Levi Strauss & Co (LEVI) Q2 2021 Earnings Call Transcript

Good day, ladies and gentlemen, and welcome to Levi Strauss & Company Second Quarter Earnings Conference Call for the period ending May 30, 2021. All parties will be in a listen-only mode until the question-and-answer session at which time instructions will follow. This conference is being recorded and may not be reproduced in whole or in part without written permission from the company. A telephone replay will be available two hours after the completion of this call through July 15, 2021, one week after call for a telephone replay. Please use the conference ID 3784584. This conference call also is being broadcast over the Internet and a replay of the webcast will be accessible for one quarter on the company's website, levistrauss.com. I would now like to turn the call over to Aida Orphan, Senior Director, Shareholder Relations at Levi Strauss & Company.

Thank you for joining us on the call today to discuss the results for our second fiscal quarter of 2021. Joining me on today's call are Chip Bergh, President and CEO of Levi Strauss and Harmit Singh, our CFO. We have posted complete Q2 financial results in our earnings release on our IR section of our website, investors.levistrauss.com. The link to the webcast of today's conference call can also be found on our site. We would like to remind everyone that we will be making forward-looking statements on this call, which involve risks and uncertainties. Actual results could differ materially from those contemplated by our forward-looking statements. Please review our filings with the SEC, in particular, the Risk Factors section of the quarterly report on Form 10-Q that we filed today for the factors that could cause our results to differ. Also note that the forward-looking statements on this call are based on information available to us as of today and we assume no obligation to update any of these statements. During this call, we will discuss certain non-GAAP financial measures. Reconciliations to the most directly comparable GAAP financial measures are provided in today's earnings release on our IR website. These non-GAAP measures are not intended to be a substitute for our GAAP results. Finally, this call in its entirety is being webcast on our IR website and a replay of this call will be available on the website shortly. Today's call is scheduled for one hour. So please limit yourself to one question at a time to give others the opportunity to have their questions addressed. And now I'd like to turn over the call to Chip.

