Revolve Group, Inc. Q2 FY2022 Earnings Call

Good afternoon. My name is Dennis, and I will be your conference operator today. At this time, I would like to welcome everyone to Revolve's Second Quarter 2022 Earnings Conference Call. Thank you. At this time, I'd like to turn the conference over to Erik Randerson, Vice President of Investor Relations at Revolve. Thank you. You may begin.

Good afternoon, everyone, and thanks for joining us to discuss Revolve's second quarter 2022 results. Before we begin, I'd like to mention we have posted a presentation containing Q2 financial highlights to our Investor Relations website located at investors.Revolve.com. I would also like to remind you that this conference call will include forward-looking statements, including statements related to economic conditions and their impact on consumer demand in our business, operating results and financial condition, our current expectations regarding the continued impact of the COVID-19 pandemic on our business, operations and financial results, including on our near-term sales in Greater China, our growth, including growth in active customers and market opportunities and related macro and industry trends, the expected impact on delivery times from opening our first East Coast fulfillment center, our marketing and technology investments and marketing events, the launch of our Remi Beta collaboration, the extension of our brand ambassador program to include Forward, our freight costs and our outlook for net sales, gross margin, operating expenses and effective tax rate. These statements are subject to various risks, uncertainties and assumptions that could cause our actual results to differ materially from these statements, including the risks mentioned in this afternoon's press release as well as other risks and uncertainties disclosed under the caption Risk Factors and elsewhere in our filings with the Securities and Exchange Commission, including, without limitation, our annual report on Form 10-K for the year ended December 31, 2021, and our subsequent quarterly reports on Form 10-Q, all of which can be found on our website at investors.Revolve.com. 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 and free cash flow. We use non-GAAP measures in some of our financial discussions as we believe they provide valuable insights on our operational performance and underlying operating results. 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. And our non-GAAP measures may be different from non-GAAP measures used by other companies. Reconciliations of non-GAAP measures to GAAP measures as well as the definitions of each measure and their limitations and our rationale for using them can be found in this afternoon's press release and in our SEC filings. Joining me on the call today are our Co-Founders and Co-CEOs, Mike Karanikolas and Michael Mente; as well as Jesse Timmermans, our CFO. Following our prepared remarks, we'll open the call for your questions. With that, I'll turn it over to Mike.

Hello, everyone. We delivered strong results in the second quarter, highlighted by record net sales that increased 27% year-over-year, gross margin expansion to record levels for a second quarter, and continued strong growth in active customers. We delivered these results despite macroeconomic conditions that became more challenging as the quarter progressed, creating cost pressures that impacted profitability and also contributed to a moderate year-over-year growth trend in net sales in June that has continued into the third quarter. With that as an introduction, I'll briefly recap our results. In the second quarter of 2022, our net sales were $290 million, a 27% increase year-over-year. We added 124,000 active customers during the quarter, the highest ever for a second quarter and representing 39% growth year-over-year. Impressively, growth in active customers in the first half of 2022 has already exceeded our total growth in active customers for the full year in 2019. Gross margin expanded approximately 30 basis points year-over-year to 55.9%, an all-time high for a second quarter despite inbound freight costs remaining elevated. However, below the gross margin line, we faced increasing pressure on operating expenses that contributed to softer-than-expected profitability measures in the second quarter. Our second quarter net income of $16 million and adjusted EBITDA of $27 million declined 48% and 24% year-over-year, respectively, against a difficult prior year comparison when our net income had increased more than 100% year-over-year. Importantly, net income and adjusted EBITDA were 28% and 42% higher than pre-pandemic levels in the second quarter of 2019, respectively, further illustrating our continued focus on profitable growth. The increased cost pressures were mainly within selling and distribution and more specifically, customer shipping expenses. There are two main reasons why these costs came in higher than expected. First, we incur fuel surcharges on every package that we ship to our customers and on return packages. Our fuel surcharges in the second quarter were more than four times what they were in the prior year and had a material impact on the selling and distribution line item for the second quarter. While our premium price points enable us to absorb these costs more efficiently than if we were operating at lower price points, we do expect some moderation in costs from the peak. These surcharges continue to create real cost pressure in the near term. The second is our return rate. We had anticipated that our return rates would increase year-over-year as our product mix of net sales continued to normalize. However, our return rate has trended even higher than pre-COVID levels in the first half of the year. Historically, the main factors that influence return rates include the mix of sales by category, by geography, by segment, and the mix of full price and markdown sales. One of the primary drivers of the higher return rate compared to pre-COVID levels is a fast-growing percentage of our international net sales coming from countries like Canada, where we offer hassle-free returns— a major growth catalyst that has resulted in Canada net sales quadrupling in just the past six quarters. Our return rate in Canada has approximately doubled since late 2020 when we launched hassle-free returns for Canadian customers. Yet it's a trade-off we'll make all day long, considering the exceptional growth of our localization efforts in the markets. Another factor was our mix of full price sales, which have a higher return rate. The mix of full price sales was higher than we anticipated for the second quarter and was significantly higher than in 2019. And finally, on a normalized basis, we did experience an overall increase in the return rate this quarter due to what we believe is the shift in consumer behavior likely driven by the challenged macro environment's effect on consumer sentiment. Shifting gears to net sales performance by geography, our U.S. net sales increased 30% year-over-year, outpacing international net sales growth of 14% from a year ago. Our international trends reflect continued strong growth in Western regions like Canada and the U.K., where we've made excellent progress with our localization initiatives, partially offset by foreign currency headwinds resulting from the stronger U.S. dollar and temporary headwinds in China due to COVID-19 preventative measures. As I mentioned earlier, customer activity continues to be a bright spot. Our active customers are becoming more productive, illustrating our success in capturing a greater share of wallet. For the trailing 12-month period, net sales per active customer were $488, an increase of 9% year-over-year. This data is quite encouraging, considering that new customer growth has been really healthy for the past several quarters, and that revenue per customer tends to increase significantly over time. Consider that in 2021, customers who had purchased from Revolve in a previous year represented 49% of our total active customers for the year. Yet these more tenured customers generated 77% of total net sales for the year. I'd also like to highlight that the significant majority of our newly acquired customers in recent quarters have purchased from us at full price since our full-price customers consistently generate a higher lifetime value than customers acquired through markdowns. Our consistently strong cross-financial results also reflect our long-term focus on building trust with the customer. Core to building this trust is operational excellence and exceptional service levels. I'm excited to share that we began operating our first East Coast fulfillment center, which we expect will raise the bar on our ability to delight customers with even faster delivery times for key East Coast geographies. We have seen firsthand how much our West Coast customers appreciate and value our one-day delivery time frames available for many regions surrounding our Los Angeles fulfillment center. The power and stickiness of compelling service levels are also clearly evident in performance within our international markets. Almost universally, in international markets where we've invested to elevate service levels, our growth has accelerated in the months to follow. To wrap up, we believe our results for the past several quarters demonstrate that we are gaining meaningful market share. And more importantly than just outpacing the competition, we're uniquely doing that while generating significant profitability and cash flow year after year. Our ability to self-fund the strengthening of our balance sheet year after year affords us a great deal of financial flexibility to invest where we see opportunities to drive shareholder value. It's particularly important in an uncertain market environment like we're operating in today, where inflation is at a 40-year high and U.S. consumer sentiment was at the lowest reading on record in June. I'm extremely proud of how well our team has navigated through this increasingly challenging macro environment. Mike and I have seen multiple economic cycles over nearly 20 years, and we have complete confidence in our team's ability to execute through the most challenging environments as we demonstrated and profitably navigated through uncertainty in the early stages of the pandemic. Our team and technology are battle-tested and have emerged stronger through this volatile period, and we are primed and ready for what lies ahead. Now over to Michael.

