Levi Strauss & Co

NYSE:LEVI

Earnings Call Transcript 2018-Q4

[Operator]

Good day, ladies and gentlemen, and welcome to Levi Strauss & Co. Fourth Quarter and Fiscal Year Earnings Conference Call for the period ending November 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 February 11, 2019. Please use conference ID 5788266. 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 annual financial report on Form 10-K with the SEC, which is now available on our website.

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

[Charles Bergh, executive]

Thank you, Aida. Good afternoon, everyone, and happy Chinese New Year. Thank you for joining us today. We had a strong finish to the year and an outstanding fiscal 2018. We delivered revenues of $5.6 billion, up 14% on a reported basis and 13% in constant currency. We haven't delivered that rate of growth in more than 25 years, and this is on the back of 8% reported growth in fiscal 2017. Importantly, we did it profitably with adjusted EBITDA up 13% for the year.

It's clear we've built a solid foundation, and the investments we've made over the last several years in retail and omnichannel, marketing and category diversification are paying off.

Our growth was strong and broad-based and included the following highlights, all in constant currency on a full year basis: men's was up 8%, women's up 28%, bottoms up 8%, tops up 37%, wholesale up 11%, direct-to-consumer up 16%.

All 3 regions grew, with Europe leading the pack, up 21% for the year, and nearly every market we operate in, grew.

We're gaining market share as the growth we're delivering outpaces the category. These results reflect the strength and diversification of our business and Levi's evolution into a lifestyle brand.

Levi's brand continued its momentum and maintained its position at the center of culture, with 13% revenue growth after delivering 9% growth in 2017. We also had a number of strategic collaborations that drove positive buzz and energy, including Justin Timberlake, Peanuts and Mickey Mouse.

Our where-to-play strategic choices to grow our profitable core business, expand for more and become a leading omnichannel retailer all continued to pay off. First, one of our profitable core business, total men's bottoms, our biggest business, was up 3% for the year, consistent with our expectations. Our top 10 wholesale customers grew 10% for the year. U.S. revenues were up 8%, and our next 4 largest markets grew 10% collectively. When this collection of profitable core businesses grows, it generates the cash to invest in our other strategic choices.

Second, our strategy to diversify the business by expanding for more continued to deliver strong results. As noted earlier, our total women's business grew 28%, exceeding $1.6 billion in revenue and now represents almost 1/3 of our total business. This was the 14th consecutive quarter of growth in women's, with the last 8 quarters being double digit. Yet despite this important impressive performance, we remain underpenetrated in women's and have a long runway of growth ahead of us.

Our total tops business grew 37%, surpassing the $1 billion milestone. This business has more than doubled since 2015, reflecting growth across a wide spectrum of tops, not just graphic tees, but fleece, outerwear and trucker jackets for men and women.

Our third strategy is to become a world-class omnichannel retailer. Our direct-to-consumer business grew 16% for the year and has now grown double digits for 11 consecutive quarters. Since we last spoke, we opened our new flagship store in New York's Times Square, which is the largest Levi's mainline store in the world. It's an incredible shopping experience, and it is far outperforming our previous Times Square location.

Our own e-commerce business also continues to contribute to our direct-to-consumer success, with full year growth of 16%. We executed a number of strategic e-commerce partnerships throughout the year, which are an important part of our goal to be where our consumers are.

In 2018, we continued to make progress in key focus areas of the business: U.S. wholesale, China and Dockers. Despite more than 300 wholesale door closures last year, we grew our U.S. wholesale business 7%, driven by Levi's women's and Signature. We fully expect that this channel will continue to be challenging, but just as we demonstrated last year, we are going to continue to play to our strengths and look for ways to profitably grow our business.

Strengthening our business in China continues to be a priority, and it's encouraging that our mainline outlet and shop-in-shops were up for the year. China represents roughly 20% of the global apparel market, yet it's less than 5% of our business today. So we see China as a huge long-term opportunity. We believe we have the right leadership and plans in place to grow our business in this key market and deepen our engagement with the Chinese consumer.

We remain steadfast in turning around Dockers business, and we're pleased to see pockets of growth this year, driven by the relaunch of the Signature Khaki and ongoing marketing investments around the Always On campaign. The brand is doing especially well in Europe, growing 16% for the year, driven by the casual, Khaki and cargo pant as well as tops.

Overall, it was a great fiscal 2018, and we've got a lot of momentum that we need to continue. I credit all of our teams around the world for delivering an outstanding year for the company.

And now I'll turn it over to Harmit to walk you through the fourth quarter and year-end financials. Harmit?

