Heritage-Crystal Clean, Inc
Q3 2008 Earnings Call Transcript

Published: 15 Oct 2008

[Operator:]

Welcome to the HeritageCrystal Clean Inc. third quarter 2008 earnings conference call. (Operator Instructions) Some of the comments we will make today are forward looking. Generally, the words "aim," "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "plan," "project," "should," "will be," "will continue," "will likely result," "would" and similar expressions identify forwardlooking statements. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forwardlooking statements. These risks and uncertainties include a variety of factors, some of which are beyond our control. These forwardlooking statements speak as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. Please refer to our SEC files, including our registration statement on Form S1 as well as our earnings release posted on our website for a administer more detailed description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures we may use on this call, such as earnings before interest, taxes, depreciation, and amortization, or EBITDA, are nonGAAP measures. Reconciliations of nonGAAP financial measures to GAAP financial measures are included in our press release and may be obtained by visiting the investor relations section of our website, of www.crystalclean.com. With us today from the company are the President and Chief Executive Officer, Joseph Chalhoub; the Chief Financial Officer and Vice President of Business Management, Gregory Ray; and the Chief Accounting Officer, Ellie Chaves. At this time, I would like to turn the call over to Joseph Chalhoub.

[Joseph Chalhoub:]

We are pleased to report on our third quarter of 2008. Last night, we issued our third quarter press release and posted it on our website on our investor relations page for your review. Today, we will discuss the financials and our operations in the third quarter and respond to questions you have relating to these results. We are pleased to report that our third quarter results were quite good, consistent with our previous report. We achieved sales growth of 22% over the same quarter in 2007. Our pretax income for the latest quarter was $2.8 million, which reflects an improvement of 55% compared to the year ago quarter. We operated 54 branches at the end of the latest quarter, an increase of 6 from a year ago. Of these branches, there were 47 that were in operation throughout both of the third fiscal quarters of 2008 and 2007; and these contributed same branch sales growth of $4.1 million or 20%. Our daily sales are now approaching $440,000, up 22% from one year ago. In the third quarter, our sales team performed admirably as demonstrated by our growth in the face of the slowing economy. Our [distillation tower] for solvent recycling continues to positively impact our business for the third quarter of 2008. This system, commissioned in late 2007, recycles used solvent using clean recycled solvents that we blend and resupply to our customers. During the latest quarter, our recycling throughput increased, helping us to reduce our accumulated stock inventory. In contrast to our solvent recycling program, our reuse program captures used solvents, which we sell to industrial firms that manufacture roofing products. This is historically a somewhat seasonal market. During this third quarter, reuse sales were not as strong as the previous quarter and reuse inventory remains relatively flat. Because the solvent that we buy is produced from crude oil, our unit cost for solvent continued to increase in the latest quarter. However, the fact that we cover most of the value of the used solvent through our recycling and reuse programs partially mitigates these cost increases. While our total volume of solvent products in inventory decreased during the quarter, increasing pricing during the quarter led to an overall increase in the value of our current inventory. For much of the quarter, we continued to experience increases in all our energysensitive costs, driven by higher crude oil prices within the cost of sales line in our financial statements. The cost increases on the solvent we purchased were more than offset by higher margins for our reused solvent sales and recycling program. As we benefited from the FIFO inventory accounting, so more reused product [inaudible] recycled solvent that had been carried in our inventory at historically lower value. While we have enjoyed the benefits of appreciating inventory values for the past two quarters, we don't anticipate that this will continue. If solvent prices decline further, we would likely need to record a reduction in the value of our solvent inventory. Although lower solvent prices would also lead to lower cost of sales for the company, that would translate into improved margins provided that pricing was stable. In our operating expense line, again, we experienced high cost, both for vehicle fuel and thirdparty transportation costs during the quarter. The additional fuel surcharge to customers and selective price increases on certain customers implemented in the second quarter have partially mitigated these increased costs. We are pleased with our report card for the third quarter, including the performance of our employees and the continued patronage of our customers and the support of our shareholders. Our chief financial officer and vice president, business management, Mr. Gregory Ray, will now further discuss the financials and then we'll open the call to your questions.

