Capri Holdings Limited (CPRI) Q3 2023 Earnings Report, Transcript and Summary

Greetings. Welcome to Capri Holdings Limited Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note, this conference is being recorded. At this time, I'll now turn the conference over to Jennifer Davis, Vice President of Investor Relations. Ms. Davis, you may now begin.

Good morning, everyone, and thank you for joining us on Capri Holdings Limited third quarter fiscal '23 conference call. With me this morning are Chairman and Chief Executive Officer, John Idol; and Chief Financial and Chief Operating Officer, Tom Edwards. Before we begin, let me remind you that certain statements made on today's call may constitute forward-looking statements, which are subject to risks and uncertainties that could cause actual results to differ from those we expect. Those risks and uncertainties are described in today's press release and in the Company's SEC filings, which are available on the Company's website. Investors should not assume that these statements made during this call will remain operative at a later time, and the Company undertakes no obligation to update any information discussed on the call. Unless otherwise noted, all financial information on today's call will be presented on a non-GAAP basis. These non-GAAP measures exclude certain costs associated with COVID-19-related charges, the impact of the war in Ukraine, ERP implementation costs, Capri transformation costs, impairment charges, restructuring and other charges. To view the corresponding GAAP measures and related reconciliation, please view the earnings release posted on our website earlier today at capriholdings.com. Now, I would like to turn the call over to Mr. John Idol, Chairman and Chief Executive Officer. John?

