LEVI - NYSE

Good day, ladies and gentlemen, and welcome to the Levi Strauss & Co's Second Quarter Earnings Conference Call for the period ending May 28, 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 & Co.

Thank you for joining us on the call today to discuss the results for our second fiscal quarter of 2023. Joining me on today's call are Chip Bergh, President and CEO of Levi Strauss; and Harmit Singh, our Chief Financial and Growth Officer. We have posted complete Q2 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 everyone that we will be making forward-looking statements on this call, which involve risks and uncertainties. Actual results could differ materially from those contemplated by our forward-looking statements. Please review our filings with the SEC, in particular, the Risk Factors section of our Form 10-K and the information included in our quarterly report on Form 10-Q that we filed today for the factors that could cause our results to differ. Also note that the forward-looking statements on this call are based on information available to us as of today, and we assume no obligation to update any of these statements. During this call, we will discuss certain non-GAAP financial measures. 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 measures are included in today's press release. Finally, the call in its entirety is being webcast on our IR website, and a replay of this call will be available on the website shortly. Please note, for the balance of the remarks, Chip and Harmit will reference year-over-year revenue growth in constant currency. 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 Chip.

Thank you, and welcome everyone to today's call. We delivered a solid quarter in line with our expectations. Our results reflect two very different dynamics in our business, on one hand, strong DTC and International and on the other continued softness in U.S. wholesale, which I will address in a moment. Revenues for the quarter were down 9%. However, this was mostly attributable to the $100 million shift in revenue from Q2 into Q1, primarily due to the ERP implementation in the U.S. which we discussed on our last call. Excluding this shift, Q2 was down 2% versus prior year and first half revenue was flat against a difficult plus 23% comparison versus year ago. Our strategic growth priorities are performing at or above our plan. Our DTC business, the most premium expression of the Levi's brand globally continues to perform very well, up 14% in Q2 with broad based positive comp growth and AURs up mid-single digits. The continued strength of our DTC first strategy, which grew to a record 44% of total sales in the first half underscores our confidence in unlocking Levi's tremendous brand value. Our international business also remained strong growing 8% or 10% excluding Russia, led by continued momentum in Asia and Latin America. International has been the fastest growing part of our business over the last few years and it represents one of our largest opportunities going forward. However, this strength in International and DTC has been more than offset by a soft U.S. wholesale business. Today, U.S. wholesale represents less than 30% of our total revenues, down from 40% a decade ago as our strategic focus has been to grow DTC and International. And while first half U.S. wholesale revenue was down from last year on difficult comparisons, U.S. wholesale revenues are still up 2% versus 2019 with gross margins up as well. There are two main drivers to the slowdown of our U.S. wholesale business. First, the macro effects of higher inflation and a slowing U.S. economy has put increased pressure on the price sensitive consumer. Second, as we have mentioned for several quarters, our inventory backlog created supply chain challenges in our U.S. distribution centers resulting in our inability to fulfill all demand. The lower fill rate resulted in higher customer out of stock and less newness on the floor the last few quarters. We're taking a number of actions to address these issues, regain competitiveness and restore growth to our U.S. wholesale business. First, we are taking surgical price reductions on a select number of our Red Tab Tier 3 wholesale offerings, which we know are most price elastic and where the price gap versus competition widened too far. Importantly, we are not taking price reductions in U.S. mainline full price stores, nor the vast majority of our U.S. wholesale assortment including the 501 and women's fashion fits, which are all less price sensitive. Finally, we are not taking any price reductions on our international businesses where we continue to demonstrate strong pricing power as seen by the results. Second, with the ERP implementation behind us, and as our inventory levels continue to improve, we are seeing an improvement in order fill rates, now nearly back to historical levels, which will result in better sell-in for us and in stock positions at retail. Further, this will allow us to deliver the strong newness we have lined up to hit floors in July for the key back to school and holiday seasons. We are confident that these actions will improve our U.S. wholesale results going forward. Now let's turn to the progress we achieved in executing our three strategic priorities, starting with our first priority, leading with our brands. Due to the ERP shift, I'll speak to the brand's