posted on: May 11, 2006 | about stocks: JCP    

J.C. Penney Company, Inc. (JCP)
F1Q06 Earnings Conference Call
May 11, 2006 9:30 a.m. EST

Executives

Mike Ullman - Chairman, CEO
Ken Hicks - President, Chief Marketing Officer
Bob Cavanaugh - CFO
Bob Johnson - VP IR

Analysts

Deborah Weinswig - Smith Barney Citigroup
Bernard Sosnick - Oppenheimer & Co.
Christine Augustine - Bear Stearns
Bob Buchanan - A.G. Edwards & Sons
Michelle Clark - Morgan Stanley
Stacy Turnof - Merrill Lynch
David Glick - Buckingham Research
Jeff Klinefelter - Piper Jaffray
Bob Drbul - Lehman Brothers
Michael Exstein - Credit Suisse First Boston
Michelle Tan - UBS Warburg
Dana Cohen - Banc of America Securities

Presentation

Operator

Good morning, ladies and gentlemen. At this time I would like to welcome everyone to the JCPenney first quarter earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Bob Johnson, Vice President of Investor Relations. Sir, you may begin your conference.

Bob Johnson

Thank you, Natasha and good morning, everyone. Thank you for joining us on the call this morning to review JCPenney's first quarter earnings. We've scheduled this call the last about 45 minutes, which includes time for questions and answers.

Before we begin, let me remind everyone that the discussion this morning includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which reflect the Company's current view of future events and financial performance.

The words expect, plan, anticipate, believe, and similar expressions identify forward-looking statements. Any such forward-looking statements are subject to risks and uncertainties, and the Company's future results of operations could differ materially from historical results or current expectations. For more details on these risks, please refer to the Company's Form 10-K and other SEC filings.

Also, please note that no portion of this call may be rebroadcast in any form without the prior written consent of JCPenney. Replays of the webcast of this call will be available for up to 90 days. For those listening after May 11, 2006, please note that this recording will not be updated and it is possible that the information discussed is no longer current.

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

Ken Hicks

Thank you, Bob, and good morning. We are pleased with our first quarter operating performance, particularly the improvement we continue to see in gross margin and SG&A leverage. Total sales increased 2.5% for the quarter and comparable department store sales increased in line with expectations at 1.3%. This was on top of a 2.8% comp store sales increase last year. This marks the 12th consecutive quarter that we've delivered a comparable store sales increase at JCPenney.

The best performance continued to come from our Southeast and West regions. Looking at sales by merchandise category, overall, we saw good results in most categories during the quarter, although certain categories, such as women's apparel, continue to be soft, as they are across the industry. We had sales gains in both fashion and basic merchandise, and our private brands continue to perform very well.

The strongest divisional performances came from children's, family shoes, fine jewelry, and men's. Additionally, we saw solid performance in categories such as women's size sportswear, men's accessories, housewares, and decorative accessories and home.

In our women's apparel business, we are taking aggressive action with markdowns to keep our inventory fresh, as well as building or key brands and adding new brands such as a.n.a. In addition, we continue to develop brands such as [E. Spiff], which we will introduce this fall in traditional careerwear.

Moving on to direct, we are pleased with sales in direct for the quarter, which increased 3.9%. Direct sales were led by children's and shoes. The Internet continues to be our fastest-growing sales channel, increasing over 22% for the quarter. Inventory in both stores and direct remained at planned levels.

Turning now to total Company operating results, gross margin was up 80 basis points from last year, ending at 41.9% of sales. Gross margin continues to benefit from the performance of our private brands, as well as continuing improvement in seasonal transition and merchandise flow. The continued development of our planning and allocation systems has supported our margin improvements.

SG&A expenses were leveraged 40 basis points, ending at 33.2% of sales. SG&A expenses reflect leverage of salary costs and efficiencies in the direct channel, as well as the launch of our JCPenney branding campaign in March.

First quarter operating profit increased to 369 million, up nearly 20% from last year, an improvement of over $60 million. Looking ahead to the second quarter, we expect both comparable department store and direct sales will increase in the low single-digit range in the second quarter. Internet sales should continue to grow in line with industry trends. We continue to plan for a moderate operating margin improvement.

