Carter's Inc

NYSE:CRI

Earnings Call Transcript 2018-Q4

[Operator]

Welcome to Carter's Fourth Quarter 2018 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 fourth quarter and fiscal 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 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 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.

I would now like to turn the call over to Mr. Casey.

[Michael D. Casey, Chairman and CEO]

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 exceeded the sales and earnings goals that we shared with you in October. We had a very strong finish to the year with high-single-digit growth in our retail and wholesale businesses. Our analysis suggests that young children's apparel was a good source of growth for many retailers in the fourth quarter, particularly during the holiday shopping periods. In our retail business we achieved the strongest growth in comparable fourth quarter sales in five years driven by positive store comps and double-digit growth in ecommerce sales.

The quarter got off to a good start as weather turned cooler. We saw strong demand for our fall product offerings with comparable sales up 9% in October. On a combined basis, sales in November and December grew nearly 5% including good growth during the Thanksgiving and Christmas holiday shopping periods. Our retail segment contributed nearly 70% of our sales growth in the fourth quarter. We continued to see the strongest traffic to our co-branded stores with comparable sales in the quarter up about 10%, up nearly 6% for the year. These stores offer consumers the convenience of shopping two of the best known brands in children's apparel in one convenient location.

We continue to assess the performance of our various store models. With the success of our co-branded stores and convenience of shopping online, we are seeing fewer visits to our legacy outlet stores. Over the next five years, we plan to close over 10% of our stores in the United States as the leases expire. These are lower-margin stores, many in declining outlet centers. There's no compelling reason to accelerate these store closures given they collectively are cash flow positive.

We plan to replace the sales of closed stores by opening over 100 more profitable co-branded stores in better centers closer to the consumer. We believe the Gymboree store closures may provide a new $100 million growth opportunity for us. We have evaluated every Gymboree, Crazy8, and Janie and Jack store location. Our stores share many of the same locations with Gymboree in the outlet centers. We have less overlap in malls and off-mall locations.

Historically we have focused our store growth on non-mall locations with good results. That said, today we have about 50 mall based stores which have been a good source of growth for us. Given our success with malls we plan to very selectively pursue new opportunities given the Gymboree closures.

Our mix of e-commerce sales grew to 32% of our U.S. retail sales in the fourth quarter, up 3 percentage points from the prior year. 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 2017 international consumers ranked carters.com as one of their top three favorite websites during the holiday shopping season together with Amazon and Ralph Lauren. That said, we saw less demand than expected from international consumers shopping online with us in the fourth quarter.

Our analysis reflects a direct correlation between unfavorable changes in exchange rates and international demand for our brands, particularly from Brazil, Argentina, and Russia. In years past, as exchange rates improved, international demand for our brands also improved. In 2019, we expect to see continued softness in international demand in the first half and improved trends in the second half.

With respect to our wholesale business, we saw a very good growth in the fourth quarter driven by our exclusive brands for Target, Wal-Mart, and Amazon. No other company in young children's apparel has developed these meaningful sources of growth with three of the largest retailers in the world. We believe Target, Wal-Mart, and Amazon were the largest beneficiaries of the Toys “R” US store closures. Each of them provides a broader product offering for families with young children, especially newborns, relative to our retail stores and other retailers.

The Toys "R" Us and Bon-Ton closures weighed on the growth we had forecasted last year. Collectively, they contributed over $100 million in sales in 2017 and less than $20 million in sales last year. As you may know, we had expected to recapture at least half of the lost sales to these retailers last year. We invested in additional targeted marketing to their customers and saw a good return on those investments. We saw a nice lift in sales at our stores within a 5 mile radius of the closed Toys "R" Us stores so did some of our wholesale customers.

Our best analysis suggests that we achieved about 85% of our $40 million sales recapture assumption last year. Thankfully, with the passage of time following those store closures, we are seeing an improved trend in some of our key replenishment product categories. If those trends continue, we may recapture more of the lost sales this year. We expect to see further consolidation of our wholesale sales over time with fewer, better, and stronger retailers. Last year, our top five customers contributed about 60% of our wholesale sales. Sales to those top five customers grew about 4%. We're forecasting low single-digit growth in wholesale sales in 2019 with sales to our top five customers up about 5%.

Despite the effect of door closures in 2018, our brands continue to have the most extensive presence of any young children's apparel brand in the country. Our brands are currently sold in over 17,000 stores in the United States. We are also uniquely positioned in the market with our ability to sell our brands through the websites of the largest retailers of children's apparel in North America. Online sales of our brands to our top wholesale e-commerce customers grew over 30% last year. And with the support of our wholesale customers, we expect online sales of our brands to exceed $1 billion next year.

Our international business grew 4% last year to nearly 12.5% of our total company sales. Sales were down a bit in the fourth quarter largely due to a transition in our business model for China. We believe China continues to be a meaningful source of growth for us overtime. It is a highly fragmented $24 billion market with four times the number of annual births relative to the United States.

In 2018, we decided to change our business model for China. We are transitioning from a retail and wholesale model to a licensing model. The old business model was generating sales but not profitability and we concluded there was not a clear path to profitability. Earlier this month, we entered into a licensing agreement with a new China partner. Our new partner has demonstrated retail expertise in young children's apparel in China. One of the principals in this new venture has been one of our largest suppliers of baby apparel for the past 20 years. Beginning this year, our new partner will source our product offerings for the China market, and we'll manage both the online and offline experiences for Carter’s and OshKosh B’gosh brands. We believe this new model will provide consumers with a better experience with our brands and enable a more profitable growth strategy for us in China.

Going forward we are forecasting mid single-digit growth in international sales driven by the growth in our multichannel operations in Canada and Mexico and growth through our wholesale relationships with Costco, Wal-Mart, Amazon, and other retailers representing our brands throughout the world. Since our last call with you we have revisited the growth we believe possible over the next five years. We're forecasting over $4 billion in annual sales by 2023 and about $500 million in operating income. Those growth objectives equate to low single-digit growth in sales, mid single-digit growth in operating income, and high single-digit growth in earnings per share.