[Gregory Ray:]

Again, I am very happy to be with our investors today for HCCI's third earnings conference call since becoming a public company. During the latest quarter, I met with many of our shareholders or prospective shareholders; and I am proud to continue to tell our story. Our SG&A expense in the third quarter increased to 16.7% of sales, up from 15.6% of sales in the third quarter of 2007. This increase includes approximately $370,000 of costs associated with being a publicly traded company that we did not incur in the year ago quarter, including director compensation and insurance, incremental legal and accounting fees, and SarbanesOxley consulting. Our interest expense for the third quarter was only $24,000, down from more than $300,000 in the third quarter of 2007 reflecting the paydown of our debt with proceeds from our IPO. Taxes, for the third quarter of 2008, were $1.2 million. In the prior year, as a limited liability company, we were not subject to federal or state corporate income tax. In our financial statements, we have reported our net income and EPS in both GAAP and pro forma presentations. Where the pro forma is calculated as if we had been a C corporation during 2007 and paid state and federal income taxes and which also adjusts our share count to reflect our March 2008 reorganization. For your reference, we have posted on our company website the historical pro forma information for all quarters of 2007. Our operating income for the third quarter was $2.8 million, compared to $2.1 million in the third quarter of 2007. Our earnings per share both on a basic and diluted basis was $0.15 per share, an increase of 67% compared to the pro forma EPS in the year ago quarter. On these financial measures, we believe that we exceeded analyst's expectations for our performance. I share Joe's satisfaction with our financial results for the quarter, and I thank you for your continuing interest in HeritageCrystal Clean. At this time, I will turn control of the call over to our operator, and she will advise you of the procedure to submit your questions.

[Operator:]

(Operator Instructions) Your first question comes from Randy Hugen Piper Jaffray.

[Randy Hugen Piper Jaffray:]

It was good to see the samebranch sales continue to move up. Could you go into some of the drivers behind the increase? Is it largely a function of the surcharges?

[Joseph Chalhoub:]

Well, the sales increases that we experienced this quarter and last quarter, there are a lot of factors that go into sales increases. The surcharges are only a very, very small piece of that increase. The majority of the increase is organic, different lines of businesses, and price increase, including the surcharge, is not a big factor in that increase.

[Randy Hugen Piper Jaffray:]

So it's not a big driver of the continued increases in your samestore sales metric?

[Joseph Chalhoub:]

Definitely not the surcharge, definitely not.

[Gregory Ray:]

On a longterm basis, when we think about samebranch sales growth, and you have seen our statistics over several quarters now where we've been running at the doubledigit rate for samebranch sales growth. Typically, on a yearoveryear basis, that statistic almost always has in it one regular price increase. Over the last several years, while we've raised parts cleaning prices a little bit more than other services, the average blended price increase has probably been in the neighborhood of 5%, plus or minus 1% across the board. The remainder of that would be volume growth in samebranch sales. I think that in the latest quarter it's possible that because of the surcharge, we could have picked up another 1%. I am just shooting from the hip here, but it wasn't a big number in terms of driving a higher rate of samebranch sales growth.

[Randy Hugen Piper Jaffray:]

Could you remind us how this industry overall has faired during previous recessions? And then also comment on if you have seen any impacts with your clients from the economic slowdown?

[Gregory Ray:]

Historically, the industry through recession has been resilient. As you know, our management team has been in the industry for 30 years now. We don't recall having seen substantial negative impact on our business when the general U.S. economy has been in a slowdown mode. That may partly be a factor of serving many small customers. There's a significant turn rate in that customer base. But we've never seen major impacts from that. Certainly, at HeritageCrystal Clean, where we've got this high growth rate for us in the last several years, we don't expect there to be a major impact due to a kind of modest U.S. recession. I am sorry, your second point? I forgot.

