A.K.A. Brands Holding Corp. Q3 FY2022 Earnings Call

Greetings and welcome to the a.k.a. Brands Holding Corp. Third Quarter 2022 Earnings Conference Call. All participants are currently in a listen-only mode. A question-and-answer session will follow the formal presentation. This conference is being recorded. It is now my pleasure to introduce your host, Ms. Emily Schwartz. Thank you. Please proceed.

Good afternoon. Thank you for joining a.k.a. Brands third quarter 2022 conference call to discuss the results release this afternoon, which can be found on our website at ir.aka-brands.com. With me on the call today are Jill Ramsey, Chief Executive Officer; and Ciaran Long, Chief Financial Officer. Before we get started, I'd like to remind you of the company's safe harbor language. Management may make forward-looking statements, which refer to expectations, projections and other characterizations of future events, including guidance and underlying assumptions. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those expressed. For a further discussion of risks related to our business, please see our filings with the SEC. Please note, we assume no obligation to update any such forward-looking statements. This call will contain non-GAAP financial measures such as adjusted EBITDA and adjusted EBITDA margin. Reconciliations of these non-GAAP measures to the most comparable GAAP measures are included in the earnings release furnished to the SEC and available on our website. With that, I'll turn the call over to Jill.

Thank you, Emily, and thanks, everyone, for joining our call this afternoon. I'd like to start by congratulating the Culture Kings team on the grand opening of their first U.S. store this past weekend and appreciating all of our teams for their ongoing hard work, agility, and grit in what continues to be a dynamic and challenging macroenvironment. As we discussed last quarter, during this time of less predictable demand, we are focused on improving profitability while building great brands for the long term. Demand remains impacted by inflationary pressures on consumers, shifts in customer spending, and a competitive marketing landscape. Despite these headwinds, I'm pleased that the U.S. region, our largest, had solid net sales growth of 8% in the quarter on top of very strong 84% growth last year. However, net sales overall decreased 4% to $156 million or were flat when adjusted for foreign exchange impact. Australia declined 9% or negative 2% in constant currency. Like the U.S., Australia is experiencing macro effects from consumer inflationary pressure and a shift back to stores post-pandemic. Additionally, we were impacted by significant FX headwinds, which Ciaran will discuss further when he takes you through our financials and revised outlook. Thanks to the agility and swift work of our teams, we increased our gross margin rate by 50 basis points and improved EBITDA margin by 220 basis points on a sequential basis while continuing to make progress on our inventory position. We took a number of actions during the quarter, including marketing spend reallocations, inventory optimization, and team and resource rightsizing. We anticipate another challenging quarter, and we will be prudent about identifying efficiencies in our operation and managing inventory while balancing our long-term focus on growth. A.k.a. Brands is the next generation of fashion, and our flexible, asset-light model enables us to adapt quickly during dynamic market conditions. Our data-driven approach to merchandising combines test-and-repeat buying with short lead times and a high mix of exclusives. This allows us to efficiently manage our inventory and deliver strong gross margins while navigating shifts in consumer demand and supply chain dynamics. We have a modern approach to marketing, combining a social-first strategy with performance and in-house channels to attract and retain customers at low cost. Our ability to quickly shift spend across channels and geographies ensures we optimize our marketing yield during dynamic times. We have a unique mix of talent with veteran e-commerce leaders and operators who have experienced multiple economic cycles combined with innovative next-gen talent. Importantly, we continue to build our brands' awareness and expand our customer base, as evidenced by a 23% growth in active customers compared to the same period last year, led by growth in the U.S. We are still in the early days of our U.S. market awareness and have significant opportunities ahead of us. We made great progress on our growth initiatives this quarter, and I'm pleased to share some highlights. While I usually start with the women's brand, what I'm most excited to talk about today is the Culture Kings' grand opening. Our first Culture Kings U.S. flagship store opened on Saturday, November 5, in the iconic Forum Shops at Caesars, Las Vegas. It's an unrivaled retail experience unlike any