Earnings Call: Q3 2016

Oct 11, 2016

Good day, ladies and gentlemen, and welcome to the Levi Strauss and Company Third Quarter Earnings Conference Call for the period ending August 28, 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 2 hours after the completion of this call through October 14, 20 16 by calling 1-eight fifty five-eight fifty nine-two thousand and fifty six in the United States and Canada and 1-four zero four-five thirty seven-three thousand four hundred and 6 for all other locations. Please use conference ID 821-98658. This conference call also is being broadcast over the Internet and a replay of the webcast will be available for 1 month on the company's website, levistrauss dotcom. I would now like to turn the call over to Chris Ogle, Vice President, Treasurer and Investor Relations at Levi Strauss and Company. Thank you. Good afternoon, everyone, and welcome to our Q3 2016 conference call. I'm pleased to introduce members of the Levi Strauss and Company management team. With us here today are Chip Berg, 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. And now I'd like to turn the call over to Chip Berg. Thanks, Chris, and good afternoon, everyone. Thanks for joining us today. We're pleased with the Q3 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 3rd quarter and up 5% on a constant currency basis. Gross margins remained solid and 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 percent of total company revenues and 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 3rd quarter comparisons on a year over year basis in U. S. Dollars unless I indicate otherwise. 3rd quarter net revenues of $1,000,000,000 grew 4% on a reported basis and 5% excluding $11,000,000 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 5 $93,000,000 as compared to $573,000,000 last year despite unfavorable currency translation effects of approximately $5,000,000 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. 3rd quarter SG and A expense of $449,000,000 was down from $455,000,000 on a reported basis. Currency favorably impacted SG and A by $4,000,000 As a percentage of revenues, SG and 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 $146,000,000 was 14% higher than prior year on a reported basis and 15% higher on a constant currency basis. As a percentage 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. 3rd quarter net income grew to $98,000,000 as compared to $58,000,000 last year. The increase primarily reflected higher adjusted EBIT margins and lower charges this year related to our productivity initiative. Now I'll share more detail on the 3rd quarter results of our three regions. Net revenues in the Americas grew 2% on a reported basis and 3% excluding $8,000,000 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 $5,000,000 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 5,000,000 dollars 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 Q3, 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 Q4. 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 1st 9 months of 2016 was a net use of $11,000,000 reflecting our higher inventory, capital expenditures and a larger dividend as compared to prior year. Total available liquidity at quarter end was $937,000,000 comprised of cash of $272,000,000 $665,000,000 available under our credit facility. Net debt was $835,000,000 and our leverage declined to 1.8 from 2.2 a year ago. Now turning to our outlook for the year and 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 and A as a percentage of revenue to be approximately 50 basis points higher compared to prior year primarily driven by continued rate to consumer investments. Given favorability in advertising costs this quarter, we now expect advertising as a percentage of revenue to be in line with prior year. Capital approximately $10,000,000 lower than prior estimates as a result of timing of projects. And we remain on track to open 70 company operated stores in 2016. Chip, back over to you. Thanks, Harmit. We delivered 3 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 Q3, while global women's revenue was up high single digits even as we anniversaried the relaunch in August of last year. And we've continued to expand in the emerging markets of India and Russia with double digit revenue growth. And our direct to consumer expansion and overall execution at retail has helped us grow despite ongoing challenges in Dockers and the declining U. S. Wholesale channel where we still have work to do. Heading into the Q4, 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. And with that, we'll take your questions. Thank you. Your first question comes from William Greuter with Bank of America Merrill Lynch. Good afternoon. Hi, 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 Q4? 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 Q4? Or will there be additional markdown risk moving into 2017? Sure, Bill. Let me address, 17? Sure, Bill. Let me address both the questions. Our gross margins on a year to date basis are 51.3%. And while we don't necessarily guide margins quarterly, we are indicating that we stand by our previous guidance of ending the year at 51%. So you can do the math and probably get an expectations for quarter 4. Going back to what drove margins in quarter 3, I indicated that the margins reflected essentially a 300 basis points impact and this is an adverse impact, which is a combination of transaction impact, thanks to currency as well as our inventory management efforts. And if you split the 2, I'd say 2 third is the currency impact, which is transaction in nature. It includes the Brexit impact of $5,000,000 that I spoke about earlier. And 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 continue so we've done quite a bit in quarter 3 in the U. S. And we continue to believe we'll be doing that through the end of quarter 4. And our 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. 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. And that's largely driven by 2 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 2 part question. That is That does help. And then you mentioned weakness in Dockers and 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. So our issue with Dockers is fundamentally concentrated here in the U. S. Dockers did decline in the 3rd 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 kind of as we speak. The stretch product is selling well. The stretch product that's been in stores up through the Q3 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. So 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. So if I think you said that most of the inventory increase is concentrated in the U. S. Related to the soft wholesale. Is that correct? Yes. I would basically again these are broad numbers, but I'd say 2 third 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. And about a third is largely in international and driven also largely thanks to our growth in our direct to consumer channel. Okay. So I mean if we were to I know you don't give this sort of detail, but would that imply that like inventory for the U. S. Wholesale is up like 30 plus percent year over year? We again don't break it up. But the one thing I would tell you, Grant, the wholesale business at least from our perspective has long lead times. And the moment and this problem began when we saw demand softening sometime this time a year ago. So 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 4. And 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. So my last question, if you can give a little bit more color on the $7,000,000 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. And the $7,000,000 charge was really thanks to the resolution of a dispute that we've had with a vendor. And in essence, it's the reversal of a charge that was taken years ago. And 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. So if we wanted to look at it on a recurring basis, maybe we'd back that $7,000,000 out? Great. And even if you did that, Grant, you'll see that our adjusted EBIT earnings growth is largely fairly strong for the quarter. Sure. Yes. Okay. Thank you for the information. I appreciate it. Thanks, Graham. Your next Thanks, Graham. 