Good afternoon, everyone. I'm Kimberly Greenberger, Morgan Stanley's branded apparel and footwear and softlines retail analyst. We're very pleased to host Levi's at our Life After COVID conference. This is their first participation at a Morgan Stanley retail conference. As many of you know, Levi's is one of the world's largest brand name apparel companies and global leader in jeanswear. With nearly $6 billion in sales in the latest year and over $6 billion in market cap.
Today, we're joined by Harmit Singh, Executive Vice President and Chief Financial Officer, Chris Ogle and Aida Orphan, representing investor relations. Harmit joined Levi in 2013, continuing a successful career across various industries. Prior to his current role, Harmit held a number of chief financial officer positions at multiple global companies, including Hyatt Hotels, Pizza Hut, and Yum! Restaurants International. Harmit, welcome, thanks again for being here.
Thank you, Kim, for having us, and we're looking forward to our first retail conference with Morgan Stanley and your team.
Thank you so much. Today we plan to discuss Levi's broader direct-to-consumer and e-commerce strategies, as well as how COVID-19 may have changed Levi's business and strategies. We'll start today's session with a moderated question and answer format, followed by audience questions. For those of you joining us via the webcast, please click the Ask a Question button on the webcast to submit your questions. There can be a slight delay here, so we encourage you to submit those questions early. Before we dive in, I need to remind everyone that you can find important disclosures on the Morgan Stanley Research Disclosure website at www.morganstanley.com/researchdisclosures.
Additionally, Levi's comments today may contain forward-looking statements and non-GAAP metrics subject to the safe harbor statements and reconciliations in Levi's SEC filings. Please note in our discussion today, Levi's will not be discussing the current quarter trends or any updates to their outlook for the fourth quarter and beyond, as provided in the recent third-quarter earnings call. With that, I'm happy to get started with our first question for the day. Harmit, COVID-19 has altered the way many global brands seek to connect with consumers. Can you start by sharing with us how you are seeing COVID-19 change consumer behavior and how Levi has altered its strategies for a post-COVID world?
Thank you, Kim. Thanks, everybody, for participating and attending today's meeting. This is my fifth recession. My first recession was in Asia in the late 1990s. It's my first in the apparel industry. As you think through the different crises that we have faced, the pandemic being one of them, we have a playbook. Our playbook is all about managing through the crisis, but emerging stronger. To your question about how are consumers' behavior changing. I think it starts with the orientation of the consumers towards strong brands.
We believe the workplace is casualizing and casualizing at a faster pace. The digitization of the consumer experience has accelerated. What would have taken probably years is happening very quickly. Importantly, we believe that consumers are becoming a lot more conscious. They're moving from conspicuous consumption to conscious consumption, which really plays to our strengths. It's all about brands that not only focus on value, but values.
It's about driving sustainability, keeping safety of the consumers at the forefront. As you know, in quarter three, we announced the launch of our recommerce program. It's a $28 billion, $30 billion market, and it's our first entry into it. Levi's is one of the few brands that are sold and resold. People collect it and resell it. We thought we might as well lead from the front. In terms of your question on strategies. We are pivoting to focus on three important priorities for us going forward. One is, we have great brands. We're going to be brand led, and that's all about ensuring that we're able to generate and drive trust for our consumers, as well as reach out to the younger consumer. The second is, we are going to be a D2C-led company.
This company grew up as a wholesale company. We think D2C is the way to go. D2C, direct-to-consumer business, has grown double digits pre-COVID, and it allows us to connect directly with our consumer. It also has a higher gross margin as well as allows us to build more of a lifestyle orientation for our product. The third focus is about diversification. Diversifying geographically, diversifying our product categories, diversifying our channels, and diversifying our brand portfolio. All this is underpinned by a couple of things.
One is what we call digitization of our consumer, employee, and customer experience. The second is a real focus on financial discipline and growing margins, improving our ROI, et cetera, driving working capital management. The third is all about operations excellence. That's how we're thinking about it, and we're using this time, as I talked about, emerging stronger to accelerate our transformation that began seven, eight years ago.
