Central Garden & Pet Company
Q3 2013 Earnings Call Transcript

Published: 8 Aug 2013

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to Central Garden & Pet's Third Quarter of Fiscal Year 2013 Financial Results Conference Call. My name is Sue, and I will be your operator for today. [Operator Instructions] I would now like to turn the call over to Steven Zenker, Vice President of Investor Relations and Communications. Please go ahead.

[Steve Zenker:]

Thank you, Sue. Good afternoon, everyone. Thank you for joining us. It is my pleasure to welcome you to today's call and to introduce our other speakers. With me on the call today are John Ranelli, Central's President and Chief Executive Officer; Steve LaMonte, President of our Garden segment; and Lori Varlas, Central's Chief Financial Officer. As reminder, we issued a press release this afternoon providing results for our third quarter ending June 29, 2013. The press release is available on our website at www.central.com. Before I turn the call over to John, 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 expectations for future revenue growth, margin improvement and improved profitability, are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those set forth in or implied by forward-looking statements. These risks are described in Central's Securities and Exchange Commission filings. Central undertakes no obligation to publicly update these forward-looking statements to reflect new information, subsequent events or otherwise. Now I will turn the call over the John Ranelli, President and CEO of Central.

[John R. Ranelli:]

Thanks, Steve. Good afternoon, everyone. Obviously, none of us are pleased with the financial results. As we announced last quarter, we expected our third quarter earnings would be lower than the third quarter last year. We knew that this quarter would be difficult because our results would be compared against our performance in the third quarter of 2012 when our sales were up over 10% the prior year. Difficult comparisons aside, our actual results for this quarter were lower than we anticipated at the time of our second quarter earnings call. In last year's third quarter, the Pet segment benefited from the shipment of backlogged orders and the initial sell-in of high-margin flea and tick products in a new channel of distribution. We didn't have either of these factors working for us this year, resulting in lower sales and profitability in our Pet segment. Although our Pet business was down, it performed in line to our expectations, but our Garden business results were disappointing. While Garden sales in the quarter were close to the prior year level, we had expected them to grow, even when comparing against a strong 2012 third quarter, which, like Pet, benefited from the shipment of delayed orders. Our margins were negatively impacted by several factors that Steve and Lori will elaborate on later in the call. But, suffice it to say, we are looking carefully at the businesses to address the margin and other issues we are facing. Our key priorities for the future have not changed since I spoke to you in May on my first call as CEO. As a reminder, they are to bring profits to the bottom line through a more balanced approach of increasing sales, improving margins by providing customer-first service, delivering customer-first innovation through our strategy of product, product and more product, while improving on whatever is not working as planned, all while reducing expenses and building our branch. To support these priorities, we have recently completed putting in place experienced leaders in each of our major businesses. They are working with their functional counterparts in a recently introduced matrix organization, and are directly accountable for the results of their business. We are also establishing more collective partnering relationships with our retail customers. We are building the retail environment of the future as we develop products, marketing and point-of-purchase displays, consistent with our retailers' plans. Leaders from our sales, marketing, supply chain and shared service areas are coming together to work as an integrated team. As just one example of how this is benefiting the company and our customers, our fill rates have improved significantly. This improvement is being enthusiastically received by our customers and it is also energizing our sales force. We will not be satisfied until our customers recognize Central as the industry leader in customer service. With regard to innovation, as we improve customer confidence, we are working hand-in-hand with our retailers at developing new products to meet our customers' and consumers' needs. Due to the length of the product innovation cycle from product development to shelf placement, it takes longer to deliver results from innovation than it does to improve fill rates and customer service. We have a lot of work ahead, but developing innovative, new products is a real critical priority. Turning to improving profits in the near term, during May earnings call, I highlighted 2 specific actions, which we took to immediately begin increasing our profitability. These actions demonstrate my commitment to expense reductions and margin improvements. The first action was a new expense reduction initiative, and the second action was the implementation of price increases in our Pet segment, which we undertook in my second month. These initiatives are intended to begin addressing our gross margin and expense issues which prevent earnings from reaching the bottom line. Our expense reduction initiative had 2 parts

[Steven LaMonte:]

