Levi Strauss & Co (LEVI) Q3 2022 Earnings Call Transcript

Good day, ladies and gentlemen, and welcome to the Levi Strauss & Company Third Quarter Earnings Conference Call for the Period Ending August 28, 2022. All parties will be in a listen-only mode until the question-and-answer session, at which time instructions will follow. This conference call is being recorded and may not be reproduced in whole or in part without written permission from the company. This conference call is being broadcast over the Internet, and the replay of the webcast will be accessible for one quarter on the company's website. I would now like to turn the call over to Aida Orphan, Vice President of Investor Relations at Levi Strauss & Co.

Thank you for joining us on the call today to discuss the results for our third fiscal quarter of 2022. Joining me on today's call are Chip Bergh, President and CEO of Levi Strauss, and Harmit Singh, our CFO. We have posted complete Q3 financial results in our earnings release on the IR section of our website. We'd like to remind everyone that we will be making forward-looking statements on this call, which involve risks and uncertainties. Actual results could differ materially from those contemplated by our forward-looking statements. Please review our filings with the SEC, particularly the Risk Factors section of the Quarterly Report on Form 10-Q that we filed today for the factors that could cause our results to differ. Also note that the forward-looking statements on this call are based on information available to us as of today and we assume no obligation to update any of these statements. During this call, we will discuss certain non-GAAP financial measures. These non-GAAP measures are not intended to be a substitute for our GAAP results. Finally, this call, in its entirety, is being webcast on our IR website and a replay of this call will be available on the website shortly. Today's call is scheduled for one hour, so please limit yourself to one question at a time to give others the opportunity to have their questions addressed. And now, I'd like to turn the call over to Chip.

