American Eagle Outfitters Inc Q2 FY2021 Earnings Call

Greetings, and welcome to the American Eagle Outfitters Second Quarter 2021 Earnings Conference Call. As a reminder, this conference is being recorded.

Good morning, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Executive Chairman and Chief Executive Officer; Jen Foyle, President, Executive Creative Director for AE and Aerie; Michael Rempell, Chief Operating Officer; and Mike Mathias, Chief Financial Officer. Before we begin today's call, I need to remind you that we will make certain forward-looking statements. These statements are based upon information that represents the company's current expectations or beliefs. The results actually realized may differ materially based on risk factors included in our SEC filings. The company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Also, please note that during this call and in the accompanying press release, certain financial metrics are presented on both a GAAP and non-GAAP adjusted basis. Reconciliation of adjusted results to the GAAP results are available in the tables attached to the earnings release, which is posted on our corporate website at aeo-inc.com, in the Investor Relations section. Here, you can also find the second quarter investor presentation. As a note, our second quarter fiscal 2021 results are primarily compared to second quarter fiscal 2020 with comparisons to second quarter fiscal 2019, included where applicable. And now I'll turn the call over to Jay.

Thank you, Judy, and good morning, everyone. I'm very proud to announce a record second quarter, fueled by strong customer demand for our products and brands. Financial results exceeded our expectations. Revenue increased 35% over last year. On a comparable basis, revenue increased 19% to 2019. Sales of $1.2 billion and profits of $168 million were the highest in our history. With our renewed focus entering this year, we are running the business better than ever across the board. As I said in January, we have the best talent in the industry, and these results are clear evidence of that. So I'd like to start by thanking the entire AEO family for this significant accomplishment. Their passion, talent, and commitment are taking our brand and company to new heights. As I also said at our January investor meeting, we are on offense, emerging from 2020 with strength and focus. Our real power, real growth plan is our guiding light. I'm very pleased how we are making swift progress on our pillars, putting us ahead of schedule on our financial targets. Today, the team will take you through the details of our performance, but I'd like to start with a few highlights. Aerie just continues to deliver exceptional multiyear growth. As the brand is scaling, we are seeing significant profits flow through. This quarter was one more proof point of the excitement behind this brand. I couldn't be more optimistic about the potential ahead as we make our way to the next $1 billion in revenue. American Eagle is simply proving to be a powerful brand we always knew it was. Its dominant market position, combined with a fresh focus on inventory management, have resulted in the best margins and profits in years. Under Jen's leadership, we energized product and marketing our yearly results and the timing couldn't be better. As the #1 jeans brand, we are well-positioned to capitalize on strong demand fueled by emerging trends. Across channels, stores and digital are firing on all cylinders and driving meaningful profitability. Our multiyear investment to improve our customer shopping experience and enhance our supply chain are delivering strong new trends. We're gaining new customers, and the relaunch of our loyalty program has been a success. Across operations, we are creating efficiencies, increasing our speed and agility. The supply chain delivered great results even in the face of headwinds. While we made great progress, we are just hitting our stride. I see so much opportunity for us to generate incremental value moving forward. Our focus on ROI is also evident in the second quarter. We drove incredible margin recovery and cash flow. Our balance sheet is healthy, and we're operating from a position of financial strength. I'm pleased that in June, we raised our quarterly cash dividend by 31%, reflecting our confidence in the strength and sustainability of future cash flow. Everything we do at AEO is done with purpose. We run our day-to-day business in keeping with our values to build a better world. To that end, we are making great progress on creating more sustainable products. This year, we have more than doubled the number of our most sustainable real good styles across all merchandise categories. Wider energy reduction and responsible sourcing remain top priorities. I'm extremely pleased by recent recognition from staff at antisemitism.org for our dedication to combat racism by creating an inclusive and diverse corporate culture. This is something we strive for every day through innovative associate programs designed to build a collaborative environment. This spring, we helped raise over $1.7 million for important causes, including Bring Change To Mind and It Gets Better, two organizations making an impact to uplift youth and support mental health. I am really proud of all the work we are doing to strengthen belonging within our company and our communities. AEO's top talent is a keystone of our great company. Last month, AEO was named Fast Company's Best Places to Work for Innovators, a distinction that recognizes our deep commitment to encouraging innovation across the organization. As the pandemic continues, our top priority is to keep our people safe. Our leading health and safety measures remain in place across all facilities. We have consistent communication support and education for our associates and stronger encouragement of vaccinations. Before I turn it to Jen, I want to reiterate how pleased I am with our performance year-to-date and how excited I am for what's to come. We continue to execute well across all areas of the company. Although the current operating environment is presenting challenges from the ongoing pandemic and supply chain disruption, there's a lot within our control. I'm very pleased with current business trends. We continue to see strong demand for our brands, the macro backdrop is favorable, consumers are spending, and new fashion trends are a positive. We are focused on leveraging the agility we gained last year and the strength of our capabilities to deliver to our customers and post a strong second half. With all this in mind, I have confidence in our ability to achieve operating income of $600 million this year. With that, I'll turn the call over to Jen.

