Bath & Body Works - Q2 2024

Transcript

Operator (participant)

Good morning. My name is Ted, and I will be your conference operator today. At this time, I would like to welcome everyone to the Bath & Body Works second quarter 2023 earnings conference call. Please be advised that today's conference is being recorded. During the question and answer portion, you may ask a question from the phone by pressing star one. I will now turn the call over to Ms. Heather Hollander, Vice President, Investor Relations at Bath & Body Works. Heather, you may begin.

Heather Hollander (VP of Investor Relations)

Thank you. Good morning, welcome to Bath & Body Works second quarter 2023 earnings conference call. Today's call may contain forward-looking statements related to future events and expectations. Please refer to this morning's press release and the risk factors in Bath & Body Works' 2022 Form 10-K for factors that could cause the actual results to differ materially from these forward-looking statements. Today's call contains certain non-GAAP financial measures. Please refer to this morning's press release and supplemental materials for important disclosures regarding such measures, including reconciliations to the most comparable GAAP financial measure. Joining me on the call today are Gina Boswell, Chief Executive Officer; Julie Rosen, President, Retail; and Eva Boratto, Chief Financial Officer. I'll now turn the call over to Gina.

Gina Boswell (CEO)

Thank you, Heather, and good morning, everyone. Thank you for joining us today. Before I discuss our performance and progress in the quarter, I'd like to thank our teams for consistently delivering terrific service to our customers, remaining agile in a dynamic environment, and executing on our strategic initiatives. We're also very pleased to have welcomed Eva Boratto as Bath & Body Works' new CFO at the beginning of this month. She is a seasoned executive with over three decades of financial, operational, and retail experience, and she's already hit the ground running. You'll of course, hear from Eva on today's call. Now, moving on to our second quarter results. Net sales were in line with our expectations, declining 3.6% compared to the prior year.

Adjusted diluted earnings per share of $0.40 were better than planned, with the majority of the outperformance driven by the benefits of our cost optimization initiatives, increased Average Unit Retails, or AURs, and improved merchandise margin. In fact, year-over-year merchandise margin rate increased modestly for the first time in nine quarters. I continue to be very pleased with our team's ability to drive efficiency in the business while building the capabilities to drive future growth.

In the second quarter, we once again showcased our exceptional innovation capabilities with the completed rollout of our new hand soaps, all of which are formulated without parabens, sulfates, and dyes, continued delivery of newness through our Gingham fragrance collection, the addition of grooming to our men's offering, the successful limited launch of our new fragrant haircare line in July, which has received a very positive response from our customers, and finally, the launch of hand soap refill cartons in July, providing our customers with a convenient, sustainable solution. We were also pleased with our Mother's Day results and executed well in our June semi-annual sale, delivering merchandise margin rates above our expectations. From a category perspective in the second quarter, our body care sales increased versus the prior year. Home fragrance and soaps and sanitizers sales declined as expected, driven by post-pandemic normalization.

Importantly, year to date, we've increased unit share across these product categories. As expected, we continue to see some pressure on basket size during the quarter. To be clear, we aren't seeing any trade down in our business, but we've observed that the customer is carefully managing their spending against the backdrop of a challenging macroeconomic environment. As we look ahead to the remainder of the year, we remain focused on delivering innovation and building capabilities to position our company for above-industry growth when our categories normalize. Our revenue is approximately 40% above 2019 levels, and we have diverse opportunities and multiple initiatives designed to deliver long-term top-line growth and margin expansion. We're making progress on the five key areas that I outlined on our last call. First, elevating the brand through innovation and upgrades to our forms, packaging, and merchandising.

Second, extending our reach through adjacencies and international growth. Third, engaging with our customers by fully leveraging the strength of our loyalty program, enhanced technology, and more personalization. Fourth, enabling a seamless omnichannel experience by advancing our digital platforms and connecting them with our stores. Finally, enhancing operational excellence to drive efficiency. Julie will speak to our progress in brand elevation and extending our reach in a moment, but I'd like to dig a little deeper on the other three. Turning to our work to better engage with our customer. We are deepening our connection across the customer journey, building on our history of connecting with the customer through fragrance, outstanding products, and a terrific shopping experience, whether online or in store.

Our customer segmentation analysis identified the customer groups that represent our biggest growth opportunities and has given us a better understanding of their unique needs and motivations. These insights are now informing our innovation, merchandising, and marketing, and enabling us to be more effective and efficient in reaching our target customer segments. We're also building our technology capabilities to implement a more personalized, targeted approach to marketing and promotions rooted in data and analytics. Through this work, we plan to increase trial of new product, encourage cross-channel and cross-category shopping, build a customer's basket, and drive incremental trips. Now that we have successfully completed the vast majority of our IT separation from Victoria's Secret, we will begin testing personalized marketing and optimized promotions this fall, then apply these capabilities more broadly and derive more value from them beginning next year.

Our loyalty program continues to be a key component of customer engagement. This August, we anniversary the national launch of our loyalty program, we remain pleased with our enrollment of nearly 38 million members, with loyalty sales representing approximately three-quarters of our U.S. sales since launch. While we'll continue to build on up on our impressive enrollment, our primary focus is on increasing engagement. For example, in the second quarter, we not only invited our loyalty members to vote for the featured fragrances in our laundry product, we then gave them exclusive access to a preview sample event. Next, we gave our loyalty members a sneak preview of our Halloween collection and an exclusive early Halloween shopping event prior to the national launch. We have more benefits planned, and we're excited to test new capabilities, such as accelerators, in the third quarter.

