KTB - NYSE

Greetings, and welcome to the Kontoor Brands' Q2 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Eric Tracy, VP, Corporate Finance and Investor Relations. Thank you. You may begin, sir.

Thank you, operator, and welcome to Kontoor Brands' second quarter 2023 earnings conference call. Participants on today's call will make forward-looking statements. These statements are based on current expectations and are subject to uncertainties that could cause actual results to materially differ. These uncertainties are detailed in documents filed with the SEC. We urge you to read our risk factors, cautionary language and other disclosures contained in those reports. Amounts referred to on today's call will be on an adjusted dollar basis, which we clearly defined in the news release that was issued earlier this morning. Adjusted amounts exclude the impact of restructuring costs. Reconciliations of GAAP measures to adjusted amounts to be found in the supplemental financial tables included in today's news release, which is available on our website at kontoorbrands.com. These tables identify and quantify excluded items and provide management's view of why this information is useful to investors. Unless otherwise noted, amounts referred to on today's call will be in constant currency, which exclude the translation impact of changes in foreign currency exchange rates. Joining me on today's call are Kontoor Brands' President, Chief Executive Officer and Chair; Scott Baxter; and Chief Financial Officer, Rustin Welton. Following our prepared remarks, we will open the call for your questions. We anticipate the call will last about an hour. Scott?

