Michaels Companies Inc
Q3 2020 Earnings Call Transcript

Published: 3 Dec 2020

[Operator:]

Good morning. My name is Andrew and I will be your conference operator today. At this time, we'd like to welcome everyone to The Michaels Companies Fiscal 2020 Third Quarter Financial Results Conference Call. Please note, this event is being recorded. Thank you. And now I'd like to turn the call over to your host, Jim Mathias, Director of Investor Relations. Mr. Mathias, you may begin the conference.

[Jim Mathias:]

I'd like to welcome you to our fiscal 2020 third quarter financial results conference call. Presenting on this morning's call are our CEO, Ashley Buchanan; and our CFO, Mike Diamond. Note for today's call, the supplemental slide deck available on our Investor Relations website contains additional financial content to support today's discussion.

[Ashley Buchanan:]

Thanks, Jim. Good morning, everyone. I hope you're all staying safe and healthy what continues to be an unprecedented year. Before I get into our quarterly results, I want to start by acknowledging the hard work of the entire Michaels team. Throughout this year, our team members have navigated a host of unprecedented challenges with resilience and tenacity. To recognize their hard work, I'm excited to announce today that we are awarding our team members a onetime holiday bonus. We're in a much stronger position operationally, financially and strategically than we at the start of this year due to our team members hard work and dedication in serving our maker customers. Moving to our strong third quarter results, we delivered significant sales growth, margin expansion and strong free cash flow generation. Our relentless focus on serving our customers helped to drive a 16.3% comparable store sales growth in the quarter, a 162% increase in operating income and over 100% increase in diluted earnings per share. Free cash flow remains a particular strength for Michaels as we generated approximately 380 million in the third quarter and on a year-to-date basis, Michaels has generated 633 million in free cash flow.

[Michael Diamond:]

Thanks Ashley and good morning everyone. Michaels continues to make progress on our key strategic initiatives, which enabled us to deliver strong sales growth in the third quarter. Third quarter sales totaled $1.4 billion, an increase of 15.1% on a year-over-year basis. Comp store sales grew 16.3% year-over-year. As Ashley mentioned, our strong third quarter performance was driven by strength across our core arts and crafts business, as well as accelerated sell-through of our seasonal Fall and Halloween inventory during this quarter. Our exiting sales trends for the third quarter were in the mid-single digits which we expect to continue in the fourth quarter moving down the income statement. Third quarter gross profit increased 32% from a year ago to $582 million. The drivers of this increase were occupancy cost leverage due to strong demand throughout the quarter, a lower promotional cadence for the quarter, reflecting our disciplined pricing approach and the continued benefits from ongoing pricing and sourcing initiatives. These drivers position Michaels well for gross margin dollar improvement and sustainable long-term growth, even as we continue to make growth investments and see a higher mix of e-commerce sales. Finally, we saw a small impact on third quarter gross profit from tariffs and have largely lapped the tariff impact at this point. SG&A for the quarter was 26.5% of sales, an increase of 10 basis points from the third quarter of last year. SG&A increased in absolute dollars on a year-over-year basis, primarily due to an increase in performance-based compensation, as well as an increase in professional fees associated with ongoing initiatives intended to drive growth and profitability. These increases were partially offset by the cost containment actions we have taken this year. In addition, this quarter we took an impairment charge of $9.4 million primarily related to the relocation of our support center that we expect to complete early next year. Operating income was $199 million, an increase of 162% in the quarter. Adjusted operating income was approximately $201.6 million, up nearly 72% from the year ago period.

[Ashley Buchanan:]

Thanks Mike. Now slightly over a month into our fourth quarter, I am encouraged by the progress The Michaels team has made and how well our strategic initiatives have taken hold. We remain focused on executing on the key pillars of our maker strategy as we work to make Michaels a one-stop shop for arts and crafts. We will continue to focus on gaining market share as we attract and retain new customers and deepen our connection with existing customers. We have made significant strides to sustainably improve our operations in a short period of time and we look forward to sharing more on our progress in the future. And operator, let's move to the Q&A portion of the call.

[Operator:]

The first question will come from Christopher Horvers of JPMorgan. Please go ahead.