Beyond that, we're focused on fully integrating our loyalty experience throughout our channels. We are still in the early innings of our loyalty program, and we are confident in our ability to drive more sales and improve merchandise margin while attracting more customers to the program. Moving to the next area of focus, which is enabling a seamless omni-channel experience. Although we have a strong, profitable digital business, our digital assets are largely transactional. As we move to more experiential integrated platforms, we plan to drive higher sales, more discovery, and larger baskets through personalized landing pages, immersive content, and product recommendations. In the second quarter, we introduced personalized recommendations on our website and mobile app. This month, we'll begin to deliver personalized email content.

Later in the third quarter, we plan to test immersive video content on our website and mobile app, with a broader launch planned for the fourth quarter. As you know, we completed our national rollout of buy online, pickup in store, or BOPUS, in the first quarter. BOPUS orders increased 25% in the second quarter as customers are increasingly choosing this convenient option. Approximately 30% of BOPUS customers made an additional purchase in store when they picked up their order, which is a testament to the power of the outstanding in-store experience delivered by our talented associates, iconic fragrances, and compelling assortment. Delivering a seamless omni-channel experience will allow us to convert more single-channel customers to dual-channel customers, which on average, increases spend threefold. Finally, we are enhancing operational excellence and efficiency through $200 million of planned annual cost savings across the company.

We are on track to deliver approximately $150 million of those savings in 2023. Eva will share additional details on our plans for the second half of the year shortly. Eva will also provide an update to our fiscal 2023 guidance, which reflects our bottom line outperformance in the second quarter and sales expectations for the second half of the year. As I touched on earlier, the customer has been cautious in managing their spending amidst a softer macroeconomic backdrop. They are still responding to newness, innovation, and our compelling seasonal events. We are taking action to deliver innovation and build the capabilities that will allow us to better serve our customers, drive above-industry growth, and deliver margin expansion.

Bath & Body Works has a highly differentiated business model positioned at the intersection of consumer goods and retail, and a strong fleet of profitable stores, both off-mall and in-mall, that position us close to the customer. We have a vertically integrated supply chain, which allows us to respond quickly to changing customer and macro trends, along with a strong balance sheet and a history of superior growth and free cash flow generation. As we navigate macroeconomic pressures, I am confident that we have a diverse set of opportunities to profitably grow the business and create value for our shareholders, building on the strong foundation that exists today. With that, I'll turn the call over to Julie.

Julie Rosen (President, Retail)

Thank you, Gina. We started the second quarter with a strong Mother's Day, delivering newness with our Gingham olfactory collection and a strong gifting assortment. As you know, our vertically integrated supply chain allows us to read and react to trends quickly, and we leveraged this capability as we chased winners and delivered additional inventory to meet customer demand. As Gina mentioned, we executed well in our June Semi-Annual Sale, and we're pleased to deliver merchandise margin rates above our expectations. We were very intentional in structuring this year's event to drive early interest by offering compelling price points on sale products and introducing full price, new summer season products alongside the event. We took fewer markdowns over the course of the event and delivered better-than-expected merchandise margin rates.

Turning to category performance, second quarter body care sales increased slightly versus last year, a sequential improvement from the first quarter. Body care was propelled by growth in fine fragrance mist, travel, as well as our men's business, which posted a double-digit sales increase this quarter and remains one of our fastest-growing product lines as we add new forms and merchandising ideas. At the beginning of the quarter, we launched men's grooming, which performed well and exceeded our expectations. We're very excited about the growth of our men's business, as it is bringing in new customers to our brand and also garnering the attention of younger customers. The home fragrance and soaps and sanitizers categories both declined versus last year, as expected, driven by continued industry-wide post-pandemic normalization trends, which we have discussed previously.

Sales for the home fragrance and soaps and sanitizers categories collectively represent just over half of our business. We remain market leaders in these categories and have gained unit share year-to-date, even as the categories experience pressure at the industry level. We remain focused on innovating and positioning for future growth in these categories. For example, Wallflowers once again outperformed candles as customers are spending less time at home. We're leaning into the demand by increasing our assortment of scent control Wallflower heaters and offering decorative innovations, such as the projection Wallflowers in our Halloween collection, which illuminate and project festive images. Turning to our strategic initiatives, as Gina mentioned, I'll provide some detail on how we're making progress in elevating our brand and extending our reach to accelerate growth. This quarter, we continued to deliver innovation in product and merchandising.

This was visible in our refreshed core hand soap offering, including the completed rollout of our new formulation made without parabens, sulfates, or dyes. Additionally, we have rolled out foaming hand soap refills in recyclable paper cartons to all U.S. stores, allowing customers to conveniently refill their soap containers and minimize waste. Beyond soap, we're innovating and elevating our product and packaging while staying true to the brand heritage. For example, this month, we brought back fan favorite, Coco Shea and Water, in new and elevated packaging and formulation. We also added a sensitive skin product with colloidal oatmeal. This ingredient-led collection is an expansion of our wellness category and intended to provide the additional moisture, hydration, and sensitive skin solutions that our customers are seeking.

