Aug 23, 2017
Operator
Greetings and welcome to the American Eagle Outfitters' Second Quarter 2017 Earnings Conference 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 your host, Ms.
Judy Meehan, Vice President of Investor Relations for American Eagle Outfitters. Thank you.
You may begin.
Judy Meehan
Good morning, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Chief Executive Officer; Chad Kessler, Global Brand President of the AE Brand; Jen Foyle, Global Brand President of Aerie; and Bob Madore, Chief Financial 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. The Company undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise, except as required by law.
Also, please note that during this call and in the accompanying press release, certain financial metrics are presented on both a GAAP and non-GAAP adjusted basis. Reconciliations of adjusted results to the GAAP results are available in the tables attached to the earnings release, which is posted on the Company's website at www.ae.com in the Investor Relations section.
Here you can also find the second quarter investor presentation. And now, I would like to turn the call over to Jay.
Jay Schottenstein
Okay. Good morning and thank you for joining us today.
I'm pleased with our progress this quarter, and that we delivered sales and earnings above our guidance. This mark our 10th consecutive quarter of positive comparable sales growth.
In the current environment this is an accomplishment our team can be very proud of. The quarter was highlighted by the top-line growth, although margins were pressured by incremental promotions.
As we move forward, we're highly focused on opportunities to engage our customers, drive stronger demand and improve profit flow through. Our e-commerce business was a positive standout once again, as we registered our 10th quarter in a row of double-digit sales growth.
We saw a strong online traffic at both brands consistent with our vision of delivering the best online shopping experience. Our web business now represents 23% of total revenue.
On the brand advertising front, we are prioritized digital marketing, which has been highly effective at attracting new customers. In a few weeks, we'll launch a new rewards program.
In a minute Bob will review some of the work on our real estate portfolio. But, let me reiterate that our store base is strong and highly profitable.
Our stores represent a critical brand and customer touch point and yet we are continually reviewing our portfolio looking to optimize the fleet. The focus is on finding the right balance between stores and digital on a market-by-market basis.
Although, we are operating in an environment of intense competition, I can say with confidence that we have two of the best specialty apparel brands in America. Our brands are uniquely positioned with broad consumer appeal, supported by omnichannel capabilities and the infrastructure that leads the market.
Our merchandise and design teams continually challenge themselves on product and fabric innovation to ensure that we are raising the bar to offer our customer the best fashion, quality and value. In the American Eagle brand by leveraging our strength such as our Signature Jeans, we see untapped opportunity not only in North America but globally.
The Aerie brand is emerging as one of the most exciting new concepts with the customers incredibly passionate about what Aerie stands for. We will continue to fuel the momentum and look forward to realizing Aerie as a billion dollar brand over the next few years.
In closing, I'd like to thank the amazing team of associates across AEO. Our focus is operating from a position of strength and the team is highly capable and focused.
I view the current environment as an opportunity where we will continue to capture market share and execute our growth strategy. Thank you.
Now, I like to turn it over to Chad.
Chad Kessler
Thanks Jay. Good morning everyone.
In the second quarter, we made good progress in a number of areas, as we continue to evolve the AE brand. With our strong demand across all of our bottoms category, AE jeans performed extremely well, where we saw record sales and margins again this quarter.
Overall, American Eagle brand comps were flat which is an improvement from the first quarter trend. Following a slower start to the quarter, we saw demand strengthen during June and July with more seasonal weather and a positive response to updated collections and promotional events.
As expected the digital business had very strong growth fueled by higher traffic and strong conversion. Women's apparel posted a positive mid-single digit comp with strength across most categories.
Our team has done a remarkable job getting inspiration from our customers ensuring we have the right fashion, updated fits, washes and [indiscernible] within a well curated collection. Following several quarters of weak performance men's apparel showed improvement.
We saw record performance in men's bottom and a good turnaround in tops. The work the team has done to evolve this business is beginning to pay off and we feel good about our prospects for continued progress.
Now as we look ahead, we are excited about our market position and further opportunities for growth. American Eagle is clearly the go-to-destination for jeans, in fact across all the demographics we are the number two denim retailer in America and across jeans brands we are in second place and growing.
Our strength in jeans has been a major factor in our success to-date and will continue to fuel our success going forward. To be successful in this transforming environment, I believe brands must be famous for something.
Our goal is for the AE brand to be synonymous with jeans and to be the number one jeans brand period. We offer the best innovation, the broadest assortment, the best fits, quality and value.
Although we are well positioned today, we see significant opportunity for additional growth. For example fewer than 40% of our transactions during the back-to-school time period currently include a jean.
We see this as meaningful upside. In a few weeks, we will be launching our revamped loyalty program immediately converting over 15 million current numbers and ramping up our efforts to attract new customers with a significantly upgraded overall experience.
The program will be fully digital with complete integration across shopping channels and will build more levels of rewards including around AE Jeans. As we enter the fall season I'm very optimistic, although it's still early we have seen improving trends for this back-to-school season.
And I will believe we are well positioned this year for a better second half. We have improved product and strong marketing support with exciting events planned to engage our customers throughout the following holiday season.
