TWST: Where are you focusing your attention these days in the specialty retail space?

Ms. Chen: It seems like the missy retailers are holding up a little bit better. That customer has pulled back since holiday of 2006, and it seems like she is now ready to shop. We're seeing that strength come from female shoppers aged from the 20s up into the 40s and 50s. She is finally embracing some of the fashion, and the retailers are also doing a better job of merchandising the outfits and teaching her how to wear the new fashion.

TWST: What's been your view of the back-to-school season thus far? How do you expect it will turn out?

Ms. Chen: It has been a little bit softer than expected. We think it's a combination of the weather, meaning the heat wave that we've been having across the country, with Labor Day being once again in week two of September. A lot of times we have shoppers procrastinate until the last minute, and we could see that happen again. Last year, when the calendar was similarly placed in terms of Labor Day being in week two, we actually saw stronger September sales trends than August. So given what we've seen so far, we could see that replay itself this year.

TWST: So we may see stronger sales later on. If we do, would that connote more discounting?

Ms. Chen: I think many of the retailers are actually expecting that. So since they came into the third quarter with inventory levels so clean, we may not see the heavy discounting. If by the end of week one of September we don't start to see some pickup in traffic trends, then yes, I think the heavy discounting could begin by mid-September. But for now we feel like the inventories are much cleaner in the teen environment and perhaps merchandise margins could be preserved.

TWST: The National Retail Federation estimated 16% growth in back-to-school sales over last year. Do you feel that's too optimistic?

Ms. Chen: Yes, we certainly do. We had also conducted a survey to parents and teens in late July. It was a nationwide survey of over 500 teens and almost 1,000 adults across all income buckets, and they indicated to us their budget plans were pretty much flattish year-over-year. We think that was more reflective of some of our channel checks and other primary research we've conducted. And I think in this scenario, it becomes even more of a zero-sum gain for different companies to try to grab market share.

TWST: What are some other key insights that you came out of that survey with?

Ms. Chen: I think, as expected, price was a primary driver of store selection. We also saw a growing inclination to shop at discounters and big-box retailers. However, we did see specialty stores place much higher in preference amongst teens. And then I think within some of the store brands, we were surprised to see Old Navy and Gap (GPS) lose a little bit of resonance, but Aeropostale (ARO), American Eagle Outfitters (AEO), Hollister and Abercrombie & Fitch (ANF) continuing to dominate the rankings.

TWST: You mentioned inventory levels are pretty tight. Would you speak to that in more detail? There have been reports of some issues there, especially in the teen space.

Ms. Chen: I think definitely when we entered July, many of the companies had indicated plans to enter Q3 or the fall season with inventory levels up low double digits, certainly outpacing sales trends, and the concern was that it could unravel into some kind of price war. Now that we've gone through most of the reporting season, we're pleased to see that American Eagle Outfitters, as an example, was planning to have inventory up double digits, but they ended up exiting Q2 up only about 1%. So they were able to take very drastic measures in July to clear through excess goods. They came out much healthier, and we see that as a positive for the teen space. That's why, as I alluded to earlier, perhaps we won't see the discounting happen until September, which is disappointing in early trends.

TWST: What's been your take on the earnings season, which has been dominated by what seem to be pretty muted outlooks for the second half of the year?

Ms. Chen: I think you've definitely hit on the key there. It's been a little bit of a mixed bag in terms of stock reactions. On average, the companies have hit Q2 consensus numbers or their guidance, and then on the guidance going forward, they've been very muted, very conservative, which makes sense if the August trends they're seeing are very soft. The stock reactions have been interesting because expectations have been low for many of the companies going in. Sometimes we're getting a pop in the stock even though everything is in line. I think going forward, the possibility for the group is that if the weather should change or if consumers do hit the stores in September as we expect, we could actually have sales and results coming in better than the muted guidance. And with some of these stocks trading at discounted values relative to historical multiples, I think that's where there could be an opportunity for the group and maybe also give investors some enthusiasm around the holiday opportunity.

