Levi Strauss & Co Q1 FY2024 Earnings Call

Good day, ladies and gentlemen, and welcome to the Levi Strauss & Company's First Quarter Fiscal 2024 Earnings Conference Call for the period ending February 23, 2023. All parties will be in a listen-only mode until the question-and-answer session, at which time, instructions will follow. This conference call is being recorded and may not be reproduced in whole or in part without written permission from the Company. This conference call 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, Vice President of Investor Relations at Levi Strauss & Company.

Thank you for joining us on the call today to discuss the results for our first quarter 2024. Joining me on today's call are, Michelle Gass, our President and CEO and Harmit Singh, our Chief Financial and Growth Officer. We have posted complete Q1 financial results in our earnings release on the IR section of our website, investors.levistrauss.com. The link to the webcast of today's conference call can also be found on our site. We'd like to remind you 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 our 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. These non-GAAP measures are not intended to be a substitute for our GAAP results. Reconciliations of our non-GAAP measures to their most comparable GAAP measure are included in today's press release. Finally, this call is being webcast on our IR website and a replay of this call will be available on the website shortly. Please note that Michelle, and Harmit will be referencing constant currency numbers unless otherwise noted. 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 the call over to Michelle Gass.

Thank you and welcome everyone to today's call. The year is off to a strong start with both Q1 revenue and adjusted EPS coming in above our expectations. Revenues of $1.6 billion were down 8% on a constant currency basis due to last year's $100 million shift from Q2 into Q1 related to the ERP implementation in the U.S. Excluding this shift, as well as the impact from exiting the Denizen business in Russia, Q1 revenues were flat. Adjusted diluted EPS of $0.26 came in better than our expectations driven by a 240 basis point increase in gross margin and prudently managing our expenses. Our performance this quarter reflects many proof points that our strategies leading with our brands, operating as a direct-to-consumer-first business, and diversifying our portfolio are working. We are fueling consumer demand resulting in meaningful U.S. share gains in both men's and women's segments, driven by newness and innovation, as well as continued strength in our core offerings. We are continuing to see strong momentum in our global direct-to-consumer business, where we have now delivered eight consecutive quarters of robust comp growth. Our e-commerce business again achieved strong growth of 12% on top of mid-teens growth last year. We're particularly excited about the continued acceleration in our overall women's business, which was up about 14% in DTC globally for the quarter. We're encouraged by the performance of our largest market, the U.S. We saw sustained progress in DTC, which was up 10%, as well as continued stabilization in U.S. wholesale for Levi's brands, which was up low single digits. Stepping back, we are building a stronger business in the U.S., underscored by significant growth and operating margin expansion across channels in Q1. Revenue in the global wholesale channel, while down, was in line with expectations as the actions we have taken to improve this business are working. Importantly, global wholesale gross margins increased as both owned and channel inventory levels are much improved. Through our transformational pivot to operating as a DTC-first company, we're bringing operational rigor and a narrower strategic focus which will set a solid foundation for sustainable, profitable growth. Through our productivity initiative, Project Fuel, we remain focused on driving cost efficiencies, and during the quarter, we took concrete actions in rightsizing our organization. In addition, we have activated an initial reduction of nearly 15% of our product assortment and are deprioritizing footwear. These efforts, together with the recent decision to exit Denizen, not only improve our cost structure, but also provide an unlock in simplifying and streamlining how we work. While it’s early in the year, we started the year strong and are encouraged by the trends we're seeing in business. As a result, we are increasing our adjusted diluted EPS guidance for the year. Harmeet will share more. I will now talk you through the results of the quarter in the context of our strategic priorities, starting with our first priority leading with our brand. First, the jeans category has stabilized in the U.S., now flat to the prior year after several years of volatility. Importantly, over the same time period, Levi's outperformed the category, growing two points of share in men and one point of share in women. We are also making progress in our key youth target, gaining share with those aged 18 to 30 in the past quarter. Levi’s picked up share among the middle-income consumer, which is critical given these are the largest consumers of the category. We are continuing to outperform the category with higher-income consumers, demonstrating the success of our efforts to elevate the brand. Market share growth is being driven by the exciting innovation we are introducing to the category, as well as our ongoing commitment to keeping the brand at the center of culture, driving deep connections with fans around the world. Just last week, we reaffirmed our place at the center of culture with the launch of our global breakthrough and interactive Live in Levi's campaign. As part of a digitally-led 360-degree media activation that kicked off with our advertising film, The Floor Is Yours, we're inviting everyone to participate in a dance open call across social media platforms for a chance to showcase their talent and Levi’s style in an exclusive new music video. Moving to product, we continue to see strong performance in our core offerings while also introducing newness and innovation in denim and beyond. A clear barometer for the strength of our core business, the 501 was up 23% in DTC, on top of 32% growth in the prior year. We're seeing strength in loose fits for both men's and women's, both up more than 40% in the quarter. For example, we launched six new baggy styles for women for which sales were up 50%. We continue to see an evolution to low-rise and wider leg openings, both performing strongly. We see an incredible opportunity to own the head-to-toe denim apparel lifestyle, and in doing so, we expect to expand our addressable market for denim overall. Denim skirts, dresses, and jumpsuits again saw positive results, increasing triple digits in the quarter. We are also seeing strength in our denim tops assortment with our iconic Women's Western at more than 40%. Looking forward, we are leaning into this opportunity and introducing new denim top silhouettes across blouses, corsets, vests, and more. As shared on our last call, we are working on an