Welcome to Nelly Group Q3 report 2022. Today, I am pleased to present CEO Ludvig Anderberg and CFO John Afzelius. For the first part of this call, all participants will be in listen-only mode. During the Q&A session, participants are able to ask questions by dialing star five on their telephone keypad. Now I will hand the conference over to Ludvig Anderberg. Please go ahead.
Approximately 2.4 million orders with us every year. Together with our 1.3 million followers on social media, we play a major role in providing our customers with daily fashion inspiration. As previously communicated, we are working with a number of actions during the quarter. We have a strong profitability focus in everything we do with Nelly at the moment. Our top priority is to increase our assortment efficiency.
We are working with creating a clearer assortment, and an improved customer journey and customer experience through a tighter and more condensed assortment. We will always also improve the structure of our assortment, focusing our Nelly brand towards products where we see a high volume and profit-driving possibilities. We will also use our Nelly brand with an extension of high-fashion products to drive brand and awareness. External brands will be invested in selectively where we see an opportunity to drive demand and profitability. During the quarter, we have worked a lot with marketing optimization, and we will continue to do so in the time to come. We will focus our market activities on micro-influencer activities rather than larger influencer collabs and events. Marketing would also be focused on directly sales-driving activities, where we also integrate our brand marketing in all our channels rather than driving specific brand activities.
Since investing and implementing our new and automated warehouse last fall, we have been focusing on realizing our targeted cost savings. We will continue to do so, and we are on plan with this, and we will reach our targeted cost savings during 2023. We will also look at improving our freight to income cost ratio on the logistics side. During the quarter, we have launched our updated Nelly.com site, a modern and API-based front-end solution that will improve performance and maintenance. We will also move forward with evaluating our IT structure to remove cost and drive efficiency. As communicated during the summer, we have implemented a smaller and more direct organization, and it has been launched during the quarter with good results.
We have also appointed new business, key business leaders to drive our transformation. A little bit about the performance of Nelly during the quarter. During the quarter, we saw a weak online market in our segment, and we saw a 9% reduction in our net revenue. But despite this decline in revenue, we have already now seen efficiency improvement costs. Our previously communicated cost savings program is progressing well and running according to plan. I will now hand over to John to give you the details of the financial results for the quarter.
Thank you very much, Ludvig. Please let me provide some more details then on the Q3 financials. If we start on slide seven. Net revenue declined, as Ludvig said, by 9% in the third quarter. While we saw a continued increase in organic traffic, paid traffic was lower. As I will return to, we spent significantly less on performance marketing in the quarter, and paid sessions were consequently down compared to last year. With the largely flat conversion rates, orders were down in line with sessions, but sales then fell less than orders as the average order value increased. During the quarter, campaign activity was high in our markets as Ludvig alluded to, and customer acquisition competition continued to be tough.
The return rate fell by 0.8 percentage point to 36.2% during the third quarter, mainly due to mix effects in our procurement. As you may be aware of, mix, there is a large difference between return rates in different categories. Significant difference actually. We can see that LTM last 12 months rolling return rates stabilized in Q3 at levels lower than those recorded prior to the pandemic. As you probably aware of, we saw significant changes in the return rate during the pandemic. If I then turn our focus on gross margin. Gross margins decreased by 4.3 percentage points to 41.5% in Q3.
The main reasons for the lower gross margins were initially or firstly, lower margins due to high level of campaign activity, as I mentioned, both internally, as we activated our inventory more aggressively, but also in the market in general, we've seen a rather intense campaign pressure and campaign activity. Secondly, we saw a lower share of own brands in the quarter. This also contributed negatively to the gross margin. On the positive side, just as we saw in Q2, not enough, though, to counterbalance the negatives that I just mentioned was the higher freight fees from customers that we received during the quarter. This comes as we have adjusted our freight terms previously during the year. We see a better cost coverage there.
The low gross margin compared, combined with the lower net revenue resulted in a SEK 25 million gross profit decrease in the quarter. Let's take a look at the cost side of the P&L. Just to be clear, the pink bubbles are the delta compared to last year in absolute terms. The gray bubbles illustrate the warehouse project, the cost that incurred last quarter. To be perfectly clear, we have no warehouse project costs in this quarter, obviously, because that project was closed last year. I wanted to include those for comparison, as I will refer to those numbers several times during this presentation. Firstly, fulfillment and distribution costs were SEK 22 million lower than last year.
