Earnings Call Transcript - LVLU Q4 2022

Operator, Operator

Good afternoon, and welcome to Lulu's Fourth Quarter and Fiscal Year 2022 Earnings Conference Call. Today's call is being recorded, and we have allocated 1 hour for prepared remarks and Q&A. At this time, I'd like to turn the conference over to Naomi Beckman-Straus, General Counsel at Lulu's. Thank you. You may begin.

Naomi Beckman-Straus, General Counsel

Good afternoon, everyone, and thank you for joining us to discuss Lulu's fourth quarter and fiscal year 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 leadership transition, management's expectations, plans, strategies, goals and objectives and their implementation, our future expectations regarding financial results, references to the year ended December 31, 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 1, 2023 filed with the SEC on March 14, 2023, 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. Joining me on the call today are Executive Chairman of the Board, David McCreight; our CEO, Crystal Landsem, President and CIO, Mark Vos; and our CFO, Tiffany Smith. Following our prepared remarks, we'll open the call for your questions. With that, I'll turn the call over to David.

David McCreight, Executive Chairman

Thank you, Naomi, and good afternoon, everyone. I want to begin by thanking the Lulu's crew, who continue to do a tremendous job executing on our strategy and pleasing our millions of brand fans. I am delighted to pass the baton to Crystal Landsem, who officially assumed the role of CEO on March 6, 2023. Crystal has been a wonderful partner who has a deep understanding of our business and customers, embodies our core values and has consistently demonstrated her leadership as we've scaled and grown the company these last few years together. As we've communicated in November, I've transitioned to the Executive Chairman role after rewarding few years as Lulu's CEO. This transition has been part of a long-term plan since I joined the company, and I am thrilled to leave the business in the capable hands of this excellent management team. Their commitment to the brand and the Lulu's customer is inspiring. Over the next few seasons, I'm confident Crystal and team will continue to make great strides in building on Lulu's strong brand equity and evolving our go-to-market strategy for the future. I can't wait to see what Lulu's does next. I'll turn it over to Crystal so you can now hear directly from her as CEO. Crystal?

