Ladies and gentlemen, thank you for standing by, and welcome to the Burlington Stores Inc. Second Quarter 2020 Earnings Call and Webcast. At this time all participant lines are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session to ask a question during the session. [Operator Instructions].

I would now like to hand the conference over to your speaker today, David Glick, Senior Vice President of Investor Relations and Treasurer. Please go ahead.

David J. Glick - Senior Vice President of Investor Relations

Thank you, operator and good morning everyone. We appreciate everyone's participation in today's conference call to discuss Burlington's fiscal 2020 second quarter operating results. Our presenters today are Michael O'Sullivan, our Chief Executive Officer; and John Crimmins, Chief Financial Officer.

Before I turn the call over to Michael, I would like to inform listeners that this call may not be transcribed, recorded or broadcast without our expressed permission. A replay of the call will be available until September 3, 2020. We take no responsibility for inaccuracies that may appear in transcripts of this call by third parties. Our remarks and the Q&A that follows are copyrighted today by Burlington Stores. Remarks made on this call concerning future expectations events, strategies, objectives, trends or projected financial results are subject to certain risks and uncertainties. Actual results may differ materially from those that are projected in such forward-looking statements. Such risks and uncertainties include those that are described in the company's 10-K for fiscal 2019 and in other filings with the SEC, all of which are expressly incorporated herein by reference. Please note that the financial results and expectations we discuss today, are on a continuing operations basis. Reconciliations of the non-GAAP measures we discuss today to GAAP measures, are included in today's press release.

Now here's Michael.

Michael O'Sullivan - Chief Executive Officer

Thank you, David. Good morning everyone and thank you for joining us on this morning second quarter earnings call. I hope that you are all keeping safe and well in these very challenging and difficult times. We are glad that you could join us.

Before we discuss our business results and outlook, I would like to take a moment to talk about racial justice, the cruel killing the George Floyd in May of this year triggered widespread protests and a long overdue reflection and discussion on racial inequality. At Burlington, we are fortunate to have a diverse community of associates and customers. We are very proud and appreciative of this diversity. We have used the time over the last couple of months to challenge ourselves on what additional things we can be doing, to further promote equity, inclusion and diversity within Burlington, and in the communities in which we operate.

With input and ideas from associates around the company, we have put together a program that includes some short-term actions, but more importantly, includes processes, and resources that will support other longer-term initiatives. We do not have all of the answers, but we are committed to confronting the difficult questions. My reason for raising this topic in this forum, is that I know that there are several investors listening to this call, who share our passion to drive positive change on these very important issues. My purpose is to make you aware of our commitment and also to invite any of you who are interested in hearing more, about our equity, inclusion and diversity initiatives to reach out to me, John or David.

Now, I would like to turn to our business update. We are going to structure this morning's discussion as follows. First, I will begin with an update on the second quarter. Second, I will talk about how we are thinking about the third quarter. And thirdly, I will offer some commentary on the longer-term outlook. I will then hand the call over to John to provide more financial details. After that, we will be happy to respond to any questions that you may have.

Okay, let's start with the second quarter. There were certainly some highs and some lows in the second quarter. We began we're opening stores in the middle of May and by the end of June, we had reopened all, but a handful of our stores. Following the reopening of our stores, we experienced an exceptionally strong sales trend, driven by pent-up demand and by our own great clearance values. This strong sales trend continued into the second half of June, to then sell off dramatically, as we struggled to replenish the depleted inventory levels in our stores.

I realize that by now, this is a familiar narrative. Our off-price peers have described a similar pattern. But I would say that we probably experienced more significant highs and lows than they did. Our trajectory was more V-shaped if you like.

There were several reasons for this. We started off with leaner inventories in our stores. We were more aggressive in clearing aged merchandise, and we had lower pack and hold inventory to pull back on. Given all these factors, it might be helpful to provide some additional color on how the quarter unfolded month-by-month. When we firstly opened stores in May, we saw very quickly, the traffic and sales levels were well ahead of our expectations. So we moved very fast to fund our buyers and to go back into the marketplace. We were probably one of the first retailers to go back into the markets to buy goods. At that point, we saw tremendous availability across merchandise categories. Our merchants were able to buy merchandise at really terrific values. In May and June, we wrote hundreds of millions of dollars of orders. At that point in the quarter, we were flying. We were exactly where we wanted to be. Strong sales trends, a lot of liquidity, and a huge availability of merchandise. In normal times, as an off-price retailer, those are all the things that you want. The trouble of course, is that these are not normal times.

Although we had written the orders and have bought the merchandise, so if our vendors struggled to deliver the receipts as quickly as we needed them. They themselves were coming back from a standing start, bringing their own distribution facilities back up to life. The newly purchased merchandise receipts only started to flow in earnest in July. This was later than we needed, and it meant that from late June to mid-July, the inventory levels in our stores fell well below acceptable levels. This was very frustrating. We could see the sell-throughs that we were getting on the limited receipts that we were writing in stores, so we know that we left significant sales dollars on the table.

