U.S. Markets open in 6 hrs 28 mins

Edited Transcript of M earnings conference call or presentation 14-Aug-19 1:30pm GMT

Q2 2019 Macy's Inc Earnings Call

CINCINNATI Oct 5, 2019 (Thomson StreetEvents) -- Edited Transcript of Macy's Inc earnings conference call or presentation Wednesday, August 14, 2019 at 1:30:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Jeffrey Gennette

Macy's, Inc. - Chairman & CEO

* Michael P. McGuire

Macy's, Inc. - Head of IR

* Paula A. Price

Macy's, Inc. - CFO & Executive VP

================================================================================

Conference Call Participants

================================================================================

* Alexandra E. Walvis

Goldman Sachs Group Inc., Research Division - Research Analyst

* Brian Douglas Callen

BofA Merrill Lynch, Research Division - VP and Research Analyst

* Charles P. Grom

Gordon Haskett Research Advisors - MD & Senior Analyst of Retail

* Jay Daniel Sole

UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst of Softlines & Luxury

* Kimberly Conroy Greenberger

Morgan Stanley, Research Division - MD

* Lorraine Corrine Maikis Hutchinson

BofA Merrill Lynch, Research Division - MD in Equity Research and Consumer Sector Head in Equity Research

* Matthew Robert Boss

JP Morgan Chase & Co, Research Division - MD and Senior Analyst

* Michael Charles Binetti

Crédit Suisse AG, Research Division - Research Analyst

* Oliver Chen

Cowen and Company, LLC, Research Division - MD & Senior Equity Research Analyst

* Omar Regis Saad

Evercore ISI Institutional Equities, Research Division - Senior MD and Head of Softlines, Luxury & Department Stores Team

* Paul Trussell

Deutsche Bank AG, Research Division - Research Analyst

* Paul Lawrence Lejuez

Citigroup Inc, Research Division - MD and Senior Analyst

* Robert Scott Drbul

Guggenheim Securities, LLC, Research Division - Senior MD

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good morning and welcome to Macy's Inc. Second Quarter 2019 Earnings Conference Call. Today's hour-long conference is being recorded.

I would now like to turn the call over to Mike McGuire, Head of Investor Relations. Please go ahead.

--------------------------------------------------------------------------------

Michael P. McGuire, Macy's, Inc. - Head of IR [2]

--------------------------------------------------------------------------------

Thank you, operator. Good morning, everyone, and thanks for joining us on this conference call to discuss our second quarter 2019 results and our full year 2019 outlook.

With me on the call today are Jeff Gennette, our Chairman and CEO; and Paula Price, our CFO. Jeff and Paula have several prepared remarks to share, after which we'll open it up for a question-and-answer session. (Operator Instructions)

In addition to this call and our press release, we have posted a slide presentation on the Investors section of our website, macysinc.com. The presentation summarizes the information in our prepared remarks as well as some additional facts and figures regarding our operating performance and guidance. Additionally, our Form 10-Q will be filed in a few weeks, and that too will be available on our website at that time. I do have one administrative note to share, and that is that we will be adjusting the timing of our typical quarterly earnings release beginning with our next quarterly earnings call, which will be on Thursday, November 21. As a rough rule of thumb and barring any minor conflicts, going forward we plan to release our results for the first through third quarters on the third Thursday after the quarter end. However, the timing of the fourth quarter call is not planned to change. In addition, we will now be publishing our earnings release 1 hour earlier and moving up the time of our call to 8:00 a.m. Eastern time for all quarterly results. So please mark your calendars accordingly.

Keep in mind that all forward-looking statements 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 mentioned today. A detailed discussion of these factors and uncertainties is contained in the company's filings with the Securities and Exchange Commission.

In discussing the results of our operations, we'll be providing adjusted net income and diluted earnings per share amounts that exclude the impact of impairment and other costs. You can find additional information regarding these non-GAAP financial measures as well as others used in our earnings release and during this call on the Investors section of our website.

As a reminder, today's call is being webcast on our website. A replay will be available approximately 2 hours after the conclusion of this call, and it will be archived there following the call for 1 year.

Now I'd like to turn this over to Jeff.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [3]

--------------------------------------------------------------------------------

Thank you, Mike, and good morning, everyone, and thanks for joining us.

So Paula and I will take you through our second quarter results, and then we will open up the line for Q&A. As you saw in our press release this morning, Macy's Inc. delivered another quarter of comparable sales growth. We achieved a 0.3% increase in comparable sales on an owned plus licensed basis. Our earnings per share was $0.28, well below our expectation.

As we communicated on our first quarter earnings call, we walked into the second quarter with elevated spring inventory. The second quarter got up to a very slow start. As we moved deeper into the quarter, it became clear that inventory was a mounting problem due to a combination of factors: a miss on fashion in our key women's sportswear private brands, slow sell-through of warm weather apparel and the accelerated decline in our international tourism business. We took the necessary markdowns to clear inventory. The unanticipated markdowns impacted our gross margin for the second quarter by almost 1 full point. We now enter the fall season with the right inventory level and mix to meet anticipated customer demands with improved freshness and liquidity to respond to in-season fall trends. We remain confident in our annual comparable sales guidance of flat to up 1%. That said, in light of our second quarter results, we are lowering adjusted earnings guidance by $0.20 for the full year. We now expect adjusted earnings per share in the range of $2.85 to $3.05 including asset sale gains or $2.60 to $2.80 minus asset sale gains.

When I step back and look at the business more broadly, while we had our seasonal inventory challenges in the second quarter, there are many areas of the business that are performing well. Our brick-and-mortar business is healthier led by our Growth 50 stores and Backstage expansion. Our digital business delivered its 40th consecutive quarter of double-digit growth. We make good progress on our 2019 strategic initiatives. All are on track and expected to contribute to comparable sales growth in the back half of the year.

So to quickly review them. Growth 150. 100 additional Macy's stores are receiving the Growth treatment. Work on these stores will be complete and ahead of last year's Growth 50 rollout well in advance of the holiday season. We continue to see strong performance from the original 50 Growth stores and expect a similar sales lift in the 100 ones that are now -- where the work is being completed. These 150 stores make up approximately 50% of Macy's brick-and-mortar sales.

Backstage. In 2019, we're expanding Backstage to another 50 stores with 47 of them already complete. We now have more than 200 Backstage within a Macy's across the country. And it's encouraging to see that the Backstage locations within Macy's stores open for more than 12 months continue to comp mid-single digits. We are getting better at off-price every day. Our Backstage distribution center in Columbus, Ohio is now up and running. This DC operates on the Google Cloud platform giving us improved efficiency, speed and scale to support the continued growth of our off-price business. As part of our supply chain strategy, we will roll this Google Cloud platform out to our other distribution centers in 2020 providing additional network flexibility and speed for both Macy's and Bloomingdale's.

Third, Vendor Direct. We continue to aggressively grow the SKUs and brands we're able to offer our customers on macys.com through Vendor Direct. We're now halfway to our goal of adding 1 million SKUs this year. Our customers love the expanded selection. Vendor Direct only has upside. It adds sales and gross margin and increases both customer satisfaction and traffic to the site. The 0 capital and inventory investment make for a very high ROIC rate.