Crystal Landsem, CEO

Thank you, David, and good afternoon, everyone. I'm honored and thrilled to have assumed the role of CEO. It's been an incredible 7 years so far at Lulu's, and I'm very much looking forward to leading this exceptional and dedicated team as we continue to execute our long-term growth plans. I'd like to start with some full-year highlights following our first full year as a public company, followed by our key priorities for 2023. 2022 net revenue of $440 million was up $64 million or 17% year-over-year from $376 million in 2021. Adjusted EBITDA of $29.1 million, an 11.4% 3-year CAGR despite not incurring public company expenses and developing infrastructure to position Lulu's for long-term growth. Active customers grew 17% over last year with an all-time record of repeat customers engaging with our brand. We implemented automation and robotics in our distribution center network, driving operational efficiencies, cost savings and increased employee morale by vastly reducing travel distances to pick, pack and ship orders, also resulting in an improved customer experience by reducing the time between order and shipment. Roughly 83% of our units sold without markdown pricing, right in line with pre-pandemic years. And those units sold on markdown sold on average at a higher, more profitable net merchandise margin than pre-pandemic periods. We completed the move of our creative studio to a location adjacent to our Southern California buying office. And already, we're seeing the benefits of that move through strong new product conversion, which we expect to continue in the future. We continue testing and expanding more into brand awareness marketing while maintaining first order contribution margin profitability and year-over-year active customer growth. Our marketing initiatives remain efficient and impactful. At its core, Lulu's continues to be a profitable, data-driven growth concept with a customer-led assortment, and we believe the runway is long. We believe we have significant opportunity to grow our brand fan community and occupy more space in her closet. Our consumer insights and customer feedback tell us she is seeking opportunities to experience our brand beyond our digital platform, and we believe there is consumer demand outside the U.S. In addition to capturing more wallet share in the digital space, we see an opportunity to broaden our distribution channels across both digital and physical platforms, increase our international penetration and pursue incremental wholesale opportunities. Consistent with everything we do at Lulu's, we will follow a data-driven, test-and-learn, capital-light strategy when pursuing these opportunities, which is further supported by our strong balance sheet. We have benefited from robotics and automation investments and see opportunity to further increase operational efficiencies through continued investments across our distribution facilities. Above all, we believe 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 and foremost, we are not a fast fashion retailer. We are a lifestyle brand whose loyal customers appreciate the durability, uniqueness and quality of our assortment relative to the price. As a reminder, over 90% of the items we sell are Lulu's branded. Further, and unlike many in the apparel industry, shifting demand does not necessarily mean obsolete inventory and excessive markdowns. Roughly half of our inventory can be carried from one season to the next and much of the remaining half is often brought back as a reorder product the following year. Also, our data-driven product development reduces fashion risk so we're able to respond appropriately from an inventory perspective when preferences do change; second, we have a nimble and largely variable cost structure and the largest components of our operating expenses, specifically in marketing, staffing and product costs for the future. So we're in a position to adjust a large part of our cost structure on an as-needed basis in order to preserve profitability; third, we believe we have one of the fastest inventory turns in the industry. Our data-driven merchandising process allows for optimization of inventory turns. So even in the most challenging macroeconomic environments, we're able to stay nimble and take a brand-friendly surgical approach to our inventory management; fourth, we have a capital-light model, which typically generates positive cash flow from operations. Thanks to our bespoke internal technology platforms and our highly skilled operations teams, we're able to react to demand patterns quickly, enabling us to expand or contract our distribution networks just in time with minimal impact to the business or the balance sheet versus needing to invest in large-scale operations ahead of unknown growth trajectories. And finally, we have a solid balance sheet without any term loan debt, bolstered by strategic investments, resulting in further operational efficiencies as well as an agile business model with a nimble cost structure. With significant liquidity available, we believe we are well positioned to navigate the evolving business conditions and continue to invest in future growth and capitalize on our brand potential. Moving on to the fourth quarter. We generated revenues of $91 million and produced a modest adjusted EBITDA deficit of about $1 million. I'm proud of our team's ability to manage through such a dynamic and evolving environment. As a reminder, unlike many consumer brands, Q4 is our smallest quarter from a revenue perspective, while fixed expense levels remain fairly consistent throughout the year. Our LTM active customer count continues to grow, increasing 17% from last year to 3.2 million. Average order value declined modestly by 2% in the fourth quarter. That being said, like others in the industry, we witnessed inconsistent consumer behavior during the quarter, characterized by volatile traffic trends and conversion. We attribute this to macro pressures leading our customer to be more discerning with her spending. Similar to our peers, we responded to this by shifting marketing spend to product discounts. Our assortment resonated with our customer during Q4, and she thought items that could be worn for many occasions. We are particularly pleased with the gains we experienced in some of our non-dress categories. These gains reinforce our conviction in the opportunity to occupy more space in her closet beyond the core occasion wear categories. For 2023, based on the uncertain macro consumer environment, combined with the return to pre-pandemic wedding event cycles, we are targeting revenues of $410 million to $430 million. Driven by the combination of maintaining flexibility on product pricing to meet customer demand in the near term that is likely to temporarily soften merchandise margins, as well as maintaining investments in order to catalyze future growth and expansion of our brand across both digital and physical distribution channels, we estimate our adjusted EBITDA will be between $23.1 million and $25.6 million. As we announced last week, Tiffany Smith, our former VP of Finance, assumed the role of CFO on March 6, 2023, and she will provide more details about Q4 and 2023 guidance. I am thrilled to have Tiffany take over this role given her intimate knowledge of Lulu's financials, her holistic and strategic approach to financial decision-making and her genuine love for our customer. As expected, the leadership transition has been seamless given that Tiffany, Mark and I have all collaborated in developing the long-term strategy building for Lulu's. We expect to maintain the same focus and vision for the company that we've previously communicated, including growing brand awareness and attracting new customers, retaining, enhancing and broadening our existing customer relationships through physical and digital channels, pursuing further product category expansion and developing international markets. Before I turn it over to Mark to provide an update on operational and marketing efforts, I'd like to express my gratitude to our team and their relentless dedication to building our brands and creating value for our shareholders in this very dynamic ever-changing environment. And now I'd like to turn the call over to Mark Vos, our President and Chief Information Officer. Mark?

