Express (EXPR) Q2 2018 Earnings Conference Call Transcript

Express (EXPR)
Q2 2018 Earnings Conference Call
Aug. 29, 2018 9:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Greetings, and welcome to the Express Inc. second-quarter 2018 earnings conference call. [Operator instructioons] As a reminder, this conference is being recorded. It's my pleasure to introduce your host, Mark Rupe, vice president, investor relations for Express. Please go ahead, Mark.

Marke Rupe -- Vice President, Investor Relations

Thank you, Kevin. Good morning, and welcome to our call. I'd like to open by reminding you of the company's safe harbor provisions. Any statements made during this conference call, except those containing historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Actual future results may differ materially from those suggested in forward-looking statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC, including today's press release. Express assumes no obligation to update any forward-looking statements or information except as required by law. In addition, during this call, we will make reference to adjusted operating income, adjusted net income and adjusted diluted earnings per share, which are non-GAAP measures. Information necessary to reconcile these non-GAAP measures can be found in our press release, which has been filed as an exhibit to our Form 8-K with the SEC and is available on the company's Investor Relations website.

Our comments today will supplement the detailed information provided in both the press release and the investor presentation. With me today are David Kornberg, president and CEO; Matt Moellering, executive vice president and COO; and Perry Pericleous, senior vice president and CFO. I will now turn the call over to David.

David Kornberg -- President and Chief Executive Officer

Thank you, Mark. Good morning, and thank you for joining us. Before getting into the quarterly details, I would like to make a few comments on our positioning and commitment to driving improved profitability. Express is a leading omnichannel retailer focused on building strengths through key initiatives across product, brand and customer experience.

We are committed to returning Express to sustainable and profitable long-term growth, and we took another important step forward in this pursuit during the second quarter, delivering earnings that exceeded our guidance. Comparable sales grew for the second consecutive quarter. And for the third consecutive quarter, earnings increased relative to the prior year. We are making solid progress on a number of fronts and there are a lot of reasons for us to be optimistic about our future.

Our e-commerce sales growth is exceptional. Our newly expanded omnichannel capabilities are starting to produce benefits, outlet stores are performing well. We continue to see positive trends within our loyalty program, and we are realizing our targeted cost savings. That said, we still have a lot more work to do.

Over the past couple of years, we have seen profitability decline, and we are the first to recognize that bridging the gap to a more acceptable level of profitability represents the most significant opportunity to drive shareholder value. The business has regained its footing over the past two quarters through our initiatives, leading to both positive comps and increased earnings. And our capital investments have returned to more normalized level. We have positioned the business to move forward and believe that returning it to a mid-single-digit operating margin over the next three years is a reasonable and appropriate goal.

To achieve this, we must be successful across four key areas. First, we need to drive customer acquisition and retention through more consistent product execution, more effective marketing spend and delivering a continuous and holistic brand and customer experience across all channels. This includes successful products introduction, like extended sizing, building customer engagement through more personalized service offerings like styling and further growth in our NEXT loyalty program. Second, we need to continue driving retail sales through double-digit e-commerce growth while improving overall store productivity.

We remain confident in the growth outlook for e-commerce and are focused on improving our store performance. Third, we need to realize the benefits from our systems investments and omni-channel capabilities. We have begun to see the initial positive results and expect to capture more significant benefits going forward. And fourth, we must be relentless in the way we continue to go after opportunities to cost savings.

We have been successful in realizing our targeted savings to date and remain on track to achieve the $44 million to $54 million cost savings target by the end of 2019. We have also begun to benefit from reduced occupancy costs. I look forward to updating you on each of these four areas on future calls. Now turning to the quarter.

Comparable sales increased 1% and grew for the second consecutive quarter, and earnings per share of $0.03 marked the third consecutive quarter of growth relative to the prior year. From a product perspective, our men's business continued to perform well, with strength in denim, casual pants, shorts, and suits. We also saw a relative improvement in shirts and expect that this will further build in the third quarter as we increase the penetration of performance shirts. Women's saw above-average performance in dressy woven tops, knit tops, dress pants, casual pants, skirts, jackets, and shoes.

