J.C. Penney Q2 2006 Earnings Conference Call Transcript (JCP)

J.C. Penney, Inc. (JCP)
Q2 2006 Earnings Conference Call
August 10, 2006 9:30 am ET

Executives

Bob Johnson - VP, IR
Ken Hicks - President, CMO
Bob Cavanaugh - CFO
Mike Ullman - Chairman, CEO

Analysts

Deborah Weinswig - Citigroup
Adrianne Shapira – Goldman Sachs
Bernard Sosnick – Oppenheimer
Stacy Turnof – Merrill Lynch
Christine Augustine – Bear Stearns
Dana Cohen – Banc of America
Jeff Klinefelter – Piper Jaffray
David Glick – Buckingham Research
Liz Dunn – Prudential
Michelle Tan – UBS
Bob Drbul – Lehman Brothers
Dana Telsey – Telsey Advisory Group
Jeff Simpson – Cleveland Research

Presentation

Operator

Good morning. My name is Jackie and I will be your conference operator today. At this time, I would like to welcome everyone to the JCPenney second quarter 2006 earnings release conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Bob Johnson, Vice President and Director of Investor Relations. Sir, you may begin your conference.

Bob Johnson

Thank you, [Jackie], and thanks everyone for joining us on the call this morning to review JCPenney’s second quarter earnings. We’ve scheduled this call to last about 45 minutes, which includes time for Q&A.

Before we begin, let me remind everyone that the discussion this morning includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 which reflect the company’s current view of future events and financial performance. The words expect, plan, anticipate, believe and similar expressions identify forward-looking statements. Any such forward-looking statements are subject to risk and uncertainties, and the company’s future results of operations could differ materially from historical results or current expectations.

For more details on these risks, please refer to the company’s Form 10 K and other SEC filings.

Also, please note that no portion of this call may be rebroadcast in any form without the prior written consent of JCPenney. Replays of this webcast will be available for 90 days. For those listening after August 10, 2006, please note that this reporting will not be updated and it is possible that the information discussed is no longer current.

On this morning’s call, we will have three speakers. First Ken Hicks, President and Chief Merchandising Officer, will review our department store and direct business. Bob Cavanaugh, Chief Financial Officer, will then discuss operating results and review our financial position, and Mike Ullman, Chairman and Chief Executive Officer will conclude the prepared remarks with his observations. We will then open the call for questions.

Ken will begin.

Ken Hicks

Thank you, Bob, and good morning. We’re obviously pleased with our second quarter operating performance and with the continued improvement in sales, gross margin and SG&A leverage.

In department stores, total sales increased 7.1% for the quarter, on top of a 5.1% increase last year and comparable to department store sales increased better than original expectations, up 6.6%, which follows a 4.2% increase last year. This marks the 13th consecutive quarter that we’ve delivered a comparable store sales increase at JCPenney.

Second quarter results reflect strength and consistency across all merchandise divisions and region of the country. Geographically, the best performance continued to come from the western and southeastern regions of the country, with substantial improvement in both the northeast and central regions.

Looking at sales by merchandise category, the strongest divisional performances came from fine jewellery, children’s and women’s accessories, which have performed well all year. All apparel lines, especially women’s, improved throughout the quarter, with good customer response to our new product offerings, and we had sales gains in both fashion and basic merchandise and our private brands continued to perform well.

We took aggressive action in our apparel business throughout the quarter, keeping our merchandise fresh and we are pleased with the current inventory position as we enter the fall season.

Moving on to direct, Internet continues to be our fastest-growing sales channel, increasing nearly 25% for the quarter. This was on top of a 35% increase last year.

In total, direct sales for the quarter increased 2.7% and were led by women’s apparel, intimate apparel and children’s.

Turning now to operating profit, second quarter operating profit increased to $271 million, up over 27% from last year for improvement of over $58 million.

Gross margin was up 30 basis points from last year, ending at 38.4% of sales. Gross margin continues to show strength and is benefiting from good performance of our private brands and from the increasing effectiveness of our planning and allocation technology, which is driving better product flow.

SG&A expenses were leveraged 70 basis points, ending at 32% of sales. SG&A expenses reflect leverage of salary and marketing costs, as well as efficiencies in our direct channel. SG&A dollars increased in line with expectations, including additional expenses for new stores and rising utility and fuel costs.

Looking at inventory entering the third quarter, total inventories and comp store inventories are essentially flat to last year as we enter the third quarter. Inventories are well-balanced between basics and fashion merchandise, with less clearance merchandise than we had in stores a year ago. The stores set date for back-to-school was mid-July, the same timing as last year.

For the rest of the year, we believe that it’s prudent to plan conservatively for the second half of the year, especially given the current environment. We expect comparable department store sales to increase low single digits in both the third and fourth quarters.

Direct sales are expected to increase low single digits in the third quarter, and increase mid-single digits in the fourth quarter due to an additional week in our fiscal year. The 53rd week will have no impact on comp stores, since it’s taken out of that calculation. Bob will have some additional comments on the 53rd week in a moment.