end-to-end reset of our tops business and we are seeing early success with tops outperforming the overall business driven by about 10% growth in DTC. We are building out our core essential assortment in categories like t-shirts, wovens, and polos to provide a perfect pairing to our denim bottoms, and we're investing in capability building, including new key leadership hires. We recently filled the newly created role of Vice President Tops Design, which will be critical in setting the design direction for Levi's Tops. We are successfully extending our authority in categories beyond denim. We recently launched our active tech pant in the U.S., which has received a very strong initial response, with demand for the product stronger than expected in both wholesale and DTC. We are chasing into inventory and we're excited to continue fueling this new product line with additional innovations planned throughout this year and next as we roll out this platform globally. As we move through the year, we will accelerate newness and drive innovation by extending our non-denim authority into categories like shorts, skirts, and dresses for the season ahead. And given the positive early trends in our Performance Cool and lightweight denim collections, we will continue building out those platforms to bring to the consumer our innovative denim fabrication, giving them the fit and style they love with more versatile, year-round end use. Shifting to direct-to-consumer, our second strategic priority. DTC continued to grow rapidly, up 8% on top of 16% growth in the prior year. We achieved these strong results by delivering positive comp sales across our stores, growth in e-commerce, and adding new stores. Increasing productivity and profitability in our stores is a key focus of Project Fuel, and we are gaining traction. Overall, for the quarter, we saw increases in traffic, UPT, and AUR in DTC channels. We're building bigger baskets through our focus on having the right assortment in the right store at the right time, where new Strauss are driving positive momentum and better in-stock positions. In addition to top-line growth, we are seeing a greater degree of leverage on our cost base, such as improving our management of controllable retail costs, like optimizing store staffing and scheduling. We're encouraged by these results and have multiple initiatives underway to further improve the core wall economics of our stores. The success we're having in brick-and-mortar also gives us confidence in our store opening strategy. The majority of net new stores this year will be in Asia where we see a lot of runway for growth. One great example is our recently reopened Kyoto store in Japan, located in one of the city's most vibrant shopping districts. Delivering consumers an immersive shopping experience, this store is representative of the culture and history of this city and features the best of Levi's. Another example in Europe is our flagship store in Paris reopening ahead of the Summer Olympics. Located in the heart of one of the most highly trafficked and desirable shopping destinations in the world, Champs-Élysées, this store will offer Levi's fans from France and around the world the fullest and best expression of our denim lifestyle offerings. These stores and others coming are representatives of our commitment to bringing elevated shopping experiences to the world's most desirable locations while also driving a scalable and profitable store portfolio. Our e-commerce business continues to gain momentum with 12% growth on top of 14% growth in the prior year. This is a direct result of the investments we've made to enhance the consumer experience, including improved search, navigation, and filtering capabilities. We are also creating a more engaging experience by upgrading our product imagery and videos, addressing a key consumer need, helping people find the perfect fit. As we make our pivot to be a DTC-first company, we remain committed to wholesale and the actions we're taking to elevate our performance in this channel are gaining traction. After adjusting for the revenue shift related to the ERP implementation in Q1 2023, the Levi's brand within U.S. wholesale grew for a second consecutive quarter, up low single digits and was substantially more profitable than last year. We remain encouraged regarding the outlook of our global wholesale business and expect sequential improvement as we move through the year. Improved sellout trends along with expanded wholesale assortment gives us optimism. Turning now to our third strategy, the diversification of the business. As I referenced earlier, we are pleased with the ongoing momentum we're seeing in our largest market, the U.S. Beyond that, diversifying geography continues to be a key part of our growth strategy and today, international comprises nearly 60% of total revenues. While International was down 2% in Q1, International DTC grew high single digits and Asia achieved record revenues in the quarter driven by double-digit top-line growth in many markets. Let me address Europe. We continue to be pleased with the performance we are seeing in our DTC channel, which was up 4% excluding Russia. We saw notable improvement in DTC business in response to new corset launched with sequential improvement in the quarter month over month and February up double digits. This strength has continued into March. While the European wholesale channel has been challenging, our key customers are excited about the amplified denim lifestyle offerings that we are delivering and we're seeing positive wholesale pre-book orders in the second half of the year. We continue to expect the total Europe segment to return to growth in the second half of this year. Moving to other brands, we continue to make solid progress; both Beyond Yoga and Dockers expand our portfolio and our addressable market. When we look at our category portfolio, we are excited about the diversification we're making beyond denim bottoms. Dockers' sales trends improved versus the prior quarter, down 9% adjusting for the shift in wholesale, as strong performance in DTC up 14% was offset by lower wholesale sales. Inventory levels for the Dockers brand have shown sequential improvement and are now at their lowest level since March of 2023. We're encouraged by the positive customer reaction to our new product launches, including the recently released Dockers Go Pant, the brand's first active pant that has quickly become one of the top-selling items in stores across the globe. Beyond Yoga was up 11% on top of similar growth in the prior year, driven largely by strength in e-commerce. We are making investments to grow brand awareness and unleash the growth potential of this incredible brand. In summary, we have started the year strong. With many of the headwinds we faced over the past 18 months resolved, most notably the congestion at our U.S. distribution centers and accelerating momentum across the world, and especially in the U.S., we are well-positioned for the years ahead and I'm confident in our ability to achieve our objectives for 2024 and beyond. And with that, I will turn it over to Harmeet to cover the financials.

