Levi Strauss & Co (LEVI) 2022 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co. Third Quarter Earnings Conference Call for the period ending August 28, 2022. (Operator Instructions). This conference call is being recorded and may not be reproduced in whole or in part without written permission from the company. This conference call is being broadcast over the Internet and a replay of the webcast will be accessible for one quarter on the company's website, levistrauss.com. I would now like to turn the call over to Aida Orphan, Vice President of Investor Relations at Levi Strauss & Co.

Thank you for joining us on the call today to discuss the results for our third fiscal quarter of 2022. Joining me on today's call are Chip Bergh, President and CEO of Levi Strauss; and Harmit Singh, our CFO. We have posted complete Q3 financial results in our earnings release on the IR section of our website, investors.levistrauss.com. The link to the webcast of today's conference call can also be found on our site. We'd like to remind everyone that we will be making forward-looking statements on this call, which involve risks and uncertainties.

Actual results could differ materially from those contemplated by our forward-looking statements. Please review our filings with the SEC, in particular, the Risk Factors section of the quarterly report on Form 10-Q that we filed today for the factors that could cause our results to differ. Also note that the forward-looking statements on this call are based on information available to us as of today, and we assume no obligation to update any of these statements. During this call, we will discuss certain non-GAAP financial measures.

These non-GAAP measures are not intended to be a substitute for our GAAP results. Finally, this call, in its entirety, is being webcast on our IR website, and a replay of this call will be available on the website shortly. Today's call is scheduled for 1 hour. (Operator Instructions). And now I'd like to turn the call over to Chip (inaudible).

Good afternoon, and thanks for joining us today. As you know, and I've heard from other companies, macro conditions deteriorated since we last spoke with you in early July. As we move through the third quarter, a confluence of pressures from inflation to falling consumer sentiment to rising interest rates began to result in softer consumer demand, while our industry continued to experience supply chain disruption and a heightened promotional environment. Not surprisingly, this made for a challenging quarter.

Despite this, we were able to deliver solid results with net revenue growth of 7% on a constant currency basis, which translates to plus 1% on a reported basis. While this was below our own internal expectations for the first time in several quarters, our teams responded to this very dynamic environment by focusing on controlling the controllables. We took quick action to both stay competitive and protect the bottom line, resulting in a double-digit adjusted EBIT margin of 12-plus percent. I've talked before about the importance of strong brands during uncertain times.

Our brands remain very strong, delivering strong growth despite the challenging environment. Specifically, excluding the impact of foreign exchange, we delivered constant currency growth across our key brands with Levi's plus 6% and Dockers plus 13%. But beyond the revenue results, there are other key proof points that underscore the strength of our brands. First, this quarter, we delivered the Levi's brand highest third quarter revenue in a decade with growth across categories and genders.

We've made meaningful progress winning over the next generation of fans, continuing to gain share with the 18- to 30-year old age segment in the U.S. while maintaining our leadership position across consumers of all ages. And our unaided brand awareness remains well above competition across most markets. Second, the strength of the brand has equated to pricing power. AURs were up mid-single digits in a more promotional environment and the pricing we've taken to offset inflation has largely stuck. Third, and as a result of our pricing power, our gross margins, though off modestly versus a year ago primarily due to currency and discounting, remained strong and are still nearly 400 basis points higher than pre-pandemic levels as we have successfully offset significant inflationary cost increases.

Fourth, our direct-to-consumer business continued to deliver outsized growth plus 8% in constant currency, which, by the way, Harmit and I will continue to refer to in the balance of our remarks, driven by increases across our stores and e-commerce business. Having strong powerful brands and a diversified business with scale mattered during these volatile times. These advantages allowed us to grow global wholesale by 6% and total U.S. company revenue by 5% despite a number of U.S. wholesale customers slowing orders. To put the U.S. results in context, we significantly outperformed both the overall jeanswear market which based on NPD data, declined by mid-single digits during the June through August quarter and the overall U.S. apparel market, which slowed to only 1% growth.

I think it's also important to note that despite the past 3-month decline in the jeanswear category, it is still up mid-single digits versus pre-pandemic. Despite the quarterly category softening, we remain confident about the long-term trend of casualization, continuing to be a tailwind for the business. In addition, even with continuing supply chain constraints, our team took swift action to minimize the impact of just $30 million to $40 million or about 2 to 3 percentage points of revenue growth. As the operating environment becomes more challenging and supply disruptions continue, our unique and durable competitive advantages will continue to set us apart from the competition.

