Hugo Boss AG

XETRA:BOSS

Earnings Call Transcript 2018-Q3

[Operator]

Good day, and welcome to the HUGO BOSS Third Quarter Results 2018. Today's conference is being recorded. At this time, I would like to turn the conference over to Christian Stoehr, Head of Investor Relations. Please go ahead.

[Christian Stoehr, Head of Investor Relations]

Good afternoon, ladies and gentlemen. My name is Christian Stoehr. I'm heading up the Investor Relations activities at HUGO BOSS, and I would like to welcome you to our third quarter 2018 financial results presentation. Today's conference call will be hosted by Yves Müller, CFO of HUGO BOSS. So without further ado, let's get started. And over to you, Yves.

[Yves Müller, CFO & Member of Managing Board]

Thanks, Christian, and good afternoon, ladies and gentlemen. Also from my side, welcome to all of you who join us for our third quarter results conference call. In the next 20 minutes, I will present to you our operational and financial performance before opening the floor to your questions.From our press release earlier this morning, I'm sure you have noticed that our performance during the third quarter was negatively impacted by the challenging market environment, which affected the broader apparel industry. Before we take a closer look at our third quarter financial performance and the outlook for the remainder of the year, let me start by highlighting some operational developments that we have achieved over the course of the last few weeks. Starting with a major achievement that we have made on the distribution side. To further strengthen our digital services, we agreed with Zalando, our largest online wholesale partner, to intensify our successful partnership going forward. The focus of the new cooperation model is the use of the Zalando partner program, which enables us to serve customer requirements even better than before. As of October 11, we are now independently managing the presentation and distribution of BOSS Businesswear, which is available at Zalando for the first time. Importantly, the new partnership with Zalando does not only offer commercial opportunities. It's also an important step forward in taking more control over the distribution of our brand in the online space, from pricing to presentation to fulfillment. We are very excited about this move and look forward to further strengthening our partnership with Zalando in the years to come while, at the same time, increasing our controlled distribution in the online world.Back in September, BOSS took center stage at the New York Fashion Week, where our BOSS Menswear and BOSS Womenswear presented their Spring/Summer 2019 collections under the theme California Breeze. Taking inspiration from coastal cities and the modern houses overlooking the Pacific Ocean, the seamless overlap of beach and metropolitan life has influenced a fresh new collection, incorporating a relaxed and surf-inspired vibe. The event was attended by several superstars filling up the front row, including supermodel Barbara Palvin, actor Jamie Dornan, and basketball player, Tim Hardaway, Jr. At the same time, the event left a strong mark in the digital world, where we reached more than 50 million fans and followers throughout our various social media and brand channels.On the HUGO side, we continue to make strong progress in strengthening the brand's store network across metropolitan areas. This third quarter has seen a total of 5 store openings in metropolitan cities, among others, London in White City and in Paris in Le Marais. In total, we now have almost 20 HUGO stand-alone stores across the globe, which speak directly to the fashion-forward customer. Expanding HUGO's store network is an important element in order to further sharpen the brand's unique positioning in the contemporary fashion segment. We will therefore continue to open HUGO freestanding stores in key metropolitan areas over to the coming quarters.To conclude the operational highlights during the third quarter, let me also highlight a major achievement in the area of sustainability, which, as you know, is a firm part of our group strategy. In September, HUGO BOSS was included into the Dow Jones Sustainability Indices World for the second consecutive year. As such, the group is 1 of 4 companies in the textiles, apparel and luxury segment to have qualified for the index this year. Further, inclusion of HUGO BOSS in this index does not only underscore the progress made in implementing and executing our sustainability strategy, it also shows that our guiding principle, acting responsibly, is generating value for the company, its employees, shareholders, customers, business partners and the society alike.With this, ladies and gentlemen, let me finish my quick review on the operational highlights by emphasizing that we are encouraged by the further progress we have achieved regarding our strategic priorities, which will shape the future of our company. It is important that we continue to push and proceed with our strategic initiatives independently of short-term developments as there's no doubt they will be all contributing to the long-term success of our company. With this being said, let's change perspective and take a detailed look at what drove the financial performance during the third quarter. Overall, currency-adjusted group sales increased 1% in the quarter as robust growth in the Americas and Asia Pacific was largely offset by a slight decrease in Europe, where the challenging market environment was a major constraint for the region. In euro terms, sales remained stable at EUR 710 million as we continued to experience a slight negative translation effect in the third quarter following the appreciation of the euro against several currencies compared to the prior year period.So let's go straight into regional performance, starting with Europe, our largest region, where the extraordinary long and hot summer, along with a late start into the Fall/Winter season, put a strain on the overall apparel market. In particular, traffic in Continental Europe was below our own and market expectations, with increasing promotional activity putting additional pressure on that region. Consequently, Germany and France experienced a sales decline of 13% and 8%, respectively. This development was in part due to the aforementioned market conditions, resulting in comp store sales of minus 4 and plus 1, respectively. In addition, delivery shifts from the third quarter into the second quarter had a meaningful negative impact on the wholesale business of both markets.In contrast, Great Britain continued its strong momentum from the previous quarters and was once again the strongest market in Europe with currency-adjusted sales growth of 11%. Altogether, our own retail business in Europe recorded a low single-digit sales increase in the third quarter, driven by low single-digit comp store sales growth.Looking at our wholesale business. Sales declined at a mid-single-digit rate, in line with our