We have the interest and potential to outperform these growth objectives. Our current projections reflect nearly $2 billion in cash flow from operations over the next five years. Though currently we believe there are relatively few attractive acquisition opportunities, we continue to explore opportunities we believe would provide a new source of growth and attractive returns on investment. Absent better alternatives to allocate capital we plan to continue returning excess capital to our shareholders through share repurchases and dividends. Our growth plan is focused on five key strategies which are winning in baby, aging up our brands, leading in e-commerce, expanding globally, and investing in new growth opportunities.

Baby apparel represent over 50% of our annual apparel sales. Our stores are rated as moms favorite place to shop for apparel for their newborn to 24 month old child. Last year nearly 90% of millennials shopping for newborn apparel purchased the Carter's brand. Though annual births have trended lower in recent years we have expanded our customer base through our marketing efforts. We are also seeing higher frequency of visits and customer retention.

In May we will re-launch our little baby basics product offering. This product offering is the core of our Carter's brand providing the everyday essentials for a newborn to 24 month old child. It is the best selling baby apparel product offering in the United States and a high margin replenishment business for the largest retailers of our Carter's brand.

In the fourth quarter we saw a growth in every age segment in our retail business. The largest and fastest rate of sales growth was in our product offering for 8 to 10 year old children. Carter's has the largest share of children's apparel in the baby and toddler age segments two to three times this year of our nearest competitors. In fall 2018 we've launched an extension of the Carter's product offering to serve the needs of families with young children up to about a 10-year-old child. This new strategy was driven by market research which indicated consumers wished to stay with the Carter's brand longer. Based on that input we added new size ranges to the carter's brand. By entering this slightly older age segment we now have an opportunity to gain share in a much larger market.

With respect to leading in e-commerce we have the best performing branded website exclusively for young children's apparel in the United States with twice the share of our nearest online competitor. In 2019 we are launching new capabilities to further strengthen the consumer's experience shopping with us. Later this year we expect to enable same day pick up of online orders in our stores. As we've seen in recent years nearly 15% of our online customers choose the free ship to store option and about a quarter of those customers increase their purchase when they visit our stores. We believe our new same date pickup service will further enhance the convenience of shopping with us and drive more traffic to our stores.

We have also invested in capabilities to enable us to ship online orders from our stores. This new service is designed to expedite the fulfillment of e-commerce orders and will be tested with consumers later this year. Our brands are sold in about 85 countries through our e-commerce capabilities and relationships with retailers throughout the world. We will continue to pursue opportunities that enable profitable expansion in new markets. Over the next five years about 60% of our international sales growth is forecasted to be driven by Canada and Mexico.

Earlier this year we restructured our international organization to enable better collaboration between our U.S. operations and our teams in Canada and Mexico. Over the past five years we have made significant investments in consumer facing and revenue driving capabilities in the United States. With this new organization we plan to leverage those investments and extend those capabilities to support the growth we envision possible in North America.

As we view it today our organic growth rate is about 2% to 3% percent a year. Over the next five years we plan to close almost as many stores as we plan to open. With nearly 850 stores in the United States we are one of the largest specialty retailers for young children's apparel. We don't currently see a need for significantly more stores just better stores in better locations.

Our wholesale customers do a great job presenting our brands in their stores and they have been good partners and a source of growth for many years. Over time however, growth in our wholesale segment will be limited by the growth collectively planned by the largest retailers for their own businesses. Faster sales growth in international markets is possible but to do so profitably has been challenging so we will pursue a more profitable pace for growth expanding globally over the next five years.

We aspire to achieve a sales growth rate twice what would otherwise be possible organically. Over the past 15 years we have acquired brands and businesses that contributed over $1 billion in sales in 2018. Acquisitions have enabled us to strengthen our multichannel model and reach more consumers with our brands. We have a team devoted full time to exploring acquisition opportunities for us and they are supported by external resources.

We search for brands and businesses focused on the needs of families with young children, led by strong management teams and a track record of profitable growth. It is intentionally a tight screen given the risk of any acquisition. We'll be patient with our search for new brands and businesses to ensure future acquisitions provide new sources of meaningful growth and attractive returns for our shareholders.

We believe that the fundamentals of our business have never been stronger. We are the largest branded marketer of young children's apparel in the United States and the largest supplier of young children's apparel to the largest retailers in the country. We have built a diversified business model which has enabled 30 consecutive years of sales growth and a cash flow model that has enabled us to return nearly $2 billion in excess capital to shareholders since 2007.

Over the past 10 years we have managed to grow through the recession, the cotton prices, shifts to private label brands in destocking initiatives. We're now faced with the risk of tariffs, continued decline in annual births, and customer store closures. The constant through all of these challenges over the years has been the strength of our brands which have served the needs of multiple generations of consumers and the quality of Carter's employees who are focused on providing the best value and experience in young children's apparel. That focus has served us well over the years.

In summary we had a strong finish to the year. Before reporting a record level of sales and profitability for 2018 and a record level of free cash flow the outlook for our business is good and we have built a unique multi-brand, multichannel model which we believe is well positioned to grow and gain market share. We're committed to strengthen our business and provide better performance for our shareholders in the years ahead.

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

[Richard F. Westenberger, EVP and CFO]

Thank you Mike, good morning everyone. I will begin on Page 2 with our GAAP income statement for the fourth quarter. Rest of my comments will speak to our results on an adjusted basis. Our GAAP results for both this year and 2017 included some unusual items which are detailed in this morning's press release. The items that I draw your attention to would be a minor charge in this year's fourth quarter related to the transition of our business model in China.