Thanks, Aida, and good afternoon, everyone. Our second quarter performance was better than we expected, reflecting broad-based strength across our business as we continue to see recovery from the pandemic. Our results reflect the enduring power of our brand in a time when consumers are seeking out authenticity from companies that reflect their own values. In addition to seeing strong denim and casualization trends, we are also benefiting from the ongoing execution of our strategic initiatives. And we are excited to see consumers returning to our stores as markets reopen with sequentially improving traffic trends. While the pandemic continues to impact our business, we are encouraged by accelerated revenue recovery in the quarter with all regions and channels growing versus prior year and compared to Q2 2019 reported revenues are down only 3 points. The recovery was led by the U.S. and sales exceeded Q2 2019 levels in more than 10 markets across the globe, including China. For the third quarter in a row, we delivered a record gross margin, which led to our highest second quarter adjusted EBIT margin ever, despite continued investments behind advertising and our growth initiatives. As we look ahead, we are confident the strength of our business will continue. In fact, we are now expecting growth versus 2019 levels one quarter earlier than previously anticipated with better structural economics. Let me share a few highlights from the second quarter. Demand for our brands remains strong globally. Our men's bottoms business continues to gain traction and has nearly returned to pre-pandemic levels. And our women's bottoms business has now exceeded Q2 2019 revenue, up 9%. The looser fits that we launched pre-pandemic are continuing to drive growth and increased as a percent of both men's and women's bottoms assortments, now representing nearly half of each. We launched our multi-platform global marketing campaign, Buy Better, Wear Longer. We partnered with leading influencers and change-makers like Jaden Smith, Emma Chamberlain, Marcus Rashford and more to raise awareness and be voices for change in implementing more environmentally sustainable apparel production and consumption methods. Reaction to the campaign has been overwhelmingly positive, generating strong growth in our average daily brand mentions across global social platforms and a significant lift in brand consideration and purchase intent after consumers experienced and engaged with the campaign ad. Building off the success of our 5:01 Live series, the Levi's brand through a global virtual festival on May 20th to celebrate the birthday of the Levi's 501 Jean, which has provided effortless cool style to working men and women, rock stars and everyone in between for decades. Broadcast around the world from our official Levi's Instagram account, the festival featured musical performances, meaningful conversations, and do-it-yourself denim personalization and repair sessions with in-house tailors. The celebration resulted in hundreds of PR stories and generated 4 billion impressions. And we continue to bring energy to the market through a number of exciting, high-profile collaborations with Valentino, Mew-Mew, and Denim Tears, yielding strong sell-throughs and elevating the brand with distribution and premium doors and features across leading publications. In our DTC channel, we've continued to accelerate our omni-channel capabilities to ensure that our consumers can get product wherever and whenever they choose. Our company-operated e-commerce business grew 42% on a reported basis, a great result considering we were lapping strong growth in the prior year. We were particularly pleased that the growth rate remains strong even as brick-and-mortar stores reopened in the second quarter. We're investing in leading technology and expanding our fulfillment capabilities. And earlier this month, our largest distribution center in Henderson, Nevada became our first owned-and-operated facility to fulfill orders for e-commerce, retail and wholesale channels. Over time, we expect to increasingly leverage our owned DCs to fulfill e-commerce orders, which will drive more agility and inventory positioning, reduce lead times and accelerate expansion of e-commerce margins. To ensure a seamless and frictionless experience across all channels, we continue to invest in our omni-channel capabilities. In the U.S., demand served by ship from store grew versus 2020. Internationally, we continue to expand ship from store in Europe, successfully launching in Belgium, the Netherlands, France, Spain, and Denmark. We're now accepting PayPal and Venmo in all of our U.S. stores as it extends our reach, especially for Gen Z. We've implemented pivotal improvements to our buy online, pick up in store program like the shop-to-store function and we saw an increase in both this volume and higher units per transaction after it was launched on the site. Shop-to-store is expected to launch on our app in Q3. We continue to look for ways to enhance the consumer experience and have made significant progress in optimizing our return capabilities, including contactless returns, allowing consumers to easily return merchandise in more than 2,500 drop-off locations within the U.S. Physical stores remain an important part of our business to build awareness and connect with consumers in a meaningful way, including driving higher loyalty member enrollment. As traffic to our stores continues to increase, conversion in AURs remains strong and we're seeing better full price sell-throughs. As store productivity levels continue to recover, we are confident in the outlook of our DTC business and we will continue to invest in growing all segments of this channel. We also remain focused on diversifying our business. Lapping one of the most unusual quarters in our history, all regions, channels and categories grew significantly versus last year. The U.S. was by far our strongest market this quarter with growth of 4% versus Q2 2019 on strong wholesale and e-commerce performance and China returned to growth compared to 2019. As one of our largest growth opportunities, we remain focused on maintaining this momentum. In Europe, it's clear that consumer demand for the brand remains strong. As was the case last fall when Europe reopened in May, revenues bounced back quickly and posted strong growth versus 2019. Our global wholesale business neared 2019 levels and is much more profitable with a higher share of digital. Our wholesale strategy is working and we saw robust results in the U.S., which saw sales up versus 2019. Demand for our premium products remains strong and we continue to expand that business with premium retailers, including Nordstrom, where our men's and women's products can now be found in all stores. Our other brands, Dockers, Signature, and Denizen, all had strong quarters. Dockers grew over 100% versus Q2 2020 with a much higher gross margin. And the Signature brand even exceeded Q2 2019 by nearly 30% due to success with Walmart and continued expansion on Amazon with Signature Gold. We're using digital, data and AI to dramatically improve the consumer experience and deepen connections, leveraging every touch point to better connect and engage our fans. We will continue to deliver compelling consumer experiences digitally. We just launched our global TikTok channel, which generated more than 100 million views in the first six weeks since its launch and we held our first shoppable live stream event on Levi.com in the beginning of June. Through data and AI capabilities, we created a more cohesive and personalized consumer experience on our app and with our loyalty program. Our app continues to exceed expectations with a 20% increase in downloads compared to Q1. We're also seeing increases in average order value sequentially and the app contribution to e-commerce revenue continues to increase. And in our loyalty program, consumer lifetime value of members remained substantially higher than for non-members as is units per transaction. In terms of digitizing our own business, we are transforming the way in which we plan with AI now forecasting initial demand for each product next season. Results from our first wave test showed that AI-driven demand forecasting improved accuracy. So, scaling it should enable more precise inventory investment, lead to less markdowns and clearance, prevent waste, and enhance sustainability, all of which will improve our margins. This will be powerful in combination with the ongoing work AI has been contributing to pricing and promotion. Before I turn it over to Harmit, we know that in order to thrive in a digital-first future, we need to invest not only in technology, but in our people. This quarter we launched the digital upskilling initiative, which included the industry's first machine learning boot camp, an immersive training in coding, machine learning and agile ways of working, uniquely designed for LS&Co. employees. After graduation these practitioners, now data scientists, return to the business to apply their skills and create momentum around our digital agenda. By the end of the year, we will have upskilled more than 100 employees globally. Let me now hand it over to Harmit for a review of our second quarter financials and our guidance outlook.