Thanks, John. It's a pleasure to be here today to provide an update on our Garden business. This quarter, our Garden sales declined 2% compared with last year. While a small decrease, sales did come in below our expectations as John mentioned. We had anticipated higher contributions from our new products and our control products in general. The late-breaking garden season adversely impacted sales many of our higher-margin control products. Grass seed and birdseed sales this quarter were higher than last year, but were not enough to offset the decline to controls. Last quarter sales were up 8% as retailers prepared for the Garden season and we launched our new products. However, due to soft demand for control products by consumers, resulting from the slow start to the season, demand for replenishment orders was soft in the third quarters. It certainly was a significant factor in sales coming in below our expectations. Although consumer demand did pick up in third quarter, it was too late for our control products to make up for lost ground. Our biggest disappointment was the drop in our margins. The major reason for the decline were lower profitability in our controls, decor and fertilizer businesses. Profitability was impacted by higher promotion and marketing expenses, including cost related to the launch and support of the 2 new innovative products we brought to market this spring. These new products were the ANDRO PowerFlex system and the Pennington Smart Feed sprayer. The adoption curve for market disrupting new products in the Garden industry can be slow to build. However, we had very strong retailer interest and support. Both we and our retail partners have high expectations for these innovative new products in the marketplace. In hindsight, these expectations were too high for their initial year. Several factors, including the unfavorable weather for the entire controls category, and the launch timing, impacted sell-through performance. Our customers believe strongly in these new products, and have committed shelf space and support, as we plan for our second year to successfully establish these truly an innovative products in the marketplace. Our retailers, like us, believe these innovations offer unique consumer benefits. As we look back, we experienced the sales gain of 2.5% over our second and third quarters combined, with a modest pickup in consumer takeaway, as measured at point of sale. Our margins, however, are simply unacceptable. We believe we have many levers to address profitability and we have developed a plan of action to do so. With that, I'll turn it over to Lori.

[Lori A. Varlas:]

