Levi Strauss & Co (LEVI) Q3 2020 Earnings Call Transcript
Updated: Oct 21, 2020
Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co.'s Third Quarter Earnings Conference Call for the period ending August 23, 2020. [Operator Instructions] 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 two hours after the completion of this call today through October 13, 2020. Please use conference ID number 7768738. This conference call also 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 hand the conference over to Aida Orphan, Senior Director Shareholder Relations and Risk Management at Levi Strauss & Co.
Aida Orphan -- Senior Director, Investor Relations and Risk Management
Thank you for joining us on the call today to discuss the results for our third fiscal quarter of 2020. Joining me on today's call are Chip Bergh, President and CEO of Levi Strauss; and Harmit Singh, our Executive Vice President and CFO. We have posted complete Q3 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 would like to remind everyone that we will be making forward-looking statements on this call, which involve risks and uncertainties, including risks and uncertainties as a result of the COVID-19 pandemic. There are significant uncertainties about the duration and extent of the impact of this pandemic. The dynamic nature of these circumstances mean that what is said on this call could change materially at any time and that actual results could defer materially from those contemplated by our forward-looking statements. Reported results should not be considered as an indication of future performance. Please review our filings with the SEC, in particular the Risk Factors section of the quarterly report on Form 10-Q that we filed today for a discussion of 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's date. We disclaim any obligation to update any forward-looking statements except as required by law. During this call we will discuss certain non-GAAP financial measures. Reconciliations to the most directly comparable GAAP financial measures are provided in the earnings release on our IR website. These non-GAAP measures are not intended to be a substitute for our GAAP results. 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.
And now, I'd like to turn over the call to Chip.
Chip Bergh -- President & Chief Executive Officer
Thanks everyone for joining us today. Our third quarter results were substantially better than we expected, demonstrating the strength of our brand, the power of our diversified business model and the resilience of our teams around the world. Our brand is the strongest it's ever been and as the lockdowns lift, we're seeing consumers coming into stores on a mission. Levi's remains the clear number 1 brand in the denim category and has grown market share during this period driven by our success in women's. Levi Strauss is an iconic lifestyle brand also positions us to benefit from the casualization trends that have been accelerated by the pandemic. Through it all, our values have guided our actions, reinforcing that how a company gets through a crisis is just as important as getting through it.
Although the pandemic is changing the apparel industry, our results reinforce my confidence and optimism about our future. We are transforming our business by focusing on the areas that will drive our success, including first, elevating our brand from product innovation, deepening our connection with our consumers, and leaning into our values. Second, accelerating the digitization of our business, including leveraging our use of data and analytics and accelerating the rollout of omni-channel capabilities. And third, diversification across geographies, product categories and distribution channels with an increased focus on direct-to-consumer. Beginning with elevating our brand, during this pandemic we've held our share of leadership in men's and we've grown share in women's in Europe and China.
In the U.S., we grew our total apparel share in digital and also gained share in key accounts as we outperformed competition. We continue to launch collaborations that drive energy and buzz for the brand. Just last week for Fashion Week the surprise Levi's by Valentino collaboration unveiled on the runway in Milan featuring an updated version of our 517 boot cut jeans that we originally released in 1969. And as people seek out more casual comfort, we're defining and leading trends with the launch of new looser, more relaxed silhouettes across bottoms and tops, including our women's non-graphic tees which grew in Europe driven by our soft and comfortable perfect tees and baby tees. At Levi's we've always believed that making a difference in the world is also good for business. We have a strong track record and take our responsibility to the environment very seriously.
Our fall campaign is focused on sustainability and features our newly launched collection featuring cottonized-hemp, a leading fabric innovation that saves a substantial amount of water and uses fewer pesticides in cotton. And just yesterday in the U.S. we launched Levi's Secondhand, a first of its kind buyback and re-commerce program, which creates a marketplace that will allow consumers to purchase previously launched Levi's directly from us, as well as turn in worn jeans and jackets in-store for credit for its future purchase. We developed secondhand with Gen Z in mind as they search for uniqueness and character in their clothing to assert their individuality. More than half of Gen Z shops in the secondary market and they're looking for the real thing.
