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Drugstore.com Inc. (NASDAQ:DSCM)

Q3 2008 Earnings Call

November 5, 2008 5:00 pm ET

Executives

Brinlea Johnson – The Blue Shirt Group

Dawn G. Lepore – President, CEO, and Chairman of Board

Tracy Wright – Chief Finance Officer

Analysts

[Brian Russo] – Banc of America Securities

Operator

Good afternoon ladies and gentlemen. Welcome to the Drugstore.com earnings conference call. (Operator Instructions) I would now like to turn the conference over to Brinlea Johnson of the Blue Shirt Group. Please go ahead, ma'am.

Brinlea Johnson

Good afternoon welcome to the Drugstore.com third quarter 2008 earnings call. With me today is Dawn Lepore, Chairman and Chief Executive Officer, Tracy Wright, Chief Finance Officer and Rob Powers, Chief Accounting Officer.

Before we get started we would like to remind you that the information on this call may include forward-looking statements. Words such as expect, believe, anticipate and similar expressions are intended to identify forward-looking statements which involve risks and uncertainties that could cause Drugstore.com’s actual results to differ materially from those discussed in the forward-looking statements. In particular comments about Drugstore’s anticipated future revenues, earnings and growth rates are forward-looking. Factors could cause actual results to differ materially from anticipated results as declared in our periodic filing with the SEC.

I’d also like to point out that during the call we do mention certain non-GAAP financial measures which will be explained during the call. A reconciliation of these non-GAAP measures to those comparable GAAP measures can be found in our earnings press release which was made available prior to today’s call.

Finally today’s call is being recorded and will be available for replay on Drugstore.com’s website at www.drugstore.com under Corporate Information. In addition the earnings press release for the third quarter 2008, including a summary of our financials and supplemental financial information discussed on this call, will also be available on our website, also under Corporate Information. With that I’ll turn the call over to Dawn Lepore, Chairman and Chief Executive Officer.

Dawn Lepore

Good afternoon everyone and thank you for joining us. Despite the more challenging economic environment that we are all facing, I’m pleased with the revenue growth and margin expansion Drugstore.com reported in the third quarter. Specifically in the third quarter core OTC revenue grew over 12% which compares to just 6% Ecommerce growth reported by comp scores during the same period.

Beauty.com, our prestige beauty business, grew over 32% and is up 39% year-to-date. Our vision business increased 5% over last year and has exhibited double-digit growth so far for the year.

Gross margins were a record at 28.6%, up 90 basis points sequentially and up 190 basis points year-over-year. Contribution margin dollars grew over 21% year-over-year and we delivered adjusted EBITDA of over $3.6 million up 20% sequentially and 76% year-over-year.

While our sales growth was in line with our previous guidance, we did see an impact from the slowdown in the economy, specifically in the last two weeks of the quarter. Prior to this period, core OTC sales were tracking nicely at over 14% growth, with Beauty.com sales up 40% year-over-year. These growth rates dropped dramatically in the last 10 days of the quarter.

Clearly we are dealing with unprecedented economic disruption and it’s very hard to predict consumer behavior. At the same time we are really encouraged by the rebound we saw in October with OTC sales increasing 10.5% over last October and strong double-digit growth in vision.

In our industry we do not believe that anyone is recession proof, but we do believe that we have a strong value proposition and are more recession resistant than many others. Looking into the fourth quarter, we are cautiously optimistic that we can sustain October’s momentum and benefit from our customer's holiday spending. Currently we expect to grow 9% to 12% in our core OTC business and to post high double-digit growth in our vision business.

Today there are three main messages that I would like you to take away. Number one, we are executing on plan, centering our business on our higher growth core businesses, OTC, beauty and vision and are reaping the benefits of our profitability initiatives and driving margin expansion.

Number two, in good times and bad, we will benefit from our very attractive customer demographic, strong customer base and unique online platform which is characterized by a broad assortment of SKUs, lower price points and a high number of replenishment items.

And number three, looking ahead we will continue to ramp a number of growth initiatives that position us for incremental revenues on top of the growth in our core business such as our new international platform, our online OTC store, developed as part of our strategic partnership with Rite Aid, and the expansion of our prestige beauty vendor relationship.

Now let’s discuss the financial highlights for the third quarter and then I’d like to focus on the strategic positioning of the company that underscores my confidence in our long-term growth and profitability.