Since mid-July, we have brought inventory levels back up. But candidly, it has taken a lot longer than we would have wanted. Some of our vendors are still having issues with their distribution systems. In addition, like a lot of other retailers, we have run into staffing issues getting our own distribution centers up to full capacity. With all that said, as inventory levels have increased since mid-July, we have seen a significant improvement in our trend.

Let me offer up some data. For inventory flow, we prioritized the stores that we opened in May, that was just over half the chain. These stores are now at approximately the inventory levels that we want. Their sales levels are trending down approximately 20%, but are on an improving trajectory. The rest of the chain is a couple of weeks behind. We don't know where the sales trend will settle out, once inventory levels where we want them to be, but we are pleased with the improvement we have seen since mid-July.

That is all that I can say about Q2 in my prepared remarks. I would like to move on now to talk about Q3. I don't think you will be surprised to hear me say that the upcoming quarter is extremely unpredictable. Back to school has been delayed, and may not happen at all. Local unemployment assistance has come to an end or came to an end at the beginning of the quarter, and it is unclear what if any additional stimulus spending there will be. And of course, there is continuing uncertainty and anxiety about the COVID-19 pandemic, with many experts predicting that there could be another resurgence in the fall. This is about as unpredictable a quarter as I can ever remember.

Now let me give you a sense of how we are thinking about and managing the quarter. We have what I will call, a baseline plan, which currently assumes that comp sales will be down about 20% for the quarter. Let me explain what this baseline plan is. We use it to manage and control receipts and expenses. It is not intended to be a reliable prediction, of what is going to happen, but rather a baseline to manage against. We review this plan every week, and we adjust the plan up or down, based on changes in the sales trends or the outlook. In this environment, our approach is to manage our business conservatively, control liquidity, manage expenses, and be ready to chase the business or to pull back, based on the sales trend and external developments.

The other point that I would like to make, is that this may be what life is going to be like for a while. With this level of uncertainty, it is very challenging to plan and manage the business, but we have to assume that the underlying drivers of this uncertainty are not going to go away in the third quarter. In fact, it could continue for the next several quarters, and possibly well into next year. Obviously, we would like for things to normalize sooner, but we need to be prepared, and we need to recognize that this uncertainty could continue for some time.

Let me step away from that point to talk about the longer-term outlook. Our assessment is that the retail industry has been undergoing a significant restructuring for some years now, and that this started long before the pandemic. We believe that the two principle underlying drivers of this industry restructuring are; the consumers' need and desire - growing need and desire for value, and secondly, the growth of e-commerce. We believe that both of these trends undermine the viability of traditional department store and specialty retailers, and that they have been forcing these retailers to adapt to rationalize, and to close stores. The strategic implications for off-price are twofold. First of all, the consumer need for value has naturally been driving market share gains to off-price for many years. More recently, the growth of e-commerce has been a further catalyst for this growth.

As the growth of e-commerce has driven other retailers to close even more physical locations, many of the more value-oriented shoppers from these stores have made their way to off-price. That is why, off-price retail has been growing over the last several years, in parallel with the growth of e-commerce. In the categories that we sell and at the price points that we offer, it is very difficult for e-commerce to satisfy the needs of the value-conscious shopper. So as a result, off price retail has been gaining market share.

We do not anticipate the COVID-19 pandemic reversing or diminishing these trends. In fact, we believe that the COVID-19 and its aftermath is more likely to enhance the strategic trends that I have just described, by creating an even stronger consumer and economic need for value, and by driving more closures of competitive bricks and mortar retail stores. We think it is possible that this will create an even bigger market share opportunity for off-price retail.

The COVID-19 pandemic has created a situation that in the short term, possibly for the next several quarters, a situation that will be very uncomfortable and challenging for all of us to manage through, but for the reasons that I've described, we believe that once we get to the other side, the longer-term market share opportunities for off-price retail could well be greater, than they were at before.

With that, I would now like to turn the call over to John, to provide more detail on our financials.

John Crimmins - Executive Vice President and Chief Financial Officer

Thank you, Michael and good morning everyone. Let me start with the review of the income statement. For the second quarter, total sales decreased 39%. Sales in reopened stores decreased 14%. Sales in reopened stores, includes all stores that were open prior to the end of the second quarter of fiscal 2019 and reports the sales increase or decrease at these stores for the days the stores were opened in the second quarter, against sales for the same days in the prior year.

As Michael discussed, our sales trends varied across the quarter, driven by the timing of our store reopenings. Generally, as our stores reopen, sales were very strong, driven by pent-up demand and our aggressive clearance markdowns. Sales were stronger than we expected during the first weeks after reopening, and then they weakened significantly, as inventory levels were depleted. It took longer for us to reestablish appropriate inventory levels than we would have liked, for the reasons Michael discussed, and this hurt our sales performance. But as inventory levels increased and began to return to targeted levels, we did see sales trends improve. This really began in mid-July and has continued into August.