Additionally, we will continue to enhance the customer experience both online as well as in stores, where we're testing new store prototypes this fall. Thanks to my teams for their hard work.
Now, I'll turn the call over to Jen.
Jen Foyle
Thanks Chad. Good morning everyone.
I'm very proud to report that Aerie had achieved double-digit sales growth in 14 consecutive quarters. This quarter we achieved a 26% comparable sales increase, building on a 24% increase last year.
I'm absolutely thrilled with the teams' execution and accomplishments. Our customers' passion and support for Aerie and Aerie Real validates our strong belief that we are uniquely positioned in the market and well positioned for sustained growth.
In the second quarter, we saw strength across most product categories. It was especially gratifying that the new areas of expansion such as Swim apparel including Chill.
Play. Move exceed our expectations.
We are pleased to see so much enthusiasm around our emerging new categories. The team did a great job identifying new trends and differentiating our collections with updated styles, silhouettes and fabric innovation.
Our categories extension, our natural product adjacencies that complete the Aerie lifestyle. For example our soft knit tops, leggings and fleece, fit perfectly within the brands.
And yet we continue to focus on intimates at the core of our business, in fact next week, we are excited to launch a new collection Real Me designed with absolute comfort and movement in mind. We saw impressive growth continue online, where we offer our customers a unique engaging and convenient shopping experience, combined with our sister brand AE, our customers have complete outfitting right at their fingertips currently nearly 40% of our sales are being realized through our digital channel.
As we expand our footprint in markets with new brick and mortar stores, we are gaining new customers and have seen the online penetration rise dramatically in those markets. Customer acquisition is strong and we saw double-digit increase in our customer database.
Our marketing team continues to do a great job, creating a unique brand experience and inspiring our customers every day. Our Aerie customers are truly impassioned by Aerie real and the strong message of body positivity which is at the center of everything we do.
As we continue to grow, we are building and elevating our best talent and fueling our overall capabilities. We are bringing more and more agility than speed to our process.
Looking forward, I'm excited about how we position for the remainder of this year, and we are very excited about the long-term growth and the future of Aerie. Thanks to my team again for their many contributions to the success.
And now I'm going to turn the call over to Bob.
Bob Madore
Thanks, Jen, and good morning, everyone. The team managed the business well through a difficult spring season.
Although, we're not satisfied to report earnings below last year, promotions were up which put increased pressure on margins as we faced a slower start and less favorable weather conditions early in the season. Yet sales trends improved from the first quarter, with healthier sales metrics including positive traffic, transactions and a higher average unit retail price.
We ended the second quarter in a better inventory position with clearance units down to last year. And we ended the period in a strong financial condition.
Now looking more closely to the details of the quarter. Total revenue increased 3% to $845 million from $823 million last year; comparable sales were up 2% for the period following the 3% increase last year.
Additional sales information can be found on Page 9 of the investor presentation. This quarter by brand, American Eagle comps were flat and Aerie comps increased 26%.
We saw a mid-single digit increase in the average unit retail price due to product mix. The average dollar sale was down in the low-single-digit due to lower units per transaction.
Online traffic was very strong and while store traffic was negative, we saw improving trends throughout the spring season in addition to outpacing mall traffic in the second quarter. On a consolidated basis, traffic and transactions increased driving the 2% comp growth.
Adjusted gross profit decreased 4% to $294 million from $307 million last year; gross margin rates declined 240 basis points to 34.9% of revenue. The reduction in margin was primarily due to increased promotional activity.
Buying, occupancy and warehousing costs delevered 30 basis points. SG&A dollars rose 2% to $204 million compared to $200 million last year driven by strong sales we leveraged SG&A expense by 20 basis points to a rate of 24.1% of revenue.
We invested in advertising primarily digital, which was partially offset by a lower compensation expense. Depreciation and amortization increased $1 million to $40 million and deleveraged 10 basis points to 4.8% as a rate to revenue.
Adjusted operating income of $50 million compared to $69 million last year and the operating margin declined 230 basis points, 6% as a rate of revenue. The effective tax rate decreased to 34.7% compared to 36.5% last year due to overall mix of earnings in jurisdictions with various tax rates.
Adjusted EPS of $0.19 decreased 17% from $0.23 last year. In the second quarter, we incurred restructuring related charges totaling $21 million or approximately $0.07 per share.
This consisted of restructuring charges corresponding to our initiatives to close or convert company-owned and operating stores in the United Kingdom, Hong Kong and China to license partnerships. Additionally, the company incurred charges related to the planned exit of a joint business venture.
Now regarding inventory which can be found on Page 10 of the investor presentation. We ended the quarter with inventorial cost of $433 million up 3% from last year which was better than we expected.
Ending inventory units were flat last year while the average unit cost was up 2% reflecting continued investments in bottoms and Aerie apparel. Currently, we expect third quarter ending inventories to be up in the mid-single digits.
Capital expenditures totaled $46 million in the second quarter and we continued to expect CapEx to be in the range of $160 million to $170 million for the year, roughly half of this spend relates to store projects and the balance to support the digital business, omnichannel tools and general corporate maintenance. We ended the quarter with total cash of $193 million compared to $248 million last year.
