American Eagle Outfitters, Inc.

Greetings and welcome to the American Eagle Outfitters first quarter 2022 conference call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Judy Meehan. Please go ahead.

Good afternoon, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Executive Chairman and CEO, Jen Foyle, President, Executive Creative Director for AE and Aerie, Michael Rimpel, Chief Operating Officer, and Mike Mathias, 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. And now I'll turn the call over to Jay.

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Thanks for joining the call today.

This was a complex quarter with many macro variables to navigate through. Total revenue increased over last year, but was well below our expectations. Lapping stimulus payments and pent-up demand, combined with rising inflation and higher gas prices, weighed on our results. Adding to these pressures, the weather was unseasonably cold to happening sales of spring goods. Higher freight and expenses delivered droves, and operating profit result that was well below plan and what we are capable of delivering. In hindsight, our buys and overall plans were too optimistic for the current environment. We are taking swift measures to reset. We will clear through spring goods in the second quarter and be in better position for the second half of the year. We have adjusted our forward inventory plans to reflect a more measured demand outlook. We're also looking after our expense base in a more meaningful way. Despite near-term challenges, I want to emphasize that our brands, operations, and organizations are on solid ground. Area revenue increased 8% in the quarter and has more than doubled since 2019. Operating profit is up over 5% compared to 2019. Area continues to present incredible growth prospects for the future, and highly desirable product categories With a strong brand platform, we see exciting potential as we reach more new customers. Brand expansion has been successful with a positive reception to new area offline locations. Innovation is at the core of the creative team, and we look forward to new product introductions this fall. American Eagle is a destination for you. It's loved by our customer base and consistently shows up as the top brand in our demographics. For well over a decade, AE has consistently ranked as a top favorite brand in the Piper Sandler Taking Stock and Team Survey. The AE brand remains highly profitable and extraordinary cash flow. Now, as we look to rebalance assortments and right-set plans for the current environment, I'm confident we will see improvement. Over the past few years, great work has been done to optimize the real estate portfolio and strengthen projects product margins, and that work continues to generate underlining benefits. Regarding our new logistic business, Quiet Platform has been actively signing up new customers. We are excited to announce new accounts, including Fanatics and Saks Office. Michael will provide more details in a minute. I am very optimistic about this business. We have hired amazing talent into the business, from some of the best technology, fulfillment, and logistics companies in the world. We are extremely pleased with the benefits Quiet is providing to our brands and see this as an exciting growth vehicle. Now a moment on ESG, where we continue to advance our progress. In the second half of this year, we look forward to introducing more real good products across our brands, demonstrating our commitment to environmentally responsible and sustainable design and production. I'm also happy to share that we are exceeding several of our water reduction goals ahead of schedule. We look forward to sharing more about progress when we release our ESG report this summer. Before I turn the call over to Jen, I want to underscore our laser focus on resetting our plans and making improvements across areas of opportunity. It's likely the near-term environment will remain volatile. I believe that every challenge creates an opportunity. That's what has enabled this company to endure for the long term. We've been through challenging periods in the past. We've always come through a stronger company. With that, I'll turn it over to Jen.