Internet sales should continue to grow in line with industry trends through the rest of the year. We continue to plan for moderate operating margin improvement in the balance of the year.

From a merchandise perspective, we have a number of exciting growth initiatives at JCPenney that we believe give us many opportunities for back-to-school and the back half.

We’re ready for business in key areas such as footwear, where you’ll see skate shoes, wedges and clogs and the addition of Rule by Steve Madden and Skechers’ Air Raider to our assortment.

In women’s accessories, you’ll see our new Flirt brand in intimate apparel, and additional new styles and colorations in handbags. Earlier this year, we announced East Fifth, a private brand in women’s traditional apparel and accessories and the product is arriving in stores now. In addition, we continue to see strong performance from ANA, our new, modern, casual women’s brand in apparel, footwear and accessories.

In young men’s, juniors and children’s, we highlighted our Arizona brand with great merchandise presentations in denim bottoms, knit woven tops and screened T’s.

And our Campus Shop returns with an extended assortment of great bedding and accessories. We have everything students need to rock their dorm.

We’ve got some great brand launches during this year’s back-to-school season. In girl’s apparel, we’re introducing Stevie’s by Steve Madden. In young men’s, we’ve introduced Vans to the Surf and Skate customer, and the X Games brand in boys is being carried in over 600 stores as an exclusive line at JCPenney.

We will continue to make an emotional connection with our core JCPenney customer through an integrated marketing campaign during back-to-school. This theme, You’ve Got It Inside, is supported with in store graphics and advertising throughout the month of August, showing our customers that JCPenney has the merchandise they want as they head back to school.

In August, JCPenney will be the exclusive retail sponsor of the 2006 Teen Choice Awards which airs on August 20. Additionally, the company will also sponsor the JCPenney Jam, the Concert for America’s Kids, which includes many of the hottest names in music today. The concert will air in prime time on CBS on August 22 and will benefit the JCPenney After School Fund. Finally, JCPenney will be the exclusive retail sponsor of the MTV Video Music Awards, the No. 1 teen cable show of the summer, which airs on August 31.

Online, our back-to school advertising includes the interactive JCPenney VTS.com brand experience site, which allows users to interact with virtual teen characters, explore their rooms and celebrate their individuality. Users can click and buy the fashions the characters are wearing, as well as check out other fashions they might be interested in.

We will also continue to make progress on our joint initiative with Sephora, where we will offer the best of the successful Sephora concept in our stores and on jcp.com. We added Sephora to jcp.com on August 3, and we plan to add Sephora to five stores this fall, including our new off-mall store in Fort Worth, Texas, which will open October 1. Additionally, we will add Sephora to existing mall stores in Aventura, Florida, Queens, New York and Sacramento and Glendale, California. Next year, we plan to open Sephora primarily in our new stores, with a limited number of existing stores also receiving the concept. A more extensive Sephora rollout is planned for 2008.

Before I turn the call over to Bob Cavanaugh, I want to let you know what we’re doing in our stores. We’re opening 25 new stores in the third quarter. Five stores were opened in early August and 20 stores will open on October 6. Seventeen of these stores will be in our new, successful off-mall format. We’re planning for inventory levels to increase slightly in support of these new stores, and we expect to recognize pre opening costs of about $12 million in the quarter. This puts us on track to open 28 new stores in 2006 as planned.

Looking ahead, as we previously announced we will continue to expect to open 50 new stores per year in 2007 through 2009, with the majority in our off-mall format. We’ve completed the new point-of-sale system rollout, both under budget and ahead of our original schedule. The new POS system allows all of our stores to participate in a customer service survey which utilizes the signature capture pad to collect individual satisfaction ratings from all of our customers. We continue to see benefits of faster checkout times and Internet access. By having our POS terminals connected to jcp.com, we can satisfy our customers needs by providing access to a broader assortment of merchandise than could be carried within the four walls of each store.

In summary, we’re pleased with our second quarter operating profit as we continue to see consistent improvement in our bottom line. We are clearly focused on executing the growth initiatives in our long-range plan, which include opening 25 new stores in the third quarter, adding exciting brands such as East Fifth, Vans, X Games and Stevie’s, and making an emotional connection with our customers through our integrated marketing campaign which includes exclusive retail sponsorship of key events such as the MTV Video Music Awards, which has the highest teen viewership share of any show during the summer.

With that, I’ll turn the call over to Bob Cavanaugh.

Bob Cavanaugh

Thanks, Ken, and good morning, everyone.

Today we reported record second quarter operating [profit] of $271 million. This represents a 27.2% increase from last year. As a percent of sales, operating profit was 6.4%, improving 100 basis points from last year’s 5.4%. As Ken just discussed, we’re pleased with the improvement in operating profit which was positively impacted by all key drivers. Sales gains improved gross margin and leveraged SG&A.

Net interest expense in the quarter was $32 million, and continues to benefit from rising short-term interest rates on our cash investments.

