Welcome to Nelly Group Q2 report 2022. Today, I'm pleased to present CFO John Afzelius-Jenevall. For the first part of the call, all participants will be in listen-only mode, and afterwards there will be a question and answer session. During the question and answer session, participants are able to ask questions by dialing star five on their telephone keypad. I will now hand the call over to John Afzelius. Please go ahead.
Thank you for the introduction. If we go to slide two, my name is John Afzelius, Chief Financial Officer of Nelly. I will today firstly briefly share what Nelly is for those of you who are new to the case, and then go through the developments of the quarter. Before I go through the financials and our sustainability work, I will also detail what we're doing to restore profitability. We will open up towards the end for those of you who have registered to ask questions, so please do so, well ahead of the end of the presentation. Proceeding to slide three for an introduction of Nelly.
Nelly was founded in Borås, the e-commerce mecca of Sweden, in 2004 and has been since one of the pioneers within fashion for young women in the Nordics, online fashion, that is. We are online only and have a large follower and customer base and over two million members on Nelly. Social media is our backyard, and about 20% of our target group visit us on a weekly basis. We're listed on the Stockholm main list based in Borås, have about 250 employees and revenues of SEK 1.3 billion. On slide four, we present Denise. Denise represents our target group, and her appearance is important to her. She shops about 18 times a year for her appearance, and at Nelly, she can conveniently not only find what she's looking for but also find inspiration.
In short, we don't aspire to grab all female shoppers, but for the young woman in the Nordics looking for trendy but affordable fashion, we shall be at our top of mind. After this very brief introduction to Nelly, let's look at the second quarter highlights on slide five. Nelly saw revenues decline by 14.5% in a weak e-commerce market. The campaign activity and competition for the online customers was significant as customers used physical stores to a greater extent than in the previous two years. While the market has contributed to this most unsatisfying development, it is also clear that we have not delivered what our customers want frequently enough. Meanwhile, our relevance for the young woman has not deteriorated.
Despite lower order volumes and consequently sales, neither brand awareness nor customer consideration that we measure regularly, for Nelly has fallen in aggregate, and the number of members and the number of followers, is also intact. On the positive side, the gross margin increased by almost 2 percentage points in the quarter, and we saw record low fulfillment costs in our new automated warehouse. On the organizational side, there was significant changes towards the end of Q2 when a number of new leaders in Nelly were appointed. All of them were internally recruited, apart from Ludvig Anderberg, who will join as new CEO in August. Ludvig is not entirely new to Nelly but actually held both the CFO and CEO title when he left in 2018. A warm welcome back to Ludvig.
While there is no cash flow impact from this charge, the accounting effect of these changes is a SEK 10.5 million charge, a provision that I will revert to in the financial section of the presentation. Before going through the Q2 financials, let's proceed to slide six. The main owners of Nelly, the board, and the management are most dissatisfied with the weak profitability development, and we're working closely together in a number of work streams aiming to restore and improve profitability. Firstly, as regards our assortment, we're working to increase the sales of our own brands, as we know that this both drives margins and is one of our key competitive advantages. We will continue to work with external brands, but we will be rather picky and only invest in brands that drive demand and profitability for Nelly.
We will also decrease the width of our assortment, both to drive efficiency and profitability, but also to simplify for the customer in finding the right product for her. Secondly, we will continue our day-to-day optimization as regards performance marketing. This has yielded positive results with improvements over the last couple of quarters, and we are encouraged to continue with these incremental but important improvements. As regards other marketing channels, we will focus more on smaller influencers and less on larger influencers, collabs, and large events, and in general, focus more on directly sales promoting activities. Thirdly, while the progress on fulfillment cost is most pleasing, we will continue to drive efficiency in operations but also trim the fixed cost base of the warehouse and the operations.
Improvements in the net between freight income and cost were visible already in this quarter, but we will target to improve this ratio even further. Lastly, we have a strong focus on efficiency and cost throughout our business. We're overhauling our IT system architecture to drive both efficiency and also to remove cost. As I mentioned on the previous slide, we have already appointed new leaders to drive this transformation towards restoring and improving profitability. We have a strong focus to drive down cost through simplification of processes and our business. Please let us proceed to slide seven to have a look at the Q2 financials. If we start on the top of the P&L with the revenue development, we note that net revenue, as I mentioned, fell by 14% in the quarter.
