Party City Holdco Inc.
Q2 2017 Earnings Call Transcript

Published: 6 Aug 2017

[Operator:]

Good morning, my name is Emily, and I will be your conference operator today. I would like to welcome everyone to the Party City's Second Quarter 2017 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to Mr. Ian Heller, Associate General Counsel of Party City. Thank you, Mr. Heller. You may now begin.

[Ian Heller:]

Thank you, operator. Good morning, everyone, and thanks for joining us. This morning, we released our second quarter 2017 financial results. You can find a copy of our press release on our website at investor.partycity.com. Now I'd like to introduce our executive team who are here on today's call. We have Jim Harrison, our Chief Executive Officer; Dan Sullivan, Chief Financial Officer; Gregg Melnick, President; Ryan Vero, President of our retail division; and Mike Correale, Chief Accounting Officer. We'll start the call with some prepared remarks by Jim and Dan before we open it up for Q&A. Please note that in today's discussion, management may make forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995 regarding their beliefs and expectations about the company's future performance, future business prospects or future events or plans. These statements are subject to risks and uncertainties that could cause actual results to differ materially from these statements. Although we believe that the expectations reflected in these forward-looking statements are reasonable, we can give no assurance that such expectations will be realized. We expressly disclaim any duty to provide updates to our forward-looking statements, whether as a result of new information, future events or otherwise. We urge everyone to review the safe harbor statements provided in our earnings release as well as the risk factors contained in our SEC filings. During today's call, we will refer to both GAAP and non-GAAP financial measures of the company's operating and financial results. For information regarding our non-GAAP financial measures and reconciliations to the most directly comparable GAAP measures, please refer to the earnings release. And with that, I'll turn the call over to Jim Harrison.

[James Harrison:]

