Carters Inc Q3 FY2020 Earnings Call

Hello, and welcome to Carter's Third Quarter 2020 Earnings Conference Call. On the call today are Michael Casey, Chairman and Chief Executive Officer; Richard Westenberger, Executive Vice President and Chief Financial Officer; Brian Lynch, President; and Sean McHugh, Vice President and Treasurer. After today's prepared remarks, we will take questions as time allows. Carter's issued its Third Quarter 2020 Earnings press release earlier this morning. A copy of the release and presentation materials for today's call have been posted to the Investor Relations section of the Company's website at ir.carters.com. Before we begin, let me remind you that statements made on this conference call and in the Company's presentation materials about the Company's outlook, plans and future performance are forward-looking statements. Actual results may differ materially from those projected. For a discussion of factors that could cause actual results to vary from those contained in the forward-looking statements, please refer to the Company's most recent annual and quarterly reports filed with the Securities and Exchange Commission and the presentation materials posted on the Company's website. On this call, the Company will reference various non-GAAP financial measurements. A reconciliation of these non-GAAP financial measurements to the GAAP financial measurements is provided in the Company's earnings release and presentation materials. Also, today's call is being recorded. And now, I would like to turn the call over to Mr. Casey.

Thank you very much. Good morning, everyone. Thank you for joining us on the call. Before we walk you through the presentation on our website, I would like to share some thoughts on our business with you. Carter's is making good progress, recovering from the market disruption caused by the pandemic. Thanks to the support of our employees worldwide, we exceeded our sales and earnings goals in the third quarter. We achieved a record gross profit margin in the quarter with improved price realization and fewer and better promotions. We reduced our spending and inventories below prior year levels. We also strengthened cash flow and liquidity in the quarter and gained market share. With respect to business trends, we got off to a good start in July with sales running more than 90% of prior year sales. We had substantially all of our stores opened heading into the 4th of July weekend and retail sales over that holiday shopping period comped up 7%. In August, we saw sales trend to about 87% of prior year sales as schools delayed reopening. With children starting their school year learning virtually at home, there was less of a need to shop for back-to-school outfits. September was the largest month so far this year in sales and earnings contribution. September sales ramped up to 95% of prior year sales. That's the best performance we've seen since the pandemic began to impact us in March. Our Labor Day holiday sales were the strongest in the past three years, with comparable retail sales up 15% during that shopping period. And in October, sales are trending over 90% of prior year sales. With respect to product performance, we continue to see good demand for our baby apparel and sleepwear product offerings. Our baby apparel and sleepwear contribute about 70% of our total apparel sales. We own five times the share of our nearest competitors in each of these product markets. Our playwear sales improved in July as families prepared for the beginning of a new school year. Sales dipped in August when it became clear that schools would not reopen and then rebounded in September as consumers shopped for cooler weather outfitting. We launched our Little Baby Basics product offering in late June to coincide with the store reopenings. This is the core of our baby product offerings and the best-selling newborn apparel in the United States. It's a high-margin replenishment program and one of our strongest performing launches in recent years. Replenishment trends since the launch are much better than last year. In the third quarter, our retail sales improved to 97% of third quarter sales last year. That's the strongest recovery in sales relative to our Wholesale and International segments. Understandably, the pandemic has accelerated the shift to online purchases. With fewer store visits, we reduced our hours of store operations by over 20% in the quarter. On a per hour basis, our store sales were better than last year. Though store traffic was lower, we saw higher conversion rates and higher units purchased per transaction. We believe those better metrics reflect the strength of our product offerings, our compelling value proposition, and a high service level provided by our store associates. Our stores that historically benefited from tourism, including international guests, saw the largest decline in traffic. These stores only represent about 11% of our U.S. stores but drove about 40% of the decline in comparable sales in the quarter. Until tourism and cross-border travel resume to pre-pandemic levels, these stores will likely underperform our other stores. Thankfully, what we saw in lower store performance in the quarter was largely offset by stronger growth in eCommerce sales. Given the mix and level of eCommerce inventories, we were less promotional than last year, and as a result, we saw eCommerce profitability in the quarter. Similar to our store experience, online demand from international customers continues to trend lower than last year. The biggest declines in demand were from Brazil, Argentina, and Europe. Historically, these were three of our best sources of international demand on our U.S. websites. These markets were particularly hard hit by the pandemic and stronger dollar. We continue to benefit from significant investments made in recent years in our online shopping experience. Our websites were relaunched in the third quarter last year and improved the presentation of our product offerings, ease of search and navigation, and speed of checkout experience. In the third quarter, our stores fulfilled 24% of our eCommerce orders. We've invested in technology that helps us optimize the profitability and speed of delivering those purchases. To improve the convenience of shopping with us, we now offer same-day pickup and curbside pickup services in over 600 of our stores in the United States. These new omni-channel services are margin accretive relative to shipping from our distribution center to the consumer's home. Our omni-channel customers, those who enjoy both the online and in-store experience, are our highest value customers with annual spending more than twice that of our single-channel customer. Going forward, we expect our stores will play an important role in supporting our eCommerce customers. Currently, about 85% of our stores in the United States are located in open-air centers, which we believe gives us an advantage relative to our mall-based competitors. Open air centers provide a better, more convenient experience for same-day pickup and curbside pickup of online purchases. We plan to continue opening stores located in more densely populated areas and plan to close stores in more remote and declining centers. We currently plan to open less than 100 co-branded stores over the next five years. We also plan to close about 25% of our stores as leases expire. Nearly 60% of those closures may occur by the end of next year. 80% of those closures are planned by the end of 2022. These are generally older, lower-margin stores in declining centers and less likely to