Thanks, Mike. Before I get into the details of the quarter, I want to pause to highlight that with today's results, we have now crossed the $1 billion in net sales milestone for our trailing 12-month period. This is a huge accomplishment for not only me and Mike but for the many employees that joined us along the way when we were doing $10 million, $100 million, or even $500 million just a few years ago, leading up to the IPO. Thanks to all of you, it has been fun, challenging, rewarding, and even more exciting that we still have so much opportunity ahead. Now, as we think about the quarter, we were able to deliver strong double-digit growth in an environment that became increasingly challenging as the quarter progressed. Taking it a level deeper, our product category trends for the second quarter confirmed that our core Revolve customer was getting out again in force, driving incredible growth in dresses with particular strength in special event styling. She is traveling, going to weddings, and living her life to the fullest. For these truly special occasions in life, Revolvers are the trusted source for inspiration and our go-to fashion destination. The reopening this year has been most evident in the Revolve segment, where net sales increased 30% year-over-year in the second quarter despite international headwinds. To capitalize on the return of an active social lifestyle and channel this summer, we kicked off the second quarter with the exciting revival of Revolve Festival after a two-year hiatus. Overall, the festival in 2022 was more impactful than ever on many levels. Event highlights featured our incredible line of performers, including Post Malone, Jack Harlow, and Velo, and the unbelievable caliber of field attendees. We also hosted hundreds more influencers than ever before with a strategic focus on a new network of content creators to further expand our reach and diversify into new social media channels. I'm pleased to share that we have made great progress in connecting with our consumers through these newer social media channels. I'm especially encouraged by the increased engagement with our compelling video content on TikTok and Instagram Reels. In the second quarter, new views of our TikTok content more than doubled sequentially compared to the first quarter of 2022 and nearly tripled year-over-year. As I touched on last quarter, we are teaming up with the context model, Reeder, to create a size-inclusive brand collaboration that will launch next week. Remi has partnered with us in several margin activations over the past year, and our follower engagement and personal brand momentum is truly impressive. What's especially exciting is that this is our first brand collaboration, which truly expands our market potential and the size increase. We have worked closely with our team to ensure that we provide the best products. Throughout the process, Remi has been sharing insights into the design and development process with a highly engaged community. On the heels of Revolve Festival, we will continue to invest and actively create further excitement for our brands with our impactful in-person marketing events, building on our already strong connection with the next-generation consumer. The third quarter got off to an exciting start with our evolved summer activation in Puglia, Italy, and our team just returned from a successful brand ambassador event in the Dominican Republic. We have several other events planned, highlighted by a return to New York for Fashion Week this September. Across the business, we will continue to invest heavily in our proprietary technology, which we view as a significant competitive advantage. My team is constantly building out internal technology to drive increased conversion rates and revenue, greater operating efficiencies, and an even better experience for our customers. For instance, within just the past few months, the technology and data science teams have developed proprietary internal applications that leverage machine learning and our rich data set to further optimize the customer experience and drive operating efficiencies through enhanced show detection and package optimization. On the site, we continue to elevate our personalization, product recommendation, and search functionality and recently launched an application that leverages machine learning algorithms to dynamically and in real-time, recommend outfits for our customers to complete the look. We're in the early innings of leveraging AI technology with some exciting projects in the pipeline that we believe will drive both revenue and operating efficiency in the medium term. Shifting gears forward, our foreign net sales for the second quarter increased 14% year-over-year against an incredibly difficult prior year comparison when net sales increased over 150%. Importantly, over the last three years, our compound annual growth rate for net sales is 36%, meaningfully outpacing industry benchmarks. We are continuing to innovate and invest. An exciting development was our recent launch of Forward buyback. Our proprietary sell program is dedicated to circular luxury shopping. Forward buyback extends the life cycle of high-end designer bags from coveted brands, allowing our customers to exchange their past purchases for credit to shop our full product offering. It enables us to expand our customer touchpoints and deepen our relationship with our customers while further strengthening the value proposition for our loyalty program members since, in addition to the credit, loyalty members earn up to 2,000 points for eligible handbag exchanges. Forward buyback leverages our renowned customer experience and service capabilities to deliver an extensive assortment of luxury handbags from our top luxury brands at incredible value, including from the causes of Forward's Save Director, Kendall Jenner. The response has been very exciting, exceeding our expectations. Initial feedback from our luxury brand partners has been outstanding, and we've achieved more than 40% sell-through of our initial inventory within the first couple of weeks. We also continue to expect the successful marketing efforts that will drive our much larger base of customers, capitalizing on our strong customer loyalty and the highly complementary merchandising assortment between Revolve and Forward. Ever since we launched the Forward loyalty program last year, we have driven increased overlap between Revolve and Forward active customer base month after month. We are still in the very early innings with a long runway for driving further cross-shopping between Revolve and Forward in the future. In the coming months, we plan to expand our successful Revolve brand ambassador program to include Forward. The Forward expansion of the brand ambassador program will leverage the same proprietary technologies of all programs. Momentum in the Revolve brand ambassador program has been nothing short of incredible, so we have high hopes for the potential of the Forward brand ambassador program as well, particularly since Forward has historically been less active relative to Revolve regarding working with influencers. So stay tuned for this exciting launch in the weeks ahead. To wrap up, I am very proud of how well our team has navigated through the extreme cycles of ups and downs in the past few years. We believe we have demonstrated a unique track record for outperforming the competition in times of disruption and volatility, leveraging our strong team, operational excellence, and data-driven and customer-centric approach to nearly everything we do at Revolve. While there is considerable uncertainty ahead, I'm extremely confident in our team and know that we are in a position of strength heading into whatever lies ahead with the economy. I'm excited about our future and believe we are well-positioned to gain further market share, particularly from legacy retailers in the months and years to come. Now, I'll turn it over to Jesse for a discussion of the financials.