Good afternoon, and thanks for joining us today. As you know, and have heard from other companies, macro conditions deteriorated since we last spoke with you in early July. As we move through the third quarter, a confluence of pressures from inflation, falling consumer sentiment, and rising interest rates began to result in softer consumer demand, while our industry continues to experience supply chain disruption and a heightened promotional environment. Not surprisingly, this made for a challenging quarter. Despite this, we were able to deliver solid results with net revenue growth of 7% on a constant currency basis, which translates to a 1% increase on a reported basis. While this was below our internal expectations for the first time in several quarters, our teams responded to this very dynamic environment by focusing on controlling the controllables. We took quick action to both stay competitive and protect the bottom line, resulting in a double-digit adjusted EBIT margin of over 12%. I've talked before about the importance of strong brands during uncertain times. Our brands remain very strong, delivering robust growth despite the challenging environment. Specifically, excluding the impact of foreign exchange, we delivered constant currency growth across our key brands with Levi's up 6% and Dockers up 13%. But beyond the revenue results, there are other key proof points that underscore the strength of our brands. First, this quarter we delivered the Levi's brand's highest third quarter revenue in a decade with growth across categories and genders. We've made meaningful progress, winning over the next generation of fans, continuing to gain share with the 18 to 30-year-old age segment in the US, while maintaining our leadership position across consumers of all ages, and our unaided brand awareness remains well above the competition across most markets. Second, the strength of the brand has equated to pricing power. Average Unit Retail prices were up mid-single digits in a more promotional environment and the pricing we've taken to offset inflation has largely stuck. Third, and as a result of our pricing power, our gross margins, though off modestly versus a year ago, primarily due to currency and discounting, remain strong and are still nearly 400 basis points higher than pre-pandemic levels as we have successfully offset significant inflationary cost increases. Fourth, our direct-to-consumer business continued to deliver outsized growth of 8% in constant currency, driven by increases across our stores and e-commerce business. Having strong powerful brands and a diversified business with scale matter during these volatile times. These advantages allowed us to grow global wholesale by 6% and total US company revenue by 5%, despite a number of US wholesale customers slowing orders. To put the US results in context, we significantly outperformed both the overall jeanswear market, which, based on NPD data, declined by mid-single digits during the June through August quarter, and the overall US apparel market, which slowed to only 1% growth. I think it's also important to note that despite the past three-month decline in the jeanswear category, it is still up mid-single digits versus pre-pandemic. Despite the quarterly category softening, we remain confident about the long-term trend of casualization continuing to be a tailwind for the business. In addition, even with continuing supply chain constraints, our team took swift action to minimize the impact to just $30 million to $40 million or about 2 to 3 percentage points of revenue growth. As the operating environment becomes more challenging and supply disruptions continue, our unique and durable competitive advantages will continue to set us apart from the competition. Let me walk you through the progress we made across our strategic priorities during the quarter, again, all in constant currency. Our first strategic priority is brand-led. As mentioned, Levi's brand grew 6% versus prior year, and almost 10% ahead of 2019. We're driving growth in our bottoms business by delivering a pipeline of fresh and innovative products as we define new trends and introduce new fits. We continue to build upon our success with looser fits with the launch of our new Baggy Dad, a signature '90-style which delivered strong performance, as did our new Boot Cut and Straight Fit launches. The trend toward looser fits in women's was also accompanied by a shift from high to mid rises, which were up 20%. The Iconic 501 family again posted double-digit growth across men's and women's. After 149 years, this fit continues to resonate. We continue to position the Levi's brand at the center of culture by partnering with leading brands and cultural icons on product collaborations. The GANNI collaboration returned this year and was featured on the runway at the Copenhagen Fashion Week and sold out in two weeks. And the new Levi's denim tears collection was worn by Golden State Warriors guard Steph Curry on the cover of October's Rolling Stone. We also recently launched the second iteration of our buy better, wear longer campaign designed to inspire shoppers both young and young at heart, while highlighting the quality and the timeless style of Levi's. Additionally, this campaign underscores the durability of a pair of Levi's, which is important in today's environment where consumers are looking for quality and value for money. This is the highest-scoring ad in copy testing that we've had since I joined the company over a decade ago, reflecting how much this message resonates. Moving onto our second priority. Total company DTC channel grew 8%, owned and operated mainline and outlet stores grew in the third quarter mid-single digits with traffic and Average Unit Retail both up versus prior year. Again, another sign of the strength of our brands. And even as consumers return to our stores, e-commerce grew 16% driven by the Levi's brand in Asia, Beyond Yoga, and Dockers. Overall, e-commerce was up 64% versus 2019 with the Americas and Europe segments up double digits and Asia more than doubling. Globally, the Levi's app continues to achieve increased engagement with monthly active users again up double digits, along with 17% growth in revenue. And we made progress in deepening our direct personalized relationships with our consumers via our global loyalty programs, which saw double-digit growth in total members and revenue. We also grew our global wholesale business by 6%, driven by the Levi's brand across Asia and the Americas. In the US, the Levi's brand was up low-single digits, with strong growth in women's new fits. This growth was offset by a 12% decline in our value brands, Signature and Denizen, which are most sensitive to changes in consumer discretionary spending. Further, this business was impacted by a reduction in Denizen women's distribution at Target as we've expanded Levi's Red Tab. As a reminder, our value brands only comprise a mid-single-digit percentage of our total net revenues. Our third strategic priority is diversifying our portfolio, and we continued the strong momentum we have achieved in each of our major growth opportunities with women's, tops, international, and our other brands, Dockers and Beyond Yoga, each contributing positively to third quarter growth. Our total company women's business grew 8%, above men's strong performance of 6%. The women's business was driven by Levi's bottoms, which were up 7% and saw notable strength in the Americas. Additionally, the small but growing women's business on Dockers was completely additive as was Beyond Yoga. For the total company, tops saw 12% growth as we continue to diversify our offerings. Levi's tops were up 8%, driven primarily by men’s, which grew 14%. We continue to see strength in tees, wovens, and polos where our Levi's women's business saw positive growth across non-graphic tees, dresses, and sweaters. Our international business grew 8%, even as we navigated a more challenging consumer environment in Europe and in China. We saw encouraging strength across Asia, which, excluding China was up 68%, as well as in several of our largest and important European markets, notably, the UK and Spain. Our updated Dockers brand with its California casual aesthetic posted 13% growth, driven by both Average Unit Retail and volume, while also delivering strong profitability that exceeded our plan. The brand delivered growth across major geographies and channels. The US was up 2% and international brick and mortar and e-commerce saw notably strong gains. Dockers women's and tops businesses also saw strong growth and grew as a percentage of the brand's sales. Beyond Yoga contributed $22 million to net revenue with solid consumer demand in the quarter with company-operated e-commerce sales up strong double digits on a pro forma basis. It launched at 28 colleges across the country as the brand continues to build awareness and reach new consumers. Perhaps most exciting at the end of last month, Beyond Yoga opened its first permanent store located in Santa Monica, showcasing the brand's full array of category offerings for the first time. While we're just getting started, we believe there is an attractive long-term opportunity to grow the brand's presence through retail. Finally, one of our most important companywide objectives is leading the industry in environmental stewardship. Last week we released our Annual Sustainability Report, which includes a comprehensive set of disclosures and introduces a new slate of sustainability goals that cut across our three main pillars of climate, consumption, and community. You can find the report online in the Sustainability tab of our website. In closing, we continue to achieve steady progress against our long-term objectives as we navigated a more difficult environment in the third quarter. While we expect it to remain challenging over the next few quarters, I am confident in our ability to navigate the near-term headwinds and importantly deliver on our long-term goals for the following five reasons. First, we have strong brands. Second, our categories are structurally attractive with long-term tailwinds from the casualization trend and denim cycle. Third, we have the global scale to react to disruptions and manage through inflationary pressure with competitive sourcing. Fourth, we have a diversified business model where some of our biggest opportunities are gross margin accretive and generate higher AURs. And fifth, we have a seasoned and proven team that has delivered excellent results while managing through challenging times. Levi Strauss & Co has separated itself from competition in challenging times in the past by making the right moves. We believe the current environment is an opportunity for us to do this again. We will operate with discipline and lean into our strengths to further expand our lead for the years to come. Now over to Harmit.

