J.C. Penney Q2 Earnings Call Transcript

123jump.com Staff
22 Sep, 2010
New York City

The department store chain retailer net quarterly sales fell 0.1% to $3.94 billion on comparable store sales rise of 0.9%. Net income in the quarter was $14 million or 6 cents per diluted share, compared to net loss of $1 million or breakeven per share in the prior-year quarter.

J.C. Penney Company, Inc. ((JCP))
Q2 2010 Earnings Call Transcript
August 13, 2010 9:30 a.m. ET

Executives

Kristin Hays – Vice President, Investor Relations
Robert B. Cavanaugh – Executive Vice President and Chief Financial Officer
Myron E. Ullman III – Chairman and Chief Executive Officer

Analysts

Deborah Weinswig – Citigroup
Adrianne Shapira – Goldman Sachs
Dana Telsey – Telsey Advisory Group
Charles Grom – J.P. Morgan
Christopher Cuomo – Morgan Stanley
Robert Drbul – Barclays Capital
Lorraine Hutchinson – Bank of America/Merrill Lynch
Michael Exstein – Credit Suisse
Wayne Hood – BMO Capital Markets
Sean Naughton – Piper Jaffray
Erika Maschmeyer – Robert W. Baird & Company

Presentation

Operator

Greetings and welcome to the JCPenney Second Quarter 2010 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If any should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Kristin Hays, Vice President, Investor Relations. Thank you. Ms. Hays, you may begin.

Kristin Hays

Thank you, Jacky and thank you all for joining us on the call this morning to review J.C. Penney''s second quarter earnings. Before we begin, let me remind everyone that the discussion this morning includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which reflects the company''s current view of future events and financial performance. The words expect, plan, anticipate, believe and similar expressions identify forward-looking statements. Any such forward-looking statements are subject to risks and uncertainties and the company''s future results of operations could differ materially from historical results or current expectations. For more details on these risks, please refer to the company''s Form 10-K and other SEC filings.

Also, please note that no portion of this call may be rebroadcast in any form without the prior written consent of J.C. Penney. Replays of today''s webcast will be available for 90 days. For those listening after August 13, 2010, please note that this recording will not be updated and it is possible that the information discussed will no longer be current.

On this morning''s call, we will have two speakers. First, Bob Cavanaugh, our Executive Vice President and Chief Financial Officer, followed by Mike Ullman, J.C. Penney''s Chairman and Chief Executive Officer. Now, I''ll turn the call over to Bob.

Robert B. Cavanaugh

Thanks, Kristin and good morning everyone. I will be speaking with you this morning about our financial results in the second quarter. Mike will then provide additional color around our results and update on our strategic initiatives.

This morning, we reported second quarter earnings of $0.06 per share, compared to breakeven results last year and within our guidance of $0.05 to $0.08 per share. Including the $0.05 impact for bond premiums incurred in connection with the company''s debt tender offer completed in May.

Our second quarter results demonstrate our commitment to operational flexibility and delivering improved profitability. Sales for the quarter were challenged by the company''s performance in July, and in particular were impacted by two non-comparable factors that Mike will discuss in a few minutes.

All other financial and operational metrics exceeded plan for the quarter and first half earnings were $0.31 per share compared with $0.11 per share in last year''s first half. Gross margin exceeded plan and improved 90 basis points to a historic peak for the second quarter of 39.4%, primarily due to our ability to control unit costs through strong sourcing relationships and through more profitable sales of clearance merchandise during the quarter under our Red Zone clearance strategy.

Also contributing to gross margin was exceptional sell-through of wear now merchandise, combined with year-over-year shrinkage improvement attributable to our shrinkage reduction initiatives. Our team continues to exhibit discipline in managing our operating expenses across the entire organization, as SG&A came in much better than guidance, up only 2.5% over last year.

The increase in SG&A dollars is partially attributable to expenses related to new stores and the continued rollout of the Sephora inside JCPenney boutiques. These increases were partially offset by a reduction in the incentive compensation accrual.

Operating income for the quarter was up 41.8% to $95 million, compared with $67 million last year. As noted in the release, if we exclude the impact of the non-cash qualified pension plan expense from both this year''s and last year''s second quarter, adjusted operating income increased 7.1%.

Total operating expenses were relatively flat to last year, increasing 20 basis points as a percentage of sales. Interest expense for the quarter was $57 million, compared to $68 million in the prior year.

The company also incurred approximately $20 million in additional expenses, primarily bond premiums paid in connection with the debt tender offer I referred to earlier. The effective tax rate for the quarter was 22.2% and reflected favorable adjustments to the company''s state income taxes. And we had approximately 238 million average diluted shares for the quarter. So the bottom line, net income was $14 million or $0.06 per share for the quarter.

Moving on to our financial condition. We remain in a strong financial position, with continued flexibility to support the key components of our growth initiatives of the long-range plan. As of July 31, the company had cash and cash equivalents of approximately $2 billion. Year-to-date, our free cash flow is on plan.

Taking into consideration our free cash flow position and the financing transactions noted in the release, we ended the first half with $300 million less cash when compared to last year''s first half. And we ended the quarter with $300 million less debt or long-term debt of approximately $3.1 billion compared to $3.4 billion last year.

Capital expenditures for the quarter were approximately $113 million compared with $148 million in last year''s second quarter. We continue to reinvest in our existing stores and expect full year capital expenditures to be approximately $500 million. This includes 23 major store renovations, renovations associated with the addition of 76 Sephora inside JCPenney boutiques and store enhancements to support merchandise sets for Liz Claiborne and MNG by Mango.

Turning now to guidance for the third quarter, we expect comparable store sales to be up 2% to 3% for the third quarter. Total sales will be up approximately 100 basis points less than comparable store sales due to the expected negative impact from the discontinuation of our big book catalogs.

We expect gross margins as a percent of sales to decline modestly during the quarter, which is unchanged from our original plan. SG&A expenses are expected to be up approximately 2% compared to last year''s third quarter.

Depreciation and amortization should be approximately $129 million, net interest expense of about $57 million and we expect a tax rate of approximately 38%. We currently anticipate about 238 million average diluted shares including about two million common stock equivalents.

