Good morning and welcome to The Children's Place Third Quarter 2020 Earnings Conference Call. On the call today are Jane Elfers, President and Chief Executive Officer; Mike Scarpa, Chief Financial Officer; and Rob Helm, Senior Vice President, Finance.

The Children's Place issued its third quarter 2020 earnings press release earlier this morning. A copy of the release and presentation materials for today's call have been posted to the Investor Relations section of the Company's website. This call is being recorded. If you object to our recording of this call, please disconnect at this time. All participants have been placed in a listen-only mode, and the floor will be open for your questions following the presentation. After the speakers' remarks, there will be questions as time allows.

Before we begin, I would like to remind participants that any forward-looking statements made today are subject to the safe harbor statements found in this morning's press release, as well as in the Company's SEC filings, including the Risk Factors section of the Company's annual report on Form 10-K for its most recent fiscal year. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially. The Company undertakes no obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date hereof.

After the prepared remarks, we will open the call up to your questions. [Operator Instructions].

It is now my pleasure to turn the floor over to Jane Elfers.

Jane Elfers - President & Chief Executive Officer

Thank you, and good morning, everyone. Our back-to-school sales were significantly impacted by the move to remote and hybrid learning models across the country in response to the COVID-19 pandemic. Post the back-to-school peak, when our assortments converted to more casual options and the weather turned cooler, our sales improved, and for the quarter, we returned to profitability and generated positive cash flow from operations.

Starting with our accelerated digital transformation. Increased digital adoption accelerated by COVID-19 and supported by our digital transformation and omni-channel initiatives continued to drive online sales to an increasingly greater share of our overall sales. Digital sales accounted for 44% of our Q3 sales, and year-to-date, digital sales represent 55% of our total sales. Importantly, our continued digital growth is coming from both existing and new customers.

Since March, we have increased the number of new digital customers versus last year by approximately 100%, converted over 800,000 store-only customers to omni-channel customers, and increased our mobile app downloads by over 60%. The customers' accelerated shift to digital provides The Children's Place with continued market share opportunities as we leverage our recent digital transformation investments and our foundational personalization of initiatives to continue to acquire new customers into our omni-channel ecosystem.

Moving on to our accelerated store closure plan. As we close stores, a key measure of the success of our digital transformation and fleet optimization strategy is our ability to retain, transfer and convert our store only customers to e-commerce and omni-channel customers. Our e-commerce and omni-channel customers are our best customers. They shop with us more often and spend approximately 3 times more our non-omni-channel customers.

Today, we had some very important metrics to share with you regarding our customer transfer rate. Year-to-date through the end of September, which allows for one year of post-store closure tracking, our transfer rate has increased to 31% versus our full year 2019 transfer rate of 20%. This substantial transfer rate increase further reinforces the decision we made back in March to significantly accelerate store closures by giving us even greater confidence in our ability to continue to shift a substantial portion of our stores revenue to our digital channel.

Looking ahead to Q4, we're approaching the fourth quarter with heightened caution and expect both sales and profitability to be under pressure due to the numerous headwinds created by the pandemic, specifically a meaningfully reduced demand for dress-up product, significantly reduced store traffic, the recent nationwide spikes in COVID-19 cases resulting in additional temporary store closures, social distancing requirements and reduced mall operating hours.

With respect to our digital business, to ensure on-time holiday delivery, we have already been advised by our major carriers to move our standard shipping cut off up by three days from our original date of 12/18 to 12/15 due to the capacity constraints across the domestic transportation network. In addition, the related freight surcharges imposed by our major carriers will put additional pressure on e-commerce margins during the quarter.

Lastly and most importantly, our business model is driven by occasions and events in the lives of our customers. Historically, the multiple holiday events that occurred during Q4 made Q4 the highest sales quarter of the year. Similar to the significant negative impact we experienced from the lack of an Easter or a back-to-school catalyst, we are experiencing the same negative impact from the lack of holiday dress-up catalysts.

We reduced our dress-up receipts at the time of the holiday buy last April, but we now expect Q4 to represent historically low demand for dress-up product. This is due to the pandemic driven cancellation of nearly all school related social events, including in-person holiday parties, parades and concerts, combined with the holiday season that provides for limited socializing through strict social distancing requirements, limited family gatherings and mandated cancellations of large in-person social events.

