Ollie's Bargain Outlet Holdings, Inc. (OLLI) Q3 2022 Earnings Call Transcript

Good morning, welcome to Ollie’s Bargain Outlet Conference Call to discuss the Financial Results for the Third Quarter Fiscal Year 2022. Currently, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and interactive instructions will follow at that time. Please be advised this call is being recorded, and the reproduction of this call in whole or in part is not permitted without expressed written authorization of Ollie’s. Joining us on the call today from Ollie’s management are John Swygert, Chief Executive Officer and Interim Chief Financial Officer; and Eric van der Valk, Executive Vice President and Chief Operating Officer; and Rob Helm, Senior Vice President, Chief Financial Officer. I will now turn the conference call over to your host, Lyn Walther with ICR. Please go ahead.

Thank you. Good morning, and welcome to Ollie’s third quarter conference call. A press release covering the company’s financial results was issued this morning, and a copy of that press release can be found in the Investor Relations section on the company’s website. I want to remind everyone that management’s remarks on this call may contain forward-looking statements, including, but not limited to, predictions, expectations, or estimates and the actual results could differ materially from these mentioned on today’s call. Any such items, including with respect to our future performance, should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. You should not place undue reliance on these forward-looking statements, which speak only as of today, and we undertake no obligation to update or revise them for any new information or future events. Factors that might affect future results may not be in our control and are discussed in our SEC filings. We encourage you to review these filings, including our annual report on Form 10-K and quarterly reports on Form 10-Q, as well as our earnings release issued earlier today for a more detailed description of these factors. We will be referring to certain non-GAAP financial measures on today's call that we believe may be important for investors to assess our operating performance. Reconciliation of those most closely comparable GAAP financial measures to the non-GAAP financial measures are included in our earnings release. And with that, I will turn the call over to John.

Thanks, Lyn, and hello, everyone. Thank you for joining our call today. Before we begin, I would like to welcome Rob Helm, our new Chief Financial Officer to the Ollie's family. Rob has a strong track record in the consumer retail sector, and I am confident in his ability to be a valued contributor to Ollie's and look forward to working with him for many years. Our third quarter total sales increased 9% over last year and comparable store sales increased 1.9%. While we were pleased with our overall sales results for the quarter, we were tracking to the low end of our comp guidance until we experienced softness in business during the last two weeks of October. During the quarter, more than half of our departments generated positive comparable store sales. We saw particular strength in lawn & garden, hardware, food, health & beauty aids, and sporting goods. We were pleased with the significant improvement in our gross margin rate compared to last quarter. This was driven by lower supply chain costs and improved merchandise margin. We continue to invest in price to motivate consumers as the competitive environment is highly promotional. As consumers need to save on everyday essentials, we are seeing continued strength in our consumable categories. We believe we are well positioned to thrive in the current environment, and we have tremendous deals in our stores and in the pipeline. The closeout market remains extremely favorable with deals, deals, and more deals. We are seeing incredible opportunities across all of our categories, and the availability of deals continues to grow from both new and existing vendors. At this point, we see no slowdown in sight; we sell good stuff cheap and this type of environment allows us to emphasize our compelling value proposition to consumers. Moving to real estate, we had a busy quarter opening 15 new stores and closing one due to a relocation, which reopened early in the fourth quarter. We ended the quarter with 463 stores in 29 states, compared to 426 last year. While store opening challenges persist, we have opened 39 stores as of today, bringing us to a store count of 467 with one additional store opening planned in January. We remain pleased with the productivity levels of our new stores overall. New stores are the engine for our sales growth. We continue to face challenges in the market today with permitting and construction, and as a result, we expect to open approximately 45 stores in 2023. Our long-term plan is to open between 50 stores and 55 stores annually and are confident that our model can support over 1,050 stores in total. In terms of remodels, we are pleased with the results of our store remodel program. We have tested several different layouts and continue to learn what works best for our customers. We have remodeled 15 stores so far this year and plan to complete between five to 10 more by the end of the fiscal year for a total of 20 stores to 25 stores. Turning to our supply chain, we are well positioned to benefit from the improvements we have made to our supply chain over the past year. The environment is more favorable as pressure on transportation continues to ease, compared to last year in the first half of 2022. We're in a strong position to service our stores during the peak holiday selling season. To support our new store growth, we are finalizing plans to open our fourth distribution center in the Midwest and have agreed to purchase land in Princeton, Illinois. Together with the expansion of our York, Pennsylvania distribution center next year, our distribution center network will be able to support over 700 stores. We expect to complete the expansion of our York distribution center in the first half of 2023 and the fourth distribution center by the end of the second quarter of 2024. On the marketing front, we have made progress on enhancing brand awareness to attract new customers and motivate existing customers. As part of our 40th anniversary celebration, we unveiled a 16-foot-7-inch bobblehead of our mascot Ollie, which won the Guinness World Record for the world's largest bobblehead. This event created a lot of buzz for our brand and generated over 1,200 news mentions through our online, TV, and newspaper outlets. Our 40th birthday events, including our America's biggest cheap skate contest, combined with our enormous bobblehead led to over 1 billion impressions of our brand. We invite you to visit the Ollie's bobblehead and display at our Harrisburg, Pennsylvania store. We are excited by the results we are seeing from our social media strategy to test micro and nano influencers on platforms such as TikTok, Facebook, and Instagram, which will begin in the second quarter. We will continue to invest in and build on all forms of digital marketing. Ollie's Army continues to perform very well and accounted for over 80% of our sales and grew 5.2% during the quarter. Our busiest and most exciting night of the year, Ollie's Army Night, is this Sunday, December 11. We are thrilled once again to open our doors exclusively to Ollie's Army members. Our teams have worked tirelessly to fill our stores with tremendous deals for this special night and we can't wait to welcome our loyal bargain hunters. Come join us for a great evening of fun and bargains. If you're not a member of Ollie’s, I remind you that there's still time to enlist and share in the fun and special savings. We hope to see you there. Our civilian database, which is comprised of non-Ollie's Army shoppers, also continues to grow. In October, we began testing targeted direct mailings to these customers as part of our efforts to expand our customer base. We are encouraged by the progress we made during the third quarter; we recognize that consumers are facing significant inflationary pressures and remain focused on what we can control, which is delivering great deals to our customers. Although the environment remains uncertain, we were pleased with our Black Friday sales as customers responded favorably to our in-store deals. Our quarter-to-date comp store sales trends are running in line with our updated guidance. We have a lot of business still in front of us and believe we are in a great inventory position to finish the season strong. In closing, we are a high-growth company in one of the most attractive sectors in retail, extreme value, and we believe we have the scale, the know-how, and the relationships to benefit from the continued disruption in the marketplace. We have tremendous runway to expand our footprint, and we believe the value proposition of our business model supports our long-term growth plans. I'll now turn the call over to Rob to take you through our financial results and Q4 outlook in more detail.

