TWST: Kimberly, as we look out at 2005, what's the outlook and what are people thinking about?

Ms. Greenberger: We're feeling near-term cautious about the group, its record sales numbers during Q12004, and also about the record operating margins for most retailers in 2004. Here in the near term, we're having a difficult time finding a catalyst to drive the stocks higher, particularly given that the sector is now trading at about a 5%-10% multiple premium to the S&P 500 when it has historically traded for a 20%-25% discount multiple to the S&P 500. The valuations are feeling sort of full, and as far as the near-term catalysts, we have some risk that against the first quarter comparisons, comps could come in a little on the light side. And against record-high margins, we're just not seeing a lot of near-term upside to the earnings estimates. As we get further into the year, we get far more constructive and certainly think that, particularly given that retail started to slow down in the June time frame last year with the ramp up in oil prices, the second half of the year is looking much more interesting for the stocks.

TWST: Gabrielle, how about your perspective as we look out at 2005?

Ms. Kivitz: We're also maintaining a somewhat selective viewpoint with respect to our recommendations. I really take a bottom-up approach. The theme we've been talking about is sticking with names that are showing strong pricing power. Pricing power comes from a combination of having the right product and strong execution and should really lead to strong top line and margin performance. But echoing what Kimberly just said, valuations are not necessarily low. The PEG ratio for our group, based on our estimates, is 1.2. Strong performers are getting premium multiples, but companies that have had challenges are also trading at premiums and, in some cases, even higher premiums than the strong performers as the market is discounting some improvement in these businesses. I do think there are some opportunities for second half of the year turnarounds, but for now we're really sticking with that theme of strong pricing power.

TWST: Liz, how about your perspective as we look out?

Ms. Pierce: It is fairly similar; one of the things I am most concerned about is last year's difficult comparisons. As Kimberly mentioned, a lot of companies are operating at or close to peak margins, and other than Easter, there is not a strong spending catalyst. So the combination of peak margins and difficult comparisons does make one wonder how much higher stock prices can go. We have adopted a thesis fairly similar to what Gabrielle mentioned in terms of sticking with companies that have more or less been immune to some of the volatility in the economic environment and the geopolitical environment. We do not really see light at the end of the tunnel in terms of extending beyond that limited group of companies until we get into the second half when comparisons get a little easier.

TWST: Neely, how about your take on what 2005 is going to look like?

Ms. Tamminga: We also believe it's about stock selectivity right now. Some of the things that we are focusing on include those brands that are relevant and differentiated, as well as those brands that emanate somewhat of a status within their respective demographic groups. That said, we're coming up against very difficult comparisons, and nobody is denying that. I think those that weather the storm best are those that are levered toward the increasing price points, whether it's through better status, better quality products or further differentiation from the pack; that is how you maintain your pricing power in this environment.

TWST: What do these retailers have to do to set themselves apart?

Ms. Tamminga: I think Urban Outfitters (URBN) is a good retailing concept to point to. At Urban, they really house a portfolio of brands instead of being their own brand. Right now in fashion, it's all about having exactly that right brand, whether it's Diesel jeans or Citizens of Humanity denim or a Modern Amusement shirt from Mossimo (MOSS). It's about having something very unique and presenting it in a very boutique- y environment. There are some retailers that play that trend better than others, and I think Urban Outfitters is one of those.

TWST: Gabrielle, in this crowded environment how do these specialty merchants go about setting themselves apart from the pack from your perspective?

Ms. Kivitz: When I look at apparel retail companies, I evaluate the brand, the competitive position and points of differentiation. In terms of the fashion offering, I think they have to be trend relevant in a way that is applicable to their customer or brand. That's always important in terms of emulating whatever the trends are but to do it in a way that's right for the customer or brand. I think Abercrombie & Fitch (ANF) is a good example of a brand that is really offering differentiated product. They're a fashion leader. They're trying to become even more of a fashion leader now, and it's really all about the product, the aspirational brand and the store environment in the total package.

TWST: It becomes harder and harder. Kimberly, what's your view on what these retailers have to do to maintain and establish a position?