The lower cash balance is a result of share buybacks in the first quarter which totaled $88 million. Additionally, over the past 12 months, we returned $90 million in dividends and invested $187 million in capital expenditures.
The detail of our store openings and closings were on Page 13 through 15 of the investor presentation. We are continuing working to maximize our omnichannel business.
As I emphasize last quarter, we are evaluating [fleet] [ph] for closures and market consolidation on an ongoing basis. Additionally, we are making good progress on lease negotiations maintaining lease flexibility and successfully securing lower rents.
Over the past two years, we have renegotiated or negotiated over 350 lease renewals and secured on average of 8% reduction in cash rents. Currently, nearly half or approximately 530 leases or set to expire over the course of the next three years with 215 expiring or coming up for decision this year.
As we continue to build flexibility into our portfolio, it's notable that our stores are highly profitable and powerful vehicles for customer acquisition and engagement. Our very best customers are multi-channel customers engaging with our brands online and in stores.
As an example, roughly 80% of the online return come back to stores where we successfully convert over 40%. In addition, 20% of those transactions are up sales.
We see opportunity to move these metrics even higher. Now, looking ahead to the third quarter.
We expect third quarter earnings per share up $0.36 to $0.38, which is based on comparable sales of flat to low-single-digit increase. This guidance assumes a lower merchandise margin due to increased promotions and a low-single-digit increase in SG&A dollars compared to last year.
This compares to earnings per share of $0.41 last year and excludes potential impairment or restructuring charges. We remain focused on driving quality sales, improving our profit flow through as well as driving our strategic initiatives forward.
We believe the current retail landscape offers opportunity to gain market share and leverage strength of our brand and product offerings. Thank you.
And now we will take questions.
Operator
Thank you. At this time, we will be conducting a question-and-answer session.
[Operator Instructions] Our first question comes from the line of Randy Konik with Jefferies. Please proceed with your question.
Randy Konik
Yes. Thanks a lot.
I just want to further expand upon I guess Aerie, and then, I have a question about gross margin. Just on Aerie, obviously great numbers, they are accelerating, can you give us some perspective on how big you think those additional new younger categories in swimming apparel can be additive into the business?
Give us some update on store growth goals and how you are thinking about positioning those stores relative to -- I guess the American Eagle parent? And then, just on database management around Aerie, can you give us some perspective on how you are trying to look at females you have in the American Eagle database and how you can try to convert them to an additional Aerie, I guess consumer?
And then, lastly, just on gross margin, what's the opportunity for merchandising margin improvement in the back half? Thanks.
Jen Foyle
Okay. There are a lot of questions.
I'm going to do my best Randy. Okay.
First and foremost, these new categories are only just emerging for us. The center of our business is still in intimate and represents over 50% of our business at this stage.
But, knowing that we have these other adjacency businesses, we are pretty excited about them. And what we love about them is there are trends that are happening out there i.e.
fleece and we really were able to get on that trend early and accelerate that trend and it really offsets a little bit of softness in bras. But, we are still loving what we are seeing in bras and we have innovation there.
They were going to continue to use that to drive the bra business and get more customers in our products. Going to that, I think you asked about the database.
There is still a huge runway of getting the AE girls into our brand. Very similar to the stat that Chad mentioned in getting more customers in denim.
It's a similar story just with getting that -- the women's customer in AE into our box. So, a huge runway there.
Margins, I mean we've only just began. We are not even fully $500 million business.
So we are going to continue to leverage our units and get better costing as we expand into new market. And lastly, I think I'm doing a pretty good job by the way.
Randy Konik
Very good.
Jen Foyle
We are only really concentrated on the East Coast. So there is a definite correlation on when we open up a four-wall store and what happens to the direct business, it literally ignites and opens up that market for us.
So, we continue to look at market opportunities that we're not currently in, picking the right location, so that we can drive the direct business and really looking at it from a market perspective. So, that's how we are approaching growth.
The number that we are getting to -- we want to get towards is about 300 stores in total and that includes side by side. And we prefer the side by side opportunity.
Bob Madore
Just to elaborate a little bit on the gross margin question Randy as it relates to total company. We see opportunities for merch margin to continue to improve.
The trend we have seen from Q1 into Q2 is that the decrease to the prior year is actually decreasing or improving. We are seeing improved IMUs as we move through Q3 and Q4 and we are actually up against last year and extremely promotional high markdown period, if you remember in Q3 through Q4, you had Aero going through store liquidations and closures in addition to just a huge promotional environment.
We see that trend improving versus last year too. And just on Jen's point as far as store and market focus, Jen and the team are very focused on expanding within markets really leveraging the existing presence we have with one-off, two-off stores and digital there.
I think I pointed out this statistics last quarter where 70% of Aerie's digital revenues came from the markets where they had a brick and mortar presence. So just to exemplify Jen's point where we have a brick and mortar presence, digital pops and shows up in a big way.
