Kontoor Brands, Inc. Q1 FY2022 Earnings Call

Greetings. Welcome to the Kontoor Brands Q1 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host, Eric Tracy, Senior Director of Investor Relations. Thank you. You may begin.

Thank you, operator, and welcome to Kontoor Brands First Quarter 2022 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. First quarter 2022 results are on a GAAP basis. Select comparisons to first quarter 2021 results will be on an adjusted dollar basis, which we clearly defined in the news release that was issued earlier this morning and is available on our website at kontoorbrands.com. Reconciliations of GAAP measures to adjusted amounts can be found in the supplemental financial tables included in today’s news release. These tables identify and quantify excluded items and provide management's view of why this information is useful to investors. Comparisons will be in constant currency, unless otherwise stated. Joining me on today's call are Kontoor Brands' President, Chief Executive Officer, and Chair, Scott Baxter; and Chief Financial Officer, Rustin Welton. We anticipate this call will last about an hour. Scott?

Thanks, Eric. We appreciate all of you joining us on today's call. Before I speak to our first quarter results, I'd like to acknowledge the ongoing crisis in Ukraine. The tragic events that have unfolded in the last few months are having a profound impact on the world. Our priority continues to focus on supporting the health and safety of our team and community in the European region. From humanitarian aid donations to organically-driven initiatives from our European leaders to simplifying organizational movements in the region, we will continue to do our part and hope for a fast and peaceful resolution to this unspeakable crisis. And beyond the war in Ukraine, we also recognize the many ongoing global macroeconomic challenges, the mandatory COVID lockdowns in China, inflationary pressures, and supply chain disruptions, all weighing on the global operating environment. As we have consistently stated, Kontoor is not immune to these macro pressures. However, we rigorously pressure test our assumptions from inflationary pressures on input costs like cotton and oil or China lockdowns, attempting to best capture how these macro factors could impact our outlook. To be clear, our confidence comes from what we control. With our Kontoor-specific strategies and superior execution driving first quarter outperformance and supporting our raised guidance here today. Our first quarter results are a direct function of the incredible efforts of our colleagues around the world. Their resiliency and passion for excellence allowed us to navigate the challenging environment to deliver strong Q1 performance. Turning now to our first quarter results, we once again saw a broad fundamental strength across our portfolio, with performance coming in above our expectations and guidance for both revenue and earnings. Global revenue came in above our plan, growing 5% over last year. These gains continue to be supported by investments in elevated design, demand creation, and innovation, all of which enhance our core business. Both Wrangler and Lee experienced positive global performance in the quarter. And as you can see from our Q2 and full year guidance, we expect both brands to accelerate off the strong Q1 results. To augment our core, we continue to diversify our range of distribution into accretive new channels, such as outdoor, sporting goods, work and premium specialty, as well as scaling our digital ecosystem. During the quarter, our global and US digital wholesale business continued its great momentum, up 25% and 37% respectively. And our branded digital platform was even more impressive, with global and US owned dot-com, up 38% and 43% versus last year. Our digital platforms are significantly reshaping our model, driving deeper connections to both existing and importantly new consumers like never before. Helping drive this new channel expansion, we continue to broaden our product portfolio into new categories. As we've stated in the past, it's really important to understand the breadth of category strength beyond our core denim business across outdoor with our performance ATG line, work, tops and T-shirts, western and female. To give you some perspective on this dynamic, our core denim long bottoms business was up 8% reported in Q1. While additional categories such as workwear increased nearly 40% and T-shirts were up over 70%. What we love is our strategies and investments are creating a virtuous cycle of top line strength with solid share gains and AUR increases in our core increasingly bolstered by the scaling of new categories, most of which remain in the very early days of their growth. Outside the US despite the macro headwinds, we were able to outperform expectations. Europe was up 19% driven by continued strength in digital and D2C. While we are on the topic of Europe, I want to reiterate that we shared in early March we've worked with a small distributor in the region and do not operate directly in Russia. And as stated, the business is de minimis to our overall Kontoor portfolio. We chose to suspend operations with this distributor during the first quarter. In China even with COVID lockdowns, we were able to deliver gains during Q1 with revenue up 3% reported and 1% in constant currency. Rustin will take you through some of the specific building blocks, but our updated guidance reflects our expectations for continued macro challenges in Europe and mandatory lockdowns having a significant near-term impact in China particularly in Q2. We will seek to optimize productivity in both of these key markets near-term while investing in and positioning our brands to capture the significant market opportunities long-term. I mentioned at the beginning that we have confidence in what we control, confidence in our strategies, and confidence that our investments will continue to support accelerating, sustainable, and more profitable top line growth in the future. So while we expect macro obstacles will persist, we intend to continue to amplify investments in critical growth enablers such as digitization, demand creation, and talent, all of which we believe will help drive competitive separation both in the short and long run. Let me touch a bit more on these key areas. First, with respect to digital. As you've seen with the really strong results, not only in the quarter but over the last year plus, our investments in digital are yielding great success. A perfect example of how these investments take form is our recently launched virtual stores for both the Lee and Wrangler brands. On each of the brand sites, our