Kontoor Brands Inc

NYSE:KTB

Earnings Call Transcript 2022-Q2

[Operator]

Good day, ladies and gentlemen and welcome to the Kontoor Brands’ Q2 2022 Earnings Call. [Operator Instructions] At this time, it is my pleasure to turn the floor over to your host, Eric Tracy, Vice President of Corporate Finance and Investor Relations. Sir, the floor is yours.

[Eric Tracy]

Thank you, operator and welcome to Kontoor Brands’ Second Quarter 2022 Earnings Conference Call. Participants on today’s call will make forward-looking statements. These statements are based on current expectations and are subject to uncertainties that could cause actual results to materially differ. These uncertainties are detailed in documents filed with the SEC. We urge you to read our risk factors, cautionary language, and other disclosures contained in those reports.

Second quarter 2022 results are on a GAAP basis. Select comparisons to first quarter 2021 results will be on an adjusted dollar basis and in certain cases, we will make comparisons to 2019 results, which we clearly defined in the news release that was issued earlier this morning and is available on our website at kontoorbrands.com.

Reconciliations of GAAP measures to adjusted amounts can be found on the supplemental financial tables included in today’s news release. These tables identify and quantify excluded items and provide management’s view of why this information is useful to investors. Comparisons will be in constant currency, unless otherwise stated.

Joining me on today’s call are Kontoor Brands’ Chief Executive Officer and Chair, Scott Baxter and Chief Financial Officer, Rustin Welton. We anticipate this call will last about an hour. Scott?

[Scott Baxter, Chair and Chief Executive Officer]

Thanks, Eric and thanks everyone for joining us today. I want to start today’s call by sincerely thanking our colleagues around the world. I have been greatly humbled by our team’s agility, collaboration in resolve to not only persevere through these dynamic times, but deliver on our near-term operational results and drive industry leading TSR since our spin, all while continuing to position Kontoor for greater long-term success.

And let’s be clear, to say the macro economic environment has been dynamic simply isn’t enough. Let’s call it like it is, it’s been downright difficult from the COVID pandemic and lockdowns to the war to supply chain disruptions to inflation, the pressures that companies, consumers and people around the world have and continue to face are unprecedented. And as we have discussed on many of our recent quarterly calls, Kontoor has not been immune to these obstacles. In addition to and in the face of these challenging times, we at Kontoor have executed a spin-off, stood up an independent company, implemented a new global ERP system and set the foundation for our catalyzing growth strategy. And as you will hear more about today we are further globalizing our operating model, including relocating our European headquarters.

We are really excited about these initiatives as they better position us to attract world class talent in the region, unlock significant benefits for our organization, and further support the transition to a growth oriented model. We knew our journey would not be easy. We knew it wouldn’t be linear. But as we sit here today and even with near-term macro challenges, our strategies to further strengthen our brands, operating model and organization over the last 3 years have been tremendous. But they can’t and don’t transform our business and some of the legacy challenges overnight. This requires time and sustained execution.

I will provide greater insights on how we intend to do this in a bit. But first, let me touch on our second quarter results. Despite the uneven operating environment, we were able to expand share, POS and AURs to drive top line strength in our core U.S. business. And we are still able to deliver on our profitability goals with operating income up over 50% year-over-year and earnings up 57% coming in at the midpoint of our guidance range.

Now, this bottom line strength didn’t come without some incremental headwinds, including inflationary pressures and the much discussed retailer inventory rebalancing that caused the supply demand pendulum to aggressively swing as the second quarter progressed. While we had anticipated these factors would more fully weigh on second half results, they somewhat tempered our strong underlying brand momentum impacting our top line sooner than we expected. That said global growth was still strong up 27% in constant currency. The expected declines in our international business owing to China lockdowns and timing shifts impacted comparison in Europe were more than offset by strength in the U.S. with both the Wrangler and Lee brands up at least 40% domestically. These gains in our largest market were supported by the breadth and development of our product portfolio in Q2. Highlights in Wrangler included the women’s modern collection, augmented by the workwear in Western categories. In fact, Western summer seasonal bookings were up double-digits.

In addition, the brand’s product evolution once again saw strengthen outdoor ATG and growing momentum of its fishing sports specialty lines, Wrangler young wear. At Lee, men’s saw really strong performance within core denim, casuals and seasonals, with the brand driving share gains across all male categories in the quarter. Women’s too experienced solid double-digit growth as innovation platforms Flex Motion and Ultra Lux supported the gains.

Stepping back a bit from just our second quarter results versus last year, I think it’s important perspective to look at the first half performance compared to pre-pandemic first half 2019 providing a more normalized assessment of the business. It also gives a better indication of how we believe our strategies have and should continue to drive diversified accretive growth across our core channels, categories and geographies. Compared to the first half of 2019, first half ‘22 global revenue increased 5%, but more importantly, increased 13% excluding our proactive actions taken with VFO in India.

In terms of our core U.S. business, Wrangler and Lee increased 19% and 14% respectively over first half 2019 levels. In our largest market, both brands have driven significant share gains in the core men’s denim casual bottoms business over first half ‘19 with Wrangler up 80 points and Lee up 60 points and would be even greater if not for our proactive quality of sales actions to exit certain points of distribution. Importantly, AURs driven by mix have also increased over this time period, up double-digits in the U.S. for both brands supported by innovation, digital and expansion of the brands to more premium points of distribution.

