American Eagle Outfitters Inc. (AEO) Q2 2020 Earnings Call Transcript

American Eagle Outfitters Inc  (NYSE: AEO) Q2 2020 earnings call dated Sep. 09

Corporate Participants:

Judy Meehan — Vice President, Investor Relations

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Michael R. Rempell — Executive Vice President and Chief Operations Officer

Mike Mathias — Executive Vice President and Chief Financial Officer

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

Chad Kessler — Executive Vice President and Global Brand President – AE

Analysts:

Matthew R. Boss — JP Morgan — Analyst

Kimberly Greenberger — Morgan Stanley — Analyst

Janine Stichter — Jefferies — Analyst

Paul Lejuez — Citi — Analyst

Simeon Siegel — BMO Capital Markets — Analyst

Kate Fitzsimons — RBC Capital Markets — Analyst

Susan Anderson — B. Riley FBR Inc. — Analyst

Matt McClintock — Raymond James — Analyst

Janet Kloppenburg — JJK Research — Analyst

Oliver Chen — Cowen & Company — Analyst

Dana Telsey — Telsey Advisory Group — Analyst

Presentation:

Operator

Greetings, and welcome to the American Eagle Outfitters Second Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Ms. Judy Meehan. Thank you. You may begin.

Judy Meehan — Vice President, Investor Relations

Good morning, everyone. Joining me today for our prepared remarks are, Jay Schottenstein, Chief Executive Officer; Michael Rempell, Chief Operating Officer; and Mike Mathias, Chief Financial Officer. In addition, Jen Foyle, Chief Creative Officer for AEO Inc. and Aerie Global Brand President; and Chad Kessler AE Global Brand President will be available during the question-and-answer session.

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. Results actually realized may differ materially based on risk factors included in our SEC filings. The Company undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise, except as required by law.

Also, please note that during this call and in the accompanying press release, certain financial metrics are presented on both a GAAP and non-GAAP adjusted basis. Reconciliations of adjusted results to the GAAP results are available in the tables attached to the earnings release, which is posted on our corporate website at www.aeo-inc.com in the Investor Relations section. Here you can also find the second quarter investor presentation.

And now, I’ll turn the call over to Jay.

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Thanks. Judy, and good morning, everyone. I hope all of you are well and staying safe. In the second quarter, we delivered significant improvements throughout our business, a true testament to how well our teams are executing in these challenging times. I am truly grateful to all of our associates across the organization for their commitment to our success and the humanity they have displayed.

Underlying our second quarter results was continued focus on our 2020 priorities; protecting our people, preserving financial liquidity, and preparing for a new future. First, we continue to run our business with the well-being of our associates, customers and partners as our top priority. This includes providing the very best health and safety measures across our offices, distribution centers, and stores.

Second, we are focused on disciplined growth and making good decisions to preserve cash. Second quarter financial results were impacted by store closures early in the period, where our performance demonstrated meaningful progress in the first quarter as we sharpen our merchandise assortments, lowered inventory, and reacted to shifting customer demands.

Our online channel performed extremely well across brands. Demand rose 48%, our fastest growth rate in over a decade. Online strength was fueled by new customer acquisitions, robust traffic, and strong conversion. Investments over the past several years in our digital platform, omnichannel capabilities and supply chain are providing the engine to fuel our business and keep pace with our strong customer demand.

As Michael will discuss, we’re implementing strategic supply chain capabilities to support the holiday season and future growth. The team managed the business well, tightly controlling expenses. In total, our actions contribute to a significant improvement in our financial position. We generated a $173 million in operating cash flow during the quarter, ending the period with $899 million in cash and over $1 billion in total available liquidity.

Now, I’ll provide a little more color on our brands. First, Aerie posted exceptional results in the second quarter, with both record sales and margins. The momentum in this business was truly incredible. Revenues rose 32% to approximately $250 million in the quarter. Sales growth accelerated despite the impact of stores closures as nearly 70% of the revenue was done online.

Total customer acquisition increased 22% in the quarter, and more than doubled in the digital channel. We saw strength across categories as customers continue to embrace Aerie’s strong brand position, empowering messages and trend-right collections. In the quarter, we are pleased to launch OFFLINE, our new Activewear brand which leverages Aerie’s powerful platform, providing a fresh take on this exciting growth category.

Over a year in the making, the timing of our debut was prefect, with rising demand for active apparel. OFFLINE builds on the strong results of Aerie’s leggings, sports bras, comfy tees and fleece. The early response has been absolutely terrific. I see significant runway for growth and we are very excited about the prospects for Aerie and OFFLINE. Congratulations to the entire Aerie team for their achievements.

American Eagle’s second quarter was impacted by stores closures and mall traffic decline to a greater extend. However, we ran a healthier business which was less promotional than last quarter and we successfully cleared through excess inventory. AE’s online demand was strong, rising 21% in the quarter. We also saw significant growth in online customers. AE maintained leadership in jeans and bottoms. The team is hard at work building on that strength, improving product lines and managing customer choices more effectively. We remain committed to running a healthy business through product innovation and strong inventory disciplines.

As we announced this morning, I am thrilled to recognize Jen Foyle’s promotion to Chief Creative Officer. In her expanded role, she then would lead the creative functions for both Aerie and American Eagle. Jen is an exceptional talent who has demonstrated the ability to create, drive, and optimize successful brands and businesses. I look forward to her influence and leadership as we continue to evolve the AE product line and marketing and produce even stronger results. Jen will also continue to fuel Aerie’s tremendous growth opportunity.