Thanks, Steve. The press release we issued this afternoon covers the financial results, but let me spend a little time commenting on a few aspects of the quarter. I'd like to speak on the numbers on a consolidated basis and then provide some details on our Garden and Pet segment results. Total sales for the third quarter declined 7% compared with last year, partly due to lower sales in our Pet segment. As you may recall, last year's third quarter sales increased 10%, benefiting from the delivery of backlog products in both the Garden and Pet segments, but certainly, the third quarter comparisons versus the year ago were very difficult. Our consolidated gross margin for the quarter declined from 33.8% to 30.9%, a decline of 290 basis points from the third quarter of 2012. Both the Garden and Pet segments experienced a drop in gross margin for the quarter. The lower sales and gross margins translated into a lower operating margin, although the decline in operating margin was less than the decline in our gross margin. This is due to reduction in SG&A expenditures, primarily in Pet, including initiatives set in motion since John became CEO. SG&A expenses as a percentage of sales improved to 24.2% from 24.7% in the third quarter of last year. Our third quarter operating margin was 6.7%, down from 9.2% last year. Let's take a minute to talk about our Pet segment results. In the Pet segment, sales were down 12% reflecting the difficult comparisons mentioned earlier. Last year, Pet sales were up 19% and reflected the initial sell-in of our flea and tick products to distribution in the club channel and the delivery of backlog products from the second quarter. These events did not repeat this year. Our animal health category, which includes our flea and tick business, represent the majority of the Pet sales decline. Operating margins in our pet segment decreased 100 basis points. The operating margin was significantly impacted by the drop in volume between in the flea and tick business which carries higher margins, further, the margins were adversely impacted by higher ingredient costs. We did see improvement in our birdseed margins, reflecting price increases taken to cover last year's commodity cost increases. SG&A expenses in our Pet segment, as a percentage of sales, improved 190 basis points due to decreased marketing and salary expenses. The actions taken to improve SG&A helped offset the impact of the segment's lower gross margin on it's operating margin. Moving on to our Garden segment. As mentioned earlier, Garden sales decreased 2% versus the prior year. However, the mix of sales was meaningfully different from a year ago. Our higher margin control products sales were down significantly, impacted by the late start to spring in much of the country. Grass seed and birdseed sales were areas of strength, both showing growth. Operating margins in our Garden segment decreased 330 basis points to 5.3%. The decline was predominantly due to lower profitability in our controls, decor and fertilizer businesses. The decline in controls business margin was due to cost related to launch and support of 2 new innovative products we brought to market this spring. The decline at decor was primarily due to seasonal product returns. The decline in the fertilizer business was attributable to a change in customer mix in our private label fertilizer business. As a reminder, as we move in to our fourth quarter, the Garden season primarily spans our second and third quarter, and our fourth quarter Garden sales are a much smaller percentage of our overall annual Garden revenue. Turning back to our consolidated results. With respect to the P&L impact of our cost-saving initiatives initiated in the second quarter, third quarter results included savings of approximately $4 million. Our Q3 effective tax rate was 34.3% compared to 37.9% in the third quarter of last year. The reduction of our effective tax rate reflects additional tax credits available in the quarter that have a larger impact due to lower earnings in the quarter versus a year ago. We expect our effective income tax rate for the fiscal year to be in the range of 36% to 38%. Our net income was $13.7 million compared to $22.7 million a year ago, and our third quarter diluted EPS was $0.28 versus $0.47 in the third quarter of 2012. A few comments on our balance sheet. Net debt at quarter end was $471 million versus $391 million a year ago. Our total leverage ratio at quarter end was 4.9x, an increase from 3.9x a year ago. Although we were in compliance with all of our covenants at quarter end, we subsequently amended our credit facility to provide us with more favorable terms. Our minimum interest coverage ratio was reduced to 2.25x from 2.5x and an asset coverage ratio of 1.1x was added. Both covenant modifications are effective through March 2014. Our inventory balance increased $78 million compared to the prior year. As we've mentioned on previous calls, we had planned a higher level of inventory this year to support our customer needs and ensure robust service levels in light of last year's supply chain disruptions in both Pet and Garden. Secondly, it was a weaker-than-anticipated Garden season. We had a higher level of inventory than we planned for this time of year. Additionally, commodity cost inflation and strategic buys in our distribution businesses were also a factor in the increase. We are focused on working down our inventory balance and expect to reduce it over time. Our CapEx for the quarter was $3 million versus $10 million in the third quarter of 2012. Last year, as you may recall, we were aggressively implementing SAP in a number of our businesses. In the current year our focus has been on optimizing our systems with no significant implementations currently underway. We expect our capital expenditures to be less than $30 million this year. We did not purchase any stock under our authorized share buyback plan in the third quarter. Approximately $50 million remains available at the end of the third quarter. In summary, we had events that were included in our prior year the did not reoccur, and our Garden results did not meet our expectations. We are taking actions to improve our sales and profitability. We expect these actions, together with our focus on more efficiently servicing our customers, will deliver improved financial results over time. We appreciate you joining us for the call this afternoon. John, Steve and I would like to take your questions. Sue, would you please open the call to Q&A?

[Operator:]

[Operator Instructions] Our first question comes from Joe Altobello of Oppenheimer.

[Joseph Altobello:]

I guess I'll start with the cost savings, you mentioned $4 million in the quarter. Were there any costs related to that $4 million?

[Lori A. Varlas:]

So, as you may recall, we talked on our second quarter call, we've taken actions towards the end of the quarter and any associated costs were pretty much expensed at the end of the second quarter. The actions we took, most recently, were actually after the end of the third quarter. And the cost associated with that are fairly small.

[Joseph Altobello:]

Okay. So the $4 million is a clean number, it's not a net number essentially?

[Lori A. Varlas:]

Yes.

[Joseph Altobello:]

Okay. And the $5 million is similar to that, but quarterly, minimal [ph]?

[Lori A. Varlas:]

Yes, it will have a small amount of expenses associated with the actions, but it's not very big.

[Joseph Altobello:]

Okay, great. And then, secondly, the second round of cost savings that you guys alluded to. I assume that's incremental, and if you could quantify for us what you think that second round of cost savings could bring to the bottom line.

[Lori A. Varlas:]

I think the way to look at that is we just took some actions towards the end of our second quarter, which we indicated what the impact would be in the third quarter. The fourth quarter number has combined actions, so it's the ones taken in the second and the ones was taken most recently after the end of the third quarter.

[Joseph Altobello:]

Okay. So the second round was part of the original plan is what you're saying?