Thanks, John. And good morning, everyone. I'd like to start off by thanking John, Eric, and the rest of the team at Ollie's for the warm welcome. While I've only been here for a few weeks, I've been really impressed with the caliber of our team and the dedication of our associates. For the third quarter, net sales totaled $418 million, an increase of 9% from the prior year. Comparable store sales increased 1.9% in the quarter compared to last year. During the quarter, we opened 15 new stores and closed one store, ending the quarter with 463 stores in 29 states, an 8.7% increase in store count year-over-year. Since the end of the third quarter, we've opened an additional four stores. Gross profit margin declined 40 basis points to 39.4% compared to 39.8% in Q3 last year due to higher supply chain costs and slightly lower merchandise margin. We were pleased with our significant gross margin improvement from the second quarter, primarily driven by lower supply chain costs, which were meaningfully lower than the first half of the year. We also benefited from a higher merchandise margin compared to the second quarter. SG&A expenses as a percentage of net sales increased to 29.9%, compared to 29.7% in the prior year. The 20 basis point increase was primarily due to the deleverage of our fixed expenses related to higher selling costs, partially offset by our disciplined expense control. Operating income totaled $30 million for the quarter, flat to last year. Operating margin decreased 80 basis points to 7.1% due to higher supply chain costs, a slightly lower merchandise margin, and higher selling costs. Adjusted net income was $23 million and adjusted earnings per share was $0.37, compared to $0.34 last year. Adjusted EBITDA was $39 million, and adjusted EBITDA margin decreased 50 basis points to 9.4% for the quarter. Inventories increased 11% to $524 million in the quarter compared with $472 million a year ago, primarily due to the increased number of stores, the timing of merchandise receipts, and higher supply chain costs. In addition, it is important to note that our inventories at the end of Q3 2021 were lower than our historical level due to the supply chain disruption. Our balance sheet cash remains strong with $182 million in cash on hand and no outstanding borrowings under our revolving credit facility. Capital expenditures totaled $15 million, primarily for new and existing stores and the expansion of the York distribution center. This compares with $12 million in the prior year. During the quarter, we invested $20 million to purchase shares of our common stock. Moving on to our outlook for the fourth quarter. We have a lot of business ahead of us, including Ollie's Army Night, and believe we are well positioned to deliver great deals to our customers. However, given the uncertainty and unpredictability of the current environment, we are adjusting our expectations for the fourth quarter. We now expect total net sales of $540 million to $550 million, comp store sales of flat to 2%. Gross margin rate in the range of 38.2% to 38.4%, operating income of $66 million to $70 million, adjusted net income of $49 million to $52 million and adjusted earnings per share of $0.78 to $0.83, both of which exclude excess tax benefits related to stock-based compensation. For the full-year, we now expect total net sales of $1.817 billion to $1.827 billion, comp store sales of negative 3.8% to negative 3.3%, the opening of 40 new stores, less two relocations and one closure. Full-year gross margin of approximately 36.1% to 36.2%, operating income of $129.5 million to $133.5 million, adjusted net income of $98.8 million to $101.8 million and adjusted earnings per share of $1.57 to $1.62, both of which exclude excess tax benefits related to stock-based compensation. An annual effective tax rate of 24%, which excludes the tax benefits related to stock-based compensation and diluted weighted average shares outstanding of approximately $63 million. We expect capital expenditures in the range of $55 million related to new stores, our York distribution center expansion, costs related to our fourth distribution center, store level initiatives, and IT projects. I will now turn the call over to the operator to take your questions.

