AB Electrolux (publ) (OTCPK:ELUXY) Q3 2022 Earnings Conference Call October 28, 2022 3:00 AM ET
Company Participants
Jonas Samuelson – President and CEO
Therese Friberg – CFO
Sophie Arnius – Head of IR
Conference Call Participants
Johan Eliason – Kepler Cheuvreux
Andre Kukhnin – Credit Suisse
Akash Gupta – JPMorgan
Olof Cederholm – ABG Sundal Collier
Gustav Hageus – SEB
James Moore – Redburn
Uma Samlin at Bank – America
Jonas Samuelson
Good morning and welcome to Electrolux Third Quarter 2022 Results Presentation. My name is Jonas Samuelson. With me today, I have Therese Friberg, our CFO and Sophie Arnius, our Head of Investor Relations. I’d like to mention that this session is recorded and will be available on our website as an on-demand version.
Let’s look at our performance in the third quarter of 2022. We had slight organic growth in the quarter and an operating income at breakeven, excluding the one-time cost to exit the Russian market. The reduced earnings was due to a combination of weaker market environment and supply chain imbalances resulting in operational inefficiencies.
The decrease was mainly driven by business area in North America that reported a significant loss. Volumes declined mainly as a result of the lower market demand driven by high general inflation and low consumer sentiment coupled with high retailer inventory levels.
The supply chain constraints improved sequentially in the quarter, but still impacted operations predominantly in terms of additional costs. We delivered mix improvements in the quarter, also in this weak market environment through successful product launches. This was across our business areas, though primarily in Latin America and Asia-Pacific, Middle East, and Africa. Our strong price realization continued and we offset the significant cost inflation, mainly in raw material and logistics.
In general, promotions continue to normalize in the quarter, essentially getting back to pre-pandemic levels with seasonal promotions. In addition, the high inventory levels at retailers increased promotion in certain product categories, especially in North America and Latin America. In light of the weakening market environment, as previously communicated, we have this quarter initiated group-wide cost reduction and North America turnaround program.
The group-wide cost reduction element of the program will primarily focus on three areas. One area is to eliminate cost inefficiencies in our supply chain and production by adapting sales and production plans to what can be supplied in a stable manner and to right size the workforce in our factories.
Another area is to leverage the organizational changes, which took effect on July 1 this year. Through these changes, we have created stronger global organizations for operations, sales, administration, R&D and IT, which is also enabling efficiency gains. Finally, we are optimizing in R&D and marketing investments. This includes leveraging recent global investment programs in R&D and prioritizing the highest ROI opportunities as well as centralizing marketing and brand-building activities.
In addition to these three areas mentioned, the North America turnaround requires additional measures to return to stability and then profitability. This, as the production transformation with the two new facilities in Anderson and Springfield, includes several new product platforms in combination with a particularly challenging supply chain conditions, which have resulted in significantly elevated cost levels.
Specific for North America, key activities will be to stabilize and improve operational planning and to significantly improve cost efficiency in Anderson and Springfield to ensure cost competitiveness in these new production facilities.
We remain highly confident in the consumer appeal of the new product ranges, which also the sales execution in the quarter resulting in year-on-year market share gains proves. The turnaround will be conducted under the leadership of Ricardo Cons, who has been appointed new Head of Business Area in North America.
Ricardo has led business area Latin America since 2017 and has a strong track record of navigating in a dynamic environment and improving margins. The initiative program is for the full year 2023 expected to result in a positive year-over-year earnings contribution of SEK4 billion to SEK5 billion from a combination of cost efficiency and reduced investment in innovation and marketing. The activities implemented under the program will gradually contribute to earnings over the course of 2023 and into 2024. The full cost reduction from the program is estimated to be in excess of SEK7 billion.
The majority of the targeted savings will be realized in business area in North America. For the sake of clarity, the cost reduction from the program includes and replaces the previously communicated benefits from the SEK8 billion global reengineering program. Program is expected to lead to a restructuring charge in the fourth quarter of ’22 in the range of SEK1.2 billion to SEK1.5 billion, which will be reported as a non-recurring item. More or less the entire charge will have a cash impact throughout 2023 and 3,500 to 4,000 positions will be affected by the program.
If we go back to the third quarter, Therese will now walk us through the main drivers behind the change in operating income.
Therese Friberg
We had strong organic contribution to earnings in the quarter. We continued to have very good price realization from our list price increases implemented during the year, whilst the promotional activity essentially normalized from a previously low level. Our attractive product and brand offering generated a positive mix despite some remaining supply constraints on specific premium products.
