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Q3 2008 Earnings Call Transcript

Published: 22 Apr 2008

[Operator:]

Good day, ladies and gentlemen. Welcome to the earnings release conference call. (Operator Instructions) I would now like to introduce your host for today's conference, Mr. Farooq Kathwari, Chairman and CEO of Ethan Allen. You may begin.

[Farooq Kathwari:]

Yes. Thank you and good morning. I am Farooq Kathwari, Chairman and CEO. And with me are David Callen, our Vice President of Finance; Peg Lupton, Director of Investor Relations; and several of our other associates. Today, we are reporting the results for the three and nine months ended March 31, 2008. I will provide a brief overview and David will give detailed information of our financials, and I will then give a business update and then open for questions. During the third quarter we continued to operate in a weak economic environment. Our sales decreased by 4.3%. While the retail division sales increased by 3%, they were not enough to cover the costs associated with the major activity of opening four new design centers, of which all were relocations and adoption of many design centers acquired and opened during the last 15 months. During the quarter, we took steps to consolidate and close several design centers. This resulted in impacting our operating expenses and gross margins. Now, our EPS ex-restructuring was $0.39 versus $0.54 last year. The EPS change consisted of impact on our gross margins with a negative of $0.06, the effects on operating expenses, the results of fuller impact of design centers opened in fiscal 2007 and the new ones in fiscal 2008, and impact of negative $0.10 to our EPS. On the non-operating activities, the effect of change in shares outstanding has a positive impact of $0.06 and the less other income due to utilizing it for repurchase was a negative $0.04. We have continued to make major progress in positioning the company as a preferred brand, providing decorating solutions. I will discuss in greater details our initiatives after David provides the financial update.

[David Callen:]

