Good day, ladies and gentlemen, welcome to the Levi Strauss & Co. second quarter earnings conference call for the period ending May 29th, 2016. All parties will be in listen-only mode until the question and answer session, at which time instructions will follow. The 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 July 15th, 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 number 3450 4353. This conference call is also being broadcast over the internet, a replay of the webcast will be accessible for one month on the company's website, levistrauss.com.
I would now like to turn the call over to Chris Egol, Vice President of Treasury and Investor Relations at Levi Strauss & Co.
Thanks. 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, our President and CEO, and Harmit Singh, our Executive Vice President and Chief Financial Officer. Before we begin, I'll 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 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 could have a material adverse effect 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 investor 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, and good afternoon, everyone. Thank you for joining us today. Reported revenues were flat to prior year in the second quarter, but given the challenges facing U.S. wholesale, we were very pleased to deliver revenue growth on a constant currency basis. Gross margins expanded, and we were able to hold adjusted EBIT in line with last year, despite ongoing investments in our long-term growth strategies. With the notable exception of wholesale in the U.S., our growth was very broad based, reflecting the strength of the Levi's brand. The Levi's brand delivered another quarter of growth in men's, women's, tops, and bottoms. Our international markets continue to grow as a percent of total company revenues, and direct-to-consumer grew in all three of our regions, with growth balanced between brick and mortar and e-commerce. Harmit will now walk us through the financial details for the quarter. Harmit, over to you.
Thank you, Chip. Welcome to everyone joining our call. My comments today will reference second quarter comparisons on a year-over-year basis in U.S. dollars, unless I indicate otherwise. Second quarter net revenues of $1 billion were flat on a reported basis and grew 1%, excluding $14 million in unfavorable currency translation effects. Global revenues from our direct-to-consumer channel grew low double digit on a constant currency basis, driven both by improved performance of existing stores as well as ongoing expansion of the network. In our wholesale channel, global revenues declined low single digits on a constant currency basis. Global Dockers declined as we continued to transition to our new product offerings. The Levi's brand continued to demonstrate its inherent strength. Globally, Levi's grew low single digits on a constant currency basis. Men's revenues grew low single digits, and global women's revenue grew double digits for the fourth consecutive quarter.
Thanks to the performance of our new women's collection that we introduced in the third quarter of 2015. Gross profit for the quarter grew 4% on a reported basis to $517 million as compared to $500 million last year. Despite unfavorable currency translation effects of approximately $5 million. Reported gross margin grew 170 basis points to 51%. The improvement primarily reflected growth in a higher margin international and retail businesses, as well as lower negotiated sourcing costs. The strong margin improvement was in spite of unfavorable currency transaction effects of nearly 200 basis points. Second quarter SG&A expense of $459 million was up from $450 million on a reported basis. Currency favorably impacted SG&A by $4 million. Excluding currency, higher SG&A reflected higher advertising investment and the ongoing expansion of our retail network and e-commerce business.
We had 66 more company-operated stores at the end of the second quarter than we did a year ago. Adjusted EBIT of $63 million was roughly flat to the prior year on both the reported and constant currency basis, as currency effects were not significant. As a percentage of net revenues, adjusted EBIT was 6%, flat to last year, as our increased direct-to-consumer and advertising investments offset our higher gross margin. A detailed reconciliation of adjusted EBIT is attached to our press release. Second quarter net income grew to $31 million as compared to $12 million last year. The increase primarily reflected lower charges this year related to our productivity initiative, as well as the loss we recorded last year in conjunction with our debt refinancing. I'll share more detail on the second quarter results of our three regions.
