Levi Strauss & Co - Earnings Call - Q1 2012

Transcript

Speaker 4

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 16, 2012, by calling 800-585-8367. Please input the ID code of 68593147, followed by the pound key. This conference call is also 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 Marubio, Director of Corporate Affairs at Levi Strauss & Co.

Speaker 2

Good afternoon 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 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-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. I'd like to turn the call over to Chip Bergh.

Speaker 3

Good afternoon and thanks for joining us today. During the first quarter, we continued to focus on balancing top-line growth while improving our profitability and cash flow. I'm pleased to report that net revenue grew 4% on a reported basis and net income improved 21%. Our revenue increase reflects the commodity-based price increases we've implemented and the benefit of NIX. We also continue to feel the impact of cotton prices on margins. Cost of goods sold during the first quarter reflected higher-priced cotton, and as we have previously discussed, our price increases have not fully offset these higher costs, which continue to impact gross margin. Before Blake walks you through our financial results, I'd like to discuss the performance of our brands and the progress we're making to drive profitable growth throughout the company. Our brands continue to put the consumer at the forefront of everything we do.

This spring, the Levi's brand built on its strong heritage, adding a modern take on its classic styles with innovative new products and finishing techniques. Levi's leveraged a technology it developed in the 1960s, stay pressed, and is using it in a new brightly colored swim-fitting pant for men. The brand also rolled out new Curve ID styles for women, as well as dresses and feminine tops. We expanded Commuter Series to global markets. In February, Levi's captured the attention of the fashion world, making its first appearance at New York Fashion Week. We got a positive response to our products, and we're looking forward to the fall season. Turning to Dockers, sales were down again this quarter, and the team is focused on stabilizing the business. We're concentrating on our core product mix, and we're designing and marketing to appeal to a broader consumer base.

The Alpha Khaki is offering modern fits, colors, and styles for this spring. The reintroduced D4 Khaki and the Wear Ever series offer versatile styles for the more traditional consumer. During the quarter, the brand launched the next iteration of its “Wear the Pants” marketing campaign, featuring popular personality Bear Grylls. Our Denizen launch continues, and here in the United States, we're pleased with our progress at Target. We're continuing to invest in our retail network. Our company-operated retail stores performed well in the first quarter and grew on a comparable store basis. During the first quarter, we opened several new Levi's stores, including in Amsterdam and St. Petersburg, and we're about to open a flagship store on the Champs-Élysées in Paris.

We're refining our global operating model and organization structure to build greater synergies between our brands, be closer to consumers in the market, and deliver products that meet local consumer demand. Focusing on these improvements should also help drive productivity and reduce our operating expenses. I'm encouraged by our performance during the first quarter. With that, I'd like to hand it over to Blake.

Speaker 1

Thanks, Chip, and good afternoon, everyone. Throughout today's call, I will reference performance comparisons on a year-over-year basis unless I indicate otherwise. Total reported net revenues for the first quarter of 2012 were $1.2 billion, a 4% increase over last year. On a constant currency basis, revenues were up 5%. Growth was primarily driven by our Levi's brand and the performance of our dedicated store network worldwide. Our business continues to be impacted by the challenging global economic environments, particularly in Europe. Net revenues grew in our Americas and Asia-Pacific regions, but revenues declined in Europe. Gross profit was $549 million, down 2% from 2011, reflecting a lower gross margin and unfavorable currency effects. Our gross margin was 47% this quarter, a decline from 50% last year. As we discussed in February, we exited 2011 with a relatively clean inventory position.

Accordingly, sales to the discount channels were much lower than a year ago. However, peak cotton prices were flowing through our P&L this quarter, and as expected, higher product prices only partially offset those costs. Turning to operating expenses, our SG&A declined to $439 million, a 4% decrease from 2011. This was driven by various factors, including a reduction in A&P spending, which was partially due to timing of campaigns as compared to last year. In addition, we had lower pension costs due to some changes in our pension plan structure, as well as lower long-term incentive expenses. Going forward, we remain focused on reducing SG&A spending. Our higher net revenues and lower SG&A outpaced the impact of the gross margin compression, resulting in operating income of $110 million, up 11% over first quarter 2011.

