Earnings Call: Q2 2014

Jul 8, 2014

Good day, ladies and gentlemen, and welcome to the Levi Strauss and Company's Second Quarter 2014 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 2 hours after the completion of this call through July 14, 2014, by calling 800-585-8367 in the United States and Canada and 404-537-3406 for all other locations. Please use conference ID 6,357,720 8. This conference call also is being broadcast over the Internet and a replay of the webcast will be accessible for 1 month on the company's website, levistrauss.com. I would now like to turn the call over to Chris Ogle, Vice President, Investor Relations and Assistant Treasurer at Levi Strauss and Company. Thank you. Good afternoon and welcome to our 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 that are based on our current assumptions, expectations and projections about future events. Although these statements reflect the best judgment 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 ks, our registration statements and other filings with the Securities and Exchange Commission. 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 at the earnings webcast page in the Investors section of our website as well as in our earnings press release announcing the Q2 2014 financial results, which was furnished with the SEC today on Form 8 ks. 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. And now I'd like to turn the call over to Chip Bird. Thanks, Chris. Good afternoon, everyone, and thanks for joining us today. In the Q2, some of the challenging trends we shared with you in April continued, while some intensified. Soft traffic, increased promotions at retail and online and further declines in the women's category pressured our Americas region. On the positive side, our men's bottoms business was up despite a declining category. Our businesses in Europe and Asia improved reflecting our retail strategy and we made progress on the global productivity initiative that we launched last quarter. We remain focused on what's within our control, reflecting our commitment to drive sustainable profitable growth over the long term. Harmit will now walk you through more specifics around the financial results. Harmit? Thanks, Chip, and a warm welcome to everyone joining our call. My comments today will reference 2nd quarter comparisons on a year over year basis in U. S. Dollars unless I indicate otherwise. Total consolidated net revenues for the Q2 of 2014 of $1,100,000,000 were down 1% without the effects of currency, which negatively impacted revenues another 60 basis points. Lower revenues in the Americas were partially offset by higher revenues in Europe and Asia. On a global basis, wholesale was down 4%, while company operated retail revenues grew 6%. Excluding the impacts of licensing the Dockers women's business this year and the residual Denizen brand sales in Asia last year, total consolidated net revenues were flat. Gross profit for the quarter was 530,000,000 down 3% from $549,000,000 last year due equally to lower gross margin and the revenue decline. Gross margin decreased 90 basis points to 49% with about 20 basis points of the decline owing to currency. The remainder of the decline reflected an increase in sales of lower margin seasonal products, higher promotions at our stores and investments we made to enhance our product. SG and A and expense was down $1,000,000 to $446,000,000 reflecting low incentive comp accruals and early benefits of our productivity initiative. We accomplished this even through even though 2nd quarter SG and A included higher expenses from our expanding retail network and charges of $9,000,000 associated with the global productivity initiative. In addition, we booked restructuring charges of $19,000,000 primarily comprised of severance benefits, which brings the total one time charges related to our global productivity initiative to $28,000,000 for the quarter. We remain focused on improving and optimizing costs across the company. 2nd quarter adjusted EBIT of $93,000,000 declined 6% as compared to last year, driven equally by lower gross profit and adverse currency effects. Adjusted EBIT as a percentage of net revenues was 9%, down 40 basis points from last year. A detailed reconciliation of adjusted EBIT is attached to our press release. Net income for the Q2 declined to $11,000,000 as compared to $48,000,000 last year due to the $28,000,000 of charges related to the global productivity initiative as well as debt extinguishment charge of $11,000,000 We redeemed approximately $200,000,000 of our euro bond in May using cash on hand and $100,000,000 from our credit facility. This will favorably impact annualized interest expense by more than $10,000,000 Now I'll share more detail on the Q2 results of our 3 regions. Net revenues in the Americas of $645,000,000 were down 3% from the prior year on a reported basis and down 2% on a constant currency basis. The decline was primarily related to the women's business at wholesale, especially the Levi's product issues we have discussed as well as our decision to license the Dockers women's business in the United States to a third party. The decision to license this relatively small business is consistent with our strategy to focus on our biggest most profitable