support our focus on high-value omni-channel customers. Carter's is an attractive tenant. Our brands are viewed as traffic drivers and bring families with young children into the shopping centers. As other retailers struggle and downsize, new and more attractive real estate opportunities become available to us. It's a buyer's market, and we plan to pursue those better opportunities in better centers that provide convenience for our consumers and a high return on investment for our shareholders. Our Wholesale business also showed good progress recovering from store closures earlier this year. Sales in the third quarter were about 86% of prior year sales. The operating margin on those sales was better than last year. In the third quarter, we had growth with three of our top five wholesale customers. We continue to see good growth with our exclusive brands, with sales collectively up 10%. eCommerce demand for our brands through our wholesale customers was up over 40% in the third quarter, including triple-digit growth rates with some of our exclusive brands. The trend in online demand improved each month in the quarter. Together with our wholesale customers, the online purchase of our brands is up over 50% year-to-date. Within the next few weeks, we expect to achieve a new milestone for our company with annual online purchases of our brands exceeding $1 billion this year. Our Carter's brand wholesale sales were down about 25% in the quarter, driven by retailers cautiously planning for second half sales and our decision earlier this year to curtail fall and holiday inventory commitments. Generally speaking, most of our wholesale customers are lean on inventories, seeing better sell-throughs, higher margins, and in a chase mode, given better-than-expected demand for our brands. Given the pandemic-related uncertainty in consumer demand, we believe operating with leaner inventories is a better strategy through the balance of this year, even if it comes at the expense of fewer sales. Our decision to run lean around inventories may impact second half wholesale sales by as much as $50 million or less than 3% of our total second half sales. One benefit of running leaner on inventories this year is fewer low-margin sales to off-price retailers. Our sales to off-price retailers were down 18% in the quarter and down over 50% year-to-date. We use our stores and websites in the United States and Canada to sell through excess inventories, which were caused by store closures and related wholesale order cancellations earlier this year. As a result, we offer consumers a compelling value through our stores and websites and avoided losses that would have been incurred, selling the excess inventory to off-price retailers. International sales in the quarter were about 90% of last year's sales and contributed over 13% of our total company sales, which is comparable to last year. The strength of our International segment is in our direct-to-consumer business, which represented over two-thirds of our international sales in the quarter. We saw high single-digit growth in our retail sales, driven by a nearly 70% increase in eCommerce sales in Canada and Mexico. Many of our international wholesale relationships are with several smaller retailers, representing our brands throughout the world. These retailers have historically been a good source of sales and profitability. They've been particularly hard hit by the pandemic, stronger dollar, and other local market challenges. We currently expect that sales to these wholesale customers will be the slowest to recover from the global pandemic. Just for context, these customers contributed less than 2% of our company's annual sales in 2019. We expect a better recovery with our multinational retailers including Walmart, Costco, and Amazon. Amazon is seeing good performance from its expansion of our Simple Joys brand in Europe this past year. That should be a good source of growth for us in the years ahead. With respect to our supply chain, our team did an excellent job working with our suppliers to reduce our exposure to excess inventories. Inventories at the end of September were down over 10% compared to last year. As we shared with you in July, we're seeing delays in the receipt of products from Asia. We believe those delays were caused by reduced capacity by carriers earlier this year when demand slowed due to store closures. The delays also reflect inadequate capacity to support the surge in demand when stores reopened this summer and the precautions being taken to keep manufacturing and transportation workers protected from the coronavirus. Thankfully, our wholesale customers are lean on inventories and in need of fresh product. They have been very supportive and recognized that the delays are a function of the market disruption. As we head into the holidays, the flow of products has improved, and we do not expect shipping delays to have a material impact on fourth quarter sales. We're also managing the exposure to freight surcharges imposed by inbound and outbound carriers due to the surge in eCommerce sales and constrained capacity. Our best analysis suggests these surcharges may impact fourth quarter earnings by about $2 million. With lower input costs and excess manufacturing capacity in Asia, our supply chain team has negotiated lower product costs for spring 2021. Demand for that product offering is planned comparable to last year, and the related shipments began later this quarter. In summary, we're making good progress recovering from the disruption caused by the pandemic. We've endured a historically challenging market this past year with the unprecedented scope and duration of store closures, record unemployment, and a highly contagious and deadly virus. Thankfully, we have 20,000 Carter's employees who have demonstrated an extraordinary resilience and commitment to helping their families and their company through this crisis. Their good work is reflected in the strong performance we reported this morning. We expect the road ahead will be bumpy. That said, we believe we have a strong product offering and good marketing plans as we head into the final weeks of the year. No one knows how long the market disruption will last, what we do know is that the fundamental strength of our brands and business model should help us continue to weather the storm. We own the largest share of the young children's apparel markets in the United States and Canada with twice the share of our nearest competitors. Children's apparel is a less discretionary purchase. We focus on essential core products bought in multiple quantities on a frequent basis in those early years of a child's life. Our average price points are less than $10, providing a great value to consumers in a weaker economic environment. We are the largest supplier of children's apparel to the largest retailers in the United States. We are also the largest young children's apparel specialty retailer with one of the strongest and most profitable eCommerce platforms in children's apparel. Wherever you're shopping for young children, you'll likely see a strong presentation of our brands. I want to thank all of our employees who are focused on delivering a strong finish to this year. I'm grateful for their commitment to strengthen our brands and to serve the needs of families with young children. Over the next few months, we will refresh our growth plans based on our experiences this year. Based on our current estimates, we are planning good growth in sales and earnings next year. Richard will now walk you through the presentation on our website.