Underlying sales before returns in Nelly, in our core business, i.e. the Nordic D2C market, fell by 9% in the quarter. Despite a higher average order value and higher organic traffic, lower paid traffic and lower conversion growth rates drove down sales compared to last year. Price increases that were done early in the quarter led to a higher gross margin, but they also affected sales negatively. During the quarter, there was high campaign activity and high customer acquisition competition, when we saw customers returning to physical stores to a larger degree compared to the previous two years. The return rates was also a drag on net revenue development, returned to an increase to 40.6% compared to 36% in Q2 2021.
A more normalized behavior compared to the pandemic impacted return behavior that we saw during the last two years contributed, combined also with the price increases. Those two factors together drove return rates higher in the quarter. Taking a look at the gross margins, they increased to 47.8% compared to 46% in Q2 2021. The main reasons for the higher gross margin were firstly, more or less insignificant outlet sales in the quarter. If we compare that to last year when we sold more old stock through the outlet channel. Secondly, active work with our outgoing freight alternatives and pricing led to higher freight incomes, which also impacted margins positively.
The higher gross margin did not compensate for the lower net revenue, and as a consequence, gross profits decreased by SEK 21 million in the quarter. Let's take a look at the cost side of the P&L. Fulfillment and distribution costs were SEK 14 million lower than last year and also decreased, both measured as share of sales and per item. This was actually in spite of the lower net revenue. The first component, fulfillment costs, fell markedly both in absolute and relative terms due to the new automated warehouse in Bålsta. The progress of the new automation solution achieved target efficiency for most of the quarter, and we're very happy to see that we noted a record low fulfillment cost per item handled in the quarter.
The work to realize the targeted cost savings during the year is going according to plan. The other part of the P&L, item called the fulfillment and distribution cost, i.e. the distribution cost, fell largely in line with the lower volumes shipped in the quarter. Proceeding to marketing costs amounting to SEK 43 million in the quarter compared to SEK 40 million last year. Performance marketing cost fell, more or less in line with net revenue development. The increase that we saw in marketing spend is related to investments in influencer marketing and social media. One example being the TikTok event, Nelly House, that was done during the quarter. Admin and other operating costs amounted to SEK 83 million compared to SEK 67 million last year.
The significant increase was mainly due to the SEK 10.5 million provision for payments during the notice period for the previous CEO, the Chief Assortment Officer, the Chief Technology Officer, and other leaders who all left Nelly in June. The negative effect of this in Q2 is, as I mentioned, SEK 10.5 million. Since all but the CEO role, though, will be filled by internal candidates, the corresponding positive effect is about SEK 5 million in the H2 of 2022 and SEK 2 million in 2023. This provision does not impact cash flows. The admin and other operating costs were also negatively impacted, as we saw in Q1 and also Q4, by the higher lease related IFRS 16 amortization that has been recorded after the new automated warehouse were entered service in October 2021.
In all, EBIT in the quarter was SEK 26 million lower than last year. To summarize, the fall in operating profit was primarily the result of a reduction in net revenue and the provision for organizational changes that I've detailed. On slide eight, let's look at a few other financial aspects of the quarter. A positive highlight is that the organic traffic to Nelly sites increased in the quarter. We did, however, spend less on performance marketing, which led to lower volumes of paid traffic and consequently lower total visits to our sites were generated. In the Nordics, traffic declined by about 5%, and this, combined with an 8% lower conversion rate, implies that the number of orders fell by 14% in the Nordics.
Another highlight is the increasing AOV, average order value, which was + 9% in the quarter. We've seen a positive AOV trend since early 2021, which has been driven both by more items per order but also, and especially lately, a higher average item value. Next, I'd like to comment on fulfillment cost again. As I mentioned, this was the main contributor to the lower fulfillment and distribution cost in the quarter. Despite lower volumes handled in the quarter, fulfillment costs measured both as share of sales and per item handled reached record low levels, and this is a result of the automation investment, of course, but also a job well done by our warehouse staff. They are relentlessly trimming the new facility to drive efficiency and cost.
I was there lately taking part in working on the line and seeing myself the changes and the incremental changes that have been done that greatly increase efficiency. Well done. Cash flows in Q2 was a positive SEK 33 million. This is mainly due to positive working capital changes as the CapEx was low. Cash at the end of the quarter amounted to SEK 83 million. We did not tap into our credit facilities as per the 30th of June, and we have no interest-bearing debt if we disregard the government tax credits. Having been through the financials, I'd like to hand or to round off the presentation by highlighting our sustainability work on slide nine. In our sustainability work, we're dedicated to reach our defined and ambitious sustainability goals.
