West Marine Inc. Q3 2008 Earnings Call Transcript

Executives

Geoffrey A. Eisenberg – President, Chief Executive Officer

Thomas R. Moran – Chief Financial Officer, Senior Vice President, Assistant Secretary

Analysts

Douglas Ruth - Lenox Financial

Jeff Blaeser - Morgan Joseph & Co., Inc.

West Marine Inc. (WMAR) Q3 2008 Earnings Call October 23, 2008 11:30 AM ET

Operator

Good morning, my name is Alison and I will be your conference operator today. At this time, I would like to welcome every one to West Marine’s third quarter 2008 results conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remark there will be a question and answer session. (Operator Instruction) I will now turn the call over to Tricia Grobeck, West Marine’s financial controller, who will read the safe harbor statement.

Tricia Grobeck

Thank you, Alison. I would like to begin the call with the special note regarding forward looking statements. The statements in this conference call that relate to future plans, events, expectations, objectives, or performance of forward looking statement that are predictive or expressed expectation that depends on future events or condition that involve risks and uncertainties.

These forward looking statements include among other things, statements that relate to West Marine’s Future plans, financial results, future growth, earnings expectations, objectives, performance and similar projections including West Marine’s updated expectations for fiscal year 2008, as well as facts and assumptions underlying these statements or projections.

These forward looking statements which are included in accordance with the safe harbor provision of the Private Securities Litigation Reform Act of 1995 may involve known and unknown risks and uncertainties that may cause West Marine’s actual results and performance to be materially different from any future results or performance suggested by the forward-looking statements in this conference call.

Factors that may affect future plans, results, and performance include risks associated with West Marine's ability to operate profitably in a soft boating market. Its expected realization of operational improvement and efficiencies through its recently structuring efforts, its ability to withstand gross profit pressures while adjusting inventory levels and its ability to manage other operating expenses as well as the other factors set forth in West Marine’s Form 10-K for the fiscal year ended December 29, 2007, and its Form 10-Q for the quarter ended June 28, 2008.

Except as required by applicable law, West Marine assumes no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise. Also, this presentation includes certain non-GAAP financial performance measures including adjusted pretax income, adjusted net income, adjusted earnings per share, and adjusted selling general and administrative expenses.

For an explanation of these measures and reconciliation to the most comparable GAAP measures, please see our earnings release posted on the investor relations page of our website, www.WestMarine.com.

Now, I will turn the call over to Geoff Eisenberg, our Chief Executive Officer.

Geoff Eisenberg

Good morning, everybody. Thanks for joining us today to discuss our results for the third quarter of 2008. I am Geoff Eisenberg, West Marine's CEO. With me today are Tom Moran, our Chief Financial Officer, Deb Ajeska, our operations controller, and Trisha Grobeck our financial controller.

We have prepared some remarks, and then we will be happy to take any of your questions.

Our financial results for the third quarter of 2008 reflect the continuing sales softness stemming from reduced boating activity combined with weakness and uncertainty in the economy in general. As we have communicated to you during prior earnings calls, we remain focused on managing the business very carefully in order to maintain our financial strength and flexibility. The emphasis on controlling expenses and maximizing cash flow has kept us in a very strong position of liquidity. As we saw the worsening market conditions and lower sales levels earlier in the year, we announced a series of reengineering and cost reduction initiatives to improve West Marine’s economic performance in the shorter term while maintaining the company’s ability to deliver future growth.

We are very pleased with our progress in executing this plan and are beginning to see the benefits from it. I want to followup with a brief update on some of these initiatives.

Store closings. We are on track with our revised plans to close 25 to 30 stores by year end, with 14 having closed through the end of the third quarter. This total is a combination of store optimization closures where we replaced multiple smaller stores with a single larger store, and closures of under performing stores. We will continue to monitor closely performance in all of our markets and stores and as necessary take appropriate actions which consider both our long term market strategies as well as our short term operating results.

Supply chain. We are winding down operations at our Hagerstown, Maryland distribution center which as previously announced we expect to close by year end. As mentioned in the last call, our productivity improvements in inventory management resulted in reductions to our supply chain and storage in distribution requirements. Additionally, fewer inventories are required due to lower sales plans. While we are driving improvements in inventory productivity we are maintaining and actually increasing our broad selection and excellence in stock rates, despite having lower levels of total merchandize on hand.