expectations, reflecting the negative impact of delivery shifts compared to the prior year.In the Americas, our business returned to growth with sales up 5% in the third quarter and all markets contributing to sales growth. While we recorded particularly strong improvement in Latin America, up low double digit, our business in the U.S. also grew at a robust 5% on a currency-adjusted basis. The development in the U.S. was supported by double-digit sales increase in wholesale, where delivery shifts had a positive impact on our business. Despite an overall promotional market environment, we recorded solid comp store sales improvement in our own retail operations during the third quarter, up low single digits versus the prior year. This development was largely driven by a strong double-digit growth in our own online business, where we continue to leverage our digital capabilities and the changing customer behavior towards casual and athleisurewear.Last but not least, Asia Pacific continued its strong performance from previous quarters and recorded a currency-adjusted sales increase of 7%. While all major markets contributed to this development, the performance in the important Chinese market was once again a particular standout. Double-digit comp store sales increase in Mainland China were a driving force behind the region's overall performance, signaling ongoing repatriation of local consumption. Speaking about China, let me also be clear that we do not see any signs of a slowdown in this important market. Instead, we continue to experience strong demand from Chinese customers, and we remain absolutely confident about our short- and long-term opportunities in this market.Looking at Asia Pacific's other major markets. Sales in Japan and South Korea also continued their strong momentum and recorded high single-digit and low double-digit currency-adjusted growth, respectively.Moving over to the performance of our channels and starting with our own retail operations. Group-wide, own retail sales increased 2% on a currency-adjusted basis in the third quarter. This development was driven by a 3% increase in comp store sales with all regions contributing to this improvement. Asia Pacific, as just mentioned, continued its stellar performance and recorded high single-digit comp store sales increases. In addition, Europe and the Americas recorded low single-digit comp store sales improvements. Unchanged from the pattern witnessed during the first half of the year, a strong increase in conversion rates and higher volumes drove growth in the third quarter. Average selling price, in contrast, declined, reflecting strategic measures to strengthen our footprint in casual and athleisurewear as well as the promotional environment in Europe and the Americas during the third quarter.By retail format, growth was fairly consistent across directly operated stores and outlets. The online business continued its strong momentum from previous quarters. At 38% currency-adjusted growth, our own online business recorded its fourth consecutive quarter of strong double-digit sales increase. We continue to enjoy strong traffic increases on our hugoboss.com website following several improvement measures we implemented earlier this year, including the clear differentiation between BOSS and HUGO. In addition, conversion rates have started to improve substantially, reflecting easier navigation and better usability of our website, thus enhancing the overall shopping experience.Turning to the wholesale channel, where third quarter sales declined 2% on a currency-adjusted basis. Double-digit increases in the Americas and in Asia/Pacific were more than compensated by the expected sales decline in Europe, where delivery shifts from the third quarter to the second quarter had a negative impact on that quarter. Within our global wholesale business, online continues to clearly outperform the physical channel. While our business with large marketplaces and online platforms of leading department stores grew at double-digit rates, sales with stationary retailers were down in the light of the pressure they are facing from ongoing traffic declines.To conclude on the online -- to conclude on the top line performance in the third quarter, let's have a look at the development by brand and gender. Sales for the BOSS brand increased 3% excluding currency effects, supported by growth at both BOSS casual and BOSS Businesswear. We are particularly encouraged by a mid-single-digit growth at BOSS Businesswear as it shows that formalwear is and remains an important part of the premium apparel market and a segment where we can build on the heritage and the strength of the BOSS brand.HUGO sales declined 11% in currency-adjusted terms. While the brand's casualwear business continued to grow at double-digit rates, ongoing distribution changes once again had an adverse impact on HUGO's businesswear in the third quarter of 2018. As already highlighted earlier this year, these changes aim at sharpening HUGO's fashion-forward contemporary positioning in the marketplace by focusing on those distribution channels where the brand proposition is a better fit for the HUGO customer.By gender, our menswear business grew 1% currency adjusted in the third quarter, driven by high single-digit increases in casualwear. Our womenswear business saw a currency-adjusted decline of 7% during the quarter, mainly reflecting the further reduction of retail selling space. Womenswear sales in the wholesale channel, however, continued to develop nicely, reflecting ongoing healthy demand from major retail partners in the Americas and Europe where BOSS holds a leading position in the market.Turning below the top line. The gross margin saw a decline of 240 basis points to 62.5% in the third quarter, mainly reflecting the challenging market environment, which resulted in greater-than-expected promotional activity, particularly in the Americas and Europe. Consequently, around half of the gross margin decline is related to less favorable pricing mix, reflecting inventory valuation effect as well as higher markdowns. The other half is a result of ongoing quality investments as well as negative currency effects. The channel mix was broadly neutral in the quarter.Moving on to operating expenses, where we continue to have a tight focus on operating cost management. Selling and distribution expenses declined 1% year-on-year, driven by a slowdown in retail expansion and further progress in renegotiating rental contracts. Strict cost management also limited the increase in administration expenses, up only 1% versus the prior year, despite continued investments in the digital transformation of the business model. Altogether, operating expenses declined 1% year-on-year and as a percentage of sales, were down 30 basis points. Strict operating cost control, however, was not enough to offset the gross margin decline. As a result, EBITDA before special items declined 12% compared to the prior year quarter, amounting to EUR 126 