Operator
Thank you. Our next question comes from the line of Matthew Boss with JPMorgan.
Please proceed with your question.
Matthew Boss
Thanks. So, as we break down performance by category, women's apparel was up mid singles, but overall women posted it's first flattish comps in several quarters.
What do you see as the biggest areas of opportunity by category in the back half? And then, just on cadence, if you could speak to trends you saw as the quarter progressed and maybe any comments on back to school so far?
Chad Kessler
Yes. So, our women's business is really healthy.
We were in total women's -- we were up mid-single-digit. And we had record breaking bottoms business and the tops business continued to perform really well.
And I think that's important because I think we were showing clearly in women's over the last few quarters that we can continue to grow the bottoms business at record rates and sell tops at the same time. And we had some softness in women's accessories; some I think we did to ourselves and some I think there are just some softness in trend in women's accessories.
And similarly, dresses were softer than they had been the year prior. But, the total women's apparel business both tops and bottoms is very healthy.
So, feeling good about that. As back to school kicks in, as I said in my comments, it's very early days, we are few weeks into the quarter, but it feels like trends are improving.
Back to school is clearly a big bottoms time period and we are seeing a lot of positive response to our jeans and pants assortments broadly across men's and women's. I think we have really -- the team did a great job nailing what the customers going to be looking for and that just helps to fuel the total business.
So, I'm optimistic and I think that those trends are going to carry through fall, Bob mentioned it, but you got to remember last fall, we were up against Aeropostale closing, which really impacted Q3 and the men's business -- the slowdown in men's really started last fall. So, we ended up being more promotional than we wanted to be.
And I think with the trends we are seeing coming out of June and July and into the early days of August, I'm definitely optimistic that we can roll over some of these promotions and further close the gap to gross margins.
Bob Madore
And Matt, I will just add one last thing to Chad's point. Our comp guidance that we gave for the quarter is in line with the performance we've seen quarter-to-date just to give you a little more specifics on that.
Operator
Thank you. Our next question comes from the line of Brian Tunick with RBC Capital Markets.
Please proceed with your question.
Brian Tunick
Thanks and good morning. Was curious about the inventory growth, I think you're guiding to mid-single digits at the end of the third quarter guys.
Is that timing or is that your view point of Q4 opportunities? And then, if you could talk maybe about the men's tops business, sounds like some encouraging things are happening there.
When should we expect to see the brunt of the new product flows and the timing of the deliveries on the business, is it now or is it more opportunity as we head into the fourth quarter? Thanks very much.
Bob Madore
Yes. I will answer the inventory question.
So, inventory was better than we expected in the quarter, flat units up 3%, we are guiding to be up about 4% in Q4 driven by continued investment in bottoms as Jen's business Aerie continues to take advantage of additional lifestyle categories that are definitely in line with their target customer and resonate with that consumer. If you break down Q3 ending inventory just to give you some insights, AE brand inventory is actually down 2% versus last year and on a unit basis down 8.
Most of the increase almost all of the increase in inventory is all in Aerie. Okay, Aerie had a 26 comp in the quarter and as Jen continues to expand in new markets with brick and mortar as I mentioned, we are anticipating digital sales to come along with that.
So Aerie's inventory growth is very much in line with their sales growth and as a matter of fact I would argue that AE's inventory maybe a little light relative to their overall business and how we are planning it.
Chad Kessler
In terms of men's, we are starting to see some of the total apparel improvements taking place in the business right now. I think it's important to remember that we kept the men's customer, we didn't lose the men's customer, our bottoms business continued to grow throughout some of the challenging periods we're having in tops and we have new leadership in both design and merchandising at start of beginning this year.
And they are going to, some of their efforts have already started to pay off in terms of really being focused on the customer and meeting the customers' needs. I think you'll see really the impact of their efforts as we get into the holiday season and through on in the spring.
But we're already seeing improvement with some of the work in the product architecture they've done. We're seeing some pretty broad improvement across particularly the knits categories where we can react more quickly to their new strategies.
And, for me, I think you can see that, just look at the picture in the window Joey Bada$$ in a red hoddie, he looks great and I think, as we go into September, we go up against the softer men's business, I think we're going to see some pretty nice results.
Operator
Thank you. Our next question comes from the line of Tiffany Kanaga with Deutsche Bank.
Please proceed with your question.
Tiffany Kanaga
Hi. Thanks for taking my questions.
We'd noticed that the price points at the high-end of your women's denim have gone significantly higher lately with $19.80 pairs online. Would you talk about how much of the mid single-digit increase in AUR was driven by denim in the quarter, what kind of perception you're seeing the higher price points in the category and raise the average and max price points headed in upcoming periods?
Chad Kessler
Yes. I think it's great that you've seen our new -- that's called the dream jean.
It is the most spectacular jean we've ever produced. So thank you for letting me talk about it.
The fabric is amazing in this jean and we call it the dream jean, because you have to pinch yourself, but you don't have to pinch yourself because it's real and you've never looked better in a pair of jean. So, hopefully you're going to go and buy a pair.
