Good day, and welcome to the Abercrombie & Fitch Third Quarter of Fiscal Year 2022 Earnings Call. This conference is being recorded. At this time, I'd like to hand the call over Kate Wagner. Please go ahead, ma'am.

Thank you. Good morning, and welcome to our third quarter 2022 earnings call. Joining me today on the call are Fran Horowitz, Chief Executive Officer; and Scott Lipesky, Chief Financial Officer. Earlier this morning, we issued our third quarter earnings release, which is available on our website at corporate.abercrombie.com under the Investors section. Also available on our website is an investor presentation. Please keep in mind that any forward-looking statements made on the call are subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from the expectations and assumptions we mentioned today. A detailed discussion of these factors and uncertainties is contained in the company's reports and filings with the Securities and Exchange Commission. In addition, we will be referring to certain non-GAAP financial measures during the call. Additional details and reconciliations of GAAP to adjusted non-GAAP financial measures are included in the release and investor presentation issued earlier the morning. With that, I will turn the call over to Fran.

Good morning, and thank you for joining us today. Before we dive in, I'd like to thank our global team, their ongoing resiliency and focus on executing to our long-term goals as we navigate a dynamic global macroeconomic environment. Against a challenging backdrop, our Q3 results beat our expectations on the top and bottom line with Abercrombie sales up 10% and Hollister showing sequential sales improvement and adjusted operating margin coming in 200 basis points higher than our expectations. We're excited about our positioning going into the holiday season, continued momentum in Abercrombie and inventories healthy with the year-over-year change cut in half from our peak last quarter. I'm encouraged by the trajectory of our business, and I'm confident the steps we've taken throughout the year will put us in a position to win in Q4 and beyond. On to our Q3 results. While our global consumer continues to see significant inflation across our day-to-day lives, we were pleased to see our business improve off the second quarter, delivering flat sales in 2021 on a constant currency basis. Throughout the quarter, we continued to execute against the key pillars outlined in our Investor Day, focused brand growth, an enterprise-wide digital evolution and operating with financial discipline. These pillars give us confidence in our approach to the holiday season, which we will enter with healthy inventory levels, momentum in our key merchandising initiatives and a consumer that is engaging with us across channels. Starting with focused brand growth. We saw sales trends improve across brands compared to Q2. However, Abercrombie continued to significantly outperform Hollister as the bifurcation of the sales and gross margin performance continued in the third quarter. For the third quarter, total company net sales declined 3% to 2021. And as I mentioned, we were flat on a…

Thanks, Fran, and good morning. For the third quarter, we delivered net sales of $880 million, down 3% to last year on a reported basis and flat on a constant currency basis. We saw foreign currency pressure accelerate in the quarter, driving an approximately 300 basis point adverse impact to sales. Sales results were above our expectations as we saw trends improve sequentially at both Abercrombie and Hollister. Net sales at Abercrombie, which includes kids, rose 10% compared to 2021 on a reported basis and 13% on a constant currency basis. This compares to reported and constant currency growth of 5% and 7%, respectively, for Abercrombie in Q2. Hollister, which includes Gilly Hicks and Social Tourist, declined 12% or 9% on a constant currency basis. This compares to reported and constant currency declines of 15% and 12%, respectively, for Hollister in Q2. By region, net sales increased 3% in the U.S. and declined 18% internationally or 8% on a constant currency basis. By region, EMEA was down 22% on a reported basis and 11% on a constant currency basis, and APAC was down 26% on a reported basis and 19% on a constant currency basis. In EMEA, our strongest performance was once again in the U.K. and Middle East, and we continue to see softness in other key countries in Western Europe. Obviously, there are many unknowns in Europe this winter. So our focus is on controlling our inventory and expenses and quickly reacting to the environment. In China, our trend remained negative but improved significantly from Q2. Our gross profit rate was 59.2% compared to 63.7% last year. Key drivers of the year-over-year change were the adverse impact of exchange rates of 60 basis points and higher product costs of 370 basis points. On a constant currency basis, AUR…

[Operator Instructions] Our first question comes from Dana Telsey from Telsey Advisory Group.

