Levi Strauss & Co

NYSE:LEVI

Earnings Call Transcript 2018-Q3

[Operator]

Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co. Third Quarter Earnings Conference Call for the period ending August 26, 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 October 15, 2018. Please use conference ID 7217838. This conference call also is 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 judgment 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. Good afternoon, everyone, and thank you for joining us today. And at the outset, I want to apologize for the slightly late start. We had some technology glitches on our end here.

We delivered our fourth consecutive quarter of double-digit revenue growth, up 10% in reported dollars and 11% in constant currency. This growth was broad based across all 4 brands, men's and women's, tops and bottoms as well as all regions and channels. We've also made progress in areas where we've previously faced challenges, like U.S. wholesale and Dockers. Overall, these results demonstrate the continued strength of our business.

Now I'll briefly touch on some key highlights for the quarter, all in constant currency. The Levi's brand continued its momentum, delivering 12% revenue growth. Following our Project F.L.X. announcement in Q2, we launched a limited-edition Levi's Customization Studio in Los Angeles, which introduced our revolutionary technology to select designers and influencers, giving them the opportunity to use the laser-powered process to create a customized pair of jeans in a couple of hours. The studio is generating significant media coverage and buzz for the brand and it demonstrates the power of this concept. We also launched the second Levi's Air Jordan collaboration, which sold out in minutes online and in stores and generated 2 billion global impressions. And we introduced the Made & Crafted collection featuring celebrity and model Lily Aldridge. Both collaborations have continued to create a lot of interest with our consumers and from the media.

Looking ahead to Q4, the Levi's brand recently launched a global collaboration with Justin Timberlake, and we debuted its latest television spot, Use Your Vote, which is a continuation of our successful Live in Levi's campaign. The ad showcases people from around the world unified by one common theme: using their voice, casting their ballots and participating in the democratic process of voting, set to the powerful lyrics of Aretha Franklin's song, Think. We have high expectations that these investments in marketing will continue to make a big impact and keep the brand at the center of culture.

Turning to our 3 where to play strategic choices. First, our profitable core business remains strong. Total men's bottoms were up 1%, our 5 largest markets grew 7% and our top 10 wholesale customers grew 8%. In the U.S., revenues were up 7%, and in Europe, revenues grew 17%, reflecting continued broad-based growth across virtually all markets, channels and product categories. Second, our strategy to diversify the business by expanding for more continued to deliver strong results. Our overall women's business grew 26% this quarter, which marks the 13th consecutive quarter of growth, with the last 7 quarters at double-digit growth. Importantly, the women's bottoms business grew 21%. In spite of this performance, we know that we are underpenetrated in this business and have a long runway for more growth ahead of us.

Total tops business delivered 38% growth this quarter, driven by our logo T-shirt business. It was about this time last year that we really saw the Levi's Batwing tee takeoff as a key fashion item and we've since expanded our graphic tee business beyond this single offering. Globally, we are selling a T-shirt every second and have done so consistently for the past 2 quarters. Our tops business is closing in on $1 billion and has almost doubled in the last 2 years.

Third, we have now grown our direct-to-consumer business double digits for 11 consecutive quarters, with growth in every channel and region. We opened a flagship store in Canada in June, and we're on track to launch our new Levi's flagship store in New York's Times Square at the end of Q4. We've also deployed RFID in all of our stores in the U.S. and the U.K., which is helping us manage our inventory more effectively to make sure consumers find what they're looking for. Our plan is to expand this globally, including with our franchise partners over the next 12 months.

We've also continued to make progress this quarter in key focus areas of the business: U.S. wholesale, China and Dockers. Despite door closures with some of our major customers, we grew our U.S. wholesale business by 6%, driven by Levi's and Signature. While we know that some challenges persist in this channel, we feel confident that our strategies to diversify the business and grow with our strongest customers are working.

In China, our turnaround strategies are beginning to pay off with 12% growth in both direct-to-consumer and franchise. We also announced a new leader for the market, Amy Yang. Amy was born and raised in China and has extensive experience running global brands and a deep understanding of the Chinese consumer. We're confident she will take this business to new levels of growth.

