Clorox Q3 2022 Earnings Call Transcript

Participants

Corporate Executives

• Lisah Burhan, Vice President, Investor Relations
• Linda Rendle, Chief Executive Officer
• Kevin Jacobsen, Executive Vice President and Chief Financial Officer

Analysts

• Dara Mohsenian, Morgan Stanley
• Andrea Teixeira, J.P. Morgan
• Peter Grom, UBS Group AG
• Chris Carey, Wells Fargo Securities
• Kaumil Gajrawala, Credit Suisse Group AG
• Jason English, The Goldman Sachs Group, Inc.
• Kevin Grundy, Jefferies Financial Group Inc.
• Steve Powers, Deutsche Bank Aktiengesellschaft
• Lauren Lieberman, Barclays PLC

Presentation

[Operator]

Good day, ladies and gentlemen, and welcome to The Clorox Company Third Quarter Fiscal Year 2022 Earnings Release Conference Call. [Operator Instructions] I would now like to introduce your host for today's conference call, Ms. Lisah Burhan, Vice President of Investor Relations for The Clorox Company. Ms. Burhan, you may begin your conference.

[Lisah Burhan, Vice President, Investor Relations at Clorox]

Thank you, Erica [Phonetic]. Good afternoon and thank you for joining us. On the call with me today are Linda Rendle, our CEO; and Kevin Jacobsen, our CFO. I hope everyone has had a chance to review our earnings release and prepared remarks, both of which are available on our website. In just a moment, Linda will share a few opening comments, and then we'll take your questions.

During this call, we may make forward-looking statements including about our fiscal year 2022 outlook and the potential impact of COVID-19 pandemic on our business. These statements are based on management's current expectations, but may differ from actual results or outcomes. In addition, we may refer to certain non-GAAP financial measures. Please refer to the forward-looking statements section, which identifies various factors that could affect such forward-looking statements and the non-GAAP financial information section, including the tables that reconcile non-GAAP financial measures to the most directly comparable GAAP measures, both of which are located at the end of today's earnings release, which has also been filed with the SEC.

Now, I'll turn it over to Linda.

[Linda Rendle, Chief Executive Officer at Clorox]

Hello, everyone, thank you for joining us. I hope you and your families are well. Hopefully, you found our prepared remarks helpful. I'm encouraged that we continue to see strong consumer demand for our brands and made progress on our near-term and long-term strategic plans in the third quarter amid a highly dynamic and challenging environment.

Importantly, we delivered on our commitment to drive sequential gross margin improvement. We executed well on the factors under our control, leveraging the strength of our brands to grow share, sustained top line momentum, and begin to rebuild margin. We continue to drive our innovation pipeline, deliver cost savings, generate operational improvements across our supply chain and take additional inflation driven pricing actions, all while keeping our eye on the long term.

There is no question that it's a volatile operating environment. The rising cost inflation we are experiencing is reflected in our updated fiscal 2022 outlook. That considered, I'm confident that our fundamentals are strong and that the actions we are taking and the progress we have made put us on the right trajectory to drive long-term profitable growth and create shareholder value.

With that, Kevin and I will open the line for questions.

Questions and Answers

[Operator]

Thank you, Ms. Rendle. [Operator Instructions] Our first question comes from Dara Mohsenian with Morgan Stanley.

[Dara Mohsenian, Analyst at Morgan Stanley]

Hey, guys. In your prepared remarks, you mentioned the summer price increases. Can you just give us a bit more detail on which categories you've announced pricing, and the magnitude and what percent of your portfolio will have multiple rounds of price increases in by the summer? And then just taking a step back as we look out longer-term, obviously, some sequential gross margin recovery in fiscal Q3 It sounds like you're expecting more in fiscal Q4 in the prepared remarks. And you just discuss conceptually with this new cost outlook, with the pricing going into place, how quickly you expect to rebuild gross margins over the next few years just relative to the pronounced pressure you're expecting this year? Thanks.

