Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co.'s third quarter 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 October 15th, 2012, by calling 800-585-8367. Please input the ID code of 33420397, followed by the pounds key. This conference call also is being broadcast over the Internet, and a replay of the webcast will be accessible for one month on the company's website, levistrauss.com. I would now like to turn the call over to Chris Ogle, Senior Director of Finance, SEC Reporting, and Investor Relations at Levi Strauss & Co.
Thank you. Good afternoon, everyone, and welcome to our conference call. I'm pleased to introduce members of the Levi Strauss & Co. management team. With us here today are Chip Bergh, our President and CEO, and Kevin Wilson, our interim 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-K, 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 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, and thank you all for joining us. Before I start, I want to introduce our interim CFO, Kevin Wilson, who is joining me on this call. Kevin's been with the company for six years in a number of finance leadership roles, including Vice President of Finance for the global Dockers brand, and most recently, Vice President of Finance for the Americas Commercial Operations. With that, I'd like to turn to our third quarter performance. Total company third quarter net revenues declined 4% on a constant currency basis, and net income declined 12% on a reported basis. Both internal and external factors significantly impacted the quarter. Externally, as other companies have reported, we're seeing soft global macroeconomic trends, which have clearly had a negative effect on consumer demand. Internally, results were negatively impacted by some of the strategic business decisions we began to execute this quarter.
We believe that these decisions will not only enable us to better navigate this uncertain economic environment, but also sharpen our focus on our core business and drive profitable growth, stronger cash flows, and improved shareholder value creation over time. Despite this difficult environment, operating income improved, and our cash flow increased significantly. Kevin will take you through more details on our financial results in a few minutes. Let me walk you through my five key areas of focus. First, we're putting greater emphasis on driving profitable revenue growth. As a result, we've made strategic decisions about the brand portfolio. Last month, we began to phase out our dENiZEN brand in Asia to focus our energy and attention on our Levi's brand in this region. While this strategic change has a short-term financial impact, the phase-out of dENiZEN in Asia will benefit our total company margins and bottom line.
This decision does not impact the dENiZEN brand in the Americas, nor does it have any impact on our commitment to our business with Target. We also made the strategic decision to license the Levi's Boys business, which we executed this quarter. This decision negatively impacted third-quarter revenues as we anticipated, but it will allow us to focus on the core product offerings that drive the bulk of revenue and profits. Second, we're working to make our controllable operating costs more competitive. For example, we're working to drive sustainable organization savings in order to reduce our SGA, and we're managing our business to get better scale. You've seen the start of these actions in the quarter, and there's more work to do here. We're also continuing to manage our advertising spend to prioritize our dollars behind future campaigns.
Third, we continue to put the consumer at the center of everything we do, focusing on how our brands show up, whether it's in wholesale stores, our own retail stores, or online. We're working with key wholesale customers to improve the consumer shopping experience in a variety of ways, such as training sales associates on our fit system and improving the on-floor displays. For example, our new Levi's Denim Bar is now in nearly 700 JCPenney stores, and it looks great. We've been encouraged by the initial results. Fourth, we're driving product innovation to inspire consumers. At the Levi's brand, our first global product range hit stores in the third quarter, and we're pleased by the consumer response. This collection offered a cohesive global look with the appropriate amount of local relevance.
The fall/winter Levi's collection has a more polished look, and consumers are seeing this throughout product, marketing, and in-store experience. For women, we offered a more refined collection, including Curve ID's newest style, the skinny boot, along with elevated tops and dresses. In men's, the Levi's Commuter Series and our Nike Skateboarding collaboration combined product with performance and drove relevance with the new generation. Over at Dockers men's bottoms, the core of the brand grew again this quarter. The Signature Khaki continues to appeal to the more traditional consumer, and the Alpha Khaki is gaining traction with the younger, modern consumer. I continue to believe that the Dockers brand has long-term global upside opportunities. Last, though in many ways, first, I've been building my executive team with talented leaders that have extensive apparel experience.