Mobile. Mobile helps us create a better omnichannel experience for our customers, enabling them to shop more easily and frequently both in our stores and online. Our app is our customers' valued assistant for interacting with the Macy's and Bloomingdale's brands, and we continue to see significant increases in usage and conversion. Mobile remains our fastest-growing channel, and we have a regular cadence of new features with My Wallet, My Store and My Stylist. Many of these will improve the in-store customer experience like quick barcode pickups of online orders, localized product recommendations and in-store rewards that are exclusive to the app.

And lastly, Destination Businesses. Our 6 Destination Businesses, as a group, were up 5% for the second quarter with the strongest performance in fine jewelry, men's tailored and women's shoes. The 6 Destination Businesses account for nearly 40% of our total sales at Macy's, and all 6 are higher AUR businesses. All 6 continue to outperform the balance of the business on market share, return on investment and profitability. And we're putting additional resources behind these 6 categories to drive growth through great product, top-performing colleagues, improved environment and enhanced marketing. These destinations are the point of entry to the Macy's brand, and we see significant opportunity to drive cross-shopping, which is one of the competitive advantages of being a department store. While we're pleased with market share growth in these businesses that we've seen to date, we won't be satisfied until Macy's is taking market share overall, and we will get there business by business starting with these 6. So with these initiatives, the team are hard at work at implementing them, and we are confident that they will be important contributors to our back-half performance.

Bloomingdale's had a more challenging quarter driven largely by declines in international tourism. Women's and men's shoes in Bloomingdale's The Outlet were standouts in the quarter. And in the third quarter, we're going to be opening 2 additional Outlet stores. Bluemercury had another strong quarter. We've opened 3 new stores for a total of 167 stores across 26 states. Bluemercury freestanding stores and shops within Macy's stores both grew sales in the quarter with the shop-in-shops showing considerable growth. Bluemercury.com continues to have significant runway, growing double digits.

We will continue to innovate across all channels to strengthen relationships with our existing customers and to bring new customers into our brand. In July, we launched the second iteration of STORY at Macy's, Outdoor STORY. And we're pleased with the customer response so far. STORY brings in new customers and gives current customers another reason to visit more often. It also opens doors to new partnerships with local and niche brands as well as major players. For Outdoor STORY, we partnered with DICK's Sporting Goods and Scotts Miracle-Gro. And these collaborations allowed us to offer our customers unique products and experiences.

We're also testing opportunities in both recommerce and rental to tap into the changing customer behavior, especially among millennial and Gen Z consumers. This month, we began a pilot with thredUP, the world's largest fashion resale marketplace, in 40 Macy's doors across the country. We know many consumers are passionate about sustainable fashion and shopping resale. This partnership gives us the opportunity to reach a new customer and keep them coming back to shop an ever-changing selection of styles and brands that we don't typically carry. As it relates to fashion rental, we know that our customers want variety and discovery. Tapping into this, Bloomingdale's is launching My List, a subscription rental service, with our partner CaaStle. Learnings from Bloomingdale's will inform the development of a similar rental service at Macy's in the near future.

So as we look ahead to the second half of 2019, we are confident that we have the right plans in place to continue to grow our business. The second quarter gross margin was tough, but we now have the inventory at the right levels. We've laid down holiday 2019 as a must win for the entire organization, and we have the leverage we need to be competitive in today's environment. While consumer spending remains healthy, there are significant noise in the macroeconomy, tariffs, currency fluctuations, declining international tourism, to name a few. It's a dynamic situation and the team is prepared to respond to changes in the consumer environment.

As it relates specifically to tariffs, we're currently assessing the details that the U.S. Trade Representative's office released yesterday related to the fourth tranche of tariffs on goods imported from China. We have confidence that our scale gives us the leverage to find mitigation strategies that work for us, our vendor partners and our suppliers in China. We know from the earlier tranche of tariffs though that today's customer doesn't have much appetite for price increases.

So in closing, the first half of 2019 has been challenging, but I'm proud of the work the team has done to drive the business in this dynamic, external environment and course correct when needed. We are committed to delivering in the back half of the year. We remain focused on continued top line growth, market share growth and the growth of our customer base. But as importantly, we also have a clear line of sight into profitability growth and are hard at work on our productivity initiatives. Paula will touch on this shortly, and we will share more details together in early September.

While we know there is negative sentiment on our sector, we are confident in our plans. There is strong consumer demand for high-quality, affordable fashion. We are strengthening our relationship with our current customers and bringing new customers into the brand. Today's consumer demands the ability to shop anytime and anywhere, and we know we can deliver that convenience as an omnichannel retailer. We've stabilized the business and have a strong and aligned team. Our balance sheet is healthy, and we have the resources to invest to create long-term shareholder value.

Now I'm going to hand it over to Paula to review the second quarter and provide more detail on our outlook for the year.

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [4]

--------------------------------------------------------------------------------

Thank you, Jeff, and good morning, everyone.

While we achieved another consecutive quarter of positive comparable sales, we were not pleased with our overall performance. That said, we are fully focused on a successful fall season and confident in the benefits we expect to deliver in the second half of the year from our strategic initiatives and our Funding Our Future productivity program.

In the second quarter, we delivered sales of $5.5 billion, an increase of 0.3% on an owned plus licensed comparable basis. As Jeff mentioned, we saw strength within all of our Destination Businesses. We experienced some softness in the home category while ready-to-wear continued to be a challenge. We saw our strongest performance in the North Central region, and digital continued to deliver solid growth. International tourism sales were down approximately 9% in the quarter, accelerating the headwind sequentially.

It is encouraging to see that growth of total transactions continues to be a key driver of our positive sales comp and were up 5.3% in the quarter. Average units per transaction were down 1.8% as our Platinum customers purchased fewer units on average when they transact with us but, importantly, continue to spend more with us in aggregate. Our average unit retail was down 3% driven by the growth of Backstage, our heightened markdowns in the quarter as well as the challenging comparison to a very strong AUR performance in the second quarter of 2018.

We generated credit revenue in the quarter of $176 million, down 5.4% from last year and in line with our expectations. Our Star Rewards loyalty program continues to drive good momentum in our credit revenue with credit card penetration up 10 basis points to 46.7% in the quarter. However, there were slight upticks in fraud and bad debt. We monitor these metrics closely, and strategies are in place to mitigate our exposure over the balance of the year. We remain confident in our annual credit revenue guidance range, which remains unchanged.

Gross margin for the second quarter was 38.8%, down 160 basis points to last year. Combined, the additional markdowns just mentioned and the growth in delivery drove the vast majority of this decline. The increased delivery costs supporting online growth in our Star Rewards program were anticipated, and their impact in our margin was roughly equal to what we saw in the first quarter. However, it was the additional markdowns that were largely responsible for the much steeper decline in gross margin than we expected at the start of the quarter. With an inventory overhang to start the quarter and a tougher sales environment than we anticipated, our teams took the necessary markdowns to clear that excess spring inventory. While these markdowns resulted in a significantly lower gross margin in the quarter, we ended the quarter with comp inventory nearly flat at up 0.1% versus up 2.4% in the first quarter.