For the third quarter, we expect earnings to be in the range of approximately $0.16 to $0.20 per share and for the full year, we now expect earnings to be in the range of $1.40 and $1.50 per share as we are taking a relatively conservative approach to the economic climate and especially the moderate consumer.

In summary, with a disciplined approach to our business, we continue to have the financial flexibility to support the strategies of our long-range plan. This is enabling JCPenney to strengthen both competitively and financially and position our business for long-term success.

Now, I''ll turn the call over to Mike Ullman for more color on the company''s performance and outlook.

Myron E. Ullman III

Thank you, Bob and good morning everyone. We delivered on our plan for the bulk of the period resulting in sales increases across several core merchandise categories at regular and promotional prices that were driven by the initiatives we outlined in our analyst meeting in April.

Our core apparel lines have performed very well. We hit our internal sales plans for the quarter in all of our key categories. We also delivered record gross margins and further strengthened our financial position during the period. Comparable store sales were positive for the second consecutive quarter, increasing approximately 1% from last year.

We focused on increasing the proportion of wear now in season merchandise in our mix, enabling us to drive profitable sales at regular and promotional prices and we were able to pull forward many deliveries to meet the demand as we were selling through the merchandise earlier than anticipated. As a result, we are entering the third quarter in a very clean forward-looking inventory position.

Also, as Bob mentioned, we opened 22 additional Sephora inside JCPenney shops within a store locations to bring our total to date to 215, which will increase to 232 by the end of the year. The sales trend of stores that have a Sephora inside JCPenney are consistently performing 150 basis points higher than stores that do not yet have the concept and the sales productivity of Sephora space in the stores is three times the average of the overall store. Due to the success of this concept, we''ll continue to open approximately 75 Sephora locations per year.

To give you a sense of the sales by category, our women''s business continues to be strong driven by the success of wear now apparel. As you know, we''re up against very strong comps from last year, when our women''s apparel business was the industry leading performer during the downturn and we expect our women''s businesses to be even stronger in the second half of the year with the addition of Liz Claiborne and MNG by Mango as well as the ongoing positive changes we''re making across our apparel, accessories, shoes and fine jewelry businesses.

Our new Liz Claiborne merchandise began arriving at the beginning of this month and the response from customers has been overwhelmingly positive. The Liz brand is already beating our expectations and the official marketing launch of the brand isn''t until mid-September.

The 77 MNG by Mango shops will open next week as well as on jcp.com. We''ll reach a total of 600 stores by the end of next fall. There are really only truly five fast fashion retailers in the world, Zara, Uniqlo, Forever 21, H&M and Mango, and none of them have a department store presence in the U.S. With approximately 1,500 square feet of a shop-within-a-shop, JCPenney will be the only department store offering true fast fashion and the merchandise looks great and the shop environment will be compelling.

Our first Call it Spring by The ALDO Group shop-within-a-shop will open in September in our Manhattan store. Call it Spring will offer our customers an extensive collection of over 300 styles of up-to-the-minute on-trend footwear and accessories. Again, we''re the only department store retailer to carry an Aldo branded product outside their own specialty stores. And we''re rapidly rolling this out to 600 stores over the next 12 months.

Our men''s division had the strongest categories in the quarter, up 5.5%. We had an outstanding Father''s Day and continue to experience a great trend in our men''s business. Sportswear, for example, is up 9%. Our success is a direct result of the change we made in adding assortment, sharpening our price points and the compelling packed for floor presentations.

We''re also starting to see signs of life in our home business, due to the new initiatives being put in place by John Tighe, our new GMM of Home. Specifically, we''re seeing tracks in our soft home business, with particular strength in the more affordable items.

Our furniture and window covering businesses, however, remain tough, as a result of protracted housing slump. And improvement in these areas will be a longer term proposition. In terms of the children''s businesses, the changes we''re making are evident in our back-to-school offerings. While still early, we''re very pleased with the performance of our just launched brands of Uproar and Supergirl by Nastia and the ongoing strength of our relatively new brands including Olsenboye by Mary Kate and Ashley Olsen and Ryan Sheckler''s RS by Sheckler brand.

This, coupled with the breadth of our operating and core merchandise that kids need every year, including a terrific denim selection and school uniforms, positions us well to once again be the leading back-to-school destination. However, we do expect the peak back-to-school selling period to be very close to school openings around the country.

The timing of shopping will also, of course, be tied closely to the tax-free events that are being held in a number of states to support back-to-school shopping. Overall, we have seen great strength in our kids'' businesses as we continue to execute our growth strategy which during the quarter drove positive sales.

Our focus of driving greater value to our customers by offering sharp price points in private brand as well as increasing sales of select national brands with great brand loyalty like Carter''s, has really moved the needle in establishing JCPenney as a destination for moms.

In the second quarter, Carter''s was up almost 30% over last year''s quarter while our private brand Okie Dokie also had a great sales increase. Our successful Internet remains the largest general merchandising site exceeding $1.5 billion per year.

As you know, we made the decision to exit the big book catalog business at the beginning of the year. As it turns out, many of the former big book customers entered their orders online in the past. The loss of that sales volume this year had a negative effect on our overall Internet trend and overall comp.

Despite this non-comparable effect jcp.com was up 4.1% for the quarter, fueled primarily by double-digit rises in all apparel categories. Contributing to our strong dotcom increases in July was the introduction of guided navigation, which quickly directs customers to the right products within a few clicks. July was our first full month that it was available across all of our online categories which led to a 22% lift in the average order value for the month.

To give you some highlights for the quarter, all regions year-to-date have positive comp increases, all five regions, with the southeast being up the most on a spring season basis. Overall transactions were up 5.9% and units per transaction were up 2.3% for the quarter. AUR was down slightly as planned.

Due to our leading product development and sourcing organization and the long-term relationships we have with our overseas suppliers, our cost of goods has declined which allowed us to pass the savings on to our customers. So while our overall average AUR is down slightly, we planned it that way in order to provide our customers with the value they''re looking for while not hurting our gross margins.

This AUR strategy worked. Throughout the quarter, our private brands continued to outperform national brands by approximately 400 basis points in sales trend. And we experienced an even larger improvement of approximately 800 basis points in private brand gross profit, higher than national brands.

