American Eagle Outfitters, Inc. (NYSE:AEO) Q3 2020 Results Earnings Conference Call November 24, 2020 4:15 PM ET

Company Participants

Judy Meehan - Vice President, Investor Relations
Jay Schottenstein - Executive Chairman and CEO
Jen Foyle - Chief Creative Officer, AEO, Inc. and Aerie Global Brand President
Michael Rempell - Chief Operating Officer
Mike Mathias - Chief Financial Officer
Chad Kessler - AE Global Brand President

Conference Call Participants

Janine Stichter - Jefferies
Oliver Chen - Cowen
Jay Sole - UBS
Matthew Boss - JP Morgan
Paul Lejuez - Citi
Adrienne Yih - Barclays
David Buckley - Bank of America
Laura Champine - Loop Capital Markets
Kate Fitzsimons - RBC Capital Markets
Susan Anderson - B. Riley
Janet Kloppenburg - JJK Research

Operator

Greetings. And welcome to American Eagle Outfitters Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]

Please note, this conference is being recorded. I would now like to turn the conference over to your host, Judy Meehan, Vice President of Investor Relations. Thank you. You may begin.

Judy Meehan

Good afternoon, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Executive Chairman and Chief Executive Officer; Jen Foyle, Chief Creative Officer for AEO, Inc. and Aerie Global Brand President; Michael Rempell, Chief Operating Officer; and Mike Mathias, Chief Financial Officer. In addition, Chad Kessler, AE Global Brand President will be available during the question-and-answer session.

Before we begin today’s call, I need to remind you that we will make certain forward-looking statements. These statements are based upon information that represents the company’s current expectations or beliefs. The results actually realized may differ materially based on risk factors included in our SEC filings.

The company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

Also, please note that during this call and in the accompanying press release, certain financial metrics are presented on both the GAAP and non-GAAP adjusted basis. Reconciliations of adjusted results to the GAAP results are available in the tables attached to the earnings release, which is posted on our website at www.aeo-inc.com in the Investor Relations section. Here you can also find the third quarter investor presentation.

And now, I’d like to turn the call over to Jay.

Jay Schottenstein

Thanks, Judy, and good afternoon, everyone. I hope all of you are well and staying safe. I am very pleased with our third quarter performance, especially in the midst of the pandemic. Earlier this year, we were not expected to deliver these results and have over $1 billion of liquidity entering the fourth quarter. This was due to operating discipline, as well as much credit to the incredible teamwork across our company.

In the third quarter, we produced our best gross margin in some years and our adjusted operating income was flat to last year. Despite numerous headwinds related to COVID, we saw stronger full price selling and had limited promotional activity, leading to a meaningful increase in merchandise margin. This is a testament to the strength of our brands and our product, as well as our disciplined inventory management.

I am extremely proud of the team for their brilliant execution and ability to deliver these results while working remotely. Our approach to the policies was go on offense and play to win. That approach paid off.

Aerie extended its incredible track record of growth with a 34% increase in revenue and record profits. And AE merchandise assortment were well received and product margins improved. I am very pleased to see continued growth in our core businesses such as jeans and bottoms. I am encouraged by early improvements in areas we are looking to strengthen. When we offer great product and customer’s experiences, our customers respond and that’s our focus.

The digital channel excelled and we were successful delivering our customer promise with strong fulfillment and timely deliveries. The investments we have made over the past several years to vastly expand our omnichannel capabilities are having a meaningful impact on our business. Although, stores were impacted by negative mall traffic, we continued to outpace the mall with very strong conversion.

Our stores once again led the industry with very best health and safety measures ensuring the comfort and confidence of our customers and associates. I am very proud of how all AEO associates showed up during this crisis.

Back in March we established three near term priorities protecting our people, preserving cash and preparing for a new future. With the crisis ongoing, we remain focused on these areas. Our people are always our top priority. We continue to invest and explore new tools and technologies to make sure we offer the best measures to keep our associates and customers safe.

Thanks to efforts across the organization we quickly took steps to secure our financial health. Today AEO is among the select group of retail companies with financial strength, where we combine excellent financial with strong brands, leading operational capabilities and exceptional products. We have a winning formula for future success.

As I look ahead I am very optimistic. This past year has made our company stronger and better positioned for future growth. I have been leading AEO for many years I see more opportunities for our business today than ever before. Regarding holiday we are pleased with early trends. Yes there is significant business ahead of us.

As you will hear from the team, we are positioned, and ready to serve our customers, however, and whatever they choose to shop. We look forward to unveiling our longer term growth plans on January 21st. More details on the meeting will be provided in the upcoming weeks. In the meantime I hope everyone has a great holiday season and please stay safe.

With that, I will pass the call to Jen.

Jen Foyle

Thanks, Jay, and good afternoon. I hope everyone is safe and well. 2020 has certainly been an exceptional year for the Aerie brand. I am thrilled to report another strong quarter. Aerie posted a 34% increase in revenue during the third quarter. This is built on a 26% increase last year and marked the 24th consecutive quarter of double-digit growth.

Our momentum is outstanding and we are truly grateful for our customers and how they embrace Aerie throughout this crisis. Although, mall traffic continues to be a challenge, we are seeing a meaningful acceleration online. Aerie’s digital revenue increased rose 83% from last year and stores were up modestly. Across the Board our metrics were positive.

The AUR was particularly strong as we were significantly less promotional. Merchandise margins expanded from last year and Aerie saw a meaningful improvement in overall profitability, which hit record levels fueled by strong growth.

