Burlington Stores Inc

NYSE:BURL

Earnings Call Transcript 2023-Q2

[Operator]

Good morning. My name is Julianne, and I will be your conference operator today. At this time, I would like to welcome everyone to Burlington Stores Second Quarter Fiscal 2022 Operating Results Conference Call. [Operator Instructions]

I would now like to introduce David Glick, Group Senior Vice President, Investor Relations and Treasurer. Please go ahead.

[David Glick, executive]

Thank you, operator, and good morning, everyone. We appreciate everyone's participation in today's conference call to discuss Burlington's fiscal 2022 2nd quarter operating results. Our presenters today are Michael O'Sullivan, our Chief Executive Officer; and John Crimmins, Principal Financial Officer. Also on the call today is Kristin Wolfe, EVP and Chief Financial Officer.

Before I turn the call over to Michael, I would like to inform listeners that this call may not be transcribed, recorded or broadcast without our express permission. A replay of the call will be available until September 1, 2022. We take no responsibility for inaccuracies that may appear in transcripts of this call by third parties. Our remarks and the Q&A that follows are copyrighted today by Burlington Stores.

Remarks made on this call concerning future expectations, events, strategies, objectives, trends or projected financial results are subject to certain risks and uncertainties. Actual results may differ materially from those that are projected in such forward-looking statements. Such risks and uncertainties include those that are described in the company's 10-K for fiscal 2021 and in other filings with the SEC, all of which are expressly incorporated herein by reference.

Please note that the financial results and expectations we discuss today are on a continuing operations basis. Reconciliations of the non-GAAP measures we discuss today to GAAP measures are included in today's press release. Now here's Michael.

[Michael O'Sullivan, executive]

Thank you, David. Good morning, everyone, and thank you for joining us. I would like to cover three topics this morning. Firstly, I will discuss our second quarter results. Then, I will review our outlook for the rest of the year. Thirdly, I will talk about the longer-term outlook. After that, I will hand over to John to walk through the financial details, and then we will be happy to respond to any questions.

Okay, let's talk about our results. Comparable store sales for the second quarter decreased 17%. This was on top of 19% comparable store sales growth last year.

During this call, when describing our comp trend, I'm going to use a 3-year geometric comp stack. This is just like a simple 3-year comp stack but accounts for the compounding effect from year to year. Given our large comp numbers last year, we think this provides a more meaningful indicator of our trend. This metric is defined in more detail in today's press release.

In May, our 3-year geometric comp stack was plus 4%. In June, it was flat; and in July, minus 7%. For Q2 as a whole, it was minus 1%. This was below our guidance for a positive, low single-digit 3-year geometric stack. These results are poor, and we are very disappointed.

There were external factors that contributed to these results. And in a moment, I will describe these in detail. But before I do, let me say that no matter what external headwinds we face, we have to do better than this. On an absolute and on a relative basis, these comp results are well below our expectations.

When you look at comp performance in our business, there is no mystery about what drives these numbers. It's about offering the best value in the categories, brands, styles and price points that the customer is looking for. This is how we executed our business in Q2. But when you look at our results, especially on a relative basis, it's clear that we did not move far or fast enough.

Let me turn now to the external environment. We believe that there were 2 major factors that impacted our trend in Q2. First of all, the low- to moderate-income customer is under significant economic pressure. The low- to moderate-income customer is our core customer. Approximately 40% of the money spent at Burlington comes from shoppers with household incomes of less than $50,000. Low- to moderate-income shoppers helped drive our extraordinary growth last year, and they remain an important part of our future growth plans. But right now, they are under severe economic stress. And versus last year, they have considerably less money for discretionary spending.

The second factor that contributed to our weakening trend in Q2 was that promotional activity, especially among retailers that serve low- to moderate-income shoppers, surged. The root cause of this is that there was a massive imbalance between inventory levels and sales across retail. The glut of inventory that started to emerge in Q1 turned into a tidal wave in Q2. In normal times, promotional activity tends to be limited to seasonal merchandise and styles that have not sold well. But what we are seeing right now is that there is such an imbalance between supply and demand that most retailers are having to aggressively clear inventory.

Our customer proposition, the key reason to shop our stores, is that we offer better value than other retailers. In Q2, this value differentiation was squeezed. Our customers are, as I described earlier, heavily focused on value. They have a lot of options about where to spend their limited funds, and they cross-shop heavily, looking for the best deals.

For our customers, the top for shopping destination for apparel and footwear is Walmart followed by Target. The current level of promotional activity will not last forever. But while it does, it will create a very significant headwind for us.

Let me draw these trends together for Q2. There were external factors that contributed to our trend in the quarter. The low- to moderate-income customer is under economic stress and retailers serving these customers are flooded with promotions.

