Levi Strauss & Co

NYSE:LEVI

Earnings Call Transcript 2018-Q1

[Operator]

Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co. First Quarter Earnings Conference Call for the period ending -- end February 25, 2018. [Operator Instructions] This conference is being recorded and may not be reproduced in whole or in part without written permission from the company. A telephone replay will be available 2 hours after the completion of this call through April 16, 2018, by calling 1 [phone] in the United States and Canada and 1 [phone] for all other locations. Please use conference ID 8997477. This conference call is also being broadcast over the Internet and a replay of the webcast will be accessible for 1 month on the company's website, levistrauss.com.

I would now like to turn the call over to Chris Ogle, Vice President, Treasurer, Investor Relations at Levi Strauss & Co.

[Chris Ogle, executive]

Good afternoon, everyone, and welcome to our quarterly conference call. I'm pleased to introduce members of the Levi Strauss & Co. management team, Chip Bergh, President and CEO; and Harmit Singh, Executive Vice President and CFO.

Before we begin, let me briefly remind you of a few items. Our discussion today may include forward-looking statements, including statements regarding our strategies and expected financial and operating performance. Although these statements reflect the best judgments of our senior management, they involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by the statements, as more fully described in our annual report on Form 10-K, our registration statements, today's earnings press release and our other filings with the SEC, all of which are available on our website at levistrauss.com. We disclaim any responsibility to update our forward-looking statements. Other unknown or unpredictable factors also could have material adverse effects on our future results, performance or achievements. We provide information on our website about how we compile various measures used to describe our business performance.

Participants on today's call may discuss non-GAAP financial measures. Reconciliations and descriptions of our non-GAAP financial measures are available in the Investors section of our website as well as in today's earnings press release. Finally, today, we filed our quarterly financial report on Form 10-Q with the SEC, which is now available on our website.

And now I'll turn the call over to Chip Bergh.

[Charles Bergh, executive]

Thanks, Chris. Good afternoon, everyone, and thank you for joining us today. We had a great start to the year. Our strategies are clearly working as we, again, delivered balanced and profitable growth across our global business. The momentum we saw in the second half of last year and especially in the fourth quarter has not only continued, it has accelerated. In Q1, we've reported 22% revenue growth, 16% in constant currency, while adjusted EBIT increased 59%. The incremental investments we've made in marketing, direct-to-consumer expansion and our more diversified portfolio are paying off with growth across nearly every market, channel and category. We knew that the quarter would be a good one given the strong holiday and it turned out to be stronger than even we expected. And this momentum is giving us the opportunity to invest more in our business and brands, so that we can continue to grow and win in the future.

Now I'll touch on some of the key highlights and opportunities from the quarter, all in constant currency in the context of our 4 strategic choices. As a reminder, our strategies are to grow our profitable core business, expand for more, become a leading omni-channel retailer and achieve operational excellence. Within our profitable core business, the Levi's brand had a great quarter with 17% growth. Once again the brand grew in every channel and in all 3 regions. The Levi's men's bottoms business, which really is our core, grew 5% led by fits such as our 505, the 502 Regular Taper and the 541 Athletic Fit. Currently, the Levi's men's bottoms business is #1 in market share in 8 of our top 10 global markets. The moment we're experiencing reflects our efforts to build brand equity and stay at the center of culture. For example, our collaboration in January with Nike for the Levi's and Air Jordan collection created a lot of brand heat immediately selling out online with fans lining up outside of our stores 2 days in advance of the launch of the product. Collaborations such as these are a small part of the business, but they generate energy and excitement for the brand overall.