Customer acquisitions were up 15% in total and 62% in our digital channel. We continued to engage with our customers through social media and grassroots efforts to build the community of Aerie’s loyalist. In fact, we had some of our most incredible brand momentum on TikTok, which fuels demand and brings new customers to Aerie.

Across the Board our key categories rose in the double digits, with higher merchandised margins. I am thrilled to report that our new OFFLINE active wear brand has had an incredible debut. In October we opened our first store with a very strong customer response and now we have four stops up and running.

OFFLINE offers something unique, and different in an exciting growing category and has a big opportunity ahead of it. I can’t wait to share more details on our future plans for both Aerie and OFFLINE in January.

Aerie’s success comes down to our amazing team. To call our associates passionate is an understatement, and their loyalty and devotion to our Aerie real movement and our customers are truly remarkable. Thanks for all you do and what you stand for everyday.

Now moving on to American Eagle. The third quarter demonstrated an improvement from the first half of the year. Keep in mind, AE has a much higher store penetration than Aerie, so weak mall traffic related to COVID was a larger headwind.

On the other hand, AE’s digital channel was strong with positive brand AURs. Customer engagement was up and new digital acquisitions rose 23%. Our focus on inventory optimization and profit improvement is showing results.

We are particularly pleased and very encouraged by the strong merchandise margin, which was our best in several years. Promotional activity was well-controlled and full price selling increased across the business.

We continue to see really good demand in our leading jeans and bottoms businesses. As you know we have built an amazing franchise in AE jeans, which is an incredibly sticky category that fuels loyalty and customer retention. This business remains a priority and we continue to innovate, and invest in the category. I could not be more excited about the future as consumers increasingly embrace a casual and comfy lifestyle that plays into our strength.

We have been encouraged by recent improvements in our tops where we introduced better styles and fabrics this fall, and we will continue to build on the success as we move into spring and 2021.

We are working to enhance the quality, and create more emotional connections with our collection and a stronger point of view supported by inspiration marketing that directly ties back to the product.

We will win by refocusing on key items, but conviction while eliminating unproductive styles that do not generate strong returns. We are excited about holiday and we are ready. We feel really good about the reception to the product line and continue to move our marketing efforts forward.

In the early fourth quarter, AE launched a new product collection in partnership with Disney that’s in stores now. This collaboration unites two iconic brand equities in a unique and fun way, and customer reception has been fantastic. The capital was selling quickly and we are seeing significant engagement on TikTok.

As you know I began working more closely with the AE brand this past quarter than I have in the past. My big takeaway is that I could not be more impressed with the enthusiasm and talent across this team. There is so much exciting work in progress across marketing, products and customer experiences, and we cannot wait to share that with you in the coming quarters.

I want to thank Chad and Craig, along with the entire AE team for their endless creativity and commitment to our customer. I am very excited about our new initiatives and AE’s future and success.

With that, I will pass it on to Michael.

Michael Rempell

Thanks, Jen, and good afternoon, everyone. I would like to begin by thanking our associates and partners around the globe. Our business has bounced back much more quickly than anticipated and the credit goes to the dedication and hard work of our teams and partners.

The digital channel remains strong this quarter increasing 29% to last year. Aerie’s digital sales increased 83% and AE was up 11%. Even with all the stores open, our digital demand remained well ahead of our pre-pandemic trend.

Online sales represented 37% of our revenues in the quarter and 45% for the year-to-date. Channel KPIs were positive across the board led by double-digit traffic, conversion and transaction growth.

Third quarter digital channel margins were strong, as we reduced promotions, and maintained discipline pricing resulting in higher AURs and an increase in the basket size. As we noted last quarter, we reduced online choice counts as part of our inventory optimization strategy aimed at driving higher margins. Our third quarter results reflect this strategy and we see meaningful opportunity for additional progress moving forward.

Outside of North America, we continue to expand our international e-commerce business in licensed markets. In the third quarter, we further extended our digital footprint by launching local shopping sites in Brazil, Israel, Russia, South Korea and Turkey, building on our previously discussed market entry activity in the second quarter.

It remains early days for our digital business in many of these regions, but we are very pleased with the initial customer response and we continue to see sizable great opportunity in international markets.

In the quarter, our store channel also performed well in this still challenging environment, which included continued reduced operating hours and capacity restrictions, but health and safety remained a top priority. Store revenue decreased 16% as positive AUR and conversion were offset by traffic declines. As with the digital channel, we saw improved merchandise margin in stores.

Across channels, we continued to strengthen our customer engagement. Average customer spend rose and digital channel customer acquisitions increased 37%. Last quarter we successfully brought our loyalty program in house for the first time. This enables new capabilities with richer customer insights and greater flexibility in administrating the program.

As part of this initiative we also re-launched a new reward system designed to activate a wider range of customers by providing more frequent benefits. We are seeing very strong results from the change including better redemption rates, higher transaction value and improved margins. We have accelerated our focus on new technologies to further enhance the customer shopping experience.

Earlier this year we accelerated omnichannel shopping tools, including BOPUS and curbside pickup. In recent weeks we have been down testing self checkout in stores and same day delivery for online orders. We have also improved the paid loads speed on our website by 60% and taken steps to ensure our site can handle significant higher holiday peak transaction volumes.

Our distribution and fulfillment network is also running very well and we are prepared for continued growth in the high volumes we expect this holiday season. The four new distribution hubs have increased our overall fulfillment capacity, which will enable us to support growing digital demand.

This decentralized fulfillment network also means our inventory will be located closer to customers and stores, which has many advantages. Our customer delivery speed and our ability to replenish stores will be much quicker.