Thank you, Mike. Good morning, everyone. I'll begin on Page 2 with our GAAP income statement for the third quarter. As Mike noted, our third quarter results were meaningfully better than we had planned. Net sales in the quarter were $865 million, down 8% from last year. Reported operating income was $114 million, an increase of 35%. And reported EPS was $1.85 compared to $1.34 a year ago, representing growth of 38%. Our third quarter and year-to-date results for both 2020 and 2019 contained unusual items, which we've detailed on Page 3. We've treated these items as non-GAAP adjustments to our reported results to enable greater comparability. My remarks today will speak to our results on an adjusted basis, which excludes these unusual items. Moving to Page 4 on our adjusted P&L for the third quarter. Net sales declined 8% to $865 million, which is a meaningful improvement over the 30% decline we saw in the second quarter. We continue to see strong demand online with our U.S. eCommerce business achieving a 17% comp and eCommerce comps in Canada up nearly 60%. While gross profit dollars declined 5% due to lower sales, gross margin rate improved by 180 basis points versus last year to 44.4%. This represented record quarterly gross margin and was driven by improved price realization and continued progress in reducing excess inventory. Royalty income was roughly comparable to last year at $9 million. Spending was very well managed during the quarter. Adjusted SG&A declined to $24 million or 8% across a broad range of expense categories. Adjusted operating income grew 4% to $120 million and adjusted operating margin expanded 160 basis points to 13.8%, driven by our strong gross margin performance and management of spending. Below the line, we had higher net interest expense than last year due to the $500 million in new senior notes, which we issued earlier this year. We had other income of approximately $3 million in the quarter, largely foreign currency gains. And our effective tax rate was about 19% in the quarter, up from about 18% last year. Average share count declined 2%, driven by share repurchases in 2019. Recall that we suspended share repurchases earlier this year as part of our liquidity improvement initiatives. So on the bottom line, adjusted EPS grew 5% to $1.96, up from $1.87 last year. Turning to Page 5 with some balance sheet and cash flow highlights. Our balance sheet and liquidity remained very strong. Total liquidity at the end of the third quarter was nearly $1.6 billion, with over $800 million of cash on hand and virtually all of the borrowing capacity under our $750 million credit facility available to us. With all of the uncertainty of the current environment, we believe that having substantial liquidity, as we clearly do, is a strategic advantage for Carter's. As Mike said, we ended the quarter with inventories 11% lower than the year ago. We believe the quality of our inventory is high overall. We've made good progress in reducing excess inventory, although we're still working through some excess spring product, particularly in our stores. We're currently planning net inventories at the end of the year to be roughly comparable with a year ago. Our Q3 accounts receivable balance declined 10% compared to last year, which reflects lower wholesale sales. Accounts payable were $473 million at quarter end compared to $206 million a year ago. This increase reflects the successful extension of payment terms and rent deferrals. We continue to receive strong support from our vendors and landlords as we collectively manage through the disruptions caused by the pandemic. Long-term debt was $1 billion, up from $770 million in the third quarter of last year, which reflects our successful senior notes financing transaction in May and lower revolver borrowings. In the third quarter, we repaid $244 million, which represented all of the outstanding borrowings under our credit facility. When considering our meaningful cash position, net debt at the end of the third quarter was $158 million compared to over $600 million at the end of Q3 last year. Based on our current outlook, we believe we will have ample liquidity for the foreseeable future as our business continues to recover from the pandemic. Despite year-to-date net income, which is lower than last year, our operating cash flow was very strong at $320 million compared to $73 million last year. This increase reflects improved working capital, including lower inventory and the successful extension of vendor payment terms, which I've described. Turning to Page 7 with a summary of our business segment results for the third quarter. While sales were down, profitability in each of our business segments improved in the third quarter, and our consolidated adjusted operating margin expanded by 160 basis points over last year. Turning to Page 8. With third quarter results for our U.S. retail segment, total segment sales declined 3% compared to last year. As Mike mentioned, we saw good demand over the 4th of July and Labor Day holiday selling periods. For the quarter, total retail comparable sales declined 3.5%, reflecting strong eCommerce growth of 17% and lower store sales. September, which is the largest month of the year in our business, had particularly strong performance, with comparable store sales down only slightly versus last year. Store traffic continued to be a challenge for us and the broader industry. Consumers are understandably cautious, especially as we see virus counts rising again in many areas of the country. Our store traffic in the third quarter exceeded the industry benchmark, which we follow. While traffic was down, we saw improved conversion and higher transaction values in our stores in the third quarter. The adjusted operating margin of our retail segment improved by 50 basis points to 11.4%, driven by improved price realization, especially online, and our improved inventory position and good control of spending. Turning to Page 9. Consumers continued to take advantage of our omni-channel capabilities in the third quarter. We've worked to optimize our stores to make it convenient for customers to arrive and quickly pick up their online orders. Many customers are also taking advantage of curbside pickup, which is a new capability for us. Overall, the synergy and integration between our eCommerce and the successful extension of vendor payment terms, which borrowings under our credit facility. When considering our meaningful cash business and our nationwide network of convenient and easy to shop stores continue to grow. On Page 10, all of our recent marketing efforts continue to be highly integrated with our presence on social media. In the third quarter, we built on our leadership position by adding more followers on Instagram and Facebook than our largest peers in children's apparel combined. On Page 11, we had particularly high engagement in September with two specific promotional events. With the pandemic, many families weren't able to take their usual end of summer vacation around Labor Day. Recognizing this, we held the promotion to give away staycation packages to families. This promotion generated the highest ever social engagement for the Carter's brand. We also held a special celebration of the 125th birthday of the OshKosh B'gosh brand, which included the release of special limited edition vintage overalls in sizes for the entire family. This promotion proved very productive as we sold out of the kid sizes of these special overalls within a few weeks. Turning to Page 12. Another family tradition which has gone virtual is the announcement that a new baby is on the way. During our Baby Love event in September, we gave away 10,000 Carter's bodysuits