While we've had a fair amount of change, I feel great about the leadership team we're building. Most recently, we added the global Dockers brand president, Seth Ellison, who brings 30 years of apparel experience and a fresh perspective on product, marketing, and brand experience. With that, I'd like to turn it over to Kevin, who will walk you through our financials in more detail.
Thanks, Chip. Good afternoon, everyone. Today, I'll walk you through the total company results for the quarter, then share highlights of our regional revenue performance and close with a look at working capital and cash flow. Total reported net revenues for the third quarter of 2012 were $1.1 billion, a 9% decline from last year, reflecting the increasingly challenging global economic environment. On a constant currency basis, revenues were down 4%, driven by declines in Asia and the Americas. Gross profit was $521 million, down 9% from 2011 due to unfavorable currency effects and a $25 million charge associated with our decision to phase out dENiZEN in Asia. This charge reflects our customer support allowances and the markdown of our remaining dENiZEN inventory in that region. Gross margin was flat to a year ago at 47%.
Without the impacts of currency and our dENiZEN actions, gross margin would have improved, reflecting our growing retail revenues and our tighter inventory position. Also, we have begun to see the benefits of having passed the peak of cotton prices in the products we sourced last year. Turning now to operating expenses, our SG&A declined to $434 million, down from $489 million in 2011, and declined as a percentage of revenues as well. Included in our third quarter SG&A expense is an impairment charge of $19 million, which we recorded on the distribution center we own in Japan. Going forward, distribution in Japan will be outsourced to a third party. Net of this charge, the significant decline in SG&A was primarily driven by a combination of favorable currency effects and lower A&P spending. Some of the A&P activities have been retimed to the fourth quarter.
Traditionally, the fourth quarter is where we have a higher concentration of our A&P spend. This year will be no exception. Our organization and distribution costs also declined as compared to last year. Our lower SG&A offset the impact of lower revenues, leading to operating income of $87 million, as compared to $81 million last year. Operating margin improved to 8% from last year's 7%. Below operating income, higher interest expense is attributable to our deferred compensation plans. Our income tax expense rose, reflecting an increased concentration of our earnings in jurisdictions with higher tax rates. Our net income for the quarter declined to $28 million, compared to $32 million last year. At this point, I'd like to share a few more details on the revenue results for each region. Net revenues in the Americas declined 5%.
Increased Levi's brand sales at retail were offset primarily by the impact of our decision to license the Levi's Boys business to a third party. We now recognize a royalty rate on the licensee sales of these products in lieu of recognizing the full wholesale revenue and the related costs. This decision was made to focus our attention on our more profitable core product lines. In Europe, net revenues were down 3% on a reported basis, but grew 12% on a constant currency basis. The increase in revenues for the quarter is attributable to the order fulfillment issues we experienced in the third quarter of last year when we went live on SAP in the region. While net revenues have continued to grow in our own stores, sales to franchisees and traditional wholesale customers continued to decline, reflecting the ongoing difficult economic situation in Europe.
In Asia Pacific, net revenues were down 26% on a reported basis and 21% on a constant currency basis. The decline reflects the increasingly deteriorating conditions in the region, as well as our decision to phase out the dENiZEN brand. At this point, I'd like to turn to cash flow and the balance sheet. Operating cash flow for the first nine months of 2012 was $416 million, as compared to $17 million during the same period last year. The significantly improved cash flow reflects our tighter inventory position, as well as the decline in the cost of cotton, as well as our lower operating expenses and the timing of accounts receivable collections. As we move into the fourth quarter, we will remain focused on managing inventory units to appropriate levels.
Capital expenditures for the first nine months of 2012 were $54 million, down from the $106 million we spent last year, which included our SAP deployment. We are continuing to invest in the expansion of our company-operated retail network while being selective with our opportunities for capital spending. At the end of the quarter, our cash balance was $315 million, and we had $478 million available under our credit facility. Net debt declined to $1.4 billion from $1.8 billion at year-end. We're comfortable with our liquidity position, which is supported by our increased operating cash flows and significant availability under our credit facility. Looking ahead, we continue to be cautious due to the ongoing challenges in the economic environment. We will maintain our focus on reducing the operating expenses we can control directly, with profitability improvement, a key priority. At this point, we'd like to take your questions.
