Levi Strauss & Co - Q2 2023

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co. second quarter earnings conference call for the period ending May 28, 2023. All parties will be in a listen-only mode until the question-and-answer session, at which time instructions will follow. This conference call is being recorded and may not be reproduced in whole or in part without written permission from the company. This conference call is being broadcast over the Internet, and a replay of the webcast will be accessible for one quarter on the company's website, levistrauss.com. I would now like to turn the call over to Aida Orphan, Vice President of Investor Relations at Levi Strauss & Co.

Aida Orphan (VP of Investor Relations)

Thank you for joining us on the call today to discuss the results for our second fiscal quarter of 2023. Joining me on today's call are Chip Bergh, President and CEO of Levi Strauss, and Harmit Singh, our Chief Financial and Growth Officer. We have posted complete Q2 financial results in our earnings release on the IR section of our website, investors.levistrauss.com. The link to the webcast of today's conference call can also be found on our site. We'd like to remind everyone that we will be making forward-looking statements on this call, which involve risks and uncertainties. Actual results could differ materially from those contemplated by our forward-looking statements.

Please review our filings with the SEC, in particular, the Risk Factors section of our Form 10-K and the information included in our quarterly report on Form 10-Q that we filed today for the factors that could cause our results to differ. Also note that the forward-looking statements on this call are based on information available to us as of today, and we assume no obligation to update any of these statements. During this call, we will discuss certain non-GAAP financial measures. These non-GAAP measures are not intended to be a substitute for our GAAP results. Reconciliations of our non-GAAP measures to their most comparable GAAP measure are included in today's press release. Finally, this call in its entirety is being webcast on our IR website, and a replay of this call will be available on the website shortly.

Please note for the balance of the remarks, Chip and Harmit will reference year-over-year revenue growth in constant currency. Today's call is scheduled for one hour, please limit yourself to one question at a time to give others the opportunity to have their questions addressed. Now I'd like to turn the call over to Chip.

Chip Bergh (President and CEO)

Thank you. Welcome everyone to today's call. We delivered a solid quarter in line with our expectations. Our results reflect two very different dynamics in our business. On one hand, strong DTC and international, and on the other, continued softness in U.S. wholesale, which I will address in a moment. Revenues for the quarter were down 9%. This was mostly attributable to the $100 million shift in revenue from Q2 into Q1, primarily due to the ERP implementation in the U.S., which we discussed on our last call. Excluding this shift, Q2 was down 2% versus prior year, and first half revenue was flat against a difficult +23% comparison versus year ago. Our strategic growth priorities are performing at or above our plan.

Our DTC business, the most premium expression of the Levi's brand globally, continues to perform very well, up 14% in Q2, with broad-based positive comp growth and AURs up mid-single digits. The continued strength of our DTC first strategy, which grew to a record 44% of total sales in the first half, underscores our confidence in unlocking Levi's tremendous brand value. Our international business also remains strong, growing 8% or 10%, excluding Russia, led by continued momentum in Asia and Latin America. International has been the fastest growing part of our business over the last few years, and it represents one of our largest opportunities going forward. However, this strength in international and DTC has been more than offset by a soft U.S. wholesale business.

Today, U.S. wholesale represents less than 30% of our total revenues, down from 40% a decade ago, as our strategic focus has been to grow DTC and international. While first half U.S. wholesale revenue was down from last year on difficult comparisons, U.S. wholesale revenues are still up 2% versus 2019, with gross margins up as well. There are two main drivers to the slowdown of our U.S. wholesale business. First, the macro effects of higher inflation in a slowing U.S. economy has put increased pressure on the price-sensitive consumer. Second, as we have mentioned for several quarters, our inventory backlog created supply chain challenges in our U.S. distribution centers, resulting in our inability to fulfill all demand. The lower fill rate resulted in higher customer out-of-stocks and less newness on the floor the last few quarters.

We're taking a number of actions to address these issues, regain competitiveness, and restore growth to our U.S. wholesale business. First, we are taking surgical price reductions on a select number of our Red Tab Tier 3 wholesale offerings, which we know are most price elastic and where the price gap versus competition widened too far. Importantly, we are not taking price reductions in U.S. mainline full price stores, nor the vast majority of our U.S. wholesale assortment, including the 501 and women's fashion fits, which are all less price sensitive. We are not taking any price reductions on our international businesses, where we continue to demonstrate strong pricing power as seen by the results.

With the ERP implementation behind us, as our inventory levels continue to improve, we are seeing an improvement in order fill rates, now nearly back to historical levels, which will result in better selling for us and in-stock positions at retail. This will allow us to deliver the strong newness we have lined up to hit floors in July for the key back-to-school and holiday seasons. We are confident that these actions will improve our U.S. wholesale results going forward. Let's turn to the progress we achieved in executing our three strategic priorities. Starting with our first priority, leading with our brands. Due to the ERP shift, I'll speak to the brands results for the full first half. The Levi's brand grew low single digits on top of 22% growth last year. Levi's bottoms grew low single digits, with women's growth slightly stronger than men's.

