Joann (JOAN) Q3 2024 Earnings Call Transcript

Joann (JOAN -27.27%)
Q3 2024 Earnings Call
Dec 04, 2023, 5:00 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Hello and welcome to the JOANN third-quarter fiscal 2024 earnings conference call. All participants will be in listen-only mode. [Operator instructions] Please note this event is being recorded. I'd like to remind everyone that comments made today may include forward-looking statements which are subject to significant risks and uncertainties that could cause the company's actual results to differ materially from management's current expectations.

These statements speak as of today, and the company undertakes no obligation to update or revise any forward-looking statements to reflect subsequent events, new information, or future circumstances. Please review the cautionary statements and risk factors contained in the company's earnings press release and the recent filings with the SEC. During the call today, management may refer to certain non-GAAP financial measures. A reconciliation between GAAP and non-GAAP financial measures can be found in the company's earnings press release, which was filed today with the SEC and posted to the Investor Relations section of JOANN's website at investors.joann.com.

On the call today from JOANN are the co-leaders of the interim office of the CEO: Chris DiTullio, executive vice president and chief customer officer; and Scott Sekella, executive vice president and chief financial officer. During the question-and-answer portion of the call, we will also be joined by Rob Will, executive vice president and chief merchant for JOANN. I will now turn the call over to Chris for his prepared remarks. Please go ahead.

Chris DiTullio -- Executive Vice President, Chief Customer Officer

Good afternoon and thank you for joining us today. To start, we are pleased with our third-quarter results and, importantly, have increased our top-line full-year outlook. Our third quarter paired a focus on operational retail fundamentals with an agile data-driven approach, helping us to win in our core categories while overdelivering on the implementation and execution of our Focus, Simplify, and Grow cost-savings initiative. This has enabled us to stabilize the overall business, rightsize our expense structure, and capitalize on trending growth areas.

With continued progress and another quarter of strong execution against our strategic priorities, we were able to deliver these results despite what remains a dynamic and challenging consumer and discretionary retail environment. We remain focused on controlling what we can control while maximizing our opportunities in this market and delivering a great customer experience, both in-store and digitally. Also during the quarter, supported by the use of advanced data analytics and in conjunction with our sequentially improving average unit costs, we actioned a strategy to selectively pulse promotions on a close-to-real-time basis to drive shopper conversion and maximize gross profit dollars. With this nimble approach, we are making great progress on delivering the right pricing strategies to drive shopper conversion and have a high degree of confidence that we will continue to further optimize average unit retails as our AUCs are expected to be flat to slightly down in Q4 before turning -- fully turning to a tailwind in fiscal 2025.

In fact, our average unit costs turned favorable in October and are significantly improved on a new -- on our new inventory purchases. Our e-commerce performance was a quarter standout, driving double-digit improvement year over year. Anchored on our read-and-react business approach, we identified customer experience and site performance opportunities and swiftly implemented enhancements that resulted in an immediate uptick in shopper conversion. We have also made great progress on delivering a better and faster overall online experience, setting the stage for continued growth in this important channel.

As we look to continue to grow our e-commerce business, we are also working on a number of initiatives to drive gross profit dollars, including further work we are doing to optimize operations and utilization of our West Jefferson, Ohio omnichannel fulfillment center. The expanded use of the omnichannel fulfillment center will not only lower order fulfillment costs but will also lead to an overall improved customer experience. We are fast-tracking these efforts and look forward to updating you on our progress on future calls. And finally, we continued to successfully engage with our core customers, registering increases in our customer accounts.

In fact, we saw more of our known customers shop in the quarter versus last year, resulting in positive transaction growth from this customer cohort, signaling strength in our enthusiast base. While we are pleased with this increased engagement, as you have heard from other retailers, we are also experiencing some basket pressure by way of fewer items per transaction and are seeing customers shopping closer to their product needs versus stocking up and adding to their stash as in years prior. That said, and importantly, these customers are shopping with us frequently and converting well, validating that the JOANN brand positioning is strong and our assortments are resonating. Although there is much work ahead of us and we remain cautious due to continued uncertainty in the broader retail environment, the strategic shifts we have implemented this year, combined with our ongoing cost reduction strategies and the strong engagement over Black Friday week, give us confidence to increase our full-year top-line outlook while maintaining our bottom-line outlook.

