Carter's Inc

NYSE:CRI

Earnings Call Transcript 2018-Q2

[Operator]

Ladies and gentlemen welcome to Carter's Second Quarter 2018 Earnings Conference Call. On the call today are Mr. Michael Casey, Chairman and Chief Executive Officer; Mr. Richard Westenberger, Executive Vice President and Chief Financial Officer; Mr. Brian Lynch, President; and Mr. Sean McHugh, Vice President and Treasurer.

After today's prepared remarks, we will take questions as time allows. Carter's issued its second quarter 2018 earnings press release earlier this morning. A copy of the release and presentation materials for today's call have been posted on the Investor Relations section of the company's website at www.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 report 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.

[Michael Dennis Casey, Carter's, Inc.]

Thanks very much. Good morning everyone. Thank you for joining us on the call. Before we walk you through the presentation on our website, I'd like to share some thoughts on our business with you. We achieved the second quarter sales and earnings goals that we shared with you on the last call. Our growth was driven by our Retail and International segments.

As expected, our Wholesale sales were lower than last year, due to the loss of sales to Toys "R" Us and Bon-Ton, but were better than planned given earlier demand for our new product launches from some of our largest customers.

We meaningfully outperformed our earnings forecast in the second quarter. You may recall our quarter got off to a slow start with unusually cold weather through the first half of April. As we've seen in years past, demand during our seasonal transition period is difficult to forecast.

By late April, we clearly saw the benefit of pent-up demand for warmer weather apparel. That's the beauty of our business. Young children's apparel is a less discretionary purchase. Children outgrow their clothing rapidly in those early years of life and require more frequent refreshes of their outfits, particularly as the seasons change. As spring-like weather arrived in more parts of the country, we saw significant improvement in our sales.

Not knowing exactly when our sales trends would improve, we curtailed discretionary spending where possible to mitigate the impact of unseasonably cold weather and winter storms earlier this year. You can see the benefit of that effort in our results this morning.

All in all, we had a good second quarter and first half. We saw a good contribution from our new sources of growth, including Amazon, Skip Hop and Mexico, which largely offset the discontinued sales to Toys "R" Us and Bon-Ton.

The more meaningful portion of our year is still ahead of us. Our outlook for the year continues to be good. We have many good initiatives underway which we believe will enable us to achieve our growth objectives this year.

Our more significant initiatives include launching our Age Up strategy, improving store productivity, strengthening our eCommerce capabilities, and recapturing lost sales to Toys "R" Us. With respect to our Age Up strategy, we recently launched our Carter's KID product offering.

Beginning this summer, our younger toddler age product offering has more differentiated creative and styling relative to our products for older children. We've also added two new sizes to our Carter's brand up to size 14, consistent with our OshKosh brand. We believe this initiative will extend the relationship of our Carter's brand with families with young children.

One of the more frequent suggestions we hear from our customers and store associates is a need to extend the age range for our Carter's brand. Our research showed consumers love the beauty and value of our product offerings and would like to stay with our brands longer as their children grow. With our Age Up strategy, we will support the apparel needs of children from a newborn up to about a 10-year-old child. The early feedback from consumers on this initiative is very encouraging. We'll share some of that feedback with you this morning.

We have the number 1 market share in both the baby and toddler age segments We have the number 5 market share in the older age segment. Every point of share in that market is worth over $100 million. Our consumer data suggests we're seeing a faster rate of growth in customers shopping for our 4-14 product offerings, more than twice the rate of growth in our total retail customers.

Our Age Up strategy is being supported with an increase in marketing investments this year. Our With You From the Start brand campaign launched earlier this year. It highlights those special moments in the early years of a child's life. We're seeing a very good response to the campaign. We'll share a link to the latest phase of that marketing with you this morning

With respect to improving store productivity, as you know, our retail stores have grown to be the largest component of our annual sales. In recent years, we have improved the convenience of shopping for our brands by opening dual-branded stores closer to densely populated areas. This initiative has been very successful. Consumers continue to respond most favorably to our co-branded store format which had positive store comps in the first half. These stores provide one-stop shopping for families with young children. They offer the most productive and complementary styles from two of the most trusted brand names in young children's apparel in one convenient location.

Our new co-branded stores are our most productive stores and provide the highest return on investment. Beginning this year, we plan to open about 160 more co-branded stores by 2022, improving the mix of these dual-branded stores to at least 50% of our store portfolio, from about 20% at the beginning of 2017.

We plan to close 115 less productive stores by 2022, largely standalone Carter's and OshKosh stores, many in remotely located outlet centers. About a third of the 115 store closures are planned to occur this year. Stores scheduled for closure had less than a 2% operating margin last year – those stores to remain open had an operating margin of over 20%.