Mark Vos, President and Chief Information Officer

Thank you, Crystal. In Q4, we continued to invest in our operations to expand the foundations for growth and drive further operational efficiencies. We have finished testing and setting up our fulfillment and returns processing capacity in our Southern California facility, so we can go live as soon as this incremental capacity is needed. We are also on track with the introduction of robotics into our Northern California fulfillment center in the first half of this year. After the successful implementation of robotics in our Eastern Pennsylvania facility, we have seen a variable fulfillment labor productivity gain of over 20% in that facility, and we aim to accomplish similar results in the Northern California fulfillment center. Now some color around our customers. We are proud of our large and diverse community of loyal customers that are passionate about the Lulu's brand. At the end of Q4, we had 3.2 million active customers, compared to 2.76 million active customers at the end of Q4 in 2021, a 17% increase year-over-year, reflecting double-digit gains among new and repeat customers. In Q4 2022 compared to Q4 2021, we saw flat to positive year-over-year customer count growth in most of the middle to lower household income segments, who are drawn to our accessible luxury positioning. Customers in our loyalty program maintained higher AOV and higher order frequency, and we continue to focus on expanding the number of customers joining and staying in the program by adding loyalty benefits over time. As a reminder, the loyalty program is focused on customer engagement, not discounting. We also see continued growth in our mobile app revenue, primarily driven by continued increases in downloads and usage, combined with a higher conversion rate than mobile app. In 2023, we will continue to invest in our mobile app with features our customers are requesting and to further support our marketing efforts. In previous calls, we have mentioned that just like other retailers and brands have seen return rates remain elevated compared to pre-pandemic years. Some adjustments to our return policy will be made for heavy and excessive returners, and we remain committed to our customers by providing a safe, frictionless conversion path with our existing 10-day free return period. Switching gears to marketing. Our cost of customer acquisition in Q4 2022 was slightly higher than Q3 2022 but comparable with previous quarters and years, and we also maintained first quarter contribution margin profitability. Q4, in general, is a very competitive and expensive quarter for marketing, and we remain focused on contribution margin positive marketing investments. We were pleased to see meaningful improvements in impressions, earned media value generation, traffic and conversions in the affiliate, social and influencer marketing channels, which were also great supporting drivers of our national cadence. I am proud of the marketing, logistics, customer service and technology teams who in this dynamic environment continue to deliver first order contribution margin profitable marketing results, authentic customer experiences with Lulu's brand and expand the foundations of our continued growth. With that, I will hand the call over to Tiffany Smith, our Chief Financial Officer to discuss the quarter in more financial detail.