Thanks, Farooq. Good morning. Please note that in the earnings release last evening and in the course of our prepared remarks, reference has been made to certain non-GAAP information, which excludes the effect of restructuring and impairment charges recorded during the quarter and year-to-date ended March 31, 2008, credits recorded during the quarter ended March 31, 2007 and charges recorded year-to-date March 31, 2007. A reconciliation of this non-GAAP information to the most directly comparable GAAP measure is available on our website. Net sales in our third quarter decreased 4.3% over the prior year quarter to $235.9 million. The company's Retail division posted an increase in net sales of 3% to $172.8 million, while comparable design center delivered sales were down 1.1%. Total written sales in Retail decreased 3.8% and comparable written sales decreased 6.8% versus the prior year third quarter. Wholesale net delivered sales were $156.3 million in the quarter, down 9.1% from last year's third quarter. The quarterly consolidated gross margin was 53.1% as compared to 52.1% in the prior year period, reflecting improved efficiencies in our manufacturing and the increase in our proportion of retail sales to our total sales. While we continue to benefit in the quarter from less overhead from previously closed facilities and operational efficiencies in the wholesale divisions, our Retail division margin was negatively affected by markdowns taken to sell our floor inventory at seven design centers that were consolidated and another four that were relocated and several others that completed their product conversion over to the Lifestyle presentation in the quarter. During the current quarter, consolidated operating margin was 6.6%. Excluding the $4 million in restructuring and impairment charges, consolidated operating margin was 8.3%. Wholesale operating margins was 17.1%, while retail operating loss was 4.9% or 2.6% excluding the restructuring and impairment charges. Selling expenses increased $1.2 million as we invested in increased TV advertising and incurred higher retail compensation on higher volume of retail sales in the quarter. The total operating expenses also reflect an increase in general and administrative cost of $3.8 million, primarily for the cost of occupying and running eight additional company-owned design centers in the Retail division. Diluted earnings per share for the quarter were $0.30 on net income of $8.8 million. Excluding restructuring and impairment, diluted earnings per share were $0.39. This compares to diluted EPS of $0.54 per share and net income of $17.5 million or $17.4 excluding restructuring and impairment credit in the prior year comparable period. Our stock buyback program resulted in $3.3 million or 10.2% fewer weighted average shares outstanding during the quarter versus the third quarter last year. This benefited the remaining shareholders by about $0.06 per diluted share this quarter, while the interest income from the cash used would have generated about $0.01 per diluted share. For the nine-month period, net delivered sales were $744.1 million, a decrease of 0.4% from the prior year comparable period. Net delivered sales for the company's Retail division increased 7.2% to $548.1 million, while comparable design center delivered sales decreased 0.5%. Year-to-date written sales in retail increased 2.4% during the period while comparable written sales decreased 4.5%. Wholesale sales were $468.5 million down 5% from the prior year to-date. The year-to-date consolidated gross margin was 53.5% as compared to 52% in the prior year period, reflecting the improved efficiencies in our manufacturing and retail operations, as well as the proportional increase in retail sales relative to our total net sales year-to-date. During the nine-month period consolidated operating margin was 10.3% or 10.9%, excluding the third quarter restructuring and impairment charges. Wholesale operating margin was 17% while year-to-date operating loss in retail was 0.2% or an operating gain of 0.5%, excluding the restructuring and impairment charges. Diluted earnings per share for the nine-month period amounted to $1.58 on net income of $47 million. Excluding the restructuring and impairment charges, earnings per diluted share were $1.67. This compares to diluted EPS of $1.50 on net income of $48.7 million in the prior year, excluding restructuring and impairment charges in the prior year totaling $13.4 million related to the consolidation of two manufacturing facilities. One of which has been converted into a regional distribution center resulted in diluted earnings per share of $1.76 in prior year. The stock buyback program benefited shareholders year-to-date by about $0.17 per diluted share by lowering the weighted average shares outstanding by 2.8 million shares, or 8.6% compared to the prior year-to-date weighted average shares outstanding. Interest income on net cash used would have generated about $0.04 per diluted share. Now, some comments on the financial position of the Company. During the nine-month period ended March 31, 2008, we generated operating of $67.3 million. We used $69.7 million of our available cash to repurchase 2.3 million shares of our common stock. Also during the year, we used $46.3 million to fund capital expenditures. We spent $6.8 million to acquire a cut and sew upholstery facility in Mexico, and two design centers in the US, plus, we returned $19.2 million in cash to our shareholders through quarterly dividends. Inventories have increased 2.5% or $4.5 million during the year, mainly due the $3 million in inventory acquired with the two design centers, and the cut and sew operation in Mexico. We remain in a strong service position with respect to incoming orders, with over 90% of our case goods items available for shipment within four weeks. EBITDA for the nine-month period totaled $101.9 million or 13.7% of sales as compared to $110.8 million and 14.8% respectively in the prior year-to-date period excluding the aforementioned restructuring and impairment charges. Overall, we are very pleased with our operating results and financial standing in this challenging economic environment. Now, to Farooq for his comments. Farooq?

[Farooq Kathwari:]

Yeah. Thank you, David. On a business update, our strategic objectives continue to focus on two key elements. First, migration to an interior design based enterprise, and second, to continue to focus on style, quality value and solutions. During the quarter, we substantially completed the transformation of the 153 company operated retail design centers and many of the independent operated design centers to our Lifestyle presentations. We absorbed cost of selling the floor products and also incurred additional operating costs. The implementation of the seven Lifestyles provides a stylish projection and is helpful to both, our clients and our design consultants. And we are pleased that we will have completed this important transformation this fiscal year. We have continued our investments in training. During last nine months, we provided intensive training to 600 new design consultants at our headquarters and also brought in over 800 of our senior designers and managers to Danbury for training and consultations. We have continued our strong advertising program. Despite a tough economic environment, we have increased our advertising spending during the quarter by above 20% and above 16% for the nine months ended March 31. Our main message has been to increase the awareness of our complimentary design services because that provides a very strong comparative advantage for us. National television and direct mail have been the main mediums in getting this message across. We have made major progress in developing our new website, which we plan to introduce in August of this year. The objectives of the new website will be to combine the personal service of our designers with technology. We believe that the new website will have a major positive impact on our business. We're also pleased with the work of re-positioning of our design centers. During the quarter, we opened four new design centers, all of them relocations. During the quarter, we also closed seven new designs centers, converted four to design studio formats, and we also closed two retail service centers. As we've indicated during the last few months, we will have completed the bulk of relocations this fiscal year by opening about 20 new design centers. Going forward, we will still open and relocate a few design centers a year, and also focus on opening greater number of design studios. At the end of March, we had a total of 291 design centers, 153 operated by the company Retail division and 138 operated by the independents. During the third quarter, we did not acquire any design centers from independent retailers. For the nine months, we have acquired only two designs centers. During the last two years, about 12 independent retailers either retired, closed their design centers and in two or three instances, converted to other brands. We have made good progress in replacing these design centers, which were, in most cases, in foreign locations. These replacements include Austin, Texas to be opened in the first quarter of 2009 by an existing independent retailer, Sarasota, Florida will open this quarter, and we have already opened in St. Louis, Cincinnati markets, and this quarter we plan to open new design centers in Denver; Philadelphia; Birmingham, Alabama; Peoria, Illinois; Richmond, Virginia; Hilton Head, South Carolina; Jackson, Mississippi; Viera, Florida, and importantly, in Manhattan, a new flagship design center on 3rd Avenue and 60th Street is expected to be opened early June. All these openings give us a great opportunity to grow our business. However, they do result in short-term added costs. We are pleased that the major bulk of our relocation is completed and we expect next fiscal year to reduce our annual capital expenditures, which is about $70 million, by about 30% to 50%. Our vertically integrated structure continues to provide a competitive advantage, especially in this rising cost environment. Our costs on the average have gone up by about 3% during the last year or so, and we plan to make this up due to continued efficiency and a price increase during the next few months. With this brief business overview, I would like to open it for your questions.