new platforms allow the consumer to navigate within an interactive three-dimensional retail space, browsing items in the store setting before seamlessly adding them to their shopping cart. Drawing from an extensive portfolio of products available online and in stores, the virtual stores feature the brand's latest innovative designs, top-selling items, and current seasonal styles. Digital evolution is a critical component of our growth strategy as we enhance the overall omni-channel consumer experience. Through these new virtual stores, we are offering consumers a more immersive experience with our core products and the opportunity to engage with our brands in a curated store experience that brings to life the unique characteristics of each of our brands. This is just one example of our ongoing digital evolution leveraging a consumer-centric approach to engaging existing customers and acquire new younger audiences. The second key growth enabler I want to touch on is demand creation. Last year you heard us talk about ramping investments in advertising to support not only second half 2021 growth but the 2022 top line as well. And the returns from these investments are evident in accelerating revenue growth anticipated to be up mid-teens in the first half of 2022 and roughly 10% for the year. This again despite the difficult operating environment. The Lee Originals equity campaign that launched late last year continues to build globally having a tremendous halo effect on our core business, while also generating new business in more elevated premium points of distribution. Beyond our equity campaign, Lee is partnering with key influencers that sparked heightened brand awareness from SoHo to London to Shanghai. And these partnerships extend the brand relevant collaborations including our most recent with the iconic Smiley brand. To celebrate the 50th anniversary of Smiley, Lee has joined hands with the renowned brand on a new global lifestyle collection, bringing to life the original Smiley campaign Take the Time to Smile. The curated capsule blends iconic Lee silhouettes and Smiley positivity for a much-needed feeling of hope and optimism that is perfectly positioned for Spring 2022. And finally, we are really excited to announce that Lee will be sponsoring the Bonnaroo Music Festival this June, reinforcing the brand's long-standing relationship with music, culture, and original expression. With Wrangler in the brand's 75th anniversary celebration this year, we are enhancing demand creation efforts through our For the Ride of Life campaign in elevated social media platforms allowing the brand to reach new consumers like never before. Our brand ambassadors including Georgia May Jagger in female and Leon Bridges in men's further support this enhanced reach to younger and more diverse consumers. And authentic collaborations such as our recent partnership with the iconic music brand Fender highlight how the Wrangler brand plays at the heart of cultural influence with a focus on freedom, self-expression, and independence. I know some of you will be joining us in a few weeks down in Texas and we're really excited to share how these brands investments come to life including in our Fort Worth Stockyards Wrangler store. This full-price concept store showcases the pinnacle expression of the brand in a really elegant way and serves as a bit of a test lab and blueprint for how we think about the beginning to layer our brick-and-mortar stores within our D2C strategy. The third critical growth enabler I want to touch on is talent. As you saw us make some significant organizational announcements during the first quarter, we feel that this is exactly the right time to further invest in our people and we did just that in promoting Tom Waldron and Chris Waldeck to co-COOs augmenting their existing responsibilities as global brand presidents. We understand the natural questions around why co-COOs. So let me provide some insight into our rationale. With the completion of our ERP implementation, we now have the tools and processes in place to amplify the globalization of our operating model. Now is precisely the right time to elevate and broaden Chris and Tom's roles. Chris is taking on more leadership for go-to-market strategies in all international markets as well as global D2C while Tom has greater oversight of certain operational aspects of the business, including supply chain, product development, innovation, and procurement. And importantly, I look forward to partnering with them in the years to come to help drive this next phase of the journey. This also afforded us the opportunity to elevate other key members of our senior team, rewarding them for their incredible leadership and execution over the last few years while ensuring our go-forward organizational mindset continues to pivot towards growth. These incremental investments in growth enablers, not only digital demand creation and talent but also in supply chain, innovation, ESG, and enhanced product design capabilities, all support our brands' health and importantly improved pricing power. We've talked about this in the past but I think it's really crucial that folks understand how these investments have positioned the Lee and Wrangler brands differently than in prior years. Especially relevant given today's inflationary environment, the combination of our quality of sales efforts and cleaning up distribution and amplified brand investments has and will continue to drive a mixing up of AURs while also supporting a greater ability to strategically price. Before I turn it over to Rustin, let me close with this. The operating environment remains challenging. But I would note that since we became an independent company nearly three years ago, we've yet to operate in anything but a challenging environment. Even with the macro obstacles and even with our proactive actions to exit over $200 million of revenue and implement a new global ERP platform, our 2022 guidance implies revenue growth in the high single-digit range and EPS growth of greater than 20% over 2019 levels. And despite the macro, since the start of 2020, we've generated over $600 million in operating cash flow allowing us to materially deleverage the balance sheet while simultaneously paying a superior dividend and initiating a share repurchase program, returning $274 million to shareholders over the same period. These accelerating fundamentals and improving capital allocation optionality are a testament to our team's incredible execution through this period. This ability to navigate through difficult times while still investing for the future is powerful and gives me great confidence that Kontoor is on an excellent path. Rustin?