Thanks, Jay, and good afternoon, everyone. In the first quarter across brands, we faced difficult comparisons as we left extremely strong demand last year. Shifting macro trends and the cold spring created additional challenges, making it tough to nail down a consistent trend. As March and April played out, our plans proved too optimistic and demand fell short. Despite this, ARRI delivered good results, especially factoring in the outsized growth in 2021. First quarter revenue grew 8%, reflecting a strong 27% three-year CAGR. Swimwear was weak, we believe, driven by weather. Excluding swim, ARRI revenue grew 15% with Intimates leggings apparel and beauty. Oh, and also accessories, also posting growth versus last year. Offline by Aerie grew in the strong double digits, lapping a triple-digit growth as it continued to scale its assortment and customer base. I'm also pleased to highlight that Aerie continued to grow its customer count. Aerie's rich platform and marketing investments are resonating, Our spring campaign promoting happiness was a huge success, making hashtag Aerie Real the number two trending hashtag on TikTok. Our happy spot event generated almost 8 billion views and 2 million videos. As a leader in women's inclusivity and empowerment, we continue to push the envelope on innovation, and we ensure our customers feel our passion for our great product and the best customer experience and a brand that they can be proud to shop. In the near term, as weather has improved, we've seen seasonal categories pick up. However, we expect the environment to remain a bit choppy. We also have excess spring merchandise and are focused on clearing through it during the second quarter. This will position us for an improved second half when buys will be better aligned with demand. For the fall season, we have exciting new product launches and these are excellent additions to the Aerie collection. Looking out longer term, I remain extremely confident in the area and the offline potential growth. Shifting to American Eagle. As we cycled a terrific season last year, sales trends were a bit more challenging. Revenue declined 6%, reflecting a negative 2% three-year CAGR as we refocused our assortment and real estate footprint. Although we had a number of good performers, including dresses, accessories, jeans, and men's overalls, Demand fell short of our plans. In addition to right-sizing the inventory, we also see an opportunity to strike a better balance across our key styles. We are making those adjustments for the fall season. I continue to be proud of our leading jeans business, which is up double digits across both genders compared to the first quarter 2019. Investments to re-energize the brand and messaging are working well. We are reactivating legacy AE customers and raising engagement. In the first quarter, we relaunched our new members always campaign with a TikTok hashtag challenge that garnered almost 3 billion views. AE continues to be at the forefront of the metaverse marketing, launching on Roblox with a remarkable 10 million visitors to date. And I'm so pleased to know that AE was recognized as the best in use of media and social by Digiday. With a new team in place, we are now starting to see new processes and energy fused together to drive the business forward. I love what I'm seeing for future seasons, including this coming back to school, and I believe this new leadership team and structure will set us up for success. Across brands, our teams are rolling up their sleeves to innovate, test, and learn, and to use all the learnings we've had over the past years to get stronger, better, and faster. We've been hard at work hindsighting the seasons, We are adjusting plans for the balance of the year to be better aligned with demand levels. Although the environment could remain choppy, we are excited by the new trends and fashion and we are prepared to deliver a strong fall season to our customers. Thank you, and now I'll turn the call over to Michael. Thanks, Jen, and good afternoon, everyone.

In the midst of current challenges, we continue to manage our operations well. We are focused on innovation to ensure we can deliver the best customer experience while also driving operational efficiency and mitigating cost increases wherever we can. Channel performance this quarter reflected continued migration back to stores and solid digital results compared to outsized growth over the past few years. Store revenue increased 2%. Digital was down 6% against a 43% increase last year and 9% growth in the first quarter of 2020. Digital penetration grew in the quarter to 37% from 30% in 2019. Our mobile app continues to show strong momentum, driving more than a third of e-commerce sales and traffic in the quarter. As we've indicated in the past, mobile customers are our most engaged digital shoppers. We're also continuing to invest in new ways to drive better engagement and increase personalization. This quarter, we introduced Shop the Look, enabling customers to browse and shop head-to-toe looks curated by our stylists. We're very encouraged to see strong conversion with this tool that is double that of other site visitors. Additionally, we also enhanced our search capabilities to return more relevant results and prioritize best sellers for our customers. Now, moving to supply chains. Clearly, this environment remains challenging. Costs remain elevated versus history, and although lead times have improved slightly in the quarter, they are also still longer than any prior history. That being said, we do currently expect that freight costs for the fall and holiday seasons will benefit from lower ocean and air freight rates. And regarding product costs, we've been successful at keeping costs in check through a number of mitigation measures, including platforming fabric, diversifying production facilities, and leveraging our scale to find efficiencies. However, beginning in the fourth quarter, we expect to see some pressure from product input costs, specifically higher cotton costs. This will be more than offset by relief on the freight side, primarily lower air freight usage. In this dynamic and inflationary environment, we are regularly reviewing our pricing strategies and our promotional activity to optimize both sales and margins. And we do believe that there is good opportunity for us in the second half of the year. Now regarding quiet platforms, we continue to drive efficiency using our innovative approach to delivery and fulfillment through the use of local distribution nodes. In the first quarter, we saw further reductions in our number of shipments per order and shipped our digital orders faster, with a 13% reduction in delivery times. We are extending these benefits through our third-party quiet platform business to customers through a shared supply chain services network. We've been really encouraged by the level of engagement we've seen from other brands and retailers who share our vision for the future of the supply chain. Jay highlighted a few of our significant new customers in his comments, and we're looking forward to adding more in the coming months. We believe that edge fulfillment, shared distribution, and shared logistics is going to be as transformative to retail as the shift to omnichannel was a few years ago. It's going to help drive efficiencies and improve service that Quiet Platforms is already helping us to realize in our brands. Although we are still in the early stages of this, I'm very encouraged by our momentum and the potential that we see in this business. And with that, I'm going to turn the call over to Mike.