In fact, we will be able to fulfill approximately 400 store locations within one day and 900 within two days. In total, these capabilities will enable us to provide better customer service, while reducing the inventory in our network, optimizing shipment flows to manage delivery cost pressures and maximizing our operating flexibility.

Our organization has been planning for an unprecedented holiday for eight months and we are well-positioned to succeed. As you heard from Jen, our creative and operational teams have collaborated on very strong holiday assortments for AE and Aerie, including improvements to some of our key items. We are also prepared to manage the unique operational challenges this holiday season will present and our teams are ready to serve our customers whenever, wherever and however they would like.

In closing, we are very pleased with our third quarter results. We entered the fourth quarter in a position of strength. I hope everyone enjoys the holidays and I look forward to speaking to you early next year.

With that, I will pass the call over to Mike.

Mike Mathias

Thanks, Michael. Good afternoon, everyone. Despite ongoing headwinds from COVID 19, our third quarter results demonstrated meaningful sequential progress from the second quarter and exceeded our expectations.

The start for the quarter in August was challenging due to the late back-to-school demand, but as expected demand flattened and shifted post-Labor Day resulting in positive results in September and October.

Adjusted operating income was flat to last year reaching $103 million reflecting a 10% operating margin. The environment improved from the first half in our business further benefited from compelling products and strong cross channel execution.

Additionally, I am particularly pleased to see good progress on our inventory optimization work, which led to a significantly higher merchandise margin in the quarter. Our teams continued to perform at the highest level and have set our business up for near-term and long-term success.

Total company revenue declined 3% to last year, reflecting mall traffic declines related to COVID-19 offset by strong online sales. Mall traffic pressure had a greater impact on the AE brand given its larger store base. Traffic at both AE and Aerie outpaced the mall and our store teams executed exceptionally well, driving significantly higher customer conversion and average transaction value.

Gross profit dollars increased $8 million or 2% to last year and gross margin expanded 200 basis points to 40.2%. This is our highest gross margin rate in several years.

Inventory optimization initiatives, combined with a positive reception to our product assortment led to higher full price selling and lower promotional activity in the quarter. Lower product cost also contributed to a favorable merchandise margin.

Rent leveraged due to the impact of impairments taken recent quarters, as well as negotiations with landlords. This was partly offset by delivery and distribution center cost pressure due to the increased digital shipment volume and higher cost per shipment.

SG&A expense increased 6% due to higher incentive compensation. SG&A would have declined in the absence of incentives as we managed other controllable expenses tightly, including services, professional fees, store labor and advertising. Our store labor savings versus last year were more modest in the first half as the majority of our fleet was open for the entire quarter.

Our effective tax rate was 35%, primarily reflecting a true-up to our expected full rate due to better operating performance, including the impact of the anticipated benefits from the CARES Act. The higher tax rate represented a $0.07 EPS headwind relative to last year.

Our share count was 184 million and included 16 million shares of unrealized dilution associated with our convertible notes.

Adjusted operating income of $103 million was flat to last year, excluded from this result the $7 million in pretax incremental COVID-19 expenses and restructuring charges.

Adjusted net income was $0.35 per share in the quarter and excluded $0.02 of COVID-19 expenses and restructuring charges and $0.01 related to non-cash interest on the company’s convertible notes.

The adjusted earnings per share declined to last year reflected our higher tax rate, as well as higher net interest expense and diluted shares outstanding related to convertible debt.

We continue to manage inventory well with our quarter end position down 13%, reflecting reductions in American Eagle, as a focus on inventory optimization and to streamline assortments, reduce unproductive SKUs and achieve better alignment with our sales plans. Aerie inventory increased to support strong demand and we continued to use the strength of our sourcing organization to chase in to demand. As I have indicated inventory optimization is an ongoing priority and I believe we will have a material effect on profit improvements over the next several years.

During the quarter we repaid the remaining $200 million outstanding under our revolving credit facility and ended the period with $692 million in cash and short-term investments. Our total available liquidity, including our undrawn revolver is over $1 billion. Our only debt currently outstanding is our $415 million convertible note issuance.

We are very pleased with our success in preserving liquidity and balance sheet strength during 2020. This will remain our capital allocation priority in the near-term given ongoing external uncertainty. As business visibility continues to improve, our objective is to resume direct returns to shareholders through our long-term cash dividend program supplemented by buybacks.

We continue to expect full year capital expenditures of $100 million to $125 million in 2020 down from $210 million last year. Year-to-date capital expenditures of $93 million are down from $150 million in the first three quarters of 2019.

As discussed on previous calls, we are actively evaluating our store fleet for closures over the next several years. We plan to close at least 50 locations this year. These stores have been selected based on their lease tenure, mall profile, proximity to other stores and customer engagement levels.

We are confident we will see healthy sales and customer transfer from these locations and learning’s from these closures will inform our plans for 2021 and beyond. You will hear more about our store strategy at our Investor meeting.

Now as we look forward, we are prepared for the holiday season. We have strong plans in place and are ready for the anticipated shift in business, including a higher mix of online transactions and demand that has spread out over a more extended timeframe.

In fact, we are already seeing holiday demand take place in November. Our inventory is well managed and we expect continued AUR improvement and healthy merchandise margins. With more online shopping we expect distribution center and delivery cost to increase and we expect SG&A to increase relative to last year.

In closing, we made great progress in the third quarter. We strengthened our financial position, while also laying the groundwork for our longer-term growth opportunities. We look forward to providing more details on our multiyear plan and long-term financial targets in January.