[Linda Rendle, Chief Executive Officer at Clorox]

Sounds good. I'll start with where we are on pricing. So, as you recall, we announced a round of pricing, our first round in the fall. That was fairly broad across our portfolio. We have since taken a subsequent round that was effective this month, in April, and we're starting to see that flow through in the marketplace and then we have an additional round of pricing scheduled for July. There is also broad across our portfolio and we're actually going deeper than we had intended to go when we first announced the price increase given what we're seeing from the impact on Ukraine. So we made that decision shortly after we saw the impacts.

In total, the vast majority of our portfolio will be priced and the majority of the portfolio will also have multiple rounds across all three of those time periods by the time we get to July. Kevin can talk a bit about what that means for gross margin and sequential improvement.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Hey, Dara. On gross margin, no change to our longer-term expectations, what we've been talking about for the last couple of quarters. What I would say is, you folks, in our prepared remarks, we're really pleased with the progress we made in Q3. We sequentially improved margins, a little under 300 basis points. It's going to be more challenging for us in Q4. We have rolled in the increased energy prices as a result of that war in Ukraine. And we think that's going to be about a $30 million headwind in Q4. As a result of that, I think it would be more modest progress sequentially in Q4 and then we continue to build our plans to ensure that we continue that progress in fiscal year '23. I'll hold off. As I'm sure you can appreciate you giving exact outlook right now, we'll do that in August, but the plans, we're building would keep us on track to keep building -- rebuilding margins in fiscal year '23.

And then I would say for us beyond that nothing else has really changed with the exception that we've got increased cost headwinds. And importantly, we think we're taking the right actions to address those, as Linda just mentioned, we've increased the pricing that we've already announced they're going effect in July. So we think we're taking the right actions to address this next round of inflation we're dealing with, but as is typical, there's going to be a lag here. We'll will take a bit more of a hit in Q4 and then the actions we're taking we'll see start in our Q1 fiscal year '23.

[Dara Mohsenian, Analyst at Morgan Stanley]

Okay, great. And then can you talk a little bit about the price gap versus competition, and with the actions you're taking, if you've seen competitors move already and where that leaves you and perhaps the demand elasticity you're seeing from the price increases you already took from a consumer standpoint?

[Linda Rendle, Chief Executive Officer at Clorox]

Sure. As it relates to price gaps, we've said it would be dynamic and it certainly is as we take pricing and then the rest of the category continues to do that. So we're seeing some price gaps in line, and others where we're a bit behind, but we expect when July pricing goes into effect that the price gaps will be about what they were pre-pandemic. We don't intend to change price gaps through this action, but that's going to take a little while and a little noise to play out coming here as we take these next two increases this one this month, and of course, the one in July.

And then as we look forward into what we would experience coming into inflation from a consumer perspective, also with pricing, that's something that we're watching really closely from a category perspective. I think it's important to note that given the price gap dynamics too, we are also looking very closely at merchandising and what's happening that still continues to be lower than it was pre-pandemic. But we have seen levels increase, but I would say, on average, it's been very rational, we've seen private label and other branded players move, but we continue to watch it closely and again do not expect price gaps to be any different one when this all nets out in July.

[Dara Mohsenian, Analyst at Morgan Stanley]

Great, thanks.

[Operator]

Our next question comes from Andrea Teixeira with J.P. Morgan.

[Andrea Teixeira, Analyst at J.P. Morgan]

Thank you, operator, and good afternoon, everyone. So I wanted to just follow up on the pricing. So you announced, I'm assuming this additional pricing, not sure if you were, I was on the plan form the [Technical Issues] that you initiated now in April of course July's extra and goes into fiscal '23. But I was hoping to see you didn't change at the end, it didn't change the guidance much for the top line. So I'm assuming you're embedding some sort of elasticity. Just going back to the point earlier, are you assuming all of this has come back to normal or you are seeing still below trend? And then just drilling down on the additional pricing you're taking, what are the categories that you are, I'm assuming bags, and charcoal would be -- sorry, and and also litter would be the ones that you are taking additional pricing?