Fourth quarter 2017 included a significant net gain related to the adoption of the new tax reform legislation. Our adjusted results exclude these unusual items in both periods for greater comparability. Our full year GAAP P&L is included on page 3. Today's 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.

Moving to Page 4 with some highlights of Q4 and fiscal 2018. We had a strong finish to the year. Fourth quarter consolidated net sales grew 6% with solid growth in both our U.S. retail and U.S. wholesale segments. Adjusted earnings per share grew 22% to $2.84 reflecting largely comparable operating income and lower effective tax rate and the benefit of share repurchases.

Higher sales, lower SG&A, and a lower tax rate drove the outperformance and EPS relative to our prior guidance. For the full year consolidated net sales grew approximately 2% and were adversely affected by the bankruptcies of Toys "R" Us and Bon-Ton. Recall that we had planned operating income for 2018 to be comparable with 2017 as we had intended to reinvest approximately half of the earnings upside generated by the reduction in the U.S. corporate tax rate back into the business.

Our adjusted operating income for the full year was down approximately 8% versus that comparable objective. We had several factors which worked against us this past year. Obviously the loss of planned sales to Toys "R" Us and Bon-Ton was a big hurdle to overcome. Our sales over the important Labor Day selling period were below our expectations and in the second half of the year in particular we saw lower than planned demand from international consumers in our U.S. retail business.

Full year 2018 adjusted earnings per share grew 9% as the benefits of the lower effective tax rate and lower average shares outstanding help to offset the decline in operating income for the year. Lastly in 2018 we continued to return significant capital to shareholders through share repurchases and dividends.

Moving to Page 5 with a summary of our sales performance in the fourth quarter, sales in our U.S. retail segment grew 7% with comp sales growing 5.7% which was on top of a positive 4.5% comp in the fourth quarter of 2017. This was our eighth consecutive positive fourth quarter retail comp. Sales in U.S. wholesale grew 7% driven by growth in our exclusive brands sold at Target, Wal-Mart, and Amazon. International sales declined 2% reflecting lower demand in China and unfavorable movements in currency exchange rates which were partially offset by growth in Mexico.

Moving to our adjusted P&L for the fourth quarter on Page 6, adjusted gross margin was 43.2% percent compared to 44.9% in the fourth quarter of 2017. This principally reflects higher shipping costs and promotions in our U.S. e-commerce business and customer mix changes within U.S. wholesale. Royalty income declined modestly principally due to the timing of certain spring 2019 retail programs. Our adjusted SG&A rate levered 120 basis points to 28.4% reflecting expense leverage in all segments and lower provisions for performance based compensation.

Fourth quarter net interest and other expense was $10 million compared to $8 million last year. This increase reflects higher interest expense due to higher market interest rates and higher average borrowings versus a year ago and expense related to unfavorable movements in foreign currency exchange rates. Our fourth quarter effective tax rate was 18.9% and our average share count declined 4% compared to last year reflecting our share repurchase activity. So again on the bottom line fourth quarter adjusted EPS was $2.84 up 22% from $2.33 last year.

Turning to Page 7 with a recap of our balance sheet and cash flow, our balance sheet was in very good shape as of the end of the year. We ended 2018 with cash on hand and available borrowing capacity on our revolver totaling over $700 million. Net inventories were up 5% at year-end driven by product cost increases and higher on hand baby replenishment inventory. On a unit basis inventories grew approximately 3% in the fourth quarter, the quality of our inventory at year-end was high.

Our business continues to generate great cash flow. Operating cash flow for fiscal 2018 was $356 million up from $330 million in 2017. While our GAAP net income was somewhat lower versus last year the new tax law resulted in meaningfully lower tax payments than under the previous higher rate structure. Capital expenditures were $64 million compared to $69 million in 2017. Significant areas of investment included new stores and retail systems, enterprise technology and distribution capabilities.

2018 was another strong year of returning capital to shareholders. We returned a total of $277 million comprised of $193 million in share repurchases and $84 million in dividends. Over the last 12 years we've returned a total of $1.8 billion to shareholders and retired 38% of our outstanding shares. As noted in today's press release our Board of Directors has authorized an 11% increase to our quarterly dividend to $0.50 per share beginning with our next dividend payment in March. This represents our 6th consecutive annual increase since we initiated our recurring dividend in 2013.

Now turning to Page 9 with an overview of our business segment performance in the fourth quarter. Our consolidated adjusted operating margin was 15.7% compared to 16.3% in last year's fourth quarter. Improved profitability in international was offset by lower profitability in our U.S. retail and wholesale businesses. Corporate expenses as a percent of net sales were comparable year-over-year.

Moving to some additional perspective on our business results for the fourth quarter beginning with U.S. retail on Page 10. Total U.S. retail segment sales increased 7%, our total retail comp was 5.7% with double-digit comps in e-commerce and positive comps also achieved in our retail stores. This was our highest Q4 comp performance since 2013.

In the fourth quarter while overall domestic demand was very good, up in the high single-digits, demand from international consumers declined in the high single-digits which we believe was a result of the strength of the U.S. dollar. We saw a particular impact of lower international demand in e-commerce which caused us to be more promotional than planned in that channel in order to clear inventory.

In 2018 we opened 55 new stores and closed 41 ending the year with 844 stores in the United States. U.S. retail segment margin was 16.9% compared to 17.8% in the fourth quarter of 2017. This performance reflects the higher e-commerce promotional activity which I mentioned and higher shipping and distribution costs.

On Page 11 we've included a photo of a relatively new co-branded store in Garfield, New Jersey. In the fourth quarter co-branded stores were our best performing store type comping up nearly 10%. We've been investing recently in new fixtures in our stores which we think will better present the strength and beauty of our baby assortments. This new presentation in one of our Atlanta area stores is shown on Page 12.