As one of the most sought after brands in the secondhand space we're excited to engage with all our consumers post purchase and capture demand for previously owned Levi's. We also recently partnered with Ganni for a first ever rental-only capsule centered on circular design, which is available in both the United States and the UK and which was inspired by Levi's vintage archives. And we just launched our new sustainable Puffer Jacket made from recycled plastic bottles and waste. Not only do these jackets look and feel great, you can now warm up while keeping landfill and energy usage down. Beyond our efforts in e-commerce and sustainable fashion, we continue to drive real progress on issues such as climate and water, which is both good for business and what our consumers will be looking for going forward.
We've also been outspoken about the need to address structural racism and its intersection with other issues such as gun violence prevention and voter access. We've teamed up with Rock the Vote to make sure consumers are vote-ready and have turned over our Instagram platform to activists and nonprofit leaders to share how they're helping to get the boat out this fall. We've partnered with Hailey Bieber and filmmaker Oge Egbuonu to create a powerful PSA and portrait series with key activists and celebrities spotlighting the importance of voter education and participation. This video has generated 2.8 billion impressions with $43 million in media value. These efforts build on our leadership of the Time To Vote movement, which now includes more than 1,300 companies who have pledged that their collective 10 million plus employees will have time to cast their vote in this year's election. And we're laser focused on our own commitments to become a more diverse company as well, carrying out the commitments first announced when we released our diversity data in June.
Our or second area of focus is accelerating our digital transformation. We are seeing tremendous moment in digital selling. Our full digital sales footprint grew more than 50% in the quarter and comprised nearly a quarter of total company revenues. We've upgraded our e-commerce sites in Canada, Europe and the U.S. They are faster and feature improved navigation and search functionalities allowing consumers to quickly find products and the streamlined cart and checkout capabilities are driving increased conversion. We are also revolutionizing the way consumers can connect with the brand and shop with Levis on other digital platforms. For example, we reenvisioned the back-to-school season with a more digital approach with Gen Z in mind.
We teamed up with Kohl's to create a unique virtual closet experience on Snapchat, enabling consumers to browse an additive assortment of Denim, Truckers and Tees and then virtually mix-and-match options to create new looks. Importantly, our accelerated rollout of omni-channel capabilities position us for a successful upcoming holiday season. Buy Online, Pick-up In Store, which has been very successful will be in the majority of our U.S. fleet before the holiday shopping season begins. In Q3, shipments store fulfilled 20% of all e-commerce volume and drove optimization of margin in stores. We're expanding our U.S. loyalty program into all U.S. stores and Levi.com. We now have more than 1 million loyalty members with increased acquisition rates across all channels and repeat purchase rates have risen to 40%. Transaction size and frequency of purchase are higher for royalty members and we're using AI to personalize offers to each consumer, further cultivating loyal fans.
And on our mobile app download and acquisition rates continue to increase driven by more frequent exclusive collaborations and early product access opportunities. 70% of those downloading the app are new users. They are sticky and conversion with them is nearly double. We're making good progress leveraging use of data analytics and machine learning in more aspects of our business. The ways we deploy AI go well beyond loyalty and mobile. At our stores, AI is enabling local stores in China and the U.S. to better curate their assortments by predicting demand based on the specific profile and preferences of consumers in the vicinity of each store, which will thereby optimize the profitability of these smaller mainline doors.
And we've expanded our successful AI enabled e-commerce promotions in Europe, significantly increasing profits, revenues and units in these promotions, and adding to the share gains in women's products. By the end of this year, all e-commerce and store promotions will be AI powered across 17 countries in Europe. Internally, we're also digitizing our ways of working. We are preparing to execute our second digital global line launch for the Levi's brand this month using digital tools to assort the line and drive increased efficiency. And in June, we opened our omni-channel digital showroom in Europe, initially planned as a small-scale test for a handful of accounts. We accelerated this capability due to COVID and conducted full digital sellings for spring and summer 2021 with our top 200 wholesale and franchise partners in Europe.
Due to the great success we had, we are rapidly evolving this functionality and will begin scaling it globally over the coming months. We believe we are positioned to stay ahead of competition in this comprehensive digitization of our go-to-market capabilities. Third, we continue to diversify our business across geographies, distribution channels and product categories. Revenue from International is nearly 60% of total. Direct-to-consumer revenues were around 40%. Women's is more than a third of revenue and tops is nearly a quarter. Going forward we expect these areas of our business to continue to drive outsized growth and to represent even higher percentages of total revenues in future. On the International front, more countries are emerging from lockdown. Europe which has been our fastest growing market over the past few years is recovering strongest. While traffic remains down particularly in tourist locations, many countries in Europe are ramping up quickly with consumers patiently lining up outside our stores.