Thank you, Jay, and good morning. Wow, what a great quarter. Aerie and AE are two of the biggest brands in the market and are delivering truly exceptional results. We are making incredible progress towards the goals we laid out in January. In fact, well ahead of my expectations. We are attracting new customers, and they are spending more than ever. And I'm happy to see those trends carry into the third quarter. Let me start with Aerie. Our leading brand platform combined with products that continue to delight and excite our customers is delivering strong, consistent performance. Revenue in the second quarter rose 34% on top of 32% growth last year. I'm proud to say this marked our 27th consecutive quarter of double-digit growth. Sales metrics were very healthy. Strong demand led to significantly higher full-price sales and we strategically removed promotions. We are also mixing into higher ticket with higher margin items. I'm pleased to report broad-based strength across all product categories, which were all up in the double digits. Core intimates, bralettes and apparel and swimwear saw strong demand. We continue to gain meaningful market share in swimwear as Aerie is becoming a true destination in the category. In May, we launched our Love the Swim You're In TikTok campaign highlighting all the ways to rock your Aerie swim. The content was extremely well received, driving incremental visits and strong conversion. Aerie signature bralettes and leggings are showing incredible growth and I'm also very pleased by the success of our OFFLINE activewear brand, which continues to gain traction. Year-to-date, Aerie's customer file has expanded over 20%. Existing customers are transacting more frequently and spending more. On the marketing front, we continue to focus on giving our customers their own platform in new and innovative ways. We just launched our Real Voices campaign, amplifying the love of our brand and products through our customers' own stories. The campaign has already generated a ton of buzz, generating close to 1 billion impressions in the first week, bringing the Aerie real movement to more people than ever before. Market expansion is progressing with 60 new stores across the U.S. and Mexico and our first store in Hong Kong. As Mike will review, we look forward to further growth as we better penetrate existing markets and expand into new ones. The profit unlocked from Aerie's growth has been explosive. I am so proud of what this team has accomplished. Momentum has continued into the fall season as customers embrace our amazing brands and cozy comfy collections. I'm highly encouraged by our results and excited for our upcoming season. We remain focused on driving consistent double-digit growth and improving profit flow-through. Now on to American Eagle. I'm absolutely thrilled with the progress we are making. Second quarter results clearly demonstrate the growth and value creation we are looking to unlock. Sales rose 35% compared to 2020 and demand was positive versus 2019. Brand and product updates, along with a laser focus on inventory optimization and promotional discipline, drove strong AUR growth and significant merchandise margin expansion. Operating profit more than tripled. It was up over 30% to 2019. We are running the business with a clear agenda to true up brand profitability, excite our customers and seek further growth. While results to date have been tremendous, we are still early on this journey. AE's position as the denim destination could not be stronger. Our jeans collections continue to deliver great results across genders. We believe the current trends and shifts in silhouette will be a tremendous win for the AE business. In the quarter, our women's business reached new highs, led by ongoing strength in bottoms across both fashion income for silhouettes. Growth in the men's business was also strong. Our focus on great outfitting with updated fits and fabrics is certainly resonating. Together, new inventory and messaging, AE remains the #1 jeans brand within our demographic and the #1 women's brand across all ages. It is clear that our customers are choosing us as silhouettes transition with the new denim cycle. AE's new back-to-school campaign featuring some of the biggest cultural influencers of the moment, including Chase Stokes and Madison Bailey of Netflix' #1 show, Outer Banks, and TikTok creator, Addison Rae, has already become the most organically viewed video in the history of our brand. We also launched our first digital clothing line on Bitmoji, which has generated a staggering 1 billion try-ons to date. Looking ahead, I am excited about our fall and holiday collections. Our team has had a lot of fun bringing this AE iconic heritage to light, and I think our customers are really going to love what we're doing. Earlier this year, we welcomed Liz Brunnemer, AE's new Head of Design. She has hit the ground running. The team is energized, and I know we are better positioned than ever to leverage our strong brand position. I want to thank the AE team for springing into action and driving such strong progress in such a short period of time. There is a renewed excitement around AE, and I think we are at the very beginning of a great new chapter. Thanks also to the Aerie team for being rockstars quarter in, quarter out. We have a great slate of talent between these two teams, and I look forward to sharing the results of their amazing work with you in the quarters to come. Thanks. And now I'll turn the call over to Michael.

