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Edited Transcript of URBN earnings conference call or presentation 16-May-17 9:00pm GMT

Thomson Reuters StreetEvents

Q1 2018 Urban Outfitters Inc Earnings Call

PHILADELPHIA May 23, 2017 (Thomson StreetEvents) -- Edited Transcript of Urban Outfitters Inc earnings conference call or presentation Tuesday, May 16, 2017 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David W. McCreight

Urban Outfitters, Inc. - President and CEO of Anthropologie Group

* Francis J. Conforti

Urban Outfitters, Inc. - CFO

* Oona McCullough

Urban Outfitters, Inc. - Director of IR

* Richard A. Hayne

Urban Outfitters, Inc. - Co-Founder, Chairman of the Board of Directors and CEO

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Conference Call Participants

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* Adrienne Eugenia Yih-Tennant

Wolfe Research, LLC - MD and Senior Analyst Retailing, Department Stores and Specialty Softlines

* Courtney Ann Willson

Cowen and Company, LLC, Research Division - Associate

* Janet Kloppenburg

* Kate Bridget Fitzsimons

RBC Capital Markets, LLC, Research Division - Associate VP

* Kimberly Conroy Greenberger

Morgan Stanley, Research Division - MD

* Lindsay Drucker Mann

Goldman Sachs Group Inc., Research Division - MD

* Lorraine Corrine Maikis Hutchinson

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

* Mark R. Altschwager

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Marni Shapiro

The Retail Tracker - Co-Founder

* Paul Lawrence Lejuez

Citigroup Inc, Research Division - MD and Senior Analyst

* Simeon Avram Siegel

Nomura Securities Co. Ltd., Research Division - Senior Analyst of U.S. Specialty Retail Equity

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Urban Outfitters, Inc. First Quarter Fiscal 2018 Earnings Call. (Operator Instructions) As a reminder, this conference call is being recorded.

You may now -- I would now like to introduce Oona McCullough, Director of Investor Relations. Ms. McCullough, you may begin.

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Oona McCullough, Urban Outfitters, Inc. - Director of IR [2]

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Good afternoon, and welcome to the URBN First Quarter Fiscal 2018 Conference Call. Earlier this afternoon, the company issued a press release outlining the financial and operating results for the 3-month period ending April 30, 2017.

The following discussions may include forward-looking statements. Please note that actual results may differ materially from those statements. Additional information concerning factors that could cause actual results to differ materially from projected results is contained in the company's filings with the Securities and Exchange Commission.

We will begin today's call with Frank Conforti, our Chief Financial Officer, who will provide financial highlights for the quarter. David McCreight, President of URBN and CEO of the Anthropologie Group, will provide an update on the Anthropologie Group; and Richard Hayne, our Chief Executive Officer, will then comment on our broader strategic initiatives. Following that, we will be pleased to address your questions. As usual, the text of today's conference call, will be posted to our corporate website at www.urbn.com.

I'll now turn the call over to Frank.

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Francis J. Conforti, Urban Outfitters, Inc. - CFO [3]

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Thank you, Oona, and good afternoon, everyone. I will start my prepared commentary discussing our recently completed fiscal year 2018 first quarter results versus the prior comparable quarter, then I will share some of our thoughts concerning the remainder of fiscal year 2018.

Total company or URBN sales for the first quarter of fiscal 2018 were flat versus the prior year. This sales performance resulted from a strong 14% increase in Free People Wholesale sales and an $11 million increase in non-comp sales, including the opening of 3 net new stores in the quarter. These sale gains were offset by a 3% decrease in URBN Retail segment comp. Additionally, please note that our sales growth during the quarter was negatively impacted by approximately 100 basis points of foreign currency translation.

Free People Wholesale segment sales increase of 14% for the quarter was driven primarily by domestic growth at department stores and specialty stores. These increases resulted from growth in several categories, including women's apparel, intimates and movement. We believe Free People Wholesale has the opportunity to continue to grow domestically through their category expansion and internationally within all categories. We're still planning for double-digit Free People Wholesale growth for fiscal year 2018.

Within our URBN Retail segment comp, the direct-to-consumer channel continued to outperform stores, posting a double-digit sales increase, driven by increases in sessions and conversion rate which more than offset a decrease in average order value. Negative comp store sales resulted from average unit selling price and decreased transactions while units per transaction were up.

By brand, our Retail segment comp rate increased by 2% at Free People, while Urban Outfitters declined 3% and Anthropologie declined 4%. Our URBN Retail segment comp was the strongest in April, which benefited from the Easter holiday calendar shift, while March, which was negatively impacted by the Easter holiday shift, and February posted negative comps.

During the quarter, we opened 7 new locations, including 4 Free People stores, 1 Urban Outfitters store, 1 Anthropologie and Co. group store and 1 Food and Beverage restaurant. During the quarter, we also closed 4 locations, including 1 Free People, Urban Outfitters and Anthropologie store and 1 Food and Beverage location.

Now moving on to URBN gross profit for the quarter. Gross profit decreased 8% to $240 million versus the prior comparable quarter. Gross profit rate declined by 284 basis points to 31.5%. The decline in gross profit rate was driven by: first, higher markdowns due to underperforming women's apparel and accessories product at Anthropologie and Urban Outfitters; second, deleverage in delivery and logistics expense, primarily due to the penetration of the direct-to-consumer channel; and lastly, deleveraging store occupancy related to negative store comps.