Moving to Page 13 and a recap of our plans for our U.S. retail store portfolio, we've made good progress over the past several years and improving the convenience of shopping for our brands and improving the productivity of our store portfolio. We've found that consumers value the ability to shop with the two leading brands in young children's apparel in a single shopping trip. Our dual branded locations which present both the Carter’s and OshKosh B’gosh brands currently represent about 40% of our store base. We anticipate that the majority of future store growth will be in the co-branded store format.

Additionally as we've opened co-branded stores in recent years the proportion of our store base located in traditional further out outlet centers has declined. We expect this trend will continue as consumers look to shop closer to home versus driving longer distances to the outlets. As we've shared on our previous calls we've increased our focus on optimizing our store portfolio. Over the next five years we expect to open about 110 new stores and close just over 90 locations. We've seen good results today from closing stores with marginal profit performance at their lease expiration. We've seen a roughly 20% sales transfer rate to nearby store locations at a very attractive profit conversions.

We've seen good performance of our recent classes of new stores which are comping positively and delivering good returns. We are continuing to focus on improving the performance of our brick and mortar stores including introducing new omnichannel capabilities, refining our assortments, and improving our fixturing presentation and service.

On Pages 14 and 15 we've included some of our spring marketing for Carter’s and OshKosh B’gosh. These pages are great examples of our Easter dressing products and spring products such as t-shirts and shorts which mom is going to need for her family as the warm weather arrives around the country.

On Page 16 Skip Hop also continues to innovate in its product assortment. The plant closure shown here is a new product just introduced in the market and early selling of this item is off to a great start. We're seeing good demand for the Skip Hop brand across all channels in the United States and good growth internationally. We're planning that Skip Hop net sales will grow approximately 20% globally in 2019 with a meaningfully improved profit contribution to the company.

Page 17 highlights the continuing strength of our Carter’s and OshKosh B’gosh and Skip Hop brands on social media. We've invested heavily in building our social media capabilities in recent years. Social media has emerged as one of the most important ways that consumers especially younger parents engage with brands. Among the comparable brands we track, the Carter's brand has the highest number of followers on both Instagram and Facebook. In the fourth quarter Carter's post on Instagram elicited a great response from consumers earning 9 of the top 10 engagement scores among our peers.

Turning to Page 18 with results for our U.S. wholesale business in the fourth quarter. Sales in U.S. wholesale were strong growing 7% over last year. Growth was particularly strong in our exclusive brands which offset the loss of sales to Toys "R" Us, Bon-Ton, and Sears which collectively represented approximately $34 million in the fourth quarter of 2017. As we noted on our last call sales in the fourth quarter benefited from year-over-year calendar changes with some of our wholesale customers which resulted in volume shifting from the third quarter last year to the fourth quarter this year.

As Mike noted over the last three quarters of the year we have estimated that we recaptured approximately $34 million of sales that had been previously planned to Toys "R" Us and Bon-Ton. Most of this recapture occurred in our wholesale channel. Segment operating profit was $74 million compared to $71 million last year. Segment operating margin was 21% versus 21.7% in Q4 of last year, reflecting unfavorable changes in customer mix including greater off price channel activity than a year ago and higher shipping costs. SG&A in the segment was lower than a year ago. For the full year in 2018 sales in our U.S. wholesale segment declined 2%. For full year 2017 sales to Toys "R" Us, Bon-Ton, and Sears represented $115 million. Full year 2018 operating margin for the U.S. wholesale segment was nearly 20%.

On Page 19 we've included a photo of the Carter's baby shop at Kohls. The offset photo on the left side of the page features a special additional picture of Carter's little baby basics product which Kohls added in the front entry area of about 400 of their stores during their recent January baby sales. This picture drove excellent productivity for Kohls exceeding expectations. We continue to partner with our most significant wholesale customers to ensure a very strong presentation of the Carter’s and OshKosh B’gosh brands on the selling floor.

Developing the e-commerce channel is obviously an enormous priority and opportunity for all of our wholesale customers. On pages 20 and 21 we've included some recent screenshots from the websites of Target, Wal-Mart, and Amazon. We've been very pleased that our exclusive Just One You, Child of Mine, and Simple Joys brands play such a prominent role in driving the online businesses of the largest retailers in the country. As you note on these pages these brands are unique in their product points of view and value propositions. They provide very attractive assortment and AURs for each of these retailers.

Moving to Page 22 and international segment results for the fourth quarter. International segment net sales declined 2%, this reflects lower demand in China and unfavorable movements in foreign currency exchange rate partially offset by increased demand in Mexico. On a constant currency basis fourth quarter international segment net sales grew about 1%. For the full year 2018 international segment net sales grew approximately 4% on a reported and constant currency basis. Net sales in Mexico in the fourth quarter were approximately $15 million. We continued to be pleased with the progress we're making in Mexico. The Mexico market represented about $45 million in net sales in 2018. We believe we can meaningfully grow our business in Mexico to double its current size over the next several years.

In 2019 we will be testing some new larger retail store formats in Mexico with the goal of replicating our co-branded store format which has proven so successful in the U.S. and Canada. Canadian net sales in the fourth quarter declined 1% on a reported basis but grew 2% on a local currency basis. Canada's performance in the fourth quarter was below our expectations particularly in our stores. Canadian retail comps declined 2% and the quarter began very strongly in Canada and weakened in November and December. We believe the extremely strong October demand left us in an oversold inventory position later in the quarter in addition to the inventory mix including less of the special holiday dressing items which sold so successfully in the U.S. this past season.

We saw strong e-commerce growth in Canada in Q4 even with the adverse effects of a postal strike during the quarter. International segment adjusted operating income was $21 million comparable to the fourth quarter of 2017. Segment operating margin improved 20 basis points to 16% reflecting improved profitability in Mexico partially offset by higher promotions and expense deleverage in Canada. For 2019 we expect our international business to grow in the mid single-digits not that this reflects the planned transition of our China business from the previous e-commerce and wholesale models, to a [ph] licensed arrangement with a single partner in this market.