Volume declined significantly, mainly as a result of the large market decline in our main markets in the quarter. Our investments in consumer experience innovation and marketing increased, mainly in product development and innovation that is harder to impact within a short time frame. Cost efficiency was very negative. The supply chain constraints resulted in considerably increased cost for logistics and components as well as large inefficiencies in production. The higher cost was both inflation driven and due to use of express freights and spot buys of components.
Price did offset the continued significant cost inflation, mainly in raw material that is included in external factors and in logistics that is part of cost efficiencies. Worth mentioning is that we had a contribution from currency translation in the quarter where our method for calculating the currency translation is based on earnings last year and not this year.
Let’s take a deeper look at our price and mix development. The EBIT margin accretion for the group from price and mix in the quarter was 14.3 percentage points. This was mainly from price as we continue to have a strong price execution across all regions driven by the least price increases implemented both during this year and in 2021, to affect the significant cost inflation.
Promotional activities is now essentially normalized, which we mainly see in North America and Latin America. Mix also continued to improve in the quarter for the Group. In Europe, mix was favorable, even though the lack of specific electronic components has – still had a hampering factor. Our clear focus on our premium brands Electrolux and AEG as well as on our high-mix products showed a positive mix also this quarter.
In North America, we continue to mix up based on the new product ranges. In Latin America, mix was positive while the product launches enabled by our reengineering program are well received by our consumers and significant growth in aftermarket sales also contributed to the mix improvement. In Asia-Pacific, Middle East and Africa, mix also increased partly driven by successful product launches. An attractive product and brand offering is essential for our profitable growth and Jonas will now give you some concrete examples of what we do.
Jonas Samuelson
Yes. So this year’s IFA in Berlin in early September, several new product launches were announced. The most significant ones were new 75 centimeter watt built-in fridge freezer and the new AEG laundry range. The new built-in refrigeration ranges are result of our new product architecture investments in Susegana, Italy. The new products are extremely well received with a 4.8 out of 5 consumer star rating. Technology innovations enable reduce food waste and increased capacity, while significantly reducing energy consumption and energy costs as well as the carbon footprint.
With regard to the new laundry range, we know that washing clothes too often and at too high temperatures can affect the color and fabric and have a negative impact on the planet. Despite this, we’ve learned that nearly two-thirds of European still wash at 40 degrees or higher.
This is why we in Europe now have launched a new range with the water savings steam and function and programs which automatically adjust time, water, and energy usage based on the load. The range has features such as our ProSteam technology, getting rid of odors in 25 minutes using 96% less water than a regular washing cycle and the power clean program that cleans your clothes efficiently and remains – removes stains at only 30 degrees.
The new range of tumble dryers has been developed to minimize energy use and uses 3D scan technology to identify humidity levels inside the items ensuring that even layered garments are evenly dried. Also, I like to highlight an accessory, an add-on filter for washing machines that catches up to 90% of micro plastic fibers released by synthetic clothing. This new range provides us with a great platform to continue driving premiumness within laundry and to further strengthen the AEG brand position in Europe. These were some of examples of how we drive profitable growth.
Therese Friberg
Operating cash flow for the third quarter amounted to negative SEK1.5 billion. From a year-over-year perspective, the decline is mainly related to the lower EBIT, but also higher capital expenditure. We also paid the charge now in Q3 related to the tariff case in the beginning of the year for which we received the settlement payment in the second quarter, underlying the working capital levels stabilized during the quarter.
Inventory remained at an elevated level, partly related to inflationary pressure, but in the quarter primarily due to market demand deteriorating faster than anticipated, coupled with continued extended lead times on a regular supply that is generating a generally high component stock. Our main focus remains in optimizing the inventory level going forward. And to note here is that the exit from the Russia market in the quarter had a negative net cash impact of SEK367 million that is reported separately in the cash flow statement below cash flow after investments.
Jonas Samuelson
Let’s now go into our business areas performance in Q3, starting with Europe. The European market declined significantly in Q3, resulting in lower sales volumes. This was partially offset by strong price realization and continued mix focus. We continue to launch new premium products at a high pace as just described.
The lower volumes was the main driver of the reduced EBIT, a strong price and cost management mitigated the effects of the market. We continue to experience high inflation and supply challenges in the quarter, even if the supply constraints sequentially improved. EBIT includes a non-recurring effect of minus SEK350 million from the exit from the Russian market.
Let’s look at the European market. In the third quarter, overall market demand in Europe declined by 15% excluding Russia. Since we have executed – exited the Russian market, we will from now on present European market demand excluding Russia and the graph is reflecting this as from Q1 2020.
