Earnings Call: Q1 2013

Apr 9, 2013

Good day, ladies and gentlemen, and welcome to the Levi Strauss and Company's First Quarter 2013 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 through April 15, 2013 by calling 800-five eighty five-eight thousand three hundred and sixty seven. Please input the ID code of 2,875,821 followed by the pound key. This conference call also is being broadcast I would now like to turn the call over to Chris Ogle, Senior Director of Finance, SEC Reporting and Investor Relations at Levi Strauss and Company. Good afternoon, everyone, 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 Amit 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. 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 Berg. Thanks, Chris. Good afternoon and thank you for joining us today. We started off the year with a good quarter. We generated strong cash flow, paid down a portion of the debt and posted improved margins and net income. All this despite the top line being down 2% due to lower sales in Asia Pacific and the impact from licensing the Levi's Boys business. I'd like to turn it over to Harmit now who will walk you through the financial results in greater detail before I discuss our focus going forward. Harmit? Thank you, Chip, and a warm welcome to everyone. My comments today will reference comparisons on a year over year basis unless otherwise indicated. Total consolidated net revenues for the Q1 of 2013 were $1,100,000,000 down 2% from prior year. The decline reflected continuing challenges in Asia as well as the loss of wholesale revenues from the conversion of the Levi's boys business to a license model in the United States. These declines were partially offset by higher retail store revenues from improved performance and ongoing expansion. Despite the lower net revenues, gross profit for the quarter grew a solid 8% to $592,000,000 Our gross margin rose 4.50 basis points to 52%, primarily due to lower cotton costs. Margin also benefited from our increased retail revenues. As you may know, the benefit from lower cotton prices is largely a first half factor and our seasonality normally drives lower margins in our 2nd and third quarters. As a result, we continue to believe the gross margins for the full year 2013 will end closer to 50%. SG and A expense declined 6% to $410,000,000 outpacing the revenue decline. A and P spend decreased $13,000,000 essentially due to timing of our spring advertising campaign, which this year is scheduled for the Q2. We continue to anticipate that full year A and P spend will be higher than 2012 with most of the year over year increase happening in the second half of the year. Beyond A and P, lower SG and A primarily reflected lower severance expenses. Higher gross margins and lower SG and A drove operating income to $181,000,000 a $71,000,000 increase over last year. As previously mentioned, the benefit we're seeing from cotton will wane as we move through the year and lower first quarter SG and A primarily reflects timing and non recurring benefits. Accordingly, our expectation for full year operating margin is more conservative than our Q1 margin performance. Net income rose to $107,000,000 as compared to $49,000,000 last year due to higher operating income. Now I'll share more detail on the Q1 results for the regions. Net revenues in the Americas region of $647,000,000 were flat to prior year. Growth in our retail Levi's stores was offset by declines at wholesale, primarily the impact of licensing the Levi's Boys business. Operating income increased mainly due to the gross margin benefit from cotton and retail. In Europe, net revenues were up 2% to $297,000,000 Net revenues in our own stores continued to grow, but sales to franchisees and traditional wholesale customers declined as Southern markets remain weak. Operating income improved due to a combination of lower SG and A and currency benefits. In Asia Pacific, conditions remained challenging and net revenues were down 11%. China accounted for the majority of the revenue decline, reflecting an increasingly stiff competitive environment as well as some execution issues. Despite lower revenues, Asia Pacific 1st quarter operating income improved reflecting the Denizen brand phase out, better gross margins and lower SG and A. Now turning to cash flows and the balance sheet, where we continue to make substantial progress. Operating cash flow for the quarter of 2013 for the Q1 of 2013 was $143,000,000 a $38,000,000 increase from prior year. The improved operating results contributed to cash flows as did the benefit of lower inventory costs. We are managing inventory units at levels we believe appropriate for our business. Operating cash flow also benefited from lower pension funding and the California state tax refund we talked about on our last call. Capital expenditures in the Q1 were $21,000,000 as compared to $17,000,000 last year. We continue to expect full year CapEx in the range of $100,000,000 to $120,000,000 We paid a dividend of $25,000,000 during the Q1 of 2013 in contrast to last year when our $20,000,000 dividend was paid in the 2nd quarter. We do not plan to pay any further dividend in our fiscal 2013. At the end of the Q1, we had available liquidity of more than $1,000,000,000 as our cash balance was $450,000,000 and we had $574,000,000 available under our credit facility. Net debt was $1,200,000,000 as compared to $1,700,000,000 a year ago. Subsequent to the end of the quarter, we made additional progress against our goal to reduce debt by refinancing the senior term loan, which was maturing in 2014. Our strong cash flows enable us to prepay the loan balance in March using a combination of cash on hand and the issuance of $140,000,000 in senior notes. Due to our strong cash position, we did not have to borrow against our credit facility, which remains an important source of funding working capital going forward. In completing this transaction, we have now reduced gross debt by an aggregate of $185,000,000 during fiscal 2013. This is on the heels of paying down more than $200,000,000 of debt in 2012. This reflects our commitment to strengthen the financial health of the company by building a stronger balance sheet, deleveraging the company over time and reducing costs. With that, I'll turn it back over to Chip to discuss our progress against our strategy. Thanks, Harmit. We're beginning to see that the choices we made last year are starting to positively following areas of strategic focus. 