Thanks, Michael. Good afternoon, everyone. As the team has indicated, the top line was well below our expectations. While our plans baked in an impact of cycling stimulus and pent-up demand from last year, we underestimated the magnitude. A shifting macro environment created additional challenges with added pressure from unseasonably cold weather throughout the quarter. As a result of the top line miss, expenses deleveraged, driving an operating profit result well under our plan. We also faced headwinds from freight inflation and the ramp up of quiet platforms as we discussed in the fourth quarter conference call. Based on our first quarter performance in the current macroeconomic environment, we have moved quickly to reset our plans for the rest of the year. This includes meaningful adjustments to both inventory and expenses, which I'll discuss throughout the call today. First, let me review the details of the first quarter. We posted consolidated revenue of $1.1 billion. The revenue increase of 2% included approximately three points of growth from our supply chain acquisitions. Brand revenue declined 1%, below our expectation of a mid-to-high single-digit increase. Compared to pre-pandemic 2019, total revenue is up 19%, and brand revenue is up 16%, or $141 million. Consolidated gross profit dollars declined 11% compared to the first quarter of 2021. The gross margin rate of 36.8% contracted 540 basis points, primarily reflecting headwinds to merchandise margins from higher freight costs of approximately 340 basis points. As discussed last quarter, the integration of our supply chain acquisitions also adversely impacted the gross margin, driving 120 basis points to be leveraged. Additionally, lower revenues drove fixed costs to be leveraged. Compared to first quarter 2019, merchandise margins continue to reflect markdown in promotional discipline. Additionally, rent dollars are down versus 2019 and leveraged as a percentage of sales reflecting our measured approach to store openings and closures. Turning to expenses, SG&AD leveraged 270 basis points compared to the first quarter of 2021. The mid-teens dollar increase was in line with the guidance we provided last quarter, led by higher wages for store associates, and hours to support the recovery and store operating capacity compared to last year. Additionally, increased corporate compensation, advertising, and professional services were partially offset by lower incentive accruals. Resetting our expense base is a major priority. We are identifying savings well beyond the 60 million opportunity I discussed last quarter. Major areas of focus include store payroll and hours, corporate compensation, professional services, and advertising. Beginning in the second quarter, I expect year over year dollar growth in the low to mid single digits. First quarter operating profit of 42 million reflected a 4% operating margin. This included approximately 35 million of impact from higher freight costs and a $12 million loss from our supply chain acquisitions. We earned 133 million in operating profit in 2021 and 49 million in 2019. EPS was 16 cents per share. Consistent with the new accounting standard for convertible notes, our diluted share count of 220 million recognizes the full 49 million in shares of the under-realized dilution associated with converts, and our EPS includes an interest add-back to net income of 3 million. Breaking down the individual brand performance, area revenue increased 8 percent, and comparable sales declined 2 percent following outsized growth last year. Operating profit was 43 million, reflecting a 13.4 percent margin. This was well below last year as we lapped a near-perfect period of strong demand while experiencing higher freight costs and expense to leverage related to the salesness. Despite headwinds to the quarter on a multi-year basis, ARI's growth trajectory remains intact, growing revenue at a consistent 25% plus CAGR and 20% plus profit flow through. As I said earlier, we are adjusting our forward plans to be more consistent with these long-term trends and remain very confident in ARI's path from here. AU brand revenue declined 6%. Operating profit was $104 million with a 15.2% operating margin. This was well below an exceptional period last year, mirroring the headwinds I just discussed to Aerie's profit results, including higher freight costs. Compared to pre-pandemic 2019 levels, the operating profit and margin was stable, reflecting the benefits of our more focused brand strategy. We have downsized our North America store footprint from 891 stores in the first quarter of 2019 to 815 stores in the first quarter of 2022, reflecting a mid-single-digit reduction in gross square footage. As we right-size and rebalance AE's inventories and counter-operating expenses, I expect to see improvements to operating profits for the second half. Consolidated ending inventory costs was up 46% compared to last year. Higher costs drove roughly half of the increase. From a brand standpoint, Aerie and AE also drove half of the increase. Total inventory units were up 24 percent due to higher in-transit and on-hand inventory, including seven points of growth related to area and offline new store openings. Based on current demand trends, we're resetting inventory for the second half, and we'll clear through excess spring goods in the second quarter. We ended the quarter with $229 million in cash and total liquidity of $581 million. Capital expenditures totaled $58 million in the quarter. For the full year, we expect capital expenditures to be approximately $275 million. Turning to real estate, we continue to be pleased with our returns on new area openings with first-year returns of approximately 50%. In the first quarter, we opened 12 new area stores, including a mix of standalone and area offline side-by-side formats. For AE, we continue to make progress towards our long-term target of right-sizing the brand store footprint. Looking ahead, we maintain significant flexibility to adjust our footprint further with 40 to 50 percent of our fleet available for lease action each year. While first quarter brand performance has played out differently versus our original plan, as I noted earlier, our results continue to show meaningful progress on key strategic pillars outlined in our real power, real growth value creation plan. We're committed to preserving and building on these improvements. For the second quarter, we will be intently focused on clearing out excess spring inventory. We expect top line growth to trend similarly to the first quarter, We expect higher markdowns as we clear through excess inventory combined with continued freight inflation and the impact of our supply chain acquisitions to result in a gross margin rate of approximately 33%. As we said earlier, we're actioning expense reductions and expect second quarter SG&A to be up in the mid-single-digit range. As we reset the shifts in the macro environment, we're lowering our outlook for the full year. Using 2019 as a gauge, we expect to deliver operating profit above the full-year profit of $314 million. This anticipates total revenue growth in the low single digits with brand revenue down slightly. We expect to enter the second half better aligned with demand with a more balanced inventory position and leaner expense base, driving improved margins and profitability relative to the first half. In terms of our longer-term outlook, we'll provide an update as we see greater visibility into our business in the macro environment. With that, I'll open it up for questions.