Thanks, Michael, and hello, everyone. I'm quite pleased with our accomplishments in the second quarter delivered by the team within an extremely difficult economic climate that became even more challenging as the quarter progressed. I'll start by recapping the second quarter results, highlighted by solid top-line growth, continued strong profitability, and rapid expansion of our customer base, and we're doing it at scale. Net sales were $290 million, a year-over-year increase of 27% and an increase of 21% on a three-year CAGR basis. Revolve segment net sales increased 30%, and Forward net sales grew 14% year-over-year. Recall that Forward faced an extremely difficult comparison in the year-ago period when Forward net sales increased 161% year-over-year. From a merchandise standpoint, the dresses category represented 32% of total net sales, an increase of 8 points year-over-year that trended higher than peak levels in 2019, when dresses generated 30% of net sales. By territories, domestic net sales increased 30% year-over-year, outpacing international growth of 14% that was impacted by currency headwinds that negatively affected our international customers. Active customers increased by 124,000 compared to the first quarter of 2022, our highest ever growth for the second quarter. This growth expanded our active customer count to 2.2 million, an increase of 39% year-over-year. Looking forward, we continue to expect moderation in the quarterly growth of active customers in the second half of the year as we cycle out of the COVID comparison period for this trailing 12-month measure. Our customers placed a record 2.2 million orders in the quarter, an increase of 27% year-over-year. Average order value, or AOV, was $303, an increase of 19% year-over-year that benefited from the exceptional year-over-year growth in dresses and a very strong full-price sales mix. Shifting to gross profit, consolidated gross margin was 55.9%, our best ever margin for our second quarter and an increase of 29 basis points year-over-year. Moving on to operating expenses. Fulfillment costs deleveraged 40 basis points year-over-year, primarily due to a year-over-year increase in our return rate as well as increased labor costs. Selling and distribution costs were a significant headwind year-over-year, coming in higher as a percentage of net sales than we had expected due to our return rate trending above 2019 levels and to a massive increase in fuel surcharges that are included in our shipping costs for customer shipments. To offer some context, our fuel surcharges increased nearly 60% on a sequential basis compared to just the first quarter of 2022. Marketing deleveraged year-over-year as expected since we hosted our largest and most impactful brand marketing event of the year, Revolve Festival, for the first time in three years. Since the Revolve Festival investments were not in the prior year comparable quarter, our brand marketing investments increased by a meaningful $9 million year-over-year. We view these investments as important to building the strength of our brands over the long term. General and administrative costs also deleveraged year-over-year due entirely to a $5 million pool in connection with a pending legal matter. Adjustment for this nonroutine accrual, we achieved G&A leverage as our 27% net sales growth outpaced the growth in the remainder of the G&A expenses in the second quarter. Our effective tax rates were very different for the year-over-year comparison. Our tax rate for the second quarter of 2022 was 23%, almost 20 points higher than the 3% tax rate in the second quarter of 2021 that included meaningfully higher tax benefits. Net income was $16.3 million or $0.22 per diluted share, a decrease year-over-year that was impacted by the meaningful differences in our effective tax rate, the cost pressures referenced earlier, as well as the nonroutine accrual for the pending legal matter and G&A expense. Please note that the legal accrual is reflected in net income, since net income is a GAAP measure, but was excluded as a nonroutine item from adjusted EBITDA, our non-GAAP profitability measures. Adjusted EBITDA was $26.9 million, a decrease of 24% year-over-year against a very difficult prior year comparison when adjusted EBITDA increased 70% in the second quarter of 2021. Looking back to the pre-pandemic period of the benchmark, our adjusted EBITDA for the second quarter was 42% higher than the adjusted EBITDA reported for the second quarter of 2019. Moving to the balance sheet and cash flow statement. Lower net income year-over-year and working capital changes led to negative operating cash flow and free cash flow in the second quarter. These working capital changes primarily included continued investments in inventory, which increased $29 million during the quarter. Our inventory investments are reflective of our efforts to keep pace with the robust consumer demand we had experienced over the past several quarters. However, with the demand trend shifting during the second quarter, as discussed, our inventory balance ended the quarter in a place that is higher than we would like. While we feel good about the quality of inventory, the overall balance is elevated, and we are working diligently to bring it back in balance. Also impacting our cash flow was significantly higher cash payments for income taxes, which increased by $14 million year-over-year and sequentially compared to the first quarter. For the