American Eagle Outfitters Inc (AEO) Q3 2022 Earnings Call Transcript

Greetings, and welcome to the American Eagle Outfitters Third Quarter 2022 Earnings Conference Call. As a reminder, this conference is being recorded.

Good morning, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Executive Chairman and Chief Executive Officer; Jen Foyle, President, Executive Creative Director for AE and Aerie; Michael Rempell, Chief Operating Officer; and Mike Mathias, Chief Financial Officer. 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. 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 a 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 corporate website at www.aeo-inc.com in the Investor Relations section. Here, you can also find the third quarter investor presentation. And now I'll turn the call over to Jay.

Good morning. Thank you for joining us today. I'm pleased that we delivered third quarter results well above our expectations despite current macro conditions and tough comparisons as we lap significant pent-up demand and stimulus. While down to last year's record performance, revenue of $1.2 billion was our second highest third quarter in history and our operating profit of $118 million exceeded the third quarter of 2019. I'm also pleased that our profit margins reflected a material improvement compared to the first half of the year. Our aggressive actions to reset inventory and reduce expenses are paying off. We continue to make progress and entered the fourth quarter very well positioned. Our brands are strong and customer engagement continues at a healthy pace. Aerie remains a standout in the industry, and I'm very proud of the multiyear growth we've achieved. I'm also encouraged with the performance of our new Aerie and OFFLINE stores, which demonstrate strong acceptance by our customers. AE profits and margins improved compared to the third quarter of 2019, reflecting strong product assortment as well as the team's focus on rationalizing unproductive SKUs and closing unprofitable stores. Comp sales relative to 2019 were flat, and as Jen will review, we have plans in place to improve the trend. Quiet Platforms is providing significant operational efficiencies and needed capacity for our brands, as Michael will review. The third-party customer base is ramping up as other brands look to upgrade their supply chain operations and drive efficiencies to better compete in the current retail environment. I remain excited about the potential for Quiet. As we evaluate go-forward plans, we are exploring different options to support future growth. Overall, our third quarter was a strong step in the right direction, yet we remain highly focused on driving further improvement. In an uncertain macro environment, we are leveraging the strength of our operations to control what we can and best position ourselves to respond effectively to changing macro conditions. As the supply chain environment continues to normalize, we are using this to our advantage. We are planning inventories tightly and exercising our capabilities to chase into demand. At the same time, we are also reducing expenses and capital expenditures with a firm focus on improving the bottom line and driving stronger free cash flow. As we navigate the near term, we will cautiously invest across key strategic initiatives that provide a competitive advantage and allow our business to emerge from the current environment even stronger. I want to thank our teams for their hard work and dedication over the past several months. We were swift and took decisive actions across the business, and this is now showing up in our results. Looking ahead, we will remain focused and disciplined. Our brands remain incredibly strong. I am confident we will continue to make great progress. Now I'll turn it to Jen.