From a merchandise perspective, we have a lot of exciting growth initiatives happening at JCPenney. In April, we announced a joint initiative with Sephora under which they will offer the best of their successful Sephora concept at JCPenney. Beginning this fall, we will bring Sephora into a handful of JCPenney stores, and next year, our plans are to add Sephora, primarily in new stores, with some additional existing stores also having the concept. A more extensive Sephora rollout is planned for 2008.

Also, at our April analyst meeting, we provided details on many initiatives designed to drive future growth at JCPenney, aggressively pursuing our strategy to be a leader in retail. Let me a recap a few of those key initiatives.

First, we outlined our lifestyle merchandising initiative, which provides us an understanding of the style differences across each of our major customer groups. Having defined style preferences for each customer group allows us to develop merchandise assortments that address those preferences. Lifestyle merchandising helps us understand how our customers dress, decorate, and think about themselves and includes traditional, conservative, modern, and trendy lifestyles. We believe that our lifestyle merchandising initiatives will help us better match our assortments with our customers' needs, with the end goal of developing loyalty to our brand and building an emotional connection with our customers.

Another topic we discussed was our cycle time initiative. Through improved process and technology, our goal is to take over 20 weeks out of our cycle time in key merchandise categories. This will enable us to get merchandise to the stores faster, increase gross margins through better planning and flow, and improve inventory turnover.

Next, we shared our progress in making an emotional connection with our customer through marketing. Through television brand marketing, we continue to provide our current and new customers with the visibility to the great styles we have to offer. We also announced our exclusive retail sponsorship of the MTV Video Music Awards later this year, which we're all very excited about. Our marketing continues to communicate the styles of our great private brands in addition to the overall JCPenney brand.

You'll also notice we continue to incorporate our multi-channel initiative, that is JCP.com, into all of our brand messaging. We want to make sure our customers continue to think JCP.com and the broad assortment it has to offer.

New store growth is another area we covered at our analyst meeting. We announced plans to open 50 new stores annually, beginning in 2007, primarily in our successful off-mall format. We plan to open over 175 new stores by 2009. This translates into growth in gross square footage of about 3% per year. Currently, we have about 25 off-mall stores in operation and we have identified up to 400 new store locations.

In the first quarter, we opened two new stores and relocated another. We now have 1,021 JCPenney stores across the country. New store growth is exciting news for all of us at JCPenney, as we begin to aggressively expand our market share. We now have an opportunity to serve many customers that currently don't have access to the great private and national brands we have to offer.

Of course, our customers can always shop JCP.com 24/7. The Internet continues to be our largest store and our fastest-growing sales channel.

The bottom line is we have a growing company with new stores, powerful private brands, and the leading department store Internet business. While we have delivered consistent growth the past few years, we believe we have the right merchandise, marketing and people in place to drive JCPenney to a position of leadership in the retail industry.

Before I turn the call over to Bob Cavanaugh, just to comment on what we're doing in our stores. To date, we have installed our new point-of-sale system in nearly 70% of our stores. When completed, we will have over 35,000 new POS terminals in JCPenney stores connected to JCP.com, making it easier for us to ensure we can offer our customers a broad assortment of products, currently over 250,000 SKUs. The rollout of the new POS will be completed by August 1, in time for the back-to-school season.

In summary, we are pleased with our first quarter operating profit, as we continue to see consistent improvement in our bottom line. We are clearly focused on our long-range plan strategies, which focus on making an emotional connection with our customers, making JCPenney an easy and exciting place to shop, being a leader in performance and execution, and making JCPenney a great place to work. We have the right team in place to accelerate sales and profit growth at JCPenney. With that, I will turn the call over to Bob Cavanaugh.

Bob Cavanaugh

Thanks, Ken, and good morning, everyone. Today, we reported first quarter earnings per share of $0.90 per share. This is an increase of $0.28 per share from last year, a 45% increase. These results demonstrate consistent improvement in the execution of our business fundamentals and long-range plan.

The quarter's operating profit of $369 million represents an increase of $61 million, up nearly 20% from last year. As a percent of sales, operating profit was 8.7% compared to 7.5% last year.

