Good day, ladies and gentlemen, welcome to the Levi Strauss & Co. Quarter 1 2017 earnings conference call for the period ending February 26th, 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 two hours after the completion of this call through April 17th, 2017, by calling 855-859-2056 in the U.S. and Canada, and 404-537-3406 for all other locations. Please use conference ID number 89279970. This conference call is also being broadcast over the internet, and a replay of the webcast will be accessible for two months on the company's website, levistrauss.com.
I would now like to turn the call over to Aida Pasalic, 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. With us here today are 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 express a disclaimer in 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 as in today's earnings press release. Today, we filed our quarterly financial report on Form 10-Q with the SEC, also available on our website. I'll turn the call over to Chip Bergh.
Thanks, Aida Pasalic. Good afternoon, everyone, and thank you for joining us today. We had a strong start to 2017. First quarter revenue grew 5% in constant currency and was up in all three regions. The Levi's brand grew 6%, led by 19% growth in women's and 28% in tops. Great results given last year's strong growth. Direct-to-consumer revenue grew double digits for the fifth quarter in a row and is now approaching a third of our total business. Our international results were exceptionally strong this quarter. Revenue in the four largest mature markets, France, Germany, Mexico, and the U.K., collectively grew 17% compared to last year. These results demonstrate the importance of our long-term strategies as we continue to deliver steady top-line revenue growth despite an increasingly challenging U.S. retail environment. I'll now turn it over to Harmit to walk you through the first quarter financial results.
Thanks, Chip. Welcome to everyone joining our call. My comments today will reference first quarter comparisons on a year-over-year basis in U.S. dollars, unless I indicate otherwise. First quarter revenue of $1.1 billion grew 4% on a reported basis and 5% in constant currency. This was on top of 5% growth in Q1 2016. Direct-to-consumer revenue grew 10% in constant currency. These results were driven by performance of existing stores, as well as ongoing expansion of the network internationally and a 22% growth in e-commerce. In wholesale, revenue grew 3% on a constant currency basis, primarily reflecting strong results in Europe. Reported gross margin was 51.2%, down from a record high of 53% a year ago. The year-over-year decline in gross margin reflected an increase in sales allowances primarily related to Dockers inventory.
Slightly higher cost of products compared to Q1 of last year, driven by portfolio mix and product investments in stretch and newer finishes, and the continued unfavorable currency impact from the British pound. These factors were partially offset by the gross margin benefit from growth in our direct-to-consumer channel. First quarter SG&A expense increased to $456 million from $441 million, but was approximately flat as a percentage of revenue. Higher SG&A reflected the ongoing expansion of our retail network and e-commerce business, partially offset by lower advertising expenses due to Super Bowl 50 activation last year. We had 51 more company-operated stores at the end of the first quarter compared to a year prior. Beyond lower advertising this quarter and direct-to-consumer investments, SG&A levered slightly in the quarter.
In line with the guidance provided during our last quarterly call, earnings for the first half of 2017 are expected to be weaker than the prior year. Consistent with this expectation, adjusted EBIT in Q1 declined 11%, and net income declined 9%. About half the decline was due to the British pound, with the remainder primarily due to the other gross margin factors I mentioned. Before reviewing this quarter's regional results, I want to point out that as disclosed in our 10-Q, we have changed our methodology of allocating expenses that are incurred centrally but are in service to the business undertaken globally. In the past, most of these expenses were held in the Americas, but beginning fiscal 2017, they have been allocated across the three regions. In our view, this change better reflects regional profitability.
As a result, our regional operating margins are higher in the Americas and lower in Europe and Asia under this new method. In the first quarter of 2017, revenue grew across all three regions on both a reported and constant currency basis. In the Americas, revenue grew 2% in constant currency and 1% on a reported basis. Direct-to-consumer grew mid-single digit. Mexico and Canada both grew double digits. In the U.S., our value brands Signature and Denizen collectively grew in the low teens. However, U.S. wholesale remained challenged and declined mid-single digits, reflecting the soft environment as well as sales allowances primarily related to Dockers inventory. Adjusted EBIT for the Americas increased 2% in line with revenue growth.
