Good day, ladies and gentlemen, welcome to the Levi Strauss & Co. second quarter 2015 earnings conference call. 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 July 17, 2015, by calling 800-585-8367 in the United States and Canada, and 404-537-3406 for all other locations. Please use conference ID 65640176. This conference call also is 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 conference over to Chris Ogle, Vice President, Investor Relations, and Assistant Treasurer at Levi Strauss & Co.
Good afternoon, welcome to our quarterly conference call. I'm pleased to introduce members of the Levi Strauss & Co. management team. With us here today are Chip Bergh, our President and CEO, 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 concerning matters such as our expected financial and operational performance, including our guidance for fiscal 2015, our strategic plans, our expectations for the economy and currency headwinds to our reported revenues and earnings, anticipated full-year A&P spend, future investment in retail and e-commerce operations, reduction of controllable costs, long-term estimated savings from our global productivity initiative that are based on our current assumptions, expectations, and projections about future events.
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 annual report on Form 10-K, our registration statements, and other filings with the Securities and Exchange Commission. We expressly disclaim any responsibility to update 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'll find the appropriate reconciliations at the earnings webcast page in the investors section of our website, as well as in our earnings press release announcing the second quarter 2015 financial results, which was furnished with the SEC today on Form 8-K. Finally, today we filed our quarterly financial report on Form 10-Q with the SEC. You can link to our SEC filings from our website. Now I'd like to turn the call over to Chip Bergh.
Thanks, Chris. Good afternoon, everyone, thank you for joining us today. As we anticipated, a few of the headwinds we faced in the first quarter continued through the first half, particularly the stronger dollar that impacted our reported results for the second quarter versus last year. The stronger dollar also negatively impacted traffic in our U.S. stores, particularly in tourist areas. In light of these pressures, we were pleased to have grown second quarter revenue on a constant currency basis. We achieved this by maintaining our focus on executing our key strategies. We grew our global Levi's men's bottoms business, which is a key component of our profitable core. We expanded beyond the core by growing internationally, we invested in our global direct-to-consumer business, which increased double-digits on a constant currency basis.
Additionally, our profitability continued to benefit from the global productivity initiative we launched a year ago. We believe the execution of our strategic plan will result in sustainable, profitable growth over the long term. As we move into the second half of the year, we're excited about the introduction of the new Levi's women's denim collection, which we announced earlier this week and is already beginning to hit stores. I'll discuss this initiative and other second-half growth drivers after Harmit walks you through the financial details for the quarter. Harmit?
Thanks, Chip. Welcome to everyone joining our call. My comments today will reference second quarter comparison on a year-over-year basis in U.S. dollars, unless I indicate otherwise. Net revenues of $1 billion declined 6% on a reported basis. Excluding unfavorable currency translation effects of 700 basis points, net revenues increased 1%. On a constant currency basis, direct-to-consumer revenue growth of 10% more than offset a 3% decline in wholesale revenue. About half of the wholesale decline reflects the fact that we're moving our Women's Dockers business to a licensed model. We have now anniversary-ed the Women's Dockers exit from U.S. wholesale, thus the second half of 2015 will not be affected by this change. Gross profit for the quarter declined 6% to $500 million on a reported basis, in line with the revenue decline. Reported gross margin improved 40 basis points.
Excluding unfavorable currency effects of $43 million, gross margin expanded more than 200 basis points. The improvement primarily reflected our lower negotiated sourcing costs and continued savings from streamlining our supply chain. We also continue to benefit from growth in our higher-margin international and retail businesses. The structural economics of our gross margin continues to trend in the right direction. Second quarter SG&A expense of $450 million was up 1% on a reported basis. Excluding currency effects, SG&A increased 8%. Two-thirds of the increase in SG&A expenses related to the expansion of our direct-to-consumer business, which includes both our brick-and-mortar stores as well as e-commerce. Our company operative footprint at the end of the second quarter had 52 more stores than a year ago. The remainder of the SG&A increase reflected the earlier timing of our marketing programs this year.
