Central Garden & Pet Company
Q3 2009 Earnings Call Transcript

Published: 6 Aug 2009

[Operator:]

Welcome to Central Garden and Pet's fiscal third quarter 2009 earnings call. (Operator Instructions). I would now like to introduce Mr. Paul Warburg, Vice President and Treasurer for Central Garden & Pet. Please proceed sir.

[Paul Warburg:]

Good afternoon, everyone, and thank you for joining us. With me on the call today are Bill Brown, Central's Chairman and Chief Executive Officer and Stu Booth, our Chief Financial Officer. Before I turn the call over to Bill, I would like to remind you of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. The statements made during this conference call, which are not historical facts, including expected further margin and capital efficiency improvements are forward-looking statements. Central undertakes no obligation to publicly update forward-looking statements to reflect new information, subsequent events or otherwise. These statements are subject to risks and uncertainties that could cause actual results to differ materially from those set forth in and/or implied by forward-looking statements. These risks are described in the company's earnings press release, Form 10-K for the fiscal year ended September 27, 2008, and in other Securities and Exchange Commission filings. Additionally, the discussion on this call may include the use of non-GAAP financial measures. We have provided a reconciliation of the measures to the nearest comparable GAAP measure in our earnings press release, which is available on the Investor Relations portion of our website at www.central.com. Today's agenda is as follows. Bill will provide a brief business update and Stu will review the financial results for the quarter. We will then open the call up for Q&A. Our plan is to keep the call to approximately one hour. I will now turn the call over to Bill Brown. Bill?

[Bill Brown:]

Thank you, Paul, and thank you for joining us this afternoon. My plan today is to provide an update on the business and the operating environment. Overall, we had an excellent quarter in terms of earnings and balance sheet metrics. Our business is considerably stronger and we are cautiously optimistic that this momentum will continue. Turning to the quarter, we made progress against our three core operating objectives. Compared to the third quarter last year, we improved gross margin percentages by over 300 basis points. We lowered operating expense by approximately $6 million in the quarter and we reduced our investment in working capital by $92 million. In garden, as the season draws to a close, we benefited from improved weather conditions. It was a good year for our controls portfolio. Additionally, compared to the last two years, we benefited from lower commodity costs and we did a good job of controlling expenses. Furthermore, during the quarter, demand for our products held up well. Our POS for the quarter increased nearly double-digits in garden. In pet, consumer side of our business continued to demonstrate resiliency, while in the professional and the animal health channels, we experienced softness. This softness was related primarily to our active ingredient based products. Consumables, particularly those associated with the dog and cat category continued to perform relatively well. However, pet retailers are tightening inventory levels. We are seeing inventory decreases anywhere from mid-single digits to strong double digits, depending on the retailer. Having said that, our data continues to suggest that the POS for pet supplies in general and the POS at our key retailers for premium products remained healthy. The softness in pet sales is reflected in the gross profit, which was partially offset by continued progress in expense control. Turning to the balance sheet metrics, both garden and pet did a superb job. We reduced our investment and working capital by $92 million, compared to the third quarter of last year. As a result of our working capital initiatives and our strengthening operating performance, our quarter ending leverage ratio is 2.7 times compared to 4.1 times a year ago. I'm really proud of our folks and what they accomplished on that. In summary, we had a solid quarter and we believe we are poised to drive additional performance improvements. On the basis of a significantly stronger business, we are now developing our plans for fiscal 2010. When I returned two years ago, I said, our objective is to get the business back on operating and financial profile, to return to and ultimately surpass historical performance. We accomplished a great deal since I laid out that objective. Our folks have done a fantastic job. Our operating performance is significantly improved and our financial foundation is sound. We are hopeful that our reported earnings per share this year may approach a high watermark of $0.95 in 2006. We are now turning our focus towards surpassing this historical performance. We are in the process of implementing a series of initiatives that we believe, if executed with excellence, will drive continued operational and financial improvements. We are going to achieve further progress in capital efficiency. For example, inventory levels are still too high and we carry too many SKUs. Additionally, we're focusing on creating greater operating synergies. Our plan is to further consolidate key functional areas to drive additional operating efficiencies. Most importantly, we are developing exciting new strategies to grow our brands, which is absolutely the key to the long-term future. We will do this by leveraging our core competitive strengths, which are, a commitment to innovation and quality, our shelf presence at retail, our distribution network, and our strong relationships with our retail customers. In summary, we've made substantial progress, solidifying the business over the past 18 months. Central's foundation is meaningfully improved, and we believe we're poised to build upon these accomplishments. I am cautiously optimistic that our momentum will continue. With that, I'll turn it over to Stu, who will recap the financial highlights for the quarter and then we'll take your questions. Stu?