[Harmit Singh, executive]

Thank you, Chip, and congratulations on receiving the National Retail Federation Visionary award. Welcome to everyone joining our call. I'll walk you through our fourth quarter and full year results before turning to our outlook for 2019. My comments today will reference comparisons on a year-over-year basis in U.S. dollars, unless I indicate otherwise.

Fourth quarter net revenues of $1.6 billion grew 9% on a reported basis and 11% in constant currency. This is on top of 11% constant currency growth we reported in the fourth quarter of 2017.

Reported net revenue was up 7% in wholesale and 13% in our direct-to-consumer channel, driving strong results in all the regions. Our growth continues to be increasingly diversified, and we ended the year with strong momentum.

Our company-operated store base now stands at 824 after the net addition of 74 stores in 2018. And globally, our brand-dedicated store footprint, including franchisees, stands at roughly 3,000.

Fourth quarter gross profit of $847 million increased $64 million, inclusive of $16 million of unfavorable currency translation. Gross margin of 53.2% declined 20 basis points as the margin benefit from the shift in channel mix towards direct-to-consumer was offset by transactional FX and inventory clearance.

Heading into 2019, we took the opportunity to move some excess and obsolete inventory to start the year in a healthier place.

Fourth quarter SG&A expense of $720 million increased $86 million, inclusive of $12 million in favorable currency translation. SG&A as a percentage of revenue increased 200 basis points compared to the fourth quarter of last year.

Each of the following reflect about 1/4 of the increase: higher incentive compensation expenses driven by strong results, which also reflects the appreciation of the company's stock price; higher selling costs related to the growth and expansion of our direct-to-consumer channels, as we missed in new stores and e-commerce technology; our planned incremental advertising investments that enhance brand equity and grow revenues; and higher-than-normal distribution costs primarily in the Americas necessary to support higher growth and to address some operational inefficiencies as we responded to the levels of growth we saw.

We're investing in distribution efficiencies and capacity going forward and do not anticipate this higher distribution cost rate to persist over the long term. Beyond these increases are base SG&A costs levered, driven by a strong revenue growth.

Fourth quarter adjusted EBIT of $129 million was down from $157 million last year, as strong revenue growth was more than offset by higher costs related to increased advertising investments and higher compensation, reflecting strong company performance.

Reported net income declined 17% for the quarter to $97 million, primarily due to a tax charge related to the impact of the new tax law as well as the lower adjusted EBIT.

Now I'll share more detail on the fourth quarter results of our 3 regions. Net revenues in the Americas grew 8% on a reported basis and 9% in constant currency. Direct-to-consumer revenues for the region grew in the mid-teens, reflecting stronger traffic in both mainline and outlet stores as well as online. Wholesale grew in the mid-single digits, driven by strong growth in the Signature brand and the Levi’s women's business. Mexico and Canada continued to perform, with revenue in each up double digit this quarter, driven by growth across channels. The full region's operating income was flat, as higher revenues were offset by an increase in selling expenses and higher advertising this quarter.

Europe had another exceptional quarter. Net revenues grew 13% on a reported basis and 17% in constant currency. Growth continued to be broad based across markets, channels, products and consumer categories. The region posted several achievements, all in constant currency.

Success in the women's business continues, up 19% on the back of strong growth last year. The tops category grew 45% over prior year, with both men's and women's contributing to the growth. Direct-to-consumer revenues were up 21%, driven by continued strong traffic and conversion.

Wholesale revenues were up 14% on a broad-based growth across our customer base, primarily from the Levi’s brand, while Dockers also grew. And operating income for the region grew 32%, reflecting improved leverage driven by higher net revenues.

In Asia, net revenues grew 5% on a reported basis and 10% on a constant-currency basis, reflecting growth across all channels, including the franchise channel, demonstrating the work we have been doing there.

Operating income for the region was down $7 million year-over-year, primarily reflecting that the region's higher revenues were more than offset by incremental marketing investment and an increase in omnichannel investments. Specifically, in China, revenue was flat, which is what we expected. We are starting to see some traction in our China turnaround, and our business there is improving, as growth in direct-to-consumer offset a planned decline in e-commerce. We still have significant untapped potential in this market.

Now switching gears to our full year results. Fiscal 2018 net revenues grew 14% on a reported basis and 13% in constant currency. On a reported basis, wholesale net revenues grew 11% and direct-to-consumer grew 18%, driven by strong growth in all regions. Gross margin for the full year was 53.8%, up 150 basis points, primarily reflecting increased direct-to-consumer sales and international revenue growth as well as sourcing savings.