As we close these stores, we are assuming about 20% of their store sales will be transferred to our other stores located in an adjacent market. The profitability of those transferred sales flows through at a very high margin given the fixed cost structure of our store model. To date, we are exceeding that 20% transfer benefit assumption.

Our objective with these openings and closures is to improve the productivity of our stores and to strengthen the consumers experience with our brands. Our multi-brand customers are our most valuable customers. Our data shows that the number of our multi-brand customers grew over 20% this past year and their annual spend is 2 to 3 times that of our single brand customer.

Over the past year, 84% of our customers shopped in our stores. That's understandable given the beauty, convenience and service level in our stores. Those customers who shop both online and in our stores spend more than twice the annual amount of our online-only customers. We plan to continue investing in both our online and store experiences to improve our omni-channel capabilities, enabling consumers to shop online and then pick up their purchases in our stores and making the expanded scope of our online product offerings available to consumers shopping in our stores.

Carter's is the best-selling young children's apparel brand in the online channel in the United States, with more than twice the share of our nearest competitor. In the first half, our Retail eCommerce business continued to be our fastest growing, highest margin business. To further strengthen this component of our business, we've taken steps with our supply chain to improve the speed of delivery of our eCommerce orders. Our research shows that the quicker the delivery, the higher the satisfaction rating and annual spend by consumers. We believe this initiative will further strengthen our position as the leader in online sales of young children's apparel.

Given the strength of our multi-channel model, we have the benefit of reaching more consumers through the online capabilities of our wholesale customers. Year-to-date, the online sales of our brands through our wholesale customers is up over 30%. Last year, we strengthened our eCommerce capabilities by launching our Simple Joys brand designed exclusively for Amazon Prime customers. In Amazon's recent Prime Day event, we saw an extraordinary response to our 4 brands selling on Amazon.

Collectively, we saw our sales more than double during this event. We expect Amazon will grow to be one of our largest customers in the next 5 years. Together with our wholesale customers, we expect to achieve $1 billion in online purchases of our brands next year.

As you may know, all of the Toys "R" Us stores in the United States have now been closed. Those store closures will weigh on our Wholesale growth this year, but will provide a meaningful opportunity for us to service their customers directly and more profitably in the years ahead. Earlier this year, we adjusted our growth objectives for 2018 to reflect our best estimates of the potential impact of the Toys "R" Us store closures, and our ability to recapture those sales this year.

We are uniquely positioned to benefit from these store closures given the strength of our brand presence in over 18,000 retail store locations throughout the United States, and on Carters.com, one of the best performing websites for children's apparel. Our latest analysis suggests we've seen additional demand for nearly half of the $40 million in sales we plan to recapture this year We're expecting more progress with the recapture in the second half through higher replenishment trends and store sales now that all of the Toys "R" Us stores have closed.

Some of the risks we're managing in the balance of the year include the exposure to new tariffs on China imports and rising product costs. New tariffs imposed to date on China imports are not expected to have a material impact on our 2018 growth objectives. That said, this is a fluid situation, and we will continue to monitor the reports on trade negotiations and assess the impact, if any, on our product categories.

We now have more visibility to Spring 2019 product costs. After several years of consistently lower product costs driven, in part, by the success of our direct sourcing strategy, we are forecasting higher product costs beginning in the fourth quarter this year. Our Spring 2019 prices have been raised to mitigate the margin impact of these cost increases. Longer term, we are assuming a more inflationary cycle with low single-digit increases in product costs and consumer prices.

To help mitigate the exposure to rising product costs, we have invested in new inventory management and pricing capabilities. We believe the margin opportunity from these investments is meaningful. We have sold in our Spring 2019 product offerings to the major retailers in the United States. They understood and accepted our pricing proposals. With an improving economy, low unemployment, and the benefits of the new tax law, including higher take home pay and the doubling of tax credits for families with young children, we believe our new pricing for Spring 2019 will be supported by consumers.

In summary, we've had a good first half. We've largely recovered from the impact of the delayed start to spring sales and mitigated the impact of the unexpected closure of Toys "R" Us and Bon-Ton stores. Because of those store closures, we're forecasting our Wholesale sales down a bit this year. But, we're expecting good growth in our Retail and International businesses. And we expect Amazon, Skip Hop and Mexico will contribute more meaningfully to our growth in sales and earnings this year.

I want to thank all of our employees that helped us weather the storms and other challenges in the first half. With their support, we expect to achieve our growth objectives this year.

Richard will now walk you through the presentation on our website.

[Richard F. Westenberger, Carter's, Inc.]

Thank you, Mike. Good morning everyone. I'll begin on page 2 of today's presentation materials with our GAAP-basis income statement for the second quarter.