I am pleased to welcome the new member to AEs creative team, Craig Brommers as Head of Marketing. Craig has a wealth of experience building authentic customer engagement with leading retail and consumer brands and we’re very excited to have him on board.

Next, I’d like to briefly touch on culture at AEO. For many years, we have fostered an inclusive and diverse corporate culture, accepting people for who they are and celebrating different backgrounds and viewpoints have been at the very heart of our brands and Company. Several years ago, we established an inclusion and diversity work stream. This year, we named a Chief Inclusion & Diversity Officer, Terry Roberts. We’re very proud of the progress we’ve made and this work remains an ongoing priority for AEO.

As we prepare for a new future, we’re using this moment to take a fresh look across all areas of our business to ensure we are positioned for even greater success. I’ve always been passionate about innovation and today it’s more important than ever. Our teams are testing new experiences and technologies to engage with customers in different ways. We’re committed to providing the best experiences in retail as I recognize how crucial this would be to our future success.

Finally, we have a long history of success with the talent and experience to navigate through challenging times. Our Company is in a healthy financial position with two of the most trusted and loved brands in the market today. We will stay focused on successfully managing through the near-term while fueling the incredible growth opportunities ahead.

Now, I’ll turn the call over to Michael.

Michael R. Rempell — Executive Vice President and Chief Operations Officer

Thanks, Jay, and good morning, everyone. I’ve been really pleased with how our team stepped up during the second quarter. They maintained smooth operations, accelerated planned projects, and quickly developed solutions to meet rapidly changing customer shopping patterns and business needs.

During the second quarter, AEOs digital momentum accelerated from already strong levels. Digital demand increased 48% compared to last year. This was an improvement from 33% growth in the first quarter, well exceeding our expectations. Aerie increased a 113% to last year and AE saw a very healthy 21% increase.

KPIs were positive across the board with growth in traffic, conversion and AUR. Jeans, shorts, tees and swim were leading online categories. The penetration of our mobile channels continues to rise at over 60% currently. During the quarter, we saw 45% increase in our app downloads and approximately 39 million sessions. Our mobile app customers are the most engaged and have the highest spend levels and more than double that of non-app customers.

In June, we successfully launched our new real rewards loyalty program, which enables faster rewards at smaller increments. The new program is designed to engage more customers, create more frequent shopping and improve margin rate. We are pleased with the strong initial customer response.

This quarter, we expanded our digital footprint in key global markets. Local shopping sites opened in Japan, Hong Kong, Australia, Singapore, Taiwan and Malaysia. We also launched our new shopping site in Mexico with further upgrades planned for this fall.

We will continue to focus on expansion in important international markets where we see significant opportunity for growth. During the second quarter, we continue to fast track our supply chain transformation. We have regional hubs in Boston, Los Angeles, and Chicago with Jacksonville, Florida opening this month. Working in conjunction with our primary fulfillment centers, these hubs will provide improved delivery performance, cost benefits and sufficient capacity for us to manage digital demand for the back half of the year.

Our teams have added additional logistics partners to ensure sufficient delivery capacity during the upcoming holiday season. Given our expected strong growth in the digital channel beyond this year, we intend to strategically position additional distribution capacity in 2021 and beyond.

Moving to sourcing, our strength in this area was evident in the second quarter. Our team’s work on costing resulted in positive mark up across both brands. Notably, although we have significantly cut back on our inventory receipts, we have continued to honor our obligations to vendors and support their liquidity with timely payments. As a result, our vendor relationships remain as strong as ever and we have secured available chase capacity for the balance of the year.

As we look to the future, fueling Aerie’s growth is a major priority. In 2019, Aerie generated almost $800 million in revenue, and it remains on pace to reach $1 billion in short order. We are confident that the ultimate potential is far greater than that. Even with our success in recent years, we still have significant whitespace in core areas like intimates, swim, and lounge. These categories represent a combined $40 billion addressable market.

In addition, OFFLINE offers even more growth potential within the $16 billion women’s active apparel market. As Jay mentioned, Aerie’s digital channel has consistently exceeded expectations. However, as we look to fuel Aerie’s growth, stores are also an important selling channel and customer touch point. We know that stores generate increased brand awareness, expand customer reach, and raise average spend in under penetrated markets.

We expect that Aerie will continue to have a digital penetration above 50%, supported by a highly productive and profitable store fleet. This year, we plan to open 25 new Aerie location. This includes a few freestanding OFFLINE by Aerie stores with the first location coming this fall in Nashville.

Lastly, although these are challenging times, we are excited about the future. We’re executing well and positioning our business to emerge with strength. I’m grateful for the efforts of our teams and want to send a big thank you to our associates and partners around the globe who continue to support our business.

With that, I will pass the call over to Mike.

Mike Mathias — Executive Vice President and Chief Financial Officer

Thanks, Michael. Good morning, everyone. During the second quarter, our team has demonstrated incredible resiliency and were laser focused on the value creation levers within our control. The top line strengthened as stores successfully reopened, the digital channel accelerated, and Aerie posted exceptional growth.

Back in March, we instilled operational disciplines, cut inventory receipts, reduced spending and took numerous steps to preserve cash. These actions resulted in sequential improvement in operating earnings and positive cash flow in the second quarter, fortifying our financial position.

For total AEO, revenue declined 15% to last year, primarily due to the impact of store closures and weaker mall traffic. In addition, we lapped a $40 million benefit from Japanese license revenue in the year ago period. Store revenue declined 43% to last year. As a result of closures, we have the equivalent of 32% fewer selling days in the second quarter relative to last year.

Reduced store hours and weak mall traffic were also headwinds, offset by a very strong conversion rate. Opened stores during the second quarter delivered roughly 85% sales productivity to last year with May and June over 95% and July coming in lower as we lapped our historical high volume back-to-school peak weeks.

