Kontoor Brands : Conference Call Transcript Q4 & FY 2023 Year End Results

Kontoor Brands

Fourth Quarter and Fiscal Year 2023 Earnings Conference Call

February 29, 2024

Presenters

Michael Karapetian, Vice President, Corporate Development, Strategy, and Investor Relations Scott Baxter, President and Chief Executive Officer

Tom Waldron, Co-Chief Operating Officer, Global Brand President, Wrangler Chris Waldeck, Co-Chief Operating Officer, Global Brand President, Lee Joe Alkire, Chief Financial Officer

Q&A Participants

Bob Drbul - Guggenheim Securities

Jim Duffy - Stifel Financial Corp.

Brooke Roach - Goldman Sachs

Paul Kearney - Barclays

Mauricio Serna - UBS Group AG

Will Gaertner - Wells Fargo & Company

Operator

Greetings, and welcome to the Kontoor Brands Fourth Quarter and Fiscal Year 2023 Earnings Conference Call.

At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press "*", "0" on your telephone keypad.

As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Michael Karapetian, Vice President, Corporate Development, Strategy, and Investor Relations. Please proceed.

Michael Karapetian

Thank you, Operator, and welcome to Kontoor Brands' fourth quarter and fiscal year 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.

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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.

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.

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. In addition, we will be joined by Tom Waldron, Co-Chief Operating Officer and Global Brand President of Wrangler; and Chris Waldeck, Co-Chief Operating Officer and Global Brand President of Lee.

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. Before I discuss our results, I'd like to start with the announcement we made, this morning, on our global transformation project.

Project Jeanius is one of our most significant and important undertakings as a public company. The work we are doing will transform our organization from the legacy clone-and-go structure required at the spin to a truly best-in-class global, multi-brand platform, while unlocking significant sources of value.

Let me first start with what this project is not. This is not a cost-cutting exercise. Expense discipline is a foundational strength of our business and one that we prioritize regardless of market conditions. Rather, we are pursuing this proactively, and from a position of strength.

The steps we are taking will, fundamentally, improve our organization and, structurally, raise our profitability ceiling, creating more investment capacity to pursue growth, enhanced capital allocation, and improve our overall financial profile.

Unpacking this a bit more. When we first spun as a public company, our organization was set up to mirror our legacy structure. This was required to ensure continuity in the business while we focused on our Horizon 1 priorities, including de-levering our balance sheet, paying a superior dividend, and stabilizing our brands.

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After successfully completing Horizon 1, we embarked on Horizon 2 with a solid foundation now in place. As a result, we have grown our top-line, gained market share, and improved operating margins from 2019 levels.

But as an organization, we do not rest on our laurels. The leadership team we have in place is tailor-made for this strategy and our next phase of growth. I am highly confident now is the right time to pursue this transformational initiative.

A word you hear from us a lot is optionality. It provides the flexibility to pursue sources of value for our stakeholders, wherever that may be, while providing the resiliency to respond to the types of disruption we have seen over the last five years. Project Jeanius will add optionality well above what we have been able to deliver in the past.

It will also simplify our organization. This will result in greater visibility into the business, improved decision-making, faster speed to market, and better leverage of our global ERP system. We are also establishing a true multi-brand platform from which our brands can grow. This new structure will allow for our brand investment at a level we simply have not been able to achieve under our prior structure.

To put some specifics to this. Project Jeanius is expected to result in $50 million to $100 million of combined gross margin improvement in SG&A savings. We expect the benefits to start in the fourth quarter of this year, and ramp in '25 and '26.

A question I expect you will want to know is whether we will invest these savings back into the business, or let it flow to the bottom line. The answer is both. And that is precisely the type of optionality that will separate us in the marketplace. We will be sharing more in the coming quarters, and I am confident this will drive accelerating growth over the coming years in the next chapter of our value-creation journey.

Let's now turn to our results. Twenty-twenty-three was a landmark year for Kontoor. We connected with more consumers, introduced powerful new product stories, and launched one- of-a-kind brand campaigns and partnerships.

At the same time, the market had its share of challenges, particularly in U.S. wholesale, where macro uncertainty is impacting retail inventory levels, and we are seeing the impact of global events internationally, particularly in Europe, where consumer sentiment and spending has been uneven. We anticipate these headwinds will continue into 2024, particularly in the first half.

We also have an opportunity to better diversify our business into large and growing categories, while expanding beyond our core channels of distribution. As we outlined at our '21 Investor Day, these are significant whitespace opportunities for us. That said, we have not achieved the

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targets we set out three years ago. This is an important area of focus for us going forward, and initiatives like Project Jeanius will be key in unlocking this potential.