Ms. Greenberger: In terms of differentiation, I would second the comment that was made about Urban Outfitters being one of the retailers that has shown an ability to differentiate its products. I think differentiation comes in a number of different forms. For the Urban Outfitters and Anthropologie divisions, I think their differentiation comes not only from the product and the fashion point of view and the level of freshness that they continually strive for in their assortment, but also the shopping experience, which provides a mix of hard goods and soft goods and a very uncharacteristically interesting environment (for a mass retailer or a chain retailer) that's not easy to replicate. One of the things they do have is a visual management team on staff at every store. There's a lot of additional payroll that's required for that, but we think that the payoff is there in terms of both sales and margins. There are other ways to differentiate or to establish as a retailer. I think Chico's FAS (CHS) is another good example of a retailer that's differentiated. I think they do it on a couple of different metrics. One is fit and fashion, and two is really what I think is the magic of the business, which is their marketing and customer service point of differentiation. This is a company that reaches out to its 5 million plus frequent purchasers every month with a catalog that reminds them to come back into the store because every catalog has a coupon in it that gives them an incentive to do that. They also compensate their store level employees on a commission basis. They're one of the few retailers that does that today. Most retailers, at least in the universe that I cover, have switched over to a regular hourly wage or a salary with sales goals, but there is no real incentive to exceed those sales goals. Chico's pays their employees on commission in order to deliver very superior customer service, and I think superior customer service in this day and age is absolutely a point of differentiation. There are a number of different ways to either compete or differentiate or to establish as a retail business, whether it's through the fashion point of view, product quality and fashion, shopping experience or environment, or level of customer service or marketing. There are a number of retailers in this sector that excel at one or several of those dimensions.

TWST: Liz, how about your view on this whole idea of differentiation?

Ms. Pierce: I think it is particularly important because with lead times changing as rapidly as they have been changing, it seems that a lot of me-too or sameness develops very quickly, so retailers need to figure out what else they can do to drive that traffic. I believe that Kimberly and Neely both pointed out two companies that have great formulas, which have been very effective at driving traffic. In today's retailing environment where consumers have so many options, it is not just product or price anymore; it is about great customer service, ambience and marketing. If you look at some of the more successful retailers, there is a common theme and that is tapping into what makes that customer shop and what makes that customer commit money once they walk in the door. For each company it may be a variety of attributes and each company has to put these attributes, together into an equation to come up with their specific winning formula.

TWST: So it's not easy.

Ms. Pierce: No, I doubt any of us would say it is easy.

TWST: Gabrielle, as we look at the specialty segment, are they continuing to gain market at the expense of the old-line department stores, or is that balance beginning to come back?

Ms. Kivitz: If you look at the overall market for apparel you'd see pretty slow growth, so it really has become more a game of market share gains. Dollars are still coming out of the department stores and going to specialty retailers and to the discounters. What's unique, though, to specialty retailers is that they do have that close contact with the customer; they do have a brand that they can use to speak to that customer, and they can really read their customer better and respond to their customer faster than some of the other channels.

TWST: Neely, is there any chance that as this consolidation goes on that the department stores can come back and reestablish a position?

Ms. Tamminga: We wouldn't count the department stores out, really, because they are still the house of brands and multiple brands at that. What we are seeing right now in terms of fashion is a status cycle in bottoms, particularly with denim brands, and we haven't really seen this cycle since the 1980s. We find it very interesting that the only place to really play this in specialty retailing would be boutiques or Urban on a national basis; otherwise you have to go to Nordstrom (JWN). So we do believe that if this fashion cycle continues, department stores are going to get that traffic back. As a matter of fact, national traffic has actually been coming back here somewhat, and it's not from the teens; it's from the parents. Looking back over the past three years, national mall traffic has been on a downturn, but recently it has been coming back. We think if you talk to the mall owners, they'll tell you that teens never left, so it's the parents coming back. We even see this in the proprietary teen research that we do in which we talk with about 700 teens every six months across the United States. We also talk to some of their parents, and we noticed in our most recent survey this past fall that the parents are talking more about department stores than they have been before in the past. So we think that there could be a trend here. Don't count the department stores out.

TWST: Liz, are department stores dead or not?

Ms. Pierce: I totally agree with Neely. I have been covering the retail sector for a long time, and I have seen multiple waves of investor sentiment ranging from the death of the discounters to the death of departments or the specialty retailers. I do not think any sector ever goes completely away; their popularity just seems to ebb and flow. Although I do not cover any of the department stores at this point, they have 'walked' many categories, i.e., kids, electronics and soft home to a lot of the big box retailers. I do not believe they are going to let apparel go that easily as evidenced by the emergence of several more moderately priced high profile designer brands being showcased at department stores. So I believe the department stores are going to put up a tough fight. And Neely is right. The department stores historically have always been the launch pad for brands, which is why consumers have historically shopped there.

TWST: Kimberly, are department stores going to continue to lose share, or are they going to be able to stabilize things here?

