American Eagle Outfitters Inc  (NYSE: AEO) Q4 2019 Earnings Call Transcript

American Eagle Outfitters Inc  (NYSE: AEO) Q4 2019 Earnings Conference Call
Final Transcript

Corporate Participants:

Judy Meehan — Vice President of Investor Relations

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

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

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

Robert L. Madore — Executive Vice President and Chief Financial Officer

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

Analysts:

Kate Fitzsimons — RBC Capital Markets — Analyst

John Morris — D.A. Davidson — Analyst

Oliver Chen — Cowen & Company — Analyst

Adrienne Yih — Barclays — Analyst

Janet Kloppenburg — JJK Research — Analyst

Laura Champine — Loop Capital Markets — Analyst

Tiffany Kanaga — Deutsche Bank Research — Analyst

Dana Telsey — Telsey Advisory Group — Analyst

Rebecca Duval — BlueFin Research Partners — Analyst

Janine Stichter — Jefferies — Analyst

Kimberly Greenberger — Morgan Stanley — Analyst

Susan Anderson — B. Riley FBR Inc. — Analyst

Marni Shapiro — Retail Tracker — Analyst

Presentation:

Operator

Greetings. Welcome to American Eagle Outfitters Fourth Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note this conference is being recorded.

I would now like to turn the conference over to your host, Judy Meehan, Vice President of Investor Relations. Thank you. You may begin.

Judy Meehan — Vice President of Investor Relations

Good afternoon, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Chief Executive Officer; Chad Kessler, AE Global Brand President; Jen Foyle, Aerie Global Brand President; and Bob Madore, our Chief Financial Officer.

Before we begin today’s call, I need to remind you that we will make certain forward-looking statements. These statements are based upon information that represents the Company’s current expectations or beliefs. 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 in both the 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 fourth quarter investor presentation.

And now I’d like to turn the call over to Jay.

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Thanks, Judy. Good afternoon and thank you for joining us. I’ll start today by providing an overview of 2019, then I’ll turn it — I’ll turn it to the team for additional details on the quarter and the year. First I am pleased to report another year of record sales, which increased to $4.3 billion. 2019 marked our fifth straight year of positive comparable sales. Our ability to capture market share across American Eagle and Aerie underscores the strength of our leading brands as well as the team’s ability to execute in a disrupted environment.

Across brands and channels customer engagement was strong. We gained new customers and traffic to our stores was positive and outperformed mall averages. We also saw our digital business continue to grow at a robust pace fueled by our app and mobile channels.

Aerie delivered exceptional growth and continues to be one of the fastest-growing specialty retail concepts. After five years of double-digit sales gains Aerie had another remarkable year with consistent momentum each quarter. We have successfully expanded Aerie’s reach, gaining customers across both digital and stores. The Aerie team has done an extraordinary job delivering, expanding merchandise collection. Top line strength also fueled a meaningful profit improvement. Without a doubt Aerie is one of the most exciting emerging brands. Today more than ever, we see significant market opportunity that will continue to fuel Aerie’s momentum.

American Eagle posted ongoing growth in its signature jeans and bottoms categories where we continue to gain meaningful market share and achieve record revenue. We are the clear leader in jeans market by offering constant innovation, new styles, fits and amazing values to our customers. We will continue to fuel our power in this important category.

As we noted last quarter, AE tops have been challenging, which resulted in increased promotional activity. The team has been focused on improvement in this area and we are seeing some positive early indications, dominance in AE jeans and continuing to accelerate Aerie growth. We are also working to transform our supply chain to drive operational efficiencies and better serve our customers. You’ll hear more on these efforts throughout 2020.

At AEO, we take our responsibility as a corporate citizen very seriously. I therefore want to highlight our efforts on ESG. We have been an industry leader in our sustainability efforts. Last year we unveiled environmental goals, which include carbon neutrality in our owned and operated facilities by 2030 and a 60% reduction in carbon emissions by 2040. Building a better world is consistent with our strong values and corporate culture. We stay true to our purpose to show the world there is real power in the optimism of youth. We foster empowerment, inclusivity and hard work to drive success for all of our stakeholders.

Lastly, Bob will discuss the recent coronavirus outbreaks in more detail. However, I want to emphasize that our priority is the safety of our associates, partners and customers. Our team is monitoring the situation closely and we’ll respond to any developments.

I’m extremely proud of the Company and the progress we continue to make. Although we had some bumps in the road, AEO is an outstanding world-class organization with two of the best brands in specialty retail. We are financially healthy with a strong free cash flow enabling us to make key investments in our business while staying committed to shareholder returns.

In 2020, we will focus on our strategic growth pillars, to growing [Phonetic] our brands through signature app categories, offering exceptional customer experience across channels, improve financial returns and accelerate the market expansion for Aerie. I’m optimistic about our future. We are ready to seize on numerous opportunities. Thanks for the entire AEO team for their hard work and dedication.

And I’ll now turn the call over to Chad.

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

Thanks, Jay, and good afternoon everyone. 2019 was a year with a number of successes for AE as well as some challenges. Comparable sales increased slightly for the full year, led by strength in bottoms, including record jeans sales. Our customer file increased and traffic and transactions were positive across both stores and digital. As we noted last quarter, soft demand in certain tops categories resulted in higher than planned promotions. This weighed on our fourth-quarter performance. Comparable sales decreased 3% against the 3% increase last year. Traffic and transactions were positive reinforcing the strength of our brand. This was offset by a lower average unit retail price due to markdowns.