These headwinds are real. But as an off-price retailer, we have advantages. The overall sales trend may be weak, but we can shift into the areas that the customer is buying, and we can use the supply imbalance to deliver great value in these categories. Again, this is what we did in Q2, but our results show that we did not move far or fast enough. We can do better.

Before I move on to talk about the outlook, let me just comment on earnings.

Despite the weak trend in Q2, our margins came in ahead of expectations. There were two reasons for this. Firstly, we managed our in-store inventories very close to plan. So we didn't have a lot of excess inventories. This meant that our markdowns were modest compared to many other retailers. We could have taken broader and deeper markdowns. This might have driven sales but not necessarily earnings. Instead, we focused markdowns on excess seasonal merchandise and ended the quarter very cleanly.

The second factor that drove above-plan earnings is that with the weak sales trend, we aggressively controlled our expenses. As a result, although we came in below our guidance for sales, our earnings were above the high end of our guidance range. Later in the call, John will provide more details on this.

So what do we think happens next? I'm going to move on to the outlook, and I will split my remarks into the near-term outlook, i.e., the rest of the year, and then further out.

We believe that the current retail environment, characterized by a weak sales trend and significant promotional activity, is likely to be with us through the rest of the year. We also think that this promotional activity is likely to delay the emergence of any significant trade-down shopper. Think about it, there is really no need to trade down when every major retailer is on sale.

Based on these factors, we are lowering our guidance for the back half of the year. Our updated guidance is based on a minus 4% to minus 1% 3-year geometric stack. This translates to a 1-year comp range of minus 13% to minus 10% for the back half. As a reminder, our comp growth for the back half of 2021 was positive 10%.

Our plan for the fall assumes significant pressure on merchant margin. We had originally planned for an increase in merchant margin in the back half, but we have now pulled back on this. As I said earlier, the most important driver of sales is the value that we put in front of the customer. We need to challenge every hanger in our assortment and make sure we are offering the best value.

During this time, we will tightly control buying and liquidity, carefully manage inventories and aggressively pursue opportunities to drive down expenses. But the net effect of all this is that we expect our results for the full year to be well below our normal expectations and well below what we believe we can accomplish over the next couple of years.

Let me segue to talking about the next couple of years.

Last year, actually on this call, we described the then current situation of strong consumer spending fueled by government stimulus and a significant merchandise supply constraint. We described that situation as completely unsustainable. Let me say we believe that the now current situation, weak retail sales trends and massive oversupply of merchandise, is equally unsustainable.

In the next few months, we will start to work on our plans for 2023. To support this process, we have started to sketch out scenarios for what the retail environment could look like in 2023.

I'd like to describe the scenario that, based upon what we know at this point, we think is most likely. Firstly, we believe the inventory overhang across the retail industry is likely to clear over the next several months. We expect that by early 2023, once this overhang has cleared, promotional activity will have declined significantly.

Secondly, we anticipate that the supply environment will tighten somewhat. Many vendors have been hurt by the current imbalance, and they are likely to pull back. But with weak consumer demand, we think there will still be plenty of merchandise supply for the off-price channel. We also expect to carry attractive reserve inventory into 2023.

Thirdly, we believe that in 2023, the expense environment is likely to have changed significantly, especially for freight rates. There are already some early signs of this. We also think it is likely that by then, the labor market will have softened, which could ease pressure on wage rates.

Fourthly, we anticipate that the economy will have slowed. As this happens, inflation should moderate, thereby easing some pressure on low- to moderate-income shoppers. And this slowing economy may also drive heightened consumer focus on value, driving trade-down shoppers to our stores.

Lastly, we think that several financially weak, bricks-and-mortar retailers may have to close stores. These closures would free up potential market share and real estate.

Forecasting the future is a very risky undertaking, especially after what we have lived through over the last 3 years. But we believe the scenario I've just described isn't just possible, it's likely at some point in 2023. We are optimistic about next year. We expect to drive recovery in sales and earnings and start to get back on track towards our longer-term objectives.

I would now like to turn the call over to John to provide more details on our Q2 results and our rest of year guidance.

[John Crimmins, executive]

Thanks, Michael, and good morning, everyone. I will start with some additional financial details on Q2.

Total sales in the quarter were down 10%, while comp sales were down 17%. Our 3-year geometric comp stack was a minus 1%.

In terms of earnings, the headline is that we faced gross margin pressure in Q2, but this was more than offset by productivity and expense savings elsewhere in the P&L. Comp sales came in below our guidance range, but our adjusted EPS came in above. For Q2, our adjusted EPS was $0.35 versus the guidance range of $0.18 to $0.31.

That was the headline. Now let me provide more detail.