Thank you, Jennifer, and good morning, everyone. Overall, our performance in the third quarter was more challenging than we anticipated. However, many aspects of our business performed well. In particular, we were pleased with the continued growth in our own retail channel across all three of our luxury houses. This is a testament to the strength of our powerful iconic brands: Versace, Jimmy Choo and Michael Kors as well as the success of our strategic initiatives. However, we were disappointed with the performance of our global wholesale revenue in the quarter. Additionally, revenue in Mainland China declined significantly due to the surge in COVID cases as the country reopened. Now turning to third quarter performance in more detail. Revenue decreased 6% on a reported basis and 1% in constant currency. Total company retail sales increased mid-single digits globally in constant currency. New customer acquisition was a key driver of growth as we added more than 12 million new names to our database versus the prior year. This is the largest year-over-year increase in our history. The growth in our own retail channel as well as our large and growing customer database demonstrates the strength and desirability of our brands. However, sales in our wholesale channel declined approximately 20%, driven largely by Michael Kors. Operating margin of 16.9% was below prior year. This reflected the sales mix shift between retail and wholesale, as well as increased marketing expense to support growth and build longer-term brand equity. As a result, earnings per share of $1.84 were below our expectations. Now looking at third quarter group revenue trends by geography. In the Americas, revenue decreased 4%, with mid-single-digit growth in retail, offset by significant declines in our wholesale channel. In EMEA, revenue decreased 2% on a reported basis, but increased 9% in constant currency. This was driven by strong retail revenue, partially offset by weaker trends in wholesale. In Asia, revenue decreased 20% on a reported basis and 8% in constant currency. This reflects strong results in Japan and Southeast Asia, offset by a nearly 40% decline in Mainland China. Moving to third quarter revenue trends by brand. Starting with Versace. Revenue decreased 1% on a reported basis but increased 11% in constant currency compared to prior year. Excluding Mainland China, revenue increased 21% in constant currency. We were pleased that revenue was better than anticipated and operating margin was in line with our expectations. Turning to product. Starting with accessories which are a key component of our growth strategy, Women's Accessories was the strongest performing category with sales in our retail channel up over 40% versus prior year. We were pleased with the response to our Greca Goddess pillar, which is continuing to gain traction. With our three pillars, La Medusa, Virtus and Greca Goddess, we are making significant progress in our goal to position Versace as a leading luxury leather house. Another component of our growth strategy is to expand footwear. Versace continued to gain authority as a women's luxury footwear brand as we expanded our core offerings, with the introduction of the pinpoint collection, a new range of statement pumps characterized by a curved metal stiletto heel. Men's and women's sneakers also performed well, driven by our Trigreca, Greca and Odessa styles. Moving to brand awareness and consumer engagement. Versace continued to deepen consumer desire through powerful storytelling. The holiday campaign was inspired by Versace's deep roots within the world of theater and the arts. Model Lily McMenamy embodied high Versace drama while highlighting holiday gift offerings. Our marketing initiatives continue to focus on Versace's Italian luxury heritage. This helped contribute to an over 40% increase year-over-year in Versace's global consumer database. Overall, we were pleased with the performance of Versace as we continue to execute our strategic initiatives. Looking forward, we remain confident in the luxury house's long-term growth potential as we reinforce Versace brand codes, significantly grow accessories and footwear as well as renovate our store fleet. Moving to Jimmy Choo. Revenue decreased 6% on a reported basis, but increased 3% in constant currency compared to prior year. Excluding Mainland China, revenue increased 10% in constant currency. While revenue was below our expectations, primarily impacted by China, operating margin was better than anticipated. Turning to product. Starting with accessories, which are a key component of our Go Strategy. Women's Accessories was the strongest performing category, with sales in our retail channel up high single digits versus prior year. Seasonal updates to our iconic Bon Bon and VARENNE styles performed exceptionally well. Women's footwear sales grew, driven by dress footwear styles as people engage in social activities, enjoyed special occasions and celebrated the holidays. Sneakers also performed well with positive consumer reaction to our new Diamond Maxi. During the third quarter, Jimmy Choo launched its successful capsule collaboration with Timberland. Sandra Choi partnered with New York Native Designer, Chanel Campbell of Harlem's Fashion row, to reimagine Timberland's iconic yellow boot. The collection celebrated urban glamour and the eclectisism of New York's dynamic community. This exciting collaboration generated over 50 million impressions across social media as well as strong product sell-throughs. Now turning to brand awareness and consumer engagement. For holiday, our campaign celebrated the playful energy of the party season in London's Claridge's Hotel, where Jimmy Choo designed the 2022 Christmas Tree. The unveiling of the Jimmy Choo Tree was attended by celebrities and friends of the house, including Iris Law, Sienna Miller and Daisy Lowe. Posts by attendees generated approximately 7 million impressions across social media. Our marketing initiatives continue to underpin our focus on glamour. This helped contribute to a 20% year-over-year increase in Jimmy Choo's