Thanks, Jen, and good morning, everyone. Our record second quarter results clearly demonstrate the power of our brands and products as well as the strength and agility of our operations. Thanks to our outstanding team of associates and global partners, we were able to successfully navigate through a highly disrupted environment. I can say with confidence that we're running our business better than ever. Investments we've made to strengthen our operations and technologies for all capabilities are yielding material efficiencies and contributed to our record profit performance. Importantly, I believe these benefits are sustainable, and we're going to continue to build on them over time. Beginning with our laser focus on the customer experience, this spring, it was great to see customers return to stores, fueling a 73% increase in store revenues with strong selling across brands. We saw strength across formats at both our factory outlets, and mainline stores saw healthy growth. Our stores team did a terrific job, welcoming our customers back and fueling record high conversion. Digital demand also remained very strong, increasing 9% following a 48% increase last year. This channel continues to expand to new heights in both revenue and profitability as we leverage our multiyear investments. Consolidated second quarter digital revenues are up approximately $150 million compared to 2019, with both brands seeing solid expansion. Digital represented 35% of total revenue, up from 25% pre-pandemic. Longer term, we continue to believe that digital will represent 50% of our sales. We are continually looking for new technologies to drive better engagement and connect customer shopping experiences across our channels. As consumers reestablish their shopping rhythm post-pandemic, our business model will remain flexible in meeting them wherever and however they choose to shop. For example, our mobile sales more than doubled in the quarter as we continue to enhance the customer experience. We're thrilled to see very strong customer data, especially as we head into our key back-to-school season. We have added over 1.5 million new customers across brands since this time last year, and over 2 million since 2019. The relaunch of our loyalty program last summer has been extremely successful. Customers in the loyalty program are spending more, they're staying longer, and the average customer spend is up in the double digits. This speaks to the quality of our engagement, our product, our marketing, and the technology enhancements we've made, and we still see opportunity for continual improvement, and we're planning to experiment with new and interesting ways to better engage with our customers and to build the loyalty program going forward. As I discussed back in January, transforming our supply chain is a major priority, and the past 6 months have truly underscored the importance of strong partnerships as well as leading capabilities. We are continuing to prioritize investments in these areas. During the second quarter, our product arrived without major delays, and we were able to chase into high demand items. From a logistics standpoint, our hub-and-spoke model with regional inventory positioning and regional fulfillment is working. It's part of what's fueling efficiencies, allowing us to drive substantially greater sales and margin on far less inventory. We are delivering products to customers faster. And despite industry-wide cost increases, our delivery expense is leveraged to 50% of sales. Needless to say, I believe our supply chain platform truly is a competitive advantage. The investments we've made to date are paying off. As global supply chains continue to be disrupted, this is creating opportunities for us to become even faster, more agile, and more efficient. On that note, I'm excited to share that in the quarter, we acquired AirTerra, an innovative logistics provider. With this acquisition, we are also excited to welcome an experienced leadership team with deep expertise in logistics and a shared passion for rethinking the status quo. We will run AirTerra independently as it supports AEO's business as well as provide services to other retailers. On the product side, we feel good about our ability to maintain strong margins. Investments in our brands and products over the past several years are supporting our ability to successfully compete in higher-ticket products. As we focus on innovation, quality and value, we have selectively raised prices with very low resistance from our customers. In conjunction with strong inventory management, we have confidence in our ability to sustain high margins and offset inflationary pressures. There is no doubt that the global supply chain remains highly disrupted. Port shutdowns and factory closures are leading to longer delivery times and higher transportation costs across our industry. As Jay touched on, we're very focused on the things that are within our control. We are working closely with our partners, and we're moving production wherever possible to minimize disruption. Of course, we also will leverage the significant structural improvements we've made over the past several years, and we believe that we're well positioned during the second half of the year. In closing, I'm very pleased with our performance year-to-date. Our results are outstanding, and our teams are executing really well in all sorts of adversity. I am confident that the changes we are making to our supply chain, logistics, and operations are also setting us up to succeed well into the future. With that, I'm going to turn the call over to Mike.