For the total Company, gross profit declined 31%, reflecting a reduction in store revenue and higher delivery and distribution center costs, primarily due to higher digital transactions and an increase in cost per shipment. In addition, recall that we lapped a gross profit benefit from the Japanese licensing revenue recognized in the year ago period. These headwinds were partly offset by lower rent expense, reflecting negotiations with our landlords and the impact of impairments taken in recent quarters.

We also benefited from an increase in mark-ups and markdowns were well controlled. As a percent to revenue, gross margin of 30% declined from 36.7% last year. SG&A expense declined 12% due to cost controls implemented across the organization and lower operating expenses from store closures. Expense management remains a focus, and since the COVID crisis began, the Company has executed significant operating expense reductions versus our initial plan, primarily in SG&A.

We reported an adjusted loss of $0.03 per share in the quarter. Our adjusted EBITDA was $43 million, which compare to $132 million last year. Excluded from these result is $15 million in pre-tax incremental COVID-19 expenses and restructuring charges. Our cash generation was strong during the quarter with $173 million in operating cash flow. As a result, we ended the quarter with $899 million in cash and short-term investments after repaying $130 million of our outstanding borrowings under our revolving credit facility.

After the quarter ended, we repaid the remaining $200 million outstanding balance. Our only debt currently outstanding is our $415 million convertible note issuance. Preserving our liquidity and balance sheet strength remains our major priority and many of our recent cash preservation actions will continue over the balance of 2020.

For example, last quarter we suspended our cash dividend and share repurchases were put on hold. Our current expectation is that we will not pay a dividend in the back half of the year. In addition, we meaningfully reduced our capital spending plans, lowering our guidance to a range of $100 million to $125 million, down from $210 million last year. This remains our expectation and year-to-date capital expenditures of $61 million are down from $92 million in the first half of 2019.

We also continue to manage our inventory with discipline. Our quarter-end inventory declined 21%, primarily driven by reductions in American Eagle as we cut receipts due to store closures and our inventory optimization initiatives. The proactive cuts to inventory receipts early in this crisis enabled us to improve total company AURs, control promotional activity and end the second quarter with inventory positioned well. We have a similarly disciplined plan for the back half of the year, given uncertainty surrounding the COVID-19 pandemic.

In AE, we are clean on products heading into the fall season and we are executing on more narrow and focused assortments that require less upfront inventory buys. In Aerie, we continue to invest in inventory to support our growth momentum.

Moving to stores, we are actively evaluating our fleet and plan to increase closures over the next several years and reduce the fixed costs associated with our stores. While our fleet remains important for distribution and customer engagement, the recent success we have had acquiring customers through our digital channel in fueling our online growth gives us additional confidence in our plan to reduce our footprint.

At the end of this year, we expect to close 40 to 50 locations, which have been specifically chosen based on lease tenure, mall profile, proximity to other stores, and customer engagement levels. We are very confident in our ability to transfer customers and sales from these locations. We will rigorously monitor and analyze the results and based on these learnings we’ll identify additional AE locations to close.

We have almost 250 leases expiring this year and a similar number next year as well as an average lease term under 3.5 years. Our flexible lease portfolio will allow us to quickly exit locations that no longer makes sense.

Although we are not providing forward guidance I can share some directional comments. As you know, the American Eagle brand is the leading back-to-school shopping destination. In fact, key periods in July and August represent some of the brand’s highest volume weeks of the year. As many other retailers have previously noted, the uncertainty and delayed starts to back-to-school have put pressure on the sales for the period, especially as we have lapped our peak volume weeks.

This year, we expect demand to be spread over a more extended time frame post Labor Day into September. We are encouraged by recent performance since we have moved past those historical high volume periods.

In closing, as I’ve discussed last quarter, we are responding to the current crisis by resetting our organization to better position it for sustained success. During the second quarter, we made progress in areas like inventory and expense management and capital efficiency, and additional work is underway. With over 90% of our stores currently open, and the online channel continuing to perform well, barring an escalation of the pandemic, we expect to see continued sequential improvement from the first half of the year.

We are in the process of updating our long-term value creation strategies to ensure we capitalize on Aerie’s growth opportunities, improve AE’s profit and returns and optimize our go-to-market structure and supply chain network.

With that, we can open the call up for questions.

Questions and Answers:

 

Operator

Thank you. At this time, we’ll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Matthew Boss with JP Morgan. Please proceed with your question.

Matthew R. Boss — JP Morgan — Analyst

Great, thanks. So, maybe to start at the Aerie brand, could you speak to the inflection that you’re seeing in customer behavior? Has the brand’s momentum continued through August? And just any way to help size up opportunity of this business multi-year? Maybe any perspective on the size or margin profile longer-term would be really helpful.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

Sure. It’s Jen. Thanks for the question. Look, I think the team has done an amazing job positioning Aerie for growth. We had a five-year plan to get to $1 billion and we’re pretty much on that plan at the end of this year. So amid of this pandemic and all of the crisis that we’ve seen out there, the teams rolled up their sleeves and drove to a strategy that we positioned five years ago.

Obviously, the product assortment in Aerie are a natural adjacency to what’s going on out there. And so when we looked at the business, when March hit us off, we really repositioned flows, reposition products, repositioned everything we need to do, including driving the direct business. Our customer acquisitions are more than doubling and we continue to see that acceleration. So the teams have been really strategic on bringing customers over into the Aerie brands.

