Prospect Capital Corporation
Q2 2014 Earnings Call Transcript

Published: 9 Sep 2014

[Operator:]

Greetings, welcome to the Pep Boys Manny Moe & Jack Second Quarter 2014 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Sanjay Sood, Vice President, Chief Accounting Officer, and Investor Relations for Pep Boys. Thank you, sir. You may begin.

[Sanjay Sood:]

Good morning and thank you for participating in Pep Boys second quarter fiscal 2014 earnings conference call. On the call with me today are Mike Odell, President and Chief Executive Officer; and David Stern, Executive Vice President and Chief Financial Officer. The format of the call is similar to our previous calls. First, Mike will provide opening comments regarding our results and our strategic priorities, and then David will review the financial performance, balance sheet and cash flows. We will then turn the call over to the operator to moderate the question-and-answer session. The call will end by 9

[Michael Odell:]

Thanks, Sanjay. Good morning and thank you for joining us today. Well we have bright spots in our target areas for growth during the second quarter, they were outpaced by our decline in DIY. The deleveraging effect of 1.8% comp store sales declined at a time when we are - had been investing to grow our business, produced a decline in net income of $5.7 million from margins of $5.4 million to a loss of $0.3 million. Our service revenue for the second quarter grew 2.6% in total and dropped 0.2% on a comparable store basis. Also on a comparable store basis, customer count declined 3% while average ticket increased 2.8%. Breaking the business down further on a comparable store basis, our core maintenance and repair services grew 1.3% driven by an 8.4% increase in our brake business, and a 4% increase in our oil change business offset by declines in hot weather related categories like batteries and air conditioning which declined 2.7% and 3.2% respectively. Tire units sold were flat, which was an improvement in trend over previous quarters. Tire sales however were down 3.4% as expected due to lower prices on a year-over-year basis. As we begin the third quarter, that tire price deflation that we've been speaking to for the past four quarters, is now behind us. And lastly, retail sales declined at a faster pace than planned despite our promotional efforts which also affected our product margins. Over the past few years, we have invested in our business to drive top line sales with investments in marketing promotions, super hub speed shop, Service & Tire Centers, digital operations, and the Road Ahead. While each initiative has produced positive results, they have also brought added cost. So on a top of a declining DIY business, the result has been flattish overall sales growth with increased expenses and therefore declining profit margins. Accordingly, we have been developing and inventing plans to further cut cost related to our base business, so that we can continue to grow with out initiatives. Our target is $25 million in cost reductions on a full year run rate basis. And we are also optimizing our inventory mix in investment and are targeting a $50 million reduction from current levels by the end of fiscal 2015. As usual I want to thank our 19,000 associates for their commitment to making Pep Boys the best place to shop and care for their customer's cars. After all we are people taking care of people and their cars. While we must also look in the mirror and recognize that our execution levels have not improved enough to drive consistent sales increases. It is a competitive environment both within the automotive aftermarket and for consumer spend in general and that is why we have been pushing to change our culture to improve our customer experience, changing our marketing position with customers to attract our target customers. But it has been challenging to attract our target customers at a faster rate than we have lost less profitable low priced focus customers. What we do need to do remains clear, our new Service & Tire Centers continue to perform better than pro forma when we've built them in our Road Ahead format in the areas where our target customers live and work and we will continue to grow our footprint with this model. Our remodeled Supercenters performed very well when we convert them to our Road Ahead customer experience but only when our customer service levels matched the physical upgrades made to our Road Ahead Supercenters. Our current customer experience is good but it must be great in order to achieve our desired results. And that comes from not just giving customers what they ask for, when they walked in today, but through engaging with them to learn what really brought them into Pep Boys, so that we can provide them with the complete solution. When we convert a store to our Road Ahead model, it includes intensive customer care training. And to