Our net income for the quarter was $49 million, up from the $41 million last year. Now I'll share more detail on the first quarter regional revenue results. First, for the Americas region, we reported net revenues up 9%, primarily driven by the Levi's brand at both wholesale and retail. Higher net revenues also reflected the Denizen brand, which was not in Target at this time last year. As Chip mentioned, our Dockers business declined slightly. However, Dockers grew its full-priced men's bottoms business as a result of the pricing and product strategies we discussed with you last quarter, which is encouraging. In Europe, net revenues were down 7% on a reported basis and 3% on a constant currency basis. Our business continues to be adversely impacted by difficult economic conditions, particularly in the southern markets.

Growth continued in our Asia-Pacific region, although economic growth and consumer spending slowed in key markets such as China and India. Net revenues increased 5% on both a reported and constant currency basis, reflecting the strength of our brand-dedicated retail network. Now, turning to cash flow and the balance sheet. Operating cash flow for the quarter was $105 million, as compared to $46 million last year. Inventory values remained elevated due to higher-priced cotton, but our inventory turns have improved as compared to last year. We remain focused on managing inventory unit levels appropriate to support our business. Capital expenditures were $17 million, down from $40 million last year, reflecting a decline in our information technology systems investment due to the launch of SAP last July. We continue to invest in the expansion of our company-operated retail network during the quarter.

At the end of the quarter, our cash balance was $238 million, and we had $555 million available under our credit facility. New debt, our net debt, was $1.7 billion. We are comfortable with our liquidity position, which is supported by our increased operating cash flow and significant availability under our credit facility. In 2011, we made our dividend payment during the first quarter due to pending tax law changes. In 2012, our plan is to pay a dividend in our second quarter, subject to board approval. We're pleased with our first quarter results. However, we are cautious as we move forward due to the ongoing difficult economic environment, the impact of which is increasing in some of our emerging markets.

While we remain focused on delivering improved operating margins along with revenue growth, we will continue to be pressured by high cotton costs through at least the second quarter, and over the next few quarters, we will incur organizational transition costs as we position the company for long-term profitable growth. With that, we'll now take your questions.

Speaker 4

Thank you. The floor is now open for questions. If you have a question, please press star, then 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 a speakerphone or headset, we ask that you please use your handset. Your first question comes from William Reuter with Bank of America Merrill Lynch.

Speaker 0

Blake, in your prepared remarks regarding the higher cotton costs that are going to be flowing through in the second quarter, you just noted that we should see some relief in the second half of the year. Should we expect that margins will kind of stay around the level that they are here, or should we actually see some year-over-year increases in the back half?

Speaker 1

Bill, thanks for the question. I think you should assume that we'll still be in the high 40% for gross margin going forward. That's the guidance I think we've given in the first quarter. While cotton costs have come down due to the length of our supply chain, you know it doesn't turn itself off immediately, and it'll bleed into the third and fourth quarters and slowly help us improve our gross margin back up into the levels that we saw a year or two ago. I would moderate your forecast for gross margin to stay in the high 40%, and we'll obviously see the seasonality trends that we have seen in the past.

Speaker 0

Okay, that's useful. Your advertising that was down, you noted that it was due to a timing issue. Should we anticipate that for the year, ad spend will be pretty similar to last year? I guess, should we kind of see a pickup all at once here in the second quarter, or will that kind of be blended across the remaining three quarters of the year?

Speaker 1

I think there's a—I would go ahead and maintain the same model that you have in the past with general levels of ad spending consistent with our past performance. We tend not to have really lumpy ad spending, but there is some timing that goes between quarters. Do not assume that there's going to be one quarter where it's all dumped into the quarter, but assume some smoothness consistent with how it was last year.

Speaker 0

Okay. Lastly, you noted that the second half of the year is going to have some organizational transitional costs. I was wondering if you could help us understand the magnitude of these, whether you can even talk qualitatively. Is there anything you could help us to think about how big some of these could be?

Speaker 1

No, you know I can't give you any guidance there. All I would do is say that our focus will primarily be on our organizational costs in general, and somewhat consistent with some of the actions that we've taken in the past. I think, as we've talked about, we're going to be very focused on continuing to bring down our overall SG&A levels to get closer or to allow us to start driving the margins more aggressively.

Speaker 0

Okay, I'll leave it at that. Thank you.

Speaker 1

Great. Thanks, Blake.

Speaker 4

Your next question comes from Carruth Martinsen with Deutsche Bank.

Speaker 5

Good afternoon. Just to follow up on the organizational shifts here, what are you guys looking at? It kind of sounds like we're going to be taking some headcount out. Is it a wholesale rationalization of the business, or is it just going to be more tinkering around the edges?