We continue to look for opportunities to satisfy the customer with our jeans. Our price points, in doing so, we are committed the brand is always been about offering value and most of our jeans between $39 and $59 we have a few that are higher than that.
The dream jean is a new program that we're trying out to see if we can reach even higher. But, it's important to realize that to the customer we're offering the same value in that dream jean that we offer in our $39 and $49 jeans, we really offer a premium product at our corporate points and this will continue to -- this is unbelievable product for that price.
In terms of the AUR improvement, our AUR growth, a lot of that is driven out of the mix and the bottoms, but we aren't seeing -- we are seeing AUR growth in jeans but that's more price sort of mid-single-digit growth in the AUR and jeans, but as we mix the business more into bottoms that does impact the total AUR.
Operator
Thank you. Our next question comes from the line of Oliver Chen with Cowen & Company.
Please proceed with your question.
Oliver Chen
Hi. On the denim frontier, how are you feeling about the [indiscernible] assortment and what do you think is next in terms of keeping you separate from the pack, you've done really a good job with the stretch technology and the finishes and the distress, just curious about how you broadly see the market moving.
And the other broad question is on the digital business over time, like on a long time horizon what would you speak to as the major margin drivers in the margin opportunities in terms of different investments that may need to take place and also opportunities to leverage as the business gains more scale? Thank you.
Chad Kessler
Sure. Thanks Oliver.
I love talking about jeans. We feel really good about our current assortment.
As we've said, we continue to have record quarter after record quarter across the denim business. And as I said in the remarks we're number two as a denim brand and we're number two as a denim retailer and that just means we're going to try harder.
Our goal is clearly to be the number one denim destination and we do that really through offering a very broad democratic assortment, offering the best quality, the best fit and the best value. I feel good about our range of fits and washes, we could have -- we could fill the whole store with what we offer in jeans.
So we have -- the most important fits and washes in stores and then we have a much broader assortment available to the customer online. And as part of the new store experiences we've been looking at how can we bring a stronger denim presence and denim experience into the stores.
But, we're seeing a lot of excitement around new rises and new fits in women that's fueling a lot of growth. And then in men's we're seeing a lot of excitement on the slimmer legs.
So that's been really well-received that was the key strategy going into back-to-school and so far that's been quite successful. And then I think the other big thing that is fueling the growth right now is our wash innovation.
So, we've got a great team, we've got a great process of testing and learning. We have by far the best fit in the business not just an individual fit, but the best fit across all of our different [indiscernible] in the business.
And we'll continue to innovate fabric and offer the best quality and value and I think that's going to be the way forward. And then on top of all of that, we're really focusing the marketing and the brand positioning around jeans.
As I said, there is so much noise out there these days with, omnichannel shopping and social media and just everything going on out there and I think for a brand to win, you have to be really synonymous on something. And the goal is for American Eagle to be synonymous with jeans and jeans to be synonymous with American Eagle.
And I don't believe we've reached that yet, even though we have -- even though we're number two in the market, I see nothing but opportunity to continue to get more customers into our jeans and to grow the business.
Jay Schottenstein
Chad the big opportunity is that only 50% of our customers buy our jeans, so another 50% to play with.
Bob Madore
It was a huge growth contributor to the digital business this quarter in addition to new categories that really resonate like Swim within Aerie. There was a significant amount of swim product sold online.
Another contributor specifically to digital business margin opportunity are things such as digital exclusive products, where is the only place you can get it, where you don't have to be as promotional, which is a specific strategy of ours too. So, kind of drafting growth opportunities across the entire business within digital specifically like denim and denim growth new category growth, but then also strategies that are specific to digital we feel will help improve the digital margin.
Operator
Thank you. Our next question comes from the line of Simeon Siegel with Nomura/Instinet.
Please proceed with your question.
Gene Vladimirov
Good morning, guys. This is Gene Vladimirov on for Simeon.
Can you give a little bit of color on the performance you are seeing in the franchise stores looks like store guide for franchise implies the [toleration] [ph] from last year, so I was wondering what sort of trends you are seeing there? And then maybe can you speak to the higher advertising spends in the quarter and how we should be thinking about for the back-half of the year?
Bob Madore
Sure. So within the franchise businesses, we're going to open approximately 50 new franchise locations throughout the course of the year, I think year-to-date we've opened 22 new locations, where we are seeing significant growth within licensing, some store growth within existing markets of Israel, South Korea, Japan et cetera.
But, really the Middle East is where we're seeing a major increase. Performance-wise, we're seeing a slight improvement in our Japanese managed business, the Middle East is really feeling the growth in that business and Israel continues to grow also.
So, the major markets or countries where we have a presence are contributing relatively well within the franchise business. And as we pointed out in relative to somewhat of the restructuring activities that we've undertaken and recorded charges on, we closed all of our own locations in the U.K.
this quarter and we are actively looking to license the other markets where we have own stores such as Hong Kong and China and those are proceeding according to expectations. So that's really kind of an overview of the franchise business growth where we're seeing it and the fact that we are continuing to pursue, I call it the operating model changes that we've talked about.
We're also pursuing new markets aggressively. I'll give you a little more insight into those as we get further into the negotiations.