Let me walk you through the progress we made across our strategic priorities during the quarter, again, all in constant currency. Our first strategic priority is brand-led. As mentioned, Levi's brand grew 6% versus prior year and almost 10% ahead of 2019. We're driving growth in our bottoms business by delivering a pipeline of fresh and innovative products as we define new trends and introduce new fits. We continue to build upon our success with looser fits with the launch of our new baggie dad, a signature 90s style, which delivered strong performance as did our new boot cut and straight fit launches.

The trend towards looser fits in women's was also accompanied by a shift from high to mid rises, which were up 20%. The Iconic 501 family again posted double-digit growth across men's and women's. After 149 years, this fit continues to resonate. We continue to position the Levi's brand at the center of culture by partnering with leading brands and cultural icons on product collaborations. The Ganni collaboration returned this year and was featured on the runway at the Copenhagen Fashion Week and sold out in 2 weeks. And the new Levi's denim Tears collection was worn by Golden State Warriors Guards, Steph Curry on the cover of October's Rolling Stone.

We also recently launched the second iteration of our Buy Better, Wear Longer campaign designed to inspire shoppers both young and young at heart, while highlighting the quality and the timeless style of Levi's. Additionally, this campaign underscores the durability of the pair of Levi's important in today's environment where consumers are looking for quality and value for money. This is the highest scoring ad in copy testing that we've had since I joined the company over a decade ago, a reflection of how much this message resonates.

Moving on to our second priority. Total company DTC channel grew 8%. Owned and operated mainline and outlet stores grew in the third quarter, mid-single digits with traffic and AURs both up versus prior year, again another sign of the strength of our brands. And even as consumers return to our stores, e-commerce grew 16%, driven by the Levi brand in Asia, Beyond Yoga and Dockers. Overall, e-commerce was up 64% versus 2019, with the Americas and Europe segments up double digits and Asia more than doubling.

Globally, the Levi's app continue to achieve increased engagement with monthly active users again up double digits, along with 17% growth in revenue. And we made progress in deepening our direct personalized relationships with our consumers via our global loyalty programs, which saw double-digit growth in total members and revenue. We also grew our global wholesale business by 6% driven by the Levi's brand across Asia and the Americas. In the U.S., the Levi's brand was up low single digits, with strong growth in women's new fits. This growth was offset by a 12% decline in our value brands, Signature and Denizen, which are most sensitive to changes in consumer discretionary spending.

Further, this business was impacted by a reduction in Denizen women's distribution at Target as we've expanded Levi's Red Tab. As a reminder, our value brands only comprise a mid-single-digit percentage of our total net revenues. Our third strategic priority is diversifying our portfolio, and we continued the strong momentum we have achieved in each of our major growth opportunities with women's, tops, international and our other brands Dockers and Beyond Yoga, each contributing positively to third quarter growth.

Our total company women's business grew 8% above men's strong performance of about 6%. The women's business was driven by Levi's bottoms, which were up 7% and saw a notable strength in the Americas. Additionally, the small but growing women's business on Dockers was completely additive as was Beyond Yoga. For the total company, tops saw 12% growth as we continue to diversify our offerings. Levi's tops were up 8%, driven primarily by men's, which grew 14%. We continue to see strength in tees, wovens and polos, while our Levi's women's business saw positive growth across nongraphic tees, dresses and sweaters.

Our international business grew 8% even as we navigated a more challenging consumer environment in Europe and in China. We saw encouraging strength across Asia which excluding China, was up 68% as well as in several of our largest and important European markets, notably the U.K. and Spain. Our updated Dockers brand with its California casual aesthetic posted 13% growth, driven by both AUR and volume, while also delivering strong profitability that exceeded our plan. Brand delivered growth across major geographies and channels.

The U.S. was up 2% and international brick-and-mortar and e-commerce saw notably strong gains. Dockers women's and tops businesses also saw strong growth and grew as a percentage of the brand sales. Beyond Yoga contributed $22 million to net revenue with solid consumer demand in the quarter with company-operated e-commerce sales up strong double digits on a pro forma basis. It launched at 20 colleges across the country as the brand continues to build awareness and reach new consumers. Perhaps most exciting at the end of last month, Beyond Yoga opened its first permanent store located in Santa Monica, showcasing the brand's full array of category offerings for the first time.

While we're just getting started, we believe there is an attractive long-term opportunity to grow the brand's presence through retail. Finally, one of our most important company-wide objectives is leading the industry in environmental stewardship. Last week, we released our annual sustainability report, which includes a comprehensive set of disclosures and introduces a new slate of sustainability goals, 16 and all, that cut across our 3 main pillars of climate, consumption and community. You can find the report online in the Sustainability tab of our website.

