Levi Strauss & Co. (NYSE:LEVI) Q2 2023 Earnings Call Transcript

Levi Strauss & Co. (NYSE:LEVI) Q2 2023 Earnings Call Transcript July 6, 2023

Levi Strauss & Co. beats earnings expectations. Reported EPS is $0.04, expectations were $0.03.

Operator: Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co’s Second Quarter Earnings Conference Call for the period ending May 28, 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 second 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 Q2 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. Please note, for the balance of the remarks, Chip and Harmit will reference year-over-year revenue growth in constant currency. 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: Thank you, and welcome everyone to today’s call. We delivered a solid quarter in line with our expectations. Our results reflect two very different dynamics in our business, on one hand, strong DTC and International and on the other continued softness in U.S. wholesale, which I will address in a moment. Revenues for the quarter were down 9%. However, this was mostly attributable to the $100 million shift in revenue from Q2 into Q1, primarily due to the ERP implementation in the U.S. which we discussed on our last call. Excluding this shift, Q2 was down 2% versus prior year and first half revenue was flat against a difficult plus 23% comparison versus year ago. Our strategic growth priorities are performing at or above our plan.

Our DTC business, the most premium expression of the Levi’s brand globally continues to perform very well, up 14% in Q2 with broad based positive comp growth and AURs up mid-single digits. The continued strength of our DTC first strategy, which grew to a record 44% of total sales in the first half underscores our confidence in unlocking Levi’s tremendous brand value. Our international business also remained strong growing 8% or 10% excluding Russia, led by continued momentum in Asia and Latin America. International has been the fastest growing part of our business over the last few years and it represents one of our largest opportunities going forward. However, this strength in International and DTC has been more than offset by a soft U.S. wholesale business.

Today, U.S. wholesale represents less than 30% of our total revenues, down from 40% a decade ago as our strategic focus has been to grow DTC and International. And while first half U.S. wholesale revenue was down from last year on difficult comparisons, U.S. wholesale revenues are still up 2% versus 2019 with gross margins up as well. There are two main drivers to the slowdown of our U.S. wholesale business. First, the macro effects of higher inflation and a slowing U.S. economy has put increased pressure on the price sensitive consumer. Second, as we have mentioned for several quarters, our inventory backlog created supply chain challenges in our U.S. distribution centers resulting in our inability to fulfill all demand. The lower fill rate resulted in higher customer out of stock and less newness on the floor the last few quarters.

We’re taking a number of actions to address these issues, regain competitiveness and restore growth to our U.S. wholesale business. First, we are taking surgical price reductions on a select number of our Red Tab Tier 3 wholesale offerings, which we know are most price elastic and where the price gap versus competition widened too far. Importantly, we are not taking price reductions in U.S. mainline full price stores, nor the vast majority of our U.S. wholesale assortment including the 501 and women’s fashion fits, which are all less price sensitive. Finally, we are not taking any price reductions on our international businesses where we continue to demonstrate strong pricing power as seen by the results. Second, with the ERP implementation behind us, and as our inventory levels continue to improve, we are seeing an improvement in order fill rates, now nearly back to historical levels, which will result in better sell-in for us and in stock positions at retail.

Further, this will allow us to deliver the strong newness we have lined up to hit floors in July for the key back to school and holiday seasons. We are confident that these actions will improve our U.S. wholesale results going forward. Now let’s turn to the progress we achieved in executing our three strategic priorities, starting with our first priority, leading with our brands. Due to the ERP shift, I’ll speak to the brand’s results for the full first half. The Levi’s brand grew low single digits on top of 22% growth last year. Levi’s bottoms grew low single digits with women’s growth slightly stronger than men’s. We continue to drive denim trends with products like our super low boot giving women more options for looser fits with lower rises.

In the U.S, we’re seeing strong demand with the $100,000 plus income consumer, particularly in our mainline stores, helping drive share gains in the premium end of the jeans category in the U.S. We’ve also maintained our share leadership with the key 18 to 30 year old demographic and for U.S. jeans overall, we gained market share across men’s and women’s. The greatest story ever worn marketing campaign and celebration of the 501’s 150th anniversary generated billions of impressions globally and drove strong 501 demand, with revenues up low double digits in the first half against more than 40% growth last year. Moving on to our second priority, being DTC first. As I mentioned, global DTC delivered strong double digit growth in Q2, led by broad based positive comp sales and traffic growth across company operated stores in all geographic segments.