Taking the markdowns was certainly tough medicine, but it was important that we enter the fall season with aligned inventory and sales plans. We have achieved that, and we are confident in our plans to deliver more normal levels of markdowns in the back half of the year. Our confidence in protecting margin is supported by several factors. First, inventory is well positioned, and our fall receipt planning is much leaner, allowing us to maintain liquidity to use opportunistically as customer demand dictates.

Second, the majority of the unanticipated second quarter markdowns were related to women's sportswear private brands, which is now in a much improved inventory position and is being managed with much greater discipline. This is a problem that we can control. We put new leadership in place and are doing a deep examination of all aspects of this business, but it will take some time to get the sportswear business growing as healthily as other areas of ready-to-wear.

Third, we are being more strategic in our inventory allocation and marketing. For example, we continue to challenge the status quo to drive effectiveness and efficiency in our media, doing more with less. This includes simplifying our offers, leveraging strategic partnerships and improving our segmentation and targeting of customer. We have already taken several actions to simplify or eliminate less effective marketing promotions, saving us a few million dollars of incremental EBIT on an annualized basis.

And fourth, we are making good progress on our productivity initiatives. One initiative that we've discussed many times is hold and flow, which enables us to dynamically reallocate inventory in season based on need, resulting in fewer markdowns and out of stocks. The initial results of our tests have been encouraging. We found that hold and flow products on average generated more than $4 of incremental margin at a cost of $2, a net benefit of more than $2 each that could translate into tens of millions of dollars of incremental EBIT on an annualized basis. This gives us great confidence in operating the program at scale during the fall, and we expect to see significant EBIT benefit as a result. Additionally, we're enhancing our data analytics capabilities and getting to a more granular understanding of pricing and markdown decisions, which will also enhance our margin. We are now rolling out our new pricing capabilities at scale following our successful spring test, also with sizable EBIT benefits expected.

Moving on to SG&A. We recorded $2.2 billion of expense in the quarter, an increase of $13 million or 50 basis points on a rate basis over last year. The increase in SG&A dollars was primarily driven by investment in our strategic initiatives. As a reminder, given the front-loaded nature of these investments, we continue to expect the growth in SG&A year-over-year to be weighted towards the spring season and the benefits of the $300 million in restructuring and normal ongoing cost reductions that we previously discussed to be weighted more towards the fall season. Interest expense continued to benefit from lower debt levels and our balance sheet remains healthy. While our effective tax rate was 25.9% in the second quarter, we expect it to be 23% for the year. The variance is caused by certain normal and discrete tax benefits that occur unevenly through the year.

Summing it all up, we delivered $88 million of adjusted net income in the quarter versus $219 million last year. Included in these net income figures are asset sale gains of $5 million and $34 million, respectively. Adjusted EPS was $0.28 in the quarter compared to $0.70 last year, of which asset sale gains represented about $0.01 and $0.11, respectively. Year-to-date, cash flow from operating activities was $350 million compared to $544 million last year. The variance is due to lower merchandise payables and adjusted EBITDA offset by lower tax payments. Capital expenditures were $501 million compared to $408 million last year. We remain on track to achieve our existing guidance of approximately $1 billion of capital expenditures. Cash used by financing activities was $239 million less than a year ago as we paid down less debt this year than we did last year.

Here is our guidance. For the full year, we continue to expect approximately flat total sales growth and comps of flat to up 1% on an owned plus licensed basis. We are confident that we can deliver in the upper end of the sales range. We will be at full strength with our strategic initiatives. We have learned from our challenges during the holiday season of 2018, and consumer spending continues to be healthy, although, as Jeff noted, we are mindful of being up against some macro uncertainty, which our full guidance range contemplates.

Looking at the fall season sales specifically. We expect the fourth quarter comp to be meaningfully greater than the third quarter comp. In the third quarter, we will be cycling our toughest comp sales comparison of the year, in large part, due to the benefit we saw from cooler temperatures last October. On the flip side, in the fourth quarter, we will be cycling the disruption caused by the fire in our West Virginia mega center and the underperformance of our pre-Christmas promotional event. Gross margin in the fall season is expected to be down slightly to a year ago. Our confidence in this trend improvement is based on the 4 factors I mentioned earlier: inventory parity, merchant team liquidity, enhanced precision in our fall promotion and our productivity program.

Regarding inventory, we are expecting it to rise as we end the third quarter as we are intentionally bringing in receipts to support early November sales and the truncated holiday season. We still expect to be below last year by the end of the fall season. As we look at asset sale gains planned for the back half of the year, we anticipate the balance of our $100 million guidance to occur in the fourth quarter. We now expect adjusted EPS to be in the range of $2.85 to $3.05 or $2.60 to $2.80 when excluding asset sale gains. Any potential impact from a fourth tranche of tariffs is not contemplated in our guidance as we are still processing the details released yesterday, as Jeff noted. We are in active discussions with our vendors and suppliers to mitigate tariffs and minimize customer impact in 2019 as much as possible, and we'll know more in the coming weeks.

With respect to our overall guidance, we are confident in the outcome of what we can control. We are also mindful of what we cannot control, and we are providing guidance with prudent ranges that are cognizant of the current macro uncertainty. You can find our complete guidance in the slide presentation we posted on our website earlier this morning. As we commit it, we will be sharing more details on our Funding Our Future productivity program in early September. I, along with Jeff and Hal Lawton, our President, will lay out our productivity strategy more fully, including detail on the 6 work streams and anticipated total savings over the next 3 to 5 years.

To wrap up, while the second quarter was indeed a challenge, I'm confident that we're on the right track to accomplish both our short-term and long-term objectives. We've strengthened our balance sheet through steady debt retirement, and it is in a healthy position that allows us additional flexibility. We're making the right investments in the business, and we're hyperfocused on profitable growth. We're making good progress on the initiatives that will enhance both customers and shareholder value. Our strategic initiatives are growing our sales. Our productivity program will transform the way we work, and diligent inventory management and capital allocation are top of mind day in, day out. We're improving our management disciplines every day with data analytics, better tools and better processes. And we have a strong team that is working together to win every day.

With that, Jeff and I will be happy to take your questions.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) We will take our first question from Matthew Boss with JPMorgan.

--------------------------------------------------------------------------------

Matthew Robert Boss, JP Morgan Chase & Co, Research Division - MD and Senior Analyst [2]

--------------------------------------------------------------------------------

So Jeff, you're seeing comp lifts from Growth 50 stores and Backstage. You cited comps up mid-single digits at your 6 Destination Businesses and also commented that the consumer spending remains healthy today despite some of the crosscurrents. I guess higher level, what's preventing better aggregate comps today at Macy's? And if consumer spending were to take a step down in the back half of the year or into next year, what's your confidence in sustaining positive comps?