results for the full first half. The Levi's brand grew low single digits on top of 22% growth last year. Levi's bottoms grew low single digits with women's growth slightly stronger than men's. We continue to drive denim trends with products like our super low boot giving women more options for looser fits with lower rises. In the U.S, we're seeing strong demand with the $100,000 plus income consumer, particularly in our mainline stores, helping drive share gains in the premium end of the jeans category in the U.S. We've also maintained our share leadership with the key 18 to 30 year old demographic and for U.S. jeans overall, we gained market share across men's and women's. The greatest story ever worn marketing campaign and celebration of the 501's 150th anniversary generated billions of impressions globally and drove strong 501 demand, with revenues up low double digits in the first half against more than 40% growth last year. Moving on to our second priority, being DTC first. As I mentioned, global DTC delivered strong double digit growth in Q2, led by broad based positive comp sales and traffic growth across company operated stores in all geographic segments. U.S. DTC was also strong, led by our mainline stores, which saw continued strength in flagship and tourist destinations. We're also seeing the benefits of our investments in digital and the impact of our new Chief Digital Officer, Jason Gowans. Our e-commerce business grew 21% in Q2, driven by both higher traffic and better conversion. Strength was global and across all brands as we continue to expand the breadth of our offering online, while improving the user experience and customer journey. Consistent with driving growth in DTC and e-commerce, we just opened a state of the art digital fulfillment center for the East Coast in Kentucky and we'll begin shipping from there this month. This completes bringing our U.S. e-commerce business in-house, which will drive more agility and inventory positioning, reducing lead times, improving customer satisfaction and accelerating digital margin expansion over time. We are also continuing to expand our loyalty program, with over 26 million members, up 40% over prior year. Loyalty member transactions and average transaction values grew across all segments, a positive signal as we drive continued growth in membership. Overall, our digital and e-commerce businesses remain under penetrated versus peers and the channel represents a tremendous sales and profit opportunity for the company. Our third strategic priority is to continue to diversify the business. On a first half basis, our total company women's and tops revenues grew 1% and 3% respectively, both on top of more than 20% growth last year. Women's was driven largely by the Levi's brand, particularly in Asia. In addition to ongoing strength in denim fits for her, including lower rises, women's also saw growth from newly launched dresses, cargoes and overalls. Tops were driven by strength in Levi's men's. We remain enthusiastic about our opportunity to significantly grow these businesses as we continue to diversify our offerings. As for our other brands, Beyond Yoga's revenues accelerated double digits versus Q1, growing 28% in the quarter, driven by continued DTC strength. Overall, first-half sales were up 19%. The brand saw notable success with sports bras and dresses and it opened two additional stores in Southern California, bringing the total store count now to four. Dockers was also impacted by weakness in U.S. wholesale, while the brand experienced continued strength with DTC up 22% and international up 10% in the second quarter . Adjusting for the ERP shift, Dockers would have been flat in Q2 with sales up 8% in the first half. Before I turn it over to Harmit I wanted to share my conviction in our future and the strength of the Levi's brand around the world. Michelle and I have traveled extensively this last quarter, visiting a number of key international markets, including Mexico, India, China and Japan. And everywhere we have been the Levi's brand is incredibly strong and we are winning. We've met with consumers, customers and franchise partners and we’re inspired by their view of Levi's and our future. Our strength in DTC and international combined with the actions we're taking to fix our U.S. wholesale business give me confidence that we can accelerate as we go into the key holiday season and end-of-the year with momentum heading into next fiscal year. Finally, also giving me great confidence in our future is how Michelle has come up to speed on the business, organization and opportunities. Her current remit is big, the Levi's brand globally, all of our commercial organization through which the Levi's P&L rolls up and the digital organization. She has dug in and has played a key role in figuring out our path forward on U.S. wholesale. She is also all over our tops and women's businesses and I am confident, you're going to see a lot more good work as those products come to-market later this year and into 2024. She is also starting to make some smart organization moves to set the company up for the long-term. As I said before, I was confident when we hired her that she would be a great successor and now after six months I'm even more sure of myself as she will take this company to the next level when she becomes CEO. With that, I will turn it over to Harmit.