[Randy Hugen Piper Jaffray:]

Just if so far you have seen anything in your current operations that might suggest any sort of change among your clients because of the recession.

[Gregory Ray:]

No, I think the two things that we pay attention to closely are revenue growth yearoveryear and our accounts receivable, with the thought that accounts receivable could be an early indication of financial or economic trouble on the part of our customer base. We have not seen any erosion in our day sales outstanding statistic over several quarters, but we keep watching that with the thought that it could be a leading indicator. We're not finding any new renewed difficulty in securing new customers at this point.

[Joseph Chalhoub:]

To some extent, a slowdown in the economy affects all businesses. Some more than others. For a company like ours, and in particular our company, where we've grown about 20%, our ability to grow at that rate is going to be a function of how much resources we put in to grow our different businesses. How many new routes, branches, head count of people. The piece that is impacted by the economy is really a much smaller piece compared to the variables that we have in our control to continue to expand our business.

[Operator:]

Your next question comes from Jeff Germanotta William Blair.

[Jeff Germanotta William Blair:]

I would love to understand a little bit deeper the sources of that 20% samebranch sales growth, in particular how much of that is new customer derived versus rising average, if you will, average revenue per existing customer.

[Gregory Ray:]

We still don't really manage our business with those distinctions. We do monitor customer growth in total, and it continues to grow. We're reporting the statistics on customer count on an annual basis rather than quarterly, but I can tell you we're continuing to see growth in customers. But we have not measured how much of our revenue growth quarteroverquarter is coming from brand new customers versus crossselling of services to existing customers. I think that, historically, we haven't made a big distinction there. Sometimes, depending on the types of service, the customer crossselling is a very integrated process, where we're really intentionally cross selling. As you understand, some of our services and routes are done by different reps on different trucks. From the point of an oil rep out calling on new accounts, he may be selling to somebody that he doesn't really care whether it's an existing Crystal Clean parts cleaning customer or not. He just wants to grow the line of business that he's responsible for with them. It might be interesting information. I don't have it at my fingertips to share with you, and we don't use that measure to kind of run or grow our business. We're really focused on both new customer acquisition and crossselling and our people are equally incentive for those activities.

[Jeff Germanotta William Blair:]

My next question then is with oil prices falling, what customer pushback are you seeing in terms of price and what will be the forward impact of fuel surcharges?

[Joseph Chalhoub:]

We haven't seen any customer pushback because of the price of crude reduction. Our solvent cost and diesel fuel, as we sit today, is still much higher than where it was the same period a year ago despite the recent reduction of the price of crude. If the price of crude stabilizes and the solvent price comes down and diesel fuel price comes down, then first we don't expect customer pushback. On the other hand, we may give back some of the surcharges. Something that we would decide internally. Historically we have had price increases for a variety of factors, including energy. So any price increase is not just driven by the cost of energy. Again, historically, we haven't had a customer pushback when these things happen. We haven't gone in and put a full price increase when the price of energy first was a factor for us. We were able to move that to later during the year. So we don't expect that. We may give some of the fuel surcharge, but it's relatively a smaller piece of our total price increase.

[Gregory Ray:]

If I can add to that. When Joe talks about giving back some of the fuel surcharges, it's a marketing strategy that drives that more than customer pushback. We have now implemented our typical annual price increase in the fourth quarter. We were a little bit more aggressive this year with that than we have been in some prior years because of the greater cost increases. So tactically, what we typically would do is make that price increase implemented and if crude prices stay down where they are, or even move down further, we would probably then go back out to customers and slightly adjust or reduce the fuel surcharges with the thought that longterm, it would be our desire, if energy prices were stable, to have all of our pricing built into a single charge and not have fuel surcharges. One way to get there is keep raising our list price and diminishing the fuel surcharges.

[Joseph Chalhoub:]

The benefit of a lower cost of crude and really the product will way surpass what surcharge factor is. We have significant benefits if the price of energy and solvent come down from where they have been and where they are right now.