Thanks, Chip. Let me begin with three thoughts before we get into the numbers. We delivered a solid quarter. The net revenue is up 7% in constant currency, demonstrating the power and resilience of the Levi's brand. We delivered these results even in the face of higher FX headwinds, pandemic-related supply chain issues, and ongoing economic and inflationary headwinds impacting consumer discretionary spending in the US and Europe. Thanks to the strength of our brands, our diversified business model, and operational agility, we were able to swiftly manage expenses and exceed expectations with adjusted diluted earnings. We made progress against our long-term strategic plan, delivering growth across our attractive high-margin opportunities, including women's, tops, direct-to-consumer, international, and our Dockers and Beyond Yoga brand. By exercising control over the controllable, we are navigating the short-term while continuing to invest in our compelling long-term growth initiatives and returning capital to our shareholders. Now let's get to some additional Q3 financial details. Net revenue grew 7%, primarily driven by the US, Asia, and Latin America with broad-based increases in AURs. The direct-to-consumer channel net revenue grew 8%, driven by positive comp store sales across our mainline and outlet stores, including in the US due to increased traffic, higher AURs, and Units Per Transaction. And despite strength in the stores, our e-commerce business was up 16% and net revenues through all digital channels were up 15%. Adjusted gross margin in reported dollars was 56.9%, up more than 390 basis points versus 2019, yet contracting 60 basis points year-over-year due to unfavorable currency exchange rate impact, as well as the impact of higher product costs and lower full-price sales, particularly in the US relative to last year, partially offset by price increases and a favorable channel mix. Moving to SG&A. Adjusted SG&A expenses in the quarter were $675 million, up 6% from last year. This is at the lower end of our expectations. As we began to see the impact of the softening macro environment, we minimized spending in the quarter by reducing discretionary expenses like travel, delaying non-essential hiring and projects and we are continuing to do the same as we move into quarter four. As a percentage of revenue, adjusted SG&A was 44.5%, reflecting higher distribution expenses and ongoing strategic investments in IT and our direct-to-consumer business and a lower than expected revenue. Adjusted EBIT margin was 12.4%, contracting 240 basis points on a reported basis and 200 basis points on a constant currency basis. Adjusted EBIT dollars were down 15% on a reported basis and 8% on a constant currency basis. The effective income tax rate was 7.2% for the third quarter compared to 4.8% in the same quarter of the prior year. The lower effective tax rate relative to the company's full-year updated outlook for mid-teens was driven by the planned acceleration of certain tax-related initiatives. Adjusted net income was $161 million compared to $197 million in the same quarter of the prior year. The decrease was due to lower operating income. Adjusted diluted EPS was $0.40, which includes a $0.04 negative impact from foreign exchange, of which half was incremental to the outlook we provided in July. I’ll now take you through key highlights by segment. Recall, the regional segments include our Levi's brand, Levi's Signature, and Denizen, while the other brand segment includes Dockers and Beyond Yoga. In the Americas, revenues grew 3%, driven primarily by higher AURs across channels. DTC growth of 8% was driven by company-operated mainline and outlet stores, which benefited from increased traffic and AURs, in addition to new stores. Wholesale growth of 2% was driven by international and the Levi's brand in the US which, as Chip mentioned, was partially offset by lower revenues of our value brand. Overall, the Americas segment saw growth across all markets with the US up 2% and notable momentum across Latin America, led by the strength in Mexico. In Europe, revenues were 9% lower on a constant currency basis, which includes the 4% negative impact from the suspension of our business operations in Russia. While macro pressures, including inflation and extreme heat negatively impacted the region, several of our large markets posted growth. Our successful pricing actions delivered high-single-digit AUR growth which partially offset softer consumer demand. Though we continue to anticipate pressure from the macro environment, we remain confident in the strength of the brand in the region. And Levi's remains by far the most popular denim brand in Europe. Asia, again accelerated with greater than anticipated revenue, up 53% despite COVID-related restrictions negatively impacting markets like China. Volumes and AURs both increased strongly and wholesale and direct-to-consumer, both partially benefited from lapping wider spread COVID-related door closures last year. E-commerce was up 33%, while our company-operated stores saw gains from traffic, AURs, and new stores. The Asia segment, excluding China grew 68% with broad-based growth across markets, led by India, Malaysia, ANZ, Indonesia, and Thailand. Overall, revenue growth and higher gross margins have delivered better than anticipated operating margin expansion of nearly 2000 basis points to 7.4%. Other brands net revenue was up 44%, driven by 13% growth in Dockers and the addition of Beyond Yoga. Turning to balance sheet and cash flows. Reported inventories increased 43% on a dollar