[Operator:]

(Operator Instructions) Our first question is from Todd Schwartzman. Your line is open.

[Farooq Kathwari:]

Hi. Good morning, Todd. Todd, are you there?

[Operator:]

Please check to see if your phone is on mute.

[Todd Schwartzman:]

Hello. Farooq, can you here me?

[Farooq Kathwari:]

Yes, now.

[Todd Schwartzman:]

Okay. What kind of price increase are you planning?

[Farooq Kathwari:]

Todd, the price increase in not going to be all across the board. It is going to yield out approximately about 2%, 2.5% across the board. It was, in fact, approximately 30% of our product line across the board with about 2.5% yield.

[Todd Schwartzman:]

Is that 30% for starters or eventually it will impact 30% of the product line?

[Farooq Kathwari:]

It will impact 30% of the product line when we implement it in the next few months.

[Todd Schwartzman:]

Okay. And as far as SG&A as a percentage of sales it's been trending higher for just about four years now, do you see the trend reversing anytime soon next two or three years?

[Farooq Kathwari:]

Yes. And that is very much tied to two factors. One is these major investments we have made in design centers, new design centers, larger design centers. And I'm pleased that bulk of that is now completed. The second, of course, is this is a percentage of sales, and our sales in the last couple of years are not where they should be, as we increase our sales for all these investments we have made, and we expect to have our SG&A as a percentage of sales come down.

[Todd Schwartzman:]

Okay. On the advertising, on the TV campaign, for how much longer are you committed to the current campaign, not so much in terms of the absolute dollars spend, but just the existing message, the focus on the design service?

[Farooq Kathwari:]

Well, Todd, we have actually accelerated. Our competitive advantage is the fact that we provide personal decorating services, and most people do not know that. And in fact, in the last one year since we started our current campaign, we did about last year at this time, and the message is that we will help you with that little or as much as you like is getting across. We are now starting to see people come into our design centers asking for this service. What you will see is that we will, in fact, rise above the message. End of the day, we want people to come and make appointments before they come in. We have 3,000 design consultants. And as you can understand, more and more people are now starting to just start making appointments. End of the day, we want appointments, and that will make a better utilization of our people, plus we've got to create right expectations with our consumers. We still want them to come in and see our design consultants, but better would be for our clients as well as our design consultants if their time is used well. And people fully understand before coming in what we do. So that's the reason that this message is very important and we held up this message until we felt comfortable that our design centers were in the right places. We felt comfortable that we had the right design associates in the last three years. At least 50% of our design consultants that we have put into place are new. We've put in 300 project managers into place. Because once you create expectations that you will provide service, you better do it. Now, that we are doing it, we are going to raise the bar and get that message across. And I believe as the economy improves, we want to make sure that that message is out there.