Thank you. Our first question comes from Brad Thomas with KeyBanc Capital Markets. Your line is open.

Hi. This is Taylor Zick on for Brad Thomas. I appreciate you taking the question. I was wondering if you could talk a little bit more about the cadence of the sales during the quarter? And then if you can talk anymore about how the holiday is shaping up more specifically? Thanks.

Sure. With regards to the overall cadence of the quarter, as I said initially, our trends are running really strong and at the low end of our guidance until the end of the 11th week of the 13 week quarter. We had some slowdown in business mainly related to warmer weather, and obviously, we're locked and loaded for the cold weather at this point in time, and that did not come out in the Q3 perspective. But obviously, looking at the overall, the quarter was actually August and September were pretty much in line with each other, and October was definitely the drag on the overall quarter. And as we said, we're liking the way the fourth quarter is shaping up. We had a strong Black Friday day and a Black Friday weekend, and we continue to see some nice trends in the business. So we're obviously pretty comfortable where we're sitting today and we feel good with the business.

Got it. Thank you. If I could just squeeze one more in, can you talk about how the toy and maybe the seasonal, or maybe just generally how the discretionary items are performing versus the more stable items?

Yes. Obviously, there’s just a couple of questions there, toys are a seasonal item, as well as holiday. So, and then we have a ton more discretionary items within our stores. Discretionary is performing well, as you can note in our top selling departments lawn & garden and hardware are definitely under discretionary. Those were our top two departments in the quarter. So we're definitely seeing some pressure on some discretionary items that are higher ticket, but we believe the value proposition we're providing is pretty strong, and the consumers are responding as well with what we're offering. With regards to toys, obviously, last year was a little unique to where there were a lot of supply chain disruptions. People were worried that there was going to be a shortage of holiday goods. So we believe the toy sales were pulled forward a little bit into Q3 last year. So it made it a little bit of a tougher Q3 for us. There's still 17 shopping days to go for the rest of the holiday period. We're in very good shape with toys, and we feel like we're in the season pretty strong.

Thank you. Best of luck.

Thank you.

Our next question comes from Peter Keith with Piper Sandler. Your line is open.

Hi. This is Matt Edgar on for Peter. Thanks for taking our questions. Just real quickly, how is the closeout backdrop, kind of, changing sequentially? I know you mentioned that you're getting more and more closeouts, but just how is it changing and then how is the margin on those closeouts changing? Appreciate it.

Yes, the overall closeout business has been strong and it's getting even stronger. The deals we are securing are becoming larger, and we're observing positive trends. While we cannot predict the specific timing of deals, we are experiencing encouraging activity in several categories that have us excited. The flooring sector, automotive, lawn and garden, domestics, and housewares are currently our largest contributors to deal flow. Our closeout margin profile has remained consistent year-over-year. We are optimistic about our margin profile associated with these deals and anticipate continued momentum in the business moving forward.