Speaker 1

Let me start, and then Chip might want to add in here. I think, as Chip talked about in our last quarterly call, we've been working on improving our organizational effectiveness, and that's a combination of focusing on both brands and our commercial operations in all of our markets. I'd call it an evolutionary process versus an overnight process. It's something that comes through controlling our spending as much as it is actively reducing spending. It's a combination of those two, and you'll see it, I think, over the next 12+ months versus all at one time because of the complexity and the geographic diversity of our business.

Speaker 3

I guess, Carruth, I would just add that you know we're very focused on the notion of balanced growth, and we recognize that we need to grow the bottom line faster than the top line. One of the things that's within our control are our own internal cost structures. We're looking for how do we drive productivity, get more efficient, and work the structure so that we get the most productivity out of the organization that we've got. As Blake said, I think it's going to come over a period of time. It's not going to be one fell swoop. We're going to try to do this in a smart, smart way.

Speaker 5

Okay. I thought I heard you say that the full-priced Dockers had gotten some traction, and I was kind of wondering how did that fit in with the reintroduction of some of the lower price points, more traditional styles that you guys carry in that product line?

Speaker 3

That's definitely working. It's contributing. We walked away from a couple of core fits back about a year ago. We reintroduced them this past fall, and it's representing close to 20% of the total Dockers business. It's mostly selling at full price, now full price at lower price points, but it is definitely contributing to some of the traction that we're getting on the men's bottoms business on Dockers.

Speaker 5

Okay. Just from a housekeeping perspective, what should we be thinking about for CapEx this year as you kind of walk back the IT investments?

Speaker 1

Our targets that we set last quarter, and I think we're still consistent in the view, is around $100 million. The bulk of the decline year over year has been from the IT investment and our SAP rollout in Europe, as well as just some of the general infrastructure costs that we've had over the last couple of years.

Speaker 5

All right. Thank you very much, guys. Appreciate it.

Speaker 1

Thanks, Carruth. Next question.

Speaker 4

Your next question comes from Grant Jordan with Wells Fargo.

Speaker 5

Good afternoon. My first question, you touched on this a little bit, but it sounds like the reduction you saw in SG&A in the quarter was not due to the efforts you've been making to reduce SG&A costs at this point?

Speaker 1

I would say that it's the start of that process, but more of it was due to timing associated with A&P spending, as well as some of the costs associated with our deferred comp and our long-term compensation structures. All of those are a result of us focusing on more effective A&P spending, more targeted, as well as a continual effort to keep focus on the overall organizational costs. If you're thinking about your models for the year, I would continue to keep your A&P spending levels fairly consistent with what you've had in the past, yet continue to expect more focus on SG&A each quarter as we roll forward over the next three to six quarters.

Speaker 5

Okay. That's helpful. My next question, you talked a little bit about, I think you said the economic impact in some of your regions was increasing as you moved into this quarter. Can you expand on that a little bit?

Speaker 1

Yeah. I think where we saw the biggest impact, it continues to be Europe, and that's in countries like Spain, Italy, Greece, Turkey. The countries where you would expect to see the biggest economic impact, the highest level of unemployment, the greatest level of consumer pain in the market. Those are the places where we see immediate impact. We have seen less impact in the northern countries, but all of Europe is in an economic doldrum in many ways. I think, as you probably saw with China and India during the quarter, we've seen some slowing of the rapid growth there, and we're seeing that show up as well in some of the consumer spending patterns of our consumer base in our stores and in our partner stores.

Speaker 5

Okay, great. Thank you.

Speaker 1

Next question.

Speaker 4

Your next question comes from Todd Harpfinger with UBS.

Speaker 5

Yeah. Congratulations on a good quarter. I guess to get my hands around SG&A a little bit better, can you kind of break out like A&P a little bit better? You said to run it kind of consistent with what we had in the models in the past, but it used to run like 6.4%, 6.5%, then it ticked up to 7.4%, then back down to 6.6%. I assume you're talking about around like 6.6%, or it was like.

Speaker 1

I'd say in that range. You know, obviously, we're focused on it. It's clearly a huge strength from Chip's background around marketing and advertising, and we're rethinking a lot of our programs and our ways that we operate around the world. We haven't traditionally operated on a fixed percentage of revenue, but I think if you keep it in that 6%, 6.5% range, that's probably good for your model.