Thanks Chip. Good afternoon everyone. I hope all of you, your families, and loved ones are returning back to the new norm as economies recover, the vaccination pace accelerates globally, and consumer demand for apparel improves. The momentum of our business continues to accelerate as we significantly outperformed our revenue and profit expectations in the quarter. The structural economics of our business has sustainably improved versus 2019 and I am confident of achieving our adjusted EBIT margin target of 12%-plus. I'll share more on guidance in a few moments, but we are thrilled that the recovery is happening faster than we thought. And we are now poised to deliver total company growth versus 2019 in quarter three, a full quarter earlier than previously expected. And that's even before we are firing on all cylinders given store traffic and tourism have not yet fully recovered. As I walk you through our second quarter results, my comments will reference constant currency comparisons on a year-over-year basis in U.S. dollars unless I indicate otherwise. Where meaningful, I will also share comparisons to 2019. Second quarter net revenues of $1.3 billion grew 148% compared to second quarter 2020 and adjusted diluted earnings per share was $0.23, both exceeding our guidance. Compared to second quarter of 2019, constant currency revenues were down only 4%, a sequential improvement in sales and adjusted diluted EPS was significantly ahead of 2019, driven by improved structural economics of the business. Let me share some color on the detail. Despite an increasing number of markets opening, our e-commerce business, which represents 8% of our total revenues, grew 37% in the second quarter compared to prior year. We are really pleased with this given we are lapping strong growth. Compared to second quarter 2019, our e-commerce business has grown 71%. Total digital ecosystem sales growth also accelerated to 68% over prior year and represented 23% of sales in quarter two and compared to second quarter 2019, our total digital business has nearly doubled. DTC brick-and-mortar is still recovering, given many markets have not fully reopened. We are seeing traffic return and importantly our key performance metric at retail remains strong. Compared to quarter two 2019, global wholesale was down only 2% and U.S. wholesale was up by 6%. Importantly, U.S. wholesale gross margin and profitability is the strongest it has been in a while. Our second quarter adjusted EBIT was $115 million and our 9% adjusted EBIT margin was a second quarter record high, despite higher advertising as a percentage of revenues, showcasing our record gross margins. Relative to 2019, reported adjusted EBIT margins were up 280 basis points. Record adjusted gross margin of 58.2% represented a 670-basis point expansion compared to quarter two 2020. AURs grew across channel, genders, products, and regions. Compared to second quarter 2019, gross margin expanded 490 basis points. The bulk of the increase for both comparisons was driven by several sustainable attributes, including a higher proportion of sales from our DTC channel, the price increases we have taken across all channels and a number of geography, a higher share of women, which now has sustainably higher gross margins than men, and COGS saving from a globally diversified supply chain. The quarter's gross margin expansion also reflected some other temporary benefits across all channels, including wholesale, like a higher share of denim bottoms, lower levels of promotions, and other off-price selling, which collectively amounted to roughly 100 basis points of benefit to gross margins. These manifested in the quarter to a higher degree than we previously anticipated. To reinforce, the majority of the factors driving margin expansion are structural and sustainable. DTC sales, both brick-and-mortar and digital, have the highest gross margin and our strategies will drive DTC to a higher percentage of our total business in the years ahead. It is also pertinent to note that even after the price increases we have taken, both in the past and for the second half of 2021, we still have pricing power to not only offset cost inflation, but to also improve our gross margins as well. Importantly, we have negotiated most of our product costs through the first half of 2022 at very low single-digit inflation. Adjusted SG&A was $628 million. Excluding an unfavorable currency impact of approximately $8 million, adjusted SG&A was in line with Q2 2019. This is despite higher incentive as we are exceeding our expectation and higher ROI growth investments towards advertising, DTC, AI, and technology, as those increases were funded by savings that we have actioned last year. Now, I'll share a few highlights from our three regions. Second quarter revenue in the Americas increased 150% compared to prior year. Compared to the second quarter of 2019, Americas revenue grew 4% led by wholesale and digital. Expansion of wholesale gross margin underscores the healthier business we have built in the region. Versus Q2 2019, company e-commerce grew 51% and the full digital ecosystem grew 61% and represented nearly 20% of sales. Total revenues from brick-and-mortar stores in the region nearly reached 2019 levels, despite the significant impact of tourism not having yet recovered. And the region's operating income was $153 million, up 52% against the second quarter of 2019, reflecting substantially stronger gross margin and ongoing cost control. Within the Americas region, the U.S. business is structurally a lot stronger today than it was pre-pandemic for several reasons. It has a larger digital business, a higher share of revenues with financially healthier and more premium customers, more full-price sales, pricing power, and a higher retail productivity, especially critical as we open more full-priced stores. We are confident we can continue to grow the U.S. business over the long-term. Turning to Europe, revenues increased 165% versus 2020, reflecting strong demand as markets in the region reopened. Compared to the second quarter of 2019, Europe's revenues were down 12% as direct-to-consumer, brick-and-mortar, and franchise remained down, given more than a third of those were closed during the quarter. These declines were partially offset by growth in our e-commerce business and digital wholesale. Company e-commerce grew 80% compared to 2019, while the full digital ecosystem in Europe has doubled and now represents over a third of the region's sales. Importantly, Europe exited the quarter with revenue in May growing high single-digit compared to May 2019. Operating margin has expanded 80 basis points since Q2 2019, despite the sales decline, reflecting higher gross margin and cost discipline. Asia revenues grew 113% compared to prior year. Compared