TWST: We've heard a lot about price wars between companies, such as Abercrombie, American Eagle and Aeropostale, for jeans. How widespread are battles like that? What do you predict will be the end result of those strategies?

Ms. Chen: It's definitely widespread. We're seeing it even from the more adult retailers, like Gap, and some kids retailers, too. Gymboree (GYMB) and Children's Place (PLCE) are participating, trying to use a key category like denim to drive attention. However, it probably has not been playing out as many companies would hope, just because it's been so hot that shoppers are not focused on buying long, thick bottoms, like jeans. The positive is that jeans are very seasonal goods, so retailers can probably hold on to them until Q4. And therefore, we're starting to see a pullback on some of the promotions based upon jeans, and that is, in our opinion, a positive. Instead I think retailers are trying to focus on maybe some of the tops category or shorts or skirts if they still have some of that in stock, and then also some of the lighter weight non-denim fabrications that are now starting to gain traction.

TWST: Another story we've heard a lot about is the international expansion taking place among several companies that seek to take advantage of the cache awarded to American brands in Europe and Asia. What do you look for when evaluating a company's international strategy and growth potential?

Ms. Chen: I think definitely one of the first things we look at is brand equity - if there is the appetite for that retailer abroad. Secondly, how are they testing the waters before jumping in with store openings? In many cases, we're seeing them maybe ship internationally or partnering up with a third party, like NET-A-PORTER in the case of J.Crew (JCG), and then measuring the demand. I think the third is understanding how are they allocating the capital? Do they want to spend the cap ex themselves or do they want to partner up with local expertise through more of a franchise/joint venture? So I think in the case of Guess? (GES), it's a great example of combining a retail and wholesale strategy to enter some of the new markets and seeing very good results. The Asian market for them was up 43% in the second quarter, and Europe continues to grow, up 18% in local currency. So I think that is a business strategy that we think has been very successful.

TWST: You mentioned customers at the missy stores are opening up their wallets a bit. What's your take on consumer confidence at the moment? Are you seeing some positive signs? Do you expect to see them soon?

Ms. Chen: What we're expecting to see is very lumpy shopping patterns. We hope they'll be out for back-to-school shopping in September, but then as we get into October, in sort of a non-event month, we expect that to pull back and then pick up again closer to Black Friday and much closer to Christmas or the holiday season. Also this year, we're once again expecting January, the clearance time frame, to be much more important - partly because of our survey telling us consumers care a lot about price, but also because of a multiyear shift that we've seen just happen, with gift cards rising, and more people getting money as presents and really taking advantage of the bargains after December. So that's the kind of a pattern we're expecting to see from the consumer, and certainly the headlines about double-dip are not going to help. So hopefully we'll get more headlines like today, where I guess jobless claims were a little better than expected, and that could have a boost in consumer confidence.

TWST: Are you somewhat optimistic as you look ahead to the holiday season?

Ms. Chen: I think that we're a little optimistic, especially relative to some of the expectations embedded in the group right now. We do think that when the season comes and when the holiday is here, people will get out and shop. It's just going to be much more condensed and much more compressed within maybe the week right before Christmas rather than that long season we used to see in years prior.

TWST: We've heard a lot about rising costs for cotton and the potential for rising prices from Chinese manufacturers. How is that affecting the space, if at all?

Ms. Chen: Definitely an overhang on the group. What we've started to hear, however, is that costs are not rising as much as I think investors had feared. Many of the companies have conveyed that costs could actually be flattish in the first half of next year, then with pricing increasing in the second half. Certainly that's a lot better than we thought. For some of the other companies that are seeing pressure in costs, they quantify it to be somewhere in the 3% and at most 5% range, and I think depending on the store, some of them may be able to pass it through because of their brand equity or maybe higher fashion quotient in the product. And so I think overall the companies have done a good job of mitigating that. We don't really expect that to be as big of a threat as consumer confidence.

TWST: I saw a quote from George Feldenkreis from Perry Ellis. He said apparel prices will go up without a doubt, and that American consumers will have to accept it. Are you hearing that attitude in the space? How do you expect that to play out?