We're also planning on adding approximately 10 new retail stores in Canada in 2019. Pages 23 to 27 highlight the extensive distribution our brands enjoy in key markets around the world. On Page 23 we've included a photo of a new Carter’s and OshKosh B’gosh co-branded store Istanbul. E-commerce is an important channel for many of our international partners and on Pages 24 through 27 we've included examples of the websites serving consumers in India, Brazil, Israel, and Russia. As of the end of 2018 our international partners operate in nearly 780 retail locations and 45 websites in approximately 85 markets worldwide.

On Pages 28 through 31 we've included a few pages for your reference summarizing our full year performance in 2018. Despite the challenge of the unplanned bankruptcies and liquidations of two significant wholesale customers we still delivered top line and bottom line growth for the year. We also launched new growth initiatives, continued to invest in important retail and enterprise technology initiatives, and developed a new and we believe more profitable path forward in China.

Turning to Page 32 with a recap of our growth opportunities over the next five years. As Mike noted in his remarks we believe we can grow our consolidated net sales to over $4 billion by 2023 which would represent a compound annual growth rate of approximately 3%. Our U.S. retail business is expected to be the most meaningful contributor to our growth led by continued growth in the e-commerce channel. We also see contributions to growth from our U.S. wholesale and international businesses. We are committed to margin expansion in our business and believe we can grow profitably at a rate faster than sales driven by improved profit contributions from our new growth initiatives including Skip Hop, Mexico, Simple Joys, with Amazon a potentially higher return business model in China and improved sourcing, pricing, and inventory management disciplines.

We're also strengthening our focus on productivity and efficiency initiatives with the objective of optimizing investment and spending across the enterprise. We'd like to see spending grow at a rate less than the growth rate of gross profit. As Mike said we're open to adding new sources of growth through M&A, our bar for acquisitions is appropriately high, importantly that we have the resources and strength to pursue those assets which we find compelling. To the extent we don't utilize our significant projected cash flow from M&A we would look to continue to distribute excess capital to shareholders through dividends and share repurchases.

Moving to our outlook for 2019 on page 34, there are several important factors to keep in mind as we look ahead to the first quarter of 2019. First, the Easter holiday falls later this year which we believe will shift some holiday related demand to our second quarter this year compared to the first quarter in 2018. Second, we have not yet fully anniversaried discontinued sales to Toys "R" Us and Bon-Ton which contributed approximately $13 million in net sales in the first quarter of 2018. We will be past this comparability issue by the end of the first quarter.

Our retail businesses in the U.S. and Canada are off to a slower than planned start to the year, we believe as a result of the current cold weather around the country. It's important to note that March is an extremely significant month for our U.S. retail business roughly equal in volume to January and February combined. Given the significant weather disruption we saw in March last year we think the comparisons this year may be favorable for this year's outlook for this important selling period. Due to these factors we expect first quarter consolidated net sales will be down approximately 4% to 5% and adjusted EPS to be in the range of $0.65 to $0.70 per share.

For the full year 2019 we expect net sales to increase approximately 1% to 2% and adjusted earnings per share to increase approximately 4% to 6%. This outlook contemplates sales growth in all segments, improvement in our operating margin, SG&A leverage, and continued share repurchases. 2019 operating cash flow is expected to be strong in the range of $375 million to $400 million, capital expenditures are planned to be approximately $85 million up somewhat from 2018 due to investments in retail systems, corporate technology infrastructure, and our distribution network.

Risks that we're monitoring include the status of trade negotiations between the United States and China, international consumer traffic and demand in our U.S. retail businesses, the level of promotional activity in the marketplace, and the performance of our wholesale customers. And with those remarks we're ready to take your questions.

[Operator]

[Operator Instructions]. We will take our first question from Susan Anderson of B. Riley FBR. Please go ahead.

[Susan Anderson, B. Riley FBR]

Hi, good morning. Congrats on a really nice quarter. I was wondering if you could talk about the older kids’ business, it sounds like it continued to be strong in the quarter. I guess have you seen that business get competitive in terms of promotions with the Gymboree liquidations, and do you think that you'll be able to maybe take some market share from Gymboree even though you're not necessarily in the malls except through wholesale? And then also I was curious are you seeing any of those in-mall wholesale customers potentially want to take on more older kid products from you guys?

[Richard F. Westenberger, EVP and CFO]

Couple of things. On the age up, we launched that Carter's Kids line last fall. We supported it with great marketing and added -- in adding those sizes, we can address a child up to about 10 years old. So the product sold really great from toddler through size 14. Our sales grew high-single digits last fall, most of it from adding those new sizes 10 to 14. I think we did about an extra $14 million in the fourth quarter. So we continue to drive that initiative with great product, things like sibling dressing and events and uniform and denim all places we think we can gain share. So it's a good nice opportunity for growth.

As far as Gymboree, Mike said you know we think that's a potential $100 million opportunity to capture market share. Their liquidation has become -- it's begun in earnest, so first half could be a little bit disruptive for us, but we've got 200 stores located in the same center as Gymboree. 150 of those are in outlets and they also had a meaningful presence in the malls. So, we've got only about 50 mall locations, our performance there has exceeded expectations, so we're going to look at malls as a potential growth opportunity given this void in the market and some more attractive rents we're seeing.

As far as wholesale, I would say the biggest incremental business we've got there is toddler. We dominate in baby, a lot of folks have our toddler business but several new -- several customers last fall intensified the toddler component of the business with us, so we're happy about that performance, and overall we think this is a good vehicle growth for our company. Again Mike said we tend to have about 90% of the moms buy the Carter's brand when they have a child, and if we can keep those folks in the brand another year or two, all the way through a 10-year-old child, we think that will be a good thing for our company.