But, we see further major market opportunities to grow the franchise business.
Operator
Thank you. Our next question comes from the line of John Morris with BMO Capital Markets.
Please proceed with your question.
John Morris
Thanks. Congratulations on the improvement guys and the good start to back-to-school so far.
I think this -- well I guess this would be for Bob and/or maybe a little bit of commentary from Chad on his thoughts. We can see on the metrics look pretty good at the store level, you've got improving AUR, comp transactions up, traffic up high-single that's all consolidated.
So some of that's Aerie, but it has to -- have to figure there is really nice metrics improvement at the Eagle division as well. Wondering if you feel like you could pull back a little bit more on promos?
And then one quick follow-up what's your thought about pulling back on promotional activity?
Chad Kessler
Yes. John, we definitely are seeing as we said nice trend recently and coming into the back-half as Bob mentioned earlier, we ended up being more promotional than we wanted to be last fall.
I tend to believe a lot of times that our competitors promotions don't have that much of impact on us, but the Arrow closure is definitely impacted us in Q3 as well as the general slowdown in men's and having to take the full box more promotional to try to make-up for that. So, if we see the trends continuing that we are seeing now, we should definitely be able to get promotions more in line or hopefully even less than last year which would help flow through to the gross margin.
John Morris
That's super helpful. And then, comp traffic, this is sort of an extension here, I mean comp traffic on a consolidated basis high-single digits I think you mentioned store traffic was down.
Chad Kessler
Yes.
John Morris
So I'm inferring that e-com very, very strong is that a good [adventure] [ph] here for fall how much do you want us to read into that?
Chad Kessler
So I think we're going to see that continue that e-commerce really a lot of the traffic growth coming there, but what's important is mall traffic is definitely been a headwind over the past over many quarters. But what's changed in Q2 that Bob mentioned is that we're still seeing traffic down, but our traffic is better than mall traffic.
And we've been sort of pacing with mall traffic and it seems like we're starting to see a little separation in the AE brand and overall mall traffic which, I think bodes well for the second half.
Operator
Thank you. [Operator Instructions] Our next question comes from the line of Paul Lejuez with Citigroup.
Please proceed with your question.
Paul Lejuez
Hey, thanks guys. Can you talk about the relationship between third quarter and fourth quarter net income historically fourth quarter is a larger net income quarter for you guys last year that wasn't the case.
How do you look at that, did something changed last year that should change the way we think about 4Q versus 3Q, so just wondering, asking for guidance for fourth quarter, but just how to think about that from a big picture perspective and obviously excluding the extra week this year? Thanks.
Bob Madore
Yes. I mean with the extra week factored in this year in Q4, you should be thinking of Q3 net income and Q4 net income performing at somewhat comparable levels on a dollar basis.
If you look at the extra week in Q4, it's worth about $45 million in sales and $0.03 of EPS impact, but roughly they track somewhat comparably from a net income perspective Q3 and Q4.
Jay Schottenstein
Well, last year you also had a fourth quarter that was very promotional.
Bob Madore
Very promotional, you are right.
Jay Schottenstein
The competition was going crazy.
Bob Madore
Yes.
Jay Schottenstein
All the store closings, everybody was getting everything away.
Operator
Thank you. Our next question comes from the line of Janet Kloppenburg with JJK Research.
Please proceed with your question.
Janet Kloppenburg
Good morning, everyone, congrats on the progress. I was wondering Chad if you could talk about the likelihood that the American Eagle brand comps could jump positive in back half driven by the higher AUR denim or perhaps continuing progress in the men's business?
And I also wanted Jen to touch a little bit on the softness in bras you saw on the second quarter and maybe what that is related to and I think you are looking for improvement during the third quarter? And just lastly for Bob, I think you said that the third quarter guidance included an outlook for merch margins to be down in the third quarter and I'm just wondering given the trends and the clearance levels being what they were -- why should we expect that.
I think Chad just said wanted to be less promotional in the quarter. Thanks.
Chad Kessler
Jen, I'm really optimistic about the back half, for the first two quarters combined AE was basically flat and we had super cold temperatures for most of that entire time period that I think was definitely a headwind in the business. As we come into June and July and early days of Q3, we are running ahead of last year and I think that we should be able to see that continue.
We come up against, starting Q3 as I said the men's business getting really soft, Arrow closures from last year, if we continue to see this sort of separation between us and mall traffic and as the men's business continues to improve, I'm definitely optimistic for opportunity to post positive comps in the AE brand. And of course, there are things that could happen in terms of the environment and weather and what not, but I definitely think we have an opportunity for positive comps in Q3.
Jay Schottenstein
Yes. If I could add to what Chad is saying, Chad it only takes one program, extra program to kick in that makes all the difference.
And last year, we ran short on certain goods and so our objective this year to make sure on the right programs that are strong that we got right now early like we did last year.
Bob Madore
And Jen, on your point about expectations of Q3 margin being down versus [indiscernible] that's true that is what I said. But, what we are seeing is that being down on a basis point percentage continuing decreasing from Q1 where we are 270 basis points down to Q2 where we were 240 basis points down to last year and we expect Q3 and Q4 continue and improve trend, but to be down versus last year and still.