global consumer database. Overall, we were pleased with the progress at Jimmy Choo as we continue to execute on our strategic initiatives. Looking forward, we remain confident in the luxury house's long-term growth potential as we reinforce Jimmy Choo's brand codes, significantly grow accessories and expand our casual footwear offering. Now turning to Michael Kors. Revenue decreased 7% on a reported basis and 4% in constant currency compared to prior year. We were pleased with the continued growth in our own retail channel with constant currency sales up low single digits despite greater declines in Mainland China. However, we were disappointed with Michael Kors' wholesale, which declined approximately 25% during the quarter. Operating margin was below prior year due to the sales mix shift between retail and wholesale as well as increased marketing expenses in our retail channel. To provide some additional color around wholesale, revenue at POS declined in the mid-teens as sales lag trends in our own retail channel. We had anticipated a sequential improvement at POS during the holiday shopping season, but that did not materialize. Therefore, we shipped less into the channel as we did not want to end up with excess inventory, which will result in additional markdowns. As you know, we have been elevating the Michael Kors brand and product. We believe our elevation strategy is working well, particularly in our own retail channel. We continue to believe that elevating Michael Kors is the right strategy for the brand. Now turning to product. In accessories, sales in our own retail channel increased low single digits globally. Consumers responded positively to core iconic collections, featuring Michael Kors Signature and hardware. We drove newness and excitement in Signature with seasonal updates featuring metallic logo prints. As a result, Signature represented approximately 55% of accessories sales during the quarter. Looking at footwear. We continue to believe we can significantly expand Michael Kors footwear to drive incremental revenue. Footwear sales in our retail channel increased low double digits as we delivered exciting fashion featuring iconic hardware branding elements and signature detailing. Men's remains one of the strongest performing categories in retail, and we remain enthusiastic about our opportunity to expand the accessories collection. Men's third quarter retail sales increased strong double digits globally, led by Signature product. In December, Michael Kors collaborated with Italian luxury sportswear brand, Ellesse, for a second time to create a sporty and glamorous ski capsule collection. The collaboration created energy and excitement, generating approximately 140 million impressions on social media as well as solid sell-throughs. Now turning to brand awareness and consumer engagement. For holiday, our consumer communication embodied Michael Kors Signature glamour and optimism, infused with the joy of the season. Bella Hadid captured the jet-set chic glamour of Michael's designs for the season's festivities. Additionally, in Asia, we amplified the campaign with renowned Chinese model, He Cong. Our marketing initiatives continued to underpin our jet-set storytelling. This helped contribute to a 17% year-over-year increase in Michael Kors global consumer database, demonstrating the strength and desirability of the brand. Overall, we were disappointed with the performance of Michael Kors in the third quarter. Given lower wholesale revenue, we recognize the need to reset our operating expense structure. We are beginning to take measures to better align operating expenses with the change in revenue by channel. Looking forward, we remain focused on our long-term growth initiatives to elevate the Michael Kors brand and reinforce our jet-set codes. We anticipate future growth, driven by our own retail channel, where we can leverage our brand momentum and personalized connections with consumers to drive revenue growth. Now looking ahead to the fourth quarter for Capri Holdings. We expect continued momentum in our own retail channel, driven by each of our brands strategic initiatives. However, in the wholesale channel, we now anticipate an even greater sequential decline relative to the third quarter. Due to weakness in our wholesale POS performance during the third quarter, which has continued into the fourth quarter, we are further reducing shipments into this channel. Now turning to fiscal '24 for Capri Holdings. We anticipate total revenue and earnings growth in the mid-single digits. In our own retail channel, we anticipate solid growth, driven by our strategic initiatives, client-telling and personalized strategies as well as a recovery in China as the country reopens. In the wholesale channel, we expect revenue to decline in the mid-teens with trends normalizing in the back half of the fiscal year. Looking forward, we remain focused on executing our strategic initiatives to drive sustainable future growth. Our three powerful iconic brands have enduring value and strong brand equity. We remain confident in our ability to achieve our long-term revenue and operating margin targets over time due to the resilience of the luxury industry, the strength of our portfolio and the talented group of employees executing our strategic initiatives. Before turning the call over to Tom, I would like to welcome Cedric Wilmotte as our new Chief Executive Officer of Michael Kors. Cedric has proven himself to be a versatile leader within our luxury fashion group, as President of Michael Kors EMEA for over 13 years, as well as the interim CEO of Versace for the last year and the COO of Versace currently. The Board, Michael and I are confident that Cedric's leadership will help to further accelerate Michael Kors strategic initiatives and brand momentum. Importantly, Cedric's appointment ensures that we have three experienced and talented CEOs at each of our luxury fashion houses. I am confident that we now have the right management team in place to execute our long-term strategic initiatives. Now let me turn the call over to Tom.

