Kontoor Brands : Conference Call Transcript Q1 2024

Kontoor Brands Inc.

1Q 2024 Earnings Conference Call

May 2, 2024

Presenters

Michael Karapetian, Vice President, Corporate Development, Strategy and Investor Relations Scott Baxter, President, CEO and Chair of the Board

Joe Alkire, EVP and CFO

Q&A Participants

James Duffy - Stifel Financial Corp.

Robert Drbul - Guggenheim Securities

Brooke Roach - Goldman Sachs

Mauricio Serna - USB Group AG

Laurent Vasilescu - BNP Paribas

Will Gaertner - Wells Fargo & Company

Paul Kearney - Barclays Capital

Operator

Greetings, and welcome to the Kontoor Brands First Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press Star 0 on your telephone keypad. As a reminder, this conference is being recorded.

It is now my pleasure to introduce Michael Karapetian, Vice President, Corporate Development, Strategy and Investor Relations. Thank you, Michael. You may begin.

Michael Karapetian

Thank you, operator, and welcome to Kontoor Brands' First Quarter 2024 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 often be on an adjusted dollar basis, which we clearly defined in the news release that was issued earlier this morning. Our outlook is presented on an adjusted dollar basis.

Reconciliations of GAAP measures to adjusted amounts can 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.

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Unless otherwise noted, amounts referred to on this 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 Joe Alkire. Following our prepared remarks, we will open the call for questions. We anticipate this call will last about one hour. Scott?

Scott Baxter

Thanks, Mike, and thank you to everybody joining us on today's call. We are pleased with our better-than-expected start to the year. Compared to our outlook provided in February, we saw a broad-based upside from revenue, gross margin and earnings. Joe will unpack the details, but our relative strength in the quarter, combined with improving visibility gives us confidence to raise our full year guidance.

I will step through the highlights in a bit, but first, let me start with the organizational announcements we made in March. As we discussed last quarter, we have commenced Project Jeanius to transform our organization. This multiyear project is focused on driving three things: first, create a global best-in-classmulti-brand platform; second, simplify the organization to increase speed and efficiency; and third, free up investment capacity to accelerate growth and increase profitability.

As part of these actions, Tom Waldron has been appointed COO. You've had a chance to hear from Tom during our year-end calls. He is an incredibly talented leader who has led the return to growth and strong profitability for Wrangler. From 2019 to 2023, Wrangler has grown revenue at a mid-single-digit CAGR and expanded reported profit margins by over 300 basis points. In his new role, Tom will amplify our strategic playbook across both brands to drive improvements throughout the organization, from our commercial and go-to-market teams to global operations.

We have also elevated Jenni Broyles to EVP and Global Brands President of Wrangler and Lee, and Ezio Garciamendez to EVP and Chief Supply Chain Officer. Congratulations to both Jenni and Ezio, who have joined our executive leadership team. The team we have in place has a proven track record of success at every position, and I am confident will drive the next leg of our value creation journey.

Now let me touch on highlights from the quarter. Wrangler's momentum continues with product and demand creation platforms that are elevating the brand like never before. While wholesale pressures are impacting the near term, as expected, the strength of our DTC business and point-of-sale outperformance are real proof points, Wrangler is winning with the consumer.

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During the quarter, Wrangler's global DTC business grew 8%, and we gained 60 basis points of market share in denim longs according to Circana. This marks the eighth consecutive quarter of market share gains for the brand. To support this momentum, Wrangler continues to diversify beyond denim. In fact, approximately half the business is now outside of denim bottoms, reflecting the success we have had expanding into new categories.

Outdoor is a great example, which is now an approximately $200 million business. The investments we are making in the team and our product development capabilities are helping to drive further penetration in this large and growing category, leading to successes like the outdoor performance cargo, which is one of the fastest-growing pants in Kontoor's history. And Wrangler ATG is elevating the brand into newer channels of distribution such as specialty sporting goods supported by new launches like the ATG Chino and Cliffside Utility this fall, as we are on track for another year of double-digit growth in outdoor.