six-month year-to-date period, net cash provided by operating activities was $24 million and free cash flow was $22 million, with both measures down significantly year-over-year from the record cash flow generation in the prior year period. Our balance sheet remains debt-free and cash and cash equivalents as of June 30, 2020, were $238 million, an increase of $18 million from June 30, 2021, yet lower than the first quarter of 2022. While there's understandably been quarter-to-quarter fluctuation, consider our cash generation over the three years that we have been public. The cash position on our balance sheet at quarter-end was more than five times higher than our cash position three years ago on June 30, 2019, just after we completed the IPO. This cash generation was purely operational without external financing, a clear and powerful indicator of our operational strength and scale. Now, let me update you on some recent trends in the business since the second quarter ended and provide some direction on our cost structure to assist your modeling of the business. Starting from the top, as Mike mentioned, there is a great deal of weighing on the consumer today with inflation at a 40-year high and U.S. consumer sentiment reaching a record low point in June. It's also important to recognize that our customer is younger and earlier in her career and income progression, often spending a disproportionate share of her wallet on discretionary apparel. The current stock market could also have a dampening influence on consumer discretionary spending with a higher income luxury consumer. These pressures mounted as the quarter progressed, negatively impacting consumer demand and our top line, particularly in June and continuing into the third quarter with net sales growth of approximately 10% year-over-year for the month of July. Given the uncertain macro environment and considering that our comparisons are more difficult in the second half, we encourage investors to model further moderation in our year-over-year net sales comparisons for the balance of the third quarter from the approximately 10% growth in July. Since our net sales growth rate accelerated through 2021 and with the economy looking uncertain at best, we continue to expect the fourth quarter to be the most difficult comparison of the year. Shifting to gross margin, we are very pleased with our gross margin performance that exceeded our second quarter outlook provided just last quarter despite continuing headwinds on inbound freight. A key driver of our strong gross margin performance for the past two quarters has been full price selling at record levels. However, consistent with the outlook we shared coming into the year and particularly with greater inflationary pressures and very low consumer confidence, we continue to expect our mix of full price sales to moderate in 2022. We expect this moderation to begin in the third quarter and further moderate in the fourth quarter on a sequential basis, while still remaining higher than pre-pandemic levels for the full year 2022. As a result, for the third quarter, we expect gross margin of between 53.5% and 54%, and we expect the fourth quarter gross margin to be sequentially lower than the third quarter. Fulfillment, we now expect fulfillment expenses of around 2.7% of net sales for the full year 2022, consistent with our performance for the first half of the year. We continue to view our fulfillment operations as extremely efficient from a cost and performance standpoint within the context of the broader industry, particularly in the current environment. Selling and distribution; we now expect selling and distribution costs as a percentage of net sales to remain around the 18% range for the rest of 2022, relatively consistent with the second quarter's 17.9% of net sales. This higher run rate than our previous outlook is due to our return rate trending higher than 2019 pre-pandemic levels and to the exponential increase in fuel surcharges that I talked about earlier. Marketing. Late in the second quarter, we began to feel the effects of the weaker consumer in our marketing efficiency measures. With many consumers coming back in the current environment, we are simply seeing a less responsive consumer. We now expect our marketing investment to be in a range of approximately 17% to 17.5% of net sales in 2022 and up from our prior outlook of 15.8% of net sales as we assume that marketing efficiency will remain challenged in the near term. For the third quarter, we expect marketing to represent approximately 18% of net sales, down from the 19% in the third quarter of 2021. General and administrative. We now expect G&A expense of approximately $115 million for the full year, with the increase from our prior estimates entirely due to the $5 million accrual I mentioned earlier related to a pending legal matter. For the third quarter, we expect G&A expense of approximately $29.5 million. Lastly, let me touch on our tax rate. With asset tax benefits in future quarters, we continue to expect our effective tax rate to be around 24% to 26%. While we anticipate a very challenging macro environment in the months ahead, we are confident that with our strong brand and operational excellence, we can navigate through these short-term challenges and continue to gain market share. We believe we remain well positioned to deliver on our long-term profitability targets over time. With that, we'll open it up for your questions.