Thank you very much, Ian. Good morning, everyone, and thank you for joining us today. I will begin by summarizing our performance for the second quarter as well as reporting on the progress we're making against our strategic growth initiatives. Then I'll ask Dan to discuss our financial results in further detail as well as our full year guidance. The second quarter was another active quarter for our company with good progress made against our growth objectives. We delivered strong financial results, made a key strategic investment in the digital invitations business, continued the integration of the Granmark acquisition in Mexico as well as the 36 franchise stores that were acquired in Q1 and took important steps to advance our efforts to improve the shopping experience for our consumer, both in our stores as well as online. Consolidated revenues grew at just under 5% on a reported basis or 5.7% when adjusted for currency. Overall, we are pleased with the quarter, as on a consolidated basis, we met both our top and bottom line objectives despite a slightly softer than expected comp. On the retail side of our business, while cycling our strongest comp quarter in 2016, we posted a 6.7% net sales increase in constant currency and a slightly positive brand comp, reflecting continued strength in our seasonal business, and most notably, graduation. Unfortunately, weakened juvenile party basket, largely reflective of the absence of strong licensed properties, and slight declines on our solid color businesses mitigated much of the strength of seasonal. We also saw a nice increase in our e-commerce sales, which were up 6.5%. At the halfway point of the year, comp growth is a solid 1% year-over-year. More on our retail businesses in a moment. The consumer product businesses reported net revenue growth of 1.8%. This is a very solid performance in light of the continued foreign exchange headwinds as well as the significant impact of eliminating previously recognized franchisee sales as a result of the acquisitions we have made. Adjusting for these 2 factors, net revenue grew by nearly 8%, highlighted by a 23% constant currency increase in our international businesses. Q2 served as a strong reminder of the multiple levers of the top line growth that our business model enjoys. And in the quarter, we once again demonstrated the fundamental strength of our vertical model with strong top line growth, further gross margin accretion and good cost control across the businesses. All of these resulting in double-digit EBITDA and EPS growth, which Dan will talk more about shortly. Now I'd like to review the progress we made during the second quarter against some of our key strategic priorities. In our retail business, we remained focused on improving our overall selling culture and enhancing consumers' in-store experience. As I said previously, we have over 780 company-operated stores, and we believe that there is a meaningful opportunity for us to provide a much better support to our consumers' discovery process as they explore our unmatched depth of product assortment. In addition, we believe that we can improve our store operations, which will make our stores easier to shop for our consumers and easier to operate for our associates. As traffic levels further stabilized in Q2, following similar results from Q1, our comp store sales results for the quarter underscores the importance of retail focus initiatives that are already underway. These efforts are aimed at simplifying many aspects of our store operations in order to redirect more of our associates' time and attention to customer-facing activities. Improved in-store efficiency will enable this reinvestment and our broader evolution into a more customer-focused selling organization. Dan will cover the impact of these initiatives during his comments. Complementing our store operations' initiatives are opportunities to enhance our product merchandising. We are focused on improving our offering, tailoring our assortment of strengthening product adjacencies and in-store signage with primary focus currently in our solids business. We want to facilitate greater easy shopping, better communicate both the quality and value we offer and deliver even more compelling product assortments to our consumers. These improvements will be better reflected in our mounting campaigns, where, following our recent appointment of Hill Holliday, we will be creating more of an emotional connection for our customers around events and life celebrations through a combination of social, digital as well as traditional advertising. This overall commitment to improving our customer experience also extends to our online businesses, where we are strengthening our overall digital platform. In the quarter, we deployed full store inventory availability checks and finalized our preparation for buy online, pick up in store, which we will be piloting later this month. Increasing our relevance to the consumer in the digital space is a key enabler of our growth strategy, and I will touch upon several of our specific digital initiatives shortly. Moving on to - for a moment to our consumer products businesses, which, as most of you know, is a key competitive differentiator for us. We have a number of recent successes to discuss. Expanding our share of shelf and, most notably, our manufactured share of shelf continues to be core to our strategic plan and separates us from other retailers by fueling gross margin gains as it expands our share of the value chain. In the second quarter, we increased our manufactured share of shelf metric to over 25%, up almost 100 basis points over the same period last year. Growing our manufacturing competencies uniquely positions us to continue to enhance our gross margins while also developing innovative products that can serve broader consumer markets. We refer to these growth opportunities as our alternative markets business. By virtue of our unequaled national footprint as a party specialty retailer and our high unaided brand awareness, we enjoy an unparalleled position when consumers are planning an in-home celebration. As consumers continue to seek experiential celebrations, both in and out of home, our alternative markets activities will position us well to participate in these, generally, out-of-home celebrations. While still a relatively small component of our consumer products businesses, we are excited by the double-digit growth performance of our alternative markets business during the quarter. In Q2, we showed continued strength in international wholesale growth with sales up 70% on a reported basis and, as I mentioned earlier, 23% in constant currency. This growing consumer awareness and acceptance of the category reinforces our growth outlook. In Q2, we saw double-digit growth across the U.K. and Australia, demonstrating our strong retail partnerships with retailers such as the BIG W and Morrison's, just to name 2. Pursuing accretive acquisitions, which expand our core capabilities and geographic reach, continues to be a core competency and key growth driver. The integration of the Granmark acquisition is going very well and is ahead of schedule. We have already moved production of a portion of our letter banner requirements, which were previously sourced from third-party factories in Asia, to our own Mexican facility. Over the next year or so, we will look to add other categories, such as invitations and cutouts, taking advantage of both the favorable economics that our own manufacturing provides as well as increased speed to market that this acquisition offers. Just recently, we also announced the acquisition of Print Appeal, providing us entry into the highly attractive and profitable personalized products business. Although a relatively small acquisition, we are very excited about the opportunity it creates and the platform it offers in both personalization and products. Ultimately, it adds either promotional or products or through our own retail distribution. This is another example of the attractive growth avenues which exist for our consumer products business outside of traditional party retail channel. And finally, our digital initiatives. In addition to the improvements to our digital platform that I mentioned earlier, we continue to grow our portfolio of digital assets, as you saw from the recent announcement of our minority investment in Punchbowl, a technology platform leader for online invitations and digital greetings. The digital platform, that is now available on partycity.com, provides our customers unlimited choices to personalize their online invitations and greeting cards, even enabling their invitations and parties to be seen from beginning to end, including a full assortment of licensed characters. We are very pleased to gain entry into the invitation space as it provides us exposure to the party thrower earlier in the party planning process and outside of our traditional party's goods and decoration businesses. It also reinforces our overarching strategy to continue to gain share of the party wallet. In support of the strategy of gaining share of the party wallet, last quarter, we announced a partnership with venture capitalist firm Ampology to develop Kazzam, an online marketplace where party hosts can choose from a full spectrum of vetted service providers for party activities and entertainment as well as to order party supplies. Kazzam, much like Punchbowl, expands our digital assets and will connect us with the party host earlier in the party planning process. Like Punchbowl and Print Appeal, Kazzam will help us meet the growing consumer need for especially unique party celebrations and experiences. We are working on the launch of an initial pilot in the test market of Dallas with [indiscernible] acquisition efforts just beginning. It is certainly too early to get into the more detailed and specifics of our pilot, but we're excited to be building out our digital capabilities and better leveraging our powerful Party City brand across many channels. And I will have more to say on this business in the coming quarters. So in summary, it was a good quarter, which was largely in line with our expectations from an overall top and bottom line perspective. While retail comps were slightly softer than forecasted, which we have reflected on our updated full year comp outlook, we are very pleased with the underlying strength in our vertical model and our resulting profitability. Given our first half performance, we're on track to deliver on our previously provided full year net sales and earnings guidance. We continue to progress against our key initiatives and look forward to updating you on our Q3 call. Before handing the call over to Dan, a few words on Halloween. I am extremely pleased with our overall readiness, and our product availability and in-stock position will be strong. Our Party City stores and temporary Halloween City stores will be well prepared for the holiday, and we'll have ample labor to ensure that we meet the needs of our consumers leading up to and throughout their Halloween celebrations. Our new advertising campaign will also be launched in conjunction with Halloween, and I'm confident that it will resonate well with the consumer. This is, of course, a meaningful event for our business, and our dedicated team of associates are committed to making it a successful holiday. And now I would like to turn the call over to Dan to discuss our results in more detail and our full year guidance.