We're seeing improvement in the Dockers brand with positive growth this quarter, driven by setting the floors in the U.S. and strong performance in Europe, which we attribute to the relaunch of Signature Khaki and the successful Dockers Always On campaign. We will continue to invest marketing dollars in Q4, and we are optimistic that the brand is on the right path long term. We've also made progress to set up the company for the future, including changes to our management team and organization structure that will accelerate direct-to-consumer growth, consolidate end-to-end accountability and elevate marketing. Overall, I'm pleased with our performance in Q3, and I'm confident that we will finish the year strong. Our diversified portfolio is delivering, and we are making smart investments in the business that will enable us to continue to win.

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

[Harmit Singh, executive]

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

I'm pleased to report third quarter revenue of $1.4 billion, up 10% on a reported basis and 11% in constant currency. Year-to-date, this reflects 16% growth on a reported basis and 13% in constant currency. 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 as we have 65 more stores than we did a year ago. Sales through our own e-commerce sites grew 15% in constant currency this quarter and comprises approximately 12% of the direct-to-consumer channel. In the wholesale channel, global revenue grew 10% in constant currency, reflecting strong results in all regions. Gross profit dollars for the quarter grew 13% and gross margin of 53.2% was up 140 basis points, primarily driven by continued direct-to-consumer and international growth.

Third quarter SG&A expense of $583 million increased $73 million. SG&A as a percentage of revenue increased 160 basis points compared to last year. These increases primarily reflect higher selling costs related to the growth and expansion of our direct-to-consumer channel as we invest in new stores and e-commerce technology and our planned incremental advertising investments that enhance our brand equity and grow revenue. Higher incentive compensation expenses in the quarter were offset by an adjustment of $9.5 million made in the third quarter of 2017 to correct the timing of stock compensation accruals for retirement-eligible employees. Third quarter adjusted EBIT of $162 million was up from $147 million last year, driven by higher revenue and gross margin. Net income increased $40 million, primarily reflecting lower taxes, higher operating income and gains on the company's hedging contracts as compared with the third quarter of 2017.

Now I'll share more detail on the third quarter, focusing on the results of each of our 3 regions. In the Americas, revenue grew 7% on a reported basis and 9% in constant currency. Our wholesale business in the region grew 7% and was driven by strong growth in Levi's women's as well as men's and women's products in Signature. Direct-to-consumer grew 13%, driven by higher traffic and conversion across all channels and the performance and expansion of our company-operated retail network. Mexico and Canada continued to perform, with revenue in each up double digit this quarter, driven by growth in all channels. The full region's operating income increased 4% as higher revenues were partially offset by higher direct-to-consumer and advertising expenses this quarter.

Europe had another really strong quarter with revenue up 17% in constant currency and on a reported basis. The revenue growth was broad based across all channels. Wholesale grew 19%, reflecting the strength of the brand and the expanded product assortment across our customer base. Direct-to-consumer revenue was up 15% in constant currency, driven both by performance from existing stores, reflecting higher traffic and conversion, as well as new stores opened in the past year. The diversification of our portfolio in Europe continues to yield results, and the women's segment and tops now comprises more than half the region's revenue. The region's operating income grew 25%, reflecting higher revenues and gross margins, partially offset by direct-to-consumer and advertising investments.

In Asia, revenue was up 10% in constant currency and up 8% on a reported basis, reflecting growth across all channels. Revenue from company-operated stores grew double digits, primarily driven by comp store performance and net store expansion. The franchise channel turned in positive growth for the first time this year, reflecting the work we've been doing in this channel, and our China business grew double digits. The region's operating income grew 30% on a reported basis, reflecting higher revenue and gross margin, partially offset by higher SG&A to support retail expansion.

Turning to the balance sheet and cash flows. Inventory turns are up versus prior year. In dollar terms, our overall inventory was up 14% compared to this time last year, in line with revenue growth across the globe. Cash from operations for the first 9 months of the year was $205 million, a decrease of $90 million from last year. The decrease primarily reflects accelerated contributions to our pension plan of $80 million that we made in connection with the change in tax law.