Total SG&A expenses for the quarter were up 3.5% to $219 million versus the prior comparable quarter. Total SG&A as a percentage of sales deleveraged by 102 basis points to 28.7%. The growth and deleverage in SG&A primarily related to approximately $6 million of nonrecurring expenses incurred in the quarter. These expenses related to severance and fees associated with our store organization project. Without these expenses, our SG&A growth rate would've been less than 1% and our deleverage would've been approximately 25 basis points.

We estimate the annualized savings related to our store organization project will be approximately $25 million. We believe we will incur approximately $2 million of additional costs related to this project in the second quarter, but on a net basis, we'll begin to see savings related to the project in the second quarter and going forward. We still believe our store experience, including creating unique compelling spaces with great customer service, remains an important part of our brands and our relationship with our customers. We believe this project will enable us to maintain these critically important points of differentiation while reducing our expense structure, which is necessary due to the decline in traffic to stores.

Operating income for the quarter decreased by 58% to $21 million, with operating profit margin deleveraging by 386 basis points to 2.8%. The nonrecurring costs associated with the store organization project noted above negatively impacted operating profit margin by approximately 80 basis points.

Our effective tax rate for the quarter came in at 44.1% versus 39.6% in Q1 last year. Similar to last year, this increase is primarily due to the ratio of certain foreign losses to global taxable profits in the first quarter. Additionally, contributing to the increased rate is the new accounting standard related to stock compensation accounting. This new guidance requires all tax effects related to share-based payments to be recorded through the income statement as discrete adjustments versus additional paid-in-capital on the balance sheet under the previous rules. This change has no effect on cash taxes paid.

Net income for the quarter was $11.9 million or $0.10 per diluted share. The nonrecurring costs associated with the store organization project noted above negatively impacted earnings per diluted share by approximately $0.03 per diluted share. Additionally, the higher tax rate in the first quarter negatively impacted earnings per diluted share by an additional $0.02 when compared to 36.5%, which is what we believe our annual effective tax rate for fiscal 2018 could be.

Turning to the balance sheet. Inventory was $359 million, which was flat versus the prior year. Retail segment comp inventory decreased by 3.3% at cost. The decrease in the Retail segment comp inventory was offset by inventory to stock our non-comp stores. We believe overall inventory is well controlled as it is in line with our Retail segment sales comps.

By brand, we believe Anthropologie brand is slightly higher than where it should be, while both Urban Outfitters and Free People are well controlled.

We ended the quarter with $409 million in cash and marketable securities and have 0 drawn down on our asset-backed line of credit facility. Capital expenditures came in at $24 million for the quarter, and we are planning for approximately $90 million in total capital expenditures for fiscal year 2018.

The capital spend for fiscal 2018 is primarily driven by new, relocated and expanded stores followed by investments in direct-to-consumer-related technology.

As we enter the second quarter of fiscal year 2018, it may be helpful for you to consider the following:

We are planning on opening 19 new stores during the year while closing 8 stores due to lease expirations. Urban Outfitters is planning on opening 1 new store in North America while closing 2 stores and is planning on opening 3 new stores in Europe. Anthropologie is planning on opening 4 new stores, including 1 expanded format store and closing 2 stores, all in North America. Free People is planning on opening 10 new stores and closing 3 stores, also all in North America. The Food and Beverage division has opened 1 restaurant adjacent to an expanded format Anthropologie and closed 1 restaurant adjacent to an Urban Outfitters.

Now moving on to gross profit. We believe URBN's gross margin rate for the second quarter could decline at a rate greater than the year-on-year decline in the first quarter of fiscal 2018. This decline could be due to increased markdowns and lower initial markup on women's apparel products at Anthropologie and Urban Outfitters, deleverage in delivery and logistics expenses related to the increased penetration of the direct-to-consumer channel and deleverage in store occupancy related to negative store comps.

Based on our current plan, we believe SG&A could grow at approximately 2% for the second quarter and 1% for fiscal year 2018. Our planned annual SG&A growth rate primarily relates to marketing and direct-to-consumer technology investments to continue to support our strong direct-to-consumer channel sales growth.

Finally, as stated earlier, our fiscal year 2018 annual effective tax rate is planned to be approximately 36.5%. Similar to fiscal year 2017 and as seen in the first quarter of fiscal 2018, we believe our fiscal year 2018 quarterly effective tax rate will be higher in the first half of the year and lower in the second half of the year due to the ratio of certain foreign profits and losses to global tax profits in those periods.

As a reminder, the foregoing does not constitute a forecast, but is simply a reflection of our current views. The company disclaims any obligation to update forward-looking statements.

Now it's my pleasure to pass the call over to David McCreight, President of URBN and CEO of the Anthropologie Group.

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David W. McCreight, Urban Outfitters, Inc. - President and CEO of Anthropologie Group [4]

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Thank you, and good evening, everyone. As Frank mentioned, in Q1, we experienced a negative 4% comparable sales decline versus last year and commensurate margin pressure. Transactions for the quarter were flat, but average order declined as a result of continued challenges in women's apparel, which is overshadowing excellent strides made in other areas of the group.

Staying finely tuned to our customer has always been an important aspect of our brand. It's this intimate awareness that has helped us shape a brand experience and offer that has resonated with many, extending through multiple stages of her life.