American Eagle men’s and women’s jeans were standout delivering another best ever quarter marking the 26th consecutive quarter of record jeans sales. The category was healthy with AURs up and promotions contained compared to last year. We continue to gain market share as we assert ourselves as the clear destination for jeans. We are winning through innovation in fabrics, fits and new styles that are a natural extension of our collections, such as women’s curvy and men’s air flex. We have strong plans in place to continue our momentum in this category in 2020.

During the holiday season. I was pleased with the customer response to women’s sweaters and fleece and men’s teddies [Phonetic]. We also continued to see strong momentum in accessories, a category we have invested in over the past few years. This includes our new Mood personal care line, which is also performing well.

Positive brand traffic throughout the holiday and post holiday periods enabled us to successfully clear through challenging styles in men’s and women’s tops. We ended the quarter with inventories in good shape and carryover units down to last year. Looking ahead to 2020, bottoms, led by jeans, will continue to be our growth engine. In tops, we are planning inventories cautiously to strengthen pricing power and rebuild margins. In addition, we are focused on better product execution.

In women’s, we expect to see improvements through strong key item bear tops and Ts and to benefit from year-round fleece business. We are encouraged to see some improvement based on a favorable response to new items. Although the men’s area has been more challenging, customers remained highly engaged with the AE brand and continued to fuel driving trends in jeans, active bottoms, underwear and fleece. We look forward to seeing the results of upcoming collections and hope to see signs of an improvement starting in the second quarter. Our marketing and engagement strategies at AE are centered on creating unique ways to authentically connect with our customers. For example, the essence of our brand platform AE and me is a collaboration between our customers and our brand. We have real customers co-create our campaigns, which has been very well received and continues to deepen the connection with our customers, fueling positive traffic and customer KPIs.

Although we are not pleased with our execution in certain areas during 2019, it is important to emphasize that the American Eagle brand has a healthy foundation. Our brand is a clear destination for our customers, particularly in our leading signature categories. AE is the number two most popular apparel brand for our customer segment, second only to NIKE. We continue to see strong traffic to our stores and website and have a growing customer file including higher retention and re-engagement rates. In addition, we have scale, are fully omni-channel capable and generate very strong free cash flow.

In 2020 we are focused on starting to rebuild profitability to a level that better reflects the strength of our brand and our organization. I want to thank the AE team for their hard work and commitment in 2019. As a result of the team’s continued efforts and creativity I am confident in our ability to deliver stronger 2020.

Now, I’ll turn it over to Jen.

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

Thanks, Chad and good afternoon everyone. 2019 was a fantastic year for Aerie marking our fifth straight year of double-digit sales growth. In total, we posted a 28% sales increase, a 20% comp sales growth, higher margins and improved profitability. Aerie grew both its customer base and loyalty program participation at a double-digit rate for the year and also grew on average customer spend. We started this journey several years ago to offer a fresh take on the intimates and soft dressing market. I’ve been thrilled with how the customers have embraced Aerie. The core values that we stand for, body positivity, inclusivity and empowerment continue to resonate with so many customers.

Our merchandise collections have been well received and we are successfully expanding into new areas of growth. Our role models, ambassadors and events such as Aerie Real Talks, we are building such a strong community and we broadened our reach by opening new stores in new markets, which also are fueling a strong omni-channel business. I’m so proud of the incredible Aerie team who make it happen every day and are working hard to deliver another banner year in 2020.

Looking back at the fourth quarter, it was terrific as well, fueled by a strong holiday offering. Total fourth quarter revenue increased by 29%, comp sales grew by 26%. This built on a 23% growth last year, resulting in a two-year increase of nearly 50%. The quarter also marked our 21st consecutive quarter of double-digit sales growth. Key performance metrics continued to be very, very healthy. We saw an increase in transactions and a higher average transaction size. This was delivered by a meaningful rise in the average unit retail price. In a highly competitive season we were able to control promotions, improving our gross and operating margins compared to last year.

Strong performance continues to be broad based with our major categories delivering comp increases. Our apparel growth was led by strength in leggings an important loyalty category for us. Our core bras and undies remained consistent growth categories as well. We are also very excited about our product pipeline for the spring season. Our newly launched real good sustainable swim line made from recycled water bottles has been amazing. We are looking forward to building an additional real good sustainable product line in the future.

We opened 65 new stores in 2019 and closed five, bringing our total for the year to 332. We are seeing very strong returns from our investments in new and remodeled stores as well, including exceptional growth trends in newer markets like Dallas, Houston and Denver. As we have discussed in the past, our store strategy fuels our digital business, which now represents more than 45% of the revenue. We have a robust store opening plan for 2020 with a heavy emphasis on stand-alone locations and expect to reap continued benefits from our expanded footprint.

In January, we were thrilled to introduce eight new Aerie role models to inspire 2020 as the year of change for Aerie. We also continued to grow our network of college brand ambassadors leveraging existing loyalties to build an authentic presence on campuses. And as we look ahead, we have so many exciting plans to continue to fuel our momentum in 2020 and beyond. I look forward to sharing more details in the future.