Ms. Greenberger: The most recent NPD data we have access to did show a slight share loss in 2003. The 2004 numbers are still being finalized, so we don't have those yet. But prior to the 2003 time frame, the department stores had been losing share at a faster rate. So it looks like, in line with what my colleagues are indicating, the flow has been stemmed here, and the department stores do seem to be bouncing back. What is interesting today and what may be helping the department stores is that a lot of small emerging brands are capturing a tremendous amount of buzz, especially among the celebrity community, and because of our fascination in this country with all things celebrity, it's being quickly disseminated to the masses through publications like InStyle magazine and other celebrity-watch magazines. Many of those brands seem to be housed in department stores. So I would say unlike years past where department stores had a fashion cycle that they could capture and then subsequently potentially lose share, now it seems that there is actually a return of buzz around many of the brands that department stores are carrying. But I would absolutely agree that it's much more among the young contemporary brands rather than the more 'missy' oriented brands. But department stores are secondarily making strides with their private label programs, and many of them have decided that they need to increase their commitment to the private label in a way that makes them greater head-to-head competitors with the specialty segment. And we'll see if they can execute the task of vertical integration as well as the specialty sector has. The jury is still out. The retailer that seems to be doing the best job at a private label business, according to Deb Weinswig, our broad lines analyst, is J.C. Penney (JCP), so she thinks that they're ahead as it relates to that. I think that is a point of differentiation for department stores, whereas in the past they've really not had much of a point of differentiation, at least among one another if you looked at department stores of the same price point.

TWST: Gabrielle, as we look out this year and next, are these specialty retailers going to continue to open stores aggressively, or is the slowdown in mall construction going to constrain them?

Ms. Kivitz: We are expecting most of these retailers to continue to open stores. There still is a lot of growth opportunity for a number of companies. However, over the last few years we have seen a slowdown in growth rates as it becomes increasingly difficult for these companies to sustain high growth rates on larger store bases. We are also in an over- stored environment, which is something that has been talked about for a long time, but I do think that there are still demographic opportunities where the market is under-stored. One untapped demographic opportunity is men and women in their 20s. That demographic is growing as the older segment of Generation Y has graduated from college, and these individuals are moving to cities and starting their first jobs. Retailers capitalized on this generation when they were teenagers, and now the lifestyles and needs of these customers are changing. There aren't a whole lot of retailers that focus on that segment or do so in a way that's relevant to the preferences and or tastes of this generation or to their new lifestyles. I also think the baby boomer customer has been under-served or maybe misunderstood, and there could be room for retailers to expand in this segment and really appropriately address that customer as well. So although we will probably continue to see a slowdown in growth rates, there's room for brands that have strong competitive positions, particularly those that serve untapped demographic opportunities. Gap (GPS) and Limited Brands (LTD) were historically the pioneers in this industry and have set standards in a lot of ways as well. Both of these companies now are really looking at more or less flattish square footage growth. There are still some growth opportunities, but overall it's really flattish. The focus at both of these companies, in addition to finding new growth opportunities, is really about how to maximize the existing brands and improve sales-per- square-foot productivity and profitability.

TWST: Liz, what's your take on expansion potential for this space?

Ms. Pierce: Depending on the retailer's target audience, I would actually use the word selective when describing expansion. But the interesting thing about retail is the very low barriers to entry. The retail sector is always evolving. So even though we may think square footage growth is limited right now, new concepts seem to be born when we least expect it. Another thing that is happening right now is older companies are closing stores and retrenching while they look for new ways to drive growth. Thus, I believe it is hard to look beyond the next couple of years and determine how much square footage growth is really legitimate.

TWST: Neely, are expansion opportunities still available?

Ms. Tamminga: Absolutely. Though it's not so much whether expansion is there or not, it's where it is going. If you look at where the real estate developers are building right now, the focus is less about the traditional regional enclosed mall and more about the off-mall lifestyle center (of course, lifestyle centers here meaning a strip center with a lot of shrubbery and good parking). That's certainly where the trend seems to be going. The attraction is about focusing on the right age and income demographics. So you have a baby boomer customer who might prefer to shop off-mall, so opening more deals toward the off-mall kind of makes sense. For the retailer it's advantageous because the lease deals are better. So we think it's going to be more about these off-mall lifestyle centers in terms of near-term development.

TWST: Neely, whom are these off-mall centers catering to? Is this the big box discount side or more the up-scale?