Thanks. In the second quarter we delivered on our objectives for revenue, profitability and inventory, while continuing to advance our strategic initiatives in a challenging environment. We delivered strong results in our global direct-to-consumer channel and are seeing positive momentum in our international business. These businesses today make-up the majority of our total revenue and are the primary drivers of our long-term growth and margin objectives. We also made progress in several other key areas of our business. In the quarter we meaningfully reduced our inventory position and our U.S. service levels improved as we exited the quarter, giving us confidence to now say we will end the year with inventories below prior year levels, ahead of our initial plan. Also, highlighting our commitment to long term investment, we accomplished a major milestone with our U.S. ERP upgrade, a cloud solution allowing us to leverage data more productively. That is also the foundation to growing our DTC and digital businesses. Related revenue impacts are also now behind us. While we are lowering our outlook for the back-half of the year, given the dynamics impacting U.S. wholesale, we have several initiatives Chip mentioned to drive stronger results in this business in the second half and the longer term. In the second half revenues, gross margins, EBIT margin and EPS are all expected to be up to prior year. To put this into perspective, second half sales are expected the same run-rate as the first-half. The back-half will also benefit from incremental sales drivers and margin tailwinds from lower product costs and freight, laying a solid foundation for next year. And we will end the year with a structurally stronger business with a higher growth and gross margin accretive DTC and international businesses, representing a greater share of the company. I will now provide more color on our Q2 performance and then move to our outlook. Total company revenue of $1.3 billion decreased 9% versus prior year, down 2% when adjusting for the ERP shift. Our DTC channel posted 14% growth on top of 22% growth in Q2 2022 with continued broad-based positive comp sales growth across geographies, driven by higher traffic and volume. Company operated e-commerce also accelerated, up 21% with growth across all segments and brand. Global wholesale was down 22%. Excluding the shift, the channel declined low double digits on top of nearly 20% growth last year. Growth was strong in Asia and Latin America, but more than offset by softer performance in the U.S and Europe. Adjusted gross margin was a record 58.7% up 50 basis points against last year's record Q2 performance. Favorable channel and geographic mix, price increases, lower airfreight and FX more than offset the impact of lower full price sales and higher product costs. As a reminder, our H1 2023 gross margins are approximately 300 basis points higher than 2019. We continue to expect several transitory cost headwinds to abate in the second half. I'll provide more color momentarily when discussing our outlook. Adjusted SG&A expenses in the quarter were $753 million, up 6% to last year. The increase was primarily to support DTC growth with company operated store count up 6%, as well as A&P investment to support our 501 marketing campaign that largely ran in H1. Adjusted EBIT margin was 2.4%, in line with our expectation and adjusted diluted EPS was $0.04. Here the key highlights by segment. In the Americas, net revenues declined 22% on top of 17% growth a year-ago. DTC, growth of 6% was driven by all markets. Latin America, in particular, saw continued momentum with 18% growth driven by the strength in Mexico, Brazil and the [Andes] (ph). Europe again grew, excluding Russia, up 1% on top of a 15% increase last year due to broad based DTC growth across all countries. DTC, excluding Russia was up 14% on top of more than 60% growth last year. Europe saw growth across most countries led by increases in Italy, Germany, the UK, Poland and Spain. Asia’s very strong performance further accelerated with revenues up 27%, driven again by growth across all channels, particularly DTC. We are encouraged by the improved trends we are seeing in China, which saw sales return to pre pandemic levels and growth across all channel with notable strength in mainline brick and mortar. Thailand, Turkey, Japan and India we're also highlights. Asia has operating margins also expanded 370 basis points to 12.3% due to higher gross margin and stronger SG&A leverage. Now looking to our balance sheet and cash flows. We continue to make progress on our plan to sequentially improve inventory levels. Q2 inventory dollars were up 18%, up 15 point improvement from last quarter and units were up 8%. Importantly, inventory improvement did not come at the expense of margin and current inventories are healthy, with gold co-products representing more than two-thirds of total inventory. We continue to expect