Europe had an exceptional quarter, with net revenues up 15% in constant currency and up 12% on a reported basis, despite unfavorable currency impact of approximately $7 million from the weaker British pound. Revenue growth was broad-based across all channels and markets, with wholesale up high single digit and direct-to-consumer up high teens. Direct-to-consumer growth was driven by new company-operated stores opened over the last 12 months, in addition to performance from existing stores reflecting higher traffic and conversion rates. Our e-commerce channel also grew double digits. The diversification of our portfolio in Europe continues to yield results, with growth of 34% in women's and 48% in tops. For the region, adjusted EBIT grew 27%, reflecting higher gross margins and SG&A leverage.
In Asia, net revenues were up 2% on both a reported and constant currency basis, as double-digit growth in company-operated stores and e-commerce throughout the region was offset by continued decline in the franchise channel in China. Following from last quarter, we continue to work with our franchise partners in China to stabilize and improve performance in this channel. While we continue to be long on China, the process of stabilizing the franchise business could take some time. China, as a reminder, represents less than 5% of our overall business, but nearly a quarter of our business in Asia. As a result, the region's adjusted EBIT declined 12%. Turning to the balance sheet and cash flows, ending inventory was slightly higher than a year ago, reflecting higher balances in Europe, driven by the region's growth and inventory in Asia, which we continue to manage down.
Improving inventory management across the world is a key focus of ours. We have invested in end-to-end planning systems and continue to refine our processes to drive closer alignment between customer orders and delivery. We've elevated the importance of specific inventory metrics in our management compensation plan. As mentioned on our last earnings call, we expect to end 2017 with inventory balances about flat to prior year. Our full-year gross margin guidance of approximately 51% reflects the efforts we are making to manage inventory levels down. During the first quarter, our board of directors declared a cash dividend of $70 million for 2017, payable in two installments during the first and fourth quarters of this year to better match the seasonality of our cash flows. In contrast, last year, we paid the full dividend of $60 million during the second quarter.
As a result, free cash flows for this first quarter was negative $2 million compared to positive $28 million last year, driven by the change in timing of the dividend payments this year. Total available liquidity at quarter end was approximately $1.1 billion, comprised of cash of $369 million and $746 million available under our credit facility. Net debt at the end of the first quarter was $672 million, down from $810 million last year, and our leverage declined to 1.8 from 1.9 a year ago. Subsequent to quarter end on February 28th, we refinanced a portion of our debt at a significantly lower interest rate. We issued EUR 475 million of euro-denominated bonds at an interest rate of 3.375% in replacement of our U.S. dollar bonds at 6.625%. Annually, this generates roughly $18 million in interest expense savings.
Average cost of debt is now around 4%, down from around 6% a year ago. In addition to the favorable market conditions, this transaction reflects the strength of our balance sheet and our solid business results over the last four years. With that, I'll turn it back over to Chip.
Thanks, Harmit. A strong start to fiscal 2017. Our strategic priority is to grow the core, expand the reach of our brands, and become a best-in-class omni-channel retailer, have enabled us to deliver revenue growth in a tough environment and at a time where many others continue to see year-over-year declines. In our core business, the U.S. retail landscape is increasingly challenged. Our largest U.S. wholesale customers have announced over 200 planned store closures in total for the year. The biggest challenge to growing the core is our U.S. Dockers business, which declined in the high single digits this quarter. The escalating pressure from a soft U.S. wholesale environment, which makes up about two-thirds of Dockers' global business, continues to be the biggest factors. Complicating matters further is our ongoing product conversion to stretch fabrication.
While we're confident this is necessary to meet consumer trends, getting the older product off the floor is taking longer than expected, despite the markdowns that we've taken. However, as the category leader, we remain long on the Dockers brand, and our near-term strategies to get the business turned around include the ongoing transition of the Easy Khaki to stretch, which is off to a great start, the introduction of Smart 360 Flex later this year, which is a new four-way stretch fabric across a variety of fits. Based on the success of Dockers retail internationally, we're expanding our channels of distribution in the U.S. and will be testing a few Dockers outlet stores over the next 12 to 18 months. These stores will also provide a venue to demonstrate the breadth of the Dockers product line head to toe.