Tiffany Smith, Chief Financial Officer

Thanks, Mark, and good afternoon, everyone. Let me start out by saying how excited I am to be taking on the CFO role. I look forward to engaging with you and working closely with Crystal, Mark and David to continue to execute our long-term growth strategies. Moving on to the fourth quarter. While we were not immune to the challenges faced by the market, we reported a loss per share of $0.14, which is an improvement of $4.55 compared to a loss per share of $4.69 in the fourth quarter of 2021. Adjusted EBITDA for the fourth quarter was a loss of $972,000 compared to positive adjusted EBITDA of $6.4 million in the same period in 2021. Our Q4 adjusted EBITDA margin was negative 1.1% compared to a positive 6.6% in the same period in 2021. Moving on to the balance sheet and cash flow statement. We believe our balance sheet remains strong and positions us well to execute our long-term growth plans and manage through near-term macro uncertainty. Similar to the past several quarters, one key change compared to last year worth noting is we adopted the accounting lease standards under ASC 842 at the beginning of fiscal 2022, resulting in offsetting assets and liabilities reflected on the balance sheet this year that were not reported on the 2021 balance sheet. We ended the quarter with cash of $10.2 million and a balance of $25 million drawn on our revolver, resulting in net debt of roughly $14.8 million. In light of recent disruptions in the banking industry, it is important to highlight that we maintain our corporate banking relationship with Bank of America. Our inventory balance at quarter end was $43 million, up $21 million from the same period last year. The majority of this growth was planned and intentional to better support our fast-turning model. As a reminder, in Q4 2021, we were turning over 9 times on an LTM basis and had indicated our need to chase into more inventory, not only to better serve our customers, but to also insulate us from supply chain risk, specifically from China. Year-ending inventory levels were down $6.2 million or 13% from Q3 2022 levels as consistent with our seasonal fluctuations. We anticipate our year-over-year inventory growth comparisons will normalize and be more in line with revenue growth beginning in Q2 2023. On an annual basis, we feel a year-ending inventory balance of $43 million in a year with $440 million in net revenue is a solid way to end the year and prepare for the upcoming busy season in late Q1 and Q2. We remain a very quick inventory turning brand with what we believe are industry-leading turns. As always, we aim to be disciplined in our inventory management approach and we'll continue to relentlessly pursue further optimization of inventory levels that balances the customer experience and minimizes markdown risk. As a reminder, our data-driven buying model results in roughly 70% of our buyers being proven sellers with lower markdown risk. New styles during the quarter resonated particularly well, which gives us conviction in the strength of our reorder pipeline. We are a fresh fashion concept, not fast fashion, which means our inventory mostly consists of products that are relevant across seasons and in many cases, for multiple years. So we're less exposed to inventory obsolescence and the ensuing markdown risk. Nothing speaks to this more than our average number of units sold on markdown, which in a normal non-pandemic year, were consistently between 16.5% to 17%. 2022 was no exception to that, with roughly 16.6% of units sold with markdown pricing. Said differently, approximately 83% of units were sold without markdown pricing. Also worth noting, our gross merchandise margin for products sold on markdown have increased over time, with 2022 being roughly 10 percentage points higher than pre-pandemic years. We continue to operate a highly capital-efficient business that positions us to generate positive cash flow. Moving on to guidance. We are expecting 2023 full year net revenues between $410 million and $430 million. As you think about modeling revenue for our business, in a normalized year, our net revenue is typically highest in our second and third fiscal quarters due to demand seasonality for event dressing with Q4 typically representing the lowest net revenue and profit quarter of our fiscal year. We are not a gifting destination and typically do not participate proportionately in holiday peak season sales volume like other retailers in our space. As it relates to 2023 first half comparisons, Q1 and Q2 last year reflected 62% and 27% year-over-year net revenue growth, respectively, as those quarters benefited from pent-up demand as our customer refreshed her wardrobe to return to her social calendar as COVID-related constraints eased, including wedding-related events which are expected to decline in 2023. Recent revenue trends in the first 9 weeks of the quarter are pacing to negative mid- to high teens when compared to our 62% comps in Q1 '22, with the declines primarily attributed to the general macroeconomic environment as well as the previously cited decline in wedding-related events. For modeling purposes, our guidance contemplates that we expect to return to positive comps in the second half of 2023. Adjusted EBITDA is expected to be between $23.1 million and $25.6 million. This equates to an adjusted EBITDA margin of between 5.6% and 6%. Our adjusted EBITDA guidance captures incremental investments in support of longer-term initiatives. Our guidance targets are for the full year 2023. To set expectations for modeling purposes, our quarterly adjusted EBITDA margin rates have similar seasonality fluctuations as our net revenues and will likely fluctuate above or below our full year guidance rate depending on the quarter. As a result of paying down our long-term debt following the IPO, we continue to expect modest levels of interest expense for 2023 at approximately $1.1 million, in line with 2022, driven by a lower outstanding balance on our revolving line of credit, offset by higher interest rates. We currently have $25 million drawn on our $50 million revolver. Our guidance contemplates that we will begin paying down the revolver in Q1 2023 and to be net debt free by the end of 2023. Stock-based compensation expense for the quarter was down $5.8 million from Q4 2021, primarily due to IPO-related stock-based compensation expense accelerations in the prior year. Stock-based compensation expense is expected to be approximately $16 million to $19 million in 2023, which captures $1.2 million in accelerated expenses in Q1 associated with David McCreight voluntarily forfeiting his unvested stock options and the conversion of certain potential performance-based bonuses from cash to equity-base for 2023 tied to net revenue and adjusted EBITDA financial criteria. For 2023, we expect a weighted average fully diluted share count of approximately 40.6 million shares. Moving on to capital expenditures. We expect to invest between $5 million and $6 million. We're focused on setting the stage for future growth opportunities, enhancing the customer experience and driving further operating efficiencies. For 2023, we will continue to invest in distribution center automation and robotics capabilities, which are expected to drive further labor efficiencies. And with that, I'll pass it back to Crystal for closing remarks.