I love working for this Company and working for Jay Schottenstein because he’s always coming from a position of strength. When people are closing, bankruptcies are happening, we’re opening up doors and I think that’s one of the most important thing we can continue to focus on as we grow AEO yield portfolio. There is weakness out there and there’s businesses to be taken a lot of market share.

That said, we have a plan to get to $1 billion in Aerie. And I think there’s more acceleration to be had, based on the demand from the customer. And even in some of the categories that one wouldn’t expect, swimwear had an exceptional run in Q2. Who would’ve thought, I don’t know who is wearing bikinis on Zoom meetings, but somebody is because we regained that share and I’m certainly excited with that business.

So, there is so much opportunity here. We mentioned OFFLINE. We’re opening up two new stores. The demand was there, we saw it. And what I love what’s happening is, Aerie naturally built off of AE’s metrics and where we should open stores and how we should leverage that intel. And then, now what we have is, we have Aerie in over 300 locations and now we can leverage that — all those metrics to really grow OFFLINE.

So, I couldn’t be more excited and Michael mentioned that’s a $16 billion opportunity. So we’re going to continue to chip away, but I can only add that we will always remain hungry and there’s always opportunity to do better year-over-year.

Matthew R. Boss — JP Morgan — Analyst

That’s great. And then just a follow-up. On gross margin, how are you planning, Mark, on — in the back half, relative to expansion that you saw in the second quarter. And similarly for markdowns, how are you thinking about third quarter and back-to-school markdowns or promotional activity that you’re seeing out there whether with your own products or laterally across the mall?

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

In Aerie, we’ve been really highly focused on pulling back on promotions and getting paid for all the work we put into our product and we’ve seen obviously our margins accelerate and we’re going to continue to focus on that, going back on promotions and driving better quality value relationships.

And that will happen the same for AE. They’ve done an amazing job positioning this for acceleration next year. We have lots of opportunity on that side of the business and I think they’ve been very cautious and smart about positioning growth for next year.

Operator

Thank you. Our next question comes from the line of Kimberly Greenberger with Morgan Stanley. Please proceed with your question.

Kimberly Greenberger — Morgan Stanley — Analyst

Great, thank you so much. The inventory is looking really quite clean here coming out of Q2 and I wanted to see if you could give us a little bit more color on the ability of your supply chain to really react where you’re seeing demand in the product? Are there a number of weeks that you could cite in terms of when you see demand, how quickly could you get that product back into store, if you, for example, are running low in certain categories. We’re just looking for color on the responsiveness within the supply chain. Thanks.

Michael R. Rempell — Executive Vice President and Chief Operations Officer

Hey Kimberly, it’s Michael Rempell. I’ll take that — I’ll take that question. Yeah, look, we’re certainly proud of the team’s efforts from a sourcing perspective. We discussed in our last call that we did aggressively cleaned inventory in the first half of the year to prepare for the second half of the year. So when you’re looking at our inventory being down 21%, the composition of that is really all fresh product for fall.

And what we did is, in conjunction with positioning inventory conservatively, we’ve positioned fabrics and capacity with the majority of our key suppliers to allow us to chase the business. So, we feel very confident that as the business is trending and as we’re seeing changes as we are today, we’re responding on a continual basis to further refine the assortment and get in the product that’s working. Our chase is generally 30 to 45 days. So we’re still making calls today that are going to affect the holiday season.

Kimberly Greenberger — Morgan Stanley — Analyst

Great, that’s very encouraging. And Michael, could I just ask one quick follow-up on your store closure discussion. It sounds like you’re taking a good hard look at the fleet. And I’m wondering if you could just tell us, if you could wave a magic wand and have your fleet downsized to what you would characterize as perhaps a more ideal level. Understanding Aerie is growing and American Eagle is the brand that you would expect to downsize, what does your optimal store fleet number look like here in the U.S.?

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Kimberly, this is Jay — Kimberly, this is Jay. We’re still looking at that. We’re studying that like on a regular basis. And we still don’t have the answer, but we’re very close to having the answer. But Michael, if you want to answer it, you can answer it too.

Mike Mathias — Executive Vice President and Chief Financial Officer

Yeah, it’s Mike Mathews, I can jump in. Yeah. As we said, we’re going to close 40 to 50. We have — at the same time, our real estate team reviewing our market studies again for post COVID expectations, store-by-store, market-by-market. We have 250 leases expiring at the end of this year; another 250 in 2021. So those 500 stores are definitely a focus of those market studies.

And we believe there will be some rationalization in place in terms of number of doors within that 500 beyond the 40 to 50 closures. Could be repositions, square footage rationalizations. There is definitely a lot of work underway and we’ll have more answers down the road, but we don’t have a specific number as of today.

Operator

Thank you. Our next question comes from the line of Janine Stichter with Jefferies. Please proceed with your question.

Janine Stichter — Jefferies — Analyst

Hi, good morning. Thanks for taking my question. Wanted to go a little bit more into the back-to-school trends. Is there any way you’re able to provide some perspective on the performance you’ve seen in markets where schools had actually gone back? And then, understanding that season will look a lot different this year, do you have any expectations for overall recapture of back-to-school business versus let’s say a typical year? Thank you.

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Hi, yes, so back-to-school, we are the brand of choice, as Mike said, for back-to-school and largely based on being the jeans brands for this generation. Back-to-school definitely started later. It started later across the country and we saw demand start later. That impacted both Q2 and the beginning of Q3. What we’re seeing is school typically go back all at different times and we look at early mid and late back to school markets and we did see a significant impact sort of as the calendar rolled through those markets and we saw the decline in mall traffic and demand that Mike talked to.