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [3]

--------------------------------------------------------------------------------

So Matt, we -- I think you hit the headlines about what is good in our business right now. The one you didn't mention was that digital overall is quite strong really led by mobile. But when you look at the other pieces of the business that are a challenge right now, ready-to-wear, particularly ready-to-wear sportswear, and some of the soft home categories definitely depress the strength of those winning categories to the comps that we're quoting. So when you look at the quarter, the quarter definitely got off to a slow start. And you see the combination of factors that we're quoting on that, that led us to the decision that where we expected strong sell-through, stronger sell-throughs in seasonal product, that didn't happen as we worked all the way through May and into early June. So we made the decision mid-June to take the appropriate markdowns so that we enter the fall season with the right inventory levels on all of our spring and summer. And we were able to flow all of our fall products that we have a lot of confidence they're going to get us ready for the fall. So we now have our inventory in line. We took the medicine. It did affect our overall gross margin by a full point in the second quarter.

Now let me take you through why we're confident about the back half of the year. So first off, we're entering the back half of the year with a comp above 0.5%. We've guided the full year at flat to up 1%. We just -- to mention what Paula just said, we do expect that the fourth quarter is going to be meaningfully better than the third quarter. Third quarter last year, we -- was our strongest quarter. And that mostly was buoyed by the cold weather that we had in the month of October. The month of October was a very strong month for us. But on the flip side, as you remember, from the fourth quarter of last year, we're cycling all the disruption that we saw in the fire as well as the promotional event change that we made. And what we quoted last year was that it was about a 70 basis point degradation to the fourth quarter comp. So we're lapping that. So the holiday 2019, we're very focused on that. The entire organization is aligned and engaged to make that happen. It's a must win for us. And we have a lot of confidence in looking at our content, looking at our promotions. We take every opportunity to test what's going to be important in the fourth quarter. So you saw just now in the Black Friday in July, we were really testing item price velocity, using all of our analytics [capabilities] to make sure that we've got the right items built. We're very confident in our seasonal hiring, our entire fulfillment network, what we're doing with customer events and engagement. We also know that our digital business is a much higher penetration in the fourth quarter than the other 3 quarters. It penetrates higher. It's worth about 90 basis points of comp in the fourth quarter.

And just lastly, Matt, to give -- what gives us confidence is that we're bringing into the fall the full complement of all of the strategic initiatives in 2019 that we've been building and we’ll be building and complete by the end of October. So that comes with us. And that's why we're confident that we're going to have a positive comp in the fall season to add to the positive comp that we had in the spring season.

--------------------------------------------------------------------------------

Operator [4]

--------------------------------------------------------------------------------

(Operator Instructions) We'll take our next question from Kimberly Greenberger with Morgan Stanley.

--------------------------------------------------------------------------------

Kimberly Conroy Greenberger, Morgan Stanley, Research Division - MD [5]

--------------------------------------------------------------------------------

Jeff, I wanted to just ask about the store base and how you're thinking about it. You talked about the brick-and-mortar fleet being healthier. I'd love to hear what you mean by that. It would seem if the digital business is still growing double digits, it would seem that the stores are still negative. But as you look at the fleet, what is it that you're seeing that's healthier? And do you need to take another look at your store base with maybe a potential eye towards some additional store closures?

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [6]

--------------------------------------------------------------------------------

Yes, Kimberly. So let's just talk about stores in general. So just to repeat our store segmentation strategy, so we have our flagships, which include Herald Square; we've got our magnet stores, which really are touched on by our growth initiatives; and then we have our neighborhood stores, which are very important for fulfillment and convenience for our customers that live in those localized areas.

So we really have a line of sight on what growth looks like for magnets and flagships. The growth strategy really led by our Growth 50 gave us all the confidence in getting growth out of those buildings. We talked about how those Growth 50 stores have outperformed other stores in the Growth 100 by 3 full points. Those stores are positive comping. The customer engagement in those particular stores is much higher than our other store fleet. So what we've done is we have applied all of those learnings to the next 100 stores, which is what we call the Growth 100. And what you're quoting, that Growth 150, which will be complete by the end of October, touches about 50% of all of our brick-and-mortar sales.

Separate from that is what you have -- many of our flagships that are classified differently that add to that 50%, clear line of sight about what we need to do to make those better. So we've got a lot of initiatives with what we're doing with new experiences like b8ta and Market and STORY, trying new concepts like thredUP that are all adding new opportunities in these stores. Many of these stores are touched by Backstage. The neighborhood stores, I would expect those to continue to negatively comp, but they're becoming more profitable because we're operating them more efficiently, with less square footage. The customers are really using them big for fulfillment, a higher percentage of their sales are moving through fulfillment. So we're handling their expectations in those particular stores.

We're always looking at our portfolio to look at does it make sense? We're never going to say we're done, but we do believe this national footprint that we have. We're servicing a national customer. We know that when we close a store, we're firing customers. We lose their business online. We'll make all those decisions very carefully. So this segment dictation strategy really serves a customer that shops between our stores, satisfying her needs. It also satisfies how we're building the omnichannel business through digital and mobile. And so we'll be very careful about any Exodus that we do in future store closures.

--------------------------------------------------------------------------------

Operator [7]

--------------------------------------------------------------------------------

Our next question comes from Lorraine Hutchinson with Bank of America.

--------------------------------------------------------------------------------

Lorraine Corrine Maikis Hutchinson, BofA Merrill Lynch, Research Division - MD in Equity Research and Consumer Sector Head in Equity Research [8]

--------------------------------------------------------------------------------

I wanted to follow up, Jeff, on the comment you made about the consumer not wanting to see price increases. And can you just give us a little bit more information on your expectations around the tariffs? What are the mitigation strategies? And are price increases off the table for you? Or will you try to do some selectively?

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [9]

--------------------------------------------------------------------------------

So let me just tell you what our experience has been. So obviously, tranche 1 and 2, there was no significant impact. In tranche 3, there was very limited impact when it was at 10%. But on May 10, that went to 25%. And so we did play with selective price increases in categories like luggage and housewares and in parts of furniture. And we learned from that experience that the customer had very little appetite for those cost increases, so we had to make adjustments.

So I -- to answer your question, Lorraine, I think when you're talking about tariffs going to 25%, then you get into what do you do, how are you working with your vendors, how do you get more make and value into those products that gives you the permission from a customer's perspective because of how they're looking at the value of those goods to raise prices. So when we're thinking about tranche 4, we've had some time to digest this. Even into this morning, we're looking at which of the remaining pieces that are touching our business that come in from tranche 4 are being affected as of September 1 versus December 15. I would tell you that we are looking at no price increases on any content that is touched by tranche 4.

So we're looking at what is our risk for the way that it's now been because you've got some categories based on 1 fiber that come -- that's being taxed by -- on September 1 for this other same category, but different fiber that is being affected as of December 15. So looking at all of that and rolling it, I think we recognize that our risk to annual guidance in 2019 would be no more than $0.05. I think on a long-term basis, we believe that we will work through solutions on 10%. We're working closely with our manufacturing partners. We're leveraging our scale and our strong relationships with our sourcing partners as well as our vendor partners who source out of China. So I think that 10% is manageable in the short and long term. I think when it goes to 25%, you're dealing with a whole other series of dynamics that I would not say we wouldn't have to raise prices.