[Daniel Sullivan:]

Thanks, Jim, and good morning, everyone. I'll provide further insight on our financial and operating performance for the quarter before discussing our outlook and guidance for 2017. And then we'll open up the call for questions. As Jim said, we're pleased with our overall second quarter top and bottom line financial performance, driven by continued execution of our business fundamentals, strong top line growth, further gross margin gains, good cost control and strong cash flow generation. In the quarter, we grew consolidated revenues 4.9% to $544.9 million or 5.7% growth when adjusted for currency. We expanded our gross margin rate by 50 basis points on a constant currency basis, grew our adjusted net income by almost 18% and delivered adjusted EPS of $0.28 per share. We also generated over $77 million in free cash flow, up 12% year-on-year. In our retail segment, sales increased 6.3% on a reported basis or 6.7% in constant currency, largely result of growing our retail square footage over 6% in the first 6 months of this year and almost 12% over the last 12 months, primarily through franchise acquisitions and new store growth. At quarter's end, our store network totaled 936 stores, 789 of which were corporate stores as we opened 5 new stores, acquired one independent store and closed one company-owned store during the quarter. We were also active in optimizing our existing fleet of stores, completing 7 relocations and 9 remodels in Q2. As mentioned, our brand comparable sales, which include our U.S. and Canadian permanent stores and our North American e-commerce business, increased 10 basis points in the quarter, which was on top of a 3.8% growth rate last year in Q2. As foreshadowed last quarter, the Easter shift did not have a material impact on our comps for the quarter. Transactions were slightly positive, a continuation of the Q1 trend, and strength in our seasonal and balloon categories was largely offset by sluggish performance in certain everyday categories. In Q2, our seasonal business is comprised largely of Easter, summer and graduation, all of which performed well for us with graduation being a key highlight. The slightly softer everyday business is primarily attributable to our juvenile birthday and solids categories. As mentioned, we saw continued strong growth on our metallic balloon business as our customers continue to respond well to our product innovations and line extensions. Our North American e-commerce sales increased 6.5% in the quarter, which we were pleased with, especially in light of last year's highly successful introduction of our party kits, which were well received by our customers and helped deliver a 17% comp sales increase in Q2 of last year. In the quarter, we're also encouraged by the solid underlying performance of our web business, including a 2% increase in visits and double-digit growth in customer conversions. With our year-to-date comp growth of about 1%, we are pleased with the overall first half performance and also recognize the opportunity to improve. You've heard us discuss the need to enhance the shopability of our stores, create a more customer-friendly and service-oriented shopping experience and increase overall associate customer engagement. During the quarter, we began piloting certain in-store operational processes and initiatives, all of which are designed to simplify store operations and help our associates to run better stores. Initial results are positive, and we will expand our pilot to a further set of stores for deeper evaluation. We also began to test enhanced selling activities in select pilot stories, where we added labor and focused on comprehensive selling skills training and deploying broader selling tools and in-store technology for our associates, all in an effort to enable our associates to generate ideas and harness creativity and inspiration in the party planning process with our customers and then utilize our full breadth of product assortment to meet the customers' needs. Although it's extremely early in our pilot process, we are encouraged by the initial results, which support our belief that focused selling and increased customer engagement offers us a significant opportunity to generate sustainable basket growth. Turning to our non-vertical consumer products business. Total revenues increased 7.8% after adjusting for foreign currency and the elimination of $5.6 million in sales due to the acquisition of 36 franchise stores since April of last year. International sales rose approximately 23% on a constant currency basis, driven by a combination of strong organic growth across our key markets as well as the recently announced Granmark acquisition in Mexico with notable double-digit growth in the U.K. and Australia. In both of these markets, our strong national retailer businesses, in part driven by our expanding store-in-store concepts, fueled our results. Our consolidated gross profit margin was 40.6% or 30 basis points above the same quarter last year. And on a constant currency basis, our gross profit margin increased 50 basis points. This was driven primarily by 150 basis points increase in share of shelf to 78.5% as well as the positive mix shift associated with our metallic balloon's growth and was partially offset by increased promotional activity in our retail business. Importantly, our manufactured share of shelf grew almost 100 basis points in the quarter to over 25%, a reminder of the inherent strength of our vertical model and the opportunity that remains to further increase our gross margins by fully leveraging our existing manufacturing assets. In the quarter, we remained disciplined in our cost management. Operating expenses included $6 million of Kazzam startup costs. And excluding these costs, our expenses were well leveraged, decreasing 90 basis points in rate of revenue versus Q2 of last year. More specifically, retail operating expenses decreased 150 basis points in rate as a percentage of our retail sales as we accelerated our efforts to increase store productivity and simplify store operations while also realizing the benefits of the recently announced restructure. We also saw lower advertising expense in Q2 as we better balanced TV and digital advertising and shifted our media focus to Q3 and our new campaign ahead of Halloween. Our adjusted net income of $33.3 million represents growth of 17.6% and margin growth of 60 basis points. Adjusted EPS was $0.28 per share, an increase of almost 17% versus last year and almost a 25% increase when excluding the startup cost associated with Kazzam. Our adjusted EBITDA increased 13.5% to $96.5 million or an increase of 130 basis points versus last year in rate. During the quarter, we delivered free cash flow, defined as adjusted EBITDA less CapEx, of $77.1 million, an increase of over $8 million versus the second quarter of last year. Cash flow from operations was a source of $72 million, and working capital was a source of $17 million in the quarter. CapEx totaled $19.4 million while we allocated $17 million towards debt pay down and $8 million towards acquisitions. We ended the quarter with net debt of about $1.7 billion, resulting in a debt leverage ratio of 4.1x. And at the end of the quarter, we had approximately $329 million available on our existing asset-based revolver. Looking to our full year guidance. As Jim mentioned, our business model is uniquely built on a diverse stream of revenues and multiple profit levers. As such, we continue to expect revenue for 2017 to be in the range of $2.35 billion to $2.45 billion. Comp sales growth is now expected to be approximately 1%. We continue to project full year adjusted net income of $148 million to $158 million or $1.23 to $1.30 per share. We still expect adjusted EBITDA to be in the range of $400 million to $417 million. As I mentioned, we are working on initiatives, many of which are well underway, to drive sustainable top and bottom line improvement as we focus on enhancing our customer experience, maximizing our asset base, leveraging the strength of our brand and eliminating waste across our business. The financial impact of these efforts in 2017 is minimal and is reflected in our full year guidance. Finally, we continue to expect our debt leverage at the end of 2017 to be approximately 3.5x. For all other detail around our outlook, please refer to our press release. And with that, I'd like to turn the call back to the operator and open it up for questions.