million. Importantly and contrary to our initial expectation, currency effects had a negative impact on EBITDA of EUR 5 million. EBIT and net income declined 20% and 18%, respectively, also reflecting the swing in the other operating income expense line.From a regional perspective, the sales decline in Europe, coupled with a slight increase in operating expenses, led to an adjusted EBITDA margin decline of 300 basis points to 30.8%. In the Americas, the increase in sales did not result in operating leverage as the overall market environment continued to be promotional. And consequently, the EBITDA margin of the Americas saw a decline of 660 basis points to 14.7%. Asia/Pacific, however, experienced a significant increase in the adjusted EBITDA margin, up 400 basis points to 17.8%. This development is mainly due to the strong top line development as well as the slight decline in operating expenses.While so far my comments have related to the performance in the third quarter, let me also quickly summarize where we stand after the first 9 months. Group sales were up 12% currency adjusted and 1% in euro terms, with all regions contributing to this performance. Europe was up 3% and the Americas grew 4%, both in currency-adjusted terms. Asia/Pacific clearly outperformed both regions and recorded strong currency-adjusted sales growth of 9%. While tight operating cost management resulting in the 600 -- in a 60 basis points operating leverage expenses (sic) [ operating expenses leverage ], the decrease in the gross margin of 120 basis points led to a 5% decline in EBITDA before special items, amounting to EUR 331 million.Let's now move on to the balance sheet. At the end of September, inventories were up 20% both in euro and currency-adjusted terms. While the majority of the inventory growth aims at further supporting the positive sales momentum, especially in our own retail business, let me also be clear that the like-for-like performance in the third quarter was obviously somewhat weaker than initially expected, reflecting the unusual long and hot summer in Europe. As a result, inventory levels are higher than expected and clearly not at the level I want -- like them to be.To ensure that inventory levels come down towards year-end, we have taken immediate action and implemented short-term as well as structural measures. In this context, we have not only adjusted the merchandise buying for the remainder of the year, we also realigned our internal processes to further optimize the amount planning going forward. Based on the measures taken and the expected acceleration of topline growth in the fourth quarter, which I will speak about in a moment, I remain confident that inventory levels will see a normalization towards the end of 2018. Despite the increase in inventories, trade net working capital saw a modest increase at the end of September, up 11% compared to the prior year. This development reflects our strict discipline in trade terms management as well as concerted collection efforts. As a percentage of sales, average trade net working capital was up 10 basis points to a level of 19.4%.Looking at our investment activity. Capital expenditure increased 12% in the first 9 months, largely driven by the anticipated step-up of store renovation. This continues to be a strong focus area of investments not only in 2018 but also beyond. The increase in capital expenditure, together with higher cash outflow from the inventory changes, resulted in the decline in free cash flow down to EUR 13 million at the end of September. Nevertheless, we continue to forecast free cash flow for the full year to reach the initial targeted range of between EUR 150 million and EUR 200 million as we forecast a significant increase in free cash flow in the fourth quarter. This will be driven by the anticipated earnings increase and cash flow following the reduction in inventories.Now ladies and gentlemen, after reviewing the financial performance of the third quarter and the first 9 months, let me spend a few minutes on our outlook for the remainder of the year. Despite these challenging market conditions in the third quarter, we remain confident of reaching our full year top and bottom line guidance as we confirmed this morning. We continue to expect currency-adjusted sales to grow at a low to mid-single-digit rate in 2018, supported by mid-single-digit comp store sales increases. The gross margin, which we had initially forecast to remain broadly stable year-on-year, is now expected to decline between 50 and 100 basis points as we account for the gross margin decline during the third quarter. Lastly, we continue to forecast EBITDA before special items to be within our guided range of minus 2% and plus 2% compared to the prior year, as we expect operating expense leverage to compensate for the gross margin shortfall, reflecting our strict cost management.Importantly, the confirmation of our full year top and bottom line outlook stems from our conviction that the fourth quarter of 2018, which traditionally is the strongest in terms of sales, will see a significant improvement in sales and earnings. We expect the top line momentum to accelerate in the fourth quarter, driven by robust comp store sales improvement in our own retail business. This assumption is supported by a positive business development in our own retail operations in October. We are particularly encouraged by the strong performance of our Chinese business during Golden Week, which was not only well above last year but also represented one of the most successful Golden Weeks in our history in China. In addition, we forecast our wholesale business to improve relative to the performance seen during the first 9 months. Our gross margin is expected to improve during the fourth quarter compared to the first 9 months as we forecast a reduction in markdowns. In addition, we will annualize quality investments which had started back in the fourth quarter of 2017 and which will provide a further tailwind to the development of the gross margin.Lastly, we will continue to strictly manage our cost base during the fourth quarter to ensure that we continue to generate operating expense leverage as we approach year-end. In this year, the third quarter has already shown our high level of cost discipline. Together with my BOSS colleagues, I will ensure that this discipline will be lived and acted upon each and every quarter from hereon. And while I have every confidence that we will reach our full year 2018 guidance, more importantly, I also remain convinced that we will return to sustainable profitable growth as of 2019. As we consistently pursue our strategic initiatives, we see plenty of opportunities for our business that will enable us to grow in a sustainable and profitable manner in the years to come. On that front, my board colleagues and I will give you a detailed update during our upcoming Capital Markets Day next week. And with that, ladies and gentlemen, I'm now happy to take your questions.