So where did Anthropologie apparel miss the fashion mark and why is it taking so long to correct? Unfortunately, the assortment over the past several quarters did not properly reflect the established archetypes. The style references became less identifiably Anthropologie outside of our unique aesthetic lanes. Additionally, the assortment architecture followed the momentum of Her increasingly casual lifestyle, but as the casual assortment built nicely, the merchants overcorrected and missed some of the other dressier occasions in Her life, appropriate styles for social gathering and work. So we will continue to adapt to Her more casual attitude, but we'll maintain a better balance across the spectrum of Her apparel occasion needs.

Am I confident it will be corrected? In a word, yes. We have heard from thousands of customers who have shared their perspectives, encouraging us to take the necessary steps to course correct. The apparel archetypes initially outlined are attractive to our customer. We have a team gaining brand experience and hope to see progress this fall.

While apparel has faced self-inflicted challenges here in North America, the U.K. team has seen notable successes over recent months with double-digit positive comp sales in apparel. The U.K. assortment reflects a broader range of lifestyle occasions from casual to dressy and continued the unique appeal through qualities in the special pieces that make Anthro beloved.

Now turning to our category expansion strategies. I'm proud to report that home continues to realize double-digit sales growth over 9 sequential quarters, with nearly half of all sales coming through digital and the expectation to reach 75% in coming years. We remain very optimistic about the future growth of our home business. Recent research indicates that many of our customers are not yet aware of the impressive breadth of the new home assortment. A small minority of our markets have the ability to see the decor in person. Our website is being modified this summer to improve the home digital shopping experience. Our supply chain efforts are improving costing and reducing the size of future inventory investments. And we have yet to introduce our broader home offer to the untapped interior designer trade. In fact, Anthropologie home is exploring wholesale opportunities as several national and international department stores have approached us to carry our line.

The pending category expansions, lack of assortment awareness by millions of our existing customers and untapped new market potential all suggest that the ultimate revenue target for the home strategy looks more than achievable. I would like to thank Andrew and his home team for their continued progress toward our goal of becoming a leading home destination.

Beauty has also continued to deliver impressive growth. Our vision of bringing an artfully curated assortment wrapped in the halo of the distinctive Anthropologie experience has garnered the attention of small artisanal brands as well as industry titans. Future beauty initiatives include continued expansions in color and skin, securing additional special brands, building our online beauty community and gaining exposure for our own brand lines.

I want to take a moment to recognize Catherine and the beauty team for their innovative approach to curating an experience tailored to the Anthropologie customer and defying the conventions of an overcrowded industry space.

When speaking to growth and evolution, I would be remiss in not mentioning BHLDN and Terrain. Both have consistently delivered double-digit growth with a combined 40% CAGR over the past 5 years. Success stems from their ability to create captivating experiences and offerings in specialized industries.

As with home and BHLDN, assortment evolution and distribution expansion will fuel growth in the coming years. For BHLDN, growth will come from opening more BHLDN boutiques in top markets within Anthropologie stores, further digital evolutions and building on the cult-like brand following. Terrain's growth will continue with logical category extensions, accelerating Design by Terrain and the opportunity for Terrain to evolve into the leading component of Anthropologie home's outdoor living offer.

As customers devote increasing portions of their time and money on experiences, both brands are nicely positioned being not only purveyors of products, but enablers of activities, special occasions and memory making. The performance to date of these young brands point to a successful path for unlocking additional value from the Anthropologie Group platform, one with millions of passionate followers. Congratulations to Nicole, Beth and their teams for building their brands and business models.

While the assortment takes center stage, the shopping experience, be it in stores or online, must deliver to, if not surpass, expectations. Consumer retail behavior is fundamentally changing. She is engaging in new ways online and her expectations for stores are evolving. Across URBN, we are taking a thoughtful approach to the role each channel plays in our growth. In stores, we are catering to the attributes that make in-store shopping not only relevant, but often preferred. Our stores are a place to escape, a place to be inspired and a place to find unique items you can't find anywhere else. This is true both of our core stores and also of our expanded Anthropologie and Co. footprints. Now more than ever, we are evaluating investments to ensure our processes and activities are spent on high-impact areas for our customers. We surgically reduced store operating expenses while working to preserve the special customer experience and are investing in complementary omnichannel initiatives.

Stores will remain a critical part of our future. Over time, the actual number of locations will contract in North America, but the overall square footage may grow. The Anthropologie and Co. format has delighted our core customers, but we're also seeing the benefits of adding new customers while also supporting the sales of retail advantage categories on the web.

Direct sales for home, jewelry, accessories and beauty outperform the brand in large-format markets by up to 25%. We believe the larger format experience will play a significant role for the Anthro brand in the future, but we will remain patient for the real estate market dynamics to adjust to supply and demand pressures.

It should come as no surprise that more of our customers are participating through digital channels, driving direct-to-consumer to over 1/3 of total group sales. Stores continue to deliver one of the most unique, delightful shopping experiences in the industry and they remain our largest channel. Simultaneously, many of our retail customers are becoming omnichannel brand participants and new customers are entering the brand through digital. Dick will review the cohesive URBN channel strategy, but I want to share a few specific digital updates for Anthropologie.

This year, we plan to continue to grow our digital store across categories, increasing digital SKUs by 25%; as with our sister brands, enhance our digital storytelling by leveraging our customers' creativity and passion to inspire each other; and in an effort to reduce friction from shopping digitally with Anthro, we are introducing a new perk for our loyalty members, a permanent path to free shipping.