[Linda Rendle, Chief Executive Officer at Clorox]

Sure. So we had always planned to take an April price increase, which of course is in market now. July we had intended to take, but we are going broader and deeper in that pricing given what we're seeing as impacts from the war in Ukraine, but we keep -- we're keeping that timing in July. And as -- you're right that will impact mostly as we look forward into fiscal year '23 but April will start to help in Q4. As it relates to the categories that we're pricing, this is pretty broad pricing in April and July.

You mentioned bags will be part of both of those increases happened in April, will happen again in July given what we're seeing in the resin market, but we'll be pretty broad across the rest of our portfolio as well. And we would expect, given what we're seeing across the pricing across our competitors that that will be true for the remainder of the category competitors' private label, and branded. As we look at what we expect to see beyond that it's -- I think it's going to depend on what we see for energy for the remainder of the year what we see in commodities. But we feel like we've taken the right amount of pricing based on what we are announcing in July in order to deal with the environment that we're seeing right now.

[Andrea Teixeira, Analyst at J.P. Morgan]

And any additional distribution that is embedded getting out of the quarter and into the fourth quarter that you regain given your service levels improved that you would highlight?

[Linda Rendle, Chief Executive Officer at Clorox]

Yeah. So we did see an increase in total distribution points and share of assortments in this latest quarter which was great to see. So total distribution points were up 10% and we grew share of assortment by a full point. And that is a number of things, one, of course you highlight, which is the fact that we're back into supply in many of our categories and service levels are improving, but importantly too, this is the good work our sales and marketing teams are doing on category growth plans with our retailers and of course the innovation that we have in-market that's performing really well and we're seeing strong distribution results behind all of that.

So in total, in a very good place from a distribution perspective and we would continue to expect to make progress in Q4 based on what we know our plans to be in the coming couple of months.

[Andrea Teixeira, Analyst at J.P. Morgan]

Thank you, Linda. I'll pass it on.

[Operator]

Our next question comes from the line of Peter Grom with UBS.

[Peter Grom, Analyst at UBS Group]

Hey, good afternoon, everyone. Hope you're doing well. So I just wanted to ask about the company's updated organic sales outlook, and I could be clearly overthinking this, but if you go back through the last few quarterly releases each provided some comment around the return to the company's long-term organic sales algorithm of 3% to 5% and maybe I missed it today, but I didn't see one. It really just could be implied in the comment around sequential improvement, but a 3-point range for the full year implies a pretty wide gap for 4Q. So just how are you thinking about organic sales growth in the fourth quarter and how does that inform your view on returning to the algorithm long term? Thanks.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Hey, Peter. Thanks for the question. In regard to our outlook, it is, and we've talked about this before, it is wider than what we would typically have this time of year, and we think that's appropriate for the environment we're operating in. Having said that, we feel very good about sales expectations in the fourth quarter. As we said, we expect sequential improvements from what we landed Q3 at 2%. But I think the items are also thoughtful about that widens range. Keep in mind we were taking another round of pricing that went into the market in April.

As Linda, just mentioned our expectation, similar to our previous round is the elasticities will be slightly better than we've seen historically. So that's embedded in the outlook as well. And then also keep in mind, competition is taking quite a bit of pricing right now at the same time and while we don't know what they're doing or should we, if they go before us, after us, the amounts they go will create some variability in our results as well. So with all that in mind, we think it's appropriate to have a bit wider range. But having said that, nothing has changed since we spoke last quarter. We're very much on track for the top line for the full year, and again expect sequential improvement from where we landed in Q3, but the range is a bit wider for the reasons I mentioned.

[Peter Grom, Analyst at UBS Group]

Okay, that's super helpful. And then maybe just one point of clarification. Linda, I think you mentioned in the prepared remarks that you transitioned external manufacturing from the large groups to just a few strategic suppliers and just going back to last quarter, that was widely discussed is a key driver of the gross margin pressure you were dealing with. So can you maybe unpack that comment a bit? Is that just related to the number of suppliers you were using, or are you kind of now closer to that 80-20 mix in terms of in-house versus outsourced manufacturing. Thanks.