Lastly, of course, I’d like to thank this amazing Aerie team who live and breath Aerie’s brand DNA every day. Our success speaks to the hard work, passion and talent to this entire organization. We’ve entered 2020 with momentum and we look forward to achieving our milestone of $1 billion in short order.

And now I’ll turn the call over to Bob.

Robert L. Madore — Executive Vice President and Chief Financial Officer

Thanks, Jen. Good afternoon, everyone. For the year American Eagle and Aerie both delivered record revenue and continue to win in AE jeans, which is a key growth pillar for the Company. Expanding Aerie has also been our priority and the brand demonstrated exceptional growth throughout the year. That strong momentum, including profit improvement, continued into the fourth quarter.

Overall, the quarter was challenging for the American Eagle brand. As discussed on our third quarter call, soft demand in certain tops categories resulted in more promotional activity than we had originally planned. This pressured profitability in the quarter. However, we experienced continued traffic and transaction gains and a strong response to our promotions and clearance events. This enabled us to successfully clear through holiday merchandise and end the quarter with inventories in a better position than we expected.

Turning to the fourth quarter results. My comments will focus on adjusted financials, which exclude certain items. You can find details on these adjustments in the press release and tables on pages 6 through 8 of the investor presentation. Total revenue for the 13 weeks increased 6% to a record $1.31 billion compared to $1.24 billion last year. Comparable sales increased 2% following a 6% increase in the prior year and marked our 20th consecutive quarter of positive comp growth. Additional sales information to be found on page 10 of the investor presentation.

By brand, American Eagle comps declined 3% compared to a 3% increase last year. Positive comps in digital were offset by decline in stores. Aerie comps increased 26% following a 23% increase in the prior year with significant strength across channels. On a consolidated basis, store comps declined approximately 3%. Digital sales increased at a double digit rate. Our online penetration increased to 33% of revenue in the fourth quarter and 29% for the year, up 200 basis points and 100 basis points to last year respectively.

For the total Company, quality of sales was mixed in the quarter with increased traffic and transaction growth offset by lower average unit retail price due to greater promotional activity. Gross profit dollars decreased 5% to $408 million. The gross margin rate was 31% of revenue, down from 34.6% last year. Higher markdowns were the primary driver of the decline. Distribution center and delivery expense also deleveraged partially offset by lower incentives and a slight rent leverage.

SG&A expense of $287 million decreased slightly from $288 million last year. As a rate to revenue, SG&A leveraged 130 basis points to 21.8% of sales. Lower incentives were partially offset by higher professional fees. Depreciation and amortization increased 8% to $44 million, up 10 basis points to 3.4% as a rate to revenue. During the quarter, we incurred impairment and restructuring charges of $76 million, approximately $65 million related to the non-cash impairment of 20 stores, including $25 million to impair the right of use asset we added to the balance sheet as part of the change in lease accounting rules in the beginning of the year.

Despite the impairment of 20 locations, our overall fleet is profitable and healthy. We will continue to proactively manage our real estate portfolio as we have done in recent years. The remainder of the charges primarily reflected severance and other costs, some of which related to a review of our store organization structure and payroll model. Adjusted operating income of $77 million, excluded these charges and compared to $101 million last year. As a rate to revenue adjusted operating income declined to 5.8% from 8.2% last year.

Our GAAP effective tax rate of negative 187% compared to a positive 26.5% last year, reflecting the impact of valuation allowances on impairments and restructuring charges this year. Our adjusted effective tax rate decreased to positive 19.9% compared to 26.5% last year due to favorable changes in income tax reserves, a reduction in non-executive — non-deductible executive compensation and other benefits. Fourth quarter adjusted earnings per share of $0.37 exceeded our guidance of $0.34 to $0.36 and compared to EPS of $0.43 last year.

Total ending inventories at cost increased 5% to $446 million, which was better than we expected. Inventory units increased 2%. The inventory increase primarily represented new denim styles and Aerie growth. We were pleased with our ability to clear holiday merchandise during the fourth quarter and we entered 2020 with clearance units down to last year.

Now a few comments and highlights regarding our annual results. Total revenue for the 52 weeks increased $272 million or 7% to a record $4.3 billion compared to $4 billion last year. Consolidated comparable sales for the year increased 3% building on an 8% increase last year. Despite some volatility in the quarter, AE brand comps were up slightly for the full year against a 5% increase last year. Aerie accelerated sequentially each quarter and grew comps 20% for the year building on a 29% comp growth last year.

Gross profit dollars increased $35 million to $1.52 billion and as a rate to revenue, gross margin decreased 160 basis points to 35.3%. SG&A of $1.03 billion increased 5% and leveraged 40 basis points to 23.9% as a rate to revenue. For the year adjusted operating income of $314 million decreased 7% from $339 million last year. As a rate to revenue adjusted operating income decreased to 7.3% from 8.4% last year. This excluded impairment and restructuring charges of $80 million this year and restructuring and related charges of $2 million last year. Annual adjusted EPS of $1.48 was flat to last year.

Our strong financial position remains a competitive advantage. We ended the year with $417 million in cash and short-term investments and no debt. We delivered strong free cash flow in 2019, which enabled us to invest in our business and also return significant cash flow to our shareholders. We paid dividends of $93 million and we repurchased 6.3 million shares for $112 million in the year.