Thanks, Eric, and thanks for all of those joining us on today's call. I'm going to focus my comments today on three areas. First, I'll discuss key highlights from the second quarter, including our continued share gains in the U.S., momentum in D2C, which we believe provides the best indication of brand health and the strong results of our international business led by APAC. Most importantly, I'll touch on why we believe that KTB investment thesis is so uniquely positioned given how under-indexed we are in D2C in international. Second, I'd like to share how strategic investments in key growth pillars, including demand creation, have and are expected to support our market outperformance in the near term, but also drive increasingly diversified and accretive growth across categories, channels and geographies over time and how we took amplified action here in the second quarter to reduce nonstrategic spend and improved operating efficiencies, both of which helped fund these critical growth enablers. And lastly, before I pass it to Rustin, I'll provide perspective on why I'm confident in Kontoor's glide path despite the uneven macroenvironment, this is evidenced in not only our reaffirmed '23 guidance, excluding the restructuring charges, but in our accelerating topline we anticipate here in the third quarter. Let me start with highlights from our second quarter. I'm pleased to share that we delivered Q2 results largely consistent with both our expectations and commentary we provided on our first quarter call. Global Kontoor revenue was essentially flat year-over-year as strength internationally, particularly in the China region, was offset by a low single-digit decrease in U.S. wholesale. Within the U.S. market, continued strong POS and share gains were tempered by challenges in seasonal products and softer shipments during the quarter as retailers remain cautious with their open to buys. I'll touch on this a bit later, but fortunately, this dynamic has begun to turn more positive here in the third quarter. From a share perspective, according to Circana, which focuses on the U.S. total measured market, we continued to outpace the market in our U.S. wholesale in core denim business during the second quarter. A few key callouts. For the last three months, Kontoor brands outperformed the market by approximately 100 basis points. And in men's bottoms, Kontoor outperformed the market and our largest competitor by over 160 and 200 basis points, respectively. Our share gains in the core are a direct function of a few key factors. First, it reflects the incremental investments in our brands across innovation, design and demand creation, that drives competitive separation. And second, we were very mindful with strategic pricing, including both where we priced and how much we priced, understanding the elasticity of our consumer with a focus on using innovation and newness to support incremental pricing. In terms of pricing, I appreciate why this may be top of mind for the investment community, and I will expand in more detail when I discuss our outlook. However, I want to highlight that the full year guidance we provided in March of this year already assumed a more aggressive pricing and promotional environment in the second half of '23. Beyond share gains in the core, we also saw a nice category expansion during the second quarter as we continue to diversify the product portfolio and extend our reach to new points of distribution. Global highlights on a reported basis included non-denim long bottoms and T-shirts increasing 12% and 24%, respectively, while outdoor was up high single digits. Further indication of our brand's health and consumer wallet share, our D2C business once again delivered broad-based strength in the quarter. Globally, Kontoor D2C increased 15% with own.com and owned retail, both growing mid-teens. In the U.S., D2C grew 9%, balanced across brands with Wrangler increasing 10% and Lee increasing 8% versus last year. And international D2C accelerated in Q2, increasing 25% with Wrangler increasing 14% and Lee increasing 28%. And speaking of our international business, the second quarter saw a return to growth overall, up 13% as continued choppiness in Europe and wholesale was offset by D2C as well as broad gains in APAC. China in particular saw significant recovery increasing 93% compared to last year. Rustin will touch on this a bit later, but while growth rates in the quarter and in future periods will be impacted by prior year lockdowns and restrictions, we are encouraged by the overall healthier marketplace and ongoing investments that will support material improvements in both our wholesale and retail businesses over time. As you all know, D2C and international are key areas of growth for Kontoor going forward. And given the significant white space that still remains ahead, B2C and international make up only 12% and 21% of our last 12-month mix, respectively. The Kontoor investment thesis is uniquely positioned relative to many in our competitive set. We have more mature D2C in international operations. The diversified and accretive growth that D2C and international affords is still very much ahead of us. This supports a more profitable growth algorithm over time. And we will continue to use ongoing structural gross margin accretion to help fund amplified investments in critical growth enablers such as talent, technology, innovation and demand creation, creating a virtuous cycle for the sustained top line growth long term. We see opportunities to lean into these areas in the third quarter in the upcoming holidays and into '24. We also will be proactive with strategic actions that help evolve our operating model for the go forward, including the restructuring