Good morning and welcome to The Children's Place Third Quarter 2021 Earnings Conference Call. On the call today are Jane Elfers, President and Chief Executive Officer, and Rob Helm, Chief Financial Officer. The Children's Place issued its third quarter 2021 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. [Operator Instructions].

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 in the Company's SEC's 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 to your questions. We ask that each of you limit yourself to one question so that everyone will have an opportunity.

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

Jane Elfers - President and Chief Executive Officer

Thank you and good morning, everyone.

We delivered another outstanding quarter with sales, gross margin, operating margin, and EPS all at record levels. To help put the magnitude of our turnaround into perspective, our Q3 adjusted operating income of $117 million exceeded our full-year 2019 adjusted operating income of $111 million. The significant structural changes we made to our business in 2020, combined with the accelerated digital investments we made pre-pandemic and our strategic pricing reset, all continued to be key drivers of our accelerated operating margin expansion.

Our digital business has always been our highest operating margin contributor due to its high UPT, low single-digit return rates, and lower overhead costs versus our stores channel. And with the pandemic-driven acceleration of our digital business, we are now gaining additional leverage on fixed overhead costs and driving significantly higher digital margins. As our digital business continues to grow on both the top and bottom lines, we are making additional investments in marketing and technology to continue to support this growth. Our digital sales represented an industry-leading 45% of our Q3 sales versus 35% in 2019, and we are targeting an approximately 50% steady-state annual digital penetration. We are focused on investing in brand awareness through our digital marketing channels, and we are seeing higher cost efficiency on marketing spend versus prior to the pandemic.

With respect to customer acquisition, we've leveraged our marketing tactics and focused our additional investments to achieve a 50-50 split between digital and stores acquisition, which is approximately in line with where our digital penetration is planned going forward. Year-to-date, we've seen an 18% increase in our new customer file, and with customer acquisition balanced between our channels, combined with our industry-leading 30% transfer rate, we're benefiting from the improved channel mix, which has also resulted in significantly higher average spend per customer. As of the latest NPD report, we increased our market share by 17% for Q3 versus 2020, while at the same time delivering a 900 basis points increase in gross margin versus Q3 2020, fueled by a significant double-digit AUR increase in both channels, and we achieved a strong market share performance despite having significantly fewer stores versus Q3 2020.

We continue to see a shift towards mobile and our mobile app results continue to exceed our expectations. Over 71% of our digital transactions now come through a mobile device and our active mobile users are up 26% on top of the significant file increases we saw during the pandemic in the first half of 2020.

Our School is Back Giveaway, that we launched in August, was very successful with respect to increasing our mobile app downloads and will further propel our mobile share for this upcoming holiday season and beyond. We launched Afterpay, a buy now, pay later option for our customers in conjunction with the launch of back-to-school selling, and we remain impressed with Afterpay's performance to date, with AOV running 72% higher than the average of our non-buy now, pay later tender options. As we highlighted in our investor deck, we partnered with Afterpay and the Kardashians on our Christmas Family Pajama campaign, which resulted in almost 2 billion impressions for our brand. We continue to focus on leveraging Afterpay's ability to reach new millennial and Gen Z customers through our partnership.

With respect to our fleet optimization strategy, due to our ability to secure very favorable lease terms, we are now planning to close approximately 275 stores by the end of full year 2021 versus our original target of 300 stores. While we've realized significant occupancy savings to date, we remain well positioned with respect to lease flexibility with over 80% of our remaining stores having a lease action within the next 18 months.

Before I get into brand specifics, I want to thank Greg Poole and our entire sourcing team for their tireless efforts during these past 18 months. They've gone above and beyond in every respect, and we are so grateful for the impressive results they delivered during these very difficult times.

With respect to Gymboree, we're very pleased to see the continued strong customer response to our third quarter product launches and to see the overwhelmingly positive response to our first deliveries of holiday dress-up product. Clearly, many families are planning to begin to resume their normal activities, and we expect to continue to see increased momentum in this important brand. Our design team continues to do an incredible job of artfully resurrecting the Gymboree brand and we could not be more proud of the results they are delivering.

As you may have seen on November 9th, we launched our newest brand, Sugar & Jade, targeted to the $8 billion U.S. tween market. We're thrilled to be able to offer the tween customer a dedicated digital-only brand. Based on the strength of our big girls' business, Sugar & Jade is a natural extension of our core competency, and we currently have over 4 million names on our file, to whom we are actively marketing Sugar & Jade. While managing all the challenges of the pandemic, our design team has done a spectacular job, bringing Sugar & Jade to life, and we're excited to see the potential for our newest brand.

