Kontoor Brands, Inc. Q3 FY2023 Earnings Call

Greetings and welcome to the Kontoor Brands' Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Eric Tracy, VP, Corporate Finance and Investor Relations. Thank you. Please go ahead.

Thank you, operator, and welcome to Kontoor Brands' third quarter 2023 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. 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 today's call will be in constant currency, which exclude the translation impact of changes in foreign currency exchange rates. Joining me on today's call are Kontoor Brands' President, Chief Executive Officer and Chair; Scott Baxter; and newly appointed Chief Financial Officer, Joe Alkire. Following our prepared remarks, we will open the call for your questions. We anticipate the call will last about an hour. Scott?

Thanks, Eric, and thanks to all of those joining us on our call. I'm pleased to share that we delivered Q3 results above our expectations, most notably with an upside to our topline. Our strategic playbook is working, which is why I’m so confident in the next phase of Kontoor's evolution, even as we assume a more challenging macroeconomic backdrop. On the bottom line, excluding the duty charge, which Joe will provide more detail on shortly, operating results also exceeded our plan. Global Kontoor revenue increased 8%, including about a point of foreign exchange benefit, with particular strengths in the US across both wholesale and D2C. Within the US market, ongoing strong point of sale and share gains were driven by accelerating shipments during the quarter. According to Circana, focused on the US total measured market, we continued to outpace the market in our US wholesale and core denim business during the third quarter and here to start Q4. Notably, for the last three months, Kontoor Brands outperformed the market by approximately 140 basis points and in men's bottoms, we outperformed our largest competitor by 170 and over 250 basis points, respectively. In women's, our lead business gained over 60 points of share to the market, outpacing our closest competitor by 30 basis points. Importantly, even after aggressive pricing actions taken by select peers, we've continued to see market share gains. For example, over the last month, our Wrangler men's bottoms business outpaced our largest competitor by over 250 points, while Lee's men's outperformed by roughly 150 points. Our share gains in the core are in large part due to strategic investments in our brand across innovation, design, and demand creation. I'll touch on examples of our elevated demand creation and innovation platforms shortly. This strength in our core is complemented by category extensions as we diversify our product assortment beyond denim bottoms. Global highlights on a reported basis include outdoor apparel, which is up more than 30%. Our D2C business once again delivered broad-based strength in the quarter. Globally, Kontoor D2C increased 6%, led by our own.com, up 10%. In the US, own.com increased 11%, balanced across brands with Wrangler and Lee both experiencing double-digit gains. International D2C remained healthy in Q3, increasing 5%, with Wrangler increasing 21% and Lee increasing 2%, or up 15% excluding China. And within international, we did see choppiness during the quarter with expected softness in China more than offsetting reported gains in Europe. Importantly, we are seeing China trends accelerate here in Q4 and continue to anticipate the region to return to significant growth in the quarter, increasing by over 20%. D2C and International are key areas of growth for Kontoor going forward with significant whitespace in each, as these segments represent only 12% and 21% of our last 12-month mix, respectively. The KTB investment thesis remains highly differentiated relative to many of our peers that operate more mature D2C and international businesses, and the diversified and accretive growth that these opportunities afford is still very much ahead of us. We will use ongoing structural gross margin improvement from these areas to help fund amplified investments in critical growth enablers such as talent, innovation, and demand creation, creating a virtuous cycle for sustained topline growth over the long term. So, let me touch on these a bit more in detail. First, with demand creation. Starting with Wrangler, Q3 was the biggest demand creation quarter the brand has ever experienced in its 75-year history. Strategic partnerships with Sandro, Stroud, Mini Rodini, and Barbie not only support our efforts to reach female and youth demographics, but also do so in an elevated brand-enhancing manner across the globe. The Wrangler and Barbie collection was our best and fastest-selling collaboration ever. Inspired by powerful cowgirls, the collection combines heritage denim with bold prints, further advancing Wrangler's diversification strategies to attract new and younger consumers while remaining authentic to the brand. Also in Q3, 'Made by Cowboys For Cowboys' took on a whole new meaning as Wrangler became the official jeans of America's team, The Dallas Cowboys. The sponsorship will run over three years, amplified via an integrated media platform, signage, and activations at AT&T Stadium. Social content featuring players and cheerleaders, retail promotions, and a monthly concert series will