[Todd Schwartzman:]

Got it. Could you maybe provide some numbers to the statement that the sales decline in April has been considerably reduced?

[Farooq Kathwari:]

Todd, I put it in because I know you asked me this question, what happened in April so I had to say that. And then, I also mentioned that our business does get impacted depending upon when Easter is, because we don't do much business that weekend. And this year it was in March, so we also wanted to make sure that while in April our business is much better, it is for two factors. First is, even though economy is still bad people are still very concerned, but March was unfortunately somewhat unique in the sense that we could see that our clients are concerned with what was taking place. So in April, still with concerns, but a little bit less concerned, and Easter behind us, I think for the last three weeks we would be down just a couple of percentage points relative to last year, while in March the percentage decrease was much larger.

[Todd Schwartzman:]

Okay. And finally, can you talk a little bit about what you're seeing in raw materials now? Thanks.

[Farooq Kathwari:]

Our raw materials cost is somewhat of a mix situation. Our domestic raw materials like lumber, there we have been able to hold prices because of total supply and the demand is less. Anything to do with petroleum-based is a major factor. Our utility costs have gone a little over 8%, mostly due to a 40% increase in the cost of diesel fuel. We deliver our product nationally ourselves. Everyday we have a best delivered priced to our consumers' home. So, fuel becomes a very important factor. Our petroleum-based products, relating to foam, relating to some cut fabrics, all of those and finishing material is up. So I would say that on a -- if you take a look at from a selling percentage point and a gross margin perspective, we would end up by approximately having an annual cost increase of about 2.5%. And that's what we want to take care of in our price increase.

[Todd Schwartzman:]

Thank you.

[Farooq Kathwari:]

All right.

[Operator:]

Thank you. Our next question is from Joe Feldman. Your line is open.

[Farooq Kathwari:]

Yeah. Hi, good morning.

[Joe Feldman:]

Hi. Good morning, guys. First question was about the CapEx. You're cutting for '09, it looks like 30% to 50%, and then going forward from there, should we just expect it to be normalized of this new base or will it kind of come back up to the $70 million level?

[Farooq Kathwari:]

Well, it will come up only if you really have a great opportunity to increase our business, expand our business. At this stage, I would say that it would remain at the reduced level that I have talked about.

[Joe Feldman:]

Got it. And then, another question was about the inventory. It seems they grew in line with the sales for the retail business. I guess we are just curious as to the complexion of it, because I know you were trying to clear out some of the inventory from some of the stores that had been closed and just how you feel about the current inventory situation?

[Farooq Kathwari:]

I always believe that it should be lower. And to make it lower, it does require many structural initiatives. I mean over the years as you know, we have substantially increased our presence in region without having much of an increase in inventory. And the reason has been some structural changes, which is our everyday best price has greatly helped us in number of ways. It has helped us in forecasting. It has helped us in making sure that our products go to our retail service centers in deliverable manner. In other words, chairs go with tables and buffets go with tables that they are, and the sofas are delivered in time. We also cut down our delivery time. Right now, 90% of our case goods are shipped within four weeks, which means 60%, 70% are shipped within a week or 10 days. Fortunately, at this time 70% of our upholstery is being shipped within four weeks. Now, all of that has resulted in faster turnover. 60%, 70% -- obviously 87% of all products in our retail service center are sold. And we wanted to reduce even that. So I would say that, as we continue to improve ours efficiency than our structure, we should have the rate of increase. Our inventory should be lower than the rate of increase in our sales.

[Joe Feldman:]

Got it. Okay. And then, the one last one that I wanted to ask before letting others asks is, on same-store sales, it actually came in pretty well from my perspective like they have given the current environment. And we are just trying to figure out the complexion of that and really what drove it. Was it the fact that you've got so many more relocated stores that are coming back into the comp base at this point? Or if you could just discuss what helps drive the comp?

[Farooq Kathwari:]

I got it. We are not happy with this number. I am not happy. It should have been better with all the work that we've done. So the results, I mean, we did better relatively than anybody else. I know that, but we have the opportunity of even doing better. And the results have been, this whole focus of the fact that we are today providing first. Now you know today, not where there was a high point market a couple of weeks back, today, anybody who is just selling a product and a price is having a rough time. If we didn't have the service element of 3,000 professionals, we would not have the kind of same-store sales we just mentioned, and more importantly we won't have the gross margin. As you can see, we increased our gross margin despite the tough economic environment. So I think the service model that we have is helping us in better same-store sales as well as maintaining our margins.

