Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co. third quarter earnings conference call for the period ending August 28th, 2016. 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 October 14th, 2016, 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 82198658. This conference call also is being broadcast over the internet, and a replay of the webcast will be available for one month on the company's website, levistrauss.com.
I would now like to turn the call over to Chris Ogle, Vice President, Treasurer, and Investor Relations at Levi Strauss & Co..
Thank you. Good afternoon, everyone, and welcome to our third quarter 2016 conference call. I'm pleased to introduce members of the Levi Strauss & Co. management team. With us here today are Chip Bergh, our President and CEO, and Harmit Singh, our Executive Vice President and Chief Financial Officer. 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 Securities and Exchange Commission, all of which are available on our website at levistrauss.com.
We expressly 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. You will find the appropriate reconciliations and descriptions of our non-GAAP financial measures at the Earnings Webcast page in the Investors section of our website, as well as in today's earnings press release. Finally, today we filed our quarterly financial report on Form 10-Q with the SEC, which is available on our website. Now I'd like to turn the call over to Chip Bergh.
Thanks, Chris. Good afternoon, everyone. Thanks for joining us today. We're pleased with the third quarter results. We saw broad-based revenue growth across all three regions, despite the continued challenging environment, particularly in U.S. wholesale. Reported revenues were up 4% in the third quarter and up 5% on a constant currency basis. Gross margins remained solid. Adjusted EBIT grew 14% year-over-year. The Levi's brand delivered another quarter of growth in men's, women's, tops, and bottoms. Our international markets continue to grow in dollars and as a % of total company revenues. Direct-to-consumer grew 14% on a constant currency basis, with improved performance and expansion across all three of the regions. Harmit will now walk us through the financial details for the quarter. Harmit?
Thank you, Chip. Welcome to everyone joining our call. My comments today will reference third quarter comparisons on a year-over-year basis in U.S. dollars, unless I indicate otherwise. Third quarter net revenues of $1 billion grew 4% on a reported basis and 5% excluding $11 million in unfavorable currency translation effects. Global revenues from our direct-to-consumer channel grew 14% on a constant currency basis, driven by improved performance of existing stores, ongoing expansion of the network, and double-digit growth in e-commerce. In our wholesale channel, global revenues grew modestly. Gross profit for the quarter grew 3% on a reported basis to $593 million as compared to $573 million last year, despite unfavorable currency translation effects of approximately $5 million. Reported gross margin declined slightly by 20 basis points to 50%. The decline resulted from unfavorable currency transaction effects and inventory management efforts, which together total approximately 300 basis points.
These unfavorable factors were largely offset by growth in our higher margin international business and lower negotiated sourcing costs. Third quarter SG&A expense of $449 million was down from $455 million on a reported basis. Currency favorably impacted SG&A by $4 million. As a % of revenues, SG&A was 38%, 200 basis points lower than prior year. Excluding currency, the decline was driven by lower advertising costs, lower restructuring related charges, and a benefit from resolving a vendor dispute. These lower costs were partially offset by our ongoing investments in our retail network and e-commerce business. Adjusted EBIT of $146 million was 14% higher than prior year on a reported basis, and 15% higher on a constant currency basis.
As a % of net revenues, adjusted EBIT margin was 12%, up 100 basis points compared to last year as a result of improved leverage on our direct-to-consumer investments and lower advertising costs. A detailed reconciliation of adjusted EBIT is attached to our press release. Third quarter net income grew to $98 million as compared to $58 million last year. The increase primarily reflected higher adjusted EBIT margins and lower charges this year related to our productivity initiative. I'll share more detail on the third quarter results of our three regions. Net revenues in the Americas grew 2% on a reported basis and 3%, excluding $8 million in unfavorable currency effects. Adjusted EBIT for the Americas was up 5% on a constant currency basis. The revenue growth was driven by higher revenues in Mexico, in both wholesale and direct-to-consumer channels.