Net revenues in the Americas declined 5% on a reported basis, and 4% excluding $8 million in unfavorable currency effects. The region's revenue decline was due to lower volumes in our U.S. wholesale business, as well as the impact of the Dockers transition. Direct-to-consumer revenues from our stores and e-commerce in the U.S. continued to grow low single digits on improved conversion. As a reminder, our Americas region includes our businesses in Mexico and Canada, both of which are growing. Mexico, which is nearly 10% of the region's revenues, was up double digit in the second quarter, with growth in the wholesale channel and in our stores there. Adjusted EBIT for the Americas declined 14%, reflecting the lower revenues and higher advertising expenses. In Europe, net revenues grew 8% on a reported and constant currency basis as currency effects were roughly neutral.
Growth was driven by direct-to-consumer expansion and performance concentrated in Russia, Germany, and France. Adjusted EBIT in Europe grew 12%, reflecting the revenue growth and a higher gross margin. In Asia, net revenues were up 8% on a reported basis and were up 12% without $6 million in unfavorable currency effects as revenues grew in all channels in the region. China, India, and Japan again comprised the majority of the region's growth in the quarter. Adjusted EBIT in Asia grew 6% on a reported basis, driven by the higher net revenues. Turning to the balance sheet and cash flows. Inventory dollars and units remain elevated both from last quarter and compared to a year ago. The inventory increase at the end of the quarter remains concentrated in core products in the U.S.
We will continue to proactively manage inventory down, ensuring that we strike the right commercial balance between cash flows and margins, especially since our inventory build primarily reflects core products. Our actions so far include reducing orders of core products as well as planning the clearance of select units through promotions and discount retailers. Overall, we now expect total company inventory at the end of fiscal 2016 to be approximately 10% higher than prior year. The increase at year-end will be concentrated in Europe and Asia, reflective of the strong revenue growth we are driving in our international markets. Working through inventory in the second half of 2016 may put some pressure on gross margin. Given that our year-to-date margins are at 52%, we continue to believe our full-year margin will be at least 51%.
Free cash flow for the first six months of 2016 was $13 million, up from $8 million last year. This is despite $14 million more in capital expenditures and dividend payments this year. Total available liquidity at quarter end was nearly $1 billion, comprised of cash of $360 million and $611 million available under our credit facility. Net debt was $807 million, a modest decrease from $834 million at year-end, and a leverage decline to 2.0 from 2.2 a year ago. Before I turn it back over to Chip, let me take a moment to share key year-to-date financial highlights. As anticipated, our second quarter comparisons to prior year were not as strong as first quarter comparisons. Our achievements in the first half of 2016 have set us well to deliver on our full-year financial objectives.
First half revenues were up 3% on a constant currency basis, driven by strong international and direct-to-consumer growth. This despite the unfavorable impact of the Dockers transition costs, which were roughly half a point of consolidated first half revenues. Gross margin for the first half exceeded 52%, an almost 400 basis points expansion compared to prior year when excluding the nearly 200 basis point unfavorable transactional impact of currency effects. First half adjusted EBIT of $187 million grew 8% compared to the first half of 2015 on a constant currency basis, despite nearly $45 million in higher expenses related to our direct-to-consumer investments and advertising spend. Finally, a few comments on Brexit. While the long-term impact of this event is uncertain, we will focus on what we can control and will continue to make prudent decisions to support our growth across Europe.
The U.K. is an important part of our business, representing about 15% of our business in Europe and almost 4% of our global consolidated revenues annually. The immediate impact has been the devaluation of the pound, which, if it stays, will result in more muted growth rates for Europe than we'd have otherwise seen. As we have done when we have faced the impact of significant currency fluctuations in the past, we will evaluate various methods to mitigate the issue, including pricing, product assortments, sourcing negotiations, cost controls, and refining our hedging strategies. However, during the second quarter, the currencies in which we do business around the globe have generally strengthened against the dollar. As such, our estimates for the consolidated full-year impact of a stronger dollar have improved from what we anticipated at the beginning of the year.
Even including the impact of Brexit, we now anticipate full year unfavorable currency translation effect will be in the ranges of 200 basis points for revenues and 400 basis points for adjusted EBIT. Chip, back to you.
