Earnings Call: Q2 2012

Jul 10, 2012

Please input the ID code of 9,509,1283 followed by the pound key. 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 Maruvio, Director of Corporate Affairs at Levi Strauss and Company. 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 Blake Jorgensen, our 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 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 Berg. Good afternoon, and thanks for joining us today. Our second quarter results reflect the intensifying macroeconomic headwinds around the world. As many multinational apparel and consumer goods companies have indicated, growth markets, particularly those in Asia, have begun to exhibit a broad slowing trend, and conditions in Southern Europe worsened. In this environment, total company net revenues for the 2nd quarter declined 4% on a reported basis, and net income declined 37%. While revenues were down in Asia and Europe, revenues grew modestly in the Americas driven by our retail stores. As we anticipated, high cotton costs continue to put pressure on margins, although our pricing actions and expense management partially offset the impact to the bottom line. As we told you last quarter, we've begun taking steps to manage our controllable costs. The deteriorating conditions now underscore how important it is to address the underlying structural economics of our business and make tough choices to improve operating margin while focusing our investments. Let me walk you through what we're doing in greater detail. 1st, we are executing on a multiyear commitment to reduce costs and strengthen our operating model. We're focused on driving sustainable organization savings in order to reduce our SG and A. For example, we're managing our business to get better scale. You've seen us moving to a global matrix operating model through the appointments of new executive positions, including our commercial operations leads and a Global Head of Retail and E Commerce. Also, as you know, we announced the new Levi's brand leader. This reflects the 3 pillars of our new organizational structure, our global brands, global retail and commercial operations. During the Q2, we continued to reorganize our teams behind this model. We're making our commercial operations pan brand in order to serve our wholesale customers more efficiently and gain greater economies of scale across our brands. We're also consolidating country operations and reducing layers of management. We expect to activate this leaner operating model toward the end of this fiscal year. 2nd, we are focused on being a best in class global retailer. Retail is an important pillar in our new operating model. Across the regions, our store network continued to drive sales growth in the second quarter, we see opportunities to grow our retail business profitably. In order to achieve this goal, we are focusing on service and the brand experience as well as closing underperforming stores, moving to locations with better foot traffic and where it makes sense, opening stores that effectively showcase our brands. During the quarter, we opened a Levi's store on the Champs Elysees, and last month, we moved our successful Levi's SoHo store to an even better location. In addition, we're building a global e commerce platform that will deliver a consistent experience for consumers around the world. Our own e commerce will complement the e commerce efforts of our wholesale partners. And 3rd, as always, we will put the consumer at the center of everything we do, driving innovation and a great consumer experience. We're working with our wholesale customers to enhance the consumer shopping experience in a variety of ways, such as training sales associates on our FIT system and improving on floor displays. The Levi's brand continues to focus on offering products with craftsmanship and innovation. Our more modern slim fitting 5 11 continues to gain traction. We're expanding our innovative performance wear this fall with a limited capsule skateboard collection with Nike and the next global rollout of our own commuter series. We're working to capture consumers' attention through engaging marketing and social media programs. Though we have selectively scaled back advertising during the quarter, we remain committed to supporting our brands with marketing programs that have a high return. For example, we connected with consumers on Facebook for a denim birthday celebration on May 1 or 501. Turning to Dockers, the Alpha Khaki with its slimmer modern fit is resonating well with the younger audience, particularly in Europe, and our Wear Over series is also gaining traction. The core of the brand, men's bottoms, grew slightly in the quarter. We're stabilizing the business by rightsizing the brand's cost structure, licensing where it makes more financial sense and streamlining our product mix. With that, I'll turn it over to Blake, who will walk you through our financials in more detail. Thanks, Chip, and good afternoon, everyone. Total reported net Thanks, Chip, and good afternoon, everyone. Total reported net revenues for the Q2 of 2012 were $1,000,000,000 a 4% decline from last year. On a constant currency basis, revenues were down 1% as declines in Europe and Asia offset the modest growth in the Americas, reflecting the increasingly challenging global economic environment. Gross profit was $481,000,000 down 11% from 2011, reflecting higher cost of goods sold and unfavorable currency effects. As expected, our gross margin declined notably in the quarter to 46% from 49% a year ago. Our spring season represents the tail end of the peak cotton prices in the products we sourced last year. And while our price increases have partially offset these costs, we determined that additional price increases in this economic environment would not benefit our results. Turning to operating expenses. Our SG and A declined to $435,000,000 down from $476,000,000 in 2011. This was primarily