The Lovesac Company (LOVE) Earnings Call Transcript & Summary

Thanks. Morning, everybody. Joining me today are Shawn Nelson, our Chief Executive Officer; Mary Fox, President and Chief Operating Officer; and Donna Dellomo, Chief Financial Officer. Prior to beginning, I want to note that certain information we'll cover will contain forward-looking statements about upcoming events and how our finances will perform in the future. Such statements cover our expectations going forward, financial projections, plus our plans and prospects. Results in reality could vary significantly from what those statements describe. To understand these risks and uncertainties, please look at the company's SEC filings, including the press release issued today. Forward-looking statements shouldn't be treated as forecasts of what will happen later. Each forward-looking statement made during this call rests on assumptions and beliefs held as of today, and we assume no duty to revise them, unless applicable law requires it. Today's discussion will also feature non-GAAP financial measures, among them EBITDA and adjusted EBITDA. These non-GAAP measures ought to be viewed alongside our GAAP results, not as a replacement for them or separately from them. A reconciliation from the closest comparable GAAP financial measure to that non-GAAP financial measure appears as supplemental financial information in our press release; at this point I'd like to hand the call to Shawn Nelson, Chief Executive Officer of The Lovesac Company.

Thanks, Rachel. Morning, everybody, and I appreciate you being with us today. To kick things off, I'll walk through what stood out in our third quarter of fiscal 2023, then talk about how well Lovesac is positioned in this industry. After that, Mary Fox, who serves as our President and COO, will bring you up to speed on where we stand with the strategic initiatives we've been pursuing this quarter. Last, Donna Dellomo, our CFO, will go through the financials along with several other points tied to our outlook in greater depth. Jack Krause, our Chief Strategy Officer, is here in the room as well and will take part in the Q&A. Through the third quarter, conditions in the industry stayed difficult, reflecting the heavy inflationary burden sitting on the U.S. consumer. What we saw is that the furniture segment as a whole has recently fallen in the mid-teens percent range compared with the prior year. Even with that kind of operating climate, we once more posted solid results against hard comparables set by a record in Q3 a year ago. Keep in mind, too, that what we report is a live reading of demand. Sactional, Sacs and StealthTech items nearly always leave within just a few days of the order being placed, moving by FedEx or common carrier, rather than sitting in drawn-out backlogs of the kind that occasionally inflate sales for other competitors in home furnishings; since we have more than 210 physical locations, largely situated in shopping malls, we are right now in the middle of our biggest quarter when measured by sales, profitability and cash flow. We expect to close out this fiscal year with in excess of $75 million of total liquidity, a figure that takes in cash, cash equivalents and what's available under our line of credit. Ours is a solid balance sheet carrying no debt, capable of absorbing any additional macro turbulence that could show up as we move into next year. The way we keep beating expectations and taking share speaks to a business model that's different from the rest, covering our value proposition and patented innovation, the Designed For Life platform, a sustainability foundation, rising brand awareness and consumer adoption, plus an in-stock position that leads the industry. We look at our in-stock position, and our inventory itself, as an enormous competitive edge. There's nothing seasonal about our inventory, and it's built deliberately so that fashion risk stays minimal to nonexistent. A handful of key evergreen SKUs account for most of it. Sactional, along with every one of the newest inventions on the platform, stands as the opposite of obsolescence. Take StealthTech too — as a recently introduced add-on, it was built to work in reverse compatible fashion with every Sactional piece ever sold across roughly the last decade. Thanks to our elevated in-stock levels, we've captured considerable market share and lifted customer satisfaction by getting product to the consumer fast before, throughout and now following the pandemics as well. As we let inventory levels normalize on their own through this holiday season's peak, which is occurring at this very moment, and then into next year, we're watching working capital turn into a source of positive cash flow. As I've mentioned previously, the total addressable market we can go after is sizable — $46.2 billion across the couch and home audio TAM — and when you pair that with how fragmented this market is, it gives us a really appealing, long path ahead for expansion and for taking share as we keep innovating, which widens what's possible for us in these categories and in new ones down the road. Now let me walk through how we did in the third quarter. Net sales came to $134.8 million in total, a rise of 15.5% compared with the same period a year ago. Comparable sales across the board grew 8.9%, with strength spread widely among both new and existing customers, and our adjusted EBITDA loss came in at $8.4 million, which beat what we had expected for the quarter, helped by gross margin declines that were smaller than planned. In our view, Q3 brought the hardest comparisons we've encountered so far, or that we will encounter for the rest of this fiscal year. These results make us quite proud, particularly given the gap they show relative to the furniture category overall, which has been running down in the mid-teens recently. When you use that as your baseline for comparison, it really highlights how resilient our business model is, along with our brand, which we've spent years building in a very deliberate way. Even against this difficult macro environment, we're creating real-time demand for our superior products. No less than 38% of customers recently surveyed say they did not cross-shop their Sactionals purchase against any competitor at all. That signals the strengthening power of our reputation and genuine demand for this brand and this product, beyond shoppers who are simply browsing the marketplace for a sofa. What's more, our results demonstrate the skillful, nimble execution by the whole Lovesac team, who work relentlessly to stay agile amid these choppy conditions; the culture of excellence we're building together makes us proud. We remain highly disciplined when it comes to costs, even as we keep investing throughout the business to back our growth initiatives. After 4 years of growth rates near 50%, headcount growth has consistently trailed. So with essentially all hiring at Lovesac now frozen as a precaution, our cost model doesn't require any drastic rationalization to match what is by now a substantial revenue base. During last quarter's call, I talked about how much technology and supply chain matter, and about our determination to put the needed infrastructure in place to underpin our multi-year growth runway. So we were delighted to share news that John Legg has joined us as Chief Supply Chain Officer. John's deep industry knowledge, his leadership experience and his vision will be essential to establishing best-in-class supply chain operations here at Lovesac. He'll keep strengthening our world-class supply chain network, which underpins our unmatched customer experience, our Designed for Life products and our circle to consumer philosophy. Mary will update you on the wide-ranging progress we're making on our growth initiatives, so I'd like to turn to what we're concentrating on as we finish the year and head into the next one. As we look forward, given how we're performing so far this quarter, we feel good about where we stand going into the holiday season, which is so critical. We're experiencing meaningful relief on costs, particularly when it comes to inbound freight, and some of that upside is beginning to show up in Q4, though the bulk of it should be captured in the next fiscal year. That said, the widely talked about inflation affecting major cost categories is still weighing on our cost structure overall, and labor is a clear example. We keep pulling levers to partially counter those inflationary effects, even while staying very surgical about any pricing moves. Among those levers are tweaking promotional programs and steering our merchandising and mix across channels, something the team has executed quite well so far, as our results show; they also include disciplined expense control and thoughtful prioritization of spending so that we put money into the areas that matter most to strengthen our foundation for growth. When we think past Q4 and toward next year, we aren't prepared to give guidance yet, but I do want to offer some perspective on how we're thinking about next year. Our expectation is that the macro environment stays difficult; in that kind of setting, we think we'll keep substantially outpacing our category and delivering growth, though at a rate that's more modest than what we've seen this year on the whole.