follow. This connection of two iconic American brands doubles down on our Texas Heartland, and we couldn't be more excited about future opportunities to build on the partnership. As we began Q4, the demand creation momentum for Wrangler continues. Just yesterday, we teased the launch of our collaboration with iconic premium Bourbon brand Buffalo Trace. Fittingly, it kicks off with a launch party next week at New York City hotspot, Rai's Bar. And then in December, the brand once again takes over Las Vegas at the Wrangler National Finals Rodeo. This year promises to be even more special as country music superstar and our first female music endorser, Lainey Wilson, hot off her record-breaking nine CMA nominations, is scheduled to open the Rodeo on December 15th. Lainey will also host a four-night concert series sponsored by Wrangler to close out the biggest weekend in Rodeo, wearing her iconic Wrangler flares and Bell Bottoms on and off stage. Turning to the Lee brand, Q3 saw another quarter of tremendous return on marketing investment and importantly, this was apparent on a global scale. During the third quarter, the Lee brand launched its newest and most iconic female fit, the Rider Jean, inspired by our very first women's denim line, the Lady Lee Rider, and made modern for today's woman. The global campaign shot by Mark Seliger launched mid-September and has sparked new excitement in our women's premium denim collection. Additionally, trend-right collaborations with culturally relevant brands such as Dragon Ball Z, Roaring Wild, and Daydreamer continue to extend Lee's reach to a younger, more diverse audience. In Q3, Lee ramped up its presence in Southern California as the Lee and Daydreamer partnership took over the iconic Fred Segel Shop on Sunset Boulevard with a two-week showcase of the collection. This launch leaned heavily into Daydreamer's LA cool aesthetic through key premium distribution in Fred Segel and Revolt. In September, the brand hosted a unique, one-of-a-kind experiential event at the Ed Sheeran concert at SoFi Stadium in L.A. with attendees, influencers, and celebrities from all over the world. The momentum has carried into Q4 as Lee is currently ramping digital campaigns in support of its Ultralux and extreme motion innovation platforms. To further drive brand separation in the marketplace, we are amplifying our focus on innovation as our pipeline is healthy and accelerating. A perfect example of innovation that cuts across both product and manufacturing is the Indigood platform, which continues to scale, delivering water and cost savings. We recently announced that we surpassed our 2025 water savings goal of over 10 billion liters of freshwater, two years earlier than anticipated. This accelerated accomplishment demonstrates our commitment to sustainability and the effectiveness of the Indigood program, which also creates an important industry standard for others to follow. I'm proud of the work we are doing to save water with platforms like Indigood and other cutting-edge technologies, such as digital printing, driving towards a future where all jeans can be created using zero freshwater. Other innovation platforms such as Extreme Motion, Ever Fit, and Ultralux for Lee, as well as ATG in a performance specialty fishing line Wrangler, Angler, not only diversify our offerings but also elevate their appeal that mixes up average unit retails and gives the brands increasing permission to play in more premium points of distribution. We have a ton of brand momentum for the balance of the year and into 2024; just one of the factors that gives me great confidence in the future. We don't develop this heat without investing strategically behind the brands. We will continue to amplify our strategic spending in support of diversified growth across categories, channels, and geographies. But make no mistake, we love how we are positioned in taking share within core US wholesale with incredible partners such as Walmart, Amazon, and Target, as well as Western Specialty. Retailers that align and support our brands' value proposition with consumers are especially important given the macro challenges around the world. Structurally accretive growth particularly in D2C and International helps fund these key investments, as does our ongoing evaluation of our operating model to find ways to reduce non-strategic spending, simplify processes, and enhance efficiencies, including within our supply chain. Our proactive restructuring actions last quarter, along with amplified inventory actions we are taking now, are good examples of strategic investments for a healthier foundation to build upon. Rest assured, we are just in the beginning stages of transforming our model for the future, with substantial opportunities to unlock value over time. Stay tuned for more information on this. These actions also help accelerate cash generation, creating significant opportunities to return cash to shareholders, as evidenced by our recently announced increase to the dividend. Our capital allocation flexibility remains robust. This combination of cash flow optionality and resilient fundamentals, even during a challenging macro environment, creates a powerful backdrop supporting superior total shareholder returns over time. We look forward to sharing more on our long-term strategic vision at our Investor Day. Joe?