With that, we can open the call up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] our first question comes from the line of Janine Stichter with Jefferies. Please proceed with your question.

Janine Stichter

Hi. Thanks so much for taking my question and congrats on the progress. Great to see the lower markdown control and the inventory control. I guess I am wondering how you are thinking about planning your inventory into spring just given what is still pretty challenging invisibly and then you learned from what seems to be a reduction SKU count. How you are thinking about your investment in SKUs for the core Eagle brand? Thank you.

Jen Foyle

I can take that Janine. So, I think, we have learned a lot about in the back of this year related to inventory optimization in terms of our positioning of inventory to sales and then our expectations of merchandise margin expansion in relationship to sales as well.

We are continuing to plan inventory conservatively into the spring season. We don’t believe -- I think we all know that the impact of the pandemic is not completely behind us. We expect definitely some headwind there through the rest of the winter here and in to Q1.

So we are definitely still planning inventory down in relationship to our sales expectations with really similar range to what we are seeing today, even our third quarter ending inventory being down 13% related to our -- in relationship to our down 3% sales as we head into the spring season it’s a similar relationship that we are planning.

Janine Stichter

Okay. Great. And then maybe just a follow-up on SG&A, is the range of increase expected to be similar to what it was in 3Q and is the main driver there still incentive comp or is there anything else we should think about?

Jen Foyle

No. We are expecting very similar SG&A performance and incentives would still be the driver of what was a 6% increase in the third quarter similar mid-single digits increases what we are expecting, incentives would be the driver. The only other uncertainty there is exactly how revenue comes to us by channel, which it will be variable nature to SG&A based on that outcome as well.

Janine Stichter

All right. Thanks so much. Best of luck for holiday.

Jen Foyle

Thank you.

Operator

Our next question comes from the line of Oliver Chen with Cowen. Please proceed with your question.

Oliver Chen

Hi. Nice quarter. Jay, we had a question for you. We were curious about your thoughts on the future of the mall as you look across retail and what you have seen and what you expect in the future, particularly as you think about higher productivity malls in American Eagle locations versus lower productivities and what kinds of transformations may need to happen in store? But also just love your take as you rapidly have many different strategic priorities in reinventing the store experience at large. What’s happened with the pandemic that has been your biggest changes in those priorities? Thank you.

Jay Schottenstein

Okay. First of all, 60% of our locations come up in the next 12 months to 24 months. It gives us a lot of flexibility. Right now in a mall that key to the customer experiences given the safe shopping environment.

One thing we are very proud of is when we reopen our stores we make sure there was enough social distancing. This was not emphasized on the call yet. But if you look at the inventory levels at the store, our inventory maybe down 13%, but the American Eagle stores are down 30 plus% at the store level

So these stores have been performing very well considering they have 30% less inventory choice in the store. Look the pandemic is and if you have the right merchandise and its right at sales. We have items that are just blowing off the shelves right now. We wish we had more certain items that are going hot right now. So I think it’s really given its focus on the special programs and really drive it that way to the business.

Look, as far as the customers go, we are going to want to go out and shop. People are shopping to get out, every one -- you could see what’s happening right now, the government is telling people CDC don’t travel on airlines like a record amount. We just pray that everyone stays safe this week. We pray that people practice social distancing when they are traveling and that they don’t spread it anymore.

But at the same time, we are very optimistic with the vaccine on the horizon. I believe the next few weeks we will start giving the vaccine out. And my personal gut is in the next by the late winter, early spring things are going to be starting to coming back on to normal.

At that same time, the customers when they come back into the malls on a regular basis they don’t want to have experiences and they want to be excited when they go shop too. They are going to be looking for sharp merchandise. They are going to be looking at sharp looking stores.

And one thing is that through this whole time I am very proud of our team as that we haven’t stopped. I mean our store operations people -- our store designers we are challenging them to say what the stores will look like in the springtime, what are the things we have to add.

And then for the merchandize side our designers it was amazing that through all this pandemic back in April everything was shut down. Our designers were still designing. They were doing it via Zoom, by remote, it was amazing, the product, the fabrics that we were able to develop around the world without being able to travel it spoke volumes about our jeans.

So I am very proud of my team. They have done a great job. They are keeping the product fresh. I think one day we will be proud you if you walk in our store you see fresh merchandize and you see new stuff and you see exciting stuff and between Jen and Chad they have done a great job there.

Oliver Chen

Thanks, Jay. Very helpful. Best regards.

Jay Schottenstein

Thank you.

Operator

Our next question comes from the line of Jay Sole with UBS. Please proceed with your question.

Jay Sole

Great. Thanks so much. My question is on merchandise margins and Aerie versus American Eagle right now. How did those trend during the quarter compared to last year and how do they compare to each other? And then secondly, is it possible to give it just a little bit more color on what you have seen in November month-to-date, may be compare to what you saw in October? Thank you.

Jen Foyle

Yeah. Just setting up against what you have heard, we have done an incredible job managing our inventory and that was a priority, while maximizing growth in Aerie. Certainly, as you can see we are near that $1 billion mark. We are really excited about it. This team planned to hit $1 billion by the end of 2020 and its right in front of us. So we are really excited about Aerie.

But going back we did it with integrity and not over assorting and in both brands. So AE did one of heck of a job managing inventory and keep up stores. And I will tell you, just kudos to the store team they leveraged the hell out of Q3. When a customer enters that door, they were greeted, they we are safe and we converted those customers. So I couldn’t be more proud of the AE team.