In the quarter, Western Europe declined by 15% and demand in Eastern Europe by 19%. Market demand is now also at a lower level than before the pandemic and declined by 8% compared to the third quarter of 2019. Consumer confidence levels were low with consumer demand being negatively impacted by the higher general inflation, increased interest rates and geopolitical tensions.
This trend accelerated sequentially. In addition, high inventory levels at retailers amplify the decline in market demand. There are some signs of consumers mixing down, mostly in the lower price points though, which increases the polarization in the market.
Let’s continue with business area in North America, which reported a substantial EBIT loss with slight organic sales growth. The loss was the result of significantly elevated cost levels due to supply chain imbalances in combination with a weaker market environment. To be more specific, the challenges related to significant supply chain congestion in cost, high production inefficiencies and planning and ramp-up instability, altogether cost very high-cost inefficiencies and unstable output.
Despite this, market share increased in the core appliances year-over-year, even though volumes declined due to the weaker markets. The strategic decision to move away from certain source product categories with low profitability contributed to the lower sales volumes. Mix developed favorably confirming the consumer appeal of our new product ranges. The price offset has significant cost inflation, mainly in material and logistics. As previously mentioned, turnaround measures aiming at taking North America back to stability and profitability were initiated in the quarter under the leadership of retailer accounts.
Looking at the U.S. market, industry shipments of core appliances in the U.S. decreased by 9%, but still increased slightly compared to the third quarter of 2019 by 1%. High general inflation and increased interest rates impacted consumer sentiment negatively. The drop in consumer demand was amplified by high inventory levels at retailers.
Market demand for all major appliances including microwave ovens and home comfort products decreased by 13% year-over-year. We’ve not yet seen a clear shift in demand towards lower price points, but expect to see a shift towards mid or value price points based on the economic outlook.
Let’s move on to Latin America. Consumer demand dropped substantially in Brazil and Chile, while increasing in Argentina. Electrolux continue the strong price execution supported by a high number of successful launches in laundry and food preparation. Aftermarket sales continue to grow partially compensating for lower market demand. EBIT increased despite the challenging market conditions, driven mainly by the strong price and effective cost controls.
Finally, turning to Asia-Pacific, Middle East and Africa, market demand remained solid in key markets, which in combination with improved product availability led to improved volumes. Mix continued to develop favorably driven by product launches, also supporting solid price execution.
The strong profitability was driven by solid top-line in combination with efficient cost control. Price almost offset significant cost inflation, including currency headwinds in the quarter. Further list price increases were implemented in the quarter.
So let’s turn to our market outlook. The market environment has since 2020 been highly volatile and it continues to rapidly change. Inflation is soaring to historically high levels, increased interest rates and supply constraints exacerbated by uncertainty regarding the coronavirus pandemic and the war in Ukraine, result in limited visibility. We maintain our regional market demand outlook for the 2022 full year.
In the first half of the year, global supply chain constraints impacted the industry’s ability to fully meet underlying demand. In the third quarter, the slowdown in consumer demand was the main constraint for industry shipments, while the global supply chain situation improved. This was in line with our expectations and we anticipate this to also be the case in the fourth quarter.
Let’s look at our 2022 full-year volume demand view year-over-year for the specific regions. In Europe, we expect market shipments to be negative. High general inflation, rising interest rates, and Russia’s invasion of Ukraine have resulted in a sharp drop in consumer confidence and has – hence also in consumer demand. Replacement is to some extent mitigating this demand decline.
In North America, market shipments are estimated to be negative for the full year compared to 2021, but above pre-pandemic levels. The year-over-year decline is mainly driven by a slowdown in consumer demand, a soaring general inflation and rising interest rates negatively impact consumer sentiment.
Lately, we’ve seen a slowdown in new home starts and expect that to continue into 2023. However, on the positive side, we expect support from existing home remodeling as home owners are expected to remain in their homes and utilize equity to drive home improvement and kitchen remodeling. In Latin America, we expect consumer demand for 2022 to be negative, driven by Brazil and Chile.
In both Brazil and Chile, higher general inflation and increased nominal interest rates combined with reduction of government aids and uncertainty on the political situation contribute to the negative demand view. In Argentina, consumer demand growth is expected to continue in 2022, but we have to bear in mind that it’s from a weak baseline from several years that is starting to catch up. And finally, we estimate market demand in the Asia-Pacific, Middle East and Africa region to be positive for the full year 2022, mainly driven by our two largest markets, Southeast Asia, and Australia.
In general, underlying consumer demand has been solid across most markets in the region so far, even if we have seen some signs of slowing growth lately. The uncertainty going forward is mainly around potential pandemic restrictions and impact from higher general inflation on consumer demand.