Thank you, Scott, and thank you all for joining us on today's call. As Scott mentioned, we are very pleased with our first quarter results, results that came in above expectations driven by our catalyzing growth strategies. I will start with a review of the quarter before providing additional context on our outlook for the balance of the year. As a reminder, comparisons will be in constant currency unless otherwise stated. Additionally, my discussion of 2022, first quarter results are on a GAAP basis and will be compared with adjusted results from 2021, which we believe is the most relevant and accurate method for investors. My comments will focus on key highlights, and I will refer you to this morning's release for additional detail on the quarter. Beginning with revenue, Global revenue increased 5% compared to the prior year. Growth was broad-based across brands, categories, channels, and geographies, reflecting the progress we are making against our initiatives. We saw particular strength in our digital businesses, as well as strategic growth categories, including the incredible performance in Ts and workwear that Scott highlighted earlier. In addition, the growth we are seeing is healthy, as we continue to chase demand in the marketplace. On a regional basis, US revenues increased 4%, driven by continued momentum in key channels and categories. It is important to note domestic revenue and corresponding profitability results were significantly tempered by year-over-year comparisons associated with timing shifts in advance of the North American ERP implementation in the first quarter last year. In our digital business, US owned dot-com increased 43% compared to the prior year supported by continued AUR increases across both brands. Our investments in our digital platforms are also helping to drive growth with new consumers. During the quarter, female had the number one selling style on wrangler.com and the female business on lee.com saw similar success. International revenues increased 9%. We saw strength across most markets and channels including 19% growth in EMEA and 18% growth in international D2C. Turning to our brands. Global revenue of our Wrangler brand increased 4%. Growth was driven by continued strength in western and workwear as well as healthy contributions from Ts and female. In addition, we saw sustained momentum in Wrangler's digital business with US owned dot-com increasing 57% in the quarter. Wrangler international revenue increased 20% driven by digital. In China, revenues grew nearly 30% as we continue to make progress scaling the brand across e-commerce and brick-and-mortar. Despite our expectations that mandatory lockdowns in key China markets will impact near-term results, our excellent progress with the Wrangler launch gives us tremendous confidence for the brand, when conditions normalize in the region. In EMEA, revenues grew 26% with growth in nearly all markets. As Scott mentioned earlier, Russia and Ukraine are de minimis to our overall revenue and we do not own or operate direct business in these countries. Turning to Lee. Global revenue increased 7%. Lee US revenue increased 9% driven by continued demand at wholesale, new distribution wins and our digital business with US owned dot-com increasing 17%. Lee international revenue increased 4% driven by 13% growth in EMEA, partially offset by moderating trends in China as a result of COVID-related lockdowns starting in March. I will touch on our expectations for China later in my remarks, but we remain very confident in the long-term opportunities for the Lee brand in the region. And finally, from a channel perspective, US wholesale increased 3%, non-US wholesale grew 7%, and global-owned dot-com increased 38%. Now on to gross margin. Gross margin decreased 140 basis points compared to adjusted gross margin last year. As you would expect, there are a number of structural and transitory dynamics impacting gross margin. So let me expand on this a bit. As we have discussed, we continue to see benefits from structural margin enhancements, such as channel, geographic, and product mix, as well as ongoing supply chain initiatives. These structural drivers combined with strategic pricing contributed a positive 70 basis point of net margin improvement in the quarter and more than offset the impacts from inflation including cotton, ocean freight, and labor. However, as you would expect, we are also seeing elevated transitory costs, such as airfreight, as we expedite shipments due to current supply chain constraints and as we chase demand. These factors resulted in a 210 basis point headwind in the quarter. We continue to have confidence in our ability to drive long-term gross margin expansion from our structural initiatives while working through these near-term transitory headwinds. I will provide additional color on our gross margin expectations for the balance of the year in our outlook. SG&A expense was $196 million, or a $15 million increase versus first quarter 2021 adjusted SG&A. Investments in demand creation, digital and IT investments, product development, and distribution expenses more than offset fixed cost leverage on improving revenue and lower compensation-related expenses. As we have discussed, amplifying investments in strategic areas such as digital and demand creation are important drivers of our catalyzing growth strategy and are expected to support strong demand in 2022 and beyond. Earnings per share was $1.40 compared to $1.43 in the same period in the prior year on an adjusted basis. Now turning to our balance sheet. First quarter inventories increased 24% compared to last year. As we have discussed, we continue to chase demand with second quarter revenues expected to increase 30% to 32%. We are very encouraged by the broad-based momentum we are seeing in both Wrangler and Lee and anticipate improving inventory stock levels by the end of the second quarter. We finished the first quarter with net debt or long-term