businesses. In Europe, net revenues improved 3% on a reported basis and grew modestly without the benefit of currency. Retail revenues grew from the expansion and improved productivity of our store network. And though wholesale declined again, trends appear to be stabilizing in the region and our efforts to improve product availability are helping to drive sales. In Asia, revenues were down 2% on a reported basis, but grew 2% without the effect of currency. Improved product availability and product and marketing campaigns in several markets drove the revenue growth. On our liquidity, our liquidity position remains solid as we continue on the path to build a stronger balance sheet. At quarter end, we had $386,000,000 in cash on hand and $625,000,000 available under our credit facility, yielding total available liquidity of $1,000,000,000 Net debt of less than $1,100,000,000 was consistent with year end. Our leverage as defined by our gross debt to adjusted EBITDA ratio of 2.6% at quarter end was slightly higher than a year ago. Inventory balances grew again this quarter, primarily reflecting our plans to improve product availability for our growth initiatives in the second half and the expansion of our store network in Europe and Asia and to a lesser extent reflecting lower than anticipated sales in the Americas. Inventory remains higher than we'd like in some parts of Asia and we continue to work through inventory in the United States as we navigate the issues we discussed over the last few quarters. In the second half of the year, we have a plan to aggressively manage inventory down. And while we expect sequential improvement in year over year in comparison, inventory will remain elevated through the Q3. We continue to expect inventory to be in line with prior year by the end of 2014, driven by revenue initiatives which Chip will talk about and inventory initiatives across all channels. Free cash flow for the first half of the year was $14,000,000 Lower cash flow this year has largely been driven by lower receivable collections, our lower net revenues and higher inventory purchases as well as cash restructuring charges. While we expect traffic at retail to remain challenging, we are still optimistic that we will grow full year revenue and adjusted EBIT. We will make additional progress on our productivity initiatives. Our focus remains on profitably building this business for the long term. Chip, back to you. Thanks, Harmit. Let's take a moment to talk about what's working and what's not, starting with the areas that we're addressing. Our U. S. Wholesale business decline was once again primarily attributable to lower sales in our Levi's women's business. As we've discussed with you previously, our fashion miss in juniors and misses has exacerbated already difficult conditions in the women's jeans category, which is down double digits at major domestic retailers. Our new designs are just beginning to hit floors across the United States this quarter and we are seeing some early success. We remain optimistic about the product changes we're putting in place, but this is only the first step in a multi phase effort to turn the women's business around. So while we expect sales comparisons to improve as we move into the Q4 of 2014, the full rollout of the enhanced product, marketing and on floor communications will occur in 2015. Turning to what's working. Our core Levi's men's bottoms business continues to grow in a declining category and performed well at key customers in the Americas. In particular, sales of our 5.11 and 5.13 grew significantly compared to prior year. We'll build on this momentum in the second half of twenty fourteen with our new Livin' Levi's campaign, which centers on our icons, the core that drives our business. And company operated retail was up 6% on a global basis as growth in Europe and Asia offset a decline in the Americas. We continue to expand our retail network and to drive sales through improved conversion on lower traffic at our brick and mortar stores. Our global e commerce business was flat as international growth was offset by a decline in the United States. Our promotional cadence domestically did not keep pace with the external environment. We are realigning our online strategy with market realities as we continue on the path to become a world class online retailer. As discussed in the past, this is a key strategic priority of ours and we're strengthening the foundation of this business, including introducing new leadership this past quarter. In Europe, 2nd quarter revenue growth was enabled by our efforts to enhance product availability in the region, and we're seeing some stabilization in several key markets. And in Asia, revenues grew again in constant dollars. Programs we've launched in India and Japan drove sales successes in those markets. In China, we rebalanced inventory following the Chinese New Year season, though underlying sales trends were positive. My recent trips to our key growth markets of Russia, India and China was a great reminder of how incredibly strong the Levi's brand equity is around the world. And as Harmit mentioned, we made progress on the global productivity initiative that we launched last quarter to drive cost savings and improve our agility. Based on the