And your first question is from Edward Yruma with Piper Sandler. Please go ahead.

Hey, guys, thanks so much for taking my questions. I want to dig down a little bit on inventory. I know you said obviously that levels are a little higher than you would like. Can you talk about how long you think it will take to get the order book resized, actions you're taking? And I guess how much of it is influencing order book versus taking markdowns on inventory that's already on the balance sheet? Thank you.

Sure. We feel good about the quality of our inventory. We think it's good stuff that's generally going to retain its value. We just have too much of it. A lot of that is due to the softening demand that we saw in the quarter and into Q3. From our perspective, we want to work through it at a measured moderate rate. We think it's good inventory, so we don't feel the need to do excessive markdowns. At the same time, there's going to be some level of activity that will decrease gross margins. So expect to see a little of that throughout the year. In terms of when the inventory position will right-size, certainly, it's our hope that by the end of the year, we'll be in a much better place with inventory, but it is an uncertain environment. So we're going to have to see how everything plays out.

Thank you.

Your next question is from the line of Mark Altschwager with Baird. Please go ahead.

Good afternoon, thanks for taking my questions. I wanted to start with just a bigger picture question on the revenue growth outlook. I guess a pretty wide gap between what's implied for the growth rate in Q3 and Q4 and the longer-term plans for 20% plus. So we fall on the macro. But just hoping you could provide us with a little bit more color on how you're thinking about the medium-term growth outlook for the company with this weaker macro backdrop? And also how you're planning spending and the level of flexibility we should expect as we model out the margins. Thank you.

Yes. With regards to the longer-term growth outlook, we feel very confident in that. Certainly in the short term, medium term, if you're looking a couple of quarters out. We continue to see a challenged macro environment and softening consumer demand. And so that should certainly be reflected in expectations for upcoming growth in the next quarters. From our perspective, the softening consumer demand we're seeing currently doesn't impact the long-term trajectory and long-term story. Obviously, we've been through a pretty choppy macro environment in the past two years. Unfortunately, we're seeing a little bit more of that, but it doesn't change our plans or our 2023 outlook.

Thank you. And maybe just a quick follow-up there. We obviously all saw the flexibility in the model as you manage through the pandemic. I guess, how would you approach marketing any differently or would you approach marketing differently as we enter this slowdown? The last time we had events totally shut down, consumers shut down and buying key elements of your assortment. I'm just wondering how you think about marketing in a slowdown scenario.

Yes, it's interesting. I think last time it was a very unique situation in terms of the level of depth of change to consumer behavior as well as our ability to execute events. That said, we generally like to go with kind of where the winds are blowing. The Revolve brand is centered around consumers looking and feeling great and living their best life. Certainly, right now, consumers aren't feeling that way. So I think it's a balance of continuing to invest for the long term. We have some really exciting events and investments that we're going to be making in Q3 that we plan to continue to do. We think those are great investments while also taking into account the best timing for those investments in general.

Yes. This is Michael Mente speaking. One other thing I would add is that our balance sheet is extremely strong. So we will also be opportunistic. One thing that I looked for I'd do very much so is that in more challenged economies, there's definitely less competition for certain resources, whether it be employee talent or marketing resources, both digital performance marketing or brand marketing with influencers, and such. So we'll be very opportunistic not to lose focus on staying long-term minded and doing what we think is best over the long term. So it could be a great time for us in that regard.

Your next question is from the line of Camilo Lyon with BTIG. Please go ahead.

Thank you. I was hoping you could unpack a little bit more about the components of the deceleration that you saw in fold here at the end of the quarter and into the start of Q3. Specifically, around basket size category changes, frequency, trade down, anything you're seeing and how we should think about the assortment changes, if any, outside of the inventory rationalization that you're contemplating to meet a more inflationary sort of compressed environment.

Yes. Generally, the slowdown that we saw was fairly broad-based in nature. That said, there are some interesting takeaways. One is that the higher-priced items are holding up better than some of the mid- and low-priced items. That's not to say that some of the discounting won't come into play, but it seems clear from our consumers that those levels are holding up a bit better. In terms of other trends, we're also seeing that traffic isn't holding up as well as conversion rates and revenue per session, which I think is consistent with the remarks we made about feeling good about our inventory; we just have a bit too much of it.