Clearance AUR through our Red Zone clearance program was up 3.9%. We began this program at the beginning of the season and its benefits are very clear. Our merchants can now accelerate the markdown on slow selling merchandise on a more timely basis and have it available for sale in the parent department locations throughout the store.

This approach improves our flow of new, fresh merchandise sold at regular and promotional price points, while maintaining consistent presentation of clearance merchandise which is moving out at a faster rate and more profitably. Yet another key initiative is the ramp-up of our JCP rewards program which now has reached eight million members by the end of the quarter.

JCP rewards customers visit JCPenney stores about two times more per year than non reward customers and spend approximately $100 more per year. For the back half of the year, we''ll be launching some major program enhancements that will continue to drive top line sales for us with this very important and very loyal customer.

Total inventory at the close of the quarter was up approximately 7% over last year. This includes customer facing inventory in stores and is approximately 5%, in line with the company''s initial plan for sales to improve sequentially in the second half of the year. While the inventory is up compared to our updated sales guidance for the third quarter, we''re very comfortable with the level as it includes private brand merchandise that we pulled forward to avoid overseas disruptions that may have negatively impacted our future deliveries during the back half and we''re holding this merchandise in our logistics facilities until its planned set dates.

Additionally, a portion of the inventory increase includes the company''s in transit merchandise from our international sourcing organization in support of JCPenney''s growth initiatives including a higher sales mix of our private brands and the launch of Liz Claiborne in our stores and on jcp.com. And remember, we are now sourcing the Liz Claiborne brand ourselves, so the inventory ownership there is reflected earlier in the cycle. Again, we''re very comfortable with our levels of merchandise.

Mall traffic was up throughout the quarter and that was mirrored in JCP store traffic, as well. As has consistently been the trend, traffic in our off-mall stores is about 350 basis points higher than our mall-based stores.

As we have mentioned, offsetting our positive sales trend at the end of the quarter were the impact of two non-comparable items that distorted our true operating performance for the balance and will distort our operating performance for the balance of the year. So we want to call them out to you now so they don''t impact your point of view about the vibrancy of our business or your perception of our competitors'' market share performance.

The discontinuation of the big book catalog will impact total sales this year. This is particularly true in July as we''re up against two big book catalog drops from last year. This resulted in a 200 basis point hit to our total sales in July and 160 basis points for the quarter.

The other non-comparable is our Red Zone clearance strategy transition which allows us to move through clearance at a much smoother cadence throughout the year versus our previous clearance strategy of having large clearance downloads at the end of each season. Two of the largest downloads occur at the end of July and again in mid February.

So with that, we''re up against our first big clearance download this last week of July. I should note that while the July clearance wasn''t a surprise to us, as we knew it was coming in retrospect we could have handled it better as we ultimately gained back much of our comp sales increase that we earned throughout the quarter during that final week of July.

Overall, we''re very pleased with our Red Zone clearance program. It''s working and we''re selling our clearance merchandise earlier in the cycle and more profitably. That said, one week is a brief moment in time, given what we learned from it, we''ll work to mitigate short-term impact in the future.

And so overall we''re encouraged about where our business is heading and we''re managing it well, as you can tell from our net and operating income results. So in conclusion, Bob shared with you our guidance for the third quarter and the balance of the year, what reflects is a conservative approach to what continues to be an uncertain consumer climate, particularly for the moderate consumer.

Having said that, we''re on a journey to fundamentally transform JCPenney from a traditional catalog-based department store to a retail destination for discovering great style at compelling prices and we''re on track with our plans to do just that. We''re creating a sustainable enterprise where customers receive attentive personalized service and are inspired by our merchandise offerings, with engaged associates who choose to invest their careers with us and where we maintain a strong financial position even during the tough economic climate.

As you know, growing top line sales is an important objective of our long range plan, we''ve identified merchandise growth opportunities that will entice current customers to visit more frequently, engage and attract new and younger customers and increase customer spending overall.

We have a compelling merchandise offering for our customers with half of our business in industry leading private brands and the other half in the best of national exclusive brands. As we continue to invest and power up our private brands, we expect they will continue to grow at a faster rate than national brands and to continue to provide great value to our customers and higher profitability for us and we''re bringing innovation to what we offer to our customers.

JCPenney continues to implement game-changing merchandise growth concepts that will not only drive higher sales per square foot but help establish JCPenney as a style destination. Sephora inside JCPenney, Liz Claiborne, MNG by Mango, Call It Spring by ALDO are clear examples of this.

Jcp.com is the leading general merchandise site on the Internet and continues to grow. We’ve done a lot of the hard work during the recession to overhaul our entire digital platform. Customers are changing the way they interact through technology and the retail competitive landscape, especially online, has changed even more dramatically. We''re on the forefront of these changes. Our investment in the future of retailing is a competitive advantage and one that''s not easily replicated.

The actions we''re taking are the right ones for our customers, our associates and our investors. We are intently focused on growing the top line, maintaining our margins while maintaining a strong financial position, that allows us to pursue our growth initiatives. While we''re committed to delivering progress every quarter, our overall objective of our journey is to build a long-term sustainable franchise and shareholder value.

With that, we''ll open the line for your questions. Operator.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, at this time, we will 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’d 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 pose for questions. Thank you. Our first question is coming from Deborah Weinswig of Citigroup.

Deborah Weinswig – Citigroup

Great. Thanks so much and appreciate all the color. So in terms of the gross margin improvement, I think that your guidance had been for modest improvement. Can you just provide some color around your strong performance in the quarter?

Myron E. Ullman III

I think it comes back to our product development sourcing success. Our costing is more favorable than we had planned but obviously we continue to work on particularly the private brand merchandise, keeping the quality at a very high level but improving our costing.

Deborah Weinswig – Citigroup

And then if we look at some of the guidance, your same store sales comparison, as you mentioned, Mike, a year ago you had some of the -- it had industry leading comps driven by the women''s business, so your comparison is much more difficult. What gives you the confidence in the 2% to 3% comp guidance in the third quarter, just considering what you''re cycling?

Myron E. Ullman III

We identified 14 growth initiatives that we began the year, getting our store merchandising executives focused on building for the fall season. We''ve been tracking those ever since. And I think something like 11 of the 14 are at the planned levels or above, so we feel very confident that what we''ve invested in terms of inventory and our focus at the store level on those initiatives, that we can deliver the comps. However conservative they may seem with the overall external environment, we feel very good that we can create that business from those investments.