Dresses were also above average, showing solid improvement during the quarter. Our extended size offering is performing well. We are gaining good insight and customer feedback, which we are leveraging to build on this opportunity for the future. While it was only a small piece of our second-quarter assortment, receipts are building, and we expected to contribute incrementally in the back half of 2018 and more significantly into 2019.

From a channel perspective, e-commerce sales growth remained outstanding. Sales increased 37%, and this was on top of the 28% growth in the same period a year ago. And as a percentage of sales, e-commerce accounted for 25% of net sales, up from 19% in the prior year. We continue to see solid improvement in our key performance metrics and strong growth from the Express mobile app.

E-commerce is also benefiting from our newly expanded omni-channel capabilities. The percentage of e-commerce orders fulfilled by our approximately 400 active ship from store locations is growing rapidly, and we continue to refine the algorithms to further increase fill rate and improve order processing efficiencies. The ship from store opportunity is expected to increase margin in the back half of 2018 and into 2019, which will help stabilize the pressure from channel mix shift. We also continued to test buy online, pick up in store.

In July, we added another five stores to the test in New York City and have installed lockers in certain location to gain insight on the added convenience of self-service pickup and returns. We have learned a lot through the test to date and are working to optimize the profitability with the expectation that we will continue to methodically roll out this capability to select stores over the next 12 months. Switching to our store performance. We saw good performance from our outlet stores during the second quarter.

Outlet stores have been a very successful growth strategy for us and have quickly become a sizable portion of our business. They have not only allowed us to capture a share of the market not previously served, but they have also played an important role in optimizing our retail store footprint. In the past few years, we have converted more than 60 retail stores to the outlet format, including 27 in the second quarter. The convergence has driven meaningful productivity improvements in these locations and as a result, remain a viable opportunity for us to further optimize the retail footprint.

As for our retail stores, they continue to perform at a level below where we believe they are capable of performing. And while their role has evolved greatly as a result of our omni-channel transformation, their productivity remains an important lever in our profitability. We have various efforts under way to improve the performance trend. We've increased our inventory and marketing investment in core categories and are focused on strengthening the results.

We are also evaluating the ability to drive productivity improvements by managing our overall inventory more efficiently. With the ship from store now in place, we can hold more inventory in stores to ensure proper debt without added risk. We also have key technology investments under way that have the opportunity to drive overall retail store efficiency. We're in the process of rolling out an upgrade to our store point-of-sale system.

We're currently testing RFID in 15 stores to understand the potential for increased sales from improved inventory accuracy and are moving forward with the planned implementation of our new assortment planning system. And we have significant flexibility with our retail store leases. Approximately, 60% are up for renewal in the next three years, which represents another tangible opportunity for us to drive improved profitability. As it relates to our marketing efforts, we are optimistic that our full initiatives will drive increased customer acquisition and retention.

We recently extended and expanded our relationship with the NBA, which covers the next two seasons. We will continue with our successful NBA Game Changers campaign featuring five players and will launch an NBA collection this holiday. And Karlie Kloss is returning to support our September [Inaudible] campaign. Karlie is inspiring, confident and embodies the experience of our customers, and we are glad to have her more prominently featured supporting the brand.

In addition, we have various other initiatives in place to drive awareness and customer acquisition. From a wholesale perspective, we recently partnered with Cintas to offer Express merchandise to the hospitality industry and separately launch ExpressForBusiness, an e-commerce site targeting B2B opportunities. We are also launching a subscription-based rental service in October called Express Style Trial, which will focus initially on women's apparel. And for the third year, we are continuing our collegiate ambassador program, Express You, and have expanded our reach to 44 campuses across the U.S., up from 24 in 2017.

As it relates to customer retention, we continue to be pleased with the trends we are seeing in our loyalty program. Express NEXT is a compelling and recognized loyalty program in the industry, and we continue to see growth in members as well as in Express NEXT credit card customers. And lastly, we are confident that we will be able to leverage our investments in data analytics to increase customer acquisition and retention. We recently consolidated all of our customer data in-house, which provides us a unique advantage to leverage our data more holistically and with greater precision.