In closing, we continue to achieve steady progress against our long-term objectives as we navigated a more difficult environment in the third quarter. While we expect it to remain challenging over the next few quarters, I'm confident in our ability to navigate the near-term headwinds and importantly, deliver on our long-term goals for the following 5 reasons: first, we had really strong brands; second, our categories are structurally attractive with long-term tailwinds from the casualization trend and denim cycle; third, we have the global scale to react to disruptions and manage through inflationary pressure with competitive sourcing; fourth, we have a diversified business model where some of our biggest opportunities are gross margin accretive and generate higher AURs; and fifth, we have a seasoned and proven team that has delivered excellent results while managing through challenging times.

LS & Co. has separated itself from competition in challenging times in the past by making the right moves. We believe the current environment is an opportunity for us to do this again. We will operate with discipline and lean into our strengths to further expand our lead for the years to come. Now over to Harmit.

Thanks, Chip. Let me begin with 3 thoughts before we get into the numbers. We delivered a solid quarter with net revenues up 7% in constant currency, demonstrating the power experience of the Levi's brand. We delivered these results even in the face of higher FX headwinds, transitory pandemic-related supply chain issues intensifying in the U.S., resulting in our inability to fulfill orders as well as stiffening ongoing economic and inflationary headwinds impacting consumer discretionary spending in the U.S. and Europe. Thanks to the strength of our brand, our diversified business model and operational agility, we were able to quickly manage expenses and exceed expectations for adjusted diluted earnings.

We made progress against our long-term strategic plan. delivering growth across our attractive high-margin opportunities, including women's tops, direct-to-consumer, international and our Dockers and Beyond Yoga brands. By exercising control of the controllables, we are navigating the short term while continuing to invest in our compelling long-term growth initiatives and returning capital to our shareholders. Now let's get to some additional Q3 financial details. Net revenue grew 7%, primarily driven by the U.S., Asia and Latin America with broad-based increases in AUR.

Direct-to-consumer channel net revenue grew 8%, driven by positive comp store sales across our mainline and outlet stores, including in the U.S. due to increased traffic, higher AURs and UPTs. And despite strength in the stores, our e-commerce business was up 16% and net revenue through all digital channels were up 15%. Adjusted gross margin in reported dollars was 56.9%, up more than 390 basis points versus 2019, yet contracting 60 basis points year-over-year, due to a 30 basis points unfavorable currency exchange rate impact as well as the impact of higher product costs and lower full-price sales, particularly in the U.S. relative to last year, partially offset by price increases and a favorable channel mix.

Moving to SG&A. Adjusted SG&A expenses in the quarter were $675 million, up 6% from last year at the lower end of our expectations. As we began to see the impact of the softening macro environment, we minimized spending in the quarter by reducing discretionary expenses like travel, delaying nonessential hiring and projects. And we're continuing to do the same as we move into quarter 4. As a percentage of revenue, adjusted SG&A was 44.5%, reflecting higher distribution expenses and ongoing strategic investments in IT and our direct-to-consumer business and our lower-than-expected revenues.

Adjusted EBIT margin was 12.4%, contracting 240 basis points on a reported basis and 200 basis points on a constant currency basis. Adjusted EBIT dollars were down 15% on a reported basis and 8% on a constant currency basis. The effective income tax rate was 7.2% for the third quarter compared to 4.8% in the same quarter of the prior year. The lower effective tax rate relative to the company's full year updated outlook for mid-teens was driven by the acceleration of certain tax-related initiatives. Adjusted net income was $161 million compared to $197 million in the same quarter of the prior year.

The decrease was due to lower operating income. Adjusted diluted EPS was $0.40, which includes a $0.04 negative impact from foreign exchange, of which, half was incremental to the outlook we provided in July. I'll now take you through key highlights by segment. Recall the regional segments include our Levi's brand, Levi, Signature and Denizen, while the other brand segment includes Dockers and Beyond Yoga. In the Americas, revenues grew 3%, driven by higher AURs across channels.DTC growth of 8% was driven by company-operated mainline and outlet stores, which benefited from increased traffic and AURs in addition to new stores.

Wholesale growth of 2% was driven by international and the Levi's brand in the U.S., which as Chip mentioned, was partially offset by lower revenues of our value brand. Overall, the Americas segment saw growth across all markets, with the U.S. up 2% and notable momentum across Latin America, led by the strength in Mexico. In Europe, revenues were 9% lower on a constant currency basis, which includes a 4% negative impact from the suspension of our business operations in Russia. While macro pressures, including inflation and extreme heat, negatively impacted the region, several of our large markets posted growth.