We are also advancing our consumer insights and research capabilities, as part of our evolution to a more data-driven organization, allowing us to better align with changing consumer buying habits and behaviors. This behind-the-scenes work is a great example of how we are becoming a more efficient organization with targeted investments that generate higher returns.

And finally, we have a strong pipeline of demand creation platforms and collaborations. Lainey Wilson's first collection launches later this year, and based on early reads is on track to become the largest global collaboration to date. We are also continuing our very successful collaboration with STAUD in the second quarter, which is helping to bring the right balance of newness, while reaching a younger female consumer. And we are amplifying the brand with events at the ACM Awards and Stagecoach, where we are the official denim sponsor. These are great examples of how we are building momentum throughout the year with demand creation investments that fit together and deepen the connection with our consumers.

Turning to Lee. Similar to Wrangler, Lee experienced softness at wholesale, as retailers tightly managed inventory levels. As we discussed last quarter, the business was also impacted by conservatism on seasonals. That said, we are seeing green shoots from our innovation platforms and with our younger female consumer.

On the men's side, we continue to advance our innovations focused on comfort. These platforms now account for two-thirds of our U.S. men's business and our genuine distinction in the market. And within female, our heritage collection and iconic rider platform is expanding the brand's reach, while being supported by new equity campaigns. This is translating to share gains and growth at point-of-sale. During the quarter, POS in the U.S. increased 2%, and market share in denim longs gained 40 basis points, as measured by Circana.

Looking ahead, we have several initiatives that give us confidence. First, our improving product development capabilities are enabling category expansion. Our tops business has been a great success story and is on track to deliver strong double-digit growth for the year and Lee Golf

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launches in the second quarter with innovative fabrications that are appealing to a broad range of male consumers. We are excited about the potential in this growing category, as part of Lee's office to outdoor evolution.

Second, our innovation pipeline is getting the most significant addition in years. Lee x will launch later this year and combines elite comfort with world-class aesthetic. This will be a true platform that crosses denim and non-denim tops and bottoms at a price point that simply does not exist for this level of performance.

And last but not least, we are getting sharper with our brand positioning in the marketplace. This foundational level work is a significant focus for the second half of the year and is part of the new multi-brand platform we are developing. We are conducting an end-to-end assessment to ensure alignment with our refreshed consumer segmentation, brand investments and product development. We are confident this will pay significant dividends in the years ahead.

Before I turn it over to Joe, let me close with a perspective on the balance of the year. Since we spoke in February, point-of-sale has improved for both brands. We have continued to gain share. The wholesale channel has found better balance and gross margin expansion exceeded our expectations. We also made further progress working down our inventory position, ending the quarter 24% below prior year levels.

Combined with our better-than-expected profitability, we now expect to generate more than $335 million in cash from operations this year. As a result, our capital allocation optionality continues to improve, allowing us to return $48 million to shareholders during the quarter, including $20 million in share repurchases under our new $300 million authorization.

Longer term, Project Jeanius planning is well underway with impacts expected to start in the fourth quarter. We have a line of sight to the higher end of the $50 million to $100 million of annualized run rate savings, none of which are included in our guidance. That will structurally raise our profitability ceiling, while significantly increasing our investment capacity to drive more profitable growth over time.

While the near-term environment remains dynamic, we are operating from an offensive position. We are off to a better-than-expected start and have improving visibility to the balance of the year. I am confident we are on a path to drive strong value creation for all stakeholders. Joe?

Joseph Alkire

Thanks, Scott, and thank you all for joining us today. Let me start by providing perspective on our first quarter results relative to the outlook we provided in late February. Our results were stronger than expected, driven by higher revenue, gross margin, earnings and cash flow. Our brands continue to drive market share gains in our largest points of distribution and POS and inventory levels at retail improved modestly late in the quarter.

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Gross margin expansion was stronger than expected, driven mainly by lower product costs and favorable mix. And when combined with further inventory reductions supported robust cash generation and capital allocation optionality, as evidenced by the $48 million of cash returned to shareholders through share repurchases and dividends in the quarter. Overall, we're pleased with our start to the year.