Deborah Weinswig – Citigroup

And any early read on Liz Claiborne?

Myron E. Ullman III

As I said in my prepared remarks, we''re quite gratified. Obviously, we have Liz & Co. still on the floor and being cleared, but I would say from our store checks everybody is very enthusiastic about the response.

Deborah Weinswig – Citigroup

And then, obviously you''ve had some experience now with the Red Zone. How would you say that''s performing versus your expectations?

Myron E. Ullman III

Well, as I said in my prepared remarks, I think we were a bit maybe unprepared or not properly prepared for the big spikes but we experienced at the end of July of last year. We were unable to offset those within the month. Having said that, the whole strategy''s built around clearing the merchandise on a more profitable basis.

So it hasn''t deterred us from our overall objective on an annual basis or 12 month basis we feel we''ll hit our objective on the bottom line. It just doesn''t show up well in terms of the cadence month to month. But as I said, we''re going to look for ways to mitigate the effect on the next two that we face.

Deborah Weinswig – Citigroup

Okay. And then last question, with the off-mall stores outperforming 350 basis points higher than on-mall, when might we see you reaccelerate your off-mall rollout?

Myron E. Ullman III

We''ll be announcing some additional off-mall stores shortly. We''re not going to go chase deals in a commercial real estate environment that is not robust, but where there are opportunities, we''ll obviously pursue them. Quite honestly, we''re gratified that a lot of the new stores we''ve opened the last three or four years are performing very well. We were very concerned about the housing areas that didn''t fully develop. That we might see a protracted shortfall in those stores but we focused on them in the last several years and they''re performing at or above the store trends.

Deborah Weinswig – Citigroup

Great. Thanks so much and best of luck.

Operator

Thank you. Our next question is coming from Adrianne Shapira of Goldman Sachs.

Adrianne Shapira – Goldman Sachs

Thank you. Good morning. Mike, on the inventory, could you help us share your comfort in terms of inventory up 7%? And if you could give us some color, how much of it was pulled forward merchandise and where you would like to see inventory levels at the end of the third quarter?

Myron E. Ullman III

Essentially, we''re right on plan at the end of July. And as we said, we plan to bring in some of the merchandise earlier because we want to be sure, given the container shortages and the various things that are going on in Asia that some of our new launches were adversely affected by that. So one part of our comfort is that the additional inventory''s essentially invested in the growth categories that we planned at the beginning of the year, Claiborne being a big one.

As I mentioned, we now own the Claiborne merchandise all the way back to the source, where in the past, which is not comparable because the Liz & Co. merchandise was produced through Claiborne. We owned it only at the point of entry to the U.S. So that''s a bit non-comparable.

So in terms of right now as we forecast out the fall season, as Bob mentioned, we''re a bit more concerned than we would have been at the beginning of the year about the consumer environment. So we''re going to be looking very carefully at revising some aspects of our sales inventory toward the rest of the year but we don''t see any major issue at this point.

Adrianne Shapira – Goldman Sachs

Okay. So beyond the third quarter, in terms of heading into the fourth, give us a sense in terms of, as you said, a bit more cautious, how we should be thinking about sales and inventory levels as we enter the fourth quarter?

Myron E. Ullman III

I think most retailers, as they thought about 2010 at the beginning of the year, were very optimistic that they were up against very soft numbers and it would be easy to be up against those comps. But I think all of us have found a relative slowing down of the consumer economy in the last three or four months.

So I think most retailers is what we heard in Asia -- we were there for a week a couple weeks ago talking with all the suppliers. They''re seeing across the board more caution in terms of forward inventories. So I think it''s prudent for us to also be cautious. Having said that, our cycle times are shorter than our competition, our relationship with our suppliers is more longstanding and certainly they''re very attentive to our needs so we think we''ll be in decent shape to react.

Adrianne Shapira – Goldman Sachs

Shifting gears to the margin, just peak gross margins, it sounds as if for the third quarter we should be looking for gross margins to be down. If inventory''s in good shape help us think about why gross margins would be down.

Myron E. Ullman III

The big book catalog, well, we can give you all the reasons why we should get out of the business, one aspect that was good is it actually was a fairly high margin business because it was the most conservative products we had and frankly, just looking at the three books themselves, they were quite profitable. The problem is, over time, with higher printing costs and higher postage and the customer migrating more and more to online, at some point they were going to be a major drag. So we''ve chosen to take the hit this year and it will have a detrimental effect on margins in the third and fourth quarter.

Adrianne Shapira – Goldman Sachs

Okay. When we look beyond the back half in terms of margins, help us think about how we should be thinking about what the right level is, especially maybe give us some of your insight into inflation pressures given your extensive sourcing capabilities?

Myron E. Ullman III

I think anybody that''s spent any time looking at the situation, particularly in China for 2011, would tell you there''s a lot of headwinds, particularly the cost of cotton, labor shortages, believe it or not, social costs, minimum wages and just the overall domestic environment in China is such that there''s much more domestic demand which is putting pressure on costing overall, particularly for apparel.

Fortunately, we started to diversify our sourcing locations four or five years ago so we have a balance of sourcing across Vietnam, Bangladesh, Indonesia, Turkey, India. So we probably have less of an impact from China by itself. The cotton crop upcoming looks like it''s stronger than the last. So I think anybody that thinks that they''re going to get cost improvement in ''11 probably hasn''t studied the facts.

I think our view is that our cost impact will be less than our key competitors, but it would be naive to think we''re going to be sheltered completely. The last time there was apparel cost increases was probably in 1992. So consumer''s gotten the benefit as have retailers, the benefit of the deflationary category, if there''s such thing as a benefit of a declining retail but we don''t see that continuing in 2011.

Adrianne Shapira – Goldman Sachs

And thoughts in terms of passing that on?

Myron E. Ullman III

I think the broad line retail sector has the lowest pricing power of any sector in the economy, according to studies we''ve seen. So we expect to have to run our business more effectively to be able to shield the customer from those cost increases.

Adrianne Shapira – Goldman Sachs

Great. Thank you.