[Christopher Horvers:]

So my first question is, you're expecting mid single-digit comp in the fourth quarter, you talked about 20% through the end of September and obviously the mid-single digit exit rate in October. So can you talk about what drove that, was that earlier seasonal sell-through and thus did the core categories slowed down? And is it fair to say it was more decorating this year like you said smaller gatherings and - but more of them. Are you seeing that surge again here in November and you're just basically saying, once we get through the holiday to core period that will revert back down to that mid-single digit trend.

[Michael Diamond:]

Yes, Chris, let me start with that one, so let me start first with the Q3 aspect. And I think - I would say a couple of things. The first is, we saw strong growth across all of our categories including both the core arts and crafts and the seasonal offering. Now we did sell through our seasonal as you mentioned a little bit earlier than normal, but that aligns with our maker strategy and really making sure that we are delivering what the customer wants. Overall, we think our comp strength actually bodes well and demonstrates the proof point of our strategy that by making sure we can be the arts and crafts retailer for the maker, we are selling the items they want.

[Ashley Buchanan:]

Yes, I'll just add a little bit. So, as you recall from our previous discussions and earlier calls that we tightened up the Fall and Halloween by this year versus last year and that was twofold. One was, we were heavy going into last year and so we purposely did that to improve the sell through. And I would say one of our biggest issues last year was actually getting holiday product post Halloween onto the floor, mainly because of the excess clearance in Halloween. So that strategy actually worked, we generated better sell through earlier in the month, then we were successfully able to get holiday product onto the floor. Now if you look into next year with the implementation of our seasonal DCs that we're putting in, we'll be able to lengthen the fall Halloween season at the same time that we flow holiday product in tandem. So our strategy for next year will actually be even better than this year, but we are very pleased with how Halloween and fall sold through. Also to kind of look through what that means for holiday, if you look at Halloween, it's pretty much a set and forget type of product, you set it once and you let it sell through, it's pretty much at the core of business for us and a little bit of crafting. If you look at holiday, it's a little bit different, it's a longer season for us, there's the tree, there is tree, then there is gift giving on top of arts and crafting on top of it. So we feel good about our strategy on how we exited Q3 and starting Q4.

[Christopher Horvers:]

So is it then fair to assume that you've seen a re-acceleration here in November because of the decor side and gifting side?

[Michael Diamond:]

Yes, I mean, look, I would say we are very pleased with how we have started with Q4 for both the arts and crafts and the seasonal. But there's also a lot of uncertainty as we look forward through the rest of Q4 as it relates to the macro environment, both from a customer demand as it relates to COVID, but also how municipalities are treating the recent outbreak. And so we're very pleased with how the quarter has started, but we want to make sure we're prudent in our fourth quarter perspective and that's why we've mentioned the mid-single digits.

[Christopher Horvers:]

And so my follow-up is on the cash flow side, I mean your inventory sort of inventory days, payable days, your third quarter cash was much higher than we had expected. So can you talk about your outlook for sort of working capital and do we have to give back some of that inventory where you build inventory to the end of fourth quarter, will payable days come down. And then you have a lot of cash, you're looking at balanced capital allocation, why wouldn't you sit there and say we could actually take another slug of debt and pay that down and take some of the burden off to leverage ratio or even go out there and do some combination with share buyback given how flush you are with cash?

[Michael Diamond:]

Yes, absolutely, there were a couple of different things embedded in there. So let me first start with the capital allocation framework and then I can address the others. I think look we laid out our capital allocation framework in Investor Day and we remain committed to, the first is ensuring that we're going to grow the business and make sure we invest in the business to demonstrate the sustainable long-term growth that we know this brand is capable of. After that we look at debt repay down and we demonstrated a commitment to that as part of the refinancing where we paid back $150 million of our debt. There is then opportunistic share repurchases and then we'll consider M&A as it comes along. Obviously, all of those are things we're considering, particularly given the macro environment, we wanted to make sure as we get through Q4, we understand what's happening from a consumer demand, as well as municipalities and their actions before we continue to execute across that capital allocation framework. To your second point around cash flow, we believe that a towering strengths of Michaels both now and over the long term is it significant free cash flow generation and we think that's going to be something that we'll continue for years. This year, this quarter we saw a benefit not only from the increased performance, but as part of our activities over this year from COVID, we went back to vendors and talk to them about normalizing our payment terms. And so, part of what we're seeing now is the benefit of that, some of that will come back in Q1 as we fulfill our obligations to those terms, but it doesn't change the fact that we expect Michaels over the long-term to continue to generate significant free cash flow.