store out there with 14,000 square feet of selling space, an LED staircase, the largest hat wall in the world, live in-store DJs spinning daily, a half basketball court, a bar, a Secret Room with rare and exclusive merchandise, and an on-site customizer for sneakers and apparel, a recording studio, and more. In addition to some Vegas-only features, the flagship store includes the best of Culture Kings' signature in-store activities and games, including the legendary Sharp Shooter basketball challenge, The Holy Grail arcade, and one-of-a-kind giveaways that all add to the excitement and unforgettable atmosphere in store. Similar to Culture King's other stores, the U.S. flagship serves as a powerful marketing engine and is a key accelerator of brand awareness in the U.S. Known for their experiential stores and unique retailtainment model, Culture Kings frequently hosts athletes, DJs, and music artists for in-store appearances. DJ Drama was spinning Ferg's top 5, and several other streetwear influencers attended the opening. All of this creates great buzz, brand association, and awareness for Culture Kings. On top of the immersive experience, the flagship officially introduces the U.S. consumer to Culture Kings' 18 exclusive in-house fashion brands, including Carre, Saint Morta, Goat Crew, and Loiter. These in-house designed brands make up approximately half of the Culture Kings business today and are a key focus area for the U.S. expansion. No one brings together the elements of streetwear lifestyle quite like Culture Kings. In addition to the popular in-house fashion brands, the store sells thousands of styles from 60 leading third-party brands, including fan gear, footwear, and hats. And online, the customer can find even more great selections. We are confident that Culture Kings will become the new authority in streetwear and capture significant white space in the U.S. market. As Culture Kings expands in the U.S., they continue to build their brand penetration of exclusive products with an emphasis on the fast-growing printed tees and hoodies segment. As a reminder, our print-on-demand capability allows Culture Kings to quickly jump on trends and print licensed properties at attractive gross margins. This quarter, Culture Kings had a successful collaboration with Netflix, licensing their Stranger Things property, which exceeded expectations. They continue to ramp the print and licensing business and will deliver 30 new collaborations, including Playboy, J. Cole's label Dreamville, and a series of world-exclusive UFC events and talent in the fourth quarter. While Culture Kings' current priority is U.S. expansion, we're pleased that the Australian stores rebounded in the third quarter with the return of live events and in-store activation. Turning to Mnml, our streetwear brand specializing in denim and bottoms. I'm excited to share that the synergies between Mnml and Culture Kings are coming to fruition. Mnml is now the fastest growing brand on Culture Kings' website, and there is a dedicated section and wide range of Mnml assortment at the Culture Kings' store in Las Vegas. We were pleased with the performance of Mnml during the opening weekend. It was both one of the top performing brands overall and the best-selling brand in the bottoms category. We're also pleased with Mnml's ability to quickly leverage shared learnings and resources from the a.k.a. platform. They're shifting their merchandising strategy to align with our proven test-and-repeat model, enabling them to drop more new styles on a faster production timeline. Turning to our women's brands. Princess Polly, our largest brand, continues to be a top fashion website for female teens, as ranked once again by the most recent Piper Sandler survey. While we have seen macro impacts on demand this fall in line with the broader market, I remain incredibly confident that we're still in the early innings of expanding this brand and am bullish on its growth potential in the U.S. and globally. Given that roughly 70% of Princess Polly's customers are students, a primary focus this quarter was the homecoming and back-to-school season. Their expanded homecoming collection, which featured new, more formal dresses, along with existing favorites, exceeded expectations and gives them confidence to expand their formal wear offering. Princess Polly also expanded their back-to-school assortment focused on casual apparel, which was further amplified on social media by Princess Polly's growing community of college ambassadors who serve as powerful micro-influencers. Princess Polly continues to make headway on their mission to make on-trend fashion sustainable and accessible. They've made great progress expanding their sustainable range made with lower impact materials and will surpass their goal of converting 40% of their new styles to low impact fabric by the end of the year. They continue to transform their supply chain to support