Wonderful. Okay. Excellent. That's a great introduction. Maybe we can just talk about the past year, and build on that. As you mentioned, Levi is redirecting its efforts to growing its direct-to-consumer business and sort of shifting a little bit the strategic focus in the organization. Since the onset of COVID, we've obviously seen a marked acceleration in your e-commerce growth already. It's been really exciting to see.
I think during your third quarter call, you mentioned that you expect higher growth rates in the channel post-COVID, so the growth rate at a higher rate to be sustained, and that your e-commerce business could double in size within a five-year timeframe. Do you think COVID has actually enhanced, in some ways, Levi's long-term direct-to-consumer revenue opportunity? How do you see COVID altering the e-commerce opportunity, both on your own website and on some of your partner brand websites?
Yeah. It starts and ends with the consumer. The puck was already headed there. COVID basically accelerated the way the consumer shops, and we are focused on riding that wave. Let me talk a little bit about the business. About 10 years ago, our direct-to-consumer business, and I include our franchise business, which is reported in wholesale, but we have over 2,000 franchise doors around the world. If you take the two, it was about 26% of our total revenues. In 2019, it was close to 44%. It's higher today.
What we have talked in our Q3 earnings is, it's going to be north of 50% of our business. The gross margins on our direct-to-consumer business are higher than wholesale. For example, our e-commerce gross margins are 20 percentage points higher than wholesale. In brick-and-mortar, EBIT margins are accretive to the company operating margins.
More importantly, it allows us to engage and connect directly with our consumer. Our global digital footprint, in this, Kim, I include not only our levi.com and dockers.com sites, I include our pure players like the Zalandos, the Amazons, the Tmall, and the .com of our wholesale customers. That digital footprint is expected to grow over time. It was, I think, a little over 20% in quarter three. It was about half that pre-COVID. We think over time it gets to a third of our business and allows us to directly engage. What we are doing on our end is accelerating our omni-channel capabilities, buy online, pick up at store.
We've launched an app. This morning there was excitement in the same family because my daughter discovered we just relaunched our collaboration with New Balance sneakers. She went to the app w e didn't have an app s he went to the app, tried to order it i t was already sold out. I'm trying to figure out a way to get her some shoes. I think that's the advantage w e didn't have an app w e were testing it pre-COVID w e've accelerated that. We have a loyalty program today w e have over a million consumers. It's exciting because the stats that I like to see now, revenue and EBIT is great, but I want to see the new consumers that are signing up.
I want to see repeat. I want to understand what lifetime value is, and that only can come with direct engagement of our consumers. We're seeing great repeat. Repeat is close to 40%. We are able to market programs on a more digitized way. We're also using AI. Our algorithms are geared towards people who are spending more.
People who are not spending is geared to trying to drive them to the brand, et cetera. I think a lot to come, but very excited about where DTC can take us over time. It's all about direct engagement with our consumer, which we can then bring back to our wholesale customers and say, "This is how we are doing it. Why don't you do it this way?" I think the magic of the two is music, right?
Absolutely.
Yeah.
Absolutely. That's an excellent segue into the next question here, which is just about your wholesale strategy. Obviously, wholesale remains of critical importance to Levi. Can you run through your U.S. wholesale strategy, and how you see this channel evolving in the next year or even the next five years?
Yeah. Many years ago when DTC was 26% of our business, US wholesale was over 50% of our business. It's down to about 30%. I think over time, it settles in the mid to high 20s. The component of it, and we have some great wholesale customers, the component of it is healthier. Over time will grow, right? The reason we feel good about it, if you take our quarter three, the non-digital business with our largest traditional brick-and-mortar department stores was less than 10% of our total revenues. It used to be much higher years ago.
Our focus with the traditional retailers is all about driving more business in the productive doors. The underperforming doors will close. We kind of build that into our algorithm and our model, but we are really focused on the productive doors and building more of a lifestyle orientation in the productive doors with higher AURs. In terms of why I believe U.S. wholesale will be healthier, you heard about our expansion opportunity with Target. That's a healthier business. We are focused on driving more of a premium distribution, so that the AURs go up.