And we have a number of projects under way to increase overall personalization with our customers to drive improved conversion and purchase metrics. So in summary, the business has regained its footing, and we are confident that our initiatives across product, brand and customer experience will drive improvement in sales, operating margin and earnings in the coming years. We continue to believe strongly in the long-term opportunity of our business and have repurchased 6.1 million shares for $49 million to date under our existing $150 million share-repurchase program. I would like to close by thanking everyone at Express for their hard work, dedication and determination.

Our team is extremely talented and they care deeply about the Express brand. Importantly, everyone here understands that our company is capable of delivering more, and I'm confident that you will see the traction we have achieved during the first half of 2018 continue and that the fruits of our collective and continued hard work will grow into the all-important holiday season and into 2019. I would now like to turn the call over to Perry.

Perry Pericleous -- Chief Financial Officer

Thank you, David. Good morning, everyone. I'm going to start by reviewing our second-quarter results followed by discussion of our third-quarter and fiscal 2018 outlook. Second-quarter net sales were $494 million, a 3% increase as compared to $481 million last year.

Comparable sales increased 1%, including 37% e-commerce comp growth and store comps of negative 7%. The continued expansion of our omni-channel capabilities is transforming the way in which our customers view and engage with us and how we manage our business. As the lines between our retail stores and e-commerce channels become increasingly intertwined, we have started the process of invigorating our reporting approach as it relates to comparable store sales and e-commerce sales. We intend to provide an update on our third-quarter earnings call in late November.

Turning to gross profit. As a reminder, last year's second-quarter gross profit was negatively impacted by a $1.3 million inventory adjustment related to the exit of Canada. Our second-quarter gross profit was $140 million, an improvement of $6.6 million compared to the prior year, or approximately $5.4 million after taking into account the negative impact of Canada. Second-quarter gross margin was 28.4% and expanded by 60 basis points compared to the prior year, or 40 basis points when you adjust for the negative impact of Canada.

This marks our third consecutive quarter of year-over-year improvement. Merchandise margin contracted by 30 basis points during the quarter. While we achieved our targeted sourcing-related cost savings, we face incremental pressure from shipping enhancement costs, driven by higher rates and increased volume due to the significant growth in e-commerce sales. In addition, we have seen higher shipping costs related to our expanded omnichannel capabilities with ship from store now active in approximately 400 of our retail stores.

This was expected and will allow us to capitalize on the ship from store margin opportunity. While ship from store is driving some incremental shipping costs due to higher level of [Inaudible] orders, it reduces our future markdown risk by lowering our preclearance inventory going into the full season. To be clear, our merchandise margin performance in the second quarter does not change how we think about the year. We remain comfortable with the 50 basis points of merchandise margin improvement for the full year, which we discussed on our Q4 2017 earnings call in March.

And as a reminder, we expect our sourcing-related cost savings to be the primary driver of merchandise margin improvement in 2018 with our omni-channel benefits neutralizing the impact from the ongoing mix shift in our business. Buying and occupancy cost improved by 70 basis points due to increased sales and favorable lease renewals. This improvement was partially offset by higher fulfillment cost related to the significant growth in e-commerce sales. SG&A expenses came in at the lower end of our expectation at $138 million, up $3.5 million, or 3%, year over year.

And as a percentage of sales, they were flat as compared to last year at 27.9%. The absolute dollar increase relative to last year was driven primarily by investments in technology and e-commerce as well as wage inflationary costs and incentive compensation. Operating income was $2.7 million, or 0.5% of sales, an improvement from last year's adjusted operating income of $1.6 million. And second-quarter earnings per diluted share was $0.03, an improvement from last year's adjusted EPS of $0.01 per share.

Now turning to our balance sheet and cash flow. Our balance sheet remains healthy. We ended the quarter with $191 million of cash and cash-equivalents, as compared to last year's $173 million. Inventories at quarter-end were $270 million, a 6% increase as compared to last year's $256 million.

The increase was driven primarily by extended size inventory as we look to build on this opportunity for the future and to a lesser extent, the timing of deliveries being one week further into the full season due to the shift in the retail calendar. We remain comfortable with the level and composition of our inventory heading into the full season. However, I do want to point out a modeling item as it relates to third-quarter inventory levels. Given the shift to the retail calendar and the fact that Black Friday week falls in the third week of November this year, we will have more receipts late in the third quarter as compared to the prior year.