with the message 2021 Looking Bright to celebrate the happy news of a new baby set to arrive in 2021. Moving to Page 13. Since the pandemic began, we've been providing families with ideas for activities while they spend more time at home. We recently initiated a twice-a-week email series for parents with toddlers and babies with new ideas and tips for fall. These communications have continued to deepen our relationships with our customers and reinforce that no brand understands parenthood better than Carter's. On the next page, it seems clear that we will all be living with the reality of social distancing for a while longer. Like so many other things, the tradition of kids visiting Santa will be different this year, realizing that we've collaborated with the innovative and popular Cameo platform in order to deliver personalized virtual messages from Santa to thousands of children for Christmas. On the next several pages, we've included examples of some of our marketing for the holidays. Maybe this year, more than most families are looking forward to being together and celebrating the holidays. On Page 15, we've seen strong demand for our holiday products, Halloween, Thanksgiving, and Christmas products are all exceeding expectations and last year's performance metrics. On Page 16, Carter's is known for our pajamas, especially Christmas PJs with sizes for everyone in the family. On Page 17, we also have extensive offerings for special outfitting for dress applications for the holidays. And this year, on Page 18, we have toys from Skip Hop and Carter's. In the majority of our stores, we will introduce special Santa's toy shops for the holiday season. Moving to Page 19 with a recap of U.S. wholesale results for the third quarter. While net sales were lower than last year, our sales were meaningfully better than we had expected. The upside to our forecast was due to several factors. We saw some earlier demand for fall product from several retailers, replenishment demand for Little Baby Basics was strong, and the impact of the delay in the arrival of product, which we mentioned on our last call, was less severe than we had forecasted. All of our wholesale customers are investing in and growing their online businesses, which has translated into strong demand for our brands. Demand for our exclusive brands at Target, Walmart, and Amazon was strong in the third quarter with combined sales growing 10% over last year. Our Skip Hop brand grew nicely in the wholesale channel this quarter. With consumer spending more time at home, Skip Hop's Home Gear, Playtime, and Bath Time products have proven very popular. As Mike said, sales of the Carter's brand were down in the quarter, in part due to the fact that in the early days of the pandemic, we proactively canceled a good amount of fall and winter inventory commitments, and given that many customers have understandably chosen to run leaner on inventory in the current environment. Shipments to the off-price channel declined meaningfully in the third quarter as we're more effectively using our own retail channels to clear excess inventory. U.S. Wholesale adjusted segment income was $67 million in the third quarter compared to $73 million a year ago. Adjusted segment margin improved by 140 basis points to 22.3%, reflecting lower inventory-related charges which were partially offset by higher bad debt expense. On Page 20, we launched our core Little Baby Basics collection annually. This year, we did so in late June, which is somewhat later than normal. These products are the everyday essentials that every parent of a newborn needs. We're seeing very strong performance of Little Baby Basics this year. We sell these signature products in multiple channels, including at some of our largest wholesale accounts such as Kohl's and Macy's. Performance in our own stores on carters.com and in our International business has also been strong. Beginning on Page 21, we've included a few slides that highlight our exclusive brands, which are available at Target, Walmart, and Amazon. But just one new brand continues to enjoy good momentum. Target has invested in several digital campaigns highlighting Just One You. These campaigns have increased awareness of the brand among new and existing guests at Target. Sleepwear for infant and toddlers has been a particularly productive category with plans for continued momentum in the fourth quarter with Christmas pajamas and a broad assortment of sibling dressing products. On Page 22, on the Child of Mine brand at Walmart. In the third quarter, eCommerce sales of Child of Mine more than doubled over last year. Here too, investments in brand marketing have driven good productivity and momentum in Child of Mine, which we expect will continue into the holiday selling period. Finally, on Page 23, our Simple Joys brand continues to resonate with consumers. We have a strong partnership with Amazon and Simple Joys has grown to be one of our largest brands. We participated in another successful Prime Day recently, where we posted a significant increase in sales. The Simple Joys assortment has expanded over the past few years and now includes Baby, Toddler, and Pajamas up to size eight, as well as shoes and accessories. Moving to Page 24 and third quarter results for our International segment. International net sales declined 10% to $114 million. This decrease was principally driven by lower wholesale shipments to markets outside of North America due in part to the stronger U.S. dollar as well as the disruptions caused by the global pandemic. Canada delivered a very good quarter overall, with retail comparable sales growing 7%. Online demand continued to be strong with eCommerce comps up 58%. Store comps in Canada were down a bit, but the arrival of colder weather and good back-to-school demand helped boost sales. Net sales in our Mexico business were down year-over-year, reflecting a weaker peso and lower wholesale sales. We're making good progress in the retail portion of the business in Mexico. Our new larger co-branded stores are performing well and eCommerce, which we launched late last year, continues to post strong growth. International adjusted operating margin expanded 270 basis points to 15.8%, driven by strong performance in Canada that was partially offset by a lower contribution from our partners business. On Page 25, we've included a photo of one of our newest stores in Mexico. The store is our sixth larger format co-branded store. Initial consumer reaction has been very positive. In Q3, this store has quickly become one of our best-performing locations in Mexico. Page 26, we've included pictures from the first three stand-alone Carter's stores in Brazil, two in São Paulo and one in Rio de Janeiro. These stores are operated by Riachuelo, our exclusive partner in Brazil. As many of you know, we've had a strong following by Brazilian consumers shopping with us in the United States over the years, so establishing a direct presence in this important market is a good step forward. Early reaction from consumers to these new stores has been very positive. Turning to Page 27 with our outlook for the balance of the year. As with last quarter and given the ongoing market disruption caused by the pandemic, we're not providing sales and earnings guidance today. We expect that COVID-19 will continue to have a significant impact on our operations in the fourth quarter. We're assuming that store traffic will continue to be lower than last year, and we're mindful of the risk of the resurgence of COVID-19 in key markets in North America. We expect that online demand will continue to be strong in the fourth quarter, and we're planning for continued gross margin expansion.

