Feb 26, 2014
Executives
Brian Logan - VP, IR and Controller Michael Jeffries - CEO Jonathan Ramsden - CFO and COO
Analysts
Stephanie Wissink - Piper Jaffray Brian Tunick - J.P. Morgan Randy Konik - Jefferies Kimberly Greenberger - Morgan Stanley Janet Kloppenburg - JJK Research Paul Lejuez - Wells Fargo Adrienne Tennant - Janney Capital Markets Matthew McClintock - Barclays Capital Anna Andreeva - Oppenheimer Lindsay Drucker Mann - Goldman Sachs Dana Telsey - Telsey Advisory Group Oliver Chen - Citigroup Paul Alexander - Bank of America Merrill Lynch Marni Shapiro - The Retail Tracker Barbara Wyckoff - CLSA Omar Saad - ISI Group John Morris - BMO Capital Markets
Operator
Good day and welcome to the Abercrombie & Fitch Fourth Quarter 2013 Earnings Results Conference Call. Today's call is being recorded.
[Operator Instructions]. At this time, I would like to turn the conference over to Brian Logan.
Mr. Logan, please go ahead.
Brian Logan
Good morning and welcome to our fourth quarter earnings call. Earlier today, we released our fourth quarter sales and earnings, income statements, balance sheet, store opening and closing summary and an updated financial history.
Please feel free to reference these materials available on our website. Also available on our website is an investor presentation, which we will be referring to in our comments during this call.
Today's earnings call is being recorded, and the replay may be accessed through the internet at abercrombie.com under the Investors section. The call is scheduled for one hour; joining me today are Mike Jeffries and Jonathan Ramsden.
Before we begin, I remind you that any forward-looking statements we may make today are subject to the Safe Harbor statement found in our SEC filings. In addition, due to the 53rd week in the fiscal 2012 retail year, fourth quarter comparable sales are compared to the 13-week period ended February 2, 2013.
After our prepared comments this morning, we will be available to take your questions for as long as time permits. With that, I will hand it over to Mike for some opening remarks.
Michael Jeffries
Good morning everyone and thanks for joining us. 2013 was a challenging year, with sales and earnings falling well short of the [indiscernible] we set at the beginning of the year.
After three years of positive growth and our combined U.S. chain store plus direct-to-consumer comparable sales metric, that metric turns negative for 2013, against the backdrop of a challenging retail environment, particularly, in the teen space.
The significant decline in store traffic that began in July continued through the holiday season, and as yet, has shown no sign of abating. Despite that difficult context, it is important that we return to positive growth, particularly in our core-U.S.
business and the steps we are taking as we execute against our long range strategic plan, should put us in a position to achieve this goal. For the fourth quarter, we were pleased to see some sequential sales improvement, and that we were able to exceed our earnings guidance coming into the quarter.
In addition, our direct-to-consumer business was particularly strong and represented nearly 25% of total sales for the quarter, up in all regions, with particularly strong growth in Asia. We are also pleased by the excellent results we are seeing in our new stores in China and Japan.
We now have seven Hollister stores in Mainland China, including our newest stores, at the IST Mall in Nanjing. Overall, our stores in China posted a 35% increase in comparable store sales for the year.
We look forward to the opening of our Shanghai A&F flagship store in April, which will further support our growing brand awareness in Asia. We plan to open approximately five additional stores in China in 2014, including two mall-based A&F stores.
In Japan, we opened our second Hollister store at Lalaport Shin Misato in Tokyo during the quarter. Similar to our first store in Yokohama, volume is annualizing at more than twice our initial plan, and four wall margins are well above our hurdle rates.
These stores have been an important test for us, and we are reviewing our ability to accelerate our plans in Japan, given the success we have seen. During the quarter, we also opened our first store in the Middle East at the Mall of the Emirates in Dubai.
This store is also exceeding our initial projected volume, and is on track to be one of the top Hollister stores globally. We look forward to additional openings in the Middle East in 2014.
While showing some modest improvement, comps across most countries in Europe remain significantly negative, with Scandinavia again being an exception. The general economic outlook in Europe remains uncertain, with youth unemployment remaining stubbornly high in most of our core markets.
Notwithstanding the sustained comp declines we have seen, our productivity in Europe remains well above the mall average. From a merchandise standpoint, we performed well in outerwear for the quarter, with comps up strongly across genders and brands.
We continue to see high potential in this category. Our accessories, underwear and intimates businesses also did well for the quarter, and our denim business remains solid, comping positively on across [indiscernible].
In our last earnings call, we laid our four key priority areas, and I would like to take a few minutes to speak to each of those. First, continuing to improve fashion in our female business is a critical objective, and ties very closely to our objective of driving productivity from our U.S.
stores. We are taking aggressive steps to evolve our assortment and shorten lead times, and increased style differentiation.
Lowering our average unit cost will also help us to be more competitive on AURs in this part of the business. We are now testing close to 100% of our assortment, and we have new technology, that enables us to test much earlier in the product development cycle.
We are deploying new fabric platforming processes, that are reducing lead times, particularly in Chase, which is now a significant component of our fashion business, and we will begin to include shorter lead times, vendor designed product in our assortments for the first time this quarter. Our second key priority is increasing brand engagement through enhanced marketing initiatives and campaigns.
During the fourth quarter, we spent an incremental $5 million in marketing, which produced good results. For 2014, we are approaching this aggressively including a significant increase in planned marketing expense.
