Kontoor Brands, Inc. Q1 FY2021 Earnings Call

Greetings. Welcome to Kontoor Brands First Quarter Earnings Call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. Please note this conference is being recorded. At this time, I’ll turn the conference over to Eric Tracy, Senior Director, Investor Relations. Eric, you may now begin.

Thank you, operator, and welcome to Kontoor Brands first quarter earnings conference call. Participants on today’s call will make forward-looking statements. These statements are based on current expectations and are subject to uncertainties that could cause actual results to materially differ. These uncertainties are detailed in documents filed with the SEC. We urge you to read our risk factors, cautionary language and other disclosures contained in those reports. Amounts referred to on today’s call will often be on an adjusted dollar basis, which we clearly defined in the news release that was issued earlier this morning. Adjusted amounts exclude the impact of restructuring and separation costs, business model changes and other adjustments. Reconciliations of GAAP measures to adjusted amounts can be found in the supplemental financial tables included in today’s news release, which is available on our website at kontoorbrands.com. These tables identify and quantify excluded items and provide management’s view of why this information is useful to investors. Unless otherwise noted, amounts referred to on this call will be in constant currency, which excludes the translation impact of changes in foreign currency exchange rates. Constant currency amounts are intended to help investors better understand the underlying operational performance of our business, excluding the impacts of shifts in currency exchange rates over the period. Joining on today’s call are Kontoor Brands’ President and Chief Executive Officer, Scott Baxter; and Chief Financial Officer, Rustin Welton. Following our prepared remarks, we will open the call for questions. We anticipate the call will last about an hour. Scott?