Operator

Thank you. Our next question is coming from Dana Telsey of Telsey Advisory Group.

Dana Telsey – Telsey Advisory Group

Good morning, everyone.

Myron E. Ullman III

Good morning.

Dana Telsey – Telsey Advisory Group

Hi. Can you give us a little update on the home area, what you''re seeing there and plans for the future? And then as you think about the new merchandising initiatives, whether it''s Liz Claiborne, whether it''s Mango, how do you look at their impact on the gross margin? Thank you.

Myron E. Ullman III

Okay. As to the home business, I think John and his team done a very good job of what I would consider to be getting the floor organized in a logical manner and the introduction of some new innovation like the Pure Perfection towel which has gone very well and the realignment of our bedding business. So the soft home part of our business is starting to respond. Stores have been very enthusiastic about what they saw for fall.

At our recent store managers meeting, one of the most well-received sessions was the powering up of big bold statements in soft home. As I mentioned in my prepared remarks, we think the big ticket furniture and window covering business will respond more slowly, just by the reality of the housing slump being protracted beyond what was originally envisioned.

We think it''s going to take another six months or so to see the full benefit of the changes they''re making but we''re starting to see signs of life. And certainly, we always look to our sales associates because they''re the best customers we have and the best authority on how we''re doing and they feel very good about what they see on the floor.

As to the margin impact on Liz and MNG by Mango, Liz is actually a very favorable margin impact to us because part of our deal with the Liz Claiborne Corporation was for us to produce the merchandise which gave us 500 or 600 basis point improvement in gross profit even on the comparable sales. So the fact that it''s also across more categories and we expect to grow it aggressively over the next five years, we think it''s nothing but a positive to GP.

MNG by Mango, frankly, is not driven on the basis of being a great GP contributor but it is a contemporary fashion attraction and we''ll only have it in 77 stores this fall. We''ll learn as we go. They have proven in their business, in the core Mango business, that they can turn the merchandise profitably until we obviously experience that with our customers, we won''t have as much information as they currently have. They''re very enthusiastic about going from 12 stores in the U.S. to 600 in a little over a year.

So this is a big opportunity for them as well, as we''ll market aggressively one of the most successful fashion concepts in the world. So I think if department store executives were candid, they would tell you that probably $20 billion to $30 billion of volume has come out of department stores by the five fast fashion retailers ramping up a very successful business model. We think it''s a real coup to have one of those resident at the entrance of our biggest stores.

Dana Telsey – Telsey Advisory Group

Thank you.

Operator

Thank you. Our next question is coming from Chuck Grom of J.P. Morgan.

Charles Grom – J.P. Morgan

Thanks. Mike, if you can help us connect the dots on your top line outlook. I believe you said in your prepared remarks that you''re more concerned on the consumer today than you were in the spring and you''re going against tougher compares in the back half, yet you''re guiding to comps up 2% to 3% above what you did in the first half of the year.

I guess, can you just help us get a better understanding of how much of a lift you''re baking in from either the 14 initiatives that you spoke to earlier or the Liz and MNG new brand launches?

Myron E. Ullman III

First of all, virtually all the comp increase in the back half was driven off our growth initiatives. If you look at the Liz Claiborne ramp-up, you look at 77 more Sephoras, you look at our JCP rewards increases, if you look at what we have planned in terms of guided navigation on dot com, our center core merchandise initiatives, whether it be the tops business across all businesses or the accessories category, modern shoes, we basically identified the growth categories at the beginning of the year and we knew most of those were not going to be accretive in the first half.

What we tried to say is, as we thought about the year, we weren''t going to look to the consumer economy to help us at all in 2010. Now, we think there might be a slight drag on the consumer portion of this. And we have to create not only the pulse, but we have to make it work harder to get to our comps. So I think anybody''s objective about the current environment saw a gradual slowing of the economy.

I think, to be candid, the upper quartile customer never ran out of money and those that cater to that customer have been smart in terms of looking at the merchandise they have on the floor and offering more value in a sector that really wasn''t very value oriented in the past. I think the bottom quartile is obviously families that are getting by taking care of the needs of their family. And they don''t have much flexibility beyond that. The middle two quartiles, which are our core customers, have had the brunt of essentially the effect of the job situation.

The country basically hasn''t reemployed a worker at this point, as new entrants to the workforce of 125,000 a month is larger than the average job increases per month. So to be realistic, consumer constriction of credit, the job loss situation and the protracted housing situation has had the biggest impact on the middle income consumer. So as a store that''s proud to be aligned with that consumer, we have to recognize that they have issues and we obviously want to help them get through this by offering great value. But our customer tends to be more urban, more ethnic, and more impacted by the economy than many others in the overall retail landscape.

Charles Grom – J.P. Morgan

Okay. So is it safe to assume that maybe one to two points of a comp from some of these new brand launches, if I look at your guidance relative to what you did in the first half?

Myron E. Ullman III

I would say more than that. I would say virtually all of our comp would be considered to be from these initiatives.

Charles Grom – J.P. Morgan

Okay. Great. And then can you shed any light on how you think the quarter will progress in terms of month to month cadence? You''ve got an easy compare here in August and then it gets a little bit harder. Any color on August trends? We''re a couple weeks in so far.

Myron E. Ullman III

I think it''s fairly even across the three months, to be honest. I think that back-to-school is the hardest to read. The four week August for us, for example, our best business right now happens to be in Texas because school starts earlier. So if we looked at Texas, extrapolate it across the country, we''d be very, very satisfied with back-to-school.

Having said that, it''s been the hottest in 60 years this summer, so the bottoms business has not been great. The coats business has not been great. If it starts to be more seasonal in temperature and people start to feel more animal spirits about getting back to school. I think we''ll feel more optimistic but right now we''re treating August as if it''s on the trend for the quarter.

Charles Grom – J.P. Morgan

Okay. Great. And then in terms of the big book hit, you said 160 bips in the second quarter. I didn''t recall you quantifying that in the first quarter and then maybe a question for Bob would be I think the last time you reported catalog costs, at least in my model, was in 2005 and we had that at around $255 million. And I know not all of that is for the big book but you speak to the hit from not doing the big book. But could you quantify the expense benefit you''re getting from not printing and distributing that book?