[Stu Booth:]

Thanks Bill. Recapping the quarter's performance, we performed well due to improved weather conditions, gross margin expansion, cost reduction and reduced working capital, which drove significant earnings per share improvement. Turning to reported financial results, net sales for the third quarter of fiscal 2009 were $482 million, compared to sales of $493 million a year ago, a decline of 2%. Branded product sales were $407 million, a decline of 3%, and sales of other manufacturers' products were $76 million, an increase of 2%. Garden segment sales increased approximately $14 million or 5% to $267 million, compared to the third quarter of 2008, due primarily to sales of garden chemical and control products. Garden branded product sales increased approximately 6% to $231 million, and sales of other manufacturers' products were $37 million, essentially unchanged. Pet segment sales were $215 million, a decline of 10%. The decline was due primarily to pet products that sell into the professional and animal health channels, and inventory reduction initiatives at retail. Pet branded product sales decreased 13% to $176 million. Sales of other manufacturer's products increased 3% to $39 million. The company's gross profit for the third quarter was $165 million, an increase of 8%, compared to a year ago. The decrease was due primarily to a combination of higher sales and improved margins in garden, partially offset by lower sales and margins in pet. Gross profit, as a percentage of net sales, increased 320 basis points to 34.2%. The improvement was due primarily to greater contribution from, higher margin garden control products and a combination of lower input cost, and improved pricing for our wild bird feed products. Selling, general and administrative expenses for the third quarter were approximately $113 million, compared to $119 million a year ago, a decline of $6 million. The improvement was due primarily to the consolidation within our garden distribution operations, lower freight and fuel cost and company wide cost management. Operating income for the quarter was $51.6 million, compared to $33.9 million a year ago, an increase of 52%. Garden segment operating income was $35.3 million, compared to $12.6 million in the year ago period, an increase of 180%. Pet segment operating income was $29.8 million, compared to $32.7 million in the prior year period, a decrease of 9%. Net interest expense for the quarter was $5.2 million, compared to $9 million in the year ago period. The lower interest expense is due to lower balances and lower borrowing rates. Our borrowing rate for the quarter was approximately 4.1%, compared to 5.3% a year ago. Our effective tax rate was 32.3% for the quarter, compared to 37.3% a year ago. Our rate for the quarter was lower than our statutory rate due primarily to the realization of approximately $1.7 million of research and development credits. Year-to-date we have recognized approximately $0.05 per fully diluted share in tax benefits. Net income for the quarter was $31.1 million or $0.44 per fully diluted share. This compares to net income of $15.6 million or $0.22 per fully diluted share in the same period last year or an increase of 99% and 100% respectively. Capital expenditures for the quarter totaled approximately $3.3 million, compared to $4.2 million last year. Now turning to the balance sheet; comparing June 27, 2009 balances to June 28, 2008 balances, accounts receivable were $263 million, a decrease of approximately $30 million or 10%, compared to last year. Inventories were $314 million, a decrease of $57 million or 15%, compared to last year. Accounts payable were $117 million, a decrease of $2 million or 2%, compared to last year. As of June 27, 2009, total debt stood at $409 million, compared to $584 million last year. Addressing our credit agreement, our current debt-to-EBITDA ratio, as defined by our credit agreement, is approximately 2.7 times, compared to 4.1 times a year ago. The maximum for the leverage covenant in our bank credit agreement was 4.75 times. Finally, during the quarter, we repurchased approximately 550,000 shares of our common stock at an average price of $9.36. I will now turn the call back to Bill. Bill?