Thanks, Eric, and thank you, all, for joining us. Let me state at the outset, we will intentionally keep our prepared comments a bit tighter today as we look forward to articulating greater detail on our evolving strategies with you at our upcoming Investor Day in a few weeks on May 24. But today, we are really pleased to share our first quarter results, results that continue to accelerate across nearly all areas of our business. Our performance in the quarter demonstrates how the powerful combination of strategic investments and solid execution come together to yield improving fundamentals and we think this quarter provides a greater example of the opportunity ahead as we are just getting started. As always, I'm going to start by thanking our global team with a special call out to those colleagues working on our ERP implementation. It is this dedication to excellence by our employees around the world that is at the core of this quarter's strong performance. And it’s why I’m so confident in Kontoor’s future. We have much more work to be done, and we will remain humble and focused on areas within our control, but I know our colleagues are committed to delivering on our strategic plan. Over the last two years we have consistently communicated the following strategy to drive more profitable and sustained growth over the longer term. First, enhance and accelerate our core U.S. wholesale business. Second, elevate our direct connection with consumers through channel expansion, focused on evolving our B2C and digital ecosystem. Third, thoughtfully extend our reach around the globe, prioritizing opportunities within the China region. And fourth, diversify our product mix through category extensions, amplifying outdoor, workwear and t-shirts. In support of these long-term growth opportunities, we have also discussed where we are distorting TSR accretive investments and enablers, including elevating and prioritizing the highest ROI demand creation platforms, scaling product and manufacturing innovation with sustainability and ESG initiatives, unlocking productivity through the implementation of our global ERP and digital infrastructure to generate improved data analytics and consumer insights, and finally, developing world-class talent to build a high-performance, purpose-led and increasingly growth-minded culture. Let me now share some of the highlights from the first quarter that provide great proof points of how these strategies and investments are paying off. Overall reported revenue increased 29% over the first quarter of last year. It is important to note that even with the timing of shipments to have our regional ERP implementation, we saw significant top-line upside to our internal expectations. I would also point out that compared to the first quarter of 2019, we experienced 3% growth. And this growth would have been even greater, excluding quality of sales and strategic exits we’ve made over this time period. So a great sign of our business not only normalizing, but accelerating on a two-year basis. Our U.S. business continues to see strengthening trends, with both Lee and Wrangler up compared to last year. Importantly, compared to 2019, we also saw strength across both the U.S. wholesale and digital channels. While fiscal stimulus has certainly contributed to increases in domestic consumer spending, our brands are absolutely benefiting from investments across marketing, product innovation, and design, all of which are allowing us to take share and drive higher AURs in the marketplace. According to NPD, the Wrangler and Lee brands continued to see strong share gains, another quarter of outpacing the market. It’s pretty straightforward, our investments are working. Within demand creation, Wrangler introduced Georgia May Jagger as the face of its women’s heritage denim collection, allowing us to reach a younger female consumer and driving significant brand heat that cascades from premium to value. At Lee, a heightened emphasis on social media channels, as well as collaborations with high-profile influencers are driving gains across engagement, traffic and conversion. If you haven’t seen the recent InStyle shoot on Instagram, featuring Jennifer Lopez in newly designed Lee products, I encourage you to take a look. This was organic, what an incredible statement and brand-elevating moment for Lee. We remain committed to amplifying our demand creation efforts, focusing on the TSR bolstering areas and this includes digital. We continue to see strong returns on our investments in transforming our digital ecosystem. While Q1 experienced great growth over 2020, more impressive were U.S. digital gains relative to 2019 with own.com increasing 70% and digital wholesale increasing 132%. Given the accretive nature of this channel, financially and strategically, we will continue to invest dollars to drive elevated and sustained growth in digital. More details to come on the building blocks for this growth at our Investor Day in a few weeks. We also continue to invest in talent across global positions, including design and marketing. We are building a world-class team with an increasing focus on developing the growth-oriented organizational mindset. In addition, over the past few months, we have welcomed two new members to our Board of Directors. Today, we announced the appointment of Mark Schiller, the President and CEO of The Hain Celestial Group. In March, we welcomed Rob Lynch, the President and CEO of Papa John’s, as we further build out our team and capabilities. Both Mark and Rob will bring incredible experience and insights to our Board. Turning to our investments within innovation, our foot remains on the gas pedal. During the first quarter, we expanded one of our key sustainability platforms, Indigood, to include additional water savings technologies. We also recently announced a collaboration with Panda Biotech to accelerate the commercialization and scale capabilities of hemp grown in the U.S., further proof of our commitment to be a leader in sustainability and to ensure responsible sourcing worldwide. Momentum in our outdoor line, ATG, is increasing, taking the Wrangler brand to additional channels and extending our reach to new consumers. Elevated design within Lee is also driving increasing permission for the brand to play in premium points of distribution. Enhanced innovation supports pricing and the mixing of AURs, a critical component of brand health. I'm sure most of you’ve heard or read about the potential emergence of a denim cycle. We see this differently, realizing cycles by definition are finite. We are focused on structural change, not cyclical trends. This speaks to the investments we are making in the brand, which not only allow us to participate in casualization or denim cycles, but actually drive them. Not only are we taking share, but we are expanding the marketplace. We are doing just that in our core and our largest market. Outside the U.S., we continue to see improvement despite an uneven macro environment. Europe revenue was down 5% on a constant currency basis. We expect conditions to remain difficult, but the evolution of our digital platform and new business development programs should help mitigate near-term headwinds and position us for long-term success in the region. In China, our ongoing strategic investments continue to yield accelerating results with first quarter revenue showing triple-digit increases year-over-year and 20% constant currency growth compared with 2019. Our premium lifestyle offerings, strong collaborations and partnerships with key local influencers positions the Lee brand well in the region. We are pleased to share that the Wrangler launch in China has exceeded our expectations, building momentum throughout the quarter and setting the foundation for scaled growth. Finally, let me provide an update on new business development. As we discussed over the last several quarters, despite the challenging environment, we have remained on the offense to take our brands into new points of distribution driven by diversified incremental category extensions. Our Lee business with Walmart continues to gain momentum with increased category offerings this spring and solid visibility into the fall order book. Regarding our Wrangler ATG line within North America, we continue to build in the core mass channel but also expand within new channels such as outdoor specialty and sporting goods; SCHEELS, a premium sporting goods retailer, is where the ATG lines can take the Wrangler brand, launching this spring and extending to additional stores this fall. We are thrilled to announce a significant new program within our Wrangler workwear business with a key domestic retail partner. More to come on this and other exciting expansions, but this certainly represents a tremendous opportunity for the work business as a testament to how our investments support category extensions, channel diversification and new business development wins. Before I hand it over to Rustin, let me close with this: Over the last few years, we have strived to do what we say, delivering near-term results while continuing to invest in the long-term, and we’re doing just that. We couldn’t be more excited to share greater details on our go-forward plans and evolving strategies at our Investor Day in a couple of weeks. So we look forward to it and hope all of you can join us. Rustin?