Thanks, Michelle. We delivered better than expected results in Q1 driven by continued outperformance in Global DTC and stabilization in U.S. wholesale. Most importantly, we achieved these results while also improving the structural economics of the company. Together, these established a strong base for profitable growth for ‘24 and years to come. In the quarter, we delivered significant gross margin expansion and we continue to expect further improvement this year and beyond from the structural drivers of our strategies to grow DTC, Women, and International, as transitory headwinds continue to shift to tailwind. We delivered disciplined cost management while also investing in our key growth initiatives. The productivity initiative we launched in Q1 will drive efficiencies across the company, both in ‘24 and ‘25, while positioning us to realize the growth potential of our business. We expect the combination of margin improvement and operating leverage to enable us to deliver sustainable bottom-line growth, and the greater efficiency in our active inventory and working capital management is enabling us to generate strong free cash flow. This allowed us to return cash to shareholders through dividends, restart the stock buyback program, and acquire our distributor in Colombia, all consistent with our capital allocation strategy. As we look ahead, based on the trends we are seeing in our business today, we are confident in our ability to deliver accelerated sales in H2 and are positioned to deliver continued improvement in profitability and margin expansion in 2024. As a result, we are increasing our full year earnings outlook. And with that, I will turn to our results. Q1 net revenues were $1.6 billion reflecting continued momentum in our global direct-to-consumer channel, which grew 8%, up 25% on a two-year stack and acceleration from Q4. Gross margin of 58.2% was better than expected and improved 240 basis points year-over-year. Expansion was driven by lower product costs, the shift to DTC, and the fact that wholesale mix was abnormally elevated in the prior year due to the ERP implementation. These factors offset both FX headwind and the analysis of the strategic price reduction we took in U.S. wholesale in H2 last year. Adjusted SG&A expenses in the quarter increased 1.2% to $766 million compared to $757 million last year, slightly better than expectations as we start to see the benefit of our cost control actions, including Project Fuel. Adjusted EBIT margin declined 200 basis points to 9% compared to 11% in the prior year. The decline was almost entirely due to the sales deleverage resulting from the $100 million ERP shift. Adjusted diluted EPS was $0.26 ahead of our expectations, primarily driven by the outperformance in both revenue and gross margins. Before turning to our segment highlights, let me spend a moment on the restructuring charges we took in the quarter. As we launched Project Fuel in January to accelerate profitable growth while driving cost savings. Since then, we have taken actions to streamline our organization structure with the elimination of approximately 12% of our global workforce. Other actions being implemented will improve DTC productivity and our SG&A as we deliver savings across indirect procurement and other initiatives. We also made the decision to close our manufacturing facility in Poland as we optimize our supply chain to enable both agility and lower costs. After a strategic review of our categories, we have decided to wind down our small Levi's footwear business. This, along with the decisions to exit Denizen last quarter, will help our plans to unlock the true potential of the Levi’s brand globally. These actions put us on the path to achieve approximately $100 million in savings in 2024 and more in 2025. Now let's review the key highlights by segment. In the Americas, DTC achieved 11% growth, which was more than offset by a decrease in wholesale largely due to the shift in wholesale shipments in the prior year. Operating margin increased 160 basis points to 18% due to increased gross margin across both channels and lower SG&A. This was largely driven by our U.S. business, which is more profitable today than last year. We also just closed our acquisition of our Levi's brand distributor in Colombia, including approximately 40 owned and operated Levi’s retail stores. This transaction further underscores the tremendous opportunity that exists to accelerate DTC growth within Latin America and further diversify our business geographically. This follows a very successful 2019 acquisition of our distributor in Chile, Peru, and Bolivia that has significantly surpassed our revenue and profitability expectations, and we're very optimistic on the outlook for the business in Colombia. In Europe, DTC net revenues increased 4% excluding Russia. Growth was driven by positive performance in company-operated stores and in e-commerce. Wholesale net revenue decreased 13% excluding Russia as wholesale orders from our retail partners remain conservative. As