Myron E. Ullman III

It''s a complicated question, Chuck, because we stopped dropping the big books, there''s three per year, we stopped at the beginning of the spring season. But the impact in the first quarter wasn''t as great because the book lasts for four or five months. So the biggest impact of it actually ended up in the second quarter. We probably didn''t fully realize how much of it was online entry in the past until we started looking more closely at it and realized a lot of that catalog business, that more conservative merchandise, that customer is not seeing this merchandise in a book this year so she couldn''t order it if it wasn''t there.

The books themselves, as I said, they probably at one point averaged over $400 million of volume per book. It gradually has been declining to where it''s about half of that today. So the costing is an interactive process, reengineering our infrastructure which we started two years ago by aligning merchandising into one organization, and marketing and media planning into one organization.

Today it''s blended, so it''s a little hard to identify which part today would have been allocated to the big book but gradually our catalog business is declining and our direct mail and our guided media to allow people to shop online is increasing. So the point I made was that printing a 600 or 800 page document, with the postage increases and the printing costs, not to mention the ecological impact of producing this thing. We decided it was time to take the hit. While it''s detrimental to this year, we think it''s the right thing to do and we''ll reinvest a lot of that media into direct mail and things that are related more to dotcom.

Charles Grom – J.P. Morgan

Okay. Great. Thanks very much.

Operator

Thank you. Our next question is coming from Michelle Clark of Morgan Stanley.

Christopher Cuomo – Morgan Stanley

Hi, guys, it''s actually Chris Cuomo here filling in for Michelle. Just had a question on the SG&A guidance, looks like you''re guiding up 2% for sales around 2%. Just could you talk about how we should think about the relationship between SG&A and sales go forward and is there any sort of one-time items from an SG&A perspective in the third quarter? Thanks.

Myron E. Ullman III

SG&A is a little bit complicated because of last year we didn''t have the salary increases and this year obviously we''re up against that. And we also moved our salary increases from August 1 for most of our associates to May 1. So the impact conceptually was a little bit higher in the second quarter incrementally than it would be in the third.

Having said that, we also have new stores in the mix, new Sephora locations in the mix, and benefit costs and so forth. So we don''t think there are any big surprises in SG&A but clearly you keep lowering the comp expectation obviously it puts more and more pressure on SG&A. We''re going to take a hard look at expenses in the second half to be sure we''re expensed properly.

Christopher Cuomo – Morgan Stanley

All right. And then if I could, just one follow-up. Mike, in the past you''ve talked about your customer service scores and I think you''ve called out the highly satisfied customer and actually you were tracking in the low 60s, I think you had mentioned that on your Analyst Day. Just wondering if you could update us in terms of how you''re trending in terms of customer service scores in that highly satisfied index?

Myron E. Ullman III

Be happy to. We''re very proud of our customer service and obviously American Express poll being number one two years in a row for stores is a great kudos to our people. We are tracking in the low 60s in terms of overall highly satisfied. Our goal for the year is to try to hit 65 by the end of the year. We''re on track to do that. We''ve had a couple point improvement since the beginning of the year.

It gets harder because obviously as you get higher scores, it''s incrementally more difficult to get them up. But we believe we have the best customer service of any anchor in the mall and, frankly, we have the only customer service in the off-mall environment. And we think that while that''s a big investment, we think that investment in the long term builds customer loyalty and allows us to sell merchandise that''s more stylish and higher quality because we have someone there to assist the customer with the purchase.

We also think robust online access in our store through our Find More allows customers to be helped by our sales associates online. All of our sales registers are dotcom capable and we have 100 stores now with Find More specialized fixtures that help with that. So we''re very proud of the customer service aspect of it. Our associate engagement continues to go up. We think there''s a direct correlation between highly engaged associates and highly satisfied customers.

So once again this year our score went up from 80 to 81 on highly engaged. We think that''s a great result given the environment and how hard everybody''s working.

Christopher Cuomo – Morgan Stanley

Great. Thanks for the detail.

Myron E. Ullman III

Thank you.

Operator

Thank you. Our next question is coming from Bob Drbul of Barclays Capital.

Robert Drbul – Barclays Capital

Hi. Good morning.

Myron E. Ullman III

Good morning.

Robert Drbul – Barclays Capital

I''ve got two questions. First, could you clarify on the comp components, I''m having trouble making the math work, I think, with some of the numbers that you gave. Transactions, 5.9, UPT 2.3 and AUR down slightly but the comp was up around 1%. I just don''t understand how those numbers work to get that, Mike?

Myron E. Ullman III

First of all, as you know, the arithmetic is difficult because there''s a mix issue as well. So if your big ticket business or your fine jewelry business has a change in AUR, obviously the AUR might be five or six times the AUR of an apparel item on average across that category. The math works, believe me. It''s not hocus-pocus. I don''t know exactly what you''re using, but we gave you the numbers as they exist.

Robert Drbul – Barclays Capital

And then it sounds like Liz is off to a good start. I think when you look back at some of the other new brand launches that you had, such as American Living, can you talk about what you learned from that and when you look at an MNG by Mango, do you think that that can be as successful or how would you think about that?

Myron E. Ullman III

Let''s talk about American Living for a minute. Clearly, opening 40 categories at once in a recession at the best price point would not be what you would design at the beginning. But we motored through that. I''m happy to say our margins now at American Living are quite respectable and we think we have it now with the right marketing and the right imaging, the right assortment, the right sizing, the right price. It''s been hard work.

But I think we''re very proud of American Living, it represents a very important statement on our floor. Liz Claiborne''s very different in the sense that it builds on 30 years of an iconic brand that''s the number one or number two most recognized apparel brand by the women of this country. So we feel it''s much more readily accepted across multiple categories. We''re adding it to categories and accessories in the home that will be well-received from day one.

MNG by Mango is frankly in a very narrow set of categories. So it''s primarily in apparel and accessories and a few handbags. They''re very confident about that business and we don''t really have to invent anything. We don''t have to create the brand from scratch. They have thousands of stores, particularly in Europe, with a very strong alignment to how they market and the impactful imaging that they have.

So we feel that this is a narrower appeal because obviously it''s a more updated contemporary customer but again it''s a very small part of the store, as well. In essence, it''s less than 2% of the store space.