Real estate and other contributed pre-tax income of $9 million this year, primarily from ongoing real estate operations, compared to $14 million last year.

Gains from the sale of property, net of impairments or other charges, were approximately $1 million this year and $8 million last year.

As noted in previous guidance, the income tax rate was about 28% in the second quarter. This includes the effects of $26 million in one time federal and state tax credits which were [pulled out] in our earlier guidance. Excluding these tax credits, the effective tax rate was 38.8% for the quarter. As a reminder, in last year’s second quarter, we had $5 million of state tax credits, which added about $0.02 per share to earnings.

With about 235 million average diluted shares, earnings from continuing operations for the quarter was $0.75 per share, up 63% from last year’s $0.46 per share. The tax credits mentioned earlier enhanced current year earnings by approximately $0.11 per share. In addition, earnings were enhanced by fewer shares outstanding as a result of our ongoing share repurchase program.

Moving on to our financial condition, as of July 29 the company had cash investments of nearly $2.4 billion. We ended the quarter with long-term debt of about $3.5 billon, with the next scheduled debt maturities of approximately $425 million in 2007.

Capital expenditures for the quarter were $323 million, which was in line with plan and compares with $233 million last year.

As we reviewed at our April analysts’ meeting, our full-year capital plan is nearly $300 million higher than last year, primarily in support of new store growth initiatives and, as Ken just discussed, we will be opening 25 new stores in the third quarter, so Capex will accelerate in the back half.

For the full year, we continue to expect capital expenditures to be about $800 million.

We continue to expect free cash flow for the year to be about $200 million.

Included in this guidance is a provision for a $300 million pension fund contribution. Last week, Congress passed new legislation to help strengthen the funding status of the country’s pension system. This legislation is awaiting the President’s signature, which may come as early as next week.

During the quarter, we repurchased 8 million shares of common stock for approximately $530 million. This represents about 70% of the current authorization. These share repurchases are partially offset by the exercise of employee stock options for diluted share calculation purposes. We expect the current repurchase program to be completed in the third quarter.

Looking ahead to the third and fourth quarters, as Ken noted we expected comparable department store sales to increase low single digits in the third and fourth quarters and we expect direct sales to be up low single digits in the third quarter and up mid-single digits in the fourth quarter, including sales from this year’s 53rd week.

We anticipate moderate improvement in operating profit rate in the back half of the year. We expect the 53rd week of this year to generate about $200 million in sales, $150 million in department stores and $50 million in direct, with about $65 million in expenses. Because January is generally considered more of a clearance month, we anticipate a minimal impact upon fourth quarter earnings from the 53rd week.

Net interest expense is expected to be about $40 million in the third and fourth quarters, reflecting lower cash balances due to the share repurchase program and the funding of eight seasonal borrowing needs.

We are forecasting a more normalized tax rate of about 38.5% through the remainder of 2006 and beyond. This reflects the 35% federal rate, plus state taxes. We continue to plan for a full-year 2006 tax rate of about 37%.

We expect to have approximately 228 million average diluted shares in both the third and fourth quarters, and we now expect to have about 232 million average diluted shares for the full year. All of this share count guidance includes about 3 million common share equivalents.

For the third quarter, we anticipate earnings to be in the area of $1.07 per share. For the fourth quarter, we expect earnings to be approximately $1.84 per share. Remember that last year’s fourth quarter included $0.12 per share related to one time tax benefits. Rolling this new guidance into the full year provides for earnings of approximately $4.55 per share.

In summary, we had an excellent second quarter. We continue to see continued, consistent improvement in the fundamentals of our business, with improvement in gross margin and SG&A leverage, with some additional benefit from our share buyback program. As we look to the second half and the macroeconomics and competitive retail environment, we believe we are well-positioned to execute our long-range plan and continue to position JCPenney as the first choice for our customers, whether in our existing stores, new stores or on jcp.com.

Now I’ll turn the call over to Mike Ullman.

Mike Ullman

Thank you. We are gratified with our second quarter results. It certainly reflects solid execution by our team on our growth initiatives as outlined in our five-year plan.

We had top line growth in stores and in Internet and catalog, in gross margin improvement, expense leverage and operating profit growth.

Looking forward to the third quarter, as Ken mentioned, we’re opening 25 new stores, the most in over 20 years, two-thirds of which will be in the off-mall format. Beginning in 2007 as announced at our analysts’ meeting, we’ll begin opening 50 stores per year. Our first Sephora stores will be this fall in October, with five stores ramping up beginning in ‘07 and certainly much more in ’08.

We believe that we have brands that inspire and continue to strength our brand offering within the context of lifestyle merchandising. We believe our customers are finding the styles that they want at a quality that they expect from JCPenney at a very smart price. We think this is particularly important in this current market environment.

We’re also investing heavily in our people. We honestly believe our team is a key differentiator in our performance. We’re confident in their ability to continue to implement our aggressive growth plan, and we now look forward to any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Deborah Weinswig of Citigroup.