Our top 5 mature global markets, the U.S., France, Germany, Mexico and the U.K., collectively grew 13%. And our global wholesale business grew 15%, primarily driven by our key customers. We're encouraged by the progress we're making on Dockers, while the brand declined slightly, we are seeing a strong consumer response to our Smart 360 Flex Khaki and Easy Khaki. This quarter, we also debuted the second installment of the Always On marketing campaign for spring 2018. In the second half of this year, we'll continue transitioning to new products. Our second strategic choice to expand for more and create a more balanced portfolio continued to take shape this quarter. Our total Levi's women's business grew 28% across all regions and channels. The majority of the quarter's growth was driven by the 700 Series jeans collection and the 311 Shaping Series with skinny fits and high-rise continuing to be our best sellers. Globally, our total tops business grew 38%. This is a business that we keep expanding as we strengthen Levi's as a lifestyle brand. Graphic logos remained strong, including Batwing Tees, Hoodies and Sweat Shirts. In Europe, this quarter, tops growth outpaced bottoms in both men's and women's. While we're pleased with our success in tops, we still have significant upside opportunity in this category. Our 2 value brands, Signature by Levi Strauss and Denizen continued their momentum collectively growing more than 30%. Women's overtook men's in the first quarter becoming largest business for each of these brands. Beyond the core markets, our international business collectively grew in the mid-teens. China represents the biggest opportunity in this group. We've been focused on turning our business in China around and we're starting to see some traction. While revenues declined as planned in the franchise channel, revenues from our company-operated stores and e-commerce grew in the quarter. It will take time, but we are optimistic that the strategies we're implementing will pay off over the longer term.

Our third strategic choice to become a leading omni-channel retailer resulted in 18% growth in our direct-to-consumer business this quarter. We continue to see strong performance in our retail stores, driven by optimized assortments, strengthened in-stocks and improved service. We're also seeing results from the investments we've made last year, both in new stores, such as Osaka as well as remodels of existing store locations, such as SoHo, which has had impressive growth since it relaunched in Q4. And last month, we opened our first flagship store in Latin America, the store is located in Mexico City in the heart of the historic district of Madero Street and it represents the best of the brand in terms of location, store design, assortment and experience. We also delivered strong growth online this quarter, including expanding our e-commerce presence with the new website launch in India.

And we continue to focus on our fourth strategic choice to achieve operational excellence around the world and drive higher productivity. At the end of February, we announced Project F.L.X., a new operating model that will change the way the jeans are designed, made and sold. F.L.X. uses a combination of proprietary digital design and manufacturing capabilities that will give us the ultimate balance of agility and sustainability, while upholding the Levi's standards of craftsmanship, quality and authenticity.

And with that, I'll turn it over to Harmit to walk you through the first quarter financial results. Harmit?

[Harmit Singh, executive]

Thank you, Chip. Welcome to everyone joining our call. My comments today will reference first quarter comparisons on a year-over-year basis in U.S. dollars unless I indicate otherwise.

First quarter revenue of $1.3 billion, grew 22% on a reported basis and 16% in constant currency. Wholesale revenue grew 21% on a reported basis, primarily reflecting strong results in Europe and the Americas. Direct-to-consumer revenue grew 24% on a reported basis. These results were driven by performance of existing stores as well as ongoing expansion of the store network internationally and e-commerce, which grew 29% on a reported basis.

Gross profit dollars for the quarter grew 31% and gross margin of 55% was up 370 basis points, driven by direct-to-consumer and international growth, lower product sourcing costs and a favorable transactional currency impact of about 100 basis points, primarily from Europe.

First quarter SG&A expense of $564 million, was up 24% over prior year. The dollar increase of $108 million was comprised primarily of higher selling costs related to growth and expansion of our direct-to-consumer channels, our planned incremental advertising investments, higher incentive compensation expenses, reflecting the appreciation of the company's stock price and higher annual bonus accruals and $18 million in unfavorable currency translation. Importantly, however, despite the dollar increase, SG&A, as a percentage of revenue, increased only 60 basis points compared to last year. Excluding the nearly 100 basis points from higher advertising investments, our base business levered, including direct-to-consumer.