We will launch a global marketing campaign for Hollister this summer, featuring an evolved positioning, which we are very excited about. We are committing significant spend toward the campaign, which will be delivered through events, key offers, and social media.
For A&F, we expect the launch of a similar campaign for back-to-school. Both campaigns are leveraging our in-depth customer research, and are also benefiting from the learnings of our additional marketing spend in the fourth quarter.
This included an aggressive push to reach more fashion bloggers, which has generated more than 17 million impressions to-date. We are a leader in social media, partnering with Facebook and Twitter, to unlock new customer targeting opportunities over the Black Friday and winter sale periods.
We are also excited about the latest installment of our A&F rising stars campaign, which features seven new faces across movies, television and music. To date, we have generated over 100 million media impressions related to this campaign, appearing on Access Hollywood, E!, Teen Vogue and other relevant media.
In addition, our first A&F star Twitter chat with actor Diego Boneta, was a trending topic on Twitter. Third, we made excellent progress on the restructuring of our cost base and Jonathan will give more details on this in a moment.
As we move forward, we believe the next big area of opportunity lies in lowering our merchandise average unit cost. Our average unit cost will be down on a full year basis for 2014, weighted towards the back half of the year, and we see additional opportunity, as we move growth, particularly for Hollister.
Fourth, we continue to focus on ensuring we are properly organized to execute against our strategic plan. We are making progress on our search for our brand precedence, and next month, we will move to a vertical organization structure by brand, for most of our categories in design, merchandising, and planning.
We believe these actions will support a number of key objectives, including increased brand differentiation, and increased accountability. [Indiscernible] for immediate priorities, we continue to focus on disciplined execution against our long term plan initiatives.
From a strategic standpoint, it is clear that we need to be thinking outside of the confines of our existing vertical specialty retail model. This includes, looking at selling third party brands through our channels, and selling our branded merchandise through third party channels.
As you know, the partnership between Kids and Hollister was very successful last fall, and we are continuing that collaboration with new SKUs later this year. We have a long list of additional collaborations in the work, across footwear, apparel and accessories, which we are excited to launch in the coming months.
We know our target customer values in these [indiscernible], and we believe they can improve our brand positioning, while driving incremental sales and margin. As we look forward to 2014 and beyond, there is much work ahead of us, as we navigate a rapidly changing difficult and uncertain environment.
However, we are encouraged by the progress we are making, as we continue to execute against our long ranged plan objectives, and are committed to achieving meaningful improvements in our business. Now let's go to Jonathan.
Jonathan Ramsden
Thanks Mike and good morning everyone. I will start with a short recap for the quarter, and then talk about our outlook for 2014, and the key drivers of our longer term financial objectives.
For the quarter, the company's net sales were $1.299 billion, down 12% to last year, with approximately 6% of the decline attributable to the extra week in last year's fiscal quarter. including DTC, total comp sales were down 8%, with comp store sales down 16% and comp DTC sales up 24%.
Total DTC sales, including shipping and handling were up 18%. Total U.S.
sales including DTC were down 13%, with comp sales down 8%. Total international sales, including DTC were down 9%, with comp sales also down 9%.
Overall, sales are better than expected, particularly, during the holiday season. Within the quarter, comparable sales were weakest in January, reflecting in part, significantly lower promotional activity compared to last year.
The gross margin rate for the quarter was 440 basis points lower year-over-year, which was in line with expectations, and reflected an increase in promotional activity during the high volume holiday season, including shifting promotions in the direct-to-consumer business, and an adverse effect from the calendar shift. While on an adjusted non-GAAP basis, operating expense for the quarter was $621 million versus $692 million last year.
This excludes pre-tax charges of $44 million, which are detailed on page 4 of our investor presentation. The expenses for the quarter came in significantly below forecast, as we were able to accelerate savings from the profit improvement initiative, which totaled approximately $25 million for the quarter.
This was partially offset by additional marketing expense of approximately $5 million for the quarter. On an adjusted non-GAAP basis, operating income for the quarter was $155 million versus $252 million a year ago.
Operating margin on an adjusted basis decreased 530 basis points, primarily resulting from gross margin erosion. The tax rate for the quarter excluding effective charges was 31.4%, which reflects a benefit from a higher proportion of earnings being generated from international operations than previously expected.
For the quarter, the company reported adjusted non-GAAP EPS of $1.34 versus $2.01 last year. Relative to initial guidance for the quarter, results are better than expected due to higher sales and gross profit, greater expense savings and a lower tax rate, with each contributing approximately equally.
Turning to the balance sheet, we ended the quarter with approximately $600 million in cash and cash equivalents, and borrowings under the term loan of $135 million. We ended the quarter with total inventory costs of 24% versus the low levels a year ago, due to in-transit significantly contributing to the increase.
Excluding in-transit, inventory was up 16% and by a somewhat lesser amount on a unit basis. Also keep in mind, that the increase this year is of a $0.37 decrease last year, due to low fall carryover inventory, delayed spin receipts, and less inventory in-transit.
On a two year basis, inventory is down 22%. During the quarter, we closed 16 of our standalone Gilly Hicks stores and incurred charges of approximately $37 million related to the restructuring.
We expect the remaining stores to be substantially close by the end of the first quarter of fiscal 2014. Excluding charges associated with the restructuring, we incurred an operating loss of approximately $30 million related to Gilly Hicks for the fiscal year.