With the challenging environment existing in our industry, we believe our inventory availability will be a key competitive advantage for us. We are very please to be in a storm financial condition; enable to keep our stores and distribution centers appropriately stocked in order to maximize sales.

Port Supply. We are on schedule with implementing previously announced changes in our port supply for sales segment. These include modifications to our in-store wholesale pricing model, additional account qualification requirements, and a restructuring of our internal and external sales functions, support functions and delivery services. We expect to continue to grow market share while improving profitability in this business.

Direct sales. We are in the process of closing our Largo, Florida call center and anticipate it to be completed by the end of this year as planned. We are transitioning to a new teleservices technology that allows many of our sales, technical, and customer service associates to work from home or in what we term, our virtual call center, which we expect will provide improved flexibility and cost savings. Other call center associates will continue to be housed in our support center located in Watsonville, California.

We are continuing with plans to shift on our investment mix in the direct segment, but a higher proportion moving towards westmarine.com and less to printed catalogs. While we remain committed to a multi-channel approach in communicating with costumers via stores, internet, and direct mail, we expect to improve customer service as well as operational and financial productivity by reducing the total number of pages we print and mail in each year.

Store operations and support departments. In these areas, we have continued to focus on reengineering, simplifying processes, restructuring our organizations, and prioritizing activities with a careful eye towards maximizing return on investment. We are increasing expenditures in areas that will support our future growth strategies. In managing our support areas, we are challenging ourselves to perform at higher levels even when budgets are lower. As in the other areas in our Company, we are reacting to this tough sales period by making ourselves leaner, by raising productivity, and improving our service metrics, which we believe will better help us serve our customers.

Real estate. While being acutely aware of current boating market conditions, we remain committed to prudent investing in our real estate optimization initiative which moves us towards having pure larger stores with better economics and a larger footprint to better meet our customers’ needs with broader and more specialized assortments. Consistent with the strategy, in the third quarter, instead of opening new standard sized stores we have expanded existing profitable stores located in San Pedro, California and Key Largo Florida. Construction is well underway at both of our two new prototype flagship stores located in Jacksonville, Florida and Brick, New Jersey and we are on track for openings in the first quarter of next year.

As we previously communicated, the flagship prototype which currently ranges from approximately 25 to 30 thousand square feet will allow us to expand our offerings of core for the boat products, present a broader selection of, for the boater lifestyle products and include enhanced opportunities to provide product information and display for the benefit of our customers. We are continuing to build a pipeline of future sites for flagships and we will carefully assess the timing for opening additional stores.

We have began to see some opportunities in certain markets relating to lower cost of real estate, whether it is in relation to lease renewals of existing stores or the leasing of new sites. We are actively assessing these opportunities and we will respond appropriately.

Planning for 2009. We are well into our planning and budgeting process for 2009. A general approach is to continue promptly react to the realities of the current market condition by right sizing our Company. While at the same time making appropriate investments in our sales and operation strategies designed to fuel future growth. Though we are currently assuming that 2009 market conditions will remain soft for boating, we will continue to improve our operational execution, remain focused on cash flow. And maintaining a strong balance sheet and we will continue to pursue market share gains in all of our business channels.

In summary, even with the market challenges we face this year, our fundamentals remain strong. We are pleased to have once again been able to reduce debt levels versus this time last year; and our access to untapped liquidity remains at approximately $100 million. Our credit facility runs well in the 2010 before it needs to be renewed.

In summary, within a tough environment, West Marine remains a healthy Company and we continue to be excited about our future. Tom will now review the key financial measures of the business with you.

Thomas Moran

Thank you, Geoff and good morning everyone. I will start by reviewing our 2008 third quarter financial results. These results were affected by several significant events which I will discuss in a moment. Excluding the impact of these items so that we can give you a more meaningful comparison to last year, West Marine recorded adjusted pre-tax income of $5.6 million for the 13 weeks ended September 27, 2008 as compared to adjusted pre-tax income of $10.6 million last year.