[Bill Brown:]

Thank you, Stu. All of us are pleased with our results for the quarter and the progress we continue to make. As you may guess, there are a number of our managers and our employees who listen to this call as well, and to all of them I want to say, congratulations and thank you. It's your energy, your focus and your commitment that has allowed us to deliver these kinds of results. We are doing a better job of controlling our costs, managing our working capital, and driving our gross profit margin expansion. While there are a number of factors that could conceivably, adversely impact our results, including the economic environment and weather, we continue to be cautiously optimistic that the momentum that we have generated will continue. With that, we'll now take your questions. Operator, if you would open up the call to Q&A.

[Operator:]

(Operator Instructions) Our first question comes from the line of Joe Altobello of Oppenheimer.

[Joe Altobello:]

First question is on the, the top line. This year you are down, I guess year-to-date about 2 or 3% or so. How much of that is business that you guys have chosen to walk away from?

[Bill Brown:]

I haven't thought about a lot of business that we've chosen to walk away. There is some of it, but I think most of it is reflective of the economic climate and in particularly what's going on in the animal, and the vet, and professional pieces of the business.

[Joe Altobello:]

Okay. So, it's more macro than anything you guys are doing internally?

[Stu Booth:]

Joe. We've talked about SKU rationalization and the fact that we have 177,000 SKUs in our portfolio right now and one of the things we have been doing, as we've talked about before, systematically, going through our SKUs and limiting those SKUs that are not profitable or not showing as much margin as we'd like in terms of contribution and we've probably reduced our sales somewhere in the range of 15 to $20 million year-to-date related to SKU rationalization or discontinued items. But, as Bill said, the large measure of it is really the general economic condition, but that's just kind of an undercurrent that's working through this as well though.

[Joe Altobello:]

Got it.

[Bill Brown:]

Important thing is, we see ourselves either holding or increasing share. We do not see ourselves loosing share and we're strongly position to move forward from this.

[Joe Altobello:]

Okay. Then in terms of the things you talked about earlier, Bill, about growing the brands, I think you are talking about more fiscal '10 and beyond. Could you sort of elaborate on what types of thing you are doing, whether that's promotion spending or increasing distribution?

[Bill Brown:]

It's more a focus on, what are the leverage points around each brand, and what's the best way for that brand to move forward and grow? We have tremendous competitive strengths and those I enumerated on the deal with the brands, the positions they hold in the marketplace, the relationships with our retailers, our distribution network and we are looking at how to energize that even further, and most importantly, innovation, innovation, innovation and super commitment to quality. So, all of those points are going, and the strengthening of the kind of folks that we have working on branding and the branding initiatives is shifting in a very strong, positive way. That's an important element of our long-term growth.

[Joe Altobello:]

Okay. So, doesn't require any significant increase in investment, it's more just doing the things differently, it's how I interpret that

[Bill Brown:]

I would say that's a good way. How about you Stu? We are still very disciplined.

[Stu Booth:]

Yes. Very disciplined in using our investment in people, and basically, marketing and advertising promotion and innovation dollars more wisely.

[Bill Brown:]

I would add one additional comment.

[Joe Altobello:]

Sure.

[Bill Brown:]

Where we see strong gross net contributions from products that can benefit from large marketing spend, we are very prepared to make those investments and those commitments. So you've got to see it and you've got to know you're going to get the payoff and that's where the discipline comes in.

[Joe Altobello:]

Then one last one. The operating margin this year, I think year-to-date you are up or actually on track with your plus 200ish basis points or so. In terms of order magnitude, what should we expect for fiscal '10? I mean, is it something similar to that or is it going to be difficult to replicate that going into next year?

[Bill Brown:]

Well, our goal is always to surpass and I don't like to think about difficult to replicate but we're not in the business of doing forecasting or guidance. So, I think I'll stop right there.

[Operator:]

Our next question comes from the line of Bill Chappell of SunTrust Bank.

[Bill Chappell:]

Just want to dig a little bit more into the pet top line. I am just trying to understand, why, especially the vet channel would be so weak, and should that continue on a go forward basis or is it just really one quarter type issue?

[Bill Brown:]

Well, I think one of the good examples is in the cattle. One of our good products, not the most important, but an important product that has to do with control of parasites and flies with feed through product for cattle. I think you're well aware that the cattle market, the dairy market collapsed. People were slaughtering animals and not taking care of their herds in the same way they used to, because it doesn't pay. So, we see contractions there that are quite dramatic.