We expect to incur approximately $10 million in additional charges associated with Gilly Hicks in 2014, and that excluding those charges, the brand will operate on a breakeven basis. Excluding Gilly Hicks, we closed 46 U.S.
stores during the year, bringing a total closure since 2010 to 220. Turning to 2014 and beyond, our financial objective remains to drive significant improvement on return on invested capital, through a combination of disciplined capital allocation and operating margin improvement.
Starting with capital allocation, we anticipate 2014 capital expenditures of around $200 million or slightly greater, which includes the effects of some timing shifts from 2013. As discussed at our Investor Day in November, our 2014 capital expenditures are prioritized towards DTC and IT investments to support growth initiatives.
This includes the major projects to reconfigure one of our distribution centers here in New Albany, to be a dedicated direct-to-consumer facility. This will provide the additional infrastructure necessary to support unit volume growth from our expanding web exclusive assortment, and also improve processing speed.
CapEx related to new international store openings will be significantly lower than in recent years, and prioritize towards key growth markets of Japan, China, and the Middle East. We expect to open 16 full priced international stores throughout the year, including the A&F flagship store in Shanghai, and a small number of A&F mall-based stores.
Overall, our ROI on 2014 CapEx is expected to comfortably exceed our 30% objective. As we announced earlier this morning, the board has approved $150 million accelerated share repurchase to be executed during the first quarter this year into the existing open share repurchase authorization of 16.3 million shares.
The accelerated share repurchase reflects our confidence in our ability to achieve significantly improved performance and create sustainable value for our shareholders. We anticipate additional share repurchases over the course of the year, utilizing free cash flow generated from operations, in addition to utilization of existing or additional credit facilities.
With regards to operating margin improvement, in our November Investor Day presentation, we identified four key drivers. The improvement in U.S.
store productivity in AUR, growth in DTC penetration, profitable international growth and cost reduction. On cost reduction, we now expect gross savings from our profit improvement initiatives to be at least $175 million, of which approximately $30 million was recognized in 2013, and an incremental $145 million will be recognized in 2014.
We expect to realize some additional savings beyond 2014. The majority of these savings are included in operating expense, with a smaller element included in gross margin.
Over half of the savings been generated are expected to come from store operations work stream, other areas of significant savings are stores repair and maintenance, store packaging and supplies, IT and corporate overhead. Partially offsetting these savings, we expect to increase 2014 marketing expenditures by approximately $30 million or greater as compared to 2013, with the expenses skewed disproportionately towards the first half of the year.
This is on top of the additional $5 million we spent in the fourth quarter of 2013. Going forward as Mike alluded to, we believe there is potential to achieve meaningful savings in AUC beyond the modest reduction baked into our 2014 outlook, particularly with regards to Hollister.
On DTC, we anticipate another year of strong growth in 2014, both in the U.S. and internationally, with the segment margin remaining in the mid to upper 30s.
The investments we have made in the DTC business resulted in conversion rates being up significantly across all sites in 2013, and we plan to continue to invest in DTC, including increasing our assortment of web exclusive styles, completing the order management system upgrades to support on-the-channel initiatives, advancing mobile capabilities and expanding international language and payment options. With regard to U.S.
school productivity, alongside some of the initiatives Mike referenced, we continue to see store closures as a significant part of the equation. We currently expected to close 60 to 70 stores in the U.S.
during 2014 through natural lease expirations. Significantly, our average remaining lease term per U.S.
chain stores has roughly halved in the past three years, and we have over 500 leases up for renewal, between now and the end of 2016. This gives us significant flexibility to respond to changing retail dynamics in U.S.
Moving on to our earnings outlook for 2014, based on assumption of a high single digit decline in comparable store sales and an approximate 20% increase in comparable direct-to-consumer sales, the company projects full year diluted earnings per share in the range of $2.15 to $2.35. The sales projection does not include any benefit the company may realize during the year, from its long range pan initiatives, but also does not reflect further potential deterioration in underlying trends.
The guidance assumes a gross margin rate for the full year, that is flat to down slightly compared to fiscal 2013, with continuing AUR pressure and lower shipping and handling revenues relative to sales, offsetting AUC improvement and the benefit from the company's profit improvement initiatives. The above guidance does not including remaining charges related to the restructuring of the Gilly Hicks brand, other impairment and store closure charges, or charges related to the implementation of the profit improvement initiative.
We anticipate a full year tax rate of approximately 35%, and a weighted average share count of approximately 78 million shares, excluding the effect of share repurchases, including those pursuant to the announced accelerated share repurchase. With that, I am going to hand it over to Brian to provide some more details on our results for the quarter.
Brian Logan
Thanks Jonathan. As reported, fourth quarter comp sales were down 8%.
By brand, comp sales including direct-to-consumer were down 6% for Abercrombie & Fitch, down 8% for Abercrombie Kids and down 10% for Hollister. Across brands, female performance remains weaker than male.
Changes in foreign currency exchange rates versus a year ago benefited sales by approximately $9 million. Also, due to the extra week in the fiscal 2012 calendar, sales for the prior year comparable 13-week period ended February 2, 2013, had approximately $82 million less in sales versus the reported 14-week period ended February 2, 2013, which adversely affected fourth quarter year-over-year sales and earnings.
The gross profit rate for the fourth quarter was 59.0%, 440 basis points lower than last year's fourth quarter gross margin rate, reflecting an increase in promotional activity. Stores and distribution expense for the quarter was $506 million, down from $570 million last year.