Within merchandising, we're evolving our storytelling to broader, inspirational brand storytelling, including recommendations for selecting and using the product, as well as creating the perfect gift. We demonstrated elements of this within our Gingham offering, which was designed to be an immersive shopping experience. This included new fragrances in Gorgeous, Fresh, vibrant, and Gingham Legend for men across multiple forms, as well as front-of-store and digital takeovers and beautiful gifting options. As we work to extend our reach, we're leveraging our core strengths in fragrance and innovation to expand into adjacent categories, including fragrant hair care, men's, wellness, and laundry. We're also building on the success of our international business. As I mentioned, this quarter, we expanded our men's product portfolio to include grooming. The first stage of our expansion focused on face and beard care and launched in the advance of Father's Day.

In September, we are expanding into men's hair and shaving. As part of our ongoing innovation cycle, we tested fragrant hair care products last summer, and we're very pleased with the customer response to our fragrance-led positioning. In the second quarter, we launched hair care in approximately 560 stores and online, with shampoo and conditioner in five of our signature scents and dry shampoo in three. The launch has exceeded our expectations, and we plan to complete the rollout to all U.S. stores next spring. This month, we're excited to elevate the mundane with the launch of our laundry line, including many of our best-selling fragrances across a limited number of stores and online.

Initial customer feedback from our preview sample event has been very positive, with customers noting that our laundry detergent is an exciting new way to add another layer of their favorite scent to their daily routine. As we work to broaden our customer base and attract the younger customer, we know that lip products represent an important opportunity. Therefore, we're upgrading, expanding, and relaunching our in-store assortment and visual presentation of our lip products across a limited number of stores this fall, with additional expansion to follow early next year. With the addition of fragrant hair care, laundry, and lip, we are now able to offer our iconic fragrances across as many as 22 product forms.

We are also committed to extending our reach geographically and continue to evaluate opportunities to build on the success of our international business and drive significant growth through further market expansion, new stores, and digital growth with our partnership-based model. As we look ahead to the third quarter, we are very excited about the launch of Halloween. We launched Halloween one week later this year to better align with the customer mindset. For the first time, we are placing this assortment at the front of our stores to give it additional prominence, and we're expanding our most-loved scents, such as Vampire Blood, across categories. For our fall assortment and scents, we've listened to the customers and are bringing back our iconic fall scents, such as Leaves and Pumpkin Pecan Waffles, in new and elevated packaging.

For Hispanic Heritage Month, we are featuring a perfumer series celebrating Patricia Bilodeau and her long-standing contribution to our fragrance portfolio, including customer favorite, Strawberry Pound Cake. Bath & Body Works is an outstanding, beloved brand, and we are excited about what's ahead as we continue to deliver new, compelling products and capitalize on opportunities for profitable global expansion. In closing, I'd like to thank our teams for their dedication to delivering industry-leading innovation and service and delighting our customers. With that, I'll turn it over to Eva.

Eva Boratto (CFO)

Thank you, Julie, and good morning, everyone. I'm excited to join you today and honored to be part of this outstanding company. Over the past several weeks, I've spent my time immersing in the business while engaging with the executive leadership and finance team. I've also had the opportunity to participate in the financial planning process and observe the progress the teams have made on the company's strategic initiatives. The last few weeks have reinforced my belief that Bath & Body Works is on the right path to capitalize on the tremendous opportunities ahead and create significant long-term value for shareholders. Today, I'll start by reviewing our second quarter financial results, then I'll provide an overview of our guidance for the third quarter and fiscal year 2023.

Starting with the second quarter results, we generated adjusted diluted earnings per share of $0.40, exceeding our guidance range of $0.27-$0.32 per diluted share. Our adjusted results exclude the gain on the early extinguishment of debt associated with the debt repurchases in the second quarter. We were pleased with our second quarter operational outperformance, resulting from the benefits of our cost optimization initiative, increased AURs, and improved merchandise margin. EPS also benefited from interest expense favorability, in part associated with the repurchase and retirement of debt in the second quarter, and tax rate favorability, resulting from the resolution of certain discrete tax matters related to the Victoria's Secret spin-off. Net sales for the second quarter were $1.6 billion, in line with our expectations. The year-over-year decline of 3.6% was driven by a decrease in both transactions and average dollar sale.

In U.S. and Canadian stores, second quarter sales totaled $1.1 billion, a decrease of 1% versus the prior year. Second quarter direct sales of $329 million decreased 10% compared to last year. Adjusted for BOPIS, direct demand decreased 6% in the second quarter. As a reminder, BOPIS sales are recognized as store sales, and we completed the BOPIS rollout to U.S. stores in the first quarter. International sales were $86 million and declined 4% versus last year. Note, on a year-to-date basis, international sales increased 4%. There are two components to our international net sales: royalties collected off franchise retail sales and wholesale revenue generated by the product we sell to our franchise partners.

While wholesale revenue declined in the second quarter due to lower orders and shipments, total international system-wide retail sales posted a double-digit increase, propelled by new store openings and strong sales for the June Semi-Annual Sale event. Our guidance for the back half of the year assumes that our international net sales return to growth. Our gross profit rate for the second quarter decreased by 90 basis points compared to prior year Q2, representing a year-over-year sequential improvement of 255 basis points from the first quarter. Merchandise margin rate improved modestly year-over-year for the first time in nine quarters. This improvement was driven by deflation benefit, increased AUR, and reduced transportation costs, partially offset by continued investment in product formulations and packaging innovation.