Our first question is coming from Paul Lejuez with Citigroup. Please go ahead.

Can you talk about what's happening at point-of-sale at the big three retailers you're partnered with on the Wholesale business? Just in terms of what's happening in POS versus the rest of the business, the rest of the wholesale business? I'm trying to get a sense of sell-through versus sell-in and what that might imply for when business might stabilize? Just if you could comment on that.

Sure. I'd say sales of the top three, the ones that you're referencing, have been brisk. I think, by and large, many of our wholesale customers are lean on inventories, in part because we, earlier this year, when the pandemic hit, curtailed our inventory commitments for fall and holiday. We did not do that for the exclusive brands. We did do that in the core Carter's Wholesale business. But with respect to Target, Walmart, Amazon sell-throughs, point-of-sale, over-the-counter, sales have been brisk, and we expect it will continue to be through the balance of the year.

And Mike, did I hear you say that you're planning your spring demand to be flat versus last year? Is that at a company-wide level? Maybe if you could talk about how you're thinking about demand in Retail versus Wholesale for spring?

Sure. That's relative to spring '20 and that's the Carter's brand, we're planning the Carter's brand spring '21 comparable to spring '20. So there's some indication based on that demand that things may stabilize. Time will tell. I think a lot depends on how we get through the holidays. We have two important months ahead of us. And I think of some retailers, I remember our top-to-top meetings earlier this year in January. It was clear some retailers did not have the holiday performance that they had expected. So, they planned holidays '20 more conservatively, and that's a better place to be to be leaner on inventories. At least what we're getting a signal for spring '21 that there might be some stabilization and that perhaps they may have recognized they went a little too lean on spring '20. So, we'll see. But the next two months are important for many retailers, just to see if they can continue to see good momentum in their online businesses.

Right. Aren't you lapping really big declines in spring of '20? So to plan the business down, just wondering, do you risk not having enough inventory if things do bounce back?

Yes. Yes, that is a risk. Yes, it sure is. And we decided earlier this year to run leaner on inventories. I think it's a much healthier model when you're lean on inventories. You're seeing better sell-throughs. You're seeing better price realization. You're seeing less product on the clearance rack at the back of the store at the end of the season. So at least near term, with the uncertainty in the market, we're going to continue to run lean on inventory.

Our next question comes from David Buckley with Bank of America. Please go ahead.

I want to ask about the better profitability across all channels, the improvements in gross margin and expense management. Looking to the fourth quarter and into next year, how much of this do you view as sustainable, particularly as sales trends continue to recover?