Turning to our channel diversification, with the focus on digital, our first half ‘22 global owned.com increased 111% and our U.S. owned.com increased 140% compared to 2019. However, we have been able to deliver this performance despite the multitude of macro challenges by making the long overdue investments to support these brands like never before in key growth enablers such as talent, demand creation and innovation. From a demand creation perspective, both Lee and Wrangler continued to amplify brand heat in Q2 and have exciting plans for the balance of the year.

First, with Lee, the team continues to enhance marketing efforts to elevate brand positioning, particularly within digital spend, integrated seasonal demand creation, including the streaming summer campaign, free your originality by Lee originals, drove holistic digital experiences across consumer touch points supporting 61 million digital media impressions and a 103% year-over-year increase in social media traffic during the quarter. Authentic, brand right partnerships also remained key in Lee’s premiumization strategies, including the second drop of the highly successful collab with The Hundreds that launched in May.

And perhaps the most exciting moment in Q2 and reflective of how different the brand is showing up in the market compared to years past, we sponsored the Bonnaroo Music Festival in June, celebrating American culture in the spirit of originality. Brand activation events were highlighted by the original Lee Tree, not only a one of a kind piece of art made of 900 square feet of Lee denim scraps, but an interactive brand experience that allows music goers and brand aficionados old and importantly new make their mark by decorating the tree with additional leaves throughout the festival. It is exactly these types of demand creation investments that have helped support Lee’s elevated brand health reflected in Q2 domestic men’s denim casual bottom share gains, which increased 50 points over last year in AURs that increased 22% over 2019 levels.

With Wrangler, the brand’s 75th anniversary celebration continued in the second quarter, with demand creation efforts to our For the Ride of Life campaign in elevated social media platforms, allowing the brand to reach new consumers like never before. Similarly, distorted investments in digital saw meaningful growth including 73 million additional media impressions and significant year-over-year growth in traffic to wrangler.com. Authentic collaborations such as our recent partnership with iconic music brand Fender, highlights how the Wrangler brand plays at the heart of cultural influence.

Augmenting the Fender collab, Wrangler has further leaned into its brand connection with music to catalyze consumer engagement, acting as the exclusive denim sponsor of the two Lollapalooza music festivals in Chicago and Berlin as well as Austin City Limits, a collaboration with these three iconic music festivals, celebrating self expression in shared passion for music, fashion and culture kicked off with our 75 Days of Summer, a sweepstakes offering 75 days of prizes to destination music festivals. In the Wrangler booth in interactive customer space, brand enthusiasts are able to buy exclusive denim festival merchandise and personalize it with free laser customization specific to the event. A complete line of Lollapalooza by Wrangler apparel, including tees and denim is available on wrangler.com.

Finally, we are really excited to amplify Wrangler’s 75th anniversary with an upcoming New York City event, including a preview of our Wrangler Leon Bridges collection, followed by a performance by the Grammy Award winner himself. I know some of you on this call will be joining us for that event. We can’t wait to share this with folks. As you can see, we have an incredible amount of brand elevating activation with both brands and we will continue to invest behind these demand creation efforts to drive brand equity, consumer reach and top line growth in ‘22 and beyond.

So, let me now close with how we think about the go forward. As you have seen, we have lowered our outlook today, not necessarily an indication of the healthy momentum we are experiencing in our own business. Recall from our initial guide back in March, we anticipated the back half to be more greatly impacted by these factors, but to reflect an even more conservative view of the macro backdrop, particularly retailer inventory rebalancing and ongoing lockdowns in China. Despite the macro headwinds, we remain focused on executing our strategies. As we have stated frequently, we anticipate that future revenue will be driven by outsized growth in category, channel and geographic expansion. This is important as we look to diversify our portfolio beyond U.S. wholesale.

As I said earlier, this doesn’t happen overnight. We are absolutely investing in those accretive areas. First, channel diversification in enhancing our digital platform. While leveraging our global brick-and-mortar learnings to further develop a holistic, full-price D2C omni-channel experience for our consumers, while we have established a target of 10% digital penetration by 2023, our opportunities to vertically integrate our D2C model showcase Pinnacle product and more directly connect with our consumer are much greater, and importantly, accretive margins.

From a category perspective, you have already seen the tremendous strides we have made to evolve our product portfolio beyond denim bottoms. But we remain in the early days. And what we love is the breadth of this category of growth across Western, outdoor, workwear, tees, female, and really importantly, its authentic natural extensions that leverage each of the brand’s evenness.

And finally, turning to international expansion, we remain highly under-index in markets outside of us as most of our peers do nearly 50% of their business internationally, so a significant opportunity for us to nearly double the size of our business over time. As we have discussed, we expect macro pressures to weigh on international, particularly China over the near-term, but we continue to aggressively invest in positioning ourselves for substantial long-term growth across both Asia and Europe.

Highlighting this investment to enhance growth, I am excited to announce today that in Q3, we made the decision to further globalize our operating model, including the relocation of our mega headquarters to Geneva, Switzerland. With the implementation of our global ERP infrastructure and foundation now complete, it’s the ideal time for us to further drive global operating efficiencies and accelerate our transition to a growth oriented organizations. For long-term benefits, these actions are significant, including providing greater capital efficiency, improving go-to-market capabilities, enhancing access to best in class talent and driving SKU rationalization. The announcement reflects our commitment even when macro conditions remain difficult to continue to strategically invest for long-term, sustained, profitable growth.

