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

Yes. I mean it's the #1 topic within the company. And so it's -- if it's an investor concern or question, it's also a company question or concern. What we try and do -- in a backdrop where supply chain issues continue to remain, we are not out of the woods there. If someone said we are out of the woods, I'd say, while it's got a little better we're not out of the woods. And I'm still am chasing on a daily basis product because you have to match what consumers want and what you have. And so it's always a wonderful dance. But -- so there's a supply chain piece. The other thing that's, as you asked in our business, we do have a lot more core, so you can carry it from season to season, and that's important. The 29% number that you saw, which was growing year-over-year. I think the best -- because last year, inventory positions around the industry and relative to us were lower. So the best way to look at inventory in my view, is look at it versus '19. And '19 was versus up 24%. We have received goods earlier than we normally get just because lead times have become a lot more difficult and longer and supply chain issues. So we have about 10% or so that we have received earlier. And then Beyond Yoga, we took back our distributor and quarter licensee in Thailand, that added about 3%. So if you take that out, inventory growth in '19 is in the low double digit, and our expectation on sales based on the guidance we've given in quarter 2 is around that number. So it's a good inventory growth to sales ratio comparison. We are -- on a daily basis, I look at what I can defer and cut just to manage exposure. And this number already includes a lot that was cut. So we have to just ensure that we balance demand and supply. What happens to inventory over the next couple of quarters, we are implementing -- upgrading to the new SAP on the cloud platform in Q1 or Q2 of next year. And so we will build inventory for the U.S., which is largely a core market. It really starts in Q3 and Q4 and then things get better in Q1 and Q2 of next year. So it is a bit of consumption of working capital, but the balance sheet is fairly strong at the company. We have a lot of cash. We have access to liquidity. And so we feel generally comfortable. And so we're trying to balance demand and supply as -- and ensure that we don't build a lot of inventory that we will need to mark down. And because inventory is largely sold through seasons, the markdown risk for us is relatively lower than a lot of others.

Okay. And then, 2 of your major customers in bellwethers in the industry, right, Target and Walmart have lowered their outlooks, right, in the recent weeks and months and have cited elevated inventory in apparel within their channels. So can you just help us frame your exposure to both retailers and any visibility you have on some near-term order trends? And then maybe taking a step back, just zooming out for your full U.S. wholesale business, are you seeing any pockets of concern with inventory in the channel?

Yes, again, I'm not going to comment on quarter 3 for a whole bunch of reasons. It's always a discussion with retailers. Relative to Walmart and Target, it's -- first, overall, our exposure to any one customer is not concentrated. So we don't have a customer who is about more than 10% of our business. Walmart and Target, both are in the mid-single digit as a percentage of sales. And the decline that we saw, at least in the quarter 2 was in the mid-single digits. The -- and a lot of our product, even at -- our value product is core. It's not seasonal. So you don't have Valentine product, for example, on the shelf, so you don't have stuff like that. And so as we have discussions with our retailers. It's clearly a question of, okay, how much inventory do you have? What's the sell-through rates? And how much can you replenish over time? We look at trade inventory levels. And again, look back in '19 and trade inventory levels when we reported our quarter 2 were generally in line with what we had in '19. And so that's how we are managing through this, Chris. We did talk about Europe, where customers do prebook and the prebook orders were still up for the second half in the high single digits, so that -- we gave that indication there. The only other thing I would say relative to a couple of years ago, the brand's in a much stronger position. We do bring traffic to retailers. And I think some of them have publicly said it. I mean, goals -- in our recently announced the Silver Tap program, which some of you have seen, but that is where we sorted the Silver Tap, took calls, and it's a big driver of how they bringing traffic to their doors. And so I think having the brand in a stronger position does drive a better leveraging with retailers as they think through inventory. And I've been through 6 recessions. I hope I don't go through a seventh, but I've been through 6. And one of the things I've noticed -- and this is not necessarily true of Levi's as all the great brands, the one has been associated with. Even in tough times, consumers turn to brands they trust. So if you have a dollar to spend, you spend it on the brands you trust or in products that are more relevant than not. And so our job is to ensure that we continue to engage with the consumers and continue to build that experience so if they have limited dollars, it's spent on the brands to trust versus the other brands.