Our overall U.S. business was down, driven by continued softness in Levi's and Dockers at wholesale. This was partially offset by growth in our direct-to-consumer business as well as Signature and DENIZEN. In Europe, with the exception of Turkey, we grew in every market. The region's net revenues grew 9% on a reported basis and 10% in constant currency. Consumer trends remain strong in key markets such as the U.K., Germany, Russia, and France. About half the region's growth was in women's, reflecting continued strong consumer response to our new products and the anniversary of the women's launch in August of last year. Adjusted EBIT in Europe grew 8% on a constant currency basis, reflecting the revenue growth. Our results in Europe were strong this quarter despite the weaker pound post-Brexit, which unfavorably impacted revenues and adjusted EBIT by approximately $5 million.
In Asia, net revenues grew 5% on a reported basis and 6% in constant currency, reflecting direct-to-consumer expansion and wholesale performance. Growth in India and Japan was partially offset by softness in mainland China and Hong Kong. Adjusted EBIT in Asia declined $5 million on a constant currency basis due to lower gross margin reflecting the promotional environment and our continued investments expanding our retail network. Turning to the balance sheet and cash flows. At the end of the third quarter, inventory dollars were 26% higher than prior year, concentrated in Levi's product that will carry over and be sold in future quarters. We remain focused on reducing our inventory by year-end. Earlier in the year, we took actions to cut future production orders to manage down inventory levels, and this will have a notable impact in the fourth quarter.
However, we now expect to end 2016 with inventory in the range of 20% higher than we ended last year. This is due to continued softness in U.S. wholesale, as well as inventory build reflecting our strong growth in Europe. Free cash flow for the first nine months of 2016 was a net use of $11 million, reflecting a higher inventory, capital expenditures, and a larger dividend as compared to prior year. Total available liquidity at quarter end was $937 million, comprised of cash of $272 million and $665 million available under our credit facility. Net debt was $835 million, and our leverage declined to 1.8 from 2.2 a year ago. Turning to our outlook for the year. This is on a full year basis. We continue to expect profitable revenue growth this year in constant currency.
We are on track to grow full year gross margin to approximately 51%. We continue to expect SG&A as a percentage of revenue to be approximately 50 basis points higher compared to prior year, primarily driven by continued direct-to-consumer investments. Given favorability in advertising cost this quarter, we now expect advertising as a percentage of revenue to be in line with prior year. Capital expenditures are expected to fall within the range of $110 million-$120 million, approximately $10 million lower than prior estimates as a result of timing of projects. We remain on track to open 70 company-operated stores in 2016. Chip, back over to you.
Thanks, Harmit. We've delivered three solid quarters this year. For the year to date on a constant currency basis, revenues are up 4%, gross margins are more than 51%, and adjusted EBIT margin has expanded 100 basis points. Broad-based revenue growth across all of the regions demonstrates that our strategies are working. Of our core businesses, Levi's men's bottoms continue to grow globally, and our core international markets of France, Germany, Mexico, and the U.K. are all showing strong growth. We've successfully expanded the reach of our brands as tops again comprised a substantial portion of our growth in the third quarter, while global women's revenue was up high single digits, even as we anniversaried the relaunch in August of last year. We've continued to expand in the emerging markets of India and Russia with double-digit revenue growth.
Our direct-to-consumer expansion and overall execution at retail has helped us grow, despite ongoing challenges in Dockers and the decline in U.S. wholesale channel, where we still have work to do. Heading into the fourth quarter, we're focused on what we can control and remain committed to delivering our full-year constant currency financial objectives of profitably growing revenues and gross margins. With that, we'll take your questions.
Thank you. The floor is now open for questions. If you have a question, please press star then the number one 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. Your first question comes from William Reuter with Bank of America Merrill Lynch.
Good afternoon.
Hey, Bill.
I was wondering if you could talk a little bit more, first about what we could expect for the gross margin challenges in the fourth quarter, and then, I guess with your expectation that inventories are now going to be 20% higher at the end of the year. That's a pretty big difference. Will you take all of the markdowns that you expect to have to take on that product during the fourth quarter, or will there be additional markdown risk moving into 2017?
