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Express Inc (NYSE:EXPR)
Q1 2019 Earnings Call
May 30, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning. My name is Casey, and I will be your conference operator today. At this time, I would like to welcome everyone to the Express, Inc. First Quarter 2019 Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions)

Thank you. Allison Malkin of ICR. You may begin your conference.

Allison Malkin -- Investor Relations

Thank you. Good morning and welcome to our call. I'd like to open by reminding you of the Company's safe harbor provision. 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.

Our comments today will supplement the detailed information provided in both the press release and the investor presentation available on the Company's Investor Relations website. With me today are Matt Moellering, our Interim President and CEO, and Executive Vice President and COO; and Perry Pericleous, Senior Vice President and CFO.

I will now turn the call over to Matt.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Thanks Allison. Good morning, everyone, and thank you for joining us. On today's call, I'll review highlights from the quarter and provide an update on the key priorities we outlined at the start of the year. I will then turn the call over to Perry to discuss our financials in more detail and review our second quarter guidance.

Before we talk about the quarter, I'd like to make a few comments regarding our recent CEO announcement. Last week, our Board of Directors appointed Tim Baxter as CEO of Express effective June 17th. Tim was most recently CEO of Delta Galil Premium Brands, which includes specialty retail brand 7 For All Mankind, Splendid and Ella Moss. Prior to that, Tim spent more than 26 years with Macy's in a variety of roles including Chief Merchandising Officer. As our Chairwoman, Mylle Mangum commented in the press release last week, the Board is very confident in Tim's ability to help us return Express to growth. He is a seasoned retail executive and a strong merchant with expertise in both department stores and specialty retail.

For those of you who don't know Tim, he is very accomplished at building and managing brands and is an expert in brick and mortar and e-commerce. He led the integration of Macy's stores and Macys.com in 2015 and drove record sales and growth for their e-commerce site over the next two years. He also led the merchandising teams at Macy's, Macy's.com, Macy's Backstage off-price concept and Bluemercury. As Chief Merchant at Macy's, Tim oversaw all product categories including many that were among the largest in the US including ready-to-wear, dresses, men's tailored, men's collection, fragrance, handbags, fashion jewelry and shoes. I've met with Tim and I know I speak for the entire team at Express when I say we're all looking forward to working with him.

Now turning to our first quarter results. Our comparable sales and earnings exceeded our guidance. First quarter net sales decreased 6% with negative 7% comparable sales and EPS with a loss of $0.15. As we indicated on our fourth quarter call, we had a soft start to the year. However, the health of the business improved throughout the quarter. We are making significant progress on the implementation of the initiatives we embarked on at the start of the year.

Our retail business, which includes both stores and e-commerce saw a negative 9% comp overall. From a retail product perspective, there were bright spots in our women's business led by casual pants, jackets, dresses and footwear. That said, we continue to see underperformance in tops which we are working aggressively to address. Our men's retail business outperformed women's with comp growth achieved in graphics, denim, casual pants and underwear. We saw negative comps in shirts and accessories. It is important to note that we were able to significantly pull back on promotional activities in the back half of the quarter in both men's and women's, and we'll continue to look for opportunities to pull back on promotions going forward. We believe these actions will position us as a healthier business for top line and bottom line growth in the future. Perry will discuss the composition of our merchandise margins in more detail during his remarks.

I'll now turn to our factory outlet stores which had a negative 2% comp. Within the FO, we saw positive comps in sweaters, jackets, skirts and accessories on the women's side, and positive comps in denim, graphics, dress pants and jackets on the men's side. So the first quarter marked solid progress toward the goal we outlined on our last call. While we are pleased to see the early benefits of our actions, we are obviously not satisfied with our overall results and are aggressively focused on the work that lies ahead to position Express for long-term profitable growth.

As a reminder, we are focused on improving three critical areas of the business in 2019, product, brand and product clarity, and customer acquisition and retention. I will now discuss the progress we are making against each of these and highlight areas of continued opportunity.

First, as it relates to product, we have several initiatives under way to help us make the right changes to our offerings. While we are starting to see progress in this area, we still have work to do to improve the assortment on a consistent basis. We are doubling down on customer insights and applying the learnings to how we make buying decisions and curate our assortment. We have made good progress against this initiative in a short period of time, but still have a significant amount of work to do to ingrain this into all buying and customer experience decisions.