Our strategy to expand the reach of our brands has generated significant revenue growth, allowing us to outpace the overall market. Momentum in both our women's and tops business has continued at a steady pace for five consecutive quarters, largely driven by the success in both categories internationally. Our value brands, Signature and Denizen, in total, grew double-digit rates. The investments we've made in omni-channel are driving top-line results as consumers increasingly use multiple channels during their shopping journey. Despite traffic declines, our company-operated stores continue to post year-over-year growth, driven by strong conversion and steady AURs. E-commerce is fueled by higher traffic conversion and average unit retail. We also opened 18 company-operated stores during the first quarter and remain on track to open approximately 80 for the full year. In summary, I'm pleased with our first quarter results.
We remain committed to achieving our financial objectives for the year and will continue to focus on investing in the areas of growth and diversification for the long-term health of the business. With that, operator, we'll take questions.
Thank you. 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. Our first question will come from the line of Jenna Giannelli with Citigroup.
Hi there. Good afternoon. Thanks for taking the question. I wanted to ask a little bit just on the top-line. I know when we had started, when we'd come into 2017, you'd guided for constant currency revenue growth around 1%-3% for the full year. This quarter, we came in at 5%. What do you think was the big driver in the outperformance versus your expectations? Was it any particular region, channel, product category? Any of the drivers there would be helpful.
Hey, Jenna. I think, if you take a look at the results, we had really exceptionally strong results in Europe, way beyond what we expected, and very strong results on women's and tops globally, which is really what's fueling the growth. That plus we continue to see just strong quarter-over-quarter growth in direct-to-consumer. Those are the areas of the business that really stand out for us. We had a strong first quarter a year ago, too. Comping 5% over that strong quarter a year ago gives us a little bit of confidence as we start the year.
Okay.
Jenna, it's still fairly early in the year.
Okay.
We're not changing our revenue guidance for the full year. Headwinds in the U.S. relative to wholesale continue, and Chip's talked to you about the Dockers decline, et cetera. Again, we're here to grow this business for the long term and still feel good about the 1-3 full year constant currency guidance and revenue growth.
Okay, great. Thank you. Just on the inventory, it looks like we ended the quarter up a lot less than we had last quarter. We're working through some of that. How much of the gross margin erosion that we saw in the quarter was a result of that, in addition to the factors that you called out affecting margin?
You're right. We're working through inventory. It takes a little time, and given that we have reasonable amount of cash, we want to balance offloading the inventory and doing it in the right way. As we said earlier, we have a lot of core inventory, and that's where we can maintain the balance. To your question about margins, about, I'd say, a third of the decline was caused by inventory. The way I'd split the margin decline year-over-year, I'd say a third is caused by the decline in the depreciation or the weaker pound. A third is as we have increased sales allowances for Dockers and some of the Levi's products, which is really managing through some of the older inventories and older styles. About a third is through investments we've made in packaging stretch and newer finishes.
On a full-year basis, we still expect to deliver gross margins of about 51%. We will probably take another quarter or so to manage through some of the inventory issues. Hopefully get back to inventory levels at the largely flat by the end of the year.
Great. Thanks. That's really helpful. Then just one final one, if I may. You guys touched upon some of the closures from some of your large wholesale customers, Macy's, JCPenney. Are your sales with them going down commensurately with those store closures, or are they making efforts to maybe do some recapture in neighboring stores or their online business, or is it generally a one-to-one, the business goes down when you see a store closure?
It's not exactly proportional, I guess, is probably the quick top-line answer.
Okay.
