Prospect Capital Corporation
Q1 2013 Earnings Call Transcript

Published: 11 Jun 2013

[Operator:]

Greetings, and welcome to Pep Boys' First Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Sanjay Sood, Chief Accounting Officer and Controller for Pep Boys. Thank you. Mr. Sood, you may begin.

[Sanjay Sood:]

Good morning, and thank you for participating at Pep Boys' First Quarter 2013 Earnings Conference Call. On the call with me today are Mike Odell, President and Chief Executive Officer; David Stern, Chief Financial Officer; and Scott Webb, Executive Vice President, Merchandising, Supply Chain and Digital Operations. 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 Dave will review the financial performance, the balance sheet and cash flows. We will then turn the call over to the operator to moderate a question-and-answer session. This call will end by 9

[Michael R. Odell:]

Thanks, Sanjay. Good morning, everybody. Thank you for joining us today. My comments today will highlight for you both our first quarter results, as well as our strategic efforts to deliver a better customer experience that differentiates Pep Boys among our targeted customer segments when they shop and care for their cars. We're then pleased to report an improved revenue performance and continued growth in comparable store service customer count. Our store chains have been working diligently to make Pep Boys the best place to shop and care for your car, and it is nice to be rewarded with some top line sales growth. Our biggest sales and profit lever is to continue to improve how we engage with and care for our customers. And under the new leadership of Chris Adams for the past 90 days, our teams have been working to build rapport with our customers before launching into the fact-finding and problem-solving phases of customer service. This effort includes intensive focus on customer care that is not as simple as it may sound but, when executed correctly, makes a meaningful difference in the customer experience and in our results. So we are thankful for the tireless efforts of our associates to be friendly, do it right, keep our promises and show compassion as they serve our customers. For the first quarter of 2013, comparable store sales grew 1.0%, with a 3.9% increase in service, partially offset by a 2.1% decline in retail. Overall, comparable store sales trends have continued to be positive during the first month of our second quarter. While we are pleased with our improving revenue performance, we also know that we need to convert our sales into profit at a higher rate. Net income for the first quarter improved by $2.8 million from $1.1 million to $3.9 million. Gross margins declined 160 basis points in total primarily due to heavier promotional activity in our retail business, higher levels of point-of-sale discounting and investments in technicians in our service business. Margin rates improved as the quarter progressed and have continued to improve in the second quarter. In regards to technician payroll, we continue to invest in this core competency, which is the foundation of our business, and got ahead of schedule during the first quarter as we prepare for the summer seasonal demand. Disappointingly, this temporary setback conceals the progress we have made with our tire margins and also our service and tire center overhead absorption. On a positive note, SG&A expenses declined slightly in dollars on the higher sales, resulting in 80 basis points of improved leverage. Interest expense declined $2.8 million due to lower debt levels and interest rates following our refinancing late last year, and also our tax provision benefited $3.8 million from state hiring credits related to job creation and enterprise zones. Our bigger profit leather -- levers are improved gross margins and leveraging our expense structure with comparable store sales gains, both of which we expect in the second quarter. There have been no significant changes in our balance sheet or cash flow profile since year end. Inventory increased due to investments in new stores, Speed Shops and seasonal buys [ph]. Our strategically important service maintenance and repair categories remained steady. The only service category that experienced a decline on a comparable store basis was tires, which declined low-single digits. However, margin dollars on tires increased mid single digits as gross margin rates continued to recover. Service technician payroll did increase as a percent of sales due to investments in technician capability that I mentioned previously. Maintenance services grew double digit on a comparable store basis, while repair services grew high single digit on a comparable store basis. And comparable store service customer count increases also remained healthy at 4.3% for the quarter. This is the fourth consecutive quarter that comparable store service customer count has been positive. As we have stated previously, we do continue to see the impact of the decline in new car sales that started in 2008. Our sweet spot is vehicles between 5 and 13 years old, and we see the impact as these new cars age deeper into their normal maintenance and repair cycle. This trough in maintenance for newer cars affected oil changes first, then tires and now brakes, and this will continue category by category, with batteries next. The good news is that the headwind does turn into a tailwind since new car sales have increased every year since 2009. We have already been through the trough with oil changes and basic maintenance and we're cautiously optimistic that we will see improving demand for tires this year. While brake sales have been soft in our DIY and Commercial businesses, brake sales in our service bays continue to be positive. Vehicle complexity also continued to increase, which supports the competitive advantage that we enjoy with our technicians' skill level that allows them to perform the medium and heavy work that folks cannot and do not -- or do not want to do for themselves. That's why we continue to invest in quality technicians. We also continued to invest in our online experience, which continues to grow in importance as the source of customer acquisition and retention. The latest additions are more service options online, buy online, pay in store and live chat. Last quarter, I spoke about our target customers and shared some of the following facts