That said, just shorter answer, Aerie margins were right in line, merch margins were in line with AE, which were best in show in years so and you have heard the flow through numbers. So, we are right in line. The work we have done in Aerie are AUR’s are at an all time high, same for AE and we are going to continue that progress.

Our focus as we head into the next year into next year is going to be quality over quantity so we can compete on our own terms and really design and develop and innovate the best products out there in the mall. Did I answer both of your questions by the way? I got little excited about the $1 billion mark.

Jay Sole

Definitely. If you could hear a little about November month today and certainly I will get back to the queue.

Jen Foyle

Okay. November -- okay. We are here. Okay. So November, we have actually seen acceleration on the numbers that we just quoted in Q3. I am sure there’s some pull-forward, you see all of our competition and the big price the Amazon’s of the world, people are pulling their promotions in their lead there could be some shipping constraints.

Well, I have to say, you heard from Michael Rempell, our operations are best in interest. We spent there and we are seeing the rewards. It’s amazing. I tested every -- you name it, I tested every competition and let me tell you, every competitor including Amazon and I have seen great results on our shipping and our time to the doors.

So that’s been a priority of ours, and I will say, just the inventory management -- on the inventory management and our ability to move those units where we are selling them, he wasn’t kidding we are really thrilled about it.

So, look we had some huge hurdles ahead of us, Black Friday is not here yet, we have a couple of big weeks in front of us, who knows with COVID certainly fingers crossed we hope that this pandemic ends and that our teamwork’s, so we have to be very cautious where we place our inventories, but I think we are in a position to come from a point of strength.

Jay Sole

Got it. Thank you so much.

Operator

Our next question comes from the line of Matthew Boss with JP Morgan. Proceed with your question.

Matthew Boss

Great. Thanks and congrats on the improvement. So, maybe first question, can you just keep customer acquisition trends that you are seeing that there are initiatives in place to retain new customer’s post the pandemic? And Jen, what do you see as the opportunity to leverage assortment synergies at the American Eagle brand, maybe just from a high level, as you dig in?

Jen Foyle

Yeah. So customer acquisition continues to be double-digit. We are in about the 15% zone. So, we continue to get new customers in our door and retention is top of mind. I like what we are seeing though. Based on some of our new product offerings, including OFFLINE, we are starting to see a little hedge towards an older customer.

So she’s liking some of the versatility with our product offerings and we are going to continue to focus on that as we build the OFFLINE assortments and make sure that we are growing in Aerie the lounge our intimate space and building on that as we open up OFFLINE stores.

I will tell you in same malls, we are seeing pure incrementality. So again in a mall where we opened up in OFFLINE, in Aerie we are seeing similar results as far as cost on the Aerie side and then pure growth on the OFFLINE side.

So I couldn’t be more thrilled with the results and we are going to continue to make sure that we are massaging those investments and the offerings in both categories, so we can really leverage the opportunity, it’s a $16 billion opportunity on the OFFLINE side and I think we are going to show up in such a unique way and I am really excited there’s lots of good things in store on OFFLINE and for Aerie too.

As far as looking at the broader assortments with AE and Aerie, I love looking and I said, right, so we have the ability now to really share our learning’s on both sides, but really focusing on what we do best. The results in denim were nothing far from unbelievable in Q3 when really September opened up.

They just continue to innovate there our new cozy jean that we just offered for holiday. The timing couldn’t have been more perfect. It’s really seeing -- really making a headway and I am really pointing to new business opportunities in denim and I am excited about that but I am not going to share all my secrets and we will continue to focus on AE the outside, I call it, the outside brands right?

They are the ones that go out on the street and they wear the clothes outside and AE Aerie is little bit more indoors. So I think we can continue to play on those -- play that way with each other’s brand and understand our assortment and make sure we are maximizing both. I think we have lots of market share to gain as we approach the future seasons and really a lot of growth opportunity and I think we have a great solid plan to get us 2023.

Matthew Boss

Great. And just a follow up on gross margin, could you help quantify the magnitude of merchandise margin expansion in the third quarter? Maybe how best to think about drivers of gross margin in the fourth quarter and I am sure it’s a topic for the Analyst Day. But is there any way to unpack the gross margin opportunity that you see multiyear at the American Eagle brand or even maybe just high level some of the drivers to think about?

Mike Mathias

I can cover. Thanks. I can cover the overall makeup of gross margins. So, yes, gross margin leveraged by 200 basis points. As you know, the merchandise margin expansion we were thrilled with, obviously, is around 500 points -- almost 500 points in the quarter offset by just a mix shift of the digital business, delivery and distribution costs associated with that and then as we all know omni industry in this additional expense there they are going to be dealing with.

So, that was the makeup of the 200 points in the third quarter. The fourth quarter as you know, it’s typically a more promotional environment. We do -- we are expecting even more of a shift to digital. So we are expecting improvement in gross margin not to the same level as we saw in the third quarter though because of those two points.

Operator

Our next question comes from the line of Paul Lejuez with Citi. Proceed with your question.

Paul Lejuez

Hey. Thanks, guys. And I am curious if you could talk about the trends at Aerie versus AE throughout the quarter, both from the store and digital perspective. I am just trying to understand the fluctuations in each business, just given the weaker start to back to school? I think you said that November quarter-to-date was better than more an acceleration versus 3Q? But curious about how it’s performing relative to your October exit rate? And then just one follow up, I am curious to what you are seeing in terms of customer overlap between Aerie and AE in recent quarters versus what you have seen in pre-pandemic? Thanks.

Mike Mathias

Yeah. Thanks. This is Mike. I can take…

Jen Foyle

I can…

Mike Mathias

Go ahead.