be successful requires not just product knowledge but also the right personality and selling skills. As a result, our associate turnover has been high. When our vision is achieved it resonates with our customers and our associates but it is hard work to get there. The turnover rates as we’ve converted some of these markets had been – as high as 40%. It took us several months to get it right in Tampa. It was coming along more quickly in the Bay Area. We’ve had mix but improving results in Boston, New Hampshire, coming out of gate, and meanwhile Charlotte which we grand opened strong a few weeks – which we grand re-opened a few weeks ago, opened very strong. Denver, Cincinnati and Baltimore are next three markets. The challenge has been what we call the associate remodel, which is actually harder than the store remodel. Charlotte is performing better because of strong leadership and more lead time between when we started the associate remodel and when we started the store remodel which is our model going forward. We get some sales lift from both the associate remodel and the store remodel, but it is the combination of the two that really produces the great results. We now have 30 Supercenters and 45 Service & Tire Centers either opened in or changed to the Road Ahead format. As the physical remodels have progressed, we have refined our skill to include a range of alternatives from full to moderate investment to be determined on a store-by-store basis, thereby reducing the expected average Supercenter investment to approximately $400,000. To-date all of the grand re-opened Road Ahead Supercenters have received a complete remodel at a gross cost of approximately $550,000. Our next three markets again Denver, Cincinnati and Baltimore will include the range of alternatives. The moderate investment version focuses on the exterior rebranding, customer lounge and speed shop at a cost of approximately $300,000 to $350,000. As best as we can forecast today and knowing that we will continue to learn and adjust along the way, out of our 571 Supercenters that we have today, we expect to convert 508 to the Road Ahead format. That will leave 63 Supercenters that may or may not want the remodel investment and our candidates for future sale opportunistically or closure upon lease exploration. However, all of the stores will receive the Road Ahead intensive associated remodel and customer care training. Turning to priority number three, we will continue to invest in the successful growth of our digital business. Digital sales continue to grow especially in service and we're up 52% this past quarter. Work is underway to grow ecommerce sales even faster to offset some of the decline in store base retail sales. Combined, digital sales now account for 4.6% of our total sales. The automotive aftermarket is accelerating in its move to the digital world and we see this area as critical to our successful omni-channel Road Ahead strategy. However, our retail business also remains important as a source for new customers, as we not only use tires and oil changes to acquire new service customers, but also use the installation of wipers, batteries and bulbs for retail customers to acquire new service customers. Once introduced the Pep Boys service capabilities, the focus is on developing relationships that allows us to perform all of our customers' maintenance repair services, from schedule maintenance to brakes, front end parts and alignments to major repairs. So to recap the three primary components of our business strategy, number one is to continue to lead and grow our service business - lead with and grow our service business, which represents a largest and faster growing segment of the automotive aftermarket. Number two, is the transformation of our Supercenter store and experience to differentiate our brand with our target customers. And three is the extension of our digital business to drive omni-channel growth in both our service and retail businesses. From a business today perspective, our number one priority is to accelerate our associates intensive customer care training, in advance of the physical store remodels. And I would like to note that through the first five weeks of the third quarter, overall comp store sales have improved to a positive 1.1%. But while we are encouraged by these recent results, we also know that we are still not achieving our potential. It's exciting and rewarding although also challenging to witness this transformation of our 93-year old brand. The excitement among our associates in the Road Ahead market is amazing, as is the overwhelmingly positive customer reaction to this new experience in both customer associate engagement and in sales. Thank you for your interest in the Pep Boys Manny Moe & Jack. I’ll now turn the call over to Dave Stern, our Chief Financial Officer to review our financial results in more detail.

[David Stern:]