Net interest expense in the quarter was $34 million and continued to benefit from rising short-term interest rates on our cash investments. Real Estate and Other contributed income of $13 million. This is principally related to ongoing real estate operations as well as a gain on the sale of property. Last year, income from Real Estate and Other was $22 million, primarily from real estate gains.

So adding all this up, we ended the quarter with pre-tax income from continuing operations of $348 million. On a per-share basis, income from continuing operations for the quarter was $0.90 a share, up 45% from last year's $0.62. Net income per share, which reflects the impact of discontinued operations, was $0.89 per share, compared to $0.63 per share last year.

Moving on to our financial condition, as of April 29, the Company had cash investments of about $2.8 billion. We ended the quarter with long-term debt of about $3.5 billion with the next scheduled debt maturities of approximately $425 million in 2007.

Capital expenditures for the quarter were $126 million, which was in line with plan and compares with $97 million last year. And, free cash flow for the quarter is on plan. We continue to expect free cash flow for the year to be about $200 million.

Earlier this year, we announced that the Company's Board of Directors approved a plan to increase the dividend by 44%, from $0.50 per share to $0.72 per share on an annualized basis. The result was that the first quarter dividend, which was paid on May 1, increased to $0.18 per share from $0.125 per share.

Additionally, the Board of Directors approved a new, $750 million share repurchase program in February. We did not repurchase any stock in the quarter, given the important strategic programs related to store growth, as well as the Sephora initiative, which were announced in mid-April. We continue to plan that the repurchase program will be completed in 2006 and that share repurchases will essentially be offset by the exercise of employee stock options.

Looking ahead to the second quarter, as Ken noted, we expect both comparable department store and direct sales will be up low single digits for the quarter with modest improvement in operating profit, principally from SG&A leverage. As we announced in February, we expect a lower second quarter tax rate of about 27%. This includes the impact of expected tax credits.

Please note that, after the second quarter, we are forecasting a move to a more normalized tax rate of 38.6%. This reflects a 35% federal rate plus state taxes. So, we continue to plan for a full year 2006 tax rate of about 37%. Beginning in 2007, we expect an effective tax rate of approximately 38.6%.

For the second quarter, we anticipate earnings to be in the area of $0.60 per share, representing an increase of about 30% over last year. For the year, we expect earnings from continuing operations to be in the range of $4.24 to $4.34 per share. This rolls in the results of the first quarter. We expect to have about 238 million average diluted shares in the second quarter, including about 3 million common stock equivalents.

In summary, our team is pleased with the consistent improvement in the fundamentals of our business. The improvement in operating profit clearly indicates we are making progress in achieving the goals of our long-range plan. Now, I will turn the call over to Mike Ullman.

Mike Ullman

Thank you, Bob. As Bob and Ken mentioned, we are pleased with our performance in the first quarter. We are particularly pleased as we begin our second year of our five-year growth plan. We're making important progress in all 17 of our key initiatives, particularly the additional new growth in off-mall stores for 2007 and our addition of the Sephora concept to all of our stores going forward, in new stores particularly next year and ramping up in other stores beginning in '08.

Our JCP.com growth continues to be strong and an important part of our multi-channel strategy.

As Bob mentioned at the analyst meeting, our 16% compound annual growth rate for EPS through 2009 is an important part of our optimism going forward.

We believe, looking at the second quarter, looking at the consumer in terms of their expectations, their sentiment as well as the effect of fuel prices, we believe we're well-positioned with great style and quality at a smart price, and we are competing effectively in the malls and particularly taking on new growth in the off-mall concept with 28 stores this year and 50 in the following years.

So I will stop here and respond to any questions you may have at this time.

Bob Johnson

Natasha, we are ready to go to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Deborah Weinswig, Citigroup.

Deborah Weinswig - Citigroup

Good morning and congratulations on a great quarter. At the analyst meeting, you had talked about a lot of customer research that you had done. I believe you had divided your customer base into deciles. With that data, what kind of change might there be in the direct business in regard to the number of catalog mailings and who they are being sent to, or just how are you rethinking that business?

Mike Ullman

Well, I think, in our catalog business, as we mentioned at the meeting, we are very focused on our specialized books and how they might relate to the JCP.com business as a guide to using the JCP.com. We have a number of specialized catalogs in addition to our three big books. Obviously, the more we know about the decile performance of our customers, the more targeted those mailings can become, so they may result in fewer pages for some books and certainly more targeted to the best customers, going forward.