[David R. Stern:]

Thanks, Mike. Good morning, everyone. This morning, I'll review our results on both a GAAP and a line-of-business basis. The last page of our press release includes financial information in a line-of-business format. Sales for the first quarter of 2013 were $536.2 million, an increase of $11.6 million or 2.2% from $524.6 million in the first quarter of 2012. This increase was composed of a $6.4 million increase from noncomparable store locations and $5.2 million from the 1.0% increase in comparable store sales for the quarter. The increase in comparable store sales was comprised of an increase in service revenue of 4.2%, while merchandise sales were essentially flat, up 0.1%. Gross profit for the first quarter of 2013 was $121.8 million, a decrease of $5.8 million or 4.6% from the first quarter of 2012. Gross profit margin, which is fully loaded with occupancy costs, warehousing and service payroll, was 22.7% of sales, a decrease of 1.6 percentage points. Excluding the impairment charge of $1.2 million in the first quarter of 2013, gross profit margin decreased by 1.4 percentage points to 22.9% from 24.3% in the first quarter of 2012. This decrease in gross profit margin was primarily due to higher payroll and related expenses of 90 basis points and lower merchandise margins of 80 basis points due to increased promotional activity, partially offset by a sales shift to higher-margin service revenues. Selling, general and administrative expenses for the first quarter of 2013 as a percentage of revenue were 22.1%, a decrease of 0.7 percentage points from the first quarter of 2012. In dollars, selling, general and administrative expenses decreased $1.5 million or 1.3% from the prior year primarily due to lower media spend of $2.5 million and due to not having merger-related costs of $1.6 million that were incurred in the first quarter of 2012. These were partially offset by higher professional services costs and credit card fees. Interest expense for the first quarter was $3.7 million, a decrease of $2.8 million primarily due to the reduced debt level and interest rate resulting from the refinancing that took place in the third quarter of 2012. During the first quarter of 2013, we recorded an income tax benefit of $3.7 million primarily as the result of the $3.8 million tax benefit from state hiring credits. During the first quarter of 2012, income tax was $0.8 million. Net income for the first quarter of 2013 was $3.9 million or $0.07 per share compared to net income of $1.1 million or $0.02 per share in the first quarter of 2012. I will now turn to our results by line of business, as opposed to the GAAP basis, for our service center and retail operations for the first quarter of 2013. The Service Center business, which includes service labor revenue and installed merchandise and tires, generated revenue of $287.0 million in the first quarter of 2013, an increase of 5.9% or $15.9 million over the $271.1 million reported for the first quarter of 2012. This increase was primarily due to a 3.9% increase in comparable store revenues or $10.5 million, and the additional contribution of $5.4 million from noncomparable locations. The growth in service center comparable store revenues was due to an increase in customer count of 4.3%, partially offset by a decline in average transaction amount of 0.4%. The increase in customer counts was due to the strength in our maintenance and repair business, led by increased oil change transactions which have a lower average transaction amount. The promotion of oil changes is designed to attract new customers to Pep Boys to introduce them to our full-service capabilities in order to satisfy their future needs. Service center gross profit was $52.0 million, a decrease of 3.5% or $1.9 million from $53.9 million in the first quarter of 2012. Excluding the $1.0 million asset impairment charge in the first quarter of 2013, Service Center gross profit as a percentage of Service Center revenue declined to 18.5% from 19.9% in the same period of the prior year primarily due to increased payroll and related costs due to upfront investment in our technicians; and increased store occupancy costs, partially offset by improved product gross margin. Although tire revenue was essentially flat, tire gross profits increased due to an increase in product margin rate. The Retail business generated sales of $249.2 million in the first quarter of 2013, a decrease of 1.7% or $4.3 million from the $253.5 million in the first quarter of 2012. The decrease was primarily due to lower comparable store sales of 2.1% or $5.3 million, partially offset by the contribution from our noncomparable locations of $1.0 million. Retail comparable store sales declined as a result of a decrease in 3% in customer count, partially offset by an increase of 0.9% in the average ticket. The Retail business generated gross profit of $69.8 million in the first quarter of 2013 versus $73.8 million in the first quarter of 2012. Excluding the asset impairment charge of $0.2 million in the first quarter of 2013, the Retail gross margin rate decreased to 28.1% from 29.1% in the same period of the prior year. The decrease in Retail gross margin was primarily due to increased promotional activities, which did not lead to the anticipated lift in sales in the quarter. Moving to the balance sheet and cash flow. During the first quarter of 2013, cash decreased by $3.1 million to end the quarter at $56.1 million. Cash used in investing and financing activities offset the cash flows generated from operating activities. Inventory at the end of the quarter was $648.1 million, an increase of $6.9 million from $641.2 million at the end of last year. Inventory balances increased primarily due to seasonal purchases, investments in our new stores, adding Speed Shops to existing Supercenters and the conversion of Supercenters to Super Hubs. Accounts payable, including the trade payable program, remained essentially flat at $394.6 million at the end of the first quarter of 2013, as compared to the end of 2012. The accounts payable to inventory ratio at quarter end was 60.9%, a decline of 0.6% from the end of 2012. Capital expenditures in the first quarter of 2013 were $12.8 million and primarily consisted of 4 service and tire centers; 2 Supercenters; information technology enhancements, including our e-commerce initiatives and parts catalog enhancements; as well as our regular facility improvements. Capital expenditures at the end of first quarter of 2012 were $11.9 million. Net property and equipment of $647.6 million declined by $9.6 million during the first quarter of 2013 primarily due to depreciation exceeding capital expenditures and the $1.2 million asset impairment charge recorded during the quarter. Free cash flow in the first quarter of 2013 was negative $2.7 million compared to free cash flow of $41.3 million in the first quarter of 2012. Free cash flow is defined as cash flow from operating activities plus amounts financed under our trade payable program, which is included in cash flows from financing activities, less cash flow from investing activities. Our prior year cash flows included $20 million of net cash generation from expanding our accounts payable to inventory ratio by 4.1 percentage points due to increased inventory purchases and improved vendor payment terms. We continue to anticipate capital expenditures of approximately $65 million for 2013. This includes approximately $3 million for remodeling the Tampa market; as well as the addition of 38 new locations, 31 of which will be service and tire centers and the remaining 7 will be Supercenters; the conversion of 15 Supercenters into Super Hubs; the addition of 50 Speed Shops to existing Supercenters; information technology enhancements to improve the customer experience; and required expenditures for our existing stores, office and distribution centers. These expenditures are expected to be funded by cash on hand and net cash generated from our operating activities. Additional capacity, if needed, exists under our existing line of credit. Finally, regarding our gross profit rate for the quarter. We ran some promotions and price tests that resulted in a lower gross profit rate for the quarter. Of course, some are -- also worked well, and we will use this information going forward as we plan. And with this, we project that we will have gross profit rate improvement for the remainder of the year. I'll now turn the call over to the operator to begin the question-and-answer session.