Thanks, Mike. Good morning, everyone. This morning, I will review our results on both a GAAP and a line of business basis. The last page of our press release includes financial information in the line of business format. Sales for the second quarter of 2014 were $525.8 million, a decrease of $1.8 million or 0.4% from the second quarter of 2013. The decrease is primarily driven by a decline in comparable store sales of 1.8% or $9.3 million, partially offset by sales from non-comparable store locations during the quarter at $7.5 million. Comparable store service revenue increased by 5.4%, while comparable store of merchandise sales declined by 3.8%. Gross profit, which includes service payroll, warehousing and occupancy costs, for the second quarter of 2014 was $124.3 million, a decrease of $14.4 million or 10.4% from the second quarter of 2013. Gross profit margin was 23.6% of sales, a decrease of 265 basis points. Excluding the impairment charges of $2.7 million and $1.7 million in the second quarter of 2014 and 2013 respectively, gross profit margin was 24.2%, a decrease of 240 basis points from the prior year. This decrease was primarily due to lower product margins due to increased promotional activity, higher employee costs and higher occupancy costs. Selling, general, administrative expenses were flat in the second quarter of 2014 to 2013 at 22.9% of revenue. In dollars, SG&A expense for the second quarter was $120.6 million, a decrease of $300,000 or 0.3% from the second quarter of 2013. Higher media spend and increased store expenses due to store count growth were offset by reduced compensation accruals. Operating profit for the second quarter was $3.3 million, a decrease of $14.5 million from the prior year. The current year includes the impairment charge of $2.7 million and severance charge of $800,000 compared to an impairment charge of $1.7 million and a severance charge of $700,000 in the prior year. Adjusted for these items, operating profit for the second quarter of 2014 was $6.8 million, a decrease of $13.3 million from the comparable period last year. Interest expense for the second quarter was $3 million, a decrease of $600,000 compared to the second quarter of 2013. Income tax expense for the second quarter of 2014 was $800,000 or an effective rate of 130%, compared to $9.3 million or 63% for the prior year. The current year includes a $900,000 charge related to recording state valuation allowances in certain tax jurisdictions while the prior year included $2.5 million charge primarily due to recording valuation allowance against state hiring credits as a result of tax law changes. The net loss for the second quarter of 2014 is $300,000 or $0.00 per share compared to the net income of $5.4 million or $0.10 per share in the second quarter of 2013. Net earnings for the first six months of 2014 were $1.3 million or $0.03 per share compared to $9.2 million or $0.17 per share for the first six months of 2013. The 2014 results included on a pretax basis, $3.8 million impairment charge, $4 million charge for litigation and $1.1 million severance charge. The 2013 results included on a pretax basis, a $2.8 million impairment charge, and $700,000 severance charge. Additionally, there were previously referenced valuation allowances and tax expense. I will now turn to our results by a line of business basis as opposed to a GAAP basis for our service center and retail operations for the second quarter of 2014. The service center business, which includes service labor and installed merchandise, generated revenue of $288.3 million in second quarter of 2014, an increase of 2.6% or $7.4 million compared to the second quarter of 2013. This increase was primarily due to sales of $8 million in non-comparable locations partially offset by lower comparable store sales of 0.2% or $600,000. The decrease in comparable store revenue was due to a 3.4% decline in higher sales driven by a price decline as units were flat. Excluding tires, service center comparable store revenue grew by 1.3%, primarily due to brakes and oil changes partially offset by softness in weather related category like batteries and air conditioning services. Service center gross profit was $60.7 million, a decrease of 1.5% or $900,000 from the second quarter of 2013. Excluding impairment charges of $1.4 million and $1.3 in the second quarter's of 2014 and 2013 respectively, service center gross profit as a percentage of service center revenue was 21.5%, a decrease of 90 basis points from the same period to prior year primarily due to higher employee cost, lower occupancy cost partially offset by higher gross margins - I am sorry, higher product gross margins. The retail business generated $237.5 million in sales for the second quarter of 2014, a decrease of 3.7% or $9.2 million from the second quarter of 2013. The decrease was due to lower comparable store sales of 3.6% or $8.7 million, and a decrease of $500,000 from sales and non-comparable locations. Retail comparable store sales declined primarily in chemicals and filters, tuneup products and oil. The retail business generated gross profit of $63.6 million for the second quarter of 2014, a decrease of 17.5% or $13.5 million from the second quarter of 2013. Excluding the asset impairment charge of $1.3 million and $300,000 in the second quarters of 2014 and 2013 respectively, the retail gross margin rate was 27.3%, a decline of 410 basis points from the same period in the prior year. This decrease in gross margin was primarily due to lower product margins as a result of increased promotional activity, higher occupancy costs and higher warehousing costs. I will now turn to the balance sheet and cash flow. Cash at the end of the second quarter of 2014 was $38.4 million, an increase of $5 million from the prior year-end and a decrease of $26.5 million from the comparable period of last year. Inventory at the end of the second quarter was $659.5 million, a decrease of $12.8 million from the prior year and an increase of $9.7 million from the second quarter of last year. Inventory increased from the comparable period of the prior year primarily due to the 35 additional Service & Tire Centers, 47 additional Speed Shops and the introduction of new product offerings, partially offset by five fewer Supercenters. Accounts payable, including the trade payable program at the end of the second quarter was $356.6 million, a decrease of $29.2 million from the prior year, and a decrease of $19.4 million from the comparable period last year. The accounts payable to inventory ratio was 54.1%, compared to 57.4% at year-end and 57.9% for the comparable period last year. Capital expenditures for the second quarter of 2014 were $39 million and primarily consisted of the additional five Service & Tire Centers, the completed conversion of 21 stores into the Road Ahead format, the addition of 25 Speed Shops within existing Supercenters, construction and progress to remodel stores and required expenditures for information technology enhancements, including our e-commerce initiatives, as well as our regular facility improvements. Capital expenditures in the second quarter of 2013 were $24.5 million. For all of 2014, we anticipate capital expenditures of approximately $80 million. We plan to open 21 Service & Tire Centers, relocate two Supercenters, open one additional Supercenter, add 25 Speed Shops within existing Supercenters and convert 43 stores to the new Road Ahead format. I’ll now turn the call over to the operator to begin the question-and-answer session.

