Good day, ladies and gentlemen. Welcome to Levi Strauss & Co. second quarter 2017 earnings conference call for the period ending May 28th, 2017. All parties will be in a listen-only mode until the question and answer session, at which time instructions will follow. 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 on July 17th, 2017, by calling 1-855-859-2056 in the U.S. and Canada, and 1-404-537-3406 for all other locations. Please use conference ID 40251852. This conference call also is being broadcast over the internet. A replay as a webcast will be accessible for 2 months on the company's website, levistrauss.com. I would now like to turn the conference over to Aida Orphan, Investor Relations at Levi Strauss & Co.
Good afternoon. 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 judgments 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 quarterly report on Form 10-Q, 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 investor section of our website, as well in today's earnings press release. Today we filed our quarterly financial report on Form 10-Q with the SEC, which is now available on our website. I'll turn the call over to Chip Bergh.
Thanks, Aida. Good afternoon, everyone. Thanks for joining us today. We're very pleased with our second quarter and first half results. Our strong performance year to date demonstrates the strength of our diversified business and our ability to deliver against our 2017 priorities despite the challenging retail environment. We had a really good quarter, with revenues increasing 7% in constant currency, driven by broad-based growth across all channels and geographies. Our strategies are working and our business is stronger and more diversified than it's been in decades. Adjusted EBIT grew 7% for the quarter, even as we continue to invest in brand building and expanding our direct-to-consumer business. We're pleased with our performance across our Levi's Signature and Denizen brands, as well as our international business during the quarter.
The Levi's brand grew 9% globally, led by momentum in women's and tops, both of which are key to our Expand for More strategy. This quarter marks eight consecutive quarters of growth for our women's business, which is up 24% this quarter and now represents over $1 billion annually. Our tops business grew 39% and was the largest driver of the year-over-year increase in total company units sold, with 3 million more tops sold during the quarter. The Levi's Batwing tee continues to be a runaway success. This year marks the 50th anniversary of the Batwing logo, the strong performance of our branded apparel worldwide signals the power of the Levi's brand in the marketplace. Europe continued to be our strongest region globally, up 20% this quarter in constant currency. Our four largest mature international markets, France, Germany, Mexico, and the U.K., collectively grew 13% this quarter.
Revenue grew across all channels of distribution. Globally, the wholesale channel grew 4% in constant currency, primarily reflecting 18% growth in Europe. We continue to see consistent growth in our direct-to-consumer channel, up 14%. Our performance this quarter and year-to-date reinforces that LS&Co. is a different business than it was five years ago. The execution of our strategies have helped place the company in growth mode, which is an exciting and energizing place to be. We're investing in our brands and direct-to-consumer channel and innovating for the future. We also recognize the areas where we still have work to do. Our brands continue to offer significant organic growth opportunities, including strengthening the Dockers business, returning U.S. wholesale to growth, building on the momentum we've seen in tops and women's, as well as improving our business in key emerging markets around the world, including China.
In summary, although the environment is still incredibly challenged, we remain focused on leveraging our brand portfolio, returning U.S. wholesale to growth, and continuing the expansion of our international and direct-to-consumer businesses. The strong top-line growth we've seen year-to-date is a testament to the execution of our strategies and the hard work of our teams around the world. With that, I'll turn it over to Harmit for a review of our financial performance and an update to the full fiscal year outlook. Harmit?
Thank you, Chip. Welcome to everyone joining our call. My comments today will reference second quarter comparisons on a year-over-year basis in U.S. dollars, unless I indicate otherwise. I'm pleased to report second quarter revenue of $1.1 billion, up 6% on a reported basis and 7% in constant currency. Global revenue increased across all regions and channels. Direct-to-consumer revenue grew 14% in constant currency, driven by the performance of existing stores, expansion of the network internationally, and the growth of our e-commerce business. Direct-to-consumer now represents about a third of total company revenue, within that, sales through our own e-commerce sites comprise 13% of the direct-to-consumer channel. In the wholesale channel, global revenue grew 4% in constant currency, reflecting strong results in Europe. Global wholesale revenue was up for the second consecutive quarter.