[Operator:]

[Operator Instructions] Our first question comes from the line of Bret Jordan with BB&T Capital Markets.

[Bret David Jordan:]

A quick question on that last comment about improving on the gross margins for the balance of the year. Are you thinking about sequential improvement or year-over-year improvement in gross margin? And I guess, to dig a little deeper, if you look at the increased labor expenditures, is that labor at the core stores, or is that incremental labor added to the STC stores as well?

[David R. Stern:]

It's a -- the labor piece is, I guess, a little bit of both, but it's more of the comp STCs. So that's really is a -- it's a comp basis in terms of the increase in the payroll, not the new stores. We did see improved overall margin -- or overhead absorption in the service and tire centers due to their comp growth.

[Michael R. Odell:]

And to address your question regarding gross margins, those are year-over-year improvements.

[Bret David Jordan:]

Okay, great. And I guess, as you look at the STC strategy, it sounds as if now it's in sort of a tipping point where it's beginning to be accretive to aggregate margin. Is -- was that not the case in Q1, given the labor?

[David R. Stern:]

No, they were accretive in Q1. It's really the payroll piece that diminished the margins. It was really in the comp stores and the Supercenters, mostly indiscernible] in the comp service and tire centers but mostly in the Supercenters.

[Bret David Jordan:]

Okay. And then on the retail promotions that you ran in Q1 that didn't work, could you give us any color of sort of what lines that were promoted or what you picked up from that, that you -- that just continued [ph] in Q2 the benefits of the retail marketing going forward?

[Michael R. Odell:]

Yes, the best example -- there's a couple of things. So the best example relative to retail was we ran some tests of -- different kinds of tests, actually, in the fourth quarter in different markets to see if we could stimulate retail demand, particularly of our discretionary products. And so in March, we ran a "20% off any single item." And basically, we got a lift in customer count, but it was erosive to margins and didn't do much for the top line. So it was intended to drive, again, the -- more the retail in general, discretionary in particular. And it just did -- it didn't work when we went national the same way it did when we did it in a single market in December.