Mr. Tamminga: I think you're seeing a little of both. A good example would be a development very close to me where they have Bed Bath & Beyond (BBBY) and a Kirklands (KIRK) and a J. Jill (JILL) and a Coldwater Creek (CWTR), so the mall is focusing on a variety of price points and demographics as well as shopping patterns. If anything, it just helps protect them in terms of making sure there's a traffic flow to those centers.

TWST: Kimberly, how about your views on expansion opportunities for the group?

Ms. Greenberger: I would definitely concur with the prior comments in terms of square footage growth now being promising among a few select companies. But by and large the sector-wide square footage growth has decelerated dramatically from where it was back in the late 1990s. At that point you had Gap putting up double-digit square footage growth along with Abercrombie, American Eagle Outfitters (AEOS), Pacific Sunwear of California (PSUN), and a number of the other retailers in the sector. What we're finding now is the evolution of this specialty retailer as their original concept or their core concept reaches the point of saturation. Many of the management teams are hatching a second concept and, in some cases, a third concept in order to provide additional opportunities for square footage growth. So in the sector we're seeing a certain metamorphosis among the management teams from a single-brand management or a single-regional concept management structure to one that is multi-branded or multi-concept. That is probably an indication better than any that I can point to that would say that the core businesses of many of these retailers are reaching the point of saturation.

TWST: When they reach saturation as we saw with Gap and Limited, what do they do?

Ms. Greenberger: As Liz pointed out, they retrench and right-size their real estate portfolios. Generally speaking, during the go-go growth years, most of these retailers over-expand and occasionally sign lease deals that they might later regret, so they have an opportunity to rationalize their store base and get a little smarter about their existing real estate portfolio. Many of them also look to remodel their existing concepts to maximize the efficiency of their existing square footage, and Limited Brands is in the process of doing that, particularly in the Victoria's Secret business. But once you reach that point of saturation and maximize your existing real estate portfolio, really the opportunity would be to develop a second concept. Occasionally retailers have looked toward acquisitions as an additional way to grow. Children's Place Retail Stores (PLCE) just acquired the Disney Stores recently, and about a year and a half ago Chico's acquired the White House/Black Market business, both of which we think can provide each of those retailers with some very solid square footage growth.

TWST: Liz, we've been talking about expansion here. How about the other side with consolidation? We've seen some specialty retailers fail. Are we going to see more?

Ms. Pierce: I think so because consumer preferences change and things go in and out of style. If retailers do not adapt quickly to changing consumer preferences, it sets the stage for consolidation. For example, just recently Forever 21 announced that it is acquiring Gadzooks (GADZQ). We believe the junior customer has changed and the retailers that traditionally catered to this customer have not adapted quickly enough to these changes. Two other junior retailers that continue to be under a lot of pressure are Wet Seal (WTSLA) and Charlotte Russe (CHIC). If history serves as an example, adaptation is a necessary survival tactic. Just look at what happened to Merry-Go-Round. In addition to expanding too rapidly, another reason the company did not survive is because it did not pay enough attention to the changing environment and what its customers wanted. So I would not be a bit surprised to see further consolidation and/or contraction of space; I believe rationalization of retail estate is a healthy thing.

TWST: Gabrielle, are we going to see a further shakeout in this market space?

Ms. Kivitz: I think we could. I have to agree. I think what gives longevity to a retailer is having points of differentiation. This is an industry where the barriers to entry are very low, but the barriers to success are high, so it's all about points of differentiation and establishing a strong competitive position, and then it's about a combination of product and execution. I think companies that do have that probably don't have the threat of going away. For the most part, the companies on my coverage list do have those points of differentiation and strong competitive positions, but I do think that we could see failures of smaller retailers that are falling short either on execution or on establishing a competitive position for the brand.

TWST: Neely, is a consolidation or shakeout in the space coming along?

Ms. Tamminga: Yes, I think that that's always a possibility every year. It's becoming far more costly these days to be a publicly traded company. Some of these guys are spending $1 million to $2 million this year just on Sarbanes-Oxley compliance. But I think that we'll probably see a couple of major merger/acquisition announcements in 2005 in the women's apparel space, and you could probably see some consolidation still at the core brand level if you look at the apparel brands in terms of the manufacturers.

TWST: Are we going to see more failures as well?

Ms. Tamminga: I think that's usually what happens before you come to the table for an acquisition. So yes, absolutely, I think that you could have more bankruptcies.

TWST: Kimberly, consolidation and shakeout in the space?

