Good day, and welcome to the Abercrombie & Fitch Third Quarter Fiscal Year 2019 Earnings Call. Today's conference is being recorded. [Operator Instructions] And now at this time, I would like to turn the conference over to Pam Quintiliano. Please go ahead.

Thank you. Good morning, and welcome to our Third Quarter 2019 Earnings Call. Joining me today on the call are Fran Horowitz, Chief Executive Officer; and Scott Lipesky, Chief Financial Officer. Earlier this morning, we issued our third quarter earnings release, which is available on our website at corporate.abercrombie.com under the Investors section. Also available on our website is an investor presentation. Please keep in mind that any forward-looking statements made on the call are subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from the expectations and assumptions that we mention today. A detailed discussion of these factors and uncertainties is contained in the company's filings with the Securities and Exchange Commission. In addition, we will be referring to certain non-GAAP financial measures during the call. Additional details and a reconciliation of GAAP to adjusted non-GAAP financial measures are included in the release issued earlier this morning. With that, I will turn the call over to Fran.

Thanks, Pam. Good morning, and thank you for joining us today to discuss our third quarter results. In Q3, we delivered our third consecutive quarter of constant currency revenue growth and our ninth consecutive quarter of positive U.S. comp. Our results were driven by a solid back-to-school season in August and a strong end to the quarter in October, partially offset by a challenging retail environment, including unseasonably warm weather patterns during September and ongoing disruptions in key international markets. As we look ahead, the performance we have experienced in October and early November in the U.S. and international gives us confidence for the holiday selling season. For the third quarter, we posted a flat comp versus plus 3% last year. By geography, the U.S. was a plus 3% and international was a minus 8%. By brand, Abercrombie achieved a plus 3% while Hollister came in at a minus 2%. Hollister has a deeper international penetration relative to Abercrombie and therefore is a larger impact on international results to the total comp. Taking a closer look at our U.S. results. Our plus 3% comp compared with plus 6% last year and represented an acceleration from second quarter results of a plus 2%, with all brands in positive territory. Performance was driven by ongoing double-digit growth in digital and continued above mall average traffic trends. Our positive U.S. comp was offset by minus 8% internationally. This compared to a minus 3% last year and represented a sequential decline from a minus 3% in Q2. Our international business faced a number of escalating macro headwinds in our key markets, including the uncertainty around Brexit continuing to negatively impact sales in the U.K., which is our largest international market. Beyond Brexit, ongoing protests in Europe and Asia also negatively impacted results. Specifically, Hong…

Thanks, Fran. On to our third quarter results. Net sales of $863 million were approximately flat to last year and up 1% on a constant currency basis, reflecting an $8 million adverse impact from FX. Comps came in flat against a plus 3% last year. Despite the challenging global environment, cross-channel traffic remained positive and our conversion improved quarter-over-quarter. By brand, Abercrombie returned to positive territory with a plus 3% comp while Hollister comps were a minus 2%. This compares to a plus 1% and plus 4% comp, respectively, in Q3 2018. By geography, we achieved a plus 3% comp in the U.S. on top of a plus 6% last year with each brand in positive territory. Our international comps were minus 8% and compared to minus 3% last year. Our gross profit rate of 60.1% was down 120 basis points from last year. FX adversely impacted results by 40 basis points. On a constant currency basis, our gross profit rate was down 80 basis points. Increased shrink losses accounted for an additional 50 basis points of the 80 basis point year-over-year decline, which was not previously accounted for in our outlook and reflected the results of our annual store physical inventories taking place in Q3. The remaining 30 basis points primarily related to higher AUC. China tariffs had a negligible impact on Q3 results as we expect most of this year's impact to flow through in Q4. I'll cover the rest of our results on an adjusted non-GAAP basis, which excludes pretax flagship store asset impairment charges of $10 million this year and pretax benefits of $3 million related to certain legal matters last year. Adjusted operating expense, excluding other operating income, was $494 million, flat as a percentage of sales as compared to last year. Other operating income…

[Operator Instructions] We will begin with Paul Lejuez with Citi Research.

This is Kelly for Paul. Just a question on -- could you provide some color on the merchandise margin trends by content in the U.S.? Did you have to get more promotional to drive that positive comp at Hollister? And also, if you could just give some commentary around the promotional environment, what your competitors are doing in the U.S., both in the third quarter and what you're seeing so far in the fourth quarter?

Kelly, this is Scott. Let me grab that merchandise trends by brand. I would say Hollister was a little bit more promotional than Abercrombie in the quarter. We had a little bit of that product coming through summer that we talked about. So we were using some markdowns to clear through that in the quarter. In total, our AUR as a company was about flat when you exclude FX. So I'd say that promotions were relatively in line across brands outside of a little bit of that markdown pressure in Hollister.