Advertising and promotion spending as a percentage of revenue was 6%, in line with our expectations for the full year. Adjusted EBIT of $63 million declined $30 million from the prior year. As a percentage of net revenues, Adjusted EBIT was 6% as compared to 8% last year. The decline was driven by $14 million in unfavorable currency effects and constant currency increases of $20 million in higher direct-to-consumer expenses and $13 million in higher advertising investments. A detailed reconciliation of Adjusted EBIT is attached to our press release. Second quarter net income of $12 million was up 2% from last year. We recorded a $14 million loss on debt retirement during the quarter associated with the April refinancing of our 2020 notes, which will drive interest savings going forward. I'll share more detail on the second quarter results of our three regions.
Net revenues in the Americas declined 2% in constant currency and 4% on a reported basis. The decline reflected lower wholesale revenues, primarily due to the Women's Dockers exit. Direct-to-consumer in the region was up slightly, as online growth was partially offset by lower revenues from our brick-and-mortar stores. While conversion remains strong, the retail environment remains promotional, and the traffic was increasingly challenging, particularly in domestic stores situated in major tourist destinations. Adjusted EBIT for the Americas declined 6%, reflecting higher retail and advertising investment in support of our revenue initiatives, partially offset by a higher gross margin. In Europe, net revenues grew 8% without the impact of currency but fell 15% on a reported basis as the stronger U.S. dollar continues to significantly impact our results in the region.
On a constant currency basis, revenue growth was again driven by strong retail performance and expansion, particularly in the U.K. and Russia. Adjusted EBIT in Europe declined 12% due to the negative impact of currency, but grew 24% on a constant currency basis, reflecting the higher net revenues. We have taken pricing across Europe and expect that this, along with our cost actions, will mitigate the impact of currency and protect the long-term structural economics of our business. In Asia, net revenues were up 2% without the effect of currency, but down 5% on a reported basis. The environment remains promotional, with revenue growth coming from our direct-to-consumer network, primarily in China. Adjusted EBIT in Asia declined $8 million, reflecting our retail and advertising investments. Turning to the balance sheet and cash flows.
Inventory dollars and units are up from November due to our normal seasonal build and in preparation for our women's launch. However, compared to a year ago, inventory dollars and units declined, demonstrating improved inventory management. Free cash flow for the first half of 2015 declined to $8 million as compared to $14 million for the first half of last year. A $30 million increase in cash flow from operation was offset by $10 million of higher capital expenditures and a $20 million increase in our dividend payment. Overall, liquidity continues to remain strong. Total available liquidity at quarter end was $818 million, comprised of cash of $285 million and $533 million available under our credit facility. Net debt of $906 million was flat to year-end, and leverage, as we define it, was 2.2, compared to 2.6 a year ago.
Lower leverage primarily reflected the redemption of our euro notes last year. In April, we successfully issued $500 million in 5% bonds due 2025 and used the proceeds to refinance our seven and five-year 2020 bonds. This transaction significantly improves our weighted average cost of borrowing and demonstrates the strength of our brands and our financial performance and trajectory. While debt reduction remains one of our priorities, we have no significant maturities until 2022. We anticipate that de-leveraging in the near term will be driven more by Adjusted EBIT expansion than debt reduction. We continue to make progress on our global productivity initiative. However, certain of the related actions are taking longer than expected to implement. Actions to date are still anticipated to deliver net benefits of $125 to $150 million on a constant currency basis relative to fiscal 2013.
We continue to target total net benefits of $175 to $200 million for the Global Initiative when completed. However, we now expect it will take through the end of fiscal 2016 to complete the majority of the execution. With that, I'll turn it back over to Chip.
Thanks, Harmit. As we move into the second half of the year, we remain cautiously optimistic. We're encouraged by the progress we've seen as we execute our strategic plan, and we expect growth in the back half of 2015. Our investments in our global direct-to-consumer channel continue to drive sales, not only from expansion, but also from the performance of our existing footprint and e-commerce sites. We continue to expect to open more than 60 new stores this year, and we have further enhanced consumer experience by improving in-store service and introducing key omni-channel capabilities, such as Find in Store, which we launched in the U.S. and the U.K. in the first half.