Consistent with our guidance, capital expenditures totaled $210 million for the year. In 2020 we expect capex to be in the range of $225 million to $275 million. The increase in capital spending is driven primarily by investments in our distribution network as well as Aerie store openings.

2019 store activity can be found on pages 14 through 18 of the investor presentation. Total gross square footage increased 3% for the year due to additional square footage from Aerie store openings. We opened 37 new Aerie standalone stores and closed four locations. We also opened 28 new Aerie side-by-side stores and closed one location.

For the AE brand, we opened 27 stores and closed 21 locations as we migrated our footprint to stronger locations. Our real estate priorities for 2020 are to accelerate the growth of Aerie with approximately 60 to 70 store openings, to reposition and remodel AE stores and to expand globally through our franchise partnerships. We continue to actively manage our lease portfolio and have been successful in negotiating rent reductions in short renewal periods.

Our average lease term at the end of 2019 was 3.6 years and more than half of our C mall [Phonetic] leases expire in 2020. We will continue to prioritize the best strategic locations. These include top-performing malls with positive traffic trends, attractive co-tenancies and favorable economics and additional locations in strong omni-channel trading markets. At the same time, we will continue to close non-strategic and unprofitable stores.

Now regarding our outlook. In the first quarter we expect EPS of $0.20 to $0.22 based on comp sales in the positive low single digits. This outlook includes a $0.01 headwind from the anticipated impact of coronavirus on our Hong Kong stores and another $0.01 as we lap the discontinued Japanese license business.

For the full year 2020, we would like to highlight the following. First, we are lapping a challenging 2019 and resetting our incentives in 2020. This would create a material expense headwind, particularly in the third and fourth quarters. Second, as Chad mentioned, we are working to improve our men’s tops but achieving an inflection in the business may take some time. Third, as you may recall, we will be lapping a $0.15 EPS benefit from the receipt of Japan licensing royalties in the second quarter of 2019. Keep in mind that in a typical year we generate approximately similar level of profit in our first and second quarters.

As Jay mentioned, we are closely monitoring coronavirus developments. We have a task force that is tracking the situation in real time to ensure the health and safety of our associates, customers and partners and to maintain business continuity. In addition, we’re working with our sourcing partners on migrations and currently do not anticipate any near-term supply chain disruptions. As you know, the situation remains fluid and could create ongoing uncertainty. What we know today is reflected in our first quarter guidance.

In closing, we are pleased with American Eagle’s continued momentum in market share growth in teens, strong customer engagement and positive traffic and transaction trends. We have a number of initiatives in place to deliver better fashion, manage our inventory more tightly and drive incremental efficiencies in the business. With Aerie, we have one of the best emerging new brands in the retail sector that is right for a new perspective. We will continue to fuel Aerie’s momentum, expand into the new untapped markets and seize on the significant market opportunities. While fueling the growth across AEO, we will focus on strengthening our profit flow-through and driving returns to shareholders.

I’d like to close by thanking our entire AEO team for the hard work this year. 2019 was a challenging year for the organization, but the quality of our people remains a key strength and competitive advantage.

And now, we’ll open it up to questions.

Questions and Answers:

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Kate Fitzsimons with RBC Capital Markets. Please proceed with your question.

Kate Fitzsimons — RBC Capital Markets — Analyst

Yes, hi, thank you for taking my question. I guess, looking ahead to Aerie in 2020 and the accelerating stand-alone plans, can you just speak to the productivity trends that you see in the stand-alone stores relative to the side-by-side? Just how should we think about the mix of new and infill markets as well as any sort of digital halo when thinking about the expansion plans for 2020? That would be helpful. Thank you.

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Thank you, Kate for the question. The stand-alone locations compared to the side-by-side — [Technical Issues] The standalone locations versus the side-by-side locations have a slightly lower square foot productivity and really only has to do with the size of the box compared to the side-by-side box. From a digital halo perspective, on average what we see is approximately 50% of a store’s sales volume being captured on the digital side of the business.

And as far as thinking about expansion plans for 2020, we’re very focused on expanding within trading markets and not on an adhoc basis. What we find is when we do that we get to capitalize on marketing across the trading markets, but also it drives a slightly higher digital halo.

Operator

Our next question comes from the line of John Morris with D. A. Davidson. Please see with your question.

John Morris — D.A. Davidson — Analyst

Hi. Thanks. Congratulations on the good work and the start here into Q1. Bob, I think for you a couple of questions about the COVID-19 from a sourcing perspective. We are beginning to hear from a number of people some metrics that give us a little bit of a better feel on the supply chain side. Wondering if you can tell us what percent of your factories are back up in terms of what you’re hearing from your suppliers, maybe try and give us a feel for, are they back at full capacity or some percentage of capacity?

One of the concerns is really on the raw material — second kind of sub-question, raw material side in terms of fabric. What — is that something that could impact you here into Q2? Is you’re looking to take some of those receipts? Wondering if there is any delivery delays that you’re expecting? And would you potentially incorporate some kind of additional freight expense from that, not only Q1 but Q2 as well? If you can give us a feel for that that would be great.

Robert L. Madore — Executive Vice President and Chief Financial Officer

Thanks for the questions, John.

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Bob, let Michael answer it. Excuse me.

Robert L. Madore — Executive Vice President and Chief Financial Officer

We have got our supply chain partner here and COO, Michael Rempell. So, I’ll hand it [Speech Overlap].

