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Executives

Steven Nichols - Chairman, President and Chief Executive Officer

George Powlick - Chief Financial Officer

Analysts

Christopher Svezia - Susquehanna International Group

Jeff Van Sinderen - B. Riley & Company, Inc.

Jack Ripstein - PCAP

Henry Patner - Third Avenue

Berna Barshay - Swiss Re

K-Swiss, Inc. (KSWS) Q3 2008 Earnings Call November 5, 2008 11:00 AM ET

Operator

Good day and welcome to the K-Swiss conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the Chairman of the Board and President, Mr. Steven Nichols. Please go ahead, sir.

Steven Nichols

Thank you and good morning, everyone. With me today is George Powlick, our Chief Financial Officer. We appreciate you being on the call this morning. Before I begin I would like to have George cover the Safe Harbor language. George?

George Powlick

Certain matters discussed in this press release are subject to certain risks and uncertainties that could cause actual results to differ materially, including but not limited to, non-achievement of the assumptions discussed herein, general and regional economic conditions, availability of credit, industry trends, merchandise trends, including market acceptance of the company's product offerings, customer demand, competition, the impact of terrorism, and/or a potential global conflict on the worldwide economy and order cancellations and reduced sales resulting from a slower worldwide economy. A complete description of these factors as well as others which could affect the company's business is set forth in the company's periodic filings, including its Form 10-Q for the quarter ended September 30, 2008, which is currently on file with the SEC.

Backlog as of any date represent orders scheduled to be shipped within the next six months. Backlog does not include orders schedule to be shipped on or prior to the date of the determination of backlog. The mix of futures and at-once orders can vary significantly from quarter-to-quarter and year-to-year, and therefore futures are not necessarily indicative of revenues for subsequent periods.

Steven Nichols

Thank you, George. The bottom line read on our third quarter, despite better than expected revenues and headway on our branding and product development is right in line with the abysmal results being reported at retail. There is an awful lot of pain out there in the market today, both domestic and international. The extraordinary cautious stance taken by footwear buyers continued to show up in our backlog despite our best efforts.

As you will hear this morning, we still prefer to look at the industry for its long-term growth and have fashioned our product development, branding and liquidity strategies accordingly. The breakdown of sales by product category for the third quarter of 2008 was as follows: Performance 11%, Sports Style 73%, other 16%. Our performance revenues were up 4% when compared with the prior year period. This category includes all genders of tennis, running and training.

Sports Style revenues were down 22% when compared to the prior year periods. This category includes all genders of nonperformance footwear. The biggest seller in the quarter in Sports Style were the Classics, which sold 352,000 pair, and was up 3% from the prior year period, and Lozan II with 149,000 pair.

Other revenues were up 110% when compared to the prior year period. This category includes apparel, Royal Elastics and Palladium. Excluding Palladium, the other revenue category was down 38% on a 48% decline of Royal Elastic and a 31% increase in apparel.

For the back to school season we continue to use multi-media vehicles to reach our target consumer. The advertising campaign featured lifestyle and performance, running and tennis footwear and apparel and could be seen in sport, fashion and vertical publications, outdoor, online, online and select sports programming.

Sports marketing and showcasing our performance portfolio continues to be a strong focus for K-Swiss. During the third quarter many of our athletes had great victories on national television.

Marty Fish, our top male tennis player made it to the quarter finals in the U.S. Open. David Brittan, the top junior male player made it to the finals of the U.S. Open. Vera Zvonareva, our highest ranking singles player in the history of K-Swiss won a bronze medal in the Beijing Olympics and Anna Tunnicliffe, our top laser sailor won a gold medal in Beijing as well.

In addition, K-Swiss continues to be a brand that is a leader in the triathlon space. This is far more than our advertising commitment in that we have dozens of sponsored athletes wearing and winning in K-Swiss. During the third quarter our athletes participated in podium in several full and half Iron Man, Olympic and sprint distances. We sponsored the Malibu triathlon as well as the Iron Man World Championship in Kona.

These events helped us cement our commitment to the sport of triathlon and we will launch a new 2009 running shoe, the K-ONA, which was very successful in Kona in October. We continue to build traction with our running products with running specialty stores supporting the line and their excitement building about what is to come for K-Swiss running in 2009.