The stores and distribution expense rate for the quarter was 38.9%, approximately flat to last year. Expense savings in store payroll for our management and support, and other store and distribution expense, including accelerated savings, resulted from profit improvement initiatives, were offset by the deleverage effect of negative comparable sales and higher direct-to-consumer expense.
MG&A expense for the quarter was $119 million versus $122 million last year. MG&A expense for the quarter included $3 million of charges related to the profit-improvement initiatives.
Excluding these charges, MG&A expense for the quarter was down $7 million, a decrease of 6% versus last year. Details of our international Hollister store openings for the quarter are included on the slide on page 9 of the investor presentation.
At the end of the quarter, we operated 843 stores in the U.S., and 163 stores in Canada, Europe, Asia and Australia. This concludes our prepared comments.
We will now take your questions. Thank you.
Operator
(Operator Instructions). Our first question today will come from Stephanie Wissink, Piper Jaffray.
Stephanie Wissink - Piper Jaffray
Mike and Jonathan, a question for you just on one of the strategies you outlined relative to [indiscernible] productivity initiative. I think Mike, you mentioned that an improved AUR, that's core to that strategy, but Jonathan, you also mentioned in your gross margin guidance post 2014, that you would expect some AUR decline.
So just a reflection of 2014 being a transitional year along that improvement plan, or is there something in your consumer insights that's [indiscernible] thinking the merchandise pricing structure?
Michael Jeffries
Let me respond to that Steph. We have a number of initiatives to improve our AUR, and we have gone over those before, but I will go over them again, introducing markdowns and promotions to being more conservative with our upfront buys, evolving the testing of our assortment, reducing lead times to react more quickly to our tests; increased style differentiation, and refining our presentation standards and improving our allocation accuracy.
These are a few points, the list is really longer. But, and this is a very big but, we currently operate in a very challenging retail environment, and we really expect AURs to come down.
That would be offset by some of these initiatives, but we do expect AURs to come down. We need to be competitive on price, particularly female fashion, and aggressively look, as I said in my statement, to reduce AUC to give us that flexibility.
This is a very important part of our strategy.
Stephanie Wissink - Piper Jaffray
Thank you. Best of luck guys.
Michael Jeffries
Thank you, Steph.
Operator
Next is Brian Tunick, J.P. Morgan.
Brian Tunick - J.P. Morgan
Thanks. Morning guys.
My question is, I guess on the vertical structure by brand, I think that's obviously new to all of us, and how you're thinking about it, going out and announcing brand precedence, lot of things happening on the board level. Can you may be talk about Mike, sort of your view of what kind of people you want to have running Hollister and Abercrombie's brand presidents and how you think the vertical structure is going to look a lot different than how you typically run the company horizontally by product category?
Thanks very much.
Michael Jeffries
I think what people were looking for, and I have to say, we found that there are some very well qualified people who are interested in joining this company. But they need a general management background in addition to being product oriented.
Branding initiative will enable us to have more distinguished products, product that's different from one brand to the next, and also will enable us through new insight with these new people to look at the business a little differently. It is a different concept, but one that I think is really appropriate for where the business is now.
I don't think that we are going to lose category dominance while doing [indiscernible]. I think we will still be category specialists.
A good question Brian.
Operator
Our next question will come from Randy Konik with Jefferies.
Randy Konik - Jefferies
Great. Thanks a lot.
I guess my question would be more for Jonathan. If you think about the 2014 outlook, in terms of your visibility around that, how would you compare in contrast that to when you gave the 2013 outlook, as it relates specifically to your visibility around the sales line, your visibility around the gross margin line, and your visibility around the EPS line.
Where do you feel most comfortable with those numbers that you gave this morning, and where do you feel least comfortable?
Jonathan Ramsden
Hey Randy. I think if you look back at 2013, clearly what happened was, there was a huge change in traffic in July and went on for the rest of the year, and my belief [indiscernible] comments has continued to date.
So by the way, in the first quarter, we will not be able to [indiscernible]. So that is a change in the trajectory of the business, to a number of factors, none of which necessarily fully explains why you have such an abrupt change, that has obviously been widely reported across the industry.
So I think the environment is uncertain, its particularly uncertain when we get back to school in July and start to lap that decline, what will happen. So we have taken an approach we have taken in the past to projecting sales based on the recent trends.
But I stick [ph] to your point, the range of outcomes is broader than necessarily embedded in the guidance outlook, and I think there is uncertainty out there still.
Randy Konik - Jefferies
Can you hear me?
Michael Jeffries
Yeah. Go ahead Randy.
Randy Konik - Jefferies
I guess my question, I guess specifically, if you take the three buckets, the sales line, the gross margin line and the EPS line, do you feel most confident in EPS number, given you have a cushion of share buyback, you have these cost cuts that are coming through, do you feel pretty confident in the gross margin line because of any talks of AUC declines offset by AUR kind of declines I guess. Then would you say, that the least amount of visibility in the sales line, given the environment, but because of the gross margin visibility, you feel good about the EPS visibility.
I guess that's what I am trying to get at?
Jonathan Ramsden
I think about gross margin, we have based into that, a modest AUC reduction, working hard to improve that. There is some benefit from the profit improvement initiative around $12 million, which is [indiscernible] the gross margin, which is locked in.