Gross margin of 52.3% is up from 51.1% a year ago, reflecting the margin benefit from revenue growth in our direct-to-consumer channel and international business. SG&A of $496 million is up one point as a percentage of revenue, reflecting the expansion of our retail network, e-commerce business, and higher advertising expenses. Despite this increase, we are gaining leverage on the investments in the expansion of our brick-and-mortar store network. We had 61 more company-operated stores at the end of the second quarter compared to prior year. Adjusted EBIT grew 7%, reflecting higher revenue and gross margins, and Adjusted EBIT margins improved slightly. This is despite the $6 million gain recorded in the second quarter of last year in conjunction with the sale leaseback of our U.K. distribution center.
Net income declined $30 million this quarter, primarily reflecting a $23 million charge on the early extinguishment of debt associated with the refinancing of a portion of our debt at a significantly lower interest rate. The transaction further strengthened our balance sheet and will generate interest expense savings of almost $18 million annually. Our average cost of debt has now declined to about 4% from around 6% a year ago. Moving on to regional performance. Revenue grew across all three regions in constant currency and on a reported basis for a second consecutive quarter. In the Americas, revenue grew 3% in constant currency and 2% on a reported basis, reflecting strong growth in direct-to-consumer, driven by the expansion and the performance of our company-operated retail network and higher e-commerce revenue.
Mexico, one of our key global markets, continues to perform with revenue up 8% this quarter, driven by growth in all channels across women's and men's, and in both Levi's and Dockers brands. Wholesale revenues for the Americas were up slightly, reflecting growth in Mexico and Canada. In the U.S., wholesale revenues declined 1% and performance was mixed. Lower Dockers revenue offset wholesale revenue growth in our three other brands, Levi's, Signature, and Denizen. U.S. Levi's grew 4%, reflecting strong performance in the women's business. Adjusted EBIT for the Americas increased 5%, reflecting higher revenues and gross margins driven by strong performance in the direct-to-consumer channel. The momentum in Europe continued this quarter with net revenue up 20% in constant currency and 17% on a reported basis. Revenue growth was broad-based with growth across all markets and double-digit growth across channels in women's and men's.
The benefit of our global diversified business model continues to be well executed in Europe, driving outstanding growth as our women's business increased 46% this quarter, and tops increased 48%. Direct-to-consumer revenue was up 21% in constant currency from the expansion and continued performance of company-operated stores. Positive traffic growth for the fifth consecutive quarter and strong conversion rates. Wholesale revenue was up by 18% in constant currency, led by growth in Germany. Adjusted EBIT grew 51%, driven by higher revenues, gross margin, and better leverage on our cost base. In Asia, net revenues were up 3% in constant currency and up 2% on a reported basis. Reflecting growth in company-operated stores and e-commerce, partially offset by a decline in wholesale revenues. Most markets in the region grew, though China declined 7%.
We are currently working to improve our performance in China by optimizing and updating franchise partner programs, pricing and promotions, as well as investments in product and marketing. Adjusted EBIT was approximately flat, as higher regional revenues were offset by higher selling expenses related to the expansion of our direct-to-consumer business. Turning to the balance sheet and cash flows. Ending inventory in total was slightly lower than a year ago, and the health of our inventory balance has improved since year-end as we continue to focus on optimizing inventory levels globally. We generated $100 million of free cash flow for the first six months, compared to $12 million last year. This increase was driven by a strong revenue growth and lower inventory purchases as a result of continued focus on inventory management. In addition to these business drivers, this year, we changed the timing of dividend payments.
As you recall, we split the payment into two installments during the first and fourth quarters of this year, in contrast to last year, where we paid the full dividend during the second quarter. Total available liquidity at quarter end was approximately $1.2 billion, comprised of cash of $438 million and $714 million available under our credit facility. We extended the term of our credit facility in the second quarter, securing access to substantial liquidity for another five years. Our leverage declined to 1.8 from 2.0 a year ago. Net debt at the end of the second quarter was $601 million, down from $807 million last year. Turning to our year-to-date results. Excluding $22 million in unfavorable currency translation effects, year-to-date revenue grew 6%. Direct-to-consumer sales grew 12%, while wholesale revenues were up 3%.
Gross margin of 51.8% is down 30 basis points compared to prior year, as the benefits from revenue growth in the retail and international businesses were offset by sales allowances, primarily related to Dockers product, as well as unfavorable currency transaction impact. SG&A as a percentage of sales was 44%, up 40 basis points from prior year, primarily driven by investments to expand our direct-to-consumer business. For the first six months of the year, Adjusted EBIT declined 6%. The decline reflects an unfavorable currency transaction impact of approximately $16 million, increased investments in e-commerce, and the absence of a $6 million gain recorded in the prior year related to the sale leaseback of the U.K. distribution center. Now, I'd like to share our outlook for the full year. Looking ahead, the retail environment in the U.S. remains tepid.