Thank you, Scott. And thank you all for joining us on today’s call. As Scott mentioned, we will keep our remarks brief and focus largely on the quarter due to the upcoming Investor Day on May 24. Before the first quarter review, though, I wanted to provide an update on our recent ERP implementation in North America, as I know it is a topic of interest. In addition, I want to briefly elaborate on how our strategic investments like technology are yielding improving fundamentals and enhanced optionality. As mentioned on our last earnings call, the second regional ERP implementation was scheduled in North America for early in the second quarter. I’m very pleased to report that we have successfully gone live and are executing according to plan on our transition and ramp-up activities. This is a significant accomplishment and milestone for Kontoor. We look forward to our final regional implementation scheduled for the second half of 2021. Technology initiatives like ERP and Digital are excellent examples of how we remain committed to making the necessary investments to drive long-term sustainable growth and efficiency improvements. These actions are enabling execution to enhance and accelerate our core U.S. wholesale business, expand under-indexed accretive channels like Digital, enhance international penetration in key markets like China, and extend our category reach with programs like outdoor, workwear, and t-shirts. Investments are not only leading to improved fundamentals and profitability, but also continuing to enhance optionality. On the last earnings call in early March, we mentioned that we had already made $75 million in discretionary debt repayments in the first quarter. Given performance, we made an additional incremental debt repayment of $25 million in the quarter to bring the total to $100 million during this period. With these additional repayments and despite the significant headwinds from the pandemic over the past year, we have reduced net debt or long-term debt less cash by over $320 million since the first quarter of 2020, while remaining laser-focused on investing and executing to deliver sustained long-term benefits. With this progress on de-levering the balance sheet, we are excited about the enhanced optionality as we transition to Horizon 2. Now, let’s turn to our first quarter review, focusing my comments on key highlights and encouraging you to refer to this morning’s release for additional detail on the quarter. Given the impacts COVID-19 had on prior year results, I will provide select references to the same quarter 2019 results for additional context. Beginning with revenue, global revenue increased 29% on a reported basis and was up 27% in constant currency compared to the same quarter last year. Revenue gains during the quarter were broad-based across segments, regions and channels. U.S. and international wholesale, digital wholesale and own.com all delivered strong results in the quarter. As expected and discussed on the fourth quarter 2020 earnings call, first quarter revenue benefited from a shift in the timing of shipments from the second quarter to the first quarter ahead of the company’s North American ERP implementation. As Scott mentioned, even with the timing of shipments ahead of our ERP transition, we saw significant top-line upside to our internal expectations. Strength in first-quarter revenue was partially offset by the impacts of the strategic actions announced at year-end to rationalize our U.S. outlet fleet and transition to a new licensed business model in India. Combined, these actions represented approximately 5 points of headwind in the quarter. Additionally, COVID-19 continued to negatively impact results in select channels and end markets, particularly in Europe. Compared to adjusted revenue in the first quarter of 2019, global revenue increased 3% on a reported basis. On a regional basis for the quarter, U.S. revenues increased 29% compared to the same quarter last year driven by wholesale, new business development wins, and digital. Strategic investments in our digital capabilities continue to yield strong returns. U.S. digital wholesale has increased 132% and own.com has increased 70% compared to the same quarter in 2019. Even with ongoing investments and promising early returns, we remain under-indexed and will continue to prioritize investment in this important channel moving forward. International revenues increased 30% on a reported basis and 21% in constant currency compared to the first quarter 2020. Improvement was driven by the strong China results on a one- and two-year stack basis that Scott mentioned earlier. Despite ongoing headwinds from COVID-19 in many markets, European reported revenue increased 4% over the prior year, led by Digital, where digital wholesale increased 98% and own.com increased 39%. Turning to our brands, global revenue from our Wrangler brand increased 31% on a reported basis and 30% in constant currency compared to the same quarter in 2020. Wrangler U.S. revenue increased 38%, led by broad-based strength in our wholesale, digital, Western and workwear businesses. The Western business continued to deliver strong results with revenue increasing 54% in the quarter, led by men’s and women’s bottoms. Additionally, key programming initiatives and category extensions, including ATG, the female heritage collection, and expanded distribution for workwear drove strong growth. Wrangler's international revenue was flat on a reported basis and decreased 6% in constant currency. New business development wins with our ATG program and digital growth in Europe offset the business model change in India and ongoing COVID-related impacts. Compared to adjusted revenue for the same quarter in 2019, global Wrangler reported revenue increased 10%. On a constant currency basis, Wrangler reported revenue increased 7%. Lee brand global revenue increased 37% on a reported basis and 33% in constant currency compared to the first quarter of 2020. In the U.S., Lee revenue increased 28%, driven by wholesale including new distribution wins and continued strength in digital wholesale and own.com, which increased 73% and 69% respectively in the period, broad-based across both genders and multiple categories led by denim and non-denim bottoms. Lee