Yes, and then Camilo, it's Jesse. Maybe I'll just add a couple of things to that. We did see it get progressively more challenging as the quarter progressed. If you recall, we had communicated that April was growing at plus 30% and then closing the quarter was lower than plus 30%. You can see how that played out. And then in July, we had approximate 10%. So it really started to hit us in June, which negatively impacted us significantly with macro pressure. We've also seen more challenges internationally due to the strong U.S. dollar affecting our international customer. Meanwhile, COVID lockdowns and other challenges internationally didn't impact the domestic market as significantly.

Got it. And then just one follow-up if I could. Are you testing anything to incentivize lower return rates maybe to help out on that cost side? Or are you contemplating passing through some of those cost pressures to your consumer to alleviate the margin pressure that you're absorbing?

Mike here. No, we're not looking to implement any sort of changes that would decrease the consumer experience or increase costs for the consumer side. While the increase in return rates has put pressure on margins, particularly in conjunction with the very unusual historical fuel surcharges, our model is still quite profitable. We talked about how in Canada, the results we saw from investing in the customer experience. That said, we are investing considerable time and attention into ways to reduce the return rate, just not in ways that pass the cost along to consumers. Instead, we are focusing on making it more likely that they get what they want or easier to make the decision to keep what they want.

Your next question is from the line of Michael Binetti with Credit Suisse. Please go ahead.

Hey, guys, thanks for taking my questions. I was wondering if you could help us unpack the AOV upside in the quarter here a little bit, a significant contributor in the second quarter, but the order frequency we see coming down, obviously, on a tougher compare. I'm just kind of curious, Jesse, what you're expecting in the back half, I mean, in some of your metrics there as the mix maybe continues to stabilize. And then I'm wondering, good work on the customer growth being strong. I know you mentioned that you think it moderates. But as we take the 10% July total revenue growth rate and moderated further, it's just hard to say, but is there a chance we see a minus sign on revenues in one of the next few quarters considering the cadence you gave us such as it's a little counterintuitive with the consumer where you have them today, the customer growth rate where you have it today. But you did caution us to that it would slow a little bit, so.

Sure. So on the AOV, a few things played into that. So, number one, with the strong full-price mix we saw come in stronger than we had anticipated. We had been communicating for the last several quarters that we will see some shift back to markdown under that record high full-price mix, which we've been experiencing, but it continued to hold really strong through the second quarter. That's one component. The other component is the mix of dresses being higher than last year, of course, 32% versus that 24%, but also higher than the prepandemic quarter of 2Q 2019. So that positively impacted AOV. Moreover, we saw the trend of special events influencing higher price points. We also saw the mix shift between Revolve and Forward. Revolve outperformed Forward this quarter. As for the growth outlook for the next couple of quarters, it's more about scenario planning. There's certainly a scenario that has a minus in front of it, but we are also working through other scenarios. It's a really dynamic environment right now, so we're just kind of scenario planning at this point.

And did you say the surcharges, I think, accelerated in Q2. Are you anticipating that level of surcharges to be stable to Q2 levels in the back half? Or it looks like some of the commentary we've heard around the space has suggested some loosening up in freight and surcharges. Are you expecting this level of intensity to continue?

Yes. We are seeing it, and softening may be a strong word, but definitely moderating. We're not banking on significant alleviation on that front for the balance of the year, but hoping that it does continue to come down and give us some relief there.

Your next question is from the line of Anna Andreeva with Needham & Company. Please go ahead.

Great. Good afternoon, guys, and thank you for taking my questions. I have one quick question and a follow-up if I may. Could you remind us what's the percentage of your core demographic of wallet spend on apparel and accessories? I know it's higher than average or some of the older demos, but just curious if you have any update there? And secondly, balance sheet is in great shape. CapEx levels are pretty low. Can you guys talk about how you think about uses of cash? Is share buyback something that the Board would consider? Thank you so much.

Yes. This is Jesse speaking. As we talked about in the prepared remarks, our customer is younger. She's earlier in her career and income progression, so not putting a specific percentage on that, but she does spend a disproportionate amount of her wallet on apparel and discretionary apparel. As for the uses of cash, our balance sheet is really strong compared to a few years ago when we went public. So we feel really good about that. The number one use is really putting it back into the business, and we think that's the best return on investment. With that said, we're going to be opportunistic. We're going to keep pushing, tighten screws in some areas, but really continue to invest for the long term. So that's the number one use. We also discuss other alternative uses for that cash to return to investors, including buybacks. So when we looked at a lot of things, hopefully, to go back to Michael's point on maybe some opportunity in this time, there could be some interesting things over the next quarters to years.

Your next question is from the line of Oliver Chen with Cowen. Please go ahead.

This is Jon on for Oliver. Thank you for taking my questions. Just curious to know what you're seeing in terms of the promotional environment currently and your strategy there? And also, how should we think about the return rates trending in the second half? Should we still expect that trend to be higher but just probably going to be smaller in the back half? So any color will be helpful. Thank you.

Yes. In terms of the general promotional environment, we are seeing it get a lot more promotional out there with other apparel retailers in the space, including companies that are kind of closer to us. So we think that sort of thing does affect the general consumer mindset. As we mentioned based on what we're seeing and consumer sentiment surveys, the consumer is not feeling great right now. To double down on my earlier comments, we think the inventory that we have is quite good. We just have too much of it. Consumers are not feeling quite as good right now, which means there'll be some level of increased discounting. However, we don't plan to do anything particularly significant on that front at this time.