measures taken during the second quarter. Rustin will provide more detail, but I want to be clear, the steps we've taken are not in reaction to a challenging market, but because we are in a different stage of growth relative to where we were at the spin with our global operating model and ERP implementation complete, we are increasingly focused on driving efficiencies and reducing nonstrategic spend, augmenting the gross margin accretion to reallocate capital towards TSR bolstering investments. With respect to demand creation, I'd like to share some examples of our brand elevating activations from the second quarter and future pipeline. First, with the Lee brand, the team continues to build momentum with tastemakers and trend setters attracting younger, new-to-file consumers into the brand. Our LA-based stylist showroom continues to yield strong engagement with some of the world's leading celebrities and influencers. And later this month, Lee is preparing its first-ever women's focused partnership with Daydreamer, a female-founded brand that celebrates American made graphics storytelling. Product will be offered at premium points of distribution as well as D2C, including select products made in Los Angeles. Lee is also leading into its history of innovation by expanding key platforms, including Extreme Motion. By year-end, we expect Extreme Motion will grow to over half our men's denim sales in the U.S. as consumers look to fit and comfort it provides. And we plan to build on this momentum next year with Lee's 100 years of denim anniversary. Stay tuned as we share exciting details over the coming quarters. Pivoting to Asia, Lee is partnering with leading celebrities and artists in countries such as India and South Korea to amplify our local voice in these important growth markets. And our upcoming collaboration with the rising China-based streetwear brand, Roaringwild is slated to be featured during Shanghai Fashion Week and taken globally, a great example of Lee's ability to leverage its platform to bring differentiated products to markets around the world. Turning to Wrangler. As you know, in May, we kicked off our inaugural sponsorship with the Academy of Country Music Awards with three incredible days of denim customization, artist interviews and music performances. Leading up to the award show, the Wrangler brand was in the heart of artist activity with prominent placement on media Row and the red carpet -- as well as musical performances from Wrangler country music endorsees Cody Johnson and female brand ambassador, Lainey Wilson, and we were frilled to see Lainey take home four awards, including Album of the Year in female artist of the year. Wrangler's momentum only continues in the back half of the year. I'm particularly excited about our new female and kids initiatives, including partnerships with Star and Mini Rodini, these platforms further advance Wrangler's diversification strategies to attract new and younger consumers while staying true to the brand. And as you saw earlier this week, we announced Wrangler is the official denim brand of the Dallas Cowboys. The sponsorship will be featured throughout the upcoming season and will include activations throughout AT&T Stadium, social media and monthly concert series. I recently had a chance to see what is planned on and around the Cowboy Stadium, and it is truly incredible. This authentic connection is a natural fit for two American icons and we couldn't be more excited to launch in the coming weeks. And finally, let me provide some perspective on our unique positioning going forward. During the second quarter, we took proactive strategic actions to enhance our operating model, drive greater efficiencies and improve our inventory levels. For the balance of '23, we have reaffirmed our guidance, excluding the restructuring actions taken in Q2, despite our continued assumption for a more challenging macro backdrop, particularly here in the U.S. In the face of these macro headwinds, our strategic investments are helping drive competitive separation as evidenced by our solid share gains, POS and improving shipments. Given these factors and strong proof points from quarter-to-date trends, we expect Q3 revenue growth to accelerate driven by the U.S., up mid-single digits and above our full year algorithm. Along with the improving top line, our gross margin drivers are intact, including moderating input cost pressures, reduced production downtime on healthier inventory and ongoing structurally accretive mix shifts to D2C and international. Combined, this provides optionality to lean into strategic investments to support both near- and long-term opportunities. Rustin will provide greater detail on our assumptions, but as I stated earlier, this outlook assumes a more deflationary and more promotional landscape. And importantly, we intend to exit '23 clean, well-positioned to catalyze more sustained and profitable growth long term. We will remain laser-focused on working down inventory, which coupled with improving fundamentals should support significant cash generation and increasing capital allocation optionality as we move through the balance of the year and into 2024. Finally, in closing, our results and go-forward performance always depends on our incredible colleagues around the globe. I want to especially thank our team's efforts to drive strategic actions during the quarter that help position Kontoor for future success. I'm confident that their continued commitment to the execution of our strategic playbook will help drive superior returns for all KTB stakeholders. We look forward to sharing the next phase of our long-term strategic vision at our Investor Day, which is tentatively targeted for early 2024. Rustin?