[Bret David Jordan:]

Okay. And one last question, on capital allocation. I guess you've been locked out of a buyback until [ph] this call is completed. As you look at the CapEx and where you -- expansion of the Tampa model, what are the thoughts on the share repurchase program sort of heading into the next quarter?

[David R. Stern:]

Sure. This is Dave. The board authorized the plan in mid-December, and since that time, our shares have appreciated by about 30%. So given the share appreciation, given the early results that Mike discussed regarding the initiatives around Tampa, we're currently assessing our options regarding the use of cash. It's part of balancing, maintaining our strong balance sheet, investing appropriately in the business and, of course, looking at returns to shareholders.

[Operator:]

Our next question comes from the line of Brian Sponheimer with Gabelli & Company.

[Brian Sponheimer:]

Just a question on the retail side of the house. Talk a little bit about the promotional activity that you guys implemented in the quarter and if you expect this to be a continued drag for the balance of the year.

[Michael R. Odell:]

No. As I just responded, really, to Bret's question, a big part of it was the event that we ran in March, which just it turned out to be a bust. We were trying to -- things were soft. We were trying to stimulate traffic. We had tested it in other markets in the fourth quarter, and it worked nicely, and it just -- it bombed in March. And we're not going to repeat it. The other pressure that's not necessarily promotional, but the level of customers that are finding coupons and bringing those into the stores was higher in the first quarter than it has been, so we're going to dial back on that as well.

[Brian Sponheimer:]

Okay. And just if I'm thinking about your service categories, with everyone of them being up, with the exception of tires, that kind of goes against what you were talking about as far as brakes being -- going through a bit of a cyclical downturn right now. Can you just talk about the brakes market and what you're seeing there?

[Michael R. Odell:]

So the -- on the brakes piece, so while we were up in brakes in service, brakes was just a little bit up, not up near where the rest of the service business was up. And in terms of the cyclical nature, we see that more in our retail and our commercial business. It exists in service. I just think that we've got some offers out now with -- out there with brakes that's kind of running against that cycle, to our favor. But we definitely see it affecting the retail and commercial. Scott, did you want to add anything?

[Scott A. Webb:]

The only thing I was going to add, Brian, was, I think, when you look at the total brake business out there, others that give public commentary have experienced a decline there. I believe that our promotional activity, as well as our service activity, we believe we're taking share in the brake category.

[Michael R. Odell:]

In service.

[Scott A. Webb:]

In service.

[Brian Sponheimer:]

Okay. And I -- and just one more question, on -- just on tires, whether you -- on the branded side and the non -- and the private label, non-branded. Just talk about what you're seeing from a pricing standpoint both on the input level and what you're able to pass on.

[Michael R. Odell:]

Our margins have continued to expand. That's coming more from the cost side. But actually, it's a little bit of both the cost and the sales side. In terms of splitting that between branded and non-branded, we don't really go into that.

[Operator:]

Our next question comes from the line of Simeon Gutman with Crédit Suisse.

[Daniel Engel-Hall:]

This is actually Dan Engel-Hall filling in for Simeon. I know -- just a quick one on sort of the service. I know that, obviously, part of the customer strategy has been trying to create loyal visits in just sort of [ph] the lower-ticket services, and then, obviously, retaining those customers. At this point, is that something you're seeing -- are you seeing most of those customers sort of transition to heavier work? Or is that more of a tailwind you'd expect just later on as vehicles start to age?

[Michael R. Odell:]

It's really -- it takes time to measure that. So I think we see signs of that because we have been feeling pretty good about our maintenance and our repair business, but it takes a year to see that, those trends develop.

[Operator:]

[Operator Instructions] Our next question comes from the line of James Albertine with Stifel.

[James J. Albertine:]

Just a quick sort of housekeeping item on one of your comments, talking about the sweet spot, 5- to 13-year-old cars. Can you give us a sense of which end of that spectrum is growing more rapidly as you see this sort of inflection, as it were from the past few years of deferred maintenance?

[Michael R. Odell:]

Well, what'll -- well, it's not really from the deferred maintenance. It's the cars in the pipeline. So we see, the declines right now is those cars at the front end of that 5- to 13-year old, right, because when new car sales declined in '08 and then '09, and then they've grown into '10, '11 and '12 -- it's those '10, '11, '12 they've grown -- that's grown roughly $1 million a year. As those start to hit the 5-year-old spot in, I guess, 2015, '16 and '17, that's when the tailwind starts to come in, at the front end of that 5- to 13-year-old cycle.