Improvements in merchandise margin were offset by buying and occupancy expense deleverage, primarily due to lower sales and increased occupancy expense from new store sales growth-- sales. Total SG&A deleveraged by 200 basis points, representing a year-over-year sequential improvement of 90 basis points from the first quarter. Technology expense was the biggest driver of deleverage, reflecting our IT separation costs, as well as strategic investments to drive future growth. As expected, we partially mitigated the impact of technology investments with our cost optimization work, which produced efficiency in store labor hours and home office expense. All said, our cost optimization work produced benefits of approximately $30 million in the quarter across gross profit and SG&A. Second quarter total company operating income was $188 million, or 12% of net sales.

Turning to the balance sheet, we repurchased $115 million senior notes principal for $106 million in the quarter. We remained focused on disciplined inventory management and ended the second quarter with total inventory dollars down 16% compared to last year. Heading into the second half of the year, our inventory levels are well positioned. Our overall real estate portfolio remains very healthy, with 99% of the fleet profitable and stores significantly outperforming pre-pandemic levels. In the second quarter, we continued to increase our off-mall penetration, opening 30 new off-mall North American stores and permanently closing 17 stores, principally in malls. Our international business, our partners opened 16 new stores in the second quarter, ending the quarter with 444 stores. Turning to our fiscal 2023 guidance, we are providing our 2023 guidance with comparisons to 2022.

As a reminder, fiscal 2023 includes a 53rd week, so the 4th quarter of fiscal 2023 will consist of 14 weeks. The impact of the 53rd week reflected in our guidance is estimated at $0.07 per diluted share, and our guidance excludes the impact of any further debt or share repurchase activity. With that as context, we are updating our fiscal year guidance to reflect Q2 performance, narrowing our sales range, raising our gross profit expectations, and factoring in the benefits of the debt and share repurchases through the 2nd quarter, resulting in an increase to our EPS guidance. Let me provide some additional color on these changes. For the full year, we now expect sales declines of 1.5%-3.5%, reflecting our year-to-date performance, continued macroeconomic uncertainty, judicious consumer spending, and post-pandemic category normalization across the industry.

For the first 2 quarters of the year, our sales were in line with the midpoint of our projections. Factoring in year-to-date performance and improved visibility, we are narrowing our sales range around the midpoint of our prior guidance. The company is very adept at quickly reading and responding to changing business trends. We plan to leverage that agility to chase demand and maximize sales. We are enhancing our operational excellence and efficiency and plan to deliver approximately $100 million in cost savings in the second half of the year. Approximately 30% of the savings are related to reduced transportation expense, with the remainder reflecting other benefits of our program. Including efficiency in store labor and selling productivity as we better align staffing hours to traffic, reduced expense as we optimize our call center, home office expense efficiency, and decreased indirect spend.

Gross margin exceeded our expectations in the first half of the year. We are now raising our forecast for the full year gross margin rate to approximately 43%. We continue to expect year-over-year merchandise margin rate to improve in the second half of the year, supported by greater deflation benefits and efficiency produced from our cost optimization work. These benefits are partially offset by investments in formulation and packaging upgrades to reinforce our competitive position. Overall, we expect merchandise margin rate to expand by approximately 100 basis points in the second half of the year versus prior year, resulting in improved merchandise margin rate for the full year.

We still expect buying and occupancy expense to deleverage for the year, driven by sales levels and increased expense from new store growth, with less deleverage for the remainder of the year as our new direct-to-consumer fulfillment center ramps. Our guidance still assumes a full-year SG&A rate of approximately 26%, with deleverage driven by lower sales levels, technology expense, and increased store wage rates, partially offset by the expected benefits of our cost optimization work. We now expect full-year adjusted net non-operating expense of approximately $295 million, reflecting interest expense favorability from debt repurchases through the end of the second quarter. We still expect an effective tax rate of approximately 26% and weighted average diluted shares outstanding of approximately 230 million.

For the fiscal year 2023, we are increasing our adjusted earnings per diluted share guidance range to $2.80-$3.10. We continue to plan for $300 million-$350 million of capital expenditures in 2023. We now expect to generate free cash flows of $675 million-$725 million in fiscal 2023. Turning to our third quarter 2023 outlook, we are forecasting sales declines of 2.5%-4% versus the prior year. We expect gross profit rate of approximately 42% and SG&A rate of approximately 31% of sales. We expect net non-operating expense of approximately $75 million and a tax rate of approximately 26%, and weighted average diluted shares outstanding of approximately 229 million.

Considering all these factors, we are forecasting third quarter earnings per diluted share of $0.30-$0.40. Looking now at our capital allocation, our first priority is investing in the business to drive profitable growth. We are also committed to returning cash to shareholders. In the first six months of the year, we paid $92 million in dividends, and we plan to continue paying an annual dividend of $0.80 per share, with an intention to increase the dividend over time as earnings increase. In the second quarter, we also repurchased 1.3 million shares for $50 million in the open market. In addition to returning cash to shareholders, we are committed to returning to our target leverage ratio of approximately 2.5 times gross adjusted debt to EBITDA over time.