With respect to wholesale, we remain laser focused on strengthening our partnership with Amazon, and they continue to experience very strong sell-throughs on our product. We've recently launched a new storefront on Amazon, we are significantly accelerating our investments in brand marketing and we're projecting accelerated growth with Amazon for the balance of 2021 and beyond.

As you may have also seen, we issued our 2020 Environment, Social and Governance Report earlier this week. I would encourage everyone to take a look at it as we are very proud of the significant progress we have made on our ESG initiatives and goals this past year.

With respect to current TCP business, while we're only a few weeks in, Q4 is off to a very strong start. Looking forward, we are carefully monitoring the daily changes and developments with respect to COVID. Our seasoned team will continue to manage any new developments as they arise as we have since the onset of the pandemic. While we are not providing guidance at this time, Rob will provide more color on Q4 in his prepared remarks.

In closing, 2020 was the most transformative year in our Company's history. We leveraged a very difficult period to significantly accelerate our strategic transformation and structurally reposition the Company for the accelerated operating margin expansion we are seeing today. We continue to operate at a high level, we remain firmly on offense, and we believe we are uniquely positioned to continue to deliver accelerated returns for our shareholders in 2021 and beyond.

Now, I'll turn it over to Rob.

Robert Helm - Chief Financial Officer

Thank you, Jane, and good morning, everyone.

After I review our Q3 results, I will provide some additional remarks with respect to Q4. In the fiscal third quarter, we delivered a record Q3 adjusted EPS of $5.43. Our Q3 net sales set a record, increasing by $133 million or 31% to $558 million versus last year's $426 million. With the return to in-person learning, August contributed 40% of the total sales for the quarter. We're also pleased to see strong momentum in both September and October. Our U.S. net sales increased by $113 million or 31% to $475 million versus last year's $362 million, while our Canadian net sales increased by $5 million or 10% to $53 million versus last year's $48 million. Comparable retail sales were a positive 36% versus Q3 2020. As an additional point of reference, comparable retail sales were a positive 19% versus Q3 2019. Consolidated digital sales increased 36% in Q3 versus 2020, representing 45% of our total sales.

Digital sales increased 40% in the U.S. and increased 2% in Canada. Store net sales were $278 million for the quarter, which represents approximately 89% of our Q3 2019 store net sales, despite having 252 or 26% fewer stores in Q3 2021 versus Q3 2019 as well as a high-single-digit reduction in operating hours as dictated by the mall landlords. U.S. store traffic remained under pressure, down 17% versus Q3 2019. Canada store traffic was down [Phonetic] 32% versus Q3 2019.

Adjusted gross margin. Adjusted gross margin increased 868 basis points to 43.9% of net sales, a record Q3 gross margin, compared to 35.2% of net sales last year. The gross margin increase was the result of significantly higher consolidated merchandise margins, resulting from double-digit AUR increases in both our digital and store channels, due to the impact of our strategic pricing reset and strong customer product acceptance, leverage of fixed expenses, resulting from the increase in net sales, as well as strong expense leverage resulting from our focus on e-commerce fulfillment optimization, which virtually eliminated the amount of supplemental ship from store required to support our digital business in Q3 and a $4 million reduction in occupancy expenses due to favorable lease negotiations and reductions in occupancy expense for stores closed in the past 12 months. As an additional point of reference, occupancy expenses were $10 million lower in Q3 versus 2019. These gross margin benefits were partially offset by higher inbound freight transportation costs, driven by higher container rates resulting from equipment shortages and capacity constraints at the ports and to a much lesser degree, additional air freight costs.

Adjusted SG&A. Adjusted SG&A was approximately $115 million versus $104 million last year and leveraged 375 basis points to 20.6% of net sales compared to 24.3% of net sales last year. The 375 basis point leverage was a result of leverage on the higher net sales, partially offset by higher incentive compensation accruals and higher marketing spend.

Adjusted operating income. Adjusted operating income for the quarter increased $85 million to $117 million or 20.9% of sales, a record result versus an adjusted operating income of $31 million last year and leveraged 1,349 basis points compared to the 7.4% of net sales last year.

Interest expense. Our interest expense for the quarter was $4 million versus $3.3 million last year. The increase in interest expense reflects a higher average debt balance this quarter and the higher interest rate associated with our term loan.

Tax rate. Our adjusted tax rate was 28% due to higher incentive compensation accruals in the current year.

Moving onto the balance sheet, our cash and short-term investments ended the quarter at $67 million. We ended the quarter with $174 million outstanding on our revolving credit facility. As we announced this morning, we refinanced both our revolving credit facility and term loan, reducing our term loan to $50 million as part of the transaction, enhancing our liquidity position and strengthening our balance sheet. Lastly, inventories ended the quarter up 3% versus last year.