Overall free cash flow for the first 9 months of 2018 was negative $14 million a decline of $162 million compared to the first 9 months of 2017. This was due to a decrease in cash from operations, as mentioned earlier; an additional $40 million cash used to repurchase shares of common stock in connection with our equity incentive program; and an increase in CapEx, which for the first 9 months of the year was $99 million as compared to $76 million a year ago. This was driven by increased technology investments in e-commerce and omnichannel capabilities as well as the build-out of our new flagship store in Times Square. We have opened 78 stores on gross basis in the last 9 months and remain on track for a full year target of opening approximately 100 stores gross.

Total available liquidity at quarter-end was approximately $1.3 billion, comprised of $613 million of cash on hand and $669 million available under our credit facility. Net debt at the end of the third quarter was $449 million, slightly up from $444 million at year-end, but our leverage declined to 1.5 from 1.8 a year ago. After 4 consecutive quarters of double-digit growth, which began in the fourth quarter of last year, we anticipate more muted revenue and EBIT growth in the upcoming quarter. With only a couple of months to go, we now expect full year revenue growth of around 10%, at the high end of the range we provided last quarter. And we now expect adjusted EBIT margin to be flat to slightly up, lower from our prior guidance of plus 30 basis points primarily due to higher incentive compensation, reflecting a higher revenue expectation.

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

[Operator]

[Operator Instructions] Your first question comes from the line of Grant Jordan.

[M. Grant Jordan, analyst]

I got 2 questions. The first one is you made the call out that you're seeing some progress on the Dockers in U.S. wholesale side. If you could talk about kind of what's driving that, that'd be helpful. And then the second question is I think you went over a little bit of an unfavorable SG&A comparison about compensation. If you could give us a little more detail on that.

[Harmit Singh, executive]

Chip, do you want to do the...

[Charles Bergh, executive]

Yes, sure, I'll do Dockers and wholesale. So Dockers, we do think there is some light at the end of the tunnel. You know, Grant, as you've been following us, this has been a challenge for a long time. But we did see growth this past quarter, 2%. A lot of that is from resetting the floors in the U.S., the wholesale floors for the launch of Signature 2.0, but it's the first time in a while since we delivered growth versus year ago. The -- so I think the important thing is we've now kind of set the floors with upgraded product, this is with the Flex 360 product, which we've seen really good results on some of the other fits since we've launched that about a year ago. So we're encouraged. Reception from our customers has been really, really positive and we'll start to get sell-through data here this month. So we're feeling pretty good about that. Our U.S. wholesale business, I think Roy and the wholesale team in general, we put a strategy together focused on winning with the winners, the fact that the brand is strong, the fact that we've been investing pretty significantly in marketing, it's driving a lot of traffic. It's driving traffic to our retail doors, we know that, and we think it's also helping to drive traffic at wholesale. We're also -- I think the other thing that's in play here, and we commented on it in the prepared remarks, we're doing a really good job of playing our portfolio of brands. We -- a lot of people think of us as just having Levi's, but we got Levi's, Dockers, Signature by Levi Strauss and Denizen and that combination of brands, we're playing the portfolio really well across the customer base and doing a really good job building our business with the customers that are performing right now. The fact that Levi's is really strong is also clearly helping us, and our women's business is performing exceptionally well at wholesale right now, off of relatively low base, I will admit, but that is helping to drive some of the growth as well.

[Harmit Singh, executive]

The -- Grant, to your question about incentive comp. Again like most companies, our incentive comp is driven by both the annual performance as well as the performance of our stock price, and our stock price performance I'll get into a bit more in detail. Our performance and -- both year-to-date and on expected basis is higher than we expected at the beginning of the year. So that's driving a higher accrual for the annual incentive comp. Our incentive comp is linked to stock price. Because we are a private company, we provide real stock to the executive team and phantom stock to the other senior leaders in the company. Unlike a public company, the stock or the phantom stock needs to be marked-to-market on a quarterly basis, given the expectation of where the stock is going to finally get valued. Our stock is valued couple of times a year by a third-party company and that valuation takes into account performance of the company both today and in the future as well as the industry. So the mark-to-market is the variable piece, which causes a little bit of volatility on a quarter-by-quarter basis. So as we think of the year and the EBIT margins for the year, despite our revenue growing at the pace it is and the gross margins growing at the pace they are, we're not only investing in incremental advertising, we think we've spent about 60 basis points more as a percentage of revenue in advertising this year than the year before, that's '17, which as you can see is leading to phenomenal top line results. But the variable piece on the stock comp is causing an increase in SG&A. Overall, if you think of EBIT as a percentage, our EBIT margins year-to-date are better than year ago. They're flat in the quarter. And as we think about the year, we think EBIT margins probably end the year flat to slightly better.