[Linda Rendle, Chief Executive Officer at Clorox]

Sure. Yes. We discussed, we used a broad range of external partners during the height of the pandemic to ensure that we could meet consumer demand and we built that very intentionally so that we could ensure that we built an optimized network once we got into more of an endemic phase of the pandemic. And as we head into that we've done just that we've been able to consolidate and narrow the external manufacturer portfolio we have to strategic partners. We've been able to in-house and we're working through that in Q3 and Q4. We expect the vast majority of that benefit to begin hitting in fiscal year '23, but we're well on track to doing what we talked about in terms of that supply chain optimization.

[Peter Grom, Analyst at UBS Group]

Great. Thank you. Best of luck.

[Linda Rendle, Chief Executive Officer at Clorox]

Thank you.

[Operator]

Our next question comes from the line of Chris Carey with Wells Fargo.

[Chris Carey, Analyst at Wells Fargo Securities]

Hi, everyone.

[Linda Rendle, Chief Executive Officer at Clorox]

Hi, Chris.

[Chris Carey, Analyst at Wells Fargo Securities]

Hey, how are you? I just wanted to follow up on the question around manufacturing logistics. That's great to hear. Obviously, commodities getting worse in fiscal Q4. I mean, would you expect that manufacturing and logistics line to get materially better sequentially from here starting in fiscal Q4 and going into next year as you have some of the easier comps, maybe it even turns into a net positive as you start to unwind this onerous co-man network that you have? Is that a reasonable assumption going forward?

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Hey, Chris. What I'd say as it relates to manufacturing logistics in commodities is, I do expect -- maybe I'll start with manufacturing logistics. I do expect to see some sequential improvement as we move down through the end of this year. So just this last quarter. And there's a couple of areas I'd point to. The first is what Linda talked about, we're making good progress as we said we would on optimizing our supply chain and stepping out of these third-party contract manufacturers. We're also seeing some, I would say, pull back in transportation in the spot rates. I think you've heard us talk about that the last couple of quarters. We see a significant increase in the cost of carriers in the spot market. That premium starting to come down a bit, which is a little bit of a benefit in the third quarter and I'd like to believe we're going to see that continue to go forward. So that should certainly help as well.

And then we continue to optimize our supply chain beyond just the contract manufacturers. If you recall, as part of the work we did during the pandemic, we significantly extended our supply chain to ensure we had backup suppliers, given all the disruptions we were facing. As that supply chain starts to level out, we're able to step out of some of those relationships with material suppliers that also should reduce our costs. I mean if you can imagine, we were sourcing product from Asia, we had to deal with the freight to get that product here as. We can step out of some of those and get back to our core suppliers, there is more opportunity there. So this is clearly been an opportunity for us.

As we've talked, going forward, how we will rebuild margins is really in three buckets. It first starts with our cost savings program. We're also going after the supply chain costs that we've built up over the pandemic. They were in the process of taking out. And then the pricing actions we've talked about. And as those three levers, we're going to keep pulling on that we think put us in a position sequentially keep improving margins and I'd expect to see some of that benefit flow through this quarter and then continue next year as well.

[Chris Carey, Analyst at Wells Fargo Securities]

Okay. Thank you so much for that perspective. And then one quick follow-up just on your SG&A, a little bit better versus prior expectations. How much of what you're doing this fiscal year is something sustainable that you think you can carry into next year versus things that might be a bit more point in time like lower variable compensation or anything else that might reverse back into SG&A next year with the adjusted SG&A as a percentage of sales, running pretty low, relative to historicals? So, thanks again.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Sure. And Chris maybe two points of view on SG&A. One issue is related to structural changes. In our Q3, our SG&A was about a point lower than we had projected. We have a pension program and the ability for our employees to defer compensation that they invest in the stock market. As you know, the stock market was down in the third quarter so that reduces our liabilities to our employees. That reduced it by one point. That has no impact on EPS. That's offset in other income and expense because the value of the portfolio went down to us by an equal and offsetting amount. So that's a bit of noise on the P&L and that was about a one point reduction.