While we believe slower store traffic in domestic tourist areas will remain a challenge for the next few quarters, we believe the investments in consumer experience, international expansion, and enabling technologies will all help us to maintain strong growth in retail globally. Our focus on product is also yielding encouraging results. The performance of the Levi's 501 CT, which launched this spring, contributed to solid growth in our Levi's 501 franchise in the first half. Given the success of the 501 CT, we've introduced new washes and finishes in stores for the second half of 2015. We continue to see notable strength in the second quarter in our slimmer styles, such as the Levi's 511 and the 513 for men and the 535 legging for women.
We believe the continued performance of these trend-right styles, together with increased working media dollars for the Live in Levi's campaign, will support our second half growth objective. The most anticipated product initiative for the second half will be the launch of the new Levi's women's denim collection, which is hitting retail floors now. This important global initiative hits three of our four key strategies. It will help drive our wholesale business, which is a component of our profitable core, will help us expand beyond men's by driving growth in women's, and will help elevate the performance of our direct-to-consumer channel. To ensure the success of this important initiative, we've incorporated market research insights and analyzed thousands of body types in the development of our new Levi's women's denim collection to give consumers the styles, fits, and finishes they crave.
In our own stores, you will also see a greater emphasis on women's generally. We feel good about the actions we've taken, and we are encouraged by the early performance of the redesigned products in select Levi's stores globally, as well as the positive reception by major wholesale customers. We are confident the relaunch will provide us with better positioning and will play an integral role in our success in the second half and beyond. In the second half, we'll continue to benefit from the lower costs we're seeing related to the global productivity initiative we launched last year, which helped offset the negative currency impacts to our margins this quarter.
In summary, we continue to make progress on the execution of our strategic business plans, and we're excited about the momentum we are building as we move into the second half of the year. With that, operator, we will take 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 headset. Your first question comes from the line of Carla Casella with JPMorgan.
Thanks for taking the question. I'm looking at the results in your 10-K. When you're looking at FX, the impacts for the quarter, you have some footnotes which also show that you actually had an FX management gain of $13.9 million. It's included in your other income line, which is below the operating EBITDA. Is that something we should look at as part of the EBITDA, or is that gain on items that would have been in cost of goods and SG&A?
Hey, Carla. It's Chris. Thanks for the question. Yeah, that's a good catch. We're not going to tell you whether or not to include it in the way you look at EBITDA, but you are correct that that number emanates from the revaluation of the contracts that we enter into to mitigate transaction effects, both in cost of sales and in selling. Your inference is correct.
Okay, great.
Carla, one point to note. We don't do hedge accounting. Most public companies do hedge accounting. That's why you see some of the hedging gains and losses, if any, that relate to transactions below our Adjusted EBIT.
Okay. That makes sense. There's one other item, the $7.5 million gain on the Turkish facility. Is that lumped in one of your restructuring charges that you broke out when you gave the Adjusted EBIT breakout, or is that not taken out?
No, that's part of our other line. If you, in the SG&A table, for example, other expenses, it's part of that, and I think it's cited there, in the MD&A. Adjusted EBIT includes the reflection of the gain.
Okay.
We have not Adjusted EBIT because of the gain.
You did not take the gain out of EBIT?
Correct.
Okay. On the Dockers sales, I want to make sure I've got it right. How much of the reduction was it all the licensing, or are you also cutting back any shelf space?
Most of it was licensing. As I'd mentioned, from a year-over-year basis, this is the last time we'll probably talk about the impact of licensing. Our men's business was down a bit. Overall, while the category was soft in the U.S., we believe we grew share.
Okay, great. I'll let some other people get in there. Thank you.
Your next question comes from the line of Karru Martinson with Deutsche Bank.