[Joe Feldman:]

Got it. Thanks very much and good luck with the quarter.

[Operator:]

Thank you. Our next question is from Laura Champine. Your line is open.

[Laura Champine:]

Good morning. I wanted to ask a little bit about the cut and sew facility in Mexico. I think that you commented that part of the reason inventories were up was because of that. Maybe if you could talk about what the longer term implications are for inventories, for margins on that product? How much of the leather goods will be using that facility? And maybe more generally, Farooq, why when the rest of the industry seems to be going to or have gone to fully finished leather out in China, you are choosing now to put a cut and sew facility in Mexico?

[Farooq Kathwari:]

Yes. Number of factors plus your last question, our model versus others. If you have a model that you're basically depending on finish products, then, perhaps Southeast Asia in some cases does make sense. If you're model is like us with 95% costumed product with above 3,000 different fabrics, those products, which have to be made in the United States, means that time will become very important. So our cut and sew operations in Mexico helps our domestic manufacturing of these costumed products. That's why having it closer to the United States make sense for us. In terms of the future, we have a few deals which has a tremendously great future because in the United States, cut and sew operations are not only costly, but it is very hard to get people. So it is one area where we had a tough time to getting services. So in this area of Central Mexico where we are, we're very fortunate. They are great people. They have a background in textiles and cutting and sewing. So we see that operation growing and contributing to the cost efficiency of our manufacturing in United States.

[Laura Champine:]

Thank you.

[Operator:]

Thank you. Our next question is from Budd Bugatch. Your line is open.

[Farooq Kathwari:]

Hey, Budd. We've got to get your name right.

[Budd Bugatch:]

It's all right, Farooq. We'll share our problem like that.

[Farooq Kathwari:]

Okay, Budd, go ahead and good morning

[Budd Bugatch:]

Good morning. Just a couple of questions. Talk a little bit about the store landscape now, the new design centers, how many are there? Are they included in the 291 number, the design studios?

[Farooq Kathwari:]

Budd, that's right. They are at this stage, but we just converted it to design studios. These were existing design centers in smaller markets. And the concept as you know is, if you are an interior designer, you have a studio and you have a client. So we said we will make it entrepreneurial. And these markets, it was not sufficient, it was not right for us to have a big design centre with all the operating costs. And already in the last three weeks, interesting things are happening. In these design centers that are operating, our designers number two to three, they still bring 70%, 80% of the business that the full design centers do. They have informed their clients, that's the design studio, and that they should be coming and make appointments and see them, and they will make house calls, and it's working very well. And we are going to see more of those as we go forward.

[Budd Bugatch:]

So there are four total in the chain right now, in the Company right now?

[Farooq Kathwari:]

That's right.

[Budd Bugatch:]

And they're all company-owned

[Farooq Kathwari:]

They are company-owned, yeah.

[Budd Bugatch:]

And what's the opportunity and what is the size of a design studio?

[Farooq Kathwari:]

Well, the one that we have, we basically took the current one that were anywhere from 9,000 to 12,000 or 13,000 square feet. And we took the existing building and converted them. But as we go forward, they are going to be substantially smaller, because today technology will play a very important role. That's why I said our new website is going to be extremely important, because that is going to provide all kinds of information, which in the past we needed a big store to do. So you're going to see us go anywhere from 2,000 to 5,000 square feet.

[Budd Bugatch:]

And what do you think the opportunity is nationwide.

[Farooq Kathwari:]

It's major.

[Budd Bugatch:]

You've done it again. You've gone substantially and major in two sentences without any numbers, although I get 2,000 to 5,000. Probably any idea, can you give us a feel of it?

[Farooq Kathwari:]

Budd, we'll first open 50.

[Budd Bugatch:]

Okay. You'll open 50.

[Farooq Kathwari:]

That's what our plan is and after that we will see where we go.

[Budd Bugatch:]

And by when, Farooq?