this and are committed to maintaining the same gross margins and accessible price points for customers. Princess Polly's extended size collection, Curve, also continues to gain traction and grew nearly 20% quarter-over-quarter while continuing to attract new customers. These initiatives strengthen their position with their Gen Z audience and create a competitive differentiation from other fashion players. As the digital marketing landscape continues to evolve rapidly with the rise of new channels, the popularity of new formats, and privacy updates, Princess Polly is agile and well positioned to quickly react. They constantly test new social platforms, shift content, and reallocate marketing spend to wherever the customer goes. Growing on TikTok has been a huge priority for Princess Polly as their customers shift from engaging with still imagery to video content. They grew their TikTok followers by over 40% year-over-year and are expertly balancing influencer partnerships and paid ads on the platform. Princess Polly is doubling down where they see the highest return on spend and leaning into their in-house channels even further. Subsequent to quarter-end, Princess Polly piloted a live video shopping event on their own website and drew thousands of viewers, exceeding expectations. We look forward to them launching Princess Polly Live, a video series that showcases a live shopping experience combined with authentic and interactive conversations between influencers and customers. This is an exciting initiative that they'll expand upon in the coming quarters and share learnings across our group of brands. Text message marketing, which is one of Princess Polly's highest returning channels, continues to be an outstanding marketing engine with over 1.5 million subscribers and growing. Through surveys, Princess Polly has learned text is a top channel for customers to learn of new style drops, offers, and promotions. Petal & Pup also continued to scale in the U.S. and was once again our fastest growing brand this quarter. They are leveraging the proven test-and-repeat merchandising strategy to quickly expand their assortment into accessories, jumpsuits, and matching sets, which now accounts for 10% of sales compared to 4% in the third quarter last year, further diversifying their category mix. As they also follow the a.k.a. playbook, they're expanding their penetration of in-house designed exclusive items, which come at higher gross margins. Category expansion is a key area of growth as Petal & Pup bolsters their assortment in the U.S. and they recently launched a drop-ship program for under-penetrated categories such as jewelry, shoes, and accessories. This initiative allows us to easily expand offerings and test new categories with no inventory risk while still gaining rich consumer insights. Drop-ship items now account for 20% of sales in these categories, with plans to add highly seasonal categories to the site. Similar to Princess Polly, Petal & Pup is also evolving their marketing approach as the landscape rapidly changes. The brand piloted their first shoppable event in Nashville over three days in July. The event was an incredible brand awareness exercise. Approximately 100 influencers attended, garnering 10 million social media impressions, and 5,000 people passed through the event. Petal & Pup has a large and growing customer base in the south and the middle of the country, and the success of this initial test gives us confidence to roll out more shoppable events in key cities next year. Petal & Pup and Rebdolls are both doubling down on video content through Instagram and TikTok. Petal & Pup is seeing great traction on Instagram Reels, with some reels generating over 2 million views. Before I turn the call over to Ciaran, I want to emphasize that we're laser-focused on growing our current brands profitably. While we're still committed to our M&A strategy, given the state of the market and the macroeconomic environment, we have no plans to acquire any brands in 2022. However, we remain in active conversations with highly talented founders, and we'll continue to search for the best brands. But we'll only transact when the time is right for our business and our shareholders. As we enter the fourth quarter, the macro environment remains dynamic and is rapidly changing. We are anticipating a highly promotional holiday season and a competitive marketing landscape. We will continue to pull all necessary levers to balance growth and profitability for the remainder of the year. We have an exciting quarter ahead with the opening of the Culture Kings U.S. flagship, and our women's brands are well positioned for the holiday season. While we anticipate the macroeconomic backdrop to remain fluid over the next few quarters, the strength of our brands and our flexible platform gives me full confidence that we'll deliver on our long-term goals. With that, I'll turn it over to Ciaran.