We continue to drive denim trends with products like our Superlow Boot, giving women more options for looser fits with lower rises. In the U.S., we're seeing strong demand with the 100,000+ income consumer, particularly in our mainline stores, helping drive share gains in the premium end of the jeans category in the U.S. We've also maintained our share leadership with the key 18-30-year-old demographic. For U.S. jeans overall, we gained market share across men's and women's. The Greatest Story Ever Worn marketing campaign, in celebration of the 501's 150th anniversary, generated billions of impressions globally and drove strong 501 demand, with revenues up low double digits in the first half, against more than 40% growth last year. Moving on to our second priority, being DTC first.

As I mentioned, global DTC delivered strong double-digit growth in Q2, led by broad-based positive comp sales and traffic growth across company-operated stores in all geographic segments. U.S. DTC was also strong, led by our mainline stores, which saw continued strength in flagship and tourist destinations. We're also seeing the benefits of our investments in digital and the impact of our new Chief Digital Officer, Jason Gowans. Our e-commerce business grew 21% in Q2, driven by both higher traffic and better conversion. Strength was global and across all brands as we continue to expand the breadth of our offering online while improving the user experience and customer journey. Consistent with driving growth in DTC and e-commerce, we just opened a state-of-the-art digital fulfillment center for the East Coast in Kentucky, and we'll begin shipping from there this month.

This completes bringing our U.S. e-commerce business in-house, which will drive more agility in inventory positioning, reducing lead times, improving customer satisfaction, and accelerating digital margin expansion over time. We are also continuing to expand our loyalty program, with over 26 million members, up 40% over prior year. Loyalty member transactions and average transaction values grew across all segments, a positive signal as we drive continued growth in membership. Overall, our digital and e-commerce businesses remain underpenetrated versus peers, and the channel represents a tremendous sales and profit opportunity for the company. Our third strategic priority is to continue to diversify the business. On a first half basis, our total company women's and tops revenues grew 1% and 3%, respectively, both on top of more than 20% growth last year. Women's was driven largely by the Levi's brand, particularly in Asia.

In addition to ongoing strength in denim fits for her, including lower rises, women's also saw growth from newly launched dresses, cargos, and overalls. Tops were driven by strength in Levi's men's. We remain enthusiastic about our opportunity to significantly grow these businesses as we continue to diversify our offerings. For our other brands, Beyond Yoga's revenues accelerated double digits versus Q1, growing 28% in the quarter, driven by continued DTC strength. First half sales were up 19%. The brand saw notable success with sports bras and dresses, and it opened two additional stores in Southern California, bringing the total store count now to four. Dockers was also impacted by weakness in U.S. wholesale, while the brand experienced continued strength, with DTC up 22% and international up 10% in the second quarter.

Adjusting for the ERP shift, Dockers would have been flat in Q2, with sales up 8% in the first half. Before I turn it over to Harmit, I want to share my conviction in our future and the strength of the Levi's brand around the world. Michelle and I have traveled extensively this last quarter, visiting a number of key international markets, including Mexico, India, China, and Japan. Everywhere we have been, the Levi's brand is incredibly strong, and we are winning. We've met with consumers, customers, and franchise partners, and we're inspired by their view of Levi's and our future. Our strength in DTC and international, combined with the actions we are taking to fix our U.S. wholesale business. Give me confidence that we can accelerate as we go into the key holiday season and end of the year, with momentum heading into next fiscal year.

Finally, also giving me great confidence in our future is how Michelle has come up to speed on the business, organization, and opportunities. Her current remit is big. The Levi's brand globally, all of our commercial organization through which the Levi's P&L rolls up, and the digital organization. She has dug in and has played a key role in figuring out our path forward on U.S. wholesale. She is also all over our tops and women's businesses, and I am confident you're going to see a lot more good work as those products come to market later this year and into 2024. She's also starting to make some smart organization moves to set the company up for the long term.

As I said before, I was confident when we hired her that she would be a great successor, and now, after six months, I'm even more sure of myself that she will take this company to the next level when she becomes CEO. With that, I will turn it over to Harmit.

Harmit Singh (Chief Financial and Growth Officer)

Thanks, Chip. In the second quarter, we delivered on our objectives for revenue, profitability, and inventory, while continuing to advance our strategic initiatives in a challenging environment. We delivered strong results in our global direct-to-consumer channel and are seeing positive momentum in our international business. These businesses today make up the majority of our total revenue and are the primary drivers of our long-term growth and margin objectives. We also made progress in several other key areas of our business. In the quarter, we meaningfully reduced our inventory position, and our U.S. service levels improved as we exited the quarter, giving us confidence to now say we will end the year with inventories below prior year levels, ahead of our initial plan.

Highlighting our commitment to long-term investment, we accomplished a major milestone with our U.S. ERP upgrade, a cloud solution allowing us to leverage data more productively that is also the foundation to growing our DTC and digital businesses. Related revenue impacts are also now behind us. While we are lowering our outlook for the back half of the year, given the dynamics impacting U.S. wholesale, we have several initiatives Chip mentioned to drive stronger results in this business in the second half and the longer term. In the second half, revenues, gross margins, EBIT margins, and EPS are all expected to be up to prior year. To put this into perspective, second half sales are expected the same run rate as the first half.