debt less cash of $598 million and $194 million in cash and equivalents. Our net leverage ratio or net debt divided by trailing 12-month adjusted EBITDA at the end of the first quarter was 1.6 times within our targeted range of one to two times. Finally, during the quarter we repurchased $23 million in common stock. And at the end of the quarter, we had approximately $100 million remaining under our share repurchase authorization. When combined with a strong dividend, we returned a total of $49 million to shareholders during Q1. Before getting to our outlook and as a reminder, 2021 was affected by various factors including ERP timing shifts, as well as temporary COVID shutdowns and supply chain disruptions that resulted in quarter-to-quarter volatility. These factors will primarily have an impact on first half year-over-year quarterly comparisons but are not expected to impact the full year. Given the impact of ERP timing shifts, we thought it was important to provide quarterly guidance for the first half, including an update to the second quarter here today. We do not intend to provide quarterly guidance moving forward. And now on to our 2022 outlook starting with the second quarter. Consistent with prior guidance, Q2 revenue is expected to be in the range of $640 million to $650 million, increasing 30% to 32% compared to last year. Momentum and incremental strength in the U.S. is offsetting headwinds from the COVID-related lockdowns in China, resulting in a meaningful shift in revenue composition from prior guidance. With that given developments in China a region that I know is top of mind for you let me provide additional color. Our brands are well positioned and continue to resonate with the consumer. And we began the year with February year-to-date results considerably above prior year and our plans before slowing in March and April, as traffic softened and lockdowns expanded. We have taken a conservative approach for the quarter and have adopted a more cautious view for the year in our outlook but remain optimistic about the long-term prospects for our brands in the region. And finally given geographic shifts and strength in the US, we anticipate gross margin headwinds in the quarter due to mix on lower China revenues, higher transportation inflation, and elevated transitory costs to meet consumer demand. Second quarter EPS is now expected to be in the range of $1.05 to $1.15 compared to prior guidance of $1.25 to $1.35. Now turning to our full year outlook. Revenue is now expected to increase at approximately 10% to more than $2.7 billion, up from our prior guidance in the high single-digit range. Importantly, this top line guidance assumes a few key factors including a more cautious outlook in China, uncertainty in EMEA, cautious consumer demand in light of inflationary pressures, and conservative elasticity assumptions around price increases. We expect these factors will be more than offset by key Kontoor-specific drivers including momentum on both brands driving broad-based revenue growth, strong unit and AUR growth, and strategic price increases in the second half. Gross margin is still expected to be consistent with 2021 adjusted gross margin of 44.6%. As discussed earlier, improvements in structural gains are expected to be relatively offset by higher transitory costs. In terms of structural gains, we continue to anticipate the combination of strategic pricing actions, ongoing accretive mix improvements to digital and cost savings initiatives to more than offset inflationary pressures. In fact, structural gains for the year are projected to modestly exceed our original estimate of up to 100 basis points of improvement, which has allowed us to absorb mix pressures from COVID-related impacts in China and hold our original guidance for the year. In terms of transitory cost and similar to my comments on the second quarter, we continue to expect higher expenses as we chase demand to remain through Q2 and then moderate as we move through the second half. These two elements are expected to largely offset for the full year. SG&A investments will continue to be made in our brands and capabilities. From a phasing perspective compared to adjusted SG&A in 2021, we continue to expect SG&A growth to be relatively consistent with revenue growth for the full year, with second half investment and inflation stronger than in the first half. EPS is now expected to be in the range of $4.75 to $4.85 per share up from $4.65 to $4.75. This EPS guidance does not assume the benefit of any future share repurchases. As I stated in my opening remarks, we are very pleased with the momentum we are seeing in the business. Without question, the environment remains highly dynamic but simply put our strategies are working as reflected in our raised guidance for the year. Moreover, we remain confident in our improving capital allocation optionality, which is particularly important in an uncertain environment. As we have discussed, our approach is multifaceted meaning it does not have to be either/or as we consider these options. But as you are seeing will be a combination. This is allowing us to return cash to shareholders through our superior dividend and increasingly opportunistic buybacks, which combined have returned over $270 million since the start of 2020; and to fortify our balance sheet with over $200 million of net debt reduction over the same period, ending the first quarter in a considerably stronger financial position; and to invest in our business to support future growth such as the talent and demand creation investments Scott touched on earlier; and to pursue potential accretive M&A. The combination of this optionality with improving fundamentals is powerful. And as Scott mentioned, gives us great confidence that Kontoor is on an excellent path. We look forward to sharing more on these initiatives in the coming quarters. This concludes our prepared remarks and I will now turn the call back to our operator.