I'd say we're focused on improving the profitability of the business that we have, David. There's uncertainty around the level of consumer demand. I think that uncertainty and the volatility on the top line may continue, to Mike's point, into next year. So our focus has been improving profitability really throughout the P&L. So, we're extremely encouraged by the improvement in gross margin. I'd say the single biggest contributor to that improved gross margin is the fact that we're improving our price realization in our own retail operation. Most of that's coming from eCommerce, which had become extremely promotional as a channel for us over the last few years. So, we've reversed that. And it goes hand-in-hand with that leaner inventory position. I think we've got the confidence in the beauty of our products, the quality of our brands to get paid a bit more for that, and that's what we're seeing in the P&L. So, we're certainly planning for continued progress on gross margin. We've also had a strong focus on spending management, and that discipline will continue as well.

That's great. Just given the higher profitability, can you guys also discuss how eCom performed as 3Q progressed? How it started the fourth quarter? And then what type of channel mix shift are you anticipating for the fourth quarter there?

Yes. eComm has done very well. It's strong sales and profitability, higher price realization through fewer promotions, so we feel really good about that business. Comps remain strong in Q2 and when stores started to open up early in Q3, it continued to do well. August was a little softer because we really didn't have that back-to-school event, but it rebounded strongly in September. So we've got good eCommerce business, it continues to be strong in the fourth quarter, and we're optimistic going forward.

We will go next to Susan Anderson with B. Riley. Please go ahead.

Nice job managing the quarter. On the U.S. wholesale segment, it looks like sales were still fairly significantly down the department store channel. I guess I'm curious how much of that is still due to weak demand there versus inventory constraints? And are you expecting it to continue to improve sequentially? And then just really quick on eCommerce, I think you said 24% was shipped from stores. Maybe if you could talk about the EBIT margin difference between shipping online orders from the DC versus the stores?

The wholesale performance reflects more curtailment of inventories that ranked that higher than conservative planning by our wholesale customers. They wish we had more inventory but we cut fall and holiday inventories for our wholesale customers back some portion of 30% or more earlier this year. Glad we did. Glad we did. And then the margin differential on shipping from the stores versus the DCs?

It's better. I don't think we're going to parse it out in DC based on that, but it's better all the way around. It's better from a customer experience point of view. We're seeing some capacity constraints in the small parcel channel. So consumers are able to get that product from our stores more rapidly. It makes more effective use of the store-based inventory. So, we're pleased to see the adoption from consumers and I think from an operational and execution point of view, getting better at it every day.

It's a significant new capability. The most expensive way to serve eCommerce customers is by shipping from our distribution center to their homes. We have 850 great stores from Maine to Hawaii, and we are utilizing these stores to enhance delivery speed and the profitability of fulfilling eCommerce orders. This approach also optimizes the inventory in those stores. Our technology can pinpoint where excess inventory exists, and that inventory is best utilized to fulfill eCommerce orders. This is a relatively new capability, which we refer to as omni-channel, leveraging our stores to enhance the experience for eCommerce customers. These activities contribute positively to our margins.

Next, we will move to Ike Boruchow with Wells Fargo. Please go ahead.

I wanted to focus on the wholesale channel. Mike, you mentioned leaving sales on the table for Q4, which I completely understand considering the inventory situation, but you brought up $50 million. Could you provide some context about the $50 million? Is it all off-price? Is it all low-margin revenue? I would like to understand what that revenue actually entails.

This has been a question we've heard a lot about, so I want to clarify. The Q3 shipments of our Carter's brand were significantly lower, while the exclusive brands were higher. In March, we had relationships with all of these retailers, but most of them called us and said they didn't need summer products and wanted to cancel their orders. We then made the decision to proactively cancel about 30% of the fall orders they had placed. This was a consistent action across the board. Our relationships remain strong, and our wholesale partners are very satisfied with our product performance, which is selling very well. However, the challenge is that they don't have enough inventory. This proactive approach was necessary due to the uncertainty we faced moving forward. Consequently, we experienced lower off-price sales as we managed the inventory more effectively and moved products through our retail stores. The main issue for the other wholesale customers is that they simply do not have as much of our inventory as they would like because we took steps to reduce it, considering the unknowns for fall and winter.

Yes. That part of the business, Ike, that's a high-margin component of our business, the core Carter's wholesale business is a very good margin business for us. And we intentionally decided to reduce the risk of having too much inventory in the second half of the year. We're encouraged by it. That's an opportunity for next year. So, it's a much better place to be when you're seeing very good sell-throughs. Everybody's lean on inventory. They wish they had ordered more, and they'll have an opportunity to order more for the second half of next year now.

Well, I guess just to wrap that up. I mean, I guess my question is. I know you're not giving guidance on wholesale, but $50 million is about 15% of rev. So should your wholesale business in Q4 look kind of similar to what it did in Q3, down 15%, but with better margins potentially? Just trying to understand how your bookings look and how we should be expecting your wholesale business to look in Q4.

Yes. I don't think we want to be precise around segment guidance for the quarter. I think the complexion of what's driving the business is what Mike and Brian have described. We have great momentum in the exclusive brands. We expect that, that will continue. We'll see good demand from those retailers. I think the Carter's brand will be down for the reasons that have been described that we cut back on inventory, which from a risk mitigation point of view, in the early days of the pandemic was absolutely the right strategy. And I'd say those retailers are also hungry for inventory as well. They're coming to us and asking for additional product. In some cases, we're able to support it. And as I said in my remarks, the replenishment demand for Little Baby Basics currently is really strong in the wholesale channel. And those are some of the folks who buy the core Mother Ship Carter's brand.