About your comment on structural changes, we continue to make progress in admin. We are on track to deliver our cost savings commitment this year, 175 basis points of EBIT margin expansion, and what you'll see is a nice amount of that coming from admin, typically product supply. We deliver the largest source of value, about 135 basis point goal, that'll be true this year as well. But I'd say a little bit more coming on to admin than typical and that should be structural that we can carry forward.

[Chris Carey, Analyst at Wells Fargo Securities]

Okay. Thank you, both.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Yeah. Thanks, Chris.

[Operator]

Our next question comes from the line of Kaumil Gajrawala with Credit Suisse.

[Kaumil Gajrawala, Analyst at Credit Suisse Group]

Hi, everybody. Maybe a follow-up to Chris' question, but more specific on ad spend. It looks like ad spend maybe came off a little bit or maybe was a little bit lower than plan. You obviously gave us some guide on where it's expected to be. Can you just talk about how you're thinking about that line?

[Linda Rendle, Chief Executive Officer at Clorox]

Sure. We're still on track for 10% to the year, which is exactly our commitment, then I think you know how strongly we feel about advertising as a strategic lever to build our brands and ensure we have superior value. So in this quarter just timing and on track for 10% for the year.

[Kaumil Gajrawala, Analyst at Credit Suisse Group]

Okay, great. And then I know I guess trade spend and the impact on revenue, it looks like trade spend is up quite a bit, has a bit of a mix effect as you're discussing pricing and incremental price increases. Can you just give us a context on how much of that maybe will be offset by it sounds like promo activity is increasing and such?

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Yeah. Maybe a couple of thoughts on I'll talk price mix in the impact of trade spend within price mix. If you saw our results in Q3, two points of volume growth, we had four points of benefit from pricing and then we had four points of unfavorable mix and higher trade spending and we've talked about that the last couple of quarters. We had a temporary benefit during the pandemic as we went down to smaller size to increase throughput from our plants as well as there was effectively no promotional activity on several of our categories, was a lack of product availability.

We had about a four point price mix benefit for about four straight quarters during the pandemic. That was a temporary benefit that we knew would unwind. It has been unwinding for several quarters. Q3 was the last quarter we've now lapped at and so that drag in Q3 should no longer occur as we move forward. So that four point hit increased mix and trade was really just unwinding the temporary benefit we had during the pandemic. And so while I expect to see a greater benefit from price mix going forward as we're getting the full benefit from pricing and no longer lapping that temporary benefit.

[Kaumil Gajrawala, Analyst at Credit Suisse Group]

Got it. That's useful. Thank you.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Yeah.

[Operator]

Our next question comes from the line of Jason English with Goldman Sachs.

[Jason English, Analyst at The Goldman Sachs Group]

Hey, good afternoon, folks. Thanks for taking my question. So I think you partially answered this with the pension benefit this quarter, but your guidance, historically, your EBIT margin's step up nicely in the fourth quarter from your third quarter, but your guidance implies that you're not going to see that historical progression. In fact, it suggests that you're going to see a fairly sizable degradation in operating margins from the third to the fourth quarter. So I appreciate the sequential improvement, gross margin, but what's driving the substantial dip and EBIT margins and your outlook from 3Q to 4Q?

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Yeah, Jason. Thanks for the question. And you're right, we do expect that to be the case. As you mentioned, we expect sequential improvement on the top line and we do think we'll make some very modest sequential improvement in gross margin in Q4. But what's offsetting that is two items versus on admin, you'll see an increased spending in admin. In Q4, I suspect we'll be somewhere in the 15% to 16% of sales. And that's really the timing on the investments we're making in our digital transformation efforts. They really start to ramp up in the fourth quarter.