Jen Foyle

Okay. Yeah. You start Mike. You can go.

Mike Mathias

I will take the first part of it which is with the third quarter. So as I said in my opening remarks, we definitely expected and saw a shift the back to school demand. I should say peak is a really August trough Labor Day. The season definitely flattened out and we saw a continuation of we are down in August based on that. September was we are really pleased with and really had the sort of highest penetration of the September in the third quarter than we have ever seen because of the shift in demand.

And our February we are pleased with as well. I think we saw still some of that demand coming to October based on the school timings out there market-by-market. We don’t think anything -- that was anything to do with holiday at this time. So in November we are pleased, Jen said it, I think right now we are seeing now holiday demands put up earlier November than we have typically see.

So, now we have shifted this back to school was the shift to later in the quarter, October we are pleased with results a little more normalized through our history, now I think we are seeing holiday demand pulled up earlier in November than we have ever seen. So we are shifting gears from the back-to-school fall and just holiday and it’s just going to be different animal in total. Go ahead, Jen on the second part of the questions?

Jen Foyle

Yeah. Just as far as -- yes, back-to-school, as Mike said, started out a little softer for the brand that are highly dependent in August, but we saw a nice deceleration, as I mentioned, on the last question. On denim, we are really loving what we are seeing there and that continues to be a trend and tucked inside of denim just really seeing nice movement on newer silhouette, so -- and the team is really positioned that business incredible and I really am excited about what’s to come as we move into Q1 and Q2 and into 2021 on the denim side.

Not to forget about men’s. Men’s just really over a year ago has worked tirelessly to build -- just really build back, I would say, some incredible franchise businesses and to be honest we have been chasing that business. But really out of the gate, we are just seeing so much great momentum in just, like I said, some of our driving two franchise businesses and we are chasing it and it’s nice to see men’s tops in particular coming back a lot and I think we have some exciting things happening there as well.

As far as Aerie, I don’t know. This might be the first time I think I said this on the call, but in 20 some consecutive quarters of double-digit growth, I really all categories fired in Q3 like and not just small comp site. We are talking huge comps in each category and I could not be more thrilled with the team just including intimates, we’re not going to ever forget about the core of our brand in Aerie. And I think really, we’ll be able to expand that as we open up the OFFLINE business, new doors, and expand that core side of the business. We can really then regain more momentum, even more momentum on the intimate side.

So, just really overall, I think, just the current trends have really played into Aerie’s business, but I think in the future, soft dressing isn’t going to go away, and I think, we can dominate there. It will be a continued category that I think every customer of ours and new customers want to participate in, because comfort is not going to go away with this next generation.

So yeah, we have so much opportunity in women’s tops and the team is really delivering there as I see the future assortments and just not to forget all this is wrapped up with a pretty -- with great marketing and I really have seen a pivot as we have moved into Q4.

Craig Brommers and team, they are worked and furiously. I don’t know if you have had a chance to see the Disney campaign. We are going to sell out of that product. It’s amazing the Nikki dancing with Addison. I don’t think we have done that. I hope you are getting one stance with Mickey, so he definitely likes Addison, and incredible, incredible views on that TikTok campaign and there is so much more to come there. So did I answer all your questions? I am sorry I think…

Paul Lejuez

No. I…

Jen Foyle

I said everybody…

Paul Lejuez

This one is causing an overlap as well between the...

Jen Foyle

That’s the overlap. Yeah. It was early on. We really leveraged the AE customer to build the Aerie’s file. We are starting to see really nice momentum, as the entries organically into the Aerie’s site for instance on digital. Those numbers are up double digit. And so I think we are really earning our wings so to speak on really Aerie standing on its own. We still have overlap, but we are seeing Aerie solo baskets and driving to new heights.

So, we are going to report more on this in the Investor call, but we are going to continue to focus on this. As we move into that $1 billion range, I think, we have to really then say what’s next? How are we going to approach it? What new customers can be introduced to this range, into this brand, as we continue to grow Aerie, grow OFFLINE and then continue this profitability story in American Eagle.

Paul Lejuez

Got it. Thank you. Good luck.

Operator

Our next question comes from the line of Adrienne Yih with Barclays. Please proceed with your question.

Adrienne Yih

Yeah. Thank you very much and congratulations on the great progress. I guess my question is actually Jen for you. On Aerie, you had mentioned that the gross margin now in line with that of American Eagle? I was wondering as you move towards the $1 billion level, are you at an inflexion point at economies of scale on buying, store operating expense, et cetera, such that you are at the operating margin level that you should start to see that inflexion also be in line with American Eagle? Thank you. And then I have one more.

Jen Foyle

Okay. Of course. Yeah. To answer that, simply yes. –Yeah. The plan was to accelerate Aerie’s profitability and that’s definitely the key to our future strategy. And then what was your other question?

Adrienne Yih

My other question is on the SG&A dollars. So, dollars were up mid-single digit in the third quarter. Can you just talk about the components of the SG&A and how we should think about that in the fourth quarter, the COVID-related expenses, the -- any incremental I guess employee expenses?

Mike Mathias

Yeah. Sure. So, SG&A, as we said, was up 6% in the quarter due to incentives. That impact was roughly if you back out the incentive impacts, it will be down mid-single digits. Everything else within SG&A, we are pleased that store labor was down to last year, mix of some fixed elements is definitely variable expense, services, professional fees, travel, advertising was down a bit.

So from a controllable perspective otherwise discretionary expenses, as well as variable expenses were down in the quarter. Fourth quarter we are expecting very similar kind of makeup of our SG&A, and again, like I said earlier, a little bit uncertainty of exactly how revenue comes by channel and then it will have an impact on SG&A. But as of now we are expecting a similar makeup.