Thank you, Jill, and good afternoon, everyone. We are pleased to report third quarter net sales above our expectations, along with improving profitability metrics and quarter-end inventories, despite a dramatic macro backdrop and evolving consumer environment. For the third quarter, net sales declined 4% to $156 million compared to $162 million last year. On a constant currency basis, net sales were flat. We continue to see solid active customer growth. On a trailing 12-month basis, the number of active customers in the third quarter increased 23% to 3.8 million. Total third quarter orders were flat to last year at $1.8 million, and the average order value of $85 was also flat to last year on a constant currency basis and down 4% on a reported basis. We are encouraged by the stability of our average order value as it is a reliable indicator of the desirability of our brands and products. Now I'll provide a few highlights from our three regions. In the U.S., third quarter net sales increased to $82 million, up 8% from the third quarter last year, primarily driven by the addition of Mnml as well as Petal & Pup's growth, which continued to be our fastest growing brand in the U.S. Australia net sales decreased 9% to $58 million, and were down 2% on a constant currency basis. Australia sales were impacted by the macroeconomic environment, including inflationary pressures as well as consumers returning to stores post-pandemic. Notably, in the third quarter, Culture Kings' stores were the fastest growing area of the business in Australia. Turning to the rest of the world, net sales of $16 million decreased 27% from the third quarter in the prior year. Given the significant appreciation of the U.S. dollar, we made a strategic decision to shift marketing dollars from the U.S. and Europe to our main regions, the U.S. and Australia, which have higher marketing returns. Additionally, our pricing model for markets outside of the U.S. and Australia is tied to the U.S. dollar. So when the dollar strengthens, our products become more expensive for customers in international regions. Moving to profitability. As Jill mentioned, we are pleased with the sequential improvement in profitability, driven by the initiatives we highlighted last quarter. Reported gross margins were 55.7% compared to 53.2% last year in the third quarter. The 250 basis point increase in gross margin was due to a $6 million fair value adjustment related to the Culture Kings acquisition included in the prior year. Excluding this impact, gross margins contracted 140 basis points due to increased promotional activity as we balance capitalizing on demand and maximizing profitability. Sequentially, gross margin improved by 50 basis points over Q2. Selling expenses increased by $0.9 million to $41 million. As a percentage of revenue, selling expenses were 26.6% compared to 25.1% in the third quarter of 2021. The 150-basis point deleverage was primarily due to increased costs for distribution and future store facilities. While we saw a 200-basis point sequential improvement over Q2, we expect 60 basis points of the improvement in selling expenses to continue and carry forward into Q4. Marketing expenses increased by $1 million to $17 million. As a percentage of revenues, marketing expenses were 10.6%, a 100-basis point increase compared to the third quarter of 2021. This increase was primarily due to the inclusion of Mnml, which has a higher rate of advertising spend as well as overall increases in marketing costs. We are actively working to improve marketing efficiencies by reallocating marketing investments to areas with higher returns. Based on these actions, we have seen a sequential improvement of 140 basis points in marketing as a percentage of sales compared to Q2. G&A expenses were $26 million compared to $29 million in the third quarter of 2021. G&A expenses were 16.8% of net sales compared to 17.9% of net sales in the third quarter of 2021. The decrease