The gross margin rate was 38.9%, a decrease of 320 basis points versus 2021's 2nd quarter rate of 42.2%. This was driven by a 110 basis point increase in freight expense combined with 210 basis points lower merchandise margin. About half the decline in merchandise margin was driven by higher markdowns and about half from a true-up to our shortage reserve.

It's worth calling out that although our markdown rate was higher than last year, it was still significantly below 2019 and historical levels. This was despite the extraordinarily high external promotional activity.

Product sourcing costs were $157 million versus $146 million in the second quarter of 2021, increasing 130 basis points as a percentage of sales. This deleverage was due to higher supply chain and buying costs driven by higher supply chain wages and growth of our buying and planning team, respectively.

Adjusted SG&A was $518 million versus $150 million in 2021, increasing 120 basis points as a percentage of sales, which was driven primarily by deleverage on occupancy expense.

Adjusted EBIT margin was 2.1%, 610 basis points lower than the second quarter of 2021. Our guidance for Q2 had been for 610 to 670 basis points. We were able to achieve the high end of our adjusted EBIT margin guidance by offsetting the lower-than-expected comp sales and gross margin with expense savings.

Put into the context of our Q2 2019 adjusted EBIT margin, the second quarter of 2022 adjusted EBIT margin declined by 500 basis points versus that time period. Of this, about 450 basis points were driven by freight and supply chain deleverage.

All of this resulted in diluted earnings per share of $0.18 versus $1.50 in Q2 of 2021. Adjusted diluted earnings per share were $0.35 versus $1.94 in the second quarter of 2021.

At the end of the quarter, our in-store inventories were 5% below 2021 on a comp store basis, and our reserve inventory was 52% of our total inventory versus 31% last year. In dollar terms, our reserve is more than double last year's levels. This increase was driven by our merchants taking advantage of great buying opportunities during the quarter.

In Q2, we opened 11 net new stores, bringing our store count at the end of the quarter to 877 stores. This included 13 new store openings and 2 relocations.

Now I will turn to our outlook.

As Michael mentioned, we are updating our back half forecast based on a minus 4% to minus 1% 3-year geometric stack. This implies a 1-year comp range of minus 13% to minus 10% for the second half of fiscal 2022. Based on this range and on our expectation of a continuing heavy external promotional environment, our adjusted EBIT margin is expected to decline by 160 to 80 basis points, which would generate adjusted EPS for the back half of $2.81 to $3.41. This would drive full year adjusted EPS of $3.70 to $4.30 and an adjusted EBIT margin decline of 410 to 360 basis points.

Breaking out the quarters, we are modeling Q3 at a 1-year comp decline of minus 18% to minus 15%, which translates to minus 4% to a minus 1% decline on a 3-year geo stack basis. This range should lead to a Q3 adjusted EBIT margin decrease of between 360 and 260 basis points and to third quarter adjusted EPS of $0.36 to $0.66. We are modeling Q4 at a 1-year comp decline of minus 9% to minus 6%, which for Q4 translates to the same 3-year geo stack that we are planning in Q3 of minus 4% to minus 1% decrease. Recall that our Q4 '21 comp comparison decelerated from 16% in Q3 to 6% in Q4. This comp sales range should lead to fourth quarter adjusted EPS of $2.45 to $2.75.

I will now turn the call back to Michael.

[Michael O'Sullivan, executive]

Thank you, John. Let me summarize some of the key points that we have covered this morning.

We are disappointed with our Q2 sales performance. There were 2 major external factors that contributed to our Q2 trend. The low- to moderate-income customer is under a lot of economic pressure. And during the quarter, there was a huge surge in promotional activity. We believe that these factors are likely to continue into the fall season. Our updated guidance assumes the sales trend will remain weak and that merchant margins will be pressured by high levels of external promotional activity.

Our business is all about offering the best value on the categories, brands, styles and price points that the customer is buying. We can do a much better job on this.

As we look ahead to 2023, we are optimistic. There are several factors that we think could drive a significant recovery in our sales and earnings and would start to get us back on track to our longer-term financial objectives.

Now before I turn the call over to the operator for Q&A, there are a couple of additional topics that I would like to call out.

Firstly, we recently released our latest Corporate Social Responsibility report. On this call, we do not have time to discuss the content in any detail, but I would like to encourage investors to take a look at the report on our Investor Relations website. The report describes the huge progress that we have made over the past year on our major environmental, social and governance priorities. If there are any investors who have questions about any of these topics or would like more information, then please contact our Investor Relations team.

The final thing that I would like to do before moving to questions is to comment on our CFO transition.