Mainly, of course, as we ran one warehouse instead of two warehouses as we operated last year in Q3, incurring project-related costs of SEK 12 million than in 2021. The first component, the fulfillment cost, they fell markedly mainly due to this. While we didn't see the record low warehousing costs in Q3 as we did in the second quarter, the processes of the new automation solutions are running smoothly. The work to realize the targeted cost savings during the year is going according to plan. The other part of this P&L line item, the distribution costs, they fell largely in line with the lower volume shipped in the quarter. Moving on to marketing costs. They amounted to SEK 28 million in the quarter compared to SEK 41 million a year ago.
The main reason for the significantly lower marketing spend was that the lower volumes of paid traffic that was driven to our sites, the Nelly sites. In addition to this, more cost-efficient working methods within marketing and that we held back on PR and brand marketing activities also contributed positively to this development. We were happy to see a lower marketing spend, performance marketing spend per paid session in the year in spite of the increased competition that I mentioned and in spite that we see a more tight market in that domain. Finally, admin and other operating costs, they amounted to SEK 58 million compared to SEK 64 million last year. We decreased the cost by SEK 6 million, mainly due to lower payroll costs.
Again, please note that the warehouse project-related cost in Q3 last year was SEK 6 million. All in all, EBIT in the quarter was SEK 50 million higher than Q3 last year. A quarter that in turn totaled SEK 22 million of warehouse project-related costs. To summarize, while operating costs were markedly lower this year compared to last year, also considering the warehouse-related costs that were recorded in 2021, the SEK 25 million lower gross profit implied a SEK -12 million EBIT in the quarter. Moving on to slide 8, let's take a look at a few other aspects of the quarter that we just closed. A positive highlight, just like we saw in Q2, is that the organic traffic to Nelly site increased also in the third quarter.
As we have detailed in the past, this is the kind of traffic that you really want to have. It is because of the higher conversion and because of that you don't need marketing to drive that traffic at least not initially. As I mentioned on the last slide, we did, however, spend less on performance marketing, significantly less, which led to lower volumes of paid traffic to our sites. In the Nordics, traffic declined by about 13%. The lower traffic combined with a slightly lower conversion rate implied that the number of orders fell by 16% in the Nordics. Another highlight is the continued increase in AOV, average order value. That increased 8% in the quarter.
The AOV is the product of the average number of items per parcel and the average value of these items. We have seen a positive AOV trend since early 2021, which has been driven both by more items in each order, but also a higher average item value. As I mentioned in Q3, the AOV continued to increase, but a slightly different underlying pattern because the high campaign activity that we saw and that we drove more items per parcel, which was more than compensating for the AOV drag that was caused by the campaign-driven lower average item value in the quarter. Moving on to the cost side. I'd like to comment on costs because operating costs were down by more than SEK 40 million year-on-year in the quarter.
Even considering the SEK 18 million warehouse project-related costs on the operating cost side that we saw last year and the lower volumes, it's evident that the cost base for Nelly has come down. During the quarter, we executed on the notice that is the main driver of the SEK 40 million-SEK 50 million cost reduction program that we announced in August. While we have started to see costs come down as a consequence of this initiative, we expect full annual run rate of this program to be realized by Q2 next year, 2023. Finally, commenting on the balance sheet, the cash flow and working capital changes.
Much like the first quarter, the third quarter is burdened by the building up of inventory ahead of the next quarter, in this case Q4, in which sales are seasonally strong. We saw a working capital buildup of SEK 57 million in the quarter, mainly due to higher inventory. Net cash flow amounted to SEK -43 million, similar to last year's SEK 45 million. In Q3, unlike last year, we drew SEK 30 million on our short-term credit line. After now having been through the seasonal cash flow low point of the second half of the year, we expect to build cash through the course of Q4 as we seasonally typically do. Cash at the end of the quarter amounted to SEK 41 million, and we drew SEK 30 million on the short-term credit lines.
Finally, it's worth noting that Nelly has no interest-bearing debt apart from the government tax credits. Having been through the financials, I'd like to hand back to Ludvig to comment on the progress of our sustainability work.
Thank you. Well, sustainability is an important and integral part of the work that we do at Nelly. We are working with a number of different aspects in our sustainability work internally. First of all, we are increasing the use of user-generated content on our site and in social media to celebrate our customer and show styles in a more diverse way and in more natural situations. We are at the moment participating in a project that are developing a tool for supporting and gathering analysis and insights on climate data and CO2 footprint. We have accelerated our work for a fairer industry through our supply chain by joining the International Accord for Health and Safety in the Textile and Garment Industry. With that, we will open up for questions for those of you who have registered to do so.
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 Nicklas Fhärm from SEB Equities. Please go ahead.