Thank you. At this time we will be conducting a question-and-answer session. Our first question comes from the line of Jay Sole with UBS. Please proceed with your question.

Great. Thank you so much. Scott, you talked about your comments in raising the full year guidance given macro uncertainty. Maybe can you just elaborate a little bit more on some other aspects that give you the confidence to raise that full year guidance, especially with some of the challenges on supply chain costs? And also maybe you can tell us a little bit more about your assumptions for global and US consumer demands that are embedded in the guidance? Thank you.

Sure. Hey, Jay. How are you? Thanks for the question. Good to hear from you. Jay, it stems from the momentum that we had last year. And that momentum carried into the first quarter this year which we felt really good about. And obviously, we've got a nice view of the second quarter and the rest of the year that gives us confidence in our business. But I'm going to tell you the single most important thing is this is not the company it was four years ago. We've made so many structural changes. We were landlocked a few years ago as far as the channels that we were in. But now the channel work that our team has done across the globe, the categories that we've expanded into, if you think about what's happening now globally as people go back to work and people go back to leisure, think about how we structured the company and how we're set up with people going back to leisure with our outdoor and T-shirt line, people going back to work with our denim line, which has been fantastic because consumers have now gone to a casual workwear attire which has been really important for us. Obviously, China is closed right now. But all of us know and all of us have been doing this a long time, China is going to reopen again and there's going to be some pent-up demand there. And prior to their closing, our business was really strong as we've talked about. And most importantly, our brand is really healthy there and our team is really healthy there. So it gives me really good confidence. And the fact that, since we've come out as a public company, we have navigated some incredibly difficult waters and we continue to do that. And that's a testament to the team that we've put together. But I like the work that we've done the investments that we're making in our business. We've been conservative in our elasticity assumptions and we put ourselves in a position to win from the strategies that we invest in whether it be digital innovation or our people. So feel pretty confident there. And then a little bit about demand. Right now relative to the consumer that we see globally in the North American consumer we see really good demand. We see a strong consumer. We see a consumer that I mentioned earlier that's going back to work, that's getting back into the leisure world, that's going to ball games and picnics and doing those things again, which are all really good for our business. We think that Europe and China will get healthy again. We think of course the China will open up so we feel good about that. But it's what we can control. And that's the most important thing. And what we've controlled is our new business development, the great product that we're putting out there, the demand creation, the work that we talked about that Wrangler has done with Fender, the big campaign that we have right now with both of the brands around the globe, the work that we just did with Smiley from the collaboration. So we're controlling our own destiny and I like how we're doing that and we'll continue to do that going forward.

Okay. Thanks so much.

Our next question comes from the line of Adrienne Yih with Barclays. Please proceed with your question.

Hey, thank you very much. Good morning and nice job in the first quarter. I guess Scott, can you – I'm going to stay on the topic of China for a second. Can you remind us how many Lee stores are there in China? And what's the proportion of your sales that are sort of a Tier 1 or say the impacted cities? What's the expectation for 'the normalization' or kind of like when you would see that demand normalize? And then for Rustin, a couple of questions here. Pricing power, how does the order book look for fall holiday? And any improvement in sort of like pricing power to your channel partners? My last question is, more broadly on transportation. Spot pricing on intermodal coming down, you don't have a lot of exposure to the China Far East manufacturing. So just wondering if you're embedding that into the back half in any way? Thank you very much.

Thanks Adrienne. Adrienne, I'll go ahead and start on China. And then, I'll hand the ball over to Rustin. But from a China standpoint, I look at it like this. Our business there has been extremely healthy. We introduced the Wrangler brand last year, during a difficult time to introduce it there during the pandemic, but it has caught on with the consumer and they're really now starting to get it. Our network is really stable there as far as our franchisees and our own stores. Our team is really stable. We really like the team. We really like the leadership. Most importantly, as I mentioned brand health is exceptional. We had a really good last year. We had great momentum going in this year. We are really strong in January and February. And then, obviously, the lockdown, if you think about our business as we stated before we are really strong on the Tier 1 cities the Beijing, the Shanghai the Hong Kong, and then that's where the opportunity lies. So as we build our model out as China's Tier 2, Tier 3 and Tier 4 cities get larger and more metropolitan and sophisticated we have an opportunity to go ahead and build our model out in those cities. So we think that there's really, really big green space opportunity going forward in China in a pretty significant way. And again, it's a top-of-the-line brand with extremely good brand health with a very young consumer and a brand that's very well known. We've been there 20-plus years have a really strong leadership position there. So feel really good about China going forward. And like everything else these things happen. But China will open and we will continue to grow there and feel good about the team.