Thanks, Jay, and good morning, everyone. Although we faced difficult comparisons to a stellar year in 2021, we made good progress across our brands. During the third quarter, demand levels improved from August as we cycled past peak weeks of our record back-to-school seasons last year. Despite a less robust macro, I'm pleased that we delivered results ahead of our expectations. We also saw meaningful recovery in profit margins compared to the first half for both AE and Aerie. Earlier this year, we took very deliberate steps to adjust forward receipts and clear through spring and summer goods. As a result, inventory is in much better shape, which enabled us to control promotional levels in a highly competitive environment. In fact, we achieved our second-best third quarter AUR, down just 5% to last year's record high and up nicely across brands to 2019. As I step back and look at the business, our brands are very healthy. Given the current environment, there are clearly different dynamics at play by brand. Aerie remains on a strong multiyear growth path. Since the third quarter of 2019, revenues have nearly doubled, growing roughly $170 million. Record profits have more than tripled since 2019 and also increased to last year. New store expansion and great brand affinity are fueling increased awareness, and I'm excited to note that Aerie crossed 2 new milestones this quarter, hitting 10 million customers for the first time and achieving an all-time high AUR. Compared to last year, core intimates, fleece, and apparel showed up well. I continued to be extremely pleased with our expansion of OFFLINE, where new stores are performing very well. Aerie's cult-like following in leggings is driving momentum and has given us the ability to expand into adjacent categories like sports bras and active tops, all of which are seeing great results. We expanded our winning Real Me leggings franchise, introducing a new Hold Up! technology to our waistband. We incorporated this fabrication into our sports bras and have seen amazing results for matching sets, which are a big trend. For the holiday season, I'm really excited for the new campaign, I Want Aerie, our broadest campaign positioning Aerie as the gift-giving destination. Turning to American Eagle, pressure was anticipated as we cycled last year's record results, yet we did better than expected. Our actions to intentionally reduce inventory contributed to a nice profit improvement from the first half. As noted at last year's analyst meeting, we've been focused on resetting the brand, reducing SKU counts and promotions, and selectively closing unproductive stores. As a result of these efforts, we are seeing profits improve with operating income up 14% to 2019 and better margins across channels. Rationalizing excess SKUs is providing greater focus. We are making adjustments to address emerging fashion trends and feel really good about the newness we're bringing in to the customer. For example, the Strigid denim collection launched last quarter and is doing very well. We've also shifted our assortment to emphasize new trends in woven bottoms such as cords, cargos, and wider silhouettes, all of which are seeing nice demand. As the supply chain environment continues to improve, we are becoming more nimble. We are getting back into a test-and-chase rhythm, which is a meaningful positive as we plan ahead. With new fashions, fabrics, and silhouettes all emerging on the horizon and our renewed agility to respond to near-term shifts in consumer demand, we should have a great setup going into 2023. We are also excited to launch a new sub-brand in men's, bringing innovation and newness to our men's business. Pre-launch tests have been very encouraging. We continue to leverage social commerce to explore new ways to engage with our customers. Our efforts across TikTok and the metaverse continue to drive strong engagement. Additionally, this quarter we became the first major fashion brand to launch on BeReal. While the macro is certainly not easy, my confidence in our brands and overall consumer affinity for great casual wear is stronger than ever. We remain intensely focused on innovation and seeking opportunities to drive profitable growth across our businesses. A big thank you, as always, to the Aerie and AE team for staying focused and forging ahead. I'm incredibly excited for our holiday collections, and I look forward to updating you on our performance next quarter. Thank you, and wishing everyone a safe and healthy holiday. And now I'll turn the call over to Michael.