Clearly, there's so much opportunity to build on the nascent success of the Anthropologie Group. I remain confident in our previously stated potential to double the size of the group based on: one, the scale and commitment of a well-heeled customer whose participation with the brands spans decades; two, successful early development of complementary categories; and three, relatively underpenetrated markets, both domestic and international.

As recent style misses in apparel are resolved, when coupled with the continued progress of these strategic category and brand adjacencies, could herald one of the more compelling periods of growth for Anthropologie in years.

I'd like to thank Dick, Meg, colleagues on the executive team and team members across URBN for their continued support and enthusiasm for the Anthropologie Group.

And now, I'd like to turn the call over to Dick Hayne, CEO of URBN.

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Richard A. Hayne, Urban Outfitters, Inc. - Co-Founder, Chairman of the Board of Directors and CEO [5]

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Thanks, David, and good afternoon, folks. This is a difficult period for U.S. fashion apparel retailers, and URBN's first quarter results reflect that difficulty.

Total Retail segment comps sales registered a disappointing 3% decline, well below plan. This drove increased promotional activity and more margin pressure than we had anticipated. As in previous quarters, the company saw extreme variability in results by channel. The sales shortfall in Q1 was wholly attributable to weaker-than-expected store channel performance in North America where all 3 brands encountered sluggish customer traffic and sales. This issue is impacting virtually all U.S. brick-and-mortar retailers. There are simply too many stores and too many malls in North America. We expect to see more closures and brands disappear until a healthier balance is reached.

I believe our brands deliver some of the best, most creative store experiences in the world. However, it's clear that these experiences currently aren't enough to overcome the decline in traffic and the tepid interest in apparel in stores. We intend to continue to treat our stores like the important part of the omni shopping experience they are and equip them and our associates with the technology they need to please the omnichannel shopper.

In the quarter, demand for women's apparel in stores was particularly weak. Besides the traffic problem, all brands had an assortment issue, execution in the dress category. Each brand planned its dress business down from the very robust spring '16 level. The belief was that in spring '17, some of those sales would migrate to other categories like bottoms or to the newer fashion looks of onesies and rompers. Thus, the brands planned, ordered and, therefore, sold fewer dresses during the period.

During Q1, sales of bottoms, onesies and rompers did, indeed, trend up nicely, but except for the Free People brand, increases in these categories did not offset the losses in dresses. In retrospect, dresses were planned lower than they needed to be.

Also since the dress assortment carries one of the highest average price points in the women's assortment, by ordering and selling fewer dresses, each brand's AUR suffered. Further depressing AUR during the quarter was the change in sales mix by product category. Unfortunately, problems with the store channel overshadowed the great progress made in our other 2 channels.

The URBN digital channel progress is evidenced by a strong double-digit increase in sessions which, in turn, produced double-digit direct sales gains. DTC penetration to total Retail segment jumped by almost 400 basis points to our highest penetration ever, even surpassing Q4 last year when it typically peaks.

Direct was not the only channel to show strong results. The Wholesale channel produced an outstanding quarter, which I will speak to shortly.

Due to the significant disparity in channel results, we moved aggressively during the period to bring our cost structure more in line with sales. This resulted in changes to each brand's store structure, with the elimination of some redundant positions and new job assignments throughout the store hierarchy.

Keeping North American store expenses under control as traffic falls is a challenge and will likely require cooperation from our landlords. Fortunately, in the past 24 months, they seem to be more willing to partner with us.

The digital team has also been restructured, moving from 3 separate groups, each serving a single brand with little cross-brand coordination, to a centralized configuration where resources are better prioritized and aligned. New roles were added during the period to help in the areas of personalization, mobile and omnichannel integration.

Digital improvements in the first quarter included the successful rollout of our new site platform to the Urban Outfitters brand globally, including the launch of our iOS and Android apps in Europe. With this implementation, all major brands now share a common platform. The new platform has better user speed and navigation and has resulted in double-digit basis point improvements in bounce rates and conversion. It, along with the new digital structure, should enable URBN to leverage digital investments across all brands and make improvements to our sites at a greatly accelerated pace.

Other enhancements to site functionality and convenience scheduled for implementation this year include: full inventory availability by store, pick up in store, greater site personalization, search and browse improvements, custom order furniture capabilities, improved customer communication and better service levels like faster, less expensive and more reliable delivery options.

Now I'll discuss first quarter brand highlights beginning with Urban Outfitters. UO's quarter was in line with the total company. Global Retail segment comp sales fell by 3%. Women's apparel in North America underperformed against our expectations mainly due to the issues I discussed previously. That is, poor store traffic and sales, lower dress sales and lower AUR. But in Europe, the women's category significantly overperformed with strong comp sales in both the store and direct channels. Curiously, a considerable amount of the women's product is common to both geographies, which might support the notion that one of the biggest problems facing U.S. retailers is too much supply and too many stores.

Despite the top line shortfall, the brand exited the first quarter in a clean inventory position. Total comp inventory decreased by 3% versus the prior year period and product freshness improved with a percent of aged product over 90 days falling by approximately 800 basis points. This improvement reflects the progress the team has made in adopting a faster speed-to-market discipline meant to have quicker inventory turnover and allow new product to reach the customer faster.

The Urban brand continues to see good growth in its direct channel, where all categories, except women's accessories, recorded solid regular price year-over-year sales increases. Sessions this year versus the same period last year advanced by mid-teens, and this was accomplished before the benefit of the new platform, which was installed in mid-April.