[Susan Anderson, B. Riley FBR]

Great, thanks, that's very helpful. And if I could add one follow up just on Toys "R" Us, I think you guys said we captured about 85% of the 40 million, yet obviously the wholesale and retail sales were very strong in the quarter. So I guess maybe if you could just give some color on why you didn't think you reached the 40 million, and then also just what do you think the opportunity could be in 2019?

[Richard F. Westenberger, EVP and CFO]

Just a couple of reactions; one, the market data would suggest that consumer purchases of our brands was up over 2% last year, so when we reference what we recaptured it was based on our shipments to replenish some of those sales. And replenishment business I would say trended better in the fourth quarter than it had been say in the third quarter. It just didn't reach the level that we had expected. You have seen the holiday performance reported by a number of retailers. We had very good holiday performance in that nine-week November-December shopping period. We had very good nearly 5% comp, and if you lined up our same nine weeks to the major retailers’ nine weeks, which was about a week later, their period ended the first week of January, our comps were up closer to 6%. Not every one of our customers had that kind of performance during that nine-week period. So depending on the performance they had determines what kind of replenishment we would see in our own business.

But I would say by and large we were happy with the fourth quarter, and we expect based on the current trends in our replenishment sales which is the high margin component of our major retailers business and our business, if those trends continue we'll see more of a recapture in 2019.

[Susan Anderson, B. Riley FBR]

Great and it sounds like that lack of replenishment was more department stores versus mass?

[Richard F. Westenberger, EVP and CFO]

Yes, that's fair to say.

[Susan Anderson, B. Riley FBR]

Great, thanks so much. Good luck next quarter.

[Richard F. Westenberger, EVP and CFO]

Thanks very much.

[Operator]

Thank you. We will take our next question from Heather Balsky of Bank of America. Please go ahead.

[Heather Balsky, Bank of America]

Hi, thank you for taking my question. I was hoping you could talk a little bit first on your plans around SG&A spending for 2019, and then layering on top of that what level of comps do you need I guess over the next few years to leverage operating expense, how should we think about that dynamic in terms of how you plan to spend? Thank you.

[Richard F. Westenberger, EVP and CFO]

Hi Heather, as it relates to SG&A, we're planning actually for leverage in 2019. It’s been quite a number of years since we set a plan like that. We have I think made some very good steps to constrain discretionary spending just reflective of the lower top line outlook for the business, continuing to invest in important areas, marketing, technology, that kind of forward consumer facing sides of the business, I’d say overhead areas of the business is extremely well controlled. So we're planning for low single-digit growth in SG&A and rate leverage. As it relates to where do we leverage in the retail business typically it's at that kind of 3% total retail comp level, that's the level that allows us to leverage the cost bases of the business.

[Heather Balsky, Bank of America]

Thank you. And just one follow up, in 4Q you talked about some expedited shipping initiatives, I'm just curious how those tested in the fourth quarter and how you are thinking about that going forward?

[Richard F. Westenberger, EVP and CFO]

Yeah, we did make some investments in expedited shipping. I'd say in a couple of different respects, one we wanted to try and increase the processing time through our distribution center and then once we got the products into the shipping stream themselves we spent a bit more on increasing the speed of delivery. I'd say we're still reading those results, I think we are kind of at parity with a number of our competitors now whereas a year ago we felt like we were delivering those e-commerce orders a bit more slowly than perhaps our peer group. So I think we're very comfortable, still looking for ways to get product to the consumers as quickly as we can. We do have some initiatives as it relates to testing fulfillment for instance from some of our retail stores, we will have those capabilities later this year and we will give that a good test. But clearly the consumer has elevated their expectations in terms of the speed with which they expect to get that product and we're trying to respond accordingly.

[Heather Balsky, Bank of America]

Thank you very much.

[Operator]

[Operator Instructions]. We'll take our next question from Ike Boruchow of Wells Fargo. Please go ahead.

[Ike Boruchow, Wells Fargo]

Hi, good morning everyone. Thanks for taking the question. Two questions, first one is just on the guidance for Q1, could you maybe give us a little bit more color about what retail comp is embedded in the 1Q guide, just curious how we should expect the later [indiscernible] you guys and then obviously help you when we get to second quarter?

[Richard F. Westenberger, EVP and CFO]

We had a good start out of the gate in Q1 in all of our channels. I will just say wholesale particularly good and we've had some softer business in our retail business the last few weeks. So run down a little bit, a little bit of a negative comp there at this point. We've planned Q1 down low single-digits and we're running slightly behind that right now. Keep in mind it's January and February the lightest month of the year. March is as big as January and February combined. We've got a later Easter this year which just puts about 2 points of comp into Q2. So we're monitoring some of the weather things, the tax return situation what have you but we're planning a low single-digit comp for the quarter at this point, down low single-digits.

[Michael D. Casey, Chairman and CEO]

The best way to think Ike -- the best way to think about it is what is the type of comp we are planning for the four months of the year which takes this drama already out of it, it is about a three comp.

[Ike Boruchow, Wells Fargo]

Perfect, that's helpful. And just quick follow-up maybe for Richard, there is more color on the China model and what's changing would be helpful. I get that there's a lot of changes going on right now, maybe what were the sales and the EBIT losses last year that you had with your prior partner and then what we should expect for sales and EBIT contribution potentially this fiscal year, just trying to understand the changes in the model and how it affects the P&L a bit better?

[Richard F. Westenberger, EVP and CFO]

Sure, so the previous model we had kind of a disjointed effort we think approaching that market. So we were running the e-commerce channel which is our website on T Mall [ph] and then we had a partner which was a wholesale relationship for us so we sold product to that partner and then they sold it through the retail stores that they operated. From memory sales in China last year were about $12 million so we're transitioning to a new model which is more of a royalty relationship so, that $12 million will come out of the base of our net sales and we will earn royalty income from that partner on their sales of product in China over time.