Great. That's good to hear. And then I guess maybe you just answered this on you can't really talk to timing, but how long do you think this elevated closeout environment can last?

We never know that answer to be honest with you. Closeouts have been pretty good for 40 years. So I would tell you the closeout business is pretty strong. I think what we're seeing today and the overall inventory challenges that people are facing and a lot of goods that are sitting in the warehouses. I would tell you, I think we have pretty good runway through at least the first half of ‘23.

Great. Thanks. I'll hop off.

Thank you.

Our next question comes from Jason Haas with Bank of America. Your line is open.

Good morning and thank you for taking my questions. I'm interested in whether you're noticing anything this year that might alter your long-term strategy for the business. Previously, we've discussed annual comps of 1% to 2% and gross margins of 39% to 40%. I realize there are factors that can impact those gross margins. Given the volatility we've experienced this year, which is understandable considering the current environment, are there any adjustments to the long-term strategy?

Yes, I think, Jason, the answer on that would be, I don't think the answer is no. I would tell you, I'm pretty excited about 2023 coming up because I think we're getting back to a more normalized cadence and more normalized business model and people can get their lives back to normal. So, which I think will bode well for us and everyone else in the business. I don't think that the long-term algo has changed at all. I'll call it choppiness in 2023 for us to get back to our normal algo margin may be a little bit lower on ’23 than I'd like to be, but I think we'll get there by ’24. As we said, the store growth, I'd like to be a 50 to 55, just with the permitting and construction challenges, I think ’23 will be, call it 45 stores. So we'll have a little bit of slowness in ’23 with regards to long-term algo, but I think we are right back to it and that's intact.

That’s great to hear. Can you remind us how the business performed during the last recession in 2008 and 2009? I’m also curious about the future, considering that low-income customers might continue to face pressure. To what extent do you anticipate some trading down, and could that potentially be a greater advantage moving forward?

Looking back at the 2008 and 2009 period, it's important to note that the circumstances were quite different from today. In 2009, we achieved about an 8% increase in comparable store sales, which was strong at the time. Customers responded well to the promotions we had available, especially as they faced significant financial strain. Currently, the situation varies; people have spent much more time at home and haven't spent as much as they used to. Additionally, we haven't experienced a significant financial shock like we did during the 2008-2009 crisis. However, inflationary pressures will continue to affect those in lower and middle-income brackets, and rising heating bills will add to those challenges. We expect some positive trends to return to us as a result.

Jason? It's Eric, I'll just jump in on trade down. We're seeing a similar trend in Q3, similar to Q2. We're encouraged that the customer, the higher income customer is trading down. We're continuing to see the lower income, fixed income consumers trade out. It's still a marginal benefit to us, similar to Q2, so slightly favorable. So hopefully that trend continues, we see stabilization of that fixed lower income consumer and the continued trade down of the higher income consumer moving forward.

Sounds good. Thank you.

Thanks, Jason.

Our next question comes from Edward Kelly with Wells Fargo. Your line is open.

Yes. Hi guys. Good morning.

Hey Ed.

John, you mentioned a couple of things. Q4 gross margin guidance has decreased. Could you provide more details on that? You also indicated that for 2023, gross margins are expected to be lower than initially anticipated. Can you elaborate on that as well and how we should approach it? It seems that while you're purchasing products at a favorable rate, there is still margin pressure. Could you tie these points together in terms of your outlook for Q4 and 2023?

Yes, Ed. We recently finished Q2, which had one of our lowest margins ever at about 31%, and that was quite disappointing. We had anticipated achieving close to 39.4% for this quarter, and we reached that target. We have put significant effort into returning to our expected margin levels. The slight margin change for Q4 is primarily due to a reduction in sales guidance, adjusting from a decline of 3% to 5% down to 0% to 2%. This decrease is connected to the ongoing adjustment of supply chain costs for that quarter, which is temporary and will likely recover. Looking ahead to 2023, we are experiencing strong deal flow. I believe there is potential for margin improvement, but I want to be cautious and avoid setting expectations too high. While I expect a notable increase in margin for 2023 compared to 2022, I don't want to promise a 40% margin just yet; I'm currently estimating around 39% for the full year. It would be beneficial to evaluate how supply chain costs evolve in Q4 before making any more optimistic predictions, but I don't anticipate margins falling to 36% or 37%. I believe we will end up closer to 40%.