[Operator:]

[Operator Instructions] And your first question comes from the line of Simeon Gutman from Morgan Stanley. Your line is open.

[Simeon Gutman:]

Good morning, guys. I wanted to first ask about profitability. There was a nice improvement this quarter, and you mentioned some of the drivers, share of shelf and then manufacturing. I guess big, big picture, can you tell us - are we seeing some more lag effects here from verticalization? This quarter, the share of shelf actually was up less than it was last quarter, yet the margin improvement was better. And then related to that, is the run rate of margin that we're seeing, is it still understated in that there's more upside to reflect some of the acquisitions and some of the benefits from verticalization that you've made in the past, let's say, year?

[Daniel Sullivan:]

Simeon, it's Dan. Yes, I think the - Q2 is a pretty good proxy for the strength of the vertical that we see, right? So gross margin gains, which were about 30 basis points in the quarter, 50 basis points, excluding FX, come from a number of different levers, one of which you mentioned, which is share of shelf. And no, I don't think there's a lag effect here. I think we have to remember the importance of separating total share of shelf from a really important driver, which is manufactured share of shelf. And there, we saw about 100 basis point improvement Q2 this year over Q2 last year. We also saw the structural benefits of work we've done in our sourcing organization to improve our cost base there. So I think what you saw financially in the quarter, which was revenue growth, which was gross margin accretion and which was good cost management, both in our retail business and in our wholesale business, is a really good proxy for how we think about the business and how we think about the year.

[Simeon Gutman:]

Okay. And then my follow-up, maybe tied into it, is for the back half of the year. If we extrapolate some of the margin gain that's occurred in the first half, it would imply that the holding the guidance for the full year on EBITDA would imply that there seems like there's a step-up in investment spend. Jim mentioned some investment around Halloween. I couldn't tell if that's incremental to the prior year. But I think the key question based on this guidance is, are you being conservative here and prudent? Or are there - are expenses going to ramp in the back half?

[Daniel Sullivan:]

No, I wouldn't categorize the guidance as prudent or conservative. I think the way - you have to remember that the second half of the year, for us, economically, plays out very differently than the first half, obviously, because of Halloween. So the only thing that I would point to as increased investment half 2 over half 2 last year is in our advertising campaign, and Jim talked about - we're excited about the Hill Holliday campaign. We did defer some of our advertising spend that you would've seen last year in Q2 around summer and graduation. We're going to put that behind Halloween and the new campaign. That would be the only point that I would mention that would look different year-over-year.

[Simeon Gutman:]

Okay, thanks.