Increased traffic is being driven, in part, by social media. UO Instagram followers now stand at 7 million, a 43% increase over the same time last year. And the brand was mentioned almost 0.5 million times on Instagram in the first quarter, a sequential increase from Q4 of 129%.

Moving on to the Anthropologie Group, I believe David covered much of the quarter performance information in his commentary so I won't repeat it. What I do want to reinforce is how much opportunity I believe resides in this brand. We continue to execute the strategy outlined 3 years ago at our Vision 20|20 conference. Then, as now, we realized the customers were migrating to digital. The only thing we misjudged was the velocity of that migration.

Much of our work was aimed at increasing our capabilities and fluency in categories beyond apparel. The expanded category concept was primarily designed to help drive our direct business, and secondarily, to diversify away from reliance on women's apparel. It turns out our strategy was prescient. Once the women's apparel assortment is improved, and I believe we are making progress toward that goal, the Anthropologie Group will be well-positioned to be one of the dominant lifestyle brands serving their chosen demographic across multiple categories.

I now turn your attention to the Free People brand. First, let me say that I believe the Free People apparel offering is currently among the best and freshest in all retail. In Q1, online customers enthusiastically embraced the fashion and drove strong full-price apparel comp increases. But once again, sluggish comp store sales diminished that success, so total Retail segment comp sales grew by only 2%. Relative to the other URBN brands, Free People benefits from having the highest penetration of direct sales to its Retail segment sales. This is encouraging because we believe the other brands will evolve to this higher DTC penetration as well.

The Free People Wholesale business posted impressive revenue growth in the first quarter with year-over-year sales of 14%. Increases came from gains in the core apparel offering and all customer groups, including domestic and international accounts, and department, specialty and digital stores. Expansion categories accounted for 25% of Wholesale revenues in Q1. The brand team believes this percentage will grow as new categories like FP Movement gain wider recognition and acceptance. To that end, marketing efforts in the quarter included mailing an FP Movement catalog to 390,000 customers and opening a small Movement pop-up shop in New York City.

The Free People team learned from past problems and exercised outstanding inventory control in Q1. As of April 30, total brand comp inventory this year stood 21% below last year, while the brand delivered a 10% increase in total sales. In addition, the brand realized several hundred basis points improvement in merchandise margins in the quarter. Except for comp sales in the store channel, the Free People team delivered an outstanding quarter.

That's a short look at URBN's first quarter results. Now let me turn your attention to our vision for the future. Short term, I believe the trends established in Q1 will likely persist into Q2, with some upside potential in the Free People brand. Second quarter to-date store traffic and sales at all brands continue to be challenged.

Since it's unclear if or when this trend will change, it's important for URBN to focus and invest in other areas of opportunity. Currently, we are experiencing success in 4 major business areas, and these 4 are where we see the most opportunity for future growth.

The first is digital. Digital is URBN's biggest opportunity and our primary focus. We intend to accelerate the growth of our digital reach. By this, I mean, we will enlarge our audience, add followers, expand our social media presence and, at the same time, build our content, including adding products, product categories, brands and services, along with more compelling images, video and more user-generated content. We will also continue to invest in better user experiences. This requires continual improvements to our sites and apps, greater ability to know the customer and tailor those experiences based on that knowledge and better service levels regarding delivery. We believe the total digital sales could double within 5 years.

The second is international. Non-American sales currently account for less than 10% of total URBN sales. Given the power of our brands and their recent strong performance in Europe, we believe we have substantial opportunity to extend the reach and increase the international sales penetration. To that end, last year, we created a new position, Global Head of International, and hired an executive with many years of international expansion experience. He has made significant progress in identifying and negotiating more than a half dozen new European store leases as well as franchise arrangements in multiple mid-Eastern and other countries.

We plan to open 3 new stores in Europe this year and ramp up that pace over the next several years. Besides opening more stores, we will continue to focus our international expansion efforts using our digital and wholesale channels as well.

The third is Wholesale. One of the primary strengths of our brand teams is their ability to create compelling products and experiences. In other words, to create content. Free People has grown its wholesale revenues at a double-digit pace for 5 consecutive years. This has been accomplished through a combination of enlarging the brand's reach geographically and expanding the product categories offered. And while Free People is our model, this content creation capability exists within each of our brands. We believe we can better leverage and monetize our talent by offering more of our content through the Wholesale channel. In addition, we have new and expanded categories that have amazing opportunities for a wider distribution. These range from Free People Movement to Anthropologie Home. Overall, I would like to see our Wholesale revenues double within 5 years.

The fourth is our smaller brands. We have spent almost a decade incubating our 2 brands, BHLDN and Terrain. While both brands remain relatively small, they are growing the fastest. Both benefited from becoming part of the Anthropologie Group and both have an opportunity to serve a much larger audience. I believe BHLDN annual revenues could exceed $100 million and Terrain could exceed $50 million, both within the next 3 to 5 years.

So in conclusion, the URBN brands are powerful and still possess significant untapped opportunities for growth. The 4 areas of opportunities I just discussed, if properly implemented, could add many hundreds of millions, if not billions, of dollars to our top line; this, at a time when many North American retailers are desperately searching for growth vehicles because the traditional method, opening more stores, is no longer viable.

We believe our brands have significant and exciting alternatives, and we intend to exploit them. To achieve this growth, we intend to invest for the long term. We won't be arbitrary. We will plan and we will test and learn, but our bias will be towards growth and achieving scale. We have amazing opportunities to expand an extraordinarily creative talent within the company to accomplish it. I'm quite confident we will succeed.

