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Edited Transcript of ROOT.TO earnings conference call or presentation 11-Sep-19 12:00pm GMT

Q2 2019 Roots Corp Earnings Call

Oct 8, 2019 (Thomson StreetEvents) -- Edited Transcript of Roots Corp earnings conference call or presentation Wednesday, September 11, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James Alan Gabel

Roots Corporation - President, CEO & Director

* Kristen Davies

Roots Corporation - Head of IR

* Meghan Roach

Roots Corporation - Interim CFO

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Conference Call Participants

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* Brian Morrison

TD Securities Equity Research - Research Analyst

* Janine M. Stichter

Jefferies LLC, Research Division - Equity Associate

* Matt Bank

CIBC Capital Markets, Research Division - Associate

* Patricia A. Baker

Scotiabank Global Banking and Markets, Research Division - Analyst

* Sabahat Khan

RBC Capital Markets, LLC, Research Division - Analyst

* Stephen MacLeod

BMO Capital Markets Equity Research - Analyst

* Vishal Shreedhar

National Bank Financial, Inc., Research Division - Analyst

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Presentation

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Operator [1]

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Good morning. My name is Chris, and I will be your conference operator today. At this time, I would like to welcome everyone to the Roots Fiscal 2019 Second Quarter Conference Call. (Operator Instructions)

On the call today, we have Jim Gabel, President and Chief Executive Officer; Meghan Roach, Interim Chief Financial Officer; and Kristen Davies, Head of Investor Relations for Roots.

Before the call begins, the company would like to remind listeners that the call, including the Q&A portion, may include forward-looking statements about current and future plans, expectations and intentions, results, levels of activities, performance, goals or achievements or any other future events or developments. This information is based on management's reasonable assumption and beliefs in light of information currently available to Roots, and listeners are cautioned not to place undue reliance on such information. Each forward-looking statement is subject to risks and uncertainties that could cause the actual results to differ materially from those projected.

The company refers listeners to its fiscal 2019 second quarter management's discussion and analysis and/or its annual information form dated April 2, 2019, for a summary of the significant assumptions underlying forward-looking statements and certain risks and factors that could affect the company's future performance and ability to deliver on these statements. Roots undertakes no obligation to update or revise any forward-looking statements made on this call.

The fiscal 2019 second quarter earnings release, the related financial statements and the management's discussions and analysis are available on SEDAR as well as on the Roots Investor Relations website at www.investors.roots.com.

Finally, please note that all figures discussed in this conference call are in Canadian dollars, unless otherwise stated.

Thank you. Ms. Davies, you may begin your conference.

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Kristen Davies, Roots Corporation - Head of IR [2]

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Thank you, operator. Good morning, everyone, and thank you for joining us. Jim Gabel, our Chief Executive Officer, will begin today's call by discussing our fiscal 2019 second quarter highlights followed by our strategic outlook. Then he will turn the call over to Meghan Roach, our Interim Chief Financial Officer, who will review our financial results for the quarter in greater detail. Jim will follow with some closing remarks, after which we will open up the call for questions.

I will now turn the call over to Jim.

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James Alan Gabel, Roots Corporation - President, CEO & Director [3]

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Thank you, Kristen. Good morning, everyone, and welcome to the call, Meghan. Looking at our results for the quarter, we achieved some key operational wins, all of which are important accomplishments for the long-term success of the brand and business.

Our 2 largest product categories, women's and men's, were both up year-over-year. We experienced another quarter of better-than-expected e-commerce growth, we had some exciting brand moments, and we moved out of our legacy distribution center.

Total sales for the quarter were $61.7 million, a 2.5% increase over the same period last year. However, with DTC sales essentially flat year-over-year at $48.2 million and a comparable sales decline of 2.9%, our overall Q2 2019 financial results fell below our expectations.

Soft store traffic continues to be a challenge. However, while it was down versus last year, that wasn't the case across all of our stores. And as the quarter progressed, we saw improving trends. Recognizing the growing importance of our omnichannel capabilities, we are investing in our e-commerce platform to gain further traction.

We recorded mid-double digit increases in unique visitors to our e-commerce site in the quarter, which translated into strong e-commerce sales.

With our transition to our new D.C. in the quarter, we face some delays in the flow of product to our stores, which also negatively affected our results. With us taking longer to get new products to the stores and replenish goods on the floor, our stores weren't always in a full-stock position.

Importantly, as the summer progressed and we made improvements to our product flow, especially for our top volume experience locations, we have seen same-store sales improve.

In terms of product performance in the quarter, as I mentioned, our women's and men's categories were both up year-over-year. The particularly exciting part is that the growth was driven by success in new key seasonal products. Shorts were up 30% over last year. We gained increased traction with our original sweat short for both men and women. We also increased the Essential Short, a follow on to our successful Essential Pant and Jogger, which was well received.