--------------------------------------------------------------------------------

Operator [10]

--------------------------------------------------------------------------------

And our next question comes from Paul Trussell with Deutsche Bank.

--------------------------------------------------------------------------------

Paul Trussell, Deutsche Bank AG, Research Division - Research Analyst [11]

--------------------------------------------------------------------------------

I wanted to circle back on to the digital business, which is performing well. You mentioned that the mobile business did over $1 billion last year. Just curious on any update on the total size that you're driving now through e-commerce. And also on Vendor Direct, maybe discuss in a bit more detail the type of product and SKUs that you've been adding to the website as you expanded the assortment. And now that Vendor Direct is 10% of sales, I mean help us understand how much the Vendor Direct business is driving the e-commerce growth and also how you're accounting for that in terms of taking on the wholesale versus a take rate in your top line.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [12]

--------------------------------------------------------------------------------

All right. Paul, so let me take you through mobile first. So no surprise, mobile is our fastest-growing channel. So what we told you last year, $1 billion in sales. We expected it to grow 50% in 2019. That would get it to $1.5 billion. We're on track for that when you think about our performance in 2000 -- in the first half of the year. So when we get into Vendor Direct, on this one, we're on track. What we said was that we had a goal of adding 1 million SKUs. We're halfway to that goal. So we've added 450 new vendors, 640,000 of new SKUs or -- of that 640,000 new SKUs. So we're -- we started really primarily in home, and we're now implementing more broadly. We're expanding to the full catalog of our brand partners. We're also adding new categories that we look at failed searches and really what our customers expect of us.

We always look at what our competitive set is. And as we've mentioned, our peers have a larger ratio of SKUs online to SKUs in store. So we have ways to go here. But I think the benefit of this is it's giving our customers an endless aisle. This is all really driven by data-driven personalization, and it's given us -- we have to make sure that we're hitting Macy's high standards of quality and customer satisfaction. I think in aggregate, I see nothing but upside with Vendor Direct. I don't -- I'm not going to speak to where we see it going over the long term, I'll tell you in kind of yearly increments. But we're on track to achieve all of our objectives. I think that it adds sales. It adds profit. It increases satisfaction and traffic to the site. There's minimal capital and no inventory investment. So it really makes for a high ROIC rate. And so when we quote our digital business being up double digit, that includes what we're doing with mobile, that includes what we're doing with Vendor Direct. And we can see continued growth in the entire digital channel with these -- with mobile and Vendor Direct being 2 of the big accelerants.

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [13]

--------------------------------------------------------------------------------

And so just to clarify on the accounting, Paul, to your question as well. This is a wholesale model from an accounting perspective, so it adds sales. It adds gross margin. As Jeff said, there is no inventory, no capital. So it's really quite good in comparison to, say, owned. It's similar gross margin. It just depends on the categories that you select in terms of what the actual gross margin is. But again, no inventory, no capital makes for a very strong ROIC. And so this is all good.

--------------------------------------------------------------------------------

Operator [14]

--------------------------------------------------------------------------------

Our next question comes from Chuck Grom with Gordon Haskett.

--------------------------------------------------------------------------------

Charles P. Grom, Gordon Haskett Research Advisors - MD & Senior Analyst of Retail [15]

--------------------------------------------------------------------------------

Just wondering if you guys could unpack for us the compression in gross margins in the second quarter. I think it's around 100 basis points for markdowns and 60 for delivery. Just wondering if that's correct. And I guess if you can just hold our hand for the third and fourth quarter, what offsets you could have against that 60 basis point delivery headwind?

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [16]

--------------------------------------------------------------------------------

Yes. So just again, just to step back a little bit on gross margin. When we last talked to you in May, our margin guidance factored in our expectations around the delivery expense, the pressure from that related to our growing digital business and the Star Rewards program as well as the clearance of the excess spring stock that we had at the time. As we moved deeper into the quarter, it became clearer, as Jeff mentioned, due to the factors that he mentioned, the fashion miss in key women's sportswear private brands, the slow warm weather products sell-through, the accelerated decline in international tourism that we needed to take the fast action to put us in good shape for the fall season.

And then just keep in mind that this was a fashion apparel that had in and out dates that we really needed to hit. And so when the sell-throughs did not improve as the quarter went on, we took these additional markdowns that got our inventory down to nearly flat on a comp basis, which is a really good place to be as we head into the fall season.

So just a little bit on the numbers. The gross margin, as you noted, was down 160 basis points. Again, that's about 90 basis points, almost a full point that was related to the additional seasonal markdowns. And the rest of it relates primarily to delivery headwinds, which is consistent with what we saw in the first quarter and was consistent with our expectations. So we took the markdowns thoughtfully. And as we're entering the fall season, our inventory levels and mix are in line with what we expect our customer demand to be.

And then just while we're on the topic, let me give you the thoughts on how we're looking at the fall. So I'll just reiterate the 4 points that I made earlier that give us confidence in the fall gross margin improvement. So Private Brand women's sportswear is in a much better position, and we're allocating inventory more strategically and with better tools as we head into the fall season. Receipt planning is leaner, and we will have merchant liquidity as we move through the fall season to buy opportunistically. So we're -- we feel good about that. Our fall promotions are more precise, again, better tools there. And the productivity projects that we've been testing up to this point and sharing with you, like hold and flow and markdown optimization, they really are ready to scale in the fall. And so we anticipate benefits coming from those as well.

And then just regarding the guidance, just in general, as you know, we didn't change our sales guidance. We finished the spring season with the comp above 0.5%. And as Jeff mentioned before, we have confidence in our fall strategies to continue the positive trend. So if we hit the upper end of our sales range, we see gross margin down slightly. And then to be prudent, if sales are at the lower end of our range, we would expect the gross margin rate to be a bit worse. But as I've said, we are confident in the fall plan.

--------------------------------------------------------------------------------

Operator [17]

--------------------------------------------------------------------------------

Next question comes from Jay Sole with UBS.

--------------------------------------------------------------------------------

Jay Daniel Sole, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst of Softlines & Luxury [18]

--------------------------------------------------------------------------------

Jeff, let me ask about your comment that I think you said that you see the risk of the annual guidance for 2019 to be no more than $0.05 from tariffs. Could you talk about the algorithm to get there? Is it that you feel like that if you don't change prices, the vendors basically absorb all the price increases? Or is there an element of maybe gross margin will be a little bit under pressure, but you can offset it with SG&A? Any help around that would be great.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [19]

--------------------------------------------------------------------------------

Yes. So on that, Jay, we've got -- we're looking at our own private brands where we bear the full risk of any changes that we make. And so we've looked at that. We're obviously talking very intensely with all of our vendor partners and have been really on the whole subject of tariffs for some time now. So we've gotten into a good place in terms of what price increases they are going to foist on us, what they are absorbing themselves or what they’re believing they're getting concessions from their own sourcing partners. So I think those are kind of in the -- we're looking at that in 3 parts. We're looking at what we are doing in our own private brands, what that means. And as I mentioned, what we have found is there's no customer appetite for price increases. So what are we going to do to mitigate that? And so in the short run, where we've already taken our mitigation strategies, we believe that we might have additional risk of up to $0.05 when you look at between our brand partners and our private brands based on what we learned yesterday. That would be for the balance of 2019. We're hard at work that if we continued with all of the 10% tariffs that are landing as of mid-December onward, we are looking at opportunities to mitigate that in 2020 and beyond. And we'll keep everybody posted as we work through all those scenarios.