While we continued to manage through the many short-term challenges brought on by the pandemic, we remained focused on the opportunities. We estimate that the pandemic has accelerated our long-standing transformation strategy by approximately five years with respect to store closures and digital penetration. The good news is that due to the accelerated investments we made in digital transformation prior to the pandemic and the work we had done on fleet optimization over the past decade, we were prepared. We believe that our focus on scaling our digital transformation investments and accelerating store closures further bolstered by our increased sales transfer rate positions the Company for accelerated operating margin expansion and a post-COVID environment.

And now, I'll turn it over to Mike.

Mike Scarpa - Chief Financial Officer

Thank you, Jane, and good morning, everyone. I'll start by reviewing our Q3 results. I will then provide an update on our progress on the strategic actions taken to significantly accelerate our store closures. I will then provide insight on how we are approaching the fourth quarter.

Starting with our Q3 results. In the fiscal third quarter, we returned to profitability, generated positive operating cash flow and delivered adjusted EPS of $1.44. Net sales decreased approximately 19% to $426 million, versus last year's $525 million. Our sales for the first five weeks of the quarter were significantly impacted by a decrease in back-to-school sales across all channels due to schools adopting remote and hybrid learning models. From the beginning of August through Labor Day, we dropped over 40% in total net sales. Sales were also negatively impacted by the 151 permanent store closures during the past 12 months, as well as the extended temporary store closures in New York and California, which impacted 52 stores for a significant portion of the quarter.

Immediately following Labor Day, when we passed the peak back-to-school selling period, our assortments converted to more casual options, the weather turned cooler and our sales improved. After we passed the peak back-to-school selling period, we experienced productivity at over 90% of last year's levels for our stores that reopened. Post Labor Day, our e-commerce channel rebounded and saw a sales increase of approximately 20%. Despite the negative impact from back to school, e-commerce penetration increased to approximately 44% of total net sales.

Our U.S. sales decreased approximately 20% versus last year, while Canada sales only decreased approximately 5%. Canada performed better than the United States due to almost 90% of Canadian schools utilizing 100% in-person learning.

Adjusted gross margin. Adjusted gross margin decreased 210 basis points to 35.7% of net sales, a significant improvement versus the margin declines we experienced in the first half of the year. Merchandise margin expanded in the quarter in both the digital and stores channel. The overall gross margin decrease was the result of the increased penetration of our e-commerce business, which operates at a lower gross margin and the deleverage of fixed cost due to lower sales.

Adjusted SG&A. Adjusted SG&A was approximately $104 million versus $117 million last year, and deleveraged 210 basis points to 24.3% of net sales. The 210 basis point decline was a result of the deleverage of fixed expenses resulting from the decline in sales and higher incentive compensation accruals, partially offset by a reduction in store expenses resulting from our permanent store closures, as well as a reduction in operating expenses associated with actions taken in response to the COVID-19 pandemic.

Adjusted operating income. Adjusted operating income for the quarter was $33 million versus operating income of $63 million last year, and deleveraged 430 basis points to 7.8% of sales.

Tax rate. Our adjusted tax rate was 30% versus 23% last year.

Moving on to the balance sheet. Our cash and short-term investments ended the quarter at $64 million as compared to $36 million in Q2. We ended the quarter with $179 million outstanding on our revolving credit facility, compared to $251 million outstanding on our revolving credit facility in Q2. The decrease in the revolving credit facility and the increase in cash was due in large part to the $80 million term loan financing we completed in the third quarter, as well as our positive operating cash flow. The term loan provides us with additional capital and further strengthens our financial position and provides us with increased financial flexibility.

We ended the quarter with total inventory up 9.7% versus last year, driven by sales declines in key back-to-school categories, which accounted for the entire increase in inventory. We will continue to carry this inventory to support back-to-school demand whenever schools can safely reopen for in-person learning. This product is basic, salable, go-forward product that is visible in our stores and on our website. Our seasonal carryover inventories are down approximately 45%.