Dresses, another key area of growth, were up more than 20% over last year. We saw a particular strength with our fleece dresses, we offer perennial favorite, the [eve's dress] and expanded color selection this year and saw unit sales double. Our Dockside dress was also a big spring summer success for us.

Footwear was up year-over-year as well. While it's tracking below our expectations, we still recorded a 20% increase. Like with our apparel, the second half is the stronger period for footwear, including our relaunch of a Roots classic, the Tuff Boot.

The product categories that fell short of last year were accessories and leather. Leather has been a slower built for us as we reshape our legacy business. As we saw in previous quarters, when we've introduced newness such as our Mont Royal bag or new men's laptop and Weekender bag, we have seen performance improve. Our consumers are telling us they want more new silhouettes and colors, and we are increasingly working to bring them what they've been asking for, that also includes personalization and customization. Both are still small programs, but they are being embraced by our biggest fans of the brand, and attracting new consumers into the rich community.

Custom leather orders have almost doubled year-over-year. We've also recently introduced a new sweats customization program at our largest volume experience stores. Consumers can buy our sweats and customize them right in the store with the selection of patches. For many stores the program has been so successful that we are struggling to keep the patches in stock.

Looking at our retail store footprint, at a 116, our Canadian store count included 2 new openings in the quarter as well as a relocation and expansion of 1 store. For the U.S., we finished with 8 stores, having opened on Chicago's famed Michigan Avenue in the quarter.

As we said last call, we had a really successful opening weekend in Chicago, and I'm pleased to report that the momentum has continued. It is currently 1 of our top 10 stores, and Illinois web sales were up more than 100% year-over-year in the quarter.

Looking at our other U.S. markets from an omnichannel perspective, our business continues to grow with us seeing overall sales lifts in all of our target regions.

However, our store traffic trends are not where we want them to be, more specifically, weekdays. As we weekends are improving, we also see the need to continue to build overall brand resonance in the U.S. to drive both store and e-commerce growth.

In terms of our legacy U.S. stores, we continue to evaluate each store and market to ensure that we have the appropriate long-term plan. We have decided not to renew the term on our existing New York location, is a 600-square-foot store, so not the right scale of presence for us in the brand market like New York City.

On the international front, our 13.6% increase in partner and other sales in the quarter was driven by our Asia business. However, it was primarily as a result of our partner asking for early delivery of certain orders that were initially planned for Q3 2019. And as such, we expect to see a decline in Q3.

Our partner kept their Taiwan and Hong Kong store counts consistent with Q1 at a 115 and 1, respectively.

In China, they opened one store and chose not to renew the leases for 6 locations. We ended the quarter with 34 stores in China with our partner continuing to look for new locations.

We created further brand excitement in the quarter as we remain a highly sought-after collaborator. Notably, we partnered with Maple Leaf Sports & Entertainment to create a limited edition Raptors' Championship jacket. The leather and nylon jackets produced in our leather factory, were available for sales at Real Sports and sold out within days.

Their royal highness, the Duke and Duchess of Sussex, included a custom jacket we gifted their son as part of a candidate post on their social channels, sharing the image of Archie's jacket with millions of their social media followers around the world.

Most recently, you would have seen us launch our second collaboration with Grammy-nominated, multiplatinum singer, songwriter, Shawn Mendes. It is an expanded collection that we released in celebration of his hometown stadium concert last week, complete with a more than 10,000 rose garden pop-up shop in the heart of downtown Toronto.

There were 130,000 visits to our website in the first 90 minutes after we announced a collaboration. We've had thousands of people flock to our stores across the country, and we saw considerable media coverage including 17 magazines and Rolling Stone. All in all, it was another really exciting brand moment for us.

At this point, I will pass the line to Megan to discuss our financial results in greater detail, after which I will return to discuss our outlook.

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Meghan Roach, Roots Corporation - Interim CFO [4]

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Thanks, Jim, and good morning, everyone. As Jim has already discussed some of the operational performance and sales results for the quarter, I will focus on the factors that affected DTC gross margins, SG&A and earnings. I will also address the key balance sheet items.

For the quarter, adjusted DTC gross margin was 56.7%, down 400 basis points from 60.7% in Q2 2018.

Our selling, general and administrative expenses were $40 million, up 7.4% from $37.2 million in Q2 2018.

We recorded an adjusted EBITDA loss of $4.4 million compared to adjusted EBITDA of $32,000 in Q2 2018. And adjusted net loss for the quarter was $6.2 million or $0.15 per share, compared to a loss of $2.4 million or $0.06 per share in Q2 2018.