Thank you. The floor is now open for questions. If you have questions, please press star and 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 speakerphone or headset, we ask that you please use your handset. Your first question comes from the line of William Reuter from Bank of America Merrill Lynch.
Hey, Bill.
In terms of the $25 million reduction in gross profits related to the decision to phase out of the dENiZEN brand in Asia, what was the breakdown of that? Meaning, did you have to discount products to sell through, and that was the discounting that you took? If you could help me understand how that flowed through the gross margin line.
Yeah, I can elaborate a little bit on that, on the financial impacts of the dENiZEN exit. As you mentioned in our opening comments, we talked about the $25 million impact to gross profit. Really that was driven by a couple of things. It was driven by our inventory markdowns on our own inventory, as well as some sales incentives with our customers to support the sell-through of the remaining product. It's really both of those that were the key drivers of the $25 million charge that we had.
Okay. In terms of the decision to exit the Levi's Boys business, I was wondering if you could talk, one, about how this was made. Two, how big this business is and, I guess how this might impact your sales going forward, and whether there might be other businesses you would think about doing this with.
This was a strategic decision that we made a couple of months ago. First of all, we're not exiting the business, we're licensing it. Moms and dads around the world and here in the U.S. will still be able to find their Levi's Boys business. It's a relatively small business. We don't kind of break out the components of our business. It's a relatively small business. It consumed a fair amount of resources because it is fairly intense. We've got a licensee who we work with in other parts of the world and who we've worked with on other parts of our business who really is focused on licensing kids' products, and they license kids' products from other big apparel companies. They've got scale in the kids business. It's kind of their sweet spot.
They can probably do a better job at it than we can, we've made the decision to license it to them, where we give up the wholesale revenue but take the licensing profit.
Okay. Just lastly from me, I was wondering if you could quantify or help us understand how much of the inventory decline in the quarter was a result of either the exit of dENiZEN or the licensing of the Boys.
I think the inventory decline in the quarter is really not impacted to any great extent by those two materially. It's really reduction in units as well as the cost of our inventory part of which is driven by the lower cost of cotton.
Exactly. It would probably be almost a rounding error, those two components. This is really the revaluation due to the lower cotton, and we're managing our units very aggressively, which hopefully will help us through the balance of this fiscal year.
Okay. That's all from me. Thank you.
Your next question comes from the line of Carla Casella from JPMorgan Chase.
This question is on the U.S. business. You mentioned that the retail was up. Can you comment on the wholesale business? I would've expected with the JCPenney rollout that you might've seen a bigger increase, or was it just that you replaced what was in the stores?
Are you asking about JCPenney specifically or wholesale more generally?
Well, if you'll comment on JCPenney specifically, that'd be great. I didn't expect you would, so I thought if wholesale more generally, if you could just comment on that. I would've expected more of an increase, though, because of the JCPenney. That was my thought.
Yeah. Wholesale in general was flattish, I guess, is probably the best way to characterize it. Mostly impacted, frankly, by the licensing of the Boys business out. Okay? That was the biggest impact on our wholesale business. JCPenney, I will describe kind of what we're seeing there. As I said in the earlier prepared remarks, we're pleased and very encouraged by the early results. I guess probably the best way to characterize what's happened there is, prior to the shop-in-shops going into the roughly 700 stores where we've got shop-in-shops, our business was tracking pretty closely with JCPenney's overall business, and you know what those numbers looked like. Since the shop-in-shops went in, which was roughly the beginning of August, we've seen a dramatic change in the trend line versus the going-in trend. Okay? A dramatic positive improvement in the trend line.
The other thing we've seen in the roughly 400 or 500 stores where we don't have shop-in-shops, the trend has stayed with the overall JCPenney decline. I think basically what you can say is, we can point to those shop-in-shops as having an impact on driving consumption of the Levi's brand in a very positive way.