First quarter adjusted EBIT of $175 million was up from $110 million last year, as strong revenue and gross margins drove 59% adjusted EBIT growth. So overall folks, a great quarter for the company. Despite a higher pretax earnings, we recorded a $19 million net loss for the quarter due to a noncash tax charge of $136 million related to the new tax law in the United States. The $136 million we recorded is provisional and primarily represents our best estimate of 2 things: The write-down of net deferred tax assets, that we now expect to realize at lower tax rates; and a one-time tax on undistributed foreign earnings, which you may have heard referred to as the toll charge. The $136 million provisional charge inflated our tax rate for the quarter. Without it, our tax rate would have been around 22%. Excluding the provisional tax charge, adjusted net income was $117 million, nearly double last year's $60 million.

Now I'll share more detail on the first quarter results of each of our 3 regions where revenues and profits grew on both a reported and constant currency basis. In the Americas, revenue grew 13% in constant currency and 14% on a reported basis, reflecting strong growth in wholesale and direct-to-consumer across the region. This is the best quarter the Americas region has delivered in recent history. Wholesale growth was primarily driven by our tops' accounts and included Levi's men's and a very strong growth in women's as well as higher Signature and Denizen revenues. Direct-to-consumer was driven by the performance and expansion of our company-operated retail network and higher e-commerce revenue.

Our largest market, the U.S., was up 11%. Mexico and Canada continue to perform with revenue in each up double-digit this quarter, driven by growth in all channels and nearly all categories. The full region's operating income grew 23% on a reported basis, as the higher revenues and higher gross margin were partially offset by increased selling and advertising expenses this quarter.

Europe had another exceptional quarter, with net revenue up 30% in constant currency and up 46% on a reported basis. The business continues to go from strength to strength, driven by the marketing and inventory investments we have made. Revenue growth was broad-based across all channels, markets, product and consumer categories. Wholesale grew 35%, reflecting the strength of the brand and the expanded product assortment across our customer base. Direct-to-consumer was up 25%, driven by performance from existing stores, reflecting higher traffic and conversion rates, in addition to new company-operated stores opened over the last 12 months.

Our e-commerce channel also grew mid-double digits. The diversification of our portfolio in Europe continues to yield results, with growth of 43% in women's, while our tops business nearly doubled. And the region's operating income grew 79% on a reported basis, reflecting higher gross margins and SG&A leverage.

In Asia, net revenues were up 5% in constant currency and 9% on a reported basis. Our wholesale brick-and-mortar and e-commerce channels each grew double digits. This growth was partially offset by planned decline in the franchise channel in China due to the strategic closure of nearly a 1/3 of our franchise doors in the past year, primarily smaller shop-in-shops in the departmental stores channel. Encouragingly, sales from the remaining franchise doors in China grew year-over-year. Adjusted EBIT for the full region grew 13% on a reported basis, as the higher revenues and higher gross margin were partially offset by increased selling expenses to support retail expansion.

Turning to the balance sheet and cash flows. We made progress in optimizing inventory levels globally. Ending inventory balances were higher in Europe to support the region's exceptional growth, while inventories in the Americas and Asia were in line with a year ago.

Free cash flow for the first 3 months of 2018 was a negative $35 million, a decline of $33 million compared to the first 3 months of 2017. A $17 million increase in cash from operations was offset by realized losses on our currency hedging contracts, repurchases of common stock in connection with our equity incentives program and a higher dividend payment.

CapEx for the first quarter was $31 million as compared to $25 million a year ago. On a gross basis, we opened 22 company-operated stores in the first quarter and remain on track for our full year target of nearly 100 stores. Total available liquidity at quarter-end was approximately $1.3 billion, comprised of cash of $590 million and $745 million available under our credit facility.

Net debt at the end of the first quarter was $497 million, down from $672 million last year. And our leverage declined to 1.6 compared to 1.8 a year ago.