Great. Thanks.

Thank you. Good morning, Adrienne. It's Rustin. I want to discuss the pricing power in our order book and the intermodal aspect you mentioned. Looking at inflationary cycles, each has its unique characteristics. However, our brands are in a much stronger position compared to the last cycle, and we believe we are well-prepared for several key reasons. First, the strength of our brands is crucial, as Scott highlighted. Our strategic focus on categories such as western wear, workwear, and collaborations is significantly enhancing our brand strength and momentum as we move into the second half of the year, providing us with a great opportunity to implement strategic pricing. Additionally, our investments in demand creation are boosting engagement with both new and existing customers, which we are seeing reflected in growth, particularly in the female segment mentioned in our earlier remarks. This improvement supports our confidence in our raised guidance. However, we are taking a cautious approach, as discussed in our remarks. We have been prudently cautious regarding China, EMEA, and consumer demand, as Scott pointed out, factoring this into our projections. Our updated guidance indicates that first half revenues are expected to increase by the mid-teens compared to the low-teens in our previous guidance, with full-year growth around 10%. Consequently, this suggests mid-single digit revenue growth in the second half. Despite these assumptions, we remain optimistic about our brand strength and momentum. Regarding intermodal, we are closely monitoring supply chain movements—including distribution and transportation across various modes. We are fortunate to have what we consider a world-class supply chain that supports us in navigating these challenges. In the first quarter, we noted transitory headwinds impacting our performance, and we are adjusting for the latest insights regarding intermodal and other transportation elements in our guidance, maintaining our full-year gross margin at 44.6%, consistent with last year.

Fantastic. Super helpful. Best of luck.

Thanks, Adrienne.

Thanks, Adrienne.

Our next question comes from the line of Brooke Roach with Goldman Sachs. Please proceed with your question.

Good morning and thank you so much for taking my question. There's a lot of moving pieces within the margin profile of the business. But I heard in the prepared remarks that you're now anticipating even better sequential improvement in your structural gross margin drivers relative to the last call. And I was wondering if you could talk to the drivers of that sequential improvement in the structural gross margin gain. What is it that's driving that improvement? And then perhaps on offsetting that can you quantify the pressure that you anticipate in 2Q and into the second half between China AUC and air freight? Thank you.

Sure. Good morning. Let me address those points. We are pleased that our first quarter gross margins exceeded our expectations, which is encouraging. In our guidance, we mentioned anticipating up to 100 basis points of temporary headwinds on an annual basis, mostly affecting the first half as we respond to demand. This is evident in the first quarter. For the full year, we spoke about previously anticipating up to 100 basis points of structural margin gains. Given the first quarter results and current observations, along with projected input costs that will affect the 2022 P&L, we see a chance to exceed that 100 basis points improvement structurally, prior to considering the mix impact from China. This allows us to manage the unexpected mix effects from China while remaining in that structural margin improvement range. Regarding Q2, we are approaching it with caution, especially in the Chinese market. However, we are fortunate to counterbalance the expected impact from China with strong performance in the US, allowing us to maintain our previous revenue guidance of $640 million to $650 million for the second quarter. Nevertheless, there are mix challenges impacting Q2 gross margins, with fluctuations in oil prices and other factors contributing to our guidance adjustments. This is causing some pressure on EPS for the second quarter. That said, we expect to keep the first half EPS largely in line with earlier projections, and we're confident enough to raise our full year EPS outlook.

Thank you. And then maybe just a follow-up for Scott. As you look across your network of the business across the US, can you talk to the areas of the portfolio where you're seeing the most strength in demand? And where that demand is really coming through as a result of the increased demand creation spend that you've been putting into that market? Thank you.

Yes, I can do that, Brooke. We've talked about our strong core denim business, which has seen great demand. This is partly due to our increased investment in demand creation, making people more aware of our brands, as well as our expanded channels. Additionally, there's a shift in how people dress for work and socializing, leaning towards a more casual style, and we are well-positioned to benefit from this trend. We're also focused on creating excellent products that resonate with consumers. Starting with high-end retailers like Nordstrom and offering a solid range of products contributes positively to our brand health. We are also seeing robust demand for new categories like T-shirts, outdoor apparel, and workwear, backed by significant investments. The consumer response to our outdoor category has been enthusiastic; they appreciate the value and performance of our products. The T-shirt segment has been particularly dynamic, and our workwear roots have significantly aided us in this area. One key focus for us has been developing a digitally-driven brand, as highlighted in our prepared remarks today regarding our digital business growth, which is outpacing our initial projections from Investor Day. We have assembled a team that understands consumer behavior and how they're migrating online, which enhances our brand mix. Lastly, there's strong momentum in the western business across North America. People seem eager to spend time outdoors, and I believe this trend will continue. Wrangler, having originated as a western brand, is well-positioned to thrive in this strong category. I hope this information is helpful.