As a result, this is expected to impact our Q3 end-of-period inventory in the range of mid- to high-single digits. That said, we expect inventory to return to a more normalized level by the end of the year. As it relates to operating cash flow, the slight decline year to date as compared to the prior year was driven primarily by the previously disclosed $26 million distribution of the company's nonqualified supplemental retirement plan during the first quarter. And in terms of our share-repurchase program, we repurchased 1.8 million shares for $16.4 million during the second quarter.

Under our current program, we have repurchased 6.1 million shares for $49.3 million, which reflects an average price of $8.09. We continue to have $101 million available under the share-repurchase program. With that, I will now address our guidance for the third quarter and full year. For the third quarter of 2018, we currently expect comparable sales in the range of negative 1% to plus 1%, net income in the range of $6 million to $8 million and earnings per diluted share in the range of $0.08 to $0.11.

This compares to last year's diluted EPS of $0.08. While we're making solid progress on a number of fronts and have a lot of reasons to be optimistic about our full and holiday prospects, we believe it is prudent to maintain our balance of year guidance given that the important holiday season remains in front of us. Based on the midpoint of our third-quarter guidance, we expect our operating margins to contract slightly, with gross margin expansion offset by SG&A deleverage. Turning to our full-year 2018 guidance.

We currently expect comparable sales in the range of flat to plus 1%, net income in the range of $32.5 million to $36.5 million, and earnings per diluted share in the range of $0.43 to $0.49. This compares to last year's adjusted EPS of $0.37, which includes $0.04 from the 53rd week. I do want to point out a couple of modeling items as it relates to the fourth quarter. We expect fourth-quarter net sales growth to be impacted by last year's 53rd week as well as by the shift in the retail calendar, where a larger week in November is replaced with a smaller week in January.

Together, these two items are expected to impact fourth-quarter net sales by approximately 5 percentage points, with the 53rd week last year being the primary driver. And just to be clear, this does not impact comparable sales and has always been contemplated in our guidance. In addition, as it relates to China tariffs, based on the current proposal, we have little exposure in 2018. We will continue to monitor developments and update you to the extent necessary in the future.

Turning back to the year. Based on the midpoint of our full-year 2018 guidance, we expect our operating margin to contract by approximately 20 basis points, which is flat to last year when excluding the impact from the 53rd week. This implies approximately a 2.3% operating margin for 2018. We're not satisfied with this level of profitability.

And as David indicated, our goal is to return the business to a mid-single-digit operating margin over the next three years. To achieve this, we will need to grow comparable sales in the low single digits, further expand our gross margin and lever SG&A expenses. As it relates to capital expenditures, we plan to spend approximately $58 million to $63 million in 2018, and we believe that this is the right level for the next few years. Capital expenditures during the first half of 2018 were down to last year due to timing of projects.

In terms of cash flow, our guidance embeds continued solid operating and free cash flow generation in 2018. In summary, our business is strengthening and our financial position remains sound with $191 million in cash at quarter-end and no debt. Our first half earnings came in ahead of our guidance, and we're focused on maintaining our momentum during the remainder of the year. We're committed to driving shareholder value and recognize that improving our profitability represents the most significant opportunity to accomplish this.

We look forward to updating you on our progress in late November. I would now like to turn the call over to the operator to begin the question-and-answer portion of the call.

Questions and Answers:

Operator

Thank you. [Operator instructions] Our first question today is coming from Susan Anderson from B. Riley FBR. Your line is now live.

Susan Anderson -- B. Riley FBR -- Analyst

Hi. Good morning. Nice job on the quarter. I was wondering if you could give a little bit more color on the driver of the gross margin in the back half of the year.

And do you expect it to be positive in both third quarter and fourth quarter? And I guess, and particularly, the merch margin, how do you expect that to pan out for third quarter and fourth quarter? Do you expect it to get back to growth after this quarter? And just really quick on the inventory front -- I know you talked about feeling good about inventory, but I was just curious if there was any pockets of higher inventory that would still need to be cleared in third quarter. Thanks.