international revenue increased 50% on a reported basis and 40% in constant currency. As previously mentioned, China’s sequential momentum continues to lead the improvement. Compared to adjusted revenue for the same quarter in 2019, global Lee reported revenue increased 4%. On a constant currency basis, global Lee reported revenue increased 2%. From a channel perspective, we saw broad-based improving performance during the quarter. On a reported basis, U.S. wholesale increased 37%, non-U.S. wholesale grew 30%, and global own.com increased 62% compared to the prior year. Now on gross margin. Gross margin increased 830 basis points to 46.1% of revenue on a reported basis compared to the same period in the prior year. Fundamental improvement continues to be driven by favorable channel, customer and product mix, as well as quality of sales initiatives. Additionally, the period benefited from product cost enhancements and lower inventory provisions combined with higher production volumes than the prior year. Before moving to SG&A, I want to make a couple more comments about our gross margin and future investments. As we have highlighted previously, we see opportunities for sustainable structural margin enhancements, as growth in currently under-indexed accretive channels and geographies begins to materialize. Although, improvements may not always be linear on a quarter-to-quarter basis, our first quarter gross margin performance is an excellent early proof point on how focus areas like demand creation, digital capabilities, and quality of sales are beginning to manifest. These enhancements create oxygen in our P&L for us to reinvest back into the business, and we will continue to do so. I realized that our prior year gross margin contains some COVID-related impacts in the period that may distort comparisons. Accordingly, to better illustrate the progress that has already been made, I wanted to highlight that our first quarter gross margin increased 500 basis points compared to the first quarter of 2019 on an adjusted basis. Now on to SG&A. Adjusted SG&A increased $12 million on a year-over-year basis to $181 million. Increased demand creation and higher volume-related variable expenses were partially offset by lower bad debt expenses than in the prior year. Adjusted earnings per share was $1.43 compared to $0.27 in the same period in the prior year and compared to $0.96 in the first quarter of 2019. Now, turning to our balance sheet, first quarter inventories decreased $139 million versus the prior year to $350 million or down 28%. The year-over-year decline reflects tighter inventory controls, the reduction in the VF Outlet fleet that took place at year-end, and the business model change in India. Excluding VF Outlet in India, inventory decreased approximately 21% compared to the prior year. Historically, working capital in the first quarter tends to be a use of cash, as opposed to being a source of cash. However, due to our performance in ERP implementation, working capital in the first quarter was a source of cash and is expected to be a use of cash in the second quarter. We finished the first quarter with net debt of $586 million and $230 million in cash. We anticipate prudently moderating our currently elevated cash balances towards pre-COVID levels as we move through 2021. As previously announced, our Board of Directors declared a regular quarterly cash dividend of $0.40 per share payable on June 18, 2021 to shareholders of record at the close of business on June 8, 2021. Now, onto our outlook, given the strength of the first quarter, we are raising our fiscal 2021 guidance for revenue, gross margin and adjusted EPS. Although we will not provide a quarterly outlook, I will share some additional color on anticipated quarterly cadence in light of the ERP implementations. As we shared on our fourth quarter earnings call, we anticipate some timing shifts around the implementation of our ERP. Specifically, as you would expect, we believe there were some order pattern timing shifts from the second quarter into the first quarter, somewhat tempering Q2 revenue growth rates and corresponding profitability, while aiding the first and third quarters. These timing shifts should have no impact on our full-year results. Let me now turn to specific 2021 guidance. Revenue is now expected to increase in the low-teens range over 2020 as compared to a low double-digit range in the prior guidance, including a mid-single-digit impact from the VF Outlet actions and India business model changes. We expect second half revenue to be modestly above the first half of the year. To be clear, we expect second quarter growth rates to modestly accelerate from the first quarter. Gross margin is now expected to increase by 230 to 270 basis points above the adjusted gross margin of 41.2% achieved in 2020, as compared to 150 to 200 basis points in the prior guidance. Although second quarter margins will be adversely impacted by downtime in our production facilities for the ERP implementation, the annual increase reflects continued benefits from ongoing quality of sales initiatives as well as higher anticipated growth in more accretive channels such as digital and international. SG&A investments will continue to be made in brands and capabilities. Due to the strengthening revenue and gross margin outlook, we expect to amplify SG&A investments in demand creation, digital, and international expansion. These increases will be partially mitigated by ongoing tight expense controls and sustained structural cost-containment initiatives. Adjusted EPS is now expected to be in the range of $3.70 to $3.80 per share, as compared to $3.50 to $3.60 per share in the prior guidance. We expect second half earnings on a dollar basis to be modestly above the first half of the year due to COVID recovery and the natural seasonality of the business. In closing, as Scott indicated, I would just like to reiterate how our first quarter results demonstrate improving fundamentals, driven by the powerful combination of strategic investments and solid execution. We look forward to sharing our go-forward strategies to drive greater shareholder value at our upcoming Investor Day. This concludes our prepared remarks. And I will now turn the call back to our operator.