Okay. Thanks, Jen, and good morning, everyone. Overall, I'm pleased with how we managed the business in the third quarter, particularly as we navigated through an unpredictable environment. Let me start with a review of our channel performance. This year, we faced a more constrained macro environment and amplified pressure from tough comparisons. Store revenue declined 4% to last year, while digital revenue declined 5%. However, compared to 2019 pre-pandemic levels, I'm really pleased with what we're seeing in the business. For example, brand revenue was up 14% with growth across both store and digital channels. Our digital business, in particular, has grown 35% over this period, with digital penetration expanding to 33% from 28%. We continue to invest in the speed and functionality of our digital platforms. Our mobile app business continues to be a powerhouse, driving strong engagement for both brands and accounting for approximately 40% of total digital spend. Investments in digital capabilities are going to remain a strategic focus. As we noted last quarter, we have brought together store and digital operations, creating greater efficiencies and better integration of the customer experience. I see incredible opportunities as we ensure our go-to-market strategy is best aligned with how customers are shopping. Lifestyles have changed dramatically over the past several years and shopping behaviors continue to evolve, including the dramatic shift to digital, the need for speed, and how, where, and when customers are visiting stores. Connecting the experience across all channels and creating a more seamless view of customers are top priorities. Our new mobile point-of-sale system is a great example of innovative technologies that we're leveraging to further elevate the customer experience. All U.S. stores have now upgraded to the new system, and they're seeing improved transaction speeds and shorter checkout lines. This is going to be especially beneficial as we come up on the holiday rush. The new system is flexible, provides a compelling mobile checkout experience, and incorporates several new capabilities, including a much more seamless integration of our loyalty program. We have an exciting roadmap to build out the customer engagement capabilities in 2023. This holiday, AE and Aerie will be offering virtual shopping sessions through ShopLive, a new platform connecting customers to our talented store associates for one-on-one style advice from the comfort of their homes and other one-to-many live stream shopping experiences that we're testing with Aerie. We are also focused on updating and modernizing our most productive stores; relocating in some markets to ensure we're in the best locations; leveraging data to customize our assortments and inventory levels by market; continuing to close our least productive stores, where we can confidently consolidate sales to other stores or transition to e-commerce; and investing in new technology and leveraging artificial intelligence to improve inventory visibility, placement, and ultimately productivity across channels. There is significant value to be unlocked by all these focus areas. By approaching our physical store footprint from a variety of angles, we believe we can truly maximize our brands, elevate the customer experience, and operate with a more efficient cost structure. Turning to supply chain, the environment has continued to improve. Although some volatility still remains, lead times have normalized, and factory capacity has freed up. This presents a dramatically different planning environment compared to the constraints we were operating under this time last year. We have far greater agility in our operations, which is giving us the option to buy lean, leaner, more open, and chase into demand. On the sourcing side, costs continue to stabilize. Cotton pricing has eased and freight costs are down significantly from levels seen over the past 12 months, which is going to provide a significant tailwind in 2023. On the outbound side, our investment in Quiet Platforms continues to fuel efficiencies and cost savings. I really want to underscore that the Quiet node network provided much-needed capacity to AE and Aerie over the past several months, enabling us to seamlessly handle higher inventory levels. Digital delivery costs in the third quarter were down to last year as we fulfilled orders more cost-effectively and with fewer shipments. We're also leveraging Quiet's advanced fulfillment capabilities located near customers to further reduce delivery times, with approximately 80% of online orders reaching our customers within 3 business days following checkout. Our third-party customer base service with the Quiet nodes continues to expand. Interest from prospective customers remains strong, as awareness of the business continues to grow. We are also signing new transportation, fulfillment, and technology partners onto the platform, which is further expanding our capabilities. As Jay mentioned, we believe Quiet is a very exciting business that's early in its growth curve and has the potential to transform our industry. Thanks. And with that, I'm going to turn the call over to Mike.