to the second quarter of 2019, Asia's revenues were down 13% as the pandemic continued to negatively impact several of our significant markets with roughly half the decline in the region attributable to India. But we are seeing growth in several important markets and continuing growth in digital, fueling our optimism. China grew 3% versus Q2 2019, reflecting double-digit growth in our direct-to-consumer store network in e-commerce, which we expect to continue into the second half. Our markets in Australia and New Zealand were another bright spot, up strong double-digits from Q2 2019 and company e-commerce doubled in size from second quarter 2019, while over the same time period, the full digital ecosystem in Asia grew 79% and now represents 15% of the region's sales. Turning to balance sheet and cash flows. Inventories at the end of the quarter were 12% below prior year, essentially driven by double-digit declines in both the Americas and Asia. Inventories remain healthy and primarily comprised of products that can carry into future seasons. Compared to the end of the second quarter of 2019, inventories were down 4%. Cash and liquidity remained strong and at the end of the quarter, net debt was negative $46 million and overall liquidity was $2 billion. Adjusted free cash flow through the first half of the year was $60 million, representing a 54% improvement versus the comparable period of 2019. And we continue to return cash to our shareholders. I'm pleased to announce that we are again raising the dividend to $0.08 per share for the third quarter, up from $0.06 per share and in line with pre-pandemic levels. Before sharing our second half outlook, let me take a moment to provide an update on our sales performance through June. As a reminder, to improve comparability with calendar reporting companies, we have decided to indicate revenue performance to calendar quarters when relevant. For the three-month period of April through June, revenues were up low-single-digits to the comparable period of 2019 on a reported basis, with the month of June up mid to high single-digits compared to June 2019. Now, turning to the outlook for the second half and full-year 2021. Given the structural and sustainable improvement in the business and the momentum heading into the second half, we expect a much stronger full year in both revenue and EPS than previously anticipated. We expect reported revenues for the second half of 2021 to grow 28% to 29% versus second half of 2020. This equates to reported revenue growth of 4% to 5% versus second half 2019, which includes a currency benefit of two points. From a regional perspective, relative to 2019 we expect second half reported revenues to grow in the Americas by mid-single-digits and in Europe by high single to low double-digits. Asia, despite strong growth in China, will still be below 2019 due to the ongoing prevalence of the pandemic there. From a quarterly perspective, we expect ongoing sequential improvement in our quarterly growth rate versus 2019, with Q3 growth below and Q4 above our second half growth rate. In terms of profits, we expect second half adjusted EBIT margin of 12%. And we expect to deliver adjusted diluted EPS of $0.72 to $0.76 in the second half, which would bring us to $1.29 to $1.33 for the full year. Compared to 2019, this equates to second half EPS growth of more than 26% and full year growth of more than 15%. A few color comments on our key second half assumptions beyond revenue. We expect that second half gross margin in the range of mid-56%, an increase of nearly 300 basis points above second half 2019. As per usual, we expect sequential quarterly improvement in gross margin, so Q3 lower and Q4 higher than the second half average. With the strong second half gross margin outlook, combined with our Q2 gross margin outperformance, we now expect a full year gross margin of around 57%, higher than our prior expectation of 56% and more than 300 basis points above full year 2019. And we are increasing our investment in adjusted SG&A. Second half adjusted SG&A will be about $100 million higher than it was in the second half 2019. About $30 million to $35 million reflects our estimate for unfavorable currency effects from a weaker U.S. dollar. The remaining $65 million to $70 million splits roughly equally between advertising and selling. We're increasing our advertising investment to drive our initiative and market share goals, as we fuel and elevate our brand. We expect second half advertising dollars at 7.7% of second-half revenues. This is 70 basis points higher than second half 2019. And we'll also have higher selling and variable expenses related to raising our second half revenue outlook, which is largely comprised of DTC revenues. The incremental adjusted SG&A will support accelerating profitable growth without impacting our adjusted EBIT margin target, given the associated higher gross margin and leverage from higher revenues. And finally, with respect to taxes, given the significant tax benefit we recorded in the second quarter, we now expect a lower full year tax rate of around 10% or 11%. This implies a second half tax rate in the very low teens. Before we go to Q&A, I'd like to leave you with three key thoughts. First, we beat our second quarter expectation and are raising our full year outlook. Achieving this will result in our full-year revenues nearly approaching 2019 levels, with second half adjusted EBIT margin tracking 12%, and full year adjusted diluted EPS substantially higher than 2019. And we are getting to the improved profitability in a high-quality way with higher revenue, gross margin, and disciplined cost management. Second, structurally, our business is stronger than it was in 2019, driven by a higher share of digital revenues, a healthier U.S. wholesale business and technology investments that have accelerated our DTC business, while connecting us directly with more consumers. Over the past two years, we have reshaped our P&L with higher sustainable gross margin and cost cuts which are fueling our A&P and other growth investments while delivering higher adjusted EBIT margin. This gives us great confidence to continue market leadership growth, driven by the strength of our brand and our products, especially as denim resurges and casualization trends accelerate. We remain confident that we will deliver full year adjusted EBIT margin of 12%-plus in 2022. And third, we have a very strong balance sheet with net debt below zero. We have driven this through our renewed focus on cash, which has improved our cash conversion cycle significantly as compared to 2019. As a result, we continue to have substantial liquidity to grow this business both organically and inorganically, while returning cash to our shareholders. With that, we'll take your questions.