Nice to see the progress. Can you expand on the enhancements that you've been making to Hollister and how you expect the brand to unfold in progress go forward given the people changes that have occurred there? And then any comments on -- we've been hearing about October and into November, how your trends have been exiting the quarter and into the other -- into this current quarter? And then lastly, Scott, you mentioned about product cost opportunities. How do you see it with supply chain in the first half of '23 compared to the second half?

So as you mentioned, we were pleased to see the sequential improvement from Q2 to Q3. In fact, we were pleased to see it in both of our brands. If you do take a step back, the Hollister customer, as we've talked about recently, has definitely been more impacted by inflation than our Abercrombie consumer seems to be at the moment. But we are controlling what we can control. The leadership changes came towards the end of Q2, the inventory changes -- we got on those as soon as we started to see some opportunities hit us as back-to-school kicked off at the end of the last quarter. It's exciting to see our tops business is very strong. We chased into those. Our theory there when we talk to the consumer is that perhaps they can't buy a couple pairs of jeans this year, but they want their outfits to look new, so they're putting new tops with those. We are determined to continue to see these improvements in the quarters to come, and the team is working very hard on adjusting inventories and really leaning into categories that are working. Let's see question 2, October into November. Go ahead.

I'll grab that one. So similar trends been what we've been seeing across the industry. It sounds like it was pervasive across the industry. A little bit of softness there, late October, and maybe into the first week of November. Super warm there in the Midwest and Northeast. And obviously, that's not optimal for selling cold weather products. I have seen those trends improve since like others, which is exciting. We are seeing good early selling through our cold weather categories and outerwear fleece, sweaters in the places where we need to win in Q4. So happy with the results there, the early results in those categories. On product cost opportunities as we look through -- look to next year. The great thing to see these costs coming back in, significant reductions in freight through the ocean and air as well as seeing the cotton prices stabilize here and down pretty significantly year-over-year. Obviously, it's going to take a little bit longer to see that cotton flow through. So first half of next year, cotton will be pressure, and then we'll start to see the benefits in the second half of next year. Optimistic that we'll see the freight benefit throughout the entire year, assuming those ocean costs stay where they are. So good news coming, hopefully, on the product cost front.

Our next question comes from Corey Tarlowe from Jefferies.

Congrats on the progress here. So Fran, maybe if you could just start talking a little bit about how you feel about the health of the inventory going into the holiday. It sounds like a lot of the inventory is current, and there are lots of stores, and they seem to look really good. So maybe just talk a little bit about the assortment and the health of the inventory into the holiday here. And then I have a follow-up.

Yes, we've been -- inventory has been a hot topic this year. And we've been talking about it on every quarter, and we kicked off the year by saying that we had a strategy on our inventory, which was really to pull it forward and get ourselves set up for the most important quarter of the year. So last year, we were struggling with both closures in Vietnam with our product as well as a lot of supply chain issues, and we were not going to disappoint our customers again. So we were able to get to about 36%, which is what I mentioned in my script, half of where we were last quarter. But to your point, that inventory is current. It's 92% current. We did a lot of adjusting of our inventory as we start to see the consumer respond to our product in the second quarter. So we're pleased by category and by brand on where we currently are and will be flat by the end of the year, which is what we had said as we said at our strategy. I think you said you had a follow-up. .

Great. Yes, could you just talk about how you think about the promotional environment as we head into holiday? It seems like people have been talking about more promotions that are expected to see ahead. Could you maybe just talk about how that is baked into the guide? And then, Scott, how you bridge that 5% to 7% operating margin, maybe some of the puts and takes for the Q4 that are associated with that.

