re looking at ticket prices holding steady like-for-like and selling closer to the actual ticket price.
Operator
Our next question comes from the line of Richard Jaffe with Stifel. Please go ahead.
Richard Jaffe
Thanks very much and I guess a real estate question, two parts. One is the fleet rationalization effort.
I’m wondering how you see that unfold in the following year. And then the opportunity for bricks and mortar internationally versus the franchise relationships that you’ve had in the past
Jay Schottenstein
Thanks, Richard. Fleet rationalization was something that we started in early 2014.
We went out in 2014 and said we closed 150 stores over three years. We are well in the midst of that at the moment.
I think the thing that has become a critical focus for us is really the productivity of each of the stores that we have. We have a substantial fleet.
The majority of that fleet remains profitable. Just to give you an idea, we’ve only got 23 American Eagle stores that aren’t four-wall profitable.
So the fleet itself is incredibly solid. So, I think we’ll continue the course.
We review every lease. We’ve just come through straight fleet review and just finished reviewing everything.
And ultimately, the stores will stay open, the warrants staying open, as the customers requirements demand. Thinking about international brick and motor opportunities, we’ve got a very clear strategic path around the opening of stores.
If you think about what we are doing in the back half, hopefully in the next -- by the end of this quarter, we will open our digital start in the United Kingdom. And that’s really is a way for us to identify the opportunities for expanded bricks and mortar, but also for us to leverage the technologies and opportunities we have currently in our U.S.
business, and to develop the global footprint through all of the various channels that our customer shops.
Operator
Our next question comes from the line of Rick Patel with Stephens Inc. Please go ahead.
Rick Patel
Thanks. Good morning, everyone.
Just a question on your denim business. So Denim X has been great, but some of your peers are getting into the stretchable denim category in a bigger way this year.
So given the heightened competition, how do you stand out and maintain your leadership position and then also a question on sourcing? Do you see the recent pullback in the Chinese yuan as an opportunity to reduce sourcing costs further?
And if so, when should we start to see the impact of that?
Jay Schottenstein
I think in terms of denim, we have I think the most experience in the jeans business of our competitors. And it’s not just about the fabric, I can promise you that our Denim X fabric and AEO Flex fabric is better than any of our competitor’s fabric.
All we work very closely with all of our mills to develop these fabrics, even down to the yarn suppliers as to what we’re putting in the fabric and we definitely have the best fabrics in the industry. And it takes a lot more.
I think the other critical thing is it takes a lot more than just having a seriously stretchy jeans to be in the denim business. It’s all about fit, fabric, wash every single fit, every single wash, every single CC is individually set by our tech team.
And we’re in the factories constantly making sure that they are maintaining the quality and the specs that we’re requesting. So I know that some people are trying to chase us in terms of stretch, some people are trying to chase us by even using a term flex.
But I’m confident that our jeans are superior and I know that our customer recognizes that.
Rick Patel
Right. And on the sourcing side, yes, Chad, we do expect the Chinese currency to help?
Chad Kessler
As I’ve said before, we are going to see a significant IMU improvement in the fourth quarter this year. And we expect that we already had expected that to continue through the first half of next year.
And the currency really gives us incremental opportunity on top of that.
Operator
Our next question comes from the line of John Morris with BMO Capital. Please go ahead.
John Morris
Thanks. My congratulations to everybody too as well.
My question for -- thanks, for Chad and I guess Chad and Jen. Chad, you’ve talked specifically to this a little bit in terms of the opportunity as you get into the back half but -- and Jen, love to hear from you as well.
From a product perspective, where else do you see the opportunity particularly for holiday versus last year, because last year I think was really kind of the time when you were beginning to have some noticeable impact on the assortment, so I’m thinking year-over-year. The sides where you really touched on maybe give us a little bit more flavor of where that opportunity is?
Thanks.
Chad Kessler
I think, I don’t want to get into too many specifics about holiday because obviously it’s a few months away.
John Morris
Understand.
Chad Kessler
But I think we -- I think last year, we did start to see improvement. We started to get Aerie brand head in a better direction and we’ve seen their momentum increase through this spring season.
We spend clearly holidays a critical season. The whole team here has spend a lot of time trying to make sure that our assortment would be the best curated assortment for the best innovation that we’ve offered the customer and the best value.