Despite the downturn, we think we can keep growing sales, thanks to our planned expansion of showrooms and our products that stand apart, which have the backing of years of steady brand promotion, along with the progress we're making on our various initiatives and, naturally, our innovation plans. On that last item, I'd rather not say more at this moment, but our future excites us, and we're confident about our capacity to compete and grow. The swift expansion we've achieved over the last 3 to 4 years has largely come from sharp rises in dollar outlays and deliberate, targeted marketing; indeed, our marketing outlay has climbed from $9.2 million in 2018 to a projected $71 million in total for this fiscal year, which works out to a CAGR of roughly 53%. It's probably the biggest targeted outlay within the couches subcategory in the market. The long-tail advantages of this accumulating marketing outlay have created considerable awareness for our brand, along with momentum and demand for Sactionals and StealthTech that continue. It will keep supporting the growth we expect. We've shown, and expect to keep enhancing, customer satisfaction and brand affinity by improving processes and service levels that shape the customer experience, all while aggressively gaining market share and beating the category. We're set to release our second annual ESG report, with fuller disclosures, and we'll tirelessly chase progress across all key ESG areas. We use our Designed for Life philosophy to deliver more lasting, hyphenable products to market at scale, which can have a major effect on our carbon footprint; these products can genuinely last, since they're built to endure a lifetime and made to change along with the user; we think this take on sustainability is entirely distinctive to Lovesac and will in the end establish us as the leader in this space. To date, we've already given new purpose to over 159 million plastic bottles, turning them into our Sactionals and Sac upholstery fabric, which comes from 100% recycled inputs. And we've now committed to a target of keeping more than 1 billion plastic bottles out of the waste stream. We're advancing toward our announced aims of reaching 0 waste and 0 emissions by 2040. Over the longer term, we think we can turn into a much bigger multibillion-dollar company, and we see a genuine, believable route to reach that point. To fulfill these goals, we'll keep putting money into innovation and R&D, while expanding our infrastructure carefully even amid this difficult macro climate. Our core business produces solid profitability, which isn't entirely visible in our P&L because we're currently in this investment phase; we have a robust, debt-free balance sheet and a model we trust can keep delivering relative outperformance even against a recessionary backdrop. We’re going to remain strict when it comes to expenses, managing the things that are within our power, without harming our capacity to take advantage of the expansion chance that exists for us. What we care about is creating shareholder value over the long term and putting this company in a position to capture and get the most from this wide-open growth possibility, while at the same time running the business responsibly and with strong discipline. Last, I’d like to thank everyone on the Lovesac team for how tirelessly they carry out our strategy and meet our objectives. Because of our disruptive model, we can keep expanding, prospering and innovating, and keep putting money into this business at a moment when a lot of other firms are fighting for cash and are even seeing negative growth. I couldn’t be more proud of this incredible team we have assembled, and along with our ongoing success, there are some thrilling growth possibilities for everyone who belongs to this #LovesacFamily. Having said that, I’ll turn things over to Mary, who will go over our strategic priorities and the progress we’ve made. Mary?

