Levi Strauss & Co. (NYSE:LEVI) Q1 2023 Earnings Call Transcript

Levi Strauss & Co. (NYSE:LEVI) Q1 2023 Earnings Call Transcript April 6, 2023

Operator: Good day, ladies and gentlemen, and welcome to the Life Strauss & Co First Quarter Earnings Conference Call for the Period Ending February 26, 2023. All parties will be in a listen-only mode until the question-and-answer session at which time instructions will follow. This conference call is being recorded and may not be reproduced in whole or in part without written permission from the Company. This conference call is being broadcast over the Internet, and a replay of the webcast will be accessible for one quarter on the Company’s website, levistrauss.com. I would now like to turn the call over to Aida Orphan, Vice President of Investor Relations at Levi Strauss & Co.

Aida Orphan: Thank you for joining us on the call today to discuss the results for our first fiscal quarter of 2023. Joining me on today’s call are Chip Bergh, President and CEO of Levi Strauss; and Harmit Singh, our Chief Financial and Growth Officer. We have posted complete Q1 financial results in our earnings release on the IR section of our website, investors.levistrauss.com. The link to the webcast of today’s conference call can also be found on our site. We’d like to remind everyone that we will be making forward-looking statements on this call, which involve risks and uncertainties. Actual results could differ materially from those contemplated by our forward-looking statements. Please review our filings with the SEC, in particular, the Risk Factors section of our Form 10-K and the information included in our quarterly report on Form 10-Q that we filed today for the factors that could cause our results to differ.

Also note that the forward-looking statements on this call are based on information available to us as of today, and we assume no obligation to update any of these statements. During this call, we will discuss certain non-GAAP financial measures. These non-GAAP measures are not intended to be a substitute for our GAAP results. Reconciliations of our non-GAAP measures to their most comparable GAAP measures are included in today’s press release. Finally, the call in its entirety is being webcast on our IR website, and a replay of this call will be available on the website shortly. Today’s call is scheduled for one hour, so please limit yourself to one question at a time to give others the opportunity to have their questions addressed. And now, I’d like to turn the call over to Chip.

Chip Bergh: Good morning, and welcome, everyone, to today’s call. Coming off 26% constant currency growth in our year ago period were off to a solid start to the year. We grew first quarter revenue 9% in constant currency and 6% on a reported basis to $1.7 billion, while driving strong progress on inventory and advancing the key initiatives of our strategic plan. In our direct-to-consumer business, growth accelerated to 16% in constant currency, with record DTC sales, representing 42% of global revenues, three points ahead of last year. We delivered strong growth globally. Our international business grew 11% in constant currency, accounting for 56% of our total revenues. And even excluding the planned acceleration of wholesale shipments to support our U.S. ERP implementation, we achieved solid top line results and exceeded our expectations for EPS.

Our performance this quarter clearly demonstrates our strategies are working, driven by the strength of our brands, the growth of our direct-to-consumer business and the benefits of a globally diversified business model. We continue to make progress against our three strategic priorities, leading with our brands, prioritizing our direct-to-consumer business and diversifying our portfolio. Please note that for the balance of our remarks, Harmit and I will reference year-over-year revenue growth in constant currency. Starting with our first priority, leading with our brands. Beginning with the Levi’s brand, we grew market share again this quarter, achieving share leadership in the U.S. amongst the key 18- to 30-year old target consumer group, and we continue to grow share in women’s denim bottoms closing the gap to the number one position.

In the quarter, the Levi’s brand was up 9%, with our men’s bottoms business delivering a record Q1 and women’s bottoms achieving its highest revenue of any quarter. Men’s bottoms grew 9% with growth across all geographic segments, and we continue to fuel momentum in women’s bottoms, which grew 18%. We’re planning a steady cadence of newness through the year, and we continue to lean into trends, like with our newly launched women’s XL Balloon and Noddy’s Food and the shift in rise from high to mid and wider leg openings, all of which drove solid growth in the quarter. 2023 is an important year for the Company, marking our 170th anniversary and 150th of our iconic 501, the blueprint for today’s modern blue jeans. As we celebrate the heritage of our namesake brand, we’re using this important milestone to cement the next generation of Levi’s pants.