As we step into the second half of the year, the disruption of traditional retailing is resulting in a record number of bankruptcies and store closures in the retail sector. We are balancing this challenging macro environment with confidence relative to what we can control, which is the strength of our Levi's brand and continued execution of our strategies. Taking all of this into account, coupled with a strong year-to-date performance, we are raising our constant currency revenue growth guidance to a range of 2%-4%. While we do continue to expect gross margin to benefit from direct-to-consumer expansion, we are holding our gross margin guidance at approximately 51%, reflecting unfavorable year-to-date currency transaction effects and the potential impacts from ongoing inventory management efforts. We're increasing our advertising investment to further strengthen our brands and drive long-term revenue growth and market share gains.
This reflects the belief that our brands are one of our greatest assets. Accordingly, for fiscal 2017, we now expect advertising as a percentage of revenue will be approximately 50 basis points higher than last year. SG&A as a percentage of revenue will be about one to two points higher compared to prior year, driven by the increased advertising. This is in addition to the direct-to-consumer investments we had previously communicated as part of our SG&A guidance for the year. We continue to expect that fully Adjusted EBIT comparisons will be pressured as a result of several factors, including unfavorable currency transaction impact to the first half of 2017 of approximately $16 million. Planned investments in e-commerce and advertising, ongoing inventory management efforts, and the absence of a prior year gain of $6 million related to the sale leaseback of the U.K. distribution center.
In addition to a $7 million benefit in Q3 of last year, related to the resolution of a customs dispute. Inventory at the end of the fiscal year will be up compared to prior year, primarily in Europe to service the strong demand we continue to see in the region. In summary, we are pleased with the momentum we've seen in the business midway through this year, and we remain focused on our priorities in 2017 in order to position the company for profitable growth over the long term. With that, operator, we'd like to open it up for Q&A.
The floor is now open for questions. If you have a question, please press star, then the number 1 on your telephone keypad. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound sign. Because of difficulty hearing questions asked on a speakerphone or headset, we ask that you please use your handset. The first question comes from Grant Jordan with Wells Fargo.
Good afternoon. This is David Eller on for Grant. You mentioned early in the call, a lot of success in the women's business in the tops, talking about the Levi's Batwing tee. Maybe if you could talk about any other notable fashion trends that you're seeing either in women's tops or in bottoms.
Well, as it impacts the second quarter, I think we hit most of it. Our women's business is really on fire, most notably in Europe, but it's true broadly around the world, from a bottom standpoint. You'll probably remember that we relaunched the women's business behind the 700 Series now two full years ago. That business has grown every single quarter, eight quarters in a row since we relaunched it. A lot of people are writing about the death of skinny jeans on the women's side of the business. We don't see that. Skinny is still a trend. It's still happening. 710, 711 are some of our fastest-selling items. The high-rise skinny is also very, very popular right now. The ankle skinny on the women's side of the business is very popular. We also have the 501 for women's, which is there and happening.
501 Skinny has also been a very popular addition to the line. Destruction is still relevant on both the men's and the women's side of the business. On the men's side of the business, from a bottom standpoint, the trend is clearly more towards taper and skinny. Stretch is becoming increasingly more important on the men's side of the business, just as it was on the women's side of the business several years ago. On tops, I would say the logo tee. I just came back from Europe, and I'm heading back over to Europe again next week. You see the logo tee everywhere. You could be standing at a street corner, and you're looking at the other side of the street at a crowd waiting to cross the street, and you might pick out four or five people wearing a Levi's logo tee.
It is really on fire. As we said, we sold five million more tees this quarter or five million more tops than prior year. It's largely being driven by the T-shirt program. We're giving more space to it in our stores, and giving a lot of attention to the supply chain aspect of it and just building more and more. Three million more tops, sorry. On top of that, we're piling on with fleece. As the weather gets colder, you're going to see Batwing logo fleece and just how far can we take it? We've also introduced a new graphic design of Levi's this current season, and that's off to a really good start. You'll see more and more of that. If you walk into our store, you'll see it now. It's got a retro design to it, and that's off to a quick start, too.