Ms. Greenberger: Absolutely. I do think we'll see some rationalization and failures, and consolidation to the extent that we're seeing what I would call bargain hunting-driven consolidation. This appears to me to be more reasonable than paying up for a healthy retailer, because at the end of the day there's very little asset value associated with most of these retailers. There is a tremendous amount of brand value held by some of them but obviously not all. What's interesting historically as you look at the bankruptcy trends is that every 10 or 15 years we seem to have a shakeout and it's hard to know whether that is driven by a change in fashion, a change in the retailing landscape, or exactly what it's driven by. But the last good round of bankruptcies that we had was in the 1994-1995 time frame. We had Merry-Go-Round and County Seat and a number of other retailers really struggling and shutting a lot of stores at that point. We haven't had a good cleansing in the sector since then and it certainly feels like we've had enough of a change in the landscape over the last 10 years to lead potentially to an acceleration in the cleansing or a fallout in the sector, if you will, over the next year or two.

Ms. Tamminga: I'd love to share my favorite quote from Les Wexner, the Chairman and CEO of Limited Brands. He's always said, 'Bad inventory will only give you indigestion; it's bad real estate that will kill you.' So I think if you look at who has the real estate problems, that's where you'll see the most shakeouts.

TWST: Neely, following up on that, bad real estate sounds like bad management. Is there a shortage of good management in this specialty retail space?

Ms. Tamminga: Yes, I think there's a paucity of talent, and that's mainly because of the tech boom. Wooed by bigger paychecks, people shifted their focus away from retailing as a career during the tech boom in the 1990s. So we have this great crop of old-school guys running retailers, but we're lacking some bench strength in the ranks.

TWST: Gabrielle, is there a shortage of good management in the specialty retail area?

Ms. Kivitz: I think what's going on with management in the specialty retail area is actually quite interesting. Specialty retailers historically were single-concept companies that then came out with second, third and fourth concepts to sustain growth, and they now have found themselves as quite large organizations in many cases. Some of the merchants that did a commendable job of building and growing brands may not want to run large, multi-division organizations. So now some of the larger retailers are going outside of the retail area to bring in executives who have experience running large, multi-division organizations or who can bring new expertise to the organization. Gap is one example. Mickey Drexler retired a few years ago after a very long tenure at the company. When he retired from the company, he expressed his passion for creativity, customer connection and merchandising, and said that his passions had been upstaged by the demands of running a global $14 billion company. The company then hired a CEO and CFO from outside the apparel retail area ' two individuals from Disney. Limited has gone even more the academic route and more the consulting route, and I think we may see that increasingly from other specialty retailers as their businesses grow.

TWST: Kimberly, is there a shortage of talent here?

Ms. Greenberger: If you ask retail management whether there is, for example, a shortage of merchant talent, I think they would say, 'Yes, there is a shortage.' My view is that there is something of a shortage of very solid retail talent, in part because the traditional training ground for merchant talent was the department store training program, and because of the consolidation in the industry and the problems the department stores have had, or at least the financial problems department stores have struggled with over the last 10 or 15 years, many of those programs have been downsized and/or eliminated. So there is no place now other than on-the-job training for merchants to get really terrific, well-rounded experience in the different aspects of the business. I think that is leading to a dearth of new, emerging talent. However, even the very, very, very best merchants out there, even the talent that we've got in the industry, those people can't be 100% all the time. And because the fashion business is somewhat cyclical and there's a lot of competition out there, the margin for error is quite slim. So if you're not 100% all the time, I think even the smartest, most talented merchant can look somewhat less stellar on a regular basis. And it's not because they're not incredibly talented people; it's that it is very, very difficult to execute six, seven, eight or nine or 10 lines flawlessly every year, year in, year out, without making any mistakes.

TWST: I guess we could ask Mickey Drexler about that. Liz, how about your take on the management in the industry?

Ms. Pierce: I would echo all three of my colleagues' comments. There seems to be a shortage of skilled merchants and, as Kimberly pointed out, it is likely a function of industry consolidation, especially at the department store level. Unfortunately, an additional byproduct of consolidation and the corresponding expense cutting has been the elimination of many of the buyer-training programs; programs that helped many of today's successful merchants develop their skill sets. I also believe managers struggle today because it is difficult to blend the 'art' and 'science' of retailing. Historically, retail has been thought of as more of an art, and today with so many tools at a retailer's disposal, it has also become a science and I believe the best managers find some type of happy medium between the two. If a manager has not developed the scientific skills to better understand the art, it becomes difficult to apply the science. I further worry that retailers are becoming too regimented or too automated in terms of buying and merchandising, which is unfortunate because I believe we will lose so much of the uniqueness that inspires customers to spend. So I do not want to label it bad management, I just think we have limited the development of the skill set for what it really takes to be a good merchant in today's very competitive retail arena. It needs to return to a better balance between art and science, if you will.