Looking at the full year 2023, we estimate industry shipments of core appliances to be negative in Europe and in North America. This as consumer sentiment also next year is assessed to be negatively impacted by inflation and higher interest rates. A complete market outlook for full year 2023 will be provided in the ’22 year-end report.
Let’s look at our business outlook. In 2021, the combined contribution from volume, price and mix to operating income was nearly SEK9 billion. We expect this organic year-over-year contribution to be even higher in 2022, mainly driven by price increases that already have been implemented. Through strong price execution, we have in the first nine months of the year offset significant cost inflation, primarily in raw material and logistics. We remain confident to do so also for the full year as we have done for the past four years.
And then in an inflationary environment, price increases are more accepted in the market. This, combined with an attractive product range, makes us well-positioned to continue to be successful in raising prices if needed. If we shift focus on price to the other two levers, within organic contribution, we expect the combined contribution from volume and mix to be negative for the full year. This is fully driven by volume given the current demand situation and also as a consequence of the supply chain constraints, we experienced mainly in the first half of the year.
We still expect a strong earnings contribution from mix for the full year and 2022 is our most launched intensive year ever, partly enabled by our reengineering investments. I’m very pleased with how well received the product launches have been so far also in this more challenging environment that we’ve experienced lately. This gives us confidence that we have a great platform to drive mix improvement from.
In recent year, mix improvements have contributed an average of SEK1 billion annually to operating income. Investments in innovation and marketing are for the full-year expected to increase. In light of the weaker market environment though, we’re optimizing our R&D and marketing activities and started in the third quarter to reduce discussion in spending, primarily within marketing.
The constrained global supply environment has resulted in cost inflation, especially for logistics, in particular, ocean freight, but also for electronic components. Global supply chain constraints are expected to sequentially improve also in the fourth quarter with continued risk of disruptions relating to the resurgence of the coronavirus as well as consequences of the war in Ukraine. The increased geopolitical tension has so far mainly impacted logistics through higher fuel prices and lately the availability of price for both gas and energy that have emerged as an area that is high on our agenda.
Therese Friberg
Looking at the line cost efficiency, we expect this to be negative for the year. Main drivers are cost inflation on logistics, finished goods and components as well as operational inefficiencies related to constrained environment, especially in North America. As already mentioned, we in September initiated group-wide cost reduction and North America turnaround program. We expect to see some traction of these activities already in the remaining part of 2022 in areas such as airfreight and spot buys.
As we continue to start up additional production lines and new product platforms in our factories that are part of our SEK8 billion global reengineering investments, we will also see an increase in depreciation. With one quarter left of 2022, the estimated negative full-year headwind for external factors is narrowed to be in the range of SEK8 billion to SEK9 billion from previously estimate of SEK8 billion to SEK10 billion.
The year-over-year increase is mainly driven by raw material, especially steel prices. Investments to strengthen our competitiveness through innovation, automation and modularization continue in 2022 and total capital expenditures are expected to be in the range of SEK7 billion to SEK8 billion. The increase compared to 2021 relates mainly to some timing of investments from 2021 and raw material inflation on equipment.
Jonas Samuelson
So, to sum up the quarter and the strategic drivers we delivered on, needless to say, this has been another very tough quarter with a further weakening market environment and cost challenges. But there are also highlights. I’m very pleased with the way we continue to drive mix through successful product launches also in this environment with lower consumer purchasing power and confidence levels. It shows how well our new innovative products are being received by consumers, which is a key driver for us to deliver profitable growth.
Our strong price realization continues in all regions, making me confident that price will fully offset the significant cost inflation for the full year. I’m also particularly happy with the robust performance in our business areas, Latin America and Asia-Pacific, Middle East and Africa, delivering solid results with the increased earnings through successful product launch execution and efficient cost management. We have now initiated group-wide cost reductions and North America turnaround program, instrumental to reestablish stability and profitability while simultaneously progressing on our long-term strategy.
On the next Capital Markets Update, we will share more of the progress on the program, especially in North America, which we will have a deep dive on. The other focus area for the Capital Markets Update will be on how we are strengthening the relations with consumers and, of course, the benefit including after-market sales. You’re very welcome to join on March 20, either in Stockholm or digitally. More information will follow. With that, I leave the word to Sophie.
Sophie Arnius
Thank you, Jonas. We will now open up for questions. And usually there are lot of questions, so let’s continue with just asking one question at a time per person. And then if there are time, please enter the queue again and work more questions. So with that, I leave the word to our operator.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] Our first question comes from the line of Johan Eliason of Kepler Cheuvreux. Please go ahead. Your line is open.