a combination of favorable currency effects and lower A and P spending, which we are now actively managing down given the challenging market conditions. While we remain committed to supporting our brands, we are focusing on carefully managing expenses and investing where we believe we can drive profitable growth. Our lower SG and A did not sufficiently offset the impact of lower net revenues and the gross margin compression. And accordingly, our operating income declined to $46,000,000 as compared to $65,000,000 last year. Below operating income, our results were impacted by our refinancing activities during the quarter. In May, we successfully refinanced our $350,000,000 senior notes due 2016, extending the maturity of that portion of our debt to 2022 and locking in a 200 basis point interest rate reduction. In addition, we also were able to repurchase more than half of our outstanding 2016 yeneuro bonds at a discount. Our 2016 maturities now solely consist the remaining $50,000,000 balance of yen bonds. The net impact of the refinancing activities during the quarter was an $8,000,000 charge. Our net income for the quarter inclusive of the refinancing charge, was $13,000,000 down from $21,000,000 last year. Now I'll share more detail on the 2nd quarter regional revenue results. The Americas grew net revenue a modest 1%. Increased Levi's brand sales at retail and Denizen brand sales at Target were offset by lower sales to certain major wholesale customers. Sales to lower margin channels also declined. In Europe, net revenues were down 10% on a reported basis and 2% on a constant currency basis. While net revenues have increased in our own stores, sales to franchises and traditional wholesale customers continued to decline, reflecting the ongoing difficult economic conditions in Europe. In Asia Pacific, we experienced the 1st overall business decline in 2 years as net revenues were down 12% on a reported basis and 9% on a constant currency basis. Growth continued in China but has slowed significantly, and this more tempered growth was offset by declines in other markets in the region. This was especially true in India, where we saw a substantial drop in consumer demand. We are concerned about the economic factors in Asia Pacific, and we are looking at ways to address the situation as the region has been a growth engine for some time. Now turning to cash flow and the balance sheet. Operating cash flow for the first half of twenty twelve was $328,000,000 as compared to $85,000,000 during the first half of last year. The increase in cash flow reflects our tighter inventory position and the timing of accounts receivable collection. As we move into the Q3, traditionally a period of higher working capital usage, we are beginning to see the benefits from the decline in the cost of cotton in our upcoming products. We will also remain focused on managing inventory units to appropriate levels. Capital expenditures for the 1st 6 months of 2012 were $37,000,000 down from $76,000,000 we spent last year, which included the deployment of our SAP system in Europe. We continue to invest in the expansion of our company operated retail network, but we will be prudent in our capital spending, prioritizing profitability over growth. We also paid a $20,000,000 dividend to shareholders during the quarter, an amount consistent with the last few years. At the end of the quarter, our cash balance was $278,000,000 and we had $587,000,000 available under our credit facility. Net debt declined to $1,500,000,000 from $1,800,000,000 at year end. We are comfortable with our liquidity position, which is supported by our increased operating cash flow and significant availability under our credit facility. Looking ahead, we continue to be cautious due to the ongoing troubled economic environment. While the high cost of cotton will abate during the Q3, the increasingly global economic challenges may continue to put pressure on our margins. As Chip discussed, we will focus on reducing operating expenses and will make necessary changes in order to move towards our historical profitability levels. These actions will result in some near term costs such as severance and and other one time charges associated with corporate reorganization and streamlining efforts. In our future quarterly earnings call, we will help you understand the nature of any of those charges. With that, we'll now take your questions. Your first question comes from the line of Wells Fargo. Hey, it's Grant Jordan, Wells Fargo. Thanks for taking the question. I guess, maybe just give us a little more commentary on your cautious comments on Asia. What do you think is driving that? Is it macroeconomic conditions in those countries? Hey, Grant. It seems to be a combination of a number of factors. But clearly, GDP is slowing down in the big markets in Asia. So GDP growth rates have dropped by a couple of points in both China and India here recently, a little bit of an inflation effect. And the consumer is pulling back. I mean, that's really simply what we are seeing, particularly true in China and India, where we have decent sized businesses. Okay. Has there been any competitive response there? Or do you feel like it's strictly related to the consumer overall? I think big picture, and I think you're going to hear it from other companies as well. I mean, we're already hearing it from some companies. I think big picture, it's a consumer dynamic more than anything. Okay. In terms of just how you're planning the business going into the fall, it sounds like you're going to be cautious with your outlook. But what are you hearing from retailers on back to school? I think everyone is cautious, both our competitors that we're hearing at least in their public comments and what we're hearing from retailers. At the same time, they want to make sure their stores look good and, the product mix looks good. Obviously, you've got the build out going on at JCPenney's, which, will