John Morris — D.A. Davidson — Analyst

Yeah. Good. Hey, Michael. Thanks.

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

Hey, John. Hope you’re doing well.

John Morris — D.A. Davidson — Analyst

Good.

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

Yes. So [Indecipherable] there has been a lot of activity really since January. On the sourcing side, I’m happy to say 100% of our factories and mills are back operating. They’re operating at about 75% capacity now, but they’ve really been terrific partners. They’ve worked with us to prioritize our business. And right now while we do see some delays, there is nothing that we can manage without expediting in our supply chain. It’s really too early to tell if there’ll be residual impacts from mills opening later, factories opening later and the amount of work that they have to catch up on which is I think the second part of your question. Right now we feel good about our deliveries. There might be some unanticipated delays into Q2 and later in the year. But again, we have very good partners, we have very good relationships and we feel good about our opportunities to get our product.

John Morris — D.A. Davidson — Analyst

Excellent. Thanks for that information. Good luck for spring.

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

Thanks.

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

Thank you.

Operator

Our next question comes from the line of Oliver Chen with Cowen & Company. Please see with your question.

Oliver Chen — Cowen & Company — Analyst

Hi, thank you. Our question was just about men’s relative to women’s. It sounds like men’s has been a little bit more challenging. If you could elaborate on some of the differences there and why it’s more challenging? You’ve also impressed with traffic and transactions. Would love your thoughts ahead with what you see for in-store traffic trends as well as managing merchandise margins in a tough general environment. Thank you.

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Yeah, thanks. I think part of the challenge we’ve seen in men’s is I think, well, Q4, we had some balance issues in the assortment. And I think shifted too much into out of some legacy category. The men’s trend has been a little bit longer lasting than the women’s trend and I anticipate it will take a little longer to get that back on track. And also the women’s business delivers more units on a monthly basis, which makes it easier for us to flex into what we see is working in women’s.

I do think we have seen great strength in both genders across bottoms and accessories. And I think in men’s specifically, we’re really inspired by what we see across our active assortment in both bottoms and the tops that we’ve delivered. And so we expect to be leaning into that. But it just takes a little bit more time for us to get the assortment rated.

We do see traffic and transaction trends continuing. I think that really speaks to the strength of the brand and our position as a destination for this generation for apparel especially and jeans specifically. So we will continue to lean into our brand strength and our category strength and we’re doing everything we can as quickly as we can to make sure we get the tops assortments rated in both men’s and women’s.

Operator

Our next question comes from the line of Adrienne Yih with Barclays. Please see with your question.

Adrienne Yih — Barclays — Analyst

Good afternoon, everybody. Bob what percent are you actually sourcing now from China and then Asia broadly? And also for the comp of the plus 2% [Phonetic] or the blow single digit for the first quarter, should we assume a similar spread between Aerie and AE brand?

And then one for Jen. What percent of swim are the spring product and are you hearing any chatter about kind of disruption to spring breaks in any of that sort of stuff kind of on the demand side? Thank you very much.

Robert L. Madore — Executive Vice President and Chief Financial Officer

Thank you for the question, Adrienne. We source approximately 20% of our product from China today and are constantly looking to migrate that to other countries over time, even regardless of the coronavirus situation. As for the comp plus 2% or below single digit for the first quarter, it’s a positive single digit or low-single digit comp that we gave as guidance, and I would say yes, you should expect a similar spread between AE brand and Aerie in the first quarter.

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

And how are you, Adrienne by the way?

Adrienne Yih — Barclays — Analyst

Congrats by the way.

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

Thank you. For Aerie swim represents, I would say roughly around 10% of the business. But the most important thing about swim is, and what we’ve done strategically, is the customer is demanding so much more from us. Obviously they love our platform and this community that we’re building is just outstanding. So that said, we’re able to just open up new categories and introduce to customers new categories every day and that’s what we’ve been really focused on. I have some great surprises coming. Everybody is ready for back to school. I think we have some really good ideas in the brand and some new ideas that I think we’re really going to expand on. So we’re excited about that.

And then when I think about spring breaks what I love about Aerie is our customer base is starting to become more ubiquitous. We’re getting moms and daughters shopping. So we’re able to hurdle these spring breaks and some of these smaller shifts that maybe some — some competitors are seeing. So, best news there is we’re getting more and more into our customer base. She is growing with us. Retention is up. So we’re able to really mitigate any risks there.

Adrienne Yih — Barclays — Analyst

Great. Best of luck. [Indecipherable]

Operator

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

Janet Kloppenburg — JJK Research — Analyst

Good afternoon, everyone. A couple of questions. Jen, at the end of this year you will have about 400 stores. And with such a deep penetration of digital, I was just wondering where you thought the optimal number of stores would end up. And Chad given the topic on the women’s tops versus the men’s tops, I was just wondering what your confidence level was that you could achieve positive comps, maybe in the second quarter or if that’s something that we should be thinking about for the back half? Thanks so much.