actions we've taken so far, we now anticipate total annualized savings of $100,000,000 to $125,000,000 We have more work to do over the next several quarters, and we expect to ultimately achieve annualized savings of approximately $200,000,000 when the initiative is completed. In summary, while we expect some of the external headwinds to continue, we have a solid plan to drive revenue growth in the second half, marrying great marketing with great product. Notably, we are launching the new Levi's advertising campaign, Live in Levi's, which brings to life the consumer insight that you wear jeans, you Live in Levi's. The advertising will be broad reaching and product focused back with significant media weights. In fact, Levi's will return to TV advertising in a number of key markets around the world for the first time in years in some instances. Additionally, as the NFL season approaches, we will activate marketing in connection with the launch of Levi's Stadium. The plan will be rolled out across the United States, our biggest market, and will include product, consumer and customer elements that drive enthusiasm and engagement around the most amazing stadium ever built in this country. Finally, we're excited about our fall product line, which has been well received around the world and includes new additions to the very successful commuter line, the introduction of the new fit block called the athletic fit for guys and the already mentioned women's product with the soft stretchy denim women are looking for today. With that, we can open up the line and take your questions. Your first question comes from the line of Cory Martinson of Deutsche Bank. Good afternoon. With the new designs on the Luminess front hitting the stores, I was kind of wondering overall how you feel you're positioned for back to school as we head into that season? Well, as we said in the prepared remarks, our women's business has been challenged. But we previewed this women's product with our key customers now several months ago. I think I once referred to it as our hurry up offense. We got this product basically from start to on floor in about 6 or 7 months to respond to the denim trend in women's around the soft stretchy material. And we've gotten really strong customer support from it. So we feel pretty good on the women's business that we're kind of getting back into the game. It is not just to set expectations properly. It is not the be all and end all. It is not the only thing we're going to be doing to the women's business over time. But it's a start in the right direction. And I think we will see this business start to stabilize as we head through the second half of our fiscal year. Okay. And in terms of the advertising support of the launching the Livent Levi's, I mean, should we be expecting some sort of disproportionate advertising spend here in the second half? Or is this more in line with kind of prior programs that you've had? Hi, this is Harmit. In terms of the overall spending, we are still forecasting to be within the range that we provided earlier, which is close to 6% for the year. You'll notice that the total if you look at the 6%, the advertising spend will pick up in the second half relative to the first half. So we're not spending more dollars. We are reallocating the dollars towards more media spend on TV and digital advertising and then focused on key markets across the world. So just to pile on though, as we've been going through this cost initiative, one of the things we've really been focusing on is getting more bang for our buck with our advertising and promotion dollars. So we will see a significant increase in working media dollars. So think about that as taking non working dollars and repurposing a lot of the non working dollars like agency fees and things like that into increased level of working media dollar support. So in some of the key markets, there will be a noticeable increase in our presence in television and print versus what we've seen in some of these markets over the last 12 to 18 months. It'll be significant. But without spending more dollars than what we've already guided to. Excellent. And so when we look at the annualized savings target of $100,000,000 to 125,000,000 dollars when do we think that that will kind of be fully in the numbers? And is there going to be kind of an offset to part of that kind of being reinvested into the business at all? Yes. The $100,000,000 to $125,000,000 is a net number after reinvestment. We think you're going to see the true flow through of that beginning 2015, largely because we are spending against restructuring this year and it's being paced through the year. So as you think about modeling it, it's 2015 onwards. All right. Thank you very much guys. Appreciate it. Your next question comes from the line of William Marter of Bank of America Merrill Lynch. Good afternoon guys. Good afternoon. I think you mentioned that the women's jeanswear business was down double digits, I guess, it sounds like in the first half of this year. And then I think you also referenced that the men's business was down. How much in the U. S, how much is the men's business down? The I think we set it up the men's business is actually up. Our men's business. Our men's business is up in the first