As Mike said this is one of our longstanding suppliers so they will actually source the product which is a little different. We were previously sourcing that product in some cases unique product for China which brought with it a great deal of complexity because that was product that was unique just to China. For that new partner who has that great expertise both in terms of manufacturing the product and also importantly experience with retail distribution of young children's apparel in China we think that will be a great advantage for us. As 2019 is a year of transition we're not planning I wouldn't say for material contributions of royalty income, that's probably more of a 2020 and beyond. So I'm not expecting a significant contribution in 2019. We did incur significant losses in China in 2018. The amount that ran through our P&L was probably $5 million or $6 million and then we had another 5 million or 6 million of additional charges that we have treated as adjusting items. So that apart of $11 million or $12 million of losses and that's a combination of taking charges related to that and that unique inventory for China and also just severance as we unwind the team and resources that we have put in place in that market.

[Ike Boruchow, Wells Fargo]

Got it, thanks.

[Michael D. Casey, Chairman and CEO]

This new model what we hope to do is replicate the success that we had in Canada. We had in Canada and Mexico so we started both of those relationships in Canada and Mexico through licensing arrangements. We partnered with someone who grew up in those countries and knew how to operate in those countries and had demonstrated expertise in running retail businesses and sourcing operations and that's now what we have in China. So we are as fortunate to have the experience that we've had in Canada, Mexico, and China it will be a nice source of growth for us over time.

[Ike Boruchow, Wells Fargo]

Thanks Mike

[Michael D. Casey, Chairman and CEO]

You're welcome

[Operator]

We'll now take our next question from Jim Chartier of Monness, Crespi, and Hardt. Please go ahead.

[Jim Chartier, Monness, Crespi & Hardt]

Good morning, thanks for taking my questions. So, on the Toys "R" Us disruption with most of the demand being recaptured by Wal-Mart, Target, and Amazon who have exclusive brands, now that you've got more time to plan how much of an opportunity do you see to try to recapture that? And how much of a disruption was it to have kind of Carter's lost sales and not be able to meet the demand with the exclusive brands?

[Michael D. Casey, Chairman and CEO]

It was highly disruptive. Toys "R" Us had been a very good customer of ours for years, a good margin customer because it was primarily focused on baby. And not surprisingly as we analyzed the results we saw nice slip in our stores but most of the business went to the exclusive brands primarily because those retailers sell the things at Toys "R" Us was selling; diapers, formulas, strollers, other things that we do not sell directly to consumers. And thanks to a number of our Carter's brand customers don't sell to consumers. So we're not surprised by the results. The encouraging thing is we're -- our brands are sold wherever people are shopping for young children's apparel. So people do shopping in other places and thankfully we've seen a nice lift in those exclusive brands. But we have also seen -- we're also planning good growth with our Carter's brand customers in 2019 going forward.

So, in some ways it's the Toys "R" Us closures, Bon-Time, Sears disruptive. We're encouraged by going forward, there's going to be fewer, better, stronger retailers and we do business with all of them. So that should be a nice source of growth for us.

[Richard F. Westenberger, EVP and CFO]

Jim I was just going to also add to that, the shift is something we've worked on. We've got the great business with Amazon, we grew our Amazon business about 50% last year in our first full year they are now top 10 customer and our exclusive brand Simple Joy is doing great doubled over last year. As a matter of fact Simple Joy has won the most requested fashion brands on Amazon's Christmas wish list last year and we just signed a new longer term agreement in January to extend our exclusivity with Simple Joy. So those are the types of changes we've made in the company. We continue to have channel shifts, we monitor them but we want to make sure we're there to -- wherever mom want to shop for her young children's apparel and as Mike said we're going to have to fewer stronger retailers. We've got great relationships with all of our partners but as that exclusive brand shift started to happen we're thrilled that we do have those brands and we have those relationships with those folks as well.

[Jim Chartier, Monness, Crespi & Hardt]

Great, and then you guys referenced potential disruptions from China tariffs. Can you just remind us what percentage of your product will be sourced from China in 2019 and where do you see that overtime?

[Richard F. Westenberger, EVP and CFO]

It's somewhere around 25% percent comes from China and that's largely for apparel -- for Skip Hop at a much higher percentage, closer to 100% of Skip Hop's product comes from China. The tariffs in 2018 were not meaningful, if some of the categories I think even this year it's probably -- the impact is probably somewhere less than $4 million to $5 million bucks. So it's not overly significant, it's not 0. We already pay tens of millions of dollars in duties for products coming in from China. So thankfully the tone of the dialogue on those tariffs has improved and we hope it's not a meaningful exposure for us in the balance of the year and going forward.

[Jim Chartier, Monness, Crespi & Hardt]

And then just lastly you mentioned acquisition potential going forward a number of times, so can you -- so on Skip Hop the most recent acquisition can you just give us a sense of where revenue will be in 2019 versus when you purchased it a couple years ago and where is operating profit next year versus where you want it? Thanks.

[Richard F. Westenberger, EVP and CFO]

Sure, Skip Hop is performing well. We had real strong sales growth last year of about 30%. I think Richard said that we're going to grow that about 20% this year. We finished last year about $125 million with Skip Hop and we purchased a $100 million business in 2017. We still feel that we can double that business in the first five years of ownership. I would say the profit size is not optimized yet, we had investments in talent and systems and of course we had the Toys "R" Us impact that also played in with Skip Hop as well but we've got a real strong product agenda in 2019. We're looking forward to continued growth. We have opened several different accounts, got some great new products and our direct business is also growing rapidly. So we feel very confident about the Skip Hop business.

[Jim Chartier, Monness, Crespi & Hardt]

Great, thanks and best of luck.

[Richard F. Westenberger, EVP and CFO]

Thank you.

[Operator]

Thank you and we will now take our next question from Jay Sole of UBS. Please go ahead.

[Jay Sole, UBS]

Great, thank you. Mike you mentioned if you were stronger retail partners in your wholesale business can you give us an idea of what percentage of your wholesale business right now is your top five customers?