So, what gives me confidence we can deliver? First and foremost, our brands are winning in the marketplace. In the fourth quarter, denim sell-through of both Wrangler and Lee in U.S. wholesale increased 2%, as measured by Circana, outpacing the market by 500 basis points. And for the year, we saw a similar story with sell-through increasing 1% and outpacing the market by a combined 350 points. Importantly, this is not just a 1-year story.

Over the last two years, we have consistently outperformed the market by an average of three full percentage points.

While we have seen periods of lag between sell-in and sell-through, the bottom line is: Consumers continue to choose our brands. As you will hear from Tom and Chris, each brand has its own unique story to tell that is resonating in the market.

And finally, as Joe will discuss later, we made significant financial progress in '23. We successfully worked on our inventory position, ending the year 16% below prior year levels. Gross margin has inflected with a long runway for continued expansion ahead, and our cash generation accelerated. This supports increasing capital allocation optionality, including the $139 million we returned to shareholders through dividends in share repurchases last year, as well as our new $300 million repurchase program.

I'd like to close by reiterating my earlier comments. While the market remains dynamic, we are not standing still, and I am confident we have the team and strategy to deliver on the incredible opportunities ahead. The actions we announce today will fundamentally improve how we operate and drive the next phase of accelerating value creation for all our stakeholders. Tom.

Tom Waldron

Thanks, Scott, and thank everyone for joining us today. Twenty-twenty-three was an incredible year for the Wrangler brand. We reached consumers like never before, expanded our market share and grew our direct-to-consumer business, all while navigating a challenging marketplace.

It starts at the intersection of product and storytelling. Wrangler is synonymous with cowboy culture, and that took on a new meeting last year with two of our most significant demand- creation platforms in years.

Starting with our brand ambassador, Lainey Wilson. Our partnership has exceeded all expectations. She is an incredible artist and to cap off an amazing year, she recently won the Best Country Album at the Grammy Awards. Congratulations to Lainey on her tremendous achievement.

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She is expanding her reach with new audiences while being authentically western. We can see this in the data. Lainey Picks, a collection of her favorite styles introduced throughout 2023, resulted in over 60% new-to-file consumers.

In the fall of 2024, we will be building on this momentum by launching our first Lainey Wilson Collection. This will be a full assortment designed from the ground up in partnership with Lainey, drawing from her life on and off the stage. The product is already generating excitement, and we can't wait for it to reach consumers later this year.

And with the Dallas Cowboys, in the third quarter, we became the official jean of America's Team. This connection of two iconic American brands was an immediate success and will continue over the next two football seasons. Importantly, it is reaching a broader audience in a truly authentic way.

The Dallas Cowboys consistently ranked among the most-watched games of the season, and I couldn't be more excited about building on this partnership in the coming years. And this only scratches the surface.

Our sponsorship of Wrangler National Finals Rodeo was supported by our most successful Cowboy Christmas retail store ever. Our collaborations with Buffalo Trace and Barbie continue to show the broad reach of the brand, and our new innovation platforms, such as abrasion resistance, provide performance attributes that our consumers need and love.

So, how does this all translate? Our direct-to-consumer business grew 11% last year, reflecting investments we are making in our digital platform, combined with many of the initiatives I just discussed. Our female business - a key area of focus for us- grew 5%. Our non-denim bottoms business grew 10%. And finally, in wholesale, we drove share gains in every quarter of the year.

As it relates to U.S. wholesale, as Scott mentioned, we experienced the impact of U.S. retail inventory actions late in the year, and we anticipate this to continue, over the near-term. That said, Wrangler continues to win in the marketplace. To illustrate this point, while shipments were down in the fourth quarter, our denim POS, as measured by Circana, increased 1%, outpacing the market by approximately 400 basis points.

Looking ahead to 2024, we will continue to diversify Wrangler into large and growing categories. Outdoor has been a great story and one that we will build on. Outdoor is now nearly $200 million business, growing 11% last year, and up approximately $100 million from four years ago. We will continue to advance our product development capabilities in this important category, and I see another year of strong growth ahead, supported by new launches, including our performance ATG genome.

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We will also continue to diversify our channel distribution. Outdoor provides a great opportunity to expand our reach into sports specialty, supported by improved product segmentation and elevated design. I am particularly excited about our new bespoke launch for female. This premium performance fit innovation will be sold through our digital platform and specialty retail, and the response from the marketplace has been fantastic.

At a Kontoor level, we are also highly focused on driving greater efficiency in the business. Beyond Project Jeanius, we are conducting SKU-level productivity assessment. While less visible than much of what I've discussed today, this foundational-level work is a core strength of our organization and will help make Wrangler and Lee more profitable businesses in 2024.

Finally, I want to provide a few additional thoughts on the upcoming year. First, as you have heard, Wrangler continues to win, supported by an incredible array of product and demand- creation initiatives. That said, we are planning the business prudently, particularly in the first half, as the U.S. wholesale impacted by cautious retail ordering. As we look at the back half, there are several factors that give me confidence.