Speaker 5

Gotcha. It's just kind of being a little bit more strategic as well as in shifting some away from Southern Europe, I assume?

Speaker 1

Yeah, it's exactly right. The where and how we spend it and how do we get more for, you know, more bang for the buck and how we spend it is where a lot of our attention is going right now, and spending our money much more strategically. All the advertising in the world may not bring back the consumer in southern Europe right now. We're shifting our spending and trying to be smart about how we spend the money. You know, I think Blake said it from a guidance standpoint, you should be figuring somewhere between 6% and 6.5%, and this quarter is really just a timing phasing thing more than anything else.

Speaker 5

That's understandable. I missed the part on the SAP costs. Was that a benefit for the quarter as you complete the ERP implementation in Europe, or was most of the rest due to the timing shift in the pension plan structure and maybe what you expect to benefit from the change in the structure for the year, if possible?

Speaker 1

Yeah. Most of it was from the latter. There were some small benefits from IT expenses, but the bulk of the SAP fell into capitalized software, and you can see that in the real decline in CapEx during the quarter. Down dramatically from first quarter last year when we were right in the middle of the height of the implementation. We went live, as a reminder, in July of last year. The bulk of the spending was in the tail end of 2010 and the first half of 2011.

Speaker 5

That sounds good. Lastly, can you talk about the slight reduction in your store count since it seems like your total count has plateaued recently? In your opening remarks, it sounds like you're still committed to rolling out the dedicated stores.

Speaker 1

Yeah, we're definitely still committed to rolling out stores. At the same time, like any other retailer out there, we're constantly looking for opportunities to upgrade our network, which means closing productive stores or less productive stores and either finding new locations or exiting a specific area. The bulk of the growth during the quarter was in the Asian markets where we've had quite a bit of growth, and we ended up closing some stores in the Americas markets when the leases had come due and the appropriate time to do it. In no way does that indicate any lack of focus. It's a critical part of our business. As you can see, the overall revenues coming from our store base has gone up as a percentage of total revenues during the quarter.

While it will always be a smaller part of our business due to the strength of our wholesale side of our business, we do want to continue to focus on growing that.

Speaker 3

In fact, just picking up on a point, I think the fact that we're negative, you know, net down stores quarter to quarter is because of the focus. We're much more focused on return on investment out of each store. Just like a garden, we're going to be constantly weeding and feeding to get to stronger stores, more profitable stores, and stores that return. We're totally committed to the retail space.

Speaker 5

Sounds good. Appreciate the cover and good luck with the rest of the year.

Speaker 1

Thanks, Todd. Next question.

Speaker 4

Your next question comes from Emily Shanks with Barclays.

Speaker 5

Hi, this is John Connell in for Emily today. I wanted to ask regarding the unsecured term loan, is that something you'd be proactive in looking to refinance, or can you just give us a sense on how you'd approach that decision?

Speaker 1

I'm sorry, can you repeat that?

Speaker 5

I'm sorry. With respect to the unsecured term loan, is that something you would be proactive in looking to refinance, or if you could just give us an idea of how you would approach that decision?

Speaker 1

Yeah, thanks. I think in general, we tend not to comment on refinancings, but obviously, the 2014 term loan is at a very favorable rate. We're not in a rush to be able or to focus on refinancing that anytime soon. We're going to always keep our eyes open and watch what's going on in the capital markets.

Speaker 5

Okay, that's it. Thank you very much.

Speaker 1

All right. Thanks. Next question.

Speaker 4

Once again, to ask an audio question, press Star One.

Speaker 1

Do we have another question?

Speaker 4

Your last question comes from a line of Kevin Coyne with Goldman Sachs.

Speaker 0

Hi, thanks for taking the question. Just in terms of I know the guidance is more or less high 40% for gross margin, but I was wondering if you could give us a sense, is this more or less the trough for the year, or could things potentially trough in the second quarter? As things improve, as cotton goes down in the back half, is getting back to a 50% area margin possible in the fourth quarter?

Speaker 1

Yeah. Clearly, the second quarter will be a challenge because we're still in the midst of our highest priced cotton. As a reminder, you know we put product into the supply chain anywhere between 6 and 12 months in advance because of our large volumes. When we were putting product into that supply chain, we were doing it at the highest price of the cotton as they rolled through the commodity cycle. The other piece of the puzzle that really impacts gross margin is the demand and supply mix. If we can align our demand and supply better, it eliminates the need to liquidate product to keep your inventories clean. I think we have a better sense today as to the impact of the pricing increases where a year ago we really didn't have as good a sense of what might happen.