Thanks, Michael. Good morning, everyone. I'm pleased to report another record quarter, bringing our year-to-date financial results to an all-time high. Our brands continue to demonstrate incredible momentum, driving substantial profit to the bottom line. As we navigate through macro shifts related to COVID, our success has been fueled by the initiatives outlined in our Real Power Real Growth plan back in January. Strong focus on our brands and product innovation, inventory and gross margin optimization, and real estate and supply chain initiatives are all having a positive effect on our growth and profitability. Second quarter revenue of $1.2 billion, operating income of $168 million, and adjusted EPS of $0.60 marked second quarter records for the company. The operating margin of 14.1% was our highest in 13 years. We also saw nice growth across the business compared to the pre-pandemic 2019 period. Consolidated second quarter net revenue increased 35% versus second quarter 2020. And on a comparable basis, increased 19% to 2019. The reported revenue increase of 15% included a $40 million benefit to revenue in 2019 from a change in our Japan license agreement. Across brands, sales metrics were favorable. Our average unit retail was up over 20%, led by overall strong demand, higher full-price sales, and fewer promotions. This fueled a double-digit increase in our average transaction value. As customers returned to stores, we saw a material increase in traffic trends, which drove a 73% increase in store revenue versus last year. Even with the meaningful shift, digital demand increased 9%, hurdling last year's very strong online demand growth of 48%. Note that second quarter reported digital revenue declined 5% as we lapped elevated sales due to a timing shift in shipments from the first quarter into the second quarter last year. Our digital platform, combined with our strong store footprint, is a competitive advantage, and the investments we've made continue to pay off. As Michael pointed out, logistics are a key differentiator and give us the ability to more effectively manage our business while generating meaningful efficiencies. From a brand standpoint, Aerie's multiyear growth trajectory remains strong, with revenue rising 34% from second quarter 2020 and almost 80% from second quarter 2019. Aerie's operating profit rose 132% compared to second quarter 2020, and operating margin expanded to 21%. As I've consistently highlighted, Aerie is now at an inflection point in its growth story with strong sales performance translating into significant operating leverage that is exceeding our expectations. Put some numbers around it. Second quarter operating profit of $71 million more than doubled the $30 million we realized in 2020 and was over 7x the level of operating profit in the second quarter of 2019. Moving to the American Eagle brand performance, healthy demand, low promotions, and inventory optimization drove another strong result across both revenue and profitability. We were pleased to see top-line growth of 35% from 2020, and on a comparable basis, an increase of 5% from 2019. AE brand reported flat revenue versus 2019, including the 2019 benefit from the change in our Japan license agreement. AE's operating profit jumped 234% from second quarter 2020, with margins building to 23.5%, a proof point of the significant margin opportunities for AE we reviewed back in January. I'm proud of the transformation we have driven and how we are managing the business today. We have redefined what success means for the AE brand with clear direction and focus on consistent profit and cash generation. This is driving improved sales trends as tighter inventory controls enable higher full-price sales and greater emphasis on the best-selling SKUs. Work here continues, and we see additional opportunities. Total consolidated AEO gross profit dollars were up 89% compared to the second quarter of 2020, and gross margin came in at a very healthy 42.1%. Inventory optimization and refreshed product assortments are supporting promotional discipline and higher full-price selling. This is driving healthy merchandise margin expansion, rent leverage significantly as a result of negotiated savings, store closures, and benefits from impairments. As Michael discussed earlier, delivery also leveraged reflecting efficiencies enabled by our distribution and fulfillment nodes. As a result of strong sales, we saw SG&A leverage 70 basis points versus second quarter 2020. The dollar increase to $70 million was due primarily to the reopening of our stores. We also saw increased advertising as well as incentive costs due to strong profit growth. Record operating income of $168 million reflected a 14.1% operating margin, our highest second quarter rate since 2008. Adjusted EPS was $0.60 per share in the quarter and marked a record second quarter outcome for us. Our diluted share count was $209 million, which included 36 million shares of unrealized dilution associated with our convertible notes. Ending inventory was up 20% compared to a 21% decline last year. American Eagle inventory was up 10%, and Aerie was up 16% compared to second quarter 2020 as we positioned inventory below current demand levels as part of our ongoing efforts to optimize inventory buys. As Michael mentioned, we feel confident in our ability to navigate on building supply chain challenges and secure products for our customers. I'm very pleased with our liquidity and the health of our balance sheet. We ended the quarter with $824 million in cash and short-term investments. This compares to $899 million in second quarter of 2020, which included $200 million from our revolving credit facility that we subsequently repaid in the third quarter of 2020. Capital expenditures totaled $49 million in the quarter, and $86 million year-to-date. For 2021, we now expect capital expenditures to be at the low end of our previously communicated $250 million to $275 million guidance range, reflecting cost savings on our planned projects. With regards to our real estate strategy, as I mentioned last quarter, with 450 leases either come to term or warranting action in some way this year, we have significant flexibility to manage our store fleet to support our revenue and profit agenda. We're making steady progress towards our long-term goal of rightsizing AE's store footprint. For Aerie, we are focused on markets with the greatest opportunity and are on track with our store opening schedule. Focused investments in our international business are also helping us gain traction in key markets where we see compelling long-term growth opportunity. Mexico is a good example of this, where our omnichannel selling strategy is driving healthy growth and profitability in the market. All in all, I couldn't be more pleased with our performance year-to-date. As we look ahead into the back half of the year, supply chain disruption is creating some challenges and uncertainties. We're putting our customers first and prioritizing product availability. While there will be incremental transportation costs, we believe we can offset a significant portion. Demand for our brand is healthy, our inventory optimization is enabling promotional discipline, and our supply chain transformation is creating cost efficiencies. Based on our record first-half results and the current strength in the business, we feel confident in our ability to achieve operating profit of $600 million this fiscal year. This is well ahead of our financial targets that we presented back in January. We continue to execute on our real power, real growth value creation plan with speed and confidence. Our results year-to-date are a clear proof point that we are focused on the right initiatives, positioning us well to drive continued strong financial results and returns to shareholders. With that, I'll open it up for questions.