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

Yeah. So this year, Janet, we’re going to have about 322 — well, we ended the year at 322, we’re going to open up another roughly 60 because we still are not in every market. So we have to cover every market, but we definitely aren’t going to over expand. We’re going to be really smart about where we grow and what markets we enter and what great level malls we’re going to get into. The other interesting thing that’s been happening is our renovations. [Indecipherable] amazing for us. So when we can put our new market design into some of our older stores, we’re seeing really nice comps there. And then I guess I would say when you think about the other part of our growth is where we have some older side-by-side and we can work out a nice deal in the mall, we’re going to open up stand-alone stores there as well, because, again, that’s another place where we could actually — we need some more square footage. But again, we’re not going to get sloppy with square footage. We’re going to be very strategic. We’re not going to oversize the ship by any means. So we have intense real estate strategy meetings that we are really focused on where we’re going to expend to. So we’re going to make sure we don’t over saturate this marketplace.

Janet Kloppenburg — JJK Research — Analyst

Okay. Thank you.

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

And Janet for —

Janet Kloppenburg — JJK Research — Analyst

Hi, Chad.

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

Women’s versus men’s, I think — I feel we have some really — I’m excited about some of the green shoots that we’re seeing in the women’s business in the non-bottoms business so far this spring whether it’s — I mentioned in the script, some of our key items in bear and in Ts and graphics and then I think I’m sure you’ve seen our dress shop that launched and we’re seeing some positive response across the board there. I think we’re balancing — trying to balance getting some rate back being more promotional than we intended in 2019, while also going after what’s working. So I think for Q2 we should start seeing the women’s business back — women’s tops business getting back close to, if not positive. I think the men’s business has been a longer ongoing challenge. I’d love to see — I’d like to see that we can get the whole — the entire men’s business to positive comps. But I think at this point we’re just targeting getting back to meaningful improvement in men’s tops from where we’ve been.

Janet Kloppenburg — JJK Research — Analyst

Thank you and good luck.

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

Thank you, Janet.

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

Thank you.

Operator

Our next question comes from the line of Laura Champine with Loop Capital Markets. Please see with your question.

Laura Champine — Loop Capital Markets — Analyst

Thanks for taking the question. While we’re on men’s tops, I mean it seemed as if there were some categories with holes in the assortment in Q4. Is that rectified? And Chad have you made any changes to processes or personnel in merchandising as a result of some of the gaps we’re seeing in the assortment in Q4? Thanks.

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

Thanks. Yes, we definitely had some gaps in the assortment in Q4 as we look to — I think I said in the last call, we’re really leaning into Ts and fleece because I really do believe that that’s where our guys are most heavily engaged, but in avoiding some of the legacy categories and some texture, I think we really clearly gave up some business there.

Going into spring some of those categories are not — hadn’t existed in the past. I think I really want to make sure that the team is leaning into where the customer is really shifting which is Ts and fleece. And we’re really excited about the growth of fleece and active within the assortment. But we have made some changes to the process to make sure that we really are covering any gaps that we have the balance that we need to have that we’re delivering the right assortment of customer choices and that the assortment is as productive as it needs to be to drive positive growth throughout men’s.

We have also made some personnel changes in men’s moving — we just actually recently, like this week, are moving one of the merchants from the men’s bottoms area to help shore up men’s tops. She has had a great track record and I think can help with process and making sure we’re covering what we need to cover as we move forward.

Laura Champine — Loop Capital Markets — Analyst

Great. Thank you.

Operator

Our next question comes from the line of Tiffany Kanaga with Deutsche Bank. Please see with your question.

Tiffany Kanaga — Deutsche Bank Research — Analyst

Hi. Thanks for taking our question. Would you be able to walk us through how you’re thinking about SG&A growth into 2020, whether we can see some relief on this front after all the investments you’ve made over the past couple of years and if leverage is likely?

Robert L. Madore — Executive Vice President and Chief Financial Officer

Thanks for the question, Tiffany. As far as SG&A expectations for 2020, as I mentioned in the script relative to the guidance discussion, we do have a major headwind regarding SG&A relative to resetting bonus at target. There was no bonus this year and it’s a pretty significant number on an annual basis. It’s worth about $50 million. On top of that we’re expecting SG&A growth to outpace sales growth, not only because of the incentive reset, but also additional expenses in store payroll, corporate overhead, payroll and related taxes, really driven by supporting the Aerie brand’s significant growth across the organization in addition to a slight increase in advertising. So you should expect SG&A expense next year to slightly outpace or outpace revenue growth.

Operator

Our next question comes from the line of Dana Telsey with Telsey Advisory Group. Please see with your question.

Dana Telsey — Telsey Advisory Group — Analyst

Good afternoon, everyone. As you think about the impairment charges, Bob, that you took on those 20 stores, are there other stores that would be impaired next year or how do you — take us through exactly what those stores, the elimination of them, how does that help profits go forward, what kind of sales impact does it have and how you’re planning that for next year? Thank you.

Robert L. Madore — Executive Vice President and Chief Financial Officer

Thanks for the question, Dana. We talk a lot about how healthy our real estate portfolio is, talk — speak to the fact that 95% of the portfolio is profitable. Those 20 stores that ended up being impaired really represent that 5% of unprofitable stores. The impairment charge came about really as a result of those stores not having cash flows adequate to cover the assets, not only fixed assets, but as I mentioned in my comments with the new lease accounting standard we put a very significant right of use asset on the books, which added about $25 million to that total $66 million charge. So it would have been more like call it $40 million charge.