Thanks, operator, and good morning, everybody. My first question would be if we could just discuss the balance sheet and the cash flow developments in the quarter, and in particular, the negative change in working cap. I guess we're already seeing the numbers, which obviously adds up. My question would be, is there anything else? Is there, like, any timing issues with goods being booked on the balance sheet or anything else other than, you know, regular trading in the period which explains the working cap build-up to the end of this Q3 period? Thanks.
Well, thank you, Nicklas. I'll take the liberty to answer that question. I think the short answer is no. I mean, we entered Q3 with a higher inventory than we did the year before. It was about 19% higher than Q2 outgoing stock Q2 2021. Going into this period of lower sales, we saw a higher incoming stock, so it's mainly inventory build-up. What we have done during the quarter though is that we're growing the inventory slightly less than going out of the quarter than we did going into the quarter. Considering also in that the market has been weak, we have pulled the brake on inventories.
Still, it takes a while before that brake kicks in. We did see that inventory build up in Q3. A lot of the effect of pulling the brake on that will be more visible in Q4, we expect. The short answer is no special effects really. It's more a timing issue because I think it's pretty apparent that we had planned for higher sales than we saw this quarter. I think we're not alone in the market to have done so. That's a comment on the quarter and a teaser for the next in a way.
Right. Thanks, John. Also, looking at the actual operating performance in the period, how would you like for us to look at the fact that you have a 440 basis point decrease in gross margins at the same time as local currency sales are down 12%? From the context of typically when you do markdown activities or campaign management, you would expect to have a slightly better, I would assume, effect on sales. Are you happy with the campaign work and markdown management in this period, or is this merely a reflection of the market situation?
I think I can say both. I mean, we have been. It's really a balancing act when it comes to, in the short term, to balance profitability, which is, of course, the longer term goal. Not the long term goal. The main priority for us is profitability. In a situation where we see slower sales and going in with higher incoming stock, we need to be more aggressive on campaign activity. That has, that in a market which has seen a lot of campaign activity also from other players, that then you see a big toll taken on the gross margin.
That's also another effect when we're more aggressive on the campaign with the campaign levers. It also has an effect on the own brand shares typically, which also burdens the gross margins. In this quarter, it's really us being proactive and aggressive when it comes to campaign activity, coupled with a weak market. I don't know if that. If you wanna add, Ludvig, or if that makes sense to you, Nicklas.
I think you've described it. Perfectly. Thanks.
All right. There, there's a little bit of a lag between the video and the conference call, so I'm sorry if I interrupted you, Ludvig.
Not at all.
No. Not at all. Thank you.
All right. Let's continue. If you know, if this is merely a market reflection, I mean, the reality is quite harsh, right? How do you explain the decrease in private label sales, negative 12 percentage points year-on-year to 34% of sales? Are you happy with your assortment under those conditions?
We are, as we have said, I mean, we are in the middle of a large transition of our assortment. We are not, I mean, satisfied with the mix of the assortment that we're having at the moment. I also think that in a situation, in a market situation where we have chosen to also decrease on our marketing activities and also, as I said, we are changing a lot of how we are working with our internal brands. As we go through this transition phase, we are not, of course, happy with the situation, but maybe not, I would say, not surprised with the development that we see at the moment.
Yeah. I can also add just a few. In general, that's absolutely true. In the third quarter especially, we can also highlight that we have seen a shift back, if you may, or away from some of the occasions where our own brands are strong in. Also last year, we had a big impact with the campaign. You may remember the Bianca Ingrosso campaign that we did in Q3 last year, which was entirely our own brands, which had a large impact on sales. That also adds to the lower share of own brands in the quarter. I feel. In addition to what Ludvig says, I think those two factors should be taken into account as well.
Okay. Makes obviously a lot of sense. Importantly, if I understand you correctly, you're quite happy with your own assortment. But obviously from a substantial cut to marketing, and as you also pointed to other impacts, we see the change in private label sales as reported. Correct? Is that correct? It's not the assortment as such, you would say.
I think that's a correct summary.
We, I mean.
Okay. Okay
As we have said, I mean, we are working towards a narrower and more clear assortment. That also means that we will work a lot more with depth in our assortment than we have done previously. Of course, this is a shift for Nelly, and it's a shift for our customers to get to know. We are very convinced that this will, in the long run, provide us with a much better situation and a much, well, a better customer offer that also has the possibility of driving profitability in a better way than we have seen in the past.
Right. Thanks for clarifying. My last question, and then I'll be quiet for now, and then maybe I can come back into the call later on. That would be. If private label sales are down 12 percentage points year-on-year, why aren't return rates down at least nearly at the same level, but only 0.8 percentage points, assuming that return rates on private label sales are higher than brand sales?