Thank you so much,. I will pass it on.

Our next question comes from the line of Bob Drbul with Guggenheim Securities. Please proceed with your questions.

Hi. Good morning. I have a couple of questions. First, could you provide more details about your European performance and outlook by country? Have you made any adjustments to your plans regarding expectations for the second half of the year? I'm trying to get a clear picture of how you're viewing the market and if there have been any significant changes recently. My second question is about gross margin. With respect to air freight, can you confirm if you are finished with significant air freight for the year and your gross margin expectations? Finally, could you give us an update on capital allocation, specifically regarding the share price and the current levels of shares, including the share repurchase program? Thank you.

Thank you. I'll begin by addressing the questions regarding Europe and gross margin before handing over to Scott for the capital allocation inquiry. If we take a broader view of our European operations, we are mainly focused on Western Europe, as noted earlier. We reported that the impact of Russia and Ukraine is minimal to our overall business. In the first quarter, we experienced a strong performance with a 19% increase in constant currency in Europe. It may be somewhat uneven as we progress through the year. In the second quarter, you may recall that Europe began their ERP implementation at the start of the third quarter, which affects our timing. Consequently, the second quarter in Europe will face more challenges due to the timing changes from 2021 in that market. However, we expect a stronger third quarter, particularly when compared to last year’s go-live. It's important to note that Europe, in comparison to our U.S. operations, has a significantly smaller impact. We continue to focus on what we can manage in that market. Our Wrangler brand has shown impressive performance across nearly all markets in Europe, especially in Western Europe. Regarding airfreight, we anticipate up to 100 basis points of temporary additional costs in 2022, mostly occurring in the first half of the year. Reflecting back on the latter half of 2021, we observed supply chain disruptions beginning in the third and fourth quarters, contributing to extra costs. The added temporary costs we expect will mainly be in the first half as we respond to demand and work towards a stronger inventory position by the end of the second quarter.

Hi, Bob. How are you?

Good Scott. Thank you.

Thanks. I would say for us really you think about capital allocation and how we think about it we paid our debt back much quicker than we thought because we create so much cash that we put ourselves in a really great position. So if you think about how we kind of positioned ourselves. I think back to last year we increased our dividend. We already had a very strong dividend and increased it 15% on top of that. So the yield today with a very attractive stock price is really significant obviously because of that increase in the dividend and what was already there. In addition to that, creating $1 billion in cash over a three-year period puts us in a position where if we wanted to pay back some more debt, although we feel like we're in a really good position there we could. We've been buying back shares as you know. We bought back last year and we bought back this quarter. We still have dollars available in our share repurchase program that's out there right now. So we still have a big incremental piece that we can do. We do like the stock at the price it is now. Obviously, we were buying back in the first quarter. But we're also still thinking about M&A too. But M&A has got to be right. It's got to be the right price. It's got to be the right fit. It's got to work with our company and our brand. And we have to be able to add value to it. And really be able to show the investor world why and how and make sure it has value. But I think most importantly is that we're going to continue to create this cash. And we don't have to do just one thing. That is probably the most important thing, we're creating so much cash that we can do everything I just said and still be in really good shape and execute in all. And quite frankly, as you know we're executing on a few of them right now as we speak and still generating aggressive cash. So we're going to continue to be aggressive in our share buyback going forward. We're going to continue to do everything we can to make sure we're running a really good business and investing back in the business and investing back in the brands and the people. So hopefully, that answers your question, but I really like where we sit right now.

Thank you, Scott.

Thanks, Bob.

Our next question comes from the line of Sam Poser with Williams Trading. Please proceed with your question.

Thank you for taking my question. Good morning.

Good morning.

I have a few questions. First, regarding China, you mentioned it was performing well in January and February. Could you provide more details on what you observed during that time and how that compares to what you're expecting for the second quarter, given the strong start to the year?

Good morning, Sam. It's Rustin. I'll address that question. As we noted in our prepared remarks, we experienced strong performance at the beginning of the year, significantly surpassing last year and our plans through February. However, we began to notice a decline in March and April as lockdowns spread. We are confident that this decline was not due to issues with our strategies or brands, but rather a result of reduced traffic. We are actively monitoring the situation. We have taken a cautious approach to our Q2 outlook for China given the current circumstances, which remains very dynamic. I hope that provides some additional context.

Well, I mean you said that all before. I'm wondering sort of like what it significantly mean were you up 20% going in and then it fell to low single-digit or negative? I mean that's what I'm trying to just sort of get some context to sort of the definition of significantly?

Yeah. I understand, Sam. I'm not going to break out individual numbers by market. But certainly, you know that our China growth rate is out there on a long-term basis. We're investing heavily in the region. And so certainly have growth expectations that are out there in that double-digit range longer term as we've talked about. So certainly, we're taking a more conservative look in Q2 and a cautious look on the full year, but not going to provide specific numbers.