I think the key for us is recognizing that this is now in our base. How do we keep it going? How do we keep it fresh? How do we invigorate it? How do we make sure that we've got a responsive supply chain so that when something really hits, we can get into it really quickly and just go from strength to strength?
Just so David, it shows or demonstrates the breadth of the Levi's brand, as we orient it to make it more of a lifestyle brand.
Great. Thanks for the color. Just sticking with women's for a moment, you talked about that being a billion-dollar business. What do you think is the ultimate size that you could potentially grow that to? Then also, if you could maybe make any comments on competition from leggings and yoga pants and maybe where you've seen that cycle play out.
How high is up on women's is a really good question, and I think that's also a really good question for the tops business. One of the comments that I would say, and I think we had it in the prepared remarks, is I believe we still have enormous organic opportunities just with our existing business. The traditional Apparel industry ratio of tops to bottoms is roughly three to four to one. We're not even one to one right now. On tops, we've got enormous opportunity. On women's, Levi's is the largest women's jeans brand in the world, but it's such a fragmented market that there's enormous opportunity, and I like to say to competitors, lots of share donors out there right now, right? Enormous opportunity to consolidate without needing to do any acquisitions, just by taking advantage of the growth opportunities in front of us.
I like thinking about doubling businesses. Is $2 billion out of the question on women's? I don't think so. The only question is, what's the timeframe? Can you do it in three years? Is it five years? How long does it take to do it? We're clearly focused on these, I like to call them, back to our strategy. We build the profitable core and Expand for More. Women's and tops are two of the lead items in the Expand for More part of our strategy. That part of the strategy is a big part of what's driving our growth. I think it's possible for us to double our tops business. I think it's possible for us to double our women's business, and it's just a question of how long will it take us. That's what we're focused on.
Thanks. Last question from us. On the gross margin guidance, you held that flat at 51%, despite picking up the revenue guidance. I think last quarter you talked a good bit about the allowances you were taking for Dockers and increased product costs. I think this time you called out potential impacts from inventory management and unfavorable currency. Can you really just talk about, are you expecting a larger impact from the inventory management now than you were last quarter, or are there other factors at play?
Yeah. The factors, as you know, in quarter one, our margins are down year-over-year in quarter two, largely because we had the transaction impact of currencies. We see that abating in the second half, but you do have the first half impact, which is about $16 million. In terms of your question about the health of the inventory, it's better relative to two quarters ago, but it's not where we want to be. We are clearing some inventory in China. We've got a little bit of inventory in Dockers that we got to clear and some inventory in the U.S. because of the slowdown in wholesale demand. That's why we've been, I'd say, prudent about the gross margin forecast for the year. It's an important metric, and as you've probably seen over the last couple of years, our gross margins have improved year-over-year.
Great. That's all our questions. Thank you.
Thanks, David.
Our next question comes from William Reuter with Bank of America.
Good afternoon, guys.
Good afternoon.
My first question is just with regard to your free cash flow. Your leverage is pretty low at this point. I guess I'm curious whether you guys are going to think about increasing the dividend next year, or if the board will think about that, or whether you think M&A, which historically hasn't really been a part of the strategy, could creep in, or what should we be thinking about?
I think the first thing you should understand is we are a fiscally disciplined company. We like to translate the revenue upside into cash and profits. I think your question about dividends, we've certainly increased dividends over the last couple of years. As the company has performed better, dividends have increased. We don't have a dividend policy, Bill. As you know, it's really subject to a discussion and approval by the board. The way we consider a capital deployment, yes, you have to pay down a certain amount of debt, and we think we're probably near the end of what we think aggressive pay down on debt is. We are investing a lot more to grow this company. Then, we're giving capital back to the shareholders. Going back to the question on acquisitions. As Chip said, we believe strongly that there's enough organic growth left in our portfolio.
Again, as things come up, especially in the areas of tops, women's, categories we are focused on. If it allows us the opportunity to unlock faster profitable growth, it's something we can consider given the strength of our balance sheet today.
Okay. Then you talked a lot about the strength of the Batwing tee, and you seem to be referring to Europe. I feel like wearing a logo like that is certainly a sign that in those regions, people view your brand as being cool. Are you seeing the same types of success for the Batwing tee in the U.S. as well as in Asia? I guess, what do you expect in terms of continued growth there?