Adjusted EBIT was up 13% on a reported basis, and adjusted EBIT margin was 10%, flat to prior year as higher revenues and gross margins were partially offset by higher costs related to the expansion of the company's direct-to-consumer business, increase advertising investments and higher compensation expense, reflecting stronger company performance. Additionally, we increased our charitable contribution to $11 million in 2018 after contributing $9 million in 2017.

Full year net income was flat to prior year. Comparatively speaking, most things went our way. In 2018, we delivered higher operating income and lower interest expense and recorded gains on our hedging contracts in comparison to losses on hedging contracts in 2017. Additionally, we had a debt refinancing charge in 2017. However, all these positive factors were fully offset by a one-time $143 million charge related to the change in tax law.

While we will have a lower tax rate in the future under the new law, we had to write off significant deferred tax assets to their revised lower realizable value.

Turning to our balance sheet and liquidity. At year-end, we had cash of $713 million and a total liquidity position of $1.5 billion. Net debt declined to $339 million from $444 million in the prior year and leverage declined from 1.8 to 1.6.

We delivered strong free cash flow of $95 million in 2018, a $190 million lower than the prior year. Free cash flow from higher adjusted EBIT was more than offset by inventory investments to support our growth. Additionally, we accelerated $80 million in pension contributions, paid $31 million more for share buybacks, capital expenditures increased $40 million to $159 million and our 2018 dividend payment of $90 million was $20 million higher than 2017.

The CapEx increase reflects technology investments in e-commerce and omni capabilities as well as a build-out of the new flagship store in Times Square and the opening of 115 stores on a gross basis. Our disciplined approach to capital allocation has consistently generated return on invested capital in the mid-teens over the last few years and in the high-teens in 2017 and 2018.

Inventory at year-end was up 16%, primarily reflecting high inventory levels in all regions as we gear up for 2019. Inventory turns improved in 2018, and our overall year-end inventory position is healthy, as over the last few months, we've been cleaning up some excess stock.

Finally, we wanted to provide some color on holiday results, which were really strong. For us, holiday is a combination of November and December. Keep in mind that these 2 months fall in 2 separate fiscal reporting grids and are not necessarily indicative of our first quarter 2019 results. For our recent holiday period, revenue grew low double digits year-over-year on top of mid-teens growth last year. These results reflect strong growth and higher traffic in all channels across the 3 regions. In the U.S., we discounted less than we did last year and were generally less promotional than the overall industry.

Now I will provide some guidance for fiscal 2019. Coming off a double-digit year, we anticipate that momentum will continue, albeit at a more modest pace, in part due to ongoing challenges at U.S. wholesale as well as geopolitical risks, including Brexit and the trade conditions with China. Additionally, due to the timing of our fiscal year ending the final Sunday of November, fiscal 2019 will not contain the benefit of a Black Friday, which normally represents about half a point of annual net revenues. Accordingly, we expect constant-currency net revenue growth of mid-single digits. We anticipate gross margin and SG&A as a percentage of revenue to be flat to slightly up on a constant-currency basis, primarily reflecting continued growth and investment in the direct-to-consumer channel. We expect constant-currency adjusted EBIT margin to be roughly flat.

Note that our estimates for SG&A rate and adjusted EBIT margin would be about 25 basis points better, if not for the lack of Black Friday. We are stepping up capital investments behind projects that drive profitable growth. CapEx is expected to increase by around $40 million to about $200 million, reflecting incremental investments, including initiating the implementation of a global ERP platform, increasing capacity in our distribution network and building the foundation for a new data and analytics organization.

We expect to open nearly 100 new company-operated stores on a gross basis. We have announced a dividend of $110 million, a $20 million increase from last year payable in 2 equal installments in the first and fourth quarters of 2019.

And finally, primarily given the strengthening of the U.S. dollar, we expect that currencies will unfavorably impact reported revenues and adjusted EBIT. Based on today's spot rates, we estimate the unfavorable FX impact to be roughly 50 basis points for revenue and 100 basis points for adjusted EBIT.

With that, we'll now open it up and take your questions.

[Operator]

[Operator Instructions] Your first question comes from Grant Jordan from Wells Fargo.

[M. Grant Jordan, analyst]

So revenue came in better than what we were looking for in the fourth quarter, but you didn't give much leverage on the SG&A line. Can you talk a little bit more about what some of the headwinds were there on SG&A?