Good afternoon. When you guys talk about the investments in the direct-to-consumer channel, I certainly understand opening new locations, but what are some of the other investments that you're making, and how should we think about the magnitude of the spend for the rest of the year?
Hey, Karru. Yeah, you're right. We're investing pretty significantly in e-commerce, both in terms of technology, so a chunk of capital investment last year, this year, and probably going forward. For example, some of the functionality that I talked about has been enabled by a move to a new platform, which is Hybris, which we've now executed here in the U.S. this past month on both Levi's and Dockers. We've been investing in technology, and we're going to continue to invest in it. We're playing a little bit of a game of catch up. We're also investing in the organization. We have built a true dedicated e-commerce team, and that's been funded largely from some of the savings from the productivity initiative. We've talked about making strategic reinvestments.
This is a great example where we've reinvested in headcount, the right kind of headcount, to drive our e-commerce business.
When we look at the advertising step up that we've had year to date, starting to see some of your women's advertising in the trade publications. How should we think about the spend as you support that launch? Is that going to be above and beyond the expectations, or will that fall in line with your current pace?
We have said right from the beginning of the year that our A&P spending as a percentage of sales will be around 6%. We're sticking to that. What we've consciously tried to do is smooth our spending out a little bit, instead of these huge spikes the last couple of weeks of the fiscal year. We've made a conscious decision this fiscal year to smooth our spending out. I think we were right at about 6% this past quarter. We'll continue to spend against that guidance. As we move into the second half of the year, we'll be supporting both the women's relaunch as well as the core 501. We've got marketing support above the line with working media dollars against both the men's and the women's business in the second half.
Okay. Just lastly, we've heard a lot about denim as a category being under pressure, whether it's from athleisure or other trends. How do you guys look at denim here in the second half of the year?
Well, I'm a runner, and I wear running tights every now and then when the weather's cold, but I wouldn't go to a restaurant in them. Denim's here to stay, and I think with the marketing investments we're making, we're going to see denim starting to make a rebound is the fact of the matter. It's been on the runways. Denim on denim is a key look right now, denim top with a denim bottom. I think the innovation that we're bringing to the marketplace is going to drive growth. As the market leader, as the category leader, it's up to us to continue to innovate and to drive growth. A lot of the new women's denim collection, it is about fit, but it's also about fabric, finishes, washes.
We have a range of products from regular non-stretch denim all the way to very stretch bottoms that what women are looking for. We've got a broad range in this new women's collection based on what women want. We think we've got the bases well covered.
Thank you very much, guys. Appreciate it.
Okay.
Your next question comes from the line of Grant Jordan with Wells Fargo.
Hey, guys. Thanks for taking the questions.
Go ahead.
Just to follow up on the direct, it looks like you really increased the store count this quarter. Is that gonna slow down as we move throughout the year, or is this gonna keep up?
Yeah, it's gonna keep up. We probably open on a net basis 30 stores in the year. Year-over-year, the number is over 50 because you're looking at the end of second quarter last year and the end of second quarter this year. The thing that I'd encourage you all to think about is the structure of this business
It's probably going to change over time. It was predominantly wholesale. Retail or direct to consumer is beginning to grow. We're investing behind it. If international is growing, most of international is direct to consumer. I think over time, you're going to see these investments pay back. Going back to the question of leverage on retail, our control retail business grew 10%, and that offset the wholesale decline. The investments over time, we believe will pay back.
Grant, this is Chip. The other thing I would just remind everybody, we've been very transparent with our key strategic choices, one of our key strategies is to become a leading world-class omni-channel retailer. We've been investing in that both on the e-commerce side as well as in bricks and mortar stores, and you see it playing through in our results. These are structurally attractive businesses, and as long as we do a good job executing, it can help us continue to grow profitably.
Great. Yeah. You can definitely see it in the results. I guess kind of a follow-up on the women's. Can you quantify, do you feel like you have the same shelf space as you did under the old styles with the new women's relaunch?