The back half will also benefit from incremental sales drivers and margin tailwinds from lower product costs and freight, laying a solid foundation for next year. We will end the year with a structurally stronger business, with a higher growth and gross margin accretive DTC and international businesses, representing a greater share of the company. I will now provide more color on our Q2 performance and then move to our outlook. Total company revenue of $1.3 billion decreased 9% versus prior year, down 2% when adjusting for the ERP shift. Our DTC channel posted 14% growth on top of 22% growth in Q2 2022, with continued broad-based positive comp sales growth across geographies, driven by higher traffic and volume. Company-operated e-commerce also accelerated, up 21%, with growth across all segments and brands. Global wholesale was down 22%.

Excluding the shift, the channel declined low double digits on top of nearly 20% growth last year. Growth was strong in Asia and Latin America, but more than offset by softer performance in the U.S. and Europe. Adjusted gross margin was a record 58.7%, up 50 basis points against last year's record Q2 performance. Favorable channel and geographic mix, price increases, lower air freight and FX more than offset the impact of lower full price sales and higher product costs. As a reminder, our H1 2023 gross margins are approximately 300 basis points higher than 2019. We continue to expect several transitory cost headwinds to abate in the second half. I'll provide more color momentarily when discussing our outlook. Adjusted SG&A expenses in the quarter were $753 million, up 6% to last year.

The increase was primarily to support DTC growth, with company-operated store count up 6%, as well as A&P investment to support our 501 marketing campaign that largely ran in Adjusted EBIT margin was 2.4%, in line with our expectation. Adjusted diluted EPS was $0.04. Here are the key highlights by segment. In the Americas, net revenues declined 22% on top of 17% growth a year ago. DTC growth of 6% was driven by all markets. Latin America, in particular, saw continued momentum, with 18% growth driven by the strength in Mexico, Brazil, and the Andes. Europe again grew, excluding Russia, up 1% on top of a 15% increase last year due to broad-based DTC growth across all countries. DTC, excluding Russia, was up 14% on top of more than 60% growth last year.

Europe saw growth across most countries, led by increases in Italy, Germany, the U.K., Poland, and Spain. Asia's very strong performance further accelerated, with revenues up 27%, driven again by growth across all channels, particularly DTC. We are encouraged by the improved trends we are seeing in China, which saw sales return to pre-pandemic levels and growth across all channels, with notable strength in mainline brick and mortar. Thailand, Turkey, Japan, and India were also highlights. Asia's operating margin also expanded 370 basis points to 12.3% due to higher gross margin and stronger SG&A leverage. Looking to our balance sheet and cash flows. We continue to make progress on our plan to sequentially improve inventory levels. Q2 inventory dollars were up 18%, a 15-point improvement from last quarter, and units were up 8%.

Importantly, inventory improvement did not come at the expense of margin, and current inventories are healthy, with core products representing more than two-thirds of total inventory. We continue to expect sequential improvement and to end the year below prior year levels, ahead of our plan. The peak of inventory is behind us, and we're taking a prudent approach going forward, focused on moderating receipts and leaning into our ability to chase a benefit of our globally diversified supply chain. Inventory management will be aided by our recent IT investments, including our ERP, enabling real-time visibility to our inventory on an omni-channel basis and across our network. Adjusted free cash flow was $211 million in the quarter, up from $13 million in the second quarter of prior year.

As we continue to improve our inventories throughout the year, we also expect to end the year with positive free cash flow. Our cash flow generation also allowed us to repay $100 million of our outstanding ABL borrowing this last week. In the quarter, we returned approximately $48 million in capital to shareholders via dividends, which increased 20% from Q2 last year. Dividends are up 20% in H1 versus prior year, and for Q3 2023, we've declared a dividend of $0.12 per share, in line with last quarter. Moving to our updated guidance for fiscal 2023. While we have experienced stronger than anticipated trends in our international and DTC businesses, where we expect continued strong momentum, we are lowering our outlook due to softer U.S. wholesale trends.

We are now guiding revenue growth of 1.5%-2.5% as compared to growth of 1.5%-3% previously. We expect full-year adjusted EPS to be within a range of $1.10-1.20, from a prior range of $1.30-$1.40. There are three fairly equivalent factors driving the change in guidance. First, our slightly lower revenue expectations and the resulting fixed cost deleverage. Second, lower expected H2 gross margin, mainly due to our targeted pricing actions. Third, non-operating FX losses and a higher tax rate. For the year in reported dollars by segment, we now expect a low single-digit decline in the Americas, despite continued strength in U.S., DTC, and in Latin America.

Europe's growth is still expected within the previously guided range of up low single digits, and based on stronger trends for Asia, we now expect low teens growth, an improvement from the low double-digit growth in our previous guide. Adjusted gross margin is now expected to contract approximately 90 basis points from prior year's 57.6% as compared to an expectation for a 50 basis points decline previously. The incremental 40 basis point decline is due to the strategic pricing actions we're taking to drive volume and capture market share in U.S. wholesale. Despite all the puts and takes during 2023, we expect that gross margins will end the year up almost 300 basis points versus 2019. To put into context the new guidance, I'll provide some color around our H2 expectations in total. We expect revenues to grow mid-single digits, as mentioned, versus 2019.