Deborah Weinswig - Citigroup

Obviously there's a lot of activity in the malls in the last quarter with regards to Federated/May clearances stores. Did you see any change in terms of shopping patterns or disruptions in those malls where you did overlap?

Mike Ullman

I think, initially, certainly as they were doing their going-out-of-business sales in the stores that were closing and the clearance of the May assortments, we saw heavy promotional activity although I don't think it had a material effect on us. We are starting to see some modest improvement in our business in malls where they have closed a location, and we're benefiting in our comps in those malls.

But frankly, we think our overall strategy, in terms of our pricing, the quality of our merchandise, that we're going to compete very effectively against the new Macy's. We, after all, do have a single name national department store franchise for over 100 years. So we believe our marketing and our messaging to our customer can be very effective against the new Federated.

Deborah Weinswig - Citigroup

A last question. When they should we start, without getting too excited, but when should we start to see the benefits of those cycle time reductions? How dramatic are the changes in the kind of procedures that need to take place to get there?

Mike Ullman

Well, I think, as Peter McGrath mentioned at the analyst meeting, we're going to start with a pilot, and we should see some effect of that in the next 12 to 15 months on the pilot. We currently have a very fast cycle time experience in the juniors business, so it's not as if we don't know exactly how to do it.

The most important aspect of this is how to make it to regularize this across all of our businesses. It may take several years before we reach all aspects of the apparel business, but we're quite optimistic that we have identified the near-term as well as the long-term goals by merchandise category.

Deborah Weinswig - Citigroup

Great. Thanks again and congratulations.

Operator

Our next question comes from Bernard Sosnick, Oppenheimer.

Bernard Sosnick - Oppenheimer

Thank you. I wonder if you could amplify a bit on the ability to leverage salary expenses and the programs that go into it.

Mike Ullman

I assume you mean store salary.

Bernard Sosnick - Oppenheimer

At store level.

Mike Ullman

We've had good progress from the program we've put in place almost a year ago of shifting some of the stores' selling and sales support expense from the back office and support side, to put more payroll in front of the customer and at the same time reduce our SG&A expense in the store. So we've had good progress in that area and as mentioned at the analyst meeting, that has shown up in our SG&A improvement.

Bernard Sosnick - Oppenheimer

With regard to gross margin, you said that there would be markdowns in women's apparel. I'm wondering whether or not the markdowns began in earnest during the first quarter or represent a second quarter development?

Mike Ullman

I think, in general, we are on inventory plan. We are taking our markdowns as we go. There's really no quarter-to-quarter effect incrementally because of the markdown situation. We are pleased with the way we cleared the first quarter and we're very pleased with the way we are starting the second quarter.

Bernard Sosnick - Oppenheimer

Great. Thank you very much.

Operator

Our next question comes from Christine Augustine, Bear Stearns.

Christine Augustine - Bear Stearns

Good morning, everybody. My first question is with regard to women's apparel. I'd like to know what you think is going on with that business. It has been sluggish actually I'd say for the last six to eight months through the industry. So do you see an end in sight to those decelerating trends? Are there things that you can do specifically at JCPenney to try to counterbalance? Because it is a pretty sizable piece of your overall sales.

Mike Ullman

I will let Ken comment on that initially.

Ken Hicks

Obviously, we are seeing the toughness in the women's apparel business, as you mentioned. But we think there are things that we can do and are taking actions, making sure that we have the right styles and that we offer our customers a meaningful assortment. By having a strong presence in our private brands and introducing brands such as a.n.a and East 5th, we will be filling voids that we had in our assortment. We also are making sure that the brands we have are appropriate for our customers.

We are seeing some strengthening of the business, but it's still early. But we think that we have the opportunity to continue to improve our position in women's apparel.

Mike Ullman

I think the other thing I would add is that the cycle-time initiative probably benefits women's apparel the most. Frequency of delivery and the lead time gets more fashionable merchandise in the store more often, which is obviously what the customer is looking for. It's the newness and excitement of, as Ken says, our lifestyle merchandising and our own brands.