Thank you. At this time, we’ll be conducting a question-and-answer session. Thank you. And our first question is coming from the line of Jay Sole with UBS. Please proceed with your questions.

Great. Thank you so much. I want to ask about the ERP impact and the timing of the implementation. Rustin, I think you said that the company has successfully gone live and is executing. But there are still some final regional implementations for the back half of the year. Can you maybe just elaborate a little bit on what percentage of the ERP system has been implemented and sort of what’s the risk profile right now in terms of the business, the operational risk always associated with these kinds of things? How much risk is still there? What can you tell us about that?

Sure. Good morning, Jay. Thanks for the question. In terms of the ERP impact, let me first start with where we are on the ERP implementation schedule. You may remember, Jay, we implemented our first regional implementation in Q3 of 2020. That was in our Asia region. As we indicated this morning, on our prepared remarks, we just went live in North America here early in the second quarter. As you know, Jay, we’re predominantly a North American based business with roughly 75% of our sales in North America. So certainly, the largest region is live. As I indicated in the remarks, we’re executing according to plan with our transition and ramp-up activities. Regarding the timing impact, Jay, specifically, as we said on the last call, we anticipated that there would be some timing shifts in order patterns that would really benefit Q1 and potentially Q3, while tempering Q2 a bit more. As a reminder, though, those timing shifts are expected to have no impacts on the full-year results. As we think a little more about our Q1, there were a number of puts and takes, both positive and negative, that impacted the quarter, including stimulus as Scott discussed, lockdowns in Europe, lapping the VFO in India, model changes, quality of sales initiatives, and, of course, the timing shifts with the ERP. Several of those, including ERP, are really difficult to isolate the individual impact of. But I want to emphasize for you, Jay, that even with the shifts, our Q1 top-line was broad-based and significantly above expectations, driven by the areas where you’ve seen us investing over the last several quarters, including U.S. wholesale, digital and China. We believe that KTB-specific outperformance was really growth compared to not only 2020 but also 2019, even with the drag from some of the strategic exits that we’ve executed. Scott talked about the continued share gains, and that’s what we love, the momentum and the brand, and the underlying business. That’s given us the confidence to raise the full-year outlook. We’re really happy about where we are on the ERP implementation. It’s been a significant journey. Again, two of the three regional platforms are live now, with the third one being Europe in the back half of 2021.