Additionally, we are increasing the quantities of Forward Season small bulk buys versus an assortment of mainly wear and out product. This will help us get a better read on styles and improve our ability to maximize trend-right product during the heart of the selling season. By doing so, we will have more actionable data and be able to improve our markdown efficiency at the end of the season. We have been able to effect a reasonable amount of receipts for late spring which should get us in a better position to react to results in fall. And we're taking action to stabilize our tops trend. In the second quarter, we will get early reads on key items from our fall and holiday tops assortment with some small bulk buys. We are landing an additional assortment test in select stores in August and we expect to increase the percentage of fashion tops versus key items within our assortment to differentiate our offering.

Turning now to our second focus area, brand and product clarity. We've done a lot of work in the past few months to help redefine and clarify our brand positioning. We are now putting this work into action to ensure a consistent brand message across all the customer touch points. We are improving our commercial planning process to ensure we are aligning and focusing customer messages with key fashion trends and brand work each month. We want to have clear and consistent messaging on the most important items across all customer touch points. We have a cross-functional team working on this initiative with the goal of having the new process in place by the end of the summer. We are also optimizing our product portfolio to improve clarity, particularly in our stores. It is important that all products we deliver fit within the Express brand and create a differentiated position for the customer. Where that is not the case, we need to exit these categories.

As an example, we have already made the decision to exit swim and watches. We are also looking at four-step execution in retail stores and how we can make it clear to customers what we believe in, both in our brand message and from a fashion standpoint. This will first impact our July 2019 floorset and should enable more consistent store execution as well.

To summarize the first two focus areas, we are doubling down on customer insights, creating avenues to improve the product, gathering data to make better buying decisions and improving our brand and product clarity.

The third area of focus is customer acquisition and retention, which we are addressing through a combination of analytics, new initiatives, and key partnerships and collaborations. As it relates to customer acquisition, we launched a new marketing mix optimization tool in May and we expect to have actionable output from the model at the end of July which we believe will drive higher returns on our marketing investment starting in the back half of 2019. We are also increasing our focus on growing our social media presence in customer engagement on key platforms. While we have been able to grow our reach on these social media channels over the past few months, we need to do it at an accelerated pace to reach more customers with our consistent focus brand message.

As it relates to customer retention, earlier this month we launched a new first impressions initiative with the goal of reducing 1 in 10 customers from the first 90 days of purchase. We believe this initiative presents the significant opportunity to grow our core customer base. In addition, we remain focused on signing up more customers in our NEXT loyalty program to keep them engaged in the brand longer. This has been successful for us over the past couple of years and will continue to be a focus going forward.

Partnering with key fashion influencers continues to be one of the primary ways we reach new customers and reengage existing ones. Building on the success of our Olivia Culpo collection, earlier this month, we introduced the collection designed with Rocky Barnes, a widely followed fashion model and influencer. We've seen a strong start to this collection both in stores and online, and believe it is helping introduce the brand to a new audience. We will further build on this in July by launching a limited edition collection of apparel designed by Karla Welch, one of the industry's most successful fashion stylists.

For men's, we continue to be pleased with our partnership with the NBA and our Game Changer athletes, who have helped attract new male customers to the brand. This year we will further integrate them into our content and upcoming campaigns. Additionally, the recent launch of NBA-Licensed product has been successful and we'll build on this with additional categories later this year.

Finally, we recently launched a new version of our Express app which is an important retention tool for us. App users are some of the most loyal customers and the new app speeds the shopping process and allows them to explore new content in trends.

In addition to the three focus areas, we also continue to capture the benefits from our systems investments, as well as our disciplined approach to managing expenses. As we have discussed on past calls, the organization is focused on completing the implementation of our new assortment planning software by the end of 2019. We are beginning to benefit from enhanced hindsight and capabilities which significantly improves our ability to analyze current season and historical selling, and we are optimistic about our ability to increase overall inventory productivity with enhanced planning and allocation capabilities next year.

As it relates to expenses, as we have shared previously, we have done a good job executing against our $44 million to $54 million total cost savings target and expect to complete it on plan in 2019. We continue to look for additional cost savings opportunities across the business to ensure we are operating as efficiently as possible without compromising our ability to deliver on our brand promise to our customers.