Our first question is from Oliver Chen of Cowen.

Revenue growth was really solid, but it was below somewhat elevated Street expectations. What are your thoughts on inventory availability across both brands and whether there were pockets where you may not have had enough? And how are you thinking about the ability to chase between back-to-school and holiday, depending on trends? Another follow-up on AirTerra. It sounds very innovative. Would love your rationale for purchasing that in terms of timing and how it may impact your financial algorithm longer term.

Thanks, Oliver. It's Mike. I'll address the first part of that. I appreciate your comment about somewhat elevated revenue. There are a few reasons for this. While we are all comparing to 2019, it's important to note the back-to-school shift affecting July's business and the tax-free events that moved from July to August. We've seen this impact in July. Our business certainly picked up in May and June, and the latter part of July can be linked to the back-to-school shift. From an inventory standpoint, we are very satisfied with our current position in the third quarter. We were encouraged by what we observed in August as our inventory looks strong. We believe we are well positioned for the remaining quarter and the rest of the year. I'll hand over that part to Michael concerning our outlook for the season and the AirTerra question.

Right, Oliver. So clearly, there's a lot of challenges in the supply chain. There are port slowdowns. We have some factories that are closed. Transportation is less predictable. Our team has done a tremendous job there. I mean, supply chain transformation has been a huge focus for us. And we're very focused on controlling everything that we can, and there's a lot that's within our control. So we're moving freight faster than ever. We've added carriers. We've secured our capacity. We've moved production out of closed factories wherever possible, and we've diversified the ports we're coming into. And domestically, we've sped up our supply chain by almost 1.5 weeks versus how it was previously and compared to how a lot of our competition is. Our goods are coming in, they're going directly to markets and out to stores or to customers. So our supply chain speed is better than ever. As far as chase, we really booked a lot of holiday product early based on the insights that we had from spring, summer, and the test that we did for holiday, and we feel good about the assortment that's coming in. So there is volatility, but we're managing through it. We expect that we're going to get all the freight that we want. We're going to have enough product to have a robust holiday season. And we're still chasing product. So we chase product as late as last week, and we expect that we're going to get it for the holiday. So there is variability, but we're managing through it; and we feel like we're set up for a great season. As far as AirTerra, we're extremely excited to acquire AirTerra and to welcome their terrific management team into the AE family. AirTerra, if you think about it, is really a relatively small purchase that has huge potential for us. It's a company that's focused on the middle mile, and it's really focused on bringing economies of scale and the benefits of speed and cost, and diversity to shippers of all sizes. Previously, these benefits were only available to the largest shippers, like the Amazons or Targets or Walmarts, and we looked at it as a company we wanted to use for the American Eagle business. We thought it was a great acquisition opportunity. So it completely fits with our strategy of leveraging scale and innovation to help us manage costs and improve service. They've shipped their first few packages for other customers and for us. Honestly, we're blown away by the amount of interest we've had in this business. So they have a tremendous pipeline of brands and retailers, large and small, that all want to use AirTerra. The more people that get on, the more it helps to build the AirTerra business as well as support the American Eagle business, providing economies of scale and transportation benefits for us. We think this is a big idea. It's something that we're going to be talking about in the coming weeks and quarters. And we expect that it's going to be incremental to the profitability of the company.

Our next question is coming from Paul Lejuez of Citi.

This is Kelly Crago on for Paul. Thanks for the clarity on the shift with back-to-school. Just curious if you could provide a little bit more detail on what you're seeing quarter-to-date than for back-to-school trends just how those are looking. And then just secondly, on the $600 million in operating income this year is very impressive, but it does imply a step down in EBIT margin expansion in the back half of the year versus the first half. So just curious if that's going to be free or are you assuming a more promotional environment? Any color there would be helpful.

Kelly, it's Jen. I hope everyone can hear me from London, UK. We're very pleased with the results. The back-to-school season reflects a dual narrative. Last year, American Eagle launched new products in September, while Aerie introduced OFFLINE in July. It's important to consider the changes occurring; for example, Aerie has a stronger presence in the Northeast and Eastern Coast and faced challenges from shifts into August and a later Labor Day. American Eagle managed to weather these challenges well. I see strength in both brands. American Eagle is making significant investments, and our assortment has never been better, with our team executing a top-notch strategy. Our denim looks fantastic, and I'm optimistic about the future based on recent testing meetings. We're leading in denim and adapting to new trends, which are positive factors for us. We're introducing new fashion silhouettes for both men's and women's wear, and we're continuously improving. The holiday previews for American Eagle and Aerie are very promising and align with customer desires. Regarding Aerie, we have 27 consecutive quarters of double-digit comps, which is nearly seven years. Not many retailers achieve numbers like that. Our team is performing exceptionally well, and we were ready for the back-to-school transition. We planned two deliveries this year compared to one last year to better serve our customers, especially with challenges in September. American Eagle also has a strong delivery, and the Aerie team's strategy was very astute. Our goods are performing well. Looking back at Q2, all key categories in Aerie gained market share. The OFFLINE business is flourishing in a competitive landscape, thanks to its unique approach to athletic apparel. The in-store experience is also very successful, especially with our bralette and legging categories. We still have Q3 ahead of us, and we remain humble and driven. We're working hard to secure quality for the holiday season. There are fewer months left this year, but I like the $600 million target; it's significantly above what we projected for the market, and we're on track to meet it.

