Lulu's Fashion Lounge Holdings, Inc. (LVLU) Q2 2022 Earnings Call Transcript

Good afternoon, everyone, and thank you for joining us to discuss Lulu's Second Quarter 2022 Results. Before we begin, we would like to remind you that this conference call will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements made on this call that do not relate to matters of historical fact should be considered forward-looking statements, including, but not limited to, statements regarding management's expectations, plans, strategies, goals and objectives and their implementation, our future expectations regarding financial results, references and outlook for the second half and year ending January 1, 2023, market opportunities, product launches and other initiatives and our growth. These statements, which are subject to various risks, uncertainties, assumptions and other important factors could cause our actual results, performance or achievements to differ materially from results, performance or achievements expressed or implied by these statements. These risks, uncertainties and assumptions are detailed in this afternoon's press release, as well as our filings with the SEC, including our annual report on Form 10-K for the fiscal year ended January 2, 2022, filed with the SEC on March 31, 2022, all of which can be found on our website at investors.lulus.com. Any such forward-looking statements represent management's estimates as of the date of this call. While we may elect to update such forward-looking statements at some point in the future, we undertake no obligation to revise or update any forward-looking statements or information, except as required by law. During our call today, we will also reference certain non-GAAP financial information, including adjusted EBITDA, adjusted EBITDA margin and net debt. We use non-GAAP measures in some of our financial discussions as we believe they more accurately represent the true operational performance and underlying results of our business. The presentation of this non-GAAP financial information is not intended to be considered in isolation or as a substitute for or superior to the financial information prepared and presented in accordance with GAAP. Our non-GAAP measures may be different from non-GAAP measures used by other companies. Reconciliations of GAAP to non-GAAP measures as well as the description, limitations and rationale for using each measure can be found in this afternoon's press release and in our SEC filings.

Thank you, Naomi, and good afternoon, everyone. I'm joined today with my partners and Co-Presidents, Mark and Crystal. Before I speak about the quarter, I wanted to thank the Lulu crew, who continue to do a tremendous job executing on our strategy and delighting our many customers. In this challenging macroeconomic period, we delivered year-over-year revenue growth of 27% at a healthy adjusted EBITDA margin rate of over 11%, a true testament to the power of our brand and strength of our business. We feel our broader customer metrics continue to be exceptional and at record levels for LVLU, which reinforce our confidence in our longer-term trajectory. Our fresh fashion assortment is clearly resonating with our millennial and Gen Z brand fans, and we're continuing to acquire new ones. Our active customers increased by 53% year-over-year, which included a 22% gain in new customers as we continue to grow awareness. Average order value increased 13% on a 12-month basis with double-digit gains from both new and existing customers. We believe these positive customer metrics demonstrate that LVLU continues to occupy more space in her closet and take share from the broader apparel industry. That being said, after a very strong start to Q2, in late May after our Q1 earnings call and like many others, we began to see volatility in traffic trends and conversion rates, which were likely driven by increasing macro pressures that impacted our customer spending behavior. We saw a higher level of returns, as well as shipping surcharges, which had a disproportionately negative impact on our EBITDA margins. As a result of this change in consumer behavior, we are actively managing our inventory and discretionary expenses with a more cautious outlook because of the macro environment. We view these challenges as temporary and have conviction in our long-term opportunity for continued profitable growth. Our business model is resilient and adaptable. Let me remind you of the unique characteristics, which enable us to execute through these uncertain times for the consumer and achieve our goals for long-term profitable growth. First, we have a very loyal and growing customer following, as evidenced by strong trends amongst new and existing customers, supported by our accessible price points and affordable luxury positioning, which spans broad age and income levels across Millennials and Gen Z. Second, we are not a fast fashion brand. And unlike many in the apparel industry, shifting demand does not necessarily mean obsolete inventory and excessive markdowns. The majority of our inventory can be carried from one season to the next. Also, our data-driven product development reduces risk, so we're able to respond appropriately from an inventory perspective when preferences do change. Third, we have a nimble cost structure in the largest components of our operating expenses, specifically in marketing, staffing and product costs for the future. So we are in a position to adjust our cost structure as needed for the future. Fourth, we believe we have amongst the fastest inventory turns in the industry. Fifth, we have a capital-light model with some months approaching negative working capital, which enables us to generate strong free cash flow. Finally, we have a solid balance sheet as a result of our debt reduction, and we believe we are well positioned to fund continued growth and navigate through evolving business conditions. We are reiterating our updated guidance that was issued on July 28. Please note, contained within this guidance range are investments necessary to focus on our larger mission of future brand and company growth at LVLU.