We also recognize the need to be agile in this environment and we will accordingly look to tighten non-strategic expenses. Further, the significant actions we have taken over the last several years to fortify our balance sheet and optimize our capital structure afford us increased flexibility to navigate the choppy waters. These moves, coupled with our proven strong cash flow generation, even in periods of macro uncertainty give me great confidence that Kontoor will continue to accelerate our competitive separation. Rustin?

[Rustin Welton, Chief Financial Officer]

Thank you, Scott and thank you all for joining us today. I know you all have questions on a number of macro topics, including consumer demand, inflationary pressures and retailer inventory rebalancing. So I will begin by discussing some of these key external factors before reviewing our second quarter performance and closing with how both are incorporated in our updated 2022 outlook.

Let’s begin in the U.S. As Scott mentioned, many retailers began to rebalance inventory levels during the quarter to better reflect supply and demand signals in the marketplace. While retail apparel inventory levels have been well chronicled at a macro level, I want to dig a little more into specifically our core categories and how our brands performed at point-of-sale. Over the past 3 months, the U.S. total measured market for denim bottoms, casual pants and seasonals grew in the low to mid single-digits across both men’s and women’s segments. With men’s categories performing a bit better than women’s. In men’s bottoms, our largest core segment, Wrangler and Lee significantly outperformed the market in our key categories of denim and casual pants.

As we have stated previously, we believe consumers migrate to trusted brands in times of uncertainty. With the investments made in product, innovation and demand creation that Scott outlined, the value proposition of Wrangler and Lee is as high as ever and we saw this resonate with consumers during the quarter at point-of-sale. In women’s, there was disparity across the portfolio with strength in casual pants and softness in seasonals, but Wrangler and Lee outperformed the market in the majority of categories. And while market softness in the seasonal category is noteworthy, as it is a key rebalancing focus for retailers with discounting taking place prior to end of season, our seasonal business has outperformed the market to-date.

On a broader level, retail inventory challenges have led to more restrictive open-to-buy dollars that adversely impacted our second quarter shipments and are expected to continue into the back half. But stepping back, we are very pleased with how Wrangler and Lee performed at point-of-sale in the U.S. We are clearly winning on a relative basis and how consumers continue to embrace our brands and offerings in our core categories.

In the international markets, the quarter generally played out as anticipated. In China, Shanghai reopened in line with our expectations during the quarter, but city-wide lockdowns and restrictions on movement in a number of jurisdictions such as Chengdu, Shenzhen, and most recently Wuhan remain. These restrictions are impacting consumer behavior and brick-and-mortar traffic and are contributing to a more conservative outlook for Kontoor in the back half. In Europe, FX pressures accelerated in the quarter with the euro and U.S. dollar at parity for the first time in two decades and we expect currency headwinds to continue to temper results.

Turning to supply chain. Inflation on key input cost such as cotton and crude oil, which affects freight surcharges spiked during the quarter to year-to-date highs before moderating in Q2. We are not assuming a significant benefit from recent commodity reductions in the second half of ‘22 given the 6 to 9 month lag time on impacting our P&L on many of these interests.

With this backdrop, let’s review the second quarter results. Beginning with revenue, global revenue increased 27% compared to the prior year. Growth was driven by strength in the U.S. across both the digital and wholesale channels. On a regional basis, U.S. revenues increased 40% driven by continued broad-based momentum. In addition to strength in our core, we are encouraged by the progress we are making in diversifying the business into new categories, such as outdoor, workwear and tees, all of which delivered strong growth in the quarter. And in our digital business, U.S. owned.com increased 24% compared to the prior year, supported by our distorted investments in digital, which are driving improved traffic and AURs. International revenues decreased 11%. As expected, COVID-related lockdowns in China in comparison to the ERP implementation in 2021 weighed on the quarter.

Turning to our brands, global revenue of our Wrangler brand increased 36%. Growth was driven by continued momentum in the U.S., including strong contributions from Western, outdoor and workwear. In addition, we saw strong growth in tees, which increased triple-digits compared to the prior year. In Wrangler’s digital business, U.S. owned.com increased 28% in the quarter. Wrangler international revenue increased 8% with gains in non-U.S. Americas partially offset by timing shifts related to the 2021 ERP implementation in Europe.

Turning to Lee, global revenue increased 12%. Lee U.S. revenue increased 40% driven by momentum in performance and comfort styles as well as new product platforms. We also saw strength in digital with U.S. owned.com increasing 14% and U.S. digital wholesale up 97%. Lee international revenue decreased 22%. As discussed, COVID-related lockdowns in China had a significant impact on the quarter, particularly in April and May. We did see a sequential improvement as lockdowns eased, particularly with our digital business, which saw double-digit increases in June. And finally, from a channel perspective, U.S. wholesale increased 44%, non-U.S. wholesale decreased 10% and global owned.com increased 10%.

Now on to gross margin. Gross margin decreased 260 basis points compared to adjusted gross margin last year. As we discussed last quarter, we continue to see elevated transitory costs, including air freight. These factors resulted in a 170 basis point headwind in the quarter. In addition, unfavorable geographic mix shifts resulting from China lockdowns and ERP related timing shifts in Europe resulted in a further 150 basis point decline. Partially offsetting these headwinds were the benefits from strategic pricing, which more than offset product cost pressures in the quarter.

SG&A expense was $178 million or an $11 million increase versus first quarter 2021 adjusted SG&A. As a percent of revenue, SG&A leveraged by 510 basis points in the quarter demonstrating the benefits of our highly efficient model and multiple levers to support profitability, while still investing behind key growth enablers such as demand creation, digital and IT. Earnings per share, was $1.09 compared to $0.70 in the same period in the prior year on an adjusted basis.