Perry Pericleous -- Chief Financial Officer

Thank you, Susan. To answer your question on the gross margin and provide more guidance for the balance of the year, we do expect gross margin in Q3 to expand approximately 100 basis points, and we do expect Q4 to also have a level of expansion in the gross margin. One thing to keep in mind is that Q4 is negatively impacted by the 53rd week, which last year was approximately 50 basis point. So we have to keep that in mind as we look at that.

From a merchandise-margin standpoint, we still believe that 50 basis points for the year is appropriate. And if you look at it for the back half of the year, we do expect merchandise margin to expand approximately 50 to 60 basis points for the full season. As it relates to buying and occupancy, we do expect buying and occupancy to continue to leverage for both -- for Q3. But when it comes to Q4, given the impact of the 53rd week and the shifting that we mentioned in the script, I do expect buying and occupancy to deleverage in Q4.

Again, we have to keep in mind the impact of sales and net sales in the 53rd week. As it relates to inventory, we feel good with the level of inventory going to Q3 in the fall season. The elevation of the inventory levels as it relates to August DOM are driven by the extended sizes as well as being one week further into Q3 in the fall season.

Susan Anderson -- B. Riley FBR -- Analyst

Got it. That's helpful. And just one follow-up on the merch margin. I guess, will the expansion come from just cleaner inventory in the back half? So more full-price selling, less promotions.

And if you could maybe give us an update on what you're expecting for product costs that will be great. Thanks.

Perry Pericleous -- Chief Financial Officer

The merchandise margin in the back half is driven by our overall low-cost initiatives that we've discussed all along. This time around, when you look at the impact in Q2, we did deliver the low-cost initiatives. But those were partially offset or fully offset, if you will, with some elevated cost because of the ship from store. So if you think about the total year 50 basis points that is driven by low-cost initiatives.

Between the first half and the back half, there is some shifting because of incurring additional costs in Q2 on the shipment and handling front and then getting the benefit of reduced markdowns because of lower clearance merchandise. So again, the full year is driven by LCI initiatives, the low-cost initiatives. But when you look at between Q2 and the back half of the year, there is some shifting because of how the shipping and handling costs are coming on the front end, and you're getting the benefit of having less clearance at the back end.

Susan Anderson -- B. Riley FBR -- Analyst

Got it. That's helpful. Thanks so much. Good luck next quarter.

Perry Pericleous -- Chief Financial Officer

Thank you.

Operator

Thank you. Our next question is coming from Paul Trussell from Deutsche Bank. Your line is now live.

Paul Trussell -- Deutsche Bank -- Analyst

Good morning. Thanks for taking my question. So it was very nice to see the e-commerce acceleration. Maybe just talk about the factors that you think are leading to your strong performance on dot-com.

And then also if you can provide a bit more detail on customer response to newness in your assortment and the marketing campaign and also how the in-store performed during the quarter. Thank you.

David Kornberg -- President and Chief Executive Officer

OK, Paul. So thanks for your question. I think the drivers of e-commerce, and we're pretty clear about it, have been the assortment. The mix of the assortment; the e-commerce exclusives, which have been a big driver of the business; and our ability now to ship inventory from store, which is now in 400 stores.

I think that also, obviously, a lot of work that we've done on the site in terms of ease and convenience of shopping has really helped us as well. So really, clearly, we have shown significant growth online. It is the direction of the future to be able to put on a 37% increase on top of the 28% increase last year shows that we are doing the right things. And it's really just not one thing or another.

It is the full mix of the work that we're doing online that's delivering the results. Your second question was?

Paul Trussell -- Deutsche Bank -- Analyst

About in-store performance and customer response to marketing?

David Kornberg -- President and Chief Executive Officer

Yes. The response to our marketing campaign has been very good. I think that going into the fall season, we've been focused on the right things. I'm very excited about the direction of the business going into September.

The results that we're seeing on some of the categories that are important to us in the month of September and October, and we're also getting some very good initial reads on sweaters, which makes me optimistic for the future as well.

Paul Trussell -- Deutsche Bank -- Analyst

And then just very quickly, Perry, just on the margin front. If you can just talk a little bit about SG&A and how we should think about that in the second half. It seems like a slowdown in the growth rate there versus the first half. And if you don't mind, if you can just repeat some of the color around the calendar shift impact and how we should keep that in mind for 3Q and 4Q.