Well, the direction is correct. I mean, we lower own brand sales imply lower return rates as we have seen in the quarter. So what you're implying is that you had expected a larger effect on that. Well, what we have seen in the past. During the COVID years, we saw. If I just back up the tape a bit, going into the pandemic, we saw higher return rates than we're seeing now. Of course, going into the pandemic, we saw drastically lower return rates, both from a mix perspective, but also from a customer behavior perspective, in addition to us also pulling the brakes and shutting down customers.
After that period and that shock, if you may, we've seen, as we saw in H1, an underlying increase in return rates, mainly due to a normalization of behavior. I think if you see a lower effect than you had expected, I mean, the combination of a lower own brand sales combined with, I mean, a normalization, if you may, in return rates. But it is also important to see that we're still lower than we were prior to the pandemic. Does that make sense? It either doesn't make sense or you fell out.
Sorry, I was on mute. Sorry. Thank you very much for that. All clear. I'll come back into the call later. Thanks for now.
Thank you.
As a reminder, if you wish to ask a question, please dial star five on your telephone keypad. The next question comes from Nicklas Fhärm from SEB Equities. Please go ahead.
All right, guys. Just a few follow-up questions then. Could you just elaborate a little bit on the gross margin bridge in Q3 please, discussing the FX impact, markdown impact, any other stuff that you wanna say is more or less important to explain the total deviation, please?
Yes. I'll walk you through that. It sounds like a John question. The dominant factor in the quarter was the markdown activity and the campaign activity. The B2C, what we call customer margin, was down markedly as a consequence of that, of this activity, us being more aggressive in a weak market. That was the main impact. The second impact was the own brand share as our own brands have a significantly higher purchasing incoming margin and purchasing margin. That was the second factor. On the FX side that you mentioned.
Last, I'd like to mention also the positive effect of the freight net, i.e., that the conditions to the customers, we've always taken out freight fees and return fees, but we've actually increased these and during the year. This gives a positive effect on the cost side. We have got a better cost coverage, which goes into the gross margin. It also, of course, has an effect on sales, but I mean, we're driving towards profitability, and then this is a natural step. To comment on the FX side, we are short U.S. dollars, so obviously that hurts. We're also very long Norwegian kroner, which has had a strong year-over-year development.
The net effect is a negative, but it's not that. It doesn't pop up as one of the major gross margin impacts, thanks to the strong Norwegian kroners. Did you mention another one, or did I cover the ones that you asked for? I think those are the main ones.
Absolutely. Thanks, John. Now turning to the cost side. I think if you take out the SEK 22 million reported as non-recurring items last year in Q3, the underlying development suggests a decline of 3%, which is quite good on cost management. I was just wondering if you could give us any thoughts on are there any savings included in Q3 adjusted SG&A costs this year already or has that yet to come through in Q4 onwards towards Q2 next year?
As I mentioned on the call, we're starting to see the effects of that, and that's typically because, when in practice doing this kind of cost reduction program, especially on the employee side, it's not as digital as all the effects come in on one date. In practice, you will see a sliding effect of that. There is some of that. I don't wanna put a number on it, but we have seen somewhat lower admin and other operating costs already. We will see a gradual decline until we see the full run rate by Q2 2023, and I can say that we
Perfect
We expect to see, I mean, the most clear effect is expected to come in the last month in December of 2023 since we initiated this in August. It's typically a few months lag until we see the effect.
Right. Excellent. Very clear. Final question. Have you already started and have we witnessed some effects of your sort of changes to assortments that you're planning for the future to change the customer proposition? Have we seen anything of that work in this quarter that you just reported?
If you wanna come with that.
No, I would say no, actually. Not in any significant way. These are changes that are planned for and going into spring season of 2023. Of course, we are doing what we can do in the short term with our assortment management, but the larger effects will be seen during the starting of the 2023 season.
All right. Makes sense. Thanks so much for taking all these questions. I'm very happy. Thank you.
Our pleasure, Nicklas, as always.
Okay.
There are no more questions at this time, so I hand the conference back to the speakers for any closing comments.
Thank you, and thank you for listening in on our conference call this morning. I will end by saying that what we are on our way of creating is a much more stable and profitable Nelly going forward. With the investments that we have made in our logistical solution that was implemented last year, together with the cost saving program that was communicated earlier this year, we have created a structure of the company that is set up for profitability.
This together with the changes that we are doing in our assortment that will create a much clearer customer offer and a customer structure with the possibility of raising gross margin going forward, will be the basis for a profitable and then also growing Nelly in the future. Well, once again, I would just like to say that I'm really happy to be back at Nelly and to meet all the amazing people that work in this company and with their dedication that we see every day, we will make this a very fun journey going forward. Thank you very much for listening.
Thank you.
The host has ended this call. Goodbye.