Christine Augustine - Bear Stearns

Do you think that there's something going on in the competitive landscape, or is it a fashion shift? I mean, what do you think is causing the slowdown?

Ken Hicks

Well, it's safe to say that it's obviously very competitive, but I don't think that there has been enough newness in fashion for the customer and that we're missing some of the things that she wants. That's where we are seeing the introduction of things like a.n.a are hitting exactly what she wants, giving her the value that she would like to have for that merchandise. So, it really is very competitive, and the lack of really exciting things in fashion aren't helping the business.

Christine Augustine - Bear Stearns

Are you planning to make any changes in the second quarter with regard to your promotional calendar versus what you did last year in the second quarter?

Mike Ullman

Fundamentally, it's the same cadence. Our customer understands our promotional calendar; it's been very effective. At the end of the second quarter, of course, we start the back-to-school period, which we've had five consecutive years of terrific performance in back-to-school and we're very optimistic about back-to-school this year as well. We don't see any major changes.

Christine Augustine - Bear Stearns

Thank you very much and good luck.

Operator

Our next question comes from Bob Buchanan, A.G. Edwards.

Bob Buchanan - A.G. Edwards

Good morning. Just a tremendous job, I think, of trend identification, item merchandising in that first quarter. I'm just wondering, as a follow-up to Christine's question on the women's side, I believe there have been some changes in terms of personnel at the GMM and DMM level in women's and also in juniors and girls. I'm just wondering if, Ken, you could run down some of the people changes that you've made and basically just comment as to why those changes have been made.

Ken Hicks

Well, Liz Sweeney continues and is our General Merchandise Manager for women's apparel, and we are pleased with her performance. We have made adjustments at the DMM level and we feel that we have strengthened her team significantly over the past year. Changes were made in order to get us the best team in retail, we think, in women's apparel in place. Now, I just went to market with them last week. We are now starting to see some of the benefits of that team working together cohesively. Ideas like a.n.a, East 5th, are really coming from this team and I expect to see a strong performance from them.

Bob Buchanan - A.G. Edwards

Ken, I know you don't want to mention specific names but has it involved some outside hires in women's, other parts of the business in the merchandise side, or in the product development and design area? I know, for example, you've added, I believe, a significant number of designers in line with this effort to cut the lead times.

Ken Hicks

Yes, we have brought in what we feel some very good talent in the design area from some very good companies, both brands and retailers. We've brought in some buyers from the outside, but we've also promoted some of our people inside. So, we feel we've got a nice mix of newness in our personnel, as well as some continuity from the people that we've got from within the Company.

Bob Buchanan - A.G. Edwards

Obviously, tremendous experience at the GMM level.

Ken Hicks

Yes.

Bob Buchanan - A.G. Edwards

I'm just wondering also, on the off-the-mall, if you can update us there as to what's going on there, whether there were any new test initiatives beyond Mount Juliet in Tennessee? Just comment as to how you may have beefed up your real estate staffing to deal with the different reality with regard to strip center locations.

Mike Ullman

Yes, I will comment on that. We have, in fact, beefed up our market area research, as well as our planning and our real estate team. They are up to the task. We've identified more than 50 stores in terms of the pool of opportunities for 2007, and we feel very confident about being able to deliver the 50 stores in the appropriate locations to for next year already.

In terms of the prototype at Mount Juliet, we made 20 changes in that store from our previous mall prototype, and we're going to continue to evolve that concept. We feel, at the moment, the last six stores have performed exceedingly well, and we just think it just keeps getting better and better. We are obviously focusing on productivity as well as what the customer is telling us about the experience.

The fact that we are putting Sephora in predominantly new stores next year will tell you that there will be an evolution there. It's going to being center stage as you come into the store, leading into fine jewelry, and we think that will drive productivity and excitement in that off-mall concept.

Bob Buchanan - A.G. Edwards

Great, thanks so much.

Operator

Our next question comes from Michelle Clark, Morgan Stanley.

Michelle Clark - Morgan Stanley

Thank you, good morning. Can you guys tell us what assumptions you are making in your full year guidance? First in terms of the strength of the consumer and then secondly on any market share gains resulting from consolidation in the department store sector?

