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Executives

Erica Pettit – Financial Dynamics

Bruce G. Crain – President, Chief Executive Officer

Anthony P. Cappiello – Chief Administrative Officer, Interim Chief Financial Officer

Analysts

Arnold Brief – Goldsmith & Harris

Russ Berrie & Co., Inc. (RUS) Q3 2008 Earnings Call November 11, 2008 10:00 AM ET

Operator

Good morning, ladies and gentlemen and welcome to the Russ Berrie and Company conference call. At this time all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will follow at that time. Any reproduction of this call in whole or in part is not permitted without prior express written authorization of the company. As a reminder, this conference is being recorded.

I would now like to introduce your host for today’s conference, Ms. Erica Pettit of FD.

Erica Pettit

Thank you, Chris. Good morning everyone and welcome to Russ Berrie’s third quarter 2008 conference call. If you have not viewed the press release issued this morning and would like to receive one by email or fax, please call Financial Dynamics at 212-850-5600 and someone will send you one immediately.

As stated in the company’s earnings release, this call is being webcast and can be accessed on the company’s website at www.russberrie.com. The webcast of the call will be archived online shortly after the conference call for 90 days. We will begin the call with comments from management and then we will open up the line for questions.

Before we begin we would like to remind everyone of the cautionary language regarding forward-looking statements contained in the press release. That same language applies to comments made on this morning’s conference call.

Now I’d like to turn the call over to Bruce Crain, Chief Executive Officer and President of Russ Berrie.

Bruce G. Crain

Good morning everybody. Thanks Erica and thanks everybody for joining us. I’ll start with a review of our recent performance then Tony Cappiello, our Chief Administrative Officer and Interim Chief Financial Officer will provide a more detailed discussion of our financial results. Later I’ll come back and briefly discuss our plans going forward.

Let me discuss some general trends that are affecting our businesses before diving into specifics on the I&J area or infant and juvenile business and then our gift business. We delivered consolidated top line growth and profitability during the quarter due to growth in our infant and juvenile segment, despite the extremely volatile and uncertain retailer and consumer environment that we have all been witnessing over the last months.

Our recent acquisitions of LaJobi and CoCaLo collectively performed well and were accretive to our results. Kids Line and Sassy together delivered solid organic growth for the nine months ended September 30, 2008. That said, our gift segment continued to experience sales challenges as we cycled very strong performance from last year driven by Shining Star sales in particular and the weak demand trends that persist in the gift channel.

Our gross margins are under pressure in both segments as they have been impacted by both supplier costs and a consumer environment that is straining retailer price points. Some of these margin adjustments are structural and longer term for us and some we believe are shorter term pressures that can be addressed.

Let me briefly describe a couple of the factors that have continued to impact our margin performance. First, higher cost of goods, particularly in our infant and juvenile business, persisted as raw material costs, labor and freight costs, all remained elevated. All of these are affected by the current state of the Asian supplier market that continues to be under significant costing pressures with many factories going out of business over the last year, although we are fortunate that our principal factory partners are still operating.

This sourcing environment has been further exacerbated by the ongoing unfavorable currency trends as the US dollar and Chinese Yuan exchange rate continues to weaken. Given that we source the vast majority of our products from Asia, all our product development and sourcing teams are regularly in Asia both managing costs and sourcing new programs. Recent discussions with vendors provide us with cautious optimism for managing margins in 2009 as recent tax rebates for Chinese factories have improved and declines in commodities such as oil and cotton have begun to help offset some of the margin pressures. However, ongoing concern that currency and cost uncertainties and the escalating costs of quality assurance and testing are continuing to pressure margins.

Separately, our gross margin in the gift segment was negatively impacted as a result of the mix of products sold, de-leveraging of fixed costs due to lower sales, and an additional inventory reserve that Tony will discuss later.