Yes. Kelly, just to expand on the $600 million, it's totally freight related, nothing to do with the slowdown in demand, nothing to do with anything else we're executing in terms of gross margin expansion or operating rate expansion. It likely would have been higher if not for the freight and transportation costs that we're embedding into the back half of the year. Look, we're being aggressive. We're going to incur these costs to make sure that our customer doesn't feel any difference during holiday to their experience. We believe it's definitely short term, and we'll be coming out in January with our longer-term profit targets.

Thank you. Our next question is coming from Jay Sole of UBS.

Great. Jen, could you discuss Aerie and some of the new category opportunities? You mentioned OFFLINE. Could you elaborate on where you are seeing growth, whether it's mainly in the core underwear category or beyond?

Yes, I can definitely share that. As I mentioned earlier, we saw growth across all categories in Q2, with many delivering around double-digit increases. We're particularly excited about bralettes, which are becoming popular both as everyday wear and for outings. We're keeping an eye on this trend moving forward. Our underwear sales are also performing well, especially as we've moderated our promotional efforts, leading to strong results. Additionally, matching sets of fleeces and sweats are still trending, and we'll continue to focus on that. Leggings are a crucial part of our OFFLINE business and are sold under the Aerie brand. Currently, they rank highly in our product categories, just after intimates. We're very pleased with how that segment is performing, and we plan to keep innovating and leading in this area. Our team is actively strategizing for the OFFLINE business to ensure we stay relevant for our customers. Overall, the trends look promising. It's important to adapt as we’ve seen consistent growth in comps for nearly seven years, even amidst changes in consumer behavior. Aerie has also successfully navigated these changes, particularly with our swimwear offerings, which are set to impress for the spring and summer. We will continue to focus on what works in our business as we move forward.

Our next question is coming from Marni Shapiro of Retail Tracker.

Congratulations on the impressive start to the denim season for back to school. Jay, can we discuss denim a bit? You are now either the top or second player in the denim category. How do you plan to grow that business further? With the introduction of AirTerra and your collaboration with third parties, is there a possibility of wholesaling a white label version of your denim products to support a third party? Would you consider launching a premium line or brand under the AEO Inc. name? I'm interested in your thoughts on this, as you clearly have significant influence in the denim market. Strategically, how do you envision elevating this beyond just American Eagle?

As we've always said, and the statistics show it, we are the #1 brand for the 15- to 25-year-old demographic. We are the #1 brand for baby denim in the country. If you look at our lineup, you'll see that we keep introducing new washes, new finishes and new higher price point goods too and better quality. It's a little premature, but we'll have probably announcement in a few weeks about a new denim brand because you asked the question; we are working on a new brand concept that will be introduced in the next 30 days.

That's very exciting. It seems like the right thing given the denim platform.

And the good news about our denim is we have plenty done in the cell. We don't see any, any, any problems for the fall for getting all the data. All the factories produce our denim are running. We're getting shipments on a regular basis. We have plenty of air capacity. One thing we've done is in the last two years, the internal model of this company has been logistics, logistics, logistics. We've invested in our logistics system, as Mike was talking about. We have other investments that they have been made that are also being made as we're talking. We think we put together a world-class, not a good class. Michael didn't go into people's backgrounds. We think we have some of the best logistics people in the United States, period. And what we have accomplished, it's the most amazing thing is our cost of getting the goods to our stores. For the last several months has been less than it was a year ago or two years ago. I don't know another retailer that can make that statement that their cost of getting the goods to their stores is less than it was before. With all the current costs today and all the cost increase, they will bring it. The cost is an amazing accomplishment and our logistics team is world class that have done that. So we're very proud of that. We've done things that other retailers haven't done because we know the future of this business is going to be not just the marketing and the merchandising and running great stores. It's going to be how you operate the whole flow. And if you don't do it efficiently, you'll get deep. The pandemic has just speeded up everything. A lot of these things that we put in and worked before the pandemic started, they sped it up. And at the end of the day, if you don't win in the handling of your merchandise and your cost are impacted by everything, and we realize that we have to be able to control as much as we can and we have to be the best at it. And one thing I'm very proud of is that we put together a great team, whether it be marketing, whether they are merchandise team, whether they are design, whether store operations, and definitely our logistics team. We're very proud of it.

That's fantastic. And maybe just a follow-up on that conversation about your logistics with the AirTerra acquisition. Does that allow you guys to step up your buy online, pick up in store and that element of the business so you could even further integrate your online business with your in-store business? Is that part of the strategy here? And can it make that part more efficient?