TWST: Regarding the science side, how are they doing at using technology to better their businesses?

Ms. Pierce: It has always been something of a joke that retailers are the last to adopt technology, because the 'old school' management style was basing buying decisions partly on past performance and partly on a belief that the retailer knew better than the customer what the customer wanted, and it was difficult to ever challenge that creative side. But the beauty of all the science is being able to focus, down to the SKU per store, to see what is or is not working. I believe the best merchants will try to tap into the science part of the equation that technology provides and combine their own instinct, their own perception and their own take ' i.e., the art ' to the buying and merchandising process.

TWST: Kimberly, are these specialty merchants good at utilizing technology at this point?

Ms. Greenberger: I would say that the specialty retailers are utilizing IT more now than ever, exactly as Liz had said. We are still seeing many retailers implement new IT programs, including more robust planning and allocation programs; customer relationship management programs that will help their stores target their customers a little better; and mark-down optimization programs that will help companies decide when and if to take mark-downs and how drastically to mark down items. But all of these, in particular mark-down optimization, really have just been adopted here for the last year or two. Retailers in the softlines sector were not particularly early to adopt technology relative to other parts of the economy. But now that the interest is there, they seem incredibly willing to take a look at these new technologies and then really use them to maximize their profit and loss.

TWST: Neely, are we seeing good use of IT here?

Ms. Tamminga: It's definitely improving. But I think it's tied very closely to the fact that the decision makers in the IT process, pretty much up until very recently, have come from the old school. The improvements have almost been pure systems updates (for example, purchasing new computers from the last time they had to upgrade, which was probably around Y2K issues). Necessity has been the genesis of them implementing some of these new software programs and getting all their systems up to speed. Retailers themselves will admit, with some laughter under their breath, what late adopters to the technology they have been. So I would just say that it will come. It has come slowly, but it will come with improvements. Systems improvements, we believe, could actually take the margins a little higher, past the peak that they are now seeing. Circling back to the initial comments my peers have made, we agree that we're at peak margins and we believe it's systems that can take it higher beyond peak.

TWST: Gabrielle, is IT usage going to help as we look forward?

Ms. Kivitz: Apparel retailers have higher operating margins than other retail segments, and some of this is due to the emotional impact that a brand, lifestyle, store experience or product offering can have on a consumer. Consumers are willing to pay up for fashion or for an inspirational look. Apparel retailers are able to charge a significant markup for differentiation and creativity, and because operating margins were already strong, I don't think they felt the pressing need to be innovative or proactive with systems ' compared to supermarkets, for instance. That's my take on why this group has historically been late to innovate with systems. They really didn't have to do so in order to maintain strong margins. With recent systems initiatives like the planning and allocation, markdown optimization and distribution initiatives that Kimberly, Liz and Neely mentioned, we're already seeing some benefits, and some companies have even been able to quantify the benefits to margins. I'll also mention customer loyalty programs. I think companies are realizing more and more how much they can get out of better connecting with their customer by doing a better job of tracking customer data and really being able to maximize customer loyalty programs using technology to help drive more top-line opportunities. So I do think companies are realizing more and more how helpful these improved systems can be and how they can help them reach new levels of profitability.

TWST: Neely, when you go out and talk to institutional investors at this point, what's the key question or concern you hear from them?

Ms. Tamminga: I think they're really trying to figure out where to place their money. It's really a balance between going for the growth names ' and growth has been decelerating, as we've discussed ' or just paying premium multiples for the names that have been good in terms of consistent performance.

TWST: Kimberly, what are you being asked when you go out and talk to investors?

Ms. Greenberger: Most investors, at this point, appear very interested in the turnaround stories in the sector. I would say that nine times out of 10, in meetings or in conversation, 'What's the next turnaround story?' is absolutely one of the first questions investors ask. In this sector, these retailers tend to occasionally get themselves into trouble, but the nice thing is that with every season there's a new opportunity to emerge as a better business with a more appropriate assortment. So it's sort of a revolving door of turnarounds. Last year, the really phenomenal turnaround stories were American Eagle Outfitters and Children's Place, and Abercrombie & Fitch toward the second half of last year and the beginning of this year had tremendous stock price performance, based, in part, on a turnaround in its business. So the investment community today ' particularly because of valuations ' seems to be very interested in playing the turnarounds, those retailers that are not operating at peak margins, those that have easier sales comparisons. That really seems to be where the interest lies in my conversations.