Thank you. Our first question comes from Matthew Boss of JPMorgan. Your line is open.

Thanks, and congrats on another great quarter.

Thanks, Matt.

So, maybe, Chip, in light of the global momentum, could you elaborate on current trends in the denim category and just your confidence in sustainability of this strength as we think about pent-up demand? I know you've talked about size profile changes, maybe that relative to the fashion and silhouette fit drivers of a potential multi-year denim cycle that I think you point first on last call.

Yes. With one more quarter behind us, we can confidently say that we're in the early stages of a new denim cycle. I have a lot of confidence in the sustainability of our momentum from this quarter. The strong results reflect a resurgence in the denim industry, driven by several factors. One key factor is the continuation of the casualization trend, which is happening globally, not just in the U.S. As people emerge from the pandemic and return to social activities post-lockdowns, including going back to the office, there is a renewed opportunity for wardrobe updates. Notably, about 35% of consumers in the U.S. have changed waist sizes, creating a reason for people to refresh their wardrobes. The new silhouettes we introduced before the pandemic, particularly the baggier fits, have gained significant traction. This season, almost half of our sales in both men's and women's categories have come from looser fits, marking a notable change in women's sales compared to two years ago. As bottom silhouettes evolve, they also influence tops and footwear, providing a broader opportunity for wardrobe updates beyond denim. Additionally, our efforts to expand beyond denim have yielded positive results, with styles like the XX Chino seeing a 246% increase and strong demand for shorts. In women's fashion, we've experienced good performance in dresses as well, contributing positively this past quarter. Overall, we are in the early stages of a new denim cycle centered around these new silhouettes, reminiscent of the early 1990s, and driven by the casualization trend, which gives me great confidence as we look ahead to the next few quarters.

Great. Congrats again.

Thanks, Matt.