Johan Eliason
Yes. Hi, good morning, Jonas, Therese, Sophie. Tough days obviously for you right now. I was wondering about your net debt obviously coming up now in the quarter, I think it was 2.6 or something like that. And you have a new dividend policy, previously you said dividend at least 30%, now you say around 50%. How should we think about dividends going into next year? I mean the share buybacks, you’ve already put on hold. Is there a risk on dividend falling or is it still the ambitions that dividend should be stable and hopefully growing? Thank you.
Jonas Samuelson
Yes. So clearly the debt level has increased to a higher level than what we’d like it to be over time. This is a temporary effect of the high inventory levels that we’re – that we’ve been running with the supply chain inefficiencies and then following that the rapid decline in consumer demand, but these are very current inventory.
So we will sell through in the fourth quarter and beyond and realize that sort of trapped cash in working capital over time. So the debt levels are very manageable and we’ll get through that – that hump that we have here. When it comes to the dividend, unfortunately I can’t give you any type of update on that right now because that, as you know, a Board decision and we haven’t had that discussion with the Board yet. So I can only refer to our dividend policy at this point.
Johan Eliason
Okay, thank you very much.
Jonas Samuelson
You’re welcome, thanks.
Operator
Thank you. Our next question comes from the line of Andre Kukhnin of Credit Suisse. Please go ahead. Your line is open.
Andre Kukhnin
Good morning. Thank you very much for taking my question. I’d like to talk about North America and try to segregate the kind of internal issues impact versus the external factors. Could you help us with maybe what kind of the impact was from the ramp-up issues in the quarter within that SEK1.2 billion loss? And then when we think forward about the cost saving program that you’ve not quantified, that SEK4 billion to SEK5 billion contribution, does that include dealing with the ramp-up issues or is it purely kind of a cost saving from reduction of employees and we should think about kind of ramp-up issues disappearing and savings coming through? I just wanted to make sure we don’t double up – double-count.
Jonas Samuelson
Yes. Right. So, thank you. I think good questions. And – so first of all in the quarter here for North America, we had very good price realization which did offset the, let’s call it, the ordinary inflationary pressure that we had in raw materials and logistics and so on. But on top of that, we had massive inefficiencies in our supply chain as well as in our production during the quarter and as we’ve had now for the last few quarters.
And this is driven by the fact that we still – even though it’s now improving, still have very regular supply in North America which – and that in combination with the fact that we are ramping up these new product platforms and we are very, very keen on increasing the production rate of those, that has resulted in really tremendous inefficiencies in the quarter with overstaffing, with high cost of logistics and so on.
And part of what we’re doing is, of course, reversing that and stabilizing our operations in North America, so if we go then to the impact of the cost reduction and turnaround program. So first of all, the SEK4 billion to SEK5 billion just exactly because there are so many ins and outs of that, for example, the timing of when logistics cost increases hit this year versus the timing of when they – we expect to negotiate and down next year, the impact of coming into last year with lower valued inventories versus coming into next year with higher valued inventories and so on rather than trying to piece all of those pieces apart, we’ve chosen to communicate what we see as the net benefit next year or in the two areas that we report, which is investments in innovation and marketing and in net cost, right.
Those are the two buckets that we report externally. And the combined net year-over-year full-year impact of that should be SEK4 billion to SEK5 billion. And I realize this is complex and it’s frankly somewhat complex for us because there are so many moving parts. And just to provide that sort of clarity to you, we decided to say this is that overall net year-over-year effect.
So then coming to the final part of your question, I choose to recognize it as one question by the way. But is that the ramp-up issues that we faced this year really has two consequences. One is significant cost inefficiencies. Those – the reversal of that as part of the SEK4 billion to SEK5 billion, but then, of course, our ability to drive mix and revenue through our new products have also been hampered.
So we continue to ramp up these fantastic new products that are very well received. And as that get more free flow with less disruptions, uncertainty and – which has resulted in difficulty to place these new products in effective way in retail, as that starts to roll through, we have fantastic new products that will generate higher margins. So, that’s outside of the SEK4 billion to SEK5 billion.
Andre Kukhnin
Great. Thanks, Jonas. I have a follow-up, but I’ll go back in the queue.
Jonas Samuelson
Thank you.
Operator
Thank you. Next question comes from the line of Akash Gupta at JPMorgan. Please go ahead. Your line is open.
Akash Gupta
Yes, hi, good morning, Jonas and Therese and thanks for your time. My question is also on the SEK7 billion or more than SEK7 billion cost saving program. When I look at your restructuring cost of – and that you guided for Q4 and the savings, it looks quite high number. So maybe if you can break down into how much of the savings do you expect to come from this SEK1.2 billion to SEK1.5 billion charge, which could be more structural than some of savings as – well, some of that could be discretionary and some of that could be – so maybe if you can help us understand the various state of this SEK7 billion? Thank you.