In February, we launched our largest coordinated global marketing campaign the greatest story ever worn. It kicked off during the grams where Bad Bunny also opened the shell wearing a pair of vintage 501 and has helped drive nearly 3 billion impressions with consumers worldwide. After all these years, love for the 501 has only grown and continues to experience exponential growth, a solid proof point of the strength of the brand. Q1 net revenues were up 25% on top of 50% growth last year and revenues for the 501 this year are expected to reach close to $800 million, which is nearly 70% higher than pre-pandemic on a reported basis. As we move through the year, we’re infusing energy and newness into our iconic 501 through new launches for him and her inspired by historical fits.

We also have a robust lineup of collaborations planned like our recent drop with the iconic streetwear brand Stussy, which sold out in one hour and an exciting partnership with NewJeans, the popular K-Pop girl band furthering our ambition to engage younger consumers. Our global DTC business delivered a record quarter, up 16% versus a year ago, driven by positive comp sales and traffic growth across brick-and-mortar mainline and outlet stores in all geographic segments as well as e-commerce. Our U.S. DTC business also achieved another record quarter of revenue, with especially strong performance in our U.S. flagships and larger tourist destinations. We continued our store expansion in Q1, opening 25 Levi stores globally including five mainline doors here in the U.S. The investments we’re making to elevate our consumers’ digital experience and strengthen their digital connection to our brands are paying off.

Even with consumers returning to our stores in large numbers, our e-commerce business grew 14%, driven by broad-based global growth and across all brands, including levi.com, which was up double digits. We continue to expand the breadth of our offering online while improving the user experience. Our loyalty membership was also up almost 40% in Q1 to nearly 25 million members, and this continues to translate to a higher level of spend among loyalty members. Our direct relationships with consumers and continued strong performance in our international wholesale business helped mitigate the impact of softer U.S. wholesale revenue. Global wholesale grew 4%, driven primarily by Asia and Canada. In the U.S., we accelerated approximately $100 million of revenue from Q2 to Q1 and primarily due to our Q2 ERP implementation.

As a result, our U.S. wholesale business grew low single digits on top of last year’s strong 25% growth. Additionally, while our core consumer has generally remained resilient, we continue to experience demand softness from the value-oriented consumers, most notably impacting our Signature and Denizen brands. As for our diversification strategy, we continued the strong momentum we have achieved in each of our major growth opportunities with international, women’s, tops and our other brands, Dockers and Beyond Yoga, each contributing positively to the first quarter growth. International revenues were up 11% or 14% excluding Russia. Europe saw 6% growth, excluding Russia, with most markets growing including our largest markets of France, the U.K. and Germany returning to growth.

Asia continued its strong momentum, up 22% as we experienced growth across all markets other than China. In China, after the Zero COVID policy was lifted, we have seen a bounce back in traffic with our latest results trending back to pre-COVID levels. Total company women’s revenue grew 12%, led by strong double-digit growth in both the Americas and Asia. Our tops business grew 4%, following 16% growth last year with strong performance in our DTC channel, up 12% for both women and men. And our other brands performed well in the quarter. Dockers continued to build momentum with net revenues up 29% and driven by broad-based double-digit growth across geographies and channels with DTC especially strong. Dockers e-commerce remained robust with over 30% growth in part supported by increased repeat customers and the brand’s loyalty program, which is now driving over 30% of sales in this channel across the U.S. and Europe.

And Beyond Yoga continues to make solid progress with revenues up 11%, driven by DTC AURs and volume and continued success with the brand’s expanded line of dresses. Our first two stores are off to a good start with two more planned to open in Q2, along with several further openings through the balance of the year. Finally, Michelle Gass has now been with the Company for 100 days as company President, responsible for the Levi’s brand and our global commercial and digital operations. As I expected, she and I are working together really well with both of us determined to make this a very successful transition. She has not surprisingly, landed great inside the organization, establishing her leadership very clearly on our business. For deep retail and e-commerce experience is obvious to the organization and she is already identifying both executional and organizational opportunities, which will help us accelerate profitable growth in our DTC women’s and tops businesses.