Yes, it is. This past year, we talked about our notes. A couple of years ago, they came with the concept and showed me what they thought the future should look like. And all of a sudden, the pandemic started, and within 4 weeks, we had 5 or more reestablished. It's an amazing job they did a year ago. This would give us the ability. In many markets, they will get same-day delivery to the stores and same-day delivery to the customers, being able to respond right away. We're testing technology that we're working out right now that, in our stores, we can follow every item. If something is missing, we'll know immediately and be able to fill at the same day so we can always be 100% in-stock level.

Our next question is coming from Matthew Boss of JPMorgan.

So maybe on gross margin, so both first and second quarters, more than 500 basis points above 2019. Is there anything structurally preventing similar performance in the third quarter? And Mike, do you view this as a baseline for gross margin for which to build on as we think about this year? Or are there any areas of give back for us to consider as we think about gross margin beyond this year?

Thanks, Matt. I'll answer the second part first. Yes. And you're describing it accurately. This is a new baseline to start from. So I think if you go back to our target for 10% operating margin, we talked about gross margin being in the high 30s, right? And I think we're exceeding those expectations. So I think, yes, as we talk about our targets again in January and probably what our new operating rate target will be, which will definitely be higher than 10%, probably more like the mid- to low teens operating rate. I think the new gross margin baseline is this 40% on an annual basis. So yes, we've exceeded that in the first couple of quarters. We don't see any structural reasons why this is a one-quarter or two-quarter and done phenomenon. Is it going to be something that is the new baseline going forward?

Great. And then maybe just a follow-up on the top line. As we think about back-to-school timing and the shifts that you mentioned, just to be clear and relative maybe to the second quarter, which was up mid-teens relative to 2019, is it fair to say that August has accelerated? It seems like that's what you're speaking to. And then maybe just any color on the third quarter, meaning sales growth maybe relative to mid-teens growth that you saw in the second quarter. Any way to help on August and third quarter?

Yes, I’ll address the first half of the year again. We experienced a 17% increase in Q1 2019. If you adjust for that payment while comparing to 2019, the second quarter actually saw a 19% increase, showing an uptick from Q1 to Q2. However, the more important point is that in 2019, our revenue was at a record high for the company, but we weren't satisfied with the profit derived from that revenue, largely due to unhealthy inventory levels, too many SKUs, and excessive choices. We were essentially buying revenue. While we are looking at comparisons to 2019, we are not heavily focused on that because we are establishing a new revenue baseline and concentrating entirely on generating profit and cash flow from the revenue we're currently seeing. Our attention is on capitalizing on these impressive growth areas, which will continue and be integrated into our targets when we update them in January. To respond to the question about August, comparing August to prior years is a bit of an apples-to-oranges situation. We are pleased with what we observed in August; it aligns with our expectations and is included in our guidance. Additionally, the guidance would have been higher if not for the increased freight and transportation costs. We are focused on profit and operating rates, with revenue being a part of that. Those intense comparisons to past performance are not as significant for us anymore.

Our next question is coming from Dana Telsey of Telsey Advisory Group.

Jay, you mentioned logistics and the strength of logistics. Do you see other acquisitions coming into the fold going forward that would continue to enhance your logistics abilities and potentially even drive the operating margin higher? And then just lastly, as you think about the holiday season, with the extension of back-to-school, how do you see the timing and planning for the cadence of holiday this year?

To your first question, yes. About the acquisitions, yes.

What kind of framework are you considering, and what other qualities could be advantageous?

We're working on something. I can't go into details, but there will be an announcement probably in the next couple of months.

Got it. And then just...

We are focused on providing scale, speed, cost benefits, and improved customer service for the American Eagle business. There are many opportunities arising from the current disruptions in the supply chain. This disruption presents a chance for growth. As Jay mentioned, it’s no longer enough to just have great brands and products; efficient, agile, and fast operations are essential in today's retail landscape. AirTerra exemplifies this model and will benefit American Eagle as well as other retailers. We anticipate it will become a successful and profitable entity on its own, and we are also exploring additional companies that align with this approach.

Got it. And then the cadence of holiday, how you're thinking about it?

I can answer that, if you want. Look, I think we keep on leaning on logistics here because I think it's mission-critical. I'm getting the goods where the customer demand is in today's world. We're looking at countries thinking about shutting down again. We could go into a lockdown again, who knows? God forbid. So again, the demand could change versus direct or in stores, and that's what we're prepared to address as a team. Where our customers are, we're going to provide the product for them. Certainly with a little bit of a leadership back-to-school, I think we're going to feel a little bit of that as we move along month-to-month. And then I would say, though, I do think gifting could happen early again with all this in mind similar to last year. So I think the team is ready to address that.