As Jim mentioned, we completed the move from our legacy distribution center in the quarter. I just want to take a moment to comment on all the hard work by the Roots team to facilitate this move.

It's no small feat to move a warehouse, introduce a new [MWS] and integrate it into our legacy systems. The time and effort the team put into ensuring this is facilitated should not go unnoticed. However, while we plan extensively to mitigate the disruption to the business, given the immense scale and scope for the project, we have been experiencing some challenges that have affected our ability to flow product into our stores in a timely manner, resulting the DC continuing to operate below our targeted levels of efficiency. As a result, we have been and will continue to do whatever it takes to get products to the stores and our consumers in the right time frame.

Undoubtedly this approach comes with more costs, including additional labor to support that transition. And in Q2 2019, this included the duplicate checks for our legacy DC.

The additional wage and transportation cost associated with the transition from the D.C. accounted for approximately 35% of the 400 basis points year-over-year decrease in adjusted DTC gross margins for the quarter. Similarly, we minimized the risk of the business during our busy back-to-school shopping period, we set at our agreement with a third-party distribution facility versus sales or online orders. This negatively impacted SG&A in the quarter.

We believe the challenges we are facing are short-term as we're already seeing an improvement in the flow of goods and a good ramp up and e-commerce orders being fulfilled from an integrated DC.

However, in advance of our peak selling period during the holidays, we have more work to do. And accordingly, we anticipate incurring additional costs in the coming quarters.

As a reminder, with the transition towards the new DC, you will see e-commerce distribution costs that used to sit in SG&A moving into DTC gross margin on a go-forward basis.

Another key focus in Q2 was the ongoing improvement of our overall inventory position. Accordingly, similar to last quarter, we leveraged deep discounts to sell through our aged product. We recognize that this approach likely encouraged some customers to purchase sale products in some instances, which we saw negatively impact our DTC gross margins, which are of higher sales volume as it related to markdown goods.

The markdowns, partially offset by the positive impact of product cost and mix as well as more favorable FX in the quarter, accounted for approximately of 65% of the 400 basis points year-over-year decrease in adjusted DTC gross margins.

However, we are pleased with the meaningful progress we continue to make in bringing our inventory back in line with our targets. At the end of the quarter, our inventory balance was $54 million, up 7.4% compared to $50.3 million as of Q2 2018.

Similar to last quarter, we hit another period of increased e-commerce fulfillment cost, which results primarily from strong growth in e-commerce sales, driven in part by the higher markdowns we employed to further improve our overall inventory position. These costs included higher store wages and shipping costs.

In terms of store wages, our teams were tasked with more in-store fulfillment of online orders, which increased store hours. We tend to find that clearance products are generally more spread out across our network and reside in our stores rather than a DC. In fact, ship from store in the quarter was 3x higher than Q2 2018.

Shipping costs were also higher, as on average we had more shipments per order due to the products residing in multiple fulfillment centers.

One of the long-term benefits of our integrated DC, we will be the ability to better manage our inventory from a single centralized location.

As we continue to invest in the DC and have undertaken numerous capital projects in last 12 months, debt was up year-over-year, the total amount outstanding on our credit facilities, net of cash and deferred financing costs $137.8 million at the quarter end compared to $121.5 million as at Q2 2018. We remain in line with our covenants.

As our investments in the DC slow, we expect our overall capital requirements for the business to decrease meaningfully and our cash flow to improve.

With that, I will turn the call back to Jim to discuss our outlook. Jim?

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James Alan Gabel, Roots Corporation - President, CEO & Director [5]

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Thanks, Megan. As we have moved into Q3, the trends in our business have improved. We enter the quarter with more seasonally appropriate offering, and we are seeing a great response for our back-to-school assortment. We're also working tirelessly to improve the flow of products and gain efficiencies at our DC.

As we look to the remainder of the year, we are confident in our ability to deliver year-over-year sales growth, Roots is an iconic brand with more than 4 decades of success behind us.

E-commerce continues to be a strong sales driver, and we believe the positive consumer response to our back-to-school assortment is a good indicator for how our new product introductions will be received as we move into the peak holiday periods.

We also plan to complete another renovation and relocation and add 2 new corporate-owned stores by year-end.

However, we've recorded lower-than-expected DTC sales for the first half of the year. In addition, while we and our partner continue to believe in the long-term growth prospects for Roots in Asia, all 3 of the markets that we are operating in are currently facing macroeconomic and geopolitical challenges. We are seeing an impact on the business and anticipate that, that will continue for the remainder of fiscal 2019. With these factors in mind, we expect our year-end sales results to be at the low end or fall slightly below our previously disclosed target range of $358 million to $375 million.