Mike Ullman

I think, overall, we've always planned what we think is appropriate for the economic climate as well as what we see as the business opportunities. One nice thing about retailing is you can always look back and see things that you could've done better, and we believe that we have those opportunities throughout the year.

As I said earlier, we believe we're competing very effectively against the mall-based competitors, where most of the consolidation impact is being seen. We believe that our new store strategy will gain a lot of new customers as we expand into the off-mall format.

So, we are aware of the pressure that our consumer is feeling, in terms of the effect, the potential effect of gasoline price increases, but at the same time, given the style and quality they are getting at a smart price, we believe we're very well-positioned for that kind of an economic climate. So far, she hasn't disappointed us.

Operator

Our next question comes from Stacy Turnof, Merrill Lynch.

Stacy Turnof - Merrill Lynch

Good morning, everyone. First, can you tell us what you are expecting real estate income to be at the year-end?

Bob Cavanaugh

Yes, I think our normal run rate, Stacy, for real estate operations is about $7.5 million per quarter or $30 million for the year. That would include sublease income on certain properties, as well as income from joint ventures in our JCP Realty operation. That's normal real estate operations. Anything else would be real estate income on the sale of properties on a periodic basis, and we certainly wouldn't plan that. But our plan does have a normal run rate of $30 million a year for normal real estate operations.

Stacy Turnof - Merrill Lynch

Great. My second question is would you be able to quantify the level of incremental sales from your POS systems within the store?

Mike Ullman

It would be difficult to quantify at this point. We don't have all of the point-of-sale installed, they will be by August 1. I think it's suffice to say that we've gotten good opportunity for referrals between the store and JCP.com and our catalog operations by having our sales associates have an easier link.

Their productivity is improving as they are using this new tool. To have 35,000 JPC.com-ready terminals obviously is an enormous opportunity for us. Also, the speed of check-out, which as our customers have been telling us over the years, has been an opportunity, and we are seeing that in terms of the way the new point-of-sale operation has played out.

Stacy Turnof - Merrill Lynch

Great, my final question relates to the planning and allocation systems, and that's been a big driver of gross margin. When do you think that we start to see that level of improvement slow down?

Mike Ullman

We don't predict slowdowns.

Stacy Turnof - Merrill Lynch

But in terms of we have seen a noticeable improvement to that line, and eventually when it starts to anniversary.

Mike Ullman

Well, obviously, we think that there's always opportunities to look at ways to get the right merchandise in the right place and the right quantity at the right time. We think we have those tools and those systems. Particularly the key associates, the executive talent in that area is superb.

We obviously have had most of the upside now in our results, because of the last four or five years, but they are striving to do a better job of landing that merchandise and optimizing the opportunity. But, I think it continues to be one of our important growth initiatives.

Stacy Turnof - Merrill Lynch

Great, thanks. Keep up the good work.

Operator

Our next question comes from David Glick, Buckingham Research.

David Glick - Buckingham Research

Good morning and congratulations. I was wondering if you could discuss any key learnings from the Q1 sales promotion strategy and productivity? Are you finding the right balance between promotional and branding TV? Specifically, are there any takeaways from, say, the Lowest Price Event? Did you perhaps pull back too much on that event and maybe lose some market share to Kohl's? Or any other learnings from Q1 that you could apply going forward?

Mike Ullman

Well, I think the point that you make is a good one, and that is that we are balancing our short-term responsibilities for performance with our very, very important long-term branding and messaging that we believe is very important and is resonating with the consumer. So we did launch our biggest branding JCPenney experience at the Academy Awards this year, March 5. That was extremely successful in terms of resonating with our customer and accomplished our objectives.

We have, in fact, shifted some from a straight sales promotion into brand marketing, and we will continue to do so and balance those short-term versus long-term objectives.

We believe our growth strategy is one that takes time. To resonate with new customers, we obviously are doing a great job with existing customers, but there's 50% of the middle-income female customer that has not shopped JCPenney or is not shopping JCPenney. That's the one that we stand to gain the most from in terms of brand awareness and initiatives like Sephora and the new brands that Ken mentioned.

David Glick - Buckingham Research

Were there any specific events that perhaps when you look at your plans for fall, that you might beef up? Any tweaking that you would do, or you feel satisfied with your approach to Q1?