basis. However, there are few items that are driving that increase and are worth noting. Approximately one-third relates to cost inflation and the normalization of last year's abnormally low inventory level. Another third of the increase relates to earlier receipts of core inventory to mitigate supply chain risks and the US implementation of a new ERP system in the second quarter of fiscal ’23. And the final third was driven by an increase of goods in transit. Core product, which can be sold across multiple future seasons represented approximately two-thirds of total inventories and we are comfortable with the composition and quality of our inventory. As you build inventory for 2023 and we look forward to respond to changing demand, we have reduced inventory buys for the first half of 2023 by approximately 25%. These actions should enable us to return to normalized inventory levels in line with net revenue growth by the end of quarter two ‘23. Cash and liquidity remain strong. With the end of quarter net debt of $372 million and overall liquidity of $1.4 billion, our leverage ratio remains at 1.1 times. Going to investments in inventory and inflation, adjusted free cash flow, which we define as cash flow from operating activities less property, plant, and equipment was negative $12 million in the third quarter. However, we expect adjusted free cash flow for quarter four and the full year to be positive. In the third quarter we returned approximately $74 million to shareholders. The company paid a dividend of $0.12 per share, nearly 50% higher than a year ago. Additionally, in the quarter we repurchased shares of approximately $26 million. In quarter four, the company declared a dividend of $0.12 per share, in line with last quarter. And we currently have $690 million remaining under our share repurchase program, which has no expiration date. Now let's turn to guidance. While we're confident in the strength of our brand and deep consumer connections, we are not immune to the macro headwinds the sector is experiencing. And though in the month of September we are continuing to experience momentum in our US direct-to-consumer business, which is up 10%, we are tempering our outlook for the remainder of the year to reflect ongoing supply chain disruption and macro-economic pressures. For fiscal ’22 we now expect reported net revenues to grow 6.7% to 7%, representing approximately 11.5% to 12% net revenue growth on a constant currency basis. Our outlook includes 3 points of incremental FX pressure since we guided in July. On a reported basis, we now expect to be up high-single digits, Asia mid-teens, and Europe down high-single digits. In constant currency, we expect Asia to grow in the low 20% range. Excluding FX and Russia, we expect Europe to grow high single-digit. We also now expect adjusted diluted earnings per share of $1.44 to $1.49, despite incremental FX headwind of $0.05 since we reported back in July. To put our latest full year adjusted diluted EPS guidance in context relative to where we started in early 2022, adverse FX, Russia, and China are estimated to have impacted adjusted diluted EPS by over $0.20. By focusing on what we can control, while building this business for the longer term, we have managed to offset nearly 75% of this downside. We expect our full-year adjusted gross margin to be slightly down versus last year’s 57.9%, nearly 400 basis points higher than 2019. The change from our prior outlook is driven by foreign exchange and lower full-price sales as we expect the broader marketplace to be more promotional through the end of the holiday season. As a result, we now expect our adjusted EBIT to be 11.6% to 11.8% for the year, which is approximately 60 to 80 basis points lower than the prior year on a reported basis, but 100 to 120 basis points ahead of 2019. We continue to expect $270 million in CapEx for the year as we expand our direct-to-consumer business and continue strategic investments in IT. We expect our full-year effective tax rate to be in the mid-teens, which implies a mid-single digit tax rate for quarter four. As specifically relates to quarter four, this implies that fourth-quarter net revenues will be slightly down on a constant currency basis and down approximately 6% on a reported basis. Our outlook reflects a more cautious view with regard to supply chain challenges, particularly in the US into the fourth quarter. We expect adjusted diluted EPS to be between $0.29 and $0.34. As I did in the beginning, I want to leave you with a few key points. Our vision for our long-term future remains unchanged. While we expect conditions to remain challenging in the near term, we are confident in our ability to leverage our strengths to deliver sustainable, profitable long-term growth and emerge in a stronger position. Our brands and the structural economics of our business remain as strong as ever. On top of our resilient core we are making good progress in attractive growing and high-margin areas, including our women's tops, international, and direct-to-consumer business. We are focused on controlling the controllable. We are reducing discretionary spending, but not at the expense of any of our strategic investments that continue to fuel our brand and which will enable us to deliver on our long-term growth plan. And finally, we are financially strong with a solid balance sheet and a strong diversified and scaled business model to generate the cash flow to reinvest for long-term growth, while continuing to return cash to our shareholders. And with that, operator, I would like to open it up for questions.

