Levi Strauss & Co

NYSE:LEVI

Earnings Call Transcript 2018-Q2

[Operator]

Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co. Second Quarter Earnings Conference Call for the period ending May 27, 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 July 16, 2018. Please use conference ID 5288288. 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 Aida Orphan, Senior Director, Investor Relations and Risk Management at Levi Strauss & Co.

[Aida Orphan, executive]

Good afternoon, 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.

Now I'll turn over the call to Chip Bergh.

[Charles Bergh, executive]

Thanks, Aida, and good afternoon, everyone. Thank you for joining us today. We delivered our third consecutive quarter of double-digit revenue growth, up 17% in reported dollars and 13% in constant currency. This growth was broad-based across all 3 regions, in every channel and every category. Our strategies are working. The investments we've made in the business over the last couple of years are yielding results, and we're optimistic about our long-term potential.

Now I'll briefly touch on some of the key highlights and opportunities from the quarter in constant currency, unless otherwise stated. The Levi's brand continued its momentum, delivering 12% growth and maintaining its position at the center of culture. In May, we celebrated the 145th anniversary of our iconic Levi's 501 jean, with events in key markets around the world and the successful launch of exclusive and premium 501 collections, including a collaboration with renowned stylist, Karla Welch, that created a lot of buzz for the brand. And as we kicked off festival season, Levi's was once again the unofficial uniform of Coachella, one of the most popular music festivals in the world. Our marketing activities at the festival generated more than 6 billion total impressions and an ad value of more than $21 million in the U.S. alone. And Beyoncé, who headlined the festival, wore a pair of 501 cut-off shorts during her opening performance, which is further testament to the brand's iconic status.

Turning to our 3 strategic choices. First, our profitable core business remains strong. Our top 5 mature markets and the top 10 global wholesale customers each collectively grew double digits. Our total men's bottoms business, which is still the overwhelming majority of our business, grew 1% this quarter.

Second, our strategy to diversify the business by expanding for more continued to deliver growth in underpenetrated areas, like women's and tops. Our women's business grew 33% this quarter, which marks the 12th consecutive quarter of growth, fueled by the continued success of the 700 series skinny fits and tops. Our total tops business delivered 38% growth this quarter, driven by trucker jackets, T-shirts and sportswear logo sweatshirts. Our Levi's graphic T-shirt business has now grown in double digits for 10 consecutive quarters on a reported basis. It's a pretty good indicator of how much people love your brand when they're willing to pay to wear your logo on their chest.

Third, turning to the omnichannel. We've now grown our direct-to-consumer channel in double digits for 10 consecutive quarters, driven by our e-commerce and brick-and-mortar business and international retail expansion. Our retail model is working, and we're committed to selectively opening flagships in key locations around the world. Last quarter, we told you about our flagship launch in Mexico City. And a few weeks ago, we opened a flagship in Toronto. And later this year, as you know, we're opening a new 17,000-square-foot flagship in New York's Times Square that will showcase the brand in one of the highest traffic shopping locations in the world.

Despite our strong growth this quarter, we remain focused on improving the areas of our business that still need some work, including U.S. wholesale, China and Dockers. Here's where we are on each of them. While U.S. wholesale has improved, there's still reason to be cautious about the channel, with a number of a door closures in the second quarter and the possibility of more to come. Despite this challenging environment, we are committed to continuing to grow the U.S. wholesale business by leveraging the strength of our brands, securing incremental floor space, focusing on top doors, growing our categories and expanding distribution. It's that combination of actions that drove our business to deliver high single-digit growth in the quarter in that channel.

Our China business declined 3% this quarter. Our company-operated stores grew 9%, which was offset by the planned closure of more than 100 franchise stores on a net basis in the past 12 months. We're continuing to work on the franchise model, and we're encouraged by the positive growth of our own stores in this important market.

We're seeing improvement in the Dockers brand, with growth in Europe and Mexico. Overall revenue was soft as we prepared the floor for the Signature khaki 2.0, which relaunched in late June. And we're investing marketing dollars in the second half of the year to position the new product for success. Earlier this year, we launched the second phase of the Always On advertising campaign, introducing our Dockers Smart 360 Flex Khaki, which is generating good results for the brand. There's still more work to do, but we're confident the brand is headed in the right direction.

Overall, I'm pleased with the progress we're making. Our strategies are working, and we're doubling down in the areas that are driving growth and making investments that enable us to sustain it for the long term.

And now I'll turn it over to Harmit to walk you through the second quarter financials. Harmit?