Thanks, Harmit. Against the backdrop of volatile macroeconomic global conditions and following the strong first quarter results, we were pleased to deliver revenue growth in the second quarter while holding margins. With the first half now behind us, we are optimistic to deliver our full year constant currency financial objectives of profitably growing revenues and gross margins. This is in spite of the inventory issues we have and the expectations that the U.S. wholesale environment will remain challenging as the year progresses. Our full year fiscal 2016 priorities remain the following: to return the U.S. business and the Dockers brand to growth and to sustain growth in direct-to-consumer and our international businesses. At the halfway point of 2016, our U.S. business is down to prior year and lower than we expected, which drove our higher inventory levels in the region.
Despite strength in our Denizen and Signature brands, the primary issue remains our U.S. wholesale business, which we are working to return to growth. Having said that, our direct-to-consumer channel continues to grow by offsetting lower foot traffic with conversion, with growing e-commerce and consumer reception to our Levi's women's denim collection in our stores remains strong. With respect to Dockers, revenue was down overall for the first half, in large part due to the planned product reset. A revamped Signature Khakis and stretch fabrication were available online during the second quarter. We began shipping new product to wholesale customers in May. The first wave of product is now on floors, along with improved signage and enhanced communication of the product innovations. Consumer reception has been strong, and we're optimistic about the growth opportunity in the second half of 2016. We will substantially complete the transition in the third quarter.
While we retain our aspiration to deliver full-year growth for the Dockers brand, our optimism is tempered given the challenging conditions at wholesale. International and direct-to-consumer growth continue to drive our overall results. Our investment in stores and improved execution at retail have helped us offset the impact of the declining U.S. wholesale channel. We opened more than 20 stores around the globe in the first half of 2016 and continue to expect more than 70 company-operated store openings for the full year. Direct-to-consumer revenues grew both in new and existing stores as well as e-commerce, where we continue to improve the consumer shopping experience. International revenues grew in all channels and in men's, women's, tops, and bottoms.
While key markets comprise the majority of international growth, we were very pleased to see nearly every market in Europe and Asia grow in constant currency in the first half of 2016. With that, we will take your questions.
Thank you. The floor is now open for questions. If you have any questions, 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.
Good afternoon, guys. On your first quarter call, when you guys were talking about the second quarter, you used the term much softer to describe your expectations. It seems like there are certain reasons that maybe did a little bit better than you guys expected. I guess maybe if you were to characterize how the second quarter performed, would you say that kind of as a whole, it was better than you had previously expected?
Yes. Yes is the short answer, Bill.
Bill, I think in terms of the parts, I'd say our international businesses and our direct-to-consumer channels performed a lot better. Our U.S. business was slightly softer, but the inherent strength of Levi's as a brand globally, including the women's product that we introduced about a year ago, and the international business has more than offset some of the decline.
Okay. I know historically you guys haven't broken out comps for your stores or something like that. You talked about lower traffic levels in your stores, and then better conversion. Is there any way you can provide us any numbers around how your stores are performing, whether it's any kind of metrics that a retailer would traditionally provide?
I think, historically we haven't talked about same-store sales, but if you look at our total growth of our direct-to-consumer business, you can do the math in terms of number of stores, et cetera. Our existing stores that Chip reflected in his prepared remarks. Existing stores continue to perform fairly well despite a drop in traffic. That's really driven by, I'd say, better execution in the form of higher conversion, as well as higher units per transaction. As we build Levi's into more of a lifestyle product, we are selling a lot more tops. With the introduction of women's business I talked about, the gender mix is also a lot more balanced, especially in our stores. I think those are the factors. We've invested in e-commerce, continuing to do that.
Our e-commerce business is also up double-digit. I think those are the factors driving the direct-to-consumer business.
Just lastly from me. Due to the timing of the Dockers rollout, I'm sure that some of your existing customers were reducing their purchases. I guess, was the impact of lower Dockers sales on the quarter, and I'm talking about the domestic or the Americas business. Was it enough to impact that overall revenue decline that we saw?