Given the strong momentum with which we've begun this year, we are updating some of the full year guidance we provided last quarter. We are raising full year constant currency revenue growth guidance to a range of 6% to 8%. While we are off to a great start, we're tempering our full year outlook due to the uncertainty in the macro environment as well as the fact that in the second half of this year, we'll be comping the strong growth rates we saw in the third and the fourth quarter of 2017. We're also raising our full year gross margin guidance and now expects gross margins will expand by approximately 150 basis points. We now expect full year SG&A, as a percentage of revenues to increase by approximately 120 basis points, of which about half reflects increased advertising with the balance largely driven by direct-to-consumer and technology investments. Accordingly, we expect full year adjusted EBIT margin to expand in the range of approximately 30 basis points. Given the continued weakening of the U.S. dollar based on spot rates at the end of the first quarter, we expect that currencies will favorably impact full year reported revenues and adjusted EBIT growth rates in the range of 300 basis points and 900 basis points, respectively, and will favorably impact full year adjusted EBIT margin in the range of 50 basis points. And excluding the $136 million impact from the change in tax law, we expect our full year tax rate in 2018 to be about 20%. Specifically, in regard to the second quarter, please note that we expect adjusted EBIT will be pressured by advertising expenses both due to the increase we're planning as well as our strategy to smooth our quarterly investments as compared to 2017. We are holding to the other expectations we shared with you last quarter.

With that, we'll take your questions.

[Operator]

[Operator Instructions] Your first question comes from the line of William Reuter with Bank of America Merrill Lynch.

[William Reuter, analyst]

I'm sorry if I missed this, but you were talking about increasing your investments in advertising and promotions. I could tell that, but I couldn't tell whether you're planning to increase them as a percentage of sales this year or if that was just an increase in absolute dollars? So what was that comment that you guys made?

[Harmit Singh, executive]

Yes, so what we had said, Bill, earlier when we talked about guidance for the year, we talked about taking the advertising expense as a percentage of revenue up between 50 and 60 basis points. We've talked about a 60 basis points increase on a full year basis. As a percentage of sales for quarter 1, advertising as a percentage of revenue is up 100 basis points. And that is a combination of better -- smoothening of the advertising spend through the year as well as increasing investments in media during the year.

[Charles Bergh, executive]

So kind of just to clarify. I think you got it, but it's a 50 to 60 basis point over the actuals from last year. That's what we guided at the beginning of this fiscal year. Now that we're taking our revenue guidance up, we're holding our A&P investment as a percentage of revenue at that 50 to 60 basis point guide versus last year's actuals.

[William Reuter, analyst]

Okay. And then given the strong performance of the business and balance sheet which is in, obviously, a very healthy position. Has there been any increased thoughts about M&A at this point? I guess, it would seem like you guys are going to generate a whole lot of free cash flow and seemingly are able to do good things for the brands that you have now. How about adding another one?

[Harmit Singh, executive]

Yes, so let me talk about capital deployment or cash deployment a little bit. Relative to last year, Bill, as the business has gone from strength to strength and our performance has improved, we're spending a little over $100 million across a couple of things: We were upping our capital spend year-over-year by $40 million as you know, we're sticking with that same guidance and that's largely towards technology, e-commerce as well as opening stores, primarily flagships. We were relocating a flagship in Times Square towards the end of this year. We opened a flagship in Mexico, that Chip talked about. We're -- also upped our dividends, so returning, in terms of dollars, more capital to our shareholders and we have also increased our funding towards the pension plan. We intrinsically believe that there is a lot of growth left in the brands we currently have. We underpenetrated in the tops category, where we believe that we have a lot of room to grow in the women's category, for example. So our intrinsic health of the business continues strong and there is room to grow the business organically. Having said that, as we have said in the past, given the fact that we have access to a lot of liquidity, as we look at potential M&A target, it probably needs to fit within our strategic filter as well as our financial filter. We'll maintain the discipline, but we will look at both the filters, and really, it's about growing -- further accelerating our growth in tops, further accelerating our growth in women's as well as in categories like outerwear.

[William Reuter, analyst]

Okay. And then just lastly, you're relatively close to investment grade ratings. Your credit metrics keep looking better. Have you had any recent conversations with the rating agencies on your ratings that you can share with us? That's it.