Now, specifically turning to a few things I wanted to discuss about our infant and juvenile area. First, we believe that the infant and juvenile industry has historically demonstrated that consumers typically cut back in other purchases before pulling back in purchases of most infant and juvenile products. We believe this fundamental has helped insulate our business during the economic downturn, although we have recently entered into unprecedented times that make it difficult to predict how the consumer will react on a go-forward basis.

For example, retailers are bracing for one of the weakest holiday seasons in years and are managing their inventories accordingly. We are seeing this even in every day product areas that are not necessarily typically associated with holiday shopping. To that end, some retailers have pulled back on certain orders, including reducing product inflows at least temporarily. While this has resulted in some sales postponements, our businesses continue to focus on maximizing market share and shelf space.

While we are shipping some important reorders and new programs in the fourth quarter, our principal focus is now on executing our new product launches and sales plans for 2009. Second, our strategy of building a confederation of businesses is taking shape nicely. While we are maintaining independent efforts to build our brands and focus our product focus leadership positions, we are also collaborating to identify broader operational efficiencies.

We also believe our ongoing focus on quality assurance processes and quality controls will continue to be a strength for us. We continue to work on being in the front of these issues, especially given the rapidly evolving global regulatory environment. Third, for all of our businesses, the key driver remains developing product consumers want and all the Russ businesses showed their upcoming lines at the ABC Juvenile Product Show in September in Las Vegas, which many of you know is now the largest infant and juvenile trade show event in the US.

Our businesses each had distinctive locations on the trade show floors where they previewed new products and product line extensions to retailers. Examples from each business included Kids Line who showcased their largest collection ever of Carter’s licensed products and several new blanket programs. In addition they presented more than ten new designs of bedding collections including a new organic cotton line.

Sassy showed its Hispanic focused line called BeBe, introduced new paint-free attachable and developmental toys, and debuted a web-based monitor. LaJobi launched a new Graco branded crib line and their first eco-friendly Serta branded crib mattress for specialty stores. Additionally, they brought to market a new in-house brand called Nursery 101 which provides access to opening price points.

CoCaLo featured a large line of design led and CoCaLo branded bedding separates and an extensive blanket and gift program. They also introduced CoCaLo Naturals, which is a new offering of organic products. While not a traditional show for Russ Gift, this segment was also represented at the ABC show. They showcased Sea Pals and a new licensed line of Peeps based plush for the 2009 spring and Easter season, among other offerings.

Before moving on to discussing our gift segment, I’d like to remind everyone that we are exiting our MAM distribution agreement at the end of this year. While MAM products have been an important part of our Sassy business for many years, [inaudible] recently due to currency and other issues. Even more importantly, our distribution agreement restricted us strategically from competing in certain categories and will continue to do so throughout 2009. As we build our plan for 2009, we recognize we will need to address the loss of approximately $20 million to $25 million in MAM related sales.

Now turning to the gift segment, as we stated throughout the year, we continue to experience significant sales challenges in our gift business globally and especially in our US gift business. Overall the traditional gift industry is still large but the trends remain weak as we have discussed on past calls. The independent retailer remains particularly challenged, consumer gift product preferences are evolving, retailer competition is shifting, and sourcing costs are all escalating.

While out gift team continues to make progress, the recent results are clearly inadequate. However, we have been focused on recovering sales and managing costs. Let me discuss certain areas in which we have been investing in that we believe will help Russ Gift maintain its traditional role as an industry leader, but one with improved financial performance.

First, we continue to believe in the importance of maintaining a new product pipeline through a combination of in-house creative development and leveraging select licenses that utilize our product development resources and our global supply chain, including our Asian sourcing team. In the licensed product area, Russ Gift continues to focus on developing product for and expanding the distribution of Evergreen and Iconic brands that include Curious George, Raggedy Ann and Andy, Pound Puppies, Peep, Applause, Necco candies, and Corduroy. All of these products have rich brand histories with cost-effective licenses that when co-branded with Russ or Applause can have meaningful market presence.