U.S. DTC was also strong, led by our mainline stores, which saw continued strength in flagship and tourist destinations. We’re also seeing the benefits of our investments in digital and the impact of our new Chief Digital Officer, Jason Gowans. Our e-commerce business grew 21% in Q2, driven by both higher traffic and better conversion. Strength was global and across all brands as we continue to expand the breadth of our offering online, while improving the user experience and customer journey. Consistent with driving growth in DTC and e-commerce, we just opened a state of the art digital fulfillment center for the East Coast in Kentucky and we’ll begin shipping from there this month. This completes bringing our U.S. e-commerce business in-house, which will drive more agility and inventory positioning, reducing lead times, improving customer satisfaction and accelerating digital margin expansion over time.

We are also continuing to expand our loyalty program, with over 26 million members, up 40% over prior year. Loyalty member transactions and average transaction values grew across all segments, a positive signal as we drive continued growth in membership. Overall, our digital and e-commerce businesses remain under penetrated versus peers and the channel represents a tremendous sales and profit opportunity for the company. Our third strategic priority is to continue to diversify the business. On a first half basis, our total company women’s and tops revenues grew 1% and 3% respectively, both on top of more than 20% growth last year. Women’s was driven largely by the Levi’s brand, particularly in Asia. In addition to ongoing strength in denim fits for her, including lower rises, women’s also saw growth from newly launched dresses, cargoes and overalls.

Tops were driven by strength in Levi’s men’s. We remain enthusiastic about our opportunity to significantly grow these businesses as we continue to diversify our offerings. As for our other brands, Beyond Yoga’s revenues accelerated double digits versus Q1, growing 28% in the quarter, driven by continued DTC strength. Overall, first-half sales were up 19%. The brand saw notable success with sports bras and dresses and it opened two additional stores in Southern California, bringing the total store count now to four. Dockers was also impacted by weakness in U.S. wholesale, while the brand experienced continued strength with DTC up 22% and international up 10% in the second quarter . Adjusting for the ERP shift, Dockers would have been flat in Q2 with sales up 8% in the first half.

Before I turn it over to Harmit I wanted to share my conviction in our future and the strength of the Levi’s brand around the world. Michelle and I have traveled extensively this last quarter, visiting a number of key international markets, including Mexico, India, China and Japan. And everywhere we have been the Levi’s brand is incredibly strong and we are winning. We’ve met with consumers, customers and franchise partners and we’re inspired by their view of Levi’s and our future. Our strength in DTC and international combined with the actions we’re taking to fix our U.S. wholesale business give me confidence that we can accelerate as we go into the key holiday season and end-of-the year with momentum heading into next fiscal year. Finally, also giving me great confidence in our future is how Michelle has come up to speed on the business, organization and opportunities.

Her current remit is big, the Levi’s brand globally, all of our commercial organization through which the Levi’s P&L rolls up and the digital organization. She has dug in and has played a key role in figuring out our path forward on U.S. wholesale. She is also all over our tops and women’s businesses and I am confident, you’re going to see a lot more good work as those products come to-market later this year and into 2024. She is also starting to make some smart organization moves to set the company up for the long-term. As I said before, I was confident when we hired her that she would be a great successor and now after six months I’m even more sure of myself as she will take this company to the next level when she becomes CEO. With that, I will turn it over to Harmit.

Harmit Singh: Thanks. In the second quarter we delivered on our objectives for revenue, profitability and inventory, while continuing to advance our strategic initiatives in a challenging environment. We delivered strong results in our global direct-to-consumer channel and are seeing positive momentum in our international business. These businesses today make-up the majority of our total revenue and are the primary drivers of our long-term growth and margin objectives. We also made progress in several other key areas of our business. In the quarter we meaningfully reduced our inventory position and our U.S. service levels improved as we exited the quarter, giving us confidence to now say we will end the year with inventories below prior year levels, ahead of our initial plan.

Also, highlighting our commitment to long term investment, we accomplished a major milestone with our U.S. ERP upgrade, a cloud solution allowing us to leverage data more productively. That is also the foundation to growing our DTC and digital businesses. Related revenue impacts are also now behind us. While we are lowering our outlook for the back-half of the year, given the dynamics impacting U.S. wholesale, we have several initiatives Chip mentioned to drive stronger results in this business in the second half and the longer term. In the second half revenues, gross margins, EBIT margin and EPS are all expected to be up to prior year. To put this into perspective, second half sales are expected the same run-rate as the first-half. The back-half will also benefit from incremental sales drivers and margin tailwinds from lower product costs and freight, laying a solid foundation for next year.

And we will end the year with a structurally stronger business with a higher growth and gross margin accretive DTC and international businesses, representing a greater share of the company. I will now provide more color on our Q2 performance and then move to our outlook. Total company revenue of $1.3 billion decreased 9% versus prior year, down 2% when adjusting for the ERP shift. Our DTC channel posted 14% growth on top of 22% growth in Q2 2022 with continued broad-based positive comp sales growth across geographies, driven by higher traffic and volume. Company operated e-commerce also accelerated, up 21% with growth across all segments and brand. Global wholesale was down 22%. Excluding the shift, the channel declined low double digits on top of nearly 20% growth last year.