Michelle mentioned, we are encouraged by the momentum we're seeing in our DTC business and coupled with a positive inflection in our wholesale order book in the second half gives us confidence that Europe will grow in H2. In terms of profitability, gross margins were up 200 basis points driven by an increase across both channels and most markets in segments. Asia's net revenues increased 5% compared to the prior year and are up 27% on a two-year stack. DTC revenues increased 7% driven by strength in company-operated mainline and outlet stores and in e-commerce, and wholesale net revenues increased 3%. While a relatively small business for us, we experienced a slower than expected recovery in China. We have several initiatives in place to improve our business performance in this market, including ramping up our local product engine. Excluding China and the impact of the Middle East, this segment was up 8%. We are still long on Asia and remain confident in our plans to drive high single-digit growth in this region. Now looking to our balance sheet and cash flows, reported inventory dollars decreased 14%, or 21% excluding the impact of the modification of terms with the majority of our suppliers. Comparable inventory in the U.S. remains significantly below last year's level, and we continue to make progress in Q1. Overall, inventory is also expected to end the year below prior year levels as we work to further optimize inventories by improving turns and driving more assortment productivity. Adjusted free cash flow was $214 million in the quarter, positive for the second quarter in a row as we manage inventory and working capital. We also expect to end the year with positive free cash flow. Our improved cash flow position enabled us to return $73 million to our shareholders in the form of dividends and the re-initiation of share buybacks. In the quarter, we paid out $48 million in dividends and spent $25 million repurchasing shares. We also announced Q2 dividends at $0.12 per share, maintaining the Q1 dividend per share. Now let's turn to our fiscal 2024 outlook. Looking forward, we remain confident in the strength of our brand and the execution of our strategies. We are pleased with the trends in both the category and our business that we saw in the first quarter, and these have continued into March. However, given that we've just started the year, we're taking a prudent approach to our revenue outlook while raising our full-year adjusted diluted EPS guidance slightly. With that in mind, we are affirming our full-year outlook of 1% to 3% revenue growth. Incremental headwinds from FX in Asia will be offset by the impact of the Colombia acquisition. We now expect full-year gross margin to be up about 150 basis points, which is the high end of our previously guided range. Turning to earnings, we are raising our adjusted diluted EPS estimates by $0.02 to $1.17 to $1.27, giving us stronger gross margin results and our continued commitment to expense discipline. As we look into the second quarter, we continue to expect revenue to be up high single digits. The Q2 revenue guidance reflects the shift in the ERP implementation and the exit of the Denizen business. We expect gross margins to be down approximately 50 basis points due to the higher concentration of DTC in the second quarter of ‘23 given the ERP implementation that took place in that quarter. Overall, H1 gross margins will be up approximately 100 basis points, and we expect the adjusted diluted EPS to be about $0.10 in Q2, which is 150% higher than the prior year. Before we begin Q&A, there are two points I would like to make. First, we are confident in our ability to grow the top line mid-single digits. We are seeing continued momentum in DTC globally, green shoots in the wholesale channel, and encouraging trends in the U.S. Our product pipeline is resonating with consumers and positions us to continue to grow market share. Based on the strength of our new offerings in Europe and DTC and the positive pre-book in wholesale, we remain confident that Europe will return to growth in the second half. In addition to the stores we acquired with the Colombia acquisition, we're also on pace to open a net 100-plus new system stores globally in 2024. Second, we remain focused on driving improved profitability and cash flow while being committed to delivering 15% operating margins over the longer term. We are confident in our ability to drive margin expansion through gross margin execution and expense discipline. The benefits from our Project Fuel initiative are just starting to unfold which will continue to improve the agility and efficiency of our business, and we will also continue to deliver positive free cash flow through inventory and working capital management. To close, these actions give us confidence in delivering our ‘24 commitments while setting the foundation for profitable long-term growth and enabling the company to deliver solid returns to our stakeholders. With that, I will go ahead and open up the line for Q&A.