Russ also has tremendous product development talent that has developed in-house and inspired Russ and Applause branded lines such as Sea Pals, Yamiko Plush, Bright Beginnings Baby, and many seasonal and occasion specific plush and non-plush gift offerings.

During the fourth quarter we are preparing for the January 2009 gift trade shows that will take place in all of our global markets. We will be showcasing broad product lines that are fresh and creative as well as priced correctly and right. Second we plan to continue shifting sales resources to where they will most effectively drive sales and channels, where gift product is really sold today, and where it will be shopped by the trade and consumers in the future. To that end we are continuing to develop our multi-channel selling approach to the market including a cost-effective field sales organization, key account teams, B to B and telesales resources, and web-based selling tools.

We also continue investing in enhancing our selling organization’s effectiveness by getting them the right tools and systems to strengthen our relationships and sales productivity with customers. Third, we believe our presence in the international gift sales channels will continue to have a helpful and diversified influence on our gift business.

It’s also clear that we need to continue our efforts to better manage our cost structures, especially given our reduced sales levels. On a positive note we have taken costs out and managed the cash utilization of the gift business which Tony will discuss later. However, it is critical that we continue to work on aggressive cost management and reduction initiatives to address the continued weakness of our business model and the trends in the gift industry. We will be addressing this over the next few months as we plan and enter 2009.

Finally, let me take a moment to discuss Shining Stars. Sales year-to-date have been substantially lower than 2007 and lower than originally planned for 2008, particularly in the third quarter. This relative weakness is further amplified when comparing year-over-year gift results due to the very strong results in this product line in the third quarter of 2007.

We expect out gift business will continue to experience the Shining Stars headwind in the fourth quarter as well. However, we are cautiously optimistic that sales from a broader core range in many new products will set the stage for improved performance. While Shining Star sales are down significantly, we will continue to work with our license partners as they continue to invest in the franchise and the website.

Before I turn the call over to Tony to discuss our third quarter financial performance, I’d like to say that while we continue to work on many sales, profit, and working capital improvement initiatives, we are also operating our businesses very pragmatically and carefully so we can be nimble and react as needed in this unprecedented environment.

I’ll now turn the call over to Tony to talk about our recent results. Following Tony I’ll return briefly to review some of our core strategic business fundamentals that we believe will drive our business going forward.

Bruce G. Crain

Thanks, Bruce. As you all know, the details of our results are available on our recently filed 10-Q for the third quarter as well as the press release we put out this morning, so I’ll keep my remarks relatively short. Consolidated net sales for the third quarter increased 7.1% to $108.1 million compared to $100.9 million for the third quarter of 2007. This was primarily driven by sales of $24.4 million from our LaJobi and CoCaLo acquisitions partially offset by a 31.4% decrease in the gift segment net sales.

Consolidated gross profit in the third quarter was $39 million or 36.1% of net sales compared to $40.4 million or 40% of net sales for the third quarter of 2007. Although reported infant and juvenile segment margins were favorable compared to the third quarter of 2007, after adjusting for a $3.6 million impairment charge in the third quarter of 2007 related to the MAM distribution agreement, our margins were lower due to competitive pricing constraints, increased work material costs, and the shift in product mix.

While the product mix has led to lower gross margins, some of this in part our strategy to drive sales growth in new categories that have inherently but still attractive margins and appealing return on investments. Our plan is to grow our placement and shelf position. Declining gift segment margin was primarily attributable to higher margins achieved in the prior year quarter due to favorable Shining Star margins, the de-leveraging of the fixed cost embedded in gross margins due to lower sales volume for the third quarter of 2008, and additional inventory reserve of $600 million booked during the quarter.

Consolidated SG&A expenses for the third quarter was $29 million or 26.8% of net sales compared to $27.1 million or 26.9% of net sales in the third quarter of 2007. The primary reason for this increase in absolute terms was from adding the LaJobi and CoCaLo businesses to the infant and juvenile segment. This was somewhat offset by over $3 million of lower SG&A expenses in the gift segment as we controlled and reduced costs where we could.