Our successful pricing actions delivered high single-digit AUR growth, which partially offset softer consumer demand. Though we continue to anticipate pressure from the macro environment, we remain confident in the strength of the brand in the region, and Levi's remains by far the most popular denim brand in Europe. Asia again accelerated with greater-than-anticipated revenue, up 53% despite COVID-related restrictions negatively impacting markets like China. Volumes and AURs both increased strongly and wholesale and direct-to-consumer both partially benefited from lapping wider spread COVID-related door closures last year.

E-commerce was up 33%, while our company-operated stores saw gains from traffic, AURs and new stores. The Asia segment, excluding China, grew 68% with broad-based growth across markets, led by India, Malaysia, ANZ, Indonesia and Thailand, and overall revenue growth and higher gross margins have delivered better than anticipated operating margin expansion of nearly 2,000 basis points to 7.4%. Other brands net revenue was up 44%, driven by 13% growth in Dockers and the addition of Beyond Yoga. Turning to balance sheet and cash flows. We inventories increased 43% on a dollar basis. However, there are a few items that are driving that increase and are worth noting. Approximately 1/3 relates to COGS inflation and the normalization of last year's abnormally low inventory levels. Another 1/3 of the increase relates to the intentional earlier receipts of core inventory to mitigate supply chain risk and the U.S. implementation of a new ERP system in the second quarter of fiscal '23.

And the final 1/3 was driven by an increase of goods in transit. Core products, which can be sold across multiple future seasons, represented approximately 2/3 of total inventories, and we're comfortable with the composition and quality of our inventory. As you build inventory for 2023, and we look forward to respond to changing demand, we have reduced inventory buys for the first half of 2023 by approximately 25%. These actions should enable us to return to normalized inventory levels in line with net revenue growth by the end of quarter 3.

Cash and liquidity remained strong with the end of quarter net debt of $372 million and overall liquidity of $1.4 billion. Our leverage ratio remained at 1.1x, owing to investments in inventory and inflation, adjusted free cash flow, which we define as cash flow from operating activities less property, plant and equipment, was negative $12 million in the third quarter. However, we expect adjusted free cash flow for quarter 4 and the full year to be positive. In the third quarter, we returned approximately $74 million to shareholders.

The company paid a dividend of $0.12 per share, nearly 50% higher than a year ago. And in the quarter, we repurchased shares of approximately $26 million. In quarter 4, the company declared a dividend of $0.12 per share in line with last quarter, and we currently have $619 million remaining under our share repurchase program, which has no expiration date. Now let's turn to guidance. While we're confident in the strength of a brand and deep consumer connections, we are not immune to the macro headwinds the sector is experiencing.

And though in the month of September, we're continuing to experience momentum in our U.S. direct-to-consumer business, which is up 10%, we are tempering our outlook for the remainder of the year to reflect ongoing supply chain disruption and macroeconomic pressures. For fiscal '22, we now expect reported net revenues to grow 6.7% to 7%, representing approximately 11.5% to 12% net revenue growth on a constant currency basis. Our outlook includes 3 points of incremental FX pressure since we guided in July. On a reported basis, we now expect Americas to be up high single digits, Asia mid-teens and Europe down high single digits.

In constant currency, we expect Asia to grow in the low 20% range. Excluding FX and Russia, we expect Europe to grow high single digits. We also now expect adjusted diluted earnings per share of $1.44 to $1.49, despite incremental FX headwinds of [$0.05] since we reported back in July. In total, for the full year, we now expect more than $250 million of unfavorable FX impact on net revenues and $0.13 in adjusted diluted EPS. To put our latest full year adjusted diluted EPS guidance in context relative to where we started in early 2022, adverse FX, Russia China are estimated to have impacted adjusted diluted EPS by over $0.20.

By focusing on what we can control, while building this business for the longer term, we have managed to offset nearly 75% of this downside. We expect our full year adjusted gross margin slightly down versus last year's 57.9%, nearly 400 basis points higher than 2019. The change from our prior outlook is driven by foreign exchange and lower full price sales as we expect the broader marketplace to be more promotional through the end of the holiday season. As a result, we now expect our adjusted EBIT to be 11.6% to 11.8% for the year, which is approximately 60 to 80 basis points lower than prior year on a reported basis, but 100 to 120 basis points ahead of '19.

We continue to expect $270 million in CapEx for the year as we expand our direct-to-consumer business and continued strategic investments in IT. We expect our full year effective tax rate to be in the mid-teens, which implies a mid-single-digit tax rate for quarter 4. As specifically relates to quarter 4, this implies our fourth quarter net revenues will be slightly down on a constant currency basis and down approximately 6% on a reported basis. Our outlook reflects a more cautious view with regard to supply chain challenges, particularly in the U.S. into the fourth quarter.