And then there is a mix benefit from international growth, still closed in the U.S. and so on.
So based into that guidance of flat to slightly down in gross margin, is the assumption that AURs in our core business are down year-over-year, and we feel that's a reasonable assumption at this point in time. We are obviously going back to the point Mike spoke to a second ago, hopeful though, the initiatives we have in place during the year will enable us to do better on AUR, but we need to see that before we start baking it into our outlook.
We also have the marketing, additional investments, the benefit of which is not baked into sales and margin outlook for the year. On expenses, we feel very good, obviously about the $175 million.
There is a potential to do a little bit better than that, as we go through the year. I think the biggest area of limited visibility is to appoint on the sales line.
So that we will see how we will play that as we go. We feel, based on what we can see today, what we are projecting to is a reasonable assumption.
Randy Konik - Jefferies
Very helpful. Thank you.
Michael Jeffries
Thanks Randy.
Operator
Our next question comes from Kimberly Greenberger, Morgan Stanley.
Kimberly Greenberger - Morgan Stanley
Thanks so much. Good morning.
Michael Jeffries
Hi Kim.
Jonathan Ramsden
Hey Kimberly.
Kimberly Greenberger - Morgan Stanley
My question is on international. I am looking at the full year international floor comp down 19%, that was certainly offset in part by strong growth in e-commerce.
I haven't heard you talk about the potential slow international expansion or potentially to look at some store closures there. And if you could comment specifically on the e-commerce business, are you seeing the most robust growth in dollar volume, in Europe and some of your older markets, may be Europe and Canada, or is the majority of the incremental revenue coming from new markets in Asia?
Thanks.
Jonathan Ramsden
So Kim, let me start with a little update. DTC growth is very strong, frankly in all regions, particularly strong in Asia right now.
So I think its new markets, in particular where we are seeing strong growth. Europe is also strong, and we are up solidly in the U.S.
as well, and we foresee that continuing, in spite of what we are looking to 2014. With regards to international expansion, we are opening fewer stores in 2014, with prioritizing our CapEx towards e-com, towards some key IP investments we need to make, and allocating less to new store openings.
We are very excited about what we are seeing though in Japan and China and the opening in the Middle East. So we are looking at our ability to move some of that up.
With regard to store closures internationally, we don't have any of those plans. The Fukuoka outlet store that we have talked about in the past, wanting to close at some point.
Beyond that, there are no other stores. But currently, we don't have any plans to close internationally, other than the Gilly Hicks stores in Europe.
Michael Jeffries
I think the point that the European stores, even with the decrease in sales are operating at sales levels that are above the mall averages, they are very profitable stores.
Kimberly Greenberger - Morgan Stanley
Thank you so much.
Michael Jeffries
Thanks Kimberly.
Operator
Next we will hear from Janet Kloppenburg, JJK Research.
Janet Kloppenburg - JJK Research
Good morning everyone.
Michael Jeffries
Good morning Janet.
Janet Kloppenburg - JJK Research
Mike, I probably heard you talk a little bit about your AUC objectives. I know that your quality disciplines have been the best in the industry, and I imagine that you will continue to be very strong, with respect to having some of that quality in your space.
So I wonder where the opportunity lay and how do you think [ph] you can achieve those goals? Thank you.
Michael Jeffries
I think that you are exactly right, that our quality levels are the highest in the industry, and we plan on maintaining those levels. We think that the opportunity in AUC reduction is in the Hollister brand, and we think that we have an opportunity to reengineer some of that product, take some costs out of the products, which is still maintaining the quality level that is appropriate for that customer and that brand.
Most of the cost initiatives will come from Hollister. But as we compare A&F for the rest of our competition, and Hollister, as we are looking at that brand and who the core customer is, we will be better quality than the competition, but there will be some reengineering of that product.
Janet Kloppenburg - JJK Research
Is that currently representative in the assortments, Mike, or will we see that in the back half?
Michael Jeffries
You will see that in the back half.
Janet Kloppenburg - JJK Research
Okay. So that --?
Michael Jeffries
No. And I would suggest Janet that you won't see anything.
Janet Kloppenburg - JJK Research
Okay. That's what I'd like to luck.
Lots of luck.
Michael Jeffries
Okay. Thank you.
Operator
Paul Lejuez of Wells Fargo is next.
Paul Lejuez - Wells Fargo
Hey, thanks guys. Jonathan for you, just wondering, when you think about your guidance for 2014, what are the expected charges that are not included in that guidance, and how much of those are cash, and also, are there any charges that you view as one time, that are in fact included in your guidance?
Then just -- well, I will stop there.
Jonathan Ramsden
Hey Paul. Yeah, the only specific charge of any significance is the $10 million of remaining charges related to the Gilly Hicks closures, specifically related to European stores that we haven't closed yet.
So it’s a little bit of expense related to the profit improvement initiative, that's relatively minor, about $2 million. So that's all that is not included in the guidance.
Paul Lejuez - Wells Fargo
Got you. And then just a quick one for Mike.
When you talk about selling third party brands, or selling through third parties, what sort of initiatives do you have in mind, how extensive are we talking? Thanks Mike.
Michael Jeffries
We are talking pretty extensive on third party in our existing channel. We are introducing a number of initiatives there, as the year progresses.
In terms of selling through third party, this is something we are just starting to look at. It could be a very interesting opportunity.
Interesting in terms of volume potential there. In terms of selling third party in our channels, there is a volume opportunity, but it is also a positioning device for us.