Why it's down less, it is really driven by higher IMUs in addition to slightly lower markdowns based on some of the things that Chad referred to also.
Jen Foyle
And Jen, regarding bras, we did see a little softness in bras for sure, really from the push up category, our lightly lined category still has been working for us. And we continue to innovate around that category Janet.
Bralettes were definitely saturated out there in the marketplace. But, the good thing there and I said this before, as bralettes continue to be in our top-three departments and there still be demand for them Janet.
I just think that there is a lot out there for the customer to choose from. So, what we are going to continue to do is innovate in that category, so she is excited about what she sees quarter-over-quarter and innovating our core category.
So, we are pretty excited about this launch coming up, you will see it in stores next week. So, I think the customers going to love it.
Operator
Thank you. Our next question comes from the line of Dana Telsey with Telsey Advisory Group.
Please proceed with your question.
Dana Telsey
Good morning, everyone. Can you talk a little bit about the financial impact of the loyalty program and how you see that developing and also any -- just more clarification on the joint venture that's being exited?
Thank you.
Jay Schottenstein
We see that loyalty program being -- hopefully a positive financial impact through the quarter or through the season. We have got our existing loyalty program coming to an end which has some -- we will have some coupons out there.
But, then as the new program start, it actually is rolling reward, so customers will start earning into the reward right off the back as opposed to getting them quarterly. So, we see that as possibly some upside in the back half, but it's not something we want to see how it plays out.
So, it's not really contemplated in our forecast. But, the loyalty program really -- we have so many customers in the program and the current one is really outdated, this new one is going to offer much better rewards for our best customers, it's flexible for us to update and change as we go, it's going to be integrated with our credit program and it really reinforces our leadership in jeans and has special rewards around jean.
So, as that kicks in, we do think it should pay-off with some additional sales, but that's contemplated in what we said today.
Bob Madore
Hi, Dana. To answer your question on joint venture that we are in the middle of exiting.
We tested a new retail concept that revolved around a nautical of retail store and product lines assortment. We tested it and approximately three stores and the results were not in line with our expectation.
So, what I think is one of the thing -- many things that we grade out as an organization is, we are constantly innovating and trying new things, but when they don't work, we have them fail fast and not in a material way. So, this kind of falls in to that category.
We tested some thing, didn't live up to the expectation and we are moving on to bigger things.
Operator
Thank you. Our next question comes from the line of Pam Quintiliano with SunTrust.
Please proceed with your question.
Pam Quintiliano
Congratulations on the quarter. And thanks for taking the question.
Just had for Jen, regarding the SoHo pop-up location, can you talk about any learnings that you maybe able to apply across the broader base? And then, just when we were thinking about your store growth, obviously, it's tough out there for a lot of other retailers, so given you're one of the few that's doing well expanding your store base.
Are you getting better real estate opportunities in the marketplace in terms of locations and/or terms? Thanks.
Jen Foyle
The SoHo pop-up is amazing Pam. We are so excited about it and we love having a standalone shop that's right next door to the headquarter.
So, we are always in there learning from the customers and listening to what they want and they are responding to. The team there is phenomenal and just that whole environment just -- it's exciting.
And I think it's what you read today, right? Everyone wants experience today, what's going to get them off the couch to get into a store and that certainly what are you going for and it's working out phenomenally.
What we are going to do from there is take some of those learnings and imply it into some of our new concept stores that were opening up. So, we like certain aspects of it, we love some of the live walls and what have you.
And like I said, it's a template for what we are going to do go forward. That said, regarding opening stores, Pam, we are in a really great position.
We are not over saturated. So, we can really pick and choose what markets we want to be in and what locations, obviously, going into the best centers where there still is traffic.
By the way on -- one-point is that, our traffic actually, we haven't had a problem with traffic in the area. They are actually -- we are able to drive traffic, the marketing team is doing a great job.
But, again, we are going to be very selective into what markets we go into. And as I mentioned in my opening comments, there is that correlation and Bob supported nicely with his figures that once we open a store in a new market, the direct business really follow suite.
So, we are going to pick and choose, where we want to go strategically and -- that strategy.
Bob Madore
From a total company real estate portfolio management perspective, let's say a couple of things. I gave some stats over the number of leases that we've renegotiated that came up for renewal over the course of the last three years.
Let's say all the way through the end of fiscal 2016 where that's drove an 8% cash rent reduction and it drove a 100 basis point rate reduction, I know that population of deals. What we are seeing in recent history and is part of our strategy is, we are able to do package deals with landlords for renegotiations, major developers where in recent history over the last two real estate committee meetings and two big packages we booked at, we were actually able to reduce our rent by 400 basis points across those two deals that we recently did.
So, there is clearly ability to renegotiate and drive…
Jay Schottenstein
Still keep the flexibility in short-term leases.
Bob Madore
That's exactly right. On top of that we maintain an average lease term of 3.7 years of those deals that we renegotiated over the course of the last three years and most recently.