Yes. And then on the return rate, we're factoring in an elevated return rate for the balance of the year. That said, there are some potential benefits, not encouraging you to model those benefits in. As we see a mix shift out of full pricing to markdown, the markdown generally has a lower return rate than the full price product, and that's one of the pressure points on return rate over the last several quarters. So if we do see that shift out of full-price sales towards markdowns, that may help lower the return rate there. Also, the higher return rate in the quarter reflects a higher mix of dresses, which historically has a lower return rate than other categories. With a large mix of dresses at 32%, we may see some relief on that front, but as I mentioned, we are factoring in elevated return rates as we look ahead.

Your next question is from the line of Lauren Schenk with Morgan Stanley. Please go ahead.

Thank you. I wanted to delve deeper into inventory. When you mention hoping to have it resolved by the end of the year, what year-over-year growth rate are you aiming for? Also, how are you planning your inventory purchases for 2023? Can we assume that if you can return to 20%, that's the level you will be buying at? Lastly, could you provide more details on the inventory valuation adjustment in the second quarter gross margin and its size? Thank you.

Yes. I'll take some of the first part of the question, then maybe Jesse can handle some of the technical elements at the end. As far as inventory levels we're targeting, I wouldn't want to guide to a specific level because, again, the economic environment is pretty dynamic right now. But we're looking to be in a better position in terms of inventory levels and rightsizing incoming inventory shipments relative to the demand we're currently seeing. So that's our goal as we exit the year. Looking at 2023, for the first half of the year, we are looking at moderated inventory purchases. At this time, it isn't clear how many quarters it will take to work through the softening consumer demand. We want to err on the side of conservatism to open up the year.

Yes. And on the inventory valuation adjustments, that's really business as usual. We're making adjustments every month, every quarter. That said, you can see times like last year when we were kind of chasing the demand and had lower inventory balances, there is less of that valuation adjustments and, in times like this where demand falls off with an elevated inventory balance, but it is business as usual. Larger this year than in prior years, but balances out over time.

Your next question is from the line of Jim Duffy with Stifel. Please go ahead.

Well, thank you, good afternoon. I wanted to ask a little bit more about the shift in demand that you've seen in June and quarter-to-date. Can you speak to how that's manifested in both new customer acquisition and also maybe speak to some of the behavioral changes you're seeing with the heritage customer base?

Yes, it's really broad-based. We believe it's just the macro factors playing a role. New customers are down relative to where they were in that peak Q1 period, and we saw lower year-on-year growth. However, repeat customers are performing relatively the same, so there are no changes in customer loyalty rates or anything like that. We still have a very strong customer base, and they are coming in at full price. They're going to support us well over the long term, but it has been a challenging environment, progressively worsening as we progressed through the quarter, particularly in June and then into July, where we disclosed. We're seeing more pressure on the lower-end price points compared to premium to luxury price points.

Your next question is from the line of Lorraine Hutchinson with Bank of America. Please go ahead.

I wanted to just ask for some clarity on the difference between the behavior of the Revolve and the Forward customers. I understand that the comparisons are very different. Can you just point to any metrics that would illustrate if one is holding up a little better or just how those two customers are behaving differently in this inflationary environment?

I think from a quarterly trend results perspective, we saw Forward sales decline more. But it's really important to note just the incredible comp as we were coming off of a plus 150% year-over-year. That played a huge role in Forward results, as well as Forward being impacted more by currency pressures that made Forward products, which come from a lot of big-name brands, less competitively priced in certain international markets. That said, we think Forward's trajectory momentum is great, and we see it holding up relatively well, but it's still been impacted by comps as well as the same macro sentiment shift we are seeing.

Your next question is from the line of Rick Patel with Raymond James. Please go ahead.

Hi, good afternoon, thanks for taking the questions. Can you provide color on your expectations for gross margin for Revolve versus Forward for the rest of the year? I'm just curious if you think about elevated inventory, if it skews more towards one banner versus the other? And also, if there are any other puts and takes to call out for gross margins across each of those segments.

Yes, I think we will see pressure on both segments. They've both been operating at really record full-price mix and also really high markdown margins within that markdown mix. So we do expect to see increased pressure there, just as we have communicated over the last couple of quarters. Coupled with the increased promotional environment, it makes it more challenging, especially with the current inventory position we mentioned. But we do expect to maintain strong margins relative to prior periods. On the Forward side, we expect to achieve adjusted margins of about 47%, down to about 49%, similar to what we achieved last Q2, and this still remains about five points higher than our pre-COVID era, so we consider it good progress on the Forward side.

And you touched on taking pricing up mid- to high single digits, but it looks like markdowns will also increase as you address inventory. So can you help us just with where this shakes out? I'm curious if pricing ends up being a year-over-year tailwind or a headwind as you think about the back half?

Yes. I think it probably balances. I think the bigger impact on AOV is probably a mix shift coming off a peak quarter. And you can see that historically in pre-COVID periods. We do expect price increases to moderate in the back half of the year into 2023. We're starting to see those come through. It takes time for them to come through as you said, offset by the shift to markdown, but I think overall it will balance out.

Thank you.

Your next question is from the line of Simeon Siegel with BMO Capital Markets. Please go ahead.