The short answer is yes. The Dockers decline is in two parts. One is, we're taking some of the old product back and reselling it through some of the discount retailers. That's one impact. The second impact is we're selling in the new product, from that perspective. The net impact was a decline. That was why when we indicated quarter two earlier, we had indicated a softer quarter.
Can you give us a number around what the impact of those two Dockers numbers would've been?
We've not been public about the first piece, but the second piece I highlighted in my year-to-date comment, which is the transition. That was about half a point on first half revenue.
Okay. I'll turn it over to others. Thank you.
Thanks, Bill.
Your next question comes from Carla Casella with JPMorgan.
Hi. One question on inventory. In your prepared remarks, you commented that part of the increase in inventory is growth in Europe and Asia. Can you give us a sense of how much of it is U.S. wholesale, and then how much of that might be related to men's, women's, or Dockers, or just even any kind of commentary around those three?
Yeah. I'll speak in broad numbers, but it should help you, Carla, as you think through it. If you look at our year-over-year increase, I'd say about half of the year-over-year increase reflects the lower demand in the U.S. and earlier timing of some receipts. Which is, basically our supply chain has got really efficient. It's primarily the lower demand. The other half reflects our international and direct-to-consumer business growth, as well as the fact we are resetting the Dockers flows with the new product. That's how you probably break the two. Primarily as we think about the year, it's largely a U.S. demand softness that's caused the inventory slowdown. The good news for us is it's core product.
That's why as we think about the best way to commercially balance this between cash flow and margins, we are taking a hard look at what we can promote and sell through off price versus just hold on for a little longer.
Okay, that's helpful. I'm wondering how much of the improvement in gross margin has been a benefit from lower input costs in the first half, and if that becomes more or less of a benefit as you go into the back half?
Yeah. I'd say it is a bit, I think on a broader basis, our gross margins are driven by a couple of other factors. One, I'd say about three-fifths of the gross margin improvement first half, second half, was driven by our sourcing strategies. Which is a combination of better negotiation, a simplification of our sourcing requirements given the Global Productivity Initiative. Simplification is really in the form of fewer fabrics, fewer product codes, et cetera. As well as we did shut down some of the factories we own and moved to the third-party vendors, we're seeing the benefits of that. I'd say the other two-fifths is largely driven by the fact that businesses that have higher gross margins are growing, which is international, our direct-to-consumer business.
Okay.
The input costs, broadly the way I'd look at it, if you're really trying to understand what is cotton helping or hurting, I'd say the cotton benefit broadly gets offset by wage inflation. The rest is largely negotiation and everything else.
Okay, great. That makes a lot of sense. Just as we look to the back half, I know I'm not asking for a forecast, I'm wondering from your conversations with the department stores and the other retailers, how do you expect second half promotional environment to play out? Could we see any differences in terms of timing of purchases? Are they signaling that they're going to purchase earlier or later than last year?
I guess the short answer, Carla, is, as we said in the prepared remarks, we're kind of planning for the worst and hoping for the best. Our expectation is that it's going to continue to be a challenging environment through the second half. You probably saw the headline in Women's Wear Daily two or three days ago that suggests that the second half could even be worse than the first half. Our expectation is that it's going to continue to be challenging. The inventory, we're not the only ones with inventory issues. The flush channels, if you will, or the off-price retailers are pretty stuffed. I expect that it's going to continue to be a fairly promotional environment through the second half of the year.
With respect to timing of orders and that type of thing, we have seen over since the period of time that I got here, back to school has become less and less of an event than it was five or 10 years ago. There seem to be less defined sales periods here in the U.S. and more just kind of an ongoing continuation of something's on sale somewhere all the time. I kind of expect it's going to continue to be that way for a period of time. Unfortunately.
Right. We like to hear that you're at least planning on it being weak and as we've seen from the last few quarters, you've outperformed it. Best of luck. Thanks.