[Operator]

[Operator Instructions] We will now take our first question from Antoine Belge of HSBC.

[Antoine Belge, Global of Consumer and Retail Research]

Yes. It's Antoine Belge at HSBC. I have 3 questions. First of all, regarding the performance in Q3, I know it's always difficult to isolate the impact of weather, but is it fair to say that July and August have been maybe up mid-single digit in terms of retail like-for-like before September was weaker? I mean, I'm not expecting you to give the exact number, but maybe you can give me a bit of a trend throughout the quarter. Second question relates to your guidance for the full year in terms of top line, which is unchanged overall. Could you confirm that you've kept each of the regional assumption unchanged as well and maybe your comment especially on the U.S. wholesale, which is particularly strong? So how do you see U.S. wholesale ending up 2018? I think you've done a really good job in the U.S. in recent years. And finally, with regards to the inventories, which, as you said, are up 20% at the end of September, so what was the quality of the inventories? And can you -- how can we be sure that you won't need additional provision or depreciation at the end of December to -- as you take in a relatively conservative approach at the end of September?

[Yves Müller, CFO & Member of Managing Board]

Yes. Thank you very much, Antoine, for your questions. Let's go into the answers. First of all, you tried to -- we tried to exclude the weather impact. Actually, if you take the comp store sales, we would say that we would be actually in the -- in our overall guidance if we would not have this weather impact, which is supposed to be mid-single-digit increase. So this was the impact. The second question was related to Q4 and the net sales expectation. I think it's worth to mention that if you take already the October performance in Europe, you can see that -- in the third quarter, that we have experienced really this kind of weather impact and that we see a kind of positive momentum in Europe to pick up from the net sales losses we experienced in the third quarter. So the October figures for Europe were pretty prominent. In addition to this, the wholesale -- U.S. wholesale performance was very good in the third quarter, and we continue here our good relationship, especially with Nordstrom and Bloomingdale's in the wholesale. So we remain positive regarding the U.S. overall performance for the fourth quarter. And regarding the inventories, you were talking about the quality. I can confirm that the majority of the inventory increase that we are having at the end of September is mainly coming from -- the majority is coming from NOS products, so never-out-of-stock products. So we are very confident that we can sell these products. They have all high-quality, predominantly coming from bodywear and hosiery and these kinds of products and not, I would call them, heavy products which are too fashionable. So we are confident to sell them.

[Antoine Belge, Global of Consumer and Retail Research]

Maybe 2 follow-ups. So my question regarding the sales by region, I was mentioning the overall full year '18 guidance by region. Is it the same as it was last time you communicated in August? Also, on the wholesale, so the overall guidance, I think, is up low single digits. So what will be the figure for the U.S.? I imagine it would be a bit better than the global average.

[Yves Müller, CFO & Member of Managing Board]

So overall, the regions, I can confirm that the full year guidance for the regions, which we talked about in August, will remain stable. So we will pick up especially when it comes to Europe. And regarding wholesale, we don't give any -- we don't disclose any specific wholesale performance. I think what is worth mentioning is that, in 2017, we had some delivery shifts from Q4 to Q3. So overall, we expect a good wholesale performance in Q4 for 2018.

[Operator]

We will now take our next question from Zuzanna Pusz.

[Zuzanna Pusz, Analyst]

I have 3 questions, please. So first of all, to follow up from Antoine's question. So you've mentioned that there has been some unfavorable impact of discounting on gross margin, but can you -- could you please confirm if that was simply driven by customers choosing to buy products which were marked down just because of the weather? Or was there also a higher level of promotions offered in stores to attract more traffic, if you know what I mean? Secondly, on your like-for-like growth. In case I missed it, could you please tell us what is the ASP and volumes within that? And also, on China, so you mentioned that there was -- you had a very strong Golden Week, which sounds quite promising, especially given that now there's so much noise in the market around China. So could you please confirm if these strong trends in China actually have continued? I mean, do they still continue now actually? And do you believe that this is brand-specific? Or is it just simply the repatriation of demand which you benefit from? Any color around that would be very helpful.