Mike Ullman

I think we probably do about the most analytical job I've ever been a part of in terms of analyzing our events, but we fundamentally don't shift around the promotions. It's looked at year after year, and we keep improving on it but I wouldn't say there's any major adjustments from anything from the first quarter.

David Glick - Buckingham Research

Thanks very much.

Operator

Our next question comes from Jeff Klinefelter, Piper Jaffray.

Jeff Klinefelter, Piper Jaffray

Yes, congratulations on a great start to the year. A couple of questions just on the second half. Given the guidance that you provided, obviously the second half is, taken literally, at the low or the midpoint of the range, it would be very, very modest growth. Assuming that that's conservative and you have less visibility for the third and fourth quarters.

At this point, what would be the opportunities that you would see and how would you prioritize, for example the opportunity? Would it be comping ahead of your low single digits or are there specific gross margin or SG&A opportunities that you have in those two quarters that could result in upside?

Specifically, the POS implementation. As you anniversary that or cycle through that, would that be a little relief in the second half in SG&A?

Mike Ullman

Well, I think ours is a balanced approach for the rest of the year. I think we would expect to get some gross margin improvement, clearly SG&A, as Bob pointed out. But the top line growth over plan is because the retail business is one of high leverage and you get rewarded handsomely when you exceed your sales plan. That would provide the most opportunity in terms of operating profit improvement.

Jeff Klinefelter, Piper Jaffray

Then just one follow-up would be on the consolidation question. Obviously, people are very keyed in on this at this point, the billions of dollars potentially that are up for grabs out there.

You've commented that you've seen some modest improvements in locations where stores have closed and you are now perhaps getting some of that market share. Are there strategies in place, direct-marketing strategies, mailers, buying list, things you can do to very deliberately go after that market share in those locations?

Mike Ullman

Part of our strategy there is obviously to do branding and JCPenney awareness for new customers, which we believe is effective. We are, in fact, going to benefit from some of the national brand vendors that are being walked away from in terms of the consolidation of May and Federated. We believe customers are going to be looking for some of that merchandise and in many cases, we are the best place for them to find it.

At the same time, I think the branding does have a cumulative effect in terms of people willing to try us as an alternative. If they don't see what they like anymore in the new Macy's.

Operator

Our next question comes from Bob Drbul, Lehman Brothers.

Bob Drbul - Lehman Brothers

Good morning. Can you talk a little bit about traffic versus ticket during the quarter? Can you give us any update on the sales trends in your off-mall stores, and how your off-mall stores perform?

Mike Ullman

I would just say quickly that the off-mall stores, first of all, have done very, very well, exceeded our expectations and actually the most recent stores exceed the trend of the previous two years of stores, so each year's stores seem to be getting better. I think that bodes well for our ramping up of the new stores in the next couple years.

We saw a modest increase in traffic in the first quarter, so it's a combination of ticket and traffic. It's quite clear that there was a shift at Easter, which affected everybody in terms of the way the March/April periods played out, but overall, we were satisfied with the results of traffic for the quarter.

Bob Drbul - Lehman Brothers

Great, thanks.

Johnson

Natasha, do we have any more calls?

Operator

Our next question comes from Michael Exstein, Credit Suisse.

Michael Exstein - Credit Suisse

Good morning, everyone. Two quick questions, one for Bob -- the payables didn't offset as much of the inventory as had been running for the last five or six quarters. I was wondering what that was about?

Secondly, in terms of the shortfall in the women's business, with your vast experience in watching trends, generally it's the men's business that I remember sort of slowing down during potential economic issues. What is your sense on the men's business and what it is telling you right now? Thanks.

Bob Cavanaugh

Okay, Michael, this is Bob. With regard to the cash flow differences this year over last year, really nothing to do with our payables, per sae. The difference is higher cash taxes payments. We are on a quarterly basis like virtually every other company. Given the higher income, as well as the no pension contribution last year, which of course year-over-year was a detriment from a cash tax point of view; the first-quarter payment, which really relates to 2005, is the final and fifth payment under the IRS rules. Just higher cash taxes represented two-thirds of the cash flow difference year-over-year.