On the real estate front, we continue to assess our optimal long-term store footprint given the continued convergence between stores and e-commerce. As you know, we have significant lease flexibility with an action date on over 60% of our leases in the next three years. We will provide an update on our real estate strategy and expected fleet rationalization later this year.

In conclusion, we have made significant headway on our focus areas, product, brand and product clarity, and customer acquisition and retention. And while we are certainly not yet where we want to be, we expect to build on this progress throughout the year. Express remains a relevant and resilient brand and continues to represent a solid platform for growth with millions of active customers.

Based on our action plan, we believe we will significantly change the trend of this business and we look forward to Tim joining us next month. The entire leadership team is eager to work collaboratively with him and accelerate our action plan to return Express to profitable growth.

I would now like to turn the call over to Perry.

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

Thank you, Matt. Good morning everyone. I'm going to start by reviewing our first quarter results and then discuss our business outlook. First quarter net sales were $451 million, a 6% decrease as compared to $479 million last year. Comparable sales were negative 7%, with retail comps of negative 9% and outlet comps of negative 2%. As a reminder, our reported retail comp numbers now include retail stores and e-commerce.

Our first quarter gross profit was $123 million. Gross margin was 27.1% in the first quarter, down 280 basis points as compared to the prior year. Merchandise margin contracted by 100 basis points. We were more promotional in the first part of the quarter, but as momentum built in the business, we eliminated significant number of promotions in the latter part of the quarter. The benefit of this was more than offset by quarter-end inventory valuation reserves on slow moving inventory, primarily driven by the reduction in promotional activities in the back half of the quarter. This will help make room for more units heading to fall and we believe it will improve the long-term health of the business.

Looking at buying and occupancy cost. While flat versus last year as a percentage of net sales, B&O deleveraged by 180 basis points due to lower net sales. SG&A expenses were $135 million, down approximately $5 million compared to last year. However as a percentage of sales, SG&A came in at 30%, deleveraging 70 basis points driven by the sales decline. Operating loss was $12 million as compared to last year's operating income of $3 million. First quarter operating loss was negatively impacted by $800,000 related to the new lease accounting standards. However, there was no material impact on our pre-tax loss. In first quarter, loss per share was $0.15 as compared to last year's EPS of $0.01.

Now turning to our balance sheet and cash flow. Our balance sheet remains healthy. Inventory of quarter-end -- inventories of quarter-end were $286 million, a 2.9% increase as compared to last year's $278 million. While inventory growth is above Q2 sales guidance, we're taking aggressive actions to ensure we end Q2 at levels more consistent with our sales expectations. This is reflected in our expected merchandise margin rate.

We ended the first quarter with $144 million of cash and cash equivalents as compared to last year's $185 million. The decline versus last year is primarily due to $72 million of share repurchases over the past 12 months.

Our balance sheet reflect no long-term debt and we recently renewed our $250 million asset base loan facility through 2024. Capital expenditures were $4 million. In terms of our share repurchase program, we purchased 900,000 shares for approximately $5 million during the first quarter. Under our current $150 million share repurchase program, we continue to have $45 million available.

With that, I'll now address our guidance. As we mentioned last quarter, we believe it is appropriate to provide only current quarter sales and earnings guidance at this time. For the second quarter of 2019, we currently expect comparable sales in the range of negative 6% to negative 8%. Net loss in the range of $9 million to $12 million, and loss per diluted share in the range of $0.13 to $0.17, this compared to last year's diluted EPS of $0.03.

For the full year 2019, we currently expect capital expenditures in the range of $37 million to $42 million, and as it relates to real estate activity, we currently are planning 11 retail store closures, four new outlet openings and 27 retail-to-outlet conversions. Thus, we expect 624 stores at year-end, consisting of 409 retail stores and 215 outlet stores. However, based on our earlier comments about our real estate strategy and fleet rationalization, these numbers could change given a number of lease expirations at year-end.

With that said, we're pleased that we improve the health of the business throughout the quarter and we remain highly focused on returning Express to a place of sustainable, profitable growth through our initiatives, aimed at improving product, brand and product clarity, and customer acquisition and retention.

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) And your first question here comes from Susan Anderson with B. Riley FBR. Please go ahead. Your line is open.

Susan Anderson -- B. Riley FBR -- Analyst

Hi, good morning. Thanks for taking my question. Nice to see the improvement in the quarter. Perry, I was wondering if maybe you could talk a little bit -- just give us a little bit more color maybe on the gross margin and SG&A versus your original expectation seem to have come in much better than you originally expected. So just curious, was it all pulling back on promotions for the gross margin or other things going on there? Thanks.