For the third quarter, our core OTC business grew over 12% year-over-year. More importantly during the quarter we balanced top and bottom line growth as OTC margins improved 230 basis points to 31.6% and OTC margin dollars were up over 21%.

Our OTC growth margin expansion is a direct result of our profitability initiatives, bottom line contribution from our web services agreement and advertising, and the increasing mix of higher margin categories, like Beauty.com.

Beauty, both mass and prestige continues to be a strategic focus and overall beauty sales grew over 20% year-over-year. Beauty.com sales which represent 32% of overall beauty sales grew over 32% from last year. This compares to a 1% decline reported by MPD in the prestige beauty industry. Beauty.com sales are up 39% year-to-date versus the same period in 2007. And we remain confident that we can continue to grow prestige beauty by 30% to 35% in 2008.

This quarter we added 20 new brands in a broad range of categories, including makeup artist brands Laura Geller, high-end spa brands like Canyon Ranch and Eve Lom and well-known fragrance brands like Calvin Klein and Tocca.

Year-to-date we have launched 81 new brands bringing our total brand count to 215 active brands on our site. We had another successful quarter with our exclusive beauty bags as we partnered with fashion design duo, Vena Cava to create our best gift with purchase promotion to date. This promotion was very successful with our existing customer base as well as new customers. And 11% of people redeeming this offer were new beauty customers.

Our web loyalty and advertising agreements are performing as expected as we have successfully monetized our Impressions, benefiting our bottom line. In our vision business we continue to focus on both top and bottom line growth, testing several pricing changes during the period and choosing to scale back our quarterly promotions compared to the heavily marketed prior year period.

While we only achieved 5% year-over-year growth vision in the third quarter, we have already seen vision sales returning to very healthy double-digit growth in October and believe we are on track to achieve over 10% growth in vision for all of 2008.

Moving to pharmacy as expected our Rx mail order revenues decreased 4% while contribution margin dollars increased approximately 5% over last year. While our contribution margins will continue to strengthen we expect our annualized mail order pharmacy revenues to decline by approximately $6 million due to the recent acquisition of one of our PVM partner, Medical Services Company by Express Script.

Our fourth quarter guidance includes a $1 million decline in Rx mail revenue due to this acquisition. During the course of the past two years we’ve focused on restructuring this business for profit and while we still believe Rx mail order is an important offering for our customers, we will continue to evaluate the most effective way to provide this service.

As we head into an uncertain holiday season I want to talk to you about why I am cautiously optimistic about the fourth quarter. And I’m confident in our long-term future.

First we have a highly attractive and desirable customer demographic with strong customer loyalty to drugstore.com. To be more specific, 82% of our customers are women, with the average age of 43, who are often making the buying decisions in the family. They’re mainly located in major urban markets and most importantly have an average annual income of $90,000.

Additionally, our customer satisfaction ratings are consistently among the best and our exceptional customer service and strong loyalty program help drive roughly 80% of sales through repeat customers.

Second the nature of our products is unique and our selection is unmatched. We now have over 40,000 SKUs including over 9,000 drop ship SKUs and can offer a wide selection of lower ticket items. Very few of our best selling products have high price points and we believe this will help us in the current economic environment.

Many analysts are predicting that consumers this season will favor more affordable gifts like board games over more expensive items such as electronics and we are well positioned to target this more value focused customer.

Additionally most of our strongest growth categories in Q3 like hair care, up 28%, supplements, up 57% and allergy and sinus up 35%, are categories with a heavy rate of replenishment orders and we expect this trend to continue.

Also helping us in a tougher economic environment is our focus over the last couple of years on improving profitability. After investing $800,000 this quarter in consulting expenses we have now completed our planned investments in our profitability initiative.

Significant improvements to pricing, sourcing and shipping are contributing nicely to our OTC gross margin expansion as evidenced by our third quarter OTC margin improvement of 230 basis points, year-over-year.

These profitability initiatives now enable us to be more aggressive in the marketplace. We’re able to promote when most meaningful, like during this holiday season, while still driving incremental profits to the bottom line. During the fourth quarter we expect our customers to take advantage of our compelling offerings and therefore you’ll see us run a variety of promotions including free shipping, friends and family discounts, coupons and daily deals to drive sales.