Sure, Bill. Let me address both the questions. Our gross margins on a year-to-date basis are 51.3%. While we don't necessarily guide margins quarterly, we're indicating that we stand by our previous guidance of ending the year at 51%. You can do the math and probably get any expectations for quarter four. Going back to what drove margins in quarter three. I indicated that the margins reflected essentially a 300 basis points impact. This is an adverse impact, which is a combination of transaction impact thanks to currency, as well as our inventory management efforts. If you split the two, I'd say two-third is the currency impact, which is transaction in nature. It includes the Brexit impact of $5 million that I spoke about earlier.
About a third is our focus on managing inventory down by promoting both at more retailers as well as increasing the depth of promotion in some of our retailers. We've done quite a bit in quarter three in the U.S., and we continue to believe we'll be doing that through the end of quarter four. The other thing I would just ask you to note is that the inventory that we currently have, we feel good about in terms of the health of the inventory. These are products that our core are still being sold. That's where we think we have probably the most appropriate balance between promoting the sale as well as holding inventory. Yes, we do recognize the fact that we've taken the inventory levels for the end of the year up quite a bit from last quarter.
That's largely driven by two factors. It's driven by the fact that there is continued weakness in U.S. wholesale. That's what we project. As well as we are building up inventory for 2017, largely in places that are growing well, which is Europe. Hope that addresses your two-part question.
That does help. Then, you mentioned weakness in Dockers. I guess it was not that long ago that you relaunched some products that I think you guys were potentially excited about. I guess if you can talk a little bit about how those products have done so far and maybe expand a little bit on the weakness.
Sure. Our issue with Dockers is fundamentally concentrated here in the U.S. Dockers did decline in the third quarter, and it is exclusively a U.S. wholesale issue. We have transitioned most of our product now to this stretch product. We just completed the transition on a part of the Dockers line called Signature Khaki, which is a big part of the line, and that is hitting stores as we speak.
The stretch product is selling well. The stretch product that's been in stores up through the third quarter is on a much smaller part of the line, and the growth on that smaller part of the line has not been sufficient to offset the continued decline on some of the legacy products. Our fundamental issue, though, is really concentrated on U.S. wholesale and getting that business turned back around.
Okay, that's helpful. I'll turn it over to others. Thank you.
Great. Thanks, Bill.
Your next question comes from Grant Jordan with Wells Fargo.
Good afternoon. Thanks for taking the questions. I guess my first question, I just want to follow up a little bit more on the inventory. I think you said that most of the inventory increase is concentrated in the U.S. related to the soft wholesale. Is that correct?
Yeah. I would basically, again, these are broad numbers, but I'd say two-thirds of the inventory of the increase year-over-year, the concentration is largely in the U.S., and it's a combination of softer or weaker U.S. wholesale demand and softness in Dockers. About a third is largely in international and driven also largely, thanks to our growth in our direct-to-consumer channel.
Okay. If we were to, I know you don't give this sort of detail, but would that imply that inventory for the U.S. wholesale is up, like, 30%+ year-over-year?
We, again, don't break it up. The one thing I would tell you, Grant, the wholesale business, at least, from our perspective, has long lead times. This problem began when we saw demand softening, sometime this time a year ago. Over the year, what we have done is we have actually reduced our production orders for the U.S., and you're going to see the impact of that, which is dramatic, but you're going to see the impact of that in quarter four. That's why we feel confident about the guidance and the numbers we're not talking about at the end of the year.
Okay. All right. That's helpful. Okay, my last question, if you can give a little bit more color on the $7 million vendor charge, and it looks like you're including that in the adjusted number. Is that correct?
Yes, we have included that in the adjusted number. The $7 million charge was really thanks to the resolution of a dispute that we had with a vendor. In essence, it's the reversal of a charge that was taken years ago. As a result, it's non-recurring. We can't get into more details because that was part of the resolution with the vendor.
Okay. All right. If we wanted to look at it on a recurring basis, maybe we'd back that $7 million out.