So about 40% of the total spend you'll see in Q4. And so what they rate sort of in at 15% to 16% and then let me just mention on advertising, we're not concerned about the investments by quarter. We manage the year. And so, we're still targeting 10%. So you'll see an elevated level of advertising investment in Q4 relative to Q3 that keeps us on track for 10% for the year.

[Jason English, Analyst at The Goldman Sachs Group]

And were you referring to the -- your pro forma numbers or your GAAP numbers? With that --

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Those are GAAP numbers.

[Jason English, Analyst at The Goldman Sachs Group]

[Speech Overlap] Sure. So I'm just doing all in pro forma. You've got a massive drop in your pro forma guidance for fourth quarter. So I assume it has -- that isn't actually related to the digital transformation since you guys are excluding that. Am I correct?

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

That's correct. Yeah.

[Jason English, Analyst at The Goldman Sachs Group]

Okay. So, what -- do you have something else to work?

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

No, you'll see the increased advertising will be the primary item. As we step, it will be nicely over 10%. I suspect that gives us that 10% for the full year.

[Jason English, Analyst at The Goldman Sachs Group]

Got it. And on SG&A, is incentive comp, should we expect a reload that next year?

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Yeah, we should. We're a pay-for-performance company and we're below our goals this year. So we're paying out less than our present and the expectation. We had reset that to our plans in fiscal '23. So it would step up to a targeted percent payout.

[Jason English, Analyst at The Goldman Sachs Group]

Okay. I'll follow up offline to try to get the quantum on that. Thank you very much.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Okay. Thanks, Jason.

[Operator]

Our next question comes from the line of Kevin Grundy with Jefferies.

[Kevin Grundy, Analyst at Jefferies Financial Group]

Great, thanks. Good afternoon, everyone. So, Linda, my question pertains to private label and more broadly just trade down risk and how you see this playing out, given the state of the consumer. So as we look at the Nielsen data and everyone has been very much watching that to see trade down within categories as private label gaining share. More broadly, as you know, since the start of the pandemic, that's not been the case. We've seen a little tick up more recently, but I think it stands out because it's been in some of your categories and particularly those that even historically have been more exposed to private label.

So that being bleach, charcoal, wipes. So you mentioned that you've seen private label move on price as well. Maybe just comment on how you're thinking about this now competitively and how you see this playing out. That -- the state of the consumer and potential risk there, trade down in your categories, and maybe just sort of comment on some of the share gains that we've seen in private label more recently in the syndicated data. Thanks.

[Linda Rendle, Chief Executive Officer at Clorox]

Sure. Hey, Kevin. What we're continuing to see is consumers choosing trusted brands. And you highlighted it well. We definitely saw during the pandemic, people in our categories choosing brands they could trust, given what was going on in their lives and that continues. We have seen over the last quarter a marginal improvement in private label share, pretty minimal. And we think that's mainly related to getting distribution back in line to pre-pandemic levels but no meaningful share gains and still lower than pre-pandemic.

If you also look at more leading indicators, household penetration also did not keep pace for private label during this time and we expect that to continue to have an impact as we move forward. And as we head into this period, consumers are absolutely under a lot of stress, but we're seeing what we expect in our categories at this point. Private label has taken pricing as we have taken pricing and competitors have. We're seeing pretty rational behavior there and from a consumer perspective, we continue to see what we expect.

So elasticities in line to slightly better across our categories, meaning, of course, we're seeing volume decline, but a little less than we had anticipated and we're seeing that across the category. We're going to watch it really closely, but we think we're very well positioned based off of the superior value of our brands and I know, Kevin, we've mentioned this before, but 75% of our portfolio at this time is deemed superior by consumers. Of course, that's a combination of not only price but brands and the product experience we deliver. And we continue to be laser-focused on that. So, continuing our investment in our brands, continuing on innovation, ensuring we have the right price pack architecture to ensure we cover all ranges of value for the consumer, but we feel really good about where we are. We're seeing no signs of abnormal stress with consumers in our categories, but we're going to watch it very closely as we head into this period.