Sure. So we're heading into -- this is a big week of the quarter. I think everybody knows it's the most promotional quarter of the year. Our promotional strategy, as we've stated many times, is based on what is and isn't working for us, not what is happening relative to other retailers that are out there. I'm very proud to say that our promotions are considerably less than where we were pre-pandemic and flat to where we were last year. We're seeing some nice selling already from some categories and some cold weather categories. So we are positioned to compete, and I'm personally looking forward to being out in the malls and seeing all that consumer energy this weekend.

As we think about that promo environment kind of bridging to the operating margin, we will see -- we expect to see Abercrombie AURs up again. They were up nicely there in Q3 and Hollister was down in Q3 as we continue to push on that back-to-school inventory. Again, that was inventory that we bought earlier in the year before that trend fell down kind of in that June time period. So we expect to see the same thing play through in Q4, Abercrombie AUR up, Hollister down a little bit as we continue to push through that clearance, that carryover clearance. As we think about bridging the 5% to 7% operating margin, the good thing is as we're getting closer to last year, whenever we really started to see the freight come in, so we'll still be below 2021 levels. And the way I think about it is gross margin will still see some pressure there year-over-year. While we see freight being a nice tailwind in Q4, cotton will absorb most of that as that fully comes into the P&L and flows through. On the other costs, not much else happening in AUC. We talked about AUR. And then other operating costs, we want to keep them relatively flat to last year. So really for Q4, year-over-year, it's going to be a margin story, and we'll work through the promo environment. And as Fran said, we're targeting that inventory to be flat at year-end to last year and move cleanly into 2023. And again, so the first question earlier, really excited about what we're seeing from product costs and hopefully seeing that benefit throughout 2023.

Paul Lejuez from Citi.

This is Kelly Crago on for Paul. So I just wanted to follow up on, sort of, what you're seeing from a promotional standpoint. So I guess you're saying that the Hollister brand is more promotional year-over-year. And then I guess I'm just curious, relative to 2019, what those AURs look like? And then on the other side, A&F was also -- or was less promotional year-over-year, which is driving the higher AURs than I would assume that those AURs are up relative to 2019.

Yes, let me have this one.

Clarifying the first point. .

Yes, on the first point, so when we talk about Hollister, we're not more promotional. Our promotions this year for Black Friday will be consistent to last year, that promotion has started, which is good. Where we might see some additional promotions or pricing actions versus last year will just be to continue to clean up that carryover inventory. So that's where we're assuming AURs will be down a little bit on a constant currency basis. We do have FX as a continued hurt sadly here in Q4. So that's going to hurt the AUR just on a currency basis. As we think about 2019, it's -- actually, we like where the AURs are, they're up across brands. So even for Hollister in Q3, where we had put more promotions on to move that back-to-school inventory. Those AURs are still higher than 2020 -- or I'm sorry, 2019 pre-pandemic, and Abercrombie up nicely as we kind of fully evolved that brand and that assortment. So loving the AURs that we're seeing across brands, even in light of what we've had to do for Hollister more recently. And then getting back to that cost that's coming back in to see gross margin going in a good direction go forward. And A&F something we have been talking about -- sorry, just on A&F as we've been going through, we've been much less promotional year-over-year, that brand. The momentum that we've seen there has just been amazing. And we've been able to pull off promotions, both depth and frequency.

Got it. And then just secondly on your comments around the quarter-to-date trends. So I guess you're saying that you did see a little bit of a slowdown in October, but trends have kind of stabilized, maybe improving as we get closer to the holiday. And I'm just curious, so net down to 2% to 4% is pretty consistent with 3Q. So is that kind of what you're seeing quarter-to-date? And then just curious on the kind of the comparisons as we move through the quarter. Omicron was an issue last year. There was some pull -- we think there was maybe some pull forward of demand in holiday last year. So just curious how the rest of the quarter looks on a year-over-year basis.