Thank you, Scott, and thank you all for joining us today. Before I review the third quarter, let me say how honored and appreciative I am to have the opportunity to serve as CFO of Kontoor Brands. I am thrilled to reunite with the Kontoor family, and I want to express my gratitude to Scott, the Board, and the organization for the support as I transition back into the business. I feel a tremendous amount of responsibility and stewardship to all Kontoor employees around the globe as well as those who have come before me and built the strong foundation in place today. I'd also like to extend a special thank you to Rustin, who has been a strong resource for me during the transition. He will be missed, and we wish him and his family all the best in retirement. With that, let's review the third quarter. Global revenue increased 7% compared to the prior year, as broad-based growth in the US in both wholesale and DTC was partially offset by a decline in international. Our third quarter results reflected the strong momentum of our brands, as evidenced by continued market share gains and point of sale strength across key accounts and distribution channels. On a regional basis, US revenue increased 12%. Direct-to-consumer grew 7%, including 11% growth in digital. In the wholesale channel, revenue increased 12%, with strong performance from both brands. In addition to strength in our core categories, we also drove growth in outdoor and non-denim bottoms as category expansion remains a top strategic priority. While retailers remain cautious, inventory levels in the channel continue to improve, and are more balanced as POS and shipments work towards equilibrium as we enter the holiday period. As expected, international revenue decreased 8%, driven mainly by China, which fell 19%. As we discussed last quarter, the recovery in China will not be linear, a result of COVID-driven lockdowns and re-openings from a year ago. Regarding our outlook, we anticipate more than 20% growth in the fourth quarter, and importantly, as we enter 2024, the underlying fundamentals of our business in the region have improved. Inventory levels across our retail network have returned to more normalized levels, and we are entering next year with a stronger foundation from which to grow. We see significant long-term potential in China and expect growth to accelerate next year due in part to strategic investments we are making in the region. In Europe, revenue decreased 4%, with double-digit growth in DTC offset by a decline in wholesale. While we expect the macro environment to remain difficult in the near term, we are encouraged by the strength of our DTC business across both brands supported by investments we've been making in the platform. Turning to our brands, global revenue for the Wrangler brand increased 9%, driven by growth in both wholesale and DTC. The ongoing diversification into non-denim categories continues to drive brand momentum with particular strength in outdoor and non-denim bottoms. The brand's targeted investments in demand creation, strategic partnerships, and innovation continue to drive strong market share gains across the retail landscape. In the US, revenue increased 10%, with wholesale, own.com, and brick-and-mortar all contributing to growth. Wrangler International Revenue increased 2%, driven by 21% growth in DTC and a modest increase in wholesale. Turning to Lee, global revenue increased 3%. Growth was driven by strength in the US, with wholesale increasing 23% and own.com increasing 11%. In addition to growth in core denim, non-denim bottoms also performed well in the quarter, contributing to growth. Lee International Revenue decreased 13%. In Europe, revenue decreased 3%, with 15% growth in DTC more than offset by a decline in wholesale. In APAC, as expected, revenue decreased 18%. From a channel perspective, US wholesale increased 12%, while non-US wholesale decreased 10%. Global direct-to-consumer was up 6%, including a 10% increase in own.com, and brick-and-mortar was up 2%. Turning to gross margin, as shared in this morning's release, the quarter was impacted by an unanticipated 200 basis point charge from duty expense related to prior periods. The issue was identified late in the quarter and arose from the ERP implementation dating back to 2021. Excluding the duty expense, gross margin was flat versus the prior year at 43.5%. Gross margin in the quarter also included the impact of proactive inventory management actions. These actions relate to clearing through non-core inventory as we aggressively focus on reducing overall inventory levels and exiting 2023 in a clean inventory position. While these actions negatively impact gross margin in the near term, they enhance the quality of our inventory and yield additional cash generation. Further, excluding the impact of these actions and the duty charge, gross margin increased versus last year, which was largely consistent with our expectations. The increase in gross margin was driven by channel mix, pricing, and lower transitory costs such as air freight. SG&A expense was $186 million. As a percentage of revenue, SG&A decreased 30 basis points to 28.4% versus adjusted SG&A in the prior year. Strategic investments in DTC and demand creation, alongside increased distribution costs, were partially offset by disciplined management of discretionary expenses and operating leverage. Operating income was $85 million as reported, or $99 million excluding the duty charge, an increase of 10% compared to adjusted operating income last year. Excluding the duty charge, the operating margin increased 30 basis points to 15.1%. Earnings per share was $1.05 compared to adjusted EPS of $1.11 last year. The quarter included a 17-cent negative impact from the duty charge. Excluding the duty charge, Q3 EPS was $1.22, representing a 10% increase versus prior year ahead of our expectations. Turning to our balance sheet, third-quarter inventory decreased 11% compared to last year. We made more progress than expected on inventory during the quarter due to stronger than expected revenue and inventory management actions. While inventory levels are still elevated, we remain comfortable with the quality of our inventory and its ability to support our forward growth plans. We expect inventory levels to decrease by approximately $100 million by the end of the year to approximately $500 million. We finished the third quarter with