Got it. That’s super helpful. Maybe if I can follow up, Scott, you made some interesting comments on denim, saying, you didn’t want to use the word cyclical because that sort of implies an endpoint more you see structural gains. Can you maybe elaborate on what you’re seeing right now in the marketplace? What you see with consumers that they’re doing differently that gives you confidence in the category really improving from where it was a couple of years ago?

Yeah, I think we see a fundamental shift really. We think about – to talk about the denim cycle, and that’s something that we’ll participate in and we feel real strongly about and we’re positioned extremely well. But we see this as a big movement, Jay. We see it as a global movement to customization and, you know, casualization. When we think about this, we think about the fact that we can play now globally because of our business. We’re restructuring where we’re set up around the world. We’ve got a really nice set of initiatives that play well into it. If you think about all the work we’ve done on our innovation, and all the work we’re doing on our design, you’ve seen the product that we’re producing now and how good it is globally. The demand creation portfolio we put out, some of the stuff that I talked about today with Georgia May Jagger and J.Lo, those things are really helping the consumer shift into this casualization around the globe, which is really important because we think of it as a much bigger dynamic, a much more global dynamic, and something that we’ll be able to participate in for the long term. The key thing for us is we believe we’re the ones that are driving it. We’re taking share in what we’re doing, which is really important for our business going forward, expanding the marketplace. If you were to spend time, like you do in London and New York and San Francisco globally, you’re seeing that as people come back to work, they’re dressing differently. The world went into a really tough situation that we’re all trying to come out of now. As people are coming out of it, they’re saying to themselves, 'In the future, I’d like to be a little bit more casual. Denim is going to be my play there.' We’ve positioned ourselves really nicely.

Thank you. Our next question is coming from the line of Erinn Murphy with Piper Sandler. Please proceed with your question.

Great, thanks. Good morning. I was hoping, Scott, you could talk a little bit more about the Tmall launch of the Wrangler brand. You said it exceeded expectations. How do you see that scaling in the region over time? And then, just curious, China bigger picture for both brands, what’s the promotional landscape been like versus the pre-pandemic? And then I have a quick follow-up question.

Sure, sure, no problem. From the Tmall standpoint, we feel really good about the launch. We set all of our internal expectations. It’s higher profile over there. The thing that’s really important for us, as we’ve talked a little bit about, is we have such a head start with our Lee brand. We’ve been in the marketplace for a really long time. We know the consumer. We know the market. We know the customers. We have a terrific team on the ground there. Bringing our Wrangler brand to that marketplace was a real benefit for us having that kind of expertise. We’ve seen and hit the metrics that we’ve established for ourselves. The most important thing is that our team was very strategic and smart on how we launched this first from a digital standpoint. Now, we’ll go to a physical omni-channel presence going forward, which you’re going to hear a lot more about as we approach our Investor Day on May 24. We’re really pleased with how the consumer is reacting to the Wrangler brand in China right now. From a broader perspective, you heard my comments and Rustin’s comments about how the business is doing in China. We’re really pleased with the brand and the opportunities we see in that marketplace. I liken this to the early stages, on a scale of 1 to 10; I liken us to being at a 2 currently with plenty of potential ahead. We’ll spend time unpacking that for you at Investor Day as well. Thanks for the question, Erinn.

Perfect. And then, I guess, a follow up for Rustin on just the shaping of the year. I hear you on the timing shift of ERP. But looking at how you spoke to Q2, the implicit back half guidance seems very conservative to us. It really doesn’t give you guys a lot of credit for growth, or just very modest growth in the back half to get to your low teens top-line. Can you help us think through some of the drivers there, or if we’re missing anything? Maybe it’s coming out of the India business model change, but again, that reflects very different second half versus first half growth rates.