Yes. Jen, I'll also add something to the data. We believe that this holiday shopping season will start earlier. From our perspective, we're planning our merchandise and will have a wide variety to choose from. However, we anticipate challenges for other retailers, including potential shortages of goods this fall, not just in apparel. If you want to purchase anything today, like cars or furniture, there are shortages affecting those markets too. Additionally, building a house takes longer and costs more than before. For retailers that manage to obtain their merchandise on time, this will present a significant opportunity. We feel well-positioned with an excellent selection in our stores, providing an exciting shopping experience and great online options. We're introducing our app's first live retailing synergies in the United States, which adds to our optimism. We believe our inventory will set us apart from others, creating a major opportunity for us. As a result, we expect to achieve strong sales and potentially higher prices for our goods. Ultimately, selling merchandise successfully while delivering value to our customers is beneficial for everyone. The key is having the right merchandise, and we will have it. Regarding logistics, we have already secured air freight capacity. If there is excess, we'll be selling it.

Our next question is coming from Adrienne Yih of Barclays.

Yes. My question is this is such a different company today versus 2 years ago. And I know you've gone through all the reasons why. But as we look at that sort of the early look toward the low to mid-teens, I mean, we haven't seen those types of margins for pre-2008. And I'm just wondering, last 2 quarters, you've kind of sort of in line with the Street expectations, but I'm wondering if the Street from our perspective needs to appreciate on a 2-year basis at 14% over '19 at 7% for each year, how should we think about the algorithm of top-line growth? Should it be mid- to high single digits with low double-digit EPS on growth, leverage growth to the bottom line? Because it really sounds like you are driving this business for quality sales at higher and higher profits. And then, Mike, my second follow-up question is can you quantify in basis points the freight impact to Q2 what's embedded for the second half? And how much have you been able to offset that with AIR increases?

Adrienne, I think you just summarized the situation well. This is a different company with a new focus. We are not striving for revenue targets. Instead, we are concentrated on our two brands. Aerie is expected to have a growth rate of over 30%, while American Eagle is showing some modest growth. In the second quarter of 2019, we experienced a five percent increase, normalizing for that payment. However, Mike, you observed significant growth in margin dollars on the American Eagle side. That's where I'm headed. When I refer to the 2019 baseline and the unhealthy sales we experienced, it pertains to the AE brand, not Aerie. We have modified the business model and are operating in a different manner. Inventory is healthy at the top line. To be honest, the AE brand achieved a 5% increase over 2019, setting a new record since 2019 was also a record. I'm truly pleased that we are generating comparable or even higher revenue with the income flow we are experiencing. We are establishing an impressive baseline here. Looking forward, I anticipate modest top line growth for AE and continued growth of over 30% CAGR for Aerie, focusing on revenue flow from both brands. Considering operating margin in the future, I believe we'll be discussing gross margins around 40%, low to mid-20s for SG&A, 3 to 4 points for depreciation and amortization, and a new target in the low to mid-teens for operating rate, potentially exceeding that as we optimize the flow from Aerie's revenue growth. We have additional growth stories to share as well. We've mentioned Mexico in our prepared remarks, and we see other international opportunities for healthy growth. Regarding freight costs, that's a fluctuating target. We believe our guidance accounts for everything we currently know, but it might improve. We'll observe how that develops. Our intention is to be aggressive in ensuring our products arrive on time to ensure the customer experience remains unaffected during the holiday season, which we believe can provide a competitive advantage. However, since it's a moving target, I can't provide specific basis points. For now, I will just say it's included in our $600 million estimate and may improve further.

Thank you. At this time, I would like to turn the floor back over to Mr. Schottenstein for closing comments.

Thank you. I want to express my pride in our exceptional team across marketing, merchandising, design, store operations, and logistics. We have been able to attract and retain world-class talent, which excites us. We've worked diligently to enhance our product offerings and improve customer selections, which is evident in our performance improvements, particularly with American Eagle. Notably, Aerie has achieved 27 consecutive quarters of double-digit comparable sales growth, a remarkable feat for any retailer over the past 7.5 to 8 years. Additionally, we are thrilled to introduce our new brand, OFFLINE, which has great growth potential similar to Aerie. We see vast opportunities with other brands like Outsider, Unsubscribed, and our new denim concept. Following our Investor Day last January, we outlined a three-year strategy; however, we realized we would surpass our profit goals even sooner. We plan to have another Investor Day likely next January to reset our three-year goals, and we feel optimistic. We are well positioned for the back-to-school season and are pleased with the start of September. We believe our systems and strategies will set us apart from the competition. Ultimately, we aim to be distinct, with products that our customers love and brands that enjoy significant loyalty. We recently saw unprecedented enrollment in our loyalty program, further fostering our optimism for the second half of the year. Thank you for your continued support. Our team is focused and determined to innovate and excel, and we appreciate all your support.

Ladies and gentlemen, thank you for your interest in American Eagle Outfitters. You may disconnect your lines at this time, and enjoy the rest of your day.