Thank you. The floor is now open for questions. Our first question comes from the line of Bob Drbul of Guggenheim Partners. Bob Drbul, your line is open.

Chip and Harmit, can you provide more details about how the quarter performed geographically? What changes occurred during the quarter, and how did they impact your expectations and the overall dynamics? I would also like to know your thoughts on the wholesale inventories in relation to the category changes you mentioned throughout the quarter. Thank you.

Sure, Bob. Thank you for the challenging question. As you know, we had a solid quarter, with a 7% increase. Levi's achieved record revenue for the second quarter, the highest in a decade. However, we fell short of our internal expectations. The quarter progressed quickly, and we encountered challenges including foreign exchange headwinds, ongoing supply chain issues, and a decline in demand, particularly in the Western world. We concentrated on what we could control. Regarding revenue, I would attribute the shortfall in comparison to our expectations as follows: a third was due to foreign exchange, another third was a result of persistent supply chain constraints that restricted our ability to meet existing demand, which accounted for about $30 million to $40 million in lost revenue, and finally, the macroeconomic landscape which weakened in the US and Europe. In contrast, Asia and Latin America performed well and continued to grow. In terms of earnings per share and profitability, the revenue shortfall relative to our expectations impacted us by about $0.12. We swiftly focused on controllable aspects, such as costs and tax rates, managing to keep our tax rates in the mid-teens, with hopes of maintaining this in the high teens over the long term. Now, regarding your question on wholesale, US wholesale saw low single-digit growth. Excluding our mass channel, which includes two retailers—Signature and Denizen—that faced a 12% decline, US wholesale actually grew in the mid-single digits. We keep an eye on trade inventory levels, measuring them in months. At the end of the third quarter, trade inventory levels with our wholesale customers in the US were largely similar to those in 2019. While some customers had higher levels and others had lower, that’s the overall picture we have from the data.

Great. Thank you very much.

Thanks, Bob.

Thank you. Our next question comes from Paul Lejuez of Citi. Paul, please go ahead. Your line is open.

Thanks guys. I was curious if we could talk a little bit more about inventory, maybe if you can provide any color, maybe breaking it down by region, tops versus bottoms, men's versus women's. I think, Harmit, you might have mentioned something about how much is seasonless product, but I'm also curious if you think there are any places where you have more than you'd like, where you have to be a little bit more promotional to clear through? Thanks.

I attempted to clarify the inventory and the factors contributing to its growth in my earlier remarks. One-third of the increase is primarily due to inflation in the cost of goods sold, particularly driven by higher cotton prices, along with a lower inventory base compared to last year, which was quite constrained. Another third of the increase is attributed to early receipts of core inventory aimed at minimizing supply chain risks and implementing a new ERP system in the second quarter of fiscal 2023. The final third of the increase is due to more goods being in transit. Regarding our actions, Paul and the team are mostly managing core inventory, which allows us to navigate through the seasons, with about one-third being seasonal. We do not have a significant amount of obsolete inventory; where it does exist, we are discounting and selling it. This situation has affected our gross margins in the third quarter. Initially, we anticipated a gross margin impact of about 100 basis points from items we wouldn't be selling at full price, but it's likely to be around 130 to 140 basis points. We have accounted for this in our fourth quarter projections as well. Where possible, we are quickly marking down inventory worldwide. Additionally, we have significantly reduced our purchases for the first half of 2023 by 25% as we prepare for the ERP installation. Geographically, the inventory buildup is predominantly in the US, which is primarily a core market, influenced by the nature of the core products and the ERP system's role in this process. During the ERP implementation, we typically pause shipments for about six to eight weeks, which we are currently navigating. To your point, one-third of the inventory is seasonal and varies by region, but the US has a larger core inventory compared to seasonal items.