Thank you. At this time, we'll be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. Your first question comes from Matthew Boss with JP Morgan. Please proceed with your question.

Great. Thanks. Um, so maybe Jen, just to dig a little deeper on the magnitude of the, of the one Q top line myths relative to the initial plan, I guess, how would you break apart the top line underperformance that at each of the concepts, if we were thinking about the shift in category spending, whether is it inflationary impact on your core consumer? Is there a change in competition? Just any help in terms of the magnitude of the first quarter miss?

Sure. You know, we mentioned in Aerie, as we think of the offline business, how exciting that business is. And it's still obviously in its infancy stage. So we're pretty excited about that category, Matt. And I think we're ready for some fierce competition there as we roll out stores and build on that business. And... Let me just take a step back and just say that in total, I think it was a little macro, right? Kids want experiences. Weddings are happening again. So certainly there's that occasion dressing that, you know, I think you can see in some of our competition where dresses have trended really nicely. But going back to Aerie, I'm really pleased. You know, it was fairly isolated in the swim business where we saw some myths. And if you think about that business, it's definitely more penetrated on the direct side. where we do most of the business there and direct business with softer than stores. So again, fairly isolated, which I like because we're almost through the swim season and we're pretty excited about some of the launches that are coming your way for Aerie. I just reviewed our back to school launch and it is more than exciting. I don't know what to say. I just think like we're going to continue to forge ahead. You know, this launch is very isolated in our, you know, go-to business. And like I mentioned, all of those businesses in Aerie, they're nice, you know, they did great. So hopefully that points to a turnaround in Q3 and Q4 where we definitely left some certainly margin in Q4 on the table. So I'm excited about that. Thinking about AE, look, the Denman business remains strong. We are up against, you know, our biggest year last year. But if you look back to prior years, it's still our second best volume season. So Q1, you know, past Q1. So pretty excited because we know how important that business is for the Eagle and certainly is a category that we look forward and we re-merchandise to for Q3 and Q4. Like we had some learnings in Q1 and I think the team did a knockout job re-penetrating the right fits and the right washes for Q3 and onwards. So excited about that. There were some softness in TOPS and Look, we're learning and we're moving ahead. So that's really the answer that I can say. I walked, I had the pleasure of walking Michael Rumpel through our deliveries today, some of our future deliveries, our concepts for summer and some of the spring goods. And, you know, that's what we're doing. We're looking ahead. We can learn. There's always a learning in retail. And that's how we're thinking about the business. I love the new team in American Eagle. They're just getting going. So I think there's a lot to come down the pipe there.

Great. And then, Mike, maybe in terms of the looking ahead, what exactly is the composition of the excess inventory? What's the timeline to clear through the spring merchandise? And then on the EBIT outlook to be above 2019's $314 million base, just any additional parameters you could provide I think would be helpful.