[Harmit Singh, executive]

Sure, Grant. Thanks for the question. As we explained, there were a very couple of factors that drove the deleverage of the incremental expenditure in the quarter. There were, basically, 4 factors, and contributed -- each contributes about 1/4 of the 200 basis points increase as a percentage to revenue that is reflected in the call. The first was a high incentive comp driven by strong results as we close the year and also reflects the appreciation of the company's stock price, as I've explained earlier, because we are structured as a private company, and we do grant stock to a broad-based set of employees. There is a substantial group that gets the stock, which is settled in cash and, from an accounting perspective, has to be mark-to-market every quarter. So that was one piece of it. The second is, as has been the case, as we've grown our direct-to-consumer business, we continue to invest in new stores and e-commerce technology. I mentioned in the script that we opened, on a net basis, 74 new stores. So that does contribute to incremental expenses. We did step up advertising in the quarter, as an example. Advertising as a percentage of sale was close to 9%. On an annual basis, it's 7.2%. A year ago, in '17, it was 60 basis points less. I would, at this point, note that for '19, as a percentage of revenue, we're keeping advertising flat to 2018 as a percentage of revenue, which is about 7.2%. So that was the third factor. And the fourth was higher distribution costs, primarily in the Americas, again, necessary to support the high growth. We had a bang up quarter and -- so that required us to staff up, for example, our DCs to make sure we were able to service the demand. And so that was the fourth factor. We don't expect these headwinds to continue as we step into '19. And as a result, I'd say, a large part of this happened in the quarter and will probably remain in the quarter.

[M. Grant Jordan, analyst]

Okay. That's very helpful. I guess, the only other question I would have, on the global ERP rollout, can you give us an idea of timing and kind of how you're going to test that process as it goes through?

[Harmit Singh, executive]

Yes, sure. I should have clarified. We do have an ERP system. And like most of our peers in the space, we're all upgrading to the latest and the best. That better reflects a company and a business that has higher direct-to-consumer than what existed years ago and also reflects the fact that we're a global company. It's going to be -- because we are upgrading, our rollout is going to take, I would say, a couple of years, I would say, anywhere between 3 to 5 years. We're going to do this gradually. And because we're going to do it gradually and over time, it's going to de-risk the implementation, but importantly, allow us to drive a better user experience and ensure that the conversion is less of a technology conversion, but more of a conversion on upgrade that mirrors where business is growing and, importantly, will improve the user experience that allows us to not only leverage data, but also use that to drive profitable growth long term.

[Charles Bergh, executive]

Let me just add 1 or 2 colored commentaries on this, Grant, because it's a good question. We do -- as Harmit said, we do have an ERP platform. It's actually several different instances of SAP that are really old and this is another big investment that we're making so it continue to build and strengthen the foundation -- the foundational capabilities for us as a company. And this new platform will serve as the core for all real-time transactional processing, including order management, inventory management, omnichannel allocation and a single global financial system to just help us better run the business. It's going to help us drive simplification and agility, and it's the right investment for us to be making. It is -- as Harmit said, and just to underscore it, it's a significant investment, but we will roll it out over time with a couple of lead markets starting, hopefully, soon this year. So that's kind of how we're thinking about it.

[Operator]

Your next question comes from Karru Martinson with Jefferies.

[Karru Martinson, analyst]

So you guys have talked about in the past finding the bolt-on acquisitions being careful and using them to grow the portfolio that you have. Has anything changed on that front as you guys grow your home brands, so to speak, into women's yourself?

[Charles Bergh, executive]

Yes. I'll start, Harmit. We continue to look for what I would call organic acquisitions. The best acquisitions we can do are buying back franchisees, taking back licenses and things of that nature, distributor relationships that we wind up converting all the time, and we're constantly evaluating those. We've got a few in the pipeline, and we'll see where they come out. But those have, historically, for us, been really good acquisitions. It's a business we know pretty well. It's our brands. And when we wind up buying back franchise businesses or taking back a distributor, we tend to accelerate growth in almost every single instance. They tend to be really good acquisitions, and we still have plenty of opportunities around the world in that particular category.

[Karru Martinson, analyst]

And when you guys look to China -- that's 5% of your sales today. Would the thought be to grow that organically? Or would you look to partner or perhaps bring in some M&A opportunities?

[Harmit Singh, executive]

No, it's going to be organic growth, Karru, as far as China is concerned, again, as we said, less than 5% of the business, but about 20% of the global apparel market. We have reset that business. We've got a new leader in place, and she is busy thinking through her strategic growth plan. And over time, we will walk you through the change. But the good news is that the business, after we reset it, is beginning to show signs of profitable growth. And as you know, it takes time, and we've set in ensuring and have confidence that this would be a long-term play for the company.