[Operator:]

The next question comes from Seth Sigman of Credit Suisse. Please go ahead.

[Seth Sigman:]

Just curious given the progress this year, can you elaborate on some of the strategic and operational drivers plan for next year for 2021 and give us a sense as to the puts and takes for sales as you have to lap some of these strong results. It would seem like you should be able to still grow sales next year, but will be great to get your thoughts on that? Thanks.

[Ashley Buchanan:]

Yes, from our strategic growth pillars that we outlined in Investor Day, I'm very pleased with the progress we're making. So if you look at going into next year, we expect significant improvements in our omnichannel enhancements with buy online, pick up in store, curbside, we're going to work a lot on product and category management as we bring newness to the floor and we'll continue to make progress on our pricing promotional cadence and effectiveness as we did this last quarter. As you look at the back half of '21, our seasonal distribution centers should be set up and running that will enable us to flow product much more effectively and reduce our lead times, increase in stocks, increase labor productivity, all that you take hold. And from a omni-channel - we'll keep iterating, improving the customer experience, we will be rolling out shop and scan and other services in the back half of '21 as well. And I see us continuing to expand Michaels Pro, that's been a positive offering to our customers and other B2B offerings as well.

[Seth Sigman:]

As you think about profitability and the operating margin of the business into next year, I would think some cost come back as you lap store closings from earlier in the year, but you also have plenty of incremental cost this year, you talked about the incentive comp, the bonus and I'm sure there were other COVID cost rate. So should we be thinking about flow through improving into next year and that you should be in a position to expand operating margins?

[Michael Diamond:]

Yes, look, I mean, so what I would say first of all is from a 2021 perspective, we're still going through the planning process and so we're not going to be providing formal guidance on '21. As I think through even the fourth quarter and some of its implications, we continue to be focused on making sure we're disciplined from a pricing and promotional perspective and it doesn't mean we're necessarily going to be at the exact same promotional levels as we think through the implications of COVID and coming out of the COVID period in 2021. Obviously, we're comfortable from an e-commerce perspective that a meaningful portion of our e-com is focused on BOPIS, curbside and same-day where our customers bear the fulfillment costs and therefore we are profitable from an e-commerce perspective. Overall, our key focus is making sure we continue to grow gross profit dollars in the long-term and believe over time that that will help scale the business.

[Operator:]

The next question comes from Joe Feldman of Telsey Advisory Group. Please go ahead.

[Joe Feldman:]

Wanted to follow-up - you had talked about the - in the three pillars, the merchandising side of things and focusing on improving various departments around the store. You talked about future doing more, I was just curious if you could share any thoughts on what some of those might be like what's next up that you'd like to improve to help drive the business?

[Ashley Buchanan:]

Yes, we're doing our category management process across every category in the box, it's a longer lead time, as you know, this category, this company has long lead times on product, but we're going through every category and improving newness, improving product development. We're actually making it where it goes from truck to shelf or it fits on the shelf, so it reduces touches, reducing our lead times, improving our case facts, which allows us to be more effective and efficient at store level. So there is a lot of work to be done, I'm pleased with the beginnings of it as we've got newness and got the natural kind of specialty retailer merchandising pyramid correct. But there's still a lot of work to do around improving truck to shelf and efficiency at store level. So we'll see that roll out throughout next year and I'm very pleased with how that's coming along.

[Joe Feldman:]

Got it. That's great, thanks. And then just one follow-up, with regard to the surge in COVID cases we've seen around the country, have you seen any recent changes in demand trend? I mean obviously I get at the mid-single digit that's flowed through the quarter, but I don't know if that was related or is it and is there any anticipation that you might have to close stores in some markets again? Thanks.

[Ashley Buchanan:]

It's a good question, I mean we haven't seen any real change in demand regionality outside of obviously Canada where they closed certain areas, you do see obviously demand when the store is actually closed. There is just recently been put in different capacity limits, we haven't seen a tremendous impact of that, but obviously you know we're very well aware of what could happen if we go back to March, April, we don't anticipate that, but obviously we plan, we have a very robust playbook if we have to go back to that. We weather that storm very effectively and we're better positioned now to weather then we were then. So we're prepared for all optionality and all things that might happen, but right now we're assuming that we're going to get through this just like we did last time, but better because we don't foresee a rolling closure about any municipality. But like I said, who really knows otherwise we will be providing guidance, so we're allowing ourselves optionality.