Thank you, Scott, and thank you all for joining us today. As Scott stated, we are pleased with our second quarter results that were largely consistent with our expectations despite the uneven environment. For the balance of the call, I'm going to discuss highlights from the quarter as well as our outlook, but I would like to begin by touching on the actions we took during Q2. First, on inventory. As you saw in this morning's release, we made meaningful progress in improving the health of our inventory position during the quarter, which allowed us to generate cash and further de-lever the balance sheet. As we have discussed, owned manufacturing is a competitive advantage in times like these. It allows for the proactive actions we took in managing internal production, including downtime that we discussed last quarter to more effectively right size inventories. In addition, it allows for nimble optimization of our manufacturing footprint. During the second quarter, we took steps to streamline and transfer select production in our network as part of an ongoing comprehensive analysis of our supply chain. This will not only aid in normalizing inventories but will have ongoing benefits to our operational efficiency. In fact, we now see incremental opportunities in the back half of the year to further improve our inventory position, which I will discuss later in my remarks. Second, as we discussed last quarter, we remain highly focused on driving efficiency gains and reducing areas of nonstrategic spend. Taking this measured long-term view, combined with disciplined expense controls is foundational to our operating playbook. I will discuss the impact of these actions during my prepared remarks. But during the quarter, we executed a targeted restructuring initiative, primarily in corporate functions to create greater efficiencies and enable additional strategic investments. Combined, these actions increase optionality to further invest in the business as we will do in the third quarter as well as enhance capital allocation options that help support superior TSR. With that, let's review the second quarter. Global revenue was flat compared to the prior year. Growth in D2C and international were offset by a slight decline in U.S. wholesale. On a regional basis, U.S. revenues decreased 2%. Softness in the wholesale channel was primarily driven by declines in seasonals, which more than offset increases in strategic growth categories, including outdoor and non-denim long bottoms. And while improving, we continue to see POS outpace shipments as the channel works towards equilibrium. In the U.S., D2C momentum continued with growth across both brands, including 13% growth in own.com. International revenues increased 13%, driven by strong increases in China, somewhat tempered by softness in EMEA. On China, as we discussed last quarter, we expected Q1 to mark the most significant year-over-year declines with trends improving significantly in the second quarter. We are pleased to share this is precisely what happened with China increasing 93%. And while the China recovery will not be linear as prior year lockdowns and restrictions impacted the quarter and will continue to impact comparisons in the back half, we are encouraged by the progress we made in Q2, including improving retailer inventories and supporting our brands for long-term growth in the region. In EMEA, revenues decreased 5%, driven by softness in wholesale, more than offsetting double-digit growth in D2C, tight retailer inventory controls driven by ongoing macro and inflationary headwinds continue to weigh on the region. Turning to our brands. Global revenue of our Wrangler brand increased 2% driven by strength in D2C and ongoing diversification into non-denim categories. Once again, non-denim penetration increased accounting for 48% of global Wrangler revenue. In the U.S., revenues increased 2%, driven by 10% growth in direct-to-consumer as well as gains in denim and non-denim longs, tops, and outdoor. Wrangler International revenue decreased 5%, driven by softness in European wholesale more than offsetting double-digit gains in D2C.Turning to Lee. Global revenue decreased 3%. Softness in wholesale more than offset 19% growth in D2C. Lee U.S. revenue declined 15% as decreases in seasonals had a relatively outsized impact on the quarter. Partially offsetting wholesale declines was continued growth in D2C, including 25% growth in own.com. Lee International revenue increased 27%. APAC increased strong double digits, including broad-based increases in China. In EMEA, revenues decreased 1% driven by double-digit growth in D2C, offset by declines in wholesale. And finally, from a channel perspective, U.S. wholesale decreased 3%, non-U.S. wholesale increased 9% and global direct-to-consumer increased 15%, including a 15% increase in own.com and a 16% increase in brick-and-mortar. Now on to gross margin. Gross margin decreased 250 basis points on an adjusted basis to 41%. As discussed last quarter, we increased proactive actions in managing internal production, including downtime to support the normalization of inventory. This had the greatest year-over-year impact in the second quarter as expected and helped drive the sequential inventory improvement from the first quarter. In addition, input costs further weighed on margin rates as the lagged impact of inflationary pressures works through the P&L. Somewhat offsetting these headwinds were strategic pricing and mix as well as the normalization of transitory costs, such as air freight. SG&A expense was $180 million on an adjusted basis or a $2 million increase versus the prior year. As a percent of revenue, adjusted SG&A increased 30 basis points to 29.3%. Strategic investments in D2C and demand creation were partially offset by tight expense controls. Earnings per share was $0.77 on an adjusted basis compared to $1.09 in the same period in the prior year. The quarter included a onetime discrete tax charge of $0.09 related to the remeasurement of deferred tax assets associated with the relocation of our European headquarters. Now turning to our balance sheet. Second quarter inventories increased 17% compared to last year and sequentially improved from the 52% increase in the first quarter. Compared to Q2 2019, inventories were up 16%. As discussed, while the planned production actions and downtime were completed in the second quarter, we will continue to be proactive. We feel good about the quality of our inventory, which remains primarily in core styles and now see greater opportunity to optimize inventory levels and expect an additional $75 million of inventory reduction by the end of the year. As I will touch on in our outlook, we remain focused on actively managing our working capital to drive cash conversion. We finished the second quarter with net debt or long-term debt less cash of $706 million and $82 million in cash and equivalents. Our net leverage ratio or net debt divided by trailing 12-month adjusted EBITDA at the end of the first quarter was 1.9x, within our targeted range of 1x to 2x. And as previously announced, our Board of Directors declared a regular quarterly cash dividend of $0.48 per share. Finally, at the end of the second quarter, we had $62 million remaining under our share repurchase authorization. Now on to our outlook. Revenue is still anticipated to increase at a low single-digit percentage over 2022, with second half revenue now expected to be above first half. Our guidance embeds the following expectations. First, we continue to anticipate a more challenging U.S. macro environment in the back half, particularly in the fourth quarter. That said, compared to our prior outlook, we now see relatively stronger Q3 trends in the U.S. with growth across both brands. Second, as I have mentioned previously, the recovery in China will not be linear given 2022 lockdowns and re-openings. As such, we expect the third quarter revenue decline to be more than offset by growth in the fourth quarter. For the year, we continue to expect second half revenue growth in China and above the first half performance. And finally, based on continued U.S. share gains, improving shipments in POS as well as strong quarter-to-date trends, we expect third quarter revenue to increase at a mid-single-digit rate. Gross margin is expected to be in the range of 43.5% to 44% on an adjusted basis compared to 43.1% in 2022. We continue to anticipate favorable mix to support margin rates, driven by increasing D2C penetration and improving international growth rates broadly in the back half. Additionally, as discussed last quarter, we saw peak inflation flowing through the P&L in the second quarter. We anticipate input cost pressures will ease significantly in the third quarter before inflecting to a tailwind in the fourth quarter. As a result, we continue to expect gross margin expansion in the second half, with the greatest year-over-year gains in the fourth quarter. SG&A is expected to increase at a mid-single-digit rate on an adjusted basis compared to adjusted SG&A in 2022. We are planning growth rates most pronounced in the third quarter as we distort investments in support of upcoming holiday and 2024 to continue to support separation in a choppy environment. As we have discussed, we will continue to make investments in our brands and capabilities to drive long-term profitable growth. These focused initiatives will support demand creation, D2C and international expansion. This will be partially offset by tight cost controls. EPS is still expected to be in the range of $4.55 to $4.75 on an adjusted basis, consistent with the prior outlook, excluding $0.13 associated with the restructuring charges in the second quarter. We continue to anticipate adjusted EPS year-over-year growth to be the strongest in the fourth quarter, driven by the gross margin dynamics discussed and the amplified SG&A investments in the third quarter. Finally, I want to echo Scott's comments and thank our colleagues around the globe. Despite the uneven environment, our team's strong execution against our strategic initiatives drove another quarter consistent with our expectations and gives us confidence in our full year guidance. As we enter the back half of the year, we remain laser-focused on driving profitable growth, improving cash generation while expanding capital allocation optionality and supporting our brands through strategic investments. As Scott mentioned, we look forward to sharing more on our long-term opportunities at our Investor Day, which is tentatively targeted for early 2024. This concludes our prepared remarks, and I will now turn the call back to our operator.