continue to roll out through the back to school season. So it'll be interesting to see how that looks. But I'd say overall it's a cautious view due to the economy in any of the local markets. And as Chip said, it's all really driven by the consumer not stepping up to spend. Yes. I think if you go region by region, here in the U. S, I think there's we're on shaky grounds a little bit right now. I think retailers are going to play it pretty safe in the second half of the year. We'll see that from an inventory, how they manage their inventory and open to buys, particularly true in Southern Europe. And I think we're going to see more of it with our partners in Asia as well. My last question, just kind of dovetailing on that. How do you feel about your inventory position? And do you expect to have any clearance activities going into the next quarter? We feel very good about the position. And in some portions of the world, we're actually wishing we had a little bit more where certain products are working. But clearly, if you look at our cash flow, you can see that the inventory levels have come down dramatically and we're trying to operate with as lean an inventory position as we can to eliminate the impression that we saw in the Q4 around our gross margin. So we're feeling good now and we'll continue to maintain that posture. Yes. I would just pile on to say, I think we learned the hard way in the Q4 last year. And so we're going into the Q4 this year or into the second half of the year this year, trying to manage our inventories pretty preciously. Your next question comes from the line of Bank of America. Good morning. This is Bill Reuter. Following up on that question a little bit about your inventory levels, you've said you feel good. And I think also the cotton costs you mentioned are going to abate in the Q3. But then you made cautious comments on margins. I guess it would have seemed to me that if inventory is in good shape and cotton is lower that margins could expand. Maybe you can help me make sense of that? Yes. So clearly, our gross margin well below what it was this time last year. Last year, we were at 49.5 percent or 46 percent this quarter. The negatives in that gross margin are obviously the price of cotton and the inability to continue to keep driving price up. We've been improving the quality of our product over time, but that plus the price of cotton hasn't allowed us to fully cover all that in our pricing. We've in an effort to maintain lean inventories around the world, we have discounted in some local markets and so that also has impacted our gross margins. I think the positives are and the reasons we will see some gross margin increase is obviously the cotton costs will come down in the 3rd 4th quarters. And if we can continue to maintain low inventory levels, we won't need to liquidate inventory or sell more inventory through the discount channels. I think our caution is really driven around the overall economic situation globally. And while I think historically we've guided into the low 50s in the back half of the year or for the full year, as I've said earlier this year, I think we're probably still in the high 40%. So you should see some improvement in gross margin, but we're cautious as to how fast that improvement will occur and how quickly we'll be able to see some of the benefits of the pricing that we've taken historically due to the fact that the economy is still slow. Okay. That's very helpful. And then your advertising expenses, which were down pretty considerably in the quarter, I think last quarter you'd made some kind of qualitative comments that you would expect they'd be relatively similar for the year. Have you changed your strategy? And I mean are you guys going to should we see a large year over year increase in the back half of the year to kind of offset the first half? Or is that not the way you're thinking about it? I think what you are seeing, some of that's going to translate to real cuts. I mean, frankly, we couldn't backload all of that right now, I think, even if we wanted to. So given the worsening conditions, we've pulled back some marketing support in some markets. And that's going to translate into a real cut. Now the second half, we are still planning to support our business. We do have plans. The business is seasonal and that the second half of the year going into the holiday season is really important for us. And we will be supporting the brands in the second half about in line with what we did a year ago. And I think Bill, as both Chip and I commented, our focus is on bringing the overall level of SG and A spending down. We've obviously we want to maintain appropriate level of A and P. We're going to cut back where it doesn't make sense this year. But going forward, we want to maintain that as an important expense for us. What we really start to see in the back half of the year and into next year is more non A and P spending cuts around the overall operations of the company. We're really focused on trying to drive organizational change, which should start to yield SG and A improvements over time. Okay. And then just lastly, do you have a sense for how your minimum pension contribution in 2013 could be impacted by the new legislation that increases the discount rate? Yes. It's a good question. So first off, the IRS has not yet released what the 25 year average rates are going to be. They'll publish those in August. But our early view is that if we continue to use long term averaging in our pension plans, we'd most likely see some benefit. We've already seen some benefit this year just due to structuring. As you remember, in our 10 ks, we said that we are roughly looking at $65,000,000 in 'twelve and $65,000,000 again in 'thirteen. 