Thank you, David. From an operations perspective, we have plenty of good news to report. We opened our Southern California facility at the end of last year and finished transitioning our receiving, quality control and cross-docking activities of vendor inbound products in Q1 of 2022. In Q2, we added network product replenishment activities to the mix. First, network replenishment will allow for further improvements to our algorithmic and data-driven inventory allocation to the Northern California and Eastern Pennsylvania fulfillment centers. Secondly, optimizing inventory allocations supports the reduction of our already low split ship rates of customer orders. And lastly, moving to a more just-in-time inventory replenishment of our fulfillment centers also improves the efficiency of those fulfillment centers as well as postpones the timing of the opening of the next fulfillment center. We previously shared with you that we went live in early Q2 with robotics in our Eastern Pennsylvania fulfillment center, which is also our largest fulfillment center. I'm happy to report that by the end of Q2, we consistently outperformed our internal efficiency goals and ROI calculations. I'm extending my congratulations to our distribution center teams, as well as our technology partners for a job well done. We are now also planning to introduce robotics into our Northern California fulfillment center, for which CapEx budget has been allocated in our full year 2022 guidance. Switching now to our beloved customers. We grew our active customers by 53% to 3.2 million for the 12 months ending July 3, 2022 compared to 2.1 million active customers in the 12 months ended July 4, 2021. This record in active customers was boosted by high repeat rates of existing customers and strong new customer acquisition. Second fiscal quarter 2022 over second fiscal quarter 2021 AOV growth was driven by higher units per order and higher average unit retails, net of discounts and markdowns. Indicative of our customers being impacted by economic uncertainty, average order frequency gains early in the quarter, we lost in the latter part of the quarter, resulting in a marginal increase in average order frequency in fiscal Q2, 2022 over fiscal Q2, 2021. We see continued growth in our Love Rewards loyalty program, both in member counts as well as in percent of overall transacted revenue by our loyalty members. Members that redeem their loyalty offers also drove higher revenue with a higher purchase frequency than non-Love Rewards customers. Based on this first full fiscal quarter of our relaunched loyalty program, we look forward to delivering additional value to our Love Rewards members through specific call to actions and perks. Switching to the marketing landscape. In fiscal Q2, we encountered negative impacts from the May 25 Google broad core algorithm update due to Google taking a larger percentage of many of the overall search results page real estate with, for example, more local results, dictionary definitions and web stories. Some of our rankings were also negatively impacted by Google giving more preference to content websites and in combination with reduced search volume due to the overall macroeconomic environment. At the end of Q2, Lulu's non-branded keywords traffic was down compared to Q2 of 2021. Our search engine optimization team quickly responded to the readings from the core algorithm update made and continues to make technical and content adjustments. And to date, we have seen consistent recovery and, in many cases, improvements in our average position rankings.

Thanks, Mark, and good afternoon, everyone. While we were not immune to the macro and industry-wide challenges, we were pleased that we continue to post double-digit top line growth, saw strength across many of our key metrics and continue to be profitable. During Q2, we grew our net revenue by 27% to $131.5 million, a $27.9 million increase over the same period in the prior year and the highest net revenue for any quarter in our history. Our top line growth continues to be driven by the combination of new customers acquired and increasing loyalty from our existing customer base with an all-time high number of repeat customers engaging with us during the second quarter. Total orders increased by 29% and average order value increased 13% to $137, reflecting increases in both units per transaction as well as higher average unit retails net of markdowns and discounts. We continue to be proud of our large and diverse community of loyal customers that are passionate about the Lulu's brand. At the end of Q2, we had 3.2 million active customers compared to 2.1 million active customers at the end of Q2 2021, a 53% increase year-over-year. This was up 250,000 active customers compared to our 2022 first quarter ending active customer count of 3 million. Year-to-date, we've added nearly 500,000 brand fans to our active customer file compared to our year ending 2021 active customer file. Offsetting these positives were higher-than-expected return rates above our expectations from earlier in the year. In addition, Q2 typically has a higher penetration of event dresses and this merchandise category normally produces a higher level of returns. Demand for event apparel continued throughout the quarter, beyond the typical busy season for events, driving return rates up further due to mix shift towards this higher return rate merchandise. Despite the challenges in the quarter, our business model proved resilient and enabled us to continue generating profitability. Gross margins for the second quarter fell about 380 basis points to 45.8%, driven primarily by 2 key factors: the costs associated with elevated returns; and second, high fuel surcharges and accessorial fees imposed by our carrier partners. In aggregate, we estimate that these 2 variables hurt gross margins by roughly 300 basis points. Moving down the P&L to give some insights into expense line items. Q2 selling and marketing expenses were $25.9 million, up $10.8 million from the same period in the prior year as we increased our online marketing expenses to acquire new customers and retain existing customers. We remain first order contribution margin profitable during the quarter in spite of elevated shipping and returns costs.