half of the year. The category is down. And so in a declining category, we're actually picking up share. The category is down. I think the question you're asking Bill is how much is the category down. It's kind of mid single digits. Okay. And I guess to what do you attribute the decline in the men's category overall since it shouldn't be suffering from some of the same fashion challenges that you guys have on the women's side? I believe a big part of it is we haven't there hasn't been a lot of marketing support behind jeans in general for the last 12 to 18 months category wide. So I think that's part of it. Lack of exciting new news is probably the other part of it. And that's part of the reason we're a bit bullish going into the second half as we're turning significant amounts of media back on and giving both men and women a reason to come into the stores with new product and innovation. Okay. And then just lastly, I can't remember the timing of when you your payments on the for the Levi's Stadium deal will start or maybe they already have started. How do those payments work? Yes. The payments have started. So the way you should think about it on an annual basis over 20 years, it's about $10,000,000 $10,000,000 annually. Okay. And just as a reminder Bill, what we've said in the past and we are reinforcing it again today, this is not incremental to the total advertising spend. So we are reallocating our different buckets. Okay. Thanks a lot. And I wanted to wish a happy birthday to Chris. Thank you, Bill. Awesome. Thank you, Bill. Your next question comes from the line Your next question comes from Carla Casella of JPMorgan. Hi. Thanks for taking the question. Hello, Carla. I'm wondering if there's any how much products you bring in through the West Coast ports and if a potential strike out there could have an impact on the business? We don't have the exact answer to that Carla, but we anticipate that the impact if any is going to be small. Okay. And then one technical question on the numbers that you report. In the restructuring you show on the income statement differs from the restructuring amount that you're adding back to the adjusted EBIT. What's the difference there? It's more accounting. What we're spending on the productivity initiative besides taking a hard look at the organization, we're taking a hard look at indirect procurement, our practices around that and our different processes so that we can become more nimble and agile as an organization. So the combination of the 2 is the $28,000,000 number or the $93,000,000 number that we have spent so far. What's in the restructuring bucket as guided by U. S. GAAP is truly the spending against reducing or restructuring the organization. That's the simplest way of defining it, Carla. Okay. Great. And then can you just give us a little bit more color on the online domestic online decline? Is it how have you changed that strategy? And is this something that you think will be temporary? Is it that you're off on pricing? Or what's going on behind that? Yes. It's I guess I would characterize it as a balancing act that we have to kind of manage that. As we said and as you've seen, the overall retail environment got increasingly more promotional in the Q2 of the year. This was particularly true online. Several other retailers were running 50% 60% off events site wide. And we were trying to manage the equity of the brand and manage our promotional cadence. And at the end of the day, we were uncompetitive. And so now with new leadership on the ground, we're kind of taking a look at our plans for the balance of the year because in effect we lost share online. We're taking a look at our plans for the balance of the year to say what do we need to do to at least protect our share if not build it in that channel over time. Okay, great. And then just one last housekeeping. How much was the revenue and gross margin impact from the women's dockers going through a licensing arrangement? It's small. The way you should think about it for the next two quarters about $5,000,000 a quarter is the impact on revenue. Okay. Great. Thanks. Your next question comes from Grant Jordan of Wells Fargo. Good afternoon. Thanks for taking the question. I guess first just to follow-up on the women's questions. In your retail stores, are you seeing better reception to the new product there? I think it's still early days. And it's really too early to call, Grant. But we have tested it in a couple of our key customers. And we it's gotten good early results. Okay. And then just kind of bigger picture as most of the bigger retailers as they've given guidance have called for improving trends in the second half of the year. Any kind of economic update you can give us that you're seeing going back going into the back to school season? I mean the way it's again it's different across different businesses. The way we think about the second half and just building on what Chip talked about, which is the new advertising campaign and the spending against the right media in the right markets, we are underpinning our expectations on 3 or 4 things for the second half. The first is we believe we have a solid global demand as we from our key customers. So that's the first piece. The second, we talked about the first deliveries