Now, I'll briefly review the highlights of our third-quarter performance. Total sales were 539.8 million, down 4.1% versus the prior-year period, which includes a 70-basis-point headwind from the strategic pull-forward of our Halloween assortment we discussed in the second quarter while also providing a margin benefit in the period. More importantly, normalized for the Halloween shift, third-quarter total sales were essentially in line with second-quarter trend when you adjust for the category pull-forward in both quarters. With that in mind, we see this as a clear signal the business is stabilizing.

For the full season, our largely owned brands Halloween assortment performance was strong, registering double-digit year-over-year growth with higher realized margins, validating the success of our read-and-react business approach. Notwithstanding the continued strong category performance, we see opportunity to grow this business even further next year. Expanding on our category performance for the quarter, we are winning in our core categories which have a strong correlation to our broader business. For example, we saw notable double-digit strength across needle arts, fleece, and sewing technology.

In needle arts, we saw broad demand across both our yarn and stitch categories fueled by our strategic decision to balance our best-in-class national brand assortment while also offering great value with broad selection of our owned private brands. With regards to fleece, our strong performance was buoyed by the social media trend of tie knot blankets which emerged in Q3 -- in early Q3. While this is typically one of our highest-volume fabric categories in the fall and winter months with our core customer, we are seeing great engagement from new and younger shoppers coming to JOANN for their fleece tie blanket supplies. To capitalize on this trend, we went live in November with a new and disruptive social media campaign #GETTINGKNOTTY, K-N-O-T-T-Y, knotty, on TikTok and Instagram.

This campaign targets the under-35 demo and focuses on friends, couples, and families gathering together and making tie-knot blankets for special occasions in their lives. We are encouraged with our initial results and engagement from our social media followers and are seeing a positive impact both in stores and online. In sewing technology, we saw the greatest gains in purchases of sub-$500 machines from new sewists entering the market, a strong indication we are attracting younger sewists to JOANN. As the category leader in sewing and fabric, we see this positive trend is a great indicator of overall health and strength across all generations of the sewing industry.

With regards to headwinds in the quarter, as expected, due to our strategic pullback of non-Halloween seasonal merchandise such as traditional autumn and fall-related decor and floral, we experienced a total seasonal merchandise headwind of approximately 150 basis points in the quarter. We also continue to experience persistent headwinds in our craft technology business which, for the quarter, was worth approximately 100 basis points. It's important to highlight that, as a result of our strategic pullback of non-Halloween seasonal inventory receipts, we saw exceptionally high sell-through rates with meaningfully improved profitability over the prior year, including contributing to reduced clearance inventory. As I mentioned earlier, our e-commerce performance was a standout in the quarter.

We registered strong e-commerce growth of 11.5% over last year, a significant acceleration from our trend in the second quarter with growth of 3%. Our e-commerce sales accounted for 13.1% of total company sales in the period, reflecting penetration expansion of 180 basis points. More specifically, to change our prior trends, we executed improvements to our site by enhancing our cart and checkout experience, resolving issues that provided the most friction to the customer purchase journey, substantially improving performance speed of the site, and beginning an intensive focus and edit of our product assortments, all leading to improvements in experience and shopper conversion. We also saw broad-based improved traffic with more effective marketing spend and SEO benefits from the work we've done on our core site.

We continue to prioritize and identify new opportunities to improve the online experience and drive shopper conversion. And finally, as I also mentioned, we are overdelivering on the implementation and execution of our Focus, Simplify, and Grow initiative, which Scott will go into further detail on. Our focus throughout all of this work is to realign our costs to our current revenue base, which has stabilized at pre-pandemic levels. As part of this work, during the quarter, we made the difficult decision to rightsize our corporate overhead aligned to that principle and are confident in how we are allocating resources to both support and drive the business forward.