On an after tax per share basis, again, excluding the significant events, West Marine reported adjusted earnings of $0.23 for the 13 weeks ended September 27, 2008 versus $0.28 for the corresponding period last year. This year’s results reflected significant impact from four unusual or non-operating items. First, we incurred $1.7 million or $0.05 per share for non-recurring charges connected with our restructuring plan. As Geoff discussed earlier, these expenses were related to the closure of underperforming stores and one of our distribution centers, the implementation of staffing and service model changes in the fourth supply division, the closure of our Largo, Florida call center and expense cuts and process streamlining in our support and overhead functions. Secondly, there was an additional non-cash valuation allowance taken against our deferred tax assets. This entry had no impact on pre-tax earnings but reduced after tax earnings by $0.2 million and earnings per share by a $0.01. The third of these items is a set of after impairment charges taken against four stores this quarter, which reduced pre-tax income by $0.2 million and EPS by a $0.01. And finally, the fourth item was the expense we incurred related to the ongoing SEC investigation. This lowered pre-tax income in Q3 by $0.1 million and EPS by less than $0.01. Last year the only item corresponding to any of this was less than $0.1 million and less than a $0.01 of EPS which was due to some small asset impairment charges.

The impact of all these items on the third quarter and for year-to-date are presented in a reconciliation of non-GAAP measures which is attached to today’s earnings press release which can be viewed or downloaded from the investor relations area of our website at westmarine.com. Without these adjustments, West Marine’s reported pre-tax income for the 13 weeks ended September 27, 2008 is $3.7 million. After tax income is affected by the unusually low 7% effective tax rate which reflects the impact of the non-cash valuation allowance recorded in the second and third quarters. Thus, after tax income for the period was $3.4 million, which in turn was $0.16 per share of after tax earnings. These numbers compared to last year’s reported pre-tax income of $10.5 million with an after tax income of $6.2 million and EPS of $0.28.

Those revenues for the third quarter of 2008 were $180.2 million compared to $188.4 million for the same period a year ago. The primary driver of the lower revenues was a $7.5 million decline in the store segment which was due in turn to the comparable sales decline of 4.7%. Our direct sales division declined by $0.4 million versus last year. This decline was driven by lower sales performance on catalog mailings together with fewer promotional offers throughout the third quarter. The remaining decline in our sales was in the port supply wholesale division, primarily due to lower sales to our boat dealers’ customer segment.

Gross profit for the third quarter of this year was $49.7 million, a decrease of $8.2 million compared to 2007. As a percentage of net sales, gross profit was 27.6% a decrease of 310 basis points compared to the gross profit of 30.7% last year. The decrease in gross profit as a percentage of sales was primarily the result of lower product margins which were down by 108 basis points driven by promotional activity and store closure clearance sales. Secondly, occupancy costs deleveraged by 80 basis points and buying and distribution costs deleveraged by 72 basis points. Both of these were driven by the relatively fixed nature of these expenses on the lower sales results. Finally, recognized vendor allowances declined by 54 basis points, primarily due to reduced purchases as we manage inventories in line with lower sales.

Selling, general and administrative expenses or SG&A for the quarter were $43.9 million a decreased of $3 million compared to $46.8 million for the same period last year. Expenses leverage by 40 basis points going from 24.8% of sales last year to 24.4% this year. This decrease in SG&A expenses primarily was due to a $2.8 million reduction in payroll, marketing and other variable expenses which we managed downward on lower sales. We also had the impact of reduced store count and of lower professional services expenses for information technology projects. In addition we received a $0.4 million benefit versus last year related to the timing of professional services. All of these decreases were partially offset by a $0.9 million change in expense for Canadian currency exchange impact year-over-year.

As mentioned earlier, during the quarter, we incurred asset impairment charges of $0.2 million taken on four stores and was related to the valuation of their expected future cash flows. In addition to these impairments, we recognized restructuring expenses of $1.7 million during the third quarter. Of this $0.9 million related to store closures, $0.1 million was for port supply and $0.5 million was for the one distribution center which we will be closing. We also incurred severance costs of $0.2 million for reductions in force taken at the Watsonville support center.

Moving on to interest expense, this decreased by almost 37% from $0.5 million to $0.3 million due to lower borrowing levels as well as lower average borrowing rates. Income taxes were significantly lower than last year and we anticipate that the for the full year, our effective tax rates will only be about 3% due to the full valuation allowance against our net deferred tax assets. Looking now at year-to-date results, these were also affected by the four significant events discussed earlier. Excluding their impact, we recorded adjusted pre-tax income of $11.3 million and $0.40 per share after tax for the nine months ended September 27, 2008. This compares to adjusted pre-tax income last year of $26.0 million and $0.72 per share after tax for the corresponding period. The year-to-date impact of the significant items was as follows: First, the non-cash valuation allowance had no impact on pre-tax earnings but reduced after tax earnings by $14.8 million and EPS by $0.67. Secondly, the majority of asset impairment charges this year-to-date have been taken against 40 stores and this reduced pre-tax income by $2.4 million and EPS by $0.07. Third, expenses related to the ongoing SEC investigation have lowered year-to-date pre-tax income by $2.1 million and EPS by $0.06. And fourth, the restructuring expenses incurred year-to-date were $1.7 million reducing EPS $0.05.