Crystal Landsem, CEO

Thank you, Tiffany. We'd like to take a moment to thank each of you, to Lulu's crew, our brand fans, shareholders and Board for their continued support as we continue to work towards executing on our strategy and delighting our customers. With that, we'll turn it over to questions now.

Operator, Operator

Our first question comes from Brooke Roach with Goldman Sachs.

Brooke Roach, Analyst

Crystal, I was wondering if you can talk to your confidence in driving the reacceleration of revenue growth in the second half following what appears to be a tough first half, and what assumptions are contemplated in that improved outlook? And then for Tiffany, can you talk a little bit more about the puts and takes within your margin outlook for the year? What assumptions do you have for promotionality and shipping expense among others?

Crystal Landsem, CEO

Thank you for the question, Brooke. In our business, we generally see smaller activity in Q4 and Q1, but we've been gaining momentum heading into Q2, Q3, and Q4. We anticipate this year will be quite similar. Our guidance takes into account the current macroeconomic conditions, which are not improving significantly, but we do expect a normalization of markdowns, discounts, and promotional activities compared to last year’s second half, which was unusually high. Overall, we see it as a return to normal business operations for us in the second half of the year.

Tiffany Smith, Chief Financial Officer

Sure. And Brooke, just a follow on to your second point of the question. This is Tiffany. Nice to meet you. Basically, in terms of puts and takes anticipated this year in terms of margin. Overall, we're anticipating gross margins to be relatively flat for the year, with, I would say, our merch margin probably under the most pressure in the first half of the year, given we're going up against a fairly non-promotional period in the first half of last year with some improvement on that in the second half in terms of merch margins. As that flows through to gross margin, shipping costs is a key lever there with where we have experienced cost pressures. We're working very actively. Our teams are in terms of managing the shipping costs this year, making modifications and tweaks where we can with regard to carrier diversification to help us to mitigate sort of those cost increases and pressures that we felt last year. And should those continue into this year, we feel like we've got good plans in place to mitigate those.

Brooke Roach, Analyst

Could I just ask 1 more? I think a couple of times in the script, you mentioned plans for physical channels, and perhaps wholesale. Can you talk a little bit more about that pivot into physical channels that you're planning for the year?

Crystal Landsem, CEO

I wouldn't necessarily call it a pivot, Brooke. What I would say is it's more about investing in what we had spoken about 1 year, 1.5 years ago when we originally went public. Is that we're going to be wherever our customer is and where she wants to engage with us. And we've gotten continued feedback from her that she prefers or would also like to engage with us in an in-person experience. And - while we're not ready to talk about the details of that, we will be over the next couple of quarters, providing updates around our investments and how strategically we'll be doing so. But I guess the direct answer is we will be investing in more in-person experiences, and how that manifests will be talk for our next quarterly call.

Operator, Operator

Our next comes from the line of Janine Stitcher with BTIG.

Janine Stichter, Analyst

Hoping you can elaborate a little bit more on what you're seeing in Q1 to date in terms of the sales trends, how much is being driven by active customer growth in orders versus what you're seeing on AOVs. And then within that, I would like to hear more about the promotionality that you're seeing in the environment? What does it look like as the quarter progressed in Q4 and then what you're seeing within the broader environment in Q1 to date.

Crystal Landsem, CEO

Thank you for the question. As I mentioned earlier, we are comparing against a very high 62% comp in Q1 of last year, which presents a challenge for this quarter. We anticipated this in our guidance for the 9 to 10 weeks so far, and I indicated that a roughly mid-teens negative comp aligns with our expectations. This is largely influenced by ongoing macroeconomic pressures that have not completely eased. Nonetheless, we remain confident in our overall strategies moving forward. Our cost structure is highly adaptable, allowing us to reduce variable costs and make necessary adjustments as needed.