In addition to our core business we have a number of growth initiatives which will start to contribute in the fourth quarter and have a positive impact in 2009. Two of our recent initiatives are our international platform and our online OTC store with Rite Aid.

In the next week we are launching our international site through our partnership with E4X. As we mentioned at our Analyst Day we now have access to an entirely new market of 500 million customers in 34 countries. Currently 10% of our traffic is international and we believe we can generate new sales by improving conversion as well as driving incremental traffic.

We are also launching our new online store with Rite Aid later this quarter. Rite Aid is in charge of the timing and marketing and we are confident we will have a compelling online experience for Rite Aid customers. And are excited to initiate what we believe will be the first of other strategic partnerships. These partnerships leverage our expertise in Internet marketing merchandising, fulfillment and customer care.

To summarize, we are confident in our long-term strategy and our future success. Clearly we are benefiting from the substantial changes we’ve made over the last couple of years which improve our position in this tougher environment.

There is no question that we are seeing an impact from the slowdown in the economy and as a result are lowering of our guidance for the fourth quarter to reflect the current economic environment. At the same time we are encouraged by the uptick in sales in October which we believe positions us above industry trends.

As I’m very mindful of profitability we will also continue to closely examine every expense to our cost to ensure we drive maximum dollars to our bottom line. Looking into the fourth quarter we expect that we will achieve GAAP profitability and deliver adjusted EBITDA that is the highest in company history. I look forward to keeping you updated on our progress.

With that I will turn the call over to Tracy our Chief Finance Officer for the financials.

Tracy Wright

Over the next few minutes I’ll walk you through some of the third quarter metrics and then provide an update on our fiscal 2008 guidance. Before I begin, please note that all comparisons with last quarter and last year’s numbers exclude the local pick up pharmacy business which as of September 4th we now report as discontinued operation.

Third quarter net sales were $87.8 million up 8.5% year-over-year. Core OTC continues to be a key driver of our business as net sales grew by over 12% to $60.8 million or approximately 69% of total sales in the third quarter. Total OTC sales grew to $61.2 million, our vision segment sales improve by approximately 5% year-over-year to $15.6 million and mail order pharmacy net sales decreased to $11 million.

Overall average net sales per order was $69; on a segment basis average net sales per order for the third quarter were $58 in our OTC segments, $114 in the vision segment and $161 for mail order pharmacy. Net sales from repeat customers represented 79% of totals sales in the third quarter. And new customers increased over 6% year-over-year to 325,000 bringing our total life-to-date customer base to 9.4 million unique customers. Our trailing 12-month active customer base grew by approximately 11% year-over-year to 2.5 million. Now I'll move on to gross margin.

Gross margin was 28.6% in the third quarter, our highest gross margin in company history, up 190 basis points over the prior year and benefited from our profitability initiatives as well as an improving sales mix. The strong growth margin contributed to over 21% year-over-year growth in contribution margin dollars to $17.8 million.

Moving on to expenses, marketing and sales expense for the third quarter was $7.9 million or 9% of net sales, staying flat as a percentage of revenue with the second quarter of 2008 and up from 8.5% in the prior year period. Marketing and sales expense per new customer increased to $24 compared to $23 in both the second quarter of 2008 and compared to the prior year period.

The year-over-year increase in marketing and sales expense as a percentage of sales and per new customer is largely due to incentives provided in the prior year period to launch the initial marketing campaign by PayPal and Google Checkout as well as an increase in non-cash stock-based compensation expense.

For the third quarter of 2008, fulfillment and order processing expense was $11 million or 12.5% of net sales, up from 11.9% in the second quarter of 2008 and 11.7% in the third quarter of 2007. This quarter includes 30 basis points of consulting expense to improve the DC productivity. The sequential increase in fulfillment expense as a percentage of sales was largely driven by fixed costs spread over a lower revenue base, proactive maintenance as we prepare for the fourth quarter holiday season and an increase in depreciation expense associated with the capacity expense in investment made in RDC to increase throughput.

Technology and content expense for the third quarter of 2008 was $6 million or 6.8% of net sales versus 6.2% in the second quarter of 2008 and 5.8% in the third quarter of 2007. The sequential and year-over-year increase in tech and content expense this quarter was primarily driven by an increase in depreciation expense as new technology projects were placed into service.