Ms. Chen: I think most companies are actually sounding much more positive on that front, in the sense of controlling costs, whether by going to new countries beyond China or working on maybe lowering freight costs, which appear to be coming down, and then being able to maintain the initial markup in general. Selectively they are looking at items within each category to see if maybe they could pass through 3%. But the example that I would think about is if you have a $100 garment, and if it rises by 3% to 5%, and you're really only talking about $3 to $5, most shoppers may not remember that last year it was $5 cheaper. It almost comes down to eventually what is your retail price point? What is your promotional cadence? And what's the final price that it walks out the door. And if it looks good, fashion appropriate, brand-right, we're still seeing consumers willing to spend on it.

TWST: Many of the stocks in this space have been hammered. Generally speaking, what do you think of valuations right now?

Ms. Chen: It's definitely looking very compelling for many of the names that we feel are quality companies that investors can hold for the long term. J.Crew is an example of that, where it's one of the best brands out there and reaffirmed by the survey we conducted. You've also got companies like Urban Outfitters (URBN), which is quite similar in terms of growth profile longer term. And so I think those are definitely some of the companies we would look at. Another company would be Chico's (CHS). I think for investors willing to have even a slightly higher risk appetite of dabbling into the teen space, Aeropostale is a retailer that we believe is another core holding - not only because eventually their competitors, like Hollister and Abercrombie, cannot maintain that kind of price point because they'll just continue to see their margins deteriorate, but Aeropostale's value strategy is what they do on a daily basis. So that's another name that we could potentially recommend. Guess? as well - they reported last night and the stock is down today, and that's another retailer with domestic and international growth opportunities.

TWST: Is there a unified theme to those five names when you look out over the long term?

Ms. Chen: I think we like them because not only have we seen them manage well in past downturns, but also they are controlling inventory, expenses, investing in openings or marketing appropriately to support near-term business. Also there is a lot of growth opportunity for all of those companies that are very synergistic and viable. So I think in this group, investors like to look for growth, and so we feel like these companies offer the best combination of growth and EPS expansion.

TWST: What type of growth opportunities do you see? I imagine that J.Crew and Urban Outfitters would have similar projectories.

Ms. Chen: I think for J.Crew, in the foreseeable future you could see them grow square footage by at least mid-single digits, but earnings this year is expected to hit at least 17% this year. Urban, as you mentioned, shares very similar characteristics - square footage growth in the low-double-digits range, earnings in the 20% to 30% range. And then I think if you look at a company more like Aeropostale, we're looking at mid-single-digit square-footage growth and earnings of at least 12% to 15%.

TWST: What sets them apart, as you mentioned, in more of a risky category?

Ms. Chen: I think in the near term, we certainly want to admit to the pricing environment the fact that some teen retailers are trying to recapture market share by discounting and not focusing on merchandise margin. And so when you have almost irrational players like that, in the near term it could be a little bit bumpy for every retailer in the teen space, Aeropostale included. But eventually the space will become rational again, and I think that's why we look at a company like Aero, that can manage the business in this environment and for the long haul, and they have a growth driver, like p.s. from Aeropostale, and that's why it looks very compelling to us.

TWST: You also mentioned Chico's. What do you like about that story?

Ms. Chen: I think they are the leading player for the slightly older missy customer, someone in her maybe 40s or 50s. They also have another concept called White House | Black Market that has been doing a good job of attracting the 20- to 30-year-old shopper. Management has really revitalized the marketing product design, and we're seeing margins really rebound from negative territory to hopefully hitting 10% this year. We believe longer term, we could expect that margin to get back into the mid-teens range, and so that's why we look at a company that can post 50% EPS growth this year, 30% EPS growth next year and yet trade at only nine times p/e, with almost $3 of cash per share and clearly trading at a discount because of the sentiment in the space.

TWST: There has been some talk of potential M&A deals in retail, including maybe some interest from private equity folks. Do you expect to see some deals as we go forward? If so, when might that start heating up?