--------------------------------------------------------------------------------

Operator [20]

--------------------------------------------------------------------------------

The next question comes from Paul Lejuez with Citi.

--------------------------------------------------------------------------------

Paul Lawrence Lejuez, Citigroup Inc, Research Division - MD and Senior Analyst [21]

--------------------------------------------------------------------------------

Can you talk about how big Vendor Direct was as a percentage of e-comp sales this quarter versus what it was in the second quarter of last year? Also, what the plan is for the second half, how much of a growth driver that can be to the comp? You did mention, just secondly, second quarter was off to a -- got off with a slow start. Curious if you could make any comments about how 2Q finished and how 3Q started.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [22]

--------------------------------------------------------------------------------

What I'd say on it, Paul -- let me take the first. We're not quoting what Vendor Direct is through the first half of the year. We'll definitely give you that at the end of the year. As mentioned with the previous caller, it was about 10% of the business for 2018. It is growing at a rate bigger than the average of overall income, which is double digit. So we don't break that out in kind of midstream on that.

As to how I characterize the sales flow within the quarter, it started out very slow in the month of May. And so the month of May was -- we don't often talk about weather, but in the month of May, it was particularly cold and it was particularly wet and it was across the entire country. So generally, with weather, you get some pockets of the country that are experiencing warmer weather than others, and they kind of cancel each other out. In this particular month, it was pretty tough across the board. So that's really the whole conversation about. Those are really important weeks in sell-through, in seasonal goods like spring and summer fashion deliveries, particularly shorts, tanks, tees, those types of deliveries. So very important that we responded to that. It did get better in the month of June, and the positive continued into the month of July. So what I would tell you is tough May, got better through the course of the remaining 2 months, which led to our positive comp for the total quarter.

--------------------------------------------------------------------------------

Paul Lawrence Lejuez, Citigroup Inc, Research Division - MD and Senior Analyst [23]

--------------------------------------------------------------------------------

And anything on 3Q?

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [24]

--------------------------------------------------------------------------------

I'm sorry?

--------------------------------------------------------------------------------

Paul Lawrence Lejuez, Citigroup Inc, Research Division - MD and Senior Analyst [25]

--------------------------------------------------------------------------------

Thoughts for 3Q?

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [26]

--------------------------------------------------------------------------------

Yes. We don't comment on in-quarter results, as you know, Paul.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [27]

--------------------------------------------------------------------------------

What I'd say, Paul, is that what we said earlier was that we do expect that the fourth quarter is going to be meaningfully better than the third quarter from a comp perspective.

--------------------------------------------------------------------------------

Operator [28]

--------------------------------------------------------------------------------

Next question is from Alexandra Walvis with Goldman Sachs.

--------------------------------------------------------------------------------

Alexandra E. Walvis, Goldman Sachs Group Inc., Research Division - Research Analyst [29]

--------------------------------------------------------------------------------

I had a question on tourism. You mentioned that sales to foreign tourists were down 9% in the quarter. I wonder if you could give a little more color on that and whether the shape of that tour spend has been changing over the last few quarters. Is it more a function of traffic or more a function of bucket size there and how are you expecting that to trend?

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [30]

--------------------------------------------------------------------------------

Alex, let me give you some context on international tourism, so -- and how it affects our business. So it is a significant driver in volume in 40 of our Macy's and Bloomingdale's stores. So it's the gateway cities. And many of these stores, virtually all of them, are really touched by our growth initiatives. So we're built and ready in both Bloomingdale's and Macy's for those markets. When you look at these international tourist sales, they're really some of our best transactions because they're higher AUR, they're more apt to buy full price and there's virtually no returns. So it's a very high-margin sale that you're dealing with here.

So as we mentioned, we -- our business across Bloomingdale's and Macy's was down 9% in the second quarter. And that was an acceleration from our trend from the first quarter where we were down 3%. Now we are lapping 4 now consecutive quarters of negative comps. So we're going up against a easier fall compare than what we were up against in spring. And so I think we're -- we get -- we're pretty good at this. We see that international tourism always has its ebbs and flows. This decline is not unprecedented. We've navigated through this before. But just to be on the prudent side, we took our comp from the second quarter, and we pulled that all the way through our fall expectations just to be prudent. So even though we were up against a negative -- a much easier comp in the back half, we did pull that through just to be prudent. And then where we're really focused in these 40 stores is what can we do to offset that, the international tourism. So we're really focus with those teams and our corporate teams on how we get more domestic tourists and how we really win more local customers in these very important doors. So then when you look at the composition by country, certainly, Brexit is affecting us, China is depressed. There's always ins and outs depending on what country. But I'm calling it as I see it right now. We're taking the trend from the second quarter and carrying that through the back half.

--------------------------------------------------------------------------------

Alexandra E. Walvis, Goldman Sachs Group Inc., Research Division - Research Analyst [31]

--------------------------------------------------------------------------------

Great. That's super helpful. And then one more here for you and in some ways related. I wonder if you could comment on trends in the New York market. I'm sure that tourism is having an impact there. But I wonder if you could also comment on the incremental supply in this market, as there's been a few new openings of retail areas. There's some more coming up. How are you thinking about the New York market in that context?

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [32]

--------------------------------------------------------------------------------

As expectations, if you look at the Manhattan, we have seen little change in our business at both Bloomingdale's and Macy's as a result of the new competition coming in there. We have -- some of our best-performing stores are in the Metro area. And I would attribute that to customer satisfaction scores being up, growth initiatives being in place. So where we have fought hard in those communities, we're winning. And that's not different in New York City or New York Metro versus other parts of the country. So Bloomingdale's is while they had a more difficult quarter, where they're making investments, you see it in New York City, they're having great strength in all of the areas of the Bloomingdale's 59th Street store that they renovated. Very happy with the -- that we've seen very little effect with the competition increasing in Manhattan with Bloomingdale's 59th Street. So I would say the Metro area is unaffected by what you're describing.

--------------------------------------------------------------------------------

Operator [33]

--------------------------------------------------------------------------------

Next question comes from Omar Saad with Evercore ISI.

--------------------------------------------------------------------------------

Omar Regis Saad, Evercore ISI Institutional Equities, Research Division - Senior MD and Head of Softlines, Luxury & Department Stores Team [34]

--------------------------------------------------------------------------------

I wanted to ask some follow-ups on inventory, but maybe a little bit more from a structural standpoint. Jeff, could you talk to -- and I'm following another kind of buildup in inventory and the need to markdown to clear it. Could you talk about why Macy's maybe hasn't seen more benefits from technology, using technology to run the business with less inventory, omnichannel capabilities? Is that something we can look forward to in the future around inventory? And then you also mentioned Vendor Direct, the returns efficiency of that model where you don't have to own the inventory. As you think about your physical business as well, is there an opportunity to do more concessions, marketplaces, at least with some of your big vendors where you can -- they can run the business, owning the inventory and create working capital opportunities for Macy's in that way as well? Maybe you could address those things.