We'll start back with that one. So yes, I mean, our expectation, interestingly, for this holiday is that it probably would mirror more pre-pandemic. So last year and the year before, we saw a little bit more of a flattening demand throughout from Black Friday through the holidays. Prior to that, you used to see these big spikes on the most traffic days, which would be this Black Friday week through Giving Tuesday and then some of the key Saturdays. So we are expecting a little bit more of a cadence similar to pre-pandemic.

Yes, Kelly, like you kicked off with quarter-to-date trends consistent with Q3. So I feel good where we are. Yes, a couple of weeks in October, a little tough there at the end. These are small weeks in the quarter, same thing with November week 1. So back on track. Once the weather turned, we saw some great selling in those cold weather categories I mentioned earlier. So feel good sitting here today. And as we go through the quarter, we had light inventory last year. We have the inventory this year, and we're excited to compete as we go through the quarter.

Carla Casella, JPMorgan.

Well, I wanted to ask you about -- you bought back $8 million of bonds in the quarter in the open market. What's your thought in terms of just your capital structure and whether you would consider calling those bonds, or at what point you'll take it out and look at the structure?

Carla, yes, bought back some bonds in the quarter, $8 million. We had done about $40 million middle of last year. So as we have excess cash, we look at the capital allocation stack. We increased capital investments. We've taken them for this year from $150 million to $170 million, so continuing to invest back in the business. Bought a little bit of stock back and bought the bonds back. When we think about our capital structure, we're comfortable holding the debt that we're holding. When we see opportunities like we have seen more recently where the debt trades below par, we can go in there and buy a little bit of that back in the open market, save a little bit of interest expense, nice cash payback going forward. So big picture, though, comfortable with the debt. And as we have excess cash, we'll continue to look at that capital allocation stack and see where we put the cash to work.

Okay, great. And then if I could just do 1 more question on the shipping costs. Can you just talk about freight rates and kind of where they peaked and where they are now relative to where you expect them to be in the next quarter and next year?

Yes. The peaks, I would say happened probably earlier this year, and shipping costs are tough to pin down. There's indices all over the place. But when you don't shift from just the index point somewhere in China to maybe the West Coast, we ship from multiple countries in Southeast Asia. So there's no one index that I can just grab. But what I would say is they're down pretty significantly from the peak. And with the demand environment that we're seeing out there, a lot of retailers, including us, pulled back on Q4 receipts whenever the businesses fell off earlier this summer. So the demand environment is good. Hopefully, that's tilted back in the favor of the retailers. We're seeing that come in the pricing and optimistic that, that will stick in Q4 and beyond.

Janet Kloppenburg, JJK Research Associates.

Congrats on the great progress. Fran, just a couple of quick -- first of all, clarification. I think you're saying you expect your promos to be flat for the fourth quarter and were they higher in the year-over-year in the third quarter to clear the Hollister product, but improved at A&F as driven by the AUR gain? That's the first question. Second question, what's going on with A&F men's? And should we have any concern there? And then secondly, when you look at Hollister assortments for go forward into spring, are you encouraged that we could see an inflection in Hollister's comps sometime in the first half?

Janet, I'll clear up the first one real quick and then Fran can get into it. So meanwhile -- for Abercrombie in Q3, it was down for Hollister as we pressed on pricing to clear that back-to-school inventory. As we think about going into holiday, our main promotions, [ the percent of ] stores or the promotions that we're running outside the store should be relatively consistent year-over-year. As a reminder, we rightsized that Q4 and forward inventory buy for Hollister. Where we'll focus any excess markdowns in Q4 will be on Hollister carryover inventory. So we'll see how that plays out in the selling mix in Q4. And then I'll kick it over to Fran.

Sure.

Wait, wait, wait. Can you hear me? Can you hear me? What about Hollister though? From promos, just for my notes, I just want to clarify that promos were up, would you say meaningfully, Scott, for Hollister in 3Q?

I wouldn't say meaningfully. We turned through our back-to-school inventory a little more clearance pricing. You take it a little bit lower on the markdowns, but I wouldn't call it meaningful.