That concludes my prepared remarks.

In closing, I want to thank our brand and creative leaders as well as our shared service team. I also thank and salute our 24,000 associates worldwide for their hard work, dedication and amazing creativity. Finally, I thank our shareholders for their continued advice and support.

I will now turn the call over to your 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 the line of Lorraine Hutchinson with Bank of America.

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Lorraine Corrine Maikis Hutchinson, BofA Merrill Lynch, Research Division - MD in Equity Research and Consumer Sector Head in Equity Research [2]

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The overall inventory looked to be in good shape. I was a little surprised to see Anthropologie over-bought. Can you talk a little bit about the aging there and what your plans had been for turnaround? And then just lastly, how you're thinking about inventory buys for the upcoming quarters for that brand.

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Francis J. Conforti, Urban Outfitters, Inc. - CFO [3]

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Yes, Lorraine. This is Frank. The aging at Anthropologie as well as actually all 3 of our brands right now is considerably more current than it was on a year-over-year basis. So from an aging perspective, we do look good across all of our brands. I will tell you that I think Anthropologie is a little heavier than we would like it to be heading into the second quarter, and that does pose a little bit of markdown risk for them into the second quarter as well. I would tell you going forward, our methodology has not changed, that we anticipate inventory being in line with sales within 100 basis points or so for each of our brands and for URBN going forward. So total inventory was flat which was in line with our sales; and total Retail segment comp inventory was a minus 3, which was also in line with our sales for the quarter. And I'd anticipate those ranges being consistent going forward of the ratio of inventory to sales. Thank you.

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Operator [4]

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Your next question comes from the line of Kimberly Greenberger with Morgan Stanley.

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

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My question's on e-commerce. Dick, I think you said there was over a 400 basis point increase in sales penetration online. Were you speaking about total URBN on that? And does it vary greatly by brand? And then I wanted to just ask on the e- -- or on the Anthropologie. I think, David, when he was talking, he mentioned a path to consistently get free shipping, and it sounds like that's through the Anthro cart or a loyalty program launch. Could you just talk a little bit more about what that program will involve? And if there is an expected loss of shipping revenue that would accompany the implementation of that program, that would be really helpful.

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Richard A. Hayne, Urban Outfitters, Inc. - Co-Founder, Chairman of the Board of Directors and CEO [6]

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Okay, Kimberly. I'll take the first part of it. I said almost 400 basis points. It's in the 300s and it rounds it up, so I took my license to say almost 400, but it was impressive gain in terms of penetration. So it is reasonably similar across the URBN and Anthropologie brands. So we do believe that it will continue into the second quarter as well. So David, do you want to talk about Anthropologie?

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David W. McCreight, Urban Outfitters, Inc. - President and CEO of Anthropologie Group [7]

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Kimberly, yes, your interpretation's correct. So what we've done is listen to our customer and watched, as Dick mentioned, with the priority around digital was to reduce friction in the shopping experience. And so for -- after our tests and studies what we will be launching next week will be for Anthro members; and those who aren't members, encouraging them to sign up. Free shipping for purchases over $150, and that will be every day around-the-clock. That will reduce shipping income, but we expect that, that will -- net of a net, will be more than offset by the gains and demand in net sales and customer engagement and candidly making the customers happy as well.

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Operator [8]

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Your next question comes from the line of Paul Lejuez with Citi.

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Paul Lawrence Lejuez, Citigroup Inc, Research Division - MD and Senior Analyst [9]

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Dick, you mentioned digital sales, you said, could double in 5 years. I'm curious, what do you think could happen to store sales, and what happens to EBIT margins under this 5-year plan? Over the past several years, as your e-com penetration has increased, EBIT margin has gone done. I'm just wondering when you expect that to change.

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Richard A. Hayne, Urban Outfitters, Inc. - Co-Founder, Chairman of the Board of Directors and CEO [10]

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Yes, I'm not going to talk about E, but what I will talk about is -- are the models that we do create. We have plugged in a negative single-digit comp for stores for the next 5 years. Now we certainly hope that we can beat that, but this was sort of a "what if" scenario, and we also planned our direct-to-consumer sales up, sort of in line, double-digit with the way we have been performing over the past number of years. And when you add all that up, we are not disappointed with what the results were. So we also think there's a lot of opportunity as we go forward with the stores. Almost somewhere between 10% and 12% of our store leases come up for renewal on an annual basis now for the next 5 years. And we're beginning to see a lot more movement on the part of landlords to help us on the occupancy rate side, and we believe that we'll continue to have that. My guess is it will probably accelerate, so I'm very hopeful about it.

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Operator [11]

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Your next question comes from the line of Adrienne Yih with Wolfe Research.

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Adrienne Eugenia Yih-Tennant, Wolfe Research, LLC - MD and Senior Analyst Retailing, Department Stores and Specialty Softlines [12]

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My question is also on the e-comm penetration, you said it had reached the highest ever. I think last quarter, you had said high 30s or somewhere in that range, I was wondering if you could update that and whether it was markedly different by UO and Anthro brands. I know it's significantly higher at Free People. And then Dick, your comment that you just made about leases coming due and potentially getting better rent deals, does some of this movement and some of the things that are happening and you embedding a negative comp for store level comp, does it actually make you reconsider your square footage footprint, not necessarily the unit box footprint, but the square footage itself?