1, driving our profitable core businesses and brands. 2, expanding beyond our core to build a more balanced portfolio. And 3, becoming a world class retailer. First, we're driving our profitable core businesses and core brands, which include men's bottoms for both the Levi's brand globally and for the Dockers brand in the United States as well as key wholesale accounts in the United States and Europe. The key focus of the Levi's brand this year is reinventing our classic iconic items. This started with the new 501s for spring. In the Q1, they were available in more than 30 countries around the world and the rollout continues. And while it's early days, consumers have loved the non denim color. Additionally, we launched the new Levi's Waistless collection this quarter, which features iconic products made in sustainable fabrics. With an average retail price of more than $100 this premium jean is selling well. At Dockers, the core profitable United States business men's bottoms is growing. The Signature Khaki, a key pillar of this brand, grew 10% in the U. S. During the Q1. The more modern Alpha Khaki continues to do well with sales also up double digits. Turning to wholesale, we have seen that where we invest in a superior on floor presence that drives profitable growth. This is very clear from our experience at J. C. Penney where the Levi's Denim Bar continues to perform well. We are leveraging this learning and working with other key customers to continue to evolve the consumer experience and brand presence in a customer relevant and meaningfully differentiated way. Part of building our brand presence is also advertising. As Harmit mentioned, our advertising spend in the Q1 is lower than normal levels. We remain committed to supporting our brands and we are timing our investment behind critical product launches. Our second strategy is to expand beyond the profitable core. We're looking at where we may selectively leverage our 2 strongest brands through either a new or existing product categories, consumer segments or geographic markets. We believe there are significant opportunities in women's. For example, the Levi's brand is focused on building out women's tops. This summer, consumers and customers will see elevated denim finishes, our well known iconic Western shirt and trucker jackets. Part of expanding beyond the profitable core is to concentrate on key emerging markets. Our Russia business, for example, has been growing double digits, reflecting the performance and expansion of our stores in that market. It's a profitable business and we have a good team on the ground there. Our biggest challenge right now geographically is China, whose landscape has become increasingly more competitive, most notably with vertical retailers. Improving our business there is a top priority. We're focused on optimizing the retail network and cleaning up channel inventory levels. It's going to take some time to reposition China and the broader Asia Pacific region to the growth levels we've had in past years. Despite these top line challenges, Asia Pacific's operating profits improved in the quarter due largely to our strategic choice in 2012 to exit the Denizen business and to drive good cost control. Our third strategy is to become a world class retailer. During the Q1, we saw continued growth in Europe and the Americas. Our mix continues to grow in retail, which now comprises 24% of our revenues. Our retail business yields higher gross margins and provides the best expression of our brands. We like the economics and the opportunity to control the consumer experience. An integral part of becoming a world class retailer is improving our e commerce business. We believe this part of our business provides significant upside opportunity for growth. Our e commerce business currently comprises about 3% of consolidated company revenues. And during the Q1, sales from e commerce channel rose double digits off of this small base. We've been investing in the e commerce platform to better showcase the brands and drive sales performance. In February, the new Levi's and Dockers sites went live in Europe and since launch business has met our expectation. In summary, I'm encouraged by our performance and the momentum we built in the Q1. With that, we'd like to open up the lines to take your questions. Thank you. The floor is now open for Your first question comes from Karru Martinson from Deutsche Bank. Go ahead with your question. Joining Levi's, kind of one of the first things you talked about, if I remember correctly, was taking a pause with the retail side, making sure that we get that channel profitable and take costs out. Are we at a point now, given the performance there, where we can start growing that channel again? And kind of what's the outlook there? I missed the very first part of your question, but I think I got it all. As I said, strategically, we're focused on growing our retail business. It's a profitable business for us. It's gross margin accretive to the total business. We're doing well in retail. And as I