[Stu Booth:]

I think on top of that Bill, I think at least building on the whole cattle pieces, it appears that the cattle industry has bottomed out, and so it is something that comes back quickly, that I don't know, but at some point you will probably see the replenishment of the herds. So, we think if it's not at the bottom, it's close to the bottom here.

[Bill Chappell:]

Yes. I guess, I'm just trying to understand the down double digits for the quarter, if that's something that really continues for the next two or three or say, if that's kind of a trend that we've seen the worse of it this quarter?

[Stu Booth:]

Well, Bill, the economic animal and health, and vet channel is one contributing factor to the decline, the other one that I'd call out is, we're still seeing inventory reduction at retailers. I would say, that's probably the number two contributing factor to the decline in the pet segment this quarter is that across our major retailers that we've seen still contraction in inventory.

[Bill Brown:]

So, my own view is that, as those inventory contractions bottom out, and the economy goes so far down, and they've got to restock, we certainly saw some of that in garden. This is a very strong quarter where they have been cleaning out inventories and then they had to start getting on to a normal replenishment cycle, the same thing I expect will happen in pet. I think in these professional segments our belief is a year from now those will be running. Which quarter will it bottom? I couldn't tell you for sure, but I would think next year, we wouldn't be seeing this kind of level of activity.

[Bill Chappell:]

This is a long winded way of asking, I mean gross margin for the quarter was the highest in 10 years and that's as far back as my model goes. I mean, but it seems to imply with those high margin products that weren't sold, and it can go a lot higher. Is that the right way to look at it?

[Stu Booth:]

Directionally correct.

[Bill Brown:]

Directionally it's correct.

[Bill Chappell:]

Okay. Then, one last thing, I mean is there a goal on kind of the leverage ratio where you'd start using cash for other purposes, I mean as we get to closer 2.5 times, you we want to get to 2 times, are you pretty comfortable where you are?

[Stu Booth:]

Bill, we've had for years our (inaudible) under 3 times debt-to-EBITDA and we are really pleased where our leverage ratio is right now, at about 2.7 times. We'll kind of manage the leverage ratio somewhere in that range. But, obviously we have total maximum flexibility where we are right now to manage our capital structure and optimize it for all of our growth initiatives that Bill's outlined. So, we are really in a very good position right now. For the time being we paid down debt, we have committed a little bit of cash and we are waiting for basically the execution on a very disciplined basis of our growth strategy.

[Bill Chappell:]

Great. Thanks so much.

[Stu Booth:]

Sure.

[Operator:]

Our next question comes from the line of Peter Keith of Piper Jaffray.

[Peter Keith:]

I know you had talked in last conference call about ramping up some marketing initiatives here for the back half of the year. So now that you are one quarter through that, could you just talk a little bit about the success you might have had in that and some of the programs that you're running?

[Paul Warburg:]

Well, if you remember Peter, this is Paul. We were evaluating as to whether or not we thought that the increased spend in advertising would help us drive incremental sales and I think the overall feeling was that we stuck to our original budgets and plans. Obviously, we felt that the garden season was progressing as we had hoped or perhaps even little better. So, we opted not to increase the spending materially.

[Peter Keith:]

Okay. So you've spoken before that it would be increase for both the Q3 and 4, should we expect similar pattern for Q4 now?

[Paul Warburg:]

I think it's really to (inaudible) and quite honestly we don't want to telegraph what we might doing to the marketplace.

[Peter Keith:]

Okay, that's fair. On the skew rationalization program and you talked about some of the sales that you may be forfeiting in order to drive profit. Do those sales can be more weighted towards pets or towards garden or is it pretty evenly divided?

[Bill Brown:]

I think our SKU rationalization issue runs across the company and I don't see the SKUs that we would rationalize are not going to have a significant impact on sales or profits. It's possible that as we take these SKUs out, we are going to benefit from more profits when you look at just the cost of dealing with SKUs that aren't have the proper velocity.

[Peter Keith:]

Okay. Thanks. Then last question is, there's been some commentary out that with the favorable weather and perhaps higher precipitation levels that you're seeing a longer lawn and garden season this year extending perhaps through the month of July. Is that the (pet) trend that you're seeing within your business to date?

[Bill Brown:]

We think it's a good year; we don't think it's a great year. The country as always is split here in California. We have some degree of weather softness, is it Texas that's still running the drought?