Got it. Thank you, guys. Good luck.

Thanks.

Thank you. Our next question comes from Omar Saad of Evercore. Please go ahead, Omar Saad.

Thank you for taking my question. Good afternoon. I would like to know if you could discuss the denim cycle, particularly with regards to your outlook for the next quarter. Are you observing a broader slowdown in the cycle? Are there other companies experiencing similar trends? Additionally, it seems that the retail category is showing somewhat softer trends. In light of the reopening, as people begin to dress up more, are you noticing any impact on the casualization trend? Thank you.

Yes. We discussed some of this in the prepared remarks, Omar. To share specific data, I’m referencing NPD data for the past 12 months ending in August. Overall apparel is up 11%, and denim is up 10%; notable is that we outperformed these numbers over the past year. In recent months, specifically from July to August, we observed a notable slowdown in the denim space, with denim down in the mid-single digits and total apparel only up 1%. While these figures are disappointing, they do support the idea that there’s been a shift toward more formal clothing as people attend weddings and return to the office. Our results during that period showed that we exceeded the performance of both denim and total apparel. I don’t anticipate this trend will persist for long. Also, that data pertains specifically to the U.S. The casualization trend we've discussed is no longer limited to the U.S.; it’s now a global phenomenon. Our business is focused more on men, who are returning to office environments in jeans, so I foresee a recovery in the denim market. I have consistently mentioned that we're the market leader, and I believe it’s our responsibility to foster category growth. We will keep our emphasis on innovation and strong marketing, as these elements should contribute to growth. Additionally, weather likely played a role during this period. As the seasons shift, conditions have historically been helpful. Lastly, we mentioned earlier that September’s U.S. direct-to-consumer sales were up double digits. While I don't expect the category to return to the double-digit growth levels we experienced over the last year, I do anticipate a long-term trend of mid-single-digit growth for denim. The shorter the timeframe analyzed, the more fluctuation exists in the data. I believe denim will rebound to that mid-single-digit growth in the coming months. I hope this answers your questions.

Thank you for the color, Chip.

Thank you. Our next question comes from Matthew Boss of JPMorgan. Please go ahead. Your line is open, Matthew Boss.

Hey, Latif, let's go to the next caller and come back to Matt.

Okay. Our next question comes from Chris Nardone of Bank of America. Chris Nardone, your line is open.

Thanks for taking my question. Can you discuss expectations for the trajectory of your European business relative to your 3Q results even looking out to the first half of next year? And are there any particular countries that are showing notable weakness? And any difference in how you're thinking about wholesale and DTC in the region? That would be great. Thank you.

Yes, I would say, all cards on the table here, Chris. We're probably most cautious about the business in Europe as we look ahead. As we talked in the script, we saw some countries in Europe in Q3 perform quite well. Both the UK and Spain were up nicely. We also had a number of smaller markets across Europe also perform well, performing up versus prior year on a constant currency basis. However, there were other markets that were notably soft, particularly Germany and some other markets in the north. If you strip out the impact of Russia, Europe was down mid-single digits, around 5% for the quarter. As we look ahead, the guidance we provided does kind of build in some caution, I guess, with respect to Europe. I suspect we'll see more as winter begins to hit. Now the impact on the consumer over there as they face much steeper, not just inflation, but much steeper energy costs as well. So the good thing about having such a broad global portfolio is we've got other markets as Harmit said that are performing exceptionally well that can help to offset some of that softness. The brand is still incredibly strong in Europe, but we're seeing our wholesale customers being cautious regarding their open-to-buy budget and how they're planning inventory. We are seeing some bifurcation in our business even through the third quarter, and we're kind of working through that as we think about the future.

Thank you. Our next question comes from the line of Alex Stratton of Morgan Stanley. Your line is open. Please go ahead, Alex Stratton.

Thanks for taking my question. Can you just talk about the flexibility your wholesale partners have as it relates to canceling orders if they were to see more of a slowdown? So put differently, at this moment, can they cancel any of their fourth quarter orders, your fourth quarter, the first quarter, or the second quarter and by how much? And also what kind of support would you guys offer should your retail partners have too much inventory as it kind of builds up in the broader space? Thank you.

First, I'll address your last question. As mentioned earlier, inventory levels among wholesale partners in the US are generally similar to pre-pandemic levels. This situation varies from customer to customer, as most manage their own promotion and markdown budgets once they have the product. We provide support within traditional guidelines, ensuring fair treatment across the marketplace. Regarding order cancellations, this is primarily a negotiation process. If we create products specifically for a customer, we maintain strict control over it. We produce numerous items tailored to specific customers, and once we do so, the ownership lies with them. We strive to maintain a firm stance on this. However, for more general marketplace products or those suitable for our outlet stores, the negotiation process is more flexible. I hope that clarifies things, Alex.