Thank you, Shawn, and good morning to all of you. For our company, the results in quarter 3 set a record for a third quarter, and demand rose 22%, which was faster than our revenue increase — a stark difference from the category downturn Shawn described. Compared with all of our main competitors, whose numbers largely reflected shipments pushed back from earlier quarters, our performance came in much stronger. That outstanding outcome makes us very proud, and with fiscal 2020 as the baseline, our 3-year comp growth stack stands at 146%. This shows the considerable share gains we have achieved across the last 3 years and beyond, and we believe no other brands holding meaningful share in the category have matched our pace of growth. Over that same stretch, our market position has shifted from challenger to share leader in the categories where we compete. Being the share leader across our categories reflects how focused we are on inventing and designing a product platform whose products best deliver value to our consumer, and on building an experience and ecosystem around that platform. Our evergreen inventory strategy and operational discipline have pushed customer satisfaction scores to all-time highs. The brand experience continues to win people over, and that accelerates our demand flywheel — word of mouth now ranks as our top awareness driver. Despite what's happening in the market right now, we're in a position few others are to keep growing share while staying profitable. Now I'll walk through the key highlights from our strategic initiatives. Starting with the first one: product innovation. We continue to feel good about the momentum behind StealthTech, which represented a breakthrough for both us and the category on the innovation front. This brand keeps capturing more share, and we think it has the potential to bring in hundreds of millions of dollars every year for Lovesac and to emerge as a market leader. Now for a few important points: attachment rates have kept climbing throughout the year, with adoption increasing each quarter. So far this year, orders for Sactionals that include StealthTech have an average value of roughly $9,000 — about three times the typical Sactional order value. The early momentum from this launch, plus the quarter-over-quarter gains we're seeing, give us confidence that both the product and the support behind it are steadily becoming more relevant and appealing, and that it's a powerful way to raise customer lifetime value. During this quarter, we also continued to push forward with distinctive product partnerships that resonate with our customers. That includes the recent Hocus Pocus 2 release from Disney, which performed very well, along with our collaboration with Alice and Olivia, launched during New York Fashion Week in September. That event coverage generated 1 billion impressions. Second, omnichannel experience. In quarter 3, as we keep working to improve the customer omnichannel journey, we brought back our website configurating experience. When building the new configurator, we started by listening to what customers told us, then designed the most straightforward path to purchase possible, while incorporating additional technology through augmented reality. Beyond that, we improved how channels work together by adopting some of the best methods from our various locations. Since we started, the outcomes have been pretty impressive. A few notable points: for higher-margin products such as StealthTech and Storage Seat, attachment rates are better by up to 400 basis points; digital satisfaction ratings have risen 350 basis points versus the pre-launch period year-to-date; and with the new configurator, conversion has increased by over 6%. As the year progressed, we accelerated our planned rate for opening new locations because we continue to see a strong return on capital, with a payback period of about 1 year. Our productivity leads the category, and that's why we believe the number of markets we can serve is much greater than what our rivals are able to cover. Since shoppers repeatedly demonstrate a desire to handle our items in person when making purchases, our touch point network is going to deliver a strategic edge over the long haul. We continue to work toward improved touch point economics, given that our brand's pull can drive foot traffic our way. Compared with the same period a year ago, Q3 traffic climbed 34%, a figure well above the U.S. traffic pattern Setomatic reported. Along with our real estate approach, that momentum has enabled us to secure reduced occupancy expenses, a promising indicator for the touch point's 4-wall contribution, which is already robust. We remain focused on providing a top-tier omnichannel experience. During Q3, we kicked off a trial of a new cloud-based POS system alongside PredictSpring. PredictSpring is an elite POS provider, and working with them supports our aim of leveraging technology to improve transaction efficiency, reduce manual reconciliation, and set the stage for ongoing growth. Insights gained from this will feed into a larger pilot at the start of fiscal '24. Also in Q3, we emphasized returning to Costco with our in-person road shows, which delivered outstanding results. In quarter 3, we ran more than 60 physical roadshows whose productivity matches the pre-COVID level, and productivity has risen as our teams grow accustomed to selling in the Costco environment. Finally, customer satisfaction performance. We keep seeing tremendous gains in our CSAT, because our focus on digital and post purchases, our priority drivers, is really building momentum. These gains matter a great deal, since we know that word of mouth is our #1 source of purchaser awareness; and as we build a more satisfied customer base, we expect to keep leveraging word of mouth. Our third initiative, ecosystem. The vision behind it is rooted and circled to consumer C2C and to developing an ecosystem for our customers and products, driving optimal value for our customers and for the Designed for Life product platforms they've invested in. We see that happening with the most devoted followers of our brand, and there keep being positive indications that shoppers are already moving toward creating additional worth for themselves—updating the way they present the brand so it fits better with their shifting circumstances. That pattern is something only we have in our sector, and it shows up in the customer figures we’ve reported lately: more than 4 in every 10 purchases during quarter 3 came from people who had bought before. Alongside the powerful buzz we generate, the way we allocate marketing resources keeps producing category-leading growth results, and the measures of our brand’s health keep getting better. During quarter 3, our total marketing results remained on the trajectory we had forecast, and demand generated beyond what we spend on marketing is still growing. The relationship between what a customer is worth over time and what it costs to gain them stays solid, and because we can adapt quickly—watching initiatives carefully and moving money around—we have stayed effective at driving conversions. Take SMS marketing: it has delivered outstanding results as the tactic that secures the final click, and when it comes to opening and conversion rates, our KPIs put us ahead of everyone else in the field. That approach performs especially well around major moments, delivering gains in last click sales exceeding 200% compared with the prior year.