[Stu Booth:]

No.

[Bill Brown:]

So we've got that going there. It's a good season, but it's not a great season.

[Operator:]

Your next question comes from the line of Reza Vahabzadeh of Barclays Capital.

[Reza Vahabzadeh:]

I have a couple of housekeeping questions for you; one is, what was the CapEx in the third quarter and what's a good CapEx number for the year?

[Stu Booth:]

CapEx for the third quarter was I think was $3.3 million and what we have, we'll our Q in a couple of days, but we now have on our MD&A a capital expenditure, maximum number of $20 million for the year.

[Reza Vahabzadeh:]

Got it. Do you think that's sustainable overtime, since you've had higher CapEx levels historically?

[Stu Booth:]

It's probably going to be somewhere in the 20s. I mean, if you look back overtime when we weren't ramping up SAP our CapEx was somewhere in the 20s. We've been investing CapEx in, basically, general repairs and refurbishings for our existing plant and equipment and then also making incremental investment for the support of new products that we are developing and manufacture. So it's kind of our standard run rate right now, to the extent that we do some further expansion or growth development, capital expenditures may go up.

[Reza Vahabzadeh:]

Got it. Then what's your appetite as well as your ability to make share repurchases?

[Bill Brown:]

Well. The ability is quite large and growing daily. The appetite is, what's reasonable and prudent in our judgment to drive shareholder value. All things being equal, we would rather invest in organic internal growth as the first priority. Perhaps, very disciplined in selected acquisitions that are clearly going to be very, very strong performance for us and play for 20 years in a powerful play is second priority. But I want to emphasize the discipline. Third, the repurchase of stock. One of the things that we've said about stock repurchases is that as a general practice we would want to at least offset the dilutive effects of equity comp and I think we have more than done that.

[Reza Vahabzadeh:]

Got it. Paul do you know what the (NASDAQ

[Paul Warburg:]

It's not in the bonds it's in the credit agreement.

[Stu Booth:]

I think we have about 70 million left between the Board authorization and what's in the credit agreement.

[Paul Warburg:]

That's right.

[Reza Vahabzadeh:]

Got it.

[Stu Booth:]

Rough numbers.

[Reza Vahabzadeh:]

Then your income is rising and so what is going to be your contribution in terms of taxes through our fairly large Federal budget deficit?

[Stu Booth:]

Huge. We're going to be almost a full statutory tax payer this year.

[Reza Vahabzadeh:]

Okay. So, cash tax is about the same as book tax?

[Stu Booth:]

Maybe not that high. I think we're probably cash tax as year-to-date. Well, the 13, just for rule thumb just kind of half what our book would be and that would be our cash taxes.

[Reza Vahabzadeh:]

I am sure the rest of the country will appreciate that. Thank you.

[Stu Booth:]

We're here to help.

[Operator:]

Our next question comes from the line of Alice Longley of Buckingham Research.

[Alice Longley:]

Are you hearing anything from retailers indicating that the inventory cuts by them are nearing their end or are they doing it as robustly into this fourth quarter as in the third?

[Bill Brown:]

At my level, I am not hearing from them specifically what they are doing, they just do it and you can get some measure of what they are doing by our folks that work closely with the accounts and size up what's going on. So, it's more monitoring and seeing the activity than it is a function of talking to any executive laying out the plan.

[Alice Longley:]

What's your sense of the inventory cuts in the fourth quarter? Same type of trends we've seen in the third quarter?

[Bill Brown:]

I have got to tell you, Alice, I personally don't even bother thinking about that. They are the things that we can control and we work like heck on maximizing those, the things like inventory adjustments which are transitory, and I frankly don't think about it, Paul or Stu can you add any light?

[Paul Warburg:]

I don't have much to add, other than, Alice, we always have to be inventoried right to deal with the just-in-time delivery capabilities and demands of our retailers, which are always increasing now. But that said, we, as you know, we have reduced our inventories dramatically over the last couple of years just through some better insight and operating efficiencies within the company. So...

[Bill Brown:]

We're not done.

[Alice Longley:]

All right. My other question is about the professional and animal health demand being weak. I understand the dairy market issue. But I'm sort of surprised about the theme because I would think that the one category that might hold out just fine during a recession would be animal health. So, can you give us another example of brands that are doing weak, and why they would be weak in this...