We’re making sure that inventory levels are controlled. So that we don’t find ourselves pressured from having too much inventory to be promotional.
And then another key to it, is that we have -- we test the whole assortment we haven’t -- we’ve laid out what the holiday assortment is. We haven’t set the final assortment yet.
And we certainly haven’t set the final levels yet. We still have weeks and even month or so before we have the whole holiday assortment nailed down.
So we know how critical the holiday assortment is to our performance for the year, and it’s something that we all take very seriously to make sure that we get it as accurate as we can and what we will be providing to customer. But I think that part of it, I think the second thing that’s just as important is making sure that the assortment feels -- that the outfits are terrific, that the assortment feels strong and that it will really emotionally resonate through the customer and we are pretty excited about holiday.
Jen Foyle
And in Aerie, it is really about bras. It’s our biggest category.
And we’ve layered on a whole new business, that’s actually providing incrementality to the bra assortment. So we will continue to chase and deliver on that business, which is soft layers and it’s doing extremely well.
And then similar to what happened in the first half, swim is really an extension business but again providing incrementality. As we look forward into fall and holiday, we have a fairly penetrated business in sleep, and again some of those as at leisure businesses that we’re already getting strong results.
So again, we’ll continue to look forward into that business into Q4.
Operator
Our next question comes from the line of Rebecca Duval with BlueFin Research Partners. Please go ahead.
Rebecca Duval
Hi. Good morning.
And thank you. Congratulations also.
Jay Schottenstein
Thanks. Rebecca.
Rebecca Duval
Just a quick question for Chad, it seems that we are seeing kind of an older customer shopping the stores now more often. Now, I’m just wondering if you are also noticing changes to your customer profile in both the men’s and women’s business and if you see further opportunity there?
Chad Kessler
I think there is two parts to it. First, I think that there is a lot of disarray happening in the mall-based retail today.
And I think as one of the retailers, who I think as a true lifestyle brand providing a nice, edited, curated assortment with easy outfits and terrific bottoms business, I think we really provide the customer an easy place to shop. We are very focused on edited and curating to 20-year-old customer that collegiate customer, but we believe that with the strength of our bottoms business and both men’s and women’s and with the democratic assortments we have that we do appeal to the broader base than just a 20-year-old.
And I think we do have an opportunity to see that even expand going forward.
Judy Meehan
Adam, we have time for one more question.
Operator
Thank you. Our final question comes from the line of Pam Quintiliano with SunTrust.
Please go ahead.
Pam Quintiliano
Great. Thanks so much for squeezing me in guys and congratulations on a really wonderful quarter.
So actually two quick ones. You mentioned new Aerie customer, can you just tell us who she is and can you convert her to an Eagle customer, or is she already shopping at Eagle and now just with the side-by-side make your way over the Aerie with new product there?
And then you had also mentioned that the traffic was higher than the mall average at both divisions. Obviously, product improvement is contributing to that.
But can you talk about response to recent marketing and social media campaigns and just how we think about your approach to that to the back half of the year? Thanks so much.
Jen Foyle
Yes, sure. In Aerie, I guess, first and foremost on your last question is, as far as social media.
We leaned on that heavily kicking out in Spring One with the selfie event and that was a great start. So we will continue to leverage that.
We’ve assembled the whole new social networking team that is highly focused on speaking to the girl in the way that she responds. So regarding that part of the business, it’s been highly effective.
And then the second, can you remind me of your first question please? We are so excited about the social part of the business, I forgot about your first question.
Pam Quintiliano
The new Aerie customer.
Jen Foyle
Yes. In the new Aerie customer, I said it before, I’ll say it again, we continually leveraged the AE customer base say over 16 million customers and over 50% of those are women for sure.
So we are speaking to them. We’ve leveraged some on the digital side.
If you go on to the website today, you’ll see an Aerie nab on top of the AE homepage and that certainly is driving direct traffic. So, yes, of course we’re leveraging that base.
And then we’re finding new ways to speak to the customers through those social networks I just spoke up.
Judy Meehan
Okay. Thanks everyone.
That concludes our call. We appreciate your participation today and continued interest in American Eagle Outfitters.
Operator
Thank you, ladies and gentlemen. This does conclude our teleconference for today.
You may now disconnect your lines at this time. Thank you for your participation and have a wonderful day.