[John R. Ranelli:]

Joe, this is John. It's really part of a continuous improvement program. As we mentioned in our prior calls, what we're doing is we are focusing, continually, on reducing our costs and also focusing on increasing our sales and increasing our gross margin. So, from a balanced approach, we expect to have a continuous program of reducing cost going forward.

[Joseph Altobello:]

Okay, got it. Just one last one if I could. On the last call you mentioned that -- you guys did warn us that sales and earnings would be down year-over-year. We didn't get that same warning on this call, it looks like you still have a pretty tough comp on the Pet side, at least on the top line. Are we to infer from that, that you would expect that number will be better year-over-year in the fourth quarter?

[Lori A. Varlas:]

Yes, so we don't typically provide forward-looking guidance. We did give you some qualitative guidance because we knew last year's third quarter, in 2012, had significant sales of flea and tick, as well as the shipping of backlog products in the second quarter into the third quarter. So we wanted to make sure we call that out for investors. So we typically don't provide specific quarterly guidance.

[Operator:]

The next question comes from Bill Chapelle of SunTrust.

[William B. Chappell:]

Just following up kind of on Joe's questions on the fourth quarter. I understand you're not giving guidance. But can you help us understand, I guess on the Garden side, would you have any benefit from kind of the long season or the late season on the controls products, and certainly with the rain on the East Coast and some on the Midwest, you would think that there are plenty of bugs and weeds to get rid off. And then, also, maybe give us an idea, with the excess inventory, will that put a drag on gross margins for a couple of quarters or should you work through that a little bit faster?

[Steven LaMonte:]

Sure. So, I'll address the first part of it, this is Steve. And put in the context of the very slow start in the season, as you called out. And while we've shown some growth into the controls category and for our business in the last 2 4-week periods, in a magnitude of about 10% to 12% from a consumer take away standpoint, we're now looking at a period of the year that is much lower in value, obviously, than the core of the season itself. So you can infer from that what you'd like, but the bulk of the season has passed us and we're looking at good gains to smaller volume periods versus year ago.

[William B. Chappell:]

And then on the inventory side will that...

[Lori A. Varlas:]

So, with respect to inventory, I'm clear our inventory values are elevated over a year ago. And we talked, in previous calls, that we thought it was important to build our inventories to just ensure that we had really good customer service and fill rates. As you may recall, spring of 2012, we had some supply chain disruptions. We certainly don't want that to reoccur. So that being said, we you look at what -- in our inventory balance there's certainly -- it includes from elevated inventory levels for our Garden business, it includes some strategic purchasers for our distribution businesses, as well as some commodity cost inflation. So that's all reflected in there. As it relates to the inventories going forward after the Garden season, I'll let Steve speak to that.

[Steven LaMonte:]

The inventories for Garden are higher, obviously, year-on-year, as a result of the soft season that we're coming out. Having said that, our inventories have a long shelf life to them and can bridge multiple seasons.

[William B. Chappell:]

Okay. And then just last one, maybe you can help me understand on the changes to the covenants. Is that going to change your annual interest expense? And then was that just due to the lower-than-expected results for this quarter or does that reflect kind of expectations going forward?

[Lori A. Varlas:]

Yes. So, sure. On the amendment to our debt covenant, we lowered one covenant and added an asset coverage 1x to 1x ratio as well, and that's really effective until March of 2014. We just want to ensure appropriate cushion. But as you think, as we exited our June quarter, our third quarter, we were in compliance with the covenants as they were.

[Operator:]

The next question comes from Frank Camma of Sidoti.

[Frank A. Camma:]

A lot of emphasis was placed on the flea and tick product. I know you don't quantify that or give us sales by brand. But, I mean, can you just tell us, were sales disappointing for flea and tick products? I know you had the large fill-in last year, the launch of the product, but were your expectations for the flea and tick season, this quarter, disappointing? Can you just give us a more flavor on that?

[Lori A. Varlas:]

Sure. If you look at last year's season, in 2012, we had a large sell-in. In fact, flea and tick was a major contributor for our Pet increase. Last year, Pet sales were up 19% and our operating margin was up 49%, and so we had large comps. So that, of course, was initial sell-in which didn't repeat itself. We also have, as you think about our flea and tick season -- there's a little bit of seasonality to that. We had, some say, the delayed spring. Part of that is spilled into the third quarter. But we think our products are well-positioned, they're strong and I think they met with what we expected they would do.