'twelve will clearly be below that level. Most of our funding has already happened to date, roughly $40,000,000 and we would some reduction in the last piece of funding for the year, but that's only a few $1,000,000 left in that funding. Next year, still too early to say. We'll obviously tell you that at the start of the year, but I would assume that it will most likely be below the $65,000,000 level that we had disclosed in our 10 ks for 2013. Okay. That's all for me. Thank you. Thanks, Bill. Next question. Your next question comes from the line of Deutsche Bank. Good afternoon. This is Karru Martinson. Just so I'm clear, just to confirm, I guess, you are still looking at a high 40s type gross margin for the full year, correct? Yes. We think we would still be in the high 40s, but obviously lower than what the average was last year, primarily because of the impact in the 1st two quarters this year. Okay. And then when you look at you guys talked about the reset going on with JCPenney's and there's a lot of noise here about the store within a store concept. I mean, are there any kind of upfront vendor payments or commitments that you guys need to make to pursue that strategy? No. Essentially, what we're doing with JCPenney is redirecting the historical spending that we've done with them for On-four and that's spread out over time. So no upfront spending that's really being the responsibility of J. C. Penney. And we'll see how the business performs over time and that could ultimately impact how much we spend with them going forward similar to how we did historically. But it's probably too early for us to give a real insight until we start to see how the shop in shops look as they roll out. We're excited about it. We're very supportive of J. C. Penney as a key customer. But we're we'll wait and see, but we'll know in the next couple of months as we start to see the shop in shops roll out. Okay. And recognizing the slowdown in Asia and the consumer dynamic going on there, I mean, is part of the shift though kind of this tough comparisons given the sell in and the creation of Denizen last year? And when will we kind of anniversary that feed in? Yes. It's a good we've actually we have anniversaried Denizen in Asia. And the comparisons here really are fundamentally reflecting what's happening from a consumer dynamic standpoint. So Denizen is down year over year. That's part of the Asia issue. But we're also seeing softness on our core Levi's brand as well. Yes. As a reminder, Denison is a very small business in Asia. So while we are anniversarying it, it doesn't have as big of an impact. It's actually larger in target in the U. S. And we're getting some benefit of that now in our numbers, but still it's a relatively small portion of the U. S. Overall for the Americas overall business. Okay. And perhaps I missed it, but can you provide kind of an update on what's going on in Japan? I know it's been a tough market and kind of what the outlook is there? Yes. Obviously, last year, a very difficult year with a tsunami. It appears that while the economy has not returned to normal, it has certainly stabilized to some extent and our business has also stabilized. But we're obviously continue to be cautious there, no different than we are in any market around the world. We're working very hard to improve our business and improve the channels in which our business goes through as well as our own retail stores there. And we think we're seeing some benefit, but it's still real early to tell. Thank you very much, guys. Appreciate it. Your next question comes from the line of JPMorgan. Hi, this is Paul Semenour on for Carlo Casella. I just have a few questions for you guys. First, how's Dockers doing? And have you guys gained any doors there? Dockers, our strategy has been to really refocus back on the core men's pants business here in the U. S. And the good news is that business is growing. The second thing that we've done on Dockers is get our cost structure kind of right for the size of business that we have today. And so we're making good profit progress on that business. The third thing I would say is that our business in Europe, which is a slightly different business than the business here in the U. S, the U. S, we're basically a pants business. In Europe, we've got really a real head to toe collections business, is doing pretty good, all things considered, with the tough economic environment in Europe. So we're feeling pretty good about the progress that we're making on Dockers. There's still clearly a lot of work to do. But I am confident that this brand can grow and be a significant part of our portfolio again over time. Got it. Great. And it was a good segue into the next question. Levi's Europe, obviously, economic weakness, you're saying. Can you discuss how performance varies by country? I'll give you a high level response and if Blake wants to go deeper, he can. But think about Europe as North Europe and South Europe. And if you kind of draw the line where about where that line would be, North Europe, we're doing well and growing and in some markets growing quite strongly. Southern Europe, pretty weak, declining in most markets in Southern Europe. Yes. And the only thing I would add is to the extent that you think about Eastern Europe, Russia, our business in Russia has done well. It's obviously still small there. But as the economy has improved in Russia, our business has improved. And we've done well in the Middle East, even though once again that's a small business. I think they haven't seen as much of the broader economic that had the more social impact there, but our business has sustained very well. But as Chip said, our overall worry is the broad economy in Europe. And while the South is bearing the brunt of a lot of the unemployment, the consumer is cautious almost everywhere in that market, including big markets like France and Germany. And that's why you're seeing a fairly flat business for us there that then gets impacted by the weakness in the euro as well. Yes. I think that's a great point. Just I guess one other comment. So our business is modestly down in