Paul Lejuez - Wells Fargo
Thanks guys. Good luck.
Michael Jeffries
Thank you, Paul.
Operator
Next question comes from Adrienne Tennant, Janney Capital Markets.
Adrienne Tennant - Janney Capital Markets
Good morning everybody.
Michael Jeffries
Hi Adrienne.
Adrienne Tennant - Janney Capital Markets
Hi. Mike, another question on the AUR piece of it.
So my question is, are you taking down initial tickets, and if so, in what categories? So I guess, I am asking, is the initial pricing going to be lower and more competitive with accompanying lower percentage off discounting, does that make any sense?
And then Jonathan, for you, the inventory, I know there was kind of mall traffic drop off, and so its hard to touch the inventory in the early half of the year. It still seems a little bit higher than kind of where the total sales is running.
Can you give us any color on carryover versus go forward, and then when should we see -- what's the inventory plans on the back half of the year, when should we see that kind of more in line with sales? Thank you.
Michael Jeffries
Adrienne, I would love to answer the first half of your question, but for competitive reasons, I really can't. I think the issue is, we are going after AUC, so we have opportunity.
Jonathan Ramsden
On the inventory pot, we expect them through the end of Q1 to be up, but by a lesser amount than we were at the end of the year, then we expect inventory to be down at the end of Q2 and for the remainder of the year. In terms of the composition of the carryover, both fall and spring inventory were up year-over-year.
We are very comfortable with the fall inventory carryover levels, they were really very low, with the equipment pulling last year, and that affected our business and recovery, in particular, last year. So we are comfortable with where we are in inventory.
Adrienne Tennant - Janney Capital Markets
Is there any color on Chinese New Year? Did you take any receipts early?
Jonathan Ramsden
Well it been a tentative number. We do have bigger trends in number significantly higher than a year ago, that's baked into the overall inventory.
As we said, if we excluded in-transit inventory, it was up about 16%.
Adrienne Tennant - Janney Capital Markets
Okay great. Thank you.
Good luck.
Michael Jeffries
Thank you.
Operator
Our next question will come from Matt McClintock, Barclays.
Matthew McClintock - Barclays Capital
Hi. Good morning and congrats Jonathan on the recent promotion.
Jonathan Ramsden
Thank you.
Matthew McClintock - Barclays Capital
I was wondering if we could talk a little bit about DTC. It sounds like a lot of the marketing investments that you are making, would have a meaningful impact on your DTC.
Is that kind of the channel that you are thinking about for the marketing investments? And then secondly, you discussed investing in your mobile capabilities going into 2014.
Can you give us an understanding or just an overview of how your mobile capabilities have evolved over the last year, and where you expect to get them? Thanks.
Jonathan Ramsden
Maybe just taking the first part, Matt. The marketing investments we are making, a lot of it will be delivered through digital and online, but we expect the benefit to be across channel.
So we are not expecting the benefit to be limited to the DTC channel. In terms of the changes we are making online and some of the investments we alluded to in the prepared comments, we have an expanded assortment.
Search and navigation, experience design, redesigning the Hollister website, personalization, additional international expansion, particularly focused on Asia, given the -- accordingly, you referenced a moment ago. And your point on mobile, we are seeing a huge proportion of the traffic coming through mobile.
So we are making enhancements to that experience, which we think could be meaningful. We are investing in a whole new channel.
We are finding store fully active now. We have ordering store coming along, shipping store pilots.
So there are a lot of things going on in that space. We are prioritizing CapEx towards that.
We think strong growth in the U.S. and particularly strong growth in international, which is -- I think as we have discussed in the past, particularly profitable channel, given the overall economics of that channel.
Matthew McClintock - Barclays Capital
Thank you.
Operator
Anna Andreeva, Oppenheimer is next.
Anna Andreeva - Oppenheimer
Thanks so much. I was hoping to follow-up on international.
Your performance there improved a little bit from the holiday update. Just may be talk about what are you guys seeing by region?
I think you said Europe did get sequentially better. What kind of a performance in international are you guys embedding in the high single digit comp decline for 2014, and just given the four walls have been coming down there, do you guys think that mid-20s is a sustainable level, as we go through the year.
And then just quickly, a number of retailers obviously have talked about difficult trends, quarter-to-date so far in 1Q. You guys are guiding for comps down high singles for the year.
Is that what you're earning currently? Thanks.
Jonathan Ramsden
Okay. I guess in terms of the comp trend internationally Anna, we are projecting a sequential improvement in the comps in 2014, but to some degree, that's just reflecting what we are lacking.
Its not necessarily an underlying improvement in the business. With regard to the four walls, if you look at Hollister Europe specifically, its still right around that 30% four wall rate, we are still well above.
The mall productivity in Europe, as we referenced. Some of the profit improvement initiative benefits will accrue to the international business.
Part of what's weighing on the overall international four wall margin as we still have some very low profitability stores in Japan, we have talked about in the past, and Canada operates below the 30% level. But if you look at Europe alone, its still close to 30, particularly if you look at Hollister.
I think I have addressed several of your questions, but there may be one I missed.
Michael Jeffries
First quarter performance, which I don't think Jonathan can address.
Jonathan Ramsden
We don't typically comment on quarterly performance as you know, Anna.
Anna Andreeva - Oppenheimer
Okay, terrific. Thanks so much guys.