[Stu Booth:]

No, Alice I think the key thing to point out, as Bill said in his prepared remarks is, that the consumer side of the portfolio is actually holding up relatively well, it's the professional side, the economic animal, and the vet channel. So the vet channel where you have, for example, discretionary vet visits are down, and so when you combine the economic animal, i.e. cattle and there's a decline in vet visits that's going to have some impact on our business. As I said, and I reiterate, the consumer side of the business continues to perform relatively well; dog and cat continues to perform very well.

[Bill Brown:]

Some of those products are moving through distributors, who specialize in those channels, and we can look at that and see where they are pulling their inventories down. You can see where individual consumers are pulling back on inventories. So, you've got both issues of usage and you've got issues of inventory contraction throughout the channel. I personally am okay with it, it's just the country working through what it's got to work through.

[Operator:]

Our next question comes from the line of Doug Lane from Jeffries…

[Doug Lane:]

Good afternoon, everybody.

[Paul Warburg:]

Hi, Doug.

[Doug Lane:]

I just have one sort of bigger picture question and that is, you've got segment margins now in the peak seasons March and June quarter, they are multiple 100 basis points above prior peaks and yet sales are bit down seven in the last nine quarters. I'm just wondering, how do you get sales reaccelerated again without (inaudible) back some of that margin?

[Bill Brown:]

Well, first of all, I think sales are proper for the products and the demand in the marketplace. Sometimes it would be where there isn't a demand trying to stimulate a demand doesn't make sense to me and to us in general. So, I think that where we spend, we'll be spending where the incremental contributions are quite significant and other just fine with that. I just am not particularly concerned about the decline in sales given what's going in the general economic climate. Our categories are good categories and our position is really good too.

[Doug Lane:]

I guess, I wouldn't have thought that your categories were particularly economically sensitive, but I guess it's turning out more or so that way particularly on the pet side.

[Bill Brown:]

If you break the pet into the two pieces that we've described today, the garden business, I think we have always said, is slightly in recessionary times. It's kind of the historical pattern for whatever reasons, we have seen a lift this year and it's terrific and we are delighted with it. What we are seeing on the pet side for the companion pets are doing just fine and what we're seeing on a professional and a vet, it's different. We are recessionary resistant, we are not immune.

[Stu Booth:]

Then Doug the second contributing factor to the decline in sales in pet again was inventory reduction in retail. So it's destabilizing effect going on here as well.

[Operator:]

(Operator instructions) Our next question comes from the line of Jon Anderson from William Blair.

[Jon Anderson:]

We have been hearing that obviously in the lawn and garden season this year there has been a lot of support from the major (inaudible) retailers, given that consumers aren't really spending on big ticket items, but are spending on some of the seasonal and simple businesses, are your expecting that kind of a similar level of support from retailers as you look at the 2010 season?

[Bill Brown:]

I wouldn't say any reason why it would be any less and it has the potential to be more.

[Jon Anderson:]

Just a couple of housekeeping questions. The current share repurchase authorization?

[Paul Warburg:]

Yes.

[Stu Booth:]

In terms of the number?

[Jon Anderson:]

Yes, outstanding.

[Stu Booth:]

I think we answered that just a few minutes ago. I think in rough terms, we have about $70 million remaining on our Board authorization and the (inaudible) like amount remaining under our credit agreement, just in rough terms.

[Jon Anderson:]

Okay. I guess, this is the fourth quarter in which SG&A expenses has been down on an absolute basis and I am just wondering as we kind of look ahead and think about modeling it, should we that kind of trend to continue or would there be some reason to believe why we'd see that year-over-year decline diminish going forward?

[Bill Brown:]

Well, if we were to double sales you wouldn't see a year-over-year absolute decline, but on comparable sales we would expect to be continuing to take expenses down.

[Stu Booth:]

Again if sales do recover or start to accelerate, we build a platform that we can leverage our SG&A pretty effectively now.

[Operator:]

We have no further questions at this time.

[Bill Brown:]

Well, thank you very much for joining us on the call today. We look forward to providing additional updates as we move through the year, as Stu and Paul are out at the investment events. Thanks again. Bye-bye.

[Operator:]

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a good day.