net debt, or long-term debt less cash, of $708 million and $78 million of cash on hand. Our net leverage ratio, or net debt divided by trailing 12-month adjusted EBITDA, was 1.9 times at the end of the quarter, within our targeted range. We expect net leverage to approximate 1.6 times by the end of Q3. As previously announced, our Board of Directors declared a regular quarterly cash dividend of 50 cents per share, representing a 4% increase. At the end of the third quarter, we had $62 million remaining under our share repurchase authorization. We did not repurchase shares in the third quarter. Regarding our outlook, revenue is expected to increase approximately 1% compared to 2022. This compares to our previous outlook of a low single-digit increase. Our updated outlook includes the following expectations. First, we continue to anticipate a more challenging US macro environment in the fourth quarter. We are pleased with the strength we delivered in the third quarter and are encouraged that positive point of sale trends have continued as we start the fourth quarter. However, we believe it prudent to plan the business conservatively, given the macro uncertainty. Second, we expect relatively stronger performance in international markets in the fourth quarter, driven by China, as well as continued growth from our global DTC business. Gross margin is expected to approximate 42.5% on an adjusted basis, including a 40-basis point impact from the duty charge, as well as the proactive inventory management actions, compared to our prior outlook of 43.5% to 44%. Our updated outlook implies fourth-quarter gross margin expansion of approximately 300 basis points, driven by ongoing structural mix, strategic pricing, and a decrease in input costs, partially offset by inventory management actions. As we look to 2024, based on current visibility, we expect the combination of lower input costs and structural drivers in margin, mainly DTC and international, to drive significant gross margin expansion. While we expect this to result in accelerated earnings growth, it also provides the investment capacity needed to continue investing behind our brands and enterprise strategy. SG&A is now expected to increase at a low single-digit rate on an adjusted basis compared to 2022. We will continue to prioritize investments in our brands and capabilities in support of long-term accretive growth while remaining diligent regarding discretionary spending. EPS is now expected to approximate $4.35 on an adjusted basis, including an approximate 15-cent negative impact from the duty charge. Excluding the duty charge, full-year adjusted EPS is expected to be approximately $4.50. We expect full-year operating cash flow of approximately $335 million. We expect to end the year with approximately $500 million of inventory, representing more than a 15% decrease compared to the prior year. We also expect to close 2023 with approximately $200 million of cash on hand and roughly $700 million of liquidity, supporting significant capital allocation options as we move into next year. I'd like to take a moment to highlight the fundamental profile of our business in the second half of 2023, based on our updated full-year outlook. Our quarterly results this year have been volatile from a comparability standpoint, making it somewhat difficult to understand the true underlying trajectory of our business as we move forward. Looking at our business by half presents a clearer picture and one that is more representative of our expectations going forward, the earnings power of the business, and the uniqueness of our model. For the second half, we expect approximately 2% revenue growth and, excluding the duty charge, close to 200 basis points of gross margin expansion and double-digit operating earnings growth. While we expect macro challenges to persist through at least the first half of 2024, the drivers of our second half 2023 fundamentals, mainly gross margin expansion, will carry into next year and support accelerated earnings growth and cash generation. Additionally, we expect to achieve more steady-state inventory levels, further contributing to an increase in cash generation, and we have a balance sheet that can support significant capital allocation flexibility. While we will remain disciplined and rigorous regarding capital deployment and balance sheet management, we have a number of levers to pull to drive strong total returns for stakeholders, regardless of the operating environment. To wrap up, I'd like to offer some perspective based on my observations during my first couple of months at Kontoor. First, I am confident in Kontoor's opportunity to deliver sustainable growth and returns on capital. The brands are strong, we are investing appropriately behind a focused strategy, and there is significant white space to drive accretive growth through expansion in under-indexed channels and categories. Second, there is significant opportunity to expand gross margin. We have visibility to lower input costs next year and structural margin drivers, such as DTC and International, will support sustained gross margin expansion over the medium to long term. Our global supply chain strategy is evolving, and we have identified several initiatives, including SKU rationalization, that we expect to drive incremental gross margin benefits and net working capital reductions over a multi-year horizon beyond our previous expectations. These benefits are both upstream and downstream and will fundamentally transform how we go to market and our operating model. Third, we are committed to driving greater efficiency in the business. We will pursue multiple initiatives to reduce complexity, leverage our platforms, increase agility, improve profitability, and create additional investment capacity for our brands. These initiatives will be rolled out over a multi-year horizon and will further transform our operating model and unlock significant value. We look forward to sharing more details on these topics at our investor day next year. This is an important time for Kontoor. We are focused on fundamentals, execution, and long-term total shareholder return. I am confident we have the team in place to deliver on the opportunities ahead and I am excited to partner in driving the next chapter of growth and value creation for Kontoor. This concludes our prepared remarks. I will now turn the call back to the operator.