Adrienne Yih

Okay. Great. Thank you very much. Best of luck.

Operator

Our next question comes from the line of David Buckley with Bank of America. Please proceed with your question.

David Buckley

Hi. Thanks for taking my question. I was curious if you can speak to our margin profile by channel, just e-comm versus brick-and-mortar, and where you see that heading into 2021?

Mike Mathias

Sure. It’s Mike again. Right now, we are not seeing again within our inventory optimization initiatives and aligning the channels more than we have from a proportional perspective. We are not seeing a big difference in merchandise margins between the channels.

And actually, I think, when you think about the overall cost of excess inventory, excess choices in SKUs, we typically -- the other sort of accounting, markdown reserves, post-season transfer impacts, there are other impacts of inventory beyond just our kind of week-in, week-out POS margins.

We are seeing big benefits there as well. So we are not writing down inventories to the levels we would have historically, not selling off inventory, expecting to the same level. And a lot of those from an accounting perspective, some of those impacts would hit the digital channel, just more from the accounting perspective and we are not going to see that at least right now in the short-term to the levels we have seen historically.

And to your other question of how we are setting up inventory in the spring and what we intend to do for next year, we are expecting really 2021 to be a similar impact up from our inventory optimization and reduction in choices for SKUs. Inventory relationship that fails, that focus we have. We expect the benefits to continue into 2021.

David Buckley

Thank you.

Operator

Our next question comes from the line of Laura Champine with Loop Capital Markets. Please proceed with your question.

Laura Champine

Thanks for taking my question. It’s actually on the balance sheet. It looks like accrued comp or accrued expenses were up about $73 million. What accounted for that increase in accruals?

Mike Mathias

The incentives would be the biggest part of that. There is some other noise in there as well. The incentives will be the biggest impact.

Laura Champine

Got it. And then secondly on the Aerie brand. I am certainly hearing the message that you are looking for potential closures in AE. Does not impact the store opening plans or potential for the Aerie brand?

Mike Mathias

No. Our expectations for capital investments into next year, we are definitely excited about the continuation of the Aerie story and investing in Aerie and new stores, and we are also preliminarily excited about OFFLINE performance and what that could look like in future years as well starting in 2021.

And the other point I would make about the balance sheet question you had is that, just as a reminder we did not pay any incentives in 2019. So the difference year-over-year has that included in as well. In fact, we did not pay out the bonus. We did not have incentive compensation in 2019.

Laura Champine

Got it. Thank you.

Operator

Our next question comes from the line of Kate Fitzsimons with RBC Capital Markets. Please proceed with your question.

Kate Fitzsimons

Yes. Hi. Thanks very much for taking my question. Jen, I know it’s still early days for OFFLINE stores, but I am curious if you can share just what has been some of the surprises associated as you start to roll out that concept. Just any additional insight you could give us on OFFLINE productivity maybe within an Aerie box. That would be helpful just if you give us an initial I guess taste of what OFFLINE could be here? And then next, Mike, there was a call out of some AUC benefit I believe in the third quarter. Can you just help us think about, help us look through how you are thinking about AUCs into the fourth quarter and maybe in the first half of 2021, as some of these SKU count reductions continue to take hold, but it does sound like there will be some investments in quality to come? That would be helpful. Thank you.

Jen Foyle

Well, one of our nearing surprises was a prominent influencer, she has about 7,00,000 followers. There’s -- she is not added to any what we did in Addison and we did one with Addison. She has showcased one of our leggings and organically it went viral. It was -- it happened on Friday and just it was so great to see and I love that. That’s really mean that something is resonating with the customer out there and happening naturally is just brilliance. So we loved what we saw.

So, I guess, going back to leggings and we knew that, that will be the foundation of the business. And as far as productivity, it’s still early to tell. We have a beautiful format out there. We are actually building into an old format. We have a brand-new format that we have designed and then there is a side-by-side format. So it’s a little early to tell, it’s really measured it. But I will say leggings are for sure highly profitable business and one of our most productive businesses.

I think I had too much coffee today. Did I answer all your questions? Its early days, I think, I really hasn’t, it’s early to say, but we love what we are seeing. I mean I mentioned in one of my earlier questions, we are seeing incrementally.

Again, what I really love about the team early on, we just don’t take this for granted. We have to remain humble. We have to -- I always say this and we have to remain hungry, but we are wide open to understand the customer experience in the same old and that’s how we are really going to test and scale and learn and drive the best results for each brand.

We do see this as a brand for our regulation. BUT again what we want to do with integrity, quality. Quality is just, I can’t say enough about quality and doing things really well, because that’s what is going to last the overtime and that’s how you built the brand. Chad built the brand and so it’s top of mind for me every day.

Michael Rempell

And this is Michael Rempell. I will take the second part of your question. [Technical Difficulty] Yeah. Second part of your question was about larger and what we are seeing AUC perspective? We are expecting cost benefits both in the fourth quarter and through spring and summer next year.

So, like, Jen said, we are investing in quality, but we are leveraging strong relationships, strong sourcing capabilities and we are going to see that come through in improved markups both in Q4 and in the first half of next year.

Kate Fitzsimons

Great, guys. Best of luck for holiday.

Michael Rempell

Thanks.

Jen Foyle

Thank you.

Kate Fitzsimons

Thank you so much.

Operator

Our next question comes from the line of Susan Anderson with B. Riley. Please proceed with your question.