Moving on to cash flow and liquidity. We returned to positive cash flow in Q3 and generated approximately $32 million in cash flow from operations as compared to $77 million in cash generated in Q3 last year. Between our cash position and revolving credit facility, we have ample liquidity to support the needs of our business for the foreseeable future. Capital expenditures in Q3 were approximately $9 million.

I'll now provide a brief update on our store activity in the quarter, along with planned actions we are taking to accelerate our fleet optimization initiative. We permanently closed 16 locations in the quarter, which brings our total store closures to 118 for the first three quarters of fiscal 2020. As e-commerce demand has accelerated year-to-date, we have seen a significant migration of our store only customers converting to omni-channel customers supported by the meaningful increase in our transfer rate. This data gives us continued confidence in our accelerated store closure plans, where we are targeting 300 store closures between fiscal 2020 and 2021.

We remain on track to close 200 store locations in fiscal 2020, which includes the 118 locations closed during the first nine months of the year. The roughly 80 remaining closures are targeted for January closure, post holiday. We are targeting 100 store closures at the end of fiscal 2021, which will result in a store fleet of approximately 625 locations entering fiscal 2022. By the end of fiscal year 2021, we will have reduced our reliance on our brick and mortar channel, resulting in a leaner, more profitable store footprint. This will position us to enter fiscal 2022 with 75% of our total revenues generated outside of traditional malls.

Outlook. Due to the continued level of uncertainty in the current business environment, we are not providing EPS guidance for 2020. However, we will provide our current thinking as to the pandemic's potential impact on our business in Q4. Based on the numerous headwinds Jane outlined earlier on the call, combined with the impact of the 151 permanent store closures over the past 12 months, we would expect Q4 net sales to be at or slightly lower than Q3 levels. Due to the pandemic, gross margins will continue to be under pressure in Q4.

In addition to the factors that resulted in a 210 basis point decrease in Q3, there are two additional factors that will further deteriorate gross margin. One, we anticipate roughly 150 basis points in additional gross margin dilution in the quarter due to incremental freight surcharges and capacity constraints from our major carriers. And two, we also anticipate that store closures and the related inventory liquidation will reduce gross margins by roughly 50 basis points, similar to what we saw in our Q2 when we closed 98 stores.

We expect SG&A dollars to be moderately lower than last year. As a reminder, SG&A was reduced in Q4 last year by the reversal of an incentive compensation accrual, which represents a headwind of approximately $10 million or 200 basis points to the current year expense base. Inventory levels will remain elevated due to the back-to-school and basics product that we do not plan to liquidate and that we will continue to carry to support back-to-school demand for whenever schools can safely reopen for in-person learning. We expect to continue to generate positive cash flow from operations in Q4.

Lastly, for 2021, we believe that we will be able to take advantage of what has been a favorable AUC environment so far respect to orders driven by lower input cost and excess manufacturing capacity.

At this point, we will open the call to your questions.

Question & Answers

Questions and Answers:

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Operator

Thank you. [Operator Instructions] Our first question comes from the line of Dana Telsey of Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group - Analyst

Good morning, everyone, and certainly nice to see the progress. Jane, if you think about post-back-to-school season and the pickup in sales that you saw, any difference in terms of categories that you saw, what you saw digital and online with the average order value different and how are you thinking about planning for the first half of 2021 given the holiday season is as uncertain as we've ever seen it? Thank you.

Jane Elfers - President & Chief Executive Officer

Sure. Thanks, Dana. On Q3, first to start there, as predicted, we didn't see a meaningful improvement in those key back-to-school category post-Labor Day. When you - when I refer to those categories, I'm referring to things like polos and uniforms. They just didn't pick up. We didn't see a meaningful improvement - and we didn't see a meaningful improvement in 100% in-person learning either.

We - as I think we had mentioned on the last call, we don't see a significant catalyst for these key back-to-school categories until really back-to-school 2021. These vaccines aren't approved yet and they're not planned to be widely distributed probably until late spring or early summer. So we don't think it's prudent from our side to plan a meaningful return to in-person learning prior to that time period.