Perry Pericleous -- Chief Financial Officer

Yes, Paul. So looking at the SG&A, we do expect SG&A in the second half of the year, if I look at Q3, to grow at the same rate as we had seen in Q1. And then for the second half of the year, one thing to keep in mind is that SG&A in an absolute dollar terms is going to be benefited by not having that 53rd week. So when you look at the holistic second half of the year, SG&A will be up approximately in the low single digits.

As it relates to the calendar shift, one thing to keep in mind is when you look at Q4 in absolute, year over year, last year had the 53rd week. So on a year-over-year basis, Q4 is negatively impacted on net sales by approximately 5 points compared to the comp performance. The other part that is impacting Q4 also is the fact that you're giving up November week one for January week four. So you're trading a higher volume week for a lower volume week, so that will also have an impact on the net sales.

Now when it comes to overall comps and the comp guidance, this has no impact on the comps and the entire guidance was expected -- contemplated the shifting when we provided initially back in March for the year.

Paul Trussell -- Deutsche Bank -- Analyst

Very much appreciate it. Best of luck.

David Kornberg -- President and Chief Executive Officer

Paul, Paul, sorry, I'd like to just go back on your point about stores. Look, we know that our store business needs to improve, and it has been a drag on the business now for a while. So I think I just need to address some of the points on that and what we're doing to address the business. We did talk on the call about the optimization of the footprint, and we have done a lot of work around conversions.

When you look at this year, we will be converting 29 stores of which 27 have already been done, and we've seen a real improvement in terms of the productivity of the stores. We talked a lot about the work that we're doing on customer acquisition and retention, whether it's renewing our partnership with the NBA. And I think with the work that we're doing on NEXT is also very meaningful work that's getting us results in terms of increasing the amount of cardholders that we have. I think other things that we're doing, we talked about the POS upgrades, the point-of-sale upgrade that we're doing.

And we're also doing test of RFID. And then I think the other thing is also is really going after the core categories of the business. We've increased depth of inventory knowing that we are able to use that inventory to fulfill ship from store as well. But in terms of making a more impactful statement in the store with our in-season results in that as well.

So I hope that addresses your question.

Paul Trussell -- Deutsche Bank -- Analyst

It does. Thank you for addressing it, much appreciate it.

David Kornberg -- President and Chief Executive Officer

All right. Thank you.

Operator

Thank you. Our next question is coming from Adrienne Yih from Wolfe Research. Your line is now live.

Adrienne Yih -- Wolfe Research -- Analyst

Good morning. Nice job. Stores look great.

David Kornberg -- President and Chief Executive Officer

Thank you, Adrienne.

Adrienne Yih -- Wolfe Research -- Analyst

Welcome. David, my question is can you talk about the impact of the extended sizes? How -- maybe this is joint with Perry, how does that -- how much of that is currently in the inventory? How much of that you have to plan for the back half inventory? And then the reception to that feedback, etc. Then for Perry, just I know you had the lead times, so there's kind of a natural hedge to any potential tariff impact, how much do you still source in China? And how quickly can you move it out of China? Thank you very much.

David Kornberg -- President and Chief Executive Officer

OK. In terms of your first question on extended sizes and the impact on the inventory. We see it somewhere in the region of about 2 percentage points of our inventory, 2 to 3 percentage points of the increase in our inventory at the end of the quarter on the, I think it was 5.6% increase in inventory that we talked about on the call. We're pleased with the initial response that we've seen.

We really only launched it at the beginning of the quarter. And as the goods have been flowing in, we've been seeing it have a more meaningful impact, and it's performing to its plan. So overall, we're very, very pleased about that. In terms of your question on tariffs and China, I'm going to hand that over to Matt.

Matt Moellering -- Chief Operating Officer

Yeah. Hi. Basically, we're largely unaffected by the current list of items subject to the proposed tariffs. So for the fall, it's relatively minimal.