[Operator:]

The next question comes from Simeon Gutman of Morgan Stanley.

[Simeon Gutman:]

My question first is on gross margin, can you talk through some of the drivers in Q3, what was recapture sort of what sustainable and if you have an easier comparison it looks like in the fourth quarter, is there any reason why it can't look similar especially with inventory position looking so lean?

[Michael Diamond:]

Yes, sure. So, Simeon, I would say there were - first of all, we were obviously very, very pleased with where the quarter came in from a gross profit perspective, an increase of $140 million was quite significant. There were really two drivers that drove that number in the third quarter. The first was disciplined, promotional and pricing and how we tackle that relative to where we were over the last quarter. That is something we will continue to be - we will continue to make sure we are being smart and thoughtful on our pricing and our promotional cadence, how that ultimately gets executed from a quarter-over-quarter perspective year-over-year is a little tough to know this early in the quarter. The second driver is occupancy cost leverage, which as a reminder is an expense that's included in our gross profit, obviously, when you have comps that are up 16.3% you're able to get a significant amount of leverage on the box and on our operations, with a mid-single digit that won't be as significant, but obviously we would still hope to be efficient with our box even at that level.

[Simeon Gutman:]

And just to clarify, I think you said regarding the quarter-to-date and why you're being somewhat careful with your fourth quarter - the exit rate that you provided even though there wasn't guidance, is that you are seeing some pull forward in some of this I guess seasonal product or holiday product and you want to be tentative about how you look at that? And then this is an unrelated part of the follow-up, so I apologize. Can you talk about freight both in terms of last mile and sort of inter-supply chain expenses, this is something that had come up with Michaels in the past, curious how it looks like going into 2021?

[Michael Diamond:]

Yes, so let me tackle both of those. So we - our exit rate in October and then what we've indicated for Q4 is mid-single digits. We're very pleased with how the quarter has started, but if you look at the cadence of our seasonal sell-through in Q3, it also makes us think through the seasonal profile of the Q4 business as well, which is what gives us comfort in the mid-single digit number. It's also admittedly, Ashley mentioned this from what some municipalities are doing, we're just not sure how society quite frankly is going to react over the next eight weeks. And so we want to make sure we're being prudent as we think through the potential implications of that. From a freight perspective, it is something we keep an eye on, obviously everyone in the industry is bearing increased freight costs, we have a great relationship with a lot of our providers to make sure that we won't face capacity constraints in terms of getting our product out, but it's something we continue to keep an eye on as we try to manage the business.

[Ashley Buchanan:]

And I think from a omni channel or e-commerce perspective on freight, a big portion of our sales in e-commerce still comes from BOPIS, curbside and same-day delivery. So we benefit from that mix change versus probably others I would assume.

[Operator:]

The next question comes from Kate McShane of Goldman Sachs. Please go ahead.

[Kate McShane:]

Most of mine have been answered already, but I was curious to learn more about the new customers that you saw during the quarter. Just curious who they were and what their behaviors were versus your more regular customers, are you seeing more bigger basket sizes are trading up or any kind of insight into the repeat purchases?

[Ashley Buchanan:]

Well, I'll say this, we're pleased with the total customer profile with our existing customers gaining more share of wallet and we're pleased with our new customer acquisition as well. It's been a broad-based demand across all the categories which we're very pleased with not just seasonal, but particularly our replenishable core arts and craft business, it's been a broad-based demand across all customer types. So we're very pleased with that because it indicates that our focus on our core customer, our maker customer is the right strategy. We're not too reliant on just seasonal to drive it and that's been a plan for a while, and it's clear that's actually working and paying off.

[Kate McShane:]

And I wondered if you could just comment as a follow up question with regards to holiday, I know gifting is an important piece of Q4. Is there any way to quantify gifting as a percentage of sales in the fourth quarter and how that breaks down between more child oriented by toy, crafts versus just general adult gifting?