Thank you, John, and good morning, everyone. Overall, we were disappointed in our performance in the third quarter. While we were pleased with the continued growth in our own retail channel across all three of our luxury houses, revenue in our wholesale channel declined significantly, which resulted in expense deleverage and a lower operating margin. Now turning to third quarter revenue in more detail. Total company revenue of $1.5 billion decreased 6% versus prior year and 1% in constant currency, which was below our expectations. Looking at revenue performance by brand, at Versace, revenue decreased 1% on a reported basis but increased 11% in constant currency compared to prior year. Global retail sales increased in the mid-single digits in constant currency. By geography, total revenue in the Americas decreased 4%. Revenue in EMEA increased 14% on a reported basis and 28% in constant currency. Revenue in Asia decreased 19% on a reported basis and 11% in constant currency, driven by greater declines in Mainland China. For Jimmy Choo, revenue decreased 6% on a reported basis but increased 3% in constant currency compared to prior year. Global retail sales increased low single digits in constant currency. By geography, total revenue in the Americas increased 6%. Revenue in EMEA increased 1% on a reported basis and 14% in constant currency. Revenue in Asia decreased 24% on a reported basis and 13% in constant currency driven by greater declines in Mainland China. At Michael Kors, revenue decreased 7% on a reported basis and 4% in constant currency compared to the prior year, impacted by the decline in wholesale. Looking at Michael Kors revenue by channel, global retail sales increased low single digits in constant currency. This was driven primarily by a double-digit increase in e-commerce sales, with e-commerce penetration increasing 300 basis points versus prior year. However, wholesale revenue declined approximately 25% compared to prior year. Turning to Michael Kors revenue by geography. Sales in the Americas decreased 5% driven by the decline in wholesale. Revenue in EMEA decreased 11% on a reported basis and 1% in constant currency, also driven by a decline in wholesale. Revenue in Asia decreased 18% on a reported basis and 5% in constant currency, driven by greater declines in Mainland China. Now looking at total company margin performance. Gross margin expanded 120 basis points to 66.3%, driven by moderating inbound transportation costs, price increases and channel mix. Operating expense as a percent of revenue was 49.4% compared to 42.8% last year, reflecting several factors primarily driven by the Michael Kors brand. First, the significant decline in wholesale revenue resulted in deleverage as the wholesale channel has a low variable cost structure. Second, as planned, we increased our marketing investments to support brand-building activities across the group. And third, e-commerce sales increased double digits, which resulted in higher variable costs. Due to the operating expense deleverage, total company operating margin declined to 16.9% compared to 22.3% last year and was below our expectations. At Versace, operating margin of 9.6% was in line with our expectations and compared to 12.7% last year. At Jimmy Choo, operating margin of 10.7% was ahead of our expectations and compared to 9% last year. And the Michael Kors operating margin of 22.9% was below our expectations and compared to 28.4% last year. Our tax rate for the quarter was 3% compared to last year's rate of 8.1%, primarily due to the release of a valuation allowance on U.K. deferred tax assets. Now turning to our balance sheet. We ended the quarter with cash of $281 million and debt of $1.54 billion, resulting in net debt of $1.26 billion. As part of our ongoing commitment to return cash to shareholders, we repurchased approximately $300 million worth of shares in the third quarter. Looking at inventory. We ended the quarter with $1.19 billion, a 21% increase over last year. This represents a sequential deceleration compared to the prior quarter. We continue to expect inventory levels at the end of the fourth quarter to be below prior year. Now turning to guidance. Looking at the fourth quarter, we are more cautious in our revenue outlook in the face of an increasingly uncertain macroeconomic environment. We now anticipate total company revenue of approximately $1.275 billion. This represents a decline of 15% on a reported basis, reflecting a mid-single-digit decline in retail. For wholesale, we had planned the channel down, but we are now planning it down further and forecast an approximate 35% decline. On a 52-week constant currency basis, total company revenue would be down 8%, including an increase in retail revenue in the mid-single digits. For fourth quarter revenue by brand, we forecast Versace revenue of approximately $280 million. This represents a decline of 11% on a reported basis with a low single-digit decline in retail and an approximate 30% decline in wholesale. On a constant currency basis, Versace revenue would be down 7%, including a low single-digit increase in retail revenue. As a reminder, Versace reports on a one-month lag, therefore, the significant decline in Mainland China in December will be included in the fourth quarter results. For Jimmy Choo, we forecast revenue of approximately $130 million. This represents a decline of 16% on a reported basis with a low double-digit decline in retail and an approximate 40% decline in wholesale. On a 52-week constant currency basis, Jimmy Choo revenue would be down 7%, including a low single-digit increase in retail revenue. For Michael Kors, we forecast revenue of approximately $865 million. This represents a decline of 15% on a reported basis with a mid-single-digit decline in retail and an approximate 35% decline in wholesale. On a 52-week constant currency basis, Michael Kors revenue would be down 5%, including a mid-single-digit increase in retail revenue. Now looking at operating margins. We anticipate fourth quarter operating margin of approximately 8.5%. This reflects continued gross margin expansion, offset by operating expense deleverage, primarily due to the sales mix shift between retail and wholesale. We expect this across all three brands. For Versace, we now anticipate an operating margin of approximately 10%. For Jimmy Choo, we now expect an operating margin in the negative mid-teens. And for Michael Kors, we now anticipate an operating margin in the mid-teens. Turning to our expectations around certain non-operating items. We forecast net interest expense of approximately $11 million. We expect an income tax benefit with a rate of approximately negative 20%, driven primarily by the resolution of an uncertain foreign tax position as well as anticipated mix of earnings in lower tax jurisdictions. We expect weighted average shares outstanding of approximately 126 million. As a result, we now anticipate diluted earnings per share of approximately $0.90 to $0.95. Now I would like to take a moment to share high-level thoughts around our preliminary expectations for fiscal '24. We are providing this outlook given the material change in wholesale trends. We currently expect fiscal '24 revenue of approximately $5.8 billion, a 4% increase versus fiscal '23, driven by continued growth in our own retail channels across all brands. We anticipate retail revenue will increase in the low double digits, primarily driven by growth in Asia as China reopens. Excluding Asia, we expect retail revenue to increase in the mid-single-digit range driven by our strategic initiatives. In the wholesale channel, we expect revenue to decline in the mid-teens range. Together with our partners across all three of our brands, we are taking a more cautious approach to planning the business due to the uncertain macroeconomic environment. We now anticipate wholesale penetration will decline from 27% of revenue in fiscal '23 to approximately 23% of revenue in fiscal '24. Now looking at our operating expenses. Because of the anticipated decline in wholesale revenue, we recognize the need to reset our expense structure. We plan to proactively manage expenses while also continuing to make strategic investments, particularly in marketing, to drive long-term growth. Looking at fiscal '24 operating margin. We expect modest expansion to 16.5%, reflecting gross margin expansion, partially offset by expense deleverage. We expect an effective tax rate in the mid-teens as well as higher interest expense, largely offset by lower share count. As a result, we anticipate EPS of approximately $6.40. Now, I would like to discuss our expectations regarding the cadence of fiscal '24 revenue and earnings between the first and second half of the year. Looking at revenue, in our own retail channel, we anticipate growth throughout the year. In wholesale, we expect significant declines in the first half, with trends normalizing in the back half of the year, as we anniversary the declines in fiscal '23. Relative to prior year, this will result in lower margins in the first half of fiscal '24, with margin expansion expected in the back half of the year. Looking at our expectations by brand. For Versace, we anticipate revenue of approximately $1.25 billion and an operating margin in the mid-teens range. For Jimmy Choo, we expect revenue of approximately $650 million and an operating margin in the high single-digit range. And for Michael Kors, we anticipate revenue of approximately $3.9 billion and an operating margin in the low 20% range. In conclusion, while we are disappointed with our third quarter results and our fourth quarter guidance, we remain optimistic about the long-term growth potential for Versace, Jimmy Choo and Michael Kors. Our powerful brands have enduring value and proven resilience, reinforcing our confidence in the ability to deliver strong revenue and earnings growth over time. Now, we will open up the line for questions.