General and administrative expense was $4.9 million or 5.5% of net sales, down 40 basis points from the prior year period, primarily due to lower stock-based compensation partially offset by our consulting investment in connection with our profitability initiatives. For the third quarter, stock-based compensation expense was $1.8 million. For the full-year of 2008, we expect to report $7.4 million of stock-based compensation and $11 million of depreciation expense.

On a GAAP basis, the company reported a net loss of $3.6 million or $0.04 per share, compared to a net loss of $2.4 million or $0.02 per share from the prior year period. The third quarter 2008 loss includes $1.7 million in accelerated non-cash marketing expense and $800,000 related to consulting services, as well as $1.1 million of income from our discontinued local pick up pharmacy operation.

Our adjusted EBITDA was $3.6 million, an improvement of more than 76% from the third quarter of 2007, despite investing over $800,000 in our profitability initiatives this quarter. We ended the quarter with an employee base of 850 FTEs. Cash generated from operations was $1.9 million for the quarter. CapEx for the quarter, inclusive of capitalized labor associated with internally developed software projects, was approximately $3 million. The end of Q3, with $33.4 million in cash, cash equivalents, and marketable securities, we now plan to spend approximately $13 million in CapEx in 2008.

With that as a review of third quarter results, we'll move on to our outlook for the fourth quarter of 2008. For the fourth quarter of 2008, the company is targeting net sales in the range of $94 to $99 million, net income in the range of $400,000 to $1.9 million and adjusted EBITDA in the range of $5.3 to $6.8 million dollars. We will now move on to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brian Fitzgerald – Banc of America Securities.

[Brian Russo] – Banc of America

Hi, this is Brian Russo for Brian Fitzgerald. I'm curious about, you kind of mentioned, October you saw a little bit of a recovery from September. I was wondering if you can give us your thoughts on why that might be and I guess my underlying question is you know it seems that things are you know kind of getting worse and I'm looking at your growth guidance for the fourth quarter and it looks pretty solid. I'm wondering is that conservative enough. And then I have a follow-up, thanks.

Dawn Lepore

Well, I guess, the bottom line is that, Brian, nobody has a crystal ball, including me and these are unprecedented times. What I can tell you is that OTC, and you're probably mostly talking about OTC growth, was going along about 14%. The last 10 days of September that was when all of the significantly catastrophic financial news was in the papers. The growth rate slowed dramatically as it did, I mean, consumers were obviously very taken aback on what was going on around them. In October, it bounced back to about 10.5%.

So we are looking at, for the fourth quarter, OTC growth somewhere in the 9 to 12%, or high single digits to low double digits arena and that's based on the data that we see. And we think that it's being prudent. Obviously we can't predict what this holiday shopping period will do.

On the other hand, we do have a lot of replenishment items, obviously. We have great value proposition. We have low cost items and so we do feel that consumers still will be spending some money; they're just going to be much more thoughtful and obviously spend less this holiday season. Does that make sense with what you're hearing from others?

[Brian Russo] – Banc of America

It does. And then I had one other question, just quickly. Could you provide some kind of an update on the possibility of adding department store brands such as Lancome or maybe Estee Lauder and how meaningful that could be for growth, should that happen?

Dawn Lepore

Well we've added - actually, we've added prescriptives and we've just sent out an e-mail to our customer base about prescriptives and have gotten a good response from our customers. So we're very pleased with our relationship with Estee Lauder. We've got fragrances, prestige fragrances; now we have prescriptives and we will obviously look to build that relationship over time and we believe that we will perform very well for Estee Lauder, especially when you look at the overall industry declining 1% and we had significant growth in prestige beauty.

We have said that we can grow prestige beauty 30 to 35% this year. We're not giving guidance for 2009 yet, but we continue to feel very good about growth in our prestige beauty business and that is in part because of these relationships with the larger department store vendors.

Operator

(Operators instructions) We have no further audio questions at this time. I would now like to turn the conference back over to Dawn Lepore for any closing statements.

Dawn Lepore

Thanks very much. I want to thank, again, everybody for joining us today. As we indicated, we believe we're executing on track, remain focused on accelerating the growth of our business and delivering a strong holiday season, even in these difficult times. We look forward to keeping you updated on our progress. Thank you.

Operator

Ladies and gentlemen, this concludes the Drugstore.com's earning conference call. If you'd like to listen to a replay of today's conference please dial 800-405-2236 or 303-590-3000 with the pass code 11121487.

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