Levi Strauss & Co. (LEVI) released its Q3 2019 earnings report on October 8, beating consensus estimates for revenue and EPS. Despite this beat and the broader market positive tone, following recent progress in trade negotiations between U.S. and China, Levi's stock price has dropped more than 10% in the following days after the release, as weakness on U.S. wholesale business has weighed on the sentiment surrounding the outlook for the stock.
We remain cautiously optimistic on Levi Strauss given positive developments on direct-to-consumer, international expansion, category diversification and the slight undervaluation compared to the peer group.Q3 2019 Earnings Highlights
Revenue of $1.45 billion was 0.4% above expectations, up 4% YoY on a reported basis and 5% YoY on a constant currency basis, excluding currency headwinds.
In the Americas market, reported revenue declined 3% YoY, driven by a decline in the wholesale business, impacted by Dockers line reset in the second half of 2018, strategic reduction of shipments to the off-price channel in 2019, the pending acquisition of a South American distributor and softness in department stores and chains. Direct-to-consumer segment, however, grew 9% YoY, underscoring own stores performance and the strength of Levi's brand in the Americas market, partially offsetting the weakness in the wholesale segment.
In Europe, revenue was up 14% YoY on a reported basis, following a 17% growth a year ago, with broad-based growth in direct-to-consumer and wholesale channels. In Asia, revenue grew 9% YoY on a reported basis with strength in wholesale and direct-to-consumer channels across most countries in the region, especially in India, despite modest growth in China and weak performance in Hong Kong, as ongoing protests impacted traffic in stores.
Among the biggest drivers for revenue growth, global direct-to-consumer segment was up 12% YoY, comprising 15 sequential quarters of double-digit growth, with e-commerce growth of 21% and positive e-commerce traffic trends in all 3 regions.
Women's business has also been strong, with 12% growth YoY and 11 consecutive quarterly double-digit growth, along with tops segment, which was up 17% YoY, with 15 sequential quarters of double-digit growth.
In summary, revenue contribution by region was 5 points of growth from Europe and 2 points from Asia, partially offset by decline in Americas. By category, 6 points of growth came from diversification into Levi's, women's and tops, partially offset by decline in Dockers.
Gross profit came in at $767 million and gross margins was 53%, 20 bps lower YoY on a reported basis given currency headwinds, but increased 40 bps on a constant currency basis, underpinned by direct-to-consumer and international growth, but also benefiting from price increases adopted globally, offsetting product investments during the period.
SG&A expense was up 2% YoY, corresponding to a 60 bps reduction as a percentage of revenue, as a result of lower impact from previous cash settled stock-based compensation and cost discipline. Consequently, operating income was up 8% YoY on a report basis and operating margin increased 40 bps to 11.8%. By region, reported operating income declined 7% YoY in the Americas, due to higher selling expenses. In contrast, it was up 34% YoY in Europe and up 18% YoY in Asia, reflecting revenue growth, higher gross margins and leverage on SG&A.
Adjusted EBIT came in up 2% on a report basis and up 4% on a constant currency basis, all excluding the effect of stock-based compensation, and adjusted EBIT margin was 12.2%, with 20 bps decline YoY given currency headwinds.
Adjusted net income was $128 million, down $5 million, as last year discrete tax benefit of $11 million does not apply in 2019. Finally, diluted EPS was $0.31, which was $0.03 lower YoY due to last year tax benefit just mentioned and an increase in share count that generated a combined effect of $0.05 in diluted EPS.Business Outlook
Levi's growth strategy continues to focus on diversifying the business across channels and products categories. For instance, the expansion in women's and tops have been robust in the past years, with women's already representing near a third of total revenue, while tops is almost a quarter, after growing 17% in Q3 2019.
The company is consistently developing its direct-to-consumer channels, with 12% growth in the quarter, with strength in both e-commerce and brick-and-mortar stores. Since last year, the company has added 90 own stores, on top of more than 800 existing stores globally. Totally, 100 stores openings are expected in 2019.
Unlike the international segment in general, which has been strong in the recent years, with 13% CAGR growth since 2015, China still accounts for only 3% of total revenue and remains a big opportunity going forward. In order to turnaround this scenario, Levi has taken back a portion of existent franchise stores and shifted the approach from discount model, such as Tmall, to sell predominantly full-priced products in the premium segment. With a new management in place in the region, Levi is also working on new store formats featuring a more comprehensive assortment of premium collections, driving a tailored shopping experience.
While international business accounts for near 60% of total revenue, the U.S. market is still significant. As such, despite 7% growth in direct-to-consumer, the wholesale segment in the U.S. remains challenging, with department stores and large chain stores facing structural headwinds and door closures.
Based on this scenario, the strategy for the U.S. wholesale is to avoid off-price business, which has low gross margin and is not accretive to the brand, but focus on commercializing higher-end products to premium retailers. Over time, growth in premium and digital channels should be able to offset lower sales in traditional department stores.
On the profitability side, margin pressures seems under control, as the company has successfully raised prices in all 3 main markets, which is indicative of its capability to offset inflation and currency headwinds.
For the FY 2019, management team is guiding constant currency revenue growth in the range of 5.5% to 6% and currency adverse impact of 275 bps. Fourth quarter revenue is expected to be flat to slightly down, as a result of 500 bps impact from lower off price sales, the pending distribution acquisition in South America, the unrest in Hong Kong and lack of Black Friday, since Levi's 2019 calendar year closes prior this date.
Furthermore, FY 2019 reported gross margin is expected to be similar to last year at 53.8%. Excluding currency impact, it is expected to increase in the range of 40 to 60 bps. Reported adjusted EBIT margin is expected to be in line with last year at 10.5%.
As a remark, since the company has gradually reduced the production sourced from China from just 1% to 2% of the products sold to U.S., the direct impact from tariffs are not significant to the company's financial results.Valuation
Looking at Levi P/E Forward multiple of 15.7x on a comparative basis with the broader retail and apparel peer group, Levi seems undervalued, as the P/E Forward peer group average is roughly 18.5x, implying near 18% upside and a fair value of $20.74.
After factoring in the earnings growth forecast, the figure does not changed much, since Levi long-term earnings growth forecast by analysts of 9.6% is quite close to the peer group average of 9.5%.
The scatter chart below shows the relationship among P/E Forward and earnings growth forecast for each component of the peer group. Despite the relative dispersion on this chart, it shows that Levi (marked in red) is relatively close to the average (marked in black), but still a bit skewed to the left side on P/E Forward axis and slightly above the trendline, confirming its undervaluation relative to the peer group.
Source: Data from Finbox, consolidated by the authorTakeaway
Levi's Q3 2019 earnings results show continued progress in strategic drivers for the company such as category diversification, direct-to-consumer and international growth. However, U.S. wholesale business and China market are still a work in progress.
While shares are relatively undervalued compared to the peer group, investor sentiment may potentially remain weak until a real progress can be achieved in U.S. wholesale business.
Anyway, we believe that in the long term Levi's initiatives underway can reward patient investors looking for opportunities to outperform the broader retail and apparel sectors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.