Last year the only corresponding item for the same period were impairment charges against information technology assets of $0.4 million or just over a $0.01 of EPS. Those particular assets were impaired because they were superseded by the launch of our new ecommerce platform.

So without these adjustments, West Marine’s reported pre-tax income for the 39 weeks ended September 27, 2008 is $5.1 million. Significantly higher income tax expense versus last year was driven by the non-cash valuation allowance established during the second quarter and increased slightly in the third quarter with a $14.8 million impact year-to-date. Thus, after tax income for the period was actually a loss of $9.8 million which in turn was $0.45 per share of after tax loss. These numbers compared to the last year’s reported pre-tax income of $25.6 million with an after tax income of $15.6 million and EPS of $.71.

Net sales for the first nine months ended September 27, 2008 were $520.2 million compared to net sales of $561.3 million for the same period a year ago. The primary driver of the lower sales was a $36.1 million decline in the store segment of which $33.3 million was due to the comparable sales decline of 7.1% year to date with the balance of the decline being driven by store closures within the past year. The decline in the store segment was partially offset by increased sales through stores to port supply customers. As a result, the port supply segment saw a year-to-date decline in sales of 6.1% or $2.1 million. The remaining decline in sales was in the direct channel which was down 8.3% or $2.9 million and this was due to the lower sales performance on catalogue mailing, fewer promotional offers during the first nine months of the year and fewer annual catalogue mailings in 2007 which negatively impacted first quarter 2008 results.

Gross profit for the first nine months was $150.6 million, a decrease of $20.3 million compared to last year. As a percentage of net sales, gross profit for the first nine months was 29%, a decrease of 150 basis points when compared to the gross profit of 30.5% last year. The decrease in gross profit as a percentage of sales was primarily the result of an occupancy expense deleveraged of 96 basis points as sales volume declined. This decrease also was driven by a 44 basis point reduction in recognized vendor allowances. Vendor allowances are lower year over year due to lower purchases again consistent with the sales decline. The year-to-date margin rate was also impacted slightly by promotional activity and clearance sales in closing stores during the third quarter.

SG&A for the first nine months was $139.5 million, a decrease of $2.1 million compared to $141.7 million last year. SG&A as a percentage of sales for the first nine months was 26.9%, an increase of 160 basis points compared to 25.3% last year. The decrease in selling, general and administrative expenses is primarily due to a decrease of $7.2 million in payroll, marketing and other variable expenses. These reductions which were driven by lower sales and the reduction in store accounts and the associated management of expenses downward were partially offset by $2.1 million associated with the ongoing SEC investigation and a $2.3 million change year-over-year in the impact of Canadian currency exchange rates. In addition, there was $0.5 million this year related to West Marine University, which is our national sales meeting, held in February 2008.

During the first nine months, we incurred asset impairment charges of $2.4 million, taken against the total of 40 underperforming stores. Interest expense declined by almost 40% from $3.2 million to $1.9 million, the decline year-over-year was due both to lower borrowing levels and lower average borrowing rates. Significantly higher income taxes versus last year were driven by the valuation allowance established during the second quarter and increased slightly in the third quarter with a $14.8 million impact year-to-date.

Turning to the balance sheet, inventory levels at the end of the quarter stood $245.1 million which was a decrease versus the corresponding period last year of $9.7 million or 3.8%. This decrease was 1.4% when calculated on a per store square footage basis. As Geoff said, we continue to remain highly focused on inventory management and expect to end the year at or below our originally planned levels despite significant sales forecast reductions. Accounts payable as of the end of the third quarter were down by $8.8 million versus the prior year due primarily to lower inventory purchases.