sequential improvement and to end the year below prior year levels ahead of our plan. The peak of inventory is behind us and we're taking a prudent approach going forward, focused on moderating receipts and leaning into our ability to chase, a benefit of our globally diversified supply chain. Inventory management will be aided by our recent IT investments, including our ERP, enabling real-time visibility to our inventory on an omnichannel basis and across our network. Adjusted free-cash flow was $211 million in the quarter, up from $13 million in the second quarter of prior year. As we continue to improve our inventory throughout the year. We also expect to end the year with positive free cash flow. Our cash flow generation also allowed us to repay a $100 million of outstanding ABL borrowing this last week. In the quarter, we returned approximately $48 million in capital to shareholders via dividends, which increased 20% from Q2 last year. Dividends are up 20% in H1 versus prior year and for Q3 2023 we have declared a dividend of $0.12 per share, in-line with last quarter. Now moving to our updated guidance for fiscal 2023. While we have experienced stronger than anticipated trends in our international and DTC businesses where we expect continued strong momentum, we are lowering our outlook due to softer U.S. wholesale trend. We are not guiding revenue growth of 1.5% to 2.5% as compared to growth of 1.5% to 3% previously. We expect full year adjusted EPS to be within a range of $1.10 to $1.20 from a prior range of $1.30 to $1.40. There are three fairly equivalent factors driving the change in guidance. First, our slightly lower revenue expectation and the resulting fixed cost deleverage. Second, lower expected H2 gross margin mainly due to our targeted pricing actions. And third, non-operating FX losses and a higher tax-rate. For the year in reported dollars by segment, we now expect a low-single digit decline in the Americas despite continued strength in U.S. DTC and in Latin America. U.S. growth is still expected within the previously guided range of up low-single digits and based on the stronger trends for Asia, we now expect low-teens growth and improvement from the low double digit growth in our previous guide. Adjusted gross margin is now expected to contract approximately 90 basis points from prior year's 57.6% as compared to an expectation for a 50 basis point decline previously. The incremental 40 basis point decline is due to the strategic pricing actions we are taking to drive volume and capture market share in U.S. wholesale. Despite all the puts and takes during 2023, we expect that gross margins will end the year, up almost 300 basis points versus 2019. To put it into context the new guidance, I'll provide some color around our H2 expectations in total. We expect revenues to grow mid-single digits. As mentioned versus 2019, H2 sales will maintain the same run rate as H1. Similarly, we expect U.S. wholesale to maintain the plus 2% growth rate versus 2019 we delivered in H1. Adjusted gross margin is expected flat to up slightly in H2, driven by lower product costs and freight, partially offset by our targeted pricing actions. However, because the pricing actions are evenly distributed between the corridors and the benefit of lower product costs doesn't fully materialize until Q4, we expect Q3 gross margins to contract slightly more than 200 basis point year-over-year with Q4 gross margins up slightly more than 200 basis points over prior year. Looking at H2 in total, adjusted EBIT margin is also anticipated to expand nearly a 100 basis points to roughly 11.5%, but with Q4 adjusted EBIT margin significantly higher than Q3. Lastly, we expect an H2 tax rate in the low double digits versus 1% last year. To conclude, we expect to end the year structurally stronger setting us up well for 2024 and beyond. Our stronger growth, higher gross margin, premium DTC and international businesses will account for a greater share of our revenue, nearly 45% and 60%, respectively. Driven by our ongoing execution in surgical pricing action U.S. wholesale will stabilize and end the year as a smaller share of our business at less than 30%. Inventories are expected to end 2023 below prior year levels. Our 2023 gross margin is expected to remain 300 basis points higher than 2019 and we will exit the year with Q4 EBIT margins north of 12%. And importantly, we continue to return cash to our shareholders with a payout ratio of 150% of free-cash flow substantially higher than our targeted 55% to 65% communicated at our Investor Day. Lastly, while we are lowering our H2 outlook because of U.S. wholesale, we expect the strong growth in our large fast growing DTC and international businesses to continue, which as U.S. wholesale stabilizes and COGS improves will position our unique business model to generate significant financial leverage beyond 2023. With that, we'll now go ahead and open the call for Q&A.