In addition with the softness in our Partners and Others business, lower first half DTC gross margins, impact of new U.S. tariffs, increased SG&A expenses largely due to cost resulting from higher omnichannel sales, higher store wages related to increased in-store fulfillment of online orders and our ongoing incremental cost to complete the DC transition, we now expect our adjusted EBITDA and adjusted net income to fall below our previously disclosed target ranges of $46 million to $50 million and $20 million to $24 million, respectively.

Our best estimates indicate that the softness in our Partners and Others business and the ongoing incremental cost to complete the transition to our new DC, will have a negative impact on adjusted EBITDA or approximately $5 million to $6 million.

However, it is important to emphasize that many of the pressures we are seeing are short term. We are investing in the business to support our long-term growth. We're also making sure that we are doing what is necessary in the immediate term to bring the best products and omnichannel shopping experience to our consumers.

As we complete the final elements of our DC transition and our overall capital investments decline, we are focusing our attention more closely on the best use of our cash to deliver the greatest value to our shareholders.

On that note, I will turn the call back to the operator to open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from Patricia Baker of Scotiabank.

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Patricia A. Baker, Scotiabank Global Banking and Markets, Research Division - Analyst [2]

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I have a number of questions. So one of the things that impacted the quarter, Jim, was, you said, there was soft store traffic. Can you just talk about that a little bit? And was that weather related or attributable to something else? And when you indicated that things are improving in the third quarter, does that mean -- were you referencing also the fact that traffic is improving in the third quarter?

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James Alan Gabel, Roots Corporation - President, CEO & Director [3]

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Sure. Patricia. So at the beginning of the quarter, we did see traffic being softer. And there was a weather component in some of the markets as I think other retailers have referred to.

As the quarter progressed, we did see improvement in traffic. And as we moved into August and into the last 2 weeks that we've been operating in September, we have seen positive traffic trends, both strongly at e-commerce and getting in number of the markets from our store site.

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Patricia A. Baker, Scotiabank Global Banking and Markets, Research Division - Analyst [4]

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Okay. That's helpful. And then the other big issue in the quarter was the delay of flow of product to the stores. And can you just talk about how that happened? When did you start to see that problem and where -- how far through -- how much -- at the peak of the delay of the flow and where you are now, how does it compare?

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James Alan Gabel, Roots Corporation - President, CEO & Director [5]

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Yes. So we are -- as I think Megan alluded to in her comments, it's not just moving a physical DC, it was implementing a new warehouse management system and then integrating more than 20 different IT platforms into that. And obviously, a fair amount of testing had gone on well in advance to going live. But until you go into a live environment, you start pressure testing with meaningful volumes, that's when you start to see some potential challenges.

I do want to stress that at no time was our DC not capable of shipping. It really came down to ramping up our capabilities, both on store shipments and then building up our capabilities to ship e-commerce. We did complete the physical move out of our legacy warehouse. So we are now in one facility and that we have extended with our existing e-comm partner through to the part of our October to make sure that we can fill back-to-school orders.

In terms of how we are progressing. As I look at June and July, there were periods that some of our stores had empty shelves, not completely empty but in some of our key categories. As we progressed into August, we prioritized our top 21 doors, which are highest volume doors and our experience stores in the major cities, to make sure that they had flow of goods, and we saw an improvement of flow of goods too in those locations.

I would say that right now, Patricia, we're operating about 60% capacity of where we want to be. And as you've seen through our financials, we are doing whatever it takes to help the flow of goods and in most cases that means that we're incurring additional labor cost by either working overtime or in the case of adding a second shift at our distribution center.

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Patricia A. Baker, Scotiabank Global Banking and Markets, Research Division - Analyst [6]

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Okay. Excellent. So if you're currently at 60% of capacity, do you have a target for when you think you'll be at 100% capacity?

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James Alan Gabel, Roots Corporation - President, CEO & Director [7]

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We expect as we flow into the fourth quarter that will be at about 80%, 85% capacity. And we would expect that as you move into the last part of the fourth quarter that would be close to 100%. But bear in mind that even at 80% to 85% capacity that enables us to operate at a level that we were beyond last year. But every week we are making progress. But it really -- it depends on volumes that we run through the DC and our capabilities to keep up.

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Patricia A. Baker, Scotiabank Global Banking and Markets, Research Division - Analyst [8]

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Okay. Fair enough. And then just a clarification here, you have mentioned that you extended with your e-commerce partner out to October. So that's the third-party delivery contract, if extension is successful.

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James Alan Gabel, Roots Corporation - President, CEO & Director [9]

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That's correct, yes. Yes. And so that has added additional cost as we moved into this quarter. But just with the encouraging response that we've seen to our products, both in store and online through the back-to-school period, we thought that was very prudent for us to make sure that we can ship the increased volumes that we saw from e-commerce from a third party.