Well, in our own stores, we're dedicating more space to women's than we have in the past. Across the wholesale channel, in several instances, we're combining multiple tabs into one destination location for our women's business, and that nets us on balance a bigger space. We feel really good. I've seen pictures already from some of the wholesale customers where we're set up. Those of you who are in New York, you could go to Macy's Herald Square and take a look at it. It looks great, and it brings a lot of energy to our business. I think our sales team has done a phenomenal job working with our key customers to launch this in a way that's going to make major impact in their stores.
Great. That's helpful. That's all I had.
Thanks, Grant.
Your next question comes from William Wauters with Bank of America Merrill Lynch.
Hey, guys. In your prepared remarks, you noted that you expect growth in 2015. I was wondering whether that was meant to refer to growth in revenues or growth in Adjusted EBIT or EBITDA.
It's both, Bill. Obviously, it starts with the top line. The only thing I'd want you guys to note is because we have one less week this year, the impact of that on a full-year basis is about a point.
Okay. When you guys were talking about your adjusted gross margins or kind of currency-adjusted gross margins, you highlighted two things. One, the streamlining initiatives, and then the lower price sourcing costs. I guess, if you can talk a little bit about the sizing of those two different factors. You're seeing lower price sourcing costs. How much are those prices lower on a year-over-year basis?
I think I mentioned in the prepared remarks that the impact of currency was about $43 million on margins for the quarter. If you back that out, our margins are up 200 basis points in constant currency. In terms of exact specifics, it is difficult for me to comment on that, but what I would say is our margin performance is basically a combination of better negotiation, savings from streamlining supply chain. We have optimized the network. We just talked about closing a plant in Turkey, for example, and giving that production to a third party at better prices. There's also structural change in margins, which is as we go more direct-to-consumer, the margin on the direct-to-consumer business is higher than retail. There's also international. As that business begins to hum, international businesses help our margins from that perspective.
The only other thing I would say is our product introduction also drive margins. We introduced the 501 CT in the first half of the year. Like the 501 product, the margins are higher than the average for us as a company. As we start thinking about new product introductions, et cetera, that does make an impact to our gross margin.
Okay. Just lastly from me, you guys talked about weakness at retail in the U.S., and you kind of highlighted tourist destinations. If we go and forget about those specific stores, if we just look at the non-tourist retail stores, was traffic down in those locations? If so, I guess to what do you attribute it if it's not kind of weakness in denim broadly?
As we have said in the past, traffic has been declining. If you take the last eight quarters, I'd say traffic has declined. The traffic decline is a general trend. Having said that, the traffic decline in non-tourist stores is far less than the tourist stores. I would say largely consistent with the pattern we've seen over the last couple of quarters. What we're doing about it is we're not sitting back and seeing the decline. We're actually acting upon it. We're focusing on the products that are clear consumer wins. We're really focused on growing our tops business. Chip talked about introducing tees and tee bars over the last couple of quarters. That's making a big difference. We're focused on trying to grow the business even though there's a decline in traffic.
That's pretty evident in our results, A, globally as well as in the U.S.
Do you think the decline in traffic that you guys are experiencing is any different than you're seeing across other, either apparel retailers or kind of the stores that you might be situated next to?
Difficult to comment with precision, but our understanding is it's in line.
Okay. That's all for me. Thank you.
Your next question comes from the line of Hale Holden with Barclays.
Thanks. Thanks for taking the call. I had two questions. Can you give us any specifics on what the delay getting the last $50 million under the cost reduction plan is?
Sure. It's what I call more of a programmatic rollout delay. It's an ambitious program that we're doing, transformational and global at the same time. If you go back, we did the easy lifting in terms of eliminating redundant jobs. The tough piece of it is things like we're outsourcing our back of the house. We're in the process of optimizing our supply chain network, including distribution centers, and we are integrating end-to-end planning with merchandising, and we're doing it on a global basis. From our perspective, doing it right is more important than speed, because we want to institutionalize it. It's just taking a little longer. We haven't backed out from the savings. In fact, the results of what we have already executed are panning out as we expected.
