Levi Strauss & Co. (LEVI) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Kimberly Greenberger, Morgan Stanley's branded apparel and footwear and softlines retail analyst. We're very pleased to host Levi's at our Life After COVID Conference. This is their first participation at a Morgan Stanley retail conference. As many of you know, Levi's is the world's largest brand name apparel companies and global leader in jeanswear, with nearly $6 billion in sales in the latest year and over $6 billion in market cap. Today, we're joined by Harmit Singh, Executive Vice President and Chief Financial Officer; Chris Ogle and Aida Orphan, representing Investor Relations. Harmit joined Levi in 2013, continuing a successful career across various industries. Prior to his current role, Harmit held a number of Chief Financial Officer positions at multiple global companies, including Hyatt Hotels, Pizza Hut and Yum! Restaurants International. Harmit, welcome, and thanks again for being here.

Thank you, Kim, for having us, and we're looking forward to our first retail conference with Morgan Stanley and your team.

Thank you so much. Today, we plan to discuss Levi's broader direct-to-consumer and e-commerce strategies, as well as how COVID-19 may have changed Levi's business and strategies. We'll start today's session with a moderated question-and-answer format, followed by audience questions. For those of you joining us via the webcast please click the Ask A Question button on the webcast to submit your questions, and there can be a slight delay here, so we encourage you to submit those questions early. Before we dive in, I need to remind everyone that you can find important disclosures on the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. Additionally, Levi's comments today may contain forward-looking statements and non-GAAP metrics, subject to the safe harbor statements and reconciliations in Levi's SEC filings. Please note, in our discussion today, Levi's will not be discussing the current quarter trends or any update to their outlook for the fourth quarter and beyond as provided in their recent third quarter earnings call. With that, I'm happy to get started with our first question for the day.

Harmit, COVID-19 has altered the way many global brands seek to connect with consumers. Can you start by sharing with us how you are seeing COVID-19 change consumer behavior and how Levi has altered its strategies for a post-COVID world?

Thank you, Kim, and thanks, everybody, for participating and attending today's meeting. This is my fifth recession. My first recession was in Asia in the late '90s. But it's my first in the apparel industry. And so as you think through the different crises that we have faced, the pandemic being one of them, we have a playbook, and our playbook is all about managing through the crisis but emerging stronger. To your question about how are consumers' behavior changing. I think it starts with the orientation of the consumers towards strong brands. We believe the workplace is casualizing and casualizing at a faster pace. The digitization of the consumer experience has accelerated. What will have taken probably years is happening very quickly. And importantly, we believe that consumers have been becoming a lot more conscious. They're moving from conspicuous consumption to conscious consumption, which really plays to our strengths. It's all about brands that not only focus on value, but values. It's about driving sustainability, keeping safety of the consumers at the forefront. As you know, in quarter 3, we announced the launch of a recommerce program. It's a $28 billion, $30 billion market, and it's our first entry into it. Levi's is one of the few brands that are sold and resold, people collect it and resell it, so we thought we might as well reap from the front. In terms of your question on strategies, we are pivoting to focus on 3 important priorities for us going forward. One is, we have great brands. We're going to be brand-led. And that's all about ensuring that we're able to generate and drive trust for our consumers as well as reach out to the consumer. The second is we are going to be a DTC-led company. This company grew up as a wholesale company. But we think DTC is the way to go. DTC, direct-to-consumer business, has grown double-digit pre-COVID and it allows us to connect directly with our consumer. It also has higher gross margin as well as allows us to build more of a lifestyle orientation for our product. And the third focus is about diversification, diversifying geographically, diversifying our product categories, diversifying our channels and diversifying our brand portfolio. All this is underpinned by a couple of things. One is what we call digitization of our consumer, employee and customer experience. The second is a real focus on financial discipline and growing margins, improving our ROI, et cetera, driving working capital management, et cetera. And the third is all about operations excellence. So that's how we're thinking about it. And using this time, as I talked about emerging stronger to accelerate our transformation that began 7, 8 years ago.

Wonderful. Okay. Excellent. That's a great introduction. Maybe we can just talk about the past year and build on that. As you mentioned, Levi is redirecting its efforts to growing its direct-to-consumer business and sort of shifting, a little bit, the strategic focus in the organization. Since the onset of COVID, we've obviously seen a marked acceleration in your e-commerce growth already. And it's been really exciting to see. I think during your third quarter call, you mentioned that you expect higher growth rates in the channel post-COVID, so the growth rate at a higher rate to be sustained. And that your e-commerce business could double in size within a 5-year time frame. Do you think COVID has actually enhanced, in some ways, Levi's long-term direct-to-consumer revenue opportunity? And how do you see COVID altering the e-commerce opportunity, both on your own website and some of your partner brand websites?

