Levi Strauss (LEVI -2.22%) made denim exciting again for investors when it IPOed earlier this year. The stock had a nice run, trading as high as $24 per share, well above the $17 IPO price. That streak was challenged after the company reported its Q2 2019 earnings last week.

Levi saw its stock price fall as much as 12% after reporting a decline in earnings. The primary culprit for the earnings hit: nearly $30 million in expenses related to its IPO.

However, the decline in earnings overshadowed an otherwise upbeat revision on forward financial guidance. And that should give long-term investors some hope.

A profit decline

The headline from Levi's Q2 2019 earnings report was a $48 million decline in net income from Q2 2018. Most of the decline can be traced back to $29 million in expenses related to the company's IPO, but earnings fell even after adjusting for the IPO costs.

Metric Q2 2019 Q2 2018 YOY Change
Net revenue $1.31 billion $1.25 billion 5%
Net income $29 million $77 million (63%)
Adjusted net income $69 million $83 million (17%)

Data source: Levi financial reports. Note: Adjusted net income adds back IPO expenses. YOY= year over year.

Another factor hitting Levi's financial performance was a negative impact from foreign exchange. The company indicated that foreign exchange rates impaired revenue in the quarter by $44 million and earnings by $10 million because the U.S. dollar rose in value relative to foreign currencies. Because Levi reports its earnings in U.S. dollars but generates a majority of its sales from international markets, a rising dollar devalues those overseas profits.

Finally, Levi stepped up investment in its advertising budget and e-commerce operations, which resulted in higher overhead expenses and lower profits.

The sum of these factors is a nasty headwind to earnings in the quarter, but investors shouldn't despair. Levi won't be going public again, so investors can comfortably assume the IPO expenses were a one-time item. Foreign exchange-related swings will continue to be a factor but could reverse and become a positive if the dollar weakens in the future. Finally, increased investment in promotion and operations is more reflective of a long-term impact on earnings, but these expenses are investments that will hopefully generate a return in the form of future earnings growth.

clothing hanging on a rack

Image source: Getty Images.

Weakness in the wholesale channel

The quarterly decline in profit was unwelcome, but more perturbing was Levi's reported decline in U.S. wholesale revenue -- the company's largest source of sales. 

Levi sells its apparel in two distinct channels: wholesale and direct-to-consumer. Direct-to-consumer consists of Levi's e-commerce and brick-and-mortar stores. The wholesale channel consists of third-party retailers, such as department stores and boutiques, which carry Levi's products in addition to other brands.

Levi's business has historically been centered on its wholesale channel, which still represents 60% of its revenue. Its direct-to-consumer business has been an area of investment and has driven most of Levi's growth in recent years.

The wholesale channel has been challenged as department stores and other big-box apparel retailers struggle with changing consumer preferences to shop online and at off-mall locations. This weakness was a big drag on Levi's revenue growth in Q2 and was particularly felt in the U.S. geographic segment, where 70% of sales come from wholesale customers.

On the Q2 2019 earnings call, Levi CFO Harmit Singh commented:

Our largest market, the U.S., was up 1%, as direct-to-consumer growth of 7% driven by e-commerce in new doors offset a 2% decline in U.S. wholesale. The U.S. wholesale decline was attributable to the impact of the bankruptcies and door closures that some of our customers have experienced over the last year as well as a decline in discounted sales to the off-price channel, reflecting that we're increasing -- that we're carrying substantially healthier inventory in comparison to the prior year.

The company expects weakness in wholesale revenue to persist as brick-and-mortar retailers continue to shut stores in the United States. The good news is the Levi isn't solely dependent on this channel. The company's direct-to-consumer channel now accounts for nearly 40% of revenue, and the wholesale picture isn't as bleak outside the country.

Upbeat guidance

Levi's management didn't completely leave shareholders hanging. After reporting a profit decline and revenue growth weakness, the company raised its annual financial guidance for the year.

In Q1 2019, Levi guided for "mid-single-digit" revenue growth and "flat to slightly up" adjusted profit margin. This past quarter, revenue guidance was upgraded to the "high end of the mid-single-digit range," and adjusted profit margin was updated to "slightly up." The adjustments in guidance are subtle, but at least they're positive.

The negative headlines and stock price reaction paint a decidedly negative tone, but perhaps this was an overreaction. Most of the earnings hit Levi took in Q2 has little to do with the core business, as the company won't incur future IPO costs and currency fluctuations are macroeconomic in nature. At the end of the day, Levi is still growing sales at a decent clip and is healthily profitable. The company's upbeat guidance gives investors something to look forward to.