Exactly. One of the things, if you look at the strength of our international business contrasted to the challenges in the U.S., one of the things about our international business, it's not a highly promotional environment in Europe and in Asia. As a result of that, we're able to focus on building our brand, and we've been able to do that, and it's obvious in the numbers. It's hard to build a brand when it's always on sale. What's the true value of a pair of Levi's if you're a consumer and you're always seeing the brand being footballed? It is a challenging environment to build a business.
Okay, great. Thanks. That's all my questions.
Your next question comes from Jenna Giannelli from Citigroup.
Hi there, it's Jenna Giannelli from Citi. Thanks for taking my questions. I think just kind of going back to the topic of inventory. When you think about the balance entering the quarter and then exiting the quarter, was that generally in line with your expectations, or had you hoped to maybe clear through a little bit more of that product during the second quarter?
Yeah. We had earlier in quarter one, Jenna, we had indicated that we'd probably be able to work down inventory levels to year-end at 2015 levels by the end of the year. With beginning in quarter two. Quarter two slipped a little more. We have taken our expectation of where we end the year higher than what we indicated earlier. The real reason for this, largely, so in quarter two, the real buildup was because of earlier receipts and just the timing. The reason we're indicating that we end the year 10% higher is as we, going back to the whole notion of the fact it's core product, it's a fairly promotional environment. Channels are already topped out. Why discount when it's core products? As we think about 2016, 2017, we're looking at building a little bit more inventory for those businesses.
Great. Thank you. Just one on SG&A. I know you touched on this a bit last quarter, but how should we think a little bit about the cadence for the rest of the year? When we think about some of the advertising investments that you've really made in 1Q and 2Q, how do you go about measuring the return on these investments, and have you seen any sort of benefit or uptick or response from those investments that you've made?
Yeah. Let me talk a little bit about, we anticipate SG&A at the end of the year to probably be up by 50 basis points, and that's largely 50 basis points as a percentage of revenue.
To a year ago. That's largely driven by slightly more spending on advertising and continued growth of our direct-to-consumer channel. Specifically on advertising, the quarter, I think, our advertising as a percent of revenue was about 7%. Year to date, first half is about 6.2%. I think, as you think about the year, probably 40 to 50 basis points higher. That's how we think about it. It's largely because we're balancing advertising spend through the year. Importantly, we're spending money where there's clear payback, which is international. In the U.S., it's a bit more of a balance because most of our TV money, for example, was Q2 and quarter four, and we balanced it between the first half and the second half. We have a fairly disciplined process on measuring advertising expenditure and payback.
We do the BDA analysis, as most companies do, use data as a basis to determine where to spend and how to spend and what drives the brand longer term.
Awesome. Thank you. Just one final one, if I may. It's a little bit more macro or high level. When you think about returning the U.S. wholesale business to growth, obviously styling, merchandising will drive that. Really, what's the main driver, the biggest driver potential for that to happen? Is it increasing penetration with existing customers? Is it changing the mix of customers? I know you said some of the off-price channels are a little bit full right now. Is it finding new customers? How do you rank those in terms of the opportunity or the potential to return to growth in that business?
To start with, I believe we have significant opportunities in the big core customers that we have today. They're struggling right now. Our brands, and particularly the Levi's brand, is strong when you look at our performance around the world. We think we have opportunities to go to them to say, "We can help them turn their business around. Give us more space. Give us more of an opportunity to do more than bottoms in your stores. Let us create the lifestyle brand that both Levi's and Dockers really are." If you look at the mix of bottoms to tops in most of our wholesale customers and compare it to what we do globally, and oh, by the way, we're not that great at it even globally. We have opportunities to accelerate our tops business.