also said, it gives us an opportunity to really control the presentation of the brand. So we're focused on it and we're committed to growing it. We're going to do it with moderation, I guess, given the capital constraints that we've got as a company. But we're very committed to growing our own retail business. And in that vein, would we at some point get comp store sales from the retail channel? Carlo, at this point probably not, but we've heard that message loud and clear from folks like yourself. So as we constantly review our disclosure policies, we keep that under advised. Okay. And just on weather, it's certainly been something that's getting highlighted by a number of retailers. And I was wondering what you were seeing here as we came to the tail end of the quarter and into the 2nd fiscal quarter? Yes. So I think on the last call, we talked about February being a little choppy. That choppiness continued into March. I'm not sure if it was weather or IRS refund checks. I mean, there are a lot of theories being thrown around. We did see March pick up towards the latter half, but we need to take into consideration the timing of Easter this year. And what we've said internally, and I think it's a fair statement externally too, is you can't look at March in isolation. I think we have to look at March April combined when we compare against a year ago. So it's really too early to draw any conclusions about what's really going on out there from a consumer dynamic based on the latter 2 weeks of March. All right. And just lastly on China, certainly recognizing that the market has become more competitive. When you talk about repositioning China to the new growth levels there, what is that going to entail? Well, we've got a fair amount of work to do in China, I guess, to put it out there. And in fact, Harmit and I are going to be in China in a couple of weeks along with a couple of other folks. 1st and foremost, we've got to get the inventory situation right in our stores and franchisee stores so that we can be flowing new product into the stores as we launch seasons. We need to take a holistic look at our franchise model and the number of franchisees that we have. In India, for example, we're beginning to consolidate the number of franchisees and that seems to be working, although it's early days. So and then we need to be competitive in the market against these vertical retailers who have come in pretty aggressively. And what was sufficient to win 5 years ago in China is probably necessary today, but not sufficient. And we need to make sure that everything that we're bringing into that market is competitive. The last thing I would add is, the other big change I think from a consumer standpoint in China over the last couple of years is the dramatic growth of e commerce. And just as we are as a company, we're behind the curve on e commerce broadly. We are behind the e commerce curve in China too and we need to catch up quickly on in that China too and we need to catch up quickly on in that particular channel. Thank you very much guys. Appreciate it. Thanks, Coop. Your next question comes from Carla Casella from JPMorgan. Go ahead with your question. Hi. I'll start with one follow-up on the China. How much of your Asia Pacific business is now China and or India? It's still fairly small. I think between the two markets, it would be it's still less than 50% of our Asia business. But that's one way of looking at it. The other way of looking at it is the way we look at it, which is the potential. And that's why Chip indicated there is focus in the company and even at a local level to try and understand the change in market dynamics and make sure we're investing behind the longer term growth and potential of both these markets? It is well less than 50% of the total Asia Pacific region, but it represents way more than 50% of the opportunity is the way to think about it. And we've gone backwards in both of those markets over the last 12 months. Some of that due to the decision to exit Denizen, but those two markets represent substantial upside, and we've just got to get it right in both markets. That's great. Okay. And then on the gross margin front, your gross margin was significantly better than we expected. So congratulations on that. But I'm wondering, is that seasonally strong? Was there less clearance in this quarter? Is that sustainable on a quarterly basis? Yes. So Carla, the growth in margins clearly not sustainable. Now the main driver for the margin growth year over year is cotton, which as we've indicated and you probably know, the benefit of that dramatically slows down in the second half of the year. So it's really a first half factor. The piece that will probably continue is the growth in retail and that's a very small piece. So the things you've got to just bear in mind as you look at our business. There is a seasonal effect, no pun intended, quarter 23 from a seasonal perspective, largely because we're promoting more seasonal products like shorts and tops is a lower margin business relative to our core business. So you see that impact. We are committed as we had indicated earlier to close the year at around 50%. And if you compare that to a year ago, which is where we ended in 2012, that's a little over 200 basis points. So margin growth is an area of focus, but that's where we think we trend for the rest of the year. Okay. That's great. And then also margin related, but SG and A on the SG and A front, the advertising, you mentioned that you're tying your advertising to critical launches. Can you give us an idea of the timing of the bulk of those critical launches? Is it back to school? Or is it more evenly second, third, Q4? I think you'll see quarter 2 because as we'd indicated that we move stuff into