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [35]

--------------------------------------------------------------------------------

So I'll go ahead and start on this question, Omar, and then Jeff, if he wants to add, can do so. So one of the biggest things that we're doing with Funding Our Future is developing more tools to manage our inventory and our supply chain in a much smarter, more efficient way. And so it's very much powered by technology. And we already use advanced fulfillment logic to get our customers their products in the quickest amount of time at the lowest cost for us and with the most effective inventory strategy. We use a combination of our mega centers, stores, vendor partners to offer the customers the best experience while allowing us to move inventory efficiently and cost effectively. And we're taking that a step further by taking inventory position and markdown risk into consideration as we make fulfillment decisions using data analytics. So we're really excited about our supply chain and the transformations that we're seeing.

We're also getting ahead right now with the peak holiday season by allocating more of the high-volume inventory and distribution centers to operate at full capacity and using our store fulfillment logic and options more effectively. And we're also sort of efficiently consolidating BOSS shipments to stores to reduce shipping costs. So when we think about the supply chain transformation and Funding Our Future productivity, there are a lot of different initiatives that sort of fall under that.

In addition, in terms of inventory management, we are applying data science or data analytics to our markdowns and pricing so that we can really measure the price velocity, how the inventory is moving at what prices and really get very, very smart -- smarter about how we manage our inventory. But this is a really big opportunity for us.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [36]

--------------------------------------------------------------------------------

Just to add one thing, Omar, to what Paula just said. I think the thing that we're most excited about with markdown optimization is the ability in fall season to do that at a store level. So we've been doing it at the zone level. We're now -- we've tested it and we're now ready with all of our technology to be able to do that at a store level, which is really going to help take markdowns on certain SKUs where you don't need to or you go to different levels where that's prudent. So that's going to help us with overall margin both in sales as well as gross margin improvement with markdown optimization.

And then the second part of your question about what are you learning from Vendor Direct and shifting some of the economic burden into lease or hybrid models, that is definitely always -- we're always looking for opportunities with that. And so when you look at what we learned from the market kind of retail as a service, we don't own any of that inventory. We basically are renting space that a -- and we're doing that through the -- our partnership with b8ta. And so that platform is really running all the kind of amalgamation of different retailers that are coming into that space. They basically pay a fee, basically, to be a part of that. And that's giving customers new opportunities, new things for them to see, but with no risk to us. When you think about lease, always looking at different lease options. The Bloomingdale's lease percent of their overall business is higher than Macy's. I know that Macy's will go higher over time, and we're looking for opportunities there. We definitely although always want to make sure that whatever we're doing with lease gives us the opportunity to make shifts where customers go. And so making sure that we're not tying ourselves into long-term commitments that may not be customer-focused. So we're always looking at this and expect this to continue.

--------------------------------------------------------------------------------

Operator [37]

--------------------------------------------------------------------------------

Next question comes from Oliver Chen with Cowen and Company.

--------------------------------------------------------------------------------

Oliver Chen, Cowen and Company, LLC, Research Division - MD & Senior Equity Research Analyst [38]

--------------------------------------------------------------------------------

You've been really innovative, Jeff, in thinking about recommerce and subscription. You've done a lot of work here with thredUP. Why is now the right time? And what are your thoughts on balancing your relationship with thredUP and CaaStle against your vendor matrix and also thinking about consumers looking for new items and the cannibalization risk balancing that against the opportunity?

And, Paula, just a quick follow-up. The precision in the fall promotions and thinking about that, sometimes the challenge can be in making sure you still get your fair share of traffic when you alter promotions. Would love your thought on how you're balancing the precision against the traffic risk.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [39]

--------------------------------------------------------------------------------

So, Oliver. Let me go first on your questions about kind of recommerce and rental. This is a -- when you think about kind of acquisition strategies, we have a very developed core customer who loves our brand, and we just got stickier with her decisions about shopping with us with our loyalty program. We've got a customer base in what I would call bucket 2, which is an occasional customer, that we're trying to get them to migrate up in their spend; and then we've got an entire acquisition strategy. And when you look at acquisition, recommerce and rental is really at the heart of that. And so there is many customers that love from a sustainability perspective as well as just having new content at great prices. They love what The RealReal is doing or in the case of our customer, what thredUP has been doing for some time. And so when we met with James and really said, "Okay. What's our opportunity?" He was looking at opportunities with brick-and-mortar and his own -- or partnerships. And this was a good connection for us to come together. So we're doing it now. It's rolling in. We're doing it for the back-to-school time frame, in 40 doors, is really when it's starting. And I would tell you that with the products that are selling best or those that we don't currently carry. So to your question or concern about how do your in-line vendors feel about it, it's just giving these customers additional brands that we don't carry at great prices. So I'm very encouraged. We're testing it in different parts of the store, where it's best -- how it's best received. So we're going to be -- we'll have a full analysis of it as we get through the fall season, but I'm very encouraged by this.

As it relates to rental and what you see with what Bloomingdale's just announced, which is My List, and our partnership with CaaStle, we needed to play in this game. And I'm really happy with what Tony and Denise and their teams created here. And they -- this has been under development for about 1.5 years. I think it's got some unique characteristics, but it takes the full complement of strengths of contemporary vendors at Bloomingdale's. The vendors themselves are thrilled to be a piece of -- to be a part of this. So -- and then the broader play would be what does this do to inform a similar opportunity in Macy's future. So staying on kind of the acquisition, we're really focused on digital-first strategies, what that means with influencers, what we're doing with our own colleague population with Style Crew, reinventing beauty with respect to Instagram. So these initiatives, I think, really help us with acquisitions.

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [40]

--------------------------------------------------------------------------------

And so in terms of your question regarding balancing precision and traffic risk, so what I meant by that is that we're really using better tools, better data to understand all of our promotions in terms of what's working and what's less effective. And so we're simplifying our promotions. We're measuring how effective those are, what kinds of results and outcomes they deliver. We're delayering, where it's appropriate, our promotions. We're partnering to get better data around the outcomes of our promotion. We're segmenting the customers and looking at how we target different customers with different promotions. So that's the piece that I mean when I say we're doing this with greater precision. And we are balancing that with the outcomes, outcomes like traffic and ultimately, what sales these promotions drive. So we're getting better at that. It's just another way of how we're using data and data analytics to support our decisions.

--------------------------------------------------------------------------------

Operator [41]

--------------------------------------------------------------------------------

And our next question comes from Bob Drbul with Guggenheim.