[Operator:]

Thank you. (Operator Instructions) Our first question today is coming from Bret Jordan from BB&T Capital Markets. Please proceed with your question.

[Bret Jordan:]

Hey, good morning.

[Mike Odell:]

Good morning, Bret.

[Bret Jordan:]

A couple of questions around the SG&A savings and maybe some of the inventory rationalization. Where do you think this $25 million could come from and I guess to some extent the timing on that, you talk about the $50 million inventory reduction by the end of fiscal 2015, is your SG&A target around that time too? And then I guess the follow up on the inventory, what lines do you see potentially taking out?

[Mike Odell:]

To take the expense savings first, it's a mix of – more of it – it’s a mixed of corporate G&A or overhead G&A, as well as some marketing with a higher mix towards the corporate G&A than the marketing. And that would be faster than the end of 2015 timetable. The reason for the longer timetable for the inventory is just because we need to make it orderly in terms of how we reduce the inventory levels. It's not necessarily removing lines of merchandise as it is streamlining the assortment within the lines of merchandise, and there's about I think nine different tactics that get added. But it’s something that shouldn't be as obvious to the customer in terms of fewer choices for them to make purchases.

[Bret Jordan:]

Okay. And then a question, the 63 stores that are candidates for Road Ahead, how many of those are owned? I guess as we look at those stores maybe being a low returns, is there a capital that you can take out of those if they don’t make a conversion?

[Mike Odell:]

Correct. So, we have two properties that we would sell opportunistically, one will actually close next quarter, then another one will close next year. Where somebody has a big project in mind so they don’t necessarily want our store as much as they need that space for part of a bigger project. So, those are examples where we still have good stores, but if they willing to pay for that is just a better return. The 63 stores is a larger mix towards the least stores than it is for the owned stores which will basically be running out those leases roughly a dozen or so, about a dozen a year for the next number of years – several years. And the reason for the lease facilities is that they generate enough cash to pay for the lease. So, it’s better to operate the store than to go dark and still have that lease liability which is why we’re running out. If we have an own store and we don't like to return, then we close it – I'm sorry if it’s a negative cash flow we would close it. The hard part with those is that, while they could be per sale or for lease, they are generally not great properties for us and by definition almost not great properties for someone else. The biggest opportunities are some opportunistic sales where is just higher and better use, kind of non retail for the space and then running out some of the leases that still have some term left.

[Bret Jordan:]

Okay, great. And then one last question, the 1.1 comp you’re seeing in the first five weeks, how much of that is from this tire deflation cycle essentially annualizing itself and tire units tracking more along with comps? Or is there some general improvement in the broader business driving that?