Susan Anderson

Hi. Good evening. Thanks for taking my question. Nice job managing the quarter. I guess just a follow up on the AE top trends and men’s and women’s. It sounds like you have seen an improvement, where they are at, I guess, versus where you with a hope they would be, I guess, how far along our in terms of getting just back on track and how much more throughput to go? Thanks.

Michael Rempell

Thanks for this question. We are excited about what we are seeing in tops. The teams have worked, as Jay mentioned, the teams have worked all year really focusing on great tops to go with our industry leading jeans assortments. So, really focused in mid tops and fleece, and we are really seeing that we exceeded our expectations in those categories coming through Q3 and expect to see that continue in Q4.

One of the great things we have been really working on since the start of this pandemic and we are accelerating our work with Jen, working more closely with the brand, as well as Craig Guillot, but it’s really focusing the tops assortment down, so that’s on we really want to focus next category with jeans.

But we have so much opportunity focus on quality, on value, on key item, on great marking that excites the customers. We have built an amazing bottoms business over the past years and we have more in tops. I am confident that we have taken the steps to really get that through Q4 and going into 2021 and beyond

Susan Anderson

Great. And then just one follow up, I guess, on the store traffic and sales. It sounds like you do feel like maybe some seller been pulled forward in November, but I guess with some hot spots popping up. Have you seen a slowdown in the store traffic and sales and I guess how’s that transferred online then?

Michael Rempell

We are seeing in some of the hot spots we are seeing there is some additional capacity constraints and some more traffic impacts in the stores. As Jay mentioned in the call during just amazing job converting the traffic that they are getting and leveraging traffic that we are seeing and we are seeing in places that are impacted by capacity and by traffic we are seeing that demand shift online. So that’s market state add up on past as the rest of the business, just shifting more to digital.

Susan Anderson

Okay. Great. Thanks so much. Good luck for holiday.

Michael Rempell

Thank you.

Judy Meehan

Kevin, we have time for one more question.

Operator

Our final question comes from Janet Kloppenburg with JJK Research. Proceed with your question.

Janet Kloppenburg

Hi, everyone and thanks for squeezing me in here tonight. Congrats on a nice quarter. I had a concern about the American Eagle’s inventories, the total inventory down maybe 13%, but Aerie up, so Eagles inventories have to be down quite a bit and I noticed some shortages in the stores in October? I wonder if that impacted your sales at all in the quarter, in the third quarter, perhaps late in the quarter and how you are thinking about inventory now for the AE brand.

Chad Kessler

Thanks, Janet. Yeah. We…

Janet Kloppenburg

Hi, Chad.

Chad Kessler

We -- inventories were definitely significantly down in the AE and we did have some sort of history of the quarter. We have planned the quarter fight in terms of inventory. We weren’t sure how the plan was going to help back up. The stores were opening in the late spring and early summer and how the lack of back-to-school in person would impact demand.

The good news is that demand exceeded our expectations and we were able to use inventory. We had to really drive the sales we were able to get, as well as greatly improve margins on the product that we had.

Our go-forward thinking on inventory continues to be that we want sales to outpace inventory. We believe we are always happiest when sales outpace inventory it gives us the best margin results and allows us opened up inventory for us to chase. But Q3 was little -- was definitely more out of balance and then we would want to plan going forward.

Janet Kloppenburg

Okay. And just in terms of November on the trends, I assume when you talk about acceleration you mean, it’s you have seen acceleration across both brands? And I am just wondering if you think that the promotional activity which is earlier this year or the last if we should look for that to moderate as the quarter goes along and trying to think about what impact that may have on the top line trends? Thank you.

Chad Kessler

Yeah. We are seeing the acceleration in trend in both brands. As Mike said, especially in AE brand, once we got through August we have seen -- we have been quite happy with the brand results and we have seen acceleration in both brands in November.

I think we are benefiting from to a certain extent from people shopping earlier and maybe from other people’s promotions. We have been less promotional in both brands in November to-date than we were last year. And as Jen commented, there is still a lot to go between now and the Christmas holiday but we plan to compete this week. Obviously it’s a critical week and then when we come out.

Jay Schottenstein

Hey Chad. I would also add one thing.

Chad Kessler

Yeah.

Jay Schottenstein

We think we have the sharpest merchandise out there period.

Janet Kloppenburg

It looks pretty good, Jay.

Jay Schottenstein

Thank you.

Chad Kessler

And with the -- I think with the teams have…

Jay Schottenstein

I need a quarter in there, Chad.

Janet Kloppenburg

I got it. I will.

Jay Schottenstein

I will merchandise against anybody else really.

Janet Kloppenburg

Great. And with the…

Chad Kessler

And with our inventory positions.

Janet Kloppenburg

Yes.

Chad Kessler

We have the opportunity to be less promotional through Q4 as we are already.

Janet Kloppenburg

Okay. I can’t thank you enough. All the best for a great holiday. Thanks.

Jay Schottenstein

Yeah. Thank you. Thank you.

Chad Kessler

Thanks, Janet.

Jay Schottenstein

Yeah. Thank you.

Operator

And with that, we have reached the end of our question-and-answer session and I would like to turn the call back over to Jay Schottenstein for any closing remarks.

Jay Schottenstein

Yeah. Everyone stay safe. We are going through unusual times right now and the next several weeks are very interesting weeks and hopefully our country comes through strong, everyone comes through strong, but we have to stay safe, that’s most important thing. Stay safe.

Operator

And with that, this concludes today’s teleconference. You may now disconnect your lines at this time. Thank you for your participation and have a wonderful day.