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 got to remember that in direct to consumer, we also include our owned and operated e commerce business as well. That's growing off of a relatively low base. And the combination of those two things, brick and mortar is growing, e commerce is growing at kind of an outsized growth and the combination of that results in this double digit growth in our direct to consumer business. And 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. And so 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, I think I mean, you should ask them what their challenges are. But if you want my take on it, I keep saying that their challenges are our opportunities. If you walk the floor of any of our big 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. And by contrast, if you walk through any of our own retail stores, we show up as a lifestyle brand. And 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? 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. We with the buildup that just happened, we have obviously gone back and looked at all our processes. It's a chink in our armor despite all wonderful results that we are achieving this year. We are cognizant of that. So we're taking a hard look at things we can do better as well as drive more agility internally. And there are things we will be working with our customers also going forward. So 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, Karru. Your next question comes from Carla Casella with JPMorgan. Hi. You talked about opening some new stores this year. Can you just give us a sense for the dispersion of whether how many of those are U. S. Versus EMEA versus APAC? Yes, sure. So we talked about opening 70 stores and we're sticking with that. We have a large bulk of the openings in quarter 4. I think we opened about 50% so far and 50% in quarter 4. Over time, we'll get better and we spread that out across, but that's 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. And as Chip had referenced, our business outside the U. S. Is skewed towards retail. And the balance between mainline and outlets is also a lot more balanced actually outside the U. S. So it's a good balance between mainline and outlet stores. And as I said, mostly outside the U. S. Okay, great. And then 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 was it had kind of changed by the end of by September. Are you seeing any change in that market? I would say, if anything, we've seen the business slow a little bit, but let's start with 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 Q3, we did see it slow a little bit. And we're mostly a retail business in China. It's a combination of owned and operated and franchise. And within that, it's a little bit of a tale of 2 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. And it does demonstrate that the brand is executional challenges that we're working through right now. I personally believe and I've been saying this ever since day 1, China is strategic for us. It represents enormous consumer opportunity, 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. And then 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? Yes. 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. And back to school is no longer what it was even 5 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. I mean, 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 and 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 Hallie 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 have been last year or the year before either in percentage or dollar terms? It's all I can say, it's fairly significant relative to last year for the U. S. Business. I can't get into the numbers, Harry, but it's significant. And that's why we feel good about where we think we can end the year. And the second question I had was in the direct to consumer growth in the U. S. Would it be possible if you would give us some idea of how that trended in e commerce versus outlet versus full line stores, which ones did better, specifically how the outlet section did? Yes. We don't break up the direct to consumer between e commerce and brick and mortar. The thing as I said in my prepared remarks, we there was improved performance in existing stores, which really means a big brick and mortar existing base grew. And 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. But the thing I could say is we're growing largely our growth is largely driven by higher conversion rates and higher units per transaction. And 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 digit. And then finally, European growth was really impressive. And taken from your comments that you increased 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? Yes. 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, etcetera are all performing. And 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. And our e commerce is also performing. So basically, we're hitting on all cylinders and across most markets other than 1. So it's in a knock on wood and a big shout out to the European team. 2 quarters in a row, 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. And the team is just executing great, but the brand strength particularly the Levi's brand strength, I mean, 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. And 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. I mean and 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. And so it's very broad based and very solid and it's virtually across the board and it shows what is possible, I believe. Great. Thank you for the time. I appreciate it. Thanks, Harold. Your next question comes from Gemma Giannelli with Citi. Hi. Thanks for taking the question. My first one is kind of a follow on. Hi. Kind of a follow on to an earlier one asked, but 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 they 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 mean, 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. So 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. So and again, in wholesale, unfortunately, we're mostly a classification business and mostly a bottoms business and mostly a predictable bottoms business. So 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 because I think that would help us drive growth in that channel. But we are where we are right now. And 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. No, definitely it does. Thank you. And then separately, just on the gross margin line, I know overall you're still looking for 51% for the year and for the Q3, it was pretty in line with what we were expecting. But I'd say particularly in Asia, it seems like the gross margin got hurt a little bit more than it had in previous quarters. So if you could talk about kind of what's really driving that, what's the main cause for such kind of the intense promotional environment that you're seeing there? And is it really both on the retail and the wholesale front? So Asia is has been largely promotional and not only in this quarter, we've seen that for a while. And see that in our key markets. So 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 3 as well as quarter 4. The good news in our margin is that structurally, we've been able to do a few things which should board 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 etcetera, etcetera and negotiated a lot better with our vendors. And that has had we began to see the impact sometime last year and that's continued into 2016. I think the drivers by quarter tend to vary. And one of them is promotions and that is largely driven as you know by the environment or in our case by having high inventory than we would like. And I think that's something that's going to vary over time. Okay. And then I just have one more, if I may, on Dockers. I know we've talked about it today, but, and you said it's still trending negative this quarter. But what do you think was kind of missing or hasn't really taken effect yet with the consumer in the relaunch that you did? Or is there still an opportunity to kind of go back and say, okay, we didn't do this, but we'd like to do this and 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 Kaki literally is just kind of being completed. That's the biggest part of the Dockers business. And I had it to do all over again, I would have done that much, much faster. We paced the transition to the soft stretchy material over basically the fiscal year and there's still a little bit still to be done. And it was maybe a little bit too little too late. So that's probably the biggest opportunity. We are confident that the product that we're putting into the marketplace is the right product. But the fact that SIG khaki, which is about 40% of the U. S. Business was kind of the last big chunk to go this fiscal year, we should have gotten that up sooner in the year. So, 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 is 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 Q4, which won't be until early in February. So 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.