H2 sales will maintain the same run rate as H1. Similarly, we expect U.S. wholesale to maintain the +2% growth rate versus 2019 we delivered in H1. Adjusted gross margin is expected flat to up slightly in H2, driven by lower product costs and freight, partially offset by our targeted pricing actions. Because the pricing actions are evenly distributed between the quarters and the benefit of lower product cost doesn't fully materialize until Q4, we expect Q3 gross margins to contract slightly more than 200 basis points year-over-year, with Q4 gross margins up slightly more than 200 basis points over prior year. Looking at H2 in Adjusted EBIT margin is also anticipated to expand nearly 100 basis points to roughly 11.5%, but with Adjusted EBIT margin significantly higher than Q3.

Lastly, we expect an H2 tax rate in the low double digits versus 1% last year. To conclude, we expect to end the year structurally stronger, setting us up well for 2024 and beyond. Our stronger growth, higher gross margin, premium DTC, and international businesses will account for a greater share of our revenues, nearly 45% and 60%, respectively. Driven by our ongoing execution and surgical pricing action, U.S. wholesale will stabilize and end the year as a smaller share of our business at less than 30%. Inventories are expected to end 2023 below prior year levels. Our 2023 gross margin is expected to remain 300 basis points higher than 2019, and we'll exit the year with Q4 EBIT margins north of 12%.

Importantly, we continue to return cash to our shareholders with a payout ratio of 150% of free cash flow, substantially higher than our targeted 55%-65% communicated at our Investor Day. Lastly, while we are lowering our H2 outlook because of U.S. wholesale, we expect the strong growth in our large, fast-growing DTC and international businesses to continue, which, as U.S. wholesale stabilizes and COGS improves, will position our unique business model to generate significant financial leverage beyond 2023. With that, we'll now go ahead and open the call for Q&A.

Operator (participant)

Thank you. The floor is now open for questions. If you have a question, please press star, then the numbers 1 on your telephone keypad. Due to time constraints, the company requests that you ask only one question. If you have additional questions, please queue up again. At any point your question has been answered, you may remove yourself from the queue by pressing star 1 again. Our first question comes from the line of Matthew Boss of JPMorgan. Your question, please, Matthew.

Matthew Boss (Equity Research Analyst)

Great, thanks. Chip, could you elaborate on current demand trends that you're seeing in the U.S. relative to Europe today? Could you provide an update on the denim category and market share trends? Harmit, what is your level of expense flexibility if macro trends worsened globally in the back half?

Chip Bergh (President and CEO)

Hey, Matthew, thanks for the question. I'll start with the category, then I'll dig in a little bit deeper and talk market share and the contrast between U.S. and Europe. First of all, on the category, you may remember that we only get quarterly data here in the U.S. Outside of the U.S., internationally, we don't get, we don't really get any market share data or market data, all we've got is U.S. data. As you know, since the pandemic, there have been wild swings within the category. Extreme downs, extreme peaks, extreme downs, lots of volatility. If we take a look on a past 12-month basis through May, we are up against the biggest spike in category growth.

The May 22 past 12-month versus May of 21 past 12-month was a 20+% spike in the category. That's the base that we're up against right now. If you look at it on a past 12-month basis, we're down modestly versus that peak. The key point, though, when we take a look at the denim category overall in the U.S., is the category today, on a past 12-month basis, is 12% bigger than it was in 2019. 12% bigger than the pre-pandemic period of time. That's, that's on a dollar value basis. I'll talk about market share here in a minute. In the U.S., as we talked in the script, in the prepared remarks, you know, it really is a story of two different channels. U.S. wholesale being very soft, paradoxically, U.S. DTC, much stronger.

I say paradoxically because you know, we're very strong in our U.S. mainline business, which is the most premium expression of the brand. Digging into U.S. wholesale, there are really two key dynamics, you know, both of which we have some control over, and I'll speak to that. One is, you know, clearly the lower or moderate income consumer is being squeezed. That is driving some of the big category dynamics. You know, much more price sensitivity. You know, when we look at our business, our value brands are down double digits, U.S. wholesale down double digits, and softness in that channel.

Also, you know, as we've talked through over the last several calls, we've had our own internal supply chain challenges with the inventory levels we were carrying, which were causing fill rate issues, which led to, you know, customer service issues and ultimately, customer out-of-stocks. Now that our inventory levels are returning to closer to normal levels, we are seeing our service levels improve, and as we're into this new quarter, we are seeing that those improved service levels are improving the out-of-stock conditions, which is improving sell-through. We're, you know, feeling optimistic about that. For the first half, our U.S. wholesale business is still up 2% versus pre-pandemic. Despite the fact that we're down double digits, it's up against such a big base period. As I said, paradoxically, DTC is relatively much stronger.

Full price mainline and e-com all performing really well. U.S. DTC comp, you know, kind of low to mid single digits in the second quarter and first half, and e-commerce was really strong with double-digit growth in the U.S. in Q2. I guess the last thing I will say about the U.S., I'm gonna talk market share just real briefly, which in part because it's such a key indicator of brand health. We grew market share this past quarter. Our market share was up on men's and women's. We were up two points on men's to 22%. That is more than double the number 2 brand in the marketplace. On women's, if you'll forgive me for a moment, I'm gonna take a little victory lap here.