Thanks, Michael. Good morning, everyone. The third quarter results exceeded our expectations across both revenue and profitability. As the team noted, actions to reduce inventory levels, clear through excess spring goods in the second quarter, and lower expenses resulted in a profit recovery from the first half of the year. As we continue to manage through the current environment, we remain focused on improving profitability, cash generation, and the health of our balance sheet. Third quarter consolidated revenue was $1.2 billion, down 3% to last year, including 2 points of growth from Quiet Platforms. Brand revenue declined 5%. The gross margin rate of 38.7% was ahead of our expectations of mid-30%s due to better demand and lower-than-anticipated markdowns. As noted last quarter, we ended the third quarter in a better inventory position with fresh fall goods. As a result of our inventory actions, we were able to control our promotional activity while successfully moving through units. We ended the quarter with more progress on inventories, as I'll review in a moment. Compared to last year, the gross profit dollars declined 15%, with a gross margin rate down 560 basis points against a very strong rate last year. Higher markdowns and increased product costs drove approximately 400 basis points of the decline. The integration of Quiet Platforms drove approximately 70 basis points of incremental deleverage. Rent and warehousing also increased as a rate to sales, offset by lower compensation costs. SG&A dollars declined $3 million compared to last year due to lower incentive accruals and expense actions announced earlier this year. We continue to make progress in resetting our expense base. As noted last quarter, these actions should result in over $100 million in annualized expense reductions from our original plan. We expect SG&A to be approximately flat in the fourth quarter. Although operating profit was below the third quarter of 2021, it was up compared to 2019. Operating profit of $118 million reflects a 9.5% margin. This included a $10 million loss from Quiet Platforms. As volumes ramp up into the holiday selling season, we expect Quiet's bottom line to improve sequentially. EPS was $0.42 per share and included a $1 million interest add-back to net income linked to the outstanding convertible securities. Our diluted share count was 196 million, down from 205 million last year. Now, I'll provide some color by brand. Aerie revenue increased 11%, driven by new stores. Comparable sales declined 3%, following an 18% increase last year. Aerie achieved an operating margin of 16.2%, marking a solid recovery back into the double digits as planned. Compared to 2019, total revenue nearly doubled, with operating income more than tripling to $56 million. Continued strong growth combined with higher merchandise margins are driving improved profitability for Aerie. This combination creates a durable path of profitable growth for the brand. Additionally, as new stores continue to ramp up, we're seeing improved productivity. American Eagle comps declined 10% following a 21% increase last year, fueled by an exceptionally strong back-to-school season. AE achieved an operating margin of 21%, also showing improved profit flow-through relative to the second quarter. Markdowns were more controlled, reflecting more appropriate inventory levels. As Jen mentioned, our continued focus on initiatives to improve profitability is driving results. While revenue was down 4% compared to the third quarter of 2019, I'm pleased to note that operating profit was up 14% over the same period, and brand operating margin expanded 330 basis points to 20.8%. Consolidated inventory at cost was up 8% compared to last year, with units up 7%. This reflects a meaningful improvement from last quarter's increase of 36% as we work to bring receipts more in line with demand. Inventory is current for the holiday season. We continue to expect sequential improvement with fourth quarter ending inventory plan down to last year. We ended the quarter with $82 million in cash and total liquidity of $423 million. Capital expenditures totaled $71 million in the quarter and $199 million year-to-date. For the full year, we continue to expect capital expenditures of approximately $250 million. As mentioned last quarter, we've made significant strategic investments to support the future growth of our business. This includes 85 new Aerie and OFFLINE stores over the past year, which should provide comp benefits and fuel profit expansion at Aerie in the coming years. As we focus on absorbing and growing into these investments, we expect annual CapEx to be significantly lower in 2023. Before I move on to our outlook, I want to highlight that our third quarter operating margins for both American Eagle and Aerie surpassed pre-pandemic rates achieved in the third quarter of 2019. As we think about the opportunity for margin expansion in the long run, this is a notable point. The quarter we just completed was far from perfect. Product and freight costs, while easing, were still elevated compared to the third quarter of 2019. We have a significant number of new Aerie and OFFLINE stores that are still in the process of ramping up to reach average fleet profitability. We're operating in an intense promotional environment as the industry works through historical levels of excess inventory. Additionally, we still see significant opportunities to improve inventory productivity. Assessing these factors, I'm confident that our third quarter margin performance, while reflecting a nice improvement from the first half of the year, is not our ceiling. Now on to our outlook. With key holiday selling weeks still ahead, the bulk of the quarter is yet to play out. With what is likely to be a highly promotional season in the broader market, we're guiding fourth quarter brand revenue down mid-single digits. This implies brand comps trending similar to the third quarter. We expect fourth quarter gross margins to be between 32% and 33%, on the higher end of our prior outlook of low 30%s. While we made significant progress in rightsizing our inventory position, we're taking a cautious view given the factors I just discussed. Our tax rate assumption is in the high 20%s and weighted average share count at approximately 196 million. We've made significant progress over the last 2 quarters in resetting our business, and we'll continue to prioritize profitability and cash flow improvement moving forward. Additionally, as the team noted, we've regained agility in our supply chain, and we intend to use this to our advantage. For 2023, we're planning expenses and inventory tightly, knowing we have the ability to read and react to the demand signals as they evolve. I look forward to providing more detail on our 2023 outlook on the next call. With that, I'll open it up for questions.

Our first question is from Matthew Boss with JPMorgan.

Congrats on a nice quarter. So maybe one for Jen. Could you just elaborate on the bold inventory actions that you took in the third quarter across both brands? And maybe any early read on holiday trends? And just how do you feel your assortments are positioned into the fourth quarter and holiday to potentially take market share in this competitive backdrop?

Thank you, Matt. We truly acted quickly, as we've noted before, starting in Q1. In the AE brand, we have been streamlining SKUs for over two years to remain focused on our key items and brand identity. Denim and bottoms remain central to our strategy. For both brands, we anticipated market conditions and took significant steps to manage our inventories. I’m encouraged by what I see for the holiday season. While it's still early, as Mike pointed out, we have an important week ahead. We visited various malls and observed our competition, and I believe we are operating on our own terms. While we aim to be competitive, our earnings performance reflects our approach—we ensure strong promotions, but they align with our strategy. This long-term strategy, which Mike mentioned, is what we communicated to analysts a couple of years ago: our goal is to achieve strong bottom-line results. I'm optimistic about our inventory positioning, Matt, as I believe we'll enter January with a cleaner slate and reduced clearance inventory, which should positively impact our earnings.