[Harmit Singh, executive]

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

I'm pleased to report second quarter revenue of $1.2 billion, up 17% on a reported basis and 13% in constant currency. Our adjusted EBIT was up 15% for the quarter.

Global revenue increased across all regions and channels. Our direct-to-consumer revenue grew 15% in constant currency, driven by the performance of existing stores and the expansion of the network in all regions. Sales through our own e-commerce sites grew 9% in constant currency this quarter and now comprise approximately 13% of the direct-to-consumer channel.

In the wholesale channel, global revenue grew 12% in constant currency, reflecting strong results in all regions. Gross profit dollars for the quarter grew 20%, and gross margin of 53.9% was up 160 basis points, primarily driven by the continued direct-to-consumer and international growth as well as a favorable transactional currency impact of about 100 basis points.

Second quarter SG&A expense of $594 million increased $99 million, including $16 million in unfavorable currency translation. SG&A as a percentage of revenue increased 130 basis points compared to last year. These increases primarily reflect higher selling costs related to the growth and expansion of our direct-to-consumer channels as we invest in new stores and e-commerce technology; our planned incremental advertising investments that enhance our brand equity and grow revenues; and higher incentive compensation expenses, driven by our strong results, reflecting the appreciation of the company's stock price and higher bonus accruals.

Second quarter adjusted EBIT of $77 million was up from $67 million last year, driven by higher revenue and gross margin. Net income increased $59 million, primarily reflecting gains in the company's hedging contracts in the second quarter of 2018 as compared with losses on hedging contracts, and a debt refinancing charge in the second quarter of 2017.

Now I'll share more detail on the second quarter, focusing on the results of each of our 3 regions. In the Americas, revenue grew 11% on both a constant currency and reported basis, primarily reflecting strong growth in our largest market, the U.S., which is up 10%. Our wholesale business in the region grew 9% and was driven by strong growth in Levi's women in large accounts as well as Signature and Denizen. Direct-to-consumer grew 17%, driven by the performance and expansion of our company-operated retail network. Operating income for the region, however, declined $5 million on a reported basis. This decline reflects timing of higher A&P and direct-to-consumer expenses. Direct-to-consumer investment this quarter was primarily driven by an increase in occupancy costs, reflecting lease renewals and investments in new stores. On a year-to-date basis, operating income is up 8% on a reported basis versus last year.

The momentum in Europe continued this quarter, with net revenue up 19% in constant currency and 31% on a reported basis. Revenue growth was broad-based across all channels, products and consumer categories. Wholesale grew 24%, reflecting the strength of the brand and the expanded product assortment across our customer base. Direct-to-consumer revenue was up 12% in constant currency, primarily driven by performance from existing stores, reflecting higher traffic and conversion rates. Within direct-to-consumer, the e-commerce channel grew 36%. The diversification of our portfolio in Europe continues to yield results, with growth of 30% in women's, while our tops business grew 55%, with both genders contributing to the growth. And the region's operating income grew 53% on a reported basis, reflecting higher revenue and SG&A leverage.

In Asia, net revenues were up 9% in constant currency and up 13% on a reported basis. Our wholesale and direct-to-consumer businesses each grew double digits. This growth more than offset the decline of 3% in China, largely driven by the changes we are making in the franchise channel. The region's operating income grew 73% on a reported basis, reflecting higher revenues and gross margins.

Turning to the balance sheet and cash flows. Inventory management continues to progress well, with inventory turns globally in line with last year. In dollar terms, our overall inventory was up 8% to fuel and sustain Europe's high double-digit growth. Ending inventory balances in the Americas and Asia were in line with a year ago. Cash from operations for the first half of the year was $228 million and increased $11 million from last year. This was despite the planned acceleration of pension funding of approximately $50 million.

Overall, free cash flow for the first 6 months of 2018 was $81 million, a decline of $19 million compared to the first 6 months of 2017. Our increase in cash from operations, as indicated earlier, was more than offset by realized losses on our hedging contracts, higher repurchases of common stock in connection with our equity incentive program and a higher dividend payment.

CapEx for the first half of the year was $61 million as compared to $53 million a year ago. On a gross basis, we opened 49 stores in the first half of the year and remain on track for a full year target of approximately 100 stores. Total available liquidity at quarter end was approximately $1.4 billion, comprised equally of cash on hand and availability under our credit facility. Net debt at the end of the second quarter was $359 million, down from $444 million at year-end, and our leverage declined to 1.5 from 1.8 a year ago.