Okay, that's very helpful. On the ad spend, can you quantify how much would be moved into fourth quarter from third quarter? Should we see ad spend tick up a lot fourth quarter year-over-year?
Well, I think, as I mentioned earlier, we have retimed some of the A&P spending that we have, and we don't expect the reductions thus far to continue into the fourth quarter, as that is a bigger time period where we do have higher A&P, and we tend to seasonally see more A&P in that time period. We're likely going to be in the range of what we experienced last year in the fourth quarter, give or take.
Okay, great. Just one last one. The JCPenney business as well as the boys licensing decision, were those any of the drivers behind your gross margin? Your gross margin was impressive.
Probably not in a meaningful way.
I think neither of those were as significant a driver of our gross margin improvement as some other factors that we saw. As we mentioned, gross margin of around 47% was in line with prior year levels. The dENiZEN exit did have an impact on our gross margin in the quarter.
In a negative way.
In a negative way, as did currency impacts as well. That was offset by other things that we're seeing. Increase in retail revenues. The decline in the sales to the discount channel did have a positive impact. We're also seeing the early stages of some benefits from lower priced cotton, as we're starting to see that emerge into our gross margins as well.
Great. Thanks a lot.
Thank you.
Thank you.
Your next question comes from the line of Kevin Coyne from Goldman Sachs.
Good afternoon. Thanks for taking the question. Just to follow up on the licensing. I was just wondering, is the contribution margin, once you start doing the licensing, the same or greater than when you were, let's say, manufacturing the boys business on its own?
Yeah. We don't break out the segments of the business directly. I think the way to think about this was there was a strategic component and a financial component. Both were compelling reasons to move forward with the decision to license it. We're not going to get into the weeds on the actual gross margin business to business on a small segment of the business like that.
Okay. Just related to the licensing, I think you said, that you use this partner globally, but going forward, is this something you would consider doing more in the U.S. with this partner?
Well, we use this partner in some other parts of the world. It's not totally global. If I said global, it is not an entirely global deal.
Sure.
They have scale in the kids' business. That's where they tend to focus. They work with other brands in the kids' business. That is their sweet spot, and we've got a fair amount of business with them across both boys and girls right now.
Okay.
I don't know if there's more opportunity with them in our product line. We'll consider licensing where it makes sense, both strategically and financially. I think we're in a pretty good place right now, but we'll constantly go back and look at that.
Okay. I'm not sure if you mentioned this before, but in terms of the dENiZEN impact, I know you mentioned it, the impact on gross margin, but did you mention how much you think the impact was to the top line in Asia?
I think as far as our top-line impact, as I mentioned before, the impact to gross profit was roughly split between the inventory markdowns that we had, as well as support for our customers that we provide them to help sell through the inventories. It's roughly in the ballpark of each of them was about equally contributing to that.
If you take the $25 million charge , it is about 50/50.
Okay.
Half to the top, half to the markdown, which impacted gross margin.
Great. Does this more or less complete the charges for dENiZEN Asia, or should we expect more in the fourth quarter?
I suspect as we finalize everything, there could be a little bit more in the fourth quarter, but it is going to be order of magnitude much smaller than what we have taken in the third quarter.
If I could just squeeze one final one in. I know you usually pay the annual dividend and certainly with the election coming up and potential changes in tax rules, is it a potential on the table where you would consider pulling forward next year's dividend into the fourth quarter?
Just to address that question, as has been the case for our company, we have no standing dividend policy, and dividends are subject to the approval of the board. That being said, you've seen our pattern of dividends of about $20 million a year that we've had over a period of time. We are paying attention to what's going on federally in Washington, and we're considering the tax consequences of that in our recommendations to the board, including the possibility of paying it in advance of a potential tax change going into effect.
It won't be the fourth quarter, just to be clear.
Yeah.
Okay. Our quarter ends the last Saturday in November, it would fall sometime before the end of the calendar year, outside of our fourth quarter.
Great.
That's what we're taking into account, which would be similar to what we've done in the past and a couple of years ago.