Janine Stichter, Analyst

Great. And then just on the broad promotional environment and what you're seeing quarter-to-date?

Mark Vos, President and Chief Information Officer

I can discuss the promotional environment. We are essentially seeing a continuation of what we experienced in the fourth quarter. In that regard, it's not diminishing, and we need to be involved in that. Everyone is active and making various offers, and we must ensure that we get noticed from time to time. We approach this in multiple ways, utilizing a range of promotions tailored to different objectives and outcomes, whether that involves engaging or re-engaging specific customer segments, focusing on boosting sales in particular categories, or simply rewarding customers and encouraging downloads of our app. Therefore, there is a broad spectrum of promotions. We apply this strategy as precisely as we can, not always perhaps, but especially now to ensure we are achieving all the goals we've set. Janine, welcome to the team. I look forward to collaborating with you.

Operator, Operator

Our next question comes from the line from Mark Altschwager with Baird.

Mark Altschwager, Analyst

I guess just first, I was hoping to clarify on some of the adjusted EBITDA commentary. I think you said you expect the year to follow typical seasonality, which would be lower profitability maybe in Q4. But just given the more intense sales and gross margin pressure you're pointing to in Q1, is that still the case or maybe just any more granularity on how we should be thinking about that adjusted EBITDA margin for the first quarter?

Crystal Landsem, CEO

Yes. Thanks, Mark, for the question. So I think that's a good call out and worthy of highlighting for the group because we do typically highlight our lowest profitability and lowest sales quarter of the year is in a normal year Q4. I would say Q1 is giving Q4 a little run for their money this year just in terms of the promotional environment that we're in and the negative sales comps that we're having a comp against the 62% comp from Q1 of last year and 27% in Q2. That's up Q1, I would say, this year to be a little more challenged. And so we may see that distinction between Q4 being our lowest profit, lowest sales month. But sort of moderated a little bit with Q1, and you may look at those to be a little bit more similar this year than what they've been in prior years. We still expect to see Q2 being our peak season in Q3 to still maintain that as far as what you've seen historically there.

Mark Vos, President and Chief Information Officer

Mark, that's not dissimilar than what we have always had for Q1 was just ahead of Q4. So it's not as dramatic a shift as it may seem and that the big shoulders of the business flow through are Q2 and Q3.

Mark Altschwager, Analyst

Okay. And then I wanted to follow up on AOV. I was hoping you could give a bit more color on the trend you're seeing there. It's one of the bigger quarter-over-quarter changes that we've seen. I'm just curious how we should think about that for 2023. Is this - dish level a good way to be thinking about the trend as consumer behavior address?

Crystal Landsem, CEO

Yes. Good question. AOV is just generally speaking, year-over-year context, I would say think of Q1 being relatively flat with some single-digit year-over-year growth in the sequential quarters. Figure gains coming really in the back half as we start to comp the impacts of higher markdowns and discounts.

Operator, Operator

Our next question comes from the line of Jonna Kim with Cowen.

Jonna Kim, Analyst

Just curious about your non-strategy this year as you're locking strong demand from dresses last year. And then as we think about return rates, what are some key puts and takes that we should consider in our model as you're all having a lot of demand for dresses from last year, that would be helpful.

Crystal Landsem, CEO

Yes. So we have seen great progress across a lot of our event and our non-event apparel. And what's most interesting for us right now is our new customer conversions have been increasing over pre-pandemic years in our non-dress categories. So while we're still doing a really great job with our events and our dress business in general, just the performance of our other categories and product classes specific to non-event apparel is reiterating our thesis that we can take more market share despite the macro environment. We still believe that we have confidence that going forward, we're making the right investments in the right area. The great thing about our buying model is our customer is driving the assortment. So we're able to flex and pivot wherever she's wanting to drive us. And right now, we're seeing success in many of our, I should say, non-bridal or non-wedding event-related product classes, specifically in dresses, rompers and jumpsuits, but also in our other nonevent classes.