Robert Drbul – Barclays Capital

Okay. And then just my last question is can you talk a little bit more about the Red Zone clearance strategy? And when you look at the back half here, do you think that that''s going to be a bigger component of your comp drivers for the second half of the year than it was in the first?

Myron E. Ullman III

I don''t know that it will necessarily be bigger but I think we obviously have to finish the year, get through until we annualize it. The reality is it''s a little complicated to explain in the sense that why it was so important to change it but by having five major events a year, it really forced merchants to hold markdowns so they didn''t get doubled up on markdowns.

So things didn''t necessarily clear as fast as the customer was willing to clear them. So getting off of that cadence was important, even though it''s painful. So you''re going to hit the five periods where you''re up against these big events and you will have sold through some of the clearance that would have been in those events. We are seeing higher AUR by doing it this way.

More importantly, it opens the open to buy during that period to put in wear now merchandise and that''s the biggest benefit. So it''s a little hard to explain because, frankly, some of the benefit is not shown in the markdown category, it''s shown in the sales line by landing wear now in June, or landing wear now in January.

So as I said, in retrospect, we maybe were too naive about our ability to roll over week 26 and we paid a big price for it in the comps.

Robert Drbul – Barclays Capital

Thank you.

Operator

Thank you. Our next question is coming from Lorraine Hutchinson of Bank of America Corporation.

Lorraine Hutchinson – Bank of America/Merrill Lynch

Thank you. Good morning. Just wanted to ask one more question on inventory. I guess, you had mentioned that ex some items, inventory would have been up about 5% which was in line with your initial sales plan. Now that you''re a bit more cautious on the consumer environment in the back half, what are your plans for that inventory? Can you return it or will we see some more markdowns? How do you expect to get through the somewhat elevated levels of inventory?

Myron E. Ullman III

We expect to sell it, which is the first reaction. We''ll know more after the month of August, obviously, because landing all the new Liz and all the new growth initiative merchandise, much of it is directed at the back-to-school customer. So obviously what you don''t sell, you obviously have to take price changes to get rid of it.

But given the fact that we''re reacting for the whole season, not just for one month, we''ll project out the units we want to own by the various out dates and make sure that we don''t end the season in fall in an inventory position that we don''t want to be. We''ve been very fortunate to have clean inventories coming into spring so we don''t have a lot of carry-overs.

As a matter of fact, we probably don''t have enough clearance to be up against some of the clearance selling we had a year ago. I would much rather have current inventory ready for back-to-school than have a lot of summer left over. The fact that it''s a zillion degrees in some parts of the country doesn''t serve us well in that area but in the long run you want to be basically ready for the future season.

Lorraine Hutchinson – Bank of America/Merrill Lynch

Great. Thank you.

Operator

Thank you. Our next question is coming from Michael Exstein of Credit Suisse.

Michael Exstein – Credit Suisse

Good morning, everyone. One thing that you didn''t mention about was the change in promotions that you''re doing. You''ve been running $10, $15 coupons on most weekends. Can you talk about that change in strategy? And also can you give us the order of magnitude of the unfortunate reversal of the accrual for bonuses? Thanks.

Myron E. Ullman III

On the promotion, frankly, our sales promotion is fairly comparable to a year ago. We certainly haven''t added events, discounts. You''re going to see us make some promotional changes in the back half that we think will make it clear to the customer the value they''re getting at JCPenney. We think we''ve been at a disadvantage because we haven''t messaged it particularly effectively.

Unlike some of our competitors, we''re not really layering in additional promotion. We think we''re up against that forever if you put it back in. We took 50 days out last year and we''re not going to return there.

As to the incentive comp, I don''t think it''s any secret at the end of the first quarter, we were well ahead of plan. So we accrued our incentive compensation above the plan levels for our executives and our managers. And obviously, we had to bring it back to what the trend is now because we not only accrued for what happened year-to-date but we also accrued for the forecast.

So obviously it reflects what we think the reality''s going to be for the second half of the year. The quantum of it, frankly, I don''t have it in front of me but it was --

Robert B. Cavanaugh

Not meaningful.

Myron E. Ullman III

Not material.

Michael Exstein – Credit Suisse

So would it be $10 million to $20 million or would it be less than that?

Myron E. Ullman III

Less than that.

Michael Exstein – Credit Suisse

Okay. Thanks a lot, everyone.

Myron E. Ullman III

Thanks Michael.

Operator

Thank you. Our next question is coming from Wayne Hood of BMO Capital.

Wayne Hood – BMO Capital Markets

Yeah, Mike. Just to follow-up on Mike''s question there. Are you saying that you won''t bring back the number of days that you have discounts, which we understand, but would we expect to see some layering of promotions to get the consumer to respond a little bit, maybe more two for one? Can you describe a little bit more in the fourth quarter, the fall season, what the plan is?

Myron E. Ullman III

I would say that we''re not going to layer in additional discounts. We''re not going to add any additional promotion days. So we have a promotion planned for fall season. We think it''s effective. Obviously, every week we look to make sure we''re comfortable with our ongoing plans but we don''t run promotions on an ad hoc basis. These things are planned out because of the amount of effort required in every market and every media, digital and non-digital and media and print.

We''re not going to layer in additional promotion. We think the promotion we run now is effective. Want to make it a little clearer to the customer so we might message it somewhat differently but it doesn''t mean it''s an additional discount.

Wayne Hood – BMO Capital Markets

Okay. Bob, can you unbundle the second quarter gross margin rate increase? How much of an increase did the stores see, when you strip out catalog and the other things that are impacting that? And when you guys talk about a modest decline in gross margin in the third quarter can you put some parameters around what you define as modest because in the last quarter you expected a modest increase and you were up almost 90 basis points? Is modest more like 50 for you? And then into the fourth quarter can we expect another modest decline against a difficult compare? Thank you.

Robert B. Cavanaugh

Sure. Taking, Wayne, your question regarding the second quarter first here, as Mike indicated earlier with his remarks on the impact on the big books and the profitability that they had generated, the second quarter impact there on the margins from a direct to stores, obviously there was a negative impact or hit, if you will, from the big books on margin and a further improvement, of course, therefore, on the stores. So with regard to the third quarter, I think modest decline was, as Mike said, really in our plan as we prepared for the year and in terms of quantification.