As expected, the sales decline was driven by significant decreases in traffic and AUR, reflecting our clearance pricing, which was partially offset by increases in average transaction value, and units per transaction, driven by the great values we offer. The gross margin rate was 45.8%, an increase of 440 basis points versus last year's rate of 41.4%. The clearance markdowns taken during the second quarter were funded by the markdown reserve we established in the first quarter. Low levels of clearance in the second half of the quarter, resulted in lower markdowns in the increasing gross margin for the quarter. Product sourcing costs, which include the cost of processing goods through our supply chain and buying costs, were $72 million in the second quarter of 2020 versus $82 million last year. The decrease in product sourcing costs was driven by the decrease in receipt processing activity during the quarter.

Adjusted SG&A was $402 million versus $441 million last year. The dollar decrease was primarily due to decreases in store payroll, marketing and corporate costs, while our stores were closed, partially offset by COVID related expenses and store reopening costs of about $37 million. Depreciation and amortization, excluding favorable lease costs, increased $2 million to $54 million. Adjusted EBIT decreased by $181 million to a negative $63 million, driven primarily by the lower sales volume. Net interest expense, excluding the $7 million in non-cash interest on convertible notes, was $21 million, an increase of $7 million over the last year's second quarter. The adjusted effective tax benefit rate was 55.6% for the second quarter versus last year's second quarter adjusted effective tax rate of 12.8%. The tax benefit rate, is a result of the current year losses and carryback provisions, allowing refunds for previously filed returns at a 35% rate. Additionally, the tax benefit from the exercise of stock options increased the income tax benefit this year, compared to decreasing income tax expense in the prior year.

We did not repurchase stock during the quarter. We have $348 million remaining on our share repurchase program, which remains suspended. All this resulted in diluted earnings per share loss of $0.71 versus income of $1.26 last year. Adjusted diluted earnings per share were a loss of $0.56 versus a profit of $1.36 per share last year. At quarter end, we had approximately $1.1 billion in cash, $250 million in borrowings on our ABL; face value of $805 million in convertible notes, and $300 million in senior secured notes. We had unused ABL availability of approximately $120 million. During the second quarter, we paid down $150 million on our ABL facility. We ended the period with total balance sheet debt of approximately $2.2 billion.

Merchandise inventories were $608 million versus $824 million last year, a 26% decrease. The decrease was driven by our clearance liquidation and delayed inventory replenishment, as well as by our conservative approach to planning in this uncertain environment.

Pack and hold inventory was 26% of total inventory at the end of the second quarter, the decrease from 29% last year. During the quarter, we opened three new stores, bringing our total store count to 739 stores. At the end of the quarter, 11 of these stores were temporarily closed, due to a variety of factors, including five stores that sustained damages, that will reopen over the next several months. Three temporary COVID related closings and three stores closed that were associated with our store relocation strategy, that are reopening later in the fall.

In the third quarter, we expect to open 37 new stores, with seven expected closings or relocations. In fiscal 2020, we now expect to open 62 new stores in close or relocate 26 stores. This would translate to 36 net new stores expected to be opened in fiscal 2020.

As we discussed on last quarter's call, eight stores shifted from spring 2020 to fall 2020 and 16 stores were shifting from fall 2020 to the spring of 2021. During the second quarter, we made the decision to shift two additional stores from fall 2020 to spring 2021, due to site availability issues outside of our control, resulting in a total of 18 stores shifting to the spring of 2021.

Net capital expenditures were $121 million for the first half of fiscal 2020. Net capital expenditures are still planned to be approximately $260 million, net of landlord allowances for fiscal 2020. In terms of our fiscal 2020-to-date performance, total sales declined 45%. Gross margin was 26.4% as a percentage of sales, versus 41.2% last year. Product sourcing costs were $147 million versus $161 million last year. Adjusted SG&A was $796 million this year versus $869 million last year. Adjusted EBIT decreased by $801 million, to a loss of $565 million.

Depreciation and amortization, excluding favorable lease costs, increased by $6 million to $109 million. Net interest expense, excluding the $9 million in non-cash interest on convertible notes, increased $7 million to $33 million. The adjusted effective tax benefit rate was 41.1% as compared to last year's adjusted effective tax rate of 15.4%. Combined, this resulted in a net loss of $381 million and an adjusted net loss of $352 million versus an adjusted net income of $177 million last year. Diluted earnings per share were a loss of $5.79 versus a profit of $2.40 last year. Diluted adjusted net earnings per share were a loss of $5.36 versus a profit of $2.62 last year. Our fully diluted shares outstanding were 65.8 million shares versus 67.5 million last year.

Cash flow provided by operations decreased $702 million to a negative $473 million for the first six months of 2020, driven by lower net income and changes in working capital. Net capital expenditures were $121 million for the period.