Looking ahead to 2009, we really have three key initiatives. The most important one is to re-introduce and reignite our Iconic Classic style as it defines the K-Swiss brand. This will be done with a compelling advertising campaign that is relevant to both a nostalgic consumer who fondly remembers his heritage style as well as younger consumers who want a cool alternative to the other brands out there.

We will also re-examine distribution to ensure that the style is segmented appropriately throughout different channels.

The second initiative is continuing to be a leading tennis brand with world class athletes and product. We will continue to see our K-Swiss tennis players wearing and winning in K-Swiss at grand slams and our tennis business in 2008 actually posted excellent increases and is expected to continue to grow. We also have product innovation in tennis that is being positively placed and received to 2009.

The last initiative is to establish K-Swiss as a player in the running category. In 2008 with our inroads in triathlon and placement in specialty running, we made significant progress. Looking ahead to 2009 we have a customized concept in running called My Sole Technology that is truly revolutionary. There is nothing like it currently in the marketplace and we expect to get significant press and placement on this product.

I will now turn the call over to George for a few minutes to go into our financials in more detail. George?

George Powlick

Thanks, Steven. Revenues were well above our projected range at $95.8 million, due to sales from Palladium which were not included in our second quarter guidance and better than expected sales in the U.S. from primarily close out product. However, we were still 10.7% below the prior year quarter and down 12.9% in the volume of footwear sold.

At-Once business for the quarter was 25%, not including Palladium. That compares with the -6% to 16% we had anticipated and 11% At-Once a year ago.

The company reported a loss of $100,000 or zeros per diluted share. A loss of $0.03 per diluted share if we exclude Palladium, which was near the top end of our projected range for the quarter.

For the K-Swiss brand the average wholesale price per pair decreased to $26.44 for the third quarter compared with $27.93 in the prior year period. The volume of footwear sold was 3 million pairs in the third quarter, compared with 3.5 million pairs in the third quarter of 2007.

Overall gross profit margin as a percentage of revenues was 39.9% in the third quarter, compared with 46.8% in the prior-year period and our expectation of approximately 45%. The lower margin was due to product mix and a $1.8 million accrual for an underpayment of certain business taxes and related interest in a foreign jurisdiction.

Our SG&A measured as a percentage of revenues was 39.8% compared with 40.4% a year ago, and in terms of dollars right in line with the $38 million we had projected for the quarter. Our operating margin for the third quarter was one-tenth of 1% compared with 6.4% in the prior year period. Our income tax rate was 63.5%, due to an increase in our expected annual effective tax rate at September 30, 2008, compared with June 2008, which was recorded in the third quarter. Our year-to-date tax rate is 18.3%

Our balance sheet at September 30, 2008, continued to improve with working capital reaching $368.4 million, compared with $355 million a year ago. Accounts receivable were $48 million or 45 days sales outstanding compared with 40 days the previous year. Our inventories were up 15% compared with September 30, 2007, and we ended the quarter with approximately $291.1 million or $8.35 per share in cash on the balance sheet.

I'll now turn the call back to Steven to wrap up the operational information.

Steven Nichols

Our international business was up 6.6% in the third quarter, but backlog was down 25% at September 30, 2008. Europe sales were up 9% in the quarter with a 32.9% decrease in backlog. Europe accounted for 41% of our worldwide revenues, up from 33.6% a year ago. Absent the $9.9 million of revenues from Palladium in the quarter, we would have posted a decline in international revenues we had anticipated for the third quarter. We now expect this decline in international revenues, our first in years, in the fourth quarter.

Sales in the Asian region were up 1% in the quarter and we posted a 16% decrease in backlog. Asia is our third largest region which accounts for 13% of worldwide revenue in the quarter, compared with 11.5% a year ago.

Royal Elastics lost $0.01 per share in the quarter compared with a loss of $0.01 per share a year ago. We expect to continue investing in Royal Elastics in 2008 with a net loss per share to be approximately $0.08 per share.

We remain on the sidelines once again this quarter with our share repurchase. We have approximately 3.9 million shares in our current authorization and will continue to evaluate this investment along with others we are considering.