Thank you. Ladies and gentlemen, the floor is now open for questions. Today's first question is coming from Mauricio Serna of UBS. Please go ahead.

Thanks. Good morning and thanks for taking my questions. Maybe just to start with the duty expense, can you give us more color around it? Should we think about the fiscal year 2023 EPS guide now at $4.50, really? And then on the gross margin and inventory actions, it's great to see the sequential improvement there. Could you talk more about the amplified inventory actions taken? Still seems that you want to be proactive and make sure you come out in a clean position out of 2023. Is that the way to really think about it? Thank you.

Hey, Mauricio. Good morning. It's Joe. Maybe I'll start with the duty and then I'll let Scott kick off the inventory conversation. So, yeah, on the duty, the issue primarily relates to prior periods, specifically 2021 and 2022. As we stated in the prepared remarks, we identified the issue late in the quarter, and it really dates back to the ERP implementation. For perspective, the duty charge was $13 million over a two-and-a-half-year period on total cost of goods sold over that same timeframe of several billion dollars. So, we won't get into the accounting technicalities regarding why the charge is presented as GAAP versus adjusted, but the charge was a prior period adjustment, essentially a correction of an error and just out of the period. So, this charge was not contemplated in our prior outlook. As you think about the appropriate baseline for underlying earnings in 2023, we view $1.22 and $4.50 of adjusted EPS respectively as more representative going forward.