Thank you, Crystal. We'd like to take a moment to thank each of you, Lulu crew, our brand fans, shareholders and Board for their continued support as we continue down our path for future potential. With that, I'll turn it over to questions.

I guess this question might be first for Crystal. Crystal, just thinking about the full year outlook and some of the trends you talked about impacting the gross margin in the second quarter around return rates and freight surcharges, etc. Can you give us a little bit of perspective on how you're thinking about the trend around these items impacting gross margin and then trends impacting SG&A, so we can get a little more thought on how we should be thinking through trend lines in the back part of the year in terms of gross margin versus SG&A in terms of getting to the EBITDA margins?

Sure, Randy. So our guidance is contemplating kind of as we've signaled in the previous calls that we're going to return to more of a normalized promotional lockdown cadence kind of pre-pandemic levels. We also, again, as I alluded to, have about $5 million of inventory that we think is unnecessary to carry from a balance perspective that may have a little bit of margin compression as we work through that, also contemplated in the guidance. But as it relates to return rates, we've experienced some elevated return rates, I think, like others in our space. We're expecting that to continue throughout the rest of the year. Although as mix shifts away from event dressing and more into kind of fall/pre-fall, there may be some upside in guidance around potentially lower return rates as well. But the margin flow-through or impact of margin flow-through and some of those effects are contemplated in our guidance already and we reiterate and feel pretty good about it.

Thanks for that question. In the second quarter, we experienced strong repeat rates from our existing customers along with new customer acquisition. Both groups showed favorable behavior in terms of basket size, average units per transaction, and average order values, which were all higher. However, I noted that we observed a slight decrease in order frequency towards the end of the quarter. Overall, it was a healthy quarter regarding customer metrics. We did encounter some challenges at the end of May due to a Google algorithm update, which occurs several times a year. This is something we've dealt with for years. While sometimes the updates have a positive effect, this instance was initially negative for us. It necessitated a reassessment of our trends, published content, and insights from various experts. Consequently, we began adjusting our technical SEO and content strategies to recover. In many cases, we have either recovered or improved, so I view this as a temporary dip in traffic. We are accustomed to navigating these situations, and fortunately, due to our long-standing presence in e-commerce, we maintain a robust position in organic traffic. Thus, while the temporary decline in traffic does impact our overall marketing efficiency, we have certainly noticed this effect.

And Randy, from a modeling perspective, I just want to make it clear we're still going after growth. We don't have any reason to try to pullback on our longer-term initiatives. Of course, we're watching all expenses. It's a choppy macro environment, but from an overall marketing spend perspective, we don't intend to try to cut there. We're still looking to grow that by customer file. So I would expect consistency with what we've demonstrated in the past from marketing spend perspective for the back half of the year.

And Randy, it's David here. Just following on the comments of the team, yes, we're really proud of how the Lulu crew pulled together, responded to the Google Algorithm. As Mark said, it's because we're so proficient at it that we initially felt it more severely than others who aren't necessarily advanced in those metrics and really retained a nice spot at the end of the quarter. Regarding the EBITDA margins you referred to, yes, absolutely, our roots as an entrepreneurial company focus on growing profitably, as you mentioned. Everything in our plans can achieve that. However, remember that we do have some quarterly and seasonal differences in our business. Unlike most in the industry, Q4 is our smallest quarter, so our fixed overhead impacts our EBITDA margin rate, making it lower in Q4 than in Q2.

On the second half, as we think about gross margin, will that continue to be impacted negatively by surcharges from freight and higher returns? We're also curious about July. July has been a tougher month for many versus June. However, towards the end of July, things may have improved. Would just love your take on if you're seeing kind of volatility and any read-throughs? And then, Mark, on the Google broad core update, some of the changes seem to be around video as well. As you think about your marketing techniques and plans and your artificial intelligence, like are there new capabilities that you're working on in terms of broader changes you're making? And what's your hypothesis for why it disadvantaged you?