Moving on to cash flow and liquidity, we generated $71 million in cash from operations in Q3 versus $32 million last year. Capital expenditures in Q3 were $9 million. We repurchased $32 million of stock in the quarter. As announced in our press release this morning, our Board authorized a new $250 million share repurchase program.

Now, I will provide an update on our store activity in the quarter. We closed five locations in the quarter, bringing the year-to-date closures to 47. Due to the favorable lease negotiations, we are now planning to close 275 stores by the end of fiscal year 2021 versus our previously announced target of 300 stores. Our current plan calls for an additional 50 store closures in Q4. With over 80% of our store fleet coming up for these actions through the end of fiscal 2022, we continue to maintain meaningful financial flexibility in our lease portfolio. We ended the quarter with 703 stores and total square footage of 3.3 million, a decrease of 12.3% compared to Q3 last year and a decrease of 22.6% since the onset of the pandemic.

While we're not providing EPS guidance, we want to provide you with some thoughts regarding Q4 in the current environment. We are facing the following headwinds in our business for Q4. First, the impact of 225 permeant store closures since Q4 2019, which contributed roughly $58 million in net sales in Q4 2019. Second, the impact of late deliveries and factory delays resulting from the continued disruption in the global supply chain due to the pandemic. And lastly, the uncertainty surrounding the COVID Delta variant and the impact of government mandates on our workforce. Gross margin continues to benefit from the structural changes we've made to our business, and we expect Q4 margins to exceed historical levels, but at a lower gross margin rate than Q3 due to a condensed promotional calendar in Q4 versus Q3 as well as continued pressure from higher inbound freight transportation costs, higher container rates resulting from equipment shortages, and capacity constraints at the ports, and to a lesser degree, air freight costs. We will also continue to make incremental investments in wages in our distribution center to support our e-commerce growth for this holiday season. SG&A is planned to be in the range of $118 million, primarily the result of higher incentive compensation accruals and higher levels of digital marketing spend. We are now planning for capital expenditures in the range of $40 million for fiscal year 2021, with the large majority allocated to digital and supply chain fulfillment initiatives.

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

Question & Answers

Questions and Answers:

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Operator

[Operator Instructions] We'll take our first question from Dana Telsey with Telsey Group.

Dana Telsey - Telsey Group - Analyst

Good morning, everyone, and congratulations on the progress.

Jane Elfers - President and Chief Executive Officer

Hey, Telsey.

Dana Telsey - Telsey Group - Analyst

Hi. Getting to that $117 million operating income levels, very impressive. Can you just give us an update, how do you see the supply chain situation, is it stable from the second quarter? Any sense of how you are looking at that and thinking about it as we go through the balance of this year into next year and then the Kim Kardashian marketing in the number of impressions is still impressive. Do you plan on more collaborations and how do you see marketing spend adjusting? Thank you.

Jane Elfers - President and Chief Executive Officer

Sure. Well, I think as far as the supply chain issues are concerned, I think that most people are thinking that those are going to last, at least through back-to-school of 2022, if not a little bit further. I think as I mentioned in my prepared remarks that our sourcing team has done a fantastic job with all the balls in the air for the past 18 months. As Rob mentioned in his prepared remarks, we've done a good job limiting air freight and doing some early shipments to make sure that we have the product that we needed, obviously, for back-to-school and now for holiday. So, I think we're going to continue to see the disruption, but I think we have obviously a good handle on it and a good handle on our inventory.

From a Kardashian and a collaboration perspective, we're not going to go into that on the call as far as future collaborations for competitive reasons, but we were really, really excited with the results we had and clearly from a marketing point of view, as Rob mentioned on the call, we intend to put more money behind marketing, so I'll turn that over to Rob to give you a little bit more color on that.

Robert Helm - Chief Financial Officer

From a marketing perspective, we were really impressed with how our incremental investments paid off in the third quarter. They drove a record top line for us as well as a 17% increase in market share like Jane mentioned on the call. Our marketing spend was really focused on brand building and brand awareness, top-of-funnel type initiatives including doubling down on social, expanding into mobile with partnerships like Afterpay and expanding our celebrity influencer campaigns like Jane has referenced.

Operator

We'll go next to Jim Chartier with Monness, Crespi.

Jim Chartier - Monness, Crespi, Hardt & Co., Inc. - Analyst

Good morning. Thanks for taking my question. I was curious if you could give a little more color on Sugar & Jade. What were the costs associated with launching that business, if any, in third quarter, and then what's the ultimate opportunity for that business, and then how do you see it growing over the next few years? Thanks.