On this call, we have our new and our retiring CFO. Some might call that an embarrassment of riches. I would like to welcome our newly appointed CFO, Kristin Wolfe, who joined us a few weeks ago. Kristin comes to us with over a decade of off-price experience, serving in a variety of financial, strategic and operational roles. We are very excited to have Kristin as part of the team.

Of course, on the flip side of the CFO transition, we will be saying goodbye to John Crimmins, who retires this month. This is John's last earnings call, so please ask him some tough questions. Seriously, I would like to take this opportunity to thank John on behalf of the company and the Board for his hard work and commitment to the company over the years and to wish him all the best in his well-deserved retirement.

With that, I would now like to turn the call over for your questions.

[Operator]

[Operator Instructions] Our first question comes from Matthew Boss from JPMorgan.

[Matthew Boss, analyst]

Great. so Michael, maybe taking a step back, what are your thoughts on the relative performance that we've seen from the major off-price retailers? Or said differently, comps for these retailers have historically trended together versus the wider gap that we've seen year-to-date today. So what do you think is driving this divergence, in your view?

[Michael O'Sullivan, executive]

Thanks for the question. We watch our peers very closely. We know we can learn a lot from them. So of course, we've interrogated the year-to-date performance. Let me share our assessment.

First of all, in terms of the divergence that you're calling out, the data is very clear. If you look at year-to-date on a 3-year geometric stack basis, one of our off-price peers is up in the mid-teens. The other is mid-single digits, and we're minus 1%. As you'd expect, we're not happy with this.

We think that there are really two factors that explain the difference. Firstly, the customer mix is quite different between these retailers. And depending upon who you're comparing us with, that could be more or less significant.

The low-income shopper really drove our relative outperformance versus both peers last year. Stimulus checks, et cetera, had a bigger impact on low-income customers. And I think that was really a much stronger tailwind for us than it was for our peers.

This year, those shoppers are struggling, and I think that's contributing to our weaker trend. But this demographic disadvantage won't last forever. At some point, inflation will moderate and the low-income customer will start to recover. And I think it's important to understand that longer term, that low-income customer is a large and growing demographic. And frankly, it's a demographic that really likes bricks-and-mortar retail.

It's hard to know how much that customer piece is worth, but there is a second factor that we think is important. And this one -- this is the one that matters most to me because I think we can control and influence it.

Once you adjust for any differences in customer mix, all you have left is relative execution. And to be clear, I don't mean operational execution. So for sure, there are things that we can improve, and there are things we are improving in our operations. But there's nothing there that's driving relative comp performance.

So what I mean is relative merchandising execution. Put another way, if a customer walks into one of our stores versus one of our peers', what do they see? Which store has the most compelling assortment and value? And therefore, where are they going to buy? Where are they going to spend money?

Now most retailers that are faced with a weak sales trend or a tough promotional environment are stuck because they can't do much. They just need to grind through it. But as an off-price retailer, we can shift our assortment mix to the areas that the customer is buying. And we can take advantage of supply opportunities to deliver great value in those areas. As I said in the remarks, in Q2, that is how we executed in our business. But when you look at our results, especially on a relative basis, it's clear that we really didn't move far enough. Our peers did a better job.

For me, there are really 2 -- yes, there are 2 action implications, 1 is short term, 1 is long term. Short term, for the back half of the year, we -- we're looking -- we're really looking at every aspect of value in our assortment. We need to make every hanger count in our assortment.

And then more importantly, longer term, we know we can get better at executing the model. Last year, we showed we were really good at chasing sales when the customer had money. This year, the challenge is different. The challenge is, the low-income customer doesn't have as much money, and the only way to drive the trend is by offering really great value. I think that's a muscle we need to develop more.

Now the last couple of years, we've been investing especially in merchandising to improve our execution. And I'm pretty confident that once those improvements and once those investments are bedded in, they're going to help us improve and, over time, close the gap with our peers. But yes, I come back to, and I agree with you, our Q2 comp results are evidence that we're not there yet.

[Matthew Boss, analyst]

That's great color. My second question is more focused on the multiyear. So with 2022 clearly turning out to be a tough year across retail, I guess have the challenges from this year affected your thinking about longer-term opportunities?

[Michael O'Sullivan, executive]

Yes. Good question. I think it's important to separate short-term headwinds from longer-term structural factors.

When I joined Burlington 3 years ago, my thesis was that the off-price model, with its focus on value, responsiveness to trends, ability to take advantage of supply disruption, immunity to e-commerce, well, that model, it felt advantaged to me versus other retail models. And separately, within off-price, for Burlington, I saw an opportunity to improve how we execute the model. That's really the objective of Burlington 2.0.

Now fast forwarding to today, sitting here in 2022, that strategic and investment thesis really hasn't changed. All the structural advantages of the off-price model over other retail channels still apply. And I think the improvements we're making, the stronger buying organization, the more flexible operating model, will, over time, strengthen our own execution of the off-price model.