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Richard A. Hayne, Urban Outfitters, Inc. - Co-Founder, Chairman of the Board of Directors and CEO [13]

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Let me take the first part of that, Adrienne. I'll let Frank take -- I'll take the second part, and I'll let Frank take the first. Fortunately, for us, as you know, we have not overexpanded -- or in my mind, overexpanded. We were one of the more conservative folks in terms of opening our store fleets across all of our brands. So we feel pretty good about where we are in terms of the store fleets. I do believe that the landlords are getting much more realistic about rents. And the incredible uptick that we had sort of over the last 10 to 15 years has certainly gone away. We don't see much upward pressure, but there is considerable downward pressure. So it does depend on the individual lease where they are, and so the secondary locations, we're seeing a tremendous movement. The primary locations, we're starting to see movement and that would be good, and that allows us to contain and control our occupancies.

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Francis J. Conforti, Urban Outfitters, Inc. - CFO [14]

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Adrienne, this is Frank. So for URBN to total Retail segment, our penetration is now north of 35%. By brand, that's relatively consistent for Urban Outfitters and Anthropologie. Free People has always been a different ratio as their store base and square footage is smaller relative to their total Retail segment. They're closer to a 50-50 split, with actually DTC being slightly higher than stores right now.

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Operator [15]

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Your next question comes from Lindsay Drucker Mann with Goldman Sachs.

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Lindsay Drucker Mann, Goldman Sachs Group Inc., Research Division - MD [16]

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I wanted to dig a little bit more, Frank, into the gross margin commentary you had. First, I guess my question is, why for 2Q is the expectation for gross margins to be down more year-over-year versus 1Q given where inventories are? And what's the driver of the reduction in IMU -- the outlook for reduction in IMU for the second quarter?

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Francis J. Conforti, Urban Outfitters, Inc. - CFO [17]

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Yes, Lindsay, this is Frank. So the drivers for the second quarter are the same drivers in the first quarter. So markdowns, IMU, delivery and logistics, deleverage as well store occupancy deleverage. Your question about what's different from Q1 to Q2 is, we believe that there is risk for a higher rate of markdowns and a lower IMU in the second quarter in order to clear through the underperforming women's apparel product right now, that's in the spring and summer selling season, in order to stay clean and transition into the new season being for fall and winter. So that's where the change is from quarter-to-quarter. The pressure on IMU is more about the mix of product being -- with the women's apparel being underperforming right now. It affects our overall IMU as women's apparel is one of our highest IMU classes. So that's more about mix, from a product category perspective, than anything.

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Operator [18]

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Your next question comes from the line of Janet Kloppenburg with JJK Research.

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Janet Kloppenburg, [19]

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Dick, I just wondered about the international opportunity. Do you see that equally weighted to digital and brick-and-mortar? And maybe if you could give us an idea of what your overall square footage growth rate would look like as you accelerate the international -- I assume, as you accelerate international store opening. Just some thoughts there would be helpful. And Frank, I was wondering, is there anything you can do to reduce the pressure of the delivery and logistical pressure on the gross margin line? Is there any efficiencies being built in there or scale that perhaps could alleviate that pressure or at least modify it?

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Richard A. Hayne, Urban Outfitters, Inc. - Co-Founder, Chairman of the Board of Directors and CEO [20]

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Janet, this is Dick. I don't think -- I definitely think that we will expand internationally through all 3 of our channels. Take Wholesale, to begin with, Free People is making very good strides, particularly in Europe, to increase their business there. As David mentioned, we have a number of people who are asking us about other product categories in -- from our other brands. We currently sell to Selfridges some of the home product and we have opportunities in other places as well. So I wouldn't dismiss Wholesale. I think that's going to be an important part. Of course, we have digital opportunity. Over the last 2 years, we have now gone to our platform, what we're calling our A15 site platform and it is now up with all 3 of our brands, and that allows us much greater flexibility to do the things that we need to do to grow the international DTC business as well as our domestic one. So I think that digital has a lot of opportunities. Certainly, stores. As I said, we're going to do 3 additional stores. We have not been expanding more recently, but now, we are going to expand the stores. And if you look at the number of stores we have in Europe, which is well under 100 across all brands, and then you look at the number of stores we have in the U.S., and you consider the fact that European sales in the kinds of categories that we sell are approximately equivalent in Europe as they are to the U.S., I think it starts to tell you that there's opportunity for us to expand the store fleets for all the brands in Europe. And that's been -- then, not to mention, some of the licensing and franchise agreements that we may enter into in places that are a little less friendly for us to open stores. So all in all, I think there's lots of opportunity internationally. I still rank digital across the entire world as our #1 opportunity to grow our business.

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Francis J. Conforti, Urban Outfitters, Inc. - CFO [21]

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Janet, just to answer your question around delivery and logistics, if you were to look at just strictly our direct-to-consumer channel, delivery and logistics actually have begun to leverage and we're starting to see some of the improvements there from the new facility that we put in and the teams in some of the processes that we have there. The deleverage that you're seeing is related to the increased penetration from the direct-to-consumer channel itself. So that's -- as that increases our overall mix, it's going to have an impact there on those 2 line items. Where the opportunity lies is for the DTC to offset some of that increased penetration to offset some of the occupancy expenses or rate and start to leverage out on store occupancy. We didn't realize that opportunity in the first quarter based on where our store comps were. If store comps were to improve, you would actually start to see some improvement in leverage and store occupancy offsetting the deleverage that you get in delivery and logistics from the increased penetration of the direct-to-consumer channel. Thank you.