was primarily due to a reduction in equity-based compensation and other efficiency improvement initiatives. During the quarter, we took action to rightsize our team structures to better align resources. These actions will reduce our G&A expense by approximately $2 million on an annual basis going forward. For the quarter, adjusted EBITDA was $9 million versus $19 million in the prior year. Our adjusted EBITDA margin of 5.9% compared to 11.9% in the prior year's third quarter. On a sequential basis, we delivered improvement of 220 basis points over Q2 2022. The net loss was $0.1 million or zero cents per share for the third quarter of 2022 compared to a net loss of $9.9 million or $0.11 per share in the third quarter of 2021. Our weighted average shares outstanding were approximately 128.7 million in the third quarter of 2022. Turning to the balance sheet, we ended the quarter with $31 million in cash and cash equivalents and $130 million in debt. At the end of the quarter, we had total liquidity of approximately $56 million, including $25 million available on our credit facility. Subsequent to quarter end, we drew $15 million on our revolver as we entered into the holiday period. Inventory at the end of the quarter was $137 million compared to $96 million at the end of the third quarter of 2021. The increase in inventory was primarily associated with Culture Kings' new fulfillment center, a U.S. store opening, and the addition of Mnml. Compared to the end of the second quarter, we are flat on inventory on a constant currency basis. We did see a sequential decline in inventory for our women's brands that are more fully on our test-and-repeat model. Overall, we are comfortable with the composition and quality of our inventory, and we expect to see a sequential decline in inventory dollars at the end of the year on a constant currency basis. We believe we're well positioned for fiscal 2023. Touching on cash flows, in the third quarter, we generated $12 million of operating cash flow, marking the first quarter of positive cash flow generation in fiscal 2022. We also invested $8 million in CapEx for our new flagship Culture Kings store. We expect capital expenditures to be $20 million for the full year. Turning to our outlook, as we enter the fourth quarter, we are managing our business with a disciplined approach, controlling what we can control while driving efficiencies across our operations. As we did in Q3, in Q4, we plan on optimizing marketing investments, and we'll continue taking action to reduce costs on non-customer-facing activities. As a result of the significant incremental currency headwinds, the company has adjusted its expectations for Q4 net sales and EBITDA. We now expect Q4 net sales in the range of $158 million to $165 million. Our revised outlook contemplates FX being an additional $10 million headwind year-over-year to our Q4 results, incremental to the $5 million headwind we projected when we released our results at the end of Q2. We are now expecting Q4 adjusted EBITDA of $11.2 million to $13 million. This contemplates a $1.7 million headwind from the impact of FX offset by $500,000 of cost-saving initiatives. I'll also touch on a couple of points for modeling 2023. We are currently forecasting FX rates to remain at the current levels through fiscal 2023 and to have a significant impact on our financial performance in FY '23. Through the first nine months of 2022, our revenue will be $25 million lower if we had experienced the current exchange rates for that period. With these FX headwinds, we expect our first quarter of 2023 will be our most challenging comparison for net sales due to a strong first quarter in 2022. We expect comps to become easier as we go through the remainder of FY '23. We believe we have differentiated brands and a highly efficient business model that will support long-term growth and profitability. With that, I will turn the call over to the operator for Q&A.