We expect adjusted diluted EPS to be between $0.29 and $0.34. As I did in the beginning, I want to leave you with a few key points. Our vision for a long-term future remains unchanged. While we expect conditions to remain challenging in the near term, we are confident in our ability to leverage our strengths to deliver sustainable, profitable, long-term growth and emerge in a stronger position. Our brands and the structural economics of our business remain as strong as ever. On top of our resilient core, we are making good progress in attractive, growing and high-margin areas, including our women's tops International and direct-to-consumer business.

We are focused on controlling the controllables. We're reducing discretionary spending, but not at the expense of any of our strategic investments that continue to fuel our brand and which will enable us to deliver on our long-term growth plan. And finally, we are financially strong with a solid balance sheet and a strong diversified and scaled business model to generate the cash flow to reinvest for long-term growth while continuing to return cash to our shareholders. And with that, operator, I would like to open it up for questions.

(Operator Instructions). Our first question comes from the line of Bob Drbul of Guggenheim Partners.

I guess, Chip and Harmit, just when you look at the quarter, can you talk a little bit more, I don't know, like geographically, how it materializes? When you think about the changes in the quarter and sort of how you missed your expectations or just the dynamics that unfolded? And I'd be a little bit -- I'd be interested to hear just how you think wholesale inventories are of the categories with some of the changes in the category that you talked about as well throughout the quarter?

Bob. Thanks for asking the difficult question. But as you know, we delivered a solid quarter, up 7%. And Levi's in quarter 3 hit a record revenue for that quarter in a decade. But you're right, we missed our own internal high bar. Things progressed fairly quickly through the quarter. The moment we saw headwinds -- incremental headwinds in FX, supply chain continued pressures and demand softness, especially in the Western world, we focused on the controllable. So if you think of revenue, I'd break up the miss to our own internal expectations in the following way: 1/3 was foreign exchange, 1/3 was supply chain constraints that persisted and honestly limited our ability to service demand that is out there.

So that was about $30 million to $40 million in revenue. And then the macroeconomic environment, which weakened in the U.S. and Europe, Asia and Latin America were the standouts geographically. They grew. We continue to be long on those businesses. As we think about the impact on EPS and profitability, I'd say the drop to our own expectations and revenue, which is about $0.12, we quickly focused on the controllables. So between cost and other things like tax rates. And our tax rates are in the mid-teens, we hope to sustain in the high teens longer term.

So that's where we kind of offset it. In terms of your question on wholesale and U.S. wholesale, if you think about the quarter, U.S. wholesale was up low single digits. If you back out mass channel, which is 2 retailers that we sell Signature and Denizen, which is down, as Chip mentioned, about 12%. U.S. wholesale actually was up in the mid-single digits. So overall, fairly okay. We do monitor trade inventory levels. And we measure in months. And at the end of quarter trade inventory levels in the U.S. with wholesale customers were largely similar to what it was in '19. Now there are obviously some customers are higher. Some customers are lower, but that's the way we see the data.

Our next question comes from Paul Lejuez of Citi.

Curious if you could talk a little bit more about inventory. Maybe if you can provide any color, maybe breaking it down by region, tops, first; bottoms, men's versus women's? I think (inaudible) that you might have mentioned something about how much was seasonless product. But also curious if you think there are any places where you have more than you'd like, where you have to be a little bit more promotional to clear through?

Sure. So I tried to break out the inventory, the drivers of growth in the prepared remarks, 1/3 was largely driven by inflation in COGS, which is up. As you know, cotton was higher. And a lower inventory base because last year things were very tight. 1/3 was largely driven by us bringing earlier things because of longer lead times as well as the ERP. And 1/3 was largely good in transit. In terms of the thing that we're doing, Paul and the team we are -- and most of this inventory is largely core.

So we can work through season, about 1/3 is seasonal. We don't have a lot of obsolete. The way we do have obsolete, we are marking that down and selling it, and that was -- what was impacted our gross margins in Q3. We went in thinking gross margins based on the items that we wouldn't be selling full price would be impacted about 100 basis points this probably 130, 140 basis point impact. We've factored that in Q4, too. So where we can, we are moving quickly around the world to mark things down. The other thing that we're doing is that we did reduce our buys for the first half of 2023 big time.

It's -- right now, it's down 25% because we -- as we build inventory for the ERP installation, it's important to reduce that. In terms of geographic split, Paul, the buildup is largely in the U.S., which is primarily a core market. And the reason for that build is also driven by the fact that it's largely core. And it's the ERP that's helping drive that. What happens with the ERP implementation is we do stop shipping for about 6 to 8 weeks, and that's why we're trying to work through it. And so to your point, 1/3 of the inventory is seasonal. It varies by geography, but the U.S. is more core than seasonal.