Correct.
Right.
Even if you did that, Grant, you'll see that our adjusted EBIT earnings growth is largely fairly strong for the quarter.
Sure. Yeah. Okay. Thank you for the information. I appreciate it.
Thanks, Grant.
Your next question comes from Karru Martinson with Jefferies.
Good afternoon. When you guys look at the direct-to-consumer channel, what's happening there differently than what you're seeing in wholesale? Why are you guys able to put up kind of double-digit growth there while the rest of the business kind of has those headwinds?
Well, I think probably the biggest thing is we're in complete control on how we show up, and this is a big part of the reason why we have made growing our direct-to-consumer business a key strategic priority of ours. It does show overall the strength of the Levi's brand on a global basis. The brand is resonating. The product is great. We're executing really well in our stores, and it shows in the results. You've got to remember that in direct-to-consumer, we also include our own and operated e-commerce business as well. That's growing off of a relatively low base. The combination of those two things, brick and mortar is growing, e-commerce is growing at kind of an outsized growth. The combination of that results in this double-digit growth in our direct-to-consumer business.
I've got to say, I believe we're going to continue to be able to do this. We've got still lots of upside in our direct-to-consumer business over the long term.
When we look at the U.S. wholesale business in particular, is it that it's a traffic issue, or do you feel that there's a competitive challenge, promotional challenge that's taking place in that channel?
Well, you should ask them what their challenges are. If you want my take on it, I keep saying that their challenges are our opportunities. If you walk the floor of any of the big department store customers of ours, you will see that we are basically a classification business. We're a bottoms business for them. By contrast, if you walk through any of our own retail stores, we show up as a lifestyle brand.
I think we've got enormous opportunities to partner with our biggest customers to change the shape of our business in their stores and change the trajectory of our business and their business by leveraging the strength of our brands and really showing up much more as a lifestyle brand.
Okay. Just lastly, when you look at the lead times for inventory, I know that's something that you guys have worked on over the years. Where are we today and what's the opportunity to further reduce those lead times for inventory?
I think we're at a better spot today than we were 12 to 18 months ago. With the buildup that just happened, we've obviously gone back and looked at all our processes. It's a chink in our armor, despite all the wonderful results that we are achieving this year. We are cognizant of that. We're taking a hard look at things we can do better as well as drive more agility internally. There are things we will be working with our customers also going forward. Again, I can't get into the details, but we're taking a look at the process. We're taking a look at the go-to-market calendars and definitely building better controls within the environment.
Thank you very much, guys. Appreciate it.
You're welcome.
Thank you, Karru.
Your next question comes from Carla Casella with JP Morgan.
Hi. You talked about opening some new stores this year. Can you just give us a sense for the dispersion of how many of those are U.S. versus EMEA versus APAC?
Yeah, sure. We talked about opening 70 stores and we're sticking with that. We have a large bulk of the openings in quarter four. I think we opened about 50% so far and 50% in quarter four. Over time, we get better and we spread that out across, it is what it is as of for this year. In terms of your question, Carla, the bulk of the store openings are actually outside the U.S. As Chip referenced, our business outside the U.S. is skewed towards retail. The balance between mainline and outlets is also a lot more balanced actually outside the U.S. It's a good balance between mainline and outlet stores and as I said, mostly outside the U.S.
Okay, great. The weakness you talked about in China, are you seeing that continue? Or we hit at some other companies where they saw weakness in China, but it had kind of changed by September. Are you seeing any change in that market?
I would say if anything, we've seen the business slow a little bit, let's all get kind of grounded on the facts. Greater China is still less than 5% of our total company revenue. Year to date, our results are up high single digits, but in the third quarter, we did see it slow a little bit. We're mostly a retail business in China. It's a combination of owned and operated and franchise. Within that, it's a little bit of a tale of two cities. Again, where we kind of control how we show up in our owned and operated stores, we're actually pretty happy with our results. It does demonstrate that the brand is still resonating in China. On the franchise network, we've got some executional challenges that we're working through right now.