The range of impact could be anywhere from $0.5 million to $1.5 million and that really depends on what comes out of the comment period that ends here in early September. So from a longer-term perspective, we don't want to speculate on what may happen. But if it does impact the broader apparel categories that may become subject to tariffs, we are fortunate to have alternative sources for a lot of our categories. The low-cost initiative work that has been under way for the last two and a half years has really diversified our sourcing base and given us a lot of opportunities to source in other countries as well.

So we're putting plans in place if a broader impact could occur. The current amount of sourcing we have out of China four, five years ago, closer to 40%, we're down to 26% now. So it has come down dramatically.

Adrienne Yih -- Wolfe Research -- Analyst

OK. Great. And then, Perry, just one last one for you. The merch margin to be up in the back half, is that primarily in the fourth quarter? And then just really quickly.

Is the -- you said most of that's coming from the sourcing work that you guys are doing and doing so well. But how does the actual environment look, the actual selling environment?

Perry Pericleous -- Chief Financial Officer

So when you look at the back half, Adrienne, we expect more of that to come in Q3 than Q4. We expect overall in the 50 to 60 basis points, maybe a little bit higher on an average, looking at in Q3. One thing that from the savings in the back half, and I want to clarify the previous answer I provided, is the overall 50 basis points of savings we're expecting for the year, we're expecting that to come through LCI. In Q2, our merchandise margin was down to our -- compared to last year.

But that was impacted by recognizing higher shipping and handling costs as part of the increased rate on the shipping and handling, the increased e-commerce penetration, but also because we're incurring increased shipping and handling costs because of the ship from store. That ship from store is going to translate to a benefit in the back half, driven by the fact that we're able to clear pre-redline inventory that otherwise will go to a mark out-of-stock event. So the benefits that we're going to get on the back half is by being able to have more efficient inventory overall. Again, the LCI savings, the low-cost initiative savings are coming through the 50 basis points for the year, and that is the driver overall.

There is a timing that is caused because of the shipping and handling between Q2 and the back half of the year from the benefits.

Adrienne Yih -- Wolfe Research -- Analyst

OK. Very helpful and best of luck.

Perry Pericleous -- Chief Financial Officer

Thanks.

Matt Moellering -- Chief Operating Officer

Thank you, Adrienne

Operator

Thank you, [Operator instructions] Our next question is coming from Roxanne Meyer from MKM Partners. Your line is now live.

Roxanne Meyer -- MKM Partners -- Analyst

Great. Good morning. One follow-up question on the merch margin. I'm just wondering within the second quarter if you could talk to how markdowns fared.

And then in the back half, I just wanted to clarify that it sounds like based on the ship from store that overall, you expect markdowns to be down in the second half of the year. And then, I guess, just continuing along the gross margin, do your sourcing benefits continue into 2019 or is this really a 2018 story? Thanks a lot.

Perry Pericleous -- Chief Financial Officer

So from a markdown standpoint, in Q2, our markdowns came in within our expectation. And as we've said on the prepared remarks, the merchandise margin being down in Q2 was expected. And again, it was driven by the increase of the shipping and handling rate expenses. When it comes to the back half of the year, we are expecting improvements in the overall markdown rate as well as improvements in the mark out of the store.

So the overall product margin will be better driven by the fact that right now, with the ship from store, we have the ability to clear e-commerce exclusives that are in-store, preclearance merchandise and items that otherwise would be going to mark out-of-stock event. So again, we've been an omnichannel retailer right now. We have a lot of flexibility. We've been able to optimize both our inventory and our markdowns.

Was there another question?

Roxanne Meyer -- MKM Partners -- Analyst

OK. Good. Yes. As it relates to just the gross margin, just wondering for how long are the -- or it's the sourcing initiatives that you have under way, for how long should we expect to see the benefits of that? Does that extend into -- are there incremental benefits in 2019? Or is it really more selling 2018 story?

Perry Pericleous -- Chief Financial Officer

So the initial -- the initial expectation was to go through 2018. At this point, we have not provided any guidance for 2019, but we will continue to look for opportunities to further optimize our sourcing and lower our overall AUC. So -- and that is an ongoing objective.

Roxanne Meyer -- MKM Partners -- Analyst

OK. Great. And then just one more quick one, if I may -- if I can. Dave, and you mentioned as one of your initiatives just increasing the amount of basics in the store in order to better accommodate online orders.