Because our model doesn't depend on where transactions happen, we can draw on its strength. Our online investments aim at generating sales across channels, and we convert well at every stage of the funnel, which lets us generate revenue wherever the buyer chooses to shop. Then there's our last priority: putting money into infrastructure in a measured way. During the third quarter, as I mentioned, customer satisfaction reached its peak since we began tracking it. A major reason for that is how fast we get finished orders to buyers, something made possible by what we're spending on infrastructure. Back in the second quarter, I laid out our infrastructure roadmap, and near the close of the quarter we got our fifth distribution center up and running in the Dallas-Fort Worth region sooner than planned, with full scale expected by the time the fourth quarter ends. Thanks to this extra DC, we can keep fueling our expansion and also capture savings on last-mile delivery since we're now operating nearer to buyers in the South. A limited set of SKUs that also aren't vulnerable to becoming outdated from seasonal shifts gives our supply chain an edge. That lets us hold stock knowing we'll move it, and we can handle swings in demand. Our delivery speeds to buyers lead the industry, measured in days, and during the third quarter we hit a record 98% for in-stock levels. We've been building up our supply chain strengths to produce solid unit economics, powered by our productivity loop of concentrated assortment expansion and scale efficiencies, plus refining inventory via the scheduled OMS rollout. I'm delighted that John Legg, who just became our Chief Supply Chain Officer, will oversee this effort, and we anticipate these gains appearing from fiscal '24 onward. As Donna will explain, we've also begun seeing sizable decreases in inbound freight across the latest quarter, most of which will hit our P&L during fiscal '24. So to wrap up, we're extremely pleased with how we performed financially and operationally in quarter 3. As we work toward finishing the year, our attention stays on products, the omnichannel experience and ecosystem so we can provide the finest experience and product value to our consumers. Before this year ends, we intend to have grown our business to twice its size in only 2 years, and I want to express gratitude to our teams for their tremendous efforts in achieving these results. We'll keep putting capital to work to fuel expansion and also use our scale for efficiencies and savings. We take pride in beating the category, which comes from our strong value proposition delivered by our Designed for Life business model. We'll stay on the offensive, remain agile, manage whatever is within our control and provide an excellent customer experience. I'll now hand the call to Donna so she can go over our quarter 3 results and a few points about our fiscal 2023 outlook. Donna?