And then maybe just a follow-up for Mike. So with your fourth quarter gross margin guidance more or less flat to a year ago, could you just elaborate maybe on the puts and takes if we're thinking about markdowns versus freight versus Quiet logistics? And I guess, even more so, if we think into next year, is there any reason why you couldn't see merchandise margin expansion as we lap these inventory actions?

Thanks, Matt. Yes, for the fourth quarter, we maintain our revenue guidance with brands expected to be down 5%. As Jen mentioned, we're focusing on being strategic and competitive with our promotions, without being excessively promotional, but we are prepared to compete when necessary. Regarding the revenue guidance, along with the implied negative comparisons, we anticipate continued deleverage in BOW for the quarter, and Quiet will similarly impact gross margin. When considering these factors together, we are at the higher end of our previous low 30% guidance, and we feel positive about our cautious approach. Looking ahead to next year, Michael and I can share that we actually anticipate some favorable conditions as we reflect on the past 4 to 5 quarters. Last year's fourth quarter marked the beginning of the significant effects of product costs, particularly in ocean and air freight rates, along with the air freight needed to bring our goods in. Moving forward, with our improved capabilities, it seems freight costs could become a benefit next year. Overall product costs are looking advantageous, and we believe we can return to nearly pre-pandemic levels of IMUs, which would enhance gross margin next year. Michael, do you have anything to add?

No, you said it well. I think merch margin should be better next year. We have IMU benefit. Supply chains are much tighter, so we could run the business leaner and chase into demand. And we're up against a year, Matt, that was really unprecedented. It had very long lead times, and we were going against stimulus-fueled demand. And next year, we're up against a much more normalized environment. So between IMU benefits and ending this quarter in a very good inventory position and being able to react to the business next year, which is something we couldn't do this year, I absolutely believe that we're going to have higher merch margins next year.

Our next question is from Jay Sole with UBS.

I have two questions. Jen, my first question is that you made some comments about Aerie in the opening prepared remarks that sounded really bullish. Just talk about what gives you conviction behind that bullishness given the comp was negative in the quarter. And then, secondly, for Michael, can you talk about the logistics platform a little bit, and maybe give us an idea of what has developed over the last 90 days and kind of the path to profitability as you see it, if it's next year or beyond?

Yes, Mike articulated it well. We believe that as we approach the anniversary of our new store openings, we will capture market share in those specific areas. We expect this to become a regular occurrence next year, and we are optimistic about it. Additionally, while there has been discussion about a slowdown in casual wear, Aerie is not experiencing this decline. We have launched our OFFLINE brand during COVID, and its early performance has been extraordinary. I am truly impressed with this product line. Our leggings have developed a dedicated following, as I mentioned earlier, and they genuinely stand out in the market. The team continues to innovate year after year, and that gives us fresh topics to engage our Aerie customers. We are confident in these categories and do not see any weakness in casual-style products, with Aerie serving as a solid foundation for us. We will keep delivering innovations across both brands. I am particularly proud of the new offerings at AE, as we are shifting into the right categories for new bottoms, and the quality and ideas we have are unparalleled. I am also excited about a new launch coming in early spring, although I cannot reveal the details yet.

Yes. Jay, building on what Jen mentioned, I want to emphasize that we have opened many new stores over the past year. Mike pointed this out in his comments. These openings initially created a challenge for comparable sales in the early part of this year and into the third quarter. However, starting in the fourth quarter, this trend will shift to a positive impact. As these stores reach their anniversary and become more established, we expect that they will actually contribute positively to our comparable sales. Based on historical trends, which we believe will repeat, we anticipate these new stores will provide a multi-year boost to Aerie's comparable sales beginning in the fourth quarter. Regarding Quiet, we remain very enthusiastic about its potential. We expect third-party customer revenue to significantly increase, potentially by 60% to 80% this year. Looking at our results, American Eagle's quarterly performance shows a lower cost per order and a decrease in split shipments, which is quite rare and possibly unprecedented in retail. Other brands and retailers we are engaging with are eager for similar benefits in their businesses. We have demonstrated the value of this approach, and the interest in acquiring new customers for Quiet is very strong. We will provide more details on new customers at the end of the fourth quarter. Quiet is delivering positive outcomes for American Eagle and offering distinct advantages that we believe other brands and retailers will want to leverage.