Okay. You mentioned the investment in demand creation across the board and that it was effective. Can you provide some insight into the first quarter regarding your expectations for demand creation versus what you actually achieved? For example, did the demand creation contribute to a 10% increase over your initial projections? What portion of the positive results in the first quarter can be attributed to demand creation?

When we think about demand creation, we consider the total shareholder return perspective. While we do look at it on a quarterly basis, we don't set our expectations and plans based on that. Instead, we evaluate it on a program basis. For instance, when we expedited some demand creation in the fourth quarter last year, it was intended to support not only the holiday season but also the first half of 2022. We're currently in that phase now. Scott mentioned the campaigns, and we have a positive outlook on them. The mid-single to mid-teen growth in demand creation during the first half is a critical aspect of that and helps maintain brand strength, but we won't disclose specific return figures today.

Yes, Sam, this is the first time in the past three years that our consumers have consistently seen our advertising efforts since we took over the business. Four years ago, we would quickly implement short-term campaigns and then move on, as we didn't have the budgets for long-term consistency. Now, our consumers are experiencing various exciting initiatives, and we are exploring new digital approaches like never before. It’s a consistent message, and I believe this has been very helpful and beneficial for consumers globally, which is crucial.

Thanks. One last question. When you updated your first half guidance on March 8th, many of the numbers changed. For example, a lot of the combined estimates on the Street were very close to where you ended up in Q1, and the estimates for Q2 were fairly aligned with the guidance for Q2. Can you provide some specifics on what drove the results in the last three and a half weeks of March that led you to exceed that number? Additionally, what contributed to the lowered Q2 expectations? There seems to be a bit of variability, so any context you could provide would be appreciated.

In the first quarter, we provided a revenue guidance on March 8 of $650 million to $660 million. We've been addressing demand while navigating global supply chain challenges. The demand for our products is strong, and when we have the product available, we can meet that demand. This was evident in the first quarter, where we were able to expedite product shipments and exceeded our revenue expectations. Looking ahead to the second quarter, the main issue has been China. While oil prices have fluctuated, the primary factor affecting our performance was China. We managed to maintain our top line because of the strong demand coupled with product availability. We were also able to mitigate the impact of the softness in China due to lockdowns. From a profitability standpoint, we adjusted our guidance to reflect the mix impact of shifts between China and the US, as well as inflationary pressures. This should clarify the changes from our March 8 guidance. Thank you for the question.

Thanks, Sam.

Our final question comes from the line of Jim Duffy with Stifel. Please proceed with your question.

Hi, guys. This is Peter McGoldrick on for Jim. Thanks for taking my question. I was just curious on the brand outlook into second quarter and the rest of the year. Lee, obviously, is impacted by outside China exposure. But how do you think of the building blocks to your updated guidance? What has changed over the last few months on a brand growth perspective?

Yes. Peter, thanks for the question. It's Rustin. I'll go ahead and take that with the outlook. Certainly, first quarter and as we've talked about, we see strength in both brands moving forward, as we laid out at our Investor Day. So I feel really good about both brands. You're correct that, certainly, China today is much larger in Lee than it is in Wrangler, so we'll have a little bit more of an impact from that perspective. But, again, the strength you saw in the first quarter here, with the brands being up mid-single digits to high single digits, depending upon the brand, we see strength and momentum moving forward with both brands but Lee will be more impacted by China.

Okay. And then, finally, just looking at the embedded assumptions for AURs and unit costs and their influence on gross margin for the balance of the year, what's your capacity to adjust for the rest of the year on the pricing side of the equation? And how should we expect that to progress quarterly?

Yes. Certainly, we've passed strategic price and we've reflected that in our outlook here, Peter. We're going to continue to monitor the situation, as everyone is doing. And certainly, we'll adjust accordingly, but feel good about kind of the price, the combination of that strategic pricing, mix improvement, the cost savings, we talked about that, the ability of that combination of those three to be able to offset inflation that we see today. And that's what's reflected in our guidance. Certainly, we'll continue to monitor the environment as we do every day. Thanks Peter.

Thank you.

Ladies and gentlemen, we have reached the end of the question-and-answer session. I will now turn the call over to Scott Baxter for closing remarks.

I want to express my gratitude to everyone for participating in the call today. I understand that these are challenging global circumstances right now. However, at Kontoor, all our employees around the world are fully committed to managing our environment and achieving positive outcomes for our shareholders in the future. I hope you have recognized the leadership our team is demonstrating worldwide to accomplish this goal. Thank you once again, and we look forward to reconnecting with you next quarter. Thank you.

This concludes today's conference and you may disconnect your lines at this time. Thank you for your participation and have a wonderful day.