Most of the stores that are being closed by our customers tend to be the smaller, less well-performing stores. Therefore, the impact is not really proportional, I guess. They're closing their smaller doors. Those customers are doing the very best that they can to remap that business and recapture it, either through their e-commerce sites or adjacent stores in the area. From previous experiences, for example, when Mervyn's went out of business, we didn't see all that business go away. We recaptured about two-thirds to slightly more than two-thirds. Some business does go away completely, but it'll be a relatively small, and I think manageable amount.
Okay, great. Thanks so much.
Yep.
Thanks, Jenna.
Our next question will come from the line of Grant Jordan with Wells Fargo.
Good afternoon. This is David Eller on for Grant. You talked a lot about women's and tops and Dockers. Could you maybe just give us some overall commentary on the overall denim category and maybe more specifically, the men's denim category overall?
Denim has been growing in the two%-ish range globally for the last 12 months. Our men's business, we're the market leader on both men's and women's. The growth that we're seeing in women's is also driving some category growth there. The men's business this past quarter, our men's business roughly was flat on a global basis, with declines in U.S. wholesale offset by growth in our DTC and international business.
Okay. Switching over to Europe wholesale, I think you characterized that as an exceptional quarter, broad-based growth through all channels and markets. Can you maybe just talk to either the, I guess, you mentioned women's and tops, but where's that share coming from or where are those dollars coming from?
We did have really strong 15% growth in Europe in constant currency, 12% in reported. The team is just executing really well. Remember, we had the impact, as Harmit alluded to, the impact of the weaker British pound, which had a $7 million unfavorable impact for us on the bottom line. I would characterize our business in Europe right now as being extremely well diversified. We're diversified across channels very well. Our wholesale business, which had struggled up until mid to late last fiscal year, is now growing. We grew wholesale globally despite missing and declining in the U.S., largely driven by the strength of our wholesale business in Europe. Our direct-to-consumer business in Europe is very strong. It's a combination of annualized new stores that we're still annualizing, as well as very strong results in existing stores. Double-digit growth in e-commerce as well.
We're actually seeing traffic up in our stores, broadly speaking, around Europe. I think we've mentioned in previous calls that we've put tailor shops in most of our main line doors in Europe. This trend towards personalization, and some of our tops items have really become fashion items. The white batwing logo T-shirt was a fashion item in Europe over the past year. It drives traffic. We're translating that into more sales in our doors. Again, I guess the last thing I would say is the brand is back. It's hot in Europe again. I see it when I travel to Europe. I was in Europe a couple of weeks ago. You see it when you're walking through airports. You just see more people wearing Levi's.
We have a bigger presence today than we have had probably in the last two decades in Europe. It shows in the results. I guess the last thing I would say, I've done this before on previous calls, we have a really strong team in Europe, with a lot of good continuity now. Seth Ellison, our regional president, has been on the ground for about three years. He's built a terrific leadership team there, and they're just doing a great job executing. I think it shows that execution really matters in this business. When we execute well, we can grow the business and grow it very profitably.
Okay, we've kind of heard about maybe some struggles from some of the fast fashion retailers in Europe. Do you feel like you're taking share there as well?
It's difficult to quantify where the share is coming from. It's easy to say the market's not growing at this pace, so we're probably taking share across the board.
Okay. Thank you for taking the questions.
Thanks, David.
Our next question will come from the line of Carla Casella, JP Morgan.
Hi, this is Mei Lin on for Carla. Just kind of going back to the impact department store closings. Are you able to quantify what the impact of that is in fourth quarter and first quarter, and are you through it?
The quick answer is no. It's not easy to quantify. To your second question about are we through it? No, because our department store customers have actually announced plans to close these stores, which are happening over time. As Chip mentioned, we proactively work with them, as well as the marketplace to remap where we can. This is a good opportunity for us also to try and take more shelf space in stores that are actually not closing. Broaden our offer as we expand tops and women's and the like.
Got you. Kind of regarding that, do you have any read on how the department stores are buying for the fall or winter this year? Kind of just given last year's environment?
No, we don't necessarily guide on future orders. I won't be able to answer the question with precision. What we would say that it's being the market's challenged. Our business model is fairly diversified, and that's where we're expanding the direct-to-consumer channel big time so we can take control of what we offer, how we offer it, and where we offer it.