[Operator:]

And your next question comes from the line of Stephen Tanal from Goldman Sachs. Your line is open.

[Stephen Tanal:]

Hey, good morning, guys. Thanks for the question. So love to understand a little more about how you guys view e-commerce playing into your business. How are customers using the website today? And what are sort of your high-level expectations for buy online, pick up in store? Is that - how should we be thinking about that?

[Ryan Vero:]

It's Ryan. From a customer perspective, our customers use the website for a number of different things. Obviously, there's the transactional piece of it. But also, customers are using it to find ideas and inspiration for their parties, which we do a lot of content work on to represent products in a unique way so that they can create that unique experience for their party. As it evolves around buy online, pick up in store, we launched over the last couple of months the ability to see store level inventory on the website, and customers have been using that very frequently before they come into the store, make sure what they want is in the local store. And we're just now piloting the buy online, pick up in store piece of it. I think from a perspective of how that's going to evolve, we're going to see. We're early in testing it. Our customers have been very pleased that we're bringing that to them. They've been asking for it from us. And it really does present some unique opportunities to do things online with categories like balloons that we have not had previously without them being able to pick them up in store.

[Stephen Tanal:]

Got it. That's helpful. And switching gears for a second to think about vertical integration for a moment. The opportunity of moving products from doubles to triples, as we've talked about that in the past, where are the gains coming from more recently in - category-wise? And where is the most opportunity still?

[James Harrison:]

Sure. This is Jim. Some of the gains really - as we've mentioned, our balloon business, our metallic balloon business is very strong, and obviously, we manufacture 100% of those. We're also having some - starting to see some gains now in the ACIM product line as we're starting to ramp up the production there and gaining some real traction in terms of getting to a steady state in terms of both product. And as we look going forward with the Print Appeal acquisition, we should see some substantial gains there by increasing our capabilities to offer to the consumer personalized product across multiple formats with the ability that Print Appeal brings us. And lastly, as I mentioned in my earlier remarks, we've begun bringing from Granmark a product to be manufactured in Mexico that we previously sourced from Asia. So it's really a combination of all of those pieces coming together. And as Dan mentioned, we see that continuing to grow over the next several years, not just in the second half, as we ramp-up Print Appeal, as we continue to ramp up Granmark, as we continue to ramp up ACIM. And there's no sign that our balloon business isn't going to continue to be very strong. So we see an opportunity for us to continue to have those gains.

[Stephen Tanal:]

That's helpful, thank you, guys.

[James Harrison:]

Take care, thanks.

[Operator:]

Your next question comes from the line of Matt McClintock from Barclays. Your line is open.

[Matthew McClintock:]

Hi. Good morning, everyone. Jim, I was wondering if we could talk about personalization for a second. It seems like you've been making a lot of moves in that specific direction. And as you think about the longer-term opportunity and where you want to be across your product categories, where are some of the holes in personalization or specialization, customization that you currently don't offer that you see bigger opportunities maybe in the future where you can go into?

[James Harrison:]

I think personalization is a pretty broad term. Let me try and answer your question by talking about the evolving consumer. The consumer is evolving, particularly millennial consumers, evolving to a very much of an experiential consumer, right? They're going to have parties, they want to have parties, but having a unique party, having experience around their party, having something that they can capture with a photo, with a memory and put on Facebook or Instagram or Twitter or wherever they want to go in social media and being able to satisfy that need for uniqueness, customization and personalization is one piece of that. Obviously, what we do in Halloween and mix it, match it and make it your own, creating a unique customer experience is part of that. So really, the ability to make someone's party an experience, not just a party, it's really what - where the consumer's headed, and that's what we're looking to stay in front of.

[Matthew McClintock:]

And Dan, just one quick follow-up. I'm not sure if I missed this. You brought the comp down for the full year. What part of your business are you bringing up to offset that decline to hold your full year guide for revenue at flat?

[Daniel Sullivan:]

Yes. So I think - well, the full year guide on revenue is obviously more than comps, right? So we have the new store growth and we have the franchise acquisitions playing a big part. As we think about second half comps, obviously, in principle, we think it'll be largely in line with what we've seen in the first half with a little bit of noise, as we've talked earlier around New Year's Eve and that shift. I think the second thing - then as we look at the back half of the year, we think that we'll see improvement in our solids business and many of the initiatives that Ryan has taken up with the team in retail around in-store merchandising and communication and signage. We also think juvenile birthday category will improve, as you heard Jim mention in his upfront, in large part driven by some attractive properties that come up in the second half of the year, namely Cars 3 and Despicable Me 3 and Spiderman, to name a few. So that part, we think - the second half of the year, we'll see improved performance. And then obviously, Halloween, in and of itself, while we don't see a major catalyst for change when - in the adult costume business when it moves from Monday to a Tuesday, we will be in really good inventory position for the holiday. We'll have ample labor in the store to execute, and we're excited about the Hill Holliday campaign and the connection we'll make with the consumer.