We have opportunities to do outerwear, accessories at a much accelerated rate. That's, I think, the starting point is we have opportunities to grow with our existing core customers. Second, I believe we have opportunities to accelerate growth in other wholesale customers where we either have a limited presence or no presence. I'm talking regional chains, small chains, urban chains, where there are real upside opportunities for us. We've really taken the challenge that despite the headwinds that the U.S. wholesale environment, and particularly the big customers are facing right now, that is an opportunity for us, and we can't roll over. It's such an important part of our business. We have to figure out how do we grow despite those headwinds. I think we've got a pretty compelling story to go back to every single one of our big customers and ask for more.
Awesome. Well, thank you so much. Good luck.
Thank you. Thanks, Jenna.
As a reminder, if you'd like to ask a question, please press star, then the number one on your telephone keypad. Your next question comes from Kary Martinsen from Jefferies & Company.
It's Kary Martinsen with Jefferies. Just following up on Jenna's question. When we look at the growth opportunities, you talked about becoming more of a lifestyle product. For that diversification to happen, do you feel that you have the portfolio in place today to grow from? Or do you feel that you can augment that with some tuck-in acquisitions?
The tuck-in acquisition question.
Absolutely.
I think first, we do have it. You can see it in our business around the world. We have some markets where our tops business is almost as big as our bottoms business. We've got the portfolio. Could we be helped by a tuck-in acquisition? I would not say no. There could be the right kind of opportunity down the road for us that could help us accelerate our business, either on tops or on women's, which is also a significant opportunity for us. We're underdeveloped on our women's business relative to most brands as well. I wouldn't rule it out if that's what you're really looking for, Kary.
Okay. When we look at women's, you've got impressive low double-digit growth there. As you anniversary that launch, how should we think about that growth rate? Do you feel that that's sustainable, or does that moderate here as we go through the course of the year?
I think you're going to see it moderate a little bit, but the expectation is that we are going to continue to grow the business. Obviously, 12 months ago when we launched it, we knew we would be lapping it in 12 months, and we've been planning all along, how do we keep the growth rates going? It's clear that the new product and the new product line, and the way we've organized our women's collection, it's resonating, and now we need to go from strength to strength. The expectation is we're going to continue to grow it. I wouldn't promise double-digit growths on a go-forward basis now that we're lapping the launch. We'll see. At the end of next quarter, we'll be talking about how did we do the first quarter that we're lapping it, and my expectation is we'll be talking about it continuing to grow.
Okay. Just lastly, appreciate the color on Brexit and the outlook for things that you guys control. Sitting here in the U.S. though, when we look at Brexit, was there a stoppage of that consumer just not going and shopping during the quarter? Was it as big as the headlines made it out to be? Is there some kind of a near-term third quarter impact that comes from that we should factor into our modeling and our thinking?
Kary. First, the Brexit referendum happened after our quarter ended. That's the first thing to note. Both at the run-up and post-Brexit, we haven't seen any immediate impact on consumer demand. Having said all that, as you probably have seen the reports and the complexity of the potential exit, I think it's going to take time. I think the immediate impact that we're all seeing is in the pound and the euro. What that does to drive tourism traffic or consumer spending, I think time will tell. When we report quarter three and quarter four, if you start seeing an impact, we'll probably highlight it at that point of time, but nothing in the short term that we have seen.
Thank you very much, guys. Appreciate it.
Your next question comes from Grant Jordan from Wells Fargo.
Thanks, guys. Most of mine have already been asked. If you could give us a little bit more color on which international markets you're most positive on going into the second half of the year.
Sure. It's not more positive or less positive on. I'd say if you look at our international markets, the emerging markets of India and China are long-term markets that have huge growth. In Europe, it's U.K., Germany. Germany, we're building more of a retail business. From that perspective, France is big for us, and we're doing generally well. Mexico, we talked about. Those are the big markets from that perspective.
Okay, great. Thank you.
At this time, I'd like to turn the floor back over to the company for any closing remarks.
Okay. That's it, I guess. Thank you all very much for dialing in and joining us on the call. We will be back with you at the end of the third quarter. Thanks very much and have a great summer.
Thank you. This concludes today's conference call. You may now please disconnect your lines at this time.
Thank you.