We ended 2022 with a leverage ratio of 3.1 times. Through the second quarter of the year, we have repurchased $199 million principal amount of our senior notes in the open market. We will continue to take a balanced approach to capital allocation, considering options such as additional debt and share repurchases. In conclusion, I'm excited about the future of our business. We're focused on taking the necessary actions to drive profitable growth and generate value for all stakeholders. At this time, we'd be happy to take your questions. I'll turn it over to Heather for Q&A.

Heather Hollander (VP of Investor Relations)

Thanks, Eva. For our Q&A session, we ask that participants limit their responses to one question and one follow-up. We'll now move to the Q&A session. Operator?

Operator (participant)

Yes, the phone lines are now open for questions. If you would like to ask a question over the phone, please press star one and record your name. If you'd like to withdraw your question, press star two. The first question in the queue is from Kate McShane with Goldman Sachs. Your line is open.

Kate McShane (Managing Director)

Hi, good morning. Thanks for taking our question. It was really encouraging to see that you grew AURs in the quarter. We wondered if you could talk to us a little bit more about this and what role it plays in your updated guidance today?

Julie Rosen (President, Retail)

Yes, from an AUR perspective. This is Julie, by the way. Thank you for the question. We actually, as you know, Semi-Aannual Sale plays a huge role in our Q2, we took a very balanced approach to driving sales and improving merchandise margins. Our Semi-Annual Sales event sales were below last year's event, in line with our expectations. We executed well. We offered compelling price points on sale products, while also introducing full-price, new summer season products alongside the event. The customers responded very favorably to our event. They continued to carefully manage their spending in light of macroeconomic conditions, which had an adverse effect on the impact of the number of items added to the basket. Ultimately, we took fewer markdowns over the course of the event and delivered better than expected merchandise margin rates.

I would also say that AUR increased slightly this quarter and remains significantly elevated since 2019. As a note on pricing, we have taken price increases in spring 2023. We've created more differentiated assortments to drive pricing power. As a reminder, our AUR has increased slightly this quarter, but significantly compared to 2019, and we do have a long track record of AUR growth in the positive low single-digit levels prior to the pandemic.

Eva Boratto (CFO)

Julie, if I could just add, as it pertains to our guidance, we are assuming flat AURs in the back half of the year, and we'll continue to test for opportunities to increase AURs, as Julie has just explained, and expand margin through more data-driven, targeted marketing efforts.

Kate McShane (Managing Director)

Thank you. Then if we could just follow up with a question on the candles, soaps, and sanitizers. Can you talk about what that category looks like on a stack or versus 2019, and just how it performed also versus Q1?

Julie Rosen (President, Retail)

Yes, thank you for that question. Though the home fragrance and soaps and sanitizers categories are normalizing post-pandemic, we have gained unit share year to date. We are a market leader in these categories and plan to build on that position. We do continue to innovate and position for growth in these categories. For example, Wallflowers, as I mentioned, continue to outperform, so we're leaning into that demand.

... We also recently refreshed our core soap offering, including the completed rollout of our new formulation, made without paraben, sulfates and dyes, and additionally, rolled out our foaming hand soaps in recyclable cartons. We are absolutely focused on our core businesses and innovating in them to drive growth. To 2019, all categories are up significantly in the double digits, so no category is below.

Heather Hollander (VP of Investor Relations)

All right. Thanks, Kate. We'll take the next question, please.

Operator (participant)

Next question in the queue is from Alex Straton with Morgan Stanley. Your line is open.

Alex Straton (Equity Research Analyst)

Great. Thanks so much for taking the question. I've, I've got two for you, one on guidance and then one on the longer-term outlook. On guidance, it, it seems like the full year update implies a deceleration in quarter-over-quarter growth in the fourth quarter, and I think a little bit lower sales than prior. What's driving that more conservative view on the fourth quarter? Secondly, on the long term, I know you guys have that 20% EBIT margin target out there. What do you view as the key factors holding you below that rate right now? How do you think about the timeline to getting back to that goal in the future? Thanks a lot.

Eva Boratto (CFO)

Alex, this is Eva. I'll start with your question as it pertains to the Q4 guidance. As you look at our back half of the year guidance first, right, and our full year guidance, what we've done is we've narrowed our sales range to the midpoint of what we had previously provided. That really reflects our performance that we've seen in the first two quarters that were in line with our performance. It also reflects the cautious consumer. While we haven't seen trade downs in our business, we are seeing the consumer be more thoughtful at the overall basket size. As we have this visibility, you know, there's a lot of macro uncertainty. That's how we thought about the top line in the back half of the year.

Gina Boswell (CEO)

As it relates... It's Gina, as it relates to your question around the 20% operating income margin long term, you know, there's a few things we, we feel very comfortable that as a long-term target, that's the right one. 20% is the best-in-class operating income rate for our sector, and we don't wanna limit ourselves to 20%, but we do think that that number, over time, best balances the investment in the business, you know, to drive future growth while, while maximizing shareholder return. I mean, clearly, in the last couple of years, there have been, you know, step function increases in input costs and labor and certain parts of our business, like technology. They require additional investments to fuel our growth, and those are very important as we evolve our marketing program, our loyalty, and our omni-channel.

I'm, I'm pleased with, with the, with the track that we're have on our initiatives. I'm pleased with what we expect in terms of margin recovery and a very disciplined approach to expenses, so very comfortable with that.

Alex Straton (Equity Research Analyst)

Thanks a lot.

Eva Boratto (CFO)

All right, thanks, thanks, Alex. We'll take the next question.