Now obviously, I can't ignore over the last 3 years we've seen some significant curveballs. The impact of inflation on our core customer and the tidal wave of promotions, they're just the latest of these curveballs. But it's important, I think, to realize that these things are not going to last. The last couple of years have not been normal. Sooner or later, the long-term trends will reemerge and reassert themselves, especially the relative advantages of off-price and the dividend that we're going to get from the improvements that we're making to the business. So I still have huge confidence that we're going to achieve our longer-term goals and objectives.

[Operator]

Our next question comes from Ike Boruchow from Wells Fargo.

[Irwin Boruchow, analyst]

Michael, one for you. I'd be interested to know what you think is happening with pricing across the current retail industry when you kind of look out at some of your competitors and other soft-line players out there. And then what might be the implication for price increases at Burlington when you kind of factor those things in?

[Michael O'Sullivan, executive]

It's funny, of all the topics discussed over the past year, I think this is the one that's seen the greatest evolution.

A year ago, the combination of stimulus spending, pent-up demand, tight merchandise supply meant that most major retailers were achieving higher realized prices than they had in years. So there were very few promotions and margins were very strong across the industry. Now I have to say, I think those days are over.

Now most retailers have too much inventory, and they're having to take very significant markdowns. And realized prices have really plummeted. Now my view is this is a huge overcorrection. Once the inventory bubble passes, which may take some time, then I think pricing across the industry will get more rational again. Now let me talk about what that means for us.

We talked a little bit about this, I think, on the call in May. The thing that we really care about at Burlington isn't price, it's markup. If merchandise availability means that we can buy goods at lower cost, then that should allow us to drive markup without necessarily raising prices.

Now our original plan had been to take advantage of the opening up of supply to increase our markup in the back half of the year. But as you can tell from our guidance and based on the factors we've discussed, we're much more cautious about this now. As long as the external environment remains heavily promotional, we think we're going to have to pass along some of this markup to the customer. But that said, once the bubble passes, we'll revisit that, and we expect that we would recover some of that markup.

[Irwin Boruchow, analyst]

Got it. Second one for John. So John, first off, congratulations. Best of luck with retirement. I'm not going to give you a hard one. But on the EPS performance in the second quarter, it was better than the guide despite the comp miss. Could you just kind of talk us through the puts and takes of the performance during the second quarter?

[John Crimmins, executive]

Yes. Sure, Ike, and thanks for the best wishes. And yes, it's a good question.

There certainly were a lot of moving parts in the second quarter. I think the best way to answer it is just kind of run through the G&L -- sorry, the P&L and give you a little color.

So yes, as I said earlier, gross margin delevered by about 320 basis points. 210 basis points of that was a decrease in merch margin. About half of that was driven by markdowns. And as I said earlier, the markdown rate was still significantly better than in 2019. The rest of the merch margin decrease was driven by a true-up to our shortage accrual based on physical inventory results. So we took a physical inventory in June. You measure the results, and so you make an adjustment based on what you learned from that.

We also saw a 110 basis point increase in freight expense compared to last year. Remember, last year, most of the increase in freight rates took place during Q3 and Q4. So we're still -- it's kind of still a tough compare. It gets better in the second half of the year.

Product sourcing costs delevered by about 130 basis points. About half of that was from supply chain and half was from continuing to invest in our merchandising team. Even though we did manage expenses pretty aggressively in the quarter, we're still investing in all of our Burlington 2.0 initiatives. And part of that -- some of the productivity gains that we're seeing are somewhat related to these initiatives that are underway.

On the SG&A side -- sorry, more broadly on supply chain, we also had a, similar to freight, a difficult compare for the second quarter. But we actually came in a little better than we expected, again thanks to some of those productivity gains.

SG&A delevered by about 120 basis points. That's better than we would have expected with a minus 17% comp. So again, benefit from some of the productivity improvements and the disciplined expense management on that line.

So -- we also had combined deleverage of about 30 basis points. That's the net result of depreciation expense and other income. Within other income, there were some gains from the sale of real estate of about $4 million. So a little bit of a nonrecurring item that helped us in the quarter there.

So altogether, that should account for the 610 basis point operating margin decrease that we saw. We also had some unanticipated good news in net interest expense, where we had $3 million of interest income related to a tax refund that actually nets against our interest expense in the P&L.

[Operator]

Our next question comes from Lorraine Hutchinson from Bank of America.

[Lorraine Maikis, analyst]

So your updated guidance represents a pretty significant revision. It would be really helpful if you could share more of your thinking on how you arrived at the sales guidance and also any major call-outs in terms of margin or expense assumptions and if you view this guidance as conservative.