Let's unpack the quarter in more detail. First, POS strengthened as we progressed through the quarter, and we saw a better balance between sell-in and sell-through as inventory levels at retail modestly improved and replenishment order patterns normalized. If you recall, we did not assume an improvement in either POS or inventory levels in our outlook, as we continue to plan the business conservatively. So, these results were above our expectations and drove the majority of the revenue upside in the quarter.

Second, gross margin expansion exceeded our expectations driven by lower product costs and the structural benefits from mix. Relative to our assumptions, we also realized a smaller-than- expected impact from pricing, the majority of which is timing related and will begin to impact our gross margin more meaningfully in the second quarter. Our gross margin visibility has improved relative to 60 days ago, and we now expect our full year adjusted gross margin to match our previous high of 44.6% reached in 2021.

Lastly, we continued to drive strong cash generation through improved profitability and reductions in net working capital, including a 24% decline in inventory. We are opportunistically working through our excess inventory and driving improvements in supply chain execution through higher fill rates and more efficient demand supply matching. We continue to take a conservative approach to planning the year but based on our better-than-expected first quarter results and improved visibility, we are raising our full year gross margin, earnings and cash flow outlook.

I'll dive deeper into our updated outlook in a moment, but first, let's review the additional details of our first quarter results. Starting with Wrangler. Global revenue decreased 4%. The decline was primarily driven by U.S. wholesale, offset by growth in DTC, including 7% growth in digital and 10% growth in brick-and-mortar. Retailer inventory management actions continue to impact the business near term. However, underlying brand momentum remains strong, as evidenced by improving POS, ongoing market share gains and DTC strength. Nowhere is the brand's momentum more evident than in the success in diversifying into new categories.

Wrangler's Outdoor business, led by ATG, continues to scale, as we advance our product development capabilities and reach new consumers. During the first quarter, Wrangler Outdoor grew 5%. Nearly 50% of the global Wrangler business is now in categories outside of denim bottoms. And we expect the non-denim business, including outdoor, tops and non-denim bottoms to grow at a mid-single digit rate this year. Wrangler International revenue decreased 13%. European wholesale remains under pressure due to challenging macro conditions.

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However, this was partially offset by double-digit DTC growth, supported by investments in owned stores and our digital platform.

Turning to Lee, global revenue decreased 9%. As expected, reduced shipments in U.S. wholesale and a decline in the seasonal business negatively impacted the quarter. That said, revenue for the Lee brand was above our expectations.

Similar to Wrangler, Lee is having success expanding beyond denim, particularly in tops. During the quarter, tops grew 20% and now comprise over 10% of the total business. We expect strong growth in these categories to continue for the balance of the year.

Lee international revenue decreased 5%. In Europe, revenue declined 9%, driven by ongoing macro pressure. In APAC, revenue declined 2%, as the market recovery remains uneven, and we work to further improve the quality and health of our retail network. We continue to anticipate growth in APAC for the full year.

Turning to gross margin. Adjusted gross margin expanded 270 basis points to 45.7% driven by the benefits of channel mix and lower product costs. This was partially offset by targeted pricing actions, which went into effect late in the first quarter.

Relative to our expectations, we saw greater-than-expected favorability from mix and lower input costs in addition to a smaller-than-expected impact from pricing, resulting in adjusted gross margin exceeding our expectations by approximately 160 basis points.

Adjusted SG&A expense was $195 million. Investments in demand creation, technology and DTC were partially offset by disciplined management of expenses and lower distribution in freight. And adjusted earnings per share was $1.16, consistent with the prior year.

Now turning to the balance sheet. Inventory decreased 24% to $501 million compared to our initial expectations of a 20% decline. We remain intensely focused on improving net working capital to supplement our strong operating earnings growth and drive enhanced cash generation in support of our capital allocation framework.

We finished the quarter with net debt or long-term debt less cash of $564 million and $215 million of cash on hand. Our net leverage ratio, our net debt divided by trailing 12-month adjusted EBITDA was 1.6x within our targeted range.

During the quarter, we repurchased $20 million of stock under our current authorization, and as previously announced, our Board declared a regular quarterly cash dividend of $0.50 per share. Finally, on a trailing 12-month basis, our adjusted return on invested capital was 25%.