From a margin perspective, as it relates to fuel surcharges and some of the other kind of external factors that have been affecting the business, I think if I had a crystal ball, I'd be one of the wealthiest people on the planet. But what we are contemplating in our guidance that we continue to see pressure, specifically around holiday surcharges that may or may not be passed through from our carrier partners. It's difficult to say, but our guidance is contemplated as that continues to be some headwinds for us. As it relates to overall gross margin from a merchandise perspective, we're typically higher in our separate to non-events business in the second half, which is a less mature part of our business. And so, I'd expect lower margins than our run rate, but that's a normal course of business for us in terms of Q3 and Q4. As it relates to July and so far in the quarter, we're taking a cautious approach. I think things are looking up, but we want to be very careful about how we give guidance until the macro environment stabilizes. So that said, things are good, but we expect it to continue to be choppy for at least the near term.

Yes. As it relates to the Google, I think you were referring to the video of the TikTok indexing as well as web stories that Google introduced. We are indeed playing with that and seeing how we can benefit from that. And that is part of the course. That's what we do after each of these changes to figure out what works and how does it contribute and how can we optimize that and whether that even is something that plays longer term because Google might also change these again going forward.

Sure. Oliver, you might remember from our discussions before the IPO that we are confident in our strong performance in performance marketing. We recognized the opportunity to enhance other aspects of our marketing operations. The recent changes from Google or Facebook only reinforce our commitment to make rapid progress in that area, and we're pleased with what the team has accomplished so far. We were already moving in this direction, and we aim to keep those efforts going.

Just given our customer demographic, I would say back-to-school is more so an opportunity for us from a college perspective and more specifically from a homecoming event and all the events related to sorority rushes and that sort of thing, unless they were on the back-to-school from a high school or younger demographic perspective. So it's not a big month for us, but it doesn't mean we don't participate in it. It's just in kind of a different fashion with our more college-aged demo.

Regarding the promotional environment, much of our product is either seasonless or minimally seasonal, which means we aren't facing the same pressures as other apparel brands that need to manage their retail locations and inventory. We plan to take advantage of this and aim for optimal cost recovery on our purchases. However, due to inflationary pressures, many sectors are being cautious with their spending, except for the luxury market. As mentioned by Crystal in previous calls, we are reintroducing small, consistent promotional messages to ensure our call to action remains clear, and we expect this approach to continue for the rest of the year.

From an inventory perspective, we have been working hard to improve our inventory levels to better meet customer demand and optimize stock ratios. We now feel we have sufficient inventory to manage. Overall, we are satisfied with our current inventory levels. These levels may fluctuate based on the upcoming season and our projected quarterly revenue targets. I would anticipate a stable inventory balance, with slight variations, for the next few quarters, unless there are significant changes in consumer demand. We are in a strong position regarding inventory, and Mark's team has effectively expanded the distribution centers to accommodate these fluctuations. We take a pretty surgical approach to pricing. And from an inflation perspective, we're in kind of the high single-digit impact so far from an overall costing. So we're looking at pricing on a daily basis at SKU levels. It's optimized for what sell-through and what resonates with our customer. And so, in that sense, it's sort of business as usual for us. So we've always been really well known for our event dressing, and we've been really pleased with how the team has performed in meeting demand and meeting our customer where she is for that particular demand set. That said, we've seen double-digit growth across event, nonevent, cocktail, all of our nonevent classes specifically, we've done a really good job of still getting more share of a closet in that regard. So we flex though within every quarter and whatever our customer is telling us that she wants. And so that inventory is going to flex up or down depending on the season and where we're resonating with our customers. So it's difficult to predict longer term where that's going to be.

As we discussed earlier, we are focusing on our strategy to grow the brand into a true lifestyle brand. We will continue to explore more purchasing opportunities and expand our product assortment. We are pleased with our performance in both event and nonevent categories. However, we anticipate that macro trends may cause event dressing to peak at times, influencing our SKU offerings, while there will also be periods in the fashion cycle when nonevent styles thrive. We appreciate the diversification we are cultivating, which allows us to maintain our presence as an event brand and remain top of mind for our customers.

2 for me. I guess first, not to drag too fine of a point on a couple of weeks, but as you look at your data, how important do you think gas prices are to your consumers' behavior? And would you attribute some of the strength, I guess, that you observed at the end of July due to lower gas prices? And then as a broader question, we've heard some of your peers talk about seeing kind of higher efficacy or returns from TikTok. Just as you see more eyeballs move to that channel, how do you think your analytics and platform are positioned to take advantage of content on that?

From a gas price perspective, there is definitely a subgroup of our customers with lower household incomes that shows a direct correlation between their engagement with us and gas prices. When gas prices decrease, we can anticipate this specific group to spend and engage more with us, and we are already observing signs of that. Our customers with higher household incomes appear to be less impacted by these fluctuations, although that doesn't mean they won't be affected in the future. I will leave the TikTok discussion to Mark.