First, we have good visibility into new distribution gains, driven by the product launches I discussed today, as well as increased real estate due to strong sell-through. These largely start in the second half of the year. Second, we have a strong cadence of collaboration and demand- creation platforms that are primarily back-half weighted. And finally, we will be relaunching denim at a major national retailer starting in the third quarter.

Before I hand it over to Chris, let me reiterate the confidence I have in the entire Wrangler team and our positioning as we enter the new year. I have been on this business for nearly 30 years and have never been more optimistic about the future. Chris.

Chris Waldeck

Thanks, Tom, and thank you all for joining us. I would like for you to take away one word from the day: Innovation. Lee has a deep history of bringing newness and is a standard for innovation in the world of denim. Our archives are among the deepest in apparel and allows us to draw from years of authentic heritage and craftsmanship, while always looking forward.

Our team's focus has been and will always be the consumer and answering their needs. We do this through intense focus on innovation like flexibility, fit, softness and climate control, to name a few.

To put this in perspective, in 2023, two-thirds of our U.S. men's denim business came from our innovation platforms. This year, we will launch our most significant new innovation in years. Comfort and style too often require trade-offs.Lee-X addresses this gap by taking all the comfort of our performance pant and combining it with the aesthetic of a world-class jean in a way only Lee can.

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And importantly, Lee-X will be a true global innovation platform with denim bottoms, non- denim bottoms, and tops. This combination of craftsmanship and style and comfort don't exist at our price points, and we are excited to share it with consumers, later this year.

And we are bringing these platforms to life through our successful digitally based demand- creation strategy targeting a new younger consumer the Lee-X platform was designed for. These platforms also expand our ability to engage with consumers, wherever and however they choose.

Innovation could also be found in our collaboration strategy. In December, Lee and Diesel came together to create something incredibly unique and innovative. Each jean is made with 50-50 combination of unsold Lee and Diesel jeans. Initially launched in limited collection in Europe and Japan, the first drop sold out in weeks. The second drop will be in March, globally. Combined, these strategies are opening up elevated channels of distribution and attracting new consumers to the brand.

With that, let's review our results and how we are planning the upcoming year. First, as Scott and Tom discussed, U.S. wholesale is currently seeing the impact of cautious retail ordering, and I expect this to continue, over the near-term.

That said, Lee is entering the year with great momentum, with POS accelerating over the back half of the year. As measured by Circana, Lee denim sell-through increased 4% for the fourth quarter and outpaced the market by 750 basis points. For the year, Lee outpaced the market by approximately 150 basis points, and the strength is not just in denim.

Looking at our broader categories of denim, casual pants and shorts, our sell-through grew 2% for the year and accelerated to 8% growth over the last six months. While we are seeing the near-term impacts on shipments, there is no doubt innovation-led newness is a powerful combination and is resonating with consumers.

Let me now touch on Kontoor's international business for both brands. In EMEA, the macro headwinds are expected to continue, particularly in the wholesale channel as economic disruption has weighed on retailer open to buy. We saw this in 2023 with our wholesale business declining 8% for the year. This was partially offset by growth in direct-to-consumer.

To support our growing D2C business, we are refining our brick-and-mortar strategy, leveraging best practices from our Asian market, while continuing to invest in our digital platforms. We launched a loyalty program that is already generating impressive results, including higher AOVs and repeat purchases.

Our EMEA D2C business grew 13% in 2023, and we expect another year of healthy growth, ahead. Scott talked about Project Jeanius, and we expect it to have a meaningful impact on our

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EMEA business, simplifying our go-to-market process and enabling a true pan-European business model.

In APAC, we ended the year strong, with China revenue growing 25% in the fourth quarter. The key focus for '23 was improving retail inventory levels, and the team delivered. At the end of the fourth quarter, channel inventories decreased approximately 30%, compared to a year ago. This will be a key unlock to acceleration we expect in the coming year.

We will also continue to evolve our digital strategy, leaning into newer e-commerce technologies. These live streaming platforms have, quickly, become a channel of choice for this highly sophisticated consumer, and we are seeing strong double-digit growth as a result.

Additionally, we launched an initiative to refresh over 70% of our China store fleet, over the next two years. And our licensing business is scaling, reflecting momentum for both Lee and Wrangler, as well as positive impact of new markets added, over the last two years. Combined, both brands grew double-digit in 2023.

And finally, six months ago, we had a strong leader to the region who joined us from Adidas and had previously spent 15 years with Nike. She has made an immediate impact, and I'm excited about the future for our Asia business.

Before I turn over to Joe, I'd like to provide some final perspective. First, our innovation pipeline is as strong as I've ever seen. And we have clear visibility to exciting launches, such as Lee-X, later this year. Second, the Lee brand is strong in gaining share in the market with sell-through accelerating, supported by many of the initiatives we discussed today.