[Harmit Singh, executive]

Yes, we have ongoing conversations with them. The good news is that our business is more diversified today than it was 5, 6 years ago because they look at diversification beside pure leverage. And the diversification in our case has come geographically, for example, international is now bigger than the U.S. It's come in our product categories. We are growing tops and women's as well as the channel mix. Our direct-to-consumer business now is about 1/3 of the mix, so conversations continue, but it's less about reducing debt. It is -- if we ever get even financially to ratios and metrics that make us investment grade, it'll largely be driven by earnings. Having said all that, financial policy, as you know, Bill, is important to the rating agencies. And as we think about expanding this business, both organically as well as inorganically, that'll come into play. I mean, the good news for us is, we have access to capital, and our capital structure allows for that. The last 2 rounds of financing we did, folks like yourself tell us the interest rates that we actually were able to place the bonds were very close to an investment grade company.

[Operator]

Your next question comes from the line of Grant Jordan with Wells Fargo.

[David Eller, analyst]

This is actually David Eller on for Grant. On the last call, you talked about both December and January being very good for your results. Obviously, that played out in this quarter. Could you give us a little idea of maybe how results finished the quarter in February? And may be how they started off in March for Q2?

[Harmit Singh, executive]

David, good try. The -- we don't obviously talk month to month and we don't necessarily guide quarterly. What I would say is, the quarter was strong, it started with the holiday season, which as we've said earlier is a combination of November and December for us and the fact that we had a good quarter speaks for itself. January is obviously, slightly softer month than December and Jan, just that's the nature of the market. But you have other parts of the world. Asia, for example, where Chinese New Year is a big play. So I think it's difficult to break it up by month from that perspective. The fact that we're raising our full year guidance is demonstrative of how we feel about the business. The one thing I will tell you, we don't expect the mid-teen constant currency growth rates to continue for the rest of the year. And it's really driven by a couple of factors. One is, we're going to be lapping a stronger second half. Last year, our first half was a little -- grew a little at a slower pace than second half. It still grew at a modest 5% or 6%, so I can't call it weaker, but it still grew at a slower pace. So that's one reason why we're taking our guidance -- we're taking our guidance up, but it's in the range of 6% to 8% as against anything different. And the second is just the environment. I mean, there are a few balls in the air, whether it's trade policies, tariffs, et cetera. So we just have to be fiscally prudent as we think about the future and guide the future.

[David Eller, analyst]

Great. And then you mentioned your new F.L.X. program. I would assume that was -- that is the same technology that was referenced in a Wall Street Journal article about a month ago. Could you talk about what sort of investments will be required for that program? And then kind of over what period of time you might make those investments? And if there is any other firms or competitors out there that are using similar technology?

[Harmit Singh, executive]

The investments are largely in the form of lasers, which primarily our vendors are in the process of investing as well as some digital technology that we're driving because we're pioneering some of that ourselves. In terms of the -- and we've started this -- the rollout of this product is now hitting the floors, but the real rollout is going to accelerate over the next couple of years, and we expect that to be available globally around 2020. I think in terms of financial implications, it's too early to tell, David, but there probably going to -- it's probably going to imply better margins, it's probably going to be in lower inventory, longer term, all of which will quantify over time. But I think primarily the advantages are it drives higher agility, it helps digitize how we design, make and sell our products. And then there are obvious advantages from a sustainability perspective. So I think it's broader than just a financial opportunity.

[Charles Bergh, executive]

I would just -- pile on just briefly. First of all, to answer to your question directly, The Wall Street Journal article that you referred to, yes, that does refer to Project F.L.X. And this is the way I talk about it is, this is the fourth industrial revolution meets the apparel industry. It is the digitization of apparel design and manufacturing. And I want to underscore just a couple of things. I mean, lasers have been used for 15 years in this industry. So what's new about that? What's new about it is, we've created a lot of proprietary technology that we've owned. We've actually had one patent already approved. We've got more in motion. So there is a lot of true proprietary invention that we've brought to the party here, number one. Number two, the big headline idea on this over time is today's apparel industry kind of operates on a "sell what you make basis". We make lots of product. We make it on the other side of the world. We ship it over here. And then it's on us to figure out how to go sell it. This is going to give us the potential to be much more agile, likely much closer to market where we'll be able to sell -- make what we sell. So we can be responsive to what's happening in the marketplace and turn orders around really, really quickly. It is, I think, potentially a huge disruption, and we'll see it rollout, as Harmit said, over the next couple of years. We've already been selling product that's been made with this technology for the last, almost, 12 months, just doing it blind to confirm that there are no consumer issues with it and we feel really confident about that. So it's a big idea and we'll see it expand over time and we'll have more updates on the financial impact of it, but it should be good.