Deborah Weinswig - Citigroup

Good morning and congratulations on a fantastic quarter.

Mike Ullman

Good morning.

Deborah Weinswig - Citigroup

In terms of the macro environment, Mike, can you comment a bit in terms of what you’re seeing with the consumer, you know, especially in light of the more conservative guidance in August, and is there anything that we should read into the weakness that was seen in the last week of July?

Mike Ullman

Deb, I think that we’ve been pleased that the customer seems to be very loyal to JCPenney. They understand that smart price for the quality and styling they’re getting is important in this environment. I believe that we’re getting some benefit from the competition turmoil; people looking for alternatives. I think as Macy’s Federated has announced that they want to move their business type [up market], I think that provides an opportunity for May Company customers, particularly the Marshall Fields, Hecht’s, Foleys customer to examine JCPenney.

But I think it would be prudent for us as retailers to say that pressures on the consumer are out there, whether they be increasing energy costs or adjustable rate mortgages.

I will say that we are pleased with our performance in the second quarter and I believe that we’re well-positioned to capitalize on whatever business is out there in the third quarter and if necessary, we’ll take more from the competition.

Deborah Weinswig - Citigroup

Okay and then, I’m fairly impressed with this front that you’ve seen throughout regions and categories. What would you attribute that to?

Mike Ullman

Well, I think it’s a continuation of the execution of our plan of allocation approach to running the business. I think we’re well-focused on our brands. I believe that, as we’ve gotten lifestyle merchandising better aligned in the stores, the customers are able to read what we believe in for the season. I think our strength in fine jewellery and the [home] businesses has been recognized by the customer and, as mentioned in Ken’s comments, the rebounding of our apparel business has been very gratifying.

Deborah Weinswig - Citigroup

especially on that last question – this will be my last one – with the rebound in strength in women’s, can you talk, it there anything specifically, you know, one category or another that seems to be driving that, and are you also seeing greater strength out of your private label versus national brands?

Mike Ullman

Well, I think we’ve seen continuation of the growth of our private brands. Recent consumer survey, which is blind to Penney’s asking the question, we came out No. 1 of the seven competitors in brands they were looking for which is kind of interesting since the brands are largely our own. So we feel very good about that, but that just encourages us to continue to strengthen their appeal. I just made a trip to Asia with our team and looked at what we’re doing going forward. I feel more and more confident in our ability to do that.

Deborah Weinswig - Citigroup

Great. Thanks so much and, once again, congratulations.

Mike Ullman

Thanks.

Operator

Thank you. Your next question is from Adrianne Shapira of Goldman Sachs.

Adrianne Shapira – Goldman Sachs

Thank you. Mike, you’re talking about Penney clearly benefiting from the competitive turmoil mow that Federated is coming out more aggressively with a strong Macy’s re-branding effort this fall. Could you just talk about what JCPenney is doing to kind of hold on to the share that you’ve picked up in the turmoil?

Mike Ullman

Well, I think one of our strengths is we’ve been there 100 years in these communities, with a presence. I think the customer understands that the quality has always been there, and I think as we sharpen our ability to merchandise to their lifestyle and strengthening our brands, I think we position ourselves very effectively against a national Macy’s. They’ve clearly identified they want to be at a different price point from where May Company was, and we think those May Company customers, some of the brands they’ve dropped, we have those brands in our store and we think we’re well-positioned. We do business with about half of middle America today. We’d like to validate the experience of that half and like to motivate the other half to try JCPenney.

Adrianne Shapira – Goldman Sachs

In following on your comments, I mean Federated has been talking about simplifying its pricing image, reducing couponing. Does that – does JCPenney see an opportunity to be much more aggressive with a stronger pricing message, especially for those May customers, this fall?

Mike Ullman

Well, I think we’ve been very successful during the turnaround of teaching our customer the cadence of our sales promotion. Our customer likes to buy promotionally and I think we have a good promotion, at least our surveys show that our customers appreciate the way we promote our business. Certainly, we won’t be any more promotional than we are today. If anything, our brands are earning their way in a way that doesn’t require price alone and, as we add things like Sephora and others, that strengthens our position for legitimate value and style.

Adrianne Shapira – Goldman Sachs

Great. Thank you.

Operator

Thank you. Your next question is from Bernard Sosnick of Oppenheimer.

Bernard Sosnick - Oppenheimer

Yes. Good morning. Your line-up of advertising events on TV is very impressive over the next several weeks. I’m wondering whether or not the national network spend for the back to school season is greater than a year ago, and whether you intend to follow up with concentrations of similar types of advertising at key holiday times in the calendar?

Ken Hicks

Bernie, our obvious spend is in line with what it has been in the past. What we are doing is really focusing at key times of the year, what we call events marketing. We do the Academy Awards at the start of the spring season. Obviously, back to school’s very important for our customer and so we find some of the venues that they’re going to be watching and we go to those events, and we want to own them so that we can talk to our customers about the great things we have in JCPenney’s.