[Jeff Germanotta William Blair:]

My last question. You guys are obviously proven veterans of this industry. Based on your experience of past soft patches in the economy, what's in the playbook or tool box at HeritageCrystal Clean for how to manage through those periods?

[Joseph Chalhoub:]

We would look at the daytoday new business obtainment for us and all of the factors that we have. New customers and each line of the business as we regularly manage, and to the extent we want to push the growth at the higher level, we would do that by putting more resources. On the other hand, we are sensitive about cost factors and, as we do these things, we're attempting to maintain and improve our margins. But we do have several variables in our control to mitigate any losses due to the slowdown in the economy.

[Gregory Ray:]

If I could add, when we talk about slowdown in the economy, again, this is anecdotal rather than statistical information, but there are certain aspects of some of our customer base which we think helps us in a weak economic environment. I don't want to oversell that so you. For example, on the vehicle segment side of our service business, we generate revenue from servicing automotive repair establishments that work on vehicles. If Americans are buying fewer new cars, they're often driving old cars longer and that may increase the service workload in the small shops of America that we count as customers. Additionally, I think as you know, we've often talked about how our service offers allow us to have a lot of pricing flexibility because they're very small ticket items to our typical customer. Handinhand with that is the reality that for certain accounts out there that we want to penetrate, it's not worth their time to even allow us to make a competing bid. Because a manufacturing plant that has a $5 million annual spend, they might be spending $2,000 a year on parts cleaning. And we want to come in there and help them have a better program and save $20 a year, they don't want to give us the time of day. Sales guys sometimes will remark that when there's a little bit of economic pressure, they find those purchasing managers out there more willing to schedule appointments and listen to competitive proposals, because suddenly they're more interested in possible cost savings than they have been historically in strong economic times. Those may be some reasons why we have not, as an industry, seen declines when the economy has been softer. It speaks a little bit to Joes point about how we're going to be able to plan our sales programs to maintain good growth by keeping a lot of people in front of customers making a lot of sales calls. Then obviously, I remarked earlier about AR. That is one thing we will watch more closely in these economic times. If we start to see some deterioration there, I think we just get more aggressive about holding customers to terms and chasing them more vigorously in the event that they're starting to get a little bit delinquent.

[Operator:]

Your next question comes from Craig Bell SMH Capital.

[Craig Bell SMH Capital:]

I just wanted to circle back on the surcharges and your pricing. If I understand how you guys do it, when you implement, like this year for example, the price increase. Some of that will be then leading to a reduction in the surcharge, but the net effect for you guys would be a positive. If we continue to see fuel costs going down, shouldn't that benefit you going forward?

[Gregory Ray:]

Yes, I think you understand the dynamics well. The price increase that we do typically in the fourth quarter of the year is a bigger or more significant number typically than what we try and recover through temporary fuel surcharges. We implement the price increase; we can afford to give back some of the fuel surcharge and still be net positive on pricing across the board. If energy prices stay down or come down further, we will have a longterm benefit in terms of some margin expansion compared to the yearago level. Having said that, we did also remark in the script here and will remind you that if we have a substantial decrease in pricing of our commodities, particularly solvents, we could be forced to on a onetime basis take a charge to the inventory value. But our view is that as long as pricing stays in that direction, we would quickly, over a matter of two, three, four months, recover that inventory charge in terms of improved margins and profitability.

[Craig Bell SMH Capital:]

Looking at economic picture again, if we're in a recession here, does that have any impact on what your expansion plans are or do you press ahead with your planned branch expansions in the face of thinking that you can take business as you said earlier.

[Joseph Chalhoub:]

This economic slowdown we're going through now is going to affect us. Basically we will continue to expand our businesses. We are confident of wanting to do that. We've done that historically by keeping an eye on our margins. That's going to be a factor. Our cost factors are going to be as important as our top line growth to make sure that we maintain decent margins as we continue to expand the business.