spring, so that's quarter 2. You'll see quarter 2 advertising to be probably a little higher than a year ago. But the bulk of the year over year increase is really in the second half. And it's quarter 3 quarter 4. It's difficult to predict how evenly they split, but I think the second half is where you'll see the increase year over year. And I think the one thing the one thing that we'd indicated last time is that we think on a full year basis, our spending behind advertising and promotion will be slightly higher than a year ago, more closer to the historic levels. Right. And the only thing I was going to add. So the expectation and our plan is to spend ahead of the year ago on advertising and promotion as a percent of sales. And the way it will work out is about equal first half to first half and second half significantly ahead of year ago. Okay, great. And then one housekeeping item. Yes. Go ahead. Yes. Go ahead. I was just asking one housekeeping item. The restricted payment basket, I'm assuming that grew quite a bit this quarter with the big net income increase? It's still over the $500,000,000 number and it's a favorite color question. I thought I had to ask it. Thank you. All right. Our next question comes from William Reuter from Bank of America. Go ahead with your question. Good afternoon, guys. Hi, Bill. I was curious whether you had any data in your different geographic regions that talked about how the denim market might be performing as a whole. I guess I'm curious whether in Asia Pacific whether there may have been a loss of some momentum I guess broadly in terms of just the popularity of denim? In terms of what we're seeing Bill, I mean nothing that indicates a dramatic change from our perspective. I think do you think Chris, do you think you've seen any data that's Yes. There is some of our competitors have talked about the inventory issue in China. There was definitely a consumer slowdown kind of late in the calendar year and early into this calendar year. Some of that probably will translate as we get the data to some market softness. But I don't think we're going to see any falling off a cliff type of thing. And I think it's related to just the consumer slowdown in China primarily, so which has seemed to come back here recently. I think the only emerging trend was the indicator, which is e commerce. Yes. Okay. And then you guys have given us a lot of different pieces of the improved gross margins. I guess are the gross margins at your retail up? Or is it just the mix of retail relative to wholesale when you talk about retail as being one of the contributing factors? It's both. So gross margins at retail are up modestly year over year and the mix of retail to our total business is up. So the combination of those is helping to drive our gross margin up. Okay. And then one last one on SG and A. You saw you guys had lower severance costs in the quarter. I'm curious whether we will continue to see the benefit of that over the next couple of quarters. I'm not sure when we would have anniversaried the big buckets of those costs. No. It's only quarter 1 impact. And in essence, Bill, we've taken some accruals at the end of quarter 4. And as we work through discussions with the Work Council in Europe and resolve those issues, we reversed part of that accrual. So that's really a quarter 1 impact. Okay, great. That's all from me. Thank you. Thanks. Our next question comes from Grant Jordan from Wells Fargo. Good afternoon. This is David Eller filling in for Grant. You talked about Dockers growth in the quarter, both the Alpha Tacky and the traditional bottoms. And I think on the last call, you talked about plans to launch Dockers at JCP in the second half. Have those plans changed at all in line with the recent management shakeup? Or how has your planning changed along that launch? So it's too early to say what impact the new management is having right now. We will have an improved Dockers presence in JCPenney by as early as this Father's Day. It's not going to be the elaborate shop in shop, but it will be a significantly improved presence. And the shop in shops, we'll have to wait and see as new management comes in what direction that winds up going. Okay. And then I think you also called out certain execution issues in Asia in the prepared remarks. Can you kind of talk more about that? So we had some product delivery issues right ahead of Chinese New Year. And as you all know, Chinese New Year is kind of their equivalent of Christmas. And when you miss it, you miss it. It doesn't come back. And we did have some product availability issues in China. It's kind of a double whammy because some of the product is hard to sell after Chinese New Year because it's very Chinese New Year specific. So it hurts you not once, but twice, the missed opportunity when it doesn't arrive when it's supposed to arrive. And then when it does arrive, you've got to mark it down to get rid of it. So some executional speed bumps that we hit that definitely impacted our results there last quarter. Okay. And then for the quarter inventory was down about 11% and you called out the lower cost of cotton. You talk about the inventory unit performance? I think you mentioned maybe that for the rest of the year you were looking to manage inventory units very conservatively? Yes. I mean, I think on that topic, we manage inventory tightly. We try and maintain it to sustain the level of demands we are seeing. So I think the change in the quarter was just a continued the impact of continued efforts. Our inventory positions remain fairly tight. So I don't believe you're going to see a sustained level of improvement over time. Okay. Thanks a lot guys. Yeah. Our next question comes from the line of Kevin Coyne from Goldman Sachs. Go