Our first question comes from Bob Drbul of Guggenheim.

Hi, good afternoon. I was wondering, I think you mentioned on the call market share gains and some recent category trends. Just wondering if you could share some more around what you're seeing and where you feel like the market share gains have come from. Thanks.

Thanks, Bob. Thanks for the question. Yes, first of all, we are really excited about what we're seeing in the category right now. So let's start with our biggest market in the U.S. After a couple of years of volatility, we're seeing the jeans category actually stabilize and it's now flat to the prior year. But I think most importantly, we are seeing market share gains with the Levi's brand. In the men's category, we saw two points of share gain and in women's we were up a point. And then underneath that, some really great proof points around our strategies. First, we continue to be committed to driving a business with youth and our key target, the 18 to 30-year-olds; we're seeing share gains there. With the middle-income consumer, which is a big part of the market, 40% of the category, we are seeing the category grow as well as grow with Levi's. We're continuing to pick up share with that higher-income consumer as we focus on elevating the brand. I think really attributable to everything we are doing to drive our initiatives in DTC in the U.S.; DTC was up 10%. So within denim, we're feeling good. I think you can look around even here in the U.S. and it's a denim moment. I mean, there's a lot happening in denim and for Levi's, we are driving the trends. We're excited about everything we are doing in head-to-toe denim dressing and that's really resonating across our male and female customers. On that note, we are expanding our addressable market. So we first start with this evolution from being all about denim bottoms to denim lifestyle categories like skirts and dresses, which are up triple digits in the quarter, amazing. Our tops business, as we've been talking about for some time, whether that's denim tops or perfect pairings, that was up 10% in DTC, also outperforming, so a lot of great proof points. And then beyond that, around non-denim, we are seeing great strides there as well. So non-denim was up 13% in DTC for Q1, representing 42% of our DTC channel. We are seeing that in categories like the XX Chinos and our new introduction, the active tech pant, which is doing really well both in wholesale and in the DTC, in fact, exceeding our expectations we're chasing into inventory. I would just say around women; it's a key focus for us. A third of our business today, we see that over time growing to half of our business from fashion bottoms, like I said, skirts, dresses, tops. Women's overall DTC was up 14% for the quarter, but in the U.S., it was up 19%. So I could go on and on, Bob, but there are so many great proof points that our strategies are gaining traction. The last thing I would say that's all around the U.S. But as we think about globally, the denim market is expected to continue to grow about mid-single digits. So we fully expect to grow with the category, but we also expect to exceed it and drive market share.

Our next question comes from the line of Laurent Vasilescu of BNP Paribas.

Thanks very much for taking my question. Michelle, Harmeet, we know that you're encouraged by trends in Europe. There's a lot of fear on Europe since yesterday morning. So curious to get your take on what you're seeing in that market by region. Should we still see Europe grow low single digits for the year? And then separately, I know Beyonce's album was just dropped a few days ago, but curious to know if you are seeing any boost from her Levi's titled song.

Hey, Laurent. Michelle here. I'll take both your questions. Well, first of all, as it relates to Europe, as we shared on the call, it was really Europe wholesale, where we had a tough quarter there. I'd say that was largely due to some of the macro pressures, as well as our own product deliveries. We feel like on the product side, we've corrected that. I'll get to that in a moment. But overall, we feel really good about Levi's in Europe. The brand continues to be very strong. We have many measures against our brand health. Our brand boasts the highest unaided awareness. All of our denim perceptions remain best-in-class. We're actually seeing increases in Europe on relevance, preference, and even head-to-toe denim. So those things are all headed in the right direction. A huge proof point for us, of course, is how the consumer is responding to our direct channels, both our stores and e-commerce. Overall, our DTC business in Europe, excluding Russia, was up 4%. Importantly, we saw that accelerate during the quarter. In February, DTC was double-digit, and that carried on into March, driven largely off of our new product drop. What we're seeing really in many markets, I was just elaborating in the U.S., but in Europe as well, the consumers are responding to the fashion we are bringing, so women's fashion, the looser fits, the baggy fits, the low-rise, also the rib cage, all doing well. On men's, we're also seeing the baggy trend take hold. Our tops business is improving. So that new product is what's driving DTC and what we expect will also drive wholesale. So while a softer quarter, this past quarter for Europe in wholesale, we're expecting improvement, especially in the back half. To me, the biggest evidence of that is that our pre-books for Europe are up for the back half of the year. So we are expecting Europe overall to return to growth in the back half of the year.

And Laurent, to your question about full year, yes, we do affirm that Europe would be up low single digits.