Additionally, we are pleased with the results from our recently rolled out store labor initiative and remain focused on operating as effectively and efficiently as possible, including allocating store labor to better serve customers during peak traffic periods and reducing non-value-added tasks. Our store teams are doing a great job of navigating this holiday season with new team structures and ways of working and are delivering the friendly, clever ally customer experience we promised to fulfill. With that said, I would like to take this opportunity to extend my gratitude and appreciation to our entire JOANN team. Throughout a year of great change, their unwavering dedication to helping every customer find their creative happy place is what makes JOANN truly unique and drives my confidence and excitement in our future.

Turning on to inventory. We entered the fourth quarter with very clean inventory quality with less than 5% of our total inventory in our clearance bucket. Our exposure on fashion and seasonal inventory is relatively low with basic inventory compromising approximately 60% of our total, an increase of 400 basis points to last year. Additionally, with the success of our retail pricing initiative, combined with our focus on driving core categories and our read-and-react business approach, unit sales velocity has accelerated nicely and allowed us to invest back into additional basic inventory to meet the increasing demand.

To provide a bit of color, on the current quarter, although we have many important selling days ahead of us for the holiday season, we are pleased with our trends thus far. As we all know, Black Friday and Cyber Monday are no longer single-day events, and like many others in retail, we extended our Black Friday event to a full week and Cyber Monday ran for multiple days. We are pleased with how we competed in this dynamic retail climate. Our customer is increasingly shopping us across both physical and digital channels, and we are seeing mobile shopping increase at higher levels than before.

Our holiday floral and holiday decor assortments are resonating, and we are tracking to achieve our plans in these important categories. Broadly, the categories we saw success with in Q3 have continued to be strong in the early stages of Q4. While we continue to see pressure from the shopper on items per transaction, which does provide a headwind to the total basket, we are pleased with the transaction velocity and traffic we're driving to our stores in joann.com. Before turning to outlook, I wanted to take a moment to mention our recent Corporate Responsibility Impact Report that we published in November, which outlines JOANN's corporate responsibility results for 2023.

In the report, we highlight our impact across our evergreen strategic pillars, which we take very seriously and implement across the business every day. These include creating an environment where all team members can be their authentic selves and contribute at the highest level; minimizing carbon footprint by taking action throughout JOANN and supplier operations; powering reusability and customers to tie environmental responsibility to a greater purpose; and appealing to, inspiring, supporting our diverse customer base and communities. I encourage you to review the report which you can access investors.joann.com. On to outlook.

As we look to the final quarter of the year, we are encouraged by the progress we're seeing in the business, which is a direct result of the many strategic actions we've taken and continue to execute on. As I mentioned, we are increasing our full-year top-line outlook and maintaining our bottom-line guidance, which Scott will elaborate on shortly. We remain keenly focused on winning in our core categories, further utilizing enhanced data-driven read-and-react capabilities and continued implementation and expansion of our Focus, Simplify, and Grow cost-reduction initiatives. In conclusion, I am proud of what we've accomplished over the past few quarters and recognize there is more to do.

We have made great progress to rightsize our expense structure. We have strengthened our already profitable store base with over 95% of our stores generating positive four-wall cash flow. We have made tremendous strides in our e-commerce business to improve the performance and experience with the results speaking for themselves, and we are attracting and capturing younger customers at an increasing rate through social media and the growth of our sewing technology business while continuing to engage our core. We will continue to work tirelessly on the many initiatives we discussed to fuel sales growth, improve profitability, and drive shareholder value.

With that, I will hand it over to Scott to review our Q3 results and outlook in more detail. Scott.

Scott Sekella -- Executive Vice President, Chief Financial Officer

Thanks, Chris. As Chris mentioned, we continue to execute our proactive actions to enhance our read-and-react capabilities in the third quarter. More specifically, our advanced data analytics and progress of our strategic initiatives continue to drive our results. As we close out the year, we remain cautious given the continued challenging retail environment.