Now I will turn to some comments on our outlook. As Michael described earlier, sales for Q3 is extremely difficult to forecast. Accordingly, our guidance for sales and earnings remain suspended at this time. Given this uncertainty, we are planning the business conservatively and keeping tight control over liquidity, inventory and expenses. This posture gives us the flexibility from the liquidity and open-to-buy standpoint, to flex up our receipts and opportunistic purchases, if we see a strong sales trend and outlook.

As described previously, total inventories were down 26% at the end of Q2. We are planning in-store inventories to remain well below last year's levels. We would expect them to be down about 20% to 25% on a comp store basis by the end of Q3. But, we anticipate at the end of the quarter, total inventories maybe closer to flat versus last year, driven by increased reserve inventory, specifically spring and summer pack and hold, which may grow significantly. This will depend on availability and the merchants being able to find great deals in the market.

While we are not prepared to give specific sales and earnings guidance due to the uncertainty of the current environment, we can update you, as we did last quarter on certain fiscal 2020 cash flow and expense items, that may be useful for modeling purposes. Capital expenditures, net of landlord allowances, are still expected to be approximately $260 million. We now expect to open 62 new stores, while relocating or closing 26 stores, for a total of 36 net new stores in fiscal 2020. Depreciation and amortization expense, exclusive of favorable lease costs, is still expected to be approximately $230 million, and interest expense, excluding $24 million in non-cash interest on the convertible notes, is still expected to be approximately $80 million.

Before I turn the call back over to Michael, I would like to mention that last week the company released its 2019 CSR report, which can now be found on our Investor Relations website, burlingtoninvestors.com. This report highlights our focus on the Environmental, Social and Governance or ESG issues of greatest importance to our stakeholders. Although this is only our second Annual Report, we are pleased with the progress we've made and the path we are planning for the future.

With that, I will turn it over to Michael for closing remarks.

Michael O'Sullivan - Chief Executive Officer

Thank you, John. As I wrap up my remarks, I would like to thank all of our associates at Burlington. We are operating in the midst of a global health crisis, and we recognize that this is a difficult and anxious time for everyone. I am tremendously proud and thankful to all of our associates for their hard work and commitment, over the past several months.

As I described earlier, I believe we will emerge from this pandemic stronger than ever. There is a lot of uncertainty, but we are well positioned to absorb the shocks, and take advantage of the great opportunities ahead of us.

With that I will turn it over to the operator for your questions. Operator?

Question & Answers

Operator

Thank you. [Operator Instructions]. Our first question comes from the line of Matthew Boss with JP Morgan. Your line is now open.

Matthew Boss - JP Morgan - Analyst

Great. Thanks and good morning. Michael, so it sounds like things were going well to start the second quarter. And then you ran into logistical, rather than merchandise availability issues, when you tried to replenish your store level inventories. I guess, is that the right way to think about it, and can you elaborate on the issues, and to what degree have the logistical issues been resolved at this point?

Michael O'Sullivan - Chief Executive Officer

Good morning, Matt. Thank you for the question. Yes, that's right. The way that you've characterized what happened is accurate. Our performance in Q2 was not driven by merchandise availability. There was plenty of availability. As I described in my remarks, we turned our clearance inventory very rapidly. So in late May, we were able to go back into the market and take advantage of some terrific buying opportunities. We were very pleased with the availability that we saw, and we were able to make some great deals. The problem was, that having written new orders, having bought the goods, we could not get the receipts to the stores as fast as we needed. Many vendors were struggling with their own warehouse operations and getting them up and running.

So we really needed to merchandise that we really needed to flow to stores. And in June, we weren't able to get to stores and for July, that delay in receipts was a matter of weeks. But it meant the inventory levels fell well below, when we didn't [Indecipherable]. I would say that since then, it has taken us a lot longer than it normally would, to get through the receipt backlog. In the areas where our BCs are located, we've seen staffing shortages and that hindered our ability to get our own facilities up to full capacity.

Now on the last part of your question, whether these issues have been resolved, I would say that, yes, largely they have been resolved. Our vendors' distribution facilities are up and running, and for some weeks, we've been getting a very good flow of receipts. That said, there are lingering issues. To be clear, these issues are not specific to Burlington. I would say, they are right across the industry. As distribution facilities have ramped up, there have been significant staffing shortages in major distribution hubs like Southern California. Those issues are subsiding, but they haven't completely gone away. In fact, I would say that there is a risk that they could cause additional program, as retailers start to ramp up in the fall, the holiday. I'd also anticipate those issues are going to lead to an increase in supply chain costs across the retail industry this year.

Matthew Boss - JP Morgan - Analyst

Great. And then to follow up, Michael, when would you expect inventories to be back to the levels where you would ideally want them? And how will you manage inventories going forward?