Operator (participant)

Next question is from Ike Boruchow with Wells Fargo. Your line is open.

Ike Boruchow (Managing Director and Senior Analyst in Retailing, Specialty Softlines and E- commerce)

Hey, good morning, everyone. I guess I wanted to ask a question around costs and your AUC more so into next year. Can you comment about some of your key raw materials, primarily soy, what those costs look like today, how they should flow into the P&L come next year? Just curious for some high-level thoughts over the next 12 months there. Thanks.

Eva Boratto (CFO)

Hi, Ike. This is Eva Boratto. From a deflation perspective, we experienced about $20 million of deflation in the Q2, and we expect $30 million in Q3. We expect that benefit to increase throughout the remainder of this year. As you look at raw materials, I'll just add a few comments. Overall, we did see most prices peak in 2022 with expected deflation in 2023. Wax has been an outlier with significant price volatility up and down year to date. We saw a spike in soy over the past 60 days, with some concerns over dry weather impacting the crop. We've seen an impact being smoothed via commodity risk mitigation processes, and I think they're the key things that I would highlight.

I think it's premature to comment on what we expect in 2024, and we'll certainly come back, as, as we're ready to provide our 2024 outlook.

Ike Boruchow (Managing Director and Senior Analyst in Retailing, Specialty Softlines and E- commerce)

Great. Thank you.

Eva Boratto (CFO)

All right. Thanks, Ike. Next question, please.

Operator (participant)

Next question is from Dana Telsey with the Telsey Group. Your line is open.

Dana Telsey (CEO and Chief Research Officer)

Hi, good morning, everyone. As you think about the new products that you're introducing, Julie, and what the gross margins could look like on some of the new products, is there any difference from the core gross margin to the business overall? The loyalty members, any more color on the loyalty members and their acceptance of the new products, and what statistics you're looking to hit for loyalty members by the end of the year? Just lastly, on the off-mall stores, anything you're seeing at all in terms of productivity rates, anything with what we've heard with organized crime and shrink and what you're doing? Thank you.

Julie Rosen (President, Retail)

Thanks. Thanks, Dana. Nice to, nice to hear your voice. Starting with the new products, we have launched a lot of adjacencies that we are starting to test, optimize, and roll. I just want to review them very quickly, and then I'll talk to your margin question about them. In men's, as you know, in the second quarter, we successfully launched men's grooming, and in September, we're following with men's hair and shave. We continue to focus on APDO, as it is the number 1 form in the men's market. Men's continues to be our fastest growing category in body care. The men's margin is commensurate with the shop, so we're very excited about that.

Fragrant hair care in the second quarter was launched to 560 stores and online in July. The launch has exceeded our expectations, and we expect to complete that rollout to all stores next spring. We also have lips. As we work to broaden our customer base and attract a younger customer, we're upgrading, we're expanding, and we're relaunching our in-store assortment and visual presentation of our lip products across a limited number of stores in the third quarter. Additional expansion will happen next year. Then finally, of course, there's laundry, which we are very excited about to be launching this month across a limited number of stores and online.

Initial customer feedback from our preview sample event has been very positive, with customers noting that our laundry detergent is an exciting way to add another layer of their favorite scent to their daily routine. Some of those adjacencies are commensurate with shop from a margin perspective. Others are not quite there yet, but we have a long-standing history here at Bath & Body Works, as you've, as you've seen with Wallflowers and 3-Wick Candle over the years, that with scale, we have no doubt that we will get there. I will skip to the shrink question, if that's okay, and then I will have Gina come back to your loyalty question, if that works. As is the case with other retailers, we have seen external pressures adversely impacting our shrink rates, and it has gotten worse this year.

That being said, the impact has been factored into our guidance, and we are working with our stores, with government and community partners to achieve lower loss rates over time. I'll let Gina talk to loyalty.

Gina Boswell (CEO)

Thank you. Loyalty, is, is, as you know, we're very proud of, one of the best rollouts in Bath & Body Works history in terms of the enrollment fees, you know, among the fastest in the industry. We're very pleased with the enrollment to date. As I mentioned, we, we are early stages of deriving the value from the program, but some of the things that Julie had mentioned in terms of the previews, that we've used, whether it's the laundry or the sneak preview of Halloween, we absolutely use the loyalty platform in ways to build the excitement around some of the launches. We will continue to do that.

The benefits that we have planned going forward on new capabilities like accelerators, which you may have seen in other programs, that's happening in the third quarter, so that's sort of on the come. Then actually, this month, we have our first annual member appreciation event because we're celebrating the one-year anniversary. So you'll be seeing a lot of surprise and delight, product drops. You'll see first looks, exclusive offers to reward our loyal customers. So lots going on in loyalty, and with the 38 million members strong, that's a lot to work with. So we're excited on, on the go-forward there. I think you may have had a question around off-mall as well, on, on, you know, and actually, we're quite pleased.

Dana Telsey (CEO and Chief Research Officer)

Julie can chime back in, but we're quite pleased with the traffic, both in-mall and off-mall. The off-mall sales performance exceeds the in-mall, but the traffics are actually quite good. Julie, did you want to add anything about in-mall?

Julie Rosen (President, Retail)

No, I think, I think that you have absolutely answered that question. We do have opportunities with new stores as they continue to, you know, drive a great return for us.