[Farooq Kathwari:]

I don't know. I would say that -- I like to do these things a little bit slower and when I feel very comfortable than we'll go very fast. So you are going to see us open four, five in the next few months and than after that we'll open it a little bit faster.

[Budd Bugatch:]

And of the 50, they're all company-owned.

[Farooq Kathwari:]

Well, most of them will be company-owned but our independents are also very interested in it. But I want to first make sure we get the bugs out of the system and it works.

[Budd Bugatch:]

Okay. And you said you have the Lifestyle presentation now and I think substantially all of 153 company-owned design centers, how many of the independents are now in Lifestyle presentation?

[Farooq Kathwari:]

I would say there are between 50% and 60%.

[Budd Bugatch:]

Okay. And tell me about the service centers. What do you think you're going to do on that? You've close two, how many are left now and how many stores can they service?

[Farooq Kathwari:]

Well, it is also -- I'm not giving a lot of competitive information here but anyway we want it done.

[Budd Bugatch:]

Sorry.

[Farooq Kathwari:]

You know we are operating approximately 37 centers in the United States. For instance, the one we closed. We closed one in Pittsburg, which is now being delivered; the products are being delivered from the metropolitan Washington area. We closed one in Orlando and it is being actually delivered from -- what we call [market] markets in Florida. So what we are doing is just we are leveraging our existing design centers to cover a wider area. For instance in Southern California minimum -- a number of years back, we had, I think 12 or 13 independent dealers operating 12 service centers. Today, we have one delivering a $100 million. And in Connecticut we have one delivering $80 million. In Washington we have one delivering at $70 million or $80 million. Just a few years back, there will be an 8 of 10 delivering about one-third the business. This is the reason we've been able to manage our costs especially fuel costs.

[Budd Bugatch:]

Okay. That's very, very helpful. Last question do you see any restructuring charges beyond the fourth quarter?

[Farooq Kathwari:]

Well, you never know. At this stage, we don't have anything in plan, but I always keep on looking at how to improve our structure and if we are going to make structural changes then we will have restructuring charges.

[Budd Bugatch:]

Okay. Thank you, Farooq. Good luck on the quarter and on the year.

[Operator:]

Thank you. Our next question is from Anthony Chukumba. Your line is open.

[Anthony Chukumba:]

Good morning. Yeah, I just had a question on in terms of any differences that you're seeing in performance geographically? In other words are any particular regions of the country doing any better or worse than other regions? Is the performance pretty even throughout the country? Hello.

[Farooq Kathwari:]

Yes. I am just thinking. There are the Northeast is certainly doing better. Also the fact that this just has been done -- this area did not involved that much in new home construction. Areas, for instance, in Arizona, and in southern California have been much more negatively impacted. In Nevada, we have seen certainly in this in Florida. Southwest tends to be is doing somewhat better especially in Texas because I think of the oil situation there. So there are some areas but overall, of course, it has been -- we have seen weaknesses across the country. Relatively some areas have been impacted more as I've just stated.

[Anthony Chukumba:]

Okay. And just one follow-up to that. There has been a number of furniture retailers have gone out of business recently, and I just wondered if you're seeing any impact on your business from go get business sales?

[Farooq Kathwari:]

Yeah, it is. Because of the fact, you're right. We have seen this in almost every market. We have chains that have gone out of business. We have lot of independent that have gone out of business. It's been very tough. This was the toughest periods we have seen and when I am talking about our associates in the home furnishing industry, that's one of the toughest periods we have seen in the last 30 or 40 years. And when businesses go out, they have all kind of these going out sales. So it is also another factor that has impacted our business because lots of business, of customer's attention has been diverted to these going out of sales and they're still continuing.

[Anthony Chukumba:]

Okay. Thank you for that call. That's helpful.

[Operator:]

Thank you. (Operator Instructions)

[Farooq Kathwari:]

All right. Latoya, it looks like there are no more questions. Latoya, are you there?

[Operator:]

Yes. (Operator Instructions)

[Farooq Kathwari:]

Latoya, it looks like there are no more questions, correct.

[Operator:]

Yes, sir. I am not seeing any further questions at this time.

[Farooq Kathwari:]

Then thank you very much and if you have any more questions please give a call to Peg Lupton. Thanks very much.

[Operator:]

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone have a great day.