Now, turning to our balance sheet. Second quarter inventory increased 33% compared to last year. Compared to pre-pandemic 2019 levels, inventories were flat. We finished the second quarter with net debt or long-term debt less cash of $647 million and $145 million in cash and equivalents. Our net leverage ratio or net debt divided by trailing 12-month adjusted EBITDA at the end of the second quarter was 1.6x, within our targeted range of 1x to 2x. Finally, during the quarter, we repurchased $40 million in common stock. And at the end of the quarter, we had approximately $62 million remaining under our share repurchase authorization. When combined with a strong dividend, we returned a total of $65 million to shareholders during Q2.

Before we review key assumptions regarding the outlook for the balance of the year, I’d like to take a moment to reflect on our first half results. In March, prior to COVID lockdowns in China, retailer inventory rebalancing efforts in the U.S. and incremental inflationary pressures, we provided a supplemental breakdown on our first half outlook given our ERP implementation in 2021. Specifically, we indicated that we expected global revenue in the first half of $1.29 billion to $1.31 billion or a 13% to 15% increase compared to 2021.

Although the quarter has unfolded differently than expected due to macro factors, our first half revenue grew 14% in constant currency compared to 2021. Similarly, on the bottom line, we indicated in March that we expected first half GAAP EPS of $2.40 to $2.60 per share or a 13% to 22% increase compared to 2021 adjusted EPS. We delivered GAAP EPS of $2.49 in the first half, an 18% increase in constant currency compared to 2021 adjusted EPS. Despite the many factors we have discussed, we were able to deliver top and bottom line results right in the middle of our expectations. Our agility and focus on execution, combined with our brand momentum in the marketplace, clearly gives us confidence to navigate future uncertainty. So, how are we thinking about the second half in light of everything I just covered?

Let’s begin with revenue. In our previous outlook from last quarter, we mentioned that we expected the first half global revenue to increase in the mid-teens range, with full year global revenue to increase at approximately 10% compared to 2021. This guidance implies a mid single-digit increase in the second half. Notably, we were already incorporating anticipated consumer demand softening due to inflationary pressures. Our updated outlook now assumes second half global revenue to be relatively flat compared to 2021 driven by two primary factors. First, we anticipate open-to-buy dollars to be somewhat restricted as actions to rebalance retailer inventory levels are implemented. We expect these issues will weigh on our top line more than originally anticipated, with the third quarter more pressured than the fourth quarter.

Second, given the ongoing COVID restrictions and lockdowns, we believe China will remain a challenging market and now believe it is prudent to take a more conservative approach to our second half outlook. In sum, we delivered global revenue growth in the first half of 14% in constant currency driven by U.S. growth of 19% compared to 2021. With our more cautious updated outlook, we now expect second half global revenue to be relatively flat compared to 2021.

In terms of gross margin, a few items to call out. Inflationary pressures that peaked during the second quarter will continue to pressure gross margins as will the retailer inventory rebalancing and adverse geographic mix from a more conservative approach to China. We expect these headwinds will be somewhat offset by lower transitory expenses such as air freight and continued structural mix shifts to accretive channels and strategic pricing.

Last, I want to spend a moment on SG&A. Importantly, first and foremost, we will continue to make thoughtful strategic investments as Scott highlighted, including digital, international and the globalization of our operating models to accelerate diversified accretive growth over the long run. However, in light of the uncertain macroeconomic environment, we expect tighter expense controls on non-strategic and discretionary items. Additional details on our outlook can be found in today’s earnings release. But to summarize, revenue is now expected to increase approximately 6% for the full year with second half relatively flat compared to 2021. The third quarter is expected to experience greater pressure relative to the fourth quarter.

Gross margin is now expected to approximate 43.5% compared to adjusted gross margin of 44.6% achieved in 2021. We expect gross margin year-over-year headwinds to moderate in the second half, with the third quarter experiencing greater pressure relative to the fourth quarter. Adjusted SG&A, excluding an estimated one-time charge of $18 million associated with our globalization efforts and European headquarter relocation, is now expected to increase at a mid single-digit rate compared to adjusted SG&A in 2021 relatively consistent with revenue growth. Adjusted EPS, excluding an estimated one-time charge of $0.25 per share, associated with our globalization efforts in European headquarter relocation is expected to be in the range of $4.40 to $4.50 per share.

Finally, I want to briefly provide some comments regarding inventory, cash flow and capital allocation. Since the spin, we have discussed actions to improve our inventory metrics. Looking back to 2019, our inventory levels are flat, despite higher 2022 projected revenues. Given the U.S. retail inventory rebalancing efforts during the quarter, our inventory levels did finish higher than expected. But importantly, we feel good about the quality as the majority is in poor evergreen styles and we will be working to sequentially improve from these levels in the second half. Additionally, Q4 is historically the highest generating quarter from cash from operating activities and we expect this to continue in 2022.

As we have discussed, we remain confident in our capital allocation optionality, which provides us with tremendous flexibility in times like these. We are clearly operating in a highly dynamic environment. But I want to be clear we remain laser focused on executing our Horizon 2 strategies, investing behind profitable growth initiatives to transform the model while delivering long-term sustainable shareholder returns.

This concludes our prepared remarks. And I will now turn the call back to our operator. Operator?

[Operator]

Thank you. [Operator Instructions] Our first question comes from Jay Sole with UBS. Please state your question.