[Kristin Wolfe, executive]

Lorraine, it's Kristin here. I've actually been working closely with Michael and John on developing the guidance, so let me jump in and I'll try to respond to your question.

On sales, a couple of points to call out. First, we've missed our sales guidance for the last 3 quarters. We need to start hitting or, better still, beating the guidance we give. So we think this guidance may be conservative, but this feels appropriate.

I'd also mention the sales trend is very difficult to project right now. The reason our guidance is more conservative than our year-to-date trend is we believe the promotional activity we saw pick up in mid-June will continue into the fall.

And another point I'd add is our August month-to-date geometric comp stack is running in line with this guidance.

Of course, there are a couple of factors. We haven't built these in. These could help us. If inflation slows and if gas prices continue to decline, those things could help. And then if promotional activity elsewhere slows down, we may start to see that trade-down shopper in our stores.

In terms of the margin and expense side of the guidance, as John mentioned, we're forecasting EBIT margin decline of 160 to 80 basis points in the fall. Gross margin will improve slightly. This is really due to freight driven by some moderation in import costs and less pressure to accelerate delayed receipts compared to what we saw last year. But merchant margin is now planned lower than last year. And as Michael mentioned in his remarks, much lower versus our previous expectations due to the promotional environment. And I'll also call out that the fall plan doesn't include productivity gains that will help us continue to leverage expenses, particularly in supply chain and stores, while we continue to invest in the growth of our business. And both supply chain and stores in fall of last year saw onetime hiring expenses that will not be necessary this year.

Lastly, comparing Q3 and Q4, the margin decline in the third quarter is expected to be more significant. This is really due to weaker comp sales in Q3. But also in Q4, we are lapping peak freight and supply chain cost pressures from last year.

So let me finish up by saying, yes, we do think this is a conservative plan, but this feels appropriate given the environment and the way we're managing the business.

[Lorraine Maikis, analyst]

My second question is about inventory levels. Given the weak sales outlook, how are you feeling about your inventory levels? And if the sales trend turns out to be a little stronger, are you confident that you'll be able to respond?

[Michael O'Sullivan, executive]

It's Michael. Let me try and answer that. I'll start with inventories, and then I'll talk about our ability to chase if the trend is stronger.

On inventory, I think it's important to draw a distinction between in-store inventory and reserve inventory. In-store inventory is basically what we have for sale. If you think about sales turns, markdowns and margins, this is the inventory that matters. If we have too much of this inventory, then it will turn slowly, and we'll take markdowns.

Now in Q2, our plan was to manage our in-store inventories in line with last year. And that's what we did. I was pretty happy with the execution of our inventories. We ended the quarter very cleanly, and we ended with in-store inventories, on a comp basis, just slightly below 2021 levels, but we're pretty happy with that.

Turning to reserve inventory. Reserve inventory is much higher than last year, and that's deliberate. Reserve is largely driven by opportunistic buys. In other words, merchandise where we've gotten a great deal and that we're storing for release in a future month or even next season.

The sell-through and the gross margin characteristics of reserve inventory tend to be much better than other types of buy. We manage what goes into reserve carefully to make sure that's the case, and we're pretty happy with our reserve position.

Let me finish up, though, on the last part of your question. How confident are we that we can chase sales?

I'm more confident about that now if the sales trend is strong than I have been for 2 years. This is one reason why we're comfortable with the conservative plan. If the customer ends up wanting to spend more with -- I'm comfortable we can chase it. And we can either accelerate releases from reserve when we know we have a good reserve balance, or we can go into the market and buy fresh receipts, and we know there's plenty of supply in the market. Now neither of those things was true last year. Supply was much more difficult this time last year. But now it's freed up, it really puts us in a good position to chase if the sales trend is stronger.

[Operator]

Our next question comes from John Kernan from Cowen.

[John Kernan, analyst]

John, congrats on your retirement. Kristin welcome.

[John Crimmins, executive]

Yes. Thanks, John.

[John Kernan, analyst]

So the full year operating margin embedded in the updated guidance, it obviously is quite significant deleverage versus 2019. How confident are you that you can get back to that 2019 margin structure? And any detail on gross margin and SG&A rate is appreciated.

[Michael O'Sullivan, executive]

Well, good morning, John. It's Michael. At this point, I don't think it would be fair to have Kristin -- I'll have to answer that, so let me offer an answer.

In the next several months, we'll be developing our budget for 2023. And we'll also -- when we do that, we'll go through an exercise of updating our long-range plan. So coming out of that, we should be able to provide a more specific path and time line for growing our margin.