Having said that, we did see some big positive post the back-to-school peak. Notable categories would be anything that - anything we have that's knits, graphic tees, long-sleeved knits, leggings, anything active, anything that cozy and comfortable, really, really spiked post-Labor Day. And in addition, our outerwear business really turned on when the weather got colder, also sleepwear. I think we might have mentioned sleepwear on the last call. We made a really, really big bet on sleepwear last year when we placed it, and our decision has proved to be a very good one, especially considering the impact of the pandemic and how kids are dressing. So that has really been a shining star in our business since it hit in Q3 and then certainly into Q4. Obviously, we're hoping someday sooner versus later kids get out of their PJs and go back to school and start living their lives again. So without giving away any trade secrets, I can safely say that we'll not be relying in the back half of next year on sleepwear to drive our business.

I guess the second part of your question was, how are we thinking about the first half of 2021. We don't have a crystal ball. Obviously, there is good news out there as far as these vaccines are concerned. So hope is on the way. But as we said, we do not see a meaningful return to school until next back to school, and I would also tell you that we were very, very conservative when we placed Easter, because we're much deeper into the pandemic by then, and the talk was really not to assume that there would have been a really return to normalcy in the first quarter. So we think that will definitely have smaller business in Q1 with respect to dress-up product. And then, I think we'll start to see things hopefully open up as we get into Q2 of next year.

What I would tell you is - to give you guys some insight just kind of how we think of the whole thing, as it relates to our business, the good news is that, as we mentioned in the prepared remarks that - the pandemic has accelerated our transformation strategy by really by five years. When you look at where our digital is penetrating right now, and when you look at the amount of store closures, 300 that will be done in the next 14 months or so. And then the other good news, which we really - haven't really talked about is that it's also accelerated our competitors' liquidations through massive store closure programs and bankruptcies. And the positive to that for us is not having to live through drawn out liquidations and store closures for the next several years. A lot of that is getting behind us this year, which is not something we expected to happen in such a compressed time period.

And I think when you take - you take that in mind and you remember that, our core customer is the dream customer. Currently she is a millennial, but very soon she is going to be Gen Z, and after that she is going to be always the most current kind of desirable thought after customer there is, due to the fact that she never ages. And then when you think about that, the majority of our customers grew up wearing our clothes. So we don't have those relevancy burden some of the other retailers have. She already knows us, she already loves us and she already trust us.

So we've got ample liquidity. We're going to get through the pandemic and the short-term pain that comes with that, and we're going to stay focused on the store closures and the e-comm acceleration. And when the virus has gone, hopefully, in the first half of next year, we're going to emerge with a vastly reduced brick and mortar presence. Our market-leading penetration in digital were 55% year to date, which I don't think is anyone can come close to that. We're going to have a much smaller competitor base, much earlier than we thought, which are going to drive market share opportunities also earlier than we thought. We will have done a ton of work on rightsizing our P&L. And importantly, we can't forget, we're going to have a second chance to effectively launch Gymboree, and I think all of this is really positioning us to drive accelerated operating margin expansion starting in the back half of 2021.

Operator

Your next question comes from the line of Jim Chartier of Monness, Crespi, Hardt.

Jim Chartier - Monness, Crespi, Hardt - Analyst

Hi. Sorry. Thanks for taking my question.

Jane Elfers - President & Chief Executive Officer

Sure.

Jim Chartier - Monness, Crespi, Hardt - Analyst

You mentioned that the share opportunities - I think, last quarter you mentioned that at Justice [Phonetic] there wasn't a significant overlap for back-to-school from a product standpoint. What do you see in kind of post-back-to-school in terms of potential market share gains from Justice and what do you expect for holiday in terms of market share opportunity?

Jane Elfers - President & Chief Executive Officer

Yes. Thanks, Jim. I think from a Justice point of view, they're down to 85 stores now, where 39% [Phonetic] of them were co-located and they announced they plan to close all of them post holiday. So that really is - they were 800 or 900 stores. So that is a major opportunity for us. It's on the growth side of the business. It's in the older side of the business. It sizes four to 20, which is really our sweet spot. And a lot of their business is driven off knits and dress-up type product as well. So I think we do have a big opportunity there.

They were 1.7% of the market share in 2019, about a $450 million business. So I think that we can pick up a good share of that in the stores that will be remaining as we exit 21 with a 625 locations. A lot of those will have been locations where Justice was, and I also think there is a big online opportunity there as well on the growth side of the business in those categories like dress-up and knits. They didn't really have a big business in key and in basics, that wasn't their thing. Uniforms follow things like that. So it's really coming out of the more casual categories.