[Mauricio Serna, UBS]

Hi, good morning. This is Mauricio Serna on behalf of Jay Sole and thanks for taking our questions. Just a couple of questions from our side, maybe if you could speak a little bit about the confidence that you have on this updated fiscal year ‘22 outflows, how do you feel like this numbers are compared like the level of risk that you perceive in these numbers prior to – compared to the previous outlook? And maybe if you could speak a little bit more about how are you seeing broad consumer demand, especially in your core U.S. business, how that evolved during the quarter and what you’ve seen so far into Q3? Thank you.

[Scott Baxter, Chair and Chief Executive Officer]

You bet. Hey, Mauricio. This is Scott. I will start and then I will just hand it over to Rustin. And I will speak a little bit about the consumer in our outlook and then Rustin will follow up. But in our prepared remarks, we really, really understood the challenges that we all face and we did a very thoughtful review of our business. So, that’s why we came today with our updated outlook. Hopefully, everybody understands the analysis than the thought that went into that. And we are right now really working on controlling what we can from a business standpoint. So, as we think about the consumer and think about what’s happening out in the marketplace right now, all the investments that we have made in our business through the last 4 years, the investments in the product, the investments in the design, specifically, the investments in the brands themselves that hadn’t been made before are really starting to payoff in the marketplace. And I feel and the team feels really strongly about our fundamentals and our strategy right now. And I think the thing that when you couple that with our really strong cash flow and the investments that we can continue to make in the business, I think that puts us in a really good position going forward. And you saw that in the results today, right, you saw that in the first half, you saw that in the first quarter and even in our updated outlook, as we’ve looked at it. And we understand, the dynamics of the current marketplace that we are working in, but we are going to continue to invest in the core. We are checking really well in the core, which gives us great confidence. We are going to continue to invest in our channels, our geographies and our categories in tees and work in the outdoor space, which really advantage us going forward. And I think the thing that I want to leave you with, which is really important to us is the big advancements we have made in our brands. And that’s giving us real pricing power that we have never had before in these brands and it’s given us a real conversation to weigh with the end consumer. But you think about some of the comments that I made in my prepared remarks, we have invested in the Bonnaroo festival. Something like that would have never happened before with Lee, the investment that we have made in Lollapalooza with Wrangler and Wrangler’s 75th anniversary and in some of our different collabs that we’ve had with like The Hundreds. So pleased, I am not happy, we will continue to work real hard, and then I’ll flip it over to Rustin to go ahead and talk a little bit about the outlook. Thanks for the questions.

[Rustin Welton, Chief Financial Officer]

Thanks, Scott. Good morning, Mauricio. Thanks for the question. First I will start with a comment. As Scott mentioned, I think the investments that he talked about that we are making in the brands, particularly in product and demand creation are really important. It’s really driving that value proposition we offer consumers and that is as high as it has ever been. You are seeing that in the strong sell-throughs that we talked about in the prepared remarks in the second quarter and the double-digit increases on our own us.com. So additionally, maybe a little bit more context, many of the price increases have already been put in place at retail. And I remind everyone we were strategic with our price increases. While it’s still early, we are seeing a favorable response as seen in the strong POS. That said, as we talked about, we do expect open-to-buy dollars to be more restricted until the broader inventory levels are rebalanced and we are certainly taking a more conservative view on China in this updated outlook. We have incorporated this into our updated guide. And just maybe closing Mauricio with one point, we expect the second half revenues to be relatively flat compared to 2021 as we said versus the first half, where we were up 14% globally in constant currency. So, hopefully that gives you a little perspective between Scott’s comments and mine on how we are thinking about revenue. Thank you.

[Mauricio Serna, UBS]

Thank you very much.

[Scott Baxter, Chair and Chief Executive Officer]

Thanks, Mauricio.

[Operator]

Okay. Our next question comes from Bob Drbul with Guggenheim Securities. Please state your question.

[Bob Drbul, Guggenheim Securities]

Hi. Good morning. Just a couple questions from me. Just further on the gross margin, the expectations of Q3 into Q4, how much visibility do you have on little bit on support of the retailers as they continue to work down the inventory levels and what your commitments are around the brands? And then the second question I have is just on the inventory levels at retail, where do you think we are in terms of the readjustments? Do you think it’s a 3-month readjustment and how are you really adjusting your own manufacturing plans over the next few quarters? Thanks.

[Scott Baxter, Chair and Chief Executive Officer]

Hey, Bob. How are you? Thanks for the questions. Hope you are doing well. I will go ahead and start a little bit on the support. We talked a lot about and put a lot of emphasis on making sure that we understand the business going forward and feel really confident where we are from an outlook standpoint. Our product at retail has checked really well, which is the thing that we are really happy about. But I think the key here is and I will just kind of touch on it before I hand it over to Rustin for the other two is that, we have been real thoughtful about the investments that we have made behind the brands. We have been real thoughtful about the design in the direction of the brands and winning with winners. So, for us from the standpoint of the rebalancing that’s been going on, our position is strong and continues to be very strong going forward. So pleased with the work that our teams have done globally in that respect. Rustin, you want to go ahead and take the rest?