--------------------------------------------------------------------------------

Robert Scott Drbul, Guggenheim Securities, LLC, Research Division - Senior MD [42]

--------------------------------------------------------------------------------

Just a couple more questions. On the thredUP relationship, how much square footage are you allocating in the 40 stores that you're doing? And the overlap with Backstage versus thredUP, and I guess if you could talk about that. And then just a question on national brands like you had some pressure in your private brands, but I was just wondering if you could comment on national brands and maybe even denim a little bit as a category.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [43]

--------------------------------------------------------------------------------

Okay. So square footage in thredUP is approximately 500 square feet in each of these 40 stores, very little impact. It's -- when you look at the content of Backstage, the content of Macy's, the content of thredUP is mostly discrete. So when you look at thredUP, we obviously gave them a list of vendors that we don't need products because we've either got them expressed in Backstage or in Last Act or as part of our regular portfolio. So we're really -- we're merchandising into where we saw holes in our inventory with this recommerce play. And this idea that it was preowned is very attractive to many customers not just because of the price, but also because of the sustainability. So that's how we approach that.

When you talk about national brands, like anything, you've got some national brands that are totally on the pulse of their customer, and they made all of the right decisions from a value and a content perspective, and they're winning, and others that are finding their way where their customer shifted and they're having to make adjustments. So I wouldn't characterize one series of vendors one way or another. It really depends on the business that you're in and where they are in their own evolution.

And so that's how I'd -- and then with respect to denim, what I'd tell you is that when I look at denim from the second quarter, there were really positions of strength in a number of areas. When you look at our kids business, our kids business is one of our standouts in the first half of the year. And some of that was as a result of denim. And then denim is mixed in the women's apparel area and doing quite well in men's.

--------------------------------------------------------------------------------

Operator [44]

--------------------------------------------------------------------------------

Our next question comes from Michael Binetti with Credit Suisse.

--------------------------------------------------------------------------------

Michael Charles Binetti, Crédit Suisse AG, Research Division - Research Analyst [45]

--------------------------------------------------------------------------------

Can I just ask on the categories that you guys spoke about, what confidence is there in -- I guess what's different between the spring and the fall women's apparel trends? I know you got -- you said you're confident that you're clean on inventory. But I'm trying to figure out what you see that helps boost your confidence the new assortment can drive improved traffic? And then just sticking with the top line for a second, I want to ask about the comps again. Paula, maybe can you help us -- should we think about 3Q comps within the full year range of flat to up 1%? Or should we be thinking more like 3Q comps negative switching to positive in 4Q. Just help us understand some of the dimensions.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [46]

--------------------------------------------------------------------------------

So, Michael, let me start. So what I'd tell about ready-to-wear is that ready works really in kind of 2 pieces. There's the classifications piece, which is dresses, suits, activewear, coats, swim. Those, in aggregate, are showing really healthy growth. And they've been strengths of Macy's. We see those continuing all the way through the back half of the year. When you look at sportswear, which is where we had our problem with private brands in sportswear, which is the bulk of that business, the bulk of our sportswear business is private brands. What I'd tell you is that we're in a really good inventory position for the right expectation for fall season. So what I would expect those -- it's -- this is not a rapid turnaround. I would expect that the trend that we have experienced in the sportswear business will continue through the back half of the year without the inventory overhang that's going to create a margin problem for it. So that's how I would characterize ready-to-wear.

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [47]

--------------------------------------------------------------------------------

And so what I'd say about the quarters, Mike, is that we don't guide the quarters, as you know. But as I said earlier, we do expect the fourth quarter to be meaningfully better than the third quarter. And so Q3 could be outside of our annual guidance range. So I would think about it in that way.

--------------------------------------------------------------------------------

Michael Charles Binetti, Crédit Suisse AG, Research Division - Research Analyst [48]

--------------------------------------------------------------------------------

Okay. If I could just ask a follow-up, maybe an easier one on the SG&A leverage in the second half. I know you've got some cost initiatives flowing through, and you have a little better control over that after some investments in the first half. So I guess the sales do come in above the plan. How should we think about SG&A relative to your guidance? And then if sales come in light, do you have more room that you can pull back on SG&A? Or are there still some fixed costs from the initiatives running in there that make it a little bit inflexible if sales are to the downside of the plan?

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [49]

--------------------------------------------------------------------------------

Sure. I would just repeat our guidance. In terms of SG&A at the high end of our guidance, we would expect the performance to be better in the fall than in the spring. And again, as you know, our expenses are weighted more heavily to the first half of the year because we began our investment earlier in the year and will benefit from expenses later in the year. Sales are higher. Then that -- you would see that in our SG&A leverage. If sales are lower, yes, we always manage our expenses prudently and think about different sales scenarios and what we would do there. And so we've demonstrated that we can flex ourselves in different sales environments -- or flex our expenses in different sales environments.

--------------------------------------------------------------------------------

Operator [50]

--------------------------------------------------------------------------------

The next question comes from Brian Callen with Bank of America.

--------------------------------------------------------------------------------

Brian Douglas Callen, BofA Merrill Lynch, Research Division - VP and Research Analyst [51]

--------------------------------------------------------------------------------

I just wanted to peel back on your perspective on balance sheet health. Debt reduction has been strong, but 2019 leverage looks like it could still be at or above the high end of your target range. So what option should we consider being available near term to keep the balance sheet in line with investment-grade ratings? You don't seem to be getting credit for the, I guess, 10% dividend yield. So would you consider altering that dividend payout?

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [52]

--------------------------------------------------------------------------------

So again, I would just reiterate our capital allocation strategy, which hasn't changed. We do continue to generate strong cash flows, and we use that cash flow prudently. And so just to reiterate what our priorities are, first and foremost, is to invest in the business, and so we've guided that we'll invest about $1 billion this year. Second is to maintain a healthy balance sheet, so we're significantly -- we've been significantly reducing our debt. We plan to use excess cash in 2019, as we've said before, to further reduce our debt, to be well within our target leverage range of 2.5 to 2.8x. And we look at that with and without asset sale gains. And that's important as we face into any economic environment. And being in this range gives us flexibility as well. And next, we will continue to return a competitive cash dividend to our shareholders. We're doing that, and we're committed to continuing to do that. And then the last thing is that as our cash position warrants, we will continue consider, along with our Board, resuming our share repurchase program. So that's how we think about our capital allocation strategy, and it hasn't changed.

--------------------------------------------------------------------------------

Operator [53]

--------------------------------------------------------------------------------

It appears there are no further questions at this time. I'd like to turn the conference back to your hosts for any additional or closing remarks.

--------------------------------------------------------------------------------

Jeffrey Gennette, Macy's, Inc. - Chairman & CEO [54]

--------------------------------------------------------------------------------

Thanks, everybody.

--------------------------------------------------------------------------------

Paula A. Price, Macy's, Inc. - CFO & Executive VP [55]

--------------------------------------------------------------------------------

Thank you, everyone.

--------------------------------------------------------------------------------

Michael P. McGuire, Macy's, Inc. - Head of IR [56]

--------------------------------------------------------------------------------

Thank you.

--------------------------------------------------------------------------------

Operator [57]

--------------------------------------------------------------------------------

That concludes today's presentation. Thank you for your participation. You may now disconnect.