Michael O'Sullivan - Chief Executive Officer

As I mentioned earlier, the stores that reopened in May, so just over half of our stores, we are pretty much already there in terms of getting inventory levels where we want them to be. Stores that reopened in June, should catch up in the next couple of weeks. To be clear though, even at that point, we're going to manage our inventory levels in our stores conservatively. As you probably recall, when we came into the year, our inventories were down about 15% on a comp store basis, and that was deliberate. We've historically carried more inventory than our peers, and we believe that we have the opportunity to turn our inventory faster than we have in the past, and as a reminder, before the pandemic hit in mid-March, we were running about a 3% comparable store sales growth, and that was with our inventory down 15%. At that point, we had said that we would manage our inventories down low-double digit throughout the year. But with all the uncertainty that we now face, we're going to manage them slightly more conservatively in there. And of course, we'll be ready to flex up or flex down, as best we can, depending on the trend.

Final point to make that inventory though, is that apart from the level, the content of our inventory is very different to last year. Because of what happened in Q2, we have very little aged inventory left in our assortment. We have hardly any spring merchandise left in our assortment, and hardly any clearance left in our assortment. It's all fresh, seasonally appropriate merchandise. So if the customer wants to shop in Q3, we feel that he is going to - what you will find in our store is pretty good. The trend [Indecipherable] which we should do well.

Matthew Boss - JP Morgan - Analyst

Great. Best of luck.

Michael O'Sullivan - Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Ike Boruchow with Wells Fargo with Wells Fargo. Your line is now open.

Ike Boruchow - Wells Fargo - Analyst

Hey everyone. Thanks so much for all the detail. My first question, Michael, could you give us an update on the off-price full potential strategy that you've laid out in the past? And then I'm just really curious, has the pandemic changed the way you're thinking about the opportunities of the strategy, and has it in any way, kind of slowed down your ability to make progress on that strategy?

Michael O'Sullivan - Chief Executive Officer

Good morning Ike. Thank you for the question. It's a good question. Yeah, as I described in my earlier remarks, we believe that the COVID-19 pandemic is likely to create an even stronger consumer need and desire for value, and it's also likely to increase the number and the pace of competitive store closures. So if both of those things turn out to happen, then the pandemic could actually increase the longer-term market share opportunity for off-price.

But let me transition from talking about off-price generically, to talking about Burlington specifically. As we've discussed on previous calls, we are the smallest and least profitable of the major off-price retailers; and because of this, we believe that by executing the model more effectively, we can drive significant growth in sales and profitability over the next several years. In other words, we believe we have significant upside potential.

I and the rest of the executive team recognize that it would be very easy in the current environment to focus only on the short-term challenges that we face. But that would be a mistake. The important goal here is to come out of all this much stronger than we went into it. So it's important that we build and prepare for the longer term and for the significant opportunity that we see ahead of us, and that I articulated a moment ago. So over the last several months, we've been pushing forward on a number of initiatives that together form, what we're calling Burlington 2.0, our off-price full potential strategy. As we talked about on previous calls, the initiatives behind Burlington 2.0 intended to accomplish a number of things, specifically to drive a much greater focus on merchandise value; to build more [Indecipherable] into the business, so we can better respond to sales trends; to invest in and strengthen our merchant capabilities, to place greater emphasis on opportunistic buying, and also to increase the flexibility of our operations, so we can respond to sudden changes in the business. And making progress on all of those areas is going to take some time, going to take some investments, some capital planning. But over the last few months, I would say that there has been some great work and some excellent progress. The whole organization is very energized, very focused on Burlington 2.0.

The other point that I would make - and to be clear, I would not have wished it this way. But the last few months have provided what the U.S. military might call, a live fire exercise, in many of these areas. The opportunities and the challenges that we faced in the second quarter, I would say, forced a faster paced change and innovation, than we might otherwise have achieved. Its true, necessity is the mother of invention. I'm not trying to sugarcoat here. I mean, clearly this was a frustrating quarter. It did not turn out the way that we would have wanted. But we made some mistakes and we learned some important lessons, particularly in planning, buying, distribution and transportation, and I'm determined that we're going to benefit from those lessons going forward.

Ike Boruchow - Wells Fargo - Analyst

Thanks Michael. That's helpful. And then just a quick follow-up for John, any details - I know it's a unique quarter, but any details just on the puts and takes of operating margin that took place in the second quarter? And then, if there is anything we should keep in mind going forward in the back half, would be great?

John Crimmins - Executive Vice President and Chief Financial Officer

Yeah, good morning, Ike. Thanks for your question. Yeah, there was a lot of stuff going on. Lots of puts and takes during the quarter. So I'll try and walk you through how we think about it, as we plan and manage our expenses. So you know, the biggest thing that happened in the quarter was the reduction in our sales volume, and obviously, that drives deleverage on our fixed cost base. So that's the single biggest driver, and that's probably kind of the way you might expect it to be. But normally, you would expect all of our volume related expenses to flex kind of in line with sales. But for a number of reasons, that wasn't really the case in the second quarter. So I mean just talk about some of those things. So, first, our sales decrease included huge clearance markdowns, which helped us to successfully clear our inventory, which was our primary objective. But it also meant we had more units per dollar, which of course drove worst leverage than you would normally expect in processing the units, particularly in selling costs.