We've been a member of STICA, the Swedish Textile Initiative for Climate Action, since 2019, and we're committed to reducing our climate impact. We divide our sustainability work into three areas within which we drive our work and our initiatives within the sustainability area. Empower femininity to make the young woman feel respected, confident, and celebrated. Respect the planet to reduce our climate impact and manage our resources. Fair and equal to create a safe and sound environment for employees and partners. In 2021, we're happy to say that we reached all our sustainability targets. On slide 10, we wanna share what the overall goals for 2022 and beyond are. In 2022, all our products from our own brand shall be produced in externally inspected factories.
We've currently inspected 75% of them, and we shall reach 100% before the end of the year. Next year, we're aiming to achieve net zero carbon emissions within our own operations. By 2025, we're targeting that half of our textile products shall be made by more sustainable materials, and we're currently at about 24%. Finally, by 2030, we're targeting to decrease greenhouse gas emissions by 50% along the value chain. Finally, as I conclude my presentation and before I hand it over to the moderator to open up for questions, I'd like to summarize that we are most dissatisfied with the profitability development of Nelly. The focus on restoring and improving profitability could, however, not be greater, and the direction for what to do over the next few quarters could not be.
It could not be more clear. Thank you, and handing back to the moderator.
If you wish to ask a question, please dial star five on your telephone keypad to enter the queue. If you wish to withdraw your question, please dial star five again on your telephone keypad. The next question comes from Niklas Lingblom from SEB Equities. Please go ahead. Your line is now unmuted.
Good afternoon. Thank you for the presentation, John Afzelius. A couple of quick questions, and then maybe I could get back into the call. First, I would like to ask you on the cash flow, actually. Now you reported a SEK 74 million year-on-year increase in stock and trade, yet the net change in working capital is reported at SEK +54 million in the quarter. What are the moving parts here, please?
Yes. I think one of the main contributors to the positive net working capital change is that we both repaid some of the government tax credits, but we also took up another 42 new ones. So that's roughly a SEK 30 million positive effect that goes into the working capital section of the cash flow from operations.
Okay.
Does that?
Okay.
I mean, that's what
Yeah. No, absolutely. That. Yeah. Sorry.
No, sorry. Please continue.
Okay. Let's move on. I was also wondering. I think to some extent you outlined this in the report, but I wanna ask you, since visits are down about 5%, which is actually not too bad given where everybody else are in the same quarter, I would say. Yet orders obviously down more than twice as much, -14%. Is that as simple as saying that, you know, you certainly have quite a large group of followers and they to some extent find a way still to the Nelly site, but they don't necessarily appreciate what they see or your consumer offering at this point?
If that's the case, I would also like you to comment a little bit on the stock and trade composition leaving Q2 and going into this quarter, from a markdown perspective, in current trading phase.
Yes. Well, firstly, to answer your question technically, that's, of course, easy. I mean, you mentioned yourself 5% decline in sessions. The bridge between sessions and orders is, of course, the conversion rates. The more difficult question is, of course, why the lower conversion rate? I think-
Mm-hmm
The fair answer is a combination of we did do price increases, we have seen inflation, we have seen war in Europe and a more hesitant consumer, I believe, and also this return to physical stores in that respect. I guess it's a combination of those factors that lead to the low conversion rate, which is the missing link in your bridge there. Is that a fair answer to the first question?
Yeah, it makes sense.
Yeah.
Yeah. Yeah, absolutely.
Second, implicitly, you're asking. You note that inventory volumes are going up, and should we be worried for markdowns or write-offs going forward?
Mm-hmm
First, we're coming from over the last, I'd say six or seven quarters, we've had a very positive development there. We're coming out from low levels when it comes to or high levels of inventory turnover. We were planning to sell more than this in Q2, so obviously we've been building more stock than we had planned to. We also saw close to zero outlet sales in the quarter. Should one expect more markdowns and going forward? Of course, it is a component to us. We are, as you know, and we've discussed a lot in the past, focused on the outgoing stock levels because it doesn't help.