[Yves Müller, CFO & Member of Managing Board]

Yes. Thank you very much, Zuzanna, for your questions. Your first question related to the gross margins and the markdowns. So especially what -- where were the markdowns coming from? The markdowns were coming from the fact that we already had the Fall/Winter collection in our stores. And actually, due to the hot summer, we were predominantly selling still the items from the Spring/Summer collections, which were already in the sales period. And this kind of delaying effect led to the impact that the markdowns finally went higher. So this is the kind of delaying effect, and this is what we are seeing now, that the Fall/Winter collection is selling off once the temperatures are coming down, especially when I talk about Europe. So this was the overall -- it was more a kind of delaying effect. Especially when it comes to like-for-like performance overall, we saw -- if you talk about the average selling prices, the average selling prices was down due to 3 effects. It was -- one effect is the shift towards more casual and athleisurewear. This is one effect. The second effect is the global pricing. And the third effect was actually the further markdowns. So the average selling prices went down. But overall, if you take the first 9 months of the like-for-like performance in all freestanding stores is plus 4%, and we overall overcompensated this by higher volumes and higher conversion rates. And the final question regarding China, yes, we had really a very good Golden Week in China, and we do not see any movements of slowing down the business in China so far. I think we as HUGO BOSS, with our brand BOSS, we have very good momentum since we overall decreased our prices over the year. As you know, we have now the right global pricing level. As you might recall, we are now 30% to 40% ahead of the European prices. And I think we are very good positioned. And as I noticed -- or as I spoke about this in previous calls, we have a higher customer base, and I think we are benefiting from this kind momentum of higher customer base and selling BOSS products.

[Zuzanna Pusz, Analyst]

Perfect. Just to follow up on the like-for-like composition. So is there any way you could actually quantify that? Because, I may be wrong, but I kind of remember on the back of my head that, for 6 months, I think you saw 5% decline in average selling price. So is there any, I guess, number you could actually give for Q3 just to get an idea of the underlying volume growth?

[Yves Müller, CFO & Member of Managing Board]

Directionally, the average selling prices decreased by high single digit, and the conversion rate was up low double digit. And the frequency was up low single digit. And the net sales we were selling is up low single digit, and that's sales per transaction. So this is the overall indication. And all finally end up into plus 4% like-for-like of freestanding stores, which is the best indication actually for the current collection.

[Operator]

We will now take our next question from Piral Dadhania of RBC Capital Markets.

[Piral Dadhania, Analyst]

I have 3 questions as well. Starting with weather. Perhaps you could explain to us the learnings from this summer and the third quarter performance. What's being done to make the supply chain and delivery cadence of product as you transition from the Spring/Summer to autumn/winter more flexible? Secondly, could you provide an indication of the HUGO stand-alone store performance relative to average? I think some of your pilot stores have been open for over 12 months now. You have 20 in total. If you could provide any initial indications as to how those stores are doing, that would be very helpful. And then finally, on rental contract renegotiation, you flagged it this time around and a couple of quarters prior as well. And given you have lowered your gross margin guidance but left your EBITDA growth guidance unchanged, could you perhaps just specify or give an indication of the magnitude of the savings you're seeing there and other potential OpEx offsets to be able to maintain the EBITDA guidance?

[Yves Müller, CFO & Member of Managing Board]

Yes. Thank you very much. Regarding this weather issue and learnings, what we achieved, I think we will outline this during the Capital Market Day, especially when it comes to speed. But to give you an indication, I think the learnings must be to make the switch. If you talk about the collections, 2 plus 2 collections, it's about the sizing of those collections. This is one issue, how big are the in-between collections. I talk about pre-spring and pre-fall collections, which are especially in this period of February, March and July, August. And secondly, it's about what is the role of the online channel when it comes to long tail. What I'm saying is still selling small pants -- shorts, for example, in July and August in the long tail and online -- in the online channel. So actually, omnichannel and the capabilities of playing this offers you a lot of possibilities going forward to mitigate the risks of weather and to play the different channels. If we come to HUGO and the stand-alone performance, be aware that we have now 2 different models in place. We have almost 20 HUGO stand-alone stores. So if you take the old stand-alone -- the old store concept, they have a positive like-for-like performance overall. And the new ones, they just opened 2 months ago, so it's really early to call regarding the HUGO performance because with opening ceremonies and all these things that are happening, it's too early to give you a kind of real realistic indication for this. And regarding cost savings, yes, I think rental negotiations, they will go on. We have the issue of pay-to-sales ratio to be optimized going further, which has a tremendous part, and overhead expenses as well. So these are the cost items we will see in Q4 and even going forward 2019, where I see us -- being new to the company, we see tremendous potential to reduce the cost on this side.