TikTok is an increasingly important channel, as we've seen over the last several quarters. And we have certainly invested on the content side, but also on the tooling side in order to further optimize that channel for us. And we are very happy with what we're seeing and the progress that we're making. The content that we're making, we see that based upon the engagement is better resonating with our customers, and we are also continuing to expand in that content as well as tooling to better understand the landscape across all social channels as well as what our peers are doing. And as a result, for example, we have been able to increase our earned media value, is one of the KPIs that we're tracking that we were able to increase without necessarily spending more, just becoming better at it, better content and more efficiency there.

I was hoping you could provide more insight into the changes you're observing in the macro environment and the demand backdrop. The transition towards dresses and the related expenses makes sense, but it still suggests that consumers are very engaged. I'm trying to reconcile this with the significant adjustment you made to your growth outlook for the second half of the year.

I believe we are anticipating a shift in everyday wear, particularly affecting lower household income customers, which may result in lower demand for building out their closets. Our guidance reflects caution due to the unstable macro environment and challenges like fuel surcharges that are impacting our operations. However, events continue to be a strong growth driver for us. Most of our short-term guidance is focused on less essential, less event-driven products.

Yes, Mark, the timing of our guidance is important at this time of year, similar to charting a course for a sailboat by observing the wind's strength to determine direction. We aim to provide continuous updates as we gain more confidence in our outlook. This is why we have a wider range of possibilities; we anticipate a broader range of outcomes. As we become more certain, we will share more information to give you a clearer understanding of that range.

First, I was hoping if you could give any color on just kind of the behavior you've seen from the consumer and how that may differ from the end of May to the end of July to currently different income levels, geography, any different behaviors there? And then second, as we model out the rest of the year, how should we think about AOVs as well as return rates?

From an AOV perspective, the build and de-builds across the quarters have been fairly consistent but at a higher baseline. Looking at previous years can help gauge how we're modeling AOV, which reflects the shift in customer behavior. We've observed that our customers are adding more items to their carts, which has naturally led to an increase in returns. We are taking a conservative stance on our return rate model, expecting that the higher returns will persist for the rest of the year. Between May and July, we noted an uptick in returns, often linked to negative media coverage that can lead to increased return rates, as customers may feel pressured by the macroeconomic environment. It's challenging to predict how this trend will evolve as we progress through the quarter, but we have experienced elevated return rates from May to July, coupled with weaker demand, particularly among customers with lower household incomes.

David, perhaps we can start off with a few comments on how you perceive the competitive environment against this choppier macro. Have you seen any strategic shifts with any of your competitors? And any actions that you think need to necessitate a change in Lulu's actions?

We are observing a few short-term trends and anticipate some developments in the midterm. In the short term, there is a noticeable shift in online spending, particularly among some digital consumers who appear to be reducing their performance-related spending. This observation is anecdotal, and we are continuing to monitor the situation. In the near term, we foresee a highly promotional environment driven by omni-channel players and fast-fashion brands that may have overextended themselves due to the sudden changes in consumer purchasing behavior. For us at LVLU, this situation presents two key points. First, we do not need to react drastically since most of our merchandise is not trend-driven but rather seasonless, allowing us to carry our products across different seasons. Second, we may need to introduce more targeted promotional strategies to maintain our image of affordable luxury in response to the marketing pressures from others. We believe this period represents a great opportunity to attract new customers and deliver a superior brand experience while competitors focus on aligning their inventory levels.

Just wanted to get a sense of your strategy. If your consumer continues to struggle, do you let sales decline to protect margins or would you consider more aggressively ramping promotions and marketing to maintain the higher sales growth?

I'm not sure we're actually at a point yet where we would have to decide between the 2, but I think a lot of that is solved through our pricing strategy and just how we're able to connect sell-through with pricing from that perspective. And we have a pretty broad assortment that can attract both ends of the household income spectrum, if you will. And so, I don't know that we're in a position where we really need to choose between sales growth or profitability at this point. We've got so much value proposition in our product, but I'm not sure of that yet.

Yes. One of our key principles is focused on profitable growth and customer acquisition. Our forecast will continue to reflect this approach. We will maintain our usual range as we have in the past, and we’re confident we won’t encounter issues in driving this forward. We don't need to discount excessively to maintain profitability. Given our product mix, we want to stay current, but we are not aiming for large sales spikes just to meet an artificial target. We're still in the early stages of our journey and see significant untapped market potential. The customer pullback we experienced in late May was an adjustment that we managed, and we believe it represents a minor tweak rather than a major setback. Given our business model, we can adapt quickly.

Our first question comes from Randy Konik with Jefferies. Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session. This does conclude today's conference, and you may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.