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Operator [10]

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Your next question comes from Stephen MacLeod of BMO Capital Markets.

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Stephen MacLeod, BMO Capital Markets Equity Research - Analyst [11]

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I just wanted to come back -- circle back on the traffic. You mentioned that traffic was weak sort of heading into the quarter and improved as moving into August and September. Can you just talk a little bit about what you think the traffic drivers were in terms of driving the weakness and then driving the improvements, sort of late in the quarter?

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James Alan Gabel, Roots Corporation - President, CEO & Director [12]

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I think -- well, a couple of things. We talked a bit of the weather at the beginning of the quarter as other retailers saw some softness in their business in the early part of the quarter. We can see that our conversion was down in some of our stores, and we think that, that is a reflection of customers coming into the stores and not being able to find the product that they were looking for because in some cases, we didn't get the flow of goods to those stores.

I was very encouraged by the improvement we saw in orders generated in store for online shipping to our customers. We had 120% improvement in those orders, which is very good news because that shows us that if we can't get the product to the customer in our store that our staff is getting very comfortable using the rest of our omnichannel to be able to ship them.

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Stephen MacLeod, BMO Capital Markets Equity Research - Analyst [13]

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Great. Okay. Okay, and then just along those lines, you cited in SG&A that you had some higher store wages related to increased in-store fulfillment of online orders. Would that be related to some of the challenges you saw in the DC? I mean is it -- how do I interpret that? Or can you explain exactly how that works?

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Meghan Roach, Roots Corporation - Interim CFO [14]

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Yes. I think that's a fair comment. I think as you look at the DC, as we evolve the DC over time, our intention is obviously to centralize more e-commerce shipping to the DC and that should definitely reduce cost. Right now with the stores fulfilling goods, you tend to have -- especially clearance goods, those units sitting across in our foot store locations. And so not only are you seeing increased store cost to fulfill those goods, but you are seeing increased shipping cost as you're having to ship out from also store locations across the network.

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James Alan Gabel, Roots Corporation - President, CEO & Director [15]

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But to give you an idea, Stephen. In the quarter and continuing to this quarter, our stores are shipping 3x as many orders as they did this time last year. And to Meghan's point, part of certainly the long-term investment we've made in the new integrated DC is that one physical inventory to hold that inventory back at the DC and the fill the stores that are selling fastest and then selling our e-commerce orders from that DC.

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Stephen MacLeod, BMO Capital Markets Equity Research - Analyst [16]

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Right. Okay. Okay. That's helpful. And then just looking at the full year, you talked about the $5 million to $6 million impact, which I assume is safe to assume that at least at this point EBITDA should -- target should be $5 million to $6 million lower. You talked about the factors affecting DTC sales and gross margin for fiscal 2019. Do you expect gross margins to be down year-over-year in fiscal 2019?

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Meghan Roach, Roots Corporation - Interim CFO [17]

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Yes. So we do expect to have an incremental pressure on DTC gross margins in the second half of the year. Then the interesting part of that though is it comes predominantly from the DC and from the FX headwinds and duty headwinds you do expect to incur. So we should see some positive-to-neutral impacts on the cost and mix effect of our goods as we reduce markdown. But we do anticipate to see an overall decline in DTC gross margins year-on-year.

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Operator [18]

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Your next question comes from Sabahat Khan of RBC Capital Markets.

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Sabahat Khan, RBC Capital Markets, LLC, Research Division - Analyst [19]

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Just I guess, just a follow-up on that guidance. I may have missed this earlier. But I guess when you say EBITDA guidance would be lower and then you mentioned that $5 million to $6 million amount, should we assume that your kind of new implied guidance range is about $5 million to $6 million below the low end on the range? Just trying to put some parameters around the range.

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Meghan Roach, Roots Corporation - Interim CFO [20]

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No. What we're indicating is that we're seeing very specific I think around the additional impact on EBITDA we expect to come from those 2 items. So when you look at the partners and our weakness that we're expecting to have for the year, we do expect that combined with the incremental DC cost to have a $5 million to $6 million negative impact on DC -- on the overall, sorry, adjusted EBITDA. But we are not revising guidance by a specific range downwards.

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Sabahat Khan, RBC Capital Markets, LLC, Research Division - Analyst [21]

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Okay. Great. And then I think you mentioned a little bit on the cash on the leverage earlier. Do you sort of have a time line for when some of those that DC-related cost will moderate and you can see some improvement in the leverage? And do you have a approximate range for where you expect to be on leverage by year-end?