And your second question on Beyonce. I would just say that denim is having a moment and the Levi's brand is having a powerful moment around the world. You see head-to-toe denim everywhere around the world, and Western fashion is really trending in music, as you just said. One of the things that really is significant about the Levi’s brand and we place a lot of emphasis and investment is making sure that Levi's brand remains at the center of culture. I don't think there's any better evidence or proof point than having someone like Beyonce, who is a culture shaper, actually name a song after us. So we're super proud of that, and we are very, very honored that someone like Beyonce would actually name one of her new songs.

Our next question comes from the line of Dana Telsey of Telsey Advisory Group.

Hi. Good afternoon, everyone, and nice to see the progress, Michelle and Harmit. As you talked about stabilization in U.S. wholesale, was it department stores, off-price, the discounters, what did you see in U.S. wholesale and what's your outlook going forward? And, Harmit, as you mentioned, inventory levels with the gross margin uptick in guidance for the year, any specific drivers of gross margins that we should be mindful of given compares to last year? Thank you.

Hey, Dana. I will take the first one, and then Harmit can take that second question. So as it relates to wholesale, really where we're seeing the improvement is in full-price wholesale. So it is in our partners, largely in department stores, and we're really excited with the progress. For the Levi's brand, U.S. wholesale this past quarter, we were positive. It was the second consecutive quarter of seeing positive sell-in, and we are also seeing improved sellout in that channel. It really is a direct reaction to the actions that we've taken since the congestion issues that we had last year in the supply chain are long behind us. We're filling orders at normalized levels. I'd say the partnerships with our wholesale partners have been very, very strong. I mean, this is an important channel to us. Levi's is an incredible brand to them. While we talk about rewiring the company or becoming organized around a DTC-first mentality, it's not DTC only. Wholesale will continue to play a really important role to amplify our brand and to reach consumers where otherwise we wouldn't. That said, we're seeing momentum in both sell-in and sellout. The single biggest reason is product. We're bringing a lot of newness to the channel, newness we call it in our core denim bottoms, and the core is continuing to work. I mean, I mentioned earlier in the remarks that we're seeing great traction ongoing with the 501. We're also in this denim cycle of looser, baggier styles like women's and also seeing men's willing to expand their closet with looser fits as well. There’s so much going on in fabrication and fabric innovation to provide denim that people can wear year-round. Performance Cool is one of the innovations that started to solve the need in Asia with warm temperatures. So, having made comments last year, that when the season got really hot, we didn't have enough offerings to satisfy that need. We're now expanding Performance Cool around the world, which we expect is going to really help our year as we look ahead. I think, in particular, in Europe, as I was just talking about momentum there, as well as here in the U.S. That’s being picked up by our wholesale partners too. Lightweight denim is part of this warm weather solution. And of course, there’s non-denim, and we have been so pleased to see the response in the non-denim areas with our latest innovation being the tech pant, which is just getting started in DTC and in wholesale and is off to a great start, exceeding our expectations, and we’re chasing into inventory with more expansions of the platform to come this year. So, there’s a lot working. We'll stay really close to our partners to maintain and build on that momentum.

And Dana, regarding the question on gross margins, we had a strong start to the year that has allowed us to raise the full-year expectation, as you’ve heard. So what's driving the strong start to the year? Product costs are coming to normal levels. About 240 basis points of margin improvement was driven by about 150 basis points from product costs, and about 110 basis points from the mix of DTC, half of that driven by the SAP ERP implementation that impacted Q1. Half of it is continued growth in our DTC business and the structural improvements in international, as well as the strong women's business. In the quarter, FX was a headwind, and we are analyzing the pricing initiatives that we reduced prices on in Q3 of last year. That’s really how Q1 has unfolded. Regarding Q2, if you go back and look at history, traditionally, Q2 gross margins are lower than Q1 and are usually about 100 basis points lower than Q1. However, we expect Q2 to be around 58.2%, which is practically a record high given that the only time we had a higher margin in Q2 was last year since DTC was a bigger piece of the business. The underlying factors, which are product cost, lower product costs, and lower air freight will continue through Q2. FX was a bit of a tailwind a year ago; this year it’s a bit of a headwind, so we expect H1 gross margins to be about 100 basis points better than they were a year ago. The second half of the year should see gross margins up about 200 basis points, largely because we will have recovered from the price reduction analysis and we believe DTC momentum will continue to accelerate.

Our next question comes from the line of Jay Sole of UBS.

Great, thank you so much. Michelle, you mentioned in the prepared remarks that you saw a lot of opportunity to improve the core wall economics of the company stores. Maybe can you just elaborate on that a little bit? Where do you see the opportunities? And if you can put that in context, if U.S. maybe like the top three or four margin drivers that we see that get the margins at mid-teens level over the next few years, what would those be? Thank you.