[Kevin Grundy, Analyst at Jefferies Financial Group]

That's great. Thank you. And I appreciate it. Good luck.

[Linda Rendle, Chief Executive Officer at Clorox]

Thanks, Kevin.

[Operator]

Our next question comes from the line of Steve Powers from Deutsche Bank.

[Linda Rendle, Chief Executive Officer at Clorox]

Hey, everybody, good afternoon. First, just a follow-up on the July price increase. I guess the question I'm left with after the prior discussion is just is that price increase meant to fully offset the inflation you've seen build since February or as we think about the broader gross margin rebuild, we have to lean a bit more on productivity, other levers to help that gross margin along? I just wasn't clear on the prior commentary.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Hey, Steve. As it relates to pricing, what I'd say is, this really requires lean and all the levers we have available. So it's leaning into our cost savings program. Its working to take cost out of our supply chain and is taking pricing. We believe between across all three of those activities, it puts us in a position to continue to rebuild margins. But pricing alone would not put us in a position to do that.

[Steve Powers, Analyst at Deutsche Bank Aktiengesellschaft]

Okay, fair enough. And then I guess you touched a little bit upon it with your -- just a commentary broadly on the supply chain, but could you just give us a bit of perspective as to where your service levels sits exiting the third quarter, where you feel like you've restored service levels to where you'd like them to be, where there is still some more work in the portfolio to do on that front? Just that be helpful.

[Linda Rendle, Chief Executive Officer at Clorox]

Sure. We have seen service levels improve, which is terrific news, and really my hats off to our combined team who is working out hard because at the same time, we've had to increase the portion of our portfolio that was on allocation during this time, and that's really due to two things, one, we've seen stronger demand in portions of our portfolio and then some material constraints and labor shortages across the supply chain that are impacting our ability to get raw materials. But I would say, our team is handling that, working really closely with our retailer partners, really closely with our logistics partners. And so as a result, service is improving and we expect continued improvement in Q4.

[Steve Powers, Analyst at Deutsche Bank Aktiengesellschaft]

And lastly, if I could just -- just building on the conversations you're having with Kevin around the consumer being under stress, does this -- does it change at all, does it influence the way that you approach R&D and new product prioritization as you think about fiscal '23 and beyond, just the way you're thinking about R&D are you focused more than you might normally be on hitting your value price points or is it -- are we not at that stage?

[Linda Rendle, Chief Executive Officer at Clorox]

I think it's important for us to pull all value levers and that's going to continue to be true. So our innovation pipeline always focused on doing the base work that you would expect us to do, product improvements, claims work, ensuring that we're communicating to people why our products work better than competition, and why they can trust us, and why they choose us. So, that good work is always going on in good times and in tougher times for the consumer, and we'll continue to leverage that.

Importantly though, consumers are continuing to look for innovative products that give them new experiences. So, we'll focus on the basics. But we will not take the foot off the pedal when it comes to introducing new experiences to them that help them do things better. For example, in the cleaning category, we just launched a premium line of Clorox Disinfecting Misters, they're off to a very strong start in the markets. There is -- it's a retail model. So it also helps people reduce their waste at home and really a great experience, and that's a premium-priced product, but we think it helps them get the job done at a better value at home and we expect that to continue to do really well as we head into this period.

So I would say we're always focused on that base work, but we will not take the foot off the gas on continuing to expand the presence our brands have and continue to give people new innovative solutions in our categories.

[Steve Powers, Analyst at Deutsche Bank Aktiengesellschaft]

Okay, thanks for the perspective.

[Linda Rendle, Chief Executive Officer at Clorox]

Thank you.

[Operator]

And our next question comes from the line of Lauren Lieberman with Barclays.

[Lauren Lieberman, Analyst at Barclays]

Great, thanks. Virtual good morning. Wanted to see if you could talk a little bit about expectations for the promotional environment. As incremental pricing comes in, we've heard some other companies start to talk about the inevitable build in a pressure on consumer wallets and an expectation that promotions could kick up in the second half of the year. So was just curious on your perspective on that. So I'll start there.