Our next question comes from Omar Saad of Evercore.

I wanted to see if you guys could talk about the denim cycle, especially as it relates to your outlook for next quarter? Are you seeing a slowdown, a broader slowdown in the denim cycle? There are other companies out there in the category also seem to see a little bit softer trends at retail. And especially in light of the reopening as people get dressed up again and maybe getting a little bit more dressy again, are you seeing that affect the casualization trend?

Yes. We've referred to some of this in the prepared remarks, Omar, but just to give you some real hard category data and I'm quoting NPD data, on a past 12-month basis -- this is all through the end of August. On a past 12-month basis, the total apparel was up 11%, denim was up 10%. By the way, we were up more than that on a past 12-month basis. And then in the script, we referred to the most recent 3 months through the end of August, so in July, August, where there was a significant slowdown was denim down mid-single digits and total apparel up 1.

While I'm not crazy about those numbers, what is good is if those kind of validate the narrative that has been out there, which is that there has been this transitioning into more formal attire people go back to weddings and back into the office, et cetera, et cetera. And it does -- that data does validate that. And you can put our results up against that, and we outperformed denim and outperformed total apparel, too, during that same 3-month period of time. I don't expect it's going to stay that way for long.

I -- and that data, by the way, is U.S.-only data. The casualization trend, we've talked about this for quite some time. It's no longer just a U.S. trend. It is a global trend on (inaudible). Our business skews to men, men are going back into the office wearing jeans. And we expect that denim is going to recover. I've said many, many times before, we're the market leader, and I believe it's incumbent upon market leaders to drive category growth. And we're going to continue to focus on doing that on the things that are within our control, driving innovation. We're going to continue to focus on innovation and continuing to support the business with strong marketing and marketing support.

And the combination of those things should drive growth. Let's not forget too that weather probably played a factor during this period of time as well. And as the season changes, that's been always pretty favorable. So the last thing I would add is, Harmit referred to it in the script, but we did kind of put out there the September U.S. direct-to-consumer sales, which were up double digits. So I don't think we're going to see the category get back to double-digit levels of growth that we've seen over the last 12 months.

But I do expect that the long-term trend for denim is going to be kind of mid-single-digit levels of growth over the long term. And the shorter the time frame you look at, the more volatility there is in the data. And I suspect over time, we're going to see denim bounce back to kind of that mid-single-digit level over the next few months. So hopefully, that addresses what you're looking for.

Our next question comes from Matthew Boss of JPMorgan. Okay. Our next question comes from Chris Nardone of Bank of America.

Can you discuss expectations for the trajectory of your European business relative to your 3Q results, even looking out to the first half of next year? And are there any particular countries that are showing notable weakness and any difference in how you're thinking about wholesale and DTC in the region? That would be great.

Yes. I would say our cards are on the table here, Chris. We're probably most cautious about the business in Europe as we look ahead. As we talked in the script, we saw some countries in Europe in Q3 performed quite well. Both the U.K. and Spain were up nicely. We also had a number of stronger markets across Europe also perform well, performing up versus prior year on a constant currency basis. But there were other markets that were notably soft, particularly in Germany and some other markets in the north. If you strip out the impact of Russia, Europe was down by mid-single digits, 5% for the quarter.

And as we look ahead, the guidance that we provided does kind of build in some cautiousness, I guess, with respect to Europe. And I suspect we'll see more as the winter begins to hit. What is the impact on the consumer over there as they face much steeper -- not just a much steeper inflation, but much steeper energy costs as well. So the good thing about having such a broad, global portfolio is we've got other markets, as Harmit said, that are performing exceptionally well that can help to offset some of the softness.

The brand is still incredibly strong in Europe, but we're seeing our wholesale customers being cautious to their open buy budget and how they're planning inventory. And we are seeing, as I said, some bifurcation in our business even through the third quarter, and we're kind of playing that through as we think about the future.

Our next question comes from the line of Alex Straton of Morgan Stanley.

Can you just talk about the flexibility your wholesale partners have as it relates to canceling orders if they were to see more of a slowdown? So put differently at this moment can they cancel any of their fourth quarter orders, your fourth quarter, the first quarter or the second quarter and by how much? And also, what kind of support would you guys offer should your retail partners have too much inventory as it kind of builds up in the broader space?

Well, first, I'll answer your last question first. As we said on the call, inventory levels across wholesale, broadly speaking, in the U.S., in particular, are generally in line with where they were pre-pandemic. And so relatively reasonable. Now it does vary from customer to customer. Most customers are kind of on their own after they own the product. They manage their promotion and markdown budget. We support it, but we support it within traditional guidelines so the preparing across the marketplace and are treating all customers equivalently.