[Operator Instructions] Our first question is from Bob Drbul with Guggenheim. Please proceed.

Good morning, and thanks for the questions. I have a few actually. The first one is when you look at what's happening sort of in the industry, in the space, you're reiterating guidance and third quarter is actually accelerating. Can you just talk a little more around your confidence, why you're so confident in the outlook? And then I guess the second question is just on demand creation. Can you talk a little bit more about the investments in the demand creation? There's a pretty significant pipeline, seems to be a key driver of the share gains that you've talked about. Are we thinking about this correctly? And I have one more, but I'll follow up after these. Thanks.

Hi, Bob, how are you? Scott, I'll go ahead and take that. I guess I would start, Bob, with the second quarter in that we really started to see momentum through the quarter. So we started to see some really nice share gains, which, as everybody knows, in a more sluggish environment like we've experienced share gains become really important, but share gains done strategically are even more important and that our share gains are happening because of that second question of yours are really intelligent demand creation. We're making great product. We're pricing it right. We're really thinking about our pricing from a strategic standpoint. We've got it at the right retailers. We're also now expanding our D2C and that brings momentum right into the third quarter where our shipments are starting to align with our POS. But when I think about the third quarter and I think about some of the demand creation aspects, our new Dallas Cowboys initiative, I think about Lainey Wilson joining our team as our brand ambassador and all the work she's done and these collabs that our team are coming up with. And I think I've said this before that we're now receiving a lot of calls in, and we used to make the calls outbound, but now we get an inbound and working with people like Stark, really great brand on the West Coast, Buffalo Trace and Dragon Ball

Got it. And I just one more question.

Demand -

Yes, go ahead. Sorry.

I was just going to say from a demand creation standpoint - I know you've got one more question you wanted to ask.

Yes. I mean it sort of ties in with demand creation a little bit, but I guess the dealers weren't available, but the Cowboys, it seems it seems like a pretty good -- it's like a perfect authentic partnership for Wrangler. But can you just talk to how this will be structured and how you're going to execute it?

Yes, for sure. So no, the dealers certainly love the dealers, but I think the Cowboys were a really good fit for us. I know we've done something really well, Bob, when my phone blows up like it has us from Cowboys, when I get a lot of messages from folks. And basically, the messages I get from folks are, that was a really smart move. It makes a lot of sense. Texas is a really big market for us and a really important market for us and sports is a great activation platform for us in that respect. And the way that we thought about this partnership related to whether it's going to be on social media, it's going to be in stadium, it's going to be through a concert series. We've got it kind of from every single angle when you think about it. So we're really happy about it in really can't wait to bring it to life as the rest of the year and the football season here kicks off. So again, I'm really proud of the team and some of the different thinking that we're now experiencing here after our spin-off versus what we did before. But I think we're on the leading edge of a lot of things. And I think now those examples are really baked into the business, and we're seeing the acceleration of the business because of that really smart move, so. Thanks Bob.

Thanks Scott.

Thank you. Our next question is from Will Gaertner with Wells Fargo. Please proceed.

Hi guys. Thanks for taking my questions. Maybe we could just talk a little bit about pricing and the dynamics there. We've heard competitors said they're sort of walking back pricing. I guess, number one, how much price have you taken over the last 18 to 24 months? And number two, are you baking in a more promotional environment in the back-to-school and the holiday? And then I have one more follow-up after that.

Well, I'll start that, and then I'll turn it over to Rustin to go ahead and finish. But like I made that comment a little bit earlier, we've been really smart about our pricing. We're taking pricing where we can. We know our consumer really well and understand the elasticity around our consumer. We really like the approach, and we're really thinking about the marketplace. We don't just blanket the marketplace. We put a lot of thought into this. And we've been very consistent in that over the last few years. Rustin?