We will be active when it comes to reducing those levels in our main channel. We'll also I mean, if you don't go through that, there may be more clearance sales than in the H1 , which was basically nil. We're coming from nil clearance sales. That we may see some more of that. We have been, especially towards the end of the quarter, rather active when it comes to promotional activities, and we're likely to be active in that also going forward. Yes, we're building an inventory, however, from low levels and not overly dramatic.
How much are you able to put any sort of any number on sort of the excess inventory that is, you know, likely at risk of being cleared, you know, at substantial discount?
No, I mean, no. I mean, I wouldn't like to do that. Over the last few years, it's had, I mean, or at least over the last 6 quarters, it's been very low levels. While it may be somewhat larger than that, we're not expecting, I mean, really significant volumes. Yes, there may be more, but we are going to try to use the main channels that we do have to sell as much of the season products in the current season.
Right. Thanks, John. Final question, and then maybe I could come back in later in the call. You know, obviously there's this relationship between increased share of private label sales, but also increase in return rates, right?
Yes.
My question is, I guess, not the next quarter or two, but from a strategic point of view, where do you actually think, John, that these two ratios should be? I mean, what's an appropriate level of share of sales from private labels and at that level, where would you like the return rate to be?
Yeah. First, let's just push back a little on your assumption that private label is always equal to higher return rates. I'd rather say that the main driver has been the category mix. We see extreme differences between, I mean, in the beauty category, we see very, very few returns. In the other extreme, you say, you can see party dresses where you see high return rates. It's really a category. The main difference is really between categories. Historically, Nelly has been very strong when it comes to, I mean, party dresses and dresses when it comes to our own private label.
I'm not saying that we shouldn't, that will not be the case in the future, but it's actually more a product group mix question than anything else. When it comes to private label or our own brands, really, it's clear that we want to increase that share. We will continue to have external products in the mix, but we want to come back to and beyond the close to 50% levels that we've been at historically. It's both. Your question is really what does that imply for return rates? Well, not necessarily higher because it has to do with the product group mix than anything else.
Having come through the pandemic. Going into the pandemic, we were heavily skewed towards party dresses and dresses with high return rates. Through the pandemic, we obviously saw that changing rather dramatically. Going forward, we will not strive to come back to as such a heavy way to put emphasis on party dresses and dresses. I wouldn't necessarily assume higher return rates going forward just because we wanna increase our share of own brands. Long answer to a short question.
All right.
Is that understandable?
Also very clear and very reassuring, I think. Thank you for now and maybe I should come back later in the call. Thanks.
Thanks, Niklas.
The next question comes from Ebba from DNB. Please go ahead. Your line is now unmuted.
Hi, John, and thank you for this presentation. I have a couple of questions as well. Firstly, it would be interesting to hear more specifically. You've stated that you will increase the pace of the transformation, and you also give some details here in terms of what is in focus in terms of the profitability improvements. What can we expect over the next coming quarters in terms of the focus and what will be kind of the main drivers that can help to improve profitability short term in your view?
Yes. Well, the first question is really rather simple. What is the focus? The focus is profitability, restoring profitability, and then improving profitability from historical levels. So that's the short answers. How then to get there? Well, I outlined these four components. Firstly on the assortment side, to really have a very clear focus on those components that I talked about, increasing the own share of own brands, that does impact margins positively. Secondly, being picky in our external brands. Cutting the tail, if you may, when it comes to both number of brands handled, but also looking, I mean, very sharply at what drives demand and what drives traffic for Nelly and what is profitable for Nelly.
Those brands we wanna work and do more with, we want to invest in those brands. But the opposite goes for other brands. Secondly on the marketing side, in Q2, we actually saw, I mean, we didn't see any performance marketing inflation even though we still had a rather demanding competition situation for traffic. We've become increasingly better at how we handle our performance marketing and how we buy that. But we still see potential there and those day-to-day incremental changes we believe will continue to help, and that's a pretty significant cost item. We expect or we're clearly targeting the marketing cost share of sales to come down as an effect of that.
The other part of the marketing cost that did increase in the quarter, in the last quarter and also historically, are other types of marketing, not directly short-term sales driving. We will do less of those, i.e., also cutting costs on that side. Operations we talked about. I don't think I need to outline that more. Fourthly, on when it comes to other processes, I specifically mentioned the IT system architecture. We're looking into that, prioritizing. I mean, prioritizing. We're also cutting costs. We're simplifying, doing what we need to do and we expect costs from that component to come down.