In terms of canceling orders, we -- let's say that it's a negotiation at the end of the day. If we've made products specifically for a customer, we hold the line very, very tight. So we do a number of products that are very, very specific to a particular customer. And if we're cutting product and making product for a specific customer, they own it at the end of the day. And we try to hold the line very, very hard on that. If it's a product that is more marketplace product or it's a product that we can put in our outlet stores, then it is a bit more of a negotiation. I hope that helps, Alex.

Our next question comes from Ike Boruchow of Wells Fargo.

So Chip, I just wanted to go back to the prepared remarks and just dig in a little bit more for me. So I think when you're speaking to the business at a high level, the business is being guided to negative constant currency growth in 4Q. I think you said you expect things to remain challenging over the next few quarters. I guess I know you're not going to give us guidance for next year, but can you put some context behind that, how exactly we should think about the business based on the order book or any other visibility you may have right now?

Yes. And by the way, guys, part of the reason I hesitated on that last call, the Blue Engines are in town, and we just got straight a minute ago. So it's crazy. We've got jets right over our heads here. So I guess the way I would characterize the way we're looking ahead, and I talked about this a little bit with respect specifically to Europe. There's just a lot of uncertainty right now. I mean, forecasting during the pandemic was pretty tough. But it's pretty challenging right now to get a pretty good hold on where is the consumer heading and where is the business setting, especially with customers and their open buy budgets.

And that uncertainty is caused by some of the noise and confusion and a lot of the economic signals that we're getting. Inflation is still relatively strong. We may see that begin to change over the next month or couple of months. But we're at or near full employment and wages are growing. Wages are growing across all incomes. Bank accounts are still reasonably healthy, thanks to the pandemic impact, particularly in the middle and upper segments of income. So there's some data that you can look at and say things look pretty good, but there is a ton of uncertainty.

Inflation continues to have more and more of an impact. As I said, in Europe, a lot of concern about what's going to happen during the winter with energy costs, particularly across that marketplace. But as I said, it is more of these Western markets where we're seeing these impacts we have other parts of the business that are performing incredibly well. And even within our own portfolio in the West, our DTC business is performing pretty well. And so our balanced portfolio, the strength that we're seeing in Asia, the strength that we're seeing in Latin America, the strength that we're seeing in our women's business, on Dockers, Beyond Yoga being completely additive at this point. We begin to lap that now.

These are helping to offset some of these speed bumps that we're seeing in other markets. But it is too early to comment on guidance. I can tell you guys, honestly, hand on a Bible, I haven't even seen the numbers as we're developing our plan at this point. But I expect that we will be reflecting kind of the realities as we see it with some of these uncertainties at least through probably the first half of next fiscal year. So I hope that helps, without giving you any specific (inaudible) fact.

Ike. Chip, the only thing I'd build on is from a cost perspective, what we're seeing. So Ike on one hand, we built up inventory as we close the year, but we've built up inventory when cotton was much lower than what it was for the first half of next year. As you -- as we see the future of cotton for the second half, cotton down to a little over $0.80, which is the normalized. So there should be some tailwind there in 2023. The second is some reduction in distribution costs and freight costs as we start thinking through the second half of next year.

And so I think those are the things that probably help. But as Chip said, we are here for the long term, and we'll take that view. You saw our expectations we said in the Investor Day, and so we have a north star that we're working on.

Our next question comes from Laurent Vasilescu of an Exane BNP Paribas.

Chip, I think you mentioned the value channel in the U.S. was down 12%, but then ex that, the U.S. wholesale was actually up mid-single digits for the quarter. How do we think about those guardrails for the fourth quarter. Do they converge? Does the value channel get a little bit better and the rest of the business gets a little bit worse? Any guardrails around that? And then I think you mentioned ex China, Asia was up 68%. I presume, obviously, that was on a C2C basis. Just curious to know what you're seeing in China. I know you have a small business there, but any color on what you're seeing quarter-to-date trends? Would be very helpful.

Yes. The -- why don't you talk, China? I'll just reference, so as we think at 4. And quarter 4 we're saying constant currency slightly down growth and reported down 6%. Just give us 1 second to let the blue engines do their thing. So the FX headwind, very similar to quarter 3, and that's reflected in the difference in cost (inaudible). The change in the constant currency growth in Q3 down to slightly -- down in quarter 4 is driven by really 2 factors. One is Asia has been growing at 50%, 60% is going to start lapping the normalized base.