Germany right now, and Germany has got one of the strongest economies in Europe. And it's fundamentally again, it's a consumer thing. The consumer the German consumer is a fairly conservative consumer anyway. They're being very conservative with their shopping dollars, and they're just postponing things, postponing purchases. Interesting, very interesting. Moving on, non denim seems to be growing. Are you seeing any replacement of denim space at retail with non denim or any loss of floor space there? Yes, we haven't really seen any loss of floor space. We've been introducing non denim products of our own in Levi's. There was a fairly, very successful line called Stay Press in the early spring, which essentially was a denim or jean cut using a non denim material or a blended denim material. And I think we tend to see most of the denim players extending and so keeping their same floor space just with different product mixes. Great, great. And one final question just about the JCPenney shop in shops. I don't know if you said exactly when it's going to debut precisely like the exact dates or if you have that, but that would be really helpful. And will it constitute a larger offering than what you had in JCPenney previously? And will Dockers also go in? So that's a multipart question. I think you can expect to see the Levi's shop in shops up and fully operational. I think their target will be back to school timing. So they're kind of going in pretty much as we speak right now. And I think we'll have several 100 stores up and running by back to school on Lee VIs. It will represent we will get some increased space and some increased inventory as a result of it. I've seen what the shops are going to look like. I think they're going to be really strong. It's going to definitely elevate the consumer shopping experience and make a meaningful impression. And I think it will be good overall for our business. Dockers is still in the TBD column. We're working with them to try to seal the deal on Dockers shop in shops as well, but that will be on later timing. So they're focused on their big brands first. You've read what many of them are. We're delighted that Levi's is going to be one of the first brands up and running. Got it. One last thing, I don't mean to ask too many questions, but I just want to clarify a point. There was actually something out today with regards to a potential slight change in the SG and A sharing agreement with JCPenney. I'm not sure if you answered that question earlier or not. I just want to make sure if there has been any changes, what are they or if they're material or if you can talk about that at all? Yes. What we said earlier, I'm not sure what was announced today. We obviously, we didn't announce anything other than to say that our spending with JCP will be consistent with how it has been in the past and will be over a period of time, not upfront. And so our view is we've supported their on floor investments historically and our continued support will be over time as they build out their stores and as we operate those stores. Very helpful. Thank you, guys. Next question? Your next question comes from the line of Stone Harbor. Hi, it's Jeff Kobler. Just curious about I think you said about the inventory. I think you said it was most of the decline in inventory was in units. Is that correct? Hi, Jeff. Actually, I'm not sure if I said that or not, but we did see both the unit decline as well as a dollar value decline as we're starting to build lower priced cotton inventory, but bulk of it was in units coming down over the last quarter. Okay. And then I think I heard you say, Blake, that the in the U. S, the retail stores were positive and Denizen and Target was positive contributor to sales, but then the wholesale business was down in the Q2. And is that did I hear that right? Yes, that's correct. Okay. And what's the reason for that? Is there do the your wholesale customers want less weeks of inventory or what can you elaborate? No, I think it's a combination. Obviously, you've got one major wholesale customer that's going through a transition. It's impacting their general business and you should assume it's impacted our business. But at the same time, I think wholesalers are, as Chip mentioned, being very cautious about inventory and they're seeing the slowdown in consumer demand and so they're being careful and we're seeing some of that in our business obviously. Okay. So then is it, I guess, like a few weeks of inventory that are being held by these by retailers in general in the U. S? Yes, it's hard for me to say. I think with us, obviously, they tend each retailer has a different inventory policy and in some of our products we operate with automatic inventory replenishment. So it's hard to tell exactly how much they're carrying at any one time. Right. Okay. And then I guess lastly about the pricing, just given with cotton coming down, it sounds like you're not changing prices for the second half of this year. Is that correct? Yes. That's correct. Okay. Right. In fact, just I guess the other thing I would say and Blake kind of alluded to this or mentioned it earlier, we did we've been investing in the product quality that kind of unfortunately hit right at about the same time that cotton pricing went up. So we have invested in make and it shows in the product itself. And so we are planning to hold pricing to offset that cost. All right. Good luck. Thank you. Thanks, Jeff. Next question? At this time, there are no further questions. Okay. Great. Well, I want to thank you all for joining us today and thank you for your questions. I just want to close by saying we're taking the necessary steps during this tough economic environment to make our business more competitive and drive long term profitable growth. We look forward to talking with you next quarter. Thanks a lot. Thank you. This concludes today's conference call. Please disconnect your lines at this time.