Dana Telsey (CEO and Chief Research Officer)

Thank you.

Julie Rosen (President, Retail)

All right. Thanks, Dana.

Heather Hollander (VP of Investor Relations)

Thank you. Next question, please.

Operator (participant)

Next question is from Matthew Boss with JPMorgan. Your line is open.

Matthew Boss (Managing Director and Senior Equity Analyst)

Gina, could you speak to categories of relative improvement that you saw throughout the second quarter? Maybe as you just assess the performance of some of the new category launches and early feedback, maybe relative to the normalization curve that you spoke to around candles and soaps and sanitizers, just trying to put together or maybe bridge the path forward, any way to think about a timeline to return to low to mid single digit, same-store sales and, and the multiyear, long-term target?

Gina Boswell (CEO)

Sure. We, we could talk to normalization, as well. Julie, you might want to start with the home fragrance and scent.

Julie Rosen (President, Retail)

I, I actually, why don't I talk to you about category performance relative to overall performance, just to give you a gauge of what's happening in our business, and then talk to you about how we're thinking about the back half. Body care was our top-performing category this quarter, and with positive sales propelled by fine fragrance mist, travel, and double-digit growth in the men's business. I think the exciting thing about fine fragrance mist is, you know, we just came out of Mother's Day, and that is what we hoped to sell during Mother's Day. Our home fragrance performed below the shop, with declines driven by pressure in candles, as was expected. We know this is an industry-wide trend as the category continues to normalize post-pandemic.

Wallflowers performed above the shop and better than candles, because we are seeing people fragrance their homes in different ways. I do want to mention we are still the market leader in this category, and we continue to gain unit share in versus mass, even as the category experiences broader pressure. From a soaps and sanitizers perspective, just tearing those apart, I just want you to know that soaps performed in line with shop. We completed our rollout, as I said, of our new formulations, as well as our new foaming hand soap refills. It was sanitizers that performed well below shop as that category continues to normalize. This is a broader industry issue, and we continue to gain unit share versus mass in both soaps and sanitizers.

Our back half is really assuming similar trends, and we're not really speaking to 2024 right now, Matt.

Gina Boswell (CEO)

Yeah, Matt, thank you for the question. I was only gonna say that we're not speaking to 2024. We did see normalization. We have baked in continued normalization into the back half of the year, and as well as the, you know, the macro pressures, too. Our intent and our strategies that we undertake are absolutely building the capabilities to build above industry growth going forward. We're pleased with gaining unit share in the categories that we have as they decline. Quite frankly, we're leaning into some of the pandemic trends that we believe will endure, right? So there's areas like wellness and self-care. you know, we can have categories contract, but we can take our fair share or more, and then, you know, hang on to the ones that sort of we can grow further from there.

Given our track record, you know, I feel comfortable that we'll continue to do that, gaining market share and building the capabilities for future growth so that when our categories normalize and our macroeconomic backdrop improves, we will have the customer. They're frequent, as you know, they come in, they replenish, and that's why, you know, from a personal perspective, I think unit share is a wonderful way to measure our performance.

Matthew Boss (Managing Director and Senior Equity Analyst)

Helpful color. Best of luck.

Gina Boswell (CEO)

Thank you. Thank you.

Heather Hollander (VP of Investor Relations)

Thanks, Matt. Next question, please.

Operator (participant)

Yes, the next question is from Lorraine Hutchinson with Bank of America. Your line is open.

Lorraine Hutchinson (Senior Retail Analyst)

Thank you. Good morning. The new guidance implies a nice year-over-year improvement in the fourth quarter gross margin. Can you talk about your expectations for the promotional environment over Holiday and also the sustainability of these gains into next year? Thank you.

Julie Rosen (President, Retail)

Hi, Lorraine, it's Julie. From a promotional perspective, we are actually looking at promotions being in line with last year. As you know and have seen, we are incredibly, incredibly agile in our promos. When we need to add something in, we do, and when we need to pull something out, we do. We, we see it actually in line.

Eva Boratto (CFO)

Lorraine, this is, this is Eva. I'll, I'll add a little more color on the back half of, of the year trends and sequentially Q3, Q4, how we're looking at things. As you look at the back half of the year, as you mentioned, you know, we, we're seeing margin improvement, and that's coming from a few places. One, our Q3 and Q4 merch margin, those quarters, we expect to improve 100 basis points versus LY, due to our continued efforts around supply as well as, as well as price. We are also getting a benefit as our B&O deleverage improves, particularly in Q4. It's a greater impact in Q4. Obviously, we get the ramp of the sales line, but also the ramp of our new customer fulfillment center as that ramps through, through the period.

Finally, I'll, I'll say our SG&A deleverage improves in the back half and sequentially Q3 to Q4. A sales increase, greater impact from our cost optimization. Q3 has cost elevated costs related to staffing and the seasonality of our business that we experience each, each year. Hopefully, that provides you some additional color there. In terms of durability, while we're not commenting to 2024 here today, right? From our cost initiative, we continue to target $200 million of annual cost savings, and we'll continue to strive to achieve more. We are focused on our margins, reducing costs, but also driving the, the top line.

Lorraine Hutchinson (Senior Retail Analyst)

Thank you.

Heather Hollander (VP of Investor Relations)

Thanks, Lorraine. We're ready for the next question, please.

Operator (participant)

Next question is from Adrienne Yih with Barclays. Your line is open.