Fantastic. Thanks, Joe. Mauricio, thanks for the question. We thought about what we wanted to do to position ourselves for 2024, and we started this process a little bit with our manufacturing downtime in the beginning of the year. Then we had such broad-based strength in our business that we knew we could be aggressive and clean everything up. It was the right thing to do from a hygiene standpoint for our business. It frees up a tremendous amount of cash that we can reinvest back in the brands and back in our people. We're investing back in the business because of this. It optimizes our distribution centers and supply chain, which is great. An action like this benefits almost every aspect of our business, so we're really excited about our position from an inventory standpoint heading into 2024. It's been difficult for many over the last couple of years, but right now we are in a fantastic position. Joe, any additional comments there?

Yeah, maybe just a few. These actions, as Scott said, were proactive and the right decisions for the business. We're clearing through non-core inventory. The majority of our inventory remains core, over 85% or so. In terms of these actions, our inventory levels continue to normalize. We're almost there. These actions are evergreen, but in terms of the more elevated impact, we'll be through that pretty much by the end of this year.

Thank you. The next question is coming from Bob Drbul of Guggenheim. Please go ahead.

Hi. Good morning, guys. And Joe, welcome back. Congratulations. I guess I have two questions I'd like to really focus on. The first one, Scott, from your perspective, when you look at the macro, you touch a lot of different price points now and distribution channels. Can you just give us maybe your perspective on a high level around the consumer, around the macro, sort of even more recent and in the sort of the next few weeks as you think about the holiday season? And then the second question I have is, you talked a lot about the share gains and some of the point of sale strength that you've seen in the third quarter. It seems like you're seeing it in the fourth quarter. Can you just talk a little bit more about the dynamics, maybe, pricing, competition, anything more around what you see unfolding around these share gains and the sort of categories that you're competing in? Thanks.

Sure, you bet. Good to hear your voice, Bob. Thanks for the question. I'll start and then toss it over to Joe. From a macro standpoint, we've discussed that we thought the consumer would be a little stressed as the year progressed, but I actually think we’ll have a good holiday season. The consumer always shows up around the holiday season. We've taken a lot of share in the past couple of years, which has been really important to our brands. What that means is you see our brands in a more elevated way and also in a bigger distribution from a real estate standpoint. What's happening is our brands are priced right, providing tremendous value. Two components have been really important: one, our demand creation is at a new level, and people are walking into our big customers and saying, 'hey, where are Wrangler and Lee? I have to have them.' We're seeing our brands everywhere, like at a Dallas Cowboys game or in Austin City Limits. We're gaining share thanks to strong demand creation, and the D2C standpoint is significant for us; we’re expanding both our networks. That’s why I feel good about our consumers and controlling our own destiny going forward. Joe, any comments about share gains and pricing?

Just a few on pricing, Bob. For us, pricing has been a tailwind this year. There's really nothing fundamentally different compared to the prior outlook on the pricing front. As Scott said, our market share gains remain strong. Performance at point of sale remains strong. These brands are performing at retail, and while pricing is a conversation with retailers, it's just one factor in the grand scheme of our gross margin front.

Thank you. The next question is coming from Brooke Roach of Goldman Sachs. Please go ahead.

Good morning, and thank you for taking our question. Scott, I wanted to follow-up on Bob's question and just get a little bit more sense of what's changing in the macro outlook that's caused you to be a little bit more cautious on the year. It sounds like there's a little more caution into the first half of next year, despite the ongoing strength of your brands and the share gains. Is there any one particular region, channel, or type of product that's causing this incremental conservatism?

So, Brooke, not cautious at all. I still feel great about the business. Our point of sale remains strong and positive. Our customer may be a bit more cautious in their ordering patterns, but let me really clarify this. Because our share gains are strong, our point of sale is solid, and our demand creation is hitting on all cylinders, it creates an environment where stakeholders need to reorder our products. I feel really good about what's happening in our business right now. I've been with the company as CEO for five years, and recently, I've told the team I've never felt better. This team, our business, and the products we’re creating, leave me confident. Joe, will you add anything?