Sure. Thanks, Erinn. Good morning. Thanks for the question. Obviously, one of the things is the comp. As you think about 2020 and certainly strengthening as you move through the back half of 2020 relative to the front half, that’s part of it, but let me step through the full-year impact on both profitability and earnings. Again, really strong momentum in Q1. Going into Q2, as we talked about, the ERP go-live will cause some timing shifts, benefiting Q1 as well as Q3, while tempering Q2 a bit more. As a reminder, Q2 is our lowest volume quarter. As you would expect, we will see a bit more pronounced impact on profitability, particularly as we continue to invest behind strategic initiatives and demand creation to support the top line not just in 2020, but in the back half of 2021, and in 2022 and beyond. We do expect to see modestly higher second half EPS on a dollar basis relative to the first half of the year due to COVID recovery and the natural seasonality of the business. There is a lot of macro uncertainty as Scott and I both referenced earlier, whether that’s continued lockdowns in Europe or supply chain disruptions. We are being prudently conservative and want to make sure that we’ve taken all of those considerations into account while emphasizing our investments to support long-term top-line growth in the back half. Hopefully, that provides a little more clarity on the shaping of the year.

Thank you. Our next question will be coming from the line of Adrienne Yih with Barclays. Please proceed with your question.

Good morning. Let me add my congratulations. This is the second quarter in a row where we’re really starting to see that Horizon 2 play out, so well done there.

Thanks, Adrienne.

I was wondering if you can talk about the China Wrangler launch, what you’re seeing there? How strong, I mean, China seems to be a hotbed of positive news in terms of the strength of the recovery. And on the other side, we have had some questions about denim-based retailers having exposure. I know this is a political subject, but do you have exposure, how do you know that you have – if you were to have cotton that is perhaps exposed to that Xinjiang region? Can you talk about any risk reward aspect from China upside versus any exposure?

Good morning, Adrienne. How are you? Thanks for joining us today. It’s Scott. I’ll start with your China question for Wrangler. It was a big decision for us to go there, but it was also an easy decision made early on in our strategy, given the leadership we have and the experience accumulated in the marketplace over a long period of time. We’ve been really pleased with how the consumer has received the product. Although the demand is strong, we’ve capitalized on the existing infrastructure that we have. We phased into kind of our second strategy around how do we grow the brand there, launching digitally first and now transitioning to an omni-channel presence. We feel we’re in a good position to grow the brand in China. Regarding exposure to Xinjiang cotton, we do not buy cotton directly; rather, we purchase fabric from suppliers. Our employees pride themselves on maintaining a well-established supply chain. We’ve worked with our suppliers to ensure that we are sourcing responsibly, so we feel well positioned in that situation.

Okay, fantastic. That’s super helpful. I know we’ve touched on the denim cycles, but I actually am more curious whether you think there’s a fashion shift component to it. I'm aware there’s a transference from athleisure back to denim, but can you also discuss any fashion aspects, maybe change in silhouettes?

Absolutely. I’m thrilled you asked that question because you’re the first person to pick up on that component. We have put a lot of energy, time and money into our innovation and design, which is bringing our product to a more premium level. This is important because, throughout this casualization, cities globally are transitioning into a casualization process where people returning to work or social environments will dress slightly different, desiring a more elevated fashion element from denim. We’re expanding our workplace and ensuring we’re creating the right products for future consumers in the marketplace.

Adrienne, it’s Rustin. I’ll provide a little more color on average unit costs. Certainly, we’re not immune to macro-economic challenges like port congestion, higher freight rates, and labor shortages. We’re actively monitoring input costs and have considered those in our updated outlook, where we raised our gross margins. We saw our third consecutive quarter of triple-digit gross margin increases, and in the first quarter, our gross margin improved above Q1 2019 by 500 basis points on an adjusted basis. Investments are a key focus as we think about our model moving forward. We’ve emphasized demand creation, innovation, digital, et cetera, with proactive margin improvement opportunities to help drive favorable channel and geographic mix. Our diversified supply chain, about one-third of our global production being internally manufactured here in this hemisphere, allows us flexibility and minimize inflationary pressures. So that provides clarity on how we view average unit costs and pricing.

Thank you. Our next question will be coming from the line of Bob Drbul with Guggenheim Securities. Please proceed with your questions.

Good morning. I have a couple of quick questions. Can you talk a little bit about new business development wins that you're seeing? And can you comment more on how you’re evolving your digital ecosystem? I’d be remiss if I didn’t ask about the JLO campaign. Can you give us an idea on demand creation and where you see it, specifically with these gross margin gains and the ability to reinvest? Where are you with the JLO campaign and the Georgia May Jagger campaign?