[Frank A. Camma:]

Did you say that the margins for the flea and tick products are higher than your average?

[Lori A. Varlas:]

They're certainly a higher margin product. When you think of things with active ingredients, such as controls, flea and tick products, some of those, they typically carry a higher margin than some of our other products.

[Frank A. Camma:]

And, John, now that you've had some time to review the brands, I mean, have you identified any brands that may be dragging down your overall margins here? I mean, the margins are still -- whether they come to savings or not, are still well below where even you were historically. So, I mean, have you identified anything that might warrant getting rid of?

[John R. Ranelli:]

As I'm sure you're aware, we look at all of our brands in our portfolio, and in fact, all of our businesses in the portfolio and are constantly evaluating them. Right now we don't believe that there's any brand in our portfolio that would continue to be a problem. We think we have opportunity in all of our brands. Having said that, going forward, we will be identifying which brands we want to invest in more than others, that we believe have the opportunity to be super brands and we would have much more leverage in investing in them. That is a process that's ongoing and we look forward to rolling some of those strategies out.

[Frank A. Camma:]

Okay. And just a quick question on -- just more the macro environment. Did you not see any -- housing, obviously, numbers are coming in strong. On the Lawn & Garden side now I'm talking about, do you not see any improvement from that coincidentally. I mean, I'm trying to figure out, are you losing market share or is this really the categories themselves are down?

[Steven LaMonte:]

Well, there are some indicators that are showing improvement. The current view, looking out, is for low single-digit growth within Lawn & Garden, more towards the low side of 2% to 3% of the category overall. That, at a high-level, is our view. From a point of sales standpoint, for us, we did have an increase on a year-to-date basis, on our business, a modest one of about 1%. And based on where the category is, I can't address that, because as we talked on the last call, this is a category, unfortunately, that does not have robust syndicated data to report category versus your own business.

[Operator:]

The next question comes from David Mann of Johnson Rice.

[David M. Mann:]

In terms of the cost savings that you've identified, how should we think about those numbers falling to the bottom line or will there be reinvestment of some of those savings and future savings back into the business?

[Lori A. Varlas:]

Yes. So the actions that we took are, as we've highlighted, both employee related and nonemployee related, and so we anticipate that those will continue to contribute as we move forward. Now, as you think about that on an annualized basis, clearly, some of that is going to benefit this year, some will benefit next year. We have some activities such as investment in some of our new products and some marketing that was previously planned that somewhat masked some of the savings. Going forward, as we think about the business, we'll certainly invest where we think is appropriate. But our overall goal is, clearly, to increase profitability.

[David M. Mann:]

And, John, can you talk a little more about the new product development life cycle. In perspective, the 2 products that you called out this year, that were most important, were relatively a minority piece of your business. So, talk about maybe the timeline for new product development, how much can you impact in '14 and what percentage of the business might you expect to impact in '14 or '15.

[John R. Ranelli:]

Well, with regard to percentage of the business, we're trying to identify a new product in, essentially, all areas of our business. And based on that new product and the potential of that new product, we will decide which we will invest in more than investing in others. But, as you know, we're really at the beginning stages of it. So, whether if we're starting to design and develop product now, it will be a significant amount of time before we can get those products presented in front of our customers and then onto the shelves to help our growth rate. So we are pulling as many products as we possibly can, essentially, from every division that we possibly can and every business unit that we possibly can, to get them into the marketplace as quickly as possible.

[David M. Mann:]

And then just a follow-up on the earlier question on your inventory, just to clarify that. It sounds like we should expect this heightened inventory level to continue pretty much through into the spring of next year.

[Lori A. Varlas:]

Well, I think there's various elements in there. I mean, some of the Garden products may have a little bit longer tiering life. As it relates to overall, I think we've made great progress on improving our customer service versus a year ago when we had supply chain disruptions. And so, I think, based on where we are, we're looking very closely, very carefully at how we can bring those inventories levels down over time without being, obviously, disruptive our customers. So we think there's an opportunity there, to bring them down over time.

[John R. Ranelli:]

On that point, we are, essentially, beginning meetings every Monday to bring our inventory levels down. So we're going to take an aggressive approach to reducing our inventories. But, however, we will not do it so aggressively as to impact our relationship or our performance with our customers.