I appreciate that, Mary, and hello everybody on this call. My comments will start with a look back at what we delivered in the third quarter, after which I'll walk through our outlook for the rest of fiscal 2023. The results we posted in Q3 leave us encouraged. Consolidated net sales rose by $18.1 million, which works out to 15.5%, reaching $134.8 million during the third quarter of fiscal 2023, and that gain versus the same period last year came from expansion in the retail and other channels. Within that, net sales from showrooms climbed $13.3 million, a 19% lift, to $83 million in Q3 of fiscal 2023. A major driver of that improvement was a comparable net sales gain of $10.4 million, or 18.5%, reaching $66.4 million in the third quarter of fiscal 2023, up from $56.1 million during the equivalent stretch a year earlier, which stemmed from stronger point-of-sales transactions fueled by effective promotional campaigns along with the opening of 41 additional showrooms and 13 additional kiosks. Keep in mind that point-of-sale transactions reflect orders customers place via our showrooms, and that figure doesn't necessarily match the moment control passes to the buyer or when we book net sales. Turning to other net sales, a line that covers pop-up-shop, shop-in-shop and barter inventory transactions, these grew $7.1 million, or 61.8%, to $18.5 million in the third quarter of fiscal 2023, compared with $11.4 million a year earlier. Much of that gain came from the ongoing, planned open-box returned inventory transactions we conduct with ICON, the partner handling our inventory barter, plus the return of physical Costco pop-up-shops, which had been paused across fiscal 2021 owing to COVID shutdowns, and the launch of 17 additional Best Buy shop-in-shops. At present we run 22 Best Buy shop-in-shop sites. Let me remind you that the inventory transactions we do with ICON form part of our CTC, DFL and ESG initiatives; we take returned open-box inventory and give it new purpose in return for media credits, and those credits support our advertising efforts aimed at building brand awareness and fueling net sales growth. As for internet net sales, meaning sales completed directly with customers via our e-commerce channel, those fell $2.2 million, or 6.3%, to $33.3 million in the third quarter of fiscal 2023, versus $35.5 million a year earlier, as we keep witnessing some movement back toward shopping in person. Over the first 9 months of the prior year, internet net sales are up 11%. Looking at product categories, our Sactional net sales grew 18.9%, while net sales in our other category, covering decorative pillows, blankets and other accessories, rose 36.5% against the prior year period. Because of changes in our Sac promotional activity, Sac net sales declined 11.6% during the third quarter, though they had risen 4% across the prior year 9-month period. The 300 basis point drop in gross margin rate versus a year ago resulted from roughly a 160 basis point rise in total freight costs, covering inbound and outbound freight, tariff expenses and warehousing costs, together with a 140 basis point decline in product margin caused by heavier planned promotional activity. Our gross margin rate came in above guidance, mainly thanks to reduced inbound freight costs and because the advantages of lower freight rates flowed through to the P&L sooner than we'd expected, though a modestly weaker product margin rate offset some of that. We do expect inbound freight rates to hold steady at this level through the rest of fiscal 2023, yet given how much inventory we carry to keep customers happy with the brand, the complete P&L upside from these lower rates versus last year won't show up until that inventory sells, which happens late in Q4 and on into the first half of fiscal 2024. SG&A rose 40.8% year over year, mostly because of higher employment costs from new hires and variable compensation, greater rent expense tied to 54 added touch points, and increased percent rent stemming from the rise in touch point net sales. Overhead expenses went up as a result of infrastructure investments like technology and professional fees, along with selling-related expenses driven chiefly by credit card fees connected to the net sales increase. SG&A expense as a percent of net sales climbed 720 basis points, largely attributable to planned deleverage, unemployment costs, infrastructure investments, rent, selling-related expenses, travel and insurance, partly offset by greater leverage in equity-based compensation. The deleverage in certain expenses stems from the ongoing investments we're making in the business to fuel our continued growth. Advertising and marketing expenses grew $3.2 million, or 20.3%, to $19.1 million in the third quarter of fiscal 2023, up from $15.8 million in the same period a year ago. Advertising and marketing expenses represented 14.1% of net sales in the third quarter of fiscal 2023, versus 13.6% of net sales in the prior year period. The rise in advertising and marketing as a share of net sales is mostly the result of higher media spending to support our third quarter and expected fourth quarter net sales growth. Keep in mind that advertising and marketing investments pay off across multiple fiscal periods. Depreciation and amortization rose $700,000 from a year ago to $2.5 million, chiefly because of capital investments in new and remodeled showrooms. The operating loss for the quarter was $11.6 million, compared with operating income of $3 million in last year's third quarter, driven by the factors I just described. Net interest expense of $68,000 for the third quarter was a bit above the prior year period, tied to unused line of credit fees that rose because of the increase in our revolving line of credit earlier this year. Before we move on to net loss, net loss per diluted share and adjusted EBITDA, please see the terminology and the reconciliation between each of our adjusted metrics and their most directly comparable GAAP measurements in our earnings release issued earlier today. For the quarter, we posted a net loss of $8.4 million, which works out to $0.55 per diluted share. That compares with net income of $2.8 million, or $0.17 per diluted share, in the same period a year earlier. In the third quarter of fiscal 2023, we recognized a $3.2 million income tax benefit tied to the operating loss for that quarter, versus a $200,000 income tax provision in the third quarter of fiscal 2022. Our effective tax rate climbed to 27.8% in the third quarter of fiscal 2023, up from 5.9% a year earlier, and the reason is that fiscal 2022 enjoyed the release of valuation allowances on our net deferred tax assets. As of the close of fiscal 2022, those valuation allowances had been fully released. Adjusted EBITDA came in at a loss of $8.3 million in the third quarter of fiscal 2023, compared with adjusted EBITDA income of $5.8 million in the prior year period. Adjusted EBITDA for the third quarter beat what we had expected, thanks to the gross margin declines that were better than planned, which we discussed earlier. Now on to our balance sheet. Our inventory levels match our projections. Inventory was up 63% year-over-year, and we feel very good about the quality as well as the quantity of our inventory.