There are no problems there with that. From the new business development standpoint, I’m pleased that Lee brands have identified these opportunities as having been under-invested, under-penetrated, and under-distributed, so we have a substantial whitespace globally and we’re actively attacking that. Our success with Walmart has been very encouraging with strong results since we got all our POS up. Positive developments with our ATG program are aligning well, as is our work with key global partners. I want to point to our success with SCHEELS, a premier outdoor retailer where we’re beginning to see our products positioning at the right place alongside our competition which is creating brand heat. From a digital standpoint, the work I’ve referenced regarding ERP implementation and the related achievements have provided us with a very strong starting point. The response from consumers has been enhancing and our digital partners along with our own digital.com are showing exceptional results. We believe our streamlined sizing options make us an easy sale for consumers. All of this is strengthened by incredible demand creation programs paired up directly with our strong JLO and Georgia May Jagger campaigns, both of which have driven significant engagement.

Thank you. Our next question will be coming from the line of Sam Poser with Susquehanna. Please proceed with your question.

Thank you for taking my questions. I’ve got a couple. First, just on your supply chain. What percent of your supply chain is coming from North America and not being impacted by the courts right now?

Yes, Sam, it’s Rustin. Good morning. As we talked about, our global production is roughly one-third in this hemisphere, serving our local market here, with plants in Central America servicing North America. Certainly, we have a fair portion of our production in the hemisphere, serving approximately 75% of our business here. This diversity helps mitigate some of the broader supply chain challenges you’re hearing from others in the peer set.

Thanks. Secondly, you’re increasing your marketing spend, which sounds focused on digital. How much of that digital marketing do you believe helped drive the first quarter? And how are you thinking about that within your guidance for the back half?

It’s a great question Sam. When you look at this business, we have historically been under-indexed in demand creation. Less than 5% of our revenue has been spent historically on advertising. We’ve discussed investing in these brands post-spin. You saw a slight increase in the fourth quarter as we ramped up demand creation, which certainly helped with the results both from holiday and into the first quarter. We see continued potential in this area, using our gross margin expansion to guide us in reinvesting into the brand while improving our operating margins. This is the secret sauce for us going forward.

Thank you. Our next question is coming from the line of Jim Duffy with Stifel. Please proceed with your question.

Thanks. Good morning. I wanted to start talking about gross margin, really super progress and strong margins in Q1. Rustin, it sounds like some give back in the second quarter. Is there any reason that Q1’s gross margin wouldn’t be sustainable?

Good question, Jim. First quarter was a milestone for us with three consecutive quarters now of triple-digit margin improvement. North of 46% was our strongest quarter to date, reaching nearly 300 basis points better. Gross margin expansion remains a critical focus point, enabling us to invest back into our brands while improving operating margins. While there will be some margin impacts for Q2 during the ERP implementation, our full-year outlook is optimistic based on what we’ve achieved so far. The macro uncertainties still hang as you think about supply chain issues. We want to prudently moderate our expectations, accounting for all categories as we move through the year.

Okay, great. Rustin, I wanted to ask about EBIT margin and flow-through. The guidance implies EBIT margin back above pre-spin levels. Is there any sort of framework for when you have upside how it transfers to investors versus being reinvested into the business?

Certainly, Jim, we’ll provide details surrounding our plan for SG&A and how we’re investing in demand creation at our Investor Day in a couple of weeks. The focus is on earning our way into these investments. You will see strong momentum on the brand side with investments directly supporting both growth and revenue opportunities. We know we have an exciting opportunity to reinvest back into the brands; receive positive feedback from our adjusted margins front line.

Thank you. At this time, we’ve reached the end of our question-and-answer session. I’ll turn the call over to Scott Baxter for closing remarks.

Thank you all for joining us today and we appreciate the engagement and support of our company, as well as the great questions from the community. I wanted to remind you to join us on May 24 for our Investor Day. We look forward to a great day together, and thank you again for your participation today. Have a wonderful day, everyone. Thanks.

Thank you, everyone. This will conclude today’s conference. You may disconnect your lines at this time. Thank you for your participation.