Yes. Thanks guys. Good morning. Well, as Scott said, we kind of continue to remain focused just on offering consumers a compelling value. So as you think, Will, about benefits received for price charged on all of our products. So certainly approach pricing from a very strategic perspective. As Scott said in the prepared remarks and the last question, we've been pleased with the POS strength we've seen in the U.S., the share gains and really how our brands are resonating with consumers. So as we think about our outlook, we intend to dial up that demand creation in the third quarter in support of holiday in 2024. Keeping your brands strong is really an important aspect of maintaining that price. As Scott did indicate, though, Will, we certainly do assume a more challenging environment in the back half. That's been consistent in our outlook throughout the year, and it has been embedded in our guidance and our assumptions. So you'll recall last quarter, we talked a little bit about the strength in international kind of being tempered by softness in the U.S. in the back half due in part to a more promotional environment. So we see that incremental strength now in Q3 as POS and shipments find better equilibrium and remain cautious that the Q4 will be a little bit more challenging. So we've tried to be thoughtful about not just pricing but also the promotional environment we're encountering.

And just on the restructuring, you guys took some actions around some of the nonstrategic spend to drive some efficiencies. Maybe just speak to the rationale for those actions and what sort of efficiencies are going to be driving and how that can maybe impact margins?

Sure, Will, I'll start and then hand it off to Rustin. But if you step back and think about it, we spun off a little over four years ago, when you spin off you look a little bit like your parent company, sometimes a lot like your parent company that you spin off from. We went through a really big journey with our ERP system and implementation. And now that's done. And shame on us if we don't use that in a really positive way and think about our organization and how we thought about and we spent a lot of time during that thinking about how we're going to structure this company for growth, and that's exactly what we did. We structured the company for growth. We're really thinking about all those savings, how we're going to move those into greater efficiency, additional investments into our brands, talent design, demand creation that you've heard all about today, bring all that to the forefront. But now from that mentality standpoint, we've put ourselves in a really good position. We made a really big investment, and we are going to utilize that investment going forward, and we're going to make sure that we go ahead and push that agenda. This is our future, and we're ready to embark upon it right now. Rustin, anything to add?

Yes. I'd just say, Will, you saw in the prepared remarks the charges affected gross margin by about 40 bps in the quarter, SG&A by about 100 bps in the quarter and then EPS at $0.13. I think the real takeaway is that we're really shifting the SG&A dollars from nonstrategic spend into strategic spend. And as you've heard us talk a lot about will really driving that virtuous cycle. So unlocking those greater efficiencies, allowing for those incremental investments in our brands and growth enablers that are really going to support that more sustainable, healthier top line growth moving forward.

Thank you. I'll pass it up. Thanks guys.

Thanks Will.

Thank you. Our next question is from Jim Duffy with Stifel. Please proceed.

Thank you. Good morning, everyone. Really nice work through a difficult environment. A lot of big picture opportunities to discuss, but I want to make sure I understand the near-term dynamics related to your comments. Scott, can you elaborate on comments about near-term trends just in the context of the backdrop of what you've characterized as a challenging environment. Are POS trends in recent months actually improving versus trends earlier in the year. And I'm particularly interested in the improving replenishment. Where do channel inventory stand versus historical weeks on hand? And yes, I guess the question is what's the risk of further disconnect between POS and replenishment?

I think there's a couple of things that are intersecting here. You're seeing good momentum, and that really stems from the fact, and we've talked about this a lot, that we are pricing right. We've got really great products that are great values. But in addition to that, which we haven't done previous, but we're doing now, we've really brought some great demand creation into the marketplace. But in addition to that, now you've got shipments that are aligning with POS as we head into the rest of the year, which becomes really important for us. You've got international and China now coming on stronger than it has been open and back up. So that's a really big deal for us. And as we move forward throughout the rest of the year, we're going to continue to put that pressure on all of our competitors and continue to invest in our D2C. And Jim, we think that, that is really an important factor going forward relative to how we're going to invest, and we're going to maintain that healthy balance that we have right now.

And if I may, a question on the gross margin. Rustin, really great progress on the inventory. Can you be more deliberate with where you are with respect to consuming inventory associated with higher cotton costs and higher freight costs? All this -- it seems like it should be through the P&L by fourth quarter, am I correct about that? And then with that in mind and in the context of some of the other comments about pricing expectations for a deflationary environment in the category, do you still see structural opportunity to the 46% gross margin as you outlined at the 2021 Investor Day? Thanks.