[Christian Stoehr, Head of Investor Relations]

Thanks, Piral. [Operator Instructions] Thank you very much.

[Operator]

We will now take our next question from Thomas Chauvet of Citi.

[Thomas Vincent Chauvet]

Two questions, please. The first one, on the Americas profitability, can you come back, Yves, on the significant margin pressure? I think, in the 9 months, the profitability is for the EBITDA margin is at 14%, which is more than half of what it is in Europe, for instance, despite healthy growth in the Americas. I know there's structural reasons for the lower profitability, but do you have initiatives into next year to return to a more acceptable margin level in this important market? And secondly, on HUGO, down 11% in the quarter. I understand it's largely self-inflicted. Can you reconfirm that the reduction of HUGO's presence in wholesale and some of your freestanding stores and in outlets will be over by year-end? And when you say you want to sharpen the brand's presence, do you -- have you engaged in a discussion with different types of wholesale partners to sell HUGO where perhaps the brand or the future brand should belong to -- in that kind of maybe more contemporary segment?

[Yves Müller, CFO & Member of Managing Board]

Yes. Perhaps starting with your last questions regarding HUGO. I think, yes, you're right, and we pointed out that there have been a lot of distribution changes regarding HUGO because we clearly want to focus on the fashion-forward contemporary segment. And that was the reason why we had to somehow focus on the clear proposition of the HUGO brand. There were 3 measurements. First of all, it comes to the sale of outlet channel. We've reduced this one, firstly. Secondly, we took the HUGO corners out of the BOSS store in order to clearly differentiate between the BOSS customer and the HUGO customer. We did this. And finally, and this was a big part as well, regarding wholesale partners, where we shifted back from HUGO to BOSS because, especially one big client in Germany, there was much better brand fit for BOSS than HUGO, so we remigrated from HUGO to BOSS with this regard. And these overall distribution changes, they are now executed, and they would be largely over at the end of 2018. And from '19 -- 2019 on, HUGO is supposed to grow again. But these measurements were strategically necessary to clearly differentiate between the different brands. And in addition to this, I think we have a very good cooperation, because you were talking about this, in the online work with Zalando and the wholesale format for the brand of HUGO. This is one. And secondly, we've just -- like you indicated in your questions, we have just changed the HUGO positioning into the fashion-forward floors with Galeries Lafayette, for example. We have just changed this in September, for example, to be on the right floor, where we find the fashion-forward brands. So this was done. The first question is related to the Americas and the profitability. I think, overall, yes, you are right, and we are overall not satisfied with the profitability in the Americas, especially when it comes to the U.S. And we have initiated several measurements to come back and to improve the profitability, especially in the United States. This will take some time, but we are well aware that we have to improve the profitability in the United States.

[Operator]

We will now take our next question from Melanie Flouquet of JPMorgan.

[Melanie Anne Flouquet, Head of European Luxury Goods and General Retail]

I have 2 questions. So my first question is regarding your gross margin guidance for the full year in comparison to the 9-month trend. If I'm not mistaken, then depending where Q4 cost lies, you're guiding for between minus 50 bps and plus 130 bps improvement in gross margin, so quite a wide range of guidance. I'm just wondering and trying to understand. In quarter 3, the markdown and the write-downs were at half of the pressure, so they were 120 bps down. How come you're going to have less impact in quarter 4 in your anticipation than you did in quarter 3? Is this because the excess inventory is going to be actually rotated over several quarters and we shouldn't expect a big markdown activity in quarter 4? So that's my first question. And my second question, in your full year target, you're clearly compensating gross margin pressure in quarter 3 that was bigger than expected with cost control in quarter 3 and in quarter 4. What are the pockets of costs that you identify that enabled you to compensate this gross margin pressure? And are they sustainable?

[Yves Müller, CFO & Member of Managing Board]

I don't know if I get your last question. You're talking about the cost measurements that we have to compensate the gross margin loss, right?

[Melanie Anne Flouquet, Head of European Luxury Goods and General Retail]

That's correct, yes, and whether they're sustainable.

[Yves Müller, CFO & Member of Managing Board]

Yes, okay. Thank you very much. Okay. Coming to your first questions. First of all, you were relating to the markdown in the third quarter. Yes, half of this was coming from inventory devaluations and markdowns. And as I come to Q4, we don't see that this will come back or will incur in Q4 again. Be aware that in the Q4 2017, we had high markdowns in 2017. So actually, we see a kind of markdown improvement for the Q4 2018, and that's the reason why we see an improvement overall in our margin in comparison to the first 9 months. And regarding the cost items, I think there will be a lot of sustainable cost measurements. First of all, it's the slowdown of the retail expansion, which goes overall more into remodeling the stores with less CapEx. Second of all, it's about the renegotiation of rental contracts, which make a big part. Thirdly, it's about optimizing our retail excellence with pay-to-sales ratio that we can optimize and to inject more retail experience there to have a tighter control in the pay-to-sales ratio. And fourthly, it's about overhead costs, which still can be reduced going forward. So these are the major drivers. And there's one issue regarding marketing. We are now more in Formula E instead of Formula One, so there's a shift from marketing expenditure into 2019. But overall, the marketing spendings are stable in comparison to last year.