Operator

Your next question comes from Adrienne Yih of Barclays.

Adrienne Yih - Barclays - Analyst

Good morning. Nice work on the progress from my - from our side as well.

Jane Elfers - President & Chief Executive Officer

Thanks.

Adrienne Yih - Barclays - Analyst

Jane, I was actually wondering if you can actually dive a little bit deeper into the Gymboree commentary? And then for Mike, on the merch margins or the gross margin, can you give us some color into the three components of it, the merch margin expansion and the pressure from e-commerce and then the kind of component of what [Indecipherable] deleverage - the deleverage? Where is your breakeven on that kind of broad line or the fixed cost gross margin line? And then, if you kind of drill down on that, I know you've talked about e-commerce actually being op margin, EBIT margin accretive. So I think more importantly as you shipped e-commerce, that's what we really want to know the dynamics of how much accretion we can expect from e-commerce? Thank you.

Jane Elfers - President & Chief Executive Officer

Sure. Thanks, Adrienne. I'll take the Gymboree part, and then I'll hand it back to Mike. We all talked about it a lot, the Gymboree launch three weeks prior to the pandemic. Gymboree is a business that like no other is built on occasion. So every special occasion in our young customers lives is what that business is built on, and we have not obviously had that catalyst. So we didn't have the catalyst around Easter time. We weren't able to celebrate 4th July and parades, and we certainly weren't able to celebrate Halloween and now a very important quarter, and their history is really dress up and all the holiday catalyst that come during Q4.

So mom is extremely loyal. She is really loving our products still. So we feel very strongly about that. We are getting very positive reactions from her and social media. I think we mentioned on the last call that we launched underwear. We launched Jimmy's, which was extremely well received both of those. And really what we're looking through is, we're looking through Q1 again next year, because we're not planning on having a robust Easter business in TCP or Gymboree, and we're really looking to the back half of 2001 to kind of “Relaunch Gymboree”. We still believe in it as much if not more so than we did before. We launched it, because now we have the credibility for mom that we hit the product - we hit the nail on the head with the product. And we've learned a lot. We have made some adjustments in our assortments based on her response to - the response to selling and also to her commentary.

And I think we had mentioned before that we thought it was eventually $140 million opportunity. So nothing has changed as far as our confidence in that brand.

Mike Scarpa - Chief Financial Officer

And from a gross margin perspective, we saw merch margins up in both our store channel and our e-commerce channel, probably, to the tune of about 100 basis points or so. So meaning that our e-comm penetration and deleverage on fixed expense was slightly in excess of about 300 basis points. As you think about the fixed component in our gross margin, the key is the occupancy line, which is the biggest number there, and that continues to be refined and adjusted as we continue to shut stores and negotiate with our landlord. So at this point, I'm not comfortable giving any type of like a formula out in terms of how to tend to think about deleverage a fixed based on penetration, just based on that occupancy fluctuation.

Operator

Your next question comes from David Buckley of Bank of America.

David Buckley - Bank of America-Merrill Lynch - Analyst

Hi, guys. Good morning. Mike, just to clarify, on the fourth quarter gross margin, are you planning for merch margin expansion there? And then just on the e-comm channel in the third quarter, it looks like your growth slowed a little bit versus the first half of the year. Were there anything specific supply chain wise or otherwise in terms of headwinds to the channel this quarter and anything that would potentially carry over into the fourth quarter?

Mike Scarpa - Chief Financial Officer

From - again from a gross margin perspective for the fourth quarter, we indicated that, in addition to the factors that took place in the third quarter, which was a positive merch margin, e-comm penetration and deleverage are fixed, and we've had that roughly 150 basis points in additional gross margin dilution due to the freight surcharges and some capacity constraints from our major carriers. Also, as we experienced in Q2 of this year when we liquidated 98 stores, obviously, we have about 80 plus stores that we liquidate in the fourth quarter. We expect gross margin dilution of roughly 50 basis points. So yes, we are expecting positive merch margins in Q4.