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

Thank you, Susan. So let me start from the gross margin bit. Initially, we had expected a gross margin rate of 430 basis points contraction and it came in at 280 basis points contraction compared to the initial expectation, that is better by 150 basis points. So that improvement compared to the initial expectation is driven by MMU of about 80 basis points. Denim improvement came from less promos than initially anticipated and planned for the quarter as we saw the quarter progress and we saw the improvement in the trends of the business.

From a B&O standpoint, we had initially guided for a contraction or a deleverage of 250 basis points and we came out only 180 basis points, an improvement there of 70 basis points. That was driven by the fact that initially we had guided to a negative 9% to negative 11% comp and we came in at a negative 7%. So with a improvement in the overall comp for the business, we're able to leverage the fixed cost. From a B&O standpoint, the expenses came in in line where we initially expected them.

And as it relates to your last question around SG&A. The SG&A improvement came by the improvements in terms of the comp, as well as we're able to pull back on some expenses in -- for the quarter.

Susan Anderson -- B. Riley FBR -- Analyst

Got it. That's really helpful. Thanks for all those details. And then maybe just one follow-up. Matt, you talked a little bit about the touch, read, react strategy. I know Express has always been known for their touch, read, react strategy. So I guess I was think kind of curious maybe if you could talk a little bit how it's changed over the years and what you're doing now differently versus what you had done historically or maybe even just last year? Thanks.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Sure. The one big thing that we're changing with that strategy is we're effectively bringing in more forward season goods early in small bulk quantities and it's important to note small bulk quantities. So we did some of that last year, we've accelerated that this year. So when you get into, as an example, June and July, we want to have some fall receipts and small bulk quantities across the chain delivered to the stores. We're not going to sell a lot of those products, but it gives us invaluable information to quickly react to things that are working based on historical results comparing them to historical results, to then aggressively chase the items that are resonating with the customer, so that when you get into September and October you have that product in the store in large bulk quantities during the heart of the selling season.

In the past with wear now and we got moved more toward wear-now, what would happen is by the time you got your results in late July in the August, by the time we react it to those, you were into mid to late November by the time they reach the stores and at that point you're selling with $0.50 on the $1. So we want to get the great product in earlier and if the small bulk quantities coming in June, July are not the right ones, number one is small bulk quantities, number two you still have six months to get through that product throughout the season. So you have plenty of time to glide path any of the product that's not working. So we believe this is a much better strategy for us from the perspective of getting customer information and then reacting quicker to reads.

Susan Anderson -- B. Riley FBR -- Analyst

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

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Thank you.

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

Thank you.

Operator

Your next question comes from Janet Kloppenburg with JJK Research. Please go ahead. Your line is open.

Janet Kloppenburg -- JJK Research -- Analyst

Good morning everyone.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Good morning Janet.

Janet Kloppenburg -- JJK Research -- Analyst

Hi. How are you?

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Great.

Janet Kloppenburg -- JJK Research -- Analyst

I just -- I have a couple of questions. On the inventory content if you feel like the investments by category are better aligned for the second quarter and therefore perhaps you could see further improvement in the business? And also the levels seem a little high Perry as compared to your comp guidance, maybe you could talk about clearance levels year-over-year and where you expect them to be at the end of the quarter?

And Matt, I got on a little late, so you may have talked about this, but we're hearing that early May trends or mid-May trends have been challenging. And I was just wondering if you could address that or have -- if you did address that for us? Thank you.

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

Janet, I'll take the part of the question on the inventory. While our inventory grows, if you look at the (technical difficulty) it's above the Q2 comp guidance. We have taken aggressive actions and that was at the beginning of Q1. To ensure that as we enter Q3, our levels of inventory will be more consistent with our sales expectation. So specifically what we have done in early parts of Q1, we started looking at the receipts and pulling back on receipts in Q2 and at the same time we have contemplated the appropriate level of promotions in the Q2 guidance to ensure that we get into the right level. These promotions are already reflected in the overall merchandise margin contraction that we're planning for Q2.

Janet Kloppenburg -- JJK Research -- Analyst

Shall we think the inventories will be in good shape -- the inventories should be in good shape then at the end of -- at the end of...