It's all subject to the board. It's board approval.
We would update you whenever we have something on that to share.
Thank you.
You're welcome.
Your next question comes from the line of Hale Holden from Barclays.
Did I hear you correctly that there was a $19 million reduction in SGA related to the Japanese distribution plant shutdown? Is that one time, or should we take that out of SGA going on a forward basis?
It's an increase.
It's an increase.
It's an increase in SGA. It's an impaired asset.
It was an 11% reduction including a $19 million increase.
That is correct, yes. We had a $19 million charge in the quarter that related to our distribution center in Japan.
Okay. Any update on thinking on the term loan that matures in 2014 and whether rates are attractive now or attractive enough to consider refinancing and extending that?
At this point, we have nothing to share on that. We're very comfortable with our liquidity, and we'll probably be getting with you on that as the next few periods progress.
Great. Thanks, guys.
Great.
Your final question comes from the line of Jeff Kobylarz from Stone Harbor Investment Partners.
Good afternoon. Can you comment about back-to-school period? How do you think you did in that period as far as keeping market share? Any general color there?
The interesting thing about back-to-school is it kind of spans July, August, and September. This quarter that we're commenting on only captures part of back-to-school. As we said in the prepared remarks, a pretty good overall back-to-school period. One of the things that we've observed, I think you've probably heard some of the retailers talk about it, is that back-to-school seems to be getting extended and falling more and more into September, less and less to the weeks leading up to school. Probably all kinds of social phenomenons driving that. We feel pretty good about where we are. We won't close out our real back-to-school reporting until we finish up the fiscal year because September falls into the next quarter.
Okay. There's no timing issues, I guess, as far as shipping back-to-school in August versus in September.
No
as opposed to compared to last year.
No, I thought you were really focused more on sell out as opposed to sell in. Most of back to school ships in before September, and those numbers were captured. We feel generally pretty good about the back to school period, both in our own stores and in wholesale. Sell out, though, spans both quarters.
Right. Okay. Then just given the lower cotton prices that are in the market these days that you're starting to see, can you comment at all about your pricing for going forward? Just how these lower cotton prices, how are they going to impact your pricing at all?
We've been asked this question in the past, the answer still fundamentally stays the same, which is we're investing back in our product right now. We're investing in product quality. We've launched the five-pocket upgrade jeans where we've invested back into the cost of the make, if you will. Our plan right now is to hold pricing. Of course, we've got to stay competitively priced in the marketplace, we watch that kind of day in and day out. Yeah.
Okay. All right, thanks. Then just lastly, just any comment you can make about how you're planning for the fiscal cliff issues for next year? Your inventory's down, obviously, over 20%, you said you're being conservative with your unit counts of inventory. Can you add more color to those kinds of points?
Just on inventory specifically, how we're planning our inventory through the year? I missed part of what you said in the very beginning of your question.
Well, just concerns about the fiscal cliff and what you can say about how you're planning for that in general.
Yeah. Our approach to managing really all aspects of cash, if you will, is to manage it pretty tight. You're seeing that in the numbers. We're trying to manage our inventory fairly aggressively and put ourselves into a position where we have to chase instead of putting ourselves into a position where we have lots of inventory that we then have to heavily discount and get rid of. If you remember, that's what we had to do in the fourth quarter last fiscal year. Assuming things stay on track with how the business has been coming in the last couple of months, we will hopefully end the year without needing to aggressively discount to flush inventory as we did a year ago, and that should be a help to us.
All right. Thank you for your help.
You're welcome.
Thank you.
At this time.
Okay. Well, go ahead.
At this time, I'd like to turn the floor back over to CEO Chip Bergh for any closing remarks.
Well, the closing remarks are going to be really, really brief. I want to thank you all for dialing in, and thank you for asking your questions. Thank everyone for joining us, and we'll look forward to talking with you again in February when we report our full fiscal 2012 results. Thanks very much, and good afternoon.
Thank you. This concludes today's conference call. Please disconnect your lines at this time. Have a great day.