[Linda Rendle, Chief Executive Officer at Clorox]

Sure. Hi, Lauren. What we're seeing now is promos are definitely above year-ago, but still below pre-pandemic levels and as you know for our categories, price promotion, is actually a very small portion of the volume that we sell. It's less than 10% of the volume that we do on average is on price promotion but we're watching that carefully because you're right in times of recession, that can be a lever that people pull and will pull to the degree needed to introduce new items to consumers to ensure that we're getting them at the right health periods of the year. But at this point, we don't see anything abnormal in our categories, something again that we'll watch carefully, particularly as these next rounds of pricing go in and we'll use it as a lever if we need to, as we always do, but very strategically in how we target the consumer.

[Lauren Lieberman, Analyst at Barclays]

Okay, great. And then I can take this offline with Lisah, but I did just want to throw this out on gross margin. I feel like, Kevin, your comment on sequential improvement in 4Q being there, but being not nearly as significant as you just saw Q2 to Q3, but I think to tie it to gross margins, down only 800 basis for the year, gross margins have to be significantly better sequentially. So I don't know if I'm -- it's an obvious thing that jumps out. If it's GAAP versus non-GAAP, something I'm not aware of. Yeah. So and -- even it seems to stand out. I can follow up with Lisah, if it's better for that -- for offline.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Yeah, Lauren, maybe just I'll give you a perspective, but yeah, please follow up with Lisah if this doesn't answer your question. You know, when we started last quarter, our expectation was gross margin to be in the high 30s as I think I described it for Q4. With the war in Ukraine, we're building in about $30 million of additional costs and most of that's going to hit in Q4, just the way it flows through our inventory then onto our P&L. So $30 million hit in the fourth quarter is going to add about 150 to 200 basis points of additional drag on margin above what we thought when we were talking last quarter. When you do that math, you get down to, I'd say modest sequential improvement versus where we landed in Q3. So we landed at about 36%. We're going to absorb another $30 million in Q4 and the team is working very hard to continue to expand margins in spite of the additional $30 million we're going to deal with. But it should put you then do you get to the numbers we're talking about should put you just slightly above the Q3 level which was just under 36%.

[Lauren Lieberman, Analyst at Barclays]

Oh, I -- okay. It was the absolute level in the quarter, not the year-over-year change that --

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Yeah, I'm sorry, Lauren. You're exactly correct.

[Lauren Lieberman, Analyst at Barclays]

Okay.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Yeah. The sequential improvement from where we landed in Q3.

[Lauren Lieberman, Analyst at Barclays]

Okay. Net debt clarifies it. Okay, great. Thank you so much.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Sure. Thanks, Lauren.

[Operator]

Our next question comes from the line of Andreas Teixeira with JP Morgan.

[Andrea Teixeira, Analyst at J.P. Morgan]

Thanks for my -- for the follow-up. I had a similar question to Lauren's, but now on the operating income. If I'm not mistaken, I heard 170 basis points. I'm trying to go back to the notes. Did you give us some sort of a guide for the operating income margin?

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

No, Andrea. We were talking about our cost savings goal of 175 basis points of EBIT margin expansion each year. We're on track to deliver that this year.

[Andrea Teixeira, Analyst at J.P. Morgan]

Okay. And that's embedded in the bridge that you gave out and the others, right?

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

It is.

[Andrea Teixeira, Analyst at J.P. Morgan]

Correct. Okay, perfect. Thank you for clarifying that.

[Kevin Jacobsen, Executive Vice President and Chief Financial Officer at Clorox]

Sure.

[Operator]

This concludes the question-and-answer session. Ms. Rendle, I'll now turn the podium back over to you.

[Linda Rendle, Chief Executive Officer at Clorox]

Thanks, Erica. Thanks again to everyone on the call. I look forward to speaking to you again on our next call in August. Until then please stay well.

[Operator]

This does concludes today's conference call. You may now disconnect.