Okay. And then just another bigger picture question for you, you're getting great deals today, your flyer is robust. The question is though is that consumers don't really seem to be responding in a way that historically we would have expected, I guess. Why do you think that is the case? And what does that mean even for next year?

Yes, I think the consumers are responding Ed; obviously the number one department we have, lawn & garden, is a total discretionary department, and consumers responded pretty well to that hardware as well as discretionary, and they responded pretty well to that. So I think they're responding, I just think that we're operating in a highly inflationary environment as we continue to say it's an uncertain environment. It’s a very promotional environment, so everyone's fighting for everyone's dollars. So I think that am I disappointing that we didn't keep our 3.5% comp going in the quarter? Yes. But we had some weather that impacted us that we know was not something structurally wrong with the business. And the cold weather is going to come. We'll get those sales back. So we feel like we're well positioned, and we're continuing to move forward. And I think we're getting back to a more stable operating environment. The company is on the right track and continuing to deliver increased earnings to the shareholders.

Okay. Thanks, guys.

Thanks, Ed.

Our next question comes from Jeremy Hamblin with Craig-Hallum. Your line is open.

Thanks. I wanted to come back to the gross margins for Q4. And just to understand, so it looks like you're guiding to about 75 basis points to 100 basis points below expectation. And some of that would be explained by the downside, I think, of roughly $17 million of lower sales forecasted for Q4. But I needed to understand, are some of the categories underperforming toys in particular? You're running a 15% off promotion ahead of Ollie's Army Night. I don't think that's consistent with what you've done historically. Historically toy promotions have always come after Ollie's Army Night? So I wanted to just understand whether or not there's certain categories, toys maybe being one of them, where you talked about in the prior buyout deal that toys are, I think, like 40% of that deal, but just wanted to understand if some of this was more products that you brought in that maybe aren't moving as well as you had hoped as opposed to just pressure on your consumer?

Yes, Jeremy, with regards to the Q4 margin, I would tell you, it's 100% attributable to the deleveraging of sales. The merch margin; we expect that to actually be up year-over-year, so there's not a compression in the merch margin from Q4 of ’22 to ‘21. So the implied margin guide that we're given is really related to the $17 million, $18 million of lower sales volume for the quarter. With regards to our promotional event for toys, as you know, we're operating in a highly promotional environment. Everybody is being very aggressive with the seasonal and toy items right now. We don't have a toy issue. We're trying to take advantage of the holiday period where people are shopping very heavily. And what I think all that's going to do for us is we'll have less markdowns on the post-holiday period than we normally do, and we're getting some nice impact from the overall promotional environment we're running today for a five-day period. So I'm not too worried about that. I think we're just changing dollars. And I think we'll be changing less dollars in markdowns once all is set and done. So I think we're very comfortable with where we're sitting in our inventory position.

Okay. And then just a follow-up question on the York D.C. expansion. Can you give us a sense for what the potential impact on margins might be in the first half of the year, or if it would carry on into the second half of the year?

Jeremy, the expansion of the D.C. in York will not have any impact on the margins in ’23 at all.

Okay. Got you. Okay, thanks. Best wishes.

Thank you.

Our next question comes from Eric Cohen with Gordon Haskett. Your line is open.

Good morning. Thank you for the question. I recognize that it has been a very dynamic environment. Reflecting on the past couple of quarters, guidance has not met expectations, particularly since you were at the low end for most of the quarter until the softness at the end of October. I am curious about the reasons for the underperformance and how much you would attribute to execution versus external factors. Additionally, how have you applied these insights in establishing the guidance for Q4?

Yes. I think, Eric, with regards to execution, I don't think any of it was execution. I think it's just the external factors we're all dealing with. It's not just Ollie's; it's everyone who's out there. So there's challenges with the consumer. The consumer is under significant pressure with inflation. So we're just dealing with a very uncertain environment, and I think we're navigating pretty well. I'm not ashamed of a 1.9% comp and two quarters of real positive comps. So we're just going to build off of that and continue to move forward. So I think we're in good position to execute Q4. Obviously, we're taking the guide down a little bit from where we were before. And I think it's just a prudent thing to do with all the uncertainty in the highly promotional environment we're running in. But I think we're navigating very well. I think we're locked and loaded for the remaining 17 days here at the holiday, and I think we're going to come around at the holiday and ready to go. So I think we're in good shape.