[Mike Odell:]

Our commercial business has been stronger. Our maintenance and repair business has been stronger. The tire deflation has gone away and units I think so far this quarter is down about 1% - maybe just rounding about 1% entire unit decrease.

[Bret Jordan:]

Okay. What would the comp be? Is comp inline with units this quarter?

[Mike Odell:]

Yes.

[Bret Jordan:]

Thank you.

[Operator:]

Thank you. Our next question today is coming from Brian Sponheimer from Gabelli & Company. Please proceed with your question.

[Brian Sponheimer:]

Hi, good morning Mike. Good morning, David.

[Mike Odell:]

Good morning, Brian.

[Brian Sponheimer:]

Looking in from tire supplier, if there is a significant chance that will see a recurrence of some tire tariffs on Chinese tires, or tires manufactured in China towards the back half of the year. What are you hearing on that, and if this does come to fruition, remind us what you expect the effect will be on your own tire sales?

[Mike Odell:]

First off, it's definitely been talked about quite a bit. I can’t really handicap whether or not it’ll be happen but I think probably more likely than not, but that's obviously up to what’s going on in D.C. to decide and then they got lot of things to focused on right now. In terms of the effect, basically it will end up - it will raise prices to the extent that tires are sourced from China which obviously has the biggest impact on the lower end of the market. We feel like we’re at a much better position now than we were when this happened before. When it happened before, we had a couple of things happening, we had the tariff at the same time that you had rapid growth that was consuming the – what was being sourced or what was being manufactured in China, a lot of that was being consumed domestically because they were growing so quickly. Plus, we had a relatively tightness in terms of new factories that were on paper being developed but weren't open yet, plus we had raw materials. So, there was a lot of things that were going on the last time and therefore we saw a rapid increase in our costs that was very hard to pass on fully to customers. I don't think right now we've got much more stability in terms of the other manufacturing capability that’s out there in the marketplace not just in China but around the world and particularly in Asia but not just in China. We’ve got stability relative to the raw materials. We’ve got not as robust demand in China. But probably the biggest change for us as a company is back then we sourced all of our tires from two companies and now we've got over handful of sources. And the sources that we have are not as heavily mixed in terms of China facilities as they were previously. So, I do expect that it will result in higher prices, particularly at the opening price point level. But I think that we're as a company in a better position to play in that environment clearly than we were three years ago or four years ago – how long was the first one - five years ago I guess, and they rolled off by two years ago.

[Brian Sponheimer:]

Right, at 2010, 2011, 2012 time are about. Okay, kind of switching topic here. You talk a little bit about the real estate. Have you guys thought or been approached by any other entities regarding any financial or other real estate assets recently, sequential monetization. I know you’re looking on a one-off basis, but thinking of it as more portfolio perspective, can you comment on anything like that.

[Mike Odell:]

I don’t have any comments to make on that.

[Brian Sponheimer:]

That's it from me.

[Mike Odell:]

All right, thanks Brian.

[Operator:]

Thank you. (Operator Instructions) Our next question today is coming from Ronald Bookbinder from Benchmark Company. Please proceed with your question.

[Ronald Bookbinder:]

Good morning.

[Mike Odell:]

Good morning, Ron.

[Ronald Bookbinder:]

On the reduction in the cost of the Road Ahead program from $550,000 down to $400,000. Has the IRR target improved? Or, can you just now expand the remodels to locations that would not have warranted under the $550,000 model.

[Mike Odell:]

It’s a little hard to answer because we haven't done the lower investing yet. But, we’re not expecting the different level of sales lift necessarily. Until we do it, I don't know for sure, the stores that are getting the more moderate investment, they maybe in a location where they're not as dominant in terms of their physical presence and so therefore you wouldn't invest as much in the exterior of the store, given the location store or maybe a store where the profitability is much more biased towards service versus retail. And so we still want to make the investment on the service side of the business but scale back the investment that we’re making on the retail side of the business. The demographics of the neighborhood around the store - I guess to use your words are scaling back the investment to what we think that the upside or the return is on that investment. So, when we get into the moderate, there’s a lot of different factors that could drive a store to a moderate from its physical location to it’s neighborhood to its performance.