And in China which represents a huge opportunity for us we're strengthening the business by accelerating our move away from underperforming franchisees. In our company operated stores which now comprise more than half of our revenues in China we're seeing double-digit growth outside Beijing, which was impacted by a second wave of the virus during the quarter. Just last month we opened the brand's pinnacle NextGen store in China in the heart of Shanghai's popular shopping district on Nanjing Road. Though early days, we're seeing stronger than anticipated traffic and higher than expected conversion of youth and up market consumers, elevating the brand in the market. The global women's business continues to show strength as women's share of total revenues grew to 37% of the total. The business showed pockets of growth.
In our top 10 wholesale accounts, the women's business grew 13%. Women's shorts in both traditional 501 Denim and fashion styles grew double-digits. Women's bottoms delivered half of the quarter's total Levi.com growth with strong performance in 501 shorts, cropped, ribcage and 721 high rise fits. New woven tops performed well as we increased our assortment of blouses expanding the reach and broadening the appeal of the Levi's brand to her. From a channel diversification perspective, we're increasing our focus on direct-to-consumer. We're thinking and acting DTC first as we accelerate our investments in our own direct-to-consumer and e-commerce businesses. E-commerce grew at the fastest rate ever this last quarter. Meanwhile, our store expansion strategies remain intact. Physical stores are and will be an extremely important part of our business.
We make our best impression with consumers through our Levi's stores and we've been transforming them from traditional stores into an immersive omni-channel brand experience. And while sales remain down versus prior year, we're mitigating ongoing traffic declines by driving meaningfully higher conversion. We're elevating the brand stature as we roll out multiple store formats globally, including our NextGen stores, which offer leading customization techniques and enhanced digital features to drive storytelling and sales. In the U.S., we recently opened NextGen stores in Century City, Scottsdale Fashion Square and Stanford Mall. We have two additional NextGen stores opening this fall. There remain substantial whitespace for profitable mainline stores.
In the coming years, we plan to open around 100 smaller footprint mainline doors in the U.S. from the 30 plus we have today, some of which will be NextGen. About a fourth of our current full price network in the U.S. are smaller footprint, and they're working delivering ROIC well above hurdle rates. While growth in our direct-to-consumer business will outpace that of our wholesale channel, we continue to see opportunities to reach new consumers with new and expanded wholesale distribution, which will support elevating the brand and diversify growth in wholesale, particularly in the U.S. Our new distribution, we are excited to announce that we've just launched the Levi's brand into Dick's Sporting Goods starting online and at 11 of their top flagship stores, supported by a media strategy in coordination with Dick's.
The product assortment is focused and elevated, showcasing the strength of the brand, with higher AURs and an appeal to younger consumers. Given this will be a premium priced offering, we expect this business to be incremental to our existing wholesale business. This is a big opportunity, and we expect to learn from it and identify ways to expand the partnership next year. On the expansion front, the success of our partnership with Target is one of the important opportunities before us. We're very pleased with the positioning of our brand at Target, a focused assortment of men's and women's resulting in higher than average AUR's and today we're announcing an expansion of our partnership from 140 doors to 500 doors by fall of 2021.
Particularly encouraging is that in the doors open to date, we're seeing new consumers discovering our brand without cannibalizing our business with other wholesale accounts. Denizen will remain in Target stores to address the more cost conscious consumer. We are selectively pursuing additional wholesale distribution expansion and we'll share more in the coming quarters. We believe these strategies will support future growth as well as our goal to elevate the brand in the market. And we continue to gain space within the top doors of existing customers, leveraging our expanded lifestyle portfolio and the strength of our brand to drive traffic. By focusing on their most productive doors, we seek to mitigate the impact of the inevitable closures of underperforming doors in the future.
With that, I'll now turn it over to Harmit to walk you through the results of the quarter. Harmit?
Harmit Singh -- Executive Vice President & Chief Financial Officer
Thanks Chip. Good afternoon, everyone. I hope all of you, your families and loved ones are safe and healthy. Despite revenues being below prior year, due to the pandemic, we saw substantial sequential revenue improvement from the second quarter, and we far outperformed even our own expectation. Our financial results were solid, as we delivered higher than prior year gross margins, made money in the quarter and generated even stronger cash flows than prior year, a trifecta driven by the financial discipline we're executing as a team. Consumers remain hungry for our brand and our structural economics are sound and improving, as our cost and working capital actions have put us on a clear path to emerge from this crisis, a significantly more profitable and cash generated company with ROIC in the mid teens.