Thank you. The floor is now open for questions. [Operator Instructions] Our first question comes from the line of Matthew Boss of JPMorgan. Your question please, Matthew.

Great. Thanks. So Chip, could you elaborate on current demand trends that you're seeing in the U.S. relative to Europe today? Could you provide an update on the denim category and market share trends? And then Harmit, what is your level of expense flexibility if macro trends worsened globally in the back half?

Hi, Matt. Thanks for the question. I'll kind of take this -- I'll start with the category, then I'll dig in a little bit deeper and talk market share and the contrast between U.S. and Europe. So first of all, on the category, you may remember that we only get quarterly data here in the U.S. So outside of the U.S. internationally, we don't get -- we don't really get any market share data or market data. So all we've got is U.S. data. And as you know, since the pandemic, there have been wild swings within the category, extreme downs, extreme peaks, extreme downs, lots of volatility. But if we take a look on a past 12 month basis through May, we are up against the biggest spike in category growth. So the May 2022 past 12 months versus May of 2021 past 12 months was a 20-plus percent spike in the category. That's the base that we're up against right now. And if you look at it on a past 12 month basis, we were down modestly versus that peak. The key point, though, when we take a look at the denim category overall in the U.S. is the category today on a past 12-month basis is 12% bigger than it was in 2019, 12% bigger than the pre-pandemic period of time, and that's on a dollar value basis. I'll talk about market share here in a minute. In the U.S., as we talked in the script, in the prepared remarks, it really is a story of two different channels, U.S. wholesale being very soft, paradoxically U.S. DTC much stronger. And I say paradoxically, because we're very strong in our U.S. mainline business, which is the most premium expression of the brand. But digging into U.S. wholesale, there are really two key dynamics, both of which we have some control over, and I'll speak to that. One is clearly the lower or moderate income consumer is being squeezed. And that is driving some of the big category dynamics. Much more price sensitivity, when we look at our business, our value brands are down double digits, U.S. wholesale down double digits and softness in that channel. But also, as we've talked through over the last several calls, we've had our own internal supply chain challenges with the inventory levels we were carrying, which were causing fill rate issues which led to customer service issues and ultimately, customer out of stocks. Now that our inventory levels are returning to closer to normal levels, we are seeing our service levels improve. And as we're into this new quarter, we are seeing that those improved service levels are improving the out-of-stock conditions, which is improving sell-through. So we're feeling optimistic about that. But for the first half, our U.S. wholesale business is still up 2% versus pre-pandemic. So despite the fact that we're down double digits, it's up against such a big base period. As I said, paradoxically, DTC is relatively much stronger, full-price mainline and e-com all performing really well. U.S. DTC comp kind of low to mid-single digits in the second quarter and first half. And e-commerce was really strong with double-digit growth in U.S. in Q2. I guess the last thing I'll say about the U.S. I'm going to talk market share just real briefly, which, in part because it's such a key indicator of brand health. We grew market share this past quarter. Our market share was up on men's and women's. We were up 2 points on men's to 22%. That is more than double the number two brand in the marketplace. And on women's, if you’ll forgive me for a moment, I'm going to take a little victory lot here. We took market share leadership for the first time in the 12 years that I've been here and the first time probably in decades, with one share point of growth to 7%, we were the only major brand to grow share in women's. We are also -- we maintained share leadership with our key 18 to 30 year old, which is our target consumer, and we gained one share point in the premium tier kind of which is $60 and up, again speaking to the strength of our mainline business, where we are also the market leader. Europe, real quickly, we don't have nearly as much information on market size. We don't get it. We get that data annually and same with market share. But I suspect picture is probably pretty similar. Excluding Russia, as you heard in the prepared remarks, Europe was up 2%. That's coming off of a 15% base. And the picture is pretty similar, DTC very, very strong. Our DTC business was -- excluding Russia, was up double digits. Traffic is still up mid-single digits in our own channels and comps are up double digits in Europe. Our second half comparison, by the way, get much easier, both in Europe and in the U.S. And so, that is kind of a tailwind from us from a numbers standpoint. But in Europe, we are also seeing softness in U.S. -- in Europe wholesale. The wholesale customers are being cautious with their open-to-buy budgets and wholesale in Europe was also down for the quarter. So I think without having as robust of data as we do for the U.S. and Europe, I would say the picture is fairly similar. Europe, for us, is more of a premium market. So, even in wholesale, it tends to be Tier 2 product across most of Europe at higher price points, but the general dynamics are very, very similar. Harmit, do you want to...

Yes. So let me talk the levers that we could push further. But let me just talk a little bit about what we're doing. So overall, Matt and everybody on the call, you're familiar that as things tighten, we can really tighten expenses. COVID was a good example and readjust our expense base to whatever new revenue base there is. What we've been doing so far this year because, it's not only a tale of two halves is also a tale of two worlds, and it's a tale of two channels. The channel -- international is working. Direct to consumer is working. So we're putting -- we're reallocating resources to fuel those businesses, and we're tightening costs related to U.S. wholesale. The other thing we have done overall is, we're really focused on discretionary costs, and I'll give you some examples. We have tightened travel. We've tightened new hires and the like. So for example, on travel, because we've been this business for the long term, we're still ensuring that people travel to meet customers, meet consumers, while most of the other travel is kind of on hold. If things get worse, we will look at what's still open. Hires, we're not hiring new heads. We're hiring critical heads. If things tighten, we'll tighten that and take a hard look at fixed costs from that perspective like we did during COVID. So again, realigning our cost base to drive the prospective revenues, I think, is an important principle. And we have tightened quite a bit the few other options available, but we run this business for the long term. But the important point to think about Matt is, and I think I said it in my prepared remarks, there are some critical pieces that are becoming tailwinds. COGS, for example, commodity costs and [indiscernible], which was a headwind in H1, it's going to be a tailwind, especially as we start thinking exiting the year and thinking about 2024 and ensuring that our costs are maintained, so that we drive profitability and get to that magic EBIT margin number that we laid out at Investor Day is critical for us.

It’s great color. Best of luck.

Thank you, Matt.

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

Yes. Thank you. I guess just my question probably for Harmit. When you think about the decline, the outlook that you've lowered in the second half of the year, can you just give us a little more color on the cadence expectations, you gave from gross margin, but between Q3 and Q4 and some more of the quarterly trends that you're expecting in the back half? Thanks.