Thank you. Our next question comes from Bob Drbul of Guggenheim Securities. Your question, please.

Hi. Thanks. Good evening, everyone. I hope you are all well. I have a couple of questions about pricing. Can you elaborate on your recent pricing actions? Are they proving to be effective? How much pricing are you implementing in the second half? Additionally, could you discuss the sustainability of these price increases and your approach to it? Thank you.

Hey, Harmit, you're on mute, I think. I think Harmit wants to answer here, Bob.

Yes.

Here we go.

So, Bob, regarding pricing, as we've mentioned before, we are still in the early stages. We've become more proactive because our brand is strong and our products are relevant, as Chip pointed out. We believe in adjusting pricing when the brand resonates with consumers rather than when it’s necessary. We've implemented price increases during the pandemic, and they are holding firm. In our first half, pricing likely contributed around a point to revenue and about a point to gross margins in the second quarter. Looking ahead, Chip mentioned the looser, baggier fits that command higher average unit retail prices and better gross margins. I also highlighted the women's segment, which is underrepresented but growing, and benefits from higher gross margins due to price increases we made last year, particularly in the U.S. compared to wholesale. Another aspect of pricing is the reduction in markdowns. We are leveraging AI and data analytics, along with lean inventories, to ensure our products are marked down appropriately, which has positively impacted average unit retail. Overall, AUR was up about 5% in the second quarter across various geographies and channels. We believe our pricing is sustainable. We are also ready to address any cost inflation that may arise. I've mentioned that we've managed to negotiate our first-half cost of goods at low single-digit inflation, which is slightly higher than in previous years. However, we are well-prepared for any inflationary challenges. Additionally, over the past two decades, prices in the industry have generally trended downwards. As market leaders, with the resurgence of denim, we see this as an opportunity to guide the industry.

Great. Thank you very much.

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

Hi. Good afternoon. This is Mauricio Serna on behalf of Jay Sole. I wanted to ask about Europe. You mentioned that sales in May improved versus May 2019. I think, I heard like up double-digits. So, just want to understand how that number improved throughout the quarter? And, sorry, if you could also, like, say it again what you're seeing for the third quarter by region that will be very helpful. Thank you.

Pre-pandemic, Europe was our strongest market where we were significantly ahead of competitors, performing well and experiencing double-digit growth. Prior to the recent resurgence, Europe was also demonstrating the strongest recovery; however, countries had to implement lockdowns. During the quarter, approximately one-third of our stores in Europe were closed, but as we moved out of the quarter, many of these stores have reopened. In discussing the end of the quarter, we noted that May sales in Europe were in the high single-digit range. For example, in the U.K., where retail operations are fully open, we've observed a double-digit sales increase over the past two months. The brand remains strong, and the subdued performance has mainly been due to store closures. The European team has effectively shifted towards enhancing our digital business, with e-commerce growing over 90% this quarter and our overall digital ecosystem now accounting for a third of our business. Looking ahead, while predicting the timing and nature of lockdowns is challenging, we believe in our teams' execution capabilities and their agility in responding to consumer needs, ensuring employee safety, and achieving a quick recovery. This is our perspective for Europe and other regions over the next 12 to 18 months.

Great. Thank you.

Thank you. Our next question comes from Laurent Vasilescu of Exane BNP Paribas. Your line is open.

Good afternoon. Thank you for taking my question. Harmit, you mentioned that June is expected to see mid to high single-digit growth. If I recall correctly, the guidance for the second half implies a two-year stacked growth of 4% to 5%, but that the third quarter will experience a slower growth rate. I'm trying to understand how we should interpret June's performance, as it appears June will be a key driver before a sequential slowdown. Additionally, any updated thoughts on the Target partnership as we approach back-to-school would be appreciated. Thank you.

Great. I'll take the June and the second half question and then I'll pass on the second question on Target to Chip. Back to your question, June was a good indication of what happens when lockdowns lift. And what we're seeing is consumers come back and come back big, especially to brands that have relevant products as well as brands they can trust and you're right, the numbers in June were pretty strong. But we also feel part of that is pent-up demand, part of that is people getting back to the new norm. So, as you think of the second half of the year, our expectation, clearly higher than a quarter ago, clearly reinforcing that we not only return to growth relative to 2019, but we get to growth in Q3, which is a quarter ahead of our expectations. So, that's how we're thinking about it. The other piece to note is, there are various parts of the world that are still closed. I mean, Asia, and I just referenced Japan today, we have not won the battle against the virus yet. There is still work to be done on that front. And so it's important to ensure that that's incorporated in our outlook as we think about the next six months.