Bernard Sosnick - Oppenheimer

One other thing. With regard to the same store sales increase of 6.6%, could you break that down between traffic and average price?

Ken Hicks

I think that it’s fair to say that we don’t provide that granularity at this point, except that we had improvements in traffic and felt good about what customers were buy and what part of the store they were shopping, and I think if you look just at fine jewellery, for example, we have a very, very strong trend, price points that customers are buying continues to go up which I think validates that they trust us and they’re buying the stuff that they like. That’s – the strength there is the diamond business, which we think we have a strong team and a very strong store team and we’re gaining share against specialists as well as other department stores.

Bernard Sosnick - Oppenheimer

I think the stores look terrific, and I wish you the best in the season.

Ken Hicks

Thanks, Bernie.

Mike Ullman

Thank you.

Operator

Thank you. Your next question is from Stacy Turnof of Merrill Lynch.

Stacy Turnof – Merrill Lynch

Thank you so much. Sort of a follow up to Adrianne’s question. What some of the Federated stores, particularly the May ones that have been [supported], have you seen any impact over the past month?

Then a follow up to that. Are you taking any more increase in advertising measures come time that when they do their re-branding strategy in early September?

Ken Hicks

Well, to the first question, we’ve clearly received some benefit where they’ve closed. We probably haven’t seen as much benefit from a [closer make] on these stores as Macy’s has seen because they take two stores and turn it into one store. They’re obviously getting something that shows up in their comp which is not entirely comp.

But we believe that we’re getting some benefit and we think the advantage for us is to try to make sure the customer understands we want to have them customers for a long time, just not for a month or two. So we’re not doing anything, we’re not distorting anything to try to hype the business to that customer; we’re trying to make sure they get in the store and find what they like in terms of style, quality and smart price. You won’t see any extraordinary actions on our part.

They are going to promote, apparently, that they’re the first national department store which is kind of interesting since we’ve been a national department for 104 years and we haven’t changed our name in Chicago or San Francisco or Dallas or Washington, Boston, or …

Stacy Turnof – Merrill Lynch

Then my final question is, could you give us an update on your [second time] initiative? I know that you’ve been reducing the number of weeks and where you are right now this fall?

Ken Hicks

Well, I think this was mentioned at the analysts’ meeting. This is a very important initiative for us. We think it allows us to get fashion currency there more frequently and in a shorter timeframe, obviously. It improves our inventory turn. We’re right on track in terms of what we announced at the April meeting. We’re gratified by, particularly Mike, the business over into Asia that is well understood by not just our team, but it’s well understood by our manufacturing partners and everybody’s committed to meeting our objectives.

Stacy Turnof – Merrill Lynch

Thanks so much.

Ken Hicks

Thank you.

Operator

Thank you. Your next question is from Christine Augustine of Bear Stearns

Christine Augustine – Bear Stearns

Good morning. Can you update us on your success in securing real estate for the ’07 and ’08 openings? Do you have – can you tell us what percentage of the 50 per year have been secured?

Mike Ullman

We’re ahead of the 50 in terms of sites that we can execute for ’07. We believe we’ll open 50 for sure in ’07. We have about 400 potential sites that we see over the next three or four years to pick from, and obviously we’re constantly looking at the development of those sites. Some of them are in existing malls or in relocation sites out of a mall to a nearby center that’s developing, two-thirds of which are, in fact, off-mall, either freestanding or in [similar] situations. So we feel very good about the opportunity and we do very well head-to-head with key competitors in an off-mall setting, so we feel good about the real estate [traffic].

Christine Augustine – Bear Stearns

Is there any update, Mike, on your associate engagement project? There was an update that you gave us in April. I just wondered if there were any additional statistics there.

Mike Ullman

Yeah, as we mentioned in April, we feel strongly there’s a correlation between engaged associates and store profitability, and we will do another associate survey this fall which we’ll be able to compare against the baseline from last year. But we’ve been heavily involved, not only in making sure that every store and every manager knows kind of what their objectives are and what the opportunity is in that area. We’ve been investing heavily in executive education and leadership training for our managers, strategic skills for our top people and much of the summer has been devoted to that. Ken runs a retail academy which is more or less a graduate school on retailing and strategy and team development. We have leadership classes for our key people that are running 30 people at a time. We have to get to our top 500 people. So we’re very committed to being a great place to work, and we think the first thing would be a great place to work is a great place to investment your career. So we also think that’ll have an advantage of changing, you know, lowering our turnover to the lowest in our industry.

Christine Augustine – Bear Stearns

Thank you very much for that update.

Mike Ullman

Thank you.

Operator

Thank you. Your next question is from Dana Cohen of Banc of America.

Dana Cohen – Banc of America

Hey, good morning guys. Couple questions. Just – I know you mentioned that you think you’re benefiting from the closed May stores. What about the stores, you know, as you move through the spring season, they have not had a lot of inventory. Do you have any sense of what that could have meant to the comp or to business in general?

Mike Ullman

Actually be the May Company stores?