I personally believe, I've been saying this ever since day one, China's strategic for us. It represents an enormous consumer opportunity, an enormous market opportunity for us. It is strategic. We're going to continue to focus on it. This is kind of a bump in the road that we're going to work our way through.
Okay, great. Just on the U.S. business on the wholesale front. It was warmer August, September. I'm wondering if you can give us any update on back to school or how retailers are looking at or ordering for holiday. Has it changed this year versus last, given the kind of warm start to the fall?
Yeah. I always kind of get the short hairs on the back of my neck kind of stand up when we start any business review with the weather report. Back to school is no longer what it was even five years ago when I started at this company. It's no longer an event or a weekend or a week. It kind of extends out and we're seeing that trend continue. It has kind of extended through the month of September, I guess. It's still a little early to comment real conclusively on holiday. I guess we'll probably have to wait for the next call to talk a little bit more specifically about the impact of holiday. You've probably read all the same external reports from the consulting firms and accounting firms that are publishing their retail outlook for holidays, most of which suggest a positive outlook.
We were burned by that last year, we're playing it a little bit closer to our chest, I guess, as we think about how to plan our business for the holidays.
Okay, great. Thank you.
Thank you.
Your next question comes from Hale Holden with Barclays.
Hi. Thank you for taking the call. In the U.S. and for U.S. wholesale, I was wondering if you could sort of dimensionalize the Q4 inventory reduction that you had kind of in future orders versus where you would've been last year or the year before, either in percentage or dollar terms.
All I can say, it's fairly significant relative to last year for the U.S. business. I can't get into the numbers, Hale. It's significant, and that's why we feel good about where we think we can end the year.
The second question I had was in the direct-to-consumer growth in the U.S., would it be possible for you to give us some idea of how that trended e-commerce versus outlet versus full line stores? Which ones did better? Specifically, how the outlet section did.
Yeah. We don't break up the direct-to-consumer between e-commerce and brick and mortar. As I said in my prepared remarks, there was improved performance in existing stores, which really means our brick and mortar existing base grew. That is despite a decline in traffic. The traffic declines trends continue, a little less in the U.S. than it was, say, this time last year, given all the issues we had with tourism thanks to the currency. The thing I could say is our growth is largely driven by higher conversion rates and higher units per transaction. The e-commerce growth is again, very similar. We're seeing an increase in traffic, but importantly, we're seeing e-commerce growth in the double digits.
Finally, your European growth was really impressive. Taken from your comments that you need to increase kind of inventory orders for Europe, there's nothing that you see as headwinds or that would kind of slow you down near term from recent trends there?
Yeah, no. Our European business has continued to do. If you look at the last many quarters, they continue to execute very well in Europe. Our key markets in Europe, U.K., Germany, France, et cetera, are all performing. The growth is again driven both by performance of existing retail stores as well as continued expansion as we open more stores. Also, our new women's line that we introduced this time last year continues to outperform. Our e-commerce is also performing. Basically, we're hitting on all cylinders, and across most markets other than one. Knock on wood, and a big shout-out to the European team.
Two quarters in a row.
Yeah.
We've been growing in all markets. I guess the only other thing I would add, because on a constant currency basis during the quarter, we were up double digit in Europe, which Seth Ellison, who is the President of the region, talks about it as defying gravity. The team is just executing great. The brand strength, particularly the Levi's brand strength, there are some old-timers who have been around for a while, and they talk about it as they haven't seen the brand this strong in decades. We're marketing the brand. We're on television in markets that we haven't been on air in more than a decade, and it's working. It is very broad based. It's men's, it's women's, it's tops, it's bottoms, it's retail, it's wholesale now as well. It's very broad based and very solid, and it's virtually across the board.
It shows what is possible, I believe.
Great. Thank you for the time. I appreciate it.
Thanks, Hale.
Your next question comes from Jenna, J-E-N-N-A, with Citi.
Hi. Thanks for taking the question. My first one's kind of a follow on.
Hey, Jenna.