One-third of the difference was higher savings plan contributions this year, which were accrued at year-end and it relates to 2005. So two-thirds of it tax payments, one-third of it a higher profit-sharing plan based on last year's profits.

Mike Ullman

Just on the men's business, our men's business exceeded our expectations and plan for the first quarter, as did our kids business. On the apparel side, women's was the only area that showed some weakness.

Michael Exstein - Credit Suisse

When you're talking about the payables, so you're saying the merchandising payables, which are part of the total payables that you report, were in good shape, and the inventory?

Bob Cavanaugh

We are leveraged based on the rate of inventory growth, essentially.

Michael Exstein - Credit Suisse

All right, perfect. Thank you.

Bob Johnson

Natasha, any more calls?

Operator

Your next question comes from Michelle Tan, UBS.

Michelle Tan - UBS

Thank you. Just a couple of quick questions. First, on the ad spend investment that we saw in the first quarter with the branding campaign, is that something we should expect to continue for the rest of the year as you accelerate the brand marketing initiatives?

Mike Ullman

I would say it's probably indicative directionally.

Michelle Tan - UBS

Okay, so slightly higher as a percentage of sales?

Mike Ullman

It will be around the same level of sales as last year as a total. It's just the minor shift between sales promotion dollars and branding dollars. First quarter is pretty much indicative of what you'll see going forward.

Michelle Tan - UBS

Also, just a question on the inflation/deflation side. What are you seeing in terms of near-term cost inflation? How would you expect what you are seeing for this year to impact top line and margin?

Mike Ullman

I think you have to separate the cost of goods issues between apparel and non-apparel. I think there's very little inflation in apparel. If anything, there is deflation in apparel, generally. We've been able to predict average price points about the same as the previous year, primarily if you're adding more style and quality in our garments, particularly what we produce ourselves.

There's really not a lot of inflationary pressure in our costing at this point that we've seen, and we don't plan for much for the rest of the year.

Operator

We have time for one more question, and that is coming from Dana Cohen, Banc of America.

Dana Cohen - Banc of America

Oh, great, under the wire. A couple of questions. In terms of the gross margin, can you give us a sense of order of magnitude of what contributed to the improvement of the pieces you talked about?

Then on the store closure issue, you said that you're starting to see some modest improvement; but I mean in the Mervyn stores closed at the end of January; the May stores closed at the end of March. Shouldn't we have started to see that in the April numbers?
Mike Ullman

I will mention the store closure things. I think that, first of all, the closures as a percent of our total business is a relatively small number. I think the bigger issue will be what happens when the assortments in all of their stores start to morph into the new assortments in September, I think is their timeframe. But clearly, it's more pronounced in the places where the stores have actually closed exist. I will let Ken respond to the other.

Ken Hicks

Thanks. Dana, we saw the improvement come from several key areas. One was, as Mike said earlier, continued sourcing opportunities as we take advantage of our leverage and capabilities there.

Second was our continued improvement in seasonal transition. As we do a better job of transitioning seasons, obviously we're getting benefit from that.

Then finally, our improvement in the systems capabilities that we have. and we still have an opportunity with that as we go forward and continue to enhance the systems that we've implemented. So we see the improvements in our gross profit coming from multiple areas and as we've said, have the opportunity for continued marginal improvement as we go forward.

Dana Cohen - Banc of America

Is the best way to think about it as one-third/one-third/one-third in terms of the improvement, sort of importance of contribution?

Ken Hicks

It has been but I think that will change over time. You know, it's not straight one-third/one-third/one-third every time, because it does vary based upon the season and the benefits as we implement, for example, a systems change.

Dana Cohen - Banc of America

On SG&A, with SG&A dollars growing only about 1%, can you give us any sense of, are there any buckets of big cuts in that number to keep the number as low as 1%?

Mike Ullman

I think that probably the biggest improvement is related to store selling and support expense, most of it coming out of support, back-office support, where we've reengineered how we behave there. We've been able to actually put more of our effort in front of the customer, but to overall save. That's where the biggest improvement was.

Dana Cohen - Banc of America

Great. Thanks so much.

Bob Johnson

Thank you for joining today's call. That concludes the call. Thank you very much.

Operator

This concludes today's conference call. You may now disconnect.

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