Thank you. My last question is, how do your margins compare when a product is sold online versus in a store?
The gross margins are now, again, depending what you classify in store. If you're talking about our brick-and-mortar stores, the gross margin in our brick-and-mortar stores are generally in line with the gross margin in our e-commerce platform. Generally, in the low to high 60% range. Our margins, obviously, wholesale customers are different and again, it varies by customer.
Got you. Thank you so much.
Our next question will come from the line of William Reuter with Bank of America.
Good afternoon, guys.
Good afternoon, Bill.
You guys talked about the strength in Europe and you're talking about the brand being hot, trendiness, fashion. I guess, to what do you attribute this kind of new coolness, or not the brand wasn't cool, but kind of the accelerated coolness of the brand? Was it marketing? Is it product? I guess, do you think that there is some risk, I guess, of maintaining this level of popularity in the market?
It's a good question because I wish I could sprinkle the same fairy dust on the rest of Asia and the U.S. It is a combination, I think, of product and marketing and just being in the right place at the right time and the way the teams in Europe have activated the brand. I would say that we're not trendy, fashion trendy, like a runway brand is.
We have still a significant amount of our business is core product in Europe as it is in the Americas as well. I talked about the white batwing tee. It was on the cover of Cosmo and several magazines in Europe back in the spring last year, and it became a very it item that drove a lot of traffic into our stores. A couple of good magazine covers can make a big difference is what I would say. Our advertising campaign, Live in Levi's, they've done a great job activating around that. We put media back on air in some markets that hadn't seen media in 10 years, and I think that's certainly contributed to it. I would say the way that we're executing, both in our own retail stores, but also in wholesale in many markets in Europe.
The brand comes to life as a true aspirational, lifestyle brand. Is there a risk that we're not going to be able to keep growing at 15% every single quarter? I would say yes. However, I feel very confident that the team is going to be able to continue to put points on the board in Europe, given the strength of the brand and really leveraging the DNA of the brand and bringing it to life in Europe. I'm very optimistic about our continued outlook in Europe. I'm a big believer when something's working, you keep feeding it. Things are clearly working in Europe, and we're going to try to keep feeding that hungry beast.
Bill, just a couple of points building on what Chip said. First, our business in Europe in the good old days was close to double what it is today. That's the first point. The second is, the last we looked, we don't have 100% market share, so we have opportunity to grow. The third is going back to the diversified business model. Given we're a global company, and we have different channels of growth and different brands, we feel that if something slows down or softens, something else will emerge. I think that's the beauty of the business and the business model.
I guess one final point. We talk about the strong results on tops. Tops was up 48% in Europe. Women's was up 34% in Europe last quarter. Still, I look at both of those businesses. We have enormous opportunity. The average rule of thumb in the apparel industry is you sell three to four tops for every bottom. Today, globally, we sell three to four bottoms for every top. Even in Europe, the ratio is still flipped on its head. We still have enormous opportunity for growth on parts of our business, segments of our business, like women's, where we're relatively underdeveloped versus the men's business and tops. I could go from there. There is still substantial upside opportunity.
Okay. Then, I think you mentioned in a prior question that globally the Levi's men's business was flat. When you were talking about the Americas, you talked about Denizen and Signature being up. Does this mean that the core Levi's, excluding Denizen and Signature, would've been down? How's that business performing?
No. When I said Levi's men's was flat, that was Levi's specifically. Red Tab Levi's men's business was flat.
Okay.
That excludes Signature and Denizen.
Okay. Just lastly.
We think of them as separate brands. They're value brands.
Okay. That makes sense. Just lastly, you touched upon your struggling retailers. Can you talk a little bit about, are you guys having any discussions with some of those customers? Are they pushing back on price? Do you feel like over the next couple of years that will be something that we'll begin to see with some of those?