Got it. And then maybe shifting to your European business. I believe you guys actually increased your underlying sales growth outlook last quarter despite some of the inflationary and FX headwinds facing the market. And for those of us that are not on the ground in Europe, can you just help us frame why -- what your business in Europe is all about? Why you think it's holding up better than some of the rhetoric we've been hearing from some retailers? And then are there certain countries that are really outperforming and that are strong growth spots for the company?

Yes. I mean, I think some of the well-known brands continue to see similar trends in Europe as we do. So it's not only us, number one; number two, in Q2, I think Europe was up 3% reported by 15% constant. So foreign exchange or the euro is a big drag. And our expectations were up in constant currency for the year on the back of a good Q1 and Q2 also. So coming in, we were seeing good trends. Europe, I think the headwinds are largely our business in Russia, which is temporarily suspended. Most of the stores are suspended and foreign exchange. The reason we continue to see a positive business and growth, beside the brand being really strong, pre-pandemic for a number of years, we were growing 20%. And economies are not growing 20%. I can tell you that, right? But we were growing 20%. And because the brand is strong, we execute really well. We provide more of a head-to-toe look. The assortment is more harmonized between wholesale and our owned stores. We were opening a lot of stores. We continue to open stores, et cetera. So I think those are the factors that continue to drive confidence in growth. The other thing is a large part of Europe was closed last year during COVID everything else. And now it's open. There's a lot of tourism happening in Europe today. Trying to find hotels or flights is still very difficult. And so I think tourism is returned -- has returned to the big cities. We are present. Our eastern part of -- our presence in Eastern Europe is still small, it's largely Western Europe. And those economies generally are doing well. I think the U.K., the France are doing well. Germany is probably not doing as well as those markets -- the other markets that I talked about. So overall -- and we have a strong team on the ground. So I think those are the factors that give us confidence in Europe. And Europe is a high gross margin business because direct-to-consumer is -- it is more 50-50 in direct-to-consumer wholesale than, say, the U.S.

Understood. Thank you for that. And maybe let's shift our conversation over to your margin outlook, particularly gross margins. If you can talk through some of the structural tailwinds you guys have at your backs in the coming years, which gives you confidence in your overall margin outlook that you guys provided at your Investor Day over the medium term? That's the first part of the question. And then if you could also just talk to us about how some of the headwinds such as like input costs like cotton, freight costs, when we might start to see some of that begin to roll off and actually turn into tailwinds as we look on the year-over-year comparison?

Sure. So I think, first, the longer term, this is a structure, and then I'll talk about 2022. So in terms of the structural tailwinds, the businesses that we're focused to grow and accelerate growth are largely gross margin accretive. I talked about our e-commerce business. International is higher gross margin than the U.S. and international -- our growth algorithm says we'll grow faster than the U.S. That's been our history too. Our women's business, which will grow faster than men's, is also higher gross margin. And so structurally, the areas we're focused on are gross margin accretive. So that's the structural piece of it. And that's why during Investor Day, I think we talked about gross margins growing, I think, 30 to 40 basis points a year structurally. In terms of your question about some headwinds, right, that we have seen so far. We saw higher airfreight. Q2 is a good example where airfreight cost is 80 basis points in gross margin. And we've had higher averages given the supply chain issues. I think you'll start seeing that probably taper off in the second half and then in 2023. So that's one piece. Freight generally, ocean freight has gone through the roof. It's beginning to come down. If you look at the spot rates, Ocean freight is coming down. What we have negotiated ocean freight, those rates are still lower than the spot rate. So hopefully, sometime in '23, you'll see a little bit of that, probably not in '22, but probably in '23. Cotton, which tracks at average -- I think the median is between $0.70 and $0.80 a pound. If you look at the December '22 futures, it's in the mid-90s right now. It has climbed all the way to $1.52 in April, okay? And so when we bought -- when we bought for H2 of this year in H1, there were prices higher than $1. So I think cotton begins to taper off and turns into a tailwind in the second half of next year. We already bought the first half. So the second half of next year. So I think -- that's -- those are the puts and takes, I think, on gross margin. The -- we did sell more incented units. And so I think it was 100 basis points that we built into our gross margin. Despite that, our gross margins were a record for quarter 2. If you think -- so I think -- and we've got a similar amount built in the second half. It's difficult to predict promotion levels, but given where the brand is, given the fact that we sell a lot of core. We're going to be fairly tight on markdowns and promotions, I think, even in the longer term. And we are seeing the benefit in AURs, et cetera. So I think those are the puts and takes. We have taken pricing, Chris. We started taking pricing over a year ago, we took pricing in the first half. We've taken more pricing in the second half. I think as you think forward, we'll take a little less pricing even though -- if there's inflation, we'll try and offset that through productivity and other things. And our view is as we take pricing, we look at price value. And I think the value that we continue to provide to the consumer is superior, continues to be superior to some of our competitors. And the best example is going to any large premium retailer and just look at our product and look at what that's selling for versus the others. And I think you'll understand that it's true reasonable value that the brand offers.