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Meghan Roach, Roots Corporation - Interim CFO [22]

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Yes. So in terms of the reduction, we do expect as we enter into the third and fourth quarter, by the end of the year, we will predominantly be -- done all the all the DC CapEx expenditures. So by the end of the fourth quarter, we will see an overall reduction in the debt level. I'm not going to provide you a specific target. But as you will see in previous years, the fourth quarter does tend to be our lowest [reduction] from a debt to EBITDA perspective as we do generate most of our cash during that period.

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Sabahat Khan, RBC Capital Markets, LLC, Research Division - Analyst [23]

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Okay. And then one last one just on the e-commerce strategy. How was the -- I guess the penetration there coming along? And you mentioned some incremental cost, should we assume that your e-commerce penetration maybe is coming in ahead of expectations and you have some additional cost there? Just trying to understand how far along that a strategy is today?

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James Alan Gabel, Roots Corporation - President, CEO & Director [24]

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That's accurate. And that our e-comm business is growing faster than we expected. We will be above our guided range of e-commerce. By the end of 2019, we'll be 17% to 19%. We have made significant investments in that platform whether be in payments for Apple Pay and AI fraud screening. We've added a new CRM platform that will go live this month actually. Mobile continues to be a key area that we're investing into, to help with product recommendations to -- people on their devices, whether be in store or approaching our stores. And then I think one of the areas that we are very excited about is our ability to have chat functionality at check out to help people make sure that they've got every items that they desired and that we've made the appropriate recommendations to other items they might consider.

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Operator [25]

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Your next question comes from Matt Bank of CIBC.

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Matt Bank, CIBC Capital Markets, Research Division - Associate [26]

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Starting on international, hoping you could give a bit more detail on how the business is trending there. Your partner closed 6 stores, do you expect further store closings? Then also just anything on the -- on after the underlying performance of sales there?

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James Alan Gabel, Roots Corporation - President, CEO & Director [27]

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Yes. So if you look at the 3 markers that our partner operates in, we've got consistent store counts in Taiwan, which is our most mature market with 100-plus stores. Obviously, Hong Kong, we have 1 store and that store is in the heart, unfortunately, of where we've seen the protests unfolding. China is probably the most fluid market for any brand. And knowing that lease terms in China range anywhere from 6 months up to 3 years, it is not uncommon for retailers to have a dynamic portfolio in terms of store closures and we've seen that in the past. We actually have exceeded where we thought we'd be in terms of the store counts in Asia by the end of 2019. So our partner continues to look at new locations that they believe best fit our brand and take advantage of the consumer traffic trends in China.

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Matt Bank, CIBC Capital Markets, Research Division - Associate [28]

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Okay. Great. Can you talk about accessories and leather? Do you expect these categories to continue to be challenging in the second half of the year? And then can you talk about the strategy and timing of improvements?

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James Alan Gabel, Roots Corporation - President, CEO & Director [29]

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Sure. So combined, those 2 categories represent about 25% of our business. Our accessory business has got many variables. And as we look at -- moving into the third and fourth quarter where we are the strongest in terms of our accessory business, whether be in hats or gloves or gifting items, we do expect to see our accessory business rebound.

On the leather side, as we said, it's a legacy business. Unfortunately, our products don't wear out, they wear in. And as a result, when somebody buys an iconic Banff bag, we need to give him reasons to buy a different version with different materials and colors, and we've seen that as we introduce those into the marketplace that consumers are voting for those. And we saw in the back-to-school period, you would've seen prominently on our e-comm platform and in the stores, a very prominent display of the new package called the city bags, which are takedowns or smaller versions of our iconic models. And that has performed very well with the younger consumer.

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Operator [30]

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Your next question comes from Brian Morrison of TD Securities.

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Brian Morrison, TD Securities Equity Research - Research Analyst [31]

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Sorry, my phone's been in and out, so if I missed that, I apologize. Meghan, can you just talk about your CapEx needs for the back half of the year? And then to the extent you can, can you talk about the CapEx needs in fiscal 2020 relative to this year?

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Meghan Roach, Roots Corporation - Interim CFO [32]

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Yes. So I mean, I think we're not going to provide you with specific 2020 guidance at this point. But I think it is fair to say that as we get out of the DC CapEx, you will see a significant reduction in CapEx in 2020. But I won't be giving specific target ranges at this point. And then as we go through the rest of the year, in terms of Capex requirements, we should see significant reductions. We have put in most of the CapEx related to DC already, and so there will be lower CapEx coming through the third and fourth quarter. But again, I'm not going to give you specific ranges on a quarterly basis.

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James Alan Gabel, Roots Corporation - President, CEO & Director [33]

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In that case, Brian, it does put us in an interesting position with significantly lower CapEx. And then obviously, coming into our strongest cash flow period of Q3 and Q4, to then turn our attention with our Board to how best to you use those surplus cash funds to deliver shareholder value. So that's a conversation that certainly has been accelerated based on the projection of much lower capital needs and improved cash flow.