[James Harrison:]

And then also I'd also add that our international business, as we mentioned in the first half, was very strong. And our consumer product business is putting up some pretty solid numbers as well. So I think as we look at consolidated revenues, taking into account the full vertical model, really keeps the guidance in the same - pretty much the same place.

[Matthew McClintock:]

Thanks a lot, I appreciate the color.

[Operator:]

Your next question comes from the line of Rick Nelson from Stephens. Your line is open.

[Richard Nelson:]

Thanks, good morning. I'd like to follow-up on Halloween. Amscan, your wholesale operation appears any early read you get through them on the Halloween season?

[James Harrison:]

It's kind of early, early for that. I think the read that we've gotten is pretty much consistent with what we said last year about Halloween, which was we don't believe that we lost any market share. As we look at the orders we've gotten from third-party customers on Halloween, it would be indicative of the same sort of lower buy, representing a higher carryover that we experience in our own stores. So I think - I guess the best read we get is that what we felt last year in terms of not really losing any significant market share appears to be based upon the amount of reorders we're getting or the new orders we're getting with respect to this Halloween. From a consumer standpoint, it's way too early to even talk about Halloween.

[Richard Nelson:]

Okay. Also, the manufacturing share of shelf, you're at 25% today. You've got this long-term goal of 50%. I'm curious, how much of that can be accomplished with your existing manufacturing operations? And how much do you need to acquire in order to drive that?

[James Harrison:]

It's a great question, Rick. Right now, I would say we - based upon the current configuration of product, right, we're in the 40 - little bit north of 40% range, based upon our current capabilities. Now - and I say based upon the current configuration, because I'll be honest with you, if you asked me 3 years ago is our balloon business going to be up as substantial as it's up metallic balloon business, honestly, it was a business that I personally viewed as being a fairly mature part of our business, and yet, we've had tremendous growth in it. So when we get tremendous growth in something that we're vertical in, that changes the overall product mix that we're selling at the store level. So it becomes a little bit of a dynamic shift. But based upon the current product mix and based upon our current capabilities, we're somewhere north of 40% in terms of what we could do. So within what we have right now, we have the ability to go from 25% to north of 40%.

[Richard Nelson:]

Okay. Also, the pipeline, if you could comment there. Many of your acquisitions have been in the digital arena. Do you see that continuing or significantly more manufacturing-type operations?

[James Harrison:]

I think - my personal view is I think we've been pretty balanced on our acquisitions in terms of acquiring franchisees, acquiring manufacturing capability as well as building out our digital capabilities. I think we'll continue to build out our digital capabilities the way we have, organically, where possible, through acquisition, where necessary. Additionally, with respect to franchisees, we will continue to acquire franchises. We see that as an attractive use of capital for our shareholders. And with respect to manufacturing assets that we've acquired, we're at the stage now, I believe, where we're probably going to look to integrate those as best we can and look to move that 25% to 40% as opposed to being particularly aggressive on the acquisition manufacturing assets at this stage of the game.

[Richard Nelson:]

I got you, it makes sense. Thanks a lot and good luck.

[James Harrison:]

Thank you, Rick.

[Daniel Sullivan:]

Thank you, Rick.

[Operator:]

Your next question comes from the line of Mike Baker from Deutsche Bank. Your line is open.

[Michael Baker:]

Thanks guys. A couple of questions on the same-store sales. So first of all, are you changing your back half outlook on same-store sales at all? Or is the reduction in the full year comp outlook just simply the underperformance in the second quarter?

[Daniel Sullivan:]

Yes. It's largely the underperformance of the second quarter. There's a bit of timing that we've looked at in Q3, Q4, but we haven't overall changed our outlook for the back half of the year.

[Michael Baker:]

Okay. And so then remind us, you have a much easier comparison in the fourth quarter, a more difficult comparison in the third quarter, but then again you have the New Year's Eve shift you talked about. So within that sort of 1% for the back half, I mean how should we think about the 2 quarters versus each other?

[Daniel Sullivan:]

Yes. I mean, we're not going to necessarily get into guidance at the quarter level, but you're absolutely right. You sort of hit on the key points, right? So we were about a plus 1.2% Q3 of last year, and then we obviously had the negative Q4. And we've talked a lot about that due to the Halloween shift. So as we think about the back half of the year, we obviously have that factored into our growth algorithm as well as the impact that New Year's Eve will now largely shift out into 2018.

[Michael Baker:]

And so I guess another way to maybe ask this, typically, when you see - typically, how big can that New Year's Eve shift be, in particular, relative to a Halloween shift going from a weekend to a weekday?

[Daniel Sullivan:]

I don't know that I would compare the 2, just out of absolute magnitude and the size. What we said...

[James Harrison:]

That's a Chihuahua to a racehorse.