As I walk you through additional detail on our third quarter results, my comments will reference constant currency comparison on a year-over-year basis in U.S. dollars, unless I indicate otherwise. We published the details of our reported and constant currency results in today's press release, so I will not repeat all of those here. Third quarter net revenues were down 26% due to the impact of the pandemic. We mitigated brick and mortar declines in wholesale and direct-to-consumer channels from lower traffic with strong digital business growth. Our total digital ecosystem comprised of the e-commerce sites we operate, and the online sites of our wholesale accounts grew more than 50% in dollars in Q3 and comprise 24% of total company third quarter revenues, double the share of what it was a year ago.
Specifically, our own e-commerce business grew 53% and comprised 8% of total company revenues for the third quarter, also double what it was a year prior. And the per unit metrics in our e-commerce business are very strong. Average revenue per unit is double that of wholesale. Gross margins are more than 20 points above wholesale, and the profit per unit is higher than wholesale. Our e-commerce business on a fully allocated basis was again profitable in the third quarter and year-to-date. And we expect full year profitability in 2020 a year ahead of schedule. Adjusted gross margin expanded 60 basis points. Given the environment, we were exceptionally pleased with this as it underscores the intrinsic health of our brands and channels. The price increases we have taken are sticking and we have had a higher share of sales from our direct-to-consumer channel, particularly e-commerce.
Wholesale gross margin held strong and in line with prior year as we're running the business with a low volume of promotions, and managing through inventory by leveraging our outlet network, and more than 20 new pop ups without resorting to extreme discounting or increased sales to the off price channel. Levi's AURs around the world rose slightly, demonstrating the strength of the brand. Even at higher prices our products continue to represent exceptional value, providing more opportunity to increase gross margin in the future. Adjusted SG&A was down $105 million from prior year, an 18% decline. Adjusted SG&A was again down across all regions, functions and categories of spend, primarily reflecting the cost reduction initiatives we instituted last quarter.
Turning to profit, we were able to offset the lower revenues with our stronger gross margin and cost saving actions and delivered adjusted EBIT of $84 million and adjusted EBIT margin of 8%. The strong adjusted EBIT yield is adjusted net income of $31 million and adjusted diluted earnings per share of $0.08 for the quarter, bringing both metrics back into positive territory year-to-date, a full quarter earlier than we had anticipated. Adjusted EBIT and adjusted net income were therefore only negative for one quarter because of the pandemic. Now, I'll share a few highlights from our three regions. Third quarter revenues in the Americas declined 27% in line with the total company, with the U.S. better than this, given Latin America was largely closed for the quarter. The business further diversified toward women's, which was 37% of the region's total revenue in the quarter, up from 31% last year.
The signature brand delivered double-digit growth in the quarter, reflecting the strength of our value offering. Total U.S. wholesale was only down 20% with higher gross margin than prior year. Our U.S. e-commerce business grew 61% and although traffic remained challenged in brick and mortar stores, conversion and AURs outperformed prior year in both our full service location and outlets. Europe was our strongest performing region with a revenue decline of 17%. Wholesale and retail store declines were broadly similar, but the highlight of the region was e-commerce growth of 35%. Recovery has been slower in tourist locations with non-tourist site cities on a stronger recovery trajectory. Our pop-ups in the region helped us work through inventory. And while traffic remains down, conversion and higher units per transaction reflected the consumers' high intent to buy when they came out.
Our brand equity is the strongest it has ever been and Levi's remains by far the most popular Denim brand in Europe. Asia as a region declined 41%, largely driven by the fact that India, one of our largest markets in the region was effectively closed in the entire quarter. In India, we proactively took back inventory from closed franchisees and reallocated it to pure play e-commerce, which yielded nearly 50% digital growth over prior year. We are also taking the opportunity to close underperforming stores and to upgrade and expand others into better locations, thereby retaining our net floor space in the market. Excluding India, the remainder of Asia was down 24% roughly in line with the total company though performance varied notably by market. E-commerce was a bright spot in Asia as it grew 27% for the quarter. We continue to believe Asia represents a huge opportunity for us as high brand awareness suggests there is significant room to increase our sales.