We said that we'll still feel very confident with delivering $175 million-$200 million overall as the program gets executed. Based on what we've done so far, we still think the savings are in the region of $125 to $150.
Just to add to that, Hale, what we're undertaking in some of those work streams that Harmit just mentioned, the scale and the complexity of it is pretty massive. I've been saying internally, and I'll say it externally now, that it's more important we do it right than do it fast. For example, the global business services, we're taking all of the back-office transactional work that most of which we used to do internally ourselves in the areas of HR, IT, customer service, and what am I leaving out?
Finance.
Finance. We're moving it. It's very, very complex. When you move all the back-office HR stuff, that affects employees, it affects retirees, and you got to do it right. It has turned out to be, I don't want to say more complex than we expected, we knew it was going to be complex, but challenging. We're making sure that we do it right and that results in us being a little bit more diligent, but a little bit slower in getting the full program executed. We're very confident we're going to drop to the bottom line what we committed. We're seeing this play out exactly as we had expected, with the exception of the timing.
A second question is, on the Asia gross margin decline in the quarter, you called out a higher promotional environment. Is that one country specific or one competitor specific? Any color there would be helpful.
It's across the board. It's not, Hale, a new fact. The environment has been fairly promotional. Despite that, our results have been fairly good. Both China and India have picked up from the past. Again, not something that's happened this quarter. It's something that we have seen now for a few quarters as we've invested in a new team in China, for example. Again, it's the environment there. We're doing what we can to try and grow our business and continue to grow overall margin.
You haven't seen any impact in China from the recent noise around the market there or the big push that some of the guys are doing e-com, have you?
Yeah. Nothing yet. Our e-commerce business is doing fairly well. If you ask me next quarter, I'll give you a little bit more insight because I'm headed there over the weekend.
Sounds good. Best of luck on the trip. I managed to catch the Alicia Keys Women are Badass clip. It was impressive. Well done.
Great. Good, thanks.
Your next question comes from the line of Kevin Coyne with Goldman Sachs.
Hi, thanks for taking the questions. I was just looking through my notes from the prior call, I think you gave us some help with a couple figures in terms of fiscal 2015 margins being at 50% and obviously more back-end loaded. You also mentioned some color on the impact to revenue with FX and EBIT. I apologize if I missed it, if you mentioned those figures again or reiterated them, but should we keep with those same trajectories, or should we update, are there updated numbers on that?
Sticking with the trajectory is appropriate. On the gross margins year-to-date, if I'm not wrong, our margins are slightly north of 50%. It's 50.2, I think. Our full-year gross margins are still expected to be in and around or slightly better than 50%, and we said on constant currency. Our year-to-date performance is a little better than that. Similar guidance on currency impact. We said that the translation effect of currency on revenues was between 500 to 700 basis points. We're seeing year-to-date more like 700 basis points and the impact on Adjusted EBIT twice that.
Okay.
The only other fact was CapEx, which you guys probably need to model, and we're maintaining the $110 million to $120 million range for the year.
Great. That's very helpful. Thanks. In terms of the Europe pricing that you said you took or are going to take, when does that go into effect?
Most of what we've said has already taken effect. Russia, we've taken pricing now a couple of times. Broadly in Europe, it went into effect about the early part of June, and we've taken pricing in markets like Mexico in quarter two.
Great. Just one final one. With retail becoming an ever bigger presence, do you have perhaps a same-store comparable retail figure for us?
Not yet publicly. Internally, we do measure it, and once we're ready to externalize that, we will. I would just go back and look at our retail performance consistently over the last few quarters on a total retail performance, and it's positive, like this quarter.
Okay, thank you.
At this time, I would like to turn the floor back over to the company for any closing remarks.
I guess that's it. I want to thank you all for dialing in, and we'll talk to you again after the third quarter. Thanks very much, and have a nice weekend.
Thank you. This concludes today's conference call. Please disconnect your lines at this time.