[David M. Mann:]

And then one last question. In the past, when the company has talked about the transformation, there was a lot of discussion about closing of facilities and savings coming from that. It sounds like -- since I haven't heard talk about the consolidation along those lines, is that no longer even on the board to be done in the future or should we start seeing some benefits -- or excuse me, some additional cost savings as you ramp that up again?

[John R. Ranelli:]

Our goal and strategy right now, as we've mentioned, is to focus on sales, gross margins and expense reductions going forward. And I believe that the sales and gross margin opportunities that we're aggressively pursuing both lead to significant results, as well as the expense reductions that we're putting in, are not necessarily related to investments. What we're doing is we're looking at areas in management, both vertical and horizontal, where he may have to look at, are not business critical functions being done, as well as any projects that are going on. So the concept, right now, is to be review those projects and cut them back, et cetera, while at the same time going after sales and gross margin. So the amount of investment that we have, and that we would have to execute, is really nonexistent compared to what we were doing before.

[Operator:]

The next questions comes from Karru Martinson of Deutsche Bank.

[Karru Martinson:]

When I look back at, I think, the fourth quarter call, you talked about exiting the year at kind of a $20 million run rate in terms of savings, and now you were at $9 million of savings here for the second half. And, yet, when I look at the first kind of 9 months of EBITDA, I'm just not seeing those savings anywhere close to dropping to the bottom line. So I'm wondering, is it all in sales and in investments that we're making in gross margin or where is that big shortfall coming from?

[Lori A. Varlas:]

Well, as it relates to the end of the fourth quarter, we had talked about $20 million of annualized run rate, and remember, part of that was realized in the 2012 fiscal year in essence we were part of the process, so part of it is this year. Part of it has definitely been masked by our investments in marketing and brand building and other as a company. At the same time, I will point our SG&A expenses, which we've been ratcheting down. This quarter, they were down to 24.2% from 24.7%. So there's some incremental progress in that area, but I think some of the savings, clearly, are being masked and not in the bottom line. We're committed to improving that.

[Karru Martinson:]

Yes. And, I mean, I think that's the key here. The struggle I'm having is that SG&A you guys have done an admirable job of bringing that down and yet we just kind of seem to be not getting anywhere on that front. In terms of that $5 million for the fourth quarter that you guys talked about, is any of that already committed to marketing spend or is that money that can come down to the bottom line?

[John R. Ranelli:]

There is no commitment on that $5 million into marketing spend in the fourth quarter.

[Karru Martinson:]

Okay. And when you guys talked about a slower adoption rate on the Pennington Smart Feeder. What does that mean? Does that mean that it just wasn't getting kind of the sell-through, the replacement parts, in terms of the cylinders going into them? What seemed to be the big impediment to the sales there?

[Steven LaMonte:]

So, it's a great question, and I think I have to kind of start by saying, major innovations in the Garden category that we've studied really indicate that it takes multiple years for them to queue them up to a mature sales rate. And that's a function of many things, generating awareness, generating initial trial and getting consumers, behaviorally, to stop purchasing what they're purchasing now and used to purchasing now, to stop, learn, listen, what the alternative can do for them. So, as we look at where we are, after our first season, as I said, we're disappointed with the performance. It fell below the expectations that we and other customers had. We have many learnings coming out of this year. That will impact some modifications to strategy and tactics as we go into the next season. But I think it's important to stress, our retail partners believe that these are very important innovations and they will support them in the next garden season. And we are committed to increase the momentum, as a rate of sale, on them going forward. They're part of our power brand strategy, for both the AMDRO trademark in the kill space, and Pennington in the grow space under the fertilizer segment there. So there are important initiatives, it's going to take time to build them and that's what we're committed to do.

[Operator:]

The next question comes from Carla Casella of JPMorgan.

[Carla Casella:]

I'm wondering if you can talk about the inventory increase, which raw materials are actually up in the period and are there any that are more favorable for you this period? I would assume some of them are coming down that are grain related?