Adrienne Yih (Managing Director and Senior Analyst)

Great. Congratulations on the progress. Very nice to see the merch margins. I guess I'll start there with the merch margin. First time it's up in 9 quarters. Can you talk about Eva, I think this is for you. Can you talk about that merchandise margin relative to pre-pandemic? Gina, I'd really like to see the new packaging and the elevation in Julie as well. Can you talk about sort of, you know, how you think about weaning the business off of some of these promos that kind of come out, you know, semiannual, et cetera, as you make your way toward kind of a more elevated product in particular categories, and how you think about price, you know, further price appreciation or price taking in that higher elevated category? Thank you very much.

Eva Boratto (CFO)

... Yeah, I'll start, Adrienne, with the merch margin since pre-pandemic. It is still down slight, slightly from pre-pandemic, given, given the inflation that we've experienced over the last couple of years.

Gina Boswell (CEO)

Yeah. Your question around when can we expect... I mean, I think everybody's clear on our strategies around how we elevate the brand and the product and the way we have been, and I think Julie explained well, in terms of what we did with Semi-Annual Ssale, right? To sort of have the, you know, the, the prices sort of adjust and so that we can eke out the merch margin that we had. I think what from a longer-term point of view, and it's not so long term because we're building those capabilities as we speak, is how do we move from broad-based promotions into more personalized? That has been something that we are now doing because we have successfully completed the vast majority of our separation from Victoria's Secret.

With that, in the rearview mirror, we've been putting tests in place. As an example, we introduced some personalized recommendations to our website and our mobile app, and it was a small initial test, but we see the conversion rates, you know, people engaging with personalized content, to a greater degree. That is the toolkit really to start targeting our promotions more effectively, driving efficiency there. We'll start to see those, you know, for sure, and, you know, in the quarters that follow. We're testing that right now. Beyond that, you know, the way we, you know, read, react, respond as it relates to where the customer is at is really a strength of this organization. Wherever we can get, Average Unit Retails without impacting...

You know, we basically have an analytical approach to drive elasticities like I've never seen, a very real-time dynamics here. I think when we have both testing as well as, you know, week to week, where is everybody at, we can drive the merch margin.

Julie Rosen (President, Retail)

Yeah, just one final point on that is just, you know, promos will, you know, still be a traffic driver for our business. I do believe, as Gina said, by sharpening our approach with the right technology in place, we're gonna really leverage that data and analytics to deliver that more personalized, targeted messages to our customer. What the hope is, and what we know will happen, is that we'll increase trips, spend, and engagement while reducing our reliance on those broad-based promotions.

Adrienne Yih (Managing Director and Senior Analyst)

Fantastic. Great to see the progress.

Julie Rosen (President, Retail)

Thank you.

Heather Hollander (VP of Investor Relations)

Thank you. Operator, we have time for one more question, please.

Operator (participant)

Okay, the last question is from Olivia Tong with Raymond James. Your line is open.

Olivia Tong (Managing Director)

Great. Thanks, and good morning. Wanted to ask you 2 questions. First, about trends exiting the quarter, your view in terms of back to school. You mentioned in, in earlier remarks, your expectation for flat AUR in second half. If you could talk about what's driving that, given that it had improved in Q2, you know, and if, if that, you know, maybe factoring in student loan repayment is a piece of that. Then I also wanted to touch on your approach relative to the core in terms of the new categories, whether it's bringing in any new customers or expanding the share of wallet with existing, just, you know, where that consumer is coming from. Thanks so much.

Eva Boratto (CFO)

Sure. Hi, Olivia. This is Eva. I'll start with trends exiting the quarter. Sitting here today, as we look at our August performance for the first half of the month, it's right in line with the expectations that we provided today. If your question was more asking about second quarter, our second quarter sales, normalizing for timing of events that we have, performed right in line with our expectations. You know, there were no trends month to month to call out.

Julie Rosen (President, Retail)

As far as customers go, Olivia, we do know from the data that men's is bringing in new customers and more customers who identify as male, and those customers also skew younger. We know that from our data. The other thing we are starting to see, but these are early stages, is that our lip product is also engaging a younger customer. As we roll out hair and laundry and lip and continue to test, optimize and, you know, work with men's, we will grab the data and continue to let you know how we are tracking.

Gina Boswell (CEO)

Yeah, I, I was simply gonna say, you mentioned the magic word for me, which is it is really about the core and more. As much as we talk about how the customer develops around, you know, in reaction to lip or men's and younger and more diverse, there are certainly opportunities, and our customer segmentation work is, is indicating that. The core, the core categories, are also supportive of a customer expansion, and we think there's, there's equal amounts there that we can glean.

Eva Boratto (CFO)

You had one additional question for me about, about flat AURs in the guidance. You're correct. We are assuming flat AURs in the back half of the year, and we will continue to test for opportunities to increase the AUR and expand margin through data-driven initiatives, targeted marketing efforts, et cetera. Flat is our guidance assumption.

Olivia Tong (Managing Director)

Thank you.

Heather Hollander (VP of Investor Relations)

All right. Thanks, Olivia. We want to thank you for joining today's call. A replay will be available for 90 days on our website. Thank you for your interest in Bath & Body Works. Have a great day.

Operator (participant)

This concludes today's call. Thank you for your participation. You may disconnect at this time.