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Brian Morrison, TD Securities Equity Research - Research Analyst [34]

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Okay. So summary is, strong free cash flow forecast for the back of '19 and for fiscal 2020 is what we're looking at?

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Meghan Roach, Roots Corporation - Interim CFO [35]

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Yes. That's correct.

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Brian Morrison, TD Securities Equity Research - Research Analyst [36]

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And then second question, again, just on the inventory. Looks like it's been brought down on a year-over-year basis. Can you just maybe give us a little bit of color on how you picture the overhang at this point?

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James Alan Gabel, Roots Corporation - President, CEO & Director [37]

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Sure. So -- and you're right, if I look at where we were at the end of Q4, we were up about 40%, at the end of Q1, we were 15% year-over-year, we are now up 7% year-over-year. Very encouraged by the trends we've seen through the back-to-school periods in the sale of our inventory. So we expect as we move through Q3 and Q4 that our inventory will be in a strong position to fulfill -- fill orders and will not be in a situation where we were at this time last year.

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Operator [38]

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Your next question comes from Vishal Shreedhar of National Bank.

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Vishal Shreedhar, National Bank Financial, Inc., Research Division - Analyst [39]

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Just on the balance sheet, I may have missed this of off the top. Is there a specific debt to EBITDA leverage level that management thinks is a level which they want to be below? I understand that you suspect there'll be cash generated in the future, but if you can give us that tolerance, that'd be helpful.

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Meghan Roach, Roots Corporation - Interim CFO [40]

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I think the way we look at our business is, we're obviously -- we've mainly focused on generating the best cash flow for our shareholders and making sure that we invest them in the right way. And so I think we are continuously looking at the best use of cash. So while we don't specifically provide a target debt level, if you look at our debt levels, vis-à-vis the cash flow and make sure that we are allocating funds appropriately to get the best return on investment.

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Vishal Shreedhar, National Bank Financial, Inc., Research Division - Analyst [41]

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Okay. So I understand that. The reason why I'm asking is because, I think management said in -- as response to a prior question that they'll be looking to use the future cash flows in the best way possible. So I was just wondering, if investors can look at your leverage levels and try to put their own assumptions around that, so that's why I'm asking. So is there help you can give us there?

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James Alan Gabel, Roots Corporation - President, CEO & Director [42]

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Not specifically. Obviously, as we alluded to, the 2 key areas that we're strongly looking at in terms of forward planning is a significant reduction in capital requirements and then improving cash flows, both those 2 elements will be used to evaluate how best we deliver returns back to our shareholders.

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Vishal Shreedhar, National Bank Financial, Inc., Research Division - Analyst [43]

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Okay. In terms of one of the indications in the past that you provided to us on marketing and brand spend, is management content where they are in terms of the actual level of investment in marketing? Or do we need some more here to accelerate the trends a little bit further?

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James Alan Gabel, Roots Corporation - President, CEO & Director [44]

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No. We're pleased with the progress we've been making in the marketing side. Our investments in Q2 were not dissimilar from a dollar perspective to Q2 of 2018. However, how we allocated those marketing dollars were much different. You saw us have some great brand moments that have brought new people into our social following, and we saw the lift online as a result of those especially. So you're seeing a lot more brand advertising. I think through the back-to-school period, how you saw our windows and stores set up remarkably different than they were last year, and we saw that in terms of the consumer being impressed by our products and the visual experience they saw online and in stores.

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Vishal Shreedhar, National Bank Financial, Inc., Research Division - Analyst [45]

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Okay. In terms of the store network, is management content with the store network? Is there a need to be reviewed to see if there is stores that are may be no hitting the hurdle rates that you anticipated? Is this still -- is it still reasonable for investors to expect Roots network to grow in size over time?

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James Alan Gabel, Roots Corporation - President, CEO & Director [46]

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We continue, and I think we demonstrated that last year when we closed 8 stores. We are constantly looking at our store network and understanding how we get the best value from it, whether it'd be renegotiations with landlords to get improved space in projects or larger space in projects, if we think that the traffic is there. So I think that's one thing that we've demonstrated in our ability to do is to constantly evaluating our store network and figuring it out between our e-commerce platform and our stores. It's about getting the best stores in the best locations and not necessarily the number of stores that we have within our portfolio.

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Vishal Shreedhar, National Bank Financial, Inc., Research Division - Analyst [47]

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Okay. And just one more here. Management indicated that trends are starting to improve in Q3. But Q3 last year was an outlier in terms of a little bit of weakness there. So wondering if that improvement is due to lapping easier comps or if it's actually concrete improvement that we should see extend into Q4 and Q1, et cetera, et cetera.