We are focused on driving value with our Signature and Denizen brands, driving new distribution where it makes sense, as well as growing our digital piece, which is with pure players as well as the dotcom business, because we think that's where the puck is headed. That's our focus on U.S. wholesale. I would say healthier than it was pre-COVID as we emerge from the crisis.
Fantastic. Okay, excellent. That sort of brings us to the international strategy. Maybe you could compare and contrast how international differs from the domestic business. How do you think about international expansion opportunities and category expansion opportunities?
Sure. 75% of the apparel market is outside the U.S. International today is about 60% of our business. Seven, eight years ago, international was in the minority. The business was skewed to the U.S. Over the last seven to 10 years, we have changed the structure of the business. International, if you think about product categories, in good, better, best, international is more of a better and best product category, or what we call tier 1 and tier 2. The U.S. is still primarily a good market, having grown up in the wholesale business, which we're trying to, over time, diversify.
The areas of focus internationally, Europe remains our strongest region. It was the strongest region in quarter three. The brand's really strong. We believe it's got the right balance between direct-to-consumer and wholesale. It's 50/50 between direct-to-consumer and wholesale. If you take the franchise business out of wholesale, our direct-to-consumer plus franchise is clearly on the majority. Asia has been rocky for us, but it's our greatest opportunity.
We have a wonderful track record in India and Japan. China, our business is still small. It's about 3% of our total business, and we think we can grow that over time. Clearly an opportunity t o your question about product categories, I think tops, women's, and outerwear are becoming a larger share of the business and continue to be under-penetrated. As we establish more of a lifestyle orientation, I think you'll see outsized growth as we saw pre-COVID from these categories.
Our M&A focus, which is inorganic M&A, not that we need it, because we believe we can grow this business organically in the mid-single digit growth that our growth algorithm has. Our M&A focus is around categories of accelerating tops, women's, outerwear, and potentially entering athleisure, because it's a consumer segment. It's no longer a trend, it's a consumer segment, and with the casualization of the workforce, it's something that we'd be open to look at.
Great. Fantastic. Okay. That takes us to margins and the margin opportunity at Levi. You've talked about several factors that will continue to benefit gross margin over the long run. Obviously, one of them being the growth in direct-to-consumer. You also, on your recent conference call, talked about increasing average unit prices. You mentioned today more profitable wholesale partnerships. How do you think all of these things in aggregate shape gross margin going forward?
Yeah. We're confident we can expand gross margins for the reasons you talked about. Our geographic growth international is higher gross margins. Our channel growth driven by DTC, higher gross margin. We've premiumized the brand, higher AURs. We continue to negotiate fairly well with our vendors. We take price increases and we increased our women's styles in the U.S. by $10. That is sticking. We took a price increase in quarter three in Mexico. That's sticking.
Wherever the brand is strong, which we think is in large parts of the world, expect us to take pricing because I think as we introduce new innovation in the product, as we introduce new styles, I think that will probably help. Gross margin has been a point of strength. Even during COVID, we've continued to expand it. We talked about ending the year with higher gross margins than in 2019, which means we managed our inventory really well. If you think about an ongoing growth algorithm in the post-COVID world, it does call for a 40-50 basis points increase in gross margins annually.
Fantastic. That is excellent. Okay. Next item on the P&L, SG&A. Are there meaningful differences or important differences in SG&A between the channels? How should we think about the impact to operating margin, for example, as your e-commerce business scales?