We took market share leadership for the first time in the 12 years that I've been here, and the first time probably in decades. With 1 share point of growth to 7%, we were the only major brand to grow share in women's. We are also, we maintained share leadership with our key 18 to 30-year-old, which is our target consumer, and we gained 1 share point in the premium tier, kind of which is $60 and up. Again, speaking to the strength of our mainline business, where we are also the market leader. Europe, real quickly, we don't have, you know, nearly as much information on market size. We don't get it. We get that data annually and same with market share, but I suspect the picture is probably pretty similar.

Excluding Russia, as you heard in the prepared remarks, Europe was up 2%. The picture is pretty similar. DTC, very, very strong. Our DTC business was, excluding Russia, was up double digits. Traffic is still up mid single digits in our own channel. Comps are up double digits in Europe. Our second half comparisons, by the way, get much, much easier, both in Europe and in the U.S. That is kind of a tailwind from us from a numbers standpoint. In Europe, you know, we are also seeing, you know, softness in Europe wholesale. The wholesale customers are being cautious with their open-to-buy budgets. Wholesale in Europe was also down for the quarter.

I think, you know, without having as robust of data as we do for the U.S. in Europe, I would say the picture is fairly similar. You know, Europe for us is more of a premium market, so even in wholesale, it tends to be Tier 2 product across most of Europe at higher price points, but the general dynamics are very similar. Harmit, you want to talk about-

Harmit Singh (Chief Financial and Growth Officer)

Yeah. So, let me talk the levers we'll put, we, you know, that we could push further. Let me just talk a little bit of what we are doing. Overall, Matthew and everybody on the call, you're familiar that as things tighten, we can really tighten expenses, you know, COVID was a good example, and readjust our expense base to whatever new revenue base there is. What we've been doing so far this year. It's not only a tale of two halves, it's also a tale of two worlds, and it's a tale of two channels. The channel, you know, international is working, direct to consumer is working, we're reallocating resources to fuel those businesses, and we're tightening, you know, costs related to U.S. wholesale.

The other thing we have done overall is we really focused on discretionary costs, and I'll give you some example. You know, we have tightened travel, we have, you know, tightened, new hires, and the like. So for example, on travel, because we build this business for the long term, we're still ensuring that people travel to meet customers, meet consumers, but most of the other travel is kind of on hold. If things get worse, we will look at, you know, what's still open. Hires. We're not hiring, new heads. We're hiring critical heads. If things tighten, we'll tighten that and take a hard look at fixed costs, you know, from that perspective, like we did, during, COVID.

Realigning a cost base to drive the prospective revenues, I think is an important principle. And we've tightened quite a bit. There are few other options available, but we run this business for the long term. The important point to think about, Matthew, is, and I think I said it in my prepared remarks, there are some critical pieces that are becoming tailwinds. COGS, for example, commodity costs and cotton, which was a headwind in H1, is going to be a tailwind, especially as we start thinking exiting the year and thinking about 2024. Ensuring that our costs are maintained so that we drive profitability and get to that magic EBIT margin number that we laid out at Investor Day is critical for us.

Matthew Boss (Equity Research Analyst)

It's great color. Best of luck.

Harmit Singh (Chief Financial and Growth Officer)

Thank you.

Chip Bergh (President and CEO)

Thanks, Matt.

Operator (participant)

Thank you. Pardon me. Our next question comes from the line of Bob Drbul of Guggenheim. Your question please, Bob.

Bob Drbul (Senior Managing Director)

Yes, thank you. I guess my question, probably for Harmit, when you think about the decline, you know, the outlook that you lowered in the second half of the year, can you just give us a little more color on the cadence expectations? You gave some gross margin, but between Q3 and Q4 and some more of the quarterly trends that you're expecting in the back half? Thanks.

Harmit Singh (Chief Financial and Growth Officer)

Sure, Bob. First, you know, as I mentioned in the prepared remarks, three factors driving the reduction in guidance. That's despite, you know, H2 still growing. Gross margin in H2 largely flat, but substantially up to 2019, and EBIT margin substantially better. The factors really are a slight reduction in revenue outlook, gross margin lower than what we anticipated, largely because of the targeted pricing actions that Chip talked about in his prepared remarks. The last piece is, you know, really tax rates slightly higher. In terms of the color on Q3 and Q4, you know, comparisons, as you know, sequentially ease for both sales and gross margins into Q3 and Q4. Growth improves.

Our view is you know, low single digits up in Q3 and high single digits up in Q4. The benefit of lower product costs, which is largely driven by cotton, doesn't fully materialize until Q4. You know, we still have inventory that, you know, we bought when cotton was high. We're working that through in Q3, and the new inventory is at the lower prices and is substantially different. In fact, I think COGS improvement in new prices is about 200 basis points, and so that's something that will not only we'll see in Q4, but you know, we can see a substantial piece of it in 2024. SG&A expected to be up mid-single digits in H2, weighted towards Q3.

EPS, we expected about double the EPS in Q4 versus Q3, just because of the revenue growth and the gross margin expectation. The only other thing that I would probably note, you know, for all of you, are what I call, you know, recent trends. You know, our results are as of May, but recent trends, we're seeing positive trends in wholesale sell-through, especially as Chip mentioned, we are, you know, filling orders and making sure there's stock. We're seeing, you know, similar trends in DTC, in outlets. I think as we, you know, fill and ensure the stock out situation is addressed, you know, we will see, you know, progress.