[Operator Instructions] And our first question comes from the line of Matthew Boss with JPMorgan. Please proceed with your question.

Great. So John, maybe a couple of questions. First, larger picture, could you speak to overall category demand for accessories that you're seeing today, maybe relative to pre-holiday, if there's been any change? And then how best to explain the difference that you're seeing between direct-to-consumer and wholesale as it relates to the overall health of your brand portfolio? And do you believe the reset in revenues for next year appropriately covers you for nearly any scenario from a macro perspective?

Thank you, Matt. So obviously, we are very disappointed with our third quarter results, mainly driven by the wholesale channel. We are pleased, as we said in our prepared remarks, with our own retail channel, which showed strength really across the globe with the exception of China, which had further declines than we had anticipated, and that was due to the reopening. And I think we have said that we had more stores shut down at certain points during the fourth quarter in China than we did during -- at any point during the pandemic. So that was quite difficult. And we have seen an uptick in the business there, especially in January. So, we're feeling strong and good about our own retail channel and how we're able to communicate and clientele and work directly with the consumer. And of course, you also saw that in our database growth, where we have the largest growth ever in the Company's history. And we've consistently grown the database at all three of those luxury brands every single quarter in the double-digit range. And I think that speaks to the strengths of the brands, the way the consumer is reacting to our strategic initiatives, and that's everything from the marketing to the actual product itself. And you saw in all three of our categories, we had growth in accessories. And so that really speaks to, I think, the strength of the category. I think you've also seen from many of the other reports that have happened with other luxury houses in the world, the category is strong. In terms of what happened in the wholesale category, and I'd say that's more of a North America issue where Europe performed better, although still not up to our anticipation, we have been -- and this is really more of a Michael Kors issue, we've been elevating the brand, both in positioning the way we're marketing it, the way that we have really elevated many of the products in terms of the quality, in terms of the design and in terms of the pricing. Pricing is up, on average, close to 25% since we started our price increases in 2019. I do think that the consumer was more cautious during the holiday season. We saw strong performance in our own stores through Black Friday, and then that kind of consisted right afterwards. We did not see the same rate pace and rate at the -- in particular, the North American wholesale channel. They have not -- that channel has not kept up the pace of the growth all throughout the year. We thought that part of that was an inventory issue, where we thought we -- if we could get in a better inventory position, which we did think we were in come the third quarter of the calendar year, as we had shipped, you saw in our first two quarters, had very strong wholesale shipments. And that was really to get our inventories back in line in that channel. And the performance just never came from that consumer. There is a possibility that the pricing increases that we've taken are impacting that channel differently than it's impacting our own channel. We have multiple tiers inside of our pricing. But all of our pricing has gone up. What we did see as a positive in both the North American and the European channels is where we had put our own selling staff back into the stores. We saw a fairly significant delta between the performance in those doors that had our own staffing in it and those doors that did not. And we intend on, as a part of our investment -- continued investment in the wholesale channel to take that level of staffing up. We talked about it once before. We said we'd see how that goes. And there's clearly been a positive result, especially in top-tier doors. So, we intend on continuing to invest in that. Again, in terms of category demand, we think the category continues to grow. I do have to say that the category was impacted across the department store channel, in particular, in North America. We saw it at all locations. So that was disappointing. We had expected that to really have an uptick, especially during the holiday season, and that unfortunately did not happen. And in terms of our forecast, Matt, look, all we can do is provide the best guidance. And I think we gave very fulsome guidance. We do believe that we're going to continue to see strength in our own retail channel. That seems to be consistent with what we see happening. We do think that the reopening of China, in particular, will add additional opportunity for revenue in our own retail channel. And we do see some small additional increase in the travel retail channel. Again, in particular, in Asia, we think that will rebound. So I think we're feeling comfortable with that. We've planned the business to be down quite significantly in the -- our fourth quarter and into the first quarter of next year for our quarters. And that's really to offset where we were restocking the wholesale channel. That's on a global basis. And we've planned for, again, a slightly higher decline in Q2. The back half of the year, we've planned it more or less flat, which will still be a stack year-on-year decline. And we've said wholesale would be down in the mid-teens. And by the way, that's across the group. That's just not Michael Kors. We're seeing our partners at multiple levels in the wholesale area be more conservative in their planning given some concerns around the consumer and how they might respond in general. So, I think we're taking a very prudent point of view. And then lastly, as Tom said in his prepared remarks, we're going to adjust our investments and our spend accordingly. The wholesale business for us was a profitable business and does not have a lot of fixed costs associated with it. So therefore, we'll have to make some adjustments inside of our own operations, and we're hard at work at that right now. So, I think the takeaway for us is we have three incredibly strong brands with Versace, with Jimmy Choo and Michael Kors. We believe that these are very strong brands, and we believe that our strategic initiatives are very, very solid. And we're going to stay true to those -- to that vision. And I think that worked for us as we went through COVID. And we're going to stay with that strategy as we go through this kind of change in how we're going to be running the business given a lower wholesale business that has lower associated costs up against it, and we'll continue to work our model accordingly. So thank you very much for that question, Matt.

Our next question is from the line of Omar Saad with Evercore ISI. Please proceed with your question.

This is Warren Cheng on the line for Omar. I just wanted to dig in a little bit further on the 4Q sales guidance. It's a pretty big step down, even from the 3Q change. So just to clarify, is that all coming on the wholesale side? Or did you change the outlook on the retail side, too? And then also, just if I look geographically and focusing on China, I think we all understand what happened in December for China. But looking past December, have your expectations for China changed there versus three months ago?