Sure, Bob. First, as I mentioned in the prepared remarks, three factors driving the reduction in guidance. And that's despite H2 is still growing. Gross margin in H2 largely flat, but substantially up to 2019, and EBIT margins substantially better. The factors really are a slight reduction in revenue outlook, gross margin lower than what we anticipated largely because of the targeted pricing actions that Chip talked about in his prepared remarks and the last piece is really tax rates slightly higher. In terms of the color on Q3 and Q4, comparisons, as you know, sequentially ease for both sales and gross margins into Q3 and Q4. Growth improves. Our view is low single digit up in Q3 and high single digits up in Q4. The benefit of lower product costs, which is largely driven by cotton doesn't fully materialize until Q4. We still have inventory that we bought when cotton was high, we're going to -- we're working that through in Q3. And the new inventory is at the lower prices and is substantially different. In fact, I think COGS improvement in the new price is about 200 basis points. And so that's something that will not only -- we'll see in Q4, but we can see a substantial of it piece in 2024. SG&A is expected to be up mid-single digits in H2, weighted towards Q3 and EPS, we expect about double the EPS in Q4 versus Q3 just because of the revenue growth and the gross margin expectation. The only other thing that I would probably note for all of you are, what I call, recent trends. Our results are as of May. But recent trends -- we've seen positive trends in wholesale sell-through, especially as Chip mentioned, we are filling orders and making sure there is stock. We're seeing similar trends in DTC and outlets. And so, I think as we fill and ensure the stock situation is addressed, we will see progress. And then once the prices for the targeted fit that we talked about reduced sometime in the next 30-odd days. I think that's where we feel that we can address this price-sensitive consumer and continue to accelerate consumer demand as we continue to grow share.

Thank you.

Welcome, Bob.

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

Great. Thank you so much. So my question, hoping we can talk a little bit more about this divergence in performance between the U.S. DTC channel versus the wholesale DTC channel. Maybe Chip, can you tell us how much is sort of just the performance of the channel? It sounds like that the lower income consumer, that middle income consumer is sort of reason for the divergence. But how much is it just those channels themselves are not performing that well. How much is the supply chain issue? How much sort of is the brand where maybe is the brand not resonating as much in those channels? If you can sort of unpack that a little bit, that would be helpful. Thank you.

Sure. And it's really good question, because it is kind of the big paradox as we take a look at the results, our U.S. DTC business, including e-commerce and especially including mainline, are performing really, really well. And that's -- I would say that's -- why that's a strategic focus of ours globally is, we're in control with the brand, we're in control of the consumer experience, we're in control of what we focus on in our stores, we're in control of the assortment in the stores and the consumer comes into the store wanting to buy Levi's. And we're seeing really good success there, as you heard from the results. I think the wholesale dynamic, some of it is clearly the consumer, okay? So as we said, our value brands are down double digits. U.S. wholesale is down double digits. Some of it is definitely a channel dynamic, I think that moderate to lower income consumer is definitely under pressure. And I suspect we're all reading the same newspapers, feeling the trade-offs of needing to pay for a summer vacation versus a new pair of jeans. And I think that's some of it. But we're competing now for other dollars that are being spent out of the consumer's wallet, and that moderate income consumer is having to make some tough choices now. So I think -- I suspect that that is part of it. But there's also the dynamic, as I said earlier, that's within our control. This customer fill rate issue that we've had because of our loaded inventory, as I'll say it that bluntly in prior quarters that as our inventory levels start to trend towards something that's more normal, or the congestion that we were experiencing in our distribution centers has abated and our fill rates are improving literally week over week. And as we now into the third quarter as we are seeing our fill rates improve. We're closing out out of stocks, and that is improving sell-through. So we're optimistic about that. And then the last point is this point about making some strategic, very selective price reductions, and they are only partial rollback. So over the last two years, we have taken price increases globally, including here in the U.S. and including here in U.S. wholesale. And we have widen the price gap versus the other brands in U.S. wholesale. And on some of the most price-sensitive items in our line, that price gap is too wide and we're going to fix that. But to put it into perspective, we're talking about six items in wholesale out of more than 60 items that we sell in the U.S. wholesale out of the more than 120 items that we sell in the U.S. So it's -- depending on what base you want to use, it's less than 10% or less than 5% of the total number of items in our assortment and it's going to be less than 15% of the total volume. But we know from our analysis and we've been engaging with our customers on this as well, we know from our analysis that by closing this price gap, it should stabilize this business a little bit further. So the combination of the supply chain confidence in our deliveries and addressing this price gap to be a little bit sharper versus competition in these multi-brand wholesale customers. The combination of those two things should stabilize and potentially even get our wholesale business back on track to growth in the second half of the year and give us momentum as we're going into the critical holiday period and into next fiscal year.

Got it. That’s very helpful. Thank you so much.

Thank you. Our next question comes from the line of Ike Boruchow of Wells Fargo. Your question please, Ike.