Yes, I bet, no, it's a huge focus for us. As we think about the future of our business, the growth really coming from DTC, it's critical for us to get the structural economics of the DTC channel to work harder for us. We have a lot of efforts afoot, both in our stores and on e-commerce. First I'll talk about the top-line drivers and then some of the other opportunities we have on profitability. But the first and biggest priority for us is to drive the top line. You get the top line benefit, of course, but it also helps leverage all your fixed costs, as you know, like your real estate and labor. As for the topline drivers, I would say a couple of things. Some of these are just the basics, like making sure that you're always in stock on the key items. The teams have enhanced tools today compared to even a year ago, with better systems and accountability to ensure that on X number of top SKUs, like your 511 top washes or low loose introduction for women, that we're not out of stock on the key sizes. Doing that has, as we shared the results, had a direct effect on the results we are seeing even this past quarter. Secondly, it's about innovation and newness. In a store, consumers want a more comprehensive head-to-toe look, and we're getting much more disciplined in how we're introducing newness on a monthly basis, ensuring that it's all through the lens of the Levi's brand and the close connections we see. I spoke to it in the remarks about this head-to-toe denim dressing. We are the authority in denim bottoms, and we're expanding that to being the authority in denim everything. Categories like skirts and dresses are comping at triple digits. This just says there's so much opportunity, right? Like we should have the iconic denim skirt for every woman who wants it, and we are not there yet. I will say there is a lot more upside. Same goes for tops. What's the perfect black t-shirt, white t-shirt to go with your bottoms? These kinds of things can not only drive traffic, but also drive conversion, UPT, and AUR. We're seeing increases in UPT and AUR based on the actions we're taking on the product side. In addition to product, it's about our teams in the store and having them encourage upsell and complementary sales, so we're seeing upside from that too; those are just a couple of examples. As it relates to cost, the biggest opportunity we have is becoming an expert in labor deployment and how we manage labor from the moment we open the store to the moment we close it, navigating through the week’s days, etc. A lot of focus and effort is being put here, and we're starting to see that early traction.

Our next question comes from the line of Oliver Chen of TD Cowen.

Hi, thank you very much. Hi, Michelle. Hi, Harmit. On Women's tops and dresses, is clearly a big, nice opportunity. What's ahead for timing of that and how it can and will drive upside to the model and move the needle even more? And as we think about your DTC first opportunity and strategy ahead, what do you think of speed and inventory management as well as the reality of markdown management and the cost method of accounting and making sure you're thinking about gross margin return on inventories as you become more agile and also balanced novelty versus core and also look to increase inventory flows and frequency to be agile with the customer. Thank you.

Okay, thanks Oliver. I'll take the first part and then Harmit will take the second piece. We're seeing traction already, Oliver. I mean, to the comments we made earlier, the DTC is up 8% in the quarter, and 25% on a two-year basis, and the momentum is actually accelerating, quarter-on-quarter, which is fantastic. Regarding women, I called out, DTC was up 14% overall, and 19% in the U.S. That same strength holds true for both tops and bottoms. As for the bottoms, the 501 continues, with boot cuts, flares, and the 90s baggy as all doing really well as fashion fits. On the top, what's resonating are non-graphic tees, woven shirts, and outerwear. This whole head-to-toe denim on skirts and dresses is off the charts. We're chasing into what works today, and the assortment only gets more robust moving forward. I'll quickly answer your question on speed. Go-to-market for us is one of our top priorities as we make this pivot to DTC. We are looking to shave months off our process from concept to consumer, so stay tuned on that as we’re already doing that in certain categories.

And to your question about markdowns and inventory returns, Oliver, I would say that's an opportunity for us. We can turn inventory faster in our stores and markdown cadence, given all the new products we're introducing. I think we can get a lot more scientific, and that's why we feel that the productivity opportunity in DTC is pretty high and large, and that’s what we are working on as part of Project Fuel.

A quick follow-up, Harmeet. On your guidance assumptions around margins, what was merchandise margin or what were the merchandise margin assumptions? If there's ones we should be attentive to for the year. Thanks, everybody. Best regards.

We haven't gone into those specifics, Oliver, but I'd say if you're asking specifically relative to markdowns and discounts, the margins are really driven in our view by the structural improvement in the business which is really our women’s and growth in our DTC channel. I think those are the factors that are driving the margins, and that's why it's more sustainable longer-term.

Our next question comes from the line of Christopher Nardone of BOA.

Hey, thank you guys. Good afternoon. Can you help us unpack the strength you're seeing in the North American retail business? I'd be curious if you're able to help quantify the trends you are seeing in the outlet business; first digital and then first full-price stores. Then as a related follow-up, just curious if you can help quantify how we should think about the impact of these hundred net new doors to your total sales growth for the full year. Thank you very much.