[Daniel Sullivan:]

What we did say when we gave our initial guidance is that we felt like it was probably anywhere from 25 to 50 basis points for the year would be the impact of the New Year's Eve shift.

[Michael Baker:]

Okay. So we can do some back-in math there. But then last question, in the quarter logistic curve. Any color on the trend by month? And I guess graduation being strong, that probably means, basically, a May business or a June business. Just go through the trend through the month.

[Daniel Sullivan:]

Yes. I mean, I'm not going to get into the monthly breakdown. I think I would say you hit it right. The graduation business was a call-out for us and so obviously, timing-wise, that's going to play in certain months in the quarter. There wasn't tremendous variability month-over-month, but I'm not going to get into the specifics.

[Michael Baker:]

Okay, helpful. I appreciate the color. Thanks.

[Daniel Sullivan:]

Thank you.

[Operator:]

Your next question comes from the line of Joe Feldman from Telsey Advisory Group. Your line is open.

[Joseph Feldman:]

Yeah, hi. Good morning, guys. Thanks for taking my question. So wondering if - I know in the past, we've talked about an effort you guys have been making with event venues, concerts, ballparks, different things like that and movie theaters. Any update you can share with us about that progress through the quarter?

[James Harrison:]

Sure. As I mentioned in my comments, alternative markets business was up double digits. It'll be - it's still small relative to our total volume, but it was up double digits, and we continue to make good strides.

[Joseph Feldman:]

Got it. Sorry, I missed that comment.

[James Harrison:]

That's quite all right.

[Joseph Feldman:]

Also, wanted to ask, I know it's still in test mode, but some of the changes you're making in the store from an operational standpoint and even labor adjustments. Wanted to better understand maybe the cost to do that, if there is going to be this incremental expense if you guys roll it out to all stores at some point. Should we - is that something we need to think about?

[Ryan Vero:]

This is Ryan. I'll take the first crack at that. From a cost perspective, no, there's really not a material cost involved in some of the initiatives that we have underway. A lot of our focus is around looking at opportunities to create operational efficiencies in the stores, in many ways, to turn our associates around to engage and interact with customers. So we have a number of initiatives going on in pilot mode right now, fairly early in the process. We'll be rolling out the simple ones as we prove them out in our tests and, obviously, taking a more thoughtful approach on some of the more material ones that - or more material in nature that impact the stores and, obviously, waiting through the Halloween season before we do anything like that.

[Joseph Feldman:]

I understood. Thank you. Good luck this quarter, guys.

[Ryan Vero:]

Thank you.

[Operator:]

Your next question comes from the line of Karru Martinson from Jefferies. Your line is open.

[Karru Martinson:]

Good morning. Just so we're clear on the Halloween advertising campaign. It sounds like it's more of a shift than a step-up in spend. Am I hearing that correctly?

[Daniel Sullivan:]

In terms of total spend. So I think it's a lot of things. I think it's certainly a shift in prioritization of dollars around the Halloween event. I think it's a change in media execution between digital advertising and pure traditional TV. And I think we will, because of the work Hill Holliday has done, we've gotten more efficient. And so we'll have more working dollars for us than nonworking dollars relative to nonworking dollars than we've seen in the past.

[Karru Martinson:]

Okay. And then when you look out in terms of the temporary store fleet, how has site selection gone this year, availability and pricing?

[Daniel Sullivan:]

Sure. From a site availability, not - surprisingly not as big a change from last year as you would anticipate when you read the headlines of all the retail stores closing. Part of that, the nature of the types of stores that have been closing. There are obviously geographic opportunities that do present themselves differently year-over-year. But it's been fairly comparable to what was experienced last year, maybe a little bit better.

[Karru Martinson:]

Okay. And just lastly, in terms of the labor costs. As you see minimum wage laws being implemented, what's the outlook here near term for labor expenses?

[Daniel Sullivan:]

Yes. So our labor costs obviously factor in the minimum wage, and we've already obviously moved to minimum wage in those states that require it. I think what you see us doing, which I think is just good retail practice, is countering wage inflation with running better stores, as Ryan has talked about, and making efforts to take cost and waste out of the stores. I think the added piece that Ryan and the team are taking on is then to find ways to reinvest that labor back into the selling activities. So we don't see material headwinds due to minimum wage movement in the near term, but that's largely based on the efforts Ryan and the team are taking to run better stores and take cost out.

[Karru Martinson:]

Thank you very much, guys. I appreciate it.

[Daniel Sullivan:]

Thank you.

[Operator:]

Your next question comes from the line of William Reuter from Bank of America. Your line is open.

[William Reuter:]

Good morning, guys. I'm wondering - with the general expectation that the amount of retail square footage out there over the next handful of years is likely to decline, I'm wondering if it's changed your perspective on the ultimate store growth opportunity here and what we would expect to see in terms of openings over the next couple of years.