Dana Cohen – Banc of America

Yes, I’m sorry. The May Company stores as they’ve been transitioning, there’s been a lot of disarray. How beneficial do you think that’s been?

Mike Ullman

It’s a little difficult to measure because frankly, when you’re facing disposing of inventory, that has an effect because you’re competing against merchandise that’s basically in desperation clearance, yet there is some advantage when they’re looking for basics or something that’s not in the store anymore. Then you get the benefit.

We think a strong competitor actually helps the mall and brings traffic to the mall, so we’re not afraid of competition. As a matter of fact, we like competition to be in the mall and successful. So it’s not a windfall by any means and I think we’ve earned some business; there’s no question about that. But we’ll be more impressed with ourselves if we earn that business over long periods of time by converting customers that are going to be loyal to us.

Dana Cohen – Banc of America

Then on the AUR question, just getting back to that, would it be fair to say that most of the comp was traffic versus AUR? I mean, just – can you give us some sense? Is it two-thirds, one third? Just something on that?

Mike Ullman

I would say it’s fair to say that we’re probably skewed toward traffic versus average retail.

Dana Cohen – Banc of America

Okay.

Mike Ullman

Average retail also is a function of number of units per transaction, so it’s not just the price, it’s also the number of units.

Dana Cohen – Banc of America

Okay, and then last question on the SG&A, your guidance suggests, you know, very, very modest if any growth in SG&A dollars in the third and fourth quarters, excluding the 53rd week issue.

Just, given the number of stores that are being opened in the third quarter, were those expenses booked in Q2? Is that why it’s sequentially – the growth is decelerating?

Mike Ullman

No, we’ll book the pre-opening expense in the quarter. I think that we feel that, particularly our store re-engineering program that is to put costs in the store, we’re starting to get to see the benefits of that action that was announced a year ago. We reinvested some of that savings in additional selling, which we think gives us sales leverage and obviously [inaudible] expense.

We feel good about managing our expenses. Obviously the best way to manage the expense rate down is to beat your sales plan.

Dana Cohen – Banc of America

No, no, obviously. I just was curious as to why SG&A dollars were up more in Q2 and then decelerating in the back half, given the number of store openings.

Mike Ullman

Well, I don’t know any specific reason to tell you other than the fact that we believe that we can manage expense in the third quarter more effectively against the volume.

Dana Cohen – Banc of America

Okay. Great. Thank you.

Operator

Thank you. Your next question is from Jeff Klinefelter of Piper Jaffray.

Jeff Klinefelter – Piper Jaffray

Yes, just one quick question for you. You know everyone’s trying to sort of read the crystal ball here on the consumer coming out of July, going into August. As you take a step back and look at your trends over the last several months and maybe further back, looking at past cycles, is there anything that you watch in terms of the composition, the mix of items in your market basket, that would suggest that your customer is either, you know, increasing or decreasing their willingness to spend discretionary dollars, for example? The basics versus fashion versus fine jewellery, within the mix in the basket? Anything at all that you can share on that front?

Ken Hicks

Well, I think it’s fair to say that being a department store you have the advantage of the portfolio effect of a number of different businesses. As I mentioned, fine jewellery, which is a higher ticket price, we’ve done very well. We’ve merchandized, I think, very, very well and the customer’s been excited about what we’re doing.

I will say with the slowdown in housing starts and, obviously, the concern in the real estate sector that, you know, Park Home, that trend is not as ebullient as it once was. South Home, not quite as difficult. But it’s a time when our soft goods, our apparel business, are rebounding nicely. So I think that one of the reasons for saying we’re cautious is that I don’t think anybody knows for sure exactly what the consumer’s going to do this fall. We feel we’re very well-positioned for Christmas with our gift strategy. We’re very well-positioned for back-to-school. This will be the sixth season in a row where we will lead the back-to-school business in the mall and we believe that gives us some confidence about our ability to speak to that customer, particularly the student as well as the mom.

But macroeconomic issues are something that we can’t control. We just believe we can take it from the competition.

Jeff Klinefelter – Piper Jaffray

Okay. That’s very helpful, and then just lastly would be, I know you do a lot of customer survey and feedback work. Any specific survey, exit surveys that you’ve been able to do with those Penney’s stores that are in direct competition with a closed Federated store? Are you picking up on any nuances or comments from the customers coming in that you could recognize that you are, in fact, getting a direct impact from those?

Mike Ullman

Actually, our competitive shopping and consumer research has always included Macy’s and Federated and May Company in the mix, so we did see the May Company scores going negatively as they were converting the business, but we’ve consistently done well on customer service, on having goods in stock that we advertise, in having the sizes she’s looking for, styles that inspire, brands she’s looking for. These are all issues where we’ve done well, versus May and Federated and moved up rather dramatically in the last three or four years. So it’s not that we are not aware of them as a competitor, big competitors. They apparently picked a different customer segment they want to go after. We’ll be happy to take care of the ones that they’ve chosen to be less-focused on.

Jeff Klinefelter – Piper Jaffray

Okay. Great. Thank you.