First of all, they are valued customers of ours. We really think of our customers as partners. We're in this together. The challenges that are being faced by the mid-tier department store channel today, we're working with each one of those customers on how can we partner together to help you get your business growing and to grow your business. I happen to think, and maybe it's a biased point of view, but I believe that these big department stores need strong national brands. The best way that they can communicate a value to their consumers or to their customers is through big, strong national brands. We do have significant opportunity in each one of our customers to build our business with them. Harmit talked about we're focused on how do we grow our share in these customers.
As the pie gets smaller, how do we grow our share so that we can grow our business? A good example right now is we've successfully launched our women's tops at Macy's on the women's pad, and it's working. It's not just generating incremental business on the tops business for us and for them, but it's helping to sell more jeans. We have opportunities like that, and expanding that opportunity as well at every one of our big customers. It varies from one customer to the next, but our teams are working with the customers to come up with ways that we can partner together, whether it's expanding the floor space, expanding the assortment, adding tops, adding accessories on a customer by customer basis, doing what makes the most sense for that customer so that we can grow our business and help them to grow their business.
Okay. I'll pass it to others. Thank you.
Thanks, Bill.
Our next question will come from the line of Hale Holden with Barclays.
Hi. Thanks for taking the call. I just had a couple quick ones. On the Dockers allowances, was that one-time only in the last quarter, or is that something that continues forward to clear additional inventory?
It's probably, we'll see a little bit in Q2 here, then we'll taper off towards the second half of the year.
That was a fairly sharp sequential decline in Dockers, Q4 to Q1. Do you feel like this is a six-month issue or something that continues for longer, potentially?
You're talking about the revenue? You're talking about, yeah. I think as Chip mentioned, again, more in the first half, less in the second half. It tapers off towards the second half as we start transitioning into our new product lines. Easy Khaki expands. We've begun the transition as we speak, and we introduce the 360 Flex and ramp that up. As you're probably aware, Hale, in this business, the process of transition is hard and takes time, especially when you're getting out of older styles or older fits and getting into newer styles and newer fits. This takes a little time.
Is the analogy in terms of pacing the way that the women's business went to stretch, I don't know, was it two or three years ago?
It is, a little different. I mean, the difference in the women's business relative to Dockers, is Dockers is so concentrated with our core wholesale customers. About two-thirds of our global Dockers business is with our four customers. That process, it takes time, and it's concentrated. In the case of women's, we not only had a global line that was launched globally, but we also were selling through our direct-to-consumer channel. That's why, as we think about turning it on Dockers, we are thinking about testing new outlets in the U.S. where we don't have any currently. We'll be able to offer a full range of assortments, a head-to-toe look, a newer style, the newer fits much faster.
Great. Thank you. My last question was just on Asia or Asian margins, particularly related to China. I know we talked about it a lot on the last release. The magnitude of the decline was a little larger than I was expecting. It kind of sounded, Chip, from your comments, that maybe this might continue for a while before it gets right-sized. Is that still the way to think about it?
I think let's contextualize the China business. Globally, it's still under 5%, small, that is a tale of two cities. It's small, it doesn't hurt us as much globally, but it has the potential of becoming a big business. As you think about the China business, a tale of two cities. If you look at the profile of how the revenue is split, the revenue we generate from company stores and e-commerce are about 40% of total revenues. Our franchises generate about a third, the rest is driven by our wholesale segment. The piece that's underperforming is the franchise store piece. As you know, because we don't have direct control, this takes a little time. We're working with the franchises and building capability.
We're helping them get to the newer assortments, we're working with them to remap the marketplace as they build new stores, et cetera. The whole process takes a little time. The fact is, our company-owned stores are performing well. Our e-commerce business is performing well, we feel good about our brands and our general capabilities in the market. We just think it'll take a little time to get the entire marketplace to perform.
Thank you for the time, good luck on Easter this weekend.
Thank you.
At this time, I'd like to turn the floor back over to the company for any closing remarks.
Okay. Well, I just want to thank everyone for taking the time and dialing in, and we'll talk to you all again at the end of our second quarter. Thanks very much.
Thank you. This concludes today's conference call. Please disconnect your lines at this time.