Yeah. It's a great question. It's the change in structural economics. We figured out as the puck was headed more towards DTC, we had to get ahead of it. As you know, brick-and-mortar has costs that wholesale doesn't. Both people cost, capital cost as you open stores, et cetera, and e-commerce has costs which are different from wholesale. They're higher, digital advertising costs, and there's constant upgrade in technology. We just upgraded our websites in Europe and the U.S., and that led to higher conversion rates and everything else, but they're higher costs. As we think about it, we believe that our EBIT margins do leverage on brick-and-mortar. Higher gross margin, higher SG&A for EBIT margins.
e-commerce, which used to be a drag on the P&L, which is losing money because we were investing in e-commerce people and technology over the last couple of years, actually has turned profitable this year. It's in the black a year prior to schedule. As the business continues to grow, and that's why we talked about doubling the business, we think that only drives higher profitability. Our view is if e-commerce business doubles, operating margins of a business that's double the size as today would be at par or accretive to the business from that perspective.
As you know, we talk about a company that generates high returns. Return on invested capital is important. Our brick-and-mortar stores on an average, we do this exercise annually where we look at three-year return on invested capital, not on a cash basis, but after capitalizing the lease, that's in the mid to high teens. Our assets are returning well. That's how we think about both operating margins, gross margins, and returns.
Fantastic. Okay. Thinking about operating margin targets, and if I reflect back on the third quarter call, you mentioned Levi's is on track to deliver a 12% adjusted operating margin when you get back to pre-COVID revenue levels. This represents obviously a nice level of improvement from what you actually saw in 2019 at 10.6%. What are the key factors that you see supporting this higher margin in the future on what would be similar revenue to 2019?
To go down the P&L, I'd say higher gross margins, as we talked about, given all the initiatives that we mentioned. On the SG&A, during COVID, we accelerated the structural realignment of our cost base. We took our head count, we have cut travel, we've renegotiated every contract out there with third parties, and we are renegotiating every rent for our big brick-and-mortar stores. I'm talking to quite a few landlords directly, especially the big ones in the U.S., and my team around the world, and our regional presidents are doing similar stuff.
In a combination of all this, we think structurally eliminates about $200 million. We need to reallocate half of that towards higher advertising as we scale up AI. We are upgrading our ERP. We call it Project Solar. It's part of something that I look at. Like most other companies, it's about digitizing and automating the foundational piece. We are accelerating omni and e-commerce. That's where the cost will be, or the savings, half of that will be reinvested. That's why we think once we get back to pre-COVID revenue levels, our operating margins will get to 12% or over that, and that's where we are confident that we can get there.
Fantastic. You mentioned there that you, in addition to running finance, also oversee IT. Can you talk to us about Levi's top IT initiatives and your CapEx plans? You've also mentioned progress on liquidity and working capital initiatives beyond CapEx. What are your capital allocation priorities, including any potential M&A?
When I in a company about seven half years ago, we were spending about 2.5% of our revenues on capital, and most of the technology investment was geared towards maintenance CapEx. We were fixing things that were broken. What we've done over the last two years as we developed the turnaround strategy for the company, we developed a mindset that technology is a true enabler of growth and profitable growth over time. If you take our $160 million of capital that we have guided, we spend this year, two-thirds of that is towards technology.
It's being spent on omni-channel capabilities, it's being spent on the ERP upgrade, it's being spent on AI and other initiatives, et cetera. A lot of work on the digitization, omni capabilities, et cetera, all of which will drive growth. The remaining third is largely spent on new stores. We opened 60 stores. We signaled we'll open on a gross basis 100 stores. We're spending money against that, spending money on remodel of our doors.
We're digitizing our store footprint. The consumer interaction is a lot more engaging. We have tailor shops and you can go into the store, order online, the associate ordering, et cetera. There's a lot of that's currently going on. To your question about other capital allocation. We're a dividend-paying company. That's what we said when we did an IPO. We've been paying dividends for many, many years. We actually suspended it given the lack of visibility. The fact that we were not very sure where the COVID crisis would take us. We do declare dividends every quarter, we will on a quarterly basis.
As you know, in quarter three, we generated positive cash flow, probably a little earlier than we thought. Largely because I took the opportunity to drive working capital efficiency, which is about collecting our bills. It's about making sure we pay our vendors, we pay it as per market practices, and importantly, turn and churn our inventory. Our investment in inventory is at reasonable levels. I would say, I think we'll review dividends on a quarterly basis when we report earnings. We just need to see a little bit more visibility into the future.