But as we normalized the season or get past those peak time periods, we are seeing demand return to a much healthier level. So through the month of August, as we got past early peaks, which happened in July, late July, we saw those markets return to a much healthier level and then mid markets and now we’re seeing — this is the time of year that the Northeast goes back to school and we’re seeing business return to more normal levels there.

So, seems like that curve really flattened out. And we’re optimistic about and hopeful with what we’ve seen in the last couple of weeks because it actually looks like the demand is carrying into September in a stronger way than what we’ve seen in the past. So, that really gives us optimism through the quarter as back-to-school continues.

We’re also really excited because, even in this time, we’ve been gaining share in our signature category of jeans. And we’re seeing — in back-to-school, as the business returns to better levels, we’re seeing the comps improve in jeans as well. So, we’re not walking away from a lot of great short-term opportunities in soft dressing and in comfortable dressing, but it’s really nice to see the jeans business see healthy trends as we get through back-to-school as well. So…

Janine Stichter — Jefferies — Analyst

Okay, thank you. And then, just a follow-up. It sounds like back-to-school could potentially linger into maybe even October this year. How are you thinking about planning holiday? Will you start the marketing or the floor sets earlier, that’s what we’ve heard from other companies and just wondering how you’re thinking about planning the timing of the flow?

Michael R. Rempell — Executive Vice President and Chief Operations Officer

Yeah. So what we’ve seen — we’ve seen, we’ve seen a lot. We are expecting back-to-school to continue during the Q3 than usual and those are the trends we’re seeing now. And then, for holiday, like a lot of other retailers, with the capacity constraints and traffic that we’re seeing in malls, we are going to look to see if we can pull demand up earlier in Q4 before the peak Thanksgiving week.

So, we are looking at strategies to do that. I feel really good about the Q4 assortment. We’ve reacted really aggressively to what we’ve started seeing after COVID hit and people started studying from home. So, I think the assortment for Q4 looks great. We are looking to engage customers and pull volume forward. And also, of course, making sure that we’re maximizing both channels at the times that seems right for them. So, on top of all that, we have a great holiday campaign. I think we’ll cut through a lot of noise in the mall. So, I feel confident in Q4 and I feel — and I think our strategies of trying to shift volume will hopefully play out.

Operator

Thank you. Our next question comes from the line of Paul Lejuez with Citi. Please proceed with your question.

Paul Lejuez — Citi — Analyst

Okay, thanks, guys. Can you just maybe give just a little bit more color on what you saw in the first half of August versus the back half and how that shook out stores versus online? And then, just bigger picture, you mentioned opening some standalone OFFLINE stores. Just wanted to see what the thinking was behind a separate box? Would you use that product a little bit more in either the Aerie or American Eagle box perhaps as an additional traffic driver if that product is so strong? Just want to understand the decision to open more stores there. Thanks.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

[Technical Issues] Sorry about the technical difficulty. So, of course, as we continue to open up stores, we’re starting to see momentum there. And Chad mentioned, certainly, as we move through the Labor Day and post Labor Day. So, again, we will continue to leverage the store openings. And we’re just seeing nice metrics coming out of the stores that are open. So, again, that’s something that we’re constantly monitoring and managing the inventories with direct and the new store – and all the store openings as we move, hopefully, out of COVID. Fingers crossed. That said, thinking about — can you just remind me of your second question? Sorry, the technical difficulties threw me a little bit.

Paul Lejuez — Citi — Analyst

Yeah, Sure. The — just the OFFLINE concept that you said. I think you were opening some separate boxes.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

Certainly. Yes. So, as a reminder, about a third of the stores right now is with our OFFLINE product. So we expanded that assortment as we had incredible reads on the business. That said, as I mentioned in my earlier comments, it’s warranting its own space and capacity. And so — thus the two stores that we’re opening up on the back half of this year. We’re going to learn, test and scale on that.

It’s just amazing the demand that our customer is asking for. It would only allow us to expand all of our other categories and be dominant in intimate, swim, some of the other soft dressing categories. Certainly, bras and bralette. So, I think we’re going to continue to monitor that and grow some of our tried and true businesses as we expand OFFLINE and then make sure there’s an assortment of OFFLINE always in an Aerie store if we’re not expanding into the same mall.

And then again, don’t forget with our direct results, we will always continue expansion there and leverage and drive the direct business as hard as we possibly can, because as you know, that’s where we see so many new customers coming into our door.

Mike Mathias — Executive Vice President and Chief Financial Officer

And Paul, it’s Mike. If I can add a little more color to August, just to your specific question on weeks. There wasn’t really a big difference in the weeks in August but — because in the American Eagle brand especially, it’s a hyper business typically the entire month. But just to be clear, we planned August down. We anticipated that the uncertainty around back-to-school timing was going to shift the customer behavior and that’s exactly what happened. And as Chad said, we’re very encouraged about the first 10 days of September here in terms of how we plan the business, the monthly cadence and it’s — looks like it’s coming to fruition for us.

Paul Lejuez — Citi — Analyst

Thank you. Good luck.

Operator

Thank you. Our next question comes from the line of Simeon Siegel with BMO Capital Markets. Please proceed with your question.

Simeon Siegel — BMO Capital Markets — Analyst

Thanks. Good morning. Hope you’re all doing well through all this. Can you speak to the AE versus Aerie margins at this point and where you see those longer term? And then, sorry, I assume I should I know this, but can you just remind us whether there’s any lingering impacts from the Japanese license royalties? Thank you.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

Mike, did you want to take the overall margin comment? I mean, we continue to see Aerie’s margins growing year-over-year and it was the strategy for us to continue to build quality, build better AURs. And like I said, balance out against our value pricing strategies.