[Ashley Buchanan:]

Like I said earlier, there is actually kind of three parts to our holiday seasonal business which is the three part, the trim the three part and then the gift giving piece, but we - I'd be remiss also not mention they're actually the fourth part, which is early kind of arts and crafts around holiday. So we have four parts of it. The arts and crafts starts really early in this tree, our trade in tree and gift giving and we don't breakout which segment, but with that being said historically we'd be really focused on those four segment specifically. What's great about what we're doing now is the true arts and crafts business, our SBA or our replenishable business is also doing very well and so it's just core arts and crafts as well. So it's a broad-based demand that we feel very positive about.

[Operator:]

The next question comes from William Reuter of Bank of America. Please go ahead.

[William Reuter:]

You mentioned that of the two large gross margin drivers one of them was lower pricing and promotions, given high conversion and tend to purchase when customers are in stores, how much of this do you think is due to the environment and how much of this would you attribute to your own strategies?

[Michael Diamond:]

Yes, I mean, look, it's - there's going to be - it's tough to really tease that out right now particularly given what's going on from a macro environment from a COVID perspective. I think we feel really good about our strategy both in the macro environment we face right now and going forward that we want to be disciplined around pricing and promotion. It's obviously not just about the price and promotion, it's about the offer you have, executing the strategy across the three pillars and then having a pricing and promotional cadence that actually supports that. So, I'm not going to lie and say, obviously, I think we have benefited from a consumer demand perspective based on the current macro environment, but I also think that our ability to have the right seasonal assortment that sells through earlier and at a higher rate is as much to do with how we're actually executing against the categories as it is around our pricing and promotion.

[Ashley Buchanan:]

I'll add onto that a little bit, so if you can go back a caller who we talked about tightening the holiday buys, which we did. Two things, we also that I didn't mention is, it's more unique products. So it's less commodity, less mass. So when we tightened up the buy and you got more unique product, it's sold earlier, right? And the fact that the customers like the product, we didn't feel and didn't need to remote as deeply as we did last year, it was a shift and basic product merchandising, more to a specialty retailer product merchandising versus mass. And we will continue to follow that formula into next year, because you can get the commodity massed off in a lot of places. We focus on unique product and less depth on the quality we buy and so that's why we had a better sell through and I think that's a good methodology for seasonal buyers going forward.

[Operator:]

The next question comes from Steven Forbes with Guggenheim Securities, LLC. Please go ahead.

[Steven Forbes:]

So I wanted to focus on the store resetting initiatives. Ashley, if you can - can you provide us an update on the reset plans right, as we think about next year both in terms of cadence and breadth? And then help us quantify right the potential cost implications of the rollout as we sort of try to optimize the model year and I think what I'm trying to best understand is what the level of investment spend pressure on the business is going to be in the first half right, where we have that those lower-volume quarters?

[Ashley Buchanan:]

Yes, so it's a rolling reset by category, so you'll have in pretty much all your write-ups for the fourth quarter. The cost of your resets is very minimal in the sense that this is kind of what we do, we've dramatically made the resets more efficient by how we go from truck to shelf, skew optimization, case back optimization. So the ability to put that product on the shelf on our initial kind of reset should be much more efficient than it has in the past. So we don't see a lot of headwind from what you call modular resets or product resets or refreshes in the stores next year.

[Steven Forbes:]

And then just maybe sticking with expenses given the holiday bonus payment to team members that was announced, can you just update us on where your average entry wage is today and then how you're thinking about just the average wage rates in '21 versus say a baseline for 2019?

[Michael Diamond:]

Yes, I mean we're committed to making sure that we pay a competitive wage in the markets and then we keep an eye on that across our stores by municipality to make sure we're competitive.

[Operator:]

And the last questioner today will be Carla Casella with JPMorgan. Please go ahead.

[Carla Casella:]

Given your growth in BOPIS and curbside, can you just give us a sense for the margins on a BOPIS or curbside sale versus an in-store product margin - gross margin?

[Ashley Buchanan:]

As we said in the past BOPIS, curbside, same-day delivery is basically equivalent to an in-store purchase.

[Carla Casella:]

And then on the working capital front, you mentioned that you extended some payable terms, it looks like some other costs that were deferred. Could we see working capitals flip and be use of cash in fourth quarter untypical, atypical to the seasonal patterns in the past or is it most they are going to get paid back down in '21?

[Ashley Buchanan:]

'21 is the sort of direct answer, it like we - we will see that largely in the early part of next year.

[Operator:]

This concludes our question-and-answer session and today's call. Thank you for attending today's presentation. You may now disconnect.