Sure, Matt. I mean, I'll start with inventory. I mean, I think we all know there's several factors to our ending inventory in the quarter. Freight costs are elevated. I'm talking about it for quite some time now. So that's in our cost inventory on the balance sheet, as we all know. Looking at the 24% increase in units, I'll say that a couple things. One, we're coming off of last year's March, April hyper stimulus period. So from a unit perspective, we were down more than planned, selling through more units than expected. As we said a few times now coming into this year, that we should expect that point-in-time balance sheet inventory at the end of each quarter to be almost a complete apples-to-oranges comparison this year. We know we're bringing in inventory sooner than typically planned in the big seasonal change periods just because of the supply chain length. It's planned that way, so to compare to last year is tough. But at the end of the day, as we said in prepared remarks, we plan too high. So on that plus 24% in units, could gauge about a third of that is just missing the plan and having to clear through spring and summer goods, as we talked about, that we will do here in Q2. The gross margin rate at 33% accounts for clearing through those goods. We're gonna do it in a profitable way. We've seen that over-promoting is not paying for itself, so we have a good plan in terms of how to get through those units to be cleared for back to school. And then I did forget one other piece of that inventory. We do have quite a bit of new airy and offline openings that we have inventory on hand for as well. As you know, we've got a big sort of non-comp base that's new to last year. Those are ramping up into the second quarter in terms of new stores. We'll have 90 non-comp stores as we get toward holiday. So there is an inventory component of, you know, the plus 24 units includes that as well. On the EBIT front, yeah, I mean, look, that's, That's essentially, Jen did a great job answering our trend line. We're on this multi-year trend where Aerie is looking to double to 19, to double from three years ago. That's phenomenal still, that 25% plus CAGR. We're planning the inventory and the business to achieve that for the rest of this year. AE was down miniscule digits to 19. We're looking at that being semi-consistent through the first quarter, so we hope that's conservative, but we're planning the business that way. So this EBIT guidance is accounting for continued freight pressure. It's accounting for that revenue trend line that's seven, eight points off of, at least through the first four months of the year here, it's seven, eight points off of what we thought when we came into the year. Again, very macro impacted, we believe. So if we roll that through the rest of this year with some of those cost pressures, that's the guidance. The other piece that entails is what I also said in my remarks, expenses. So we are We are very aggressively resetting the expense space around this trend. The SD&A guidance of low single to mid double digit incorporates some of that work, and I think for the back half, the work we expect to see impacts or benefit the back half. A lot of the work we're doing is to make sure going into 2023, we have that expense space reset to where we want it to be going in the next fiscal year. So we'll get some benefit from here through the rest of the year. And that guidance of hitting or really exceeding 2019 is a good place to start. We hope we can exceed that. But for now, it's a prudent place to be.

Okay, thanks. Best of luck. Our next question comes from J Sol with UBS. Please proceed with your question.

Great. Thank you so much. You know, my question is if you can just give us a little bit more information about how the quarter trended because February counts are pretty strong. If you can help us, tell us what happened in March and April and give us a sense of May, maybe to give us a sense of how you're thinking about Q2 and then also back to school, assuming back to school is going to impact the July business. You know, given you're lapping the child tax credit from last year and maybe some pent up demand because there wasn't a lot of in-person school in 2020, how are you thinking about the July business as back to school begins? Thank you.

Yeah, I can start, Jay. So yeah, February, the trend the last year was stronger. We planned it that way. We were up mid-teens. I think we said that on our fourth quarter call. But again, I was prior to laughing. Stimulus, it really hit mid-March and through April in terms of the benefit from stimulus last year. So we planned March down significantly. But then we planned April with the Easter timing being later. We had hope or we believed that April would bounce back in a somewhat positive way, even up against stimulus with some of that holiday shift timing. We know weather did not help us there, and quite honestly, I think we've learned now that the macro impact to the business from where we planned it is a little different. We planned it higher, we planned wrong, and now we're going to reset our plans around that. The thing that's been consistent, very consistent through the first quarter and even now into May is our multi-year trend line, and I think we all continue to do this, but we're still talking about 2019 because it is a grounding point knowing the volatility of the last couple years in 20 and 21. So Aerie has been very consistent on this doubling 19 trend, 25% CAGR over the three years. We're going to plan the business that way to drive profitability. AE down in mid-single digits has been consistent too. So again, that's why we're setting these plans up for the remainder of the year this way. We did see some pops as we got into May, and we did see some weather benefits finally in early May. So a little bit of a change in trend there, which is somewhat encouraging. But, you know, again, we're planning the business for the brands on this trend line that we've seen on this multi-year basis through the first three and a half months. So the answer to your question, you're July. I mean, that is really essentially what we're doing for the remainder of this year with, you know, hope that there's some potential upside to that. But it's, again, the right place to position inventory.