Yes. Regarding our relationship with Target, we are very pleased with it, and I believe they would express similar sentiments. Currently, we are present in approximately 300 Target locations with Levi's Red Tab and nearly 1,500 locations with Denizen. We are in the process of expanding to 500 Target locations in preparation for the back-to-school season. Our Q3 results will reflect this distribution growth of Levi's Red Tab to those 500 Target stores, and most of these will also feature Denizen. Denizen will additionally have an exclusive presence in around 1,275 other stores. This brings our total Target distribution to roughly 1,775 stores, with the Levi's Red Tab expansion to 500 Target locations set for back-to-school.

Great to hear. Thank you very much.

You bet.

Thanks Laurent.

Thank you. Our next question comes from Paul Lejuez of Citigroup. Please go ahead.

Thank you. It's Tracy Kogan filling in for Paul. I was wondering if you guys could update us on any supply chain issues you're currently seeing. And maybe if supply chain issues have affected your inventory levels or constraints or demand and when you think it might improve? Thanks.

We have experienced some impacts, but I believe we are managing through this better than most. The impact to the quarter was about half a point of growth for the total company, which is roughly $7 million to $8 million. Looking ahead to the second half, we expect to face continued challenges, but we will be increasing our airfreight, which is already factored into our gross margin guidance. We are addressing some of the biggest challenges. There is still a situation in Long Beach, and we are now routing most of our product into the U.S. through the East Coast, with only about 20% coming from the West Coast. We have adjusted lead-times to account for these delays. We are confident in our ability to manage the back-to-school volume and the holiday season. The team has excelled in securing guaranteed space on vessels during this challenging time when many are having trouble obtaining containers and shipping space. Their efforts have allowed us to secure guaranteed pricing as well, aiding in cost control. This situation poses a significant challenge for the industry, and we are aware of it through our customer interactions. Our diversified supply chain plays a key role in how well we are navigating through these issues.

Great. Thanks very much.

You bet.

Thank you. Our next question comes from Dana Telsey of Telsey Advisory Group. Your line is open.

Good afternoon and congratulations on the progress. Given the improvement in margin that you've seen, how do you think about the DTC margin e-commerce versus stores? Is there improvement being seen in each of those channels and how do you think about that going forward? And then just lastly, in terms of product inflation and raw material costs, how are you planning those going forward? Thank you.

Thank you, Dana, for your insights on CNBC today. In response to your question about gross margin, our direct-to-consumer business continues to provide a positive impact. Both our in-store and e-commerce gross margins are exceeding the company average. We made a strategic decision during the pandemic to accelerate our direct-to-consumer efforts, which currently account for about 40% of our business, with a goal of reaching 60%. This shift will significantly enhance our gross margins. Additionally, we are selling more full-price products and are being deliberate and disciplined regarding our promotions, all of which contribute positively. We’re also experiencing increases in average unit retail prices, which is making a notable difference. There is a small component affecting gross margins that may be temporary, and while it has been highlighted, it is manageable. This is why our gross margin in the second half, while 300 basis points higher than in 2019, is showing a slight moderation compared to the 670 or 500 basis points observed in 2019. Regarding costs, our scale and strong partnerships with vendors worldwide allow us to limit product cost increases to low single-digit percentages for the first half of 2022, boosting our confidence in sustaining gross margin growth moving forward. We are aware of inflationary pressures in media and fulfillment costs but find them manageable. Given our brand's pricing power, we believe we can implement further price increases if necessary.

Thank you.

Thank you. Our next question comes from Kimberly Greenberger of Morgan Stanley. Your line is open.

Okay, great. Harmit, I wanted to ask you about the gross margin. 57% full year gross margin this year, obviously a really exceptional accomplishment. I know you called out the 100 basis points of temporary benefits here in the second quarter and I can't recall if you gave that in Q1. But if you could just take a look at the full year, out of that 57%, is there a 25-basis point or a 50-basis point sort of give-back next year? I'm just wondering what the sustainable, if we were to think about the more structural benefits you're delivering in gross margin this year versus some of the temporary ones, if you could help us understand the breakdown within the 57% target this year that would be great.