[James J. Albertine:]

Okay, so it's sort of taking the fight on [ph] from the reduced new car sales in '08 and in '09. But trying to get a sense for our people working on cars that are older, saying it another [ph] way maybe, older cars that you probably wouldn't have worked on in the past but are starting to put more money into service and maintenance.

[Michael R. Odell:]

I think what we see is that, when the cars are newer, people spend money to keep their cars in -- right, the people with younger cars tend to drive their cars more than the people with older cars, so there's greater frequency of service. Plus, they have -- they're more likely to keep up on their maintenance, and so there's more maintenance to be done in the cars in our sweet spot and in those early years. As cars get to that 10 years and older, that's when it -- it's in that phase that they start to shift from maintaining their cars and deferring maintenance, but they get more into the repairs because things are breaking and they need to fix it to keep the car running.

[James J. Albertine:]

Understood. And then, if I may, on the Tampa market, just to dig in a little bit, just trying to get an idea of how replicable that pilot program is throughout the rest of your portfolio. And is there something about maybe Tampa real estate or something sort of unique to the Tampa market that we should consider? And then separately, I think you said, just from some initial -- some personnel changes and some initial readings, it looks like sales was up mid single digits, if I heard you correctly. Just trying to see if that's more of a retail-driven surge, or is this sort of more of a service-led sort of improvement, if you will.

[Michael R. Odell:]

Yes, let's see if I can remember all the questions. It is the result -- the result is more service led. I mean, it's helping both sides of the business, but it's definitely focused on it and more helpful to the service. There is -- we did the whole process in terms of selection of people and teaching them on how to serve -- how to build rapport with customers. As so we -- definitely, we see a positive lift just from the personnel changes, but it's much more significant when we add the physical elements to the personnel changes. In terms of Tampa, one of the reasons we've picked that market is because there's a diversity of our store base down there in terms of the types of neighborhoods that those stores are in. And the reason we believe that it's going to be replicable is that West Hillsborough is actually below average in terms of kind of the demographic around that store, relative to that portfolio. So we didn't pick, like, the best store and the best area to go do this. We picked a store kind of in the lower half, not at the bottom but the lower half, of kind of that demographic, which gives us, I guess, confidence that if it works in that, then it'll work as we trade up to the higher-demographic stores.

[Operator:]

Our next question comes from the line of Ronald Bookbinder with The Benchmark Company.

[Ronald Bookbinder:]

You talked about the POS discounting, or the coupons. It seems like, coupons, more people use them. So coupons were bringing people into the store. Were they new customers? Or were they just existing customers using a coupon?

[Michael R. Odell:]

We're seeing a higher penetration of new customers. I mean, there's some of both, but there's more new customers coming in as a result of that. But they are also being used by existing customers.

[Ronald Bookbinder:]

So when you say you're going to cut them, going forward, are you talking about a -- just reducing the volume of coupons out there, or just reducing the value, or...

[Michael R. Odell:]

I think the 2 biggest pieces are, obviously, looking at the relative payback of the different coupons and perhaps reducing the value of some of them but then also making sure that they don't -- that they're not getting abused. And that obviously becomes a store controllable.

[Ronald Bookbinder:]

Okay. And on the promotion of different items in the retail store, was that 20% off? Was that a onetime -- was that just one item?

[Michael R. Odell:]

Correct. It was a single item, with the idea being that they either trade up to -- start to build the basket or trade up to the higher-value items.

[Ronald Bookbinder:]

Oh, and they didn't build the basket, they just came in, bought the one item and left.

[Michael R. Odell:]

More or less, yes...

[Ronald Bookbinder:]

And that was a coupon also?

[Michael R. Odell:]

It was a coupon, yes, but it was generally available to everybody that came in the store.

[Ronald Bookbinder:]

So it was in, like, a flier when you walk into the store and [indiscernible] pick-up...

[Michael R. Odell:]

Correct, correct.

[Ronald Bookbinder:]

All right. Well, it's nice to see the comp side turning back positive...

[David R. Stern:]

Yes, we needed margin to go with it.

[Operator:]

Mr. Odell, there are no further questions at this time. I'd like to turn the floor back over to you for closing comments.

[Michael R. Odell:]

All right. Well, thank you, everybody, for your time and interest in Pep Boys. We're excited about our road ahead. And we look forward to talking to you again after the second quarter.

[Operator:]

That concludes today's teleconference. Thank you for your participation. You may disconnect your lines at this time.