The most recent investment was July 1st acquisition of a 57% interest in Palladium SAS. Palladium was a strong contributor in the quarter with $9.9 million in revenues and as I mentioned earlier, its net earnings was $940,000 net of minority interest. At this moment Palladium has significant seasonal sales and therefore will contribute much less in the fourth quarter.

I'll now turn the call on George to cover the other financials.

George Powlick

Thanks, Steven. As noted in our press release the total worldwide futures orders backlog decreased 29.1% to $102.8 million at September 30, 2008. The domestic backlog decreased 34.9% while the international backlog was down 25.4%. The total backlog is comprised of a 37.4% decrease in fourth quarter 2008 futures orders to $42.4 million and a 21.8% decrease in first quarter 2009 futures orders to $60.5 million. Domestic backlog is down 45.8% for the Q4 and down 23.2% for Q1. International backlog is down 31% for Q4 and down 21% for Q1 ‘09.

The current year backlog figures include Palladium. We do not intend to break out Palladium separately going forward. In anticipating the need for color, however, I will say that for the total worldwide future order backlog at September 30th, Palladium contributed $7.3 million of international. Of that amount 90% of it was for the first quarter of 2009.

As stated in the release, we expect revenues for the fourth quarter of 2008 to be approximately $45 million to 60 million and the loss per diluted share to be in the range of $0.10 to $0.35 per share. This equates to full years’ revenues in the range of $329 million to $344 million and earnings per diluted share in the range of $0.60 to $0.85 for 2008.

Our estimates for the fourth quarter of 2008 and full year 2008 continue to reflect a significant decline in domestic revenues, substantial investments in product development and marketing for the K-Swiss brand, slowdown of international operations and continued investment in the Royal Elastics brand. The estimates are based upon their following assumptions.

Gross margins for the quarter will be approximately 42%. SG&A will not rise above $35 million for the quarter and $151 million for the year. Customer order cancellations will be moderate. And the Company's growth initiatives with respect to Royal Elastics will not exceed a net loss of $0.08 per share for the full year. I would also add that these estimates do not include the impact from any disruption to the worldwide economy from a global conflict or a terrorist act here in the United States.

Our policy is not to issue guidance for 2009 until we release our fourth quarter earnings report. However, in light of the backlog decrease for Q1 ’09 and the economic climate, it is likely that our 2009 guidance will predict a significant loss.

That covers our prepared remarks. We will now be happy to answer any questions you may have.

Question-and-Answer Session

Operator

Thank you. We will now begin the question and answer session. (Operator Instructions) And our first question comes from John Shanley with Susquehanna International Group. Please go ahead.

Christopher Svezia - Susquehanna International Group

Good morning, everyone. This is actually Christopher Scuzzy in for John. A couple of questions. I guess first, the level of At-Once that you did during the quarter was obviously at a much lower merchandise margin rate than you would I guess typically attain.

How much of that was inflicted by you trying to pull back on inventories? And how much of it may be related to the environment that we’re in right now and retailers obviously knowing that you have availability and inventory and looking for some level of concessions. I was just wondering if you can kind of break out how much is inflicted by yourself and how much is just retailers knowing you guys have available inventory right now.

Steven Nichols

Number one, we don’t negotiate prices with retailers so everything we sell is at the normal pricing policies we’ve had with them for years. So there was zero change there. We did a lot of close outs and we experienced in the earlier quarters cancellations and we sold these goods as we normally do to places that we distribute our distressed goods and that got us a little extra sales but certainly it diminished the blended margin. So the margin strictly was from us cleaning out inventory that either was obsolete, or cancellation, or things like that

Christopher Svezia - Susquehanna International Group

At this point, Steve, do you think you have the inventory at a level that you feel comfortable? Have you gotten through most of that close-out product? I assume most of that is obviously in the U.S. at this point. Or do you anticipate possibly more of that as you move into the fourth quarter?

Steven Nichols

I anticipate more of that. Our inventory is higher than we would like it to be. The good news is that much of our inventory is in very basic shoes and many times we can come very close to getting our original landed cost in it. So it is normally not a horrible blood bath when we get rid of inventory.

Our distribution policy still makes our goods scarce and when they go out to the people who properly handle distressed or out of season inventory, we get relatively good prices. But no, our inventory is up 15% from the comparable reporting period and it should be down. So we have got a ways to go.