Jane Elfers - President and Chief Executive Officer

Sure. Well, we're obviously very excited about Sugar & Jade. As we said in our prepared remarks, we look at the tween market as an $8 billion opportunity. It's a very fragmented market, especially with the departure of Justice, so when you really look at what's happened in tween over the past several years, lots of brands attempt to enter the tween market or they may take a small part of their assortment offering and call it tween, but then they - many of them seem to either exit quickly or pull way back on the assortment. So, it's tricky assortment to get right. I think obviously we're uniquely positioned to get the tween assortment right for a couple of key reasons.

Number one, big girls is our sweet spot as a company. We have a strong leadership position with the big girl customer, so tween is a natural extension of our big girl customer as she moves into the next isle stage. Everyone's probably pretty aware that I believe that we have the best design team in the industry, so their ability to design a successful tween brand and our sourcing area's ability to deliver it, is a tremendous competitive advantage. As far as the sizing of Sugar & Jade, I would say that the way that I'm looking at it and we're looking at it is our strategy is to launch it small across a lot of categories so that we can use 2022 to understand what our tween girl is responding to each season and then once we dial into what she is responding to and what categories to stand behind, we'll accelerate Sugar & Jade in 2023 and beyond, and we clearly believe this can be a meaningful contributor to op margin over time.

Robert Helm - Chief Financial Officer

And from an expense perspective, I called out a $118 million for the fourth quarter. That includes the launch of Sugar & Jade, up from $115 million in the third quarter, so it's a part of that, albeit a small part.

Operator

We'll go next to Jay Sole, UBS.

Jay Sole - UBS - Analyst

Great, thank you so much. Jane, can you maybe help us understand a little bit in the third quarter what drove really the strong sales in the sense that in second quarter, the growth versus 2019 was like negative 1.5%, but now in the third quarter, it was up 6.5%, so really good sequential improvement in that growth rate. What were the key drivers of that?

Jane Elfers - President and Chief Executive Officer

Well, number one, I think we've been saying for a while that Q3 was really going to be the catalyst for our brand and that we would get our market share back starting in Q3. We talked a lot about how the essential retailers picked up a lot of share and my feeling has always been that they would give the share back to some degree once the rest of the non-essential retailers were allowed to reopen and I think when you see the 17% market share we gained and I think you see some of these reports about department stores doing better, I think that all kind of bodes well for the opening up of retail and not having it so concentrated in two or three big players.

When you look at August, Rob mentioned that back-to-school was outsized. We had called that out on the Q2 call that we believe that we would have an outsized August compared to a normal August, which is around 35% to total, based on the pent-up demand. So, we had very, very strong back-to-school performance, and as you can see by our - the huge margin gains, we were able to do it at much higher AURs, and we were in a very good stock position to handle that business and to handle that demand I think more exciting than that because we always knew we'd have an amazing back-to-school is really when you get into September and October, and we were able to keep that momentum going at much, much higher margins and much higher AURs, while we were able to drop promotions that had been dragging us down a bit in the past, so we were able to get those behind us and still have positive results in both September and October.

It really was fall product once we got past August and we got past like uniform, it really moved into more fashion-type products or seasonal basic type products and really stayed that way the whole season. I would tell you the only part of Q3 where we had a bit of a dip was in the beginning of October around the Columbus Day period when we had the warm weather, but then right after that, we came roaring back very nicely. So all in all, really pleased with how the quarter played out.

Operator

We'll go next to Paul Lejuez with Citi.

Kelly - Citi - Analyst

Hi, this is Kelly on for Paul, thank you for taking our question. I'm just curious if you could provide a little bit - more color around the commentary for 4Q quarterly trends being off to a very strong start. Does that mean you're seeing an acceleration in sales relative to the third quarter? And then, just curious about your comment around the condensed promotional calendar in 4Q versus 3Q and how that will impact the gross margin, if you could just elaborate on that, that would be great. Thank you.

Jane Elfers - President and Chief Executive Officer

Sure. Yeah, we're not going to get into the comps in Q4 because we don't want you guys to get ahead of yourselves, and I'll pass, Rob, the other part of the question.

Robert Helm - Chief Financial Officer

I think from a Q4 gross margin perspective, you'll see seasonally that every year, our Q4 gross margin dips just relative to the condensed promotional nature between the Black Friday holiday and Christmas. It's a little bit different than back-to-school in that way. However, with that being said, we do expect to deliver higher than historical gross margins than we've delivered in Q4, inclusive of those incremental investments in wages for our DC associates who are vital to our e-commerce growth as well as the higher levels of inbound transportation costs.

Operator

Thank you for joining us today. If you have further questions, please call Investor Relations at 201-558-2400, extension 14500. You may now disconnect your line and have a wonderful day.

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CHILDRENS PLACE INC

Q3 2021

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