Most of my comments today will speak to our results on an adjusted basis. We had no adjustments to our second quarter GAAP-basis results this year. Last year's Q2 results included some minor charges related to our acquisitions of Skip Hop and Mexico.

Our second quarter presentation and earnings release include reconciliations of our GAAP-basis results to the adjusted basis of presentation. I encourage you to review this information as you evaluate our results.

Turning to page 3 with some highlights of the second quarter. As Mike noted, we exceeded the sales and earnings guidance provided on our previous call in April. A good portion of our outperformance in the quarter was timing related, including some earlier demand for new product launches in the Wholesale channel and lower spending, some of which we now expect to incur later in the year than we had originally planned.

Consolidated net sales grew 1% over last year, driven by growth in our U.S. Retail and International businesses. As expected, our U.S. Wholesale business was down versus last year, although total Wholesale net sales were stronger than we had planned.

It's worth pointing out that our sales to Toys "R" Us and Bon-Ton in last year's second quarter were approximately $26 million, so we have had a significant challenge this year and as Mike said, we feel good about our progress to date in sales recapture and the progress of our growth initiatives in providing new sources of revenue.

Adjusted operating income declined 13%, driven by higher investment spending and lower Wholesale revenue, which were partially offset by a higher gross margin rate. Adjusted earnings per share were comparable to last year, reflecting in part, the benefits of a lower effective tax rate and lower share count.

Turning to page 4 with a summary of our net sales performance in the second quarter. Sales in our U.S. Retail segment grew nearly 3% which was also stronger than we had forecasted. Recall that our early Q2 Retail sales were under pressure from the shift of Easter into the first quarter and a slow start in sales which we attributed to unseasonably cold weather around the country.

We saw a particularly strong rebound in U.S. Retail sales beginning in late April, with very strong traffic and comp sales in both the store and online channels. Sales in U.S. Wholesale declined approximately 4% compared to last year, due to the reasons I've already mentioned. International segment net sales grew roughly 3%, driven by growth in Canada, the contribution from our Mexico business, and favorable movements in foreign currency exchange rates.

Moving to our adjusted P&L for the second quarter on page 5. Moving below net sales consolidated gross margin expanded 60 basis points to 44.5%, driven by sourcing efficiencies and improved price realization. Royalty income declined 8%, due to the in-sourcing of a formerly-licensed product category, the timing of licensee shipments, and the absence of royalties from our former licensee in Mexico which we acquired in the third quarter of last year.

Our adjusted SG&A rate was 37.8%, compared to 36% in the second quarter of last year. This increase reflects continued growth in our stores and eCommerce businesses, investments in marketing and expedited shipping in eCommerce, as well as incremental expenses associated with the acquired Mexico business.

Second quarter net interest and other expense was $9 million compared to $7 million last year. The increase reflects foreign currency losses and higher interest expense due to higher market interest rates and modestly higher borrowings versus a year ago.

Our effective tax rate declined to 22.8% from 34.5% last year, a result of the U.S. tax reform legislation passed last year. Our average share count declined 3% compared to last year, reflecting our share repurchase activity. So, again, on the bottom line, second quarter adjusted EPS was $0.79, comparable to last year.

Pages 6 and 7 summarize our first half results on both a GAAP and adjusted basis and are included for your reference. In the first half of 2018, top line sales grew 2% and we achieved adjusted EPS growth of 7%.

Moving to page 8 for a summary of our balance sheet and cash flow. Quarter-end inventories were up 9% versus last year, primarily driven by new growth initiatives such as Simple Joys with Amazon, Skip Hop, and Mexico. Excluding these initiatives, second quarter inventories were up approximately 3%.

Heading into the third quarter, we believe the quality of our inventory is good. Generally, we've been receipting inventory a little earlier across the business in support of the growth initiatives I've mentioned as well as in anticipation of good replenishment demand in the second half.

Inventory is expected to begin to normalize to lower levels in early Q4 and finish the year up in the mid-single digit range. Operating cash flow in the first half of 2018 was $103 million, compared to $107 million last year. Free cash flow was roughly in-line with the prior year at $71 million. We expect to generate solid operating cash flow this year, in the range of $350 to $375 million.

In addition, we've continued to make progress in returning capital to shareholders. In the first half of 2018, we completed $89 million in share repurchases and paid $42 million in dividends.

Now turning to page 10 with an overview of our business segment performance in the second quarter.

Our consolidated adjusted operating margin declined by 130 basis points, which as I outlined earlier, reflects gross margin expansion, offset by increased operational expenses related to growth of our stores and eCommerce businesses and investments in areas such as new technology and marketing.

Our U.S. Retail business was the highlight in the second quarter, with segment margin improving by 50 basis points.

In the second quarter, our U.S. Wholesale and International segments experienced margin declines, which I'll cover in more detail in a moment.