I was excited and confident when we hired Michelle as my eventual successor, and I’m even more optimistic about this company’s future today than it was before. And with that, I will turn the call now over to Harmit.

Harmit Singh: Thanks Chip. We achieved solid results in Q1 with sales up 9%, excluding the benefit from accelerated U.S. wholesale shipments primarily related to the ERP transition, our business grew low single digits. Focus on our strategic initiatives and the structural shift in our business fueled our results with our international business and direct-to-consumer channels driving almost 70% of the growth in the quarter. And we made significant progress reducing our inventory with total inventory dollars and units down meaningfully. We have achieved this in part by taking deliberate actions to clear inventory in the U.S. as well as reducing receipts in H1, putting us in a stronger position as we move through the balance of the year.

We remain committed to controlling costs with a focus on discretionary expenses while continuing to invest for the long term, including opening 18 net new stores and our ERP implementation in the U.S. following two successful implementations in Canada and Mexico. And despite the beat we delivered this quarter, we are maintaining our annual revenue and EPS guidance range, reflecting a cautious outlook on the macro environment even as we remain excited about the momentum in our direct-to-consumer and international businesses and the progress we’re making against our strategy. I will now provide more color on our Q1 performance and 2023 outlook. Net revenue increased 9%, driven by continued global momentum in our direct-to-consumer business. International revenues were up 11% with greater-than-expected results across most markets, while the U.S. was up 6%.

AURs were up mid-single digits, driven by broad-based growth across geographies, genders, categories and brands. Our direct-to-consumer channel sequentially accelerated with net revenues up 16%, driven by broad-based positive comp sales growth on top of extremely strong first quarter comp sales last year, driven by higher traffic, and higher volumes across geographies, including in the U.S. and Europe. Adjusted reported gross margin was 55.8%, 360 basis points below last year’s record 59.4% and but 120 basis points ahead of 2019 pre-pandemic levels. The deliberate actions that we took to reduce inventories in the U.S. that I mentioned a moment ago, coupled with a more promotional environment resulted in greater-than-expected pressure on gross margin in the short term, but the inventory level sets us up in a stronger position as we move through the year.

Gross margin benefited from price increases, lower freight expenses and favorable channel mix despite a negative 40 basis points impact from accelerated wholesale shipments. However, those benefits were offset by several logic transitory factors, including a 200 basis point impact from higher product costs, reflecting record cotton prices, higher ocean freight and demo charges as well as nearly 300 basis points impact from lower full-price sales. As we move through the year, the headwinds impacting gross margin should begin to recede, including from product costs given lower cotton pricing, freight and demurrage charges as well as lapping lower full-price selling and unfavorable FX from H2 last year. And the key contributors to our structurally higher margins that we have spoken to you about such as favorable channel, geographic and women’s mix will continue to benefit margins.

Adjusted SG&A expenses in the quarter was $757 million, up 7% from last year, driven primarily by a four-wall investment in support of the higher DTC sales and A&P investment to support our 501 marketing campaign for which the spend is skewed to the first half of the year. While adjusted EBIT margin came in line with our expectation at 11%, down from 14.9% last year, the decrease was driven almost entirely by the decline in our gross margin rate. Adjusted diluted EPS was $0.34, with a penny negative impact from foreign exchange. I’ll now take you through our key highlights by segment. In the Americas, net revenues grew 7% driven by the strength in DTC. The channels upload double-digits in the U.S. and achieved our second quarter of record revenue.