[Lori A. Varlas:]

Well, as it relates to the inventory balance, we have certain commodities that we sometimes buy in advance. It, obviously, depends on where the markets are. So we've had some commodity inflations. If you look at last year, there could be certain raw materials where we had the same volumes year-over-year, but if the commodity's price has risen then the value of that inventory, obviously, would escalate as well, even if it's the same amount. So if you look at commodity prices, over time, they continue to have increased and so there's a little bit of that in our inventory year-over-year. And then, traditionally, there has been some areas in our business where we have an opportunity to make a strategic buy, we will do that as well. We have a little of that on our distribution business this quarter.

[Carla Casella:]

Could you just say which commodities are up though? Is it grains, is it controls? Is it something else, packaging?

[Lori A. Varlas:]

It varies a little bit by business. So, if you think about some of our birdfeed ingredients, sometimes they go different ways, right? So, in the last several months, last 6 months probably, millet has been very, very high. It took off this year, and so that's something that would be, potentially, a higher price while sunflower has gone the other direction. So different ingredients are doing different things in the marketplace.

[Carla Casella:]

Okay. But when you said your inventory was up related to commodities, it was more the grains and not like packaging or something else like that?

[Lori A. Varlas:]

Yes. It's more related to -- not packaging but actually the raw ingredients going into our grass feeds.

[Carla Casella:]

And then the new products and controls, I think I just didn't hear properly. Did you say that they were introduced at price points that there maybe too high?

[Steven LaMonte:]

So, no, I didn't say that price points being high were the root cause. There were many factors that contributed to. One of them being the fact that we had expedited the shipping of those new products into the marketplace, which necessitated them being on the display space in floor versus being cut into the retail sections, where retailers are used to shopping for those products. When we correct that going into the next season, we expect that, that will have a positive impact, and that's just one example of some of the things that will be corrected next year.

[Carla Casella:]

Okay, great. And then did you also see -- I mean, just given your new product introduction, was there a competitive response that may have also made the performance weaker?

[Steven LaMonte:]

There's always a competitive response to any major innovation brought to the marketplace. It was anticipated that we would see meaningful competitive response. So I don't look at that as a driving contributor to the shortfall against our lofty expectations.

[Operator:]

[Operator Instructions] Our next question comes from Hale Holden of Barclays.

[Hale Holden:]

I just had one. I kind of put all your comments together. It takes a while to get new products innovated and developed. You got covenant relief through to March. You're not repurchasing shares at lower levels. So I was wondering how long do you think it takes to get back to sort a of historical level margins? Is this 3 to 6 months? Is it 6 to 12? Is it 12 to 18? Kind of give us some guide posts on that. I know you said we had a bumpy road but anyway you could narrow that down?

[John R. Ranelli:]

There are plenty of opportunities out there. In looking at our sales, gross margin and expense reductions going forward. Prices are one aspect of it and it's a delicate balance between what we need to bring to the marketplace, to reflect our increased costs, as well as the impact on the consumer and on our volume. We are constantly looking at that tool that we have to increase prices, and as you can see, I'm very pleased that we were able to increase prices in our Pet business in my second month here. We will be aggressively looking at prices going forward, but that's not the only thing we will be looking at as we will have to improve gross margins.

[Operator:]

The next question comes from Kevin Seagraves of Fort Washington Investment Advisors.

[J. Kevin Seagraves:]

I was curious on CapEx. I think at the first quarter guidance was $40 million, sounds like now less than $30 million. Can you talk about the bridge there, in terms of -- is that related to some of the projects that you've backed away from or can you just talk about what's driving the change there?

[Lori A. Varlas:]

Sure. As we began the year, we knew that we were going to moderate our pace in order to ensure that we were working hard operationally and making sure things function as we had intended, and so we delayed our SAP implementation as well as some other actions, and we weren't quite sure when that might ramp-up. As the year has progressed, we're now into our -- exited our third quarter into our fourth quarter and so the activities that were taking CapEx haven't resumed, and so we've brought the amount that we expected on our CapEx down.

[J. Kevin Seagraves:]

Okay. And then, again, going back to the new product development. John had said it takes time, which makes sense, I guess, to some degree. But then you guys launched new products last year, you launched new products this year. So I was trying to see -- you guys have obviously been developing new products and talking about new products for the last 2 or 3 years. So does that mean you're going to accelerate that, that's what you mean? You want accelerate and it takes time to get new products in the pipeline? I guess I was having trouble making sense of that, in terms of what you meant by it takes them to develop new products. Does that means you're just -- in terms of the acceleration from where you have been historically? Because I thought you guys were really focused on it the last couple of years.