Okay, got it. Thank you so much.

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Your next question comes from Janet Kloppenberg with JJK Research Associates. Please proceed with your question.

Hi, everybody. Just a couple of questions on the repositioning of the assortments. Was there enough time to get the back school and holiday assortments better positioned perhaps in the weakness that you're seeing in the TOPS business? Or do you anticipate that there'll be further margin pressure as we go through that period? It seems like you do. given the EBIT guidance, but I'd love you to talk through where you were able to make changes and if we should see greater progress at AIRI or at American Eagle. And then Jen, if you could address for me something that's confusing me is, you know, I love the assortments at AIRI, but they seem to be overlapping a lot with a lot of the women's assortments at Eagle. And I'm wondering if you contemplating any cannibalization there and how we should think about that. Thank you.

Yeah, Janet. Janet, nice to hear you. I'm sorry, Janet. I'm thinking about something else as we speak. Nice to hear you. I feel really great about how we reassorted back to school. And our famous four categories, like I mentioned in my first response, are set up to go. And, you know, so for instance, using denim as an example, not only did we look at our wash and our fit and making sure that we have the right qualities for both men's and women's and distorting there we also really like how our price positioning is so we definitely made sure that we have the good better best pricing assortments and i feel really strong that strongly that the team's really well balanced that whole denim assortment tops get stronger janice i mean with janet we don't have an issue actually in men's men's has been very strong And women, like I said, this is the most important thing. We're just getting going. We have a brand-new designer, a brand-new lead merchant, and a new head of marketing, essentially. And I think what I'm seeing for the future, we're going to get really psyched around these assortments. I feel really good, Janet. I really do.

Can you identify what went wrong in women's tops at Eagle? Because I thought they had been okay through last year, and then there's been...

They're okay. You know, it's more just about the balance of the inventory, really. It's just about how we planned it. I think Mike set that up well. We were just too aggressive about the plan. That's all. And we reset them and we reset our inventory levels. I think we're going to really reap the benefit there. Look, I like the profit margins in American Eagle. I mean, our gross margins are so strong. And we're not knee-jerking during this time. You know, we made the decision. not to overly promote, which I think was a very smart, strategic, long-term decision. Our markdown rates are at all-time lows, and we're going to ride this wave. This is what happens during these times. It's our job to get through it in the most profitable way, and I like where our inventories are positioned. I mentioned in the area that our great businesses get stronger in the back half, offline, which we've seen great results. Those assortments get bigger and stronger with new launches. So it's really, it really is swim. You know, Mike mentioned the number we've been up 15% without that category. So as that seasonality takes hold, I think I feel really good about where we're headed in areas. Um, you know, yeah, I get that question a lot. And you know what I love? I love that. I can actually see all the assortments now. And when I mentioned that, you know, that was another thing that we put in place. We used to see the American Eagle line at a very different timeframe than I saw Aerie. So not only do we have a new team in place, but we have a whole new process where we actually, I can see the various lines, you know, during similar weeks, which I think is a huge advantage. That said, I will say when there's a trend, there's a trend, there's a trend. I look at that as our opportunity to gain market share. And we see it all the time in fleece. If fleece is trending, it sells both in American Eagle women and in Aries. Now my job is to make sure that they're differentiated enough so that we can still see incrementality. So that's what we're looking towards. But American Eagle really is about, Janet, slow and steady wins the race. Not getting too aggressive, making sure that we're protecting the margins, rebuilding assortments, and setting up the plans to beat. That's really how I'm thinking about the business. And of course, you've heard the ARRI numbers. I still feel very passionate that there's growth there, particularly with offline. Thanks, Janet. Lots of luck. Thank you, Janet. Nice to hear from you.

As a reminder, if you'd like to ask a question, please press star 1 on your telephone keypad. As a reminder, if you'd like to ask a question, please press star 1 on your telephone keypad. One moment, please, while we poll for more questions. Your next question comes from Marnie Shapiro with Retail Tracker. Please proceed with your question.

Hey, everybody. And, Jen, I actually thought the talks looked really nice. So they were a great improvement over last year. But, Jay, I actually have a question for you. Thank you, Marnie.

Thank you.