Turning to balance sheet and cash flows, inventories at the end of the third quarter net of reserves were 1% higher than a year prior on a reported basis, achieving near parity with prior year a quarter sooner than expected. Our recent organic acquisitions in Singapore and South America represent three points of inventory. Excluding this, year-over-year inventory was down. America's inventory was 5% below prior year offset by Asia, which is higher. Inventory at quarter end was healthy, with more than 65% able to carry over into future season. We anticipate ending the year with total inventory down to prior year, even including the impact of the organic acquisitions. And after burning cash last quarter, our cost and working capital actions yielded strong adjusted free cash flow, a $195 million increase as compared to third quarter last year, driven by higher cash from operations and lower capex.
We ended the quarter with $1.4 billion in cash and another $600 million available under our credit facility bringing total liquidity to an ample $2 billion. Looking forward, our views on the balance of the year and beyond assume no significant worsening of the virus or dramatic reclosure of the global economy. First, given the improving strength of the business and having exceeded our own third quarter performance expectations, we see that outperformance extending into the fourth quarter. So we are banking our third quarter beat into our internal full year expectations and raising our expectations for quarter four. We started the quarter well, with much improved trends in September on revenues, gross margin, EBIT and inventory. Accordingly, we anticipate first quarter revenues will be down to prior year in the range of 14% to 15%.
We expect Q4 adjusted gross margin will be flat to slightly up compared to prior year's 54.3%, yielding full year adjusted gross margin above prior year's 53.8%. And we anticipate delivering Q4 adjusted diluted EPS in the range of $0.14 to $0.16. This includes lower Q4 adjusted SG&A of as much as $80 million to $100 million compared to prior year, despite an acceleration of advertising to around 8% of fourth quarter revenue and the incremental expenses from our fiscal 53rd week falling in the quarter. Please note that our fourth quarter estimates assume no significant foreign currency fluctuation during the fourth quarter. Our revised capex estimate for 2020 remains $160 million. Two thirds of the investment is going toward technology and our digital transformation in areas like e-commerce, omni-channel initiatives, AI and data analytics and our ERP upgrade.
And regarding stores, we have opened more than 60 doors year-to-date, primarily internationally and have added another 85 doors to our network from our organic acquisitions. We expect to selectively open about 30 more doors through the balance of the year in Type A locations, most of which will be digitally enabled, and generally would rent at much better rates than we had pre-COVID. And while recovery trends are encouraging, there remains uncertainty about the future, and therefore, we will not be paying a dividend in the fourth quarter. If our positive business trends continue, we anticipate a return to paying quarterly dividends in 2021. Turning to 2021 and beyond, I want to share some thoughts on where we intend to take this business. We still believe a return to pre-COVID revenues will occur at some point in the second half of 2021.
And the revenue recovery trajectory has improved considerably from what we thought three months ago. On our next earnings call, we expect to have more clarity on the specific timing. And while we expect recovery in various markets to remain uneven, Europe as a whole could get back to 2019 levels in the first half of 2021, given our brand and execution strength. Irrespective of revenues, our cost actions give us tremendous confidence that we will emerge from this crisis a significantly more profitable company. In fact, we now expect to achieve our adjusted EBIT margin North Star of at least 12% when we return to pre-COVID revenue levels, several years sooner than we previously anticipated and much higher than 2019's 10.6%.
This substantial EBIT margin increase assumes a higher adjusted gross margin, as well as structural cost savings of around $200 million, including the headcount, rent, travel and negotiated vendor savings we have discussed previously. We plan to reinvest roughly half the cost savings to fuel investments that are driving growth and drop the remainder to the bottom-line. Beyond 2021, we anticipate our strategies and execution will drive a structurally stronger business. More than half our total business will come from DTC and franchise channels with structurally sound economics. Specifically, we anticipate that adjusted EBIT margins for company-operated e-commerce will be at par with the total company when e-commerce is double its current size. Women's will become half our total business as it grows at a faster rate than men's.
Our global digital footprint will double to more than a third of our business with our own e-commerce comprising about half of that. And importantly, U.S. wholesale will be significantly healthier. In Q3, the non-digital business with our largest traditional brick and mortar department stores was less than 10% of our total revenue. And that's more indicative of what we expect going forward. As Chip mentioned, we are shifting our business away from their less productive doors and growing with them in their most productive doors and in the digital business. And this will complement our many opportunities to grow in healthy wholesale distribution with pure play, premium, value and the new and expanded distribution we have announced.