of our updated women's products hitting the stores and that's supported by marketing as well as on flow support. The third is the new advertising campaign and some of our new product innovations and launches we have. And last but not the least, you may recall, we have an additional week in the Q4 that includes Black Friday, just the way our fiscal work. So as we think about the second half, we believe it will be stronger than the top line performance you've seen in the first half. I guess, Grant, the other thing I would add is there's all kinds of underlying economic dynamics and factors that would suggest that the recovery should have started from a consumer standpoint a long time ago, and everybody's kind of still holding their breath waiting for the consumer to come back into the store. Our approach is plan for the worst and hope for the best, focus on the things that we can control like conversion, product, innovation, advertising. If traffic does come back, great, that's on top. And I continue to be concerned, particularly about our the underlying economic macroeconomic dynamics here in the U. S. And I think we've got to just continue to plan that it's going to be tough sledding here. Yes. Okay. Well, that's helpful. It is tough to reconcile some of the headlines we're seeing on economic news with the actual results so far. That's all I had. Thanks. Thanks. Thanks, Bill. Your next question comes from Hal Holden of Barclays. Hi. Thanks for taking the call. I had 2 quick ones. Chip, I think you said that your promotional cadence didn't keep pace with the external environment. Was that just in general to online to Carlo's question? Or was that online also in your wholesale doors? It's no, no, no. It's fundamentally an online, at some extent our own retail stores, particularly up against the vertical retailers. I think at wholesale, we were reasonably competitive. But it was it just went it kind of went pretty aggressive, the promotional the depth of the promotions as well as the frequency of the promotions, particularly online over the last quarter. And we chose not to go there to protect the integrity of the brand and our financials to some extent, mostly an online dynamic. Okay. And then can you talk about some of the drivers beyond the soft stretchy fabric that's got introduced in women's this fall that's going to accelerate growth in 2015? I think you said you were looking for a stronger pickup in women's starting next year with further new products. Yes. I mean, so I guess the way to think about it is I try to kind of think about it as building some momentum going into in the second half of the year leading into next fiscal year. And it's a combination of product across both men's and women's, marketing including the advertising campaign and continuing to focus on the things that we can control, conversion in our stores, how we show up in stores, whether it's our stores or wholesale doors and continuing to work on building the connection with consumers. So from a product standpoint, we've got the women's product that we've already talked about, which hopefully will begin to stabilize the business, particularly in our wholesale customers in the second half of this year. We've got the marketing, which we've talked quite a bit about with Liv and Levi's. It's not just television advertising. It's television, it's print. It's a significant activation on digital. We're spending about 30% of our marketing dollars on digital activation around Liv and Levi's to really build the connection with consumers. I mean one of the things just as an aside, we've got one of the most amazing brands in the world, a deep connection with consumers around Levi's. They tell stories about Levi's and that's part of what this is trying to do is bring out the stories that consumers tell about how they've lived in Levi's. And so bringing really bringing that to life in every area, whether it's above the line, television or print advertising, in store or digitally, is a big part of it. And then continue our innovation path with we've already got a very strong springsummer lineup for next year, and that will lead into more of the women's reset in 2015 as we talked about. So it's a pretty good pipeline of product, pretty good pipeline of marketing and marketing innovation. And the combination of those things should build us some momentum in the second half of the year leading into next fiscal year. Great. Thank you. I also had one last housekeeping. I noticed that you paid a dividend this quarter. Any chance you could tell us if that's it for the year or we should expect more in the second half of the year? We look at dividends payout with the Board and it's a Board decision. Our expectation is the amount we have paid out is the amount we'll pay out for this fiscal year. Great. Thank you very much. Your next question comes from Jenna Giannelli of Citigroup. Hi, there. Thanks for taking my question. Most of them have been answered, but I just have a couple. Can you give us a sense of the magnitude of the retail versus the wholesale decline just in the Americas? Were they relatively in line? Or did you see more an accelerated decline in retail specifically? I'd say wholesale was a little higher than retail, but that's on an absolute basis fairly