But for now, I think I know -- to answer the question at a high level, if you take the upper end of our updated guidance, it implies an EBIT margin for the full year 2022 that is about 420 basis points below 2019. The drivers of that EBIT margin contraction are very clear. Of the 420 basis points of contraction, 370 basis points is from higher freight and supply chain expenses. All the other line items combined, so merch margin and store costs, et cetera, all of those combined represent about 50 basis points of contraction. Now within that bucket, there are positives and negatives, but obviously, the biggest piece within that bucket is expense deleverage on a minus 1 comp over a 3-year period, which, as you can imagine, is significant.

So when we come to update our long-range plan later this year, it's pretty clear to me that there are four main buckets that we're going to be going after. And I feel pretty confident that we're going to find value in each of these.

The first, of course, is freight and supply chain. As I just said, 370 basis points of the 420 basis points of deleverage since 2019 has been in these line items. Now as we've said before, we're not expecting to get all of that back. Some of those costs, higher wage rates in the DC, for example, are going to be permanent. But other drivers of those costs, the freight rates, the fuel costs, special wage incentives that we had to give people to get staff, special shifts that we had to run that were more expensive, some of those costs should come down over time. And I think it's early, but there are signs that that's starting to happen. So that's freight and supply chain costs, and I think we can pull out quite a bit there.

The second bucket, though, second lever we would go after, if you like, is sales. Today, we've talked about why sales have declined this year, especially the impact of inflation on low-income customers, the extraordinary levels of promotional activity. And as I said in the remarks, we think those factors are temporary. So we expect our sales to pick up once we're -- once inflation moderates and once this inventory bubble passes. Add to that, we believe that the longer-term improvements we've been making to the business, especially in merchandising, will further underpin our long-term sales growth. So we think we can drive sales, and that, obviously, will drive leverage on fixed expenses.

The third bucket that we will interrogate is markup. As I think just -- Kristin just talked about, we originally planned to raise our merchant margin in the back half of this year through higher markup. And that markup was based upon an improved supply environment that we can get merchandise at lower cost out because supply has eased up since last year. Now as we've explained, we're being more cautious about that now in this environment. But once the external promotional activity begins to moderate, this is absolutely something we'll revisit.

And then maybe finish up on -- the fourth bucket that we'll interrogate is markdowns. In 2022, our markdown rates will still be well below 2019 levels, but it will be above 2021 levels. In other words, we've given back some of the progress that we made last year. It's not hard to see why we've had a sales trend that's below plan. We've had high external promotions that we've had to respond to. But again, once we get through this, we've proven to ourselves that we can turn inventory faster and we'll get back to that. So that's the fourth bucket we would expect to get value from.

Now I guess I should just maybe just finish up by saying we've always believed that we can drive margins above 2019 levels, and we continue to believe that. And in addition to the four items I just mentioned, there are additional levers. I'm not going to review now; we don't have time. But there are additional levers where -- that we believe will help us to get to double-digit margins over time. Now those include lower occupancy costs based upon a smaller, more productive store prototype and significant efficiency and productivity improvements that we expect to make in our operations.

[John Kernan, analyst]

All right. I appreciate the detail. Your comments make an easy setup for a follow-up question just on freight and supply chain expenses.

These -- all these expenses spiked in the back half of last year. I think the model suggests there was a 200 basis point headwind or so to gross margin in the second half last year. You mentioned earlier that there are signs that some of the expenses are starting to soften. We can obviously see the spot rates on ocean and trucking rates coming down. Is there any benefit of this softening in Q3 or Q4? Or is this a 2023 story?

[John Crimmins, executive]

Yes, John, thanks. I'll take that question.

So yes, as I said earlier, during the second quarter, supply chain and freight together cost about 170 basis points of deleverage. Freight was 110; supply chain, another 60. As you know, costs in both of these areas increased much more significantly in the second half of last year. So the impact on this quarter's compare is more difficult than we would expect it to be for the second half of the year. We think it will be a little bit of -- a little bit better for us in the second half of the year.

What we're seeing overall, I think, is similar to what we've heard and what you probably heard from other retailers. As you mentioned, for ocean freight, clearly spot rates have been improving. We are taking advantage of that where we can and when we can now. Spot rates are improving in a meaningful way, and we anticipate that this trend is going to continue over the next 2 quarters and into next year. It's going to help us a little bit in Q3 and Q4, but we expect it to be much more help going into next year and beyond.

For domestic freight, there's been some improvement. But so far, it's been less impactful and offset by high fuel prices. But longer term, we think there's going to be much more meaningful movement there. Just haven't really seen that much of it yet.

For supply chain costs, we do expect some improvement in the second half of the year. You'll remember last year we had significant nonrecurring incentives and hiring costs as we struggled to get our DCs fully staffed and operating at full capacity.