ahead with your question. My first question is now that you've refinanced the 2013 term loan, what are your priorities in terms of capital allocation for the rest of the year and into 2014? Sure. Rest of the year, if our cash situation allows us, we'll continue to look at what we can do relative to reduction of debt. And because that seems to be the and that is the area of focus from our perspective. I think longer term a balance between debt reduction and capital deployment to grow the business. Yes. And just as a reminder, I mean, we have called out that we do plan to invest $100,000,000 to $120,000,000 in capital. That's a combination of continuing to invest in retail and then secondly investing in systems, technologies and capabilities. And so that plan is still on and we'll make those investments. And if our cash flow allows us, we'd love to keep chipping away at the debt. No pun intended. Thanks. And then switching to Europe, looking at trends in that market, you mentioned that Southern Europe remains weak. Do you think that the rate of this is stabilizing at all? Is it accelerating? Just what are your overall thoughts there? And maybe just any sort of other trends in the other areas of Europe for you guys? Yes. It's Southern Europe continues to be weak. No immediate signs of dramatic improvement. The one so Southern Europe is really France and Italy for us. France is a big market. I think as a positive, Northern Europe seems to be performing well. U. K. Is a big market for us and continues to do well. And as we expand in Eastern Europe, largely Russia, Chip talked about Russia. We're positive about how we're performing in Russia. Our business has done well over the years. We have been growing at double digit. We have a good team on the ground and we feel bullish about that on a longer term basis. Okay. Great. And then finally just to touch on Dockers again. You recently appointed a new Chief Marketing Officer for the brand. Is there anything that you can communicate in these early days as far as any shift in strategy or plans there? Thanks. I think it's too early. She hasn't even started. So she gets here, I think, next week. We're really excited about the appointment. She's going to be terrific. And it's been a big focus of mine really almost since the day I got here, which was building a strong team in all of the critical positions. We've now got, I think, a great executive team that's been built. 9 of the 11 people on the executive team are new since I've gotten here. And now we're building bench strength at levels below the executive team members. So Adrienne, I've spoken with her a number of times and she comes to us from Under Armour where she had a great track record and we're really excited about her joining. And I expect when she gets here, she's going to make an enormous contribution. So it's all good. Great. Thank you. Our next question comes from Carla Casella from JPMorgan. Go ahead with your question. Hi. I just want to follow-up on J. C. Penney. I guess any thoughts that you have on the retailer? It sounds like you're pleased with your performance there. Are you do you I guess are you changing any of the way you deal with JCPenney in terms of the day's payment they're allowed to make or in terms of ensuring your exposure to J. C. Penney? Carla, it's Harmit. We're keeping a close eye on the receivable situation. J. C. Penney has is a valued customer. So it's a great relationship that we have. And they've been paying bills in time. Okay. And then on the inventory improvement, I know you got the question already, but I may admit you, did you give the amount of the units change was, the change in units in inventory? No, I didn't. I don't think we disclosed that. But it's sorry, Chris, do you have the number? Yes. It's grown from year end. Remember year end, we're at probably our tightest point in a long time. So as we normally do, we're building inventory as we move into the season. Right. In terms of number of days, Carla, no dramatic change when you look at it from at the end of quarter 1 relative to quarter 1 last year. Okay. And then in the factoring and insurance market, there's been a lot of press that it's gotten more expensive to protect any of your receivables from the not you specific, but companies protect from J. C. Penney. Are you seeing that as well? Or do you not use those markets? We don't as much color, essentially because given our ABL facility, we've got some constraints around that. So we don't tap it as much. We tap it for a few plants, very few. But again, because of the constraints, we're not necessarily out there thinking through those pieces right now. Okay, great. And then just in your performance there, has it it's still strong you mentioned, but is it sequentially better or worse than it was at launch? At JCPenney? Can you say quarterly quarter over quarter, is it getting better or worse in terms of the comparisons? It's right out of the gates, it was performing very well and it's still performing. I guess, if you were to look at it on a comp store basis in the roughly 700 stores where we are, it's we're growing double digit. I mean we really it's a real success. That's great. I know every time I go, I buy something in Levi's, so I'm helping. That seems to be what happens. That's the idea. It's a good thing. Buy more, you can sell more. That's all I had. Thanks. Thanks, Velda. At this time, I'd like to turn the floor back over to the company for any closing remarks. Okay. Well, no worth shattering closing remarks. I guess, I just want to thank everyone for calling in and thank you for your thoughtful questions and we look forward to talking with you again next quarter. Thank you. This concludes today's conference call. Please disconnect your lines at this time.