Kelly, the environment there for the fourth quarter is always the most promotional time of the year. With that said, we go into the quarter with the goal of being less promotional, but we certainly are prepared to compete, need be. Our inventories are in really good shape at plus 3%. They're well balanced across brands and genders, so we can make sure that we are very pointed in our promotions.

Got it. And then just I think you had some -- it sounded like a little bit more positive commentary around international trends so far in fourth quarter. So I guess just how should we be thinking about the international business, both in the fourth quarter and longer term, given we've had some sustained weakness over there for a while?

Yes, we did mention in the script that we are seeing better trends as we headed into the fourth quarter for international. It's complicated out there. There's a lot going on. The third quarter, we did see some increased activity, certainly between Brexit, Hong Kong, several protests throughout Europe, but we are focused on controlling what we can. We've talked a lot lately about building out our international team. We're excited to have those teams on the ground. In fact, I was just in London a couple of weeks ago meeting with our new team in London, running our EMEA region. And I'm heading to Shanghai in a few weeks to meet that team. So lots of good talent on the ground, helping us to really get closer to our customer. And we expect that to pay off some as we head into '20.

Yes. And longer term, we still believe in the international business. We're investing in talent that Fran just mentioned, we're investing in stores and we're investing in the digital business, and we will continue to do that.

We'll hear from Westcott Rochette with Evercore ISI.

Thinking about 2020, you still have your margin target out there for the full year, you still kind of seem confident. I know you want to get through the holiday before you give an update there. But in the kind of big buckets, where do you think the biggest improvement opportunities could be that will step you from this year to next year to hit that 5.5% target?

Westcott, yes, we are focused on achieving those targets and we are just entering the biggest part of the year, so we still have a lot to learn. We are about to embark on our annual budget process and our real estate review with all of our landlords. So we are still focused on our targets. Scott, do you want to add any more to that?

Yes, it really is getting back to the big buckets that we laid out last year in April. So top line growth, some gross margin acceleration and then OpEx leverage on top of the huge sales volume that we're walking into here this week. We're in the midst of our budget process for the year. So we have a lot to figure out on the expense side and a lot to learn from our ongoing landlord negotiations to really set up our expense structure from next year. So a lot more to come as we talk at -- in the new year.

Now we will hear from Kate Fitzsimons with RBC Capital Markets.

This is actually Shiyao on for Kate. I just want to dig a little deeper into the International comps of negative 8%. Can you give a little more color? We know that you called out some of the headwinds in U.K., Europe and Hong Kong. Can you just give more color about how those each pieces fill into the international overall comp? And then what is your expectation for 4Q that's included in the outlook?

I'll kick this one off and Fran can add in if she'd like. So starting with Brexit, it really got into the customers' mindsets as we came into Q3. There was the hard Brexit date out there for 10/31, and it's a bit paralyzing for the people on the ground in the U.K. So we saw that really creep into our business. Hollister is a little more penetrated in the U.K. -- I'd say a lot more penetrated in the U.K. than Abercrombie, where we have 25-plus stores for Hollister and just opened our fourth for Abercrombie, so it had an outsized impact. But we're also seeing some of these protests happen in other countries in Europe. France has been in the news for a while. Spain is a little more recent, where we've seen some protests that have impacted our local customer in some of those key cities in Spain. So on top of that, weather was a little warm in the international business. So with Hollister, we really saw this just kind of creep into our key countries. The good thing is that at the end of the quarter, as things got a little more seasonal and maybe died down a little bit in terms of activity, we did see that business turn on a bit. So we're optimistic going into the fourth quarter. As we think about Q4 and what's baked into the outlook, I mean, our trend has been that the U.S. business has been outpacing the international. I don't think we see a reason today why that would change as we go into Q4. But we're all about managing the total, and so that's what we're doing, trying to drive the total across the brands.

The next question will come from Janine Stichter with Jefferies.

Wanted to ask a little bit about the inventory flows. It sounds like weather was challenging for everyone during the quarter, but the impact was mitigated a little bit more at Abercrombie than it was at Hollister. Can you talk a little bit about what you're doing differently there? And I think you alluded to making some structural changes to just the way you're managing slow inventory at Hollister. So a little bit more color there would be very helpful.

Janine, yes. So our inventory, we are pleased with where inventory is heading into the fourth quarter. It's well balanced between brands as well as genders. What I mentioned during the script a little bit about Hollisters is I would say that we got a little bit more focused on chase and a little bit less focused on our key items in our assortment architecture. We noticed that probably coming out of the second quarter and heading into the third quarter and began to make those adjustments. I'm confident that the team has made those adjustments, and we are starting to see that in the initial selling for the fourth quarter for Hollister. And A&F, yes, A&F was a little bit different. A&F had much more of an investment in wear now, particularly in women's and fashion. So we saw a strong performance for A&F women's in the third quarter.