Our next question comes from Jim Chartier with Monness, Crespi & Hardt. Please go ahead.

Like, I just wanted to kind of follow up onto a comment about flat spring 2021. Is that just for the Carter's brand at wholesale? Or is that for overall Carter's including retail?

Carter's, the flagship, Carter's brand wholesale.

Okay. And so, is it reasonable to assume that the exclusive brands are planned up given the momentum that you've seen in that business?

Well, their order cycle is a bit different. We'll share more of that with you in February. We're expecting continued good growth with the exclusive brands.

How does spring flow or shift between the first and second quarter? Is summer 2021 looking flat as well, or do you expect it to be better than that?

Yes. We'll share more of that with you in February, but some of spring does start to go in December this year. That's just the normal cycle. They like to get some fresh product on the floor during the holidays and going into January. So, some of that spring does go in the fourth quarter.

Okay. And then the $50 million wholesale impact. Is that more pronounced in the third quarter than fourth quarter? Or is it more pronounced in fourth quarter?

Well, I think fall is the bigger season than holiday. So I would say more pronounced in the third quarter.

Okay. And then lastly, regarding our playwear, it seems that back-to-school had a significant impact on playwear in the third quarter. Should we expect that business to improve in the fourth quarter since it is less reliant on back-to-school to drive sales?

Yes. Back-to-school is behind us, and we experienced a decline in August, which was the worst of it. In September, as people recognized that children weren't returning to school, they shifted their focus to other product categories. For the first time in three years, we benefited from the cooler weather that came in, which always stimulates our business. When the weather changes from warm to cool, and then from cool to warm in the spring, it encourages people to shop. We experienced a significant uptick in September.

Right. And then on the store closures, are those store closures EBITDA accretive to the business overall?

I would describe them as low-margin stores, with operating margins in the low single digits. We are opening new stores with operating margins closer to 20% and closing those with low single-digit margins. In the past, we would keep stores open as long as they were cash flow breakeven or better. However, we need to consider current trends. Consumers are responding positively to our co-branded stores, and we previously made the decision to exit stand-alone Carter's and OshKosh stores. Often, we close a store when a better location opens nearby, which raises questions about why we are opening new stores while others are closing. We open new stores because they are profitable, and consumers appreciate our brand experience. Our strategy is to open stores that are closer to where consumers are, in better centers with more favorable margins, and we will close stores when leases come up for renewal or when there's a provision allowing us to decide whether to reinvest or exit. Given our current circumstances, we are more likely to exit some portion of 200 or more stores, with about 80% of those closures expected to occur over the next couple of years. Our focus is on having fewer, better, and more profitable stores close to consumers, which are more likely to serve omni-channel shoppers who enjoy shopping online and picking up in-store.

Next, we will move to Jay Sole with UBS. Please go ahead.

Mike, would it be possible to elaborate on why you're saying October was up over 90% of prior year sales when September was at 95%? And maybe is there something going on there that can explain the trend?

Sure. It's an experience we've had over the years. Any time you see a surge in demand, like we did in September with the cool weather, there's a lull. And so when the weather like here in Atlanta returned to like 80, 85 degrees, you're not thinking so much about long sleeve, long bottom outfitting. So, it's a normal type of experience that when you see a surge like we did in September, you see a lull immediately after that. But we feel good about the fourth quarter. I think we have a handle on the fourth quarter.

Can you describe the usual contribution of October to the fourth quarter on a percentage basis? Also, how significant are November and December?

I'd say September is the largest in terms of sales and earnings contribution. October will be smaller than that. I think November and December combined are more important than October, for sure just given the holidays.

Got it. With strong sell-through at wholesale and low inventories, can you provide some scenarios? Is it possible there could be a pull forward of inventory into the channel in November and December? What do retailers expect from you in that regard? Could you outline a range of possibilities for this?

I would actually say, we have seen our customers say, hey, if you got it, bring it in, bring it in, we're happy to take it. That's true this year. It's been true for years. Depending on the sell-through, if we have the product, we're happy to ship it to them earlier. And my guess is we'll see some of that this year.

Got it. And then just one last one for me. Mike, you talked about less sales to off-price this year. Is that like a strategy that you continue to want to deemphasize that channel? Or is that something where next year you could see wanting to refill and replenish that channel as well with the rest of the retail partners?

We've learned this year that we can better utilize our stores across the country, including Canada. Canada was instrumental in helping us manage some of the excess inventory that built up while stores were closed for several weeks. There are no plans to sell a significant amount of low-margin products to off-price retailers next year. We prefer the strategy we implemented in 2020 and hope to maintain it in the future.

Our next question comes from Steve Marotta with CL King & Associates. Please go ahead.

Good morning, Mike and Richard. Third quarter SG&A as a percent of sales was roughly even with last year, which is pretty remarkable given the sales decline as well as the massive shift in distribution channel mix toward e-commerce and digital. Is there anything in the quarter, from a discretionary standpoint, that was withheld? And I guess the underlying question is, given seasonality aside, can we think about this as a bit of a run rate from an SG&A standpoint? And then I have one quick follow-up.