Michael Jeffries
Thank you, Anna.
Operator
Next is Lindsay Drucker Mann, Goldman Sachs.
Lindsay Drucker Mann - Goldman Sachs
Hi, good morning everyone. I just wanted to follow-up on the international store margin.
Can you talk about the drivers of the ongoing margin decline on a four wall basis in the fourth quarter? I know [indiscernible] a little bit, but can you give a little bit more detail about whether its on the gross margin side or if there is other -- if its just the poor comp and visibility to that actually stabilizing?
Jonathan Ramsden
Its predominantly the leveraging effect of the negative comp, although most [indiscernible] were down a little bit, we did take AURs down in the fourth quarter year-over-year in those international stores. So that contributed too.
But the biggest driver is the leveraging on the negative comp.
Lindsay Drucker Mann - Goldman Sachs
And is that just proportionate of Hollister versus Abercrombie or is it both sort of moving in the same direction?
Jonathan Ramsden
Both broadly in the same direction.
Lindsay Drucker Mann - Goldman Sachs
Okay. And then as far as the comp improvement initiatives, can you talk about the areas, where from an execution standpoint, you're most mindful of ensuring that as we prosecute this margin on a cost savings in a short period, you're ensuring that there is really no impact here to your top line comp trends, consumer perception or otherwise?
Jonathan Ramsden
I think Lindsay, the area obviously that we are both focused on in that regard is, looking to what's happening in the stores, whether it’s a direct consumer interface, that's potentially affected by some of these changes. So we have been making some of these changes already in the fourth quarter.
We don't believe they adversely affected sales during the quarter, but we do need to watch that closely, but we feel confident about the $175 million.
Michael Jeffries
I'd also like to comment that we only proceeded with the store initiatives after pretty extensive tests, and we saw that the top line wasn't really effective. [indiscernible] as we go forward.
Operator
Dana Telsey with Telsey Advisory Group has a question.
Dana Telsey - Telsey Advisory Group
Good morning everyone.
Michael Jeffries
Good morning Dana.
Dana Telsey - Telsey Advisory Group
Hi. You talked a lot about the changes that you are making with product testing in the fabric platforming processes with the improvement in lead times in chase product.
When does this all take hold, and how do you see it impacting the gross margin? Thank you.
Michael Jeffries
It is already taking hold, because as I said, we are in a place that we have considerable chase. I think that all these things will impact volume, and also gross margin.
I would suspect that we should start seeing impact as the year proceeds, through shorter lead times and I think testing is a very important part of this equation. So its certainly going to affect gross margin and volume, and I can't give you a number.
Jonathan Ramsden
Then I just had one [indiscernible] to your question, but in terms of AUC, have been down for the full year, and we are anticipating it to be down more in the back half of the year, skewed to the back half of the year. So I think that's an important point to make, in terms of thinking about the gross margin cadence for the year.
Dana Telsey - Telsey Advisory Group
And how do you see pricing in 2014, given the current environment?
Michael Jeffries
As I said before, its going to be quite hard, to sustain AUR increases.
Dana Telsey - Telsey Advisory Group
Thank you.
Michael Jeffries
Thanks Dana
Operator
Next question is Oliver Chen, Citi.
Oliver Chen - Citigroup
Thanks a lot. Thanks Jonathan for all the details.
When we model our free cash flow out this year, how should we think about the net working capital items, instead it will help cash or if it will be a cash use. And also, regarding the products, Mike, and the opportunity for brand differentiation, what are the takeaways for where you see the most opportunity, as you look to differentiate the banner, whether it'd be pricing or style or targeted audience?
Jonathan Ramsden
Oliver on the first one, we expect a benefit from net working capital for the year, including or mostly driven by a reduction in inventory, and that is in part driven by the expectations that are in the -- and if your inventory is going to get a lower average unit cost, than it was into 2013, plus some other factors, including generally trying to be more efficient in our use of inventory.
Michael Jeffries
To answer the second part of your question, we think the branded structure is going to help the process differentiation, in terms of all of the factors you mentioned. A customer, a product, the positioning of each brand, and I believe its an issue of product and marketing.
We are working aggressively on both factors. This is a key focus area for us now, and I think we are making progress, I think the branded concept will only expedite that process.
But we see real differentiation in these brands. But I think its important to note that A&F and Hollister do have distinct equities and they target different customers.
Operator
Our next question will come from Paul Alexander, Bank of America Merrill Lynch.
Paul Alexander - Bank of America Merrill Lynch
Hi. Thank you.
I think last time we spoke to you guys, you were wrapping up a consultant-led qualitative study on brand perception. Are you ready to discuss the findings of that yet, or is that still ongoing?
Michael Jeffries
It has been complete. I don't think we will reveal what those results were.
I think that if you look at everything we are seeing today, you can imagine what those results were, in terms of how we are reacting for the business. We are taking these learnings seriously, and all the aspects of the business that I described today.
Operator
Next, we will take a question from Marni Shapiro, The Retail Tracker.
Michael Jeffries
Hey Marni.
Marni Shapiro - The Retail Tracker
Hey guys. Good morning everyone.
Mike, just two quick questions. If you could talk a little bit about in the past, when you've had great fashion product, you've not had price resistance, and it sounds like you're talking about, with AUR coming down and focusing on AUC, that this has changed and that even when you have good products, you are finding price resistance.