However, our consistent execution of our growth priorities and prudent management of the business gives us confidence to increase our top-line full-year outlook and maintain our bottom-line view. Now, let me turn to the third-quarter results. In the third quarter, net sales totaled 539.8 million, a decline of 4.1%, compared to last year with total comp sales also decreasing by 4.1%. As Chris mentioned, utilizing our read-and-react business approach, the strategic pull-forward of our Halloween assortment in the second quarter, which was a seasonal success, impacted our third-quarter sales by approximately 70 basis points.

Our read-and-react approach also allowed us to win in our core categories and capitalize on other marketplace opportunities. And as Chris mentioned, from a category perspective, we saw notable strength in the quarter in needle arts, fleece, and sewing technology. This performance is again a direct result of our data-driven approach to make sure we provide the right products, prices, and choices for our customers, and our core customers are continuing to engage in this space in a meaningful way. The success of our strategy to selectively pulse promotions on a week-in and week-out basis to best drive shopper conversion and maximize gross profit dollars is another great example of how we are utilizing data analytics to stay close to our consumers as we drive toward improved overall performance.

Our non-Halloween seasonal category was 150-basis-point headwind to comp sales in the third quarter due to our strategic inventory reduction. In addition, craft technology continued to underperform and represented a headwind of 100 basis points in the quarter. Our gross profit in the third quarter was 282.1 million, an increase of 4/10 of a point from the third quarter of last year. The year-over-year increase was driven largely by continued improvement in import freight costs, which had a 450-basis-point positive impact on our gross margin.

On a cash basis, in the third quarter, we realized 16.8 million of cash benefit from lower ocean freight rates. Our gross margin was 52.3% in the third quarter, an increase of 240 basis points from the third quarter of last year. The year-over-year 240-basis-point improvement was primarily driven by the previously described 450-basis-point impact from continued improvement in import freight costs, a 60-basis-point favorable product category mix impact driven by momentum in our core sewing categories, a 55-basis-point benefit from improved domestic carrier freight rates and associated surcharges, and a 40-basis-point tailwind due to improved clearance activity. This was all partially offset by a 210-basis-point decline due to the flow-through of inflationary product cost increases, a 100-basis-point decline from lower overall pricing driven by actions taken to optimize average unit retail levels, a 40-basis-point decline due to increased shipping costs associated with growth in our e-commerce business, and a 15-basis-point decline from lower vendor allowances.

Drilling down, our average unit costs were up 2.4% to the third quarter of last year, which is an improvement from what we saw in the second quarter of this year. We continue to anticipate our average unit cost comparisons to sequentially improve throughout the course of the year as we cycle these inflationary increases. And as Chris also mentioned, we expect Q4 AUCs to be flat to slightly down year over year. Average unit retails declined 1.2% relative to the same period last year.

Turning to expenses. Our third-quarter fiscal 2024 SG&A expenses increased by 1.6% from the third quarter of last year. The primary drivers of the year-over-year SG&A increase include severance and other upfront costs to implement our cost-reduction initiatives, asset impairment and disposal expenses, inflationary pressures on labor and other costs, and we lapped a favorable general insurance reserve reduction in the prior-year period. These increases were partially offset by improved operating efficiencies, including savings generated through our new store labor operating model, as well as optimized corporate headcount; favorable incentive and stock-based compensation activity; and lower store pre-opening and closing costs.

Our net loss in the third quarter was 21.6 million, compared to a net loss of 17.5 million in the same period last year. Our adjusted EBITDA in the third quarter was 37.5 million, compared to adjusted EBITDA of 40.2 million in the third quarter of last year. Moving on to our balance sheet. Our cash and cash equivalents were 28.3 million at the end of the third quarter.

As of October 28th, 2023, we had 72.1 million of availability on our revolving credit facility. Our face value of debt, net of cash, at the end of the third quarter was 1.14 billion. This reflects an increase of 90 million from the same period last year and a leverage ratio of 5.7x as measured by net debt and finance lease obligations relative to credit facility adjusted EBITDA on a trailing 12-month basis. Our inventory at the end of the third quarter was down 9% compared to the same period last year due to the optimization of inventory receipts and the reduction in excess import freight costs.