Our next question is from Paul Lejuez with Citi.

I would like to follow up on the previous question regarding Aerie being a negative factor, and how those openings have impacted us during the first three quarters of this year. I'm interested in the plan for openings next year and whether similar challenges are expected from a new batch of openings. Additionally, I would appreciate any information on the stand-alone performance of Aerie compared to the side-by-sides. You also mentioned that product costs would be a benefit; I’m curious about how that will play out in the first and second halves of 2023.

Thanks, Paul. I'll start and Michael can maybe add on to your product cost question. Regarding the Aerie stores, Michael mentioned a few points, so let me expand on what we discussed in my remarks. We have 85 stores over the past year, but looking back across all of '21 and '22, that number exceeds 130 stores. As we've indicated, our digital halo effect and investment in the brand tend to create significant digital impact alongside this new store expansion. When we add stores in existing markets, we also notice effects on the established stores. Over a 6- to 12-month timeframe, we sometimes experience a slight negative comp impact in those markets. However, after that period, we typically observe a lift in the total market. We've seen this pattern play out over the last two years. As we move into the fourth quarter, we believe Aerie's comp performance could improve. Although we discussed guidance for similar comps, depending on the business mix within Aerie, we might witness a positive comp or a stronger result in the fourth quarter. Looking ahead to '23, we're planning to open around 30 locations, so we don't expect any significant comp impact from that growth, especially as most of the 130-plus stores ramp up their maturity. This is what we refer to as the tailwind for next year and beyond, driven by significant openings and investments in the brand. We're excited about the implications for overall growth and comp growth. Regarding stand-alone versus side-by-side performance, there doesn't seem to be a substantial difference between the formats at this moment. Michael, you can provide further insights on product costs for next year.

Yes, Paul, regarding your question about the first half and second half. It's too early to comment on the second half of next year. In the first half, we certainly expect markup to be better than it was this year. We're experiencing many benefits in the business. Ending the fourth quarter with clean inventories allows us to fully benefit from a weaker demand environment while sourcing spring and summer products. I anticipate markup to be better than 2022 in the first half, and as we place receipts for spring and summer, we see markup exceeding prepandemic levels from 2019.

Our next question is from Janet Kloppenburg with JJK Research Associates.

Congrats on the improved results. Jen, can you just talk a little bit about what kind of levels of promotional activity we should see in the fourth quarter on a year-over-year basis? Inventories are in great shape and you're excited about the product and the comparisons are relatively easy, so I'm wondering what we should be watching for in the fourth quarter? And on SG&A, as we look out to next year, are there any investments that were put off for this year that we should consider for next year? And just lastly, Jay, if you could enlighten us on your thoughts about consumer spending next year and how that may impact your business, it would be terrific.

I believe we will remain competitive over the next few weeks, which are significant for us, and we aim to perform at our best. Looking ahead, I see opportunities in December to improve our operations. Last year, Aerie had some margin opportunities in the fourth quarter, and we plan to enhance that and ensure we protect it. We see December, and into January, as a key period since we are not carrying the same high inventory levels as some competitors, allowing us to reduce promotions during January, a time typically focused on liquidation. This positions us well for a successful early spring. I have just approved the spring store setup, and it looks amazing. You will see new offerings for men as well. We are committed to delivering fresh products to compete effectively.

We are very pleased with our progress to date, which has been our focus since the beginning of the year. I appreciate the efforts of the teams working across different areas. We experienced flat or slightly decreased results in Q3 and anticipate similar results in the fourth quarter. However, our work is not complete; it's still a work in progress. We are developing plans for next year. It's important to note that our focus extends beyond SG&A, even though that tends to be the topic of most questions. SG&A represents only half of our expense structure. As we plan for next year and look longer-term over the next few years, we are examining every category that influences gross margin, including SG&A and depreciation. This effort is ongoing, and we will provide more details next quarter regarding our expectations for 2023 and beyond, so please understand that we still have more to accomplish.