Hi. Thanks for taking the question. Harmit, two follow-ups on the margin guidance to reach. Just the -- I understand the big gross margin downtick in 3Q because of these pricing actions. Maybe I'm not understanding clearly, but why does that then flip in the fourth quarter and become much more favorable, whether it's year-over-year versus 2019? Like why are the gross margins improving once we get out of Q3 due to these pricing initiatives? And then just can you clarify that the SG&A up mid-single digits year-over-year in the back half? Is that what you said? Because that seems a little heavy to kind of get to the guidance that you're giving. So I just wanted to make sure I'm understanding that. Thanks.

Yes. The -- on the gross margin and why should it flip in Q4, because Q4, we will see the full impact of the lower COGS. That's the big switch. In Q3, we still have inventory that we're going to carry over into Q3. What we really did to manage inventory, because our inventory is largely core, Ike, we didn't have to dramatically mark it down. We just cut future receipts to match demand. And that's why in Q3, we still have some of the whole inventory that we're selling in and then the new inventory and new prices in Q4 that is behind us. And so, it's largely -- and that's why you see the big delta in pricing. From that perspective, the pricing is largely similar. It started -- we take pricing about a month from now, about 30 days. So you'll see a little bit of impact in Q3 and a little more in Q4, but it's largely the COGS piece that is making the difference. Our second half gross margins, I think, are going to be north of 56%. We'll end the year [with another] (ph) 56%. And relative to 2019 is still 300 basis points in H2 better. And I think we were asked this question in 2021 by some of you, because we were seeing margins improve 400 basis points relative to 2019, and I’ve estimated that point of time was probably two-thirds stakes longer term. One third, it probably goes over time because we were not promoting inventories, they are very clean, et cetera. And that's bearing out in this fashion. At that time, it's difficult to predict commodity prices. That was a huge headwind in the first half is becoming a tailwind in the second half and cotton futures, at least at this point of time, look at similar levels for 2024. So that stays then, that's a bit of a tailwind in 2024.

And the SG&A in the back half?

The SG&A for the -- for quarter three, we think mid-single digit, quarter four low single digit, H2, low to mid-single digit, on a full year mid-single digit. That's how we're thinking about it at this stage. We still are opening stores, Ike. I mean that's really driving a big chunk of it. I think we opened on a net basis 20-odd stores in the first half, in the second half, it's 50, 60 stores. So that's really driving most of the SG&A, which is really setting up DTC for the long term. But as I mentioned earlier, discretionary costs, et cetera, et cetera, are fairly tight at this stage.

Great. Thank you.

Thank you.

Thank you. Our next question comes from the line of Jim Duffy of Stifel. Your question please, Jim.

Thank you for taking my questions. More from me on the U.S. consumer environment, but a little more focus on perspective from your stores and DTC. How would you characterize your current promotional backdrop? And Harmit, what's assumed in the outlook for the second half with respect to promotions? And I'm also curious if you could speak to consumer activity in your U.S. stores in DTC. Are you seeing slowing trends and price resistance from this consumer as well? Are they buying full price? Or is volume driven by promotion? Thank you.

Yes. So what's assumed in promotions, if you recall, Jim, last year quarter four was fairly promotional. Quarter three, we began to see some promotion, but quarter four was fairly promotional. So our view is, quarter three is probably promotional, probably slightly less promotional than quarter two because inventories are getting better, trade inventories are getting better, our inventory is getting better. And quarter four, it's kind of slightly better than a year ago, and we end H2 probably slightly better than last year H2. That's what we're thinking on promotion at this time. Plus, by taking some pricing actions, in the absence of pricing actions, there were probably deeper promotion on the same fits because people wanted to set by taking pricing actions that will help offset the deeper promotions to an extent. So that's kind of kind of factored in. To your question about our own DTC business and our DTC business in the U.S. is outlets, as well as our mainline stores. Our mainline, we're seeing the consumer and largely consumers earning $100,000 plus less price sensitive. I mean, we do promote on days where it's important, like Father's Day, for example, et cetera, et cetera. Black Friday will happen, but it's very targeted. And the same cadence we have for our outlets, too. And some of the pricing, some of the Tier 3 products that Chip talked about are also sold in our outlets. So that should adjust for the outlook. But overall, we are seeing less promotions in our own stores than probably in wholesale.

I guess I would just add one other thing, Jim, is the other thing that is clearly working in our DTC channel is newness and we're right now at end of season. So if you go look online or shop around, you're going to see a lot of sales us and everybody else because everybody is trying to get ready for the next season. That product will begin hitting the floors later this month, setting us up for back-to-school. And we're really excited because we're excited about the next season and the product that we've got coming in and some of the collaborations and -- but newness definitely works. And we have no product, no problem selling through product at full price when new products [indiscernible] when it's resonating.

Thank you.

Thanks, Jim.