Operator

Thank you. Your next question is from David Glick of Buckingham Research.

David Glick – Buckingham Research

Good morning, and congratulations on a terrific quarter.

Mike Ullman

Thank you.

David Glick – Buckingham Research

Ken, I was wondering if you could give us some color on the customer recent activity to your back-to-school assortment? I’m particularly interested in what’s happening in denim.

Then secondly, I just want to clarify your August sales guidance? In your July release, it was up slightly. Obviously for Q3 you’re saying low single digits. Should we interpret that as being your August sales guidance is now up low single digits? Just a clarification, please.

Ken Hicks

With regard to the back to school merchandising, we’re seeing overall good response to our children’s merchandise, our shoes, very, very strong. The denim area is one that is, there’s some changes going on in denim. The customer is still liking the dark denim. They’re learning about the skinny leg and we’re seeing some early acceptance of it, but that’s something that will grow. I think that the juniors business continues to be one that we all work very hard to get. It is somewhat challenging, but it is one that we see coming back.

This year one of the things, because of the weather, a lot of our, you know, wear now merchandise, shorts, Bermuda shorts, skirts, short skirts, are selling very, very well and we’re seeing a very good reaction to that.

David Glick – Buckingham Research

As the weather has moderated, the temperatures, do you see denim starting to pick back up?

Ken Hicks

Yeah, our denim has performed actually fairly well. We’re pleased with where we are in overall denim.

Bob Cavanaugh

It’s a little hard to read the season because of some of the tax-free shifts by various states, so we’re getting some business later than we would have gotten it last year. In some cases, we’re getting it earlier and we’re only in Week 4 of seven, 3.5 out of seven, and the most important weeks are still ahead of us.

Ken Hicks

And a number of schools, particularly in Texas and other parts of the country, have moved back their school opening dates which make it a little bit tougher to read. One thing that we are seeing, too, is the uniform business has been very strong and we’re seeing some good reaction and that’s a business that we enjoy.

David Glick – Buckingham Research

Great. That’s very, very helpful. Then the clarification on August sales guidance?

Bob Cavanaugh

With regard to August sales, we haven’t changed that, David.

David Glick – Buckingham Research

Okay.

Bob Cavanaugh

We’re still going with the filing that we put out last week.

David Glick – Buckingham Research

Okay. Thank you.

Operator

Thank you. Your next question is from Liz Dunn of Prudential.

Liz Dunn - Prudential

Hi. Good morning. Let me add my congratulations on a great quarter. I guess my first question relates to merchandise. Where in your merchandise matrix do you think that there are holes in places that you can add newness, and can you comment specifically on some of the commentary in trade papers about your potential to do an exclusive line with Ralph Lauren?

Then my second question is, could you just give us some further color on your POS rollout? Where are you in terms of getting the benefits of that? As we move through the balance of the year, might we see further improvement in SG&A driven specifically by the POS rollout?

Thanks.

Mike Ullman

On the first question, I think we’ve had a pretty good track record of identifying opportunities much like we did in the Chris Madden launch, of finding an opportunity in the home business. Just went out and found the best partner to capitalize on that. We don’t comment on, you know, brand situations that we haven’t yet announced. We think that’s worked well for us, and will continue to do so. Let Ken [tackle that].

Ken Hicks

The – as Mike said, we are constantly looking at opportunities and you’re seeing a number of the introductions this fall with the introduction of the East Fifth traditional women’s career wear. That was something that we were not positioned well in. We feel very good about that launch.

In our children’s business, for back to school, we added two very exciting lines to big girls and big boys, with X Games and Stevie’s.

We saw in our modern casual business an opportunity and we introduced ANA this past spring and that has been a tremendous success. So we are constantly looking at the opportunities and putting in lines and getting very good reaction to those lines as we add them.

Liz Dunn - Prudential

On the POS?

Bob Cavanaugh

POS is all installed now, in every store, and all 35,000 registers are now dot com ready. I think we have 12 stores where we have a little bit of remodelling to do to continue the installation, but essentially it’s 100% complete. What we’re seeing is an excellent uptick in our ability of our sales associates to be able to look for merchandise sizes or inventory that the customer might be looking for that isn’t in the store they’re shopping in, and we will continue to escalate our education of our associates of how to better to use their new tool. We think it’s a competitive advantage. We have a legacy of being able to ship items to customers through our direct channel, catalog and Internet, and we will be very aggressive at taking our Internet to the next level.

We feel being the leader as a general merchandiser today is a great head start, but we don’t take that as an entitlement and we will continue to accelerate our dot com effectiveness and features.

Liz Dunn - Prudential

So it sounds like you’re positioning it more as a top line tool as opposed to a potential margin benefit, though that may come as well?

Bob Cavanaugh

Well, the margin in dot com is actually quite good. I mean, I think that in many cases because we can work out of one inventory, essentially, without having that inventory staged in a 1,000 places, we can get better inventory effectiveness and efficiency. So I don’t see that – I don’t see a margin deterioration at all. We want to be stocking the sizes, take care of the customer; if we don’t have it in that particular store, we can get it to the customer very quickly.