The short answer is yes. The Batwing tee has been kind of a runaway success everywhere, whether it's the plain Batwing with the Levi's inside of it. We also have the city tees. I think we're doing the city tees now in about 150 different cities around the world. It is a global phenomenon. It's most strong in Europe, and our business is most strong in Europe, as you saw from the results. It is a phenomenon really everywhere. It is, as you said, I think it is a real indicator of the strength of the brand. Somebody's not going to pay you $20 or $25 to put a T-shirt with your logo on it and walk around all day, unless they were real fans of the brand.
I think it is an indicator of the overall strength of our brand. We're going to continue to invest in strengthening our brand as you heard during the call. We're going to double down on media and investing behind brand building because it is something that's really working for us. I do think it's sustainable. To the second part of your question, the challenge that I've given the organization internally is how do we continue to lap this? We have introduced this retro nineties logo this summer, and if you walk into our stores, you'll see it. It is a different take on the Levi's logo, but it's cool and it's contemporary and it's hip and it's selling. It's a good indicator that we can lap the traditional logo with something else.
We've set a high bar for ourselves that, as I said earlier, we want to double the tops business. We've got to keep going from strength to strength here.
Bill, clearly the consumer likes it and wants it. I think in the U.S., our opportunity from a distribution perspective is to unlock tops by getting more floor space in our wholesale channel, and that's what our teams are working on.
Just lastly from me, your wholesale revenues in the U.S., I think you mentioned were down 1%. Was that reflective of the sell-through trends that we should see? I guess I'm curious because the number, there's obviously been a lot of retail store closures, and I guess with the sell-through rates have been better than your sell-in?
Yeah, I know we don't comment on sell-through for obvious reasons, Bill, but what I would say, there's always a lag. What I would say is that the reason we are down is really Dockers. We're bucking the trend on Levi's Signature and Denizen. We do talk a lot about Signature and Denizen on our value brands, but they're on a complete tear here. That's really making a difference. They're relevant products and they sell to Target and Walmart, and they're doing well. The thing that I would say is that as we continue to explore opportunity, getting more floor space, growing even in a secularly declining wholesale channel is an opportunity for us.
Okay. I'll pass to others. Thank you.
Thanks.
Thanks, Bill.
Our next question comes from Jenna Giannelli with Citi.
Hi, this is Margaret for Jenna. My question is around Amazon. How big of a customer is Amazon for you? Remind us how the margins of that business compare to your other channels and any efforts you're making to grow your brand within Amazon.
Amazon, like all of our customers, are important partners of ours. Amazon is one of our top 10 customers. We don't break out sales specifically to any of our customers. We are very focused on growing our business with them and growing our business profitably with them. At the same time, working with them on programs that are accretive to our brand and to our brand equity and accretive to them. Just a couple of weeks ago, Amazon announced the concept of Amazon Prime Wardrobe. Levi's is one of the brands in the Prime Wardrobe. I will let Amazon comment on the strength of the Levi's business or the Dockers business, but I'm pretty confident in saying that we're one of their top-selling apparel brands on their site.
We've got a great partnership with them, a great working relationship with them, and are working together to continue to grow that business. The reality is a lot of people, a lot of us, shop on Amazon, and that's where the consumer's going. We recognize that, and that's why we're there, and they're a great partner.
Okay, thank you. My other question is on comp sales. How are those trending in the retail stores? Is traffic up or down? What's driving the overall increases?
Margaret, we don't disclose comp sales. As I said earlier, given the number of stores we've opened, and the fact that our direct-to-consumer business is up in double digits, you guys can do the math. I did indicate to you that our traffic in our brick-and-mortar stores in Europe was positive now for the last five quarters. That should give you an indication. In terms of what is driving it, I think that was the second part of the question. A couple of things. One, we have relevant products. That's one that's resonating with the consumer. Second, we're executing really well. Third, as we bring and focus on lifestyle and focus on tops, our units per transaction tends to improve. A person coming in for bottoms, they're able to also buy tops and vice versa.
I think those are the factors, besides the fact that our brands are resonating well with the consumer, especially as we unlock advertising and promote our brands.
Okay. Thank you.
Thank you.
At this time, I'd like to turn this call back over to the company for any closing remarks.
Okay, I just want to thank everyone for joining us today and wish you all a great summer. We'll talk to you again next quarter. Thank you very much.
Thanks, folks.
Thank you. This concludes today's conference call. Please disconnect your lines at this time.