It does. Thank you.

Thank you. Our next question comes from Ike Boruchow of Wells Fargo. Your line is open. Please go ahead, Ike Boruchow.

Hey, thank you. So Chip, I just wanted to go back to the prepared remarks and just dig in a little bit more. When you were speaking at a high level, the business is being guided to negative constant currency growth in Q4. I think you said you expect things to remain challenging over the next few quarters. I know you're not going to give us guidance for next year, but can you put some context behind that? How exactly should we think about the business based on the order book or any other visibility you may have right now? Thank you.

Yes. And by the way, guys, part of the reason I hesitated on that last call, the Blue Angels are in town and we just got straight a minute ago. So it's crazy; we've got jet slime right over our heads here. I guess the way I would characterize the way we're looking ahead, I've talked about this a little bit with respect specifically to Europe, there's just a lot of uncertainty right now. I mean, forecasting during the pandemic was pretty tough, but it's pretty challenging right now to get a solid hold on where is the consumer heading and where is the business heading, especially regarding customers and their open budgets. That uncertainty is caused by some of the noise and confusion in a lot of the economic signals that we are getting. Inflation is still relatively strong. You may see that begin to change over the next month or a couple of months, but we are at or near full employment and wages are growing across all incomes. Bank accounts are still reasonably healthy, thanks to the pandemic impact, particularly in the middle and upper segments of income. So there's some data that you can look at and say things look pretty good, but there is a ton of uncertainty, as I said, in Europe. There is a lot of concern about what's going to happen during the winter with energy costs, particularly across that marketplace. But, as I said, it is more of these Western markets where we're seeing these impacts. We have other parts of the business that are performing incredibly well. Even within our portfolio in the West, our DTC business is performing well. Our balanced portfolio, the strength we are seeing in Asia, the strength we are seeing in Latin America, the strength we are seeing in our women's business, on Dockers, Beyond Yoga being completely additive at this point, we begin to lap that now. These are helping to offset some of the speed bumps we're seeing in other markets. But it is too early to comment on guidance. I can tell you guys honestly, I haven't even seen the numbers as we're developing our plan at this point. But I expect that we will be reflecting kind of the realities as we see it today with some of these uncertainties at least through probably the first half of next fiscal year. So I hope that helps without giving you any specific numbers.

Ike, the only thing I'd build on is from a cost perspective of what we've seen. So, Ike, on one hand, we built up inventory as we closed the year, but we built up inventory when cotton was much lower than what it was for the first half of next year. As we see the future of cotton for the second half, cotton is down to a little over $0.80, which is the normalized price. So there should be some tailwind there in 2023. The second is, some reduction in distribution costs and freight costs as we start thinking through the second half of next year. Those factors will probably help. As Chip said, we are here for the long term and we'll take that view. You saw our expectations we set on Investor Day. So we have a north star that we're working on.

Thank you.

Thank you. Our next question comes from Laurent Vasilescu of Exane BNP Paribas. Your line is open. Please go ahead, Laurent Vasilescu.

Good afternoon. Thanks for taking my question. Chip, I think you mentioned the value channel in the US was down 12%, but ex that, the US wholesale was actually up mid-single digits for the quarter. How do we think about those guardrails for the fourth quarter? Do they converge? Does the value channel get a little bit better and the rest of the business gets a little bit worse? Any guardrails around that? And then I think you mentioned ex China, Asia was up 68%; I presume, obviously, that was on a constant-currency basis. Just curious to know what you're seeing in China. I know you have a small business there, but any color on what you're seeing quarter-to-date trends would be very helpful. Thank you.

As we approach Q4, we're indicating a slight decline in constant currency growth and a reported decrease of 16%. The foreign exchange rates have been similar to Q3, which is reflected in the cost differences. The reduction in constant currency growth from Q3 to a slight decline in Q4 is influenced by two main factors. First, Asia has been growing at rates of 50% to 60%, but it will soon start comparing against a normalized base, so we anticipate growth in Asia to stabilize in the high teens rather than maintaining those previous levels. Second, for the Americas, ongoing supply chain disruptions are expected to continue into Q4, with improvements anticipated from Q1 onward, coupled with a decrease in US wholesale. This is our outlook. We are working hard to improve our performance, but this is the expectation we are setting. Regarding China, it experienced a 17% decline in Q3, but it accounts for only 2% to 3% of our overall business. As we stated on Investor Day, we don't foresee this segment becoming a significant driver of our growth in the long run.