We're working hard. I mean, compared to 2019 also, unbelievable. But, Jay, I actually have a big picture question for you because you've been through periods like this before. But I feel like as a company, American Eagle has just done so much work operationally and technology that you're coming into this tough period a very different company than you were in the past. And at the same time, you have a fashion trend in denim that's playing to your company's strength. So I guess, am I seeing this right? Or is there something else going on? Because it feels like Compared to past times when we've had these moments with the consumer or inflation or anything else, the company is much better positioned. You're starting from a stronger point to fix what is going wrong.

Is this question addressed to me or is it addressed to Jen?

No, just to you because you've been through enough of these ups and downs in business before.

Look, I've been through these ups and downs since being involved with the company since the early 90s. And look, one thing is we consistently make money no matter what the story is. You know, we got a little surprised this first quarter. And the team has made a lot of adjustments. We feel very good about the third and the fourth quarter. And we think we're in good shape. I think, like you said, we put a lot of money in our technology. We're making investments in our supply chain. We're making investments in the stores, making it easier for the customer to shop, making the experience online better. I think we're in great shape. There might be a hiccup this quarter, but the company's in great shape. We have a great team. I think we're the best team out there, period.

I'm not worried.

I feel very strong about the company. And look, we're opportunistic and there'll be a lot of opportunities for us out there also.

Fantastic. Best of luck for the summer season. Thank you.

Your next question comes from Dan Stroller with BMO Capital Markets. Please proceed with your question.

Hey, good afternoon. I just wanted to ask about the omni-channel capabilities and channel profitability. I think traditionally you've mentioned that store and e-com profitability has been relatively in line with one another. So I was just curious if that diverged at all, and if so, how you get more BOPIS orders or drive-in store transactions. Thanks.

Yeah, Dan, thanks. I can start with that question. I think the way I've described this before is, I mean, obviously we look at the channels in terms of productivity, both in top-line trend and then the profitability flow through coming through both channels. At the end of the day, though, I don't like to talk about channel profitability all that much because we are looking at delivery efficiencies. We're looking at store labor efficiencies. We're looking at really the cost of a transaction. We've reduced rent costs. So it's really about efficiencies through the P&L because, as we know, our customers don't really shop channels. They just shop us. A lot of times they're shopping on their app as they're walking into the store. We're fulfilling orders from the store directly to customers' homes. So channel profitability in general is not that different, and we're working through the expense line items that attach to each transaction to find ways to optimize. I think that's the best way to answer that question. without getting into a lot of accounting, because a lot of our accounting around channel profitability is allocations, which we don't like to get into. So it is just finding efficiencies related to every transaction and the cost of every transaction is the way we like to think about it.

Got it. Makes sense. Thank you, and best of luck.

Your next question comes from Corey Tarlow with Jefferies. Please proceed with your question.

Hi, good afternoon and thank you for taking my questions. Firstly, just a point of clarification on the inventory. Is the expectation that it will be completely worked through by the end of the second quarter? And then if so, how should we expect the remainder of the gross margin to cadence throughout the rest of this fiscal year?

Yeah, thanks. Yes, I think from a spring and summer perspective in terms of how we plan the business, we expect to be clean going into back to school. And when I say clean, we have reset our plans multiple times now for the back half so that our average inventory is in line with these trend expectations and the trends we've been seeing for almost four months now. So on average for those seasons, we're really happy with the way inventory is positioned against our current trend lines. At the end of each quarter on the balance sheet, again, you're going to see some apples and oranges comparisons in terms of just timing of inventory. So we feel really good about that. From a gross margin perspective, we provide the 33% for the second quarter, which is where we think we'll be to get through the goods we own right now. We look to the back half. We do expect to see improvement Q3. I think we gave previous guidance to be in the low 40s. We do expect to be at a very healthy gross margin. I'm not sure we'll be exactly at that rate with just a top-line trend change. But I would think targeting 40 is the right place to be for us in that third quarter timeframe. Q4, we typically, again, we're a little more promotional. It's just the nature of the holiday period. And in January is when we... You know, since you cleared through all of our fall and winter and holiday goods, so the gross margin is typically a little lower, but we do expect to see significant improvement to last year's rate because of that $60 million impact on air freight that I think Michael hit in his prepared remarks. We do not expect to incur much air freight at all in the fourth quarter compared to that $60 million number.