Thank you. The floor is now open for questions. The first question today is coming from Lorraine Hutchinson of Bank of America. Please go ahead.

Thank you. Good afternoon. I'm just curious if you're seeing any differences in customer behavior in the U.S. versus Australia? And more specifically maybe, how have customers reacted to the surgical price increases that you've implemented?

Hi, Lorraine. Look, we're seeing demand pressure across our brands and across regions. The benefit of having a portfolio is you're really able to measure that and understand the macroeconomic impact. And we're certainly seeing that pressure. I guess, one distinction is, over in Australia where we do have stores, we have seen that customer shift back into stores as we've reopened the Culture Kings stores, really gotten back into events and in-store activations. We're seeing nice growth there. Of course, they are lapping some closures from last year. Our focus really is the U.S. market, where we have a lot of continued growth and runway ahead. Just very early days and excited about what's ahead, especially for Culture Kings with that store opening. On the price increases, we had made some price increases earlier back in Q3 and monitored that very closely. We did not see any impact. We're able to get a nice 60 basis points increase in gross margins sequentially quarter-over-quarter. We do not plan any additional price increases at this time, although we are of course constantly able to optimize our pricing, given our high mix of exclusive and first-party brands and just very focused on profitability and controlling what we can control.

Thank you.

Thank you. The next question is coming from Oliver Chen of Cowen. Please go ahead.

Hi, Jill. Hi, Ciaran. Regarding the promotional activity and the gross margin, what are you forecasting ahead for that? What are you seeing in the environment there? It sounded like your inventories are under good control. Also, could you comment on customer acquisition costs or provide different comments on the call regarding the marketing costs and the efficiencies you're seeing? Going forward, has that stabilized? Do you expect it to continue to be dynamic as it's been a consideration for a lot of companies? Thanks.

Thanks, Oliver. I'll comment on the promotions and gross margin ahead and let Ciaran jump in. Then we'll come back around to the CACs. First, we are anticipating a highly promotional environment for Q4. We're already starting to see that as it has pulled forward certainly this year versus last year. It's a very different environment, very different inventory position for the whole market. We have certainly factored that into our outlook. Our brands are in quite a good inventory position. From a composition and quality of our inventory, we feel good going into Q4 and have a very flexible agile model where we can really adjust and pivot as needed in the quarter. Ciaran, anything to add on just how we forecasted that into the model?

Yeah. I think we assume Q4 will be a little bit lower than we experienced in Q3, just with the level of promotions. As we think about gross margin, we are seeing improvements or reductions in the cost of air freight and bringing in product. I think that will kind of allow us to counteract any kind of increased promotional activity we've seen. Overall, feeling good about the gross margins that we've modeled for Q4. As it relates to inventory, we're really happy with the composition and the quality of the inventory that we have. We're flat on dollars in Q3 versus Q2 and down in units within our women's brands, which shows the strength of that test-and-repeat model. On the men's brands, we still have some work to do as they have more third-party vendors and cannot adjust as quickly there. I think we'll see more of that in Q4 and as we go into next year. But overall, just very happy with the quality of the inventory.

On your question about the CACs, we have seen CACs stabilize as we have lapped the impact of iOS. I will say there is a lot happening in the marketing landscape with major changes. The biggest one, of course, being the shift from imagery to video, which is driving that downstream platform impact change as customers migrate away from Instagram and over to TikTok. Our brands have been on TikTok for some time now, really testing and learning and tuning our efficiency there. Now we are seeing that as one of our highest returning channels for us and able to shift some of our spend there, as well as into in-house channels, which are also incredibly efficient for us. For all these reasons, we have a very diversified marketing mix and the ability to shift and adjust, and we are very committed to our efficient 10% marketing spend, which is also factored into the outlook.

Thank you. Happy holidays. Best regards.

Thanks, Oliver.

Thank you. The next question is coming from Edward Yruma of Piper Sandler. Please go ahead.

Thank you for taking my question. First, could you clarify the guidance change for the fourth quarter? How much of it was solely due to foreign exchange and how much is related to trends you’re observing or a conservative approach? Additionally, can you provide some insight into the performance trajectory from the third quarter? Any comments on the exit velocity would also be appreciated. Thank you.

Sure. Yeah, as it relates to FX, Ed, I would say all of it in there is really related to the change of $10 million, which is really all related to FX. When we gave Q2 guidance, we were modeling the U.S. to Australia dollar rate at about 0.7, and we saw it all through October at about 0.63. It's obviously changing every day at the moment, but we've modeled that 0.63 through the rest of the year. Just as it relates to the trajectory in Q3, I would say it was stronger going through July and August. As we went through September, it certainly started to soften late in the month, which may impact our international customers. As we've modeled out Q4, we're using that run rate we've seen out of Q3 to project for the rest of the year.

Thank you.

Just be patient for a minute or two, and we'll work through it.

Thank you for your patience. My apologies for that. Our next question is coming from Noah Zatzkin of KeyBanc Capital Markets. Please go ahead.