Growth was strong in Asia and Latin America, but more than offset by softer performance in the U.S and Europe. Adjusted gross margin was a record 58.7% up 50 basis points against last year’s record Q2 performance. Favorable channel and geographic mix, price increases, lower airfreight and FX more than offset the impact of lower full price sales and higher product costs. As a reminder, our H1 2023 gross margins are approximately 300 basis points higher than 2019. We continue to expect several transitory cost headwinds to abate in the second half. I’ll provide more color momentarily when discussing our outlook. Adjusted SG&A expenses in the quarter were $753 million, up 6% to last year. The increase was primarily to support DTC growth with company operated store count up 6%, as well as A&P investment to support our 501 marketing campaign that largely ran in H1.

Adjusted EBIT margin was 2.4%, in line with our expectation and adjusted diluted EPS was $0.04. Here the key highlights by segment. In the Americas, net revenues declined 22% on top of 17% growth a year-ago. DTC, growth of 6% was driven by all markets. Latin America, in particular, saw continued momentum with 18% growth driven by the strength in Mexico, Brazil and the [Andes] (ph). Europe again grew, excluding Russia, up 1% on top of a 15% increase last year due to broad based DTC growth across all countries. DTC, excluding Russia was up 14% on top of more than 60% growth last year. Europe saw growth across most countries led by increases in Italy, Germany, the UK, Poland and Spain. Asia’s very strong performance further accelerated with revenues up 27%, driven again by growth across all channels, particularly DTC.

We are encouraged by the improved trends we are seeing in China, which saw sales return to pre pandemic levels and growth across all channel with notable strength in mainline brick and mortar. Thailand, Turkey, Japan and India we’re also highlights. Asia has operating margins also expanded 370 basis points to 12.3% due to higher gross margin and stronger SG&A leverage. Now looking to our balance sheet and cash flows. We continue to make progress on our plan to sequentially improve inventory levels. Q2 inventory dollars were up 18%, up 15 point improvement from last quarter and units were up 8%. Importantly, inventory improvement did not come at the expense of margin and current inventories are healthy, with gold co-products representing more than two-thirds of total inventory.

We continue to expect sequential improvement and to end the year below prior year levels ahead of our plan. The peak of inventory is behind us and we’re taking a prudent approach going forward, focused on moderating receipts and leaning into our ability to chase, a benefit of our globally diversified supply chain. Inventory management will be aided by our recent IT investments, including our ERP, enabling real-time visibility to our inventory on an omnichannel basis and across our network. Adjusted free-cash flow was $211 million in the quarter, up from $13 million in the second quarter of prior year. As we continue to improve our inventory throughout the year. We also expect to end the year with positive free cash flow. Our cash flow generation also allowed us to repay a $100 million of outstanding ABL borrowing this last week.

In the quarter, we returned approximately $48 million in capital to shareholders via dividends, which increased 20% from Q2 last year. Dividends are up 20% in H1 versus prior year and for Q3 2023 we have declared a dividend of $0.12 per share, in-line with last quarter. Now moving to our updated guidance for fiscal 2023. While we have experienced stronger than anticipated trends in our international and DTC businesses where we expect continued strong momentum, we are lowering our outlook due to softer U.S. wholesale trend. We are not guiding revenue growth of 1.5% to 2.5% as compared to growth of 1.5% to 3% previously. We expect full year adjusted EPS to be within a range of $1.10 to $1.20 from a prior range of $1.30 to $1.40. There are three fairly equivalent factors driving the change in guidance.

First, our slightly lower revenue expectation and the resulting fixed cost deleverage. Second, lower expected H2 gross margin mainly due to our targeted pricing actions. And third, non-operating FX losses and a higher tax-rate. For the year in reported dollars by segment, we now expect a low-single digit decline in the Americas despite continued strength in U.S. DTC and in Latin America. U.S. growth is still expected within the previously guided range of up low-single digits and based on the stronger trends for Asia, we now expect low-teens growth and improvement from the low double digit growth in our previous guide. Adjusted gross margin is now expected to contract approximately 90 basis points from prior year’s 57.6% as compared to an expectation for a 50 basis point decline previously.

The incremental 40 basis point decline is due to the strategic pricing actions we are taking to drive volume and capture market share in U.S. wholesale. Despite all the puts and takes during 2023, we expect that gross margins will end the year, up almost 300 basis points versus 2019. To put it into context the new guidance, I’ll provide some color around our H2 expectations in total. We expect revenues to grow mid-single digits. As mentioned versus 2019, H2 sales will maintain the same run rate as H1. Similarly, we expect U.S. wholesale to maintain the plus 2% growth rate versus 2019 we delivered in H1. Adjusted gross margin is expected flat to up slightly in H2, driven by lower product costs and freight, partially offset by our targeted pricing actions.