Tiffany Smith, Chief Financial Officer

I'll address the return rate question. Return rates are influenced not only by product categories but also by the effects of promotions and markdowns. We've projected a slight decrease in return rates for the year, primarily due to the first half of the year experiencing lower return rates year-over-year, which is related to our increased promotional activities compared to last year. Additionally, we will implement some policy changes in the coming weeks regarding return rates, aimed at preserving our customer-friendly return period, which is important for allowing customers to try different sizes and styles at home. However, we are also looking to address excessive return behavior. While we haven’t factored in decreases in return rates from these policy changes, we are maintaining a conservative outlook. We expect return rates to decrease slightly this year.

Operator, Operator

Our next question comes from the line of Noah Zatzkin with KeyBanc Capital Markets.

Noah Zatzkin, Analyst

Just a couple. I was hoping you could speak to your test and reorder model and kind of the benefits of that model as you navigate an uncertain macro. And then second, just hoping you could provide some color on inventory composition, your level of comfortability there and just your approach to bringing that in line by Q2.

Tiffany Smith, Chief Financial Officer

I'll address the first part regarding the advantages of our test-and-learn strategy. This approach is especially effective in the current challenging environment. During difficult times like these, we capitalize on our ability to adapt quickly. We have demonstrated this capability over the years, particularly during the COVID period and the subsequent year when demand surged, allowing us to embrace our agile strategy. Additionally, it's essential to highlight our reorder pipeline and how we develop it. This gives us a low-risk method to venture into new products that customers are showing interest in through their purchases, allowing us to introduce new styles. Our data-driven approach helps us determine which products to include in the reorder process. This capability, along with our entire merchandise model, positions us well to minimize risks around inventory and lower gross margin risks in the future, as we do not anticipate the same level of markdowns on outdated inventory that might be seen with other retail models.

Crystal Landsem, CEO

As it relates to our inventory positioning, I say we're pleased with how we ended the year. And as we signaled on previous calls, we have been trying to strategically slow our inventory turns to better meet customer demand, have better size and stock ratios and generally just navigate the challenges in China and the supply chain risk that we feel we're maybe disproportionately exposed to. And candidly, we're not that concerned about it. We don't lose a lot of sleep at night over our inventory. Most of it was strategic. We are heavy in some areas, but those areas are reorder products that are tested and trusted. So in that sense, we feel pretty good about our inventory levels. Candidly, we might be 1 or 2 weeks of supply heavier than we would normally be in what we feel is an optimized environment, but that's not something that really concerns us in terms of obsolescence or markdown risk just based on the inventory model that I just reviewed.

Operator, Operator

Our next question comes from the line of Randy Konik with Jefferies.

Randal Konik, Analyst

Yes, maybe with all the different pieces this year in 2023 as it relates to impacting your margin structure. Maybe just give us a reminder on how you think about what sustainable long-term kind of normalized gross margin and EBITDA margins would look like. That would be super helpful in this time of just some volatility here with the margin structure. So if you could do that, would be great.

Crystal Landsem, CEO

Yes, regarding your question, Randy, we have not yet invested heavily in controlling our cost of goods and management over pricing. We haven't pushed our vendors to enhance our margin flow-through, which has been very dynamic over the past three years. However, we have started to build internal teams to address this. We believe that in the long term, there will be significant advantages to our margin profile as we take greater control over our supply chain. We look forward to providing updates on our progress in the coming quarters.

Randal Konik, Analyst

And is there any kind of levels you want to point out to that you think that the gross margin should kind of be normalizing that or the EBITDA margins?

Crystal Landsem, CEO

I would say we should be able to perform better than our pre-COVID levels and continue to grow based on that as a baseline. I think Tiffany spoke about our markdowns being at historical lows for the first half of last year, and I think there's a lot of noise between 2020 through 2022. So I would look at improvements for pre-pandemic years, yes.

Randal Konik, Analyst

Got you. My last question...

Mark Vos, President and Chief Information Officer

Randy. It is a model that we still believe is going to scale, and there are things that we've built into the structure that will help the flow-through as we continue to scale the top line and grow our customers and stay close to this approach. So we go to market.