As I mentioned earlier, in our prepared remarks, COVID related costs and reopening costs added about $37 million to our expenses in the second quarter. So COVID related costs would include, the cost of personal protective equipment, additional cleaning, additional store staffing, including front door ambassadors, signage, supplies and other costs to support social distancing procedures within our stores and to kind of support our most important priority, which was ensuring that our customers and our associates would have a consistently safe welcoming and comfortable place to work or to shop.

The store reopening costs include everything related to preparing our stores to open back up after the extended closures and that includes training, training for our teams on new safety protocols and procedures, resetting our floors and traffic patterns to support social distancing prepping our merchandise for the clearance offering as well as signage and other promotional materials related to the terrific clearance values that we put on offer. We also had some incremental costs during the quarter as we work to accelerate supply chain processing and merchandise deliveries, to our stores to try and replenish as quick as we could our depleted inventory situation.

As Michael mentioned, this included some additional pressure on DC. There were some wage incentives we put in place to attract more DC workers, and try to improve the throughput at our DCs during the quarter. Also, you may recall from our fourth quarter call, we plan to make some strategic investments this year in our business consistent with our Burlington 2.0 full potential strategy. As Michael just discussed, we're - moving ahead on that, despite the conditions that we're facing. We had expected to cover these incremental investments with offsetting expenses during the year. So we're continuing to make these investments, but during the second quarter, they weren't fully offset by expense savings. Now, when the pandemic is behind us, we do expect the on-going investments will be offset by the expense savings as we originally planned.

So just one of the unique things, we decided to continue these investments, but we had cost increases in some of the areas that we would have been able to manage to kind of offset them. So, while most of the deleverage was based on the smaller sales against in our fixed cost base. We did have these other things going on that made the leverage maybe a little bit worse than otherwise would have been.

Ike Boruchow - Wells Fargo - Analyst

Got it. Thanks, guys. Thanks a lot.

John Crimmins - Executive Vice President and Chief Financial Officer

Thank you.

Operator

Thank you. Our next question comes from the line of John Kernan with Cowen. Your line is now open.

John Kernan - Cowen - Analyst

All right. Good morning. Michael, I have a question just on merchandise availability beyond some of the logistical headwinds you face. It sounds like there was a lot of inventory availability early on in the quarter. Has that changed at all? We have heard some other retailers and authorizers talk about tightening up supply. So how do you characterize this merchandise availability now?

Michael O'Sullivan - Chief Executive Officer

Yes, thank you, John. Good morning. Nice to hear from you. When we started buying again in May, there was there was strong availability, I would say, in almost all areas. You know, physical retail stores have been shut since March. So, so vendors, many vendors were sitting on a lot of cancelled orders. We were able to take advantage of that situation and we made some really, really great deals.

As I explained in my prepared remarks, the issues that we ran into in Q2, were driven by logistics for want of a better word, they had nothing at all to do with availability of merchandise, at least nothing to do with availability in the sense that we normally think of it. Anyway, just to come back to your question, we're now in late August, so three months on, and I would say that there's still a plentiful supply of merchandise, but there are pockets where we're tightened and I would probably point at two areas where that happened. First of all, businesses where consumer demand has been the strongest, specifically, certain categories, not all but certain categories in home.

And secondly, in some seasonal businesses where factory shutdowns earlier this year back in February, March means that there's now limited inventory of that in those categories. You know, other than those two areas, I would say there's still plenty of merchandise available. The important thing I think, to understand about availability, merchandise availability, in off-price is that it's a function not only of how much merchandise has actually been produced, but it's also a function of what is happening to the sales growth in department stores and other retailers.

Even if vendors have produced less merchandise this year and I'm sure for many vendors that can be the case. We may still see significant off-price availability, if the retailers that those goods were made for experience an even weaker trend than they had expected. Given some of the weakness that's been reported, and certainly given some of the uncertainty that's out there, it's possible, even likely that this will happen and if it does happen, it could drive additional merchandise supply into the off-price channel. It's a good example of that, maybe back-to-school. The production of many, many back-to-school categories was constrained earlier this year due to the impact of COVID-19 in Asia. I actually remember having meetings back in February and March before the pandemic hit the U.S. where people were raising concerns about the supply of back-to-school categories.

Now, depending on how things unfold over the next few weeks, the level of demand in these categories across retail could be even less than was produced. So if things turn out that way, that could generate additional price supply and in our case, that would mean, that we might take advantage of for pack and hold and actually let me just wrap up that the question by talking a little more about pack and hold. We anticipate that there may be an opportunity over the coming months to significantly increase our spring and summer pack and hold inventory levels. We've actually expanded our warehousing storage capacity to support that. But the extent to which it happens, all depends on the kind of deals that you see. As you'd expect, we'll only pack the way the very best ones [Phonetic] that our merchants can find.