Hi. Thanks for taking my questions. Just on the Culture Kings opening, could you provide any color on how you're thinking about the store opportunity there in the U.S. over time and any color on the economics of the four walls that would be really helpful. Thank you.

Noah, I appreciate your question and thank you for attending the grand opening. We are very excited about the store and would like to extend our congratulations and gratitude to the founders, Simon and Tahnee. They have a remarkable vision for these stores, and it truly stands out. I'm pleased with the early performance since it just opened last weekend. I believe we've chosen the right location, format, merchandise mix, and marketing strategy. We will continue to explore other markets and opportunities using a test-and-learn approach. Not every store will be as large as this flagship model, especially since Las Vegas is a prime tourist destination with significant foot traffic, which we have successfully capitalized on. The traffic in Vegas is definitely returning. As we expand into other markets, we will seek additional high-tourist locations. This strategy is a great way to rapidly grow our brand and connect with a diverse range of customers who are evolving quickly. I am genuinely excited about the potential here. We are just beginning, and there is significant awareness to foster and expand this brand in the U.S.

Yeah. Hey, Noah, we're certainly expecting the store to be four-wall profitable. Obviously, it will take a little bit of time to ramp up. For us, we're expecting payback on a four-wall basis to be between four and five years, not counting the broad benefit we'll get from the store. The store is about 13,000 square feet of retail space, and the rent is about $1.9 million on a GAAP basis. The AOV is generally a little higher than you see online. We feel the economics will be very strong from an EBITDA perspective once the store ramps up.

Thank you.

Thank you. The next question is coming from Dana Telsey of Telsey Advisory Group. Please go ahead.

Good afternoon, everyone. As you think about the regions, the U.S. and Australia, there was obviously a moderation in the U.S. But it seemed like the deceleration in Australia improved a little bit. What are you seeing? How does this differ by brand? How are you planning for North America and the U.S. going forward? Thank you.

In general, we have seen a bit of that demand pressure across brands and across regions. In Australia, though, we uniquely have stores and really saw that customer shifting back into stores as we started back to events and in-store activations. This really helped improve the Culture Kings part of the business and certainly helped to offset some of the online demand pressure. We are mostly focused on the U.S. and are most excited about the potential for these brands to keep scaling and growing in the U.S. market. Culture Kings is just getting started, and it's a perfect time to be opening the store, leaning in, and we’re really excited about what we're seeing ahead here.

As for the marketing spend, you mentioned the reallocation of marketing. What are you doing on that side, and how does the spend look as a result?

Between Q2 and Q3, we made some adjustments in our marketing mix and reallocated into higher returning marketing channels, particularly focusing on in-house channels, like SMS texts, where we see great returns and efficiency. We're also shifting more into TikTok, where we’ve tuned things to achieve a higher return. We shifted out rest of world marketing spend into Europe, but we adjusted that to focus more on the U.S. It's not an ideal time to push into Europe right now given the strength of the dollar. We are ensuring that we are focused on profitability and getting our most efficient marketing return. We are committed to that marketing spend at around 10% going forward, which is factored into the model.

Thank you.

Thank you. The next question is coming from Youssef Squali of Truist Securities. Please go ahead.

Thank you very much. So a couple of questions. The first is around the Q4 guide and what that implies in terms of growth of the U.S. business. I think there's probably some deceleration based on the numbers. I'd love for you to quantify that for us. Also, can you address the balance sheet liquidity? I know you decided that in 2022, you will not do any M&A. But just as you look at the business and ongoing trends through 2023, do you have enough free cash flow generation to get you through it without capital needs? Those two would be great, then I have a quick follow-up.