Now turning to our outlook. Revenue is still expected to be in the range of $2.57 billion to $2.63 billion, reflecting a decrease of 1% to an increase of 1%. We are encouraged by our better-than-

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expected start to the year and the improvement we saw in both POS and inventory levels at retail across the first quarter.

So how are we thinking about the remainder of the year? First, we continue to plan the business conservatively with the majority of the year still ahead of us. Retailers remain in a conservative posture, and we are cautious on the environment, as the consumer, while resilient, remains under pressure around the globe. We continue to assume no meaningful improvement in overall POS or retail inventory positions for the balance of the year.

Second, we have good visibility to category expansion and distribution gains, including expansion of our tops and outdoor businesses, as well as new innovation platforms in the second half of the year. And we expect ongoing growth in our DTC business, reflecting investments in our digital platform, improved product segmentation and a more robust demand creation pipeline. Taken together, we continue to anticipate first half revenue to decline at a mid-single-digit rate, followed by mid-single-digit growth in the second half of the year. Beyond the first quarter, we expect revenue growth of approximately 2% for the year-to- go period.

Moving to gross margin. Based on our stronger first quarter results and improved visibility, we are raising our outlook to approximately 44.6% from our prior range of 44.2% to 44.4%. Our updated outlook represents an increase of 210 basis points compared to adjusted gross margin of 42.5% in 2023, excluding the out-of-period duty charge. In the first half of the year, we now anticipate more than 300 basis points of gross margin expansion compared with our previous outlook of more than 250 basis points.

Our gross margin outlook includes the following assumptions. First, we will continue to benefit from the structural drivers of mix. This is expected to contribute approximately 30 basis points to 40 basis points to the full year. Longer term, we expect the benefits of mix to continue, as we scale DTC and international.

Second, we have good visibility on input costs with costs locked into the third quarter on manufacturing and into the fourth quarter on sourced product. Our visibility for the balance of the year has improved. And when combined with the proactive actions to optimize our supply chain footprint, we anticipate over 200 basis points of benefit for the year from lower product costs.

And finally, we assume a modest headwind from lower pricing promotions and the disruption from the Red Sea. Collectively, these inputs are expected to negatively impact our margin by less than 1 point. I have high confidence in our ability to drive gross margin expansion beyond our previous expectations over time, supported by Project Jeanius, but we'll share additional details on that in the coming quarters.

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SG&A is still expected to increase at a low to mid-single-digit rate. We will continue to make investments in demand creation, DTC and technology, as well as product development capabilities to support our growing innovation platforms and category expansion plans.

Operating income is now expected to be in the range of $377 million to $387 million, reflecting growth of 8% to 11% compared to the prior year, excluding the duty charge. This compares to our previous outlook of $372 million to $382 million.

EPS is now expected in the range of $4.70 to $4.80, representing growth of approximately 6% to 8% compared to adjusted EPS in the prior year, excluding the out-of-period duty charge. This compares to our prior outlook range of $4.65 to $4.75. Full year EPS growth will be negatively impacted by about five percentage points from a higher tax rate.

First half EPS is now expected to increase at a mid-single-digit rate compared to our prior outlook for EPS to be consistent with prior year levels. In the second quarter, we expect EPS of approximately $0.85, representing 10% growth.

Finally, we now expect cash from operations to exceed $335 million, primarily as a result of stronger earnings growth. This compares to our previous outlook of cash from operations to exceed $325 million.

Before opening it up for questions, I'd like to reiterate the confidence we have in our ability to deliver our 2024 objectives. We are off to a better-than-expected start to the year. The fundamental profile of the business is accelerating, and our brands are winning in the marketplace and continue to drive market share gains.

We are on track to generate significant cash from operations this year, which combined with our strong balance sheet, provides us with considerable capital allocation optionality. We are operating from a position of strength, and I am confident in our commitment to deliver superior returns for all stakeholders.

This concludes our prepared remarks, and I will now turn the call back to our operator.

Operator

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press Star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press Star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. We ask that you please limit yourself to one question and one follow-up question. One moment please while we poll for your questions.

Our first questions come from the line of Jim Duffy with Stifel.