What we initiated now in the H2 of the quarter, we have new leaders in place with a very clear mandate to drive change, to drive transformation towards more efficient, more simple operations, and to drive costs. The last bit is, of course, impacting the admin and other operating cost line. I think it's a pretty comprehensive package. We're working intensely on it. We're working shoulder to shoulder, not only with the, I mean, the company and management, and our employees at Nelly, but also with the board and our main owners. Does that answer your question?
Absolutely. Thank you. It would be interesting to hear kind of looking forward towards the H2 of this year, what is your view on kind of developments in terms of conversion rates going forward? Kind of given that we have quite a challenging consumer environment at the moment, what could we expect there, kind of given where we stand today?
I think I'll refrain from guiding on future conversion rates. What I can comment on is what we're doing internally. Something that we mentioned already in Q1 is we are launching a new site. We have positive signs that may impact our conversion rate positively. We're of course working intensely with how we market the inventory that we have, but also thinking about what and how we are purchasing for the future, for the coming seasons. But as regards consumer sentiment, et cetera, I don't wanna comment or guide on our expectation there.
It's, I mean, it's pretty clear that we did we did plan and expect a different development in Q2 than we've seen. Hence, and consequently the increase in stock and trade that we saw and that Niklas asked about as well. What we can control is when it comes to the conversion rate is going well.
Good. Thank you for that answer. Just one last question, please. In terms of the gross margin improvement, you mentioned that a key aspect was driven by changes in terms and conditions, and also that you're actively working on alternative shipping options. It would just be interesting to have a little bit more detail here on what this means specifically. I assume that these changes and improvements that we saw in this quarter, that we also can believe that this should be carried forward over the next coming quarters. Is that correct?
Yes. I mean, that's a. We internally measure what we call the postage net. I mean, the net between the freight income and freight costs. In one extreme is where you have free freight and free shipping, which we don't. We haven't had that. We have skewed our terms both when it comes to the freight-free limits. We also charge customers for the returns. We've also adjusted those levels. It also has to do with rather, I mean, small changes in how we position different shipping options in our checkout. It's more skewing terms and skewing conditions, altering the order of different freight options, et cetera, that is giving this improvement.
Yes, we wanna continue doing that. It's also not, I mean, it's not inconceivable that it has had a negative effect on sales, but we're looking at the net of that and believe we're doing the right thing.
Great. Thank you so much.
Thank you, Ebba.
As a reminder, if you wish to ask a question, please dial star five on your telephone keypad. The next question comes from Niklas Lingblom from SEB Equities. Please go ahead. Your line is now unmuted.
Right. So, John, just one quick final question. Would you care to share with us sort of the impact on cost of goods from rising inflation in the cost of goods sold in this quarter compared to the impact in the gross margin bridge I'm asking for from price changes? It would also be very meaningful if you could give us some idea of where you expect cost inflation to end up in, say, the H2 of this year.
Yes. I mean, obviously the price increases we did early in the quarter were designed to provide coverage for the cost inflation in our purchased goods and some more. The direct impact as we've mentioned in the last few quarters of the freight cost of things is not that significant. It's actually coming down somewhat, so it's less than half a percentage point in the gross margin impact. The price increases that we did were designed to compensate for that and some more.
Perfect. Yep.
Going forward, again, I'm a bit hesitant to guide on that. Of course, we've done these adjustments to compensate for what we see and for what we believe is has happened and is going to happen. We're not planning to do any additional price hikes, currently at least. I guess that indicates.
Right. Yeah. No, absolutely. I let me rephrase my question. The strategy for at least for the H2 is to try to mitigate whatever cost inflation there is by the equivalent amount of changes to price and mix. Is that fair? Whatever cost inflation would be.
I mean, I wanna. Currently, we're not planning to do anything in addition to what we've done. There is of course, it's a balancing act.
Okay. Okay
Between price increases that provide gross margin improvements, but also may improve sales of course. It's a bit of a balancing act.
Right.
We did do price increase in the beginning of Q2. We were not planning to do anything, as of yet, as of now at least.
Perfect. Very clear. Thanks again for taking all these questions, John.
That's what I'm here for, Niklas.
There are no more questions at this time, so I hand the conference back to the speakers for any closing comments.
Thank you. Nothing more from my side apart from, as I said, a very clear focus on what we're doing here and now. A clear focus on profitability, restoring and improving it. Thank you for your attention.