Jane Elfers - President & Chief Executive Officer

And then the only thing I'd add to that, David, is on the e-commerce channel. We mentioned in the prepared remarks that the major carriers have already [Technical Issues] shipping cut off by three days, which we're doing. So that will certainly impact the topline any how.

Mike Scarpa - Chief Financial Officer

Yeah. And we didn't really, from a e-comm perspective, pre and post back to school, it was a tale of two cities, because they were down 20%, and basically because there was no demand for our back-to-school clothing post-Labor Day, though, as we shifted more casual merchandise and weather got a little cooler, we saw our e-com business snap back very nicely up into the 20s. So we're pretty pleased overall with where we ended up on income.

Operator

Your next question comes from the line of Susan Anderson with B. Riley.

Susan Anderson - B. Riley FBR - Analyst

Hi. Good morning. Nice job on the progress in the quarter. I guess, just touch a little bit more on the e-comm margin. Can you talk a little bit about the operating margin differences between the stores? Is it still - is e-comm still higher on the op margin line, I guess, versus the stores, even with the higher shipping? And then as you look to use your 3PL in 4th quarter, are you expecting a significant impact from ship from store at all?

Mike Scarpa - Chief Financial Officer

Yeah. So year-to-date, e-comm is still accretive to our operating margin, and we continue to expect it to be accretive into the future. Obviously, we're seeing some freight surcharges built in Q4, but we still expect overall margins to be accretive in our e-comm business. From a radio perspective, we'll be utilizing them in Q4. They will probably represent close to 40% or so of the demand that we need to ship for Q4, and we would expect ship from store to be at a normalized rate, which is - call it in the high-single-digit range in terms of shipping for demand.

Operator

And our last question will come from the line of Marni Shapiro with The Retail Tracker.

Marni Shapiro - The Retail Tracker - Analyst

Hey, guys. Congrats on the progress here. Pretty impressive considering we didn't have back to school. Can you just talk - can you talk a little bit - I know you have relatively low returns, and I'm curious if you've seen that change at all with the significant shift online? And if you could also talk about just the habits of your customer online as far as average basket or transaction size and how frequently she visits online versus in-store, not in-store today, in-store in the past I guess?

Jane Elfers - President & Chief Executive Officer

Yeah. Well, first of all on the returns. No, we have not seen an increase in returns, which is a huge positive to our brand. We've always had a very low return rate and to continue to see that with the outsized digital increases we've seen is certainly a positive to the P&L. As far as visiting online, we have seen higher units. We have seen higher transactions from our customers. Our traffic has been very, very strong since the beginning of the pandemic, and we've had a very, very strong conversion metrics online as well. I think all of this bodes well for the foundational changes that are happening in 2021.

What we're doing now is a lot of work. As far as keeping these new customers who have come into our digital ecosystem, we need to keep them. As we mentioned, we picked up 100% over last year in new customers, and we converted 800,000 of our store-only customers. So a big focus is retaining. All those new digital customers that we've acquired since the onset of the pandemic, the timing again works really well for us. We've talked about our digital transformation a lot, and we have the tools in place down to welcome these customers into our brand and importantly the tools to engage and retain them.

So over the past year, we've been working very hard to really get, if you will, behavioral and lifecycle data into our messaging. So we've enhanced the email segmentation. We've added purchase activity. We've launched dedicated email program with curated product. We've launched a new trigger program, which is working really well for us that targets the customer. I think we talked about in the last call, potentially it targets the customer at every stage of their life cycle with respect to brand and the purchase funnel.

There are seven stages. You would have heard of most of them, abandoned cart, abandoned browse [Phonetic], welcome, tune-in, step-up, COI, confirmed opt-in, and there is 266 touch points across it. So really brings in all the foundational capabilities that we've invested in and then working on. So we feel really, really good. We're now armed with a 31% transfer rate, which is a huge, huge positive for us, and a really exciting metric, and we feel like we have the tools in our tool kit to keep these customers long-term as we continue to ramp up and accelerate this digital transformation.

Operator

Thank you for joining us today. If you have further questions, please call Investor Relations (201) 558-2400 extension 14500. This does conclude The Children's Place third quarter 2020 earnings conference call. You may now disconnect your lines and have a wonderful day.

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Q3 2020

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