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah, they will be in a better shape than what they have been for Feb BOM and May BOM. It will be more in alignment with the expected sales for Q3.

Janet Kloppenburg -- JJK Research -- Analyst

Thank you.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

And then Janet to your second question on May trends. As you know, we don't comment on monthly activity. What I will say is, our comp guidance does contemplate trends to-date as well as what we're projected to do for the rest of the quarter. What I will say is that we mentioned on the -- in the remarks that we have pulled off a significant number of promotions in the back half of the quarter for Q1 and we have continued to do that into Q2 as well. What we're trying to do is opportunistically pull off some of the unhealthy promotions that are layered into the business. Obviously that will help us from a margin perspective over time as we rightsize our inventory to create a clear value proposition for the customer and it gives us an ability to focus the customer message on actual key fashion messages and our differentiated brand position versus simply sending out communications on promotional activities. That being said, I understand this is retail and we're managing day-to-day. So we're going to opportunistically pull off where we can.

Janet Kloppenburg -- JJK Research -- Analyst

Thanks. And one more if that's OK.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Sure.

Janet Kloppenburg -- JJK Research -- Analyst

In April, could we assume that comps turn positive and maybe you could give us some outlook on the top business and how progress was made -- if progress was made there in April, maybe some thoughts on the denim category and what opportunity might lie for that business from a macroscopic (ph) area? Thank you.

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

So Janet when you look at the comps overall we had seen sequential improvements going from Q1 into the back half of the quarter. April specifically was positively impacted by the Easter shift as well as the overall trends of the business. I cannot really comment in terms of the specific numbers on the comps.

Janet Kloppenburg -- JJK Research -- Analyst

Okay. Thank you.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

And then Janet from a tops perspective, the good news is tops on the women's side we called out for a couple of quarters now is something that needs to be aggressively addressed. We are -- as I mentioned in my remarks, we are putting an optimal assortment test in place for July August time period to try to reset the tops business, particularly the casual knit tops, dressy knit tops and the dressy woven tops business. So we are taking action to recraft what that offering looks like. That being said, particularly on the casual mid side, while we're not positive, we're starting to see a little traction in the last month or so in the casual knit top business which is encouraging.

Janet Kloppenburg -- JJK Research -- Analyst

And on denim?

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Denim, from a back to school standpoint, we're -- I'm not going to go into detail on our back to school strategy at this point for competitive reasons, but we continue to focus on denim. And as you know, we have denim perfect out there in our offering that we continue to focus on to try to drive that business as well.

Janet Kloppenburg -- JJK Research -- Analyst

Thanks so much. Good luck.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Thank you.

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

Thank you.

Operator

(Operator Instructions). Your next question comes from Marni Shapiro with Retail Tracker. Please go ahead. Your line is open.

Marni Shapiro -- The Retail Tracker -- Analyst

Hey guys. Congratulations on Tim. I'm looking forward to working with him. Can you give a little bit of insight just, you know we've talked about the women's tops business for a while. I think that you guys mentioned about including some more fashion. I guess, is this true in the wear-to-work area, as well as on the casual knit side, because on the wear-to-work area historically Express has had these very big powerful hits, the Portofino and things like that. So how should we think about that commentary around that part of the business versus the casual side of the business?

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Yeah. 100% it's both on the casual and the dressy side of the business. What we do know is, we are seeing customers voting for new silhouettes, both on the woven top and the casual knit side of the business. And frankly, one of the things that we are now focusing on is more fabric diversification. I think we've gotten a little too one-toned from a fabrication standpoint and we are doing a lot more work around R&D around fabrications, particularly on the casual mid top side but also on the dressy side to create some additional texture within the assortment and to create some more interest in the business. So there's a number of things we are doing. What is critical for us is that we still need the key item drivers for sure in the tops business. But over the past a year or so, we have gotten a little too one-toned with the key item drivers focused -- relying too heavily on that without having the fashion component to go along with that that creates interest and newness in the customer's eyes. So we're trying to balance the two of those together to create a more interesting assortment for the customer.

Marni Shapiro -- The Retail Tracker -- Analyst

And have you seen the customer move more quickly on the bottom side. You have a lot of focus on the higher rise, a lot of waist high details in your store. Have you seen the customer gravitate toward that fashion on the bottom side that's giving you read-through to where you're missing it on the top side?