As we think about the guidance for Q4, we expect the same level of organic growth or organic deceleration that we've seen in Q3, Youssef, if you adjust for Mnml. In Q3, we had a full quarter of Mnml, and last year, we had Mnml for 10 weeks of the 12-week period. So there'll be a little bit of headwind from that. As we unpack it, we are seeing pressure from an AOV perspective, which is where we are modeling that out. We might be a little flat again in order volume. For active customers, there will be low single-digit growth. We're dropping off some big quarters where we acquired customers as we were coming out of Q2-Q3 last year, which will impact that. Regarding the balance sheet, it was good to see that we got back to generating strong operating cash flow of $12 million in the quarter. We did draw down some of the revolver near the end of Q3. Early in Q4, we had a couple of big payments and expect to be positive cash flow again from an operating perspective in Q4 while generating cash as we go forward into FY '23. We're still looking to do acquisitions, but we are focused first on driving organic growth and supporting our existing brands.

Any earn-outs, big earn-outs next year?

No, no earn-outs at all.

All right. Jill, you talked a number of times about SMS or text message marketing. Could you expand on that? Is that a relatively new channel for you? It seems like you're pretty excited about that. Which channels are operating the best for you at this point and for which brands?

Yes. SMS marketing or text, where you collect the customers' cell phone and reach them via text, is really replacing email as one of the most efficient in-house channels. We've been able to grow our subscriber base and our customers. We conducted focus groups recently, and the customer is very clear that this is their favorite way to hear from us about new product drops and promotions. We've seen that be a very effective way to quickly communicate with customers. It tends to drive more repeat and returning customers, so it's a great retention tool. For new customer acquisition, we're still focused on social media and our wide influencer program. We go after a much broader network of smaller influencers and have grown that with college ambassadors scaled out. Our brands are very innovative, out ahead of many others on the marketing front, and constantly testing and learning and tuning their market channels. I'm also really excited about live video; live streaming shopping is a new platform for us that we are leaning into and super excited about.

All right. Thank you both.

Thank you. The next question is coming from Ike Boruchow of Wells Fargo. Please go ahead.

Thank you for taking my question. I noticed that women’s inventory appears to be down year-over-year, while men’s inventory is somewhat elevated due to third-party sources. It seems that the liquidations are opposite of previous expectations, with men's needing to be cleared now and women’s by the end of the year. Can you explain what led to this situation? Looking ahead, will there be any notable differences between genders as we approach what is expected to be a busy promotional holiday season this year?

Let me just clarify the inventory. We haven't been doing any particular liquidations. Because of the test-and-repeat model, the women's brands are not buying out and committing to inventory. They are doing that on a very short-term basis. So they are able to adjust their inventory buys and dollars much quicker. That's why we saw in Q3 where the inventory dollars are down versus Q2 because they're sequentially down. The women's brands are still slightly up year-over-year, but much closer. The men's brands, because they're purchasing from third-party vendors, are not able to adjust their inventory as quickly. They will take longer to make adjustments. I’m happy with the inventory composition we have going into the holiday season while knowing the men's brands will take longer to adjust the dollar inventory.

Thanks for elucidating that for investors.

Thank you. The next question is coming from Michael Binetti of Credit Suisse. Please go ahead.

Hey, guys. This is Carson on for Michael. First off, congrats on a nice quarter. Thanks for taking our question here. We've heard some instances of consumers starting to trade down on lower price point categories and brands. Are you seeing that within your banners? If so, how are you positioning inventory for the spring? Did we hear you correctly that you used the September exit rate for forecasting fourth quarter? Did October perform in line with September? Or was there a change in the trend there? Thanks.

We're seeing, as we guided in August and anticipated a demand pressure in the back half, across the brands and regions. We have seen a bit of an uptick in our mix of markdown versus regular sales, which is driving that deal-seeking mindset as the customer is a little more frugal with the macro backdrop. As for how we trended out the business and the outlook, let Ciaran comment on that.

We've been using the most recent trends. We've been seeing for October and the first 10 days of November, that is what we've used to model out Q4 from a sales perspective.

Makes sense. Thanks.

At this time, I'd like to turn the floor back over to management for any additional or closing comments.

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