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Operator [22]

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Your next question comes from the line of Brian Tunick with Royal Bank of Canada.

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Kate Bridget Fitzsimons, RBC Capital Markets, LLC, Research Division - Associate VP [23]

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This is Kate on for Brian. I guess, we were just thinking about the brand margins and opportunities to recover from here, just given what you're seeing in stores and then also keeping in mind some of the shipping initiatives going on at Anthro. Realistically, how should we think about URBN margins recovering from the 9% we saw in 2016 and Anthro, the 11% we saw in 2016 as well? Over time, where do you see the opportunities on those brands just kind of considering this new retail reality with the store traffic, et cetera?

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Francis J. Conforti, Urban Outfitters, Inc. - CFO [24]

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Yes, this is Frank. I think as it relates to each of the brands right now, as we're going through this channel shift between DTC and stores, I just -- I hesitate to give a forecast as to where our brand margins could be on a go-forward basis versus historical. I think as you've seen with all of retailers supporting the demand of -- the consumer demand with 2 distinct and then overlapping channels has become a more expensive proposition. So I think getting back to historicals will be challenging, but to give a specific forecast by brand right now, I don't think is -- I don't think we have enough clarity to do so.

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Operator [25]

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Your next question comes from the line of Marni Shapiro with Retail Tracker.

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Marni Shapiro, The Retail Tracker - Co-Founder [26]

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So I guess, as you open stores a little bit more aggressively across Europe and as you think about the stores here in the U.S., most particularly in Europe, would you look to that bigger experiential Anthro model with more of a flagship and lean on the digital or would you look for smaller stores? I'm curious what the thinking is there.

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David W. McCreight, Urban Outfitters, Inc. - President and CEO of Anthropologie Group [27]

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Our conversations have -- Marni, it's David. Our conversations internationally have been varied by market. We want to make sure, given the dynamics of the space and the cost, that we represent the brands well as we enter new markets. And as Dick said, we believe the wonderful synergy is creating that brand awareness, so we want to have initial launches that are full representations of the brand, but then really maximize it digitally. And then, we're in discussions with our potential franchise partners on how they view square footage in their markets as well.

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Operator [28]

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Your next question comes from the line of Simeon Siegel with Instinet.

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Simeon Avram Siegel, Nomura Securities Co. Ltd., Research Division - Senior Analyst of U.S. Specialty Retail Equity [29]

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Frank, are you seeing any -- or I guess, you probably are -- some positive EBIT margin from the growth of Wholesale? Like what's the right way to think about what that's been doing or what that might be able to do for the remainder of the year and then beyond as that Wholesale continues to go?

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Francis J. Conforti, Urban Outfitters, Inc. - CFO [30]

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Yes, Simeon, as Wholesale continues with their strong growth, we're very pleased with the plus 14% for the first quarter with healthy margins there, great execution amongst the Free People team. And we are still -- believe that the Free People Wholesale can deliver 10% top line growth for the remainder of the year. There is a benefit to our overall margin. What I would say is exactly where that shakes out will all depend on where our Retail segment comes in, and we're not in a position right now to give a forecast for the remainder of the year.

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Operator [31]

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Your next question comes from the line of Oliver Chen with Cowen and Company.

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Courtney Ann Willson, Cowen and Company, LLC, Research Division - Associate [32]

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This is Courtney Willson on for Oliver tonight. Just diving a little deeper into the markdowns that occurred during 1Q, could you give a bit more detail just on which classification or categories within apparel saw the highest levels in markdowns? And then also, which had the highest full-price selling? And then within the dress category at Anthro, the dresses that you did have, were they sold mostly at full price or did you take markdowns there as well?

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Francis J. Conforti, Urban Outfitters, Inc. - CFO [33]

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Yes, Courtney, this is Frank again. We don't give that level of detail within our product categories as to how each is performing and specifics related to reg price and markdowns.

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Richard A. Hayne, Urban Outfitters, Inc. - Co-Founder, Chairman of the Board of Directors and CEO [34]

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Courtney, this is Dick. What I can tell you is we take markdowns in every category, and that is because, as merchants, we always make mistakes and the markdowns are a way to clear those mistakes. So if we aren't taking any markdowns in a category, it's because we're not awake because we do make mistakes all the time.

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Operator [35]

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Your last question comes from Mark Altschwager with Robert Baird.

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Mark R. Altschwager, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [36]

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So when you think about doubling the Wholesale exposure over the next, I think, you said 5 years, just how are you thinking about the various channels there, department stores versus specialty? And what role does Amazon and maybe other pure-play e-commerce platforms play within that strategy?

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Richard A. Hayne, Urban Outfitters, Inc. - Co-Founder, Chairman of the Board of Directors and CEO [37]

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This is Dick. The e-comm plays a very significant role in that the e-comm people that we sell to are doing quite well, and as a percent, are the fastest growing. Now some of those e-comm players also happen to be either specialty stores or department stores, so it's hard to categorize one against another. I -- you specifically mentioned Amazon. We do not sell Amazon, none of our brands sell Amazon, and we don't anticipate any of our brands selling to Amazon. So you can take that one off the list. But we do believe that it'll be a mix mostly of department stores; and in Europe, department and specialty stores; and across all geographies, it'll be direct. Thank you very much.

And that concludes our conversations. We thank you, and we'll see you in 3 months.

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Operator [38]

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