[Rustin Welton, Chief Financial Officer]

Yes. Thanks, Scott. Good morning, Bob. I will go ahead and start with the gross margin question you had. Again, we updated the outlook this morning, Bob, as you are well aware. We now expect gross margins to be approximately 43.5% for full year ‘22. That does compare to about 44.6% in ‘21. And obviously, our prior guide was consistent with ‘21. As you indicated in your question, we do expect Q3 to be more pressure than Q4 and that really is taking into consideration the two factors we talked about on the revenue side that are impacting the back half outlook, specifically the more conservative view in China and then the retailer – rebalancing efforts. The guide for the second half, Bob, does imply about a 42.8% gross margin that is down about 50 bps versus the back half of ‘21. Maybe just breaking down a little bit where we see some of those puts and takes on the headwind side. And in prepared remarks talked a little bit about inflationary pressures on input costs, they continue certainly spiked in the second quarter at a moderated and somewhat off of the recent peaks. But we are not assuming benefit as it takes, as we have talked about in the past, a few quarters the flow through our P&L. The second sort of major headwind, that’s out there is certainly the unfavorable geographic mix shifts from the more conservative view on China I just mentioned. There are some tailwinds as well in those numbers, certainly the structural mix shifts to accretive channels. You have seen us deliver over a number of quarters here. We will continue as we are distorting investment there. Strategic pricing, as we talked about, previously, on the calls, been very thoughtful about how we have taken pricing, particularly in the front half and back half of the year. And then air freight, should get incrementally better in H2, but still will be a net headwind for the year. Maybe if I shift over to inventory a little bit, our inventory did finish at just under $540 million. That was up about 33% to prior year. As you heard me comment, Bob, on the prepared remarks, I think it’s really telling and important to highlight that that was flat relative to 2019 on full year ‘22 revenue that’s expected to be up versus ‘19. So, Scott mentioned it, we are really seeing strong POS on a relative basis in both men’s and women’s on the retail side. Certainly seasonals, as I talked about in my prepared remarks have been an area of softness which retailers are working through. But our seasonals have outperformed the market to-date. And then certainly the broad retail inventory imbalances have had an impact on the open to buy dollars and the shipments that have affected inventory as well. So, we are working to sequentially improve inventory positions as we go through the year. But I think it’s really important that the quality of our inventory is healthy as it’s mostly in for evergreen styles. In terms of how we are modifying and managing that, Bob, I would just say, as we have talked about in previous calls, we try and stay very, very close to our retail trade partners on trends that they are seeing, and certainly have the agility to modify and react quickly to changes that they see in the demand signals, including the retail inventory rebalancing efforts that are ongoing. So, hopefully that provides a little more clarity. Thanks for the question Bob.

[Bob Drbul, Guggenheim Securities]

Great. Thank you.

[Scott Baxter, Chair and Chief Executive Officer]

Thanks Bob.

[Operator]

Okay. Our next question comes from Paul Kearney with Barclays. Please state your question.

[Paul Kearney, Barclays]

Hi everybody. Thanks for taking my question. I guess my question is on your long-term targets from your Investor Day, $5 plus in EPS and 46% plus in the gross margin. How should we think about the achievability of those and maybe potential timeline for those and what I saw on track? Thanks.

[Scott Baxter, Chair and Chief Executive Officer]

Rustin, do you want to go ahead?

[Rustin Welton, Chief Financial Officer]

Yes. Thanks Scott. I will take that. Good morning Paul. Since we hosted our Investor Day back in May of ‘21, we have seen a lot, all that’s happened in the market, certainly hyperinflation, or retail inventory rebalancing. Yet, I think it’s really important to stress that the underlying strategies that we laid out at our Investor Day are driving diversified accretive growth. And they remain intact, as you heard us talk about today in Scott’s remarks about channels, about geographic, about category extensions. So, obviously, we won’t guide ‘23 today, but maybe if we step back and look at it on a on a broader scale, ‘21 was ahead of our plans on a revenue and EPS basis. And for ‘22, with the updated outlook we laid out today, we are targeting revenue of greater than $2.6 billion with $4.40 to $4.50 in EPS. So, structurally, feel really positive about the strategy that we have. And certainly as we get later into the fall, we will talk a little bit more about timing and how it relates to ‘23.

[Scott Baxter, Chair and Chief Executive Officer]

Thanks Paul.

[Paul Kearney, Barclays]

Thanks. Just one more for me if I may. Just curious on kind of the price actions [ph] just in light of consumer pressure, inflationary pressure and inventory difficulties at the retail partners. How do you see kind of future pricing keep increases? Do you have any – and for the back half, and then what are you seeing in terms of the consumer response on your strategic…?

[Scott Baxter, Chair and Chief Executive Officer]

I will go ahead and take that Paul. And if Rustin wants to chime in he can. Paul, we look at it like this. At the end of the day, we need to make great products that our consumers really love and that they want to take out. We are seeing that right now across our businesses. We are seeing it across the globe. We are seeing it across different channels and geographies. The investment that we have made in the design teams here for both Wrangler and Lee that we hadn’t had before and key is the investments that we are making behind the brands. I would tell you, for the first time and I have been involved with this business for 15 years, for the first time here these last 2 years, and it’s accelerating. We are seeing our ability to take price and have pricing power and to have that stick. Our brands are really, really resonating with the consumer. And we are seeing it in social media. We are seeing it in different age groups, which is extremely important to us. And we are seeing it from different locations, different places, different geographies. So, we will continue to work really hard at that. But I do want to make it very clear that we do have pricing power, our brands are strong, they are resonating. And we are going to continue to make those investments because our cash flow, as you know, is very strong. And even in difficult times, we are able to do that. And we will do that.