close. Our business in the U. S. Is more geared towards wholesale. Right. Okay. And then just on the inventories being higher year over year, is most of that driven by the retail expansion? Are there any categories that are keeping the inventories higher? And then I think on the last call you said that you had some clearance inventory that you were still working through and that would be worked through by the end of 3Q. Can you give us a sense of where we are in that process? You're right inventory year over year is up. I think inventory versus the end of quarter 4 was up 14%. I'd bucket it into 2. I'd say the 2 thirds of the increase is driven by our efforts to address and improve service levels largely in Europe and Asia to support the expansion of product and marketing efforts in the second half as well as support the expansion of retail. A third is really driven by lower than planned sales, so the softer sales that we are seeing. In terms of the health of the inventory, I think it's improving quarter over quarter. We will need through the end of quarter 3 beginning quarter 4 to work through that. And we're managing inventory down aggressively. We're leveraging all channels whether it's our outlet stores, our e commerce sites as well as off price channels to try and manage inventory levels lower than what they are today. Great. Thanks. And then just one more. With respect to the $100,000,000 to $125,000,000 of net savings largely to be for 2015, Are there kind of 1 or 2 key buckets that are going to be driving those, especially as you're looking to focus more on advertising and marketing? Again these are broad numbers. I'd say 10% to 15% would find its way through lower COGS because of supply chain efficiencies. The rest is really what I call organization and distribution costs as against advertising. Okay, great. Thanks a lot. Your final question comes from Kevin Quang of Goldman Sachs. Hi, thanks. This is actually Cindy Quang on for Kevin. Just quickly on the add backs, wanted to add the $9,000,000 that you called out in SGA relate to higher consulting fees. Is that included in the $23,000,000 add back and the EBIT reconciliation? It's in the yes. So I think you have 2 pieces in the EBIT reconciliation. It's included in the $23,000,000 to be perfectly frank is $23,000,000 and there's some curtailment pension expense of 4.5 So it's included in the 28 and it's included in the 23. Okay. Thanks for that. And also, as we think about the stabilization of the U. S. Misses and Juniors due to the new designs, can you talk about how it's competitively positioned relative to competitor new launches in the second half, which I think Wrangler had also talked about maybe more stretchy fabric. Should we think about it as women's jeans as a category to be stronger in the second half, because maybe the new fabric will take share from other categories of pants like activewear and yoga pants? Or is the story more about taking share from competitor jean brands like you are doing in men's? I think it's going to be a little bit of both. Hopefully, the introduction on major brands of soft stretchy jeans will do something to drive some category growth. And hopefully, we're going to do a better job of executing it than others and that's going to result in a little bit of share growth. And so it's probably a combination of the 2. Okay. And I think in the past you may have said you would consider acquiring another brand. Is activewear a potential category of interest given if yoga pants is stealing some share from denim as a category? Is that something of interest? We don't comment on potential acquisitions. As we've said in the past, we intrinsically believe that there is tremendous growth left organically between our two brands and our presence across the world. And if an opportunity comes up in complementing that, we'll take a look at it. But right now our focus is to grow both Levi's and Dockers organically across the world. Okay. Great. And just I have a last one on the supply side. With the recent drop in cotton pricing, does that change your purchasing habits related to cotton or denim? And also I think there was a story about reduced supply sourcing from Cambodia. How should we think about any potential impact on gross margin if any? Thank you. I'd say just looking at our history this year for example, we've offset inflation with supply chain efficiencies. And over the last many years other than when cotton spiked we managed to do that. So I think you should think about us maintaining the same trajectory going forward. Relative to your question about Cambodia, we have we source our product from quite a few markets across the world and we balance risk and reward across our sourcing strategies. So if one market is a risk, we're able to offset that with another market. That's just the nature of how we've spread out our sourcing across the globe. Great. Thank you very much. Thank you. This concludes the Q and A portion of today's call. Arthur, any closing remarks? I just want to thank everyone for phoning in. Thank you for your questions and we look forward to talking to you again after the close of the Q3. Thank you all very much and have a nice summer. Thank you. This concludes today's conference. You may now disconnect. Thank you.