You know, once the prices for the targeted fits that we talked about reduce sometime in the next 30 odd days, then I think that's where we feel, you know, that we can address this price-sensitive consumer and continue to accelerate consumer demand as we continue to grow share.

Bob Drbul (Senior Managing Director)

Thank you.

Harmit Singh (Chief Financial and Growth Officer)

Welcome, Bob.

Operator (participant)

Thank you. Our next question comes from the line of Jay Sole of UBS. Your line is open, Jay.

Jay Sole (Managing Director)

Great. Thank you so much. My question, I don't think we can talk a little bit more about this divergence in performance between the U.S. DTC channel versus the wholesale DTC channel. You know, maybe Chip, can you tell us how much is sort of just the performance of the channel? It sounds like that the lower-income consumer, that middle-income consumer is sort of a reason for the divergence, but, you know, how much is it just those channels themselves are not performing that well? How much is this a supply chain issue, and how much sort of is the brand where maybe is the brand not resonating as much in those channels? If you can sort of unpack that a little bit, that would be helpful. Thank you.

Chip Bergh (President and CEO)

Sure. It's a really good question because it is kind of the big paradox as we take a look at the results. Our U.S. DTC business, including e-commerce, and especially including mainline, are performing really, really well. That's I would say that's why that's a strategic focus of ours globally, is we're in control of the brand. We're in control of the consumer experience. We're in control of, you know, what we focus on in our stores. We're in control of the assortment in the stores. And, you know, the consumer comes into the store wanting to buy Levi's. You know, we're seeing really good success there, as you heard from the results. I think the wholesale dynamic, some of it is clearly the consumer, okay? As we said, you know, our value brands are down double digits.

U.S. wholesale is down double digits. Some of it is definitely a channel dynamic. I think that moderate to lower income consumer is definitely under pressure, and I suspect, you know, we're all reading the same newspapers. You know, feeling the trade-offs of, you know, needing to pay for a summer vacation versus, you know, a new pair of jeans. I think that's some of it, that, you know, we're competing now for other dollars that are being spent out of the consumer's wallet, and that moderate income consumer is having to make some tough choices now. I suspect that that is part of it. There's also the dynamic, as I said earlier, that's within our control.

You know, this customer fill rate issue that we've had because of our loaded inventory, as I'll say it, that bluntly in prior quarters, that as, you know, our inventory levels start to trend towards something that's more normal, our. You know, the congestion that we were experiencing in our distribution centers has abated, and our fill rates are improving literally week-over-week. As we, you know, now into the third quarter, as we are seeing our fill rates improve, we're closing out-of-stocks, and that is improving sell-through. We're optimistic about that. The last point is this point about making some strategic, very selective price reductions, and they are only partial rollbacks. You know, over the last two years, we have taken price increases globally, including here in the U.S. and including here in U.S. wholesale.

We have widened the price gap versus the other brands in U.S. wholesale. On some of the most price-sensitive items in our line, that price gap is too wide, and we're gonna fix that. To put it into perspective, we're talking about six items in wholesale out of the more than 60 items that we sell to U.S. wholesale, out of the more than 120 items that we sell in the U.S. It's, depending on what base you wanna use, it's less than 10% or less than 5% of the total number of items in our assortment, and it's gonna be less than 15% of the total volume.

We know from our analysis, and we've been engaging with our customers on this as well, we know from our analysis that by closing this price gap, it should stabilize this business a little bit further. The combination of the supply chain confidence in our deliveries and addressing this price gap to be a little bit sharper versus competition in these multi-brand wholesale customers, the combination of those two things should stabilize and potentially even get our wholesale business back on track to growth in the second half of the year. Give us momentum as we're going into the critical holiday period and into next fiscal year.

Jay Sole (Managing Director)

Got it. That's very helpful. Thank you so much.

Operator (participant)

Thank you. Our next question comes from the line of Ike Boruchow of Wells Fargo. Your question, please, Ike.

Ike Boruchow (Managing Director)

Hey, thanks for taking the question. Harmit, two follow-ups on the margin guide in 2H. Just I understand the big gross margin downtick in Q3 because of these pricing actions. Maybe I'm not understanding completely, but why does that then flip in Q4 and become much more favorable, whether it's year-over-year versus 2019? Why are the gross margins improving once we get out of Q3 due to these pricing initiatives? Just, can you clarify the SG&A up mid-single digits year-over-year in the back half? Is that what you said? That seems a little heavy to kinda get to the guidance that you're giving. I just wanted to make sure I'm understanding that. Thanks.

Harmit Singh (Chief Financial and Growth Officer)

Yeah. On the gross margin, why should it flip in Q4? Q4, we will see the full impact of the lower COGS. That's the big switch. You know, in Q3, we still have inventory that, you know, we're gonna carry over into Q3. What we really did to manage inventory, because our inventory is largely core, Ike, you know, we didn't have to dramatically mark it down. We just cut future receipts to match demand. That's why in Q3, you know, we still have some of the old inventory that we're selling in, and then the new inventory and new prices in Q4, that is behind us, and that's why you see the big delta in pricing.