Thanks, everyone. Good afternoon. Jesse, what did inventory grow in units rather than reported dollars? And then I don't know if return product ends up back in inventory. So if I'm thinking about the accounting ranges, let me know, but any way to gauge what return product represents as a percentage of your ending inventory? And just whether there's been any meaningful difference in that percentage versus prior years? Thank you.

Yes. The unit growth in inventory is much less than the dollar growth. Part of that is the mix between Forward and Revolve. Part of that is just price increases we discussed. The mix has shifted back in the last year, where we were chasing inventory, and now being stocked in higher price points indicates we think the inventory is good; it's just too much given the demand shift. So the blend is significantly less than the dollar growth. You're correct that returned dollars and units go back into inventory, and that is elevated since the return rate is higher this year, which is similar to pre-COVID levels, as observed in periods during COVID wherein return rates significantly fell.

Your next question is from the line of Tom Nikic with Wedbush Securities. Please go ahead.

Hi, good afternoon, guys. Thanks for taking my questions. When you look at your overall EBITDA margin, before COVID, it was coming in the high single-digit range, and based on the inputs you gave us, it looks like it's probably going to be something like 150–200 basis points below that this year. How do we think about the bigger picture margin structure for this business? Do you think that over the long term, it’s a high single-digit margin business? Or do you think at some point you can get to the double-digit margins you had during the pandemic? How do we think about margins in a more normal environment? Thanks.

Yes. We still feel good about our 14% EBITDA target over time. That said, we're facing a unique time with cost pressure. Maybe if we take it line by line. If you look at the gross margin, we've been delivering around that 55% gross margin, which was our target. But there are going to be quarter-to-quarter fluctuations, but we still feel good about that 55% gross margin target. Given owned brands was 20% last year, we hit our peak at 36%. We still think there's a lot of room to grow over time at a moderate pace. As we evaluate fulfillment at approximately 2.7%, we compare that to the 3.3% in the pre-COVID era. So we are gaining efficiencies there. Overall, we believe the ability to maintain margins is achievable with our recent improvements in strategies and automation. Marketing needs to manage additional pressures in ensuring our efforts remain effective, and we see growing efficiencies in time as well. Lastly, G&A expenses are primarily fixed or semi-fixed, meaning we expect to get efficiencies over time with growth. In the end, I still feel good about our 14% EBITDA target over the long term. It may be challenging for a couple of quarters, but we remain confident about long-term prospects.

Your next question is from the line of Matt Koranda with ROTH Capital Partners. Please go ahead.

Hey, guys. Maybe just attacking the promotional environment question in a different way. Is there any way you can just share your thinking around your markdown approach in the second half? Your commentary suggests that you're going to be a little bit more Q4 weighted in promotionality. And I guess the simple question is just why not just mark down now and in the near term? What's the advantage of ramping in the promotions in the current macro environment?

Yes. Maybe I'll take the second part, and then you can hit on that. I think it was probably related to my comments on the sequential movement in the margin. That's more related to the full-price markdown mix and that dynamic; while working through inventory is not necessarily like a higher intentional promotional push in Q4 versus Q3.

Sorry, go ahead. There's an element of seasonality coming from Q2 to Q3. From a strategic standpoint, we're not trying to kick the can down the road or anything. We want to take a measured approach, given that we think the inventory is quality inventory. So that means the markdowns will happen over time and accumulate as well, which is the reason you'll see more impact on Q4. But we've found that historically, taking a more measured approach versus just putting a bunch of stuff on markdown all at once tends to be more effective for us.

Okay, that's fair. And then on selling and distribution, if I could. On the deleverage of roughly 390 basis points year-over-year, could you just break out cleanly for us, Jesse, maybe how much was fuel surcharge related versus the higher return rate? Or how can we quantify the entire return rates in the current quarter? And then, if I could, any color quarter-to-date in terms of changes in returns is still running at the same rate we were in 2Q?

Yes. I'd call it roughly the same level. I would say it's not significantly increasing or decreasing. So I wouldn't factor any big movements from Q2 to Q3. The best way to quantify or differentiate the impact of return rates versus fuel charges is really looking at selling and distribution pre-COVID, reflecting a 2019 level versus today's level where the return rate was closer, still a notch higher than it was back in the 2019 era. The pricing increases have driven a shift towards international challenges making it more costly regarding localization—that's one significant aspect to consider.

We have time for one final question, which comes from the line of Noah Zatzkin from KeyBanc Capital Markets. Please go ahead.

Thanks for taking my questions. Are there any P&L benefits we should be thinking about in the second half and, of course, longer term related to the opening of your East Coast distribution center? And if return rates remain elevated in the second half, should we expect less of an impact relative to operating with a single distribution center?

Yes. Over time, there are benefits, both on the outbound being able to shift to customers closer from that distribution center versus shipping all the way from L.A. to the East Coast. It's not going to account for 100% of the inventory, but there is a small impact. On the return side as well, being able to accept returns in that facility, whether that's from the eastern region of Canada or the U.S. and taking the inventory into that facility. So we expect benefits there. It wouldn't factor anything in this year, as there are some start-up costs and it will be somewhat on the fringes. However, over time, we think it will be meaningful.

Well, thank you, everyone, for joining us today and helping support us in our journey towards building one of the world's biggest fashion brands.

This concludes today's conference call. You may now disconnect.