We continue to maintain low clearance inventory of less than 5% of total, leaving us well positioned to leverage our read-and-react capabilities to further drive the top line. During the quarter, we continued to execute against our Focus, Simplify, and Grow cost-reduction initiative. As you're aware, we had previously identified $200 million of cost savings across supply chain, product, and SG&A expenses. As we implement these cost-savings initiatives, we are driving meaningful cash flow improvement in fiscal year 2024 that will continue beyond this year.

I am pleased to share that, based on our execution to date, we are increasing this 200 million target to 225 million, with the majority of this overdelivery coming in SG&A and supply chain. Drilling down, as mentioned last quarter, we finalized new agreements with our ocean freight carriers that have put us in a position to continue to experience tailwinds and will have us overdeliver on the targeted 100 million of supply chain cost reductions. We also continue to execute our broad-based initiative to reduce product costs across our business. A significant number of our domestic and import vendors have already agreed to price concessions, and we continue to expand this work into all of our product categories, giving us confidence we can deliver the targeted 60 million of product cost reductions.

Additionally, in the third quarter, we made meaningful progress on implementing SG&A reductions and building efficiencies across our organization. First, we are very pleased with the rollout of our store labor initiative that was implemented at the beginning of Q3. Similar to what we experienced during the pilot of this initiative, in addition to reduce costs, we are confident we are enhancing the in-store selling experience as we have converted more labor hours to customer-facing sales activities. And critically important, during the peak holiday selling period, we have rightsized labor hours to more effectively staff our stores during the busiest selling hours of the day.

Also, as Chris mentioned, in the third quarter, we made the difficult decision to rightsize our corporate expense structure back to pre-pandemic levels now that revenue has returned to pre-pandemic levels. Cross-functionally, we continue to focus on deploying our resources in new ways to drive better, more efficient, and more effective ways of running the business while staying true to our strategic priority of providing high-quality in-store and online experiences for our customers. Finally, during the quarter, we closed on the sale-leaseback of our corporate facility in Hudson, Ohio for a price of 34.5 million. We intend to use the proceeds to invest in the business.

Now, let's turn to our fiscal 2024 full-year outlook. We are continuing to utilize our read-and-react capabilities through advanced data analytics to capitalize on new opportunities as they arise and focus on the controllables. Our inventory position is in great shape, and we remain diligent on prudently managing all expense aspects of the business while overdelivering on our Focus, Simplify, and Grow initiative. We are cautiously optimistic for the fourth quarter of the fiscal year and believe our strategic initiatives, combined with our third-quarter top-line performance and the ongoing implementation of our cost-reduction initiatives, leave us well positioned to deliver on our updated full-year fiscal 2024 outlook.

In terms of our top line, based on a year-to-date performance and line of sight for the remainder of fiscal year 2024, we are increasing our full-year outlook and now expect net sales relative to fiscal year 2023 to be down between 1% and 2%, compared to our prior outlook of down between 1% and 3% as we outlined last quarter. This range is inclusive of a 53rd fiscal week in fiscal year 2024, which is worth approximately 2%. Based in large part on the cash benefit of the implementation of our Focus, Simplify, and Grow cost-reduction initiative and working capital and capital expenditure optimization actions, we believe we will continue to deliver a significant year-over-year improvement in free cash flow. However, given our decision to buy into some inventory positions in core categories in Q4, we now expect that we will see a year-over-year improvement in free cash flow for fiscal 2024 to be between 115 million and 135 million versus our previous expectations of 150 million and 170 million.

With this, we expect to end the year with inventory down low to mid-single digits. Also, our full-year outlook for capital expenditures, net of landlord contributions, is still expected to be between 35 million and 40 million. It is important to remember that much of the work we are doing related to our Focus, Simplify, and Grow initiatives will result in a significant cash benefit in fiscal 2024 while we expect that much of the annualized P&L benefit will be realized in fiscal 2025 due to the time it takes for inventory and related costs to cycle through our balance sheet. That said, we are reiterating our full-year outlook for adjusted EBITDA between 85 million and 95 million.