As Geoff mentioned earlier, we continue to reduce bank debt, ending the quarter at $29.3 million, which is a reduction of $1 million or 3.4% versus Q3 of 2007 and it is down over 50% from two years ago when the long term debt balance stood at $64 million. Finally, our cash flow from operating activities was $34 million year-to-date. This was the number that was indicated on our press release. At this point we are communicating an update to our previously issued 2008 guidance. We are lowering our previously communicated after tax loss range from its prior range of $0.32 to $0.42 loss per share to a revised after tax loss range of $0.55 to $0.65 per share.

This revised range does not include the following significant events. The first item is charges estimated to be $0.40 per share in connection with a restructuring of the business which includes closures of underperforming stores, the closures of our Hagerstown Maryland distribution center, implementing, staffing and service model changes in the Port Supply wholesale business, closing of the Largo, Florida call center, and finally expense reductions in process stream lining in support and overhead functions.

The second significant item is a decrease in our anticipated effective tax rate for the year to only 3%. This very low rate arises from limitations in our ability to benefit from loss carry backs or carry forwards and has an impact of $0.52 per share versus the statutory rate. The third and final item is the $14.8 million non-cash valuation allowance recorded in the second and third quarters with an impact of $0.67 per share. Including the above items, we anticipated an after tax loss of $2.14 to $2.24 per share. As previously disclosed, the impact of the ongoing SEC investigation is not being included in earnings guidance but will be recorded separately.

For the year, we are maintaining sales guidance of $625 million to $635 million. However, we are adjusting forecast comparable store sales up slightly due to the impact on a comp base of the underperforming store closures, removing them from the base together with a slight sale shift toward the store segments. As a result, our revised comp store sales expectations range is a decline of 6.5% to 8.0% versus a previously communicated decline of 7.0% to 8.5%.

In 2008, we opened four stores including one early in Q4. We will not be opening any further locations this year. This compares to the previous guidance that we would open up to seven stores. We have closed 25 stores year-to-date and expect to close of up to 5 more by year end. Finally, our capital expenditures are projected to be between $15 million and $18 million in 2008 which is unchanged from previous guidance. Operator, we are now ready to take questions.

Question-and-answer Session

Operator

(Operator Instructions). Your first question comes from Analyst Jeff Blaeser - Morgan Joseph & Co., Inc.

Jeff Blaeser - Morgan Joseph & Co., Inc.

One on the things to a sales sequential improvement I am guessing that probably looked better than the industry. What percentage would you say are market share gain and what percent would you say is generated from the store closures in terms of improvement?

Geoff Eisenberg

That is a good question Jeff, we do not exactly know market share gain and I do not know if we have the exact store closure math in front of us.

Thomas R. Moran

The store closure impact through Q3 would still tend to be pretty minimal because we had only closed 14 stores by that point. So, if you are talking about, if you look at Q3 results versus year-to-date, the store closures would not have had a much of an impact, yet. We would see more of that part in Q4; I can at least speak for that part.

Geoff Eisenberg

We do not have the exact number for you as to the impact in going forward view in Q4 of the closures. It is a little bit. But it is not a ton.

Jeff Blaeser - Morgan Joseph & Co., Inc.

On the restructuring side, it sounds like you are still looking for $20 to $25 million savings next year. Any of that is reflected in 3Q and expected to reflect in 4Q?

Geoff Eisenberg

We had -- when we were updating our business projections for this year there was a small amount reflected but most of it really gathers impact in 2009.

Jeff Blaeser - Morgan Joseph & Co., Inc.

In the terms of the promotional activity, any particular categories you are targeting for the, I guess, lower prices?

Geoff Eisenberg

Not really, it is an across the board. We look at things by category, but there is nothing that stands out in our promotional activity to highlight.

Jeff Blaeser - Morgan Joseph & Co., Inc.

And then, fourth quarter guidance tax charges, what kind of tax rates should be used in the fourth quarter?

Geoff Eisenberg

What I would say is, if you looked at our year-to-date results and the tax rate there, the full year results should be approximately 3%, the full year tax rate.

Jeff Blaeser - Morgan Joseph & Co., Inc.

The 3% is excluding all charges for the year? For benefits or…

Geoff Eisenberg

What you will see is an effective tax rate of 3% and then you would want to add to that the impact of the evaluation allowance. So, if you take your modeling or operating pretax income, you would want to, or pretax loss rather, you would want to apply a 3% tax rate to that? And then in the income tax expense line you would want to then add the impact of the 14.8 million valuation allowance. Hopefully that makes sense.

Operator

Your next question is from Douglas Ruth - Lenox Financial