We believe margin performance for both our Wholesale and International segments will be stronger in the second half of 2018 than what was achieved in the second quarter principally due to the leverage associated with the higher sales volume which we have planned for this period.

We've included our business segment results for the first half for your reference on Page 11.

Moving to our second quarter individual business segment results, beginning with U.S. Retail on page 12. U.S. Retail segment sales in the second quarter increased nearly 3% versus last year. Our total U.S. Retail comp increased 1%, driven by solid double-digit growth in eCommerce. After a challenging April due to unseasonably cold weather throughout much of the country and the shift of Easter into the first quarter, we achieved a very strong comp in May as spring-like weather arrived around the country.

U.S. Retail segment margin was 11.3%, up 50 basis points compared to the second quarter of 2017. This margin expansion reflects improved price realization and lower product costs, which were partially offset by planned investments in marketing, eCommerce fulfillment, and technology.

We have a number of initiatives in place which are intended to drive the business in the second half, some of the more significant of which are summarized at the bottom of page 12. We have high expectations for the contribution of the Age Up initiative. Our past efforts in increasing the size ranges of our brands have been very successful. We've invested in improving the capabilities of our Braselton distribution center to improve the delivery speed of eCommerce orders.

We're actively working to capture a significant portion of the children's apparel business previously held by wholesale customers which have exited the market. Our investment in marketing is also up significantly, including the new brand campaign.

And last but not least, we're focused on improving the productivity of our retail stores including new tools for workforce management, assortment planning, pricing, and inventory management.

Turning to page 13. Our brands continued to shine on social media in the second quarter, surpassing our competitors in consumer engagement. During the second quarter, Carter's, OshKosh, and Skip Hop postings on Instagram collectively earned 15 of the top 16 engagement scores, as measured by consumer interactions with each posting.

Our analysis suggests that our relative share of engagement on social media continued to grow in the second quarter, increasing our lead over peers in the market.

On the next page, one of our important initiatives this year has been the launch of the "With You From the Start" brand marketing campaign. The campaign's focus is on the Carter's brand and celebrates the parenting journey, at its various stages, as a child grows. Since the campaign's launch in March, we have achieved some very strong impressions and reach, as summarized on this slide. We're continuing to evaluate and analyze the impact of the campaign on our sales.

Moving to page 15. One of the important elements of the With You From the Start campaign is supporting the launch of our extended sizes in the Carter's brand, which we have branded as Carter's KID. This marketing is intended to educate consumers about these new product offerings. While we've offered sizes 4 through 8 for several years and have built a considerable business, many consumers still identify Carter's as a younger brand. At the bottom of this slide we've included a link to one of the new campaign videos.

Page 16 is a photo of new Carter's KID product at one of our Atlanta area stores. This product presentation and signage are intended to drive awareness of this new product offering and further establish our stores as the one stop shop for children newborn up to about age ten.

Early reaction to Carter's KID has been terrific. On page 17, we've included a few representative Facebook postings reflecting the enthusiasm of consumers for these new products from the Carter's brand.

Moving to page 18 with a brief update on OshKosh. OshKosh has had a great first half of the year, driven by the strength of its product offering and the success of the co-branded store format in the U.S. Global OshKosh sales in the first half of 2018 have grown 7%. And this year, we expect global sales of the OshKosh B'gosh brand to exceed $600 million.

The OshKosh brand remains relevant and strong in the marketplace. In a recent consumer survey, OshKosh ranked second only to Carter's in unaided awareness and quality. The brand also received high marks from consumers on dimensions such as trust, satisfaction, and Net Promoter Score.

Back-to-School will be an important period for the OshKosh brand, and this year's assortment includes an expanded school uniform offering in-store and online. Back-to-School will also be important for Skip Hop.

On page 19 we have a variety of our iconic Zoo character backpacks, corresponding character lunch bags, and meal-time accessories. As we've said, we expect to double the size of the Skip Hop business over the next five years. We're seeing very good demand for Skip Hop products in our Wholesale and International segments as well as in our U.S. Retail channels.

Moving to page 20 with results for our U.S. Wholesale business in the second quarter. Second quarter net sales in U.S. Wholesale declined 4% compared to last year. This decline was largely driven by discontinued shipments to Toys "R" Us and Bon-Ton, which again were approximately $26 million in last year's second quarter.

Overall performance in this year's second quarter was better than we had forecasted, in part due to earlier demand from several customers for new product launches.

For the full year, we're expecting U.S. Wholesale segment net sales to be down in the low single digits, which reflects growth with a number of our core wholesale customers, strong growth in this channel by Skip Hop, and the recapture of a meaningful portion of the volume we've lost with Toys "R" Us and Bon-Ton.