In conclusion, we're pleased with our third-quarter performance and are ready to deliver the fourth quarter and holiday season with a continued focus on our enhanced data-driven read-and-react capabilities, winning in our core categories, and the continued implementation of our Focus, Simplify, and Grow cost-reduction initiatives. We're very proud of our team and their continued execution against our strategic initiatives in the quarter, which, in turn, further strengthens our competitive positioning. We're confident in the future and believe that we are well positioned to deliver on our outlook for the remainder of this fiscal year and capitalize on any market opportunities for JOANN. With that, we'd be happy to take your questions.

Operator?

Questions & Answers:

Operator

Certainly. [Operator instructions] Today's first question comes from Laura Champine with Loop Capital. Please go ahead.

Laura Champine -- Loop Capital Markets -- Analyst

Thanks for taking my question. Now that the sales guide is just for that -- effectively for Q4, can you give us more information on what you expect in terms of store count year on year or any changes in the store base sequentially? And what kind of a comp range that would imply to hit your full-year guide?

Scott Sekella -- Executive Vice President, Chief Financial Officer

Yeah, hey, Laura. It's Scott. Nice to talk to you. In terms of store count, nothing has really materially changed.

You know, as the last couple of years, we've gone down, I think it was 15 last year. It'll probably be somewhat similar this year as we do open new stores and do a lot of two-for-ones and those sorts of things. So, there's not a material change to the path we've been on with our store count.

Laura Champine -- Loop Capital Markets -- Analyst

Got it. And then, on comp, would that imply a sequential improvement in the same-store sales trend?

Scott Sekella -- Executive Vice President, Chief Financial Officer

It basically implies the trend we've been on this year is what I would say from -- from -- from -- a comp perspective.

Laura Champine -- Loop Capital Markets -- Analyst

Got it. Thank you.

Operator

Thank you. The next question is from Peter Keith with Piper Sandler. Please go ahead.

Peter Keith -- Piper Sandler -- Analyst

Hi, thanks. Good afternoon, guys. You know on the -- on the comp headwinds that you've been calling out with some of the craft technology and strategic inventory reductions, maybe just to give some visibility in the out quarters, when might we think about lapping those and no longer see them as headwinds?

Chris DiTullio -- Executive Vice President, Chief Customer Officer

Hey, Peter, how are you doing? It's Chris. So, what we've really been able to do this year is reset that baseline and a lot of those seasonal businesses, so strategically pulling back earlier in the year on spring and summer decor categories, investing in Halloween, strategically pulling back in autumn and fall. We really see that reset being the new baseline that we start from, so on the seasonal -- into 2025. So, on the seasonal side, I would say, you know, we'll be a lot more comp to opportunistic next year.

On the craft technology headwind side, you know, we'll -- we continue to read and react to the business. You know, you heard us say for the full year before, we thought it would be, you know, still a headwind. And it was a little more of a headwind than we thought it would be in the third quarter. So, we continue to evaluate that and adjust as we can.

Scott Sekella -- Executive Vice President, Chief Financial Officer

We are looking to see how we can reassort if need be if the headwinds persist within craft technology as well.

Peter Keith -- Piper Sandler -- Analyst

OK, that's helpful. Thank you. And then, you know, I guess to with the -- the update to the sales guide and -- and the EBITDA guide holding, I think what it's implying is quite a bit of gross margin improvement year on year. Now, we've been kind of using adjusted gross margin we were stripping out those excess freight costs that you guys had boxed out in prior quarters.

So, if my thinking is right, with Q4, is there a -- is there a notable swing factor from Q3 to Q4 in terms of year-on-year gross margin change? And if so, what are the factors to that?