Ms. Chen: We might see some small transactions. I'm not sure we're going to see a lot of domestic acquisitions, given how saturated the domestic retail environment is. Therefore, could see companies look abroad. Certainly there had been talks about Zumiez (ZUMZ) looking at West 49 (WXX.TO) in Canada. Men's Wearhouse (MW) just acquired two corporate apparel businesses in the U.K. So I think if acquisitions were to occur, it would be one of the U.S. retailers buying a foreign player in order to have a foothold into that new market, and probably a very small acquisition that would be easy to integrate and manage. But with all the cash that these companies have on the balance sheet, we're seeing more in terms of share buybacks than pure acquisitions so far.

TWST: The last time we spoke in the spring of 2009, you said if the downturn persists beyond 2010, then we could see some bankruptcies happen in this space. Do you see anybody in that position, as the environment has remained tough?

Ms. Chen: Not at this point. The companies have all done a really good job of cutting back on cap ex and expenses, and rationalizing the store base. So we feel at this point, they'll all survive 2010 and 2011 even healthier. So we don't see that scenario playing out at this time.

TWST: Have investors noticed all the cost-cutting retailers have done? Has enough attention been given to that?

Ms. Chen: No, I think they've definitely reboarded those companies, and that's why a lot of the stocks held up pretty well in 2009 because of cost-cutting. But I think when the savings are done, you need the top line to come back in order to flow through to the bottom line. I think from that perspective, investors are more focused these days on consumer demand and prefer to see that materialize before getting too excited about consumer discretionary in general. Therefore, I think that's going to be the key driver.

TWST: Are you seeing interest in this space as you talk with investors?

Ms. Chen: It almost changes on a daily basis. Some of it is because of the macro headline today - jobless claims were good, but we are getting a mixed bag in terms of the stock performance. So it varies quite a bit. The fact that it is summer vacation is having an impact, too. Many days we're seeing light volume, and I think we'll get a better sense of interest in the group when companies report August sales and start talking about September sales trends.

TWST: Aside from the companies already mentioned, are there any others that you're positive on?

Ms. Chen: Another area that we feel good about is the kid's or children's space. We've seen in past downturns that parents, caregivers and adults will cut back on themselves but not the kids, not to mention there is a natural replenishment cycle that occurs with kids growing - it's inevitable. And within that, we like retailers including Children's Place and Gymboree.

TWST: What is it that sets those two apart from the rest of the group?

Ms. Chen: They're probably the two dominant specialty retailers in the space. I think for Children's Place, they are the lower-price-point retailer and that should translate very well in this environment. They've also appointed a new CEO who is fixing a lot of the low-hanging fruit. We're expecting them to continue to post better-than-expected results, especially in 2011. In the case of Gymboree, they've got multiple growth concepts, especially with Crazy 8, that should have improved profitability with a bigger scale. And they have one of the best management teams in this space; it's got a lot of cash per share that they can continue to utilize with buybacks, and I think that's why it has maintained such a great brand equity, and we really expect that to continue.

TWST: Are there any segments or individual companies that you're concerned about these days?

Ms. Chen: Not really. The only thing is we're getting mixed signals regarding surf/skate and whether that's making a revival or not. So we definitely look at the results from Zumiez, which has been trending better on a month-to-month basis, to see if perhaps there could be some growing appetite for that.

TWST: It sounds like you see a lot of bumps ahead.

Ms. Chen: Yes.

TWST: It's a very uncertain environment, I suppose.

Ms. Chen: Absolutely, and truly when you talk to investors, the sentiment changes weekly.

TWST: You mentioned the macro headlines being up and down. When you look at the industry, it's been the same case - if you to go day by day, it's hard to get a picture of the larger trends.

Ms. Chen: I think that's actually true and so beyond company-specific fundamentals, we do see the headlines really having big influence on how their stocks are trading on a daily basis.

TWST: Thank you. (MJW)

Note: Opinions and recommendations are as of 08/26/10.

Betty Chen

Analyst

Wedbush Securities

1000 Wilshire Boulevard

Floor 9

Los Angeles, CA 90017

(213) 688-8000

www.wedbush.com