U.S. Wholesale segment operating profit was $30 million, compared to $36 million last year. Segment margin was 14.5% versus 16.6% a year ago. This margin decline primarily reflects changes in customer mix and increased marketing spend. For the full year, we expect the operating margin for U.S. Wholesale to exceed 20%, slightly lower than last year.

On page 21, we have a photo of Carter's product at a Macy's store in Orlando. We are currently rolling out new fixtures in about 300 Macy's stores which will complement and sit adjacent to the Carter's baby pad. These fixtures will provide new capacity for a broader assortment of boys and girls toddler product, including sets and separates.

Moving to page 22 and International segment results for the second quarter. Our International segment grew 3% in the second quarter, reflecting growth in Canada, and contributions from Mexico and Skip Hop, offset somewhat by lower demand in various international markets. In the first half, our International segment grew nearly 11% over last year. Canada, the largest component of our International business, achieved mid-single digit net sales growth on a reported basis, with low single digit growth on a constant currency basis.

Canada comparable retail sales declined approximately 1%. This reflects the Easter shift of volume into the first quarter of this year and unseasonably cool temperatures that negatively affected comparable store traffic and sales in the second quarter. Canada eCommerce demand was also very strong in the quarter.

International segment operating income was $4 million, compared to $8 million in the second quarter of last year. Segment operating margin was 5.1% compared to 9.4% last year.

This margin performance reflects expense deleverage in Canada – driven by lower store sales and also in part due to one-time costs associated with insourcing eCommerce distribution. Profitability in China was also lower than last year.

Relative to the second quarter, we're forecasting stronger International segment performance in the second half of 2018, driven by improved profitability in Canada and a more meaningful contribution from Skip Hop.

Moving to page 24 and our outlook for the second half, we're planning for a strong second half, particularly in the fourth quarter. Over the past several years our business has become more weighted towards the second half, and the fourth quarter in particular, given the growth of our U.S. and Canadian retail businesses and the addition of second half weighted businesses such as Skip Hop and Mexico.

As summarized on this page, we believe we have a number of initiatives which will contribute meaningfully in the second half. We've already mentioned Age Up, Toys "R" Us and Bon-Ton recapture, and our brand marketing campaign. Additionally, we're planning for the growth rate in spending to be lower in the second half versus the first half. And we expect the benefit of the new lower tax rate and a lower share count to be more significant in the second half on the larger earnings base.

Turning to page 25 with our guidance for the third quarter and the full year. We are planning third quarter net sales to be comparable to last year. This forecast reflects expected growth in U.S. Retail and International, offset by lower sales in U.S. Wholesale. We're expecting Wholesale sales growth to rebound strongly in the fourth quarter with good expected demand from several of our larger customers and contributions from new growth initiatives including Simple Joys and Skip Hop. Third quarter adjusted EPS is projected to be comparable to the $1.70 achieved in last year's third quarter.

For the full year, we are reaffirming our previous sales and earnings guidance. Full year net sales are expected to grow approximately 3% and adjusted earnings per share are expected to grow approximately 12%. We're planning to deliver these results while continuing a good level of investment intended to drive long-term growth in our business.

And with those remarks, we're ready to take your questions.

[Operator]

Thank you. And our first question will come from Ike Boruchow with Wells Fargo.

[Ike Boruchow, Wells Fargo Securities LLC]

Hi. Good morning, everyone. Congrats on a really strong quarter. I guess, Richard for you on the wholesale and the recapture. So I think you mentioned Bon-Ton and Toys "R" Us were $26 million in Q2 last year. Can you just – is there any way to help us understand what those numbers were for Q3 and Q4 of last year?

[Richard F. Westenberger, Carter's, Inc.]

It's in the low $30 million range for both customers combined for both Q3 and Q4.

[Ike Boruchow, Wells Fargo Securities LLC]

Okay. And then you 're targeting 50% recapture on those revenues in the back half, would you say you saw any recapture of that $26 million in Q2?

[Richard F. Westenberger, Carter's, Inc.]

I think we have to-date. It would be probably a modest kind of $8 million to $10 million would be our estimate at this point across the various channels, Wholesale and our retail stores and online. The analysis is imprecise at some level, we probably have the best visibility to the commitments that we're seeing in the Wholesale channel. We have seen a lift in the performance of the first wave of stores that had closed near our own stores. We're able to measure that. But as Mike said in his remarks, we're anticipating the majority of this recapture demand will come in the second half of the year.

[Ike Boruchow, Wells Fargo Securities LLC]

Got it. And then just the last question on the spend, so your commentary around SG&A spending, sounds like it's going to be in line with – the SG&A rate in line with sales in the back half. Just can you help us understand what's going on there that deviates off of what we've seen in the first half? Is that lapping the investments that you've kind of laid out there? Last year that – some investment spend rolling off? Just how do we think about the SG&A rate dynamic in the back half? And then should that lead us on how to think about SG&A management into 2019?