[Ronald Bookbinder:]

Okay. And, the decline in the DIY business, was it just the hot weather items or is it more broad based?

[Mike Odell:]

The strengths, where we were positive in sales in DIY was in the Speed Shop categories as it relates to performance and some degree [appearance] (ph), as well as the new products that we've introduced over the past year. Weaknesses included the heat related categories, the batteries, refrigerator et cetera. Also, oil was down for us and then the parts – the rest of the other categories that I didn’t mention would have been flat to a small decrease.

[Ronald Bookbinder:]

And, you talked about the Internet growing for you guys, but the tire price deflation, do you think industry wide that the Internet is driving some of that? And if so, why do you think that we could see prices hold where they are today?

[Mike Odell:]

I think that the Internet drives pricing transparency. Whether or not that actually causes deflation - it obviously makes – it means that we've, what we find as it relates to anything that's highly sensitive to price and highly visible on the web is that a decrease in price doesn't necessarily gets enough units to afford the margin erosion. But you sure you got to be careful if you are going to raise prices because people pick up that you’re not competitive real quick. So, whether or not it causes deflation that’s kind of a broader question, I don’t know if I'm smart enough to know all the answer to that. I just know that, with transparency of price on the web, if you try to inch things up and you get out of line, people notice. But to just trash prices, it's hard to make that up in unit.

[Ronald Bookbinder:]

And, have you seen any national tire chains that more that look like they could be in acquisition for you given this ongoing tough tire environment?

[Mike Odell:]

We're not – in terms of our growth, we like what we’re doing with our Road Ahead, Service & Tire Centers, where we are taking positions where it's got our target customers and it’s quite frankly a lot of those newer areas are less competitive. And our experience on the acquisitions is that we end up picking up a mixed portfolio. We'll pick up some greatest locations and some not so great locations as you can see from the impairments that we’ve taken over the years. So, we really like what we're doing with the Road Ahead, Service & Tire Centers in terms of being very specific about our locations versus just acquiring market share.

[Ronald Bookbinder:]

Okay, great. Thank you very much.

[Operator:]

Thank you. Our next question today is a follow up from Bret Jordan from BB&T Capital Markets. Please proceed with your question.

[Bret Jordan:]

I guess – on a regional basis, did you see much dispersion in the performance? You talked about cost and it’s results on Road Ahead being mixed, whether that’s the Road Ahead or the region? Is there any – is there much difference from Western store performance, Eastern store performance or South versus North in the quarter?

[Mike Odell:]

The weakest for us would have been Puerto Rico, which is a pretty big market for us and there's been a lot of economic turmoil down there. Our strongest markets have been in the southeast, that’s obviously where we have Tampa and a lot of the culture change that we've - with the Road Ahead that were driven at Tampa has spread across to the neighboring markets. But looking at the rest from California to the East, relatively even there's some spread, but relatively consistent. I guess our other weak spot would have been more in the West not out in California but in the Arizona and Nevada markets were also weak for us.

[Bret Jordan:]

Okay. And then one last question, on the impairments, you haven’t done a meaningful acquisitions since that [indiscernible] deal. Where are we? Do you still see asset that you picked up in the last three or four years that are needing impairment or is the store based sort of shaken out by now?

[Mike Odell:]

I don't know – you want to answer that Sanjay.

[Sanjay Sood:]

Sure I can take that. Bret, we think with the impairments that we've taken, that we’re in good shape and the stores are appropriately valued, but as we know – as you know, it's a quarter-over-quarter analysis and it’s down to the individual store unit level that we take that analysis. So, were not of – aware of any now that we would forecast being impaired, but we’ll continue to do that analysis each quarter.

[Bret Jordan:]

Okay. Thank you.

[Mike Odell:]

Thanks Bret.

[Operator:]

Thank you. We've reached end of our question-and-answer session. I’d like to turn the floor back over to management for any further or closing comments.

[Mike Odell:]

All right. I want to thank you for your time, your attention and your questions. And as usual, we’re available for any follow-up discussions. Hope you have a great day. Thanks.

[Operator:]

This concludes today's teleconference. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation today.