Last year around this time, Omicron was starting to affect store traffic and we had limited visibility on inventory shipments. How are you planning to market this holiday season differently than last year? Also, could you remind us what the comparable sales trend was in the fourth quarter last year?

Yes, Eric, regarding the resurgence of Omicron last year, I believe this offers some potential benefits for us and other retailers as we approach the holiday season. I see this as a positive aspect. We haven't fully incorporated this into our projections yet; we've maintained our current stance for now. Our inventory position today is much stronger compared to last year from a seasonal viewpoint, and I believe we have a good opportunity to finish the holiday season on a high note. The key takeaway for us is to remain cautious and to proceed based on our current observations and guidance for the quarter to date.

Thank you. Our next question comes from Mark Carden with UBS. Your line is open.

Good morning. Thanks so much for taking my questions. So to start when you see deals of the magnitude of the one that you heavily advertised this quarter? How long does it typically take for you to sell through them? We expect to see much in the way of further tailwinds in 4Q? Or is the bulk of the lift from that one already taken place?

No. The sell-through of that item and those large deals takes time. While the speed is starting to slow down, we still have a good inventory position going into Q4 with that deal, and we will benefit from it. However, I must remind everyone that while that deal was exciting and heavily promoted, it is not as significant compared to our total inventory and sales velocity for Q2 and Q3 combined. It is important, but it is not the only factor.

Got it. That's helpful. Thanks. And then we've seen some states start to put out their own stimulus.

Excuse me, I missed that.

Sorry. Okay. So back to my follow-up, so we've seen some states put out their own stimulus programs recently. Are you expecting for that to have much of an impact on your comps? Or is it too small to really move the needle much?

My guess is it's probably too little to move the needle a whole lot for us. It's not that meaningful from what we've seen so far and what we're thinking.

Okay, great. Thanks so much, and best of luck.

Thank you.

Our next question comes from Simeon Gutman with Morgan Stanley. Your line is open.

Hey, guys. This is Michael Kessler on for Simeon. Thanks for taking our questions.

Hey, Michael.

First, I wanted to ask about sales per foot, sales per store in Q3. They were a little bit below 2019 levels. I know there's been, I guess, some volatility throughout this year. But I'm just curious how you view that in the broader context of your customer counts, your loyalty membership base. I guess I don't know if you would expect it to be higher or just because of the macro or in a period of depression relative in ‘19 despite some of the uplift you've had in the prior two years. I don't know of any framing around that would be great?

Yes, Michael, I agree with your assessment. We're facing significant macro challenges similar to what we encountered in 2019. Our performance is around 99.2% to 99.3% compared to that year on a comparable basis. If we had sustained our sales momentum throughout the quarter without the downturn in the last two weeks, we might have seen numbers closer to 101 or so, reflecting our initial expectations. There are ongoing macro pressures that we are all adapting to, and many consumers are feeling the strain. However, I want to emphasize that we are not projecting declines of 5%, 10%, or 15%. Overall, we're in solid condition and expect to see continued momentum in our business as we progress into 2023. We are optimistic because our deal flow remains robust, and we have the right products and offers to engage consumers effectively.

Okay, thanks. And a follow-up on the supply chain cost, the distribution transportation backdrop. It is easy. You mentioned that. Can you size up, I guess, when we might begin to see some of those benefits roll through the P&L, as far as you guys move to more contracts in the last year given the volatility? Is that something that we would expect beyond just the lapping of kind of artificially lower costs this year beyond that just the actual reduction in or the easing in the background how that might play out in ‘23 or is that more of a ‘24 dynamic?

Yes, I believe we are definitely noticing some relief in supply chain costs. We observed a significant improvement in gross margin from the second to the third quarter, approximately 600 basis points related to supply chain. The easing began to take effect during the third quarter. I anticipate that for the fourth quarter, we will see a moderate relief, with more substantial improvements expected in the first two quarters of next year. However, we are still experiencing elevated supply chain costs due to the investments we've had to make in wages and facilities. Supply chain costs have not yet returned to pre-COVID levels, and I think the elevated costs we see now may have a more permanent nature. We need to enhance our merchandise margin to offset these expenses.

Yes. I think, Michael, in terms of how we're structured on the international transportation side, we very much like how we're structured. It's been favorable for this contract season, and we like that the market is a little more favorable as well, a lot more favorable when you compare year-over-year. So the stars are aligning really well moving into 2023 in terms of our business strategy.