Jonas Samuelson
I mean, your point is accurate that the headcount reductions of 3,500 to 4,000 people that is specifically what drives the charge of SEK1.2 billion to SEK1.5 billion and that, of course, is a very significant cost reduction element. Then on top of that, we’re working very hard to eliminate areas such as express freight and logistics, air freight, spot buys and other significant inefficiencies that we’ve had in our supply chain that are not sort of inflation-related, but there are – that are real inefficiencies that we’ve had. And that’s another significant part of the of benefit.
And then, of course, we’re expecting to negotiate better freight rates and so on next year. That’s not the largest part of this – of the saving because we – the way our freight contracts work is that they run over several years. So the impact is staggered over time. And again these are – there are so many different factors as I mentioned on to the prior question that we’ve chosen not to break out the different elements here rather than just describing the way I’ve just done because otherwise everybody will be completely confused about what goes up and what goes down.
So – but that’s also why we have indicated that the full implementation run rate of this once every all of those ins and outs are washed out is then SEK7 billion. And that in turn includes that we are – just as we’ve said before, ramping up our new factories in North America to full productivity as we were targeting in our reengineering programs and that we get full sort of run rate impact of all these benefits and supply chain logistics and so on. So I think we’ll have to leave it at that level of breakdown because otherwise we would have a very confused discussion unfortunately.
Akash Gupta
Thank you.
Jonas Samuelson
Thanks.
Operator
Thank you. Our next question comes from the line of Olof Cederholm of ABG Sundal Collier. Please go ahead. Your line is open.
Olof Cederholm
Good morning, everyone. If I may follow up on the program again, maybe a bit on the timing of things. How much is reasonable to expect to come through already in Q4? And if you could also maybe, I know it’s difficult, but shed some light on the phasing of savings throughout 2023?
Jonas Samuelson
Sure. So, some of the activities that we’re taking here will have impact already in the fourth quarter, particularly the once that relate to eliminating excess freight cost and logistics and so on and really trying to stabilize what has been a very, very unstable manufacturing and logistics situation. That we expect to be favorable sequentially Q3 to Q4.
The benefit of that is not part of the four to five, that’s still the full-year year-over-year benefit. But we expect to improve sequentially just by stabilizing. And then the headcount productions and so on then happened, of course, gradually, starting union negotiations and the like here in the quarter. And then, as we go through next year – first half of next year, we start to see more and more of those benefits.
But then to the point to some of the earlier questions, specifically for Q1 that we’d last year a situation where we were still operating off a fairly attractive cost levels in our inventories whereas this year, as we roll into Q1, we’ll still have high – fairly high cost levels in our inventory. So that means that Q1 is a bit more challenging to really realize significant net gains. But then as we go into Q2, there are significant more opportunities and then we get really the traction in the second half of the year, that does kind of how to look at.
Olof Cederholm
Thank you.
Jonas Samuelson
Sure.
Operator
Thank you. Our next question comes from the line of Gustav Hageus of SEB. Please go ahead. Your line is open.
Gustav Hageus
Thank you, operator. Good morning, guys. Thanks for taking my question. So back to North America then, you referenced that some improvement to be made already sequentially into Q4. And then obviously we’re approaching discount season with Black Friday and whatnot and lot of players holding inventory as I understand in several layers. So could you shed some light a little bit on where you think net pricing competition and so forth will – how that will develop into Q4? And if you’re already seeing now sort of price slippage in the market?
Jonas Samuelson
Yes, I think to your point, we do expect the sort of Black November to be quite promotional. I would say back to pre-pandemic levels. And we’re ready for that. The benefit though of the significant price increase – list price increases that we’ve already made means that we’ll have continued good net price traction also in the fourth quarter. So, that’s not something that is of concern to us.
And in fact, I think the flip side to that is that volumes are holding up relatively speaking better in North America than in, for example, Europe because households still have money to spend and a more promotional environment also is pulling more consumers into the market. So it’s a bit of a mixed bag, but net-net, we will continue to have strong net price realization in the fourth quarter as well in North America.
Gustav Hageus
And just a short add on, if I may. We see destocking now in several layers throughout different industries. Do you anticipate – how do you feel about the sort of channel inventories for your business into Q4? Is there – do you expect sell out to be similar to sell-in, in Q4 in retail?