You know, from that perspective, the pricing is largely similar. We start, you know, we take pricing, about a month from now, about 30 days. You'll see a little bit of impact in Q3 and a little more in Q4. It's largely the COGS piece that is making the difference. you know, our second-half gross margins, I think, are gonna be north of 56%. We'll end the year north of 56%. Relative to 2019 is still 300 basis points in H2 better.

I think we were asked this question in 2021 by some of you, because we were seeing margins improve 400 basis points relative to 2019. Our estimate at that point of time was probably two-thirds takes longer term. A third, it probably goes away with time because, you know, we were not promoting, inventories are very clean, et cetera. That's bearing out in its fashion. At that time, it's difficult to predict commodity prices. That was a huge headwind in the first half, is becoming a tailwind in the second half. Current futures, at least right at this point of time, look at similar levels for 2024. That stays then. That's a bit of a tailwind in 2024.

Ike Boruchow (Managing Director)

The SG&A in the back half?

Harmit Singh (Chief Financial and Growth Officer)

Yeah, the SG&A for the quarter three, you know, we think mid-single digit, quarter four, low single digit, H2, low to mid-single digit. On a full-year, mid-single digit. That's how we're thinking about it at this stage. We still are opening stores. I come in, that's really driving a big chunk of it. I think we opened on a net basis, 20-odd stores in the first half. In the second half, it's 50, 60 stores. That's really driving most of the, you know, SG&A, which is really setting up D2C, you know, for the long term. As I mentioned earlier, discretionary costs, you know, et cetera, et cetera, are fairly tight at this stage.

Ike Boruchow (Managing Director)

Great. Thank you.

Harmit Singh (Chief Financial and Growth Officer)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Jim Duffy of Stifel. Your question, please, Jim.

Jim Duffy (Managing director)

Thank you for taking my questions. More for me on the U.S. consumer and environment, a little more focus on perspective from your stores and D2C. How would you characterize the current promotional backdrop, Harmit, what's assumed in the outlook for the second half with respect to promotions? I'm also curious if you could speak to consumer activity in your U.S. stores and D2C. Are you seeing slowing trends in price resistance from this consumer as well? Are they buying full price, or is volume driven by promotion? Thank you.

Harmit Singh (Chief Financial and Growth Officer)

Yeah. What's zoomed in promotions, if you, if you, if you recall, Jim, last year, quarter four was fairly promotional. You know, quarter three, we began to see some promotion, but quarter four was fairly promotional. Our view is quarter three is probably promotional, you know, probably slightly less promotional than quarter two because inventories are getting better, trade inventories are getting better, our inventory is getting better. Quarter four is kind of, you know, slightly better than a year ago. You know, we end H2 probably slightly better than last year, H2. That's what we're thinking on promotion at this time. Plus, by taking some pricing actions, you know, in the absence of pricing actions, there were probably deeper promotion on the same fits because people wanted to sell.

By taking pricing actions, that will help offset the deeper promotions to an extent. That's kind of, you know, kind of factored in. To your question about our own D2C business and, you know, our D2C business in the U.S. is outlets as well as our mainline stores. Our mainline, you know, we're seeing, you know, the consumer and, you know, largely consumers earning 100,000 plus, less price sensitive. I mean, we do promote on days where it's important, like Father's Day, you know, for example, et cetera, et cetera. You know, Black Friday will happen, you know, but it's very targeted. The same cadence we have for our outlets, too.

Some of the, you know, pricing, some of the, Tier 3 products that Chip talked about are also sold in our outlets, so that should, you know, adjust, you know, for the outlets. Overall, you know, we are seeing less promotions in our own stores than probably, in wholesale.

Chip Bergh (President and CEO)

I guess I would just add one other thing, Jim, is, you know, the other thing that is clearly working in our DTC channel is newness. You know, we're right now at end of season, so if you go look online or shop around, you're gonna see a lot of sales, us and everybody else, because everybody is trying to get ready for the next season. That product will begin hitting the floors later this month, setting us up for back to school. We're really excited because, you know, we're excited about the next season and the product that we've got coming in and some of the collaborations. Newness definitely works, and we have no problem selling through product at full price when new products hit the store, when it's resonating.

Jim Duffy (Managing director)

Thank you.

Chip Bergh (President and CEO)

Yep.

Harmit Singh (Chief Financial and Growth Officer)

Thanks, Jim.

Operator (participant)

Thank you. Our next question comes from the line of Dana Telsey with Telsey Advisory Group. Your question, please.

Dana Telsey (Founder and CEO)

Hi, good afternoon. As you think about the mass channel, which I think was down 13% in the prior quarter, how did the mass wholesale channel differ from the other wholesale businesses? With marketing, given the birthday of the 501, how is marketing being planned in the back half compared to last year? CapEx, is that still expected to be the same number, around $280 million, or what are you looking for there? Thank you.

Harmit Singh (Chief Financial and Growth Officer)

I'll answer the CapEx question, and I'll give the value channel to Chip. On the CapEx question, I think we'd indicated $290 odd million. Our expectation for CapEx is between $290 and $300, something like that. In and around what we talked about. Is largely oriented towards, you know, the new doors, Dana, that I talked about, and investments to on technology, really to accelerate our e-commerce business. Those are the two broad areas. Then we've had some infrastructure CapEx. We opened a digital DC. We just upgraded our ERP, and we're building the DC, which will be an omni-channel DC in Europe. That's where we're looking at some infrastructure investments really to, you know, propel and service the growth in our growth algorithm.