Yes, I take your first question. The growth in DTC in the U.S. is broadly across all three channels. Mainline is really strong. The outlet is probably strong but less strong, and our e-commerce business is actually doing fairly well. I would just say if you want to rank it: mainline, e-commerce, and outlet but all three are strong from that perspective. What we're seeing is largely driven by traffic as well as higher UPT and AUR. Conversion is an opportunity for us, and that's why we feel this can only get better over time. We are seeing the basket size improve because of newness that Michelle talked about, and better in stock is really helping the case from that perspective. I think you had a second question, Chris, sorry, what was your second question?

Yes, sure. I just wanted to see if we can talk about the impact you expect to see from these 100 net new doors. Is it impactful to the 1% to 3% total growth you're expecting? And then if you could kind of clarify where these new doors will be opening for stores?

Sure, so the 1% to 3% is impacted by a 200 basis points of a headwind because of the exit of Denizen. The gross number is more like 3% to 5%. The 100 net new doors, 70% of them are skewed towards the second half. So you see partial impact this year but probably more the following year. As you think about what's driving the DTC business, the number that we have kind of talked about, is high single-digit, low double-digit. A large piece of that is comp growth in existing stores, with the other being equally split between e-commerce and new stores. We do have, Chris, a very disciplined process where every year we review how the fleet is performing and determine the return on invested capital, which is in the high teens, and that encourages us to invest more capital and grow the store base long-term.

Our next question comes from the line of Tracy Kogan of Citi.

Hi, this is Tracy Kogan filling in for Paul. I think you guys said Europe DTC was up double digits in February, and that has continued into March. I was just wondering what March versus January and February looked like in the other regions. And then just a follow-up on gross margin. I think Harmit, you laid out the drivers of the 240 basis point increase. But what were the drivers that drove it above your expectation of up 150 basis points? What came in better? Thanks.

Yes, I think I mentioned, Tracy, to your second question, I kind of broke up the 240, 150 in product costs, lower product costs. The channel mix, which half of the channel mix was about a little over 100 basis points, but half that was the ERP-driven shift. Other factors like low air freight, etc., offset by FX headwinds and the analysis of the U.S. price reduction we took in Q3 of last year. That's what drove Q1. What was better than expected was just the strength in the DTC business, that was strong and helped out as a quarter, with the U.S. being a big piece of that because U.S. was up 10% on DTC. So that was the factor that grew the upside. Regarding your second question about, yes, we don't go into specifics, but Europe started soft and has accelerated. As Michelle said, once the new products were introduced, that I think drove consumer demand and actually has helped unlock some of the open to buy for our wholesale customers, and we're seeing that generally in the U.S. and in Europe, so that's the positive side.

So, it did improve, at least generally speaking in the U.S. and Asia as well, generally similar to Europe. Is that fair?

Yes, I would say U.S. and Europe in terms of the exit are stronger; Asia has been strong all along. We did experience a slower than expected recovery in China. We have several initiatives in place to improve our business performance in this market, including ramping up our local product engine. Excluding China and the impact of the Middle East, this segment was up 8%. We are still long on Asia and remain confident of our plans to drive high single-digit growth in this region.

Our next question comes from the line of Alex Straton of Morgan Stanley.

Great, thanks so much for taking the question. I just have a couple for you. The first, maybe for Michelle, is just taking a step back, how would you describe the state of the consumer now versus three months ago, just trying to get a sense if it's the same, better or worse? And then a second one, maybe for Harmit, just on North America margins, they definitely expanded nicely year-over-year. They're above pre-pandemic levels, but they are below where we were during COVID, I think about 20%. So what's holding that back, and is that 20% level achievable in the future for North America? Thanks a lot.

I'll take the first one really quickly. In a nutshell, I'd say we're feeling better about the consumer than we did three to six months ago. We're seeing lots of evidence of that, both in terms of our overall category, the denim space, and the stabilization we are seeing there in our biggest market in particular. The expectation globally in the denim category is to be up in mid-single digits, and then we see our own consumer respond both within our DTC performance with our DTC business up 8%, U.S. DTC up 10%, and gains with the middle-income consumer, and just market share gains across the board. We’re optimistic, more optimistic than I'd say we were three to six months ago.

And on the profitability in the U.S., yes, you're right. It's a lot more profitable than definitely a year ago. That's driven by gross margin and better management of labor, etc. that we talked about. It's not all the way to 20%, largely because when it was 20%, we were growing at a faster rate, including in wholesale. That is something that is an opportunity for us. As we unlock growth, which we are confident in doing as the year progresses, that should flow into the bottom line.

Thanks everyone. We look forward to speaking with you next quarter. Have a great rest of your day.

Thank you. This concludes today's conference call. Please disconnect your lines at this time.