The fact that we keep evergreen products in stock at all times gives us an edge over competitors, and since that merchandise isn't tied to any season, we never face the danger of carrying too much of it or needing to discount in order to bring those levels down. Our current stock position matches what we set out to achieve — staying at the front of the industry for product availability and shipping speed. Looking ahead to fiscal 2024, we anticipate that inventory amounts could come down somewhat thanks to easing costs on incoming freight, and the technology we've recently put in place lets us distribute that inventory more efficiently through programmed allocation. When the third quarter closed, we held $3.8 million of cash and cash equivalents, plus $36 million available on our revolver, with nothing drawn against it. That figure mirrors when our inventory purchases occurred along with how net sales, profitability and cash generation swing with the seasons. For our fiscal year, the fourth quarter always has been — and will be — the period producing the largest operating cash flow, which means right now we hold, and anticipate finishing the year with, combined cash, cash equivalents and credit line availability above $75 million. Additional information about how we performed financially in the third quarter of fiscal year 2023 can be found in our earnings press release. Turning to guidance, the environment we're navigating remains fluid, with a broader set of possible results for the fourth quarter. Because of that, our forecast assumes year-over-year net sales growth somewhere between the high single digits and the mid-teens. Even though quarter-to-date we're running near the top of that band, substantial holiday volume weeks still lie in front of us, so we think it's wise to build some uncertainty into what we're projecting. We anticipate continuing to reap the rewards of cheaper inbound freight working its way through the P&L, and those reduced costs should deliver their biggest boost to gross margin during fiscal 2024; for the fourth quarter, gross margin should rise slightly, by roughly 115 basis points versus the same period a year ago, since lower inbound freight expense ought to outweigh increased promotional discounting, warehousing expenses and fuel surcharges on outbound last miles. For the fourth quarter of fiscal 2023, we expect the adjusted EBITDA margin rate to climb by about 325 basis points compared with last year. That Q4 improvement over the prior year stems from the higher gross margin rate along with anticipated leverage on total operating expenses given the seasonal lift in net sales volumes; to wrap up, our third quarter fiscal 2023 results leave us feeling very satisfied. Even with macro conditions proving difficult, our team keeps delivering on our growth strategies and running this business with discipline. We feel good about where we stand going into the crucial fourth quarter, which generates the largest share of net sales, profits, and operating cash flow; we'll keep taking advantage of the appealing opportunities we see for long-term growth and gains in market share; and with that, we'd like to hand the call back to the operator now so questions can begin. Operator?