I guess within supply chain, we should also kind of mention the wage side of it. We have seen that wage inflation has slowed. The availability of labor has improved significantly since last year but still a bit of a challenge.

We think wages will likely remain at current levels. But we do anticipate some overall softening in the availability of labor, which should help overall staffing costs. Some of that, maybe a little bit of that, in the second half of this year and then looking forward.

[Operator]

Our next question comes from Kimberly Greenberger from Morgan Stanley.

[Kimberly Greenberger, analyst]

Okay. Great. Welcome to Kristin. And John, well deserved. Congrats on your retirement. I don't have a really hard ball question for you. But I did want to follow up, Michael, on your comments earlier about the sort of agility and the adjustments in the quarter and maybe year-to-date when trends -- when consumer buying patterns shifted and changed. It sounded like you would have expected maybe faster and more substantial adjustments in season. So I'm wondering if you can just reflect on what you've seen year-to-date in that agility. And where in particular do you think there's an opportunity going forward to improve responsiveness? And is that through better systems, better reporting to the merchants? Is that -- what are the sort of steps to get you -- to get the sort of the merchant and the planning team where you'd like it to be so that the responsive capabilities in the business are better in the future?

[Michael O'Sullivan, executive]

Good -- well, good morning, Kimberly. First of all, this really isn't fair. You're supposed to ask John the hard questions, not me. But I can try -- I'll try and respond.

The -- I guess, well, the right place for me to start is what have we done over the last couple of years.

We've -- in the last couple of years, we've invested in our merchandising team. We've added -- I think since 2019, we've added about 35% headcount to our merchandising team.

We've also been challenging and redesigning our planning and buying processes, our reports, our tools, all aspects of buying. And the reason we've been doing that is because it's kind of -- it's a secret source of off-price. It's what drives off-price.

And within that, there is absolutely a very -- I think, very difficult balance that merchants have to make between deciding where to spend our open-to-buy, which categories, which styles, which price points.

And I think that judgment improves with experience over time. And I think that -- we did all those things in Q1, I want to be careful to acknowledge. We did all those things in Q1. It's really when I do a comparison with our off-price peers I have to acknowledge, well, they did those things too and outperformed us.

So I kind of feel like -- again, it's like -- as I said in the script, you have to kind of strip out customer differences. But if I strip out the customer differences, I'm left with that relative merchandising execution as the thing where I think we still have opportunity, we still have a ways to go. And I -- like I can -- like I said in the script, I feel like given the talent we've brought on, given the changes we're making, we're absolutely going to be able to do that over time.

And last year -- I think last year was interesting because I felt like we really demonstrated a lot of capability chasing the trend, chasing into business as people -- customers wanted to buy when they had money. This year, I just think that challenge is a little different. And yes, like I said, we can do much better.

[Operator]

Our last question will come from Chuck Grom from Gordon Haskett.

[Greg Sommer, analyst]

This is Greg Sommer on for Chuck. I wanted to ask, how are you balancing the current better buying environment and the possibility of even better buys down the road in the second half? And when should we expect to see those buys get reflected in merchandise margins? Is that a second half known or more in 2023?

[Michael O'Sullivan, executive]

Can you just repeat that question? You broke up a little bit as you were asking the question.

[Greg Sommer, analyst]

I just wanted to weigh the balance between the current buying environment where you guys are seeing deals and the possibility of better deals emerging in the second half. And then the flow-through to better merchandise margins, whether that can come through in the second half or it's more in 2023.

[Michael O'Sullivan, executive]

Yes. No, it's a good question. We've been very careful right now. And I would say actually throughout Q2, we're very careful to hold back on buying. Right now, this is a buyer's market. In a buyer's market, patience is really what gets rewarded. So we're being very, very careful about how we're spending our open-to-buy, making sure that we're really waiting until the deal is as good as it can possibly be. And that applies to reserve just as much as inventory that we're flowing to stores.

I would say that in Q2, the buying environment was excellent. And I think it's quite likely in the back half it could be even more excellent. I think, again, it relates to all the things we've talked about: the massive oversupply of inventory, et cetera. But it means that the buying opportunity is very good.

Let me make one final point. When you have external promotions like we're seeing right now, it's so important that we get the very best deal when we're out there buying because we have to compete against those promotions. Now it can be done, and that's the value of the off-price model. But that's another reason why we're just very careful when we're buying right now.

[Operator]

We're out of time for questions today. I would now like to turn the call back over to Michael O'Sullivan for closing remarks.

[Michael O'Sullivan, executive]

Let me close by thanking everyone on this call for your interest in Burlington Stores. We look forward to talking to you again in late November to discuss our third quarter results. Thank you for your time today.

[Operator]

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.