It's Tom here. Thanks for the question. And for Q4, we've really taken a more cautious outlook due to the increasingly uncertain macroeconomic environment and also, as John mentioned, inflation impacting consumer confidence. So what we've seen there is a big step down in wholesale for -- down 35% versus prior year, and Mainland China down 35%. So in total, if I do that on an absolute dollar basis, that's pretty much the whole reduction versus our prior year for the quarter. We still expect retail to grow mid-single digits. And this is a slight change in our China outlook because we do have opportunity next year, we believe, as they are reopening. However, as they've taken away all the restrictions, the COVID cases had surge that has created, I think, a near-term pullback in traffic and results.

Our next question comes from the line of Ike Boruchow with Wells Fargo. Please proceed with your question.

John and Tom, good to hear from you guys. I guess, John, if you could just clarify two quick questions on wholesale. So I believe, based on your answer to Matt, that you're kind of talking about next year, wholesale being basically down 30% in the first half and flat in the back half. But I think you said Q2 should be worse than Q1. If I heard that right, could you just clarify why that would be? And then just within the wholesale cost structure, obviously, it's a little out of whack because of the declines. How quickly do you think it will take -- how much time do you think it will take to kind of align the cost structure so that you feel like you're in a good position to go forward from a profitability perspective out of that channel?

Sure, Ike. It's Tom here. I'll take those. So for wholesale, Q1, Q2 next year, so overall, as you mentioned, will be down 15% for the year. We expect declines in the first half as we are anniversary-ing the restocking in fiscal '23, and that's going to be more weighted to the first quarter. So, the first quarter in wholesale will be down more than the second quarter on a year-over-year basis. So hopefully, that answers the first question. And then in terms of aligning costs, as we mentioned, wholesale has a lower variable cost structure. And so we are working on a number of initiatives to reduce expenses, have embedded those into our guidance. And we're recalibrating the rate of spend across all our divisions and reducing non-revenue-generating expenses in corporate, for instance, and also a rigorous evaluation of other expenses not directly linked to consumer engagement and revenue and other areas that are driving the business. That said, we are going to continue to invest, particularly in marketing, but also in areas like e-commerce and digital that we know drive engagement and allow us to use that large database and growing database.

And Ike, I want to clarify one thing, and I understand why you asked the question. So we are planning at retail, the business down with our partners across the group in the wholesale channel in the first half of calendar year and the back half of calendar year. So this is at retail sales, not wholesale, at retail. So it's POS. We are planning the business roughly flat. And there might be some exceptions to that, whether it's Jimmy Choo planned up slightly. But in terms of impacting the total company, we think that, that's the right way to view how what may happen with the consumer in the back half of the year. And we think that's prudent with Michael Kors, given that there was such a high decline in the channel during the back half of the year. I might add one other thing, too, in terms of color. We did not have that decline last year. So in calendar 2021, we actually had a very strong performance with the Michael Kors brand in the retail -- in the wholesale, in particular, department store channel. So this was -- as I said, this could be caused by some of the price increases that we've seen happen. We can't speak to what staffing levels were in the stores, et cetera. But we know where we put our own people in. We know in our own stores where we have our own teams in place, we are doing, I think, a very good job connecting with the consumer. We also know that when you have database grow the way that we saw -- and by the way, those are predominantly consumers who are actually purchasing from us. So usually, when the database is growing, they have made a purchase from us. So that shows us that there's tremendous interest in all three of these brands. And so again, we feel confident. And I know that it's not going to be easy for many of you on this call and people listening in given the step change in the wholesale business. But again, we continue to look at the strength and the power of these three houses. We're going to have to pivot a little more quickly than we had anticipated, because we always have wanted the wholesale business to get down to around 20% of the Company sales. This just happened a little faster than we would have anticipated. But I think we've shown we can be nimble and really move forward quickly. And so, I think you can expect to see some of the fruits of our initiatives around rebalancing certain costs and areas to happen relatively quickly.

Our next question is from the line of Alex Straton with Morgan Stanley. Please proceed with your question.

I wanted to focus on gross margin here. It appears to have held in quite nicely. Perhaps could you just share your observations on the promotional environment in the quarter as well as the assumptions you have embedded in a modest expansion guidance going forward?

Thank you, Alex. I think the better news in our report was, first, our performance at our own retail stores; second, again, the database growth showing the health and the response of the consumer to our brands. And I think the gross margin also. We had a number of things that impacted the gross margin positively. Again, we've had this sequential price increase. We told you either two calls ago or last call, we are not going to be taking any more price increases. There's a little bit of it that will flow through in the first half of the year. And then we're stopping the price increases across the group. For the time being, we're going to take a pause. We also took a fairly significant price increases at Jimmy Choo and Versace as well. So we think we're in a good place in terms of where our pricing is right now. And part of that is reflecting in the gross margin. Tom will speak to some of the other areas that have also impacted it positively. So I think that you'll see two things next year. Again, you'll see a little bit of some of the freight and the benefit. That will start to show up a little bit more in next year. And secondly, there will be a channel mix. As retail becomes a bigger part, that will also show up in the gross margin. But let me have Tom speak to this year and next year.