One little minor thing, our inventory being up, we now have inventory in France with the Palladium Company and that really is not a comp number on that basis.

Christopher Svezia - Susquehanna International Group

Right, right, okay, that’s helpful.

And just switching gears on the international piece I mean obviously as you have talked about in the past the international revenue seems to be deteriorating. How much of that is a reduction on a part of yourself, maybe reducing or pulling back on distribution like you have done in the past here in the U.S. in some of those markets?

And you referenced Palladium has given you some access in France I assume for the K-Swiss brand as well. But I guess maybe you can talk about your expansion strategies that you talked about in the past about in France, Italy and Spain and what is going on in some of your core markets as well.

Steven Nichols

A beautifully phrased question. The answer is most of the problems that we have in the United States and in Europe are strictly based on us. Our brand is not properly resonating with the consumers and we are not getting the huge sell through percentages that we did a few years ago. And the only way it will be solved is by better product and better marketing. We are working diligently on that. So there is no other reason except we just have not cut the mustard correctly.

As far as Palladium in France, they are well established in France. Their business in France is about half children’s, a little different than we would plan to take palladium all over the world. And so far there has been very minor positive rub-off from Palladium to K-Swiss.

We are in the process of opening a joint showroom in Paris and there will be some positives. But basically for K-Swiss to be successful in France, it is going to have be K-Swiss and not just a hand over from another brand.

Christopher Svezia - Susquehanna International Group

Okay. So I mean it seems like you guys have all the distribution that you want in some of your core markets like Germany, Benelux and the U.K., and not looking to expand that distribution. Basically working with what you have. Is that correct?

Steven Nichols

Yes. We are sufficiently distributed in those three geographic areas and all we need is better marketing and better product. We are very fortunate the retailers we do business with us like us. They have made very, very good money on our K-Swiss brand. The brand has slowed down and we have to re-ignite it and we are in the process of attempting to do that.

Christopher Svezia - Susquehanna International Group

Okay. The last question I have is just on Royal Elastics. Obviously a fall off during the third quarter than what we have seen in the past. How much of that was Royal Elastics specific, how much of that is just the retail environment? Kind of what are your thought as you continue to invest in that brand going forward, kind of what’s your thoughts on continuing to make those investments here given what you are seeing?

Steven Nichols

Well, number one, I did reference the retail environment once or twice in my opening remarks. But that is a cop out. The real thing is that in the worst of times if you do things right you can grow and in the best of times if you do not do things right you won’t grow. So in the end everything is up to us.

We are so fortunate with our corporate structure and our assets that we have the wherewithal to re-ignite K-Swiss and/or Royal Elastics and/or Palladium into great companies, and it is up to us. So the retailers are desperate for brands that are fresh and new and exciting and in bad times they are even more desperate for brands that are fresh and new and exciting. And if we can supply that we will do great; if we don’t, we will not.

Christopher Svezia - Susquehanna International Group

Okay. Alright. Well, good luck gentlemen. Best of luck to you.

Steven Nichols

Thank you.

Operator

Thank you. Our next question comes from the line of Jeff Van Sinderen from B. Riley. Please go ahead, sir.

Jeff Van Sinderen - B. Riley & Company, Inc.

Good morning. I wonder if you guys can talk a little bit more about the re-mastered Classic and what the response has been so far to that and then I guess what kind of progression we should look for in terms of that having an impact on your business?

Steven Nichols

So we have the history of the Classic. The original shoe which was made for 30 some-odd-years was stiff and hard and heavy and we came out with a shoe about six years ago, seven years ago plus or minus, called the luxury edition. And it was softer and more comfortable and lighter. But at that time styles got bulky and thick and it was bulkier and thicker and it was a very, very large success.

So our plan is now to go back to the original Classic which is slimmer and less bulky and re-make that shoe on the basis that this LX was, with softer leathers, lighter weight, more comfortable foot bed. But it will be a little more streamlined than our Classic LX. The plan is to roll it out very, very slowly and most of the marketing behind it will be with celebrities and personalities with PR, as opposed a straight out ad campaign and with a lot of work over the internet, which we think is the best way to speak to young consumers today but it’s just not efficient.