Randal Konik, Analyst

Yes, Mark, I would like to ask you about marketing. You provided some insights during the call. We're all aware of the various changes related to Apple's privacy policies and similar matters. As you consider allocating marketing funds over the next few years, could you share your thoughts on how this allocation might change in the next three years compared to the previous three years? How do you approach this in terms of adjusting strategies to reduce customer acquisition costs moving forward?

Mark Vos, President and Chief Information Officer

Great question. Yes, we acknowledge that in the past three years, we have focused heavily on direct response performance marketing, which has been very successful for us. Our decision to shift some budget from performance marketing to brand awareness is driven not just by privacy or technological reasons, but by a belief that this change will support faster growth and enhance the efficiency of our performance marketing efforts. We are carefully transitioning funds from performance marketing to brand awareness, and so far, we've managed to do this without increasing our overall marketing expenses. We believe we are on a positive path and intend to continue pursuing this strategy to enhance our brand awareness, which is currently low and represents a significant growth opportunity for the future.

Operator, Operator

Our next question comes from the line of Edward Yruma with Piper Sandler.

Edward Yruma, Analyst

I guess, first, what is the assumed growth or lack of new customers in the '23 guide? And I know you indicated that you saw some extra growth in kind of the lower and middle-income cohort. I guess, do you believe that that's kind of pressuring results today? Are you seeing some of the same repeat behavior in some of your historical cohorts? And then as a follow-up, just so I'm clear, how much incentive comp build back is baked into the SG&A number for '23?

Mark Vos, President and Chief Information Officer

I'll address the first part. Over the past few quarters, we've observed and projected that there has been a slowdown in order frequency among our customers. They're either being more selective, spending less often, or holding out for better deals due to numerous promotions available. This situation presents various choices for our customers, which we believe is primarily influencing the order frequency. Additionally, as a result of these promotions, we have also noticed a decline in average order values. It's important to note that this isn't necessarily due to a decrease in the number of active customers, but rather a reduction in the frequency of their purchases.

Crystal Landsem, CEO

It's more a signal of the macro environment versus anything else.

Tiffany Smith, Chief Financial Officer

I’ll address your question about stock compensation. To provide some year-over-year perspective, we expect stock compensation for 2023 to be between $16 million and $19 million. There are a couple of reasons for this range. One significant factor is that we have implemented a slightly restructured performance bonus plan this year, transitioning from cash-based to stock-based bonuses for our executives, linked to key financial metrics like revenue and adjusted EBITDA. Similarly, other bonus-eligible employees will also have their bonuses tied to stock-based performance criteria. This change introduces some variability in how high we might go within that range. Without this plan, stock compensation year-over-year would likely remain relatively flat from 2022 to 2023, with the exception of some acceleration related to David's options, which are being recognized earlier in Q1 rather than throughout the year. Let me know if that answers your question.

Operator, Operator

Our next question comes from the line of Lorraine Hutchinson with Bank of America.

Unidentified Analyst, Analyst

This is Alex for Lorraine. Congratulations, Tiffany. Regarding the full year adjusted EBITDA guidance, can you clarify which key growth initiatives you are referring to that will create pressure? Additionally, do you have any flexibility on expenses as you monitor the sales trends?

Crystal Landsem, CEO

Thank you for your question. I'll address your second question first. There is considerable variability in our cost structure, allowing us to make quick adjustments based on whether sales exceed or fall short of our expectations. We have mechanisms in place to help with that. As for the overall adjusted EBITDA and the investments leading to some fixed cost deleveraging this year, I can't provide many specifics. However, it's crucial for us as a company to remain committed to long-term growth, which includes employee-related costs and payroll. It's important to continue with our key strategic initiatives established during our IPO. We are not altering our strategy; we are fully invested in our vision and direction. We aim to maintain those investments and keep initiatives progressing to ensure that we emerge from this economic downturn well-positioned for growth. We are dedicated to being ready for future opportunities and the eventual recovery of the economy.

Operator, Operator

And we have reached the end of the question-and-answer session. And I'll now turn the call back over to Crystal for closing remarks.

Crystal Landsem, CEO

Thanks, everybody. We appreciate your time and continued support and looking forward to our next call. Have a great rest of your night.

Operator, Operator

And this concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.