We have a very strong balance sheet. We have over $2 billion of liquidity between cash on hand as well as access to our revolver, which is untapped largely. Our leverage ratios have gone up largely because EBITDA, thanks to quarter two, and quarter three declined dramatically. As things come back, we think our leverage ratios improve. I've been asked whether we want to be an investment-grade company, my view is that being one notch below investment grade is a good place because we can access capital as we demonstrated.
We raised half a billion dollars, I think, in April or so, we did it at very competitive rates. To your question about M&A. We are a disciplined group. As I said, we believe there is a long runway organically. Having said that, we have a small M&A team now. A team of two, small and mighty. We look at things, but our focus is largely gonna be on three filters. It's something that culturally fits in. Sustainability is important, that should be of paramount importance.
Strategically, it should be focused on the categories I talked about and allow us to leverage our scale. Allow us access to younger consumers and allow us to accelerate our direct-to-consumer business. There is the financial criteria, which is all about driving accretive earnings as well as decent ROI. That's what we think about.
Fantastic. It looks like we've probably got time for one more question. You referenced, Harmit, in just some of the changes that you're seeing among your consumer base here, through COVID, that you are seeing an increase in consumers' focus on sustainability. Here at Morgan Stanley, we're also very much focused on the investment allocation process that involves ES and ESG lens. It sounds like there are a number of ESG initiatives at Levi. Maybe you could talk about those and have any of them changed or altered as we've gone through the pandemic?
Sure. ESG has been in our DNA. I thank Levi Strauss himself because he donated to charity from the first profit he made way back. The Haas family has done a phenomenal job. When we joined the company, we started with a real strong foundation. One of our working philosophies is profit through principles, which means that it's not only important what we make, but how we make it. I was speaking at a ESG conference yesterday, and I said, in my view, actually ESG should be expanded to add another E, which is employees.
Employees, environment, social, and governance. In terms of our initiatives, a lot of our initiatives start with sustainability, but quickly become innovative. I'll talk to you about our Project F.L.X. or Future Finish program, which is all about reducing chemicals, but it turned out to be laser technology that allows us to now finish product faster and without a lot of chemicals and at lower cost, because it allows us to churn inventory a lot faster.
During the crisis, as we have taken initiatives, our actions have been guided by our values. We extended the payment terms for our vendors, but we set up a supplier financing program with IFC to ensure that our vendors were able to access a lower price supplier financing. We had to unfortunately lay off people, we took salary cuts, even though dividends could be paid because of a wonderful liquidity situation, we decided that, manage all our stakeholders, so we kept the dividends suspended in Q3 as an example.
We continue to donate against social causes as a company. We have stood up for social justice and equality for many years. We have spent over $30+ million on driving the right causes. We have taken stands. As you know, we came up with Time to Vote, along with Patagonia, we teamed up with Time to Vote. Around the midterm elections in 2018, we came up with a coalition that expanded to about 1,800 companies and people who have given time to vote, time to volunteer, et cetera. We've just released our diversity stats.
We have been very vocal in the fact that we will be very transparent with our diversity stats. We have announced that we are under recruitment drive to add a Black person to our board. We're going to increase the representation of our leadership group so that it better represents the profile of the country. We're really focused on things like that. In my group, for example, in finance, I've established a mentorship program for diverse candidates. We just started. There's a lot that we do. Obviously, it's not enough, and it's incumbent on all of us to collect together and drive this around the world. That's what we are focused on. We think it's a core piece of our DNA and our strategy, and it's what differentiates us from a lot of others.
Well, what a nice note that is to end our session today on. Harmit, I want to thank you on behalf of Morgan Stanley for joining us today. For all of you who tuned into today's session, thank you very much for your kind attention. Have a great rest of the day.
Thank you, Kim. Thanks for inviting us, and a shout-out to Aida and Chris who helped me behind the scenes. Thank you, all of you. Have a nice day. Have a good conference.
Thank you. That concludes today's session.
Thank you. Bye-bye.
Bye-bye.