Got it. And then in an environment where freight costs continue to increase, can you highlight some key takes as it relates to how your supply chain businesses performed in the quarter and then maybe what to expect going forward? Sure. So, yeah, our supply chain business, actually, I think what Mike said in the prepared remarks was performed a little bit better than expected in Q1. We're clearly in a very disrupted supply chain environment. And to me, that only makes the impetus for people needing this kind of service greater. Clearly, positioning inventory closer to customers, being able to get supply chain efficiencies, being able to have fast and efficient delivery, You know, it is the future. It is the way that retailers are going to want to operate. You know, I said earlier, to me, it's the same as when retailers all decided to go omnichannel, or most decided to go omnichannel a few years ago. We're going to look back at this moment, and we're going to look back at the changes that Quiet's leading in the industry, and we're going to say positioning inventory on the edge, using shared capacity to do that, is as transformative to the retail landscape as omni-channel changes were years ago. So we're pleased with how the supply chain business performed. It acquired significant new customers. Jay mentioned Saks and Fanatics. We're excited to have them join. And for me, what I'm excited about is when we talk to new customers, they get it. They want to operate this way. They see this as the way in the future. And I'm very optimistic for where that business is headed. Great. Very helpful. Thank you very much and best of luck. Great.

Thanks. Your final question today comes from Rebecca Duvall with Bluefin Research Partners. Please proceed with your question.

Good afternoon. Thank you for taking my call. I have just a quick two questions. The first is you guys seem to be pretty disciplined in terms of your skew count on markdowns, particularly in comparison to 2019 levels. And so I just want to understand how you're thinking about, obviously, you have some inventory you're going to move through here in Q2. But then should we think that your goal is obviously to get to that few count reduction again in terms of markdowns? And then the second question is on raw material inflation. Obviously, denim is a huge part of the business. And we've all been paying attention to where cotton is going. And I just wanted to know where you guys stand on that and if you're able to hedge from that. Thank you.

Yes. How are you regarding skew count? Um, we continue to look at our CC counts. Um, we definitely have reduced a tremendous amount in American Eagle since I started really rationalizing denim. Um, we were way over skewed and, um, and like I said, you heard the numbers. I'm very pleased with the results looking at, you know, 2019 and the volume that we were able to drive in bottoms, um, just way more productive. And I think that's going to bode well for the future for our margins as well. Look, we're in the business of having edited, well-defined assortments. That's one thing that I really think is what we do best in both American Eagle and Harry. So again, we're going to continue to optimize. There's some more opportunity in Dennis as we move into Q3. Aerie, we've pretty much always been really disciplined there. Some learnings in offline as we've expanded that assortment, and that was really from back in Q3 last year. That's really where we saw some opportunity, and we worked on that as a team, and I'm feeling like we're in a really good place there.

Yeah, and hey, Rebecca.

Yeah, go ahead. Sorry.

It's Michael Rimpel. How are you? raw material inflation, we had platform fabrics, I had mentioned last year, very aggressively all the way through back to school this year. So we had costs, product costs locked in through back to school. You know, I expect markups, our receipt markup is up in Q3 and, you know, really at pre-pandemic levels. And Q4, we do start to feel cotton price increases, but it's more than offset by the transportation benefits that we're going to get. And actually, when you look at the receipt IMU in Q4, it's really, you know, very close to what pre-pandemic levels were also. Wow.

Well, that's great. So best of luck to you guys. Okay. Thanks a lot.

Rebecca, just one more point quickly. Just to be clear, because the current inventory levels have nothing to do with SKU count and choice counts. We're still down well over 20% to the 2019 levels. We just bought to a higher level of sales demand. That's really what we're cleaning up. It's not anything in terms of choice or SKU counts elevating again and becoming undisciplined. I think Jen said it, but I just want to make sure that's clear.

Yeah, I was thinking more like a skew count on a markdown basis. Like it's still pretty clean compared to 2019 levels. And maybe that's a reflection of the fact that you do have less skews, period. And so we can expect that to stay the same then.

Yes.

Perfect. Thank you, guys. Good luck.

All right.

Take care.

Ladies and gentlemen, we have reached the end of the question and answer session, and I would like to turn the call back to Mr. Jay Schottenstein, CEO, for closing remarks.

Please go ahead. Okay, thank you, operator. Challenges unveil opportunity. We have a very strong business with leading brands. We're using learning from this quarter to right-set our plans and deliver improved performance in the back half of the year. Thank you for your time and investment. I look forward to updating you on our progress on the next quarter call. Thank you.

This concludes today's conference. You may disconnect your lines at this time. Thank you all for your participation.