Yes. Thanks Jim. Good morning. So in terms of some of the near term, you outlined it perfectly. So the peak input cost pressures really came through the P&L in the second quarter as we had talked about. So we see that kind of easing here, those input cost pressures easing in the third quarter before inflecting to a tailwind in the fourth. So that's kind of how I would think about sort of the evolution of those inflationary pressures coming forward. I think in terms of longer term, we've had some significant sort of transitory challenges, I would say, Jim, since our Investor Day in May of '21, including the record inflation, certainly continued supply chain disruptions. And as you're aware, sort of periods of retail inventory imbalances. So we're going to continue to see some of those transitory impacts in the back half of year, as I just outlined. But I think the real key is the structural drivers and the opportunities that remain in place. We continue, as Scott said in his prepared remarks, to be under-indexed in D2C and international over the last 12 months in D2C about 12% of our rev, international about 21%. So I certainly won't guide this morning beyond '23, but we'll provide some additional color at the upcoming Investor Day. But certainly, those structural mix improvements and opportunities that are out there, Jim, for that 46% plus gross margin that we had outlined have not changed and certainly see an opportunity to reach those levels as conditions continue to normalize.

Thank you. Our next question is from Mauricio Serna with UBS. Please proceed.

Great. Thanks for taking our questions. I guess, first, on the inventory, very good progress on working it down in Q2, the improvement and the year-over-year. And it seems like there's further opportunities for the second half. Maybe you could speak a little bit more on your thoughts about how that moderation in inventory, the declines that you are expecting, how will that like lead to like better cash conversion and any opportunities there with the cash flow generation that you'll have? And then just following up on gross margin, again, like it seems like it's inflecting positive or the way you're talking about the different factors affecting it from the moderation in input cost pressures, and I know you're calling out for like even like the strongest quarter year-over-year to be Q4. Maybe you could speak about like what you're thinking about the Q3 gross margin. I know like you talked about less pressure from cost, but should that imply that gross margin begin already expand in Q3 or is it more very highly skewed to Q4? Thank you.

Yes. Good morning, Mauricio. I'll go ahead and take those. So on the inventory side, I'll start there. So certainly, we finished inventory up 17% versus previous year and 16% versus the second quarter of 2019 at pre-COVID levels. Certainly pleased with the progress we've made there, the improvement from the first quarter, where we were up 52% and then certainly in the 60%s in the back half of last year. So we're continuing to see that sequential improvement that we had outlined and really took aggressive steps here in the second quarter to continue to drive that. From moving forward, we'll continue to be proactive. We feel good about the quality of our inventory, again, remains primarily in those core styles and as we said in our prepared remarks, now see greater opportunity to optimize those inventory levels and expect an additional $75 million of inventory reduction by the end of the year. The majority of the inventory is in North America, where we continue to see the strongest brand heat and POS strength that Scott talked about, and we're now projecting Q3 and Q4 to both finish below prior year levels and expect to end the year in a better alignment with some of our historic inventory days for the business. So I think the comment you made, Mauricio, about cash generation is perhaps the most important here. So this inventory reduction is really driving that working capital improvement, driving the cash generation in the back half and just increasing the capital allocation optionality that's out there. So pleased with the inventory progress we made to date, more projected here in the back half. If we shift over to gross margin, I mentioned a little bit about where we're seeing inflation, again, kind of peak inflation hitting in that second quarter gross margin, again, projected to ease moving into Q3 and then inflect to a tailwind in the fourth quarter. We do expect gross margin expansion in the back half with the greatest year-on-year gains in the fourth quarter as you kind of indicated. Really importantly, though, I really want to highlight that the structural margin drivers, as I mentioned on the question from Jim, we expect to see in the back half here and continuing into '24 remain intact as we continue to stored our investment and our growth in these accretive areas such as D2C and international that Scott talked about, we remain significantly under-indexed in those areas. And again, that diversified and accretive growth there really affords us that much of the gross margin opportunities are still very much ahead of us. And this really supports a more profitable growth algorithm over time. So again, certainly on a journey here, managing through sort of the near-term transitory pieces, which will improve in the back half, again, but those structural drivers remaining intact are really important as we look to the future. Thanks Mauricio.

Thank you.

Thank you. Our next question is from Brooke Roach with Goldman Sachs. Please proceed.

Good morning. And thank you so much for taking our questions. I was hoping you could elaborate on your outlook for growth that you're seeing in non-denim categories such as outdoor work and tops. As you look ahead, are these double-digit growth gains sustainable into second half as you start to work against some of the tougher compares? And do you see additional distribution wins ahead in these categories?

Yes Brooke, I'll take that. This is Scott. Thanks for the question Brooke. Yes, we spent some time and we kicked a lot of those off. As you remember in our last Investor Day, and we put a lot of energy and effort behind those in that we've hired some talent in addition to the fact that we've built some great product, and we are seeing some really good momentum in those categories. And we do see really big white space, both globally and also domestically in those categories going forward, as you've seen, they've been accelerating. But the key here is that we're building really good products at a very fair price, adding a lot of value, bringing those into the family, and they're operating very well, and they're working well with our customers, too. So our consumers are really lined up with us there, makes a lot of sense that we're in those categories related to what we've always done in our history. So have a lot of confidence going forward for those categories for sure.