Scott Sekella -- Executive Vice President, Chief Financial Officer

Yeah, Peter, it's Scott. I think the biggest change in Q4 is sort of what we called out with the AUCs turning from a headwind to a tailwind. We expect them to be flat to slightly down in Q4. And then, that trend, we do expect to continue into 2025.

What I will say, that does give us some of the fuel to really read and react to the pricing for our customers. Our approach is really to maximize gross profit dollars, and so we're going to be opportunistic where we see opportunities to win.

Peter Keith -- Piper Sandler -- Analyst

And so, the AUC declines are intriguing and it sounds like something that could actually increase as a benefit next year. Could you help us unpack that a little bit and understand, I guess, the mechanism to -- to get the lower cost?

Scott Sekella -- Executive Vice President, Chief Financial Officer

Yeah, a lot of it's coming from our Focus, Simplify, and Grow initiative where we've been negotiating all year, lower cost -- lower product costs. And so, keep in mind, with our long term, you know, call it a nine-month on average, it takes a while for those units to come in and then start to sell through. So, we're getting to that inflection point in Q4. And that's what we've been talking about where we're going to see a much bigger P&L benefit next year because of that versus this year.

Peter Keith -- Piper Sandler -- Analyst

Very helpful. Thanks so much, guys.

Chris DiTullio -- Executive Vice President, Chief Customer Officer

Thanks, Peter.

Operator

Thank you. [Operator instructions] The next question is from Cristina Fernandez with Telsey Advisory Group. Please go ahead.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

Hi, good afternoon, and thank you for taking my questions. I wanted to follow up on Peter's question around the implied fourth-quarter profitability because on the EBITDA -- on the EBITDA margin, it looks like it's going to be -- you know, it's going to expand pretty meaningful to -- to double digits. So, is it primarily on the gross margin? Or what can we expect from the SG&A? I guess how much of a benefit is the -- is having the 53rd week as well?

Scott Sekella -- Executive Vice President, Chief Financial Officer

Yeah, I can -- I can touch on that. Hi, Cristina. The -- in terms of a build-off the margin piece, so SG&A will also be providing a bunch of that benefit in Q4 as now we've talked about some of our store labor structure changes that we made, we talked about the corporate structure changes that we made. So, those will all be providing benefits in Q4 as we go forward.

So, we have both the margin benefit we talked and then the SG&A tailwinds from -- from all of that as well. And the 53rd week, while we haven't disclosed exactly, it is a tailwind for adjusted EBITDA in the quarter as well.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

And then, the second question I had was around the decision to invest in inventory. Can you give more details about what categories or product lines it is, and if it's mostly inventory to be sold through in the -- in the -- in the first half of next year?

Rob Will -- Executive Vice President, Chief Merchandising Officer

Hi, Cristina, it's Rob. I'll take that one. So, we have been talking for a few quarters now about the strength in our textiles business, in particular, certain categories across the fabric business. And as we mentioned on this call, needle arts, that's where the majority of our incremental spend is, making sure that we're in stock.

We've also been talking about our basics business. And as we have seen some strength in those core categories, the basic side of the business that go along with -- that go along those projects, think sew and construction, or foam and fiber, we are increasing our in stocks to make sure that we are ready for the full project as our customers come in.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

And the last question I had, anything -- any update on the competitive environment? Are you seeing anything -- do you see anything different in the third quarter and through -- through the Black Friday period?

Chris DiTullio -- Executive Vice President, Chief Customer Officer

Hey, Cristina, it's Chris. I would say the competitive environment continues to be really pretty rational overall. I mean, as -- as we all know, the discretionary retail environment is -- is tough, and we are being, you know, thoughtful and using our data to -- to find the best retailers we can for our customer. That said, we haven't seen anything that -- that gives us pause on the promotional front with competitors, and we're -- we're pretty confident in how we're navigating the current period.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

Thank you.

Operator

Thank you. The next question is from David Lantz with Wells Fargo. Please go ahead.

David Lantz -- Wells Fargo Securities -- Analyst

Hey, guys, thanks for taking my questions. So, I was just curious if you could talk about the sales trajectory a little bit -- in a little bit more detail. I think you had mentioned that Q3-to-date trends were tracking in line with Q2, but, you know, you ended the quarter down 4.1. So, I was just curious if you could provide an additional color there.