Same for American Eagle, I think they’re positioned for margin acceleration next year. We have lots of opportunity not only in denim, but in tops which traditionally run higher margin. So I think as we look at those assortments and start to head into next year, I think there’s tons of opportunity there.

And like I said, Chad has built an amazing denim business and I think we have a lot of opportunity to get market share in tops. And I don’t know, Michael, do you want to take the balance of that question?

Michael R. Rempell — Executive Vice President and Chief Operations Officer

Yeah, the Japanese license royalties, that piece of the question, there is no lingering effect into the third quarter. I’d say it was all isolated to the second quarter.

Simeon Siegel — BMO Capital Markets — Analyst

Great, thanks a lot. Best of luck throughout next year.

Operator

Thank you. Our next question comes from the line of Kate Fitzsimons with RBC Capital Markets. Please proceed with your question.

Kate Fitzsimons — RBC Capital Markets — Analyst

Yes, thanks very much. I guess, first, I was wondering if we could provide an update on digital profitability today versus what you are seeing in stores as you’re managing around some of these higher fulfillment costs, but you are seeing — sounds like some rent relief here. So, just — where are we with the delta between the channels?

And then next quickly, Jen, congratulations on the expanded role. I guess just now that you’re going to be taking a look, you know a greater look at the AE brand, what are some of the guardrails being put up around the brands in order to make sure that the positioning remains really differentiated here, just so that we can gain confidence in Aerie’s trajectory certainly go forward as well as certainly improvement at the AE brand into next year? Thank you.

Mike Mathias — Executive Vice President and Chief Financial Officer

Hey Kate, it’s Mike. I can take the first part of the question. So, in terms of channel profitability, a lot of the initiatives we have underway in optimizing costs and especially in inventory have a definite benefit to the digital channel; inventory optimization, especially with choice count reduction, SKU count reduction. Historically, we’ve seen some margin pressure by having too much inventory, and quite frankly, maybe deemed over assorted, and that is definitely part of that initiative, and we’re starting to see that, especially with inventory being down right now in the back half and choice count and SKU count reductions being a big part of that work. So, we don’t expect margin pressure to the digital channel.

And then, I think Michael will hit on some things in terms of supply chain efficiencies and cost optimization. Those things that we’re working on in terms of delivery, overall supply chain costs will also have a benefit to the digital channel. So, we actually expect there not to be a significant gap go forward, especially into 2021 and beyond. We’re expecting very healthy margin out of the digital channel in both channels.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

Yeah. And thinking about differentiated brands, let me first say that we both are rooted and real. I think AEO has done an amazing job with their selfie campaigns and allowing individuality. And of course, #AerieREAL, the body positivity platform, has given us so much runway.

As I think about differentiation, let’s just go back to our roots. AE is rooted in denim and Aerie is rooted in intimate and layering. So, I think there is opportunity to make sure that we’re always sort of expanding on the DNAs of both of our businesses. And there are always going to be trends that do crossover, and I think this will give us opportunity, Chad and I, to partner together and really leverage each brand’s DNA, while maximizing and getting as much market share in any categories that are slightly crossed over, again, with making sure that we’re defining each brand with their inherent piece of their business, denim and intimates.

So, that’s the way we’re thinking about it. And we brought in Craig Brommers in marketing. I think he’s going to do a great job. This is his expertise really, building brands and bringing life to brands, and I think he already has some great point of views.

And Chad and I are going to — I think it’s going to be like the new Sonny & Cher duet, we’re going to hold hands and build these brands and continue to create as much and gain as much market share as we can because there’s much to grab out there, thinking about some of our competition and who’s closed over the past year. So, looking forward to that.

Kate Fitzsimons — RBC Capital Markets — Analyst

Great, best of luck.

Operator

Thank you. Our next question comes from the line of Susan Anderson with B. Riley FBR. Please proceed with your question.

Susan Anderson — B. Riley FBR Inc. — Analyst

Hi, good morning. Nice job managing the quarter. I was wondering, Chad, if you could talk about the trends, I guess, in tops. I know you came into the year with some styles not working. I mean, I guess do you feel like you’ve fixed those issues both in men’s and women’s? And then, it looks like you’ve definitely shifted much more casual type tops. So, just curious if there’s any reads on how those are performing.

Chad Kessler — Executive Vice President and Global Brand President – AE

Sure. Yeah, we did come into the year saying we had a lot of work to do in tops. And I do think we have a lot of opportunities still to go. But even with all the craziness with COVID and all the work we did to get Q2 really clean — or to finish Q2 really clean. We have made and seeing progress both in men’s and women’s tops.

In women’s, we’re really benefiting from a lot of silhouette change as the bottoms get a little looser in the tops, we’re seeing some more fitted tops starting to do really well and finding a balance between that and the oversized. I think we’re seeing a nice acceleration there. We also have made it a key point to focus on fleece through the COVID and also just as an overall trend, and really seeing nice business in Q2 and through back-to-school there. So, I feel like we’re seeing good progress in women’s tops.

And then in men’s, we’ve also started seeing improvement there. I think we lost our way a little bit getting away from some core things like soft and some more balance in the assortment across all the categories. We’re seeing great business across fleece and tees there.

And then, we’re really excited, we’ve reintroduced for back-to-school, a new version of the Eagle — of the American Eagle icon, which is something obviously only we can leverage and customers have responded really, really well. We’re really excited about that re-launch.

So, I think we are definitely starting to see progress in both the tops areas and we look to leverage that through the rest of the year and into next year. And I think, as Jen said, I’m really excited to work with Jen on the AE brand and I think we have a ton of opportunity in tops as we go forward.