Yes. No, it starts and ends with the consumer. And the puck was already headed there. COVID basically accelerated the way the consumer shops, and we are focused on riding that wave. So let me talk a little bit about the business. About 10 years ago, our direct-to-consumer business, and I include our franchise business, which is reported in wholesale, but we have over 2,000 franchise doors around the world. So if you take the 2, it will be about 26% of our total revenue. In '19, it was close to 44%. It's higher today. And what we have talked in our Q3 earnings is it's going to be north of 50% of our business. The gross margins on our direct-to-consumer business are higher than wholesale. For example, our e-commerce gross margins are 20 percentage points higher than wholesale. Brick-and-mortar EBIT margins are accretive to the company operating margins. And more importantly, it allows us to engage and connect directly with our consumer. Our global digital footprint, and in this, Kim, I include not only our levi.com and dockers.com sites, I include our pure players like the Zalandos, the Amazons, the Tmalls, and the dotcom of our wholesale customers. That digital footprint is expected to grow over time to, I think, a little over 20% in quarter 3. It was about half that pre-COVID. We think over time, it gets to 1/3 of our business and allows us to directly engage. What we're doing at our end is accelerating our omnichannel capabilities, buy online, pick up at store. We've have launched an app. I mean this morning there was excitement at the Singh family, because my daughter discovered we've just relaunched our collaboration with New Balance sneakers. And people -- and she went to the app, we didn't have an app, she went to the app, tried to order it, it was already sold out. So I'm trying to figure out a way to get us some shoes. But I mean, I think that's the advantage. We didn't have an app. We were testing it pre-COVID. We've accelerated that. We have a loyalty program today. We have 1 million -- over 1 million consumers. And it's great -- it's exciting because this task that we'd like to see now -- revenue and EBIT is great, but I want to see the new consumers that are signing up. I want to see repeat. I want to understand what lifetime value is. And that only can come with direct engagement for consumers. And we're seeing great repeat. Repeat is close to 40%. And we are able to market programs on a more digitized way. We're also using app. And our algorithms are geared towards people who are spending more. People who are not spending is geared to try and drive that -- them to the brand, et cetera. So I think a lot to come, but very excited about where DTC can take us over time. And it's all about great engagement with our consumer, which you can then bring back to our wholesale customers and say this is how we're doing it, why don't you do it this way? And I think the magic of the 2 is music, right? Yes.

Absolutely. Absolutely. That's an excellent segue into the next question here, which is just about your wholesale strategy. And obviously, wholesale remains of critical importance to Levi. Can you run through your U.S. wholesale strategy and how you see this channel evolving in the next year or even the next 5 years?

Yes. Many years ago, when DTC was 26% of our business, U.S. wholesale was over 50% of our business, it's down to about 30%. I think, over time, it settles in the mid- to high 20s. But the component of it -- and we have some great wholesale customers, the component of it is healthier. And over time, we'll grow, right? And the reason we feel good about it, if you take our quarter 3, the nondigital business with our largest traditional brick-and-mortar department stores was less than 10% of our total revenues. It used to be much higher years ago. So our focus with the traditional retailers is all about driving more business in the productive doors. In the underperforming doors, we'll close. We've kind of built that into our algorithm and model, but we're very focused on the productive doors and building more of a lifestyle orientation in the productive doors with higher AURs. The -- in terms of why I believe U.S. wholesale will be healthier, you've heard about our expansion opportunity with Target. That's a healthier business. We are focused on driving more of a premium distribution so that the AURs go up. We are focused on driving value with our Signature and Denizen brands and driving new distribution where it makes sense. As well as growing our digital piece, which is with the pure players as well as the dotcom business because we think that's where the puck is headed. And so that's our focus of -- on U.S. wholesale. So I would say, healthier than it was pre-COVID as we emerge from the crisis.

Fantastic. Okay. Excellent. And that sort of brings us to the international strategy. Maybe you could compare and contrast how international differs from the domestic business. And how do you think about international expansion opportunities and category expansion opportunities?

Sure. So 75% of the apparel market is outside the U.S. International today is about 60% of our business. 7, 8 years ago, international was in the minority. The business was skewed to the U.S. Over the last 7 to 10 years, we have changed the structure of the business. International, if you think about product categories in good, better, best, international is more of a better and best product category, or what we call tier 1 and tier 2. The U.S. is still primarily a good market, having grown up in the wholesale business, which we're trying to, over time, diversify. The areas of focus internationally, Europe remains our strongest region. It was the strongest region in quarter 3. The brand is really, really strong. And we believe it's got the right balance between direct-to-consumer and wholesale. It's 50-50 between direct-to-consumer and wholesale. And if you take a franchise business out of wholesale, our direct-to-consumer plus franchise is clearly on the majority. Asia has been rocky for us, but it's our greatest opportunity. We have a wonderful track record in India. And in Japan, China, our business is still small. It's about 3% of our total business, and we think we can grow that over time. So clearly an opportunity. To your question about product categories. I think tops, women's and outerwear are [ becoming ] the larger share of the business and continue to be underpenetrated. As we establish more of a lifestyle orientation, I think you'll see outsized growth as we saw pre-COVID from these categories. Our M&A focus, which is inorganic M&A, not that we need it because we believe we can grow this business organically in the mid-single-digit growth that our growth algorithm has, our M&A focus is around categories of accelerating tops, women's, outerwear and potentially entering athleisure. Because it's a consumer segment, it's no longer a trend, it's a consumer segment. And with the casualization of the workforce, it's something that we'd be open to look at.

Great. Fantastic. Okay. That takes us to margins and the margin opportunity at Levi. You've talked about several factors that will continue to benefit gross margin over the long run. Obviously, one of them being the growth in direct-to-consumer. And you also, on your recent conference call, talked about increasing average unit prices. You mentioned today more profitable wholesale partnerships. How do you think all of these things, in aggregate, shape gross margin going forward?

Yes. I mean in -- we're confident we can expand gross margins for the reasons you talked about. Our geographic growth, international is higher gross margins. Our channel growth, driven by DTC, higher gross margin. We premiumized the brand. Higher AURs. We continue to negotiate fairly well with our vendors. And we take price increases. And we took a -- we increased our women's styles in the U.S. by $10. That is sticking. We took a price increase in quarter 3 in Mexico. That's sticking. So wherever the brand is strong, which we think is in large parts of the world, expect us to take pricing. Because I think as we introduce new innovation in the product, as we introduce new styles, I think that will probably help. So gross margin has been a point of strength. Even during COVID, we have continued to expand it. We talked about ending the year with higher gross margins than in '19, which means we manage our inventory really well. So -- and then if you think about an ongoing growth algorithm in the post-COVID world, it does call for a 40 to 50 basis points increase in gross margin annually.