In this quarter, it helped minimize the amount of sales through the discount channels, and we would hope that we can continue to do that during the year to help keep the gross margins on an upward trend back towards that 50% mark that you referenced and that we've seen in the past.

Speaker 0

Great. Thanks. Just as a follow-up to that, was the use of the discount channel on a year-over-year basis up?

Speaker 1

We don't call out those sales, but as you can assume that the gross margins improved over the fourth quarter, you should assume that much of that might have been driven or was driven by sales through third-party discount channels.

Speaker 0

Okay. I know you mentioned the dividend. In terms of thinking about it, should we think about it in just the same general size of prior dividends, or is there any potential where it gets increased?

Speaker 1

Yeah, good question. We don't have a formal dividend policy, but what I've stated in the past has been we'll try to pay a dividend that aligns with our profitability. If you look back at the profitability over the last few years, the $20 million dividend is fairly consistent, and you should expect something in that range as well if the board obviously approves it. I called out in my script that just a reminder that the first quarter cash flows year over year were slightly different because we paid our dividend last year in December 2010 primarily due to the fact that there was a potential tax law change that ultimately didn't result in a real change, but we chose to pay our dividend anyway. Normally, we pay it in the late April, early May timeframe, and this year that would be your expectation as well.

Speaker 0

Great. Just one housekeeping, I apologize if I missed this, but I know you mentioned some pension changes. Do you have an update or can you give us what the pension cash contributions will be this year?

Speaker 1

Called out in the 10-K last quarter, the $65 million level. I think that's still the right level for you to think about from a cash side. The changes I referred to were really changes we made last year on combining some plans, we're obviously seeing some of the either expense changes or cash changes already flowing through the income statement and the balance sheet. I'd stay consistent with the $65 million number we used in the 10-K.

Speaker 0

Great. Thank you.

Speaker 1

Good. Another question?

Speaker 4

Your next question comes from Lena Rishi Parikh with Stern ID.

Speaker 0

How are you doing? In terms of the challenges that you're expecting in Q2 on margins, would you say that the cotton costs flowing through Q2 are similar to Q1, or were they higher or lower?

Speaker 1

They're similar. In some areas or products, we might have seen slightly higher costs, but in general, I think where a peak cotton really was coming through in the winter and spring seasons for us are Q1 and Q2.

Speaker 0

The price increases that you implemented, should we anticipate at least in Q2 to see some level of improvement since you've probably implemented them a while back?

Speaker 1

Yeah, I'd say that the price increases that you've seen and the coverage of the cost in Q1 will be pretty similar in Q2. In other words, we pushed prices fairly aggressively during 2011 and still haven't been able to fully cover all the cotton price increases, but we're probably to the end of our ability to push pricing much further.

Speaker 0

Can you give us any idea how volumes were in the first quarter?

Speaker 1

I think volumes are similar to what we saw in the fourth quarter. They remain challenged in the lower ends of the business where the consumer is the most challenged, where unemployment's high, or where they're getting hit with increased fuel costs or other inflationary costs. On the higher end, we haven't seen as much impact, and thus volumes haven't been impacted. It's primarily because those consumers aren't seeing the same impact. I think the trend is pretty consistent with where it's been, where we're seeing obviously some revenue increase because of pricing, but in some sectors, obviously because of volume increases as well.

Speaker 0

As a percentage of total revenue, what was licensing revenue?

Speaker 1

It's a very small number. It's under 5%, and it's really closer to 2%. We actually removed the formal call out in our financial statement because it was getting so small that the licensing business is important to us, but as our overall sales have grown, it's become less and less important to call it out.

Speaker 0

You said going into Q1, your inventory was pretty clean. Going into Q2, should we anticipate the same? I assume on a year-over-year basis, given our assumptions on unit costs, or sorry, input pricing, that units are down year over year?

Speaker 1

Yeah, you know, we tend not to try to give too much guidance on unit or quarterly inventory. All I will say is I would expect similar trends to continue during the year.

Speaker 0

Okay. Great. Thank you.

Speaker 1

Any other questions?

Speaker 4

At this time, I'll give the floor back over to the presenters for any closing remarks.

Speaker 3

Okay. The closing remarks are going to be really brief. Thanks very much for calling in today. Thanks for your questions. We look forward to speaking with you again next quarter.