There you go. You just answered it.

Thank you very much.

Thank you. Our next question comes from Jay Sole of UBS. Your line is open. Please go ahead. Jay Sole, your line is open.

Thank you so much. My question is, can you elaborate a little bit on the supply chain challenges you experienced in the quarter? And maybe help us understand some of the differences that played out versus your expectation at the end of last quarter? Maybe you can start there; that would be great. Thank you.

Jay, overall, what we say is, all parts of the supply chain are indeed improving. We're still feeling the impacts of disruption. We additionally have some congestion within our logistics and distribution network due to inventory build that we did to protect Q1 revenue as well as our ERP transition. With this congestion comes a lot of inefficiency in our distribution network. We think Q4 will be the peak, and we expect to start improvements in Q1. To offset this and build, as I said earlier, we're kind of reducing our H1 by a big time. By the end of quarter two, inventory levels should return back to normal. The congestion is largely between the ports, the transloading, and goods on our distribution center lots. We're working through it, and the majority of it is largely in the US. The US is a primarily core market, so we're working through that. We're working through the same with our customers to ensure there's minimal disruption, but it does hurt overall revenue.

Yes. The only thing I would add is, you probably heard others talk about supply chain improving significantly. Their starting point was a lot different than our starting point. Our supply chain issues are kind of in line with the issues that we had last quarter. We've left two to three points worth of growth on the table due to supply chain issues. We didn't have the major supply chain issues the way some of our peers did nine to 12 months ago, because our supply chain is more diversified relative to our peers who have a major concentration in one or two markets. The change on change is not as significant for us as it has been for some others.

Got it. Okay. Thank you so much.

Thank you. Our next question comes from Dana Telsey of Telsey Group. Please go ahead. Your line is open, Dana Telsey.

Good evening, everyone. As you think of the current macro environment and what's happening in the channels, how are you thinking of the level of promotion, whether it's by your own DTC, e-commerce, or stores? What's happening on the wholesale side by region also? And with the offsets on the gross margin side, are there offsets in terms of the magnitude, whether it happens to be freight or whether it happens to be anything else that we should note? How do you see the gross margin cadence evolving? Thank you.

Yes. Hi, Dana. Thank you for your question. Regarding our gross margin, when we entered the second half of the year, we indicated that we anticipated a contraction of approximately 100 basis points in gross margin for both Q3 and Q4. This projection was based on our expectations for the percentage of products that would not be sold at full price. As the quarter went on, we noticed an increase in promotional activities, and we had some seasonal products to mark down in the western region. In Q3, the impact on gross margin was around an additional 30 basis points, and we expect a further 30 basis points in Q4 due to a more promotional environment and inventory we want to sell at reduced prices. Ultimately, our gross margins this year will be slightly lower than last year, yet still significantly higher, by almost 400 basis points compared to 2019. We are optimistic about our long-term gross margin growth. Does that help you?

Yes. And as you see your own channels with stores and online, how do you see the cadence there?

I’ll take that question. Let’s say it like this, Dana. We won’t be entering an overly aggressive promotional environment, but we also won’t fall behind our competitors. Similar to what we did in the third quarter when the promotional activity increased, we took actions to stay competitive. However, we’re not in a position where we need to rapidly clear out a lot of inventory. We won't be leading promotions, but we will certainly remain competitive. This might not mean that we will match a 7% discount if others are offering that; instead, we might choose to promote for fewer weeks while still being competitive. Ultimately, we are focused on maintaining the strength of our brand, and being overly promotional can harm brand integrity. Thus, we aim to protect our gross margin while ensuring we don’t become uncompetitive in the market.

Got it. And just on marketing, what are your plans for marketing and marketing expense as we go through this time period?

Yes. I probably should have hit this earlier, but whether you're thinking about Q4 or thinking about next year, we're going to continue to invest in the long term and we're going to continue to make investments in DTC and e-commerce, because those are strategic for us, and we're going to continue to invest in building our brands.

Thank you. At this time, I'd like to turn the call back over to Chip Bergh for closing remarks.

Okay. Latif. Okay. Thanks everyone for dialing in. And we will talk to you again at the end of January. I wish you all happy holidays, a good fall, and happy holidays, and we'll speak with you at the end of our fiscal year in Q4 in late January. Have a good holiday and thanks for dialing in today, everyone.

This concludes today's conference call. Thank you for participating. You may now disconnect.