Hi. Kind of a follow on to an earlier one asked. We're hearing from a lot of retailers about this trend of sort of buy now, wear now, and there's sort of a mismatch in timing between what's in the stores and what customers or consumers really want to wear. Are you hearing this from your retail partners, and is this playing a role in some of the weakness of the wholesale channel? Are the retailers kind of putting pressure on you to change the type of product that you're delivering at different points in the year, or putting pressure on you to change or alter your lead times?
I've read about it in some of the trade journals. I think the fact that we're largely a replenishment type of product helps us to some extent. We haven't seen as much of an issue. Shorts hit a little bit before spring, and they're gone by the time it starts getting warm, and that's kind of the way the cycle flows on our business. Again, in wholesale, unfortunately, we're mostly a classification business and mostly a bottoms business and mostly a predictable bottoms business. I think we've been impacted less by that. I wouldn't say that that's necessarily a good thing because I'd love to have more tops at wholesale. I'd love to have more seasonal product at wholesale. I think that would help us drive growth in that channel.
We are where we are right now, and I guess the positive of that is we're not as caught up in this buy now, wear now issue that has really impacted the industry.
Okay.
If that makes sense.
No, definitely it does. Thank you. Then separately, just on the gross margin line, I know overall you're still looking for 51% for the year and for the third quarter. It was pretty in line with what we were expecting. I'd say particularly in Asia, it seems like the gross margin got hurt a little bit more than it had in previous quarters. If you could talk about what's really driving that, what's the main cause for such kind of the intense promotional environment that you're seeing there? Is it really both on the retail and the wholesale front?
Asia has been largely promotional, not only in this quarter, we've seen that for a while. We see that in our key markets. That's why the promotional cadence is a little higher, which does have an impact on gross margins. Now we have factored that, Jenna, into account, both as we thought on how the margins would finally end, both for quarter three as well as quarter four. The good news on our margin is that structurally, we've been able to do a few things which should bode us well into the future. The first is, as we grow our international and as we grow our direct-to-consumer business, that does lead and drive higher gross margins.
The second piece is, as part of our global productivity initiative, we were able to actually lower our sourcing costs as we simplified some fabric platforms, et cetera, et cetera, negotiated a lot better with our vendors. We began to see the impact sometime last year, and that's continued into 2016. I think the drivers by quarter tend to vary, one of them is promotions, and that is largely driven, as you know, by the environment or, in our case, by having higher inventory than we would like. I think that's something that's going to vary over time.
I just have one more, if I may, on Dockers. I know we've talked about it today, I know you said it's still trending negative this quarter, what do you think was kind of missing or hasn't really taken effect yet with the consumer in the relaunch that you did? Is there still an opportunity to kind of go back and say, "Okay, we didn't do this, we'd like to do this," it's an opportunity for the future to see the results that you'd like to see in that business?
I think it's a great question. The transition to Signature Khaki literally is just kind of being completed. That's the biggest part of the Dockers business. Had it to do all over again, I would've done that much, much faster. We paced the transition to the soft, stretchy material over basically the fiscal year, there's still a little bit still to be done. It was maybe a little bit too little too late. That's probably the biggest opportunity. We are confident that the product that we're putting into the marketplace is the right product. The fact that Signature Khaki, which is about 40% of the U.S. business, was kind of the last big chunk to go this fiscal year, we should've gotten that up sooner in the year. It wasn't enough, early enough to make a difference to get the business turned.
When you add the challenging wholesale environment that all of our key customers have been experiencing and the traffic declines and some of the issues that are in U.S. wholesale in general, that has just compounded the Dockers situation.
Okay. Thanks so much, and good luck next quarter.
Thanks.
Thanks.
At this time, I would like to turn the floor back over to the company for any closing remarks.
Okay. Well, thank you all for joining us. Our next call will be for the fourth quarter, which won't be until early in February. Have a great holiday, and we'll be talking with you all in several months. Thanks a lot for calling in.
Thank you. This concludes today's conference call. Please disconnect your lines at this time.