Jonas Samuelson
I do expect retail inventories to come down in the fourth quarter as well as our own inventories as we are – as we pull back quite significantly on production plans both in the latter part of Q3 and into Q4. So I think the quarter will be kind of destocking type quarter, which also makes sense because it’s also typically the highest consumer demand quarter. So it’s the right quarter to do the destocking, let’s say, from a total value chain perspective, supply chain perspective.
Gustav Hageus
All right, thank you. That’s helpful.
Jonas Samuelson
Sure. You are welcome.
Operator
Thank you. Our next question comes from the line of James Moore at Redburn. Please go ahead. Your line is open.
James Moore
Yes, good morning, everyone, and thanks for taking my question. I wondered if I could just ask a little bit more about raw materials within the external factors. Obviously, the majority of external factors is raw material. I thought it might have been a bit less this year with the metal prices coming down. And I understand that you’re hedged and I understand that you have contracts, but the nature of that hedging and contract structure can vary from year-to-year. And I wondered if you can in anyway help us think about what the carryover might look like into next year at current spot rates for both raw materials and energy, which I believe you’re moving across the buckets? Anyway [technical difficulty] because it’s quite difficult from the outside to underscore structures look like at the moment.
Jonas Samuelson
Yes. No, I think that’s fair. It’s difficult and it’s frankly quite challenging for – from the inside as well to have clarity on raw material costs going forward. So the dynamic, I would say, both on steel and plastics has been that we had very significant bump – pricing bump in spring of 2022.
We saw a run up, let’s say, from over the course of 2021, from 2020 to end of 2021. And then from that level, we saw a big spike in the spring. That has now leveled back down. And in many cases, specifically in steel, we’re now kind of below the spot levels that we’d a year ago. Right. So, we’ve cycled through that bump.
If we then look at our cost impact this year compared then to 2021 that was mainly driven by the cost run-up in 2021, which we then contracted for 2022. And then on top of that, there are certain portions of the costs that are unhedged always in there. We took some additional cost in the middle of the year. And now as Therese indicated, we’re seeing some of the benefits, so we reduced the range a bit for raw material cost headwinds as a consequence of that, of those prices coming down, on the unhedged part of our exposure.
Now, looking into next year. To your point, spot prices for many raw materials are currently at or below 2021 levels. So, hopefully that will give us an opportunity to negotiate good contracts, but of course we don’t buy at spot. It’s a bilateral agreement and we’ll see how that plays out the extent we do fixed versus variable price contracts for 2023 that’s yet to be finalized. And then finally, your point about energy.
And it’s correct that historically we’ve reported energy costs as part of our, let’s say, net cost efficiency, but since it is such a big and volatile element right now, especially in Europe, we’ve said it’s better to move that to external factors because it is truly a commodity price impact that we have there. And again the volatility of it plus the fact that we’ve the price for it because this is something that every factor in the industry will be exposed to and that is producing in Europe and we’ve to price for it.
So that will be the way it looks right now or even though that’s very volatile, there will be a headwind for next year. And then on top of that, we also have this excess inflation on labor cost, which we’ve historically not had that much of outside of, let’s say, Latin America, which is now becoming a real factor in Eastern Europe, for example, and North America and other places and that we also have to price for. So when you look at it, I think there’s a good chance that we’ll see tailwinds benefits from steel and plastics and it’s also likely that we’ll see headwinds from excess labor salary inflation and energy. How that’s going to play out? We have to come back on.
James Moore
Thank you very much. If you could scale [indiscernible] for the current year, just so we know the size of the vendors move be helpful? Thank you.
Jonas Samuelson
The reduction you mean right now or —
James Moore
Just the absolute annual cost of energy for the Group?
Jonas Samuelson
Cost of energy. Yes, no, we haven’t called it out exactly, but it’s historically a relatively minor cost, but with – if we talk about tripling or quadrupling, then suddenly it becomes a meaningful number. We’ll see how that – how that plays out now throughout the winter.
James Moore
Thank you very much.
Operator
Thank you.
Jonas Samuelson
By the way, sorry, operator. I needed to fill out one thing. And that is that energy cost is really two elements of that. One is that it’s our own manufacturing resources requiring obviously energy consumption. But also – and this is potentially actually quite significantly more important for us is that some commodities have a very, very high energy content in the production. And here we are potentially looking at additional costs and surcharges, which then we would reflect in the external factors.
Also here very significant uncertainty, but for things like glass shelves manufacturing and so on, obviously that requires a lot of energy and we have to kind of take hike for the likelihood that that’s going to be challenging for our suppliers going forward. Sorry about that. Back to you, operator.
Operator
Thank you. Our next question comes from the line of Uma Samlin at Bank of America. Please go ahead. Your line is open.