John Kernan - Cowen - Analyst

Got it. Maybe just a quick follow up. You mentioned that home still sounds pretty difficult from availability standpoint. How are the other categories affecting your business and just the general buying decisions?

Michael O'Sullivan - Chief Executive Officer

Yes, it's a really good question. Clearly, since we emerged from the lockdown, the customer has not allocated her spending evenly across merchandise areas. This is different to what's happened in the past. For example, in the period after the financial crisis, as the consumer started spending again, the increase in spending was much more evenly across categories and across businesses. This time, more so than any period I can remember. There's been a massive shift in spending between categories. So what does that shift look like?

Well, you've heard from other retailers and obviously I already just talked about a very strong consumer demand for many home related businesses. In terms of the rest of the store, within ready-to-wear there's been a significant shift, towards more casual and active classifications and therefore away from more formal structured dressier businesses. Now, I think those trends make intuitive sense, at least in the short term. You know, people are working from home, maybe they're sheltering at home, but they're certainly going out a lot less.

Now for us, those trends represent those category trends represent a challenge and an opportunity. Some of the areas that have experienced the strongest growth in demand or businesses where frankly, we're less developed than some of our competitors and the best example being home, but also some casual classifications within ready-to-wear and so ever since we've been buying again, ever since May and certainly, as we've been building back our inventories, we've been aggressively going after those businesses. So we feel like we have an opportunity to grow those undeveloped categories, but we would acknowledge that we're starting from a - from a weaker position relative to some of our peers.

John Kernan - Cowen - Analyst

Excellent. Thank you.

Michael O'Sullivan - Chief Executive Officer

Thanks John.

Operator

Thank you. Our next question comes from the line of Lorraine Hutchinson with Bank of America. Your line is now open.

Lorraine Hutchinson - Bank of America - Analyst

Thanks. Good morning. John, how should we think about your operating margin and financial model going forward? Have there been any structural changes to your expenses?

John Crimmins - Executive Vice President and Chief Financial Officer

Well, good morning, Lorraine. Thanks for your question. Yes, I think the quick answer to that is no, we don't really see any permanent structural changes to our expense base, or how we think about our operating margin expansion opportunity going forward. But I guess the biggest impact to our operating margin that we've seen, has been driven by the just big decline in sales that we've experienced so far. We do expect that post pandemic, sales are going to normalize and we expect, we will have a terrific opportunity to add to our market share driving comp sales and we're going to continue to aggressively expand our fleet of stores.

Most of the additional expenses that we've seen - I've talked about this a little bit in Ike's question, they're transitory. They are caused by pandemic related events. We don't expect them to continue, but it should be behind us, when the pandemic is behind us. Maybe the one exception there is the wage pressure for DC labor. To this point, much of what we've done to kind of attract more workers in our DCs has been more of temporary short term incentives. But there's likely to be a component of this that's permanent. It's not yet clear how significant it's going to be. But as you know, we face wage headwinds every year, and we've had a pretty good history of finding ways to offset their impact and deliver operating margin expansion. So when this thing is behind us, we do expect to have that kind of same type of operating margin opportunity that we had prior to it.

Lorraine Hutchinson - Bank of America - Analyst

Thanks. And just a follow-up, I know you suspended guidance, and there's a lot of uncertainty. That said, can you give us some direction or color on how we should think about margins in the second half of fiscal '20?

John Crimmins - Executive Vice President and Chief Financial Officer

Sure, it's really hard to forecast anything, so I'm going to stay away from numbers, but we do have some color that I think might be helpful. So for gross margin, we think that's going to be relatively stable in the second half of the year. If you think about gross margin, our inventories are really clean coming out of the second quarter, as clean as we have ever seen them. So any markdowns going forward are going to be based on how well we are able to balance the flow of inventory with the sales trend. Same challenge we have all the time, just a little bit more volatile this year.

SG&A in the second half is going to continue to be impacted by COVID related expenses in a similar way to the second quarter, but not exactly the same. We expect COVID related costs to be higher, kind of moving along the sales volume and increased traffic that we expect and hope to see in our stores in the second half. But we don't expect to be incurring the store reopening costs, at least we hope we won't be, at least to the degree that we have them in the first half of the year, when all of our stores were closed and then reopened. So we're not going to give a number expected for the COVID related costs in the second half, because it's really difficult to project. But there would be some, kind of deleverage pressure, as we continue with all the costs related to keeping our stores safe and comfortable for shoppers and associates.

Product sourcing costs as a percentage of sales, we do expect a little bit of deleverage pressure in the second half, for a few reasons. You already mentioned the DC labor shortage, which is likely going to drive some incremental costs. We're also going to see, we believe, some downward pressure on AUR. Part of that's driven by better buying, allowing us to pass more value to our customers, and some of it is going to be related to category of mix changes, and there could be some other pressure, as we continue to improve - work on improving our ability to get goods to stores faster and keep inventory at the right levels.