And then as a quick follow-up to that, is there any pockets of the business where you guys still think you have some room for further pricing? Or is the approach you're taking more dynamic and you're going to see how the consumer environment plays out and be a little bit more reactionary?

No. We continue look at pricing. But I mean a couple of things are important. One, our competitive position has to be superior for us to price. The products that we are offering need to provide good value, value in terms of relevance, right, not in terms of price. So you can price, but that's the second piece that's important. So I think pricing going forward will be more targeted, more surgical versus a general price increase that we have taken over the last 12 to 18 months. So that's how we're thinking through it. And where we have done it, pricing is sticking. We took some pricing in the second half of this year based on my walk through with stores and store managers, it continues to stick. So I think it will be more thoughtful than in the past. We're also using AI and machine learning, just trying to understand the sensitivity. I think where we will be a little bit more thoughtful in terms of assortment will be on tops because that's underpenetrated. We want to grow it, et cetera. But being the market leader in denim and the relevance of our product taking a little bit more pricing on the bottoms versus top is how we're thinking through longer term.

That was really helpful. Thanks for providing that. And then maybe I think we have time for maybe one more question before we round out this session. Let's revisit if you don't mind, your new commitment on capital return priorities. If you can walk us through that? And then maybe you can layer in how you guys are thinking about M&A? And whether that's something you think you could take action in this type of environment? Or does the management team prefer to kind of wait until we're in a cleaner environment?

Yes. So capital allocation, giving clarity on that was important and especially having a couple of years under our belt as a public company, and so as we laid down our thought is that we -- our first port of call is to spend capital to grow the business. So we're talking about 3.5% to 4% of capital. And that capital is largely new stores, remodels, technology as we build an AI machine learning shop, et cetera. We're also spending capital on improving either capacity or infrastructure. I talked about the ERP. I mean that's a 5-year project. And then the -- and the second piece is we're building distribution capacity in Europe as well as in the U.S. We are taking back e-commerce fulfillment, which is largely third-party in-house. So that's capital. The second is paying dividends. And we said we'll grow dividends in line with net income. So that's the second piece. The third is against acquisitions, both organic, which is taking back things like our distributors, some franchisees, which is high ROI and inorganic acquisitions, I'll talk in a minute. And the fourth is if there's no great ROI idea, buying back stock, and we have started doing that, as you know, more to offset dilution, but also to -- it also helps return capital to the shareholders. Return on invested capital is an important metric. It's, I think, in the mid-20s for us to ensure that we don't -- we are disciplined around capital. We have introduced return on invested capital as a metric in the long-term compensation of leaders beginning in 2023. And so we have relative TSI and now we have a return on invested capital. We also have kicker on DE&I initiatives and how that's improving the culture of the organization. So really focused on ensuring we not only grow the business by allocating capital in the right way, but also improving returns. To your question about acquisitions, we did buy Beyond Yoga last year. So things were still up and uncertain, but we decided to do it. It was funded out of cash. It was getting us into a category that continues to grow. It's complementary and allows us to own a larger share of the closet. And so that was important. I think the ink is still dry. We're still integrating it. Our job is to first ensure that, that's a success before we go out and do something different. The areas we continue to look at is how do we accelerate tops, how do you accelerate women's outerware and footwear. Those are the 4 real categories as we build more of a head-to-toe look. But I'd say give us a little time to get Beyond Yoga to accelerate and then we'd start thinking of other things. And that's not -- M&A, which is inorganic M&A, it's not built into our growth algorithm of 10% to 12% annual shareholder return. That will be on top of it.

Great. And I think we'll leave at that. So Harmit, thank you very much for your time. [ IR ] thank you as well. I hope you guys have a great summer and looking forward to catching up the end of 3Q results. So thank you, everybody, for joining, and have a great rest of your week.

Thanks, Chris, for hosting us.