Out of the 20 stores, one of those stores we’re closing. So from a sales impact perspective, it’s immaterial. And thinking about next year and do we have additional impairment risk, as I said, we’ve addressed the unprofitable real estate base with this chart. And I’m not anticipating any significant impairment charges next year.

Dana Telsey — Telsey Advisory Group — Analyst

Got it. And then just on the resetting of the incentives in 2020, how are they different from ’19?

Robert L. Madore — Executive Vice President and Chief Financial Officer

Well, they’re different in that in ’19 there was no incentive payout and that in 2020 we’re resetting to a budget achievement or target level payout which represents, as I said, about $50 million, split about a third to BOW and two-thirds to SG&A expense.

Dana Telsey — Telsey Advisory Group — Analyst

Thank you.

Operator

Our next question comes from the line of Rebecca Duval with BlueFin Research Partners. Please see with your question.

Rebecca Duval — BlueFin Research Partners — Analyst

Thank you for taking my call. So I have a question for you, Chad and one quick one for you, Bob. Chad, on the AUR last year, it was really driven by a lot of the trends out there with knits. And now that we’re going into spring and warmer weather, is there any concern on the AUR front from a women’s tops perspective that you will — obviously you’ll be lapping it, but is there any concern that you think could be any sort of headwinds there? And then, Bob, just a clarification on the earnings guidance, does that include any sort of supply chain disruptions as you guys see now and any additional freight based on what you know now in those — in that outlook?

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

Thanks. I think last spring, we definitely had a headwind with AUR and that the mix trend with all the bear came at a lower AUR and we actually sold a lot more units but struggled to comp in women’s tops in the spring season. This year we have definitely architected the assortment to make sure that that does not happen. We are planning an increase in AUR across women’s tops. We’re seeing that so far and I think with the balance we have in the assortment and the strength we’re seeing in Ts, dresses and some [Phonetic] woven tops is offsetting that bear AUR. So I expect that we should see a positive AUR comp which will be a good thing in the spring season.

Robert L. Madore — Executive Vice President and Chief Financial Officer

And Rebecca our guidance does contemplate any sort of supply chain or any disruptions that are know today. Now the only known disruptions as I pointed out in my prepared remarks are really related to our Hong Kong retail business. As Michael pointed out, really we’re not anticipating any major disruptions in the supply chain in the near future. We’ve been working very closely with our supply chain partners and recently we’ve introduced a lot of speed within our supply chain that gives us a lot of options. So we’ve sped up Ocean significantly from a day’s perspective. In addition to Aerie. So we can fit it between the two and I think we feel at this point, we can mitigate any potential delays that we know of.

Rebecca Duval — BlueFin Research Partners — Analyst

Thanks. That’s super helpful. Best of luck to you guys.

Operator

Our next question comes from the line of Janine Stichter with Jefferies. Please see with your question.

Janine Stichter — Jefferies — Analyst

Hi. Great. Thanks for taking my question. Question for Bob on the inventory. Nice to see it come in so lean. Can you maybe help us break out just how much the investment in top this down and what the balance of the inventory looks like when you strip out some of the investments in denim and Aerie? And then also what your plans are for inventory going forward? Thank you.

Robert L. Madore — Executive Vice President and Chief Financial Officer

Thanks for the question, Janine. So inventory was up 5% or $22 million in the quarter. The bulk of that increase is to fuel our denim business, women’s in particular and the Aerie business, call it $20 million for our jeans business and $13 million to $15 million to fuel the Aerie growth which is phenomenal.

We’ve cut back on our tops both in men’s and women’s inventory positions in the tune of, call it, $15 million in the aggregate by the end of the quarter. And we’re going to continue to manage those categories tightly until we see the trends turn around. We’ve got a very speedy supply chain and we’ve got the ability to chase a number of categories and SKUs and styles. So we feel really good about our ending inventory and I really have to thank the teams for clearing the inventory and us ending in a much better position than we even expected. Our clearance inventory levels are much lower than they were last year.

Janine Stichter — Jefferies — Analyst

Great. That’s helpful. And then just one clarification on the SG&A. When you talk about the SG&A growth rate outpacing revenue growth slightly, is that before adding back the incentive comp fees, just trying to understand what the underlying expense growth rate is.

Robert L. Madore — Executive Vice President and Chief Financial Officer

No, that — Janine, that includes the impact of setting targets back up for incentives [Speech Overlap].

Janine Stichter — Jefferies — Analyst

Got it. Thank you.

Operator

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

Kimberly Greenberger — Morgan Stanley — Analyst

Great. Thank you so much, Bob. And thank you for the color on just how to think about SG&A for the year. I’m wondering if you can help us just understand the sort of ebbs and flows in gross margin for the year as well. We understand, you’ve got that second quarter hurdle because of the licensing — the license breakage fee last year that’s non-recurring. Maybe just help us think about if you could, the ebbs and flows of the different pieces, if you could put together the merchandise margin as separate from some of the deleverage and BOW there that you are expecting for the year. And if there are — if there is some quarter-to-quarter volatility just in terms of how we should calibrate our model, I think that would be helpful.

Robert L. Madore — Executive Vice President and Chief Financial Officer

Sure. So we are expecting and we’re experiencing to date merch margin improvement year-over-year, but we are expecting BOW deleverage for the year. For us to leverage BOW we need to be operating at roughly a mid single-digit comp. So unless we are able to deliver that we will have a slight deleverage. It flows through to slight deleverage to gross margin for the year, almost flat. When I say slight I mean slight deleverage in the aggregate across gross margins.

Kimberly Greenberger — Morgan Stanley — Analyst

Great. Thank you.

Operator

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

Susan Anderson — B. Riley FBR Inc. — Analyst

Hi. Thanks for taking my question. I guess just a follow-up on Kimberly’s question. It sounds like you’re expecting some improved promotional environment in first quarter with the improvement in woman’s tops, I guess. And then also how are you thinking about AUCs and IMUs for the quarter. And then maybe, Jen, if you could talk a little bit about just if there — it sounds like there has been outperformance really across all categories at Aerie. But is there anything one specific that’s really driven the reacceleration in comps recently? Thanks.

Robert L. Madore — Executive Vice President and Chief Financial Officer

Thank you for the question, Susan. We are expecting improved promotional environment in the first quarter, both across AE brand but Aerie has seen some fierce significant gross margin improvement year-over-year. I mean, in the fourth quarter, it was over 340 basis points just to put it in perspective.

Looking at AUCs and IMUs, it was part of the merch margin improvement that I referred to that we’re expecting across the year. Part of that is driven by IMU improvement and AUCs are going to continue to increase as we mix more heavily into bottoms in AE brand. And as Jen and the Aerie team grow their apparel offering and particularly with bottoms too. To put it in perspective, when you think about 5% increase of inventory in Q4, 3% of that was driven by an increased AUC and the other 2% was driven by increased units.

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

And Susan really in holiday, it’s just — it was so well received, the line, and really all categories were really on fire. We just — we had a great holiday season and we mixed really well and the team is just getting smarter with the product that she’s responding to. So I think they did an outstanding job really diving in and distorting. I think it’s so important in today’s world to make sure that we’re buying the product right and distorting right. There is just so much product out there and the more we can focus on what we need to stand for and do it well, I think we’re going to continue to win. The other thing to talk about here is the digital business, because we’re still expanding into new markets the halo effect which I mentioned in my earlier discussion is incredible.

Our digital business represents 45% of the sales and we’re really able to leverage an omni-channel perspective and promotional environment. We’re able to just do both at the same time, leveraging our store business and digital, but really thinking about our promotions and how we can be less promotional. That’s something we’re highly focused on in Aerie. We’re focusing on the flow-through and how we can continue to be incremental to the total business. Dave Evakten [Phonetic] and the team is really engaged here and saw a nice start to February. So we’re looking forward to the balance of the year hoping that the virus doesn’t impact anything or the other threats. But mostly I promise you this team is engaged on delivering this year.

Susan Anderson — B. Riley FBR Inc. — Analyst

Great. Some nice job. Good luck this year.

Judy Meehan — Vice President of Investor Relations

Okay, Kevin, if we have another caller, we have time for one more question.

Operator

Absolutely. Our final question comes from the line of Marni Shapiro with Retail Tracker. Please see with your question.

Marni Shapiro — Retail Tracker — Analyst

Hey guys. The stores do look a lot better for spring, especially in the women’s side. I was just curious, I know you’re testing in a handful of cities buy online, pickup in store. And I was curious what kind of results you’re seeing and what kind of time frame you’re looking at to roll that out across the entire fleet as well as the potential to roll out ship from store as well.

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Well thanks Marni for your comments on the women’s assortment. We have worked really hard and I do think it’s looking better. So I am glad that you are seeing that. We are testing buy online, pick up in store and then the tests are going well. I think we had a lot of confidence going in and really trying to make sure it work operationally and we hope to have that rolled out by the end of Q2.

We do have ship from store, we’ve had that in place for quite some time, we call it store to door and it’s definitely a meaningful part of how we service our customers when she comes into our store environment.

Marni Shapiro — Retail Tracker — Analyst

Did you buy online ship from store or do all your shipments come and —

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Yes, we do. We’ve got buy online ship from store for about four or five years. Now it’s about 20% of the volume of direct, so always looking to optimize that.

Marni Shapiro — Retail Tracker — Analyst

And then by end of Q2 rolling out the [Indecipherable]. Fantastic. Great. Best of luck for spring, guys.

Jay L. Schottenstein — Executive Chairman and Chief Executive Officer

Thanks.

Judy Meehan — Vice President of Investor Relations

Thanks, everyone. That concludes our call today. We appreciate your participation and have a great evening. Thanks.

Operator

[Operator Closing Remarks]

AlphaStreet, Inc., 44053, Fremont Blvd, CA – 94538, USA | www.alphastreet.com

Disclaimer

This transcript is produced by AlphaStreet, Inc. While we strive to produce the best transcripts, it may contain misspellings and other inaccuracies. This transcript is provided as is without express or implied warranties of any kind. As with all our articles, AlphaStreet, Inc. does not assume any responsibility for your use of this content, and we strongly encourage you to do your own research, including listening to the call yourself and reading the company’s SEC filings. Neither the information nor any opinion expressed in this transcript constitutes a solicitation of the purchase or sale of securities or commodities. Any opinion expressed in the transcript does not necessarily reflect the views of AlphaStreet, Inc.

© COPYRIGHT 2020, AlphaStreet, Inc. All rights reserved. Any reproduction, redistribution or retransmission is expressly prohibited.