[Richard F. Westenberger, Carter's, Inc.]

So, we've had a considerable wave of investment in the business over the last couple of years; particularly within Retail. That investment is continuing this year. It will moderate a bit as we get into the second half of the year. To your point, we did start to anniversary some of the spend and investment that we made a year ago so that will benefit later in the year – Mexico in particular was acquired in the third quarter, so we'll anniversary that. That will be in the cost base.

I'd anticipate that we're going to see a lower percentage growth in dollar terms. We won't necessarily see leverage in the third quarter, but we are planning for a nice reduction in the year-over-year growth rate in spending in the fourth quarter. And we are, at this point, are planning for SG&A rate leverage in the fourth quarter, I don't believe that will translate to the entire half, but we will see leverage we believe in the fourth quarter.

As it relates to next year, I think the trend that we've seen over the last few years will continue in the sense that the rate will continue to march up as the mix shift of the business continues. So growth in the Wholesale business will be stronger, we believe next year than it was this year, but still modest relative to the growth we're anticipating from our direct businesses and that is driving a higher SG&A rate over time.

[Ike Boruchow, Wells Fargo Securities LLC]

Got it. Thank you so much.

[Richard F. Westenberger, Carter's, Inc.]

You're welcome.

[Operator]

Thank you. Our next question comes from Anna Andreeva with Oppenheimer.

[Anna Andreeva, Oppenheimer & Co., Inc.]

Great. Thanks so much. And also let me add my congrats; just trying to understand what is driving the flat sales and earnings for 3Q, maybe what was the dollar amount of the earlier demand in Wholesale? And what was the expense shift that benefited 2Q? And what kind of trends are you guys seeing in Retail quarter to-date, I think you said to expect a comp acceleration in the back half?

[Richard F. Westenberger, Carter's, Inc.]

Hi, Anna. I would say that the majority of the outperformance we had to our forecast we are attributing to timing. The amount of the Wholesale demand that shifted was probably between $5 million and $10 million, probably a similar amount of SG&A that's moving around. So that does not represent upside to the full year.

For the third quarter, in particular, it's really the Wholesale business is expected to be under some pressure. Top-line is expected to decline. And that's a variety of different issues that is some of the volume that shifted into Q2 from Q3. We do have some volume that's shifting the other direction from Q3 into Q4. And while we are anticipating good, recapture of the Toys "R" Us volume that is still a net drag on the Wholesale business. That's good margin business a year ago that's not in the base, we are planning for good growth in Retail and International as I mentioned. Spending will continue to be up year-over-year. Those are probably the – that's a major building blocks of what's driving us to the sort of flattish top line guidance and flattish earnings outlook for the quarter.

[Anna Andreeva, Oppenheimer & Co., Inc.]

Okay, that's helpful. Many thanks and best of luck.

[Richard F. Westenberger, Carter's, Inc.]

Thank you.

[Operator]

Thank you. Our next question comes from Susan Anderson with B. Riley FBR.

[Susan Anderson, B. Riley FBR, Inc.]

Hi, good morning, nice job in the quarter. I was wondering if you could give a little bit more color on the gross margin for the back half and how we should think about it relative to the first half, particularly I guess as we go into fourth quarter and we start to see the higher product costs?

[Richard F. Westenberger, Carter's, Inc.]

Sure, Susan. I would say, in the third quarter we're still planning for a good gross margin, some modest expansion year-over-year. That's largely an issue of the mix. That situation reverses a bit when we get to the fourth quarter, I think gross margins might be under a little bit more pressure in the fourth quarter because we are expecting a rebound in the Wholesale business.

Product costs will start to affect us in the spring 2019, shipments which start in the fourth quarter for the Wholesale business. We do believe we are going to cover most of that with higher pricings, so we don't think that's particularly going to be injurious to margins. We've had a very good trend in gross margins as it relates to the sourcing efficiencies that we are driving in Hong Kong. We're looking forward to that benefit continuing. Those are probably the major building blocks.

[Susan Anderson, B. Riley FBR, Inc.]

Great, that's helpful. And then last question, a follow-up on Toys "R" Us and Bon-Ton. I was curious, are you guys seeing – do you think consumers had stocked up at these liquidation events and will that kind of curtail spending as we look into the back half? It sounds like you did see a lift once for the Toys "R" Us liquidations were complete, so it seems like there was actually a benefit afterwards, but just any thoughts on if you've been able to quantify anything in second quarter and then if you do think there is going to be some lag on spending?

[Michael Dennis Casey, Carter's, Inc.]