Susan Anderson — B. Riley FBR Inc. — Analyst

Thanks, that’s very helpful. And then, I guess, just one follow-up on store productivity. I think May and June were better than July, I guess, as you cycle the peak back-to-school season last year. Do you feel like now it’s kind of stabilized or, I guess, moderated? How are you expecting that to pan out in the back half of the year? Thanks.

Chad Kessler — Executive Vice President and Global Brand President – AE

I think we’re seeing — as I said, as we went through, cycled through the early, mid, and late back-to-school market, we certainly saw impact to productivity in the stores. I think Mike mentioned in his prepared remarks that we saw the dip going into July and continuing into August in terms of productivity.

I think the other challenge we just need to see is how traffic continues through the fall season. But we built the plans off a model of leveraging that traffic and driving healthier sales than what we’re seeing in the traffic and driving better margins than what we’re seeing in the sales. So, we are seeing that come to fruition and expect to see that continue to evolve.

Susan Anderson — B. Riley FBR Inc. — Analyst

Great, that’s helpful, thanks. Good luck in the back half.

Chad Kessler — Executive Vice President and Global Brand President – AE

Thanks.

Operator

Thank you. Our next question comes from the line of Matt McClintock with Raymond James. Please proceed with your question.

Matt McClintock — Raymond James — Analyst

Hi, yes, good morning everyone. Couple of follow-ups. Just on the 40 — and by the way, also, congrats, Jen. On the 40 to 50 store closures, how are you thinking about transfer of that volume? And I know it’s probably different for every store, and I know that you’re still in the planning process for this. But any general rule of thumb of how much you can typically pick up with other stores, how much you can pick up online and how much kind of dissipates and just disappears? Is it a third, a third, a third? Is that the way to think about it?

Michael R. Rempell — Executive Vice President and Chief Operations Officer

Yeah. Hey, this is Michael Rempell. It’s something like that. I mean, we’ve done this in the past and we’ve seen very good results actually with transfer. So we’ve seen that we’ve seen that we’re able to transfer a good percentage of store sales, given the size of our fleet to another store or to the web, and generally, that increases profitability.

The challenge that Mike was outlining is what we want to prove that we can do successfully is not just transfer sales, but also continue to acquire customers in those markets. So, we have a pretty thoughtful plan laid out to not only transfer sales, but make sure that our customer acquisition stays strong and that we’re actually able to increase profitability as a result of closing stores even if those stores were historically profitable.

Operator

Thank you. Our next question comes from the line of Janet Kloppenburg with JJK Research. Please proceed with your question.

Janet Kloppenburg — JJK Research — Analyst

Hi, good morning everyone. I wanted to — and I got on a little late, so I may have missed it. But are you able to discuss or delineate the current trends at Eagle versus Aerie right now? I was just thinking Aerie may be a little less vulnerable given its exposure or focus on active and athleisure and intimates. And I was wondering how we should be thinking about the productivity of Aerie versus Eagle here in the third quarter.

And also, Chad, as you think about some of the consumer behavior because of COVID, more working from home, etc., how does that work into your inventory investment for denim as opposed to more casual active bottoms? Thanks so much.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

Hi Janet, It’s Jen.

Janet Kloppenburg — JJK Research — Analyst

Hi. Hi Jen, congrats.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

Thank you. You know it’s so amazing the market share that denim continues to dominate in. And I think it goes back to Chad and team, how unbelievably comfortable our denim bottoms are. It is practically like wearing a jegging — or I’m sorry, a legging. So, I think they’ve done a nice job with the ability to kind of weather the storm of all the soft dressing.

And I mentioned it earlier, Janet, and you might have joined late, but even in Aerie, we’re seeing some categories — not just what we’re hearing from our competition that’s working. Obviously, soft dressing, fleece, our bra categories trended in Q2 incredibly well. Leggings, sports bras, I mean you name it, we really saw all categories firing.

And I think our opportunity is, as we look ahead in the future, Chad and I to work together and grow market share together as a unified team with separate identities. And I think in the future, when we come out of this, there’s going to be fashion opportunities all over. I think we’re going to see trends emerging that we’ve never seen before and that we can capture in the AEO business and then continue to drive Aerie and grow that soft dressing athleisure piece of the business.

So, the good news is, in all these meetings, girls are still wearing tops. So, that’s a huge opportunity for us in American Eagle and in Aerie. And they want to be comfortable, and it’s something that we’re always focused on in both brands. So, I think we have a lot of runway and a lot of opportunity in the future.

Chad Kessler — Executive Vice President and Global Brand President – AE

Hi Janet, in response to your question about jeans investments, we definitely want to leverage short-term opportunities, as Jen mentioned, across joggers and leggings. And we’re also making a very keen point, as Jen also said, to emphasize the comfort and the fit of our jeans. But there’s definitely a short-term opportunity in lounge, comfortable dressing and in tops. And we are shifting inventory investments there.

But long term, we remain committed to being the number one brand in America. We gained jeans share in Q2 in our target age range, one in four pairs of jeans sold is now an American Eagle — to women is now American Eagle. It’s really incredible the strength of that business. And through Q2, we saw double-digit growth online for our jeans business.

So, that business remains healthy, and as I said, as we came through back to school and enter into September, we’re seeing the jeans business continue to be healthy and we’re chasing some of the new silhouettes in jeans through the fall season. So, in total, we’re trying to take advantage of short-term opportunities. Long term, we continue to be very bullish on jeans.