We’ve done a very good job this year in school uniforms, for example, by not having to carry every school in every store. We put out POS dot com ready terminals and taught our sales associates how to use them, and had a huge benefit.

Liz Dunn - Prudential

Okay. Thank you.

Operator

Thank you. Your next question is from Michelle Tan of UBS.

Michelle Tan - UBS

Hey, guys. Just a couple of quick questions. First of all, just a follow up on Dana’s point. Can you give us some sense of the magnitude that higher fuel and utility, possibly medical costs, might have had in the second quarter?

Mike Ullman

Well, fortunately we were able to mitigate some of the effects of utilities, particularly in our logistics function. We’ve been able to find offsets through higher productivity. But it’s probably been, I would say, $10 - $15 million worth of impact in terms of utilities in the stores and things like that. So it’s not a material issue at this point.

Michelle Tan - UBS

Thank you, and then also, the improvement that you’ve seen in women’s apparel. Do you sense that that’s primarily fashion driven, or do you see some tradeoffs in other categories? I know some people have talked about some weakness in shoes or, I guess, a moderation in the growth?

Ken Hicks

No, I’d say our accessories business, our shoe business in quite strong, and the apparel business has been strong.

I think that one of the benefits of our installation of our [inaudible] system and our quality people and planning allocations, our basics business is continuing to improve, which basically says we’re in stock, we’re in stock in high service levels in things that people need and want. So it benefits during times like back to school.

Great. Thank you very much.

Operator

Thank you. Your next question is from Bob Drbul of Lehman Brothers.

Bob Drbul – Lehman Brothers

Hi. Good morning. Two questions. The first one is, on the Sephora plans, is there an opportunity for you to retrofit more stores than you’re really planning and I guess, what would it take for you to accelerate those plans?

The second question is, as far as the optimal stores, can you just talk a little bit about the deals and the reception that you’re getting from the developers? Are the costs coming in in line with expectations better or worse than expectations?

Mike Ullman

Well, on the Sephora issue, our ramp up there is really a function of wanting to be able to execute extremely well, and many of the most successful brands and vendors within Sephora are smaller and we have to pace ourselves to be able to not swamp them. Sephora itself has a store opening plan that they’re executing for their own speciality stores. So we have an appetite for putting Sephora in many, many stores. We have agreed together in our joint initiative to start ramping up in ’07 with a full ramp in ’08 and beyond, but it’ll be a mixture of existing stores and new stores. So I would say next year, it may be half and half.

Operator

Thank you. Your next question is from Dana Telsey of Telsey Advisory Group.

Dana Telsey – Telsey Advisory Group

Good morning, everyone. Can you talk a little bit about getting the product time cycle? How fast you’re getting goods from factories and manufacturers to the stores and your ability to pick up that pace in order to maintain the level of full price selling? Thank you.

Ken Hicks

I think we mentioned at the analysts’ meeting that it varies dramatically by type of business. For example, in the juniors business we have quite fast cycles, as quick as 12 weeks in some cases. Overall, more like the rest of the industry, apparel has been about 52 weeks so our first objective, I think, was to get the 40 weeks overall and we’re on track to do that within the timeframe we stipulated.

I didn’t really completely answer the previous question was, are we having difficulty finding quality off-mall real estate deals. I would say, quite the contrary. We are a very welcome partner for many of these opportunities as you can imagine. They’re looking for people who are growing and the customers find desirable. At our most recent five-star opening, we were very gratified by the sales and expectations at opening. The things that affect us are the same things that affect other people in terms of commodities. Obviously the cost of steel and concrete, things like that, although that’s more of a one-time cost whereas the real estate deal, obviously, is getting the right deal for the duration of the store openings.

Dana Telsey – Telsey Advisory Group

Thank you.

Operator

Thank you. Your last question is from Jeff Simpson of Cleveland Research.

Jeff Simpson – Cleveland Research

At the analyst meeting you talked about doing more direct marketing towards customers that were potentially former May customers. I wonder if you have any kind of feedback from that, as you shifted dollars away from some of the people that were cherry picking you on price and whether there’s anything you could roll out from that perspective.

Mike Ullman

Well, for one thing we know some of the brands that they’ve dropped, we know the type of customers that were loyal to those brands so those would be audiences that we would go after. We believe that we have a very open message to the customer with our weekly insert. We’re obviously trying to motivate those customers to come and try the store in person and [inaudible] to find out so they determine the May assortments and start to get to a Macy’s assortment and exactly what that impact will be. But we’re not doing anything that – foolish. We’re open every day for all customers.

Operator

Thank you. I would like to hand the floor back over to Bob Johnson for any concluding remarks.

Bob Johnson

Thank you, Jackie. That concludes today’s call and thank you everyone for joining us.

Operator

Thank you. This concludes today’s JCPenney conference call. You may now disconnect.

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