Certainly, Steve. In the third quarter, there were several factors influencing SG&A. We had favorable results across almost all spending categories. Selling expenses were lower, aligning with the performance of our top line. Store expenses decreased, and we scaled back on marketing as our team effectively gauged consumer sentiment. When shoppers weren't in the mood to buy, we adjusted our marketing efforts accordingly. Distribution expenses also saw a decrease, although eCommerce fulfillment costs increased in connection with our 17% comparable sales growth. Most of our G&A accounts showed favorable trends as well, particularly since we had asked the organization to reduce expenditures due to some instability in the business during the quarter. The teams managed to limit spending where possible. Additionally, we are seeing favorable conditions concerning our performance-based compensation, which is currently at lower levels compared to a year ago. I don't anticipate this trend continuing into the fourth quarter, especially since we are opting to increase investment spending, which we can afford. We are confident in our liquidity, and over the years, we have effectively invested in ways that we believe will yield long-term benefits. If we exclude these investments, our spending run rate appears similar to what we experienced in Q3. However, considering these new investments, the year-over-year comparability may not be as favorable. We are continuing to invest in our website and plan to relaunch our mobile app, which is overdue given the increasing importance of mobile eCommerce. We are also enhancing our primary distribution center to improve the speed and efficiency of our eCommerce deliveries. In the fourth quarter, we intend to increase our marketing investments. While we reduced some brand-diluting promotions, we are reallocating those funds to brand marketing, which has proven effective for us. Importantly, we have restored compensation provisions that were previously minimized in response to the pandemic, including wages across the organization, which we believe is justified by our business performance and the outstanding contributions of our employees.

That's very helpful. So what I heard was it wouldn't be surprising to see SG&A deleverage in the fourth quarter.

Correct.

I got you. And one quick follow-up is, as it relates to royalty income, it was down significantly in the second quarter on a year-over-year basis, relatively flattish in the third quarter. Can you talk about that differential and how we could think about the line item going forward?

Yes. To your point, year-to-date, it's down significantly more than it was in the third quarter. We have started to see the effects of some structural and strategic changes we made in our relationships. The Genuine Kids agreement with Target, which was a substantial source of the decline in earlier quarters, is beginning to normalize. Additionally, categories we had in-sourced are now contributing to our sales and margin instead of relying solely on royalty income. We are beginning to see some overlap there as well. There have been market disruptions affecting many of our license partners, particularly concerning their ability to get products out of China and Asia. They are experiencing similar transportation and delivery challenges that we have seen with our apparel products, along with disruptions in the wholesale channel. When these partners sell their products to wholesale customers, we earn a royalty. As the market begins to recover, we hope our revenue stream will continue to improve.

Our next question comes from Warren Cheng with Evercore ISI. Please go ahead.

I just wanted to ask a question on the strong digital growth you're seeing, both owned and partner. Do you have the customer data to see how much of that is channel shift? So the sales that used to flow through your own stores, your partner stores, and how much of that is new customers coming out of the brand?

Yes, I believe there has been a shift from in-store shopping to online shopping, especially during the pandemic, as people have grown more comfortable with shopping from home. Store traffic has declined, but those who visit our stores are primarily there to make purchases rather than just browse. We've seen an increase in units per transaction and average transaction value. However, more consumers are choosing to shop online due to its convenience and our eCommerce capabilities, including product presentation, easy navigation and search, and streamlined checkout processes. Richard mentioned the relaunch of our app, expected in the fourth quarter, which I think will be significant as this trend continues. Interestingly, in the kids' apparel market, around 70% of purchases are still made in stores. This reflects the nature of shopping for young children's clothing; parents often prefer to experience this in-store, especially when expecting a new baby. Our eCommerce penetration was close to 40% in the third quarter, and I anticipate it will be similar in the fourth quarter, which is about 10 percentage points higher than last year. As we move through 2021, we hope the vaccine will reduce virus-related fears and improve store traffic. Fortunately, we have one of the most successful and profitable eCommerce platforms in the kids’ apparel sector, which helps mitigate challenges until conditions stabilize.

Got it. And then my follow-up is just on the exclusive programs. What is the price and volume trends? What are the price and volume trends been for that side of the business? And is there an opportunity to add more breadth to those offerings across categories or age groups?

Well, I think in terms of breadth, we have added, to the exclusive brands, we've got more online product for those accounts. And we've expanded, I think we said earlier this year, we've expanded in the toddler for target, Walmart, and Amazon. Those businesses are doing really well. And then we're looking at bigger sizes, starting with sleeper. So there has been an increase in the SKU base for what we sell those accounts as that business has grown and deserves a broader array of our products.

And that will conclude today's question-and-answer session. Mr. Casey, at this time, I will turn the conference back to you for any final remarks.

Thanks very much. Thank you all for joining us on the call this morning. Appreciate your support this past year. From all of us here at Carter's, we wish you and your families a happy and healthy holiday season together. We look forward to updating you again on our progress in February. Goodbye, everybody.

Thank you. This concludes today's call. Thank you for your participation. You may now disconnect.