Now turning to our year-to-date results. On a constant currency basis, year-to-date revenue grew 15%. Direct-to-consumer and wholesale revenues were up 16% and 14%, respectively. Gross margin of 54.4% is up 260 basis points compared to prior year, again reflecting direct-to-consumer growth and favorable transaction currency impact of about 100 basis points. SG&A, as a percentage of sales, was 44.7%, up 80 basis points from prior year, primarily driven by increased advertising investments and higher compensation expenses. And for the first 6 months of the year, adjusted EBIT increased 43%. This increase reflects the company's acceleration of revenues and higher gross margin, primarily offset by SG&A expenses as described above.

Our year-to-date results demonstrate that our growth is broad-based. We continue to diversify geographically across channels and categories. Over the last 3 years, as we've consistently grown our overall business profitably, we have made significant progress expanding in underpenetrated categories. Key metrics that show our improved diversification since 2015 include: Our international revenues grew from 49% to 57%. Direct-to-consumer has grown from 27% of our total revenues to 32%. Our women's revenue grew from 21% to 30%, and tops grew from 12% to 21%. While we're diversifying, we're continuing to grow our U.S. global wholesale and global men's bottom business.

Since we are midway into the year and performing better than our expectations, we are updating the full year revenue and FX guidance we provided last quarter. We're raising full year constant currency revenue growth guidance to a range of 8% to 10%. While our first half exceeded this range, we're tempering our full year outlook due to the uncertainty in the macro environment, including the specter of a potential trade war as well as the fact that we're lapping the stronger growth rates in the second half of 2017, particularly the fourth quarter.

Currencies continue to be volatile, with the U.S. dollar generally strengthening against most currencies. And as a result, our estimates for favorable impacts from currency will be lower than we guided from last quarter. Using spot rates at the end of May, we now expect that the favorable impact on reported revenue and EBIT growth will be approximately 150 basis points and 300 basis points, respectively.

With that, operator, we'd like to open it up for Q&A.

[Operator]

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

[William Reuter, analyst]

In terms of the increase in SG&A, you talked about how some of it was due to timing, and a lot of it was due to it being variable with regard to higher sales. Is there any way you can talk to us about if we hadn't seen a revenue growth rate like we did see, what type of deleveraging we would have seen from SG&A? I guess, how much of the increase was variable?

[Harmit Singh, executive]

Yes. It's a difficult question to respond with complete precision, but let me give it a shot. In quarter 2, our SG&A was up 130 basis points. 60 basis points of that was driven by advertising, which we believe is driving our top line and building the momentum. So it's something that we believe is paying back and important as we build the brand and maintain the momentum that we've -- you've seen over the last couple of years. The selling expenses was a combination of our investments. As we open new stores in e-commerce, I think, again, drives momentum. Difficult to time it quarter-by-quarter, but some of this momentum happens over time. The good news for us is our returns on invested capital as a company are in the high teens, and our stores are performing very well. Our direct-to-consumer business, for instance, that's grown 15% this quarter but had 10 consecutive quarters of double-digit growth, as demonstrated [ often ]. I would say the incentive comp is the variable piece because it's largely -- the 150 basis points that I talked about is largely driven by pure results. It's a combination of our belief that our annual performance will be better than expected. And the fact that our stock price is up, that's largely driven by the fact that we're performing better than our peers in the category. And I think that's reflected in the stock price. You should know, and we have kind of explained it in the past, the reason you see variability in SG&A, driven by the stock price, is largely because besides having an equity-settled program for long-term comp, we also have -- being a private company, we also have a cash-settled program. And the cash settled program is mark-to-market on a quarterly basis based on expected stock price. We do have a third party that comes and values the company broadly every 6 months, and that is represented in the results. Does that help address your question?

[William Reuter, analyst]

It does. I recognize it was a little bit challenging to quantify, and -- but that was definitely a good shot. In terms of the increase in inventory, it was lower than the increase in sales that we saw in the quarter. As we think about the next couple of quarters, you've given us some guidance for revenue growth. Would you expect that inventory growth would be in line with revenue growth? Or would it be below revenue growth?

[Harmit Singh, executive]

Yes. I'd say the last quarter, we talked about where we thought inventory would end the year. And we said probably slightly higher than a year ago. But the good news for us, and for all of you because cash is important, we're able to churn and turn the inventory around fairly -- at a decent clip. The increase of 8% largely was because of the phenomenal growth we're seeing in Europe. Americas and Asia was largely in line. So I think end of the year it'll probably be slightly higher than a year ago, and that's really -- as we build assortments and product lines for '19.

[William Reuter, analyst]

Okay. And then just lastly for me, you ended the quarter with a ton of cash in your balance sheet. How should we think about, I mean, some uses of that cash? I know you have CapEx and the dividend. But other than those 2 major uses, what should we be thinking that you guys are evaluating, whether it's M&A or something else?