[Karru Martinson, analyst]

Okay. And you guys had a fairly remarkable strong growth in both wholesale and direct-to-consumer. How do you guys differentiate with your customer base, the products that you're putting through both channels? How do you keep those separate or are they separate?

[Charles Bergh, executive]

The -- that's part of the secret sauce, I guess, particularly in some of our more complex markets. I mean, the U.S. is probably the best example. It's our most complex market. And some of our customers here in the U.S. are bigger than some countries in terms of the size of the business for us. So really big meaningful customers. We operate 200-plus stores here in the U.S. as well. We operate online with our owned and operated e-commerce business as well as with some pure-play guys. So it's an incredibly complex market. And part of the reason, I think, we've been successful over the last 18 months or so, if you're in the U.S., despite all of the challenges that the wholesale channel has faced, is the team -- the Americas team has done a phenomenal job of managing the marketplace as an ecosystem. And we had much less price disruption, if you want to call it that, where one customer starts copying another customer and the pricing goes down the rabbit hole. And part of how we do that is by doing a really good job differentiating between channels and between customers with our product assortment. And that has helped a lot. It's also helped a lot that the brand is really, really strong. We do in our mainline doors here in the U.S., of which there are only a little bit, slightly more than 30, 30, 31 mainline doors. We tend to sell better and best products, so it's premium price to the typical wholesale product in the U.S. And that's part of it as well. But, again, the reason we've been successful in the U.S. is the team has done a great job managing the marketplace as an ecosystem, doing really good product differentiation in each of the assortments with each of our big customers and finding new vectors for growth for the company and for our brands.

[Operator]

[Operator Instructions] And your next question comes from Jim Duffy with Stifel.

[Jim Duffy, analyst]

Looking to FY '19, you provide a lot of good detail on the guidance. What's the operating philosophy should revenue came in better than expectations across the year? Do you have places to reinvest that? Or is there a leverage opportunity? What's the general philosophy as you think about that?

[Harmit Singh, executive]

Yes. I'd say, clear leverage opportunity, Jim. We have shown that in '18. We started the year with an expectation as the business performed a lot stronger. We were able to do 2 things. First, we flowed the extra revenue into profit so EBIT is a lot stronger and better. And second, we took the opportunity to invest for the long term in -- against initiatives that we know pay back both in the short term and the long term. So for example, we upped our advertising investments, we did a few more remodels of the stores that we owned and operated, et cetera. And so we constantly look at finding ways where we continue to differentiate ourselves relative to our competitors, so that we can grow market share over the long term. In terms of category expansion, today, Levi's is more of a lifestyle brand. We offer head-to-toe look across our direct-to-consumer channel and slowly, but surely, also being cascaded across our wholesale customers. So we will continue to look at ways to do that and differentiate ourselves, but there will be a profit flow-through and increase in leverage.

[Charles Bergh, executive]

It'll be a high-quality problem for us to have again. But one of the things about us, Jim, is we are financially really disciplined. We will have a list of investment opportunities. And if revenue upside comes in and it creates an opportunity for us to invest in things that are going to continue to help us drive growth in the long term, we'll make those kind of investments if they're good-quality investments. And if not, we'll flow it to the bottom line and try to provide a good balance of top and bottom line growth at the end of the year.

[Jim Duffy, analyst]

Makes a lot of sense. And then the wholesale revenue growth has been consistently healthy. Is that a reflection of per-door productivity improvements? Or does it include some element of distribution growth?

[Charles Bergh, executive]

It's a little bit of both. And I couldn't break it down percentage-wise right off the top of my head. But I have characterized U.S. wholesale as a little bit of a melting iceberg and part of the challenge because that's a very profitable business for us. Part of the challenge to the team has been for every door that closes, we've got to figure out where are we going to get a new door. And so the team has been really successful in opening up new points of distribution, higher-end accounts. For example, we've got -- expanded space with Nordstrom, we've opened up Lord & Taylors and Bloomingdale's. It helps if the brand is very, very strong. And then the other thing that we've done is, the brand is very healthy, we're a traffic driver right now, and so we've used the strength of our business and the growth that we're generating in our own retail stores to convince customers to give us more space in their bigger doors. And they should be focusing on winning with the winners, and we're one of the winners right now. So it gives us an opportunity to build space in our key customers in their top doors and to help them drive traffic and revenue growth.

[Operator]

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

[Charles Bergh, executive]

All right. Great. I just want to thank everyone for dialing in. I know it's a long break between the end of our third quarter and the end of our fourth quarter. And before you know it, we're going to be back with you reporting the end of our first quarter in the next few weeks, really. So thank you all very much for dialing in, and talk to you again soon.

[Operator]

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