[John R. Ranelli:]

Looking at our new product pipeline, it's not exactly where we would like it to be, for it to be a distinguishing factor for our company going forward. As it is going to be a milestone and a critical factor, we will be increasing our spend towards improving and increasing the number of new products that will be coming to the marketplace.

[J. Kevin Seagraves:]

Okay. And then, Lori, can you talk about, on the covenant relief, I guess how much cushion you have there in terms of -- because I'm calculating your interest coverage in the low 2s right now. So I was just trying to see if -- I don't think you guys quantify that, but I don't know if you could talk just in terms of -- if the business, let's say doesn't get better over the next couple of quarters, do you have enough room or do you need the business to get better to have the cushion? Just trying to understand how much cushion you have with the new covenants.

[Lori A. Varlas:]

Sure. If you think about our -- at the end of our third quarter, the covenant was a minimum of 2.5x. We're at 2.6x. So we cleared the previous covenant hurdle. As it relates to going forward, through March, it's 2.25x. We think we're in pretty good shape. We typically don't talk at that level of detail but we passed through in the third quarter and we have a little bit more cushion. We thought that was prudent as we go into the springtime, and I think we're in good shape.

[J. Kevin Seagraves:]

Okay. Can you guys talk about decor? I think you've mentioned that the last couple of quarters being seasonal returns. Is that a different seasonal issue or is it the same thing that's just kind of going over more than 1 quarter?

[Lori A. Varlas:]

Sure. So, as it relates to our decor business, during the third quarter we had some sales returns that impacted our results. I think, given the lull of our operating income, it probably should have more than it historically have done. And so it is some seasonal purchases that was returned back by the customer. And, again, I think it has kind of to that, our results were a little bit lower than normal.

[J. Kevin Seagraves:]

Did you guys call it out in the second quarter or not? Am I remembering that incorrectly?

[Lori A. Varlas:]

In the second quarter, we actually had some products that changed out, where we were working with the retailers to replenish different SKUs. So it's a different matter. This was basically a 1 SKU this quarter, last quarter was a different matter, where it was a change out to support product at the retailer.

[Steven LaMonte:]

Yes. And, Lori, if I could just build on it. Another piece of the decor profitability is related to gross margin and a segment of the pottery business at the commodity side that we've seen some increases in input costs, and due to competitive pressure in the marketplace, we've also seen some depression on pricing. And for strategic reasons, we have supported that business.

[Operator:]

We have time for one more question. The next question comes from William Reuter of Bank of America Merrill Lynch.

[Spenser Samms:]

This is actually Spenser in for Bill. I was wondering if you'd be willing to quantify the amount of excess inventory versus planned increase in inventory in the quarter.

[Lori A. Varlas:]

The thing that we're looking at is that our businesses have different seasonality from each other, as well as from quarter-to-quarter. We had, as I had mentioned earlier, deliberately built our inventories up to ensure that we didn't have customer fill-rate disruptions, that we're not having a repeat of a couple of -- a little more than a year, last spring in 2012. And so as we look at those inventory values, we want to ensure that they're at the right level, we'll take them down from that. As you could imagine, with all the number of businesses that we have, they have different targets, different amounts that are appropriate for those businesses. So I don't think that a specific target -- it's really a target business by business, looking at churns and what do we need to support the individual.

[Spenser Samms:]

Okay. And then in the controls business during the quarter, just the promotional -- or the increased promotions, how much of that would you say, just qualitatively, was due to increased competitive pressures or more competitors versus just the weather not being what you needed it to be?

[Steven LaMonte:]

Well, in terms of the promotional spend, it was a planned spend at an investment level to initially launch the 2 new products that we've already talked about. One of the issues that created a challenge is the controls category being down quite significantly on a year-to-date basis. So, as you look at the total revenue base for controls being lower than planned due to weather, and point-of-sale sell-through rates lower than the high expectations that we had, those factors contributed to the profit story we talked about before.

[Operator:]

That was the last question.

[John R. Ranelli:]

Okay. Thank you very much and thank you for your questions and for joining us on our call today. Look forward to our next call.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.