Thank you.

Our next question comes from Robert Friedner with JPMorgan. Your line is open.

Great. It's Matt Boss at JPMorgan. So John, comps in the third quarter on a three-year geometric stack turned negative. Fourth quarter guidance calls for a similar trend. I guess, what exactly, if you could maybe help us, is the bridge from today's negative trend line, and we have seen sequential improvement broadly with closeout inventory versus positive comps next year. Is it traffic would improve? Is it something with ticket? Do we need macro to improve? Just struggling with the bridge between the three-year geometric negative in 3Q, guided negative in 4Q, and then positive comps for next year with it seems like closeout inventory having improved.

Yes, Matt, the closeout inventory and the closeout opportunities have definitely improved. The timing of when the trade down will start to outpace the trade-out of the lower income consumer is still uncertain. I believe that it is on the horizon, but I cannot specify whether it will happen at the end of Q4 or in Q1 of next year. We have noticed some early signs of this trend starting, but the exact timing is unclear. We are prepared to take advantage of it, and from our viewpoint, we are very close. Since Black Friday, we have observed some positive improvements in trends, so we are hopeful that we are beginning to see some progress. However, we need to be cautious and wait for concrete numbers before making any definitive claims. I believe we will reach that point, and it will be soon.

Okay. And then just a follow-up on expenses, so implied SG&A rate seems to be high 20s this year. How best to think about maybe puts and takes with SG&A wages and investments as we think about next year?

Yes, SG&A is definitely under pressure, Matt, and our historical rates around 25% to 25.5% are not something we expect to return to at this point. I'm anticipating rates more around 26% for SG&A in 2023 going forward, possibly a little higher, but not by much. However, I believe we will perform better than this year given our current outlook. We are facing pressures from wage increases and utility costs that we need to manage and absorb.

Great. Best of luck.

Thank you.

Our next question comes from Paul Lejuez with Citi. Your line is open.

Hey, thanks guys. You mentioned the 39% gross margin for next year is where you think you might shake out. But I'm kind of curious how you think about the promotional environment that you'll be playing in ‘23 versus what you're playing in today and how you think about the sales gross margin trade-off just from a high-level perspective. I guess implicit in that 39% gross margin, you've got to have some sort of comp assumption. Curious what you think that is? And just what happens? How do you react if the environment gets more promotional? Do you look to preserve margins or drive sales? Thanks.

Yes, Paul, the way we price and approach the market involves pricing below higher-end stores significantly. Consequently, promotional activities don't affect our margins, as I mentioned earlier regarding toys. We're adjusting the timing of markdowns but not changing the overall markdown rate since we are already competitively priced and clearing more inventory sooner rather than later. I don't expect 2023 to be as promotional as this year, but if it becomes so, we will be ready and will adjust our pricing strategy accordingly. We will keep an eye on market promotions, and our team will ensure that we maintain competitive pricing. We aim for everyday value rather than engaging in high-low pricing, providing the best prices upfront to build customer loyalty. Ultimately, I believe our approach to value positively influences how we operate our business.

Got it. Then just one follow-up on me. You guys marketed that fancy store buy, which you talked about. I think it was part of the reason that gross margins fell a bit short in the second quarter, but I'm curious if that buy has performed as well as you had anticipated? And how much of the benefit on the margin side was the third quarter event versus the fourth quarter event?

Yes. The overall deal performed well. We're very pleased with the deal, and we're excited how it performed. And as I said earlier, it's not the end all be all. There's a lot of deals we have in our pipeline and a lot of departments that performed very, very well outside of these categories. But the deal was strong, definitely impacted the margin in Q3. And obviously, it has opportunities to impact the margin in Q4. So as I said a few minutes ago, the shortfall in the margin in Q4 is not related to the merch margins. It's all sitting in supply chain and deleveraging fixed costs. So the margin, I think, is in good shape, and we feel we're in a good position here.

Got it. Thank you. Good luck.

Thanks, Paul.

And I'm not showing any further questions at this time. I'd like to turn the call back over to John for any closing remarks.

Over the past 40 years, we've grown to over 10,500 team members who are working harder than ever. We know the holiday season places extra demands on our associates, and I sincerely thank them all for what they do, not only at this time of year but every day. It's the combined experience, passion, commitment of the team that makes Ollie successful. Thank you for your support of Ollie's. As we say, we are Ollie's.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.