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James Alan Gabel, Roots Corporation - President, CEO & Director [48]

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So a couple of things. You might recall this time last year, we indicated that we were concerned about how back to school had a started. And at that time, we said that we didn't have the right completed store amount on the floor that would be -- it will be purchased by people in warmer climate.

As I look at the products that people have purchased through back to school, we've done exactly what we said we would do. We said we'd have a more appropriate and seasoning relevant range for the third quarter, so that if it was hot that we had dresses and shorts and Ts for the consumer. But at the same time, we've been fortunate with some of the cooler weather and that our fleece product has sold exceptionally well. The other thing that we do take from the third quarter is that it is a good barometer for how our products will sell through the holiday season, because in many cases we are setting the first phase of a new concept in the third quarter and then we expand that phase as we move through the over quarter into the third quarter, so if those concepts are off to a good start, the consumer is showing great interest around them, then that bodes well for how we perceive follow-on products within that concept to be received.

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Operator [49]

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Your next question comes from Janine Stichter of Jefferies.

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Janine M. Stichter, Jefferies LLC, Research Division - Equity Associate [50]

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Just a few more questions on the inventory, it's in a much better position from a quantity standpoint. Was hoping you could talk a little bit about the quality of the inventory, just the currency and how should we should think about clearance activity progressing through the back half. It sounds like there will still be a little bit of pressure on the DTC gross margin. But if you could give us any parameters on how we should think about the amount of pressure?

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Meghan Roach, Roots Corporation - Interim CFO [51]

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Yes. I think we are closing the gap on the inventory, as we said, as we remain confident in the steps we're taking to bring our inventory back in line with Q4 last year. So by the end of the year, we're pretty confident we're going to be in a good spot. I think just to clarify, we don't expect to see pressure on gross margins in the second half of the year coming from markdown. We did have a lot more heavier markdowns in the first half of the year. And so we cleared through quite a lot of inventory. And so going into Q3 and Q4, we're in a much healthier inventory position from that perspective and feel more confident that we are going to be in a good position coming to the end of Q4.

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James Alan Gabel, Roots Corporation - President, CEO & Director [52]

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Bear in mind that the reason for the heavier markdowns in the first half of the year was really twofold, one, to bring the inventory back online, but also to make sure that we were not moving clearance goods that we're out of legacy DC into the new facility and setting them up.

So as we talked about in the first half of the year, the aggressive activity we took on markdowns was really a point in time to help us move into the new DC and not necessarily a reflection of how we see the balance of the year unfolding.

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Janine M. Stichter, Jefferies LLC, Research Division - Equity Associate [53]

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Got it. That's helpful. And just so I understand, it sound like there's also been some pressure on the SG&A from the clearance activity. You talked about additional labor and just more split shipments coming from e-commerce. So should we expect that to moderate as well as you have bus clearance activity in the back half?

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Meghan Roach, Roots Corporation - Interim CFO [54]

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We do expect to see continued pressure on that aspect of it as we continue to ship from in-store. And once we get to the total consolidation of inventory of the DC and are shipping 100% of our e-commerce inventory from the DC, we do expect some reduction in the impact on SG&A. But in the near term, we have shift to continue to see some higher cost in this area.

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James Alan Gabel, Roots Corporation - President, CEO & Director [55]

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Really our approach as we've moved through the summer and into the back-to-school period is to do whatever it takes to get the product in the right place to service the customer. And in many cases, that has resulted in higher labor costs, but at the end of the day, this a long-term investment, our business, where DC is, and we need to make sure that we satisfy the consumers in key-shopping periods.

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Janine M. Stichter, Jefferies LLC, Research Division - Equity Associate [56]

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It make sense. And then just one last question. You mentioned I think some pressure from Paris. Can you just remind us what is your exposure? And if there is any way you can break out how big you expect that pressure to be?

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Meghan Roach, Roots Corporation - Interim CFO [57]

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Yes. Absolutely. So I think the good news is that unlike a lot of other retailers, we are less exposed to the tariffs because the U.S. is still a smaller portion of our business. So we anticipate the impact to be less than $500,000 on the business right now, and obviously, we're doing -- taking as many steps as we can to further mitigate those figures.

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Operator [58]

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There are no further questions at this time. I will now return the call to our presenters.

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James Alan Gabel, Roots Corporation - President, CEO & Director [59]

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Thank you, operator. That concludes today's call. Thank you again to everyone for joining us. We look forward to updating you on our progress when we report our Q3 fiscal 2019 results. Have a great day.

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Operator [60]

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This concludes today's conference call. You may now disconnect.