Myron E. Ullman III

We don''t normally give out prospective margin numbers. I think we''re at historic highs. Last year''s margin for the year was the largest in the company''s history. I think the second quarter''s margin is the highest at least in a decade. So I think we certainly don''t feel like we have margin pressure by any surprises coming. I think it''s a question of flow-through and sell-through. As we keep turning merchandise as we have been, we''re getting the favorable margin that we planned for.

Robert B. Cavanaugh

Yes and I think also, Wayne, if you run through with your respective models between the 2% to 3% comps, I think you''ll be able to, with the guidance from the SG&A and the other variables, really back into the high, low range on the $0.16 to $0.20 per share and you will have, then, what our perspective of modest is for the third quarter.

Wayne Hood – BMO Capital Markets

Great. Thanks, guys.

Operator

Thank you. Our next question is coming from Sean Naughton of Piper Jaffray.

Sean Naughton – Piper Jaffray

Thanks for taking my question. Just another follow-up on the gross margin. Can you tell us, are you expecting to have favorable sourcing cost in the back half and the gross margin pressure is really more from some additional promotions that you may be having in order to drive some traffic into your stores?

Myron E. Ullman III

We certainly know the back half costing because those goods are already bought. And I would say that''s slightly favorable as a factor. The real issue on gross profit in the back half is obviously the cadence of sell-through. If the merchandise continues to flow through and it''s sold early in the cycle, obviously margins are better. If it''s harder to sell through, obviously sales in the clearance pricing goes up and sales in the promotional and regular pricing goes down.

So our experience so far this year has been good. So if we made the right decisions on what to buy and we made the right decisions on how to promote it, we would expect to continue to have favorable result.

Sean Naughton – Piper Jaffray

Okay. Great. In terms of just your regional performance in the comp trend, is there anything in particular that you''re seeing in different states now that may have had real estate markets that are not recovering as quickly as you would have liked? And then also, more specifically, potentially on California, obviously we don''t have the Mervyn''s closures that we did last year which was a pretty direct comparison. Can you make any comment on the regional trends around the country that you''re seeing?

Myron E. Ullman III

Clearly, as you pointed out, California''s pretty tough. I would say overall experience that''s our experience, as well. We''re up against strong comparables. Also the economy there has been one of the most impacted by the housing situation. The Southeast was the strongest for us in the spring and probably twice the trend of the average.

So I would say the Northeast was weaker for us in the spring as well, although it''s gotten stronger as the season went on. So our business right now in the Northeast is quite good. So it varies by week. As I said, right now Texas looks terrific because back-to-school is upon us and we''re running very strong increases in Dallas, Houston, San Antonio, Austin, Fort Worth.

Sean Naughton – Piper Jaffray

Okay. Great. And then lastly on the marketing, obviously you''ve got some good brands in the store with Mango and Liz Claiborne coming online with some strong national brands. What strategies are you really using from a marketing perspective to really communicate with that younger consumer and let them know that this product is in the store and where to find it today? Thanks.

Myron E. Ullman III

I think we''ve improved our messaging pretty dramatically in terms of Little Red Book in women''s and Matters of Style in men''s which are now much more updated in their appearance. I think if you would take a catalog or a piece of direct mail from three or four years ago and put it alongside what we''re producing today, it''s a dramatic difference. It''s not your mother''s department store.

I think our strategy is obviously get imaging that reflects the style and character and quality of the merchandise and the customer''s responded very well to it. We know we''re under indexed in that younger customer segment in the 25 to 35-year-old customer. We think that''s a big opportunity for us because, frankly, the ones that are coming in the store are finding merchandise they relate to at significantly lower prices than other department stores.

So as much as other department stores may talk about trading into our area, the net prices to the customer is still significantly higher. So our job is obviously to communicate as effectively as possible to a broad range of customers that give us a chance for them to come and discover Mango. Call it Spring by Aldo Group or Claiborne where it''s now exclusively at Penney''s, we know that in our research before acquiring the brand that customers who are shopping for Liz Claiborne in other department stores said they would follow the brand, not the store. That was obviously a big incentive for us to go after Claiborne on an exclusive basis.

Sean Naughton – Piper Jaffray

Okay. Thank you.

Operator

Thank you. Our last question is coming from Erika Maschmeyer of Robert W. Baird.

Erika Maschmeyer – Robert W. Baird & Company

Thanks. Good morning.

Myron E. Ullman III

Good morning.

Erika Maschmeyer – Robert W. Baird & Company

I want to follow up on the promotions that you talked about. Could you just lay out a little bit more your expectations for the competitive promotional environment? It sounds like you expect a ramp-up in promotions for your competition?

Myron E. Ullman III

It''s hard to believe that any of us could actually add more promotion if you look at the landscape. But as I said, I think ours has been effective, but where we look at ways to improve it, it''s probably in the mix of how we talk about our business as well as the clarity of offers. So we had a big effort a year ago on pricing, clarity and communication. That has proven to be very successful.

I would argue that one of the reasons our men''s business is so strong is we reorganized the layout, reorganized the messaging and the clarity and the customer''s responded very well. So to the extent that those principles are now being applied across all of our businesses, looking at some of the improvement in Home, I would argue that''s part of the success there as well.

So just adding money to the promotion bucket doesn''t necessarily change the result. The effectiveness is what matters. We already are one of the largest 20 advertisers in the United States. It''s not as if we''re not spending in the category. We have a very diverse business across window coverings and furniture, beauty salon and so forth, so we''ve got a lot of different businesses under one roof and the mixing of the messaging across digital, print, and store to get the customer the appropriate view of what the offer is at JCPenney and why they should consider it, that they''re on a journey to a store that they''re going to find very appealing.

Erika Maschmeyer – Robert W. Baird & Company

Could you also talk about how the performance for your Home business has differed between online and in the stores and the reasons behind that?

Myron E. Ullman III

The online offer is quite broad. And for example in infant and baby furniture, we don''t really carry that in the store but we have a very broad assortment online and there are other examples of that. So we might have, say, 25 beds on the floor in a regular store, we might have over 100 beds in terms of top of bed fashion online or in