Sure. I'm happy to give you a little more color on Q3, and it's very similar trends for Q4. So as John mentioned, we did see moderating inbound freight costs. We benefited from the price increases that are still ongoing but will stop in the future, and the channel mix with a higher retail versus wholesale. We were not more promotional. But given the better inventory position compared to last year, we did have a more normalized level of promotional or markdown sales. And some additional headwinds included regional mix. As we've been saying over the past several quarters, Asia is a lower percentage of revenue and it's a higher margin as well as the stronger dollar, which has hurt us through the year on a margin perspective. But as we look at next year, retail will be a larger portion of the business. We expect a rebound in China, which will be a tailwind, and freight as well. This is in addition to the strategic initiatives on our brands, which, over the past several years, have driven significant improvements in gross margin across our brands, all of our brands. And wholesale, as John mentioned, in the first half, it's going to be a headwind because of deleverage with that low variable cost base. But as we normalize in the back half, those other areas will shine through.

I might also add that we feel that FX will probably not be a headwind or a tailwind next year. We're expecting it to more or less normalize. And it will still be a headwind in the first two quarters. But then by the time we get to the back half of the year, it should be normalized or just a very minor tailwind. So hopefully, some of that noise will start to come out of the performance numbers. And as you know, it's been a significant headwind for us this year. Thank you, Alex.

The next question is coming from the line of Brooke Roach with Goldman Sachs.

John, I know you mentioned pricing as a potential explanation of what could be driving additional weakness in wholesale. Along those lines, can you talk about the momentum that you're seeing across your business within various income demographic cohorts or price tiers of your product architecture? Is there any difference in sell-through trends or sell-out trends in your own retail business and outlet versus mainline stores, particularly in North America? Separately, you've had nice growth in your consumer database. Can you talked to the repeat purchase activity that you're seeing from customer cohorts that were acquired over the last few years that may be more priced sensitive?

Thank you, Brooke. Brooke, the overall -- what's very interesting about our database and the consumer and the database, and we've actually reviewed this yesterday, we're still -- and this is also, in particular, to Michael Kors, we're still dealing with a fairly high income demographic in the Michael Kors database. And it hasn't changed a lot over the last five, six, seven years, which we think is a good sign. Where there's been a concern, does a lower income consumer be driven more towards the brand? And did we lose any brand equity with more higher-income consumer? And so far, that has not been the case. What's also interesting is while we do have crossover between the channels, between e-commerce and our stores, the crossover is not as great as we continued to anticipate. So the good news for us is -- and probably 60% of our database growth, and it's pretty consistent across the group, is coming through the e-commerce channel. It's not cannibalizing the store customers. So we think that's a very healthy mix. And you can see, as Tom mentioned, we significantly accelerated our marketing activities across all three of our houses during the quarter. And that was a very distinct decision on our part to do that. We knew that many of our competitors in Europe and North America would also be accelerating their spend. And we thought to be competitive from a mind share standpoint that we had to really make sure that our brands were shining through. And so the good news for that is these databases are getting so sizable that, in certain ways, some of our direct-to-consumer marketing costs may be coming down a little bit next year. And that's because we're going to be able to mine the existing databases. And we've seen an acceleration on repeat customers inside. We've been able to, really through our data analytics tactics, get those consumers lapsed and repeat to transact with us more regularly. So we feel that there is an opportunity for us to create some leverage in next year, given the size of the databases at all three of the companies and how we can start to leverage that. And again, we're still going to invest, as Tom said, in overall marketing across the group. We think that's one of the most important initiatives to be competitive again with the European luxury houses as well as the North American competitors who have very strong brand statements. So we have to continue to invest in that, and we're going to continue to invest in our stores, renovations, et cetera. And then lastly, we think that our clienteling initiatives, we're really going to step that up over the next two years. It's going to take us more time to get to a place where we feel that, that's going to be a competitive advantage for us, but it's, again, a very important part of our strategy across the group. Thank you very much, Brooke.

The next question is from the line of Paul Lejuez with Citigroup. Please proceed with your question.

Just a couple of quick ones. Curious if you can talk about transactions versus ticket within the DTC business that you saw in the quarter and what you expect going forward. Then free cash flow assumption for F '24 and then just China, the assumption in the first half or second half of '24.

Paul, thank you. Paul, we really didn't see a lot of change in transaction or UPTs. So that wasn't an issue for us. We did see a small decline in the ticket, and that was really more of a result of -- we saw a shift to smaller -- to a return to smaller bags. And I would say, we saw that across the group, where there was much more cross bodies, small leather goods. We benefited, during COVID, over a lot of larger bags selling where people were needing to put more things in larger bags. And so, actual retail price of units was not down, but the actual transaction was slightly down, and that was more because of -- we've seen a very -- a double-digit increase in our small leather goods business, and we classify our cross bodies in that category, which really reflected, I think, people enjoying the holidays, going out and parting, dressing up. And so unit sales were slightly higher than actual retail performance, and that's driven by a lean-in by the consumer into that category of product. I'll turn over the cash flow to Tom.