[David Eller, analyst]

Great. And then for my last question, you talked about China and kind of the closure of the franchise stores for the channel. Could you just give us a reminder just kind on the overall state of the market there, kind of where your brand stands compared to competitors and kind of the future outlook?

[Charles Bergh, executive]

So Levi's is the #1 brand based on the market share data we've got in China. One of our key competitors, also based here in the U.S., is #2. We had about 650 doors in China, and when we say doors, that also includes the shop-in-shops format, which most of you are familiar with but it's basically a very small pad in the department store. Our business model is largely a franchise model in China. And over the past couple of years, we've evolved that model to fewer franchisees, more capable franchisees. But as we've gotten into it, a number of the doors that we were operating or that our franchise partners were operating were not profitable. So last year, we made the decision to close those unprofitable doors. So we've reduced our door count by about 150 doors in China last year. Most of them being the smaller shop-in-shops in the department store channel. And the department store channel, I should mention and that whole shop-in-shop concept is a declining segment of the Chinese market. I guess, the last thing I would say is, our brand, the brand health in China is very strong. We're the leading brand today, number one. And number two is, when we take a look at our own business and owned and operated, we're growing, and in the franchise stores, as we referred to in the script, in the franchise stores that are still open today, they're comping positively. So this is a little bit of, I call it, a cleanup and it's been a cleanup, and it's been heavy lifting. But we're committed to the long-term success of our business in China, it's still less than 5% of our total company. When you look at the potential of China, longer term, we have to be successful there. That should be a very, very big business over the next couple of years.

[Operator]

[Operator Instructions] Your next question comes from the line of Hale Holden with Barclays.

[Hale Holden, analyst]

I just had 2 here. You guys mentioned twice both on the script and in response to another question, tempering the outlook or not pulling forward the full beat in the first quarter due to some wariness about the macro environment. And I was wondering if you were going to rank them, is that one that you've -- one issue that you're more particularly worried about than others?

[Charles Bergh, executive]

We're looking at each other here. The biggest uncertainty I think we're facing. There are really 2, and I don't know if I want to rank them, but one is the uncertainty around trade and tariffs. That could have significant short-term impact. And then the other is, while the wholesale business here in the U.S., which reminder is still about a 1/3 of our total company's business, while we've seen some room to be encouraged, right because they had a good holiday and things have been pretty robust over the last quarter, there is still a couple of customers that are weak financially, and there are still some macro risks, I would say, in that channel here in the U.S. Our business was very strong in the first quarter in U.S. wholesale. I hope it continues, but there is risk that it might not. So I would say those are probably the 2 biggest macro headwinds that gave us claws to just temper the outlook a little bit. And then the last thing is, as Harmit said earlier, our second half last year was pretty strong and the lot of big numbers starts to come into play as we begin to lap double-digit growth in the fourth quarter last year.

[Harmit Singh, executive]

The only thing I'd say, Hale, is 6% to 8% is pretty damn good. And just as a reminder, I mean, it was not very long ago, this company was growing in the low single-digit growth. So I think we've demonstrated last year and we are sticking with the same this year, which is we're moving towards mid- to high single-digit growth company. And I think the category is not growing at this pace at all. And that speaks a lot to what's been happening over the last many years and how we've been investing to diversify both geographically as well as across product categories.

[Hale Holden, analyst]

Got it. And then sort of you hit my second question there. I do feel bad about asking the goose laying 4 golden eggs to lay a fifth one, but yes, the category is not growing as fast as you're growing, either in the geographies that you're growing or just broadly globally in jeans wear. And I was wondering if you were seeing any competitive responses? Or if you felt this was kind of a sustainable flywheel on a go-forward basis?