Mike Mathias — Executive Vice President and Chief Financial Officer

And Janet, you’re accurate — it’s Mike, you’re accurate with your assessment of sort of the impact of back-to-school on the brands. The crazy, hyper peaks we’ve built in the American Eagle brand historically puts more pressure on the AE brand going back-to-school, but Aerie is less impacted by this customer behavior, shift in business that we’ve seen in the back-to-school period.

Operator

Thank you. Our next question comes from the line of Oliver Chen with Cowen. Please proceed with your question.

Oliver Chen — Cowen & Company — Analyst

Hi, good morning. On the earlier comment about the narrow and focused assortment, what are the implications there for AUR as well as inventory planning and efficiencies you can drive there and the opportunity you see with classifications? Would also just love your view on the consumer, the Aerie consumer relative to the AE consumer and how you’re thinking about cannibalization risk as there’s classifications that are similar in both and I’m just wondering how the consumer is reacting to where they should go in the context of looking for bottoms or other apparel? Thanks.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

Chad, do you want to answer the first part and I’ll go second?

Chad Kessler — Executive Vice President and Global Brand President – AE

Sure. I think — Hi, Oliver. The narrowed assortments, I think will be a big benefit. I think over the past couple of years, we got a little too broad in both channels. We know we can drive more productivity focused on the key items and I think that that depth there will be a benefit both in stores and online. And we’re already seeing that reflected in healthier AURs and healthier margins so far in the quarter.

I think that we’ve got — I think when you look back to last year, we were over weighted in inventory. Part of that driven by the length of the longer tail in the assortment. So, I think this is something we just run aggressively after, getting more narrow and more focused. I think it helps it with upfront costs, being deeper hubs of product costs. And then being narrower helps with markdowns at the end of the quarter. So, we think this is a good strategy. We still have plenty of choices to drive the business and a lot of opportunity to grow the tops.

Jennifer Foyle — Executive Vice President and Global Brand President – Aerie

And Oliver, thanks for the question. And I believe that this is even more of an opportunity for Chad and I to partner and make sure that, again, we’re rooting our businesses in what we stand for. So, AE denim and Aerie lounge. And of course, we’re going to take advantage of trends in both categories. But again, ensuring that our looks are grounded in those businesses, I think, will help to delineate.

Even more recently and over the past year, we’ve seen trends in both businesses that we’ve both been able to maximize and dominate in, and I think there’s still opportunity there. So I think as we grow, there’s simply market share to be had with ensuring that each brand stands for its DNA and making sure that the looks are geared towards that so — and we will definitely distort those looks and make sure that those businesses are grounded there.

Judy Meehan — Vice President, Investor Relations

Okay, Melissa, we’ll take one more call.

Operator

Thank you. Our final question this morning will come from the line of Dana Telsey from Telsey Advisory Group. Please proceed with your question.

Dana Telsey — Telsey Advisory Group — Analyst

Good morning everyone and congrats, Jen. As you think about the regional hubs and the supply chain transformation that has occurred, what do you see that opportunity on the SG&A side? How much could that give you? What’s the capacity that you can garner now? And then, just lastly, as you think about the loyalty program, any updates on the loyalty program key metrics or frequency? And what type of customer you’re garnering? Thank you.

Michael R. Rempell — Executive Vice President and Chief Operations Officer

Okay, great. Hey Dana, it’s Michael. I’ll take your question. The supply chain transformation, we’re really excited about. We talked about it a little bit on the last call, but we essentially had a three-year plan to change the landscape as it came to our supply chain capabilities. And with the onset of COVID, we escalated of and are completing a lot of it in 2020.

In the second quarter alone, when you look at it, we added three new distribution centers, on-boarded new logistics partners, we brought live new returns processing and technology. And we consolidated inventory planning into the supply chain in order to speed kind of flexibility with inventory and our agility.

We also built out more advanced analytics and decision science capabilities and are starting to use machine learning in terms of how we position inventory. All these new capabilities are designed to not only provide faster delivery to customers, faster delivery to stores, but allow us to use inventory more effectively and ultimately, lower delivery costs and distribution costs.

Everyone expects, we expect, I think the industry expects that E-commerce capacity is going to be limited this holiday. But I feel great about the plans we put in place. We’re going to have plenty of capacity. We’re going to be able to provide great service levels. We’re trying very hard to leverage costs.

Certainly, our E-commerce costs against last year’s costs and I feel good that we’re going to be able to do that and we’re setting ourselves up for the future. So, we’re going to learn some lessons adding all these new capabilities, but I really believe that the supply chain work we’re doing is going to be a differentiator for this year and a differentiator for the company moving forward.

Mike Mathias — Executive Vice President and Chief Financial Officer

And Dana, I was just going to add, those costs and intended optimization and benefits will impact gross margin. They’re in our warehousing costs and gross margin, not in SG&A.

Michael R. Rempell — Executive Vice President and Chief Operations Officer

Right BOW. And, Dana, you asked about the loyalty program too. We re-launched our loyalty program in the second quarter. We’re thrilled with those results. So, we previously had a pretty successful program, but it gave out rich rewards, which was fine, but those rich reward didn’t hit or broad enough to our customer base. We changed the program to ensure that more customers got rewards, but actually lowered the value of those rewards.

And the result has been increased participation in the program, increased redemption. And we think it’s a winner for us going forward. So we also brought that technology in house, which is going to give us a lot more flexibility to adjust the program, incent customers and respond to the environment. So, we feel great about the new loyalty program. The team did an excellent job launching it.

Dana Telsey — Telsey Advisory Group — Analyst

Thank you.

Judy Meehan — Vice President, Investor Relations

Thanks, Michael. So, that completes our call today. Thanks for your participation and have a great day. Thank you.

Operator

[Operator Closing Remarks]