[Melanie Anne Flouquet, Head of European Luxury Goods and General Retail]

If I can have a follow-up, sorry, on your comment on the gross margin. So you're not expecting as many markdowns pressure, but the inventories are up 20%. So does this mean you're expecting inventories to not require significant markdown and to be -- to tail off over time rather at the end of this year? And sorry, also to follow up on the cost line. So once you -- the cost savings you're identifying seem to have been quite long-term initiatives. I'm just wondering what came in, in Q3 and Q4 that enabled you to compensate the gross margin pressure that you did not expect in your cost line.

[Yves Müller, CFO & Member of Managing Board]

First 9 months, already, we experienced an operating leverage of 60 basis points when it comes to costs. So these are the measurements that are taking place and that are increasing over quarter-on-quarter. And that's the reason why they will be coming in, in Q4. And your first question was regarding the margin, right? Yes, first of all -- yes, we have an increase of 20%. But as I pointed out, these are predominantly NOS products, and they will turn rather quickly. And we will come to an acceptable level at the end of year-end, and there will be no further markdowns necessary to sell the inventories off.

[Operator]

We will now take our next question from John Guy of MainFirst.

[John William George Guy, Managing Director]

My first question is with regards to your increased cooperation agreement with Zalando. Could you maybe sort of flesh out and quantify where you think the sales and margin opportunities might be? I mean, certainly noticing, from a channel mix perspective, you said that the impact was neutral in Q3. I would have thought that, given the wholesale decline and a very strong online, we would have seen maybe a slightly more positive contribution from a channel perspective. So can you talk about what the opportunities are with an improved cooperation agreement with Zalando? And secondly, just going to the free cash flow guidance of the EUR 150 million to EUR 200 million, the unchanged guidance on free cash flow. I mean, clearly, you're expecting an improvement in inventory. You're probably -- there's a slightly lower CapEx guidance, and you're probably looking for an increase in earnings to get you there. But I mean, going to this inventory issue, even if we adjust for the timing and phasing of wholesale, inventory would have still been up 17%. And I appreciate that you've got roughly seasonal sales of just around 60%, 20% is fashion and the rest is never-out-of-stock. But I still don't understand how you're going to be able to phase down the inventory that quickly in order to see less than 120 basis points of gross margin impact in the fourth quarter. So if you can help me with that, that would be great.

[Yves Müller, CFO & Member of Managing Board]

Coming to your first question regarding Zalando. Yes, I think we have been a lot talking already in the first 9 months about this kind of concession model, and now I'm happy to announce that we finally made it and signed this kind of contract. So be aware that I won't be too specific today because -- in this Q3 conference call. I think we will be very explicit next week in London. But just from an indication point of view, yes, we will change -- for the brand of BOSS, we will be changing from a wholesale model to a retail model. So this gives you, first of all, additional net sales. This is one effect because we account the full net sales and not the wholesale sales. And secondly, this will be gross margin accretive going forward. And your hypothesis is right, that the overall gross margin then will be increasing. So that's a kind of indication, but we will give you more color on this in the next week. And following -- free cash flow, yes, you're right. Higher earnings, lower CapEx and lower inventories, I think, they will come in, in order to make sure that we reach our guidance of EUR 150 million and EUR 200 million free cash flow. And what I think what -- be aware that we noticed already that -- pretty early in July that we are suffering from a not expected like-for-like performance, and that was the reason that we were decreasing the merchandise buy in order to decrease the inventories. So we had immediate action. I think this is our task as management, immediate action to take the inventories down. And that was -- this is one major driver that the inventories will go down at year-end and will so far -- will, as a consequence, lead to a higher free cash flow.

[John William George Guy, Managing Director]

Sorry, you just don't -- I mean, you -- inventories were up about 16% constant FX in the first half of the year, 20% unadjusted for the timing of wholesale in Q3. And you took action back in July, and I appreciate that there's a timing effect, but we haven't seen any decrease yet. So where do you think inventory as a percentage of sales gets to by the end of the year?

[Yves Müller, CFO & Member of Managing Board]

I think, at the year-end, we will experience an inventory level that is slightly above the low last year level and a mid-single-digit rate at the year-end. So be aware that a lot of those items -- I mean, inventories is not equal to inventories, so there are different inventories in the books. I think, finally, we talk about here at year-end a lot of never-out-of-stock articles, which turn very fast. And I think this is the difficult part you have to get at the end. And in connection with the merchandise buying that was decreased, that was -- these are the major factors why the inventory level will be going down. But be aware that the quality of the products is sustainable at 30th of September.

[Operator]

We will now take our next question from Jurgen Kolb of Kepler Cheuvreux.