No, I think you covered it.

Great. And then maybe a follow-up for Joe. Can you elaborate on the incremental changes in your outlook for gross margin beyond the duty charge? How much additional margin headwind are you seeing this year from inventory clearance actions? Can you contextualize the level of transitory headwinds that are still weighing on gross margin in Q4, where we might see some better visibility on those returning to normalized levels into 2024? Thank you.

Sure, Brooke. For the quarter, excluding the duty charge, gross margin was flat. That included the inventory management actions that we took, which was about 30 basis points. So, excluding those, gross margin increased year-over-year pretty much as we expected with main drivers being price mix and lower transitory costs such as air freight offset by still higher input costs moderating versus Q2, but still elevated. For the full year, we were at 42.5 or 42.9 when excluding the duty charge. That's about 60 basis points off the low end of our previous outlook, with the biggest driver being inventory actions. There's a little mix-related impact with the tightened revenue range, and we have ongoing strength from U.S. wholesale. Importantly, for Q4, we have about 300 basis points of expansion in the outlook. The drivers are really the same, pricing, mix, and as we've said all year, we expect input costs to flip to a tailwind in Q4, continuing into next year.

Thank you. The next question is coming from Will Gaertner of Wells Fargo. Please go ahead.

Hey, guys. Thanks for taking my question. So just to start off, cash generation is improving here with your inventory management. Could you discuss your capital allocation options? I noticed you didn't have any share purchases this quarter. Can you discuss your future outlook on that?

Yes, Joe, please go ahead, and then I’ll add in at the end.

On the capital allocation side, our priorities have not changed. Organic reinvestment in the business, maintaining our superior dividend, and then we have share repurchases and M&A. Near term, we’re focusing on working capital improvement. We're pleased with the inventory progress and are nearly there on the inventory side. Leverage is good and will further improve next year as we anticipate increased cash generation while gross margin recovers and our inventory normalizes. We have significant optionality and plan to remain disciplined, but we can actively deploy capital in a manner that creates total shareholder return.

I agree with everything Joe just said. If you consider how we view this as a company and our current situation, our balance sheet’s strength allows us to execute multiple strategies simultaneously. As I mentioned in my prepared remarks, we increased our dividend, representing just one of our recent actions. This balance in today’s environment is a significant distinctive advantage, especially given how our brands are performing.

And maybe just one follow-up. Regarding SG&A, your outlook reduced from mid-single-digit growth to low single-digit growth. Can you discuss where you are taking costs out, and if there is further opportunity to do so in the next year?

Yes, we are making no changes to investments in our strategic priorities: DTC, demand creation, and innovation. The reduction mainly comes from the discretionary expense side; we're just being a bit more cautious given our overall outlook.

Thank you. The next question is coming from Jim Duffy of Stifel. Please go ahead.

Hi, this is Peter McGoldrick on for Jim. Thanks for taking my question, and welcome, Joe. First, on free cash flow, can you discuss the details behind the operating cash flow guidance? I recognize this is new guidance, but with tighter inventory management, I was curious about the working capital items and other drivers of the $335 million operating cash flow guidance.

Yes, Peter, we anticipate a strong fourth quarter in terms of cash generation. This stems from margin recovery in the business, mainly driven by gross margin, and a further unwinding of the net working capital primarily from inventory. We’re looking at about $335 million for the year, which includes around $175 million-$180 million in the fourth quarter, with roughly $100 million coming from further reductions in overall inventory levels.

Okay. One follow-up. Considering the long-term financial capacity, can you comment on structural gross margin potential and any updated assessment towards the previous 46% gross margin potential outlook?

Yes, nothing fundamentally different. We still view that algorithm intact. Structural margin drivers in DTC and international will support this as input costs normalize. We expect to recover much of what we lost in the past couple of years due to inflation and supply chain disruptions. We have several initiatives that focus on gross margin and working capital that we’ll share more details about as they unfold.