Susan, it's Mike. Yes, we did. I think it's fair to assume that there was some pull forward of demand as those stores were going through their store closure sales. We have visibility into the level of sales at Toys "R" Us in the first half year-over-year, and it was probably up some portion, of 30% or 40% as they were liquidating the inventory. So I think it's fair to say there was some pull forward. And we've seen, even when the stores were closing, we didn't see an immediate benefit. There was a little bit of a time delay. And then after the stores have closed, we started to see a lift in our store sales.

So we're assuming we'll start to see more of a lift in our store sales now that all the other stores have been closed later in the third quarter, I'd say, more meaningful in August and September than we're seeing in July. I was in the stores in June. I saw the people loading up baskets full of product. Most of our Carter's brand product was – had already been sold off, but the people were clearly loading up with those store sales. And so I think that probably is weighing a bit on our July performance right now.

[Susan Anderson, B. Riley FBR, Inc.]

Great, that's very helpful. Thanks so much. Good luck next quarter.

[Michael Dennis Casey, Carter's, Inc.]

Thank you.

[Operator]

Thank you. Our next question comes from Heather Balsky with Bank of America.

[Heather Balsky, Bank of America Merrill Lynch]

Hi. Good morning. Thank you for taking my question. I was hoping you could, I guess, touch on the International business and provide any update on China. You had talked last quarter about revisiting the strategy, and I'm just curious to know where you are in that process?

[Michael Dennis Casey, Carter's, Inc.]

Sure. So I'd say China is not making the progress we had planned for this year. Just to put it in context, we'll probably do some portion of about $3.5 billion in sales this year, total company, and the China initiative is probably worth some portion of about $15 million in sales. With losses some portion of $7 million, so to lose that amount of money on a $15 million business, we think, it needs to be revisited.

The mix of sales we have is heavily weighted to our eCommerce business on Alibaba's Tmall website. And I'd say the store model is not performing as expected. The wholesale partner that we chose a few years ago has not been able to transfer their success in adult apparel to children's apparel. And so we're exploring an alternative model. That model would enable us to provide a better experience for the consumer and a much more profitable model for us.

So our objective right now is to get the foundation for China strengthened and build a better growth plan beginning next year. Still a very attractive market. Brand name recognition – the Carter's brand name recognition is growing. It's a very fragmented market; lots of small players. We continue to believe there's an absence of a strong baby apparel brand in China and so it creates an opportunity for us. We believe the store – us having a store model and an eCommerce model are consistent with the Chinese consumer's expectation.

Managing those two businesses differently, we were managing the online business. We had our partner managing the wholesale business that was probably we would say now that was a flaw in the model. Better to have one partner managing both models for us. So we'll share – have more to share with you on that progress, creating that new model later this year – or early next year.

[Heather Balsky, Bank of America Merrill Lynch]

Thank you. And just with regards to International, are you still looking for a mid-single digit growth this year? And how does FX I guess play into it?

[Michael Dennis Casey, Carter's, Inc.]

Sure. Should be mid-single digit growth this year, if not better. And longer term we'll have more to share with you early next year. But we still envision International will be a good growth business for us.

[Richard F. Westenberger, Carter's, Inc.]

We are watching the strengthening of the dollar. That could be a factor in the second half, so we're watching it.

[Heather Balsky, Bank of America Merrill Lynch]

Thank you.

[Operator]

Thank you. Our next question comes from Laurent Vasilescu with Macquarie.

[Laurent Vasilescu, Macquarie Capital (USA), Inc.]

Good morning, thanks for taking my question. I want to follow-up on a comment made last quarter; I think it was called out that sales transfer rates are in the 15% to 20% range for store closures, that compares to the guide of 50% sales transfer rate for Toys "R" Us. Could you provide further clarity on the variance between these two metrics?

[Brian J. Lynch, Carter's, Inc.]

I think you're confusing two things. We're closing old outlet stores and we have our own stores in adjacent markets. And what we're saying is 20% of those sales for the – our closed stores are transferring over to our stores. And then on Toys "R" Us, our best estimate as – Toys "R" Us has now closed all 800 of their stores, we hope to recapture some portion of $40 million of the $80 million we expected to sell to them this year.

[Laurent Vasilescu, Macquarie Capital (USA), Inc.]

Okay. Thank you very much for the clarification. And then on any update on Skip Hop's introduction in Canadian stores, the rollout of Skidaddle? And how should we think about Skip Hop overall and the growth rate this year. Should it be high singles, low teens, mid-teens? Any context would be great.

[Brian J. Lynch, Carter's, Inc.]