Chris DiTullio -- Executive Vice President, Chief Customer Officer

Hey, it's Chris. Yeah, the way we -- we looked at the quarter is when you normalize for the Halloween pull-forward that we experienced, which was a meaningful impact positively to Q2, but the negative result was it took some sales out of Q3, so, when you pull that impact out, the business was really very consistent between Q2 and Q3. And what we're really seeing is, you know, some of the categories that Rob called out and that I talked about in the -- in the earlier portion of the call, we're seeing really good strength in -- in fleece, in needle arts, in sewing technology, which gives us a lot of confidence as we head into the fourth quarter.

David Lantz -- Wells Fargo Securities -- Analyst

Got it. That's helpful. And then, can you provide an update on how you're thinking about interest expense and potential debt paydown in the coming quarters?

Scott Sekella -- Executive Vice President, Chief Financial Officer

Yeah, hey, David, it's Scott. You know, right now, we're getting the benefit kicking in of our interest rate swaps, so that -- that definitely helps. But the main thing we're focused on is getting this business back to the historical profit levels that it's been in and -- and generating cash so that we can handle that debt as it comes due in 2026 and 2028.

David Lantz -- Wells Fargo Securities -- Analyst

Thanks.

Operator

Thank you. The next question is from Steven Forbes with Guggenheim. Please go ahead.

Steven Forbes -- Guggenheim Partners -- Analyst

Good evening, Chris, Scott. I wanted to follow up on working capital. And -- and you gave some nice color there on inventory for the year-end. But payables, as a percentage of inventory, has fluctuated pretty dramatically over the years here.

So, any -- any sort of framework to think about where -- where payables as a percentage of inventory ends the year?

Scott Sekella -- Executive Vice President, Chief Financial Officer

So, if you're really asking about how does that inventory composition break down, so, you know, I think I said on the call inventory is going to be down low to mid-single digits. What I would tell you is the unit piece is actually going to be up slightly and the cost will be down. So, that's, you know, getting back to how Rob gave some color around the categories we're buying into and seeing that that's -- that's how the composition is going to work, especially as our AUCs continue to become tailwinds.

Steven Forbes -- Guggenheim Partners -- Analyst

And then, maybe -- maybe just a quick follow-up, focusing on free cash flow, right, given the change in the guidance for the year, I'm not sure if you can maybe help us frame, you know, sort of how you see the evolution of free cash flow next year in a particular scenario, whether that's sort of a flat sale scenario, just given what's happening with AUC. Is there sort of a -- is there a path to flat? Or is there -- is there any sort of framework you can provide us to help, you know, think through sort of the free cash flow output of the business as these -- these benefits start flowing through?

Scott Sekella -- Executive Vice President, Chief Financial Officer

Yeah, I mean we're still working through the exact plans for next year, but you know, when you see the momentum that we have with the cost savings and then on the product cost side as well, I see a path to positive free cash flow next year, not just back to flat, even in a -- in a sort of flat sales scenario. So, we're really excited about the momentum we have on the cost savings side, and none of that is contingent on any sort of top-line growth.

Steven Forbes -- Guggenheim Partners -- Analyst

Thanks for that. Thank you.

Chris DiTullio -- Executive Vice President, Chief Customer Officer

Thanks, Steve.

Operator

[Operator signoff]

Duration: 0 minutes

Call participants:

Chris DiTullio -- Executive Vice President, Chief Customer Officer

Scott Sekella -- Executive Vice President, Chief Financial Officer

Laura Champine -- Loop Capital Markets -- Analyst

Peter Keith -- Piper Sandler -- Analyst

Cristina Fernandez -- Telsey Advisory Group -- Analyst

Rob Will -- Executive Vice President, Chief Merchandising Officer

David Lantz -- Wells Fargo Securities -- Analyst

Steven Forbes -- Guggenheim Partners -- Analyst

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