So you mentioned the category is down, and your Q4 guidance looks a bit softer than what you previously expected. Is there anything you could share regarding how consumers are feeling right now? Are any customers putting off a buying decision? And then, on a bigger picture level, what's your thinking on how higher interest rates and a tight housing market are affecting demand? And then I've got a quick follow-up.

Maria, thanks for asking. So I think, clearly, as we're seeing — like you said, the category being down — that began earlier in the year. We've kept beating the category. And in fact, according to our most recent figures, the gap between our results and the category is widening. And as you can tell, when you look at the performance we've shared, we're coming in at the upper end of our guidance and have clearly built in some variability. Regarding what we're observing when it comes to consumer shifts or changes, I think, as everyone has reported, promotions are appearing more often in the category. So we've reacted to that, all of which was planned for, but they're far more benign than pre-pandemic levels. Demand is somewhat choppier. So take us, for instance: Black Friday was extremely strong. Then Saturday and Sunday were okay, and then Cyber Monday was really strong. We're seeing that shoppers are holding out, thinking stronger promotions will come from that side. So the shape and the timing of quarter 4, we've planned for, and we feel really good given that we're tracking at the high end of our guidance. Our quote pipelines are at record levels. We were just looking at the teams this morning. It's so strong. And with the strong promotion of <<inaudible>>, the marketing investments that Shawn discussed, we feel really good about delivering, as Donna shared, in line with our guidance. I think when it comes to any other shift among consumers, which is the second part of what you asked. Broadly, we're clearly seeing a bit of a mix shift, but that really is against the channel mix shift, with a bit of movement back to touch points compared with last year. But as you're aware, last year was really driven in quarter 3 by some broader post-COVID dynamics. When it comes to consumer purchasing, the mid to large purchase sizes, and clearly, StealthTech as well, we see that as very strong. A slight shift toward financing, but really nothing when it comes to sensitivity to discount. At the lower end, we're seeing some trends with smaller purchases, where conversion is high when they're on promotion. So very similar, Maria, to clearly what everyone else is seeing, but no other shifts that we see. But clearly, the good news is our core consumer is very affluent, and we have a great plan that we'll keep fostering through for quarter 4.

Understood. That's really useful. Mary, you mentioned this briefly, but could you say a bit more about how extensive your promotional activity is this holiday season compared with competitors, the wider retail landscape, or even earlier holiday seasons?

Yeah. For us, when we look at the promotions we've lined up, there's slightly more frequency and slightly more depth across Black Friday and Cyber Monday, yet it's not as deep as what other competitors are doing, because honestly, our brand strength is that strong. And when we consider the growth we've achieved and how sticky the brand is, extending that isn't necessary. And as Shawn mentioned, I believe 38% of our most recent customers don't even cross shop with anyone. They simply want to come to us, and they come and build out their quotes with us, obviously. Then, thinking about the marketing investments Shawn discussed, we have strong alignment on the key big weeks for the remainder of this year. Very efficient and effective, and I think I gave you a couple of examples around SMS, but there are others too. The team is very agile and they continue adjusting, so we genuinely feel good about what's planned for the rest of the quarter.