The opportunities on the internet; when I grew up there were 13 channels on my television set. Now maybe the average person has access to 100 channels; there’s an infinite amount of channels on the internet.

So it probably takes a while until you resonate. Until word of mouth gets around that they can find a message here or there. I think 2009 if we can release the re-mastered classic and then very slowly and then slowly build some ground swell that appears to be spontaneous along with it.

So really, 2009 will be preparing it for a bigger role in 2010. The earliest the shoe will really hit the marketplace is Q3 ’09.

Jeff Van Sinderen - B. Riley & Company, Inc.

Okay, and then I know you talked a little bit about inventory earlier. Just wondering, given it seems that retailers are wanting to do a little bit more in season or a little bit more at once in general. How is that impacting your planning and inventory going forward?

George Powlick

We have so many staple shoes that the risk of mark downs is very, very small that we’ve always attempted to carry slightly more inventory than we need. The alternative cost to capital today is real small. So we’ll have plenty of inventory for at-once for the retailers that are carrying shoes that are appropriate to be filled in. It’s all a question of us creating the demand for the consumer to want these. So if the demand is there, we will be able to reach it, as you can see we’ve done from time to time.

Jeff Van Sinderen - B. Riley & Company, Inc.

Fair enough, and then just given the difficult macro environment and business trends, are there any areas you’re targeting to cut expenses?

George Powlick

Yes there are and it’s real simple, everywhere. We’ve narrowed it down to everywhere. So we will get leaner and more efficient. We’ve begun it and we’re going to have to continue. So any duplication, any waste, it’s a very healthy process.

We’ve been through it twice before in the time that I’ve been at K-Swiss, and we’re fortunate that we have close to 100% variable costs over a period of a year and we’ve begun getting leaner and hopefully this will prepare us to retain absolute best scenarios and people and when we turn our business up again, we’ve got the best people in place.

Jeff Van Sinderen - B. Riley & Company, Inc.

Good to hear, thank a lot. And good luck.

George Powlick

Thank you.

Operator

(Operator Instructions) Our next question comes from the line of Jack Ripstein with PCAP. Please go ahead.

Jack Ripstein – PCAP

Hi, good morning. Thanks for taking my call. You had mentioned quickly, George, I think it was you said something to the effect of potentially of significant loss for ’09, and that’s still seems like forever away since we still have Q4. But if you guys started planning for more expense reduction, I guess, in other words saying what kind of cash consumption do you expect should this forecast you’re providing come to bare?

Steven Nichols

We’re not finished. We’re doing something called the rolling forecast now full-year ahead. It’s pretty clear to me that we’re going to experience a loss in 2009, which will not be insignificant, but I’m not talking hundreds of millions of dollars here, but it will be a significant loss to us probably. We’re not finished and we haven’t done Q4 ’09 yet, and that will consume cash, yes. Is it an enormous amount of cash? I wouldn’t say so, no, but it will consume some cash.

Jack Ripstein - PCAP

Okay, I mean in the range of 10 to 20%, is that too high? Just give us some sort of ballpark.

Steven Nichols

Out of our cash?

Jack Ripstein – PCAP

Yes.

Steven Nichols

I don’t know yet but I would say 20% is too high. I don’t know about 10%.

Jack Ripstein - PCAP

Okay, thank you very much.

Operator

Thank you. Our next question comes from the line of Henry Patner with Third Avenue. Please go ahead.

Henry Patner - Third Avenue

Hi, I was wondering if you could talk a little bit about how with a highly variable cost structure you generate losses or you expect to generate losses in ’09. Are there one-time items involved there or just upfront fixed capital that you have to meet, maybe if you could sort of bridge variable cost structure with operating losses and how that works?

George Powlick

Right, well our cost structure is not 100% variable and we have systems in place. We, over the last 18 months, spent $20 million putting in SAP and there’s a minimum to keep that going no matter what volume we do. They are sales forces that we have over United States that we won’t decimate. We would bet that we’ll come out the other end strong so there could be reduction, but the reduction might now be 100% down to equal to the business.