SG&A in the infant and juvenile segment increased from $6.7 million or 14.8% of net sales during the fourth quarter of 2007 to $11.9 million or 17% of sales in the third quarter of 2008. This increase is primarily attributable to the acquisition of LaJobi and CoCaLo, a higher allocation of corporate costs, increased product development costs and advertising expenses incurred to support our growth in the infant and juvenile segment.

SG&A in the gift segment was $17.1 million or 44.7% of net sales in the third quarter of 2008 as compared to $20.5 million or 36.7% of net sales in the prior year period. The decrease was primarily due to a reduction in selling and shipping expenses related to lower gift segment sales volume and the elimination in 2008 of advertising expenses incurred during the roll out of the Shining Star products during the third quarter of 2007.

Consolidated net income was $8.2 million or $0.39 per diluted share for the third quarter compared to consolidated income of $14.3 million or $0.67 per diluted share for the same period in 2007.

Turning to the balance sheet, we believe our capital structure is solid and we continue to plan prudently for future working capital needs and capital expenditures. Consolidated net inventories totaled $65 million for the third quarter which included the acquisitions of LaJobi and CoCaLo. Importantly, our inventory for the quarter was in line with our overall sales performance and sales outlook with higher infant and juvenile inventories that reflect the acquisitions and lower gift inventories that reflect lower sales levels. The increase in good will in tangible assets and debt reflect the acquisitions of LaJobi and CoCaLo.

Now let me turn the call back to Bruce for his closing remarks.

Bruce G. Crain

Thanks Tony. Just for everybody listening, Tony mentioned that the inventory reserve in our gift business of $600 million, that would be $600,000 of reserve there. But thanks Tony for the numbers.

Let me talk about a few fundamentals. Despite the weak current consumer and retailer environment, we believe we have tactics and strategies in place to maximize the opportunities available in today’s environment and management team approaches that will allow Russ to weather this tough economic times that likely lay ahead while also best position ourselves for the future.

Let me briefly remind everyone of the fundamental drivers of our businesses that we believe will support our companies even during difficult times. In our infant and juvenile segment, we enjoyed many favorable dynamics and attractive financial metrics even though product cost increases remain challenging. For example, we’re experiencing the strongest birth rate period since the early 1960s in the US with over 4.3 million being born annually.

As I mentioned earlier, we believe parents typically resist compromising spending on their children even in tough times and hope that this will continue to serve us well. We believe we have some of the strongest and deepest retailer relationships across the I&J industry. We also believe that we have particularly strong entrepreneurial management teams across our confederation of design and brand-led I&J businesses.

For the gift segment, results are very challenged, but we believe we are making progress and we have several significant asses we are working with including the Russ brand, the most extensive and one of the most experienced international sales and product organizations in the gift industry, some of the deepest customer relationships around the world, and we have scale advantages.

Finally, and especially given the difficult consumer markets, we’re taking what we think is a cautious and prudent approach to managing our financial position in both segments and at our corporate level during these uncertain times. In addition, we believe our financial partners and banking relationships are strong and we’re also working carefully to control expenses and guarding against deferrable operating or capital expenses.

This is an unprecedented time in recent history and despite the current challenges we are facing, we’re determined to advance our businesses and position the company and for many of you on the phone today, your company, for long term success.

In closing, I’d like to thank our employees in particular that are working hard around the world to drive our businesses as well as our supplier and retailer partners.

Now we’ll turn the call over to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Arnold Brief with Goldsmith and Harris.

Arnold Brief – Goldsmith & Harris

It looks to me like at this point the revenue base for the gift business seems to be running in the $135 million area. It lost money for three out of four quarters in ’07, probably all four quarters in ’08 and certainly the first two quarters of ’09 with the seasonal decline in revenues. You have SG&A over $75 million and the gross