And regarding men's -- so in my script, I actually get it. It's exciting second quarter for men's, we talked about seeing some green shoots. But in the third quarter, we actually saw some growth. So we are encouraged that the men's consumer is seeing how Abercrombie is back, like the women's consumer has been seeing it for quite some time now and responding to some good categories in our top, strong. Our outerwear business is strong. So we're actually very encouraged with what we're seeing in the men's business.

That's A&F?

A&F, exactly. Yes. And then for Hollister, it was great to see quite some improvement this quarter. Our expectation is to continue to see some sequential improvement. We're seeing good business on the top, as I mentioned, the consumer is looking to update their outfits. So they're buying a new top perhaps to go with their jeans. There's also a lot happening in non-denim bottoms. We've chased into categories like cargo pants, which the consumer responded to quite well during back-to-school. We didn't have enough, we've chased into those. So our expectation is to continue to see sequential improvement in Hollister quarter-by-quarter.

And do you expect a lag in Europe, Fran?

Yes. I mean international business has been challenging. There's a lot of uncertainty still in Europe. We are managing what we can in the short term, right? We're controlling our inventory. We are continuing to open up stores and we do believe in the long-term opportunity there. So we'll have to see what the fourth quarter brings. It's been challenging.

[Operator Instructions] Now I will take a question from Mauricio Serna from UBS.

Great. Congratulations on the progress. Just wanted to ask if you could elaborate a little bit more on category performance across the 2 brands, particularly interested in seeing how denim has trended during the quarter. And then maybe if you could talk a little bit about Europe and what are the pockets where you're seeing some weakness in the market? And lastly, on freight, on the Q4 outlook. I mean I think I recall from last year, there was like a 370 basis point impact. So I just want to -- I wanted to ask if you expect that to fully revert in this quarter or maybe just like a more gradual pace, so...

All right, Mauricio, let's go back up to the top here. So category performance for denim. So we're seeing actually a little bit of a difference by brand. So Abercrombie had another -- Abercrombie women's, particularly hit another record quarter in denim and the Hollister denim business has gotten sequentially better. What we're really seeing from the consumer, though, is a move into non-denim bottoms. There's a lot happening. We set another record in Abercrombie women's where we sold the best pants, I think, in over a decade or something got right over? Yes. And in Hollister often non-denim bottoms are doing very nicely, as I mentioned just quickly before about cargo pants and things of those opportunities. So we are shifting our receipts into -- leaning into what's working, and we're going to continue to do that.

All right. Let's sum up to Europe, so pockets of weakness. So where we are seeing strength, has been relatively consistent. We've seen it in the U.K. and we've seen it in the Middle East. And then kind of our next few countries, when you think about Germany, France, Italy, that's where we've seen the softness. Obviously, Germany has some significant uncertainty right now with the gas situation over the winter. So like Fran said a minute ago, we're just keeping our eyes on the region. We will control what we can control, keeping inventory lean, and we're just going to read and react as we go through the winter. On the freight side and thinking about the outlook. So yes, last year, we had about $75 million hit up with freights when we had significant air usage, high air rates, high ocean rates coming in. We're going to get a big chunk of that back this year. You don't get all of it back. It's going to take a little bit of time for those lower rates to flow through the P&L. So again, hopefully, some good things coming there in 2023. But then some of that offset of the good pickup in freight year-over-year, we'll be seeing that cotton flow through in those higher rates. So we're kind of working through the inflation and the input costs. Freight hopefully have seen the peak, and we're on the good side of it. Cotton still, we've got to get through the peak there. And then hopefully, in the back half of 2023, we'll see some benefits coming in.

And as there are no further questions in the queue, I'd like to hand the call back over to Fran Horowitz for any additional or closing remarks. Over to you.

Just want to thank everyone for joining the call today and wishing you and your families a safe and happy holiday season.

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