[Operator]

[Operator Instructions]

[Harmit Singh, executive]

Are there no further questions? Sorry, operator, didn't want to cut you off. You were saying?

[Operator]

We do have one question from the line of Jacqueline Crawford with Jefferies.

[Jacqueline Crawford, analyst]

How do you think about further diversifying your business through any additional acquisitions moving forward? And then from that, how do you think about leverage from this perspective?

[Harmit Singh, executive]

Sorry, what is your second -- the second piece of the question?

[Jacqueline Crawford, analyst]

Leverage and how it fits into any further acquisitions or diversification?

[Harmit Singh, executive]

Sure. So let me take a crack at the question. The phenomenal growth you're seeing over the last couple of years was largely driven by the strategies that were put in place and investments we've made. A core piece of our strategy was first and foremost to grow the profitable core and the core was our U.S. wholesale business, a key -- a couple of key markets as well as our bottoms business around the world and that is growing, as Chip mentioned. The other piece of the strategy was expanding for more or expanding in areas we -- where we were underpenetrated, which is essentially growing our tops business, growing our women's business and expanding in emerging markets. And diversification that has happened because as a business today, our business is, a, geographically, a lot more diversified. International as a percentage of revenue is higher than the U.S. and both are growing. Our tops and women's business have grown substantially over the last couple of years and in a big way, while growing -- while our bottoms business on the men's side has grown in modest fashion. So we believe that there is a long runway left for organic growth as we continue to diversify and grow our tops business, our women's business and our international business, and the numbers speak for themselves. So that's the first piece of it. The second piece of your question was about uses of cash and a target leverage. We have a pretty strong balance sheet, knock on wood, and thanks to the wonderful results that the teams across the world have brought to bear. We believe longer term, as we think about acquisitions, there are certain categories where we would take a hard look at, but any acquisition needs to not only be the right fit culturally as well as fit with our strategy, but also has to return a certain percentage in terms of an ROI. We don't necessarily have a target leverage ratio. We believe we're in a good place right now. We're one notch below investment grade as evaluated both by S&P as well as by Moody's. We're able to access capital at rates that investment grade companies can. So we feel good about where we are, and we're not necessarily targeting a certain leverage ratio. So over time, as you've seen our leverage ratio decline over time, the decline in leverage ratios will be a result of improved earnings as against pay down of debt. Does that address your question?

[Jacqueline Crawford, analyst]

Yes, yes. It's very helpful. And then actually speaking of ratings, there -- have you had any recent talks with rating agencies about a potential upgrade or what did they want to see?

[Harmit Singh, executive]

We continuously talk to them. We have a very transparent and open relationship with the rating agencies. In terms of discussions on our investment grade, again difficult to comment. As you know, rating agencies look at a couple of things. They look at what your financial policy is, both today and tomorrow as well as how diversified of a business you have. And in both aspects, our performance has improved and improved dramatically. Again we don't wake up every morning saying we want to be investment grade. We wake up wanting to grow the company and grow this profitably and that's what we're focused on.

[Operator]

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

[Harmit Singh, executive]

Yes. If there are any questions that people are trying to ask, but because of some telecommunication issue are not able to do it, we do have both Chris and Aida on one-on-one calls the next 2 days. So feel free to reach out and ask your questions, and we'll address them. In the absence of any further questions, we'd like to thank all of you for participating in our call and look forward to talking to you early next year as we report quarter 4 earnings. Thank you.

[Operator]

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