[Harmit Singh, executive]

Yes. The good news, as you've seen in our results, we're building this company for the long term. And we're -- we remain focused on diversifying the business towards higher-growth channels, different product categories and obviously geographies. If you think back a year ago and the deployment of capital this year versus last year, we're probably deploying approximately a little over $150 million. And that's a combination of higher CapEx, about $40 million, higher dividends and then -- and as well as using cash to buy back stock from employees. Because as a private company, that's how the program works. As well as we did this year accelerate contribution towards our pension plan. We did accelerate about $50 million so far, which is probably a onetime use of cash. In terms of additional opportunities for investment, including potential acquisitions, our criteria is to ensure that first, we -- it would be remiss of me if I don't say that we believe we have a long runway for organic growth in the company. And that is largely because we believe we're underpenetrated in tops and women's as well as a few of the categories that helped build Levi's as more of a lifestyle brand. So as we think about any potential targets, as we have said earlier, which today we have the option, given the capital structure of the company, given the cash position of the company, I think it needs to be a strategic -- a good strategic fit, as well in line with our core strategies to grow and diversify the business.

[Operator]

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

[M. Grant Jordan, analyst]

I think you hit on it a little bit, Harmit, but if you can talk about how you guys are thinking about tariffs and the trade situation, that would be helpful.

[Charles Bergh, executive]

Want me to take it?

[Harmit Singh, executive]

Yes, it's your -- probably.

[Charles Bergh, executive]

This is probably the most asked question that we're getting these days, Grant. Everybody is curious about it. In fact, Women's Wear Daily just ran the article from my interview with them, and it's all about trade wars. So I think the high-level headline message from us on this, which is really a repeat of what we've said in the past, is we are firm believers in free trade. We really believe that the global economy and the consumers around the world, and especially consumers here in the United States, have benefited from free trade. I think it's important to think about where the economy is today -- or let's go back 30 days. Where the economy is from a global standpoint and also here in the U.S., probably maybe the best place it's been in my entire adult life. And certainly here in the U.S., probably the best the economy has been when you look at rate of growth and unemployment in the last couple of decades anyway, and no sign of overheating, no sign of inflationary fears. So the economy globally is in a really good place, and this whole thing could get disrupted with an escalation of trade wars. So I'm really more concerned about it from a standpoint of the impact that it'll have on the global economy, the standpoint that it'll have on consumers, not just here in the U.S. but really globally. I mean tariffs, at the end of the day, are a tax. And at the end of the day, companies are going to have to figure out how they're going to pay that tax, and it's mostly going to come through higher pricing, which is going to slow the economies down. So we're concerned about it. There's -- we've done what we can do as a company in trying to influence trade policy in Washington. I've made trips there. We've had other people make trips there. And we'll continue to kind of work on that, but concerned about the impact it's going to have on jobs. You know from our 10-K, we diversify our supply chain. We've got it very well diversed. We've got a big global business. We've got a big global supply chain. We're really well diversified there. No country represents more than 20% of all of the production of this company. We've got strong strategic partners, many of whom have production facilities in multiple countries. So we will figure out how to weather this storm. It's really a bigger concern around the economy. So you've heard me say this a gazillion times: we're going to focus on what's within our control, and we're going to control our controllables. And that's what we've been doing, obviously planning for the worst and hoping for the best.

[M. Grant Jordan, analyst]

Great. That's good perspective. I really appreciate it. I know it's fairly early, but have you seen any slowdown in ordering since this has kind of picked up steam the last week or 2?

[Charles Bergh, executive]

No.

[Harmit Singh, executive]

No.

[Charles Bergh, executive]

Not at all.

[M. Grant Jordan, analyst]

Okay. And then my only other question is, you talk about the North America wholesale growth, which was really impressive, given the backdrop. Sounds like women's is kind of leading the way there. Is that a women's product that is taking share from other denim? Or is it taking share from other products? Or is it just turning quicker as you sell-in?

[Charles Bergh, executive]

Well, it's really -- I mean, I think we're in a really good position right now in U.S. wholesale. We're playing our portfolio really -- within the Levi's brand, we're playing the portfolio of men's, women's and also getting better representation of the brand as a true lifestyle brand, more head to toe in many customers. Because the brand is successful and hot right now, we're asking for, and in many cases getting, increased space. That helps. So we're growing faster than the categories, so we're clearly building share here in the U.S. Our women's business has been a big part of that. Women's tops, which we took back from a licensed partner about 12 to 18 months ago, has contributed to that. But I think the bottom line is, U.S. wholesale, we're going to continue to see doors close. I talk about it as a little bit of a melting iceberg. We will continue to see door closures. But again, we're going to focus on what we can control. And we're going to put a lot of energy and attention against each customer and their better doors. And how do we show up even better? How do we build our business and help them build their business, respectively, in a still challenging environment? And the fact that the brand is strong and hot, and our own retail performance in the U.S. clearly supports our potential in this market, we're seeing a lot of support for incremental space and incremental support.