I’d reiterate what Joe said. The recent ERP transition has consumed significant mind space for our organization. Now, with talented team members focusing on our back-end supply chain initiatives, we see opportunities there, as noted by Joe. We're going to channel effort into that area for ongoing improvements.

Thank you. The next question is coming from Paul Kearney of Barclays. Please go ahead.

Hey, good morning. Thanks for taking my question. Joe, can you discuss margin performance by brand? It looks like the operating margin fell almost 350 basis points versus Wrangler down 25. What drove the differential between the two? Then I have a follow-up.

Yes, Paul, if you’re looking at the reported numbers, the duty charge is embedded in there. So there’s some noise around that.

Is that primarily pulling on Lee?

No, it would affect both brands.

Okay. As we approach next year, how should we think about SG&A growth relative to this year's low single digits, especially given the investments you are making?

We'll maintain any specific guidance for next year. However, our focus remains on investing in DTC, demand creation, and innovation, while managing discretionary expenses and looking for ways to leverage those effectively.

Thank you. The next question is coming from Bob Drbul of Guggenheim. Please go ahead.

I wanted to jump back in just to follow up on SG&A and the spend, specifically on demand creation. You're discussing the brand doing as much as it has ever done this quarter with the Cowboys and Lainey Wilson. Can you explain where you are today with your dollar spend or percentage spend, and how that might proceed into next year?

For the quarter, we increased our demand creation spending at a double-digit rate. We’re excited about the impact that has had. I expect that demand creation as a percent of total will continue to rise, and we will aim to grow that investment at a rate slightly above our overall revenue growth.

I want to give a special shoutout to Holly and Bridget, who lead our demand creation platforms globally for Wrangler and Lee. The intelligent spending of our budget is paramount; we used to spend money without seeing great returns, but our teams have dramatically improved this. Noting our partnerships and modern collaborations, it’s becoming increasingly clear that we’re viewed as a brand that is growing, and that’s an exciting position to be in.

Thanks, Scott.

Thank you. The next question is a follow-up from Mauricio Serna of UBS. Please go ahead.

Great. Thanks for taking the follow-up. I just want to follow-up on two things. First, can you talk about the DTC momentum you're seeing, especially on own.com? How much does that currently represent of your sales? And regarding inventory, do you have any exposure to PFAs chemicals? This concern could influence inventory age as some retailers might try to reduce that exposure starting spring 2024, as noted by other brands. How that could affect your approach to discounting, too? Thank you.

Yes, we're pleased with our dotcom business. The growth we’re seeing is tied to significant investment. We built a robust team, and our marketing has led to substantial engagement. Our new ERP system marries well with the online business, and we see a promising future there. We’ll focus on our digital strategy moving forward. Regarding PFAs, let's get back to you with accurate information.

Thank you.

Thank you.

Thank you. The next question is coming from Will Gaertner of Wells Fargo. Please go ahead.

Hey guys, thanks for letting me come back in here. Just a question on the US wholesale. You have a big number to lap next quarter. Just how are you thinking about that regarding growth in the next quarter?

Most importantly, focus on product freshness, always enhancing core products, which we've shown well. You've heard us talk about category extensions; we've done a great job with our T-shirt and ATG business for anglers. Ancillary lines are driving growth. We’re gaining market share and real estate due to strong point of sale. I feel confident in the next quarter and appreciate our longstanding partnerships with our large customers. Our inventory sits at an A+ level.

Thank you. At this time, I'd like to turn it back over to Scott for closing comments.

Thank you all for your thoughtful questions today, and I look forward to spending time with you again next quarter. I wish all of you a happy, healthy, and safe holiday season. Thanks for your interest in our company. We are working hard to ensure we’re doing the right things. I have a terrific team, and I truly believe in our capacity to succeed. I look forward to sharing more soon. Thank you, everyone.

Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect your lines or walk off the webcast at this time and enjoy the rest of your day.