Sure. With regard to cash flow, you asked about last year, but just to comment on this year. We're at free cash flow of approximately 450 year-to-date, and our Q3 was even above that. So we had an incredibly strong cash flow quarter. We would anticipate next year that we'll have similar cash flows, that has always been a strength of the Company, that we're generating strong free cash flows across our brands. And our balance sheet is extremely strong. We noted in my prepared remarks, a net debt of $1.26 billion. And our leverage ratio is very solid and low. So we feel very comfortable with the strength of both our balance sheet and our cash flow, and we're using that to redeploy and purchase shares to return cash to shareholders. So when we look at our capital allocation priorities, still number one, invest in the business; number two remains returning cash to shareholders and then pay down debt, which we have done over time and managed very carefully. And as regards to China into fiscal '24, we expect it to grow at an outsized rate compared to the overall growth of retail. I think we had mentioned the retail business, we expect to be up double digits driven, first, by Asia, mainly reflecting China and excluding that, up mid-single digits across the remainder of the world.

Our next question is from the line of Simeon Siegel with BMO Capital Markets. Please proceed with your question.

I apologize if I missed it. But John, we'd love to hear your opinion on whether you think the domestic department store weakness is more a broader consumer demand and traffic versus the stores' attempt to reduce their own inventory? So just trying to think through how big of an industry pressure point you think it might be and how long it might last? And then Tom, if I can, how are you thinking about the Michael Kors' EBIT margins versus the pre-pandemic to the earlier point about wholesale having little fixed costs and just any help on thinking through decremental margins on wholesale from the lower revenues.

Simeon, number one, I want to say that our partners, both in North America and in Europe, have been terrific partners. So we worked very closely together all through the pandemic and exiting the pandemic. And the first half of this -- of last calendar year, we had tremendous difficulties filling the inventory needs of the department stores. And as I said to you, coming out of calendar 2021, we actually had a very strong holiday season with that channel, and we were depleted in inventories. And so we didn't really get caught up in terms of inventory at retail until almost August of this past year. The inventories got to retail. We did not see any type of a significant step change in the channels. And we were, as I said, very hopeful. And we did run some tests with additional staffing in the stores, which worked well for us. But we just didn't see the conversion with the consumer in that channel. I can't tell specifically whether it was our prices or not. But we just know the channel didn't deliver in our category and obviously, the biggest category being the accessories part of it. I don't know whether this is going to continue or not. We've seen a continuing weakness, as I've said, through January. So we've taken, again, a very prudent step. We do not want to put additional inventory into the channel to cause markdowns, which we think will cause brand erosion. And we've worked too hard to get ourselves to this point. We've said we would suffer the inventory declines if -- and the wholesale shipment declines if that meant preserving the brand, and I think we're going to continue to do that. We know that we're on the right track with elevating Michael Kors. We know we're on the right track with Versace. And I think you're going to see some very powerful things happen at Versace here momentarily. We've announced our fashion show on March 10 out in California, in Los Angeles. Our new CEO, Emmanuel Gintzburger, is hard at work, and he's making some incredible strides along with Donatella. And I think you're going to see a real step change in terms of what the product looks like, where we're going marketing-wise. So we're extremely enthusiastic about what's happening there. And Jimmy Choo has been on a pretty good trajectory through the year. And in fact, I do need to call out that Jimmy Choo did have a very strong retail performance during the holiday season. But our partners are very concerned about where the consumer is going to be next year and has taken a step change down, even with our performance on being conservative on inventory. And we're -- quite frankly, we're okay with that. We don't want to have excessive markdowns in these stores. We think that's the wrong place for us to end up. So, we have to be focused on. If you're going to believe in a luxury company and long-term brand health, then you've got to stay committed to what your strategy is. And I think ourselves and our management team are committed to that. So I'll turn it over to Tom.

And Simeon, with regard to Michael Kors operating margin long term, we continue to believe in the mid-20% range operating margin goal for the Michael Kors brand. Near term, there's definitely a step change in the wholesale revenue. And we will adjust our cost structure to address that, and we've already begun to rebalance the cost base. As we look at '24, as I mentioned, in the first half, the wholesale declines will create deleverage. But then the initiatives, the growth in retail, China and Asia becoming a larger portion of the mix, again, as they recover and little freight tailwinds, we believe, along with our strategic initiatives, will get us back on that path. Thank you, Simeon.

Best luck for the rest of the year.

I'd like to thank everyone for joining our call this morning. Again, we are very disappointed in our results for the third quarter and our guidance for the fourth quarter. That being said, we believe in the strength of our three luxury houses. We believe that we have a very good plan for fiscal year '24 on a go-forward basis. That will continue to embrace and support the strength of each of these three phenomenal brands, and we believe that we will return to the type of growth that we expect in the future. So, thank you very much for your support, and we look forward to keeping you updated. Thank you.

This will conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.