TWST: Liz, give us your perspective. When you talk to these investors, what are they asking you?

Ms. Pierce: I would say it has been a very bipolar response. As both Kimberly and Neely have pointed out, there has been a lot of interest in 'turnarounds' or 'surprises,' but I have also had several discussions about the viability of paying premium prices for a successful company. Even if the company has a good track record and significant organic growth, it is a challenge to convince investors to pay up for these attributes. Two examples are Chico's and Urban Outfitters. Based on their fairly pristine track records, unique merchandising strategies and legitimate organic growth, we believe they are core retail holdings and, therefore, deserve premium multiples.

TWST: Gabrielle, when you talk to institutions, what are the issues?

Ms. Kivitz: Investors always seem to be concerned about the volatility in comp performance in this group and really getting comfortable, particularly when comparisons get more difficult. If momentum is strong, can it continue? I think it leads back to what Kimberly and Liz mentioned; it does prompt a number of investors to actually focus on the potential turnaround stories where comparisons are easier and the chance of a miss is not as great, considering the business momentum is already weak. I think the second concern that investors have is actually one that you asked earlier ' people wondering if there are too many stores and how much real growth opportunity there is. Are the potential store bases that we talk about realistic or are they too high?

TWST: Gabrielle, what are you telling investors to do at this point?

Ms. Kivitz: As I said before, we're still very selective. Our theme is sticking with retailers that are showing very strong pricing power, and we think those companies will continue to show strong top-line and margin performance. So that's really what we're recommending. Abercrombie & Fitch and Urban Outfitters are our top picks, and we're sticking by those names. We are also recommending Aeropostale (ARO).

TWST: Liz, how about you? What's your advice to investors at this juncture?

Ms. Pierce: I have been pretty firm about sticking with companies that have had consistent execution and companies that we believe still have an opportunity for margin expansion and legitimate organic growth. But I also have been intrigued and have been pushing some ideas that I would call early-stage turnarounds. While it is a riskier strategy, there are obviously clients out there who have a high tolerance for greater risk.

TWST: What are some of the names that you like?

Ms. Pierce: We call these companies 'our best-of-breed companies,' which include American Eagle, bebe (BEBE), Chico's and Urban. The emerging turnarounds are Limited Too (TOO) and Talbots (TLB).

TWST: Kimberly, what are you telling investors to do, and what do you like?

Ms. Greenberger: Two of our favorites are Chico's and Children's Place. We like Chico's because we still like the very solid organic growth as mentioned by Liz and others on the call. The consistent execution there has also been quite good. Moreover, as you get beyond the spring, Chico's actually has easier comparisons relative to their historical comparisons the rest of the year than they've typically been up against because of things like the hurricanes in the third quarter of last year that hurt their business somewhat. We like Children's Place as a margin- expansion story. For investors who are looking for a retailer that doesn't have a peak margin with excruciatingly difficult sales comparisons, we think the acquisition integration and continued operating-margin opportunities in their core business provide for very attractive earnings growth.

TWST: Neely, how about you? What are you telling people to do, and what are your favorite names?

Ms. Tamminga: Similarly, we are telling investors who own stocks like Chico's to sit nice and tight, 'Don't sell those great retailers.' But we're not recommending that people put new money to work in those names, given the valuations and the very difficult comparisons that they're up against. That being said, on the longer-term side, for people who maybe have a longer time horizon for a couple of turnaround stories, we do believe that J. Jill and AnnTaylor (ANN) are two stocks worth investing in. Simply put, these are very relevant brands that are top of mind for their core consumers. These companies are just dealing with near-term execution or inventory issues ' it's not a real estate issue for them, it's an inventory issue ' and we believe they will overcome these near- term issues and really provide some upside to margin and earnings growth, looking long term.

TWST: What should investors look for in those two in terms of signposts that things are getting better? Comps?

Ms. Tamminga: Of course, same-store sales are the blood pressure to all of retailing, and that's something to look for ' but some of the turnaround you really won't even see until probably September of next year for AnnTaylor in terms of their core business. In the meantime, we recommend that people actually be out in stores checking out the assortment, seeing how people are responding to the product, because these are the types of brands that fly when they do work. They are getting the traffic across their lease line; that's not the problem. It's the conversion rate that can lead to upside surprises in any given month. Buy them opportunistically, and we think it will reap good rewards by year-end.

TWST: Any names to stay away from at this point, Neely?

Ms. Tamminga: I'm going to pass on that question. Some of the names that I think you would not necessarily want to own are names that we don't currently cover, so I probably can't speak to them.