[Paul Kearney, Barclays]

Perfect. One more…

[Rustin Welton, Chief Financial Officer]

Paul, I would…

[Paul Kearney, Barclays]

Go ahead.

[Rustin Welton, Chief Financial Officer]

I was just going to add, Paul, I think the investment Scott’s talking about really allow us to mix up in AURs as well, as you have heard us talk about in those prepared remarks. And that combination of mixing up in AURs, the strategic pricing we are taking, as well as cost savings initiatives that we have had, as you have heard us talk about in the last couple of quarters, really important, the combination of those offsetting some of the inflationary pressures that we are seeing from a margin perspective.

[Paul Kearney, Barclays]

Thanks. And quick one, what is the timing of the AMEA headquarter shift?

[Scott Baxter, Chair and Chief Executive Officer]

Paul, that timing is now. But let me go ahead to step back and just take everybody through kind of our process and our thought process. When we spun off 3 years ago, and when we go over 3 years ago, and when we made the decision to do this, actually, 4 years ago now, we had a very fractured business. So, what I mean by that, and I know you have all heard me talk about that as we built product in five different locations around the world and did not communicate with each other. So, Lee was building products in U.S. South America, Mexico, China, and the teams weren’t talking, building working together. Same thing with Wrangler, our systems didn’t combine. And we embarked upon two really fundamental projects for this business. We went ahead and implemented an ERP system. I know everybody on this call knows the difficulty of that so that our teams could work cohesively together around the globe. We didn’t have one system and we pulled out of another company that didn’t have one system, because their businesses were run from a geography standpoint. And then the other piece is we embarked upon globalizing this business. So, when you pull those two big strategies together, globalizing the model across the world, and then having an ERP system that can support that globalization, we now are moving to one location. And that fundamentally is going to really help us for a lot of reasons. I mean if you think about what it’s going to do for us, it’s going to help us from a capital efficiency standpoints, like I talked about. It’s going to improve our go-to-market capabilities significantly from a product, people and customer standpoint. And then in addition to that, it gives us access to a real apparel market in Switzerland. It gives us access to really good talent, and then helps us from the standpoint of how we think about our SKUs from a rationalization standpoint across the globe. So, lots of advantages, lots of reasons to do it, lots of thought that went into that. And that’s happening right now. Thank you for the question, Paul. Appreciate that.

[Paul Kearney, Barclays]

Thank you. Bye.

[Operator]

Okay. Our next question comes from Brooke Roach with Goldman Sachs. Please state your question.

[Brooke Roach, Goldman Sachs]

Good morning and thank you for taking the question. Scott, my question is on marketing investments, which have been a big focus for Kontoor this year. But I think I heard in the prepared remarks that Kontoor is looking to tighten up expense controls as a result of some of these macro headwinds. Can you clarify your plan for demand creation into the second half, any big innovations or campaigns or launches that we should be on the lookout for? And then where are the areas in SG&A that you can really flex down your spend as a result of this tighter macro?

[Scott Baxter, Chair and Chief Executive Officer]

Got it. I will go ahead and take the first part, and then I will hand over to Rustin for the second part. We, as you know, we have outlined our cash flow and our strong optionality. So, we have the ability to do multiple things in the marketplace at the same time. One of the things that we have made a decision on here is that we are going to continue to invest behind the brands in a pretty significant way. One of the things that we don’t want to do is we don’t want to stop the momentum that we had. We have created really good momentum. We have got this really good machine working right now and that we are globalizing the product line. We are creating really good product that’s taking out really well. You heard us talk about, our POS is checking extremely well. In addition to that, we have got really good talented people that are creating great designs that our consumer really likes. And then behind that we are doing and I can talk about some of the most recent stuff. So, this weekend was the bomb, excuse me, the Lollapalooza festival in Chicago. And we had our first ever store there. And it was an incredible store that we got really good feedback from that we had a ton of product that we just finished Bonnaroo. And we have got Austin City Limits coming up. We have got Lollapalooza coming up in Berlin. And we are not backing off of those investments, the 75th anniversary of Wrangler, we are just not doing it. We are going to continue with our demand, products and how we think about it, and it’s going to accelerate as ‘22 goes on into ‘23. So, focus, focus, focus on these brands, because they haven’t had it before. And the single most important thing I would tell you, and we come back to this all the time is we have put energy and money in really good thoughtful campaigns behind these two big, big powerful brands and it’s worked, The consumer has accepted them in a really significant way. Rustin, do you want to talk about some of the other piece of that?

[Rustin Welton, Chief Financial Officer]

Yes. Thanks Scott. Good morning Brooke. Certainly Scott hit it. We are going to invest behind the brands strategically Brooke. You need to be sure of that. As you saw us do this morning with the globalization and the European headquarter move. But we are in the uncertainty, certainly looking at tightening discretionary and non-strategic spend. That certainly is involving scrutinizing spending across all categories. As we have open positions that that become available, we are certainly going to take a fresh lens at those type of positions and make sure that they are needed. Same goes for whether it’s travel, or it’s training, or other factors like that. So, we are going to look at every spend that’s out there and be very wise with it as you would expect us to be in this type of environment, while continuing to invest in the business. I think that’s the key takeaway. Thanks Brooke.

[Brooke Roach, Goldman Sachs]

Thanks Rustin. And if I could just ask one follow-up on China and the more conservative view that you are taking there. Rustin, can you help us understand the proportion of the second half sales and gross margin, guidance reduction that’s attributable to the weaker China outlook versus the headwinds that you are seeing in the macro in the United States?