So I'm just wondering, as part of that story, is that coming at the expense of some of the other fashion merchandise? Or is it really just taking the ability to increase your depth in certain items? I mean, how do you -- how do you think that impacts the store environment overall?

David Kornberg -- President and Chief Executive Officer

No, I didn't say basic. I said our core categories. And when I say our core categories, what I mean is the biggest categories within our business, the drivers of our business, the few things that are going to really drive meaningful increases.

Roxanne Meyer -- MKM Partners -- Analyst

Oh, gotcha. Great. Well, thanks a lot.

David Kornberg -- President and Chief Executive Officer

OK. Thank you.

Operator

Thank you. Our next question today is coming from Rebecca Duval from BlueFin Research Partners. Your line is now live.

Rebecca Duval -- BlueFin Research Partners -- Analyst

Good morning. Thanks for taking my question and congratulations on the progress.

David Kornberg -- President and Chief Executive Officer

Thank you. Good morning.

Rebecca Duval -- BlueFin Research Partners -- Analyst

Good morning. I'm wondering how much -- with online being so strong, how much returns are weighing on some of the store's performance in terms of comparable sales? And secondly, along with the stores, you talked about outlet stores being really pleased with the performance there? Is it more of a profitability performance that you're pleased with? Or are you seeing improved traffic at the outlet versus the regular stores?

David Kornberg -- President and Chief Executive Officer

OK. In terms of the online returns, what we've seen is that there is clearly a larger amount of online returns that are affecting the retail store business. We don't break it down in terms of the overall comp, but it is something that has had an effect on the comp from the stores. So as we're seeing it grow aggressively in terms of the amount that we're selling online, we have seen the amount increasing in terms of what's being returned.

Perry Pericleous -- Chief Financial Officer

And one more thing to add to David's comment is that is why we're invigorating our overall comp reporting methodology because right now, being an omnichannel retailer and ability to have ship from store, buy online, pick up in store, being able to alter -- being in store and alter online and the returns that are in -- come to stores, we believe that by using the way that we break out our comps in the future to a more meaningful way is very important. So we're going to provide more update in our overall reporting methodology during our Q3 earnings call.

David Kornberg -- President and Chief Executive Officer

And in terms of your question about the outlets, we have seen obviously a better comp from our factory outlet stores over our regular frontline retail stores. And we have seen slight improvement on traffic going into the stores versus what we've seen going into the retail stores, but we don't break that up.

Rebecca Duval -- BlueFin Research Partners -- Analyst

Thank you. That's very helpful. And I can -- if I could just sneak one quick one in also, David, do you feel good about -- I know you've been working on this as each quarter progresses about where you're positioned now in Q3 in terms of the depth of -- I know you just talked about your key categories. But you had some adjustments from the fourth quarter of last year during the holiday.

So going into the back half, do you feel good about where you are in terms of the depth of the SKUs now?

David Kornberg -- President and Chief Executive Officer

Yes, I do. I feel a lot better about it. And I think that we've really acted on our hindsights from Q4 in terms of the areas of the business that we missed out on them. So I feel good that we've taken the right corrected measures.

Rebecca Duval -- BlueFin Research Partners -- Analyst

Great. Thank you so much, and best of luck.

David Kornberg -- President and Chief Executive Officer

Thank you, Rebecca.

Operator

Thank you. We reached the end of our question-and-answer session. I'd like to turn the floor back over to management for any further or closing comments.

David Kornberg -- President and Chief Executive Officer

Thank you again for joining us this morning. We appreciate your interest in Express and look forward to speaking with you again in late November.

Operator

[Operator signoff]

Duration: 49 minutes

Call Participants:

Marke Rupe -- Vice President, Investor Relations

David Kornberg -- President and Chief Executive Officer

Perry Pericleous -- Chief Financial Officer

Susan Anderson -- B. Riley FBR -- Analyst

Paul Trussell -- Deutsche Bank -- Analyst

Adrienne Yih -- Wolfe Research -- Analyst

Matt Moellering -- Chief Operating Officer

Roxanne Meyer -- MKM Partners -- Analyst

Rebecca Duval -- BlueFin Research Partners -- Analyst

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