[Charles Bergh, executive]

We think we've got the flywheel going. I mean, the one thing about this industry is, it is pretty fragmented, right. We've got and you can go country-by-country and in some countries we've got completely different sets of competitors, some of whom are local or regional in nature. And my view of the world is, there are still a lot of shared owners out there, and we do have the potential, given the strength of the brand today, to grow ahead of market growth and build share in doing that, and we've been doing it, most notably, on the women's business since we've relaunched that about 11 quarters ago. We've had -- we didn't talk about it explicitly but we've had 11 straight quarters of growth on our women's business and 5 of those quarters were double-digit. So it was less than an $800 million business it's now over $1 billion business. And there are a lot of shared owners out there still to be had.

[Harmit Singh, executive]

The -- Hale, the thing to consider, as you all know, there's major disruption happening in the retail space. I think what's going to separate the winners and the losers is, first, folks having great brands like us. More importantly, as we think about growing the business, investing for the long term, we're investing in direct-to-consumer. We've invested in marketing. We're diversifying our product categories. And I think that's -- and we're growing our e-commerce platform as well as investing in digitizing a whole bunch of things. That's what's going to probably need to happen. So while SG&A, for example, has increased, it's largely been driven by us investing for the long term and allows us to transform the company that once was 5 years ago to the company that we want to be 10 years from now.

[Operator]

Your next question comes from the line of Jenna Giannelli with Citi.

[Jenna Giannelli, analyst]

I just had a few follow ups. First one on the gross margin line. I appreciate, I guess the level of conservatism on the top line for the balance of the year, but when we look at the margin expansion in 1Q, I mean, and the raise to 150 basis points. Is there some level, I guess, of conservatism on the gross margin line there as well? Or could we expect some of the [fuller] product first-in-class and the expansion to continue at the same rate?

[Harmit Singh, executive]

Yes, so I don't expect the same rate of expansion in gross margin to continue for the rest of the year. If you break out what's driven the expansion in gross margins, 2/3 of it was growth in our direct-to-consumer business as well as sourcing -- product sourcing opportunities. I'd say about 100 basis points was driven by favorable FX and the U.S. dollar started weakening towards the second half of last year. So we think that, that pace of growth in margin, thanks to FX, slows down and that's why we have kind of narrowed our full year expectations on gross margin. Now the -- we are -- where we can, given the strength that we're seeing in our brands, we are reducing the level of promotional activity and markdowns, especially, as our products become a lot more relevant and the brand is -- takes of the way it has been. So you probably see a bit of that. Now that leads to higher margins. That's where you will see the upside longer term.

[Jenna Giannelli, analyst]

And I just had one more, I think, Chip in your prepared comments, you said that the first quarter surprised you guys relative to your expectations. So I guess, was there any particular area, any particular region, wholesale versus retail, any wholesale partners, in particular, that were really the driver, may be that surprised or what exceeded versus your original expectations?

[Charles Bergh, executive]

I've said for a long time that if the U.S. business is healthy, it takes care of a lot of things given the size of our U.S. business. Our U.S. business grew double-digit. And a lot of that was driven by the strength of wholesale. So that to me, anyway is the standout surprise in a pleasant way. We've put Roy Bagattini, who is the President of Americas region and his team have put a lot of emphasis in making sure that we've got our strategies right with each key customer that our plans are strong. And I think we're just doing a much better job now executing in the U.S. But the momentum continued, continued and accelerated in Europe and in direct-to-consumer. So there were pleasant surprises kind of around the pitch all the way. But the big standout, I think would be the overall strength of our business in the U.S., predominantly in wholesale, but also in direct-to-consumer.

[Operator]

At this time, I'd like to turn the floor back over to the company for any closing remarks.

[Charles Bergh, executive]

Okay. I guess, that's me. Thank you all very much for calling in, and we will talk to you at the end of the second quarter. Thanks, and goodbye.

[Operator]

Thank you. This concludes today's conference call. Please disconnect your lines at this time.