Overall, Canada was up double-digits and Latin America grew high-single-digits driven by increases across nearly all markets in the region. Europe returned to growth, with net revenues of 6%, excluding Russia on top of 21% growth in the prior year, driven by our DTC business. Geographically, growth was seen across most countries. Our largest markets France, the UK and Germany were collectively up low-single-digits with Spain and Italy were up double-digits. Strong demand for the Levi’s brand in Asia continued with revenues accelerating to 22% growth driven by all channels and markets outside China led by India. Asia ex-China was up 28%. As Chip mentioned, we are seeing trends improve in China and now expect China to turn profitable this year.

Asia operating margins also expanded 160 basis points to 18.5%, due to higher revenues and lower SG&A. And operating margin dollars were an all time record. Now looking to our balance sheet and cash flow. As discussed over the past year, as we execute the ERP transition, and as a result of actions to reduce receipts in H1, we are rapidly reducing our inventory levels. Q1 inventory was up 33% on a dollar basis a 25% sequential improvement from last quarter of up 58%. Core product represents more than 2/3 of our total inventory. We continue to expect sequential improvement quarter-over-quarter with quarter two being substantially lower than Q1 and expect levels to be in line with sales growth by the end of the year. Adjusted free cash flow was negative $272 million in the first quarter, driven by the timing of capital and the implementation of our ERP.

As a result of this, we used our revolver to support our cash position, as we sequentially improve our inventory through the year. We expect free cash flow to turn positive, enabling us to pay back our ABL draw. And of course net debt was approximately $834 million and overall liquidity was $1.2 billion. Our leverage ratio remains strong, although it did increase to 1.4 times compare to 1.1 times at the end of Q1 2022 due to a negative free cash flow. In the quarter, we returned approximately $56 million in capital to shareholders, including dividends of 48 million up nearly 20% from the first quarter of prior year. And in Q2 ’23, the Company declared a dividend of $0.12 per share in line with last quarter. Moving on to our outlook, even though we exceeded expectations in Q1, given it is early in the year and macro uncertainty, we are maintaining a cautious stance and reaffirming our fiscal 2023 revenue and EPS outlook.

We continue to expect net revenues between $6.3 billion and $6.4 billion reflecting reported growth are 1.5% to 3% year-over-year, and EPS in the range of $1.30 to a $1.40. While we’re maintaining our guidance overall, the way in which we get the head change from previous expectation, we expect the strong momentum in our global DTC and international businesses to offset softer wholesale trends in the U.S. and Europe as retailers continue to be cautious with your open to buy. As a result for the year, we expect nearly 60% of Levi’s brand revenue coming from international and DTC as a mix of our total business in the mid 40% range. Our DTC channel and international businesses are both fast growing with tremendous opportunity given our under penetration in these categories and importantly our high gross margin businesses.

In reported dollars, we continue to expect low single-digit growth in the Americas for the full year as strong growth in our U.S. DTC business and Latin America will be tempered by U.S. wholesale. We are pleased to see Europe return to growth in Q1, driven by the strength with trends coming in better than expected. The outlook has improved, but it’s still within the previously guided range of up low single digits. And based on the stronger trends we’re seeing in Asia, we now expect low double-digit growth and improvement from mid-single-digit growth in our previous guide. As I mentioned last quarter, we continue to expect ’23 to be a tale of two halves, with the first half weaker and the second half considerably stronger given a number of factors including the year, we are lapping promotional levels, record cotton prices impacting COGS in H1 and supply chain disruptions progressively getting better.

I will now provide color on Q2 and the full year. For the second quarter, the over delivery reported in Q1 will temper growth in Q2 but will not have an impact in the first half or full year. In Q2, we now expect revenues down high single digits to low double digits, given that we are in our ERP implementation and associated downtime our ability to ship product in the U.S. in excess of what we have contemplated in our guide is limited. Q2 gross margin is expected to meaningfully improve versus Q1 as a result of a higher contribution from DTC, but will be down slightly to last year’s and we continue to expect SG&A to be up mid-single digits relative to a year ago. In respect to the full year, given the higher levels of promotion than we previously anticipated, we now expect full year gross margin to be down approximately 50 basis points versus prior year’s 57.5%.