[Jurgen Kolb, Analyst]

First of all, you mentioned, Yves, that October started off very promising. If I'm not mistaken, I think, last year, October was particularly weak. So the momentum was obviously stronger in October. But if you could fill us in how November and December last year developed. Was that also a rather weakish month for you so that you're coming off from a relatively low base, first one? And secondly, you mentioned that you're planning -- or you're doing some work on better forecasting models or forecasting program. Could you give us some support or some idea as to what that means? And is that something that kicks in already short term? Or is that just a mid- to longer-term project? And what do you exactly do there?

[Yves Müller, CFO & Member of Managing Board]

Yes, coming to your first question. Actually, Jurgen, we don't disclose any monthly development. I think here, it's, I think, important that we had a very good October in contrast to last year. And I think this underlines -- this will be underlining our guidance for Q4. And over the time, November and December will get a little bit tougher, but we are confident that we can make this. And if I see the first days in November, we are all promising that we can achieve our guidance. And secondly, when it comes to inventory levels, the forecasting, I'm talking about immediate action in terms of approval process. Once the merchandising comes in, they have to be approved. The buy has to be approved by a controlling and the forensic's eye principle, and this will have immediate impact for future inventory developments.

[Operator]

We will now take our next question from Elena Mariani of Morgan Stanley.

[Elena Mariani, Vice President]

A couple of follow-ups from me. I apologize if this one is again on your inventory level. As part of your short-term and structural measures, are you also planning a different usage of outlets? And in particular, with regards to Q4 and the measures you're going to take, are you planning to move some of these items to outlet in a more like, let's say, massive way? I apologize but I still don't understand how you can talk about these items being high quality because I would imagine that they are some leftovers that are not going to be sellable in the coming quarters. So if you could further qualify -- if you could further clarify, that would be great. And then my second question is on your like-for-like trajectory. If we exclude the weather in the current quarter, you said that you were basically on track to have a mid-single-digit like-for-like. Thinking about next year, and I appreciate you're going to give further details next week, but is it fair to say that with the like-for-like in the low to mid-single-digit camp, you're going to definitely be able to achieve operating leverage and margin expansion, given all the initiatives that are going to annualize by the end of this year and also the cost savings that you've talked about?

[Yves Müller, CFO & Member of Managing Board]

Yes. Coming back to your second question regarding like-for-like. I think this will be one of the big issues next week when we talk about -- at the Capital Markets Day, about operating leverage. But overall, this is what we always said, that we envisage to have a low single to mid-single-digit like-for-like development and that this is enough, too, for operating leverage, so finally, to have sustainable profitable growth from 2019 on. So this will be enough because there's still more to come from the cost side. But be aware we will be very explicit next week. And just to give you an indication, we won't give any guidance for 2019. We talk about midterm guidance next week. And regarding your first question...

[Elena Mariani, Vice President]

And midterm would be a 3-year guidance?

[Yves Müller, CFO & Member of Managing Board]

More than this. We will talk about this next week. And regarding the inventory level, I think your explicit question was whether we want to put those items into outlet. A clear no because these are not any fashionable items. As I pointed out, they are predominantly NOS items that can be sold in wholesale. These are a lot of items that are replenished items which go to wholesale partners, which can be sold in our own retail full-price store at a full price. And so there is no indication that these items go into the outlet, and we will not shift them in Q4 to the outlets.

[Christian Stoehr, Head of Investor Relations]

Thank you, Elena.

[Operator]

We will now take our next question from Philipp Frey of Warburg.

[Jörg Philipp Frey, Senior Analyst]

Just 2 quick questions. Firstly, can you update us on the number of stores converted to the new store format and how the new store formats need a bit more time to experience how the format is performing right now? And secondly, regarding the strong increase of -- the double-digit increase of the replenishment business in wholesale, do you consider this to be more a function of the quarter's ordering of retailers or really, generally, a substantially better performance than the collection of peers?

[Yves Müller, CFO & Member of Managing Board]

First question, Philipp , I have to refer to the Capital Markets Day. We will be explicit on this next week regarding store format because I think this is a measurement that is long-lasting and does not refer actually to Q3. And regarding replenishment, I think there are 3 major effects. One is, I think, due to the structural effect on the wholesale preorders. Really, they get more prudent. So you have an inherent effect with higher replenishment business. Secondly, yes, we had a better performance relative to our peers. That is the second one. And thirdly, we had a very good bodywear and hosiery business, which is growing double digit in this specific business. So this -- from a product point of view, these are the major drivers of a double-digit growth in replenishment business.

[Operator]

That concludes today's question-and-answer session. At this time, I'll turn the conference back to the hosts for any additional or closing remarks.

[Christian Stoehr, Head of Investor Relations]

Okay. Ladies and gentlemen, that completes our conference call for today. As you know, on November 15, we will be hosting our 2018 Investor Day in London, and I would like to invite all of you to join us on the day. If you have any questions with regards to the registration process, please feel free to contact any member of the IR team. And with that, I would like to thank you and I would like to thank Yves for your participation and wish you a very good day. Talk to you again next week. Bye-bye.

[Operator]

This concludes today's call. Thank you for your participation. You may now disconnect.