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Jim Duffy

Good morning. I wanted to start, pardon my voice, fighting a cold here. I wanted to start by asking for more perspective on how the quarter and your thoughts on the year have evolved since late February, there are some moving parts. It sounds like you saw a further improvement in POS and retailer inventories in March, revenue and gross margin came in better for the quarter, but the full year doesn't pass through the revenue upside and the earnings increase was just a fraction of the Q1 earnings upside. So, I'm curious, is there something you're seeing or hearing from channel partners that's making you more cautious on Q2 and the back half of the year?

Joseph Alkire

Hey, Jim, good morning. It's Joe. I'll start, and then Scott may want to provide some thoughts on the environment. So yes, we beat Q1. We beat the outlook by approximately $25 million, largely driven by improved POS and inventory levels at retail in March. This was largely driven by our major customers in the U.S. So, this drove the majority of the upside in the quarter.

From a gross margin standpoint, also above our expectations by about 160 basis points. That was mainly due to lower product costs and a small delay in the pricing actions that we're implementing, which is a bigger Q2 impact versus our original plan.

Look, as we said in February, we're planning the business conservatively in light of the environment. We've got the toughest quarter behind us now, and the business fundamentals are positioned to accelerate across the balance of the year from here, which we're highly confident.

And I'd say from a full year outlook, we raised the first half, we raised the full year largely, as a result of stronger-than-expected Q1. We increased our gross margin assumption modestly for the balance of the year based on our increased visibility. From an overall revenue standpoint, we've got good visibility into the improvements for the balance of the year, again, largely driven by new programs and distribution gains. But from my perspective, nothing that we're seeing in the environment just being cautious on the outlook for the year.

Scott Baxter

And Jim, I would just add that the environment, it got modestly a little bit better than we thought in Q4. Really nice balance from our big customers from an inventory standpoint, thought that worked itself well through pretty good. We remain optimistic for the rest of the year. We do have some programs that Joe mentioned, both channel and category that we're excited about that we've talked a little bit about. So, a little bit conservative, but I want to make sure that we go ahead and hit our commitments going forward.

Jim Duffy

Great, thanks. A couple of related questions on the guide. Joe, the inventory progress in Q1 was meaningful. Can you speak about this in the context of the full year cash flow from operations

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guide? Really good reduction in the inventories. You increased the cash flow from ops by about $10 million. Does that assume some reinvestment in inventory later in the year?

And then, I'm also curious if you could just give us an update on the seasonals business. Is the headwind from seasonals business -- have those categories normalized? Are those headwinds behind you?

Joseph Alkire

Yes, I'll start with the inventory, Jim, and Scott can take seasonal. So yes, from an inventory standpoint, really good progress. The first quarter will be our largest year-over-year decline. We expect declines pretty much for the balance of the year, somewhere in that low double-digit range. This is contributing to the cash flow. But yes, as the grows -- the growth inflects in the second half, we will lean back into some inventory. But for the year, as a whole, inventory will be a contributor to our cash.

Overall, Jim, we still have about 130 days of inventory on the balance sheet. I would say steady state for us continues to be somewhere in that plus or minus 100-day range. So, there's still a considerable amount of cash on the balance sheet that we'll release at some point. But in terms of composition of our inventory, we still feel pretty good somewhere in that 75% to 80% range is core. So, the inventory is in good shape.

Scott Baxter

Then Jim, just a couple of comments on seasonals. After 20-plus years of riding the seasonal wave up and down and weather and all kinds of patterns and geographies, it's very typical. We've seen this play before. It's a little cool right now. But all of a sudden, here where we are and part of this area and this geography got really hot yesterday, supposed to get really hot this weekend, and we really like our position. We like our product this year. We like our distribution. We think we're in a really good spot. And just because it was a little bit cool at the beginning of the season doesn't really bother us. We've been through that before, so no issues.

Jim Duffy

Thank you, guys.

Operator

Thank you. Our next questions come from the line of Bob Drbul with Guggenheim Partners. Please proceed with your questions.

Robert Drbul

Hey, guys, good morning. And Scott, 85 in New York today. So, it's happening finally.

Scott Baxter

There it is. There it is.

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