An, finally, our China business is poised for growth, with channel inventories clean, investments in stores, and our strong leadership team in place. While we are planning the business conservatively, particularly over the near-term, this gives me great confidence as I look to the new year. Joe.

Joe Alkire

Thanks, Chris, and thank you all for joining us, today. I'd like to begin by providing perspective on the fourth quarter, before reviewing our results in more detail.

POS significantly outpaced our shipments, as we continued to drive market share gains in the U.S.

That said, the wholesale environment was challenging during the holiday period, with retailers tightly managing inventory receipts in the face of an uncertain consumer spending backdrop, which negatively impacted our revenue.

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Overall, we fell short of our revenue outlook by approximately $50 million. The POS performance of both Wrangler and Lee was fairly consistent with our expectations, as both brands continued to gain share. However, in light of the slowdown in POS, which we did anticipate, key accounts reduced inventory levels more than expected.

Despite the revenue shortfall, we are pleased with our execution and the profit inflection we delivered as a result of strong gross margin expansion, which we expect to continue in the coming year. We also took more aggressive action on our own inventory during the quarter, resulting in stronger cash generation and a healthier foundation for 2024, albeit at the expense of near-term gross margin.

I will expand on this in a moment, as well as highlight how the confidence we have in our 2024 outlook and the additional actions we announced this morning with Project Jeanius will fuel the next leg of our TSR journey and support the optionality we see in the business moving forward.

Before we review the details of our fourth quarter, I'd like to briefly touch on the additional audit period duty charge we incurred. If you recall, the duty matter was originally identified late in the third quarter and arose from our ERP implementation dating back to 2021. We recognized $13 million of audit period duty expense in the third quarter, which was an estimate, based on the information available at the time.

As a result of additional testing and procedures, we identified $6 million of additional duty expense related to prior periods and recognized the expense, accordingly, in the fourth quarter. To answer a question likely on your minds, we do not expect to incur expense related to this matter going forward.

So, with that, let's review our fourth quarter results. Global revenue decreased 9%. Two main factors impacted the quarter relative to our previous expectations. First, we experienced a greater-than-expected decline in U.S. wholesale, as retailers more aggressively managed inventory receipts.

Inventory normalization has been a theme for the majority of 2023, as we work with our partners to find equilibrium against what remains an uncertain environment.

While we anticipated a deceleration in POS, the magnitude of the inventory reductions was greater than expected and weighed on selling during the quarter.

While inventory levels at retail are currently suboptimal, we expect retailer caution to continue in the near-term. But the performance of our brands and continued market share gains is leading to expanded distribution in 2024, which we expect to drive an improvement in revenue, as we progress through the year.

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Second, in mid-2023, we began a modernization project in our distribution center network. This included process and systems upgrades to improve service levels and efficiency, most notably in support of our growing DTC business. This work continued into the fourth quarter and had a greater than expected impact on e-commerce fulfillment during the holiday period, particularly for the Lee brand.

The project is now complete, and we have returned to normal service levels.

Stepping back, full-year revenue declined 1%. We drove 9% growth in DTC with gains in both digital and brick-and-mortar, as well as 4% growth in digital wholesale. This was offset by a low- single-digit decline in wholesale, due primarily to retailer inventory management dynamics at the end of the year.

And for the second half of 2023, despite the 2% decline in revenue, gross margin expanded 120 basis points, excluding the out-of-period duty charge, operating income increased 5%, and we generated approximately $225 million of free cashflow, as a result of strong profitability improvement and reductions in inventory. We expect this fundamental profile to further improve in 2024.

Turning to our brands, global revenue for the Wrangler brand decreased 10%. The decline was primarily driven by U.S. wholesale, offset by growth in DTC and digital wholesale. For the full year, Wrangler was flat, with double-digit growth in DTC, offset by a decline in wholesale.

Outside the U.S., full-year Wrangler international revenue decreased 1%, driven by a slight decline in wholesale. This was partially offset by growth in European DTC, which increased 13%, reflecting investments in owned stores and our digital platform.

Turning to Lee, global revenue decreased 7%. Similar to Wrangler, the decline was driven by reduced shipments in U.S. wholesale, as well as impacts to DTC from the previously mentioned distribution center upgrade. This was partially offset by a return to growth in China.

For the full year, Lee revenue decreased 4%. We expect to see improvement in Lee's performance in 2024, driven by new innovation platforms, distribution gains, as well as an acceleration in China.

Turning to gross margin, as expected, adjusted gross margin inflected strongly in the fourth quarter, expanding 230 basis points, excluding the duty impact, driven by the benefits of pricing, channel mix, and lower product costs. The quarter included the impact of proactive inventory management actions, as we more aggressively cleared excess inventory in light of the environment.

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