Excellent. To begin, congratulations on the quarter. Then, for my initial question, Shawn, you've shown a lot of thoughtfulness and deep experience regarding supply chain; and right now I'm quite curious about China's function not only for Lovesac, but across the industry, and I would really like to hear what you think about the coming 5 years concerning how China will factor into your supply chain. What part will the rest of the world play? And what amount of headway do you plan to achieve in reducing the gap between the location where your product is manufactured and the location where your product gets consumed?

Yeah, Tom, I appreciate that question. We, as you're aware, have remained extremely watchful in working to broaden our supply chain; that has served as a company strength. It keeps supporting our success in various manners and shows up in various manners as the world changes. Right now, China's — so let's go back 3 years, perhaps China accounted for close to 100% of our — made up 100% of our production overseas and likely 90% of our total production; and at present, that figure has fallen to somewhere under 30%, plus we maintain backup capability for nearly every item we produce there. So we've — we build equivalent Sactionals in Vietnam, in Indonesia — pardon me, in — right, and Malaysia. And our perspective is that the world along with global supply chains keep growing more fragmented, and we desire greater diversity. So we're chasing, once more, backup supply chain production possibilities in North America, in Mexico, aggressively. And we're concentrating on the long run of becoming more vertical, even if not owned, and more sustainable manufacturing approaches, relying on more sustainable inputs, nearer to the consumer, shipping across shorter distances, smaller carbon footprint; with, naturally, the condition that we think this perspective can be executed more cheaply and lift our gross margins eventually. I mean, that — we don't merely think so, but we possess grounds to think so, that this will be the result. So all — we see all of these as merely a step toward that goal, all these actions we're taking as a step in that direction. And we think that however much China has served as an excellent supply chain for — across many areas, we're all seeing the same headlines. We all think there can be danger there. And we've witnessed recently, via COVID, what occurs when shocks hit the supply chain. And so our emphasis is on strengthening, building a robust business with supply chain diversity, backup manufacturing; and I believe we've performed well on that thus far, and we aim to stay ahead of that curve as that curve keeps emerging in real time. At the end of the day, the toughest item in this segment is going to be fabric, since, as many of you probably know, the mill supply chain in China is incredibly robust. Fortunately, we've made significant progress in Mexico and North America when it comes to finding alternative fabric sources, which gives us the redundancy we need to be ready for whatever comes our way. And naturally, we also need to keep concentrating on our first product costs, pushing costs lower, lifting gross margins higher, even as we at last start to bounce back from all the supply chain challenges—inbound freight and so on—that have dragged on those areas of our business, along with many others. So I'm grateful for the question and for the chance to talk about it. Once again, this is something we take pride in prioritizing, and ideally we're staying ahead of the curve on it.

Great. Now for my second question, you mentioned the chance for gross margin gains in the coming fiscal year driven by improved freight; so broadly speaking, how should we frame your intended allocation of those bigger gross profits if you decide to do additional promotions or marketing, or if you choose to let a larger portion reach the bottom line? Could you just discuss that at a broad level?

Yes, yes. So we expect to achieve some gross margin expansion from reduced freight rates in the next year. There are several factors we are considering, though we won't provide guidance until next year when we — there is — one portion of it will go toward offsetting some of the elevated outbound freight expenses that everyone is facing via the FedEx and the UPSs in the industry. Higher — we anticipate somewhat greater warehousing expenses simply because of rising labor cost at our 3PL, so part of that will go toward offsetting that. And a share will be reinvested into the business next year, since as we keep saying, we still need certain foundational infrastructure investments. And we do expect a share of that gross margin expansion to reach the bottom line, but we're going to manage that. You know how we operate. We're very agile, and we're going to manage that and permit as much as we believe we can reach the bottom line next year as we manage through the year; so we have — there is a use for that gross margin expansion, but we will keep operating the way we always do and very fiscally responsible and agile, and we believe we have plenty of opportunity next year.