[Michael D. Casey, Chairman and CEO]

We would say it is probably better part of 60% to 70% of our top five. Yes, they are about -- it's a high percentage.

[Jay Sole, UBS]

If you anticipate that number will increase over the next couple years?

[Michael D. Casey, Chairman and CEO]

They may, there are still some major retailers who are working hard to find relevance with consumers today. So my guess is there will be further consolidation.

[Jay Sole, UBS]

Got it and then may be just on the square footage, you gave that nice slide on page 13 showing your store plans, does the store count growth correlate with what you expect the square footage growth to be or just because you're doing more dual branded stores will there be a relatively greater increase in square footage relative to store count?

[Michael D. Casey, Chairman and CEO]

The typical model we have right now is 4,000 to 5,000 square feet. Something we have not built into the model is this new Gymboree opportunity. We're going to test a smaller mall store format and it's worked beautifully for us up in Canada. We have smaller store formats up in Canada. We have some smaller formats in the United States and there's a smaller store format in Mexico. So we've got a line of sight to what makes sense in the malls and so going forward it might be more stores but the square footage may be smaller.

[Jay Sole, UBS]

Got it and then maybe one last one, Richard, just on the gross margin in 4Q, can you just maybe parse out some of the drivers in a little bit more detail to what really changed versus last year?

[Richard F. Westenberger, EVP and CFO]

Jay your question is for the fourth quarter gross margin or for 2019?

[Jay Sole, UBS]

No for fourth quarter, the quarter we just finished.

[Richard F. Westenberger, EVP and CFO]

I think the major factor really has to do with the mix of the business so within wholesale we still have the effects of the loss of the Toys "R" Us and Bon-Ton which was very good margin business for us. We were relatively more promotional in e-commerce that's still good margin business for us but it's not quite up to our plans. We've seen a real issue around freight costs being higher, the cost to serve that e-commerce business has been increasing. I mentioned the additional investment in expedited shipping but really the operational costs around e-commerce have been in some pressure and some of those costs run through the gross margin line so that was a bit of a pressure there. We also saw some additional off price channel sales in the fourth quarter that was a feature of just being a little heavier on some of that Toys "R" Us related inventory that we were clearing through. So those were some factors that probably puts a little bit more pressure on gross margin than is typical for us.

[Jay Sole, UBS]

Got it, thank you so much.

[Operator]

Thank you and we'll take our next question from Laurent Vasilescu from Macquarie. Please go ahead.

[Laurent Vasilescu, Macquarie Group]

Good morning, thank you very much for taking my question. I want to follow up on Jay's gross margin question, curious to know how we should model the gross margin down for the first quarters, it is probably down 150 bps and then how should we think about the gross margin overall for the year and then maybe any color on the tax rate for the year?

[Richard F. Westenberger, EVP and CFO]

I would say we are planning gross margins down in the first quarter. I'd say the planning assumption for 2019 is more comparability year-over-year so we're looking for more comparable gross margins for the full year period. The factors that are affecting Q1 certainly would be the slow start to the year. The factors that I mentioned as it relates to higher freight expenses, there is a bit still of that comparability issue on Toys "R" Us in the first quarter where again that was very good margin business if not in the base at the moment but expecting good performance and actually some gross margin expansion in the second half of the year. Effective tax rate will be similar as well to 2018 in that low 20% range.

[Laurent Vasilescu, Macquarie Group]

Okay, very helpful and then I think it was called -- the adjusted SG&A level by 120 bps reflecting expense levels in all segments. And I think also lower provisions for performance based compensation, could you potentially quantify that provision and then how do we think about any -- are there any one time investment we should consider for the first quarter?

[Richard F. Westenberger, EVP and CFO]

Yeah, in terms of SG&A in the fourth quarter I believe the year over year reduction in that provision for performance based compensation is about $9 million so we did not achieve our performance objectives for the year. A good portion of that relates to the unexpected bankruptcies of Toys "R" Us and Bon-Ton but the decrease in the provision that benefited the full year actually I should say is about $9 million. It is a smaller number for the fourth quarter.

Your second question as relates to investments for the first quarter I don't think there are any unique investments. We continue to spend on some of our technology initiatives. We're working on some of the ongoing integration efforts with Skip Hop. We're transitioning some of our distribution and adding additional distribution capabilities on the West Coast and service of the Skip Hop brand -- our normal business. Some of the projects that we're doing in the first quarter nothing unusual.

[Laurent Vasilescu, Macquarie Group]

Okay, very helpful, thank you. And just last question here, last February I think he was called that the international should grow by 300 million and e-commerce ago by 400 million over the next five years. With today's call outs for the five year plan with international going about 100 million can you parse out by region and then is e-commerce still expected to grow by $400 million over the next five years?

[Richard F. Westenberger, EVP and CFO]

Well on international we trim the previous forecasts by about $100 million and that's entirely China because the new model that we have with China is a licensing model, those sales will not be coming through. Our sales line item and then we do contain and expect growth in e-commerce so we probably trimmed that by some portion of a $100 million as well relative to our forecast last February simply because we're seeing some pressure with international demand on our U.S. website. That's been a good source of growth for us over the years and just based on our experience this past year we're seeing lower demand from international consumer shopping on our U.S. website which our analysis suggest is directly attributable to the stronger dollar and the weaker exchange rates. We've seen that not only online but in our stores. Lower internationally.

[Laurent Vasilescu, Macquarie Group]

Thank you very much for all the color.

[Richard F. Westenberger, EVP and CFO]

Our pleasure.

[Operator]

That concludes today's question-and-answer session. Mr. Casey I would like to turn the call back to you for any additional or closing remarks.

[Michael D. Casey, Chairman and CEO]

Okay, thank you. Thank you all for joining us this morning. We appreciate your interest in our business and we'll look forward to updating again on our progress in April. Good bye everybody.

[Operator]

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