Uma Samlin
Hi. Good morning, Jonas, Therese, and Sophie. Thank you for taking my question. So my question is on your inventory levels and the assets at the current historical high. You have mentioned a few times during the call that the pricing of those inventories are high into next year versus the year before. So how should we think about the impact where you start to do some destocking on your inventories? I mean, what impact do you have on your profitability into the next few quarters? And how do you plan the destocking in relation to your production level in North America just when you’re ramping up in the new factories?
Jonas Samuelson
I pass on to Therese to speak into that.
Therese Friberg
Yes. So, as Jonas indicated, we are planning to reduce inventory already here going into the fourth quarter. So already, I would say, in the third quarter, we’ve had quite large production cuts compared to what we plan going into the quarter. Unfortunately, they’re not enough, let’s say, to compensate in terms of inventory levels during the quarter due to an even more rapid market decline than we anticipated.
But let’s say we’ve already taken action during the quarter. And, of course, I mean also with the weaker market outlook, we already also taken action in reducing our purchases and so forth of incoming goods. And then, of course, also for the fourth quarter, we’ve already planned for a lower production than previously.
So I would say it’s not about doing destocking through kind of heavy promotions to come through in that way, but we’ve been anticipating that we need to reduce inventories since some time and this has been an active plan on our side. Of course, as Jonas indicated, we’re going into promotional season now, so we’ll take advantage of that in certain categories where we think we would be too high to, of course, be more aggressive in those types of categories where we see it’s needed.
But when it – and then, of course, we should remember still in terms of the size of inventory, we also have an effect of the inflationary pressure that we’ve seen, hence also that will take some time going into next year of getting benefits from the cost reduction since we have also from a high value-based inventory. So it’s several different components. I think we have an active plan to bring them down, not through crazy promotions, but through active re-planning that we’ve done in some time.
Uma Samlin
Thank you. That’s very helpful. Would you be able to quantify the production cut you just mentioned?
Jonas Samuelson
No, we typically don’t do that. Because again it’s always related to a plan and we don’t have a published plan, so it becomes a meaningless number. But it’s a significant cost compared to what we were originally planned.
Uma Samlin
Thank you.
Jonas Samuelson
Sure.
Operator
Thank you. And our final question comes from the line of Andre Kukhnin with Credit Suisse. Please go ahead. Your line is open.
Andre Kukhnin
Thank you very much for taking the follow-up. Can I squeeze two quick ones? One is back on North America what I was asking and what you started saying by Q4, is there kind of – could we see a meaningful improvement in that loss kind of run rate that you saw in Q3 or is it kind of more around the edges at this stage and, as you said, primarily really Q2 next year onwards?
Jonas Samuelson
Yes, I mean, we’re pushing very, very hard, but, of course, the challenge is that what we already have in inventory at high cost and so on, means that it takes time for that role to roll through. But the activities are at a full speed and we do expect substantial significant benefits there also sequentially from reduced spot buys and express rates and things like that.
And some of that will come through in a – reasonable amount of that will come through in the quarter. But, of course, there is still a volatile environment, so challenging. But the benefit of North America is that we can take quicker actions than in Europe when it comes to employment levels and things like that. So we will get quick impact, but it still takes time to roll through fully in the P&L.
Andre Kukhnin
Great, thank you. And if I may just on demand environment, in middle of September, early September when you pre-announced, you clearly indicated look this is accelerating downwards two times the speed of prior quarter. Now that we’re six weeks forward, are you seeing any signs of that demand drop starting to level out given that it’s sort of fifth quarter in a row? Or we still in more kind of free flow – freefall environment?
Jonas Samuelson
Yes, no, I would not call it a free fall environment. I would say the run rates that we – that were established in Q3 are, I would say, kind of the run rates that we’re seeing also going forward. But, of course, the year-over-year impact of that is still quite negative. But – then the question mark is then what would happen to this winter in Europe in particular given the high energy prices and so on. I think that’s the high uncertainty level that we see.
Andre Kukhnin
Very helpful, thank you very much.
Jonas Samuelson
Sure. Thanks very much.
Operator
Thank you. And with that, I’ll hand the floor back to our speakers for the closing comments.
Jonas Samuelson
Thank you, operator, and thanks to everybody for very good questions. Yes, we recognize that this is a very tough quarter. But nevertheless, I’m very pleased with our continued strong price and mix execution. And going forward, we will most likely continue to experience a challenging market with high levels of volatility and uncertainty. However, with the program that we’re now initiating and with strong agility short-term combined with a solid long-term strategy for profitable growth, I’m confident that we remain very well-positioned to create value over time.
Thank you very much and look forward to talking to you soon again. And don’t miss out on our Capital Markets Update next spring.
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