Chip Bergh (President and CEO)

Yeah. I may be forgetting the second of the three-part question, but, the mass channel is soft. I think softer in general and the balance of wholesale, of course, the balance of wholesale also includes Amazon, which is pretty strong right now. But, you know, our value brands and I would say in general, the mass consumer overall is under, you know, pretty tough, you know, economically challenged, I guess. You saw that in their last results, their last quarter. But DENIZEN and Signature, which sell in that channel respectively, is down double digits. We do have Levi's at Target, and I would say Levi's at Target is performing roughly in line with how Levi's is performing elsewhere in the wholesale channel.

That's, I think, collectively, our focus with Target, is how do we continue to expand on the success that we've had over the last several years with Levi's at Target? I think over time, we're gonna be trading out floor space for DENIZEN for more floor space for Levi's. Did you have one other question?

Harmit Singh (Chief Financial and Growth Officer)

Dana, your question was, I think, on marketing.

Chip Bergh (President and CEO)

Oh, marketing.

Dana Telsey (Founder and CEO)

Exactly.

Harmit Singh (Chief Financial and Growth Officer)

Yeah. In the first half, we spent more than a year ago because of the 501 campaign that, you know, fell in H1. In the second half, will be a little less. We are adjusting our marketing expenses depending on, you know, which part of the world is working or not. Overall, our marketing expenses as a % of revenue is slightly lower than a year ago.

Chip Bergh (President and CEO)

Just, I mean, to be blunt, in the U.S., where U.S. wholesale is down, you know, below our plan, we've had to cut advertising expenses in the second half. We did have the 501 campaign globally. Our spending was front-loaded this year. We have had to scale back a little bit in the second half just to kind of balance the books and keep our spending as a % of revenue, roughly in line with what we guided originally. In total dollars, the spending is coming down in the second half, reflecting the softer outlook that we have on the top line.

Dana Telsey (Founder and CEO)

Thank you.

Chip Bergh (President and CEO)

You're welcome.

Operator (participant)

Thank you. Our next question comes from the line of Laurent Vasilescu of BNP Paribas.

Laurent Vasilescu (Managing Director and Senior Equity Analyst)

Good afternoon. Thank you very much for taking my question. Harmit, Chip, can you hear me?

Chip Bergh (President and CEO)

Yep, we can.

Harmit Singh (Chief Financial and Growth Officer)

We can.

Chip Bergh (President and CEO)

Hello, Laurent.

Laurent Vasilescu (Managing Director and Senior Equity Analyst)

Fantastic. Thank you very much for taking my question. Just two questions, two follow-ups. One's on Ike's question. Harmit, last quarter, you gave us a very helpful bridge around the gross margin, noting product cost was a 200 basis points headwind, promotionality was about 300 basis points. Maybe you can for the audience, can you maybe parse that out for the second quarter, and how much are you expecting in terms of promotions for the second half of the year? Then a separate question, great to hear in China that it's back to pre-COVID level. Maybe, Harmit, could you give a little bit of color on just what you're seeing in China? Are you seeing sequential improvement every month in that marketplace?

Harmit Singh (Chief Financial and Growth Officer)

Yeah. I'll quickly help answer both. H2, you know, in my prepared remarks, I mentioned gross margin versus last year, flat to slightly up, relative to a year ago. I'd say pricing, 70-80 basis points, adversely impacting. If you a year ago, COGS, second half, you know, really offsetting that's why you're largely flat. I mean, that's broadly. There's a little bit of air freight, which is a tailwind, but broadly, that's what's really driving between the two factors, pricing and the COGS benefit. The COGS benefit is, you know, less in Q3, more in Q4. We exit the year with a higher COGS benefit that obviously rolls into 2024.

To your question on China, Michelle, Chip, and I, along with our teams, were recently in China. Quarter two was a great quarter for them. The business was up big time. Business is, you know, is higher than 19. As we think over the rest of the year, our Asia guidance, which is higher than last quarter, Asia, I think we think in the high teens from, you know, double-digit growth, reflects a slight bounce back in China as along with the rest of Asia. We are gonna watch and see what happens and how the business stabilizes in China before we think about China's expectations for 2024. You know, the team that was there pre-COVID is still there.

They're long in China, and the Chinese market is a little different than some markets in Asia. The premium-oriented markets, we're really focused on premiumizing our product offers there, and that seems to be working.

Laurent Vasilescu (Managing Director and Senior Equity Analyst)

Very helpful. Thank you very much.

Harmit Singh (Chief Financial and Growth Officer)

Thank you.

Operator (participant)

Thank you.

Chip Bergh (President and CEO)

Hey, I think, I think we're gonna wrap it there, Latife. You are okay. We're at time, and I just wanna thank everybody for dialing in and for your very thoughtful, and penetrating questions. We look forward to speaking with you again next quarter.

Operator (participant)

Thank you. This concludes today's conference call. Please disconnect your lines at this time.