[James Harrison:]

I think - this is Jim. I think as we look at the marketplace and we look at our place at retail being a destination shop and having the broad assortment of product we have and the sort of environment that the consumer likes to come to our stores and see all the options and see all the product and see the product, interact with other products in the planograms, I think our expectations, in terms of aggregate store opportunity, continues to be in the 300 store range as new white space. The mix of white space versus franchisee acquisitions or independent acquisitions may move around a little bit as we look at the opportunities that might exist right now in retail, particularly for acquisitions at the franchisee or independent level. So the mix may change. But the ultimate endgame, in terms of the opportunity, remains the same.

[William Reuter:]

Okay, that's helpful. And I guess following up on that, can you talk a little bit about what you're hearing from your franchisees in terms of their performance and I guess if we might expect to see an acceleration of the acquisition of some of those as you might operate them better than they do?

[James Harrison:]

Sure. Let me speak to the broader independent market, which I'll throw franchisees in, in that bucket because as you develop to being the #1 supplier to the market, we have pretty good visibility as to what's going on at both the independents as well as the franchisees. And what we see is that whereas our comp is roughly a 1% as Dan said, most of them are comping in the negative 3% range, 3% to 4% negative comps, which I believe is indicative of perhaps some cash strain they may have as a result of the high carryover of inventories from Halloween, more so than loss of market share. It may just be more inventory position than market share. But nonetheless, I think it creates an environment for us where there's probably a more willing audience to have the conversations around acquisition.

[William Reuter:]

Okay. And then just lastly, you expect to end the year with leverage around 3.5x. Can you talk to us a little bit about what your expectation or plan is for leverage going forward, not just the free cash?

[James Harrison:]

Sure. We'll be - like I said, as Dan said, we expect to be in 3.5x range this year. Barring any significant expenditure for an acquisition, but just maintaining the template of acquisitions we've had over the last several years, we would expect to be in the 3x range by the end of next year, somewhere in that ballpark.

[William Reuter:]

Great, that's all for me. Thank you.

[James Harrison:]

Thank you.

[Operator:]

Your last question comes from the line of Geoffrey McKinney from Deutsche Bank. Your line is open.

[Geoffrey McKinney:]

Hey, good morning. Thank you. To follow on, on both question on storefront, can you give us a sense of how the 2017 vintages are doing compared to, say, 2015 and 2016 in light of the kind of the weaker comp in this quarter? Any uplift in the new stores that you've opened this year?

[James Harrison:]

It's really - it's pretty early to tell. We're 6 months into the stores, at the longest, and a couple of months at the shortest. And so it's a little too early to tell. I think we find our model still works. Our predictive model with respect to new store performance, the stores are performing in line with the model. So there's no dramatic shift of our expectation vis-à-vis the model.

[Geoffrey McKinney:]

Okay. So kind of the model as it relates to how 2015 and 2016 started for those stores. And then maybe I missed this and apologies if I did, but can you give us a sense of any concessions you're potentially seeing on the rent side, given your continued focus on expanding the store footprint, and what that might look like, given the overhang in retail square footage?

[Ryan Vero:]

Yes, sure. I mean, obviously real estate is a local issue. But as a sort of a broad general statement, there are opportunities for us to leverage the position we're in, which is a retailer that's growing stores and with a healthy financial picture that allows us to have good leverage when we're renegotiating leases with our landlords. So yes, it's been a good position for us to be in.

[Geoffrey McKinney:]

Can - is there any way to kind of - any kind of quantification of the concession you're seeing as it relates to rent or what kind of benefits you're seeing?

[Daniel Sullivan:]

Yes. I mean, we don't quantify the economics of it. I think maybe just to take a step back, the activity that we anticipate this year in relo and remodels is in line with, if not slightly more, than what we've seen in the past, right? 50 to 60 relo, remodels in a given year; 2/3 of those, relos versus remodels. And so we remain very active, which gives a good indication of what Ryan and the real estate team are seeing in the market. But we don't actually get into quantifying the terms and the economics.

[Geoffrey McKinney:]

And last one, you indicated rolling out a pilot for the buy online, pickup in store. Are you expecting that to potentially be live for this Halloween season? Or is that a longer-term initiative?

[Ryan Vero:]

So we've launched it in pilot mode in a couple of stores. And we'll monitor that and make sure we work through all the operational challenges and issues that arise out of it, and then we'll make a call. But we'll certainly have at least some of our stores running during the Halloween season.

[Geoffrey McKinney:]

Thank you, guys.

[Operator:]

There are no further questions at this time. I would now like to turn the call back over to management for closing remarks.

[James Harrison:]

Sure. Thank you, operator. Once again, everyone, thank you for joining our call. And as always, we remain available, Dan, myself at any point in time to discuss the company or answer any questions you may have as a follow-up to this quarter. But thank you all very much, and have a great day.

[Operator:]

This concludes today's conference call. You may now disconnect.