Thank you. Our next question comes from the line Dana Telsey with Telsey Advisory Group. Your question please, Dana.

Hi. Good afternoon. As you think about the mass channel, which I think was down 13% in the prior quarter, how did the mass wholesale channel differ from the other wholesale businesses? And then with marketing, given the birthday of the 501, how is marketing being planned in the back half compared to last year? And then CapEx, is that still expected to be the same number, around $280 million? Or what are you looking for there? Thank you.

So I'll answer the CapEx question, and I'll give the value channel to Chip. But on the CapEx question, I think we had indicated $290-odd million. Our expectation for CapEx is between $290 million and $300 million, something like that. So in and around what we talked about and is largely oriented towards the new doors, Dana, that I talked about and investments to -- on technology really to accelerate our e-commerce business. Those are the two broad areas. And then we've had some infrastructure CapEx. We opened a digital DTC, we just upgraded our ERP and we're building the DC, which will be an omnichannel DC in Europe. So that's why we're looking at some infrastructure investments really to propel and service the growth in our growth algorithm.

Yes. And I may be forgetting the second of the three part question, but the mass channel is soft. And I think softer in general and the balance of wholesale -- balance of wholesale also includes Amazon, which is pretty strong right now. But our value brands, and I would say, in general, the mass consumer overall is under pretty tough economically challenged, I guess, and you saw that in their last results, their last quarter. So -- but that is an in signature, which sell in that channel, respectively, is down double digits. We do have Levi's of target. And I would say Levi's of Target is performing roughly in line with how Levi's is performing elsewhere in the wholesale channel. And that's, I think, collectively, our focus with Target is how do we continue to expand on the success that we've had over the last several years with the Levi's of Target. And I think over time, we're going to the trading out floor space for Denison for more floor space for Levi's. Did you have one other question?

And Dana, your question was, I think, on marketing?

Exactly.

Yes. So in the first half, we spent more than a year ago because of the 501 campaign that fell in H1, in the second half it will be a little less and then we are adjusting our marketing expenses depending on which part of the world is working on hard. And so, overall, our marketing expenses as a percentage of revenue is slightly lower than a year ago.

Yes. And just, I mean, to be blunt, in the U.S., where U.S. wholesale is down, below our plan, we've had to cut advertising expenses in the second half. We did have the 501 campaign globally. Our spending was front loaded this year. And so, we have had to scale back a little bit in the second half just to kind of balance the books and keep our spending as a percentage of revenue, roughly in line with what we guided originally. But in total dollars, the spending is coming down in the second half, reflecting the softer outlook that we have on the top line.

Thank you.

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

Good afternoon. Thank you very much for taking my question. Harmit, Chip, could you hear me?

Yes, we can.

Fantastic. Thank you very much for taking my question. Just two questions, two follow-ups, One on Ike’s question. Harmit, last quarter you gave us a very helpful bridge around the gross margin, noting product cost was a 20 bps headwind. Promotionality was about 300 bps. Maybe you can you just -- for the audience, can you maybe parse that out for the second quarter? And how much are you expecting in terms of promotions for the second half of the year? And then a separate question, great to hear on China that is back to pre-COVID level. Maybe Harmit, could you give a little bit of color on just what you're seeing in China? Are seeing sequential improvement every month in that marketplace?

Yes. So I'll quickly help answer both. So H2, in my prepared remarks, I mentioned gross margin versus last year flat to slightly up. The -- relative to a year ago. So I'd say pricing 70 basis points to 80 basis points, adversely impacting. So a year ago, COGS second half really offsetting that. So that's largely flat. I mean, that's broadly -- there's a little bit of airfreight, which is a tailwind. But broadly, that's what's really driving between the two factors, pricing and the COGS benefit. And the COGS benefit is less in Q3, more in Q4. So we exit the year with a higher COGS benefit that obviously rolls into 2024. To your question in China. Michelle, Chip and I, along with our teams were recently in China. Quarter two was a great quarter for them. The business was up big time, businesses is higher than 2019. As we think over the rest of the year, our Asia guidance, which is higher than last quarter, Asia, I think we think in the high teens from a double digit growth reflects a slight bounce back in China as along with the rest of Asia. We are going to watch and see what happens and how the business stabilizes in China before we think about China's expectations for 2024. But the team that was there pre-COVID is still there they're long in China and the Chinese market is a little different in some markets in Asia, the premium-oriented markets. We're really focused on premiumizing our product offers there, and that seems to be working.

Very helpful. Thank you very much.

Thank you

I think we're going to wrap it there [indiscernible]. Okay. We're at time, and I just want to thank everybody for dialing in and for your very thoughtful and penetrating questions, and we look forward to speaking with you again next quarter.