[Rustin Welton, Chief Financial Officer]

Yes. I think, Brooke, certainly I am not going to guide on a particular country, as you would expect. But I think if you step back and you look at China, the quarter largely played out as expected, as you heard us talk about a little bit on our prepared remarks. Certainly, the Shanghai reopening was in line with our expectations. And we saw sequential improvement as the quarter progressed, including both in our brick-and-mortar doors and our e-comm. We saw double-digit growth in June for Lee. Certainly, there is a lot of uncertainty out there, though. We have seen lockdowns and movement restrictions that have impacted other jurisdictions including Chengdu, Shenzhen, Wuhan, those remain. I think last quarter we talked a little bit about taking a conservative approach to Q2 and a more cautious outlook in the back half of the year. Certainly, we are going to take a more conservative approach in the back half assumptions, given some of those factors. Certainly, pleased with some of the re-openings that have taken place according to our expectations, but lots of uncertainty that’s there. But I would just say as it relates to China, where I would leave this is we really continue to believe in the long-term opportunity for both Wrangler and Lee in the region. And to really hit upon Scott’s point, we are going to continue to invest to make sure that these brands are strong and healthy as the region reopens appropriately. So, hope that helps a little bit more Brooke about how we are thinking about China.

[Scott Baxter, Chair and Chief Executive Officer]

And Brooke, I would make one kind of broader comment, beyond China. We really have an opportunity internationally for these brands. And some of the actions that we have taken today with our new headquarters in Europe, as we have talked about how and why, we believe that we are under-indexed here relative to our peer set and think that there is a really nice runway here for a very long time as these brands gain acceptance across the globe and we enter new categories and geographies. So, from a broader standpoint, really like where we are very early in the game and feel like we will catch up very quickly here now that we have got the right operating systems to do that. Thanks Brooke.

[Brooke Roach, Goldman Sachs]

Thank you.

[Operator]

And our final question comes from Will Gardner with Wells Fargo. Please state your question.

[Will Gardner, Wells Fargo]

Hey, thank you guys for the question. I just wanted to ask about promotions to the channel. I know you guys you have Walmart, Target, optimizing their inventory, excuse me, but just want to know how you are thinking about it for the balance of the year, with going into holiday and to back-to-school, you heard Under Armour talk about this yesterday, how they are making a lot more promotions for the rest of the year. So, just want to know how you are thinking about that. And secondly, how that’s impacting your merch margin? Thank you.

[Scott Baxter, Chair and Chief Executive Officer]

Will, I will go ahead and start and then Rustin will take it from there. But from our standpoint, we are building product that’s checking. And people really like our product, it’s resonating really well. So, we think that we will have limited promotions going forward. We put ourselves in a really good position, the combination of our marketing and our brand campaigns relative to really good design and product, and then making sure that we understand our consumer and aligning with the right customer too from that standpoint. So, not going to be – we don’t believe we are in a position that we have to be over-promotional at all for back-to-school and/or holiday. Rustin, do you want to talk a little bit about rest?

[Rustin Welton, Chief Financial Officer]

Yes. I would just add Will, again, if you step back, as you know, our model, our top four customers Walmart, Amazon, Target and Kohl’s, not necessarily in that order. Certainly, most of those have not been promotional in nature. Certainly the retailer rebalancing efforts have been well chronicle here. But we like how we are positioned. And to Scott’s point, we are really focused on delivering product that really resonates with the consumer and delivering on that compelling value proposition that we talked about earlier. So, we have taken certainly the global landscape into consideration and our outlook that you have seen here this morning.

[Scott Baxter, Chair and Chief Executive Officer]

Thank you, Will.

[Will Gardner, Wells Fargo]

Sorry. My other question was just on AURs, just how they were a quarter. And how is the promotional environment impacting us if at all?

[Rustin Welton, Chief Financial Officer]

Yes. We talked a little bit about – yes, we talked a little bit Will about AURs in our prepared remarks. We didn’t break it out specifically by the quarter. But I think what the AUR growth that you have seen in the in double digits relative to ‘19, again, really speaks to everything we have highlighted on the call this morning. It’s the investments that we are making. It’s mixing up into that higher product, as well as strategic pricing that’s out there. So, again, as I commented a little bit earlier with Bob as our thinking about gross margins, it’s really that combination of mixing up into the AURs, cost saves and certainly strategic pricing that we are using to offset the inflationary impacts in the business – the combination of those. And we have been very thoughtful and strategic about our thinking about pricing. But really pleased with how the brands have moved and the momentum that we have seen in the AURs. Thanks Will.

[Will Gardner, Wells Fargo]

Great. Thank you so much.

[Scott Baxter, Chair and Chief Executive Officer]

Thanks Will.

[Operator]

That was our final question. I will turn it back over to Scott for closing remarks.

[Scott Baxter, Chair and Chief Executive Officer]

Well folks, thank you for the interest in our company. We really appreciate it. And thank you for all the thoughtful questions today. And I just want to leave you with this about rest assure, that we are taking all the right and necessary steps to run this business in a really sophisticated way. We really like how we have positioned ourselves going forward, and how we are going to position ourselves coming on this very dynamic marketplace. I think that’s going to differentiate a lot of companies here as we go forward. And we really look forward to talking to you about how and that process in Q3. So, look forward to the next time we get together. Thank you for the support. And thank you again for today. Have a great day everybody.

[Operator]

Thank you. This concludes today’s conference call. We thank you for your participation. You may disconnect your lines at this time and have a great day.