On top of that, yes, we are getting better locations because we are performing better; we are driving more traffic than other special retailers in the mall. It gives us an opportunity to potentially reposition the portfolio.
So, where we maybe sitting on the 20-yard today -- 20-yard line today in an AE store. If a 50-yard line location opens up that affords us the opportunity to put in an Aerie side by side.
We are going to do it. And we are looking for opportunities like that and that's where you are going to see a lot of the new store activity in the U.S.
for AE. It's really opportunities to either reposition on better location or 50-yard line or better or open up an Aerie side by side.
So, we see this market, it's challenging, don't get me wrong. We are not happy with the results below last year.
But, trends are improving and it's giving us the opportunity to make some changes in our business, in our store portfolio that I'm not sure we would have had an opportunity too before and hopefully continue to strengthen the brand the business performance.
Operator
Thank you. Our next question comes from the line of Lindsay Drucker Mann with Goldman Sachs.
Please proceed with your question.
Lindsay Drucker Mann
Hi. Thanks so much.
I just first wanted to clarify on maybe part of Matt Boss' question, which is, Chad, you talked about AE women's apparel comp at mid singles, but I think the reported comp is flat, so is it just accessories that were the negative piece that brought the overall women's comp to flat or was there something else? And my second question is, just on I think in your prepared remarks, you talked a new store prototype, any more details on what you are testing, how many are you testing and what that's about?
Thanks so much.
Chad Kessler
Yes. As I mentioned before the drag on the total's women's business was accessories and then some of the dress business in there.
But accessories offset some of the gains that we had in total women's apparel. So, those are really the two pieces.
Honestly the success in women is really broad across all the apparel categories, all the tops and bottoms apparel category. Yes.
We are working on some new store prototypes that we are pretty excited about. Jen's got this great pop-up on Spring Street.
We are working on a similar not similar in execution but a similar idea of flexible and some new customer experiences here in New York that we will talk about as that gets closer. We are also working on some new merchandising ideas and customer experiences in mall.
So, we are testing a bunch of stuff. We hope to get these things open this fall and get some learnings and then next year 2018 based on how these work, hopefully start opening some new store design.
So, it's exciting. I think we have got so much opportunity in jean and today as we said, fewer than half of the transactions included jean and I don't believe -- beyond that I don't believe that our current store environment really speaks to our denim authority as much as it could.
And so part of what we want to do in these new store prototypes and new customer experience, is make sure that denim is really front and center and that the denim experience is strong as it can be. And as we have seen in the women's tops areas, and I think look to this fall in men's tops with the leading bottoms business, we can get the customer and the jean and then get him to buy the tops go along with it.
So, I'm really optimistic about that. It's going to be great.
Judy Meehan
And Melissa, we have time for one more question.
Operator
Thank you. Our final question today will come from the line of Anna Andreeva with Oppenheimer & Company.
Please proceed with your question.
Anna Andreeva
Great. Thanks.
Good morning. And happy to have made it.
Two quick questions, follow-up on AUC, what's driving the biggest tailwinds into the back half? And should we still expect AUC favorability also spring 2018?
And then, secondly, just any initial thoughts on CapEx for next year. Should that number be coming down given potential for door closures and just given the strong balance sheet, any updated thinking on bigger share buyback?
Thanks.
Bob Madore
So, on the average unit cost question, yes, Anna. Really again driven by our investment in not only total bottoms business within American Eagle but the expansion of certain apparel categories within Aerie, which is really what's driving that.
On a like-by-like basis -- like-by-like product basis, we are actually seeing about a 3% AUC decrease. So, it's really category expansion and investment in long bottoms and apparel within the Aerie business that's driving that.
From a CapEx perspective and kind of thoughts around next year, we are in the process of starting our budget process soon, so, I don't have a specific number for you. I anticipate though that number to be comparable to this year's number or quite possibly even a little higher as we test the new store prototypes within American Eagle and particular depending upon the response and our satisfaction with those concepts, we will be looking to remodel a number of the stores in the store fleet.
So I do anticipate an increase in remodel CapEx looking out to next year for sure. And we will continue to invest in our digital business accordingly.
So, the number could be comparable to this year or slightly above, we haven't really nailed our budgets down at all this point, but I want to give you a little bit of directional guidance. From a share buyback perspective, within this market and this sector is crazy, everyday I look at my computer screen and see what's going on not only across our stock in PE that we're [winning] [ph] it any given day, the volatility is unbelievable and how other retailers impact our share price is amazing to me having said that we're always looking for opportunities to buy shares.
We're constantly -- the one constant is, we'll always do stop buybacks to offset share dilution, increase share comp dilution for sure that [sort of] [ph] minimum. And, we kind of -- but you can't time the market, you can't try to play out to the bottom we are always looking to return to shareholders through book dividends and share buybacks.
We always maintain that flexibility, I guess is what I said. But, don't have any specific plans that we can communicate at this point.
Judy Meehan
Hey Melissa that's it.
Operator
Thank you. This concludes today's teleconference.
You may disconnect your lines at this time. Thank you for your participation.