[Operator]

[Operator Instructions] Your next question comes from the line of Karru Martinson with Jefferies.

[Karru Martinson, analyst]

Just in terms of trying to reconcile, we're in the best place the economy has been in many, many years, with kind of the cautious optimism that you have on the U.S. wholesale, where is that customer going? Or where are those dollars going these days?

[Charles Bergh, executive]

I mean, I think you know the answer to that: vertical retailers and owned-and-operated retail stores, like our own, as well as online. The consumer has more shopping choices today than they've ever had before. Social shopping is becoming more of a phenomenon of the whole omnichannel experience, if you want to call it that. And I think the winning retailers are going to be the retailers that have phenomenal product, a great price value and an incredible consumer experience in their store. And so we've really been focusing on all of those things. We've invested pretty heavily in brick-and-mortar retail. We've invested pretty heavily in e-commerce, and now we're trying to knit the seams of that into a really strong omnichannel presence. If you've been into the SoHo remodel since we opened that store, we've got a Print Bar there, which creates an amazing experience inside the tailor shop. We're doing more and more of those kinds of things to give consumers a reason beyond just coming in to buy a pair of jeans as a reason to come into a Levi's store. And that's a big part of the reason why I believe our retail business is strong and healthy globally. So I think at the end of the day, smart retailers are realizing consumers have lots of choice. And they're focusing on what that consumer experience needs to be inside their stores, and they're winning with that. And I think that's the key to success longer term, whether it's for us or any retailer, including department stores.

[Karru Martinson, analyst]

And when you look at that e-commerce penetration that you guys are running at right now, I think you said 13%, how scalable is that today? And how much more investment do you need to put behind that? And how should we think about that on the CapEx spend?

[Charles Bergh, executive]

So -- and just to be clear, it's not 13% of the total company. It's 13% of our retail business, which is the way a lot of retailers report their e-commerce. So it's an apples-to-apples kind of thing. If retail is roughly 1/3 of the total company, it's therefore about 4% -- e-commerce about 4% of the total company business, but growing and growing at really healthy rates. We're going to continue to invest in e-commerce, and it's very scalable. We've been rolling out owned-and-operated e-commerce sites around the world. We rolled out Canada owned and operated, when was that, late last calendar year. We've rolled out Japan owned and operated. Recently, we did India owned and operated, which required us to take back a franchise store to have our own owned-and-operated brick-and-mortar retail in India, given the regulations there. And so it's very scalable, to answer your question. We have slightly different models in different markets depending upon the size of the market. But it's scalable, and from a consumer standpoint, it's an important aspect of our business. And we will continue to invest in e-commerce. We're very focused on how do we continue to innovate in e-commerce, so you've seen like the virtual AI-driven chat bot that we've got, that helps consumers find the right fit for them. And we'll continue to invest and innovate in this space. The other thing we're doing is with our wholesale partners, who are running their own dot-com businesses, we're sharing digital assets. We're sharing some of our innovations. We're happy to partner with our wholesale customers to help them improve their e-commerce presence with our brands. And that's working reasonably well, too.

[Karru Martinson, analyst]

And if we just look at your liquidity, $1.4 billion with cash and revolver, what are the kind of the minimum cash needs of the business? And outside of investment opportunities, where would you like to see that cash balance going forward?

[Harmit Singh, executive]

Yes. Karru, just a point to note, half of that $1.4 billion is the cash on hand. Of the cash that we have, majority of it is overseas right now. We don't need 80% of the cash that's overseas -- sitting overseas. We need a little bit for working capital. We need a little bit of working capital here. So we -- and we constantly bring home the cash that's overseas and use it to grow the company or return capital to the shareholders or the other things we've talked about. So I'd say obviously, we don't need $700 million, but we are pretty diligent about how we invest that cash, making sure that wherever we put the cash to work, it's either in line with the strategy of the company, and importantly, driving the returns that we expect to get out of our capital investments.

[Operator]

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

[Charles Bergh, executive]

And there are none. So just want to thank everybody for dialing in and for participating in this call this afternoon. And we will talk to you at the end of the third quarter. Thanks very much, and have a great summer.

[Operator]

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