Great. And then just wanted to ask a little bit about tariffs. You mentioned not raising prices this year. Any thoughts into next year with these tariffs, think about the appetite for the consumer to absorb additional price increases?

Continuing to keep our eyes on tariffs, clearly. There's a new headline every day that we're trying to track. But we're controlling what we can control. We were pleased, our sourcing team did an amazing job, as did our vendors, getting us to 16% coming out of 2019. Our expectations for 2020 is to bring that down to the low teens, and we'll continue to look for other opportunities to migrate out. So that's really where we are in tariffs. I'm sure there's much more clarity that will come in the near future. We'll continue to keep our eyes on tickets as we go through the spring season. But at this point, we are a promotional business and we have the opportunity to pull back on promotions as necessary. And that's what we work on at the start of every quarter, and we'll continue to work on that, go-forward.

We will now hear from Tiffany Kanaga with Deutsche Bank.

Would you be able to update us on the comp performance and profitability of the remodeled stores versus the older ones by brand? And also how the most recently remodeled stores have performed? And along those lines, could we expect a meaningful acceleration of the Abercrombie remodels next year?

Tiffany, it's Scott. I'll kick this one off. So the remodel performance has remained very consistent over the years. The Hollister -- I'll break it apart by brand. Hollister, we started on this journey back in 2015. The results have been very consistent. We've been very vocal on the high single-digit sales return and how that's flowed through to the 4-wall of the store over those -- over the years. Haven't seen a change there as we released the new vintage each year. On Abercrombie, we're still early on in the journey here. About 11% of our stores -- or 10% of our stores have been in the remodeled formats. What we've seen in Abercrombie is a big reduction in the size of the store. So we are very pleased with the productivity improvements that we're seeing in these stores.

Yes, just regarding 2020, as Scott mentioned earlier, we're just in the throes of all of our landlord negotiations. Obviously, we have a very strong balance sheet and we are committed to these A&F remodels. It really comes down to negotiating the size of the stores. Our goal in our remodels for A&F is to reduce our square footage anywhere from 30% to 50%. So it's a bit of a different journey than Hollister. Most of the Hollisters were more appropriately sized and we had to just redo them. The A&F is a bit of a different negotiation, having to reduce the square footage. So as we finish these negotiations, more to come on that -- more to come for that in '20.

[Operator Instructions] We will now move to Susan Anderson with B. Riley FBR.

I wanted to touch on the tops at Hollister. It sounds like you did see some improvement sequentially, but maybe still some weakness there. Maybe if you could talk about the changes you continue to make and your thoughts around fourth quarter performance there.

Sure. So Hollister specifically, the brand is healthy and well positioned. We are really the iconic global teen brand, and we did have some opportunities coming out of the second quarter and certainly in the third quarter on some key categories. As we corrected some of the opportunities from Q2 into Q3, candidly, we just did not buy them deep enough and sold through them again in the third quarter. But the team is focused on their assortment architecture, they are focused on building out their key items and they had a renewed focus on really balancing what I would call our chase opportunity as well as our -- building our key items. So some of those corrections were made in third quarter, more of those corrections were made in the fourth quarter. And we are confident in our product as we head into the busiest time of the year.

Great. And then maybe if I could have 1 follow-up. It sounds like November, the strength from October has continued. I guess for fourth quarter, do you feel like you could see some sequential improvement, both in international and then also in the U.S.?

That is always the goal when we walk into the quarter. I would definitely say that. So we are confident with what we saw at the back half of October, especially in the U.S. and also internationally. When the weather got more seasonal, some of our key must-win categories like outerwear, like fleece, sweaters, started to turn on at the end of the quarter. And that's what gives us some more confidence as we head into Q4. At this point, all the volume is ahead of us starting today into next week, and then the second peak as we get closer into Christmas. So we're ready to compete out there.

We'll now move to Marni Shapiro with The Retail Tracker.

Congratulations, the assortments really look fantastic. Could you talk a little bit about international for just a moment? I'm curious, is the traffic down in stores and online? Or is it down more significantly in stores, but you're still seeing good traction online?

Yes. Quarter-over-quarter, traffic was down. It remained positive on a cross-channel basis, but we weren't able to make up for that drop in traffic with conversion or AUR. So I'd say while remaining positive, which gets back to some of the comments Fran made on the brands, we still believe in the brands, obviously, across the international space, but we have an opportunity to drive better conversion, and that's what we'll be working on in Q4 as well as continuing to drive more traffic in all channels.