However, because the pricing actions are evenly distributed between the corridors and the benefit of lower product costs doesn’t fully materialize until Q4, we expect Q3 gross margins to contract slightly more than 200 basis point year-over-year with Q4 gross margins up slightly more than 200 basis points over prior year. Looking at H2 in total, adjusted EBIT margin is also anticipated to expand nearly a 100 basis points to roughly 11.5%, but with Q4 adjusted EBIT margin significantly higher than Q3. Lastly, we expect an H2 tax rate in the low double digits versus 1% last year. To conclude, we expect to end the year structurally stronger setting us up well for 2024 and beyond. Our stronger growth, higher gross margin, premium DTC and international businesses will account for a greater share of our revenue, nearly 45% and 60%, respectively.

Driven by our ongoing execution in surgical pricing action U.S. wholesale will stabilize and end the year as a smaller share of our business at less than 30%. Inventories are expected to end 2023 below prior year levels. Our 2023 gross margin is expected to remain 300 basis points higher than 2019 and we will exit the year with Q4 EBIT margins north of 12%. And importantly, we continue to return cash to our shareholders with a payout ratio of 150% of free-cash flow substantially higher than our targeted 55% to 65% communicated at our Investor Day. Lastly, while we are lowering our H2 outlook because of U.S. wholesale, we expect the strong growth in our large fast growing DTC and international businesses to continue, which as U.S. wholesale stabilizes and COGS improves will position our unique business model to generate significant financial leverage beyond 2023.

With that, we’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. [Operator Instructions] Our first question comes from the line of Matthew Boss of JPMorgan. Your question please, Matthew.

Matthew Boss: Great. Thanks. So Chip, could you elaborate on current demand trends that you’re seeing in the U.S. relative to Europe today? Could you provide an update on the denim category and market share trends? And then Harmit, what is your level of expense flexibility if macro trends worsened globally in the back half?

Chip Bergh: Hi, Matt. Thanks for the question. I’ll kind of take this — I’ll start with the category, then I’ll dig in a little bit deeper and talk market share and the contrast between U.S. and Europe. So first of all, on the category, you may remember that we only get quarterly data here in the U.S. So outside of the U.S. internationally, we don’t get — we don’t really get any market share data or market data. So all we’ve got is U.S. data. And as you know, since the pandemic, there have been wild swings within the category, extreme downs, extreme peaks, extreme downs, lots of volatility. But if we take a look on a past 12 month basis through May, we are up against the biggest spike in category growth. So the May 2022 past 12 months versus May of 2021 past 12 months was a 20-plus percent spike in the category.

That’s the base that we’re up against right now. And if you look at it on a past 12 month basis, we were down modestly versus that peak. The key point, though, when we take a look at the denim category overall in the U.S. is the category today on a past 12-month basis is 12% bigger than it was in 2019, 12% bigger than the pre-pandemic period of time, and that’s on a dollar value basis. I’ll talk about market share here in a minute. In the U.S., as we talked in the script, in the prepared remarks, it really is a story of two different channels, U.S. wholesale being very soft, paradoxically U.S. DTC much stronger. And I say paradoxically, because we’re very strong in our U.S. mainline business, which is the most premium expression of the brand.

But digging into U.S. wholesale, there are really two key dynamics, both of which we have some control over, and I’ll speak to that. One is clearly the lower or moderate income consumer is being squeezed. And that is driving some of the big category dynamics. Much more price sensitivity, when we look at our business, our value brands are down double digits, U.S. wholesale down double digits and softness in that channel. But also, as we’ve talked through over the last several calls, we’ve had our own internal supply chain challenges with the inventory levels we were carrying, which were causing fill rate issues which led to customer service issues and ultimately, customer out of stocks. Now that our inventory levels are returning to closer to normal levels, we are seeing our service levels improve.

And as we’re into this new quarter, we are seeing that those improved service levels are improving the out-of-stock conditions, which is improving sell-through. So we’re feeling optimistic about that. But for the first half, our U.S. wholesale business is still up 2% versus pre-pandemic. So despite the fact that we’re down double digits, it’s up against such a big base period. As I said, paradoxically, DTC is relatively much stronger, full-price mainline and e-com all performing really well. U.S. DTC comp kind of low to mid-single digits in the second quarter and first half. And e-commerce was really strong with double-digit growth in U.S. in Q2. I guess the last thing I’ll say about the U.S. I’m going to talk market share just real briefly, which, in part because it’s such a key indicator of brand health.