TWST: Kimberly, any names to avoid or worry about?

Ms. Greenberger: I think I'm going to take the Fifth on that one.

TWST: Gabrielle?

Ms. Kivitz: I'll try one out. I do have a sell rating on Charlotte Russe. I've had a sell on it since last fall. I get concerned here because I think that company at this point lacks a strong competitive position in a segment ' fashion at value price points ' that's become increasingly competitive. This has been a potential turnaround with starts and stops, but I'm not really seeing the improved product or execution quite yet. They've had some management transition recently, too. As the company comes up against tougher comparisons in the next quarter, I think things could get somewhat challenging. I think some investors have been interested in the name partly because the comp comparisons are so very easy, and operating margins have eroded so much, and people are looking at the opportunity and thinking that maybe there's a bottom here for the stock. But what's of concern is this is probably the only name on my coverage list where the competitive position is not strong enough, and there really isn't enough of a point of differentiation to garner any kind of longevity, which means that Charlotte Russe may not turn around. If things get really bad, it could ultimately turn into a Wet Seal or Gadzooks situation.

TWST: Liz, any names to worry about?

Ms. Pierce: I do not have sell ratings on any companies, so I suppose in the technical sense, I do not have any avoids. But I would echo Gabrielle's comments and the concerns I mentioned earlier about the state of the junior market and the players that operate in that space. I think the junior customer has changed, which begs the question of the viability of those companies operating in that space and whether they can adopt a formula to meet those changing needs.

TWST: So it's a space to worry about.

Ms. Pierce: Exactly, I think it's a space to worry about.

TWST: Gabrielle, any closing comments you'd like to make?

Ms. Kivitz: One thing we didn't talk about that's important is the strong balance sheets of the companies. Most of them have very large and growing cash positions with, essentially, no debt. They've been using their large and growing cash balances to aggressively buy back shares, and we expect that activity to continue. I think that's a really new, big thing going on with these companies: while the growth rates are slowing, the cash balances are growing, so investors are being rewarded in new ways.

TWST: Forgive me for not asking that. I hadn't thought of good balance sheets as going along with retail.

Ms. Kivitz: Actually, the specialty retailers do have very strong balance sheets, given the high operating margins, strong cash generation and lack of debt. We've even started to see new dividends ' Abercrombie & Fitch initiated a dividend last year ' and I think that too could continue as the cash balances grow.

TWST: Liz, any balance sheet comments to make?

Ms. Pierce: That is a great point Gabrielle mentioned, because it is the balance sheet being so healthy for a lot of these specialty retailers that gives them the ability to come up with another concept ' to do their R&D and to see what is next to ignite the square footage growth. It is one of the reasons I really enjoy the specialty retail space, because it is always evolving and there is always something new happening.

TWST: Kimberly, what's your take on balance sheet positions here?

Ms. Greenberger: I would echo my colleagues here. We've always had fairly good balance sheets in the sector. We may have never had cash balances as high as those we're seeing today. In part, we think, because the sector is more mature today than it was five years ago, the internal need, or the internal opportunity, to redeploy that cash has diminished somewhat and, as a result of that, given the strong free cash flow nature of these businesses, we've seen a steady cash build over the last two, three or four years ' and finally, shareholders are encouraging managements to take a look at using that cash for more productive uses than putting it in the bank at 1% or 2% interest!

TWST: Things like dividends and stock buybacks?

Ms. Greenberger: Exactly.

TWST: Neely, how about your take?

Ms. Tamminga: It's the same. Obviously, Limited's actions in 2004 (buying back their stock and offering a special one-time dividend) were significant. Clearly, that was pointing in the right direction for anybody else who's amassing significant increases in cash. Shareholders will encourage companies to return that or use that cash. Secondarily, I think you'll see the companies spending more on technology.

TWST: Thank you. (TJM)

Note: Opinions and recommendations are as of 03/07/05.

KIMBERLY GREENBERGER Citigroup Global Markets, Inc. 388-390 Greenwich Street New York, NY 10013 (212) 816-6409

GABRIELLE KIVITZ Deutsche Bank Securities 60 Wall Street 16th Floor New York, NY 10005 (212) 250-6311

ELIZABETH O. PIERCE Sanders Morris Harris 333 South Hope Street Suite 264 Los Angeles, CA 90071 (213) 253-2241

NEELY TAMMINGA Piper Jaffray & Co. 800 Nicollet Mall Suite 800 Minneapolis, MN 55402

For disclosure information, see www.twst.com.

Copyright 2005 The Wall Street Transcript Corporation All Rights Reserved