We remain confident that second half gross margin will sequentially improve as headwinds moderate. And we now expect the full year tax rate to be low to mid-teens versus our prior expectations of mid- to high teens. Prior to Q&A, I’d like to make three key points. First, while we expect to face continuing challenges through the year, the strength of our brand gives us confidence in sustaining our top line momentum and our Q1 performance serves as a proof point that our strategies are working. Europe’s returned to growth as well as our strengthening international performance and broad-based momentum in our direct-to-consumer business are all fueling profitable growth. Two, gross margin will progressively improve as we move through the year and headwinds abate and we expect to end the year with gross margins above 57% on our way to our long-term goal of 60%.

And three, we will continue to focus on controlling the controllables by reducing discretionary spending while continuing to invest in growing DTC as we open new doors, growth comp sales and accelerate e-commerce. With that, I’ll now go ahead and open the call for Q&A.

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Q&A Session

Operator: Thank you. The floor is now open for questions. Our first question comes from the line of Bob Drbul of Guggenheim.

Bob Drbul: I guess if I could just focus a little on inventories and gross margins to start off the call. On the inventory side, can you just talk about where you ended up in the up 33 versus your plan? Where you think inventory levels are specifically at your U.S. wholesale partner levels? And then on the gross margin side, tying it together with the inventory, can you talk about the expectations, I mean, Q2 gross margins versus your assumptions around the promotional activities specifically in the U.S.?

Chip Bergh: You asked the question that we thought you’d ask. So let’s start with it. Overall, we made meaningful progress on inventory, as I mentioned in my prepared remarks is down meaningfully both in dollar and unit terms is sequentially improving. If you could recall, we said when we reported Q4 that that’s the peak and it gets better, which is what is happening. We do believe that by the sequential improvement continues into Q2. And as I mentioned, inventory is largely clean. We did get rid of inventory to the extent we could, that did hurt margins, I’ll come to margins in a while, but I think the inventory improvement is largely driven by the fact that we proactively correct one buys and we were able to clear inventory.

To a question about, is this largely driven by the U.S.? Yes, unequivocally. It is U.S., U.S., for example, inventory levels at the end of Q4 were up 90% year-over-year and Q1 is down to 35% year-over-year. So, it’s a dramatic improvement in the U.S., and that’s why we think that it gets better progressively as the year progresses from that perspective. To your question about gross margin, the miss against our expectation was largely because we proactively were able to clear inventory as well as promotional levels were slightly higher than we anticipated. Quarter one is not a great read, if you look at it last year for full year gross margins. It will record gross margins last year when basically, there was very little promotion. Gross margins are at all-time high at 59.4%.

We ended the year at 57.5% a year ago into what’s happened on gross margins in the quarter? Let’s start with what I call the good guys, and a lot of these good guys are going to be here for a while, which is the fact that we took prices up. We are seeing lower airfreight and a favorable channel mix. So we quantify all that, it’s about 150 basis points that we see continue through the year. And then what I call or what we call transitory, it will receive as the year progresses. 200 basis points is a combination of commodity, increased cotton in H1 was barred. Our product was barred when cotton was an all-time high, that along with some demurrage costs, et cetera, is about 200 basis points. That begins to recede as we step into H2, but I think the tailwind is about, I would say, 170, 180 basis points because there is some inventory that we bought in H1 that we clear in H2.

And the rest is promotion levels, which were much higher than a year ago. The two pieces. One, last year this time, we didn’t really sell anything under the full price. Now we’re selling something a little higher and then promotions. We expect — and we’re conservatively anticipating this. This is typical to predict, but we’re anticipating that promotion levels continue through the year. So as you think about the year, annual expectation on gross margin, I think we’re going to be about relative to last guidance about 70 basis points down at the end of the year and that’s largely driven by higher promotion levels, which we expect offset by better channel mix. DTC is going to be higher. International is going to be higher. Europe is rebounding nicely.