Great. Thanks. And if I could just follow up on international. I was hoping that you could talk a little bit more about what you're seeing in terms of brand momentum in China and how the recovery is progressing. I think you mentioned in the prepared remarks that the recovery wouldn't necessarily be linear, but I'm curious what you're seeing in the early days of this recovery and how you're thinking about growth and margins in that business going forward?

I'll start, and then Rustin might have a few comments or two and I kick it over to Rustin. But in Q2, as you saw, a meaningful recovery increasing 93%. But with us, I think the key is that we've got really strong partner doors there, and we're really starting to roll out our retail initiative, which is really significant for us and how we're going to look and how we're going to operate going forward. So it's a really big initiative going forward for us. We have a new leader there, Gina, who we're really excited about, brings an incredible amount of experience in the marketplace. So that's a really big deal for us also. But going forward, our brand continue to do well. They resonate really well with the consumer there. Our largest brand, for sure, extremely healthy. Teams doing really well and very optimistic about the long-term outlook related to people, product marketplace going forward. Rustin, anything to add?

Yes. I'd just add, certainly, the comparisons year-over-year creates some noise, whether that's the second quarter, the third quarter or the full year. We are expecting growth in that back half. We did mention in the prepared remarks that the Q3 declines that we're expecting will be more than offset by the fourth quarter growth. So as you think back, Brooke, Q2 was marked by some pretty significant shutdowns in some key jurisdictions in China. Certainly, Q3 was marked by kind of a reopening, if you will, and certainly, many of our wholesale partners starting to prepare for holiday '22 and then really some unexpected fourth quarter additional lockdowns in select markets. So those year-over-year comparisons are really affected by those factors. You've heard us for several quarters now, Brooke talk about the recovery in China is not necessarily going to be linear on a quarter-to-quarter basis because of some of these compares or uniform across kind of different jurisdictions or locations within the country. Certainly, that's continuing to play out. So it is choppy. But as Scott kind of mentioned, we're pleased with the progress that the retailers have made really on improving retail inventories, which is really important, and we're going to continue to play the long game in this market with opportunities across both brands as we kind of move forward.

Thank you very much. I'll pass it on.

Thank you. Our next question is from Paul Kearney with Barclays. Please proceed.

Hi, everyone, thanks for taking my question. My question is on the U.S. wholesale business and Lee in particular. It looks like Lee kind of underperformed versus Wrangler in U.S. wholesale. I know some of that is from more seasonal you mentioned. I'm also curious whether you're seeing some of your customers gravitate more towards the Wrangler brand and how should we think about Lee U.S. for the remainder of the year? Thanks.

Yes Paul, it's Rustin. Good morning. I'll go ahead and take that. So as you mentioned, Lee U.S. was down 15% in the second quarter, really driven by wholesale being down high teens with D2C up kind of high single digits. So currently continuing to sort of see the D2C channel across both brands be a little bit stronger than the wholesale channel, particularly here in the U.S. So as you mentioned, Paul, and as we said in our prepared remarks, the quarter was difficult for seasonals. And as you know, Lee has a large seasonal business across both genders, both male and female. And as we look at our categories, specifically in the market, seasonals were the most challenged for the quarter. And that was really due in large part to the cooler weather patterns across most of the U.S. during the quarter. Certainly, across most of the U.S., a lot of that has changed over the last 45 days or so here as it's gotten significantly warmer, but it did have a relatively outsized impact on that second quarter for Lee, which is typically the seasonal shift in that second quarter. We are confident in the brand and are anticipating a strong Q3 for the brand. I think as Scott -- or as I indicated, we said we expected to see growth in both brands in the U.S. in the third quarter. For Lee specifically, we particularly see strength in that wholesale channel. And conditions have more normalized quarter-to-date, POS and shipments kind of finding a better equilibrium and then key retail partners really just being in a healthier inventory position. So certainly timing on the seasonals impact of the second quarter, but feel good about the brand.

Great. Thank you.

Thank you. As there are no further questions at this time, I am turning the call back to Scott Baxter for closing comments.

Thanks, everyone, and really appreciate your questions and your engagement with our company. Thanks, and we look forward to speaking to you again here in the upcoming third quarter. Have a happy and healthy and safe rest of the summer, and we look forward to talking to you soon. Take care, everybody. Thanks.