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Yes definitely. On the bottom side, particularly in dressy pants, the silhouette changes have been significant which gives the customer a reason to come into the store to buy for sure, also on the denim side we're seeing some of that as well. And obviously when the bottoms silhouettes change that also impacts the top silhouettes and we need to capitalize on that more than we are today.

Marni Shapiro -- The Retail Tracker -- Analyst

Fantastic, Matt, I have to say it, is quite the moment when I hear you talking about silhouette changes.

Matt Moellering

Not helping at all, right.

Janet Kloppenburg -- JJK Research -- Analyst

Best of luck for the second quarter.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

That's right. Thank you. Appreciate it.

Operator

Your next question comes from Adrienne Yih with Wolfe Research. Please go ahead. Your line is open.

Adrienne Yih -- Wolfe Research -- Analyst

Hi everybody. Good morning. I got a little bit late so forgive me if you've already addressed this, but can you talk about your direct exposure to China sourcing that may have already been covered. And then secondarily, inventory plans for the back half of the year sort of particularly from units and then Perry if you can talk about average unit cost associated with those sales out there? Thank you.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Sure. Thank you Adrienne. So I'll take the tariff question and Perry can handle the other questions. Obviously, our Q2 guidance reflects the impact of the tariffs. Longer-term, we are aggressively working to minimize our exposure to China. So there's two things we're doing right as we speak. One is working with our sourcing partners to share the impact of any tariff -- of the tariffs through cost reductions first and foremost. And the second thing we are doing is reducing our China sourcing footprint. So three years ago, we were approximately -- we had approximately 40% of our source units coming from China. This year we're just slightly over 20% of our units from China and we're targeting getting that down to 8% to 9% of the units by the middle of next year. So we continue to aggressively look for alternative sources, but obviously as you know that is not possible in the shorter term in certain categories but overall we are going to continue to reduce our footprint there and we feel like we're in a pretty good place. Perry, you want to take?

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. So Adrienne, on the inventory, you had a two part question on the inventory. One is the inventory levels in the back half of the year. And as we look at that, we haven't provided comments on the back half of the year but we have some other comments around the inventory expectation going to August BOM and it's going to be in a better shape and more in line and consistent with our sales expectations going to Q3. So throughout Q2, we're going to continue to manage the inventory levels to get them in more appropriate levels. That's one.

From an EU system point for the back half of the year, again, we haven't given any guidance for Q3 and Q4 in terms of merchandise margins or any of the implications around the China tariffs. So bearing the China tarrifs, we expect our AUC to continue to be fairly consistent to last year. And again this is excluding any of the implications of the China tariffs.

Adrienne Yih -- Wolfe Research -- Analyst

Right. Okay.

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

We're going to provide more color as we get into Q3 and Q4 around that.

Adrienne Yih -- Wolfe Research -- Analyst

Okay that's very helpful. Yeah it's nice to see those sales bouncing back Matt. Can you also talk about some of these alternative programs that you're offering in particular the rental program that was instituted I think during the -- it started during the first quarter if I recall correctly?

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Yes. So we actually launched that program in early October of last year. So it's -- and it's focused on the women's side of the business. Basically what I would say about that, from a percentage standpoint, it is -- percentage growth standpoint, it's growing very rapidly but it is a very, very small piece of the business. So it's not really registering in total at this point in time, but it's big growth on a very, very small number. So we're continuing with the offering and -- but at this point, it's not a needle mover for us.

Adrienne Yih -- Wolfe Research -- Analyst

Okay. Okay very well. Thank you very much and best of luck.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Thank you very much.

Operator

And there are no further questions in queue at this time. I will turn the call back over to Matt Moellering for closing remarks.

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Great. Thank you and -- so thank you for joining us this morning and we look forward to updating you on our progress again next quarter.

Operator

And ladies and gentlemen, this concludes today's conference call. You may now disconnect.

Duration: 0 minutes

Call participants:

Allison Malkin -- Investor Relations

Matthew C. Moellering -- Interim Chief Executive Officer and Interim President and Executive Vice President, Chief Operating

Periclis V. Pericleous -- Senior Vice President, Chief Financial Officer and Treasurer

Matt Moellering

Susan Anderson -- B. Riley FBR -- Analyst

Janet Kloppenburg -- JJK Research -- Analyst

Marni Shapiro -- The Retail Tracker -- Analyst

Adrienne Yih -- Wolfe Research -- Analyst

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