Yes, Skip Hop, we've got really strong sales growth we had in Q2. We're planning it up significantly this year. The team is doing a good job of – driving innovation. And we're exploiting this multi-channel, multi-brand CRI model. We continue to add resources and integrate with CRI where beneficial. I'd say just overview, retail is real strong. We have good growth on skiphop.com. We've got expanded distribution in our Carter's stores and real strong sales particularly in the major metropolitan and international tourist stores.

Wholesale, we do expect largely to recapture the discontinued sales from TRU this year through expanded distribution, with several key accounts. We do have the Skidaddle business at Walmart which is small to-date, but plan to grow as we add new categories like diaper bags and bath as we go through the year.

And then international is doing very well. We've got expansion of our direct business over in UK. And to your point in Canada, we are leveraging our retail distribution channels in Canada and Mexico. In Canada both in-stores, we've a good presence of the product, and on their website. We're planning strong growth this year. We bought a business. It was about $100 million last year. We continue to feel good about our strategy to at least double the next five years. This year the growth rate of Skip Hop will probably be north of 30%.

[Laurent Vasilescu, Macquarie Capital (USA), Inc.]

Okay, great. Thank you very much. And then my last question is on the incremental spend on marketing of, I think, $20 million for the year. I think marketing spend increased by about $3 million in the first quarter, per the 10-Q. How much did it increase in the second quarter and how do we think about it for the back half?

[Richard F. Westenberger, Carter's, Inc.]

We have been investing in marketing and that is growing faster than sales. I would say, a portion of the $20 million that we'd earmarked on our year-end call relates to marketing, not the entire amount. In the second quarter, from memory, total marketing was up to about $3 million year-over-year.

[Laurent Vasilescu, Macquarie Capital (USA), Inc.]

Okay. Thank you very much and best of luck.

[Richard F. Westenberger, Carter's, Inc.]

Thank you.

[Operator]

Thank you. Our next question comes from John Kernan with Cowen.

[Krista Zuber, Cowen & Co. LLC]

Hi, this is Krista Zuber on behalf of John. Just two quick questions, just circling back a little bit on the inventory target for fiscal 2018, I'm sorry could you walk us through your expectations for inventory in the second half in order to hit that mid-single digit growth target for the full year? And kind of how would you characterize your inventory levels by segment?

[Richard F. Westenberger, Carter's, Inc.]

I'd say inventory has been running a little higher. As I mentioned, we've been bringing inventory in from a timing point of view a bit earlier to support some of the various programs we have around the company.

We also have a number of new initiatives that are in kind of rapid growth mode. So we've got Simple Joys which is our new brand with Amazon experiencing terrific growth. That's a little bit of a different model for us, so we have inventory on hand to support that demand.

Skip Hop is a business that we acquired last year that's growing to Brian's comments a few minutes ago. It's growing rapidly across all of its channels so we have inventory on hand to support that. That's largely a replenishment business which is a bit different for us. And then we have inventory on hand that I would say was originally earmarked for Toys "R" Us and Bon-Ton. That's largely our best margin, highest velocity product. That's our core baby assortment. That inventory is on hand and available to be redeployed to other wholesale customers as well as demand in our own Retail channel.

So inventory levels are a bit elevated. We do think they're going to moderate. It will still be elevated in the third quarter and then moderate by the time we get into the early part of the fourth quarter, more in line with our forward sales projections. We believe the quality of the inventory is very strong at the moment.

[Krista Zuber, Cowen & Co. LLC]

Great, thanks. And then just one follow-up question just sort of any update you're seeing on the competitive environment both domestically and outside of the U.S. particularly as it relates to the promotional environment. Thank you so much.

[Brian J. Lynch, Carter's, Inc.]

I would just say that the promotional environment, some specialty retailers do appear to have a little more promotion of late, I think some folks got a little heavy on inventory with Q2 with the colder weather. And we've seen some elevated promotions from some of the specialty players recently.

Our promotional cadence was fairly consistent with last year, I think the big changes were tied to the Easter shift in Q2. And we did introduce a new Fun Cash Promotion in late April that helped our business, we think in May as well. That was a trade for our Friends & Family promotion that we ran last year. But I think our promotions overall were comparable. We may have a different flavor, but in terms of their overall effectiveness they were more effective. But I would say not anymore promotional than last year. And to my comments, I think we've seen a little bit elevated levels with some of our competitors recently.

[Krista Zuber, Cowen & Co. LLC]

Thank you.

[Operator]

And at this time I will turn it back to Mr. Casey for closing comments.

[Michael Dennis Casey, Carter's, Inc.]

Okay. Thank you very much. Thank you all for joining us on the call this morning. We appreciate your questions and your interest in our business. We look forward to updating you again on our progress in October. Goodbye.

[Operator]

Ladies and gentlemen, that concludes this morning's presentation. You may disconnect your phone lines. And thank you for joining us this morning.