So we expect Asia to grow in the high teens, but not at this level. So that's one piece. And the second is, as we think about the Americas, a combination of the supply chain disruption, which we think continues into Q4 and begins to improve Q1 onwards as well as U.S. wholesale down versus up. That's how we're building the expectation. We're working like crazy to deliver better numbers, but that's the expectation that we're setting aside. Going to China chip over to you. I think China was down in Q3, 17%, but it's only 2%, 3% of our business. And as we said in Investor Day, we don't expect this business be a major contributor to our growth longer term.

There you go. You just answered it.

Our next question comes from Jay Sole of UBS.

My question is can you elaborate a little bit on the supply chain challenges you experienced in the quarter? And maybe help us understand maybe some of the differences that have played out versus your expectation at the end of last quarter? Maybe you could start there, that would be great.

Jay, overall, what we'd say is all the parts of supply chain are indeed improving. We're still feeling the impacts of disruption. We additionally have some condition within our logistics and distribution network due to inventory build that we did to protect Q1 revenue as well as our ERP transition. With this transaction comes a loss of efficiency in our distribution network. And so we think Q4 will be the peak, and we expect to start improvements in Q1. And to offset this and build -- as I said earlier, we're kind of reducing our H1 by big time.

And so that by the end of quarter 2, inventory levels return back to normal. And the congestion is largely between the ports, the transloader and goods on our distribution center a lot. So we're working through it. And the majority of it is largely in the U.S. And U.S. is primarily a core market. So we're working through that. We're working through the same with our customers, to ensure there's minimal disruption, but it does hurt overall revenue.

Yes. The only thing I would add is you probably heard others about supply chain improving significantly. Their starting point was a lot different than our starting point. Our supply chain issues are kind of in line with the issues that we had last quarter, 2 to 3 points worth of growth left on the table due to supply chain issues. We didn't have the major supply chain issues the way some of our peers did 9 to 12 months ago because our eggs are spread across more baskets than relative to our peers who have so much of their supply chain concentrated in 1 or 2 markets. So the change on change is not as significant for us as it has been for some of the others.

Our next question comes from Dana Telsey of the Telsey Group.

As you think of the current macro environment and what's happening in the channels, how are you thinking of the level of promotion, whether it's by your own DTC, e-commerce or store? What's happening on the wholesale side by region also? And with the offsets on the gross margin side, are there offsets in terms of the magnitude, whether it happens to be freight or whether it happens to be anything else that we should note? How do you see the gross margin cadence evolving?

Yes. So Dana, thanks for the question. Our gross margin -- so when we started the second half of the year, I think we publicly said we've built in probably 100 basis points contraction in gross margin in the second half, similar in Q3, similar in Q4. And that was really saying, okay, what percentage of our products we will be not selling at full price. As the quarter progressed, promotion levels increased. We had some seasonal products. They wanted to markdown in the Western part of the world.

Quarter 3, the gross margin impact was about an additional 30 basis points. And as we look at quarter 4, it's about 30 more because we think the environment is a little bit more promotional, and we've got in some inventory that we'd like to mark down and sell. So that's how we're thinking about it. At the end of the day, our gross margins for the year will be slightly lower than last year, but still significantly higher, maybe close to 400 basis points relative to '19. So we're protecting the premise that we continue to grow our gross margins in the longer term. Does that help you, Dana?

Yes. And as you see your own channels with stores and online, how do you see the cadence there?

So I'll take that one. So let's put it this way, Dana, we're not going to be leading an aggressive promotional environment, but we're not going to be left uncompetitive. Just as we did in the third quarter when we saw that the promotional environment was heating up, we took steps to be competitive. But we're not in a place where we've got to go out and passively liquidate a lot of inventory. So we're not going to lead it. And it's not going to be less uncompetitive.

That may mean -- that may not mean that we're going to go all the way to 70% off if everybody else is going to 70% off. It may mean that we go for fewer weeks, but we'll be competitive, but we're also -- at the end of the day, we are about the strength of our brand and an overly promotional -- hot promotions brand. It's not good for brand integrity. And so we're going to do our best to protect gross margin without being competitive in the marketplace.

And just on marketing, what are your plans for marketing and marketing expense as we go through this time period?

Yes. I probably should have hit this earlier, but whether you're thinking about Q4 or thinking about next year, we're going to continue to invest in the long term. And we're going to continue to make investments in DTC and e-commerce because those are strategic for us, and we're going to continue to invest in building our brands.how tough it jets out there, those are the things that will differentiate. (inaudible)

At this time, I'd like to turn the call back over to Chip Bergh for closing remarks.

Okay. Latif?

Yes, sir.

Okay. Thanks, everyone, for dialing in. And we will talk to you again not until the end of January. So I wish you all happy holidays, a good fall and happy holidays, and we'll speak with you at the end of our fiscal year in late January. Have a good holiday, and thanks for dialing in today, everyone.

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