In this business, you need to be an optimist to succeed in retail. I'm excited about many aspects, especially the new product launches that Jen mentioned, which I believe will be very beneficial for the company. As Michael pointed out earlier, we are seeing our costs decline, with freight costs returning to 2019 levels, which gives us reason to feel hopeful. We have the capacity to respond to needs and pursue merchandise effectively. Overall, things are looking positive, and we can only focus on what is within our control. I remain optimistic, as there are many encouraging indicators. I've also read that mortgage rates are expected to decrease, and hopefully, interest rates will follow suit. I believe the future will be better than anticipated.

Our next question is from Dana Telsey with Telsey Advisory Group.

It's great to see the progress. Considering the positive factors related to freight expenses and cotton costs, how do you anticipate this impacting your margins? Jen, regarding the Aerie business, I'm really excited about the upcoming spring launch. Is there anything specific we should be looking out for during the holiday season, aside from the leggings, that could suggest an increase in sales going forward in terms of demand levels? Also, in terms of the core American Eagle business, what trends are you noticing in denim for both men and women? Any noticeable differences?

On the trends of freight and cotton prices declining, that's encouraging news. The past two years were quite the opposite. I recall that eight months ago, many were predicting that freight and cotton prices would continue to rise, but it has turned out differently. I view this shift positively. Additionally, we compete not just within the United States but in the global market. Many factories we work with also supply to other countries and continents. The market is softer in Europe and elsewhere, which allows us to purchase products at a better cost. This is an encouraging sign. One thing I take pride in is that we offer our customers an excellent selection; I believe we have the best assortment in retail. Our quality and value are top-notch. We are very excited about the work that our designers, buyers, and team have accomplished. Looking ahead to next year, the plans are very promising. Jen will provide more details on that later. Overall, I think everything is looking positive.

Yes, I agree, and Dana, regarding how things unfold, I expect improvements as we move into the spring season. It's crucial to note that our ending inventory is in good shape. If you're a retailer carrying over inventory from this year into the next, you'll likely face higher transportation and cotton costs as they affect your profit and loss statements. In our case, we will have minimal carryover. While we have some fabric platforms to manage, we are experiencing significant advantages in transportation costs, and there is a positive shift in product costs as well. As the spring season approaches, we will start with a markup advantage that is expected to increase as the season progresses.

Michael, I want to add one point. You mentioned cotton. We adhere to the rules and are very cautious about the cotton we use and where we manufacture our products. We expect our competitors to do the same. It's important for retailers in America to have a level playing field. Some retailers not based here are gaining advantages by not paying tariffs and not being accountable for their sourcing practices. This situation is unfair, and I believe Congress needs to take action to ensure that American companies can compete fairly. Analysts in the U.S. should also be highlighting that it is unjust for American companies to follow the rules while others come into this country and violate them without consequences.

That was a great statement, Jay, and it’s certainly a challenge to follow. Yes, Dana, let’s begin with American Eagle. I want to clarify my previous comment. We're launching a new product in the American Eagle brand, particularly in men's wear for the spring 1 delivery, and we're quite excited about it. Early feedback on our upcoming launch has been positive. We plan to approach this with integrity and caution to avoid overextending ourselves in a new venture, but we are genuinely enthusiastic about the initial results. On denim, while it is a staple of our brand, we are also observing a shift towards new bottom styles like cargo pants, cords, and wider fits. Our efforts to streamline denim SKUs are giving us more flexibility to explore these new styles as we navigate a somewhat softer trend. However, we remain confident in the future of denim; it’s a core aspect of our identity at American Eagle, and we take pride in that category. We also have exciting new products coming in that area, which you will see in early spring. As for Aerie, we are just beginning to ramp up our OFFLINE business, which has only been around for a couple of years. Our legging innovation is unparalleled, and we’re concentrating on that in OFFLINE. We also have exceptional fleece categories that stand out. I take great pride in the price/value offerings in Aerie, and we are not witnessing any decline in that area. We are eager about what's next for that category and are constantly looking for new ways to promote and market it. Our marketing campaigns in Aerie are innovative and engaging, truly distinguishing us in the mall. There’s plenty more to come. I just approved the spring early sets for both brands, and I must say, they are fun and refreshing, making us confident in our ability to stand out in the retail space. Intimates in Aerie are also a priority for us, and we are continuously innovating in our bras. I am optimistic about what the future holds in that area, and our aim is to please and delight our customers because that’s what we are focused on.