So if you can talk a little bit about that, and then if you can just also touch base on the -- you talked about the differentiation between the products. Are you willing to give any insights as to how you view Hollister and Abercrombie looking different in say six months from now?
Michael Jeffries
The first part of your question is, I think we are in different environments in terms of price resistance. Clearly, its an old axiomatic statement that good fashion doesn't have a price attached to it, but today it does.
We sell good fashion well at higher prices, but its still a very competitive environment and we need to be very conscious of [indiscernible] to drive the business. In terms of where the two businesses are going, I don't think I am prepared to describe to you exactly how they are going to look.
But I think you will be able to see real differences as we proceed, in terms of -- look at product, look at advertising, look at marketing, it’s a pretty all encompassing task that we are [indiscernible] to differentiate these brands.
Operator
We have a question from Barbara Wyckoff, CLSA.
Barbara Wyckoff - CLSA
Hi everybody.
Michael Jeffries
Hi Barbara.
Barbara Wyckoff - CLSA
Hi, a couple of questions. Can you talk about what percentage of the styles in the inventory now were pre-tested?
Then secondly, can you talk about progress in China? How are the new stores doing versus the first wave of opening and if Hong Kong, [indiscernible] Nanjing is I think the most recent one?
And are you seeing a difference in sales, male versus female versus the U.S. and Europe?
Also in international, how is that sole flagship doing, and can you talk a little bit about the Japan Hollister? And lastly, can you clarify whether the Emirate store is operated by your, or are you using a partner?
Michael Jeffries
Boy oh boy. Okay.
Barbara, we got a list.
Jonathan Ramsden
Okay. Emirates is a joint venture with our big budget partner in the United Arab Emirates.
So that's the answer to the first question Barbara. The Japan stores, as Mike said in the prepared comments, are doing very well.
They are roughly doubling their initial plans, so we are very happy with how that's performing. China, comes up 30% plus for the year, so we are very pleased with that.
In absolute volumes in China, not as high as they were in Hong Kong, but I think that's not surprising. The progress we are making there, is very positive.
I think your first question was percentage of style of inventory that was pre-tested?
Michael Jeffries
Okay. I will respond to that.
As of today, I'd say its about 50%, but each week, that will increase. We are setting a lot of units this week and next week, and much of that has been tested.
So as we move through the season, we are going to move to the 100% mark.
Jonathan Ramsden
I think [indiscernible] just coming back, I think probably the question was the first stores, these are the older stores. I think broadly, the trend we are seeing in stores in China is consistent across the stores that are in the comp base and those that are not.
What have we missed? Did that cover, Barbara?
Barbara Wyckoff - CLSA
The store flagships?
Jonathan Ramsden
Store flagships, it will be somewhat below. The store flagship is somewhat below plan.
Barbara Wyckoff - CLSA
Okay. Thanks.
Good luck.
Jonathan Ramsden
Thank you.
Operator
Omar Saad, ISI is next.
Omar Saad - ISI Group
Hey thanks. Good morning.
Jonathan, congratulations on the elevated responsibility that you have in the organization.
Jonathan Ramsden
Thanks Omar.
Omar Saad - ISI Group
Wanted to ask about outlets of real estate tragedy; obviously you have been closing a lot of stores in the U.S. You are going to close more in 2014, and if some of the planned openings have been outlets, I think you are up to 20 or so now.
How do you see the performance in those locations versus the more traditional regional mall, into our malls? Is it a strategy that you think you could be much bigger in that channel, as you contain to exit on profitable or less profitable real estate location to the more traditional malls?
Thanks.
Michael Jeffries
Let me answer that. We are currently testing stores, outlet stores with made per outlet product.
We have been in that business before, we have only used our outlets as clearings. So we have a roadmap for growing the outlet business, both in the U.S.
and internationally, but we need to make sure the results are where we need them to be, as we roll this out. We have two test scores that have made for outlet merchandise today; a new store format, one is in Seattle, one is in the U.K.
We are looking at these results very carefully. We are opening more test stores over the next couple of months.
We are looking at this as a real potential in terms of the business, but we have to be very sure about the results before we can see.
Operator
Our final question today will come from John Morris, BMO Capital Markets.
John Morris - BMO Capital Markets
Thanks guys. Good morning everybody.
Hey so I think in our prepared remarks, you talked about guidance not including long range planning initiatives. Just so we know, what's not included in there, what were you specifically referring to for that?
Then also, you talked about the changes, you see alterations with the new distribution center. Can you just tell specifically what those are, and the benefits you expect to accrue from those changes?
Jonathan Ramsden
Yeah so taking the first part, we had, coming out of the presentation we gave in November, we have about 150 specific initiatives, many of which we expect to hope to start seeing benefit from, as we go through 2014. But we haven't baked any benefit from that into our outlook.
But nor have we baked in, as we said earlier, any potential [indiscernible] deterioration in the underlying trend. So an example would be, the marketing expense.
So we have baked in an incremental $30 million of planned marketing expense for the year, but we haven't assumed any benefit from that, in terms of the top line or in terms of margin, as we go through the year. In terms of the DTC, we are reconfiguring as we said, one of our two distribution centers here and [indiscernible] need a dedicated direct-to-consumer facility.
That's going to enable us to increase processing times, that's going to support on the channel initiatives and other things, that are an important of our e-com plans going forward. And there is also reduced costs over time.
Operator
And that does conclude our question-and-answer session for today. And that does conclude today's conference call.
Thank you for your participation.