Obviously, the sales volume in Q3 and Q4 is going to have an impact on our product sourcing costs leverage, so it's difficult to pinpoint. But directionally that's kind of how we're thinking about it.

Overall, given our conservative inventory planning and the potential for continued depressed sales levels, we're going to expect continued deleverage on expenses. The magnitude is obviously dependent on our ability to perform as well as we can on the sales line. But as I said earlier, we think that most of the deleveraging factors we face this year are temporary, and then post pandemic, our model is going to turn back to what it was prior to the pandemic.

Operator

Thank you. Our next question comes from the line of Daniel Hofkin with William Blair. Your line is now open.

Daniel Hofkin - William Blair - Analyst

Good morning, gentlemen. Thanks for taking my question. Michael, if I could just ask one; first question then a quick follow up; my first question is, I think your description of how you're thinking about the third quarter makes a lot of sense. I was just curious, though, do you think there is a risk of being potentially too conservative? And, in the process, possibly missing a sales opportunity, if you have to chase too much?

Michael O'Sullivan - Chief Executive Officer

Good morning, Daniel. I would say that the short answer to your question is, yes, there is absolutely a risk with that. You followed off-price for a while, so you'll know that the playbook, off-price is to plan sales conservatively, but be liquid and ready to chase the trend. That approach has worked very effectively, very well historically and it's given off-price retailers significance over other retail formats.

But I would say that the current environment presents a couple of important challenges to executing that playbook. Firstly, the range of possible outcomes over the next month is much wider than we've had to deal with in the past. At the extremes, I could describe a scenario, where there's a further resurgence in COVID-19 in the fall, and potentially that could lead to further local or even regional lockdowns and then perhaps the other extreme, I could, I could describe a scenario where the number of COVID-19 cases declines over the next few months and also, as part of that scenario, perhaps the federal government reaches a compromise and passes a stimulus package that drives consumer spending.

My point is that we need to be ready to either of those scenarios, so a very wide range of outcomes. Add to that, there may be external constraints, like, some of the industry supply chain issues that we ran into in Q2. If those were to recur, they would they would hamper our ability nicely, they would hamper the ability of all retailers to chase sales in the fall.

Of course, the very fact that I'm articulating these risks means that we're aware of them, and we're taking the steps that we can to investigate them. But nevertheless, I think your question is a good one. You know, is there a possibility that we'll leave sales on the table? Yes.

In this environment there is a chance of that. There is a broader point that I would like to make before leaving this question. One of the things that we're mindful of within Burlington is that we are still in the midst of a global pandemic. Now, of course, we're competitive. We'd like to do well. We'd love to maximize sales in every quarter. But we also need to be little bit capital and to make sure that we prudently navigate our way through this uncertain period.

As I said in my earlier remarks, we expect that the next few quarters could be like this, could be difficult, could be uncomfortable. So I guess, I'd summarize out our game plan, in this situation. A game plan if you like it, you know, having two parts to it. Number one, part number one, you manage the business prudently remain as flexible as possible, that we can chase sales as best we can, or if we can pull back based upon the trend and then part number two, continue to aggressively push forward on the major elements of our Burlington 2.0 off-price for potential strategy.

We know, I think we all know that long term success is not going to be defined by the next couple of quarters. Long term success will be defined by what the world looks like coming out of the pandemic and the degree to which we're ready at that point, and we're able to take advantage of any market share opportunities that are ahead of us.

Daniel Hofkin - William Blair - Analyst

It's really helpful Thank you and then just a very quick follow up as you know, anything, any updates, especially maybe insights related to the pandemic in problems that you're seeing and some full price retail of different types that is updating you are thinking on the real estate strategy or opportunity for you guys and in the right size store, etc overtime. Thank you very much.

Michael O'Sullivan - Chief Executive Officer

Yes, that's a good thing. It kind of feeds into making sure that we keep an eye on the longer term because key part of our Burlington 2.0 strategy over the next few years is to continue to expand our stores, and continue to right size our stores so we can drive store power activity, we can drive new store economics.

So we've been over the last few months, we've been doing a lot of work. Our real estate team has done some terrific work, sort of planning out the next few years from a real estate point of view and I think what you're alluding to and I agree with you, is I feel like, given what's happening in broader retail, we are likely to see significant additional real estate opportunities open up, which we will be able to take advantage of maybe as soon as late 2021. But certainly, we would hope in 2022, 2023. So that's absolutely something we are looking at, and actually excited about.

Daniel Hofkin - William Blair - Analyst

Thanks so much. Best of luck for everything.

Operator

Thank you. This concludes today's question-and-answer session. I would now like to turn the call back to Michael O'Sullivan for closing remarks.

Michael O'Sullivan - Chief Executive Officer

Thank you for joining us on the call today. We appreciate the questions. We look forward to speaking with you all again at the end of November to discuss our third quarter results. Thank you.

Operator

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BURLINGTON STORES INC

Q2 2020

Earnings Transcript

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