Our next question is from Adrienne Yih with Barclays.

Let me express my congratulations, well done. Jen, I want to highlight your enthusiasm; this is the best I've heard you sound in a while, which is exciting. It appears that the supply chain has returned to a level where you can test, reorder, and chase effectively. My question is, as you head into the spring season, how much are you purchasing upfront compared to what you are leaving available to gauge demand? Michael or Mike, regarding inventory, could you remind us about the numbers? It was up 37% at the end of the fourth quarter, then 46%, and back to 37% in the first and second quarters. Can you clarify what portion of that was in transit? If your inventory levels decrease significantly and it was all in transit, I want to ensure that there are no concerns that you can't compare effectively, as it wasn't available for sale and had low utility. I believe you won't order excess inventory, so I want to ensure that this message is clear.

We are continuously assessing the relationship between our inventory and sales, ensuring that our sales strategy is positioned higher than our inventory levels based on our plans. This approach is a best practice for both of our brands. Generally, we maintain about 25% of our inventory available. As Michael mentioned, we are much more flexible at this time, allowing us to receive goods more quickly and efficiently, which we are fully utilizing within our supply chain. Looking ahead, what you see for the holiday season and our recent inventory releases will continue in the same manner. Additionally, with new technologies, we believe we can further enhance our inventory efficiency. I hope that clarifies your question.

Our next question is from Kimberly Greenberger with Morgan Stanley.

Jen, I wanted to follow up on what you're seeing on trends in the business. If you could just sort of frame the changing consumer preferences, if you're seeing any this year compared to last year? And how are those ebbs and flows in what consumers are gravitating to, how is that informing your buying for 2023?

Sure. I've mentioned this before: for both brands, we're focused on comfort and softness, which, combined with our price/value equation and quality, is unique. While there have been discussions about a shift towards going out and certain categories like dresses earlier this year, our core customers still prioritize comfort. We haven't noticed a decline in fleece; in fact, both businesses are seeing growth there. American casual comfort is here to stay. It's crucial for any brand to stay true to its identity. Both brands emphasize fit, with Aerie's bra categories and AE's denim bottoms being essential. Our customers want to look good in what they wear, which sets us apart as we prioritize the best fits in the industry. Going forward, we will continue to meet our customers' expectations. American Eagle is primarily a bottoms-based business, and we are evolving that area. In Aerie, we will maintain our focus on intimates while exploring exciting new categories. What I appreciate about Aerie is that our customers are increasingly asking for more from us. They want additional categories because they love our brand and what we represent, and they want to engage with our community.

We didn't cover it in the prepared remarks, but it is up to pre-pandemic levels for both brands. We don't have specifics for you right now. But yes, AUR is healthy and up in both brands.

Okay, I think we can take one more question.

Our next question will come from Jungwon Kim with Cowen.

Just one question on marketing costs. We are seeing some elevated costs for customer acquisition. Curious as to how you're managing your costs at the moment and what your plans are for next year?

Thank you. Yes. Yes, you're correct. There's definitely sort of headwinds in terms of advertising and marketing costs. We've got a lot of different moving parts within our advertising spend, so we are prioritizing that spend to make sure that we can offset those costs, not incrementally incur expenses for the company, but then redirect spend where we need to for customer acquisition and retention. So the teams are hard at work at that. It's kind of week-to-week, month-to-month conversation in terms of where investments are made. And then on a preseason planning basis, that's definitely the focus they have looking into next year. But we believe we can spend to similar levels and similar rate of sales to generate what we need to from an acquisition and retention perspective without incrementally incurring expenses.

All right. And on that note, as Mike has said, we are intently focused on improving profitability and cash flow and will be maintaining strong discipline around inventory, expenses, and capital expenditures. Our brands are healthy, our operations are resilient, and I'm confident we will emerge from the current macro stronger. I look forward to updating you on our continued progress and wish everyone a happy and safe holiday season. And on a personal note, go Buckeyes.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.