We are not prepared to provide guidance for 2022 or discuss our growth strategy since things are still stabilizing. However, we are confident that our gross margin will continue to improve year-over-year. We demonstrated this last year even during the pandemic. In this quarter, we believe there were temporary benefits of approximately 100 basis points, which translates to about 20 to 25 basis points annually. Chip mentioned the need for airfreighting products in the second half of the year, and we have factored that into our gross margin expectations. We anticipate reverting back to traditional shipping methods long term, meaning we may not need to rely on airfreight as much. As we look at the year, we believe our record gross margin performance over three quarters reflects the strength of our brand. We expect to continue growing our gross margin annually, although I'll provide more specific details in a couple of months or early next year regarding 2022. Additionally, we are confident in achieving a 12% EBIT or operating margin and growing from there starting in 2022. Overall, our outlook is that gross margin will remain positive, and we will continue investing in essential areas to drive efficiency and enhance operating margins.

Very clear. Thank you so much.

Thanks Kimberly.

Thank you. Our next question comes from Lorraine Hutchinson of Bank of America. Your question please.

Thanks. Good afternoon. I had a question about how you're thinking about future orders and how you're trying to strike a balance between meeting the outsized demand that you're seeing, particularly in some of these new fashion items and tops, this maintaining all this progress you've made on gross margin? So, where are you coming out in terms of planning your production and your inventory levels for the coming seasons?

Yes. We are making several structural changes to enhance our inventory management. We are transitioning from two seasons to four. Chip mentioned the implementation of AI-driven demand forecasting, which will improve our inventory management and help reduce lost sales. Additionally, we are increasing the percentage of common assortments globally, which enables us to move inventory between countries and affiliates. We have also developed our ability to chase demand, thanks to the excellent work of our supply chain team and operators on the ground. This means we can respond more effectively to demand instead of over-ordering and maintaining excess inventory, which helps in lowering markdowns since we are not purchasing products before we understand the trends. Regarding inventory levels, the 12% decline you've noted is not expected to last. We anticipate our inventory will be balanced in Q3, and as we plan for 2022, inventory levels might be slightly higher in the mid to high single-digit range. The positive aspect is that, even during the pandemic, two-thirds of our inventory consists of core items that can be sold across seasons. We believe we will have inventory that supports growth. If the recovery continues at its current pace, we will likely be chasing demand, which puts us in a favorable position. As Chip highlighted, we prefer to lose a sale rather than carry excess inventory that requires markdowns.

Thank you.

Thank you. Our next question comes from Carla Casella of JPMorgan. Your question please.

Hi. I'm curious you mentioned that ladies has a higher gross margin at this point. And I'm wondering what's that attributable to. Is it the mix or something else?

I would like to highlight a few points, Carla. In the past, when we weren't seeing growth in our women's segment, it negatively impacted overall company margins. However, after we launched a successful women’s product, we experienced about 15 quarters of double-digit growth. The product clearly resonated with customers. We continued to innovate by introducing new styles and implementing pricing strategies, which allowed us to increase sales volume and optimize our cost of goods sold. These factors have significantly contributed to improved gross margins in our women's business. Since this segment is still underrepresented, we believe there is substantial growth potential. As this segment expands, we anticipate continued positive contributions, indicating that our gross margins can remain sustainable. Currently, the women's segment represents just over a third of our business, and we publicly aim to grow this to at least half over time. Some markets, like Australia, already have a women's business that is on par with their men's segment, which shows that this is definitely achievable.

Okay, great. And then can I ask just one on travel? Where would you say you are in terms of travel? If you look at today versus pre-pandemic? How much more upside is there as travel reopens worldwide?

Are you talking about travel as in travel expense?

No, sales related to tourism.

Tourist sales are virtually non-existent. There was a slight increase in Q2, but it remains minimal. Our teams globally are effectively focusing on local consumers, particularly younger ones, to help offset the decline in tourist sales. It's challenging to predict outcomes, as the situation varies by country, each with different regulations for tourists. We anticipate that things may return to normal in about a year to a year and a half, but we believe we can mitigate the impact where possible.

Okay, that's great. Thanks a lot.

Yes.

At this time, I'd like to turn the call back over to the President and CEO, Chip Bergh for closing remarks.

All right. Well, thank you everyone for dialing in and for the terrific questions. We will look forward to speaking with you again at the end of our third quarter. Thanks very much and enjoy the rest of your summer.

This concludes today's conference call. Thank you for participating. You may now disconnect.