We will do advertising and marketing that is above maybe what the business in 2009 will justify in our normal percentages but that would be an investment in 2010. So, yes, we could probably shrink ourselves down to where we absolutely could be profitable but that might impede us turning the corner in 2010. I know we also think that 2009, and as I clearly said our problems are our own, but 2009 will be a tough year.

We were visiting a retailer yesterday. One of our executives were at a retailer and they’re looking for a major reduction in open to buy for the first half of the year. And they were talking about a total $10 million cancellation from all their vendors. We’re fortunate this is a retailer that mostly does at once business with us. We’ll probably be unscathed but that’s the retail climate. And 2009 will be a tough year.

We will attempt to get as lean as possible with the exception of we would be looking forward to growing our business in 2010 and leaving the brand sufficiently respected by consumers through advertising and marketing, and the core talent in place at the company to grow in 2010. So we’ll take it way, way down, but now below bare bones.

Henry Patner - Third Avenue

Maybe you could provide some color on if you were to imagine operations in more of a steady state where you weren’t trying to reinvigorate the brand. What percentage of your total costs are variable and then how does that compare to, call it this period where we’re sort of in the process of reinvigorating the brand? What percentage of your costs are variable versus fixed?

George Powlick

Well, number one, I can’t envision a scenario where we’re not going to try to reinvigorate the brand. So there will be some investment spending in ’09 that by 2010 we believe the retail climate will be better and we will be better. That’s number one.

Number two, I’m not sure what our variable costs are as a percentage. I’d have to think about it and heads of every department isn’t a variable cost. The second, third, fourth might not be, but the fifth, sixth, and seventh might. So it would require a lot of thinking to think that through.

We are very aggressively getting rid of any duplication in things that were acceptable in good times aren’t now. And we will get as lean as we can with the exception of our thought would be A, we finish with about $290 million in cash and if we consumed in 2009 some relatively small amount of that to have us positioned in 2010, that would be the smart thing to do. We will not get as lean as humanly possible, but we will get as lean as practically possible.

Henry Patner - Third Avenue

Thank you. Thank you guys.

George Powlick

You’re welcome.

Operator

Thank you. Our next question comes from the line of Berna Barshay with Swiss Re. Please go ahead.

Berna Barshay - Swiss Re

Thank you for taking my call. I just wanted to ask about currency and see what the major effects of currency are in terms of how much you’re hedged and how much that is a head wind going into sort of Q4 and ’09.

George Powlick

Well, with the dollar getting stronger against the euro and the pound, that’s the primary currency that we have to be concerned with. And our policy on inventory purchases is roughly 60%. We vary between 60 to 80% of hedged purchases, but right now we have been in the 60% mode. And with the dollar getting stronger it will make our European operations translate into less profitability.

Berna Barshay - Swiss Re

And in terms of the potential gross margin, there’s obviously the sales translation, but is that also a gross margin pressure in Europe?

George Powlick

Yes it is, absolutely because they buy in dollars and sell in euros.

Berna Barshay - Swiss Re

Sure, what’s the order of magnitude on that and is that what we can see going forward?

George Powlick

I’m not sure what you mean by order of magnitude. We do translate our financials and do have a currency effect. We’ve never disclosed it because we didn’t take any credit for it when it went in our favor and we’re not going to hide behind it when it goes against us. But it will have a negative impact now and as I see it going forward a little bit, yes.

Berna Barshay - Swiss Re

Have you every disclosed the order of magnitude of the difference of the gross margin between Europe and the U.S.?

George Powlick

No, but they have been traditionally larger in Europe.

Berna Barshay - Swiss Re

A lot of other companies see 400 or 500 basis points. Is that the order of magnitude or is it less than that?

George Powlick

We’re not going to disclose it so I don’t want to get into that.

Berna Barshay - Swiss Re

Okay, I’ll stop trying. Thanks for taking my call.

George Powlick

Thank you.

Operator

Thank you. I show no further questions at this time. I would like to turn the call back over to Mr. Steven Nichols for any closing remarks.

Steven Nichols

Thank you for your participation today and your continued interest in K-Swiss.

Operator

Ladies and gentlemen that does conclude the K-Swiss third quarter 2008 conference call. (Operator Instructions)

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Source: K-Swiss, Inc. Q3 2008 Earnings Call Transcript
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