[Operator:]

Your next question comes from Jeffrey Cooley Foster.

[Jeffrey Cooley Foster:]

If I could just ask a question about the impact of FIFO on the gross margins. Incremental gross margins over last year were about 88% and about 1,000 basis points over the total gross margins. I don't know how you want to answer this. What was the impact of FIFO or maybe we could take a look at the difference between cash flow and net income?

[Gregory Ray:]

I am not sure where you're going. If you would like to try and follow either of those lines of questioning, maybe we can get in better.

[Jeffrey Cooley Foster:]

One of the reasons given that the gross margins improved was that you're eating through inventory that has been booked on a lower cost basis than you would be buying in a spot market now. Theoretically, that's not a cash flow impact, that's more of a GAAP income impact. So there could be difference between the cash flow you generated versus the net income growth you generated. That's basically the source of my question.

[Gregory Ray:]

I will try and give you some color on that. I guess first to respond to the FIFO issue, I want to clarify, I think you probably understand it. I just want to make sure we're talking about it the same way because you were talking about buying things on a spot market. Really, the biggest source of that FIFO benefit, if we talk through that for a minute, is that we have got inventory of reused solvent. And it's accounted for on a FIFO basis. In a stable price environment, we would pick up the used solvent from our customers, value it when we put it in inventory. Sometime later when we sold it, we would take it out at that same value; and the difference between what we carried it for in inventory and the selling price would be a modest differential, but we book that into income. In this rising price environment, with FIFO accounting, we're accumulating these layers in our tank, theoretically. We put it into the tank at the old value. It appreciates in value over the six months that it takes to get to the end of that pipeline, on average. When we're selling it, we're then selling a low historic cost product at current market prices. So that's the source of improved margins there. So there's not really case where we're buying something on spot, there really isn't neatly a spot market for this used solvent, it's all stuff that we're just generating internally and then reselling to customers.

[Jeffrey Cooley Foster:]

What that argues, though, if we return to a stable or declining price environment, that your margins would be hurt in that scenario. Am I right about that?

[Gregory Ray:]

That's right. Let me help you understand how we viewed this six months ago. Because I think putting it in the context of what we were trying to do with our business in terms of a marketing and pricing strategy it's important. We shared this with some analysts and talked about it briefly on earlier calls. It bears repeating. When prices for our commodity, chemicals, solvents and fuels, hydrocarbon started to go up early this year, there was a certainly an argument that that would have been the right time to have raised our prices across the board with customers to mitigate or get them to absorb those cost increases. We chose not to do that. The reason we chose not to do that was from a marketing perspective. It's our preference, if we can, to defer our price increases and just do them at the end of each year. We think our customers prefer that. Now, the slight nuance there is we did implement some fuel surcharges. As I said earlier, relatively those were minor compared to a normal price increase. The reason that we thought we could defer our price increase until end of the year was that we knew we had this inventory, and we knew we were going get this FIFO benefit. So we were playing a balancing game for the last two quarters. Knowing we were picking up this benefit and hoping that it would last long enough that we could get to the point in time when we felt comfortable doing our typical yearend price increase. We've gotten there. We've done an increase there quarter. As inventory values come down, you're correct that that impact by and of itself will diminish our gross margin. But it's not in a vacuum, it's occurring at the time we hoped it would, where we have now got the benefit of otherwise improving margins from our price increase and we'll have to see over the next couple of months how those two factors balance out.

[Joseph Chalhoub:]

Outside of what you just said. There's also the fact that a lower price for the solvent and fuel will also benefit us on an ongoing basis because these are costs of doing business. So we will have a shortterm inventory cost correction, but we'll have a much bigger longer term benefit if the price of these commodities drops.

[Jeffrey Cooley Foster:]

I agree with that. I am just trying to figure out much of a payback there will be on the margin front now that it looks like prices are falling or stabilizing.

[Operator:]

There are no further calls and this will conclude the conference.