And are you seeing people use -- in the U.S., are you finding that people are using BOPIS? And are you seeing good conversion on BOPIS?

Yes. You know what we call it, purchase -- we call it POPinS or customer POPinS, Purchase online, pick up in store.

POPinS. Sorry.

And yes, we're seeing continued strong performance in our POPinS as well as the attachment rate that goes along with those purchases.

And David Buckley with Bank of America will have the next question.

Just a few questions internationally. What categories specifically are underperforming versus the U.S.? What percentage of your international stores are in the updated format as well?

So I'll kick off with the categories. The category that was -- underperformed the most internationally, again, was outerwear. Similar to it was in the U.S., same situation internationally with very strong -- warm, warm weather trends that we experienced in the middle of the quarter. And again, both domestically and internationally, when the weather turned, we saw a nice reaction and a shift in that trend on outerwear for both International and U.S.

On the updated format. For Hollister specifically, where we have a large majority of these things, we are behind in the new formats versus where we are in the U.S. The U.S. is over 50%, and in Europe for instance, we're under 40%. So we're getting to the point where we're going to come up on the cycle of our -- majority of our openings happened kind of back in the 2010 to 2012. So we're coming up on a couple of those lease lives as we roll forward over the next year or 2. So that's where we'll take the opportunity to put new formats in place. We just put a new format in, in Westfield London, one of the largest malls in Europe, we have a side-by-side Gilly. So as these leases come up for renewal, we're going to be getting after the new prototype.

And is the majority of the merchandise margin pressure in the fourth quarter expected to come from the international business?

I would say it's broadly around the world. I'd say this is the most promotional quarter, and we all see what's happening in the U.S., but it also is getting more promotional globally. You start in China from the Far East, then you have 11/11 into 12/12, so there are some big promotions that drive that business. And then Black Friday is really starting to creep into Europe more and more each year. So that customer locally is getting a little more accustomed to some of the promotions. So I wouldn't say it's coming from one place around the world.

Moving on to Connor Konicke with Baird.

This is Connor on for Mark. I know it's early, but last quarter, you guys talked about opening regional offices instead of centrally controlling the business internationally. Can you just talk about the initial reads and progress you're making and anything else to take away there?

Connor, yes, so we have been talking about building out these offices. I mentioned earlier that we have established London and Shanghai as those locations. We are in early innings. We've just recently hired a lot of the talent. I was in London meeting many of them just a few weeks ago. Our expectation is that we will see the benefits of that as we head into '20. As well as our Shanghai office, I'm heading there in a few weeks to meet that team. So we've made progress in hiring talent, but I would expect to see results from that as we head into '20.

Yes, and a little more around the why. We have a huge opportunity to get closer to that local customer, better localize the product, better localize the marketing, the calendar, the floor set cadence. It's a lot of the things we've talked about over the years of our opportunities, and we're now going to have the team on the ground to execute for us. So couldn't be more excited as we move into 2020.

We have a follow-up from Westcott Rochette with Evercore.

I just wanted to dig in on your gross margin guidance. First, on the shrink that you called out. I assume that's a catch-up over the balance of the year. Will that play a part in your fourth quarter guidance for gross margin? And secondly, as you look at the gross margin that you gave this quarter, knowing that you had a planned holiday and China and FX, is it any different than you kind of anticipated given the overall promotional environment that we've heard from some of the peers than you anticipated kind of 6 months ago?

Okay. Let me start with the shrink. You are correct. This was a catch-up for the year. As we went through our physical inventory cycle in Q3, we saw that our shrink rates have ticked up a little bit, so we needed to take that adjustment here in Q3 to get the reserves to where they need to be. There will be just a tiny impact in Q4 as we adjust our rates go-forward. Gross margin performance in Q4 versus 6 months ago, I would say no real change. This is the most promotional quarter throughout the year. As we think about our outlook for Q4 of down 150 basis points, around 70 of that is due to FX and tariffs. The other 80 basis points is due to a potentially more promotional environment. We want to give ourselves the ability to compete. Our inventory is in the right place coming into the quarter, so we have the ability to compete if we need to, but we're not pushed into that through a high inventory balance. So we feel like the margin outlook is reasonable and realistic based on what's in front of us today.

And ladies and gentlemen, this will conclude your question-and-answer session. I'll turn the call back over to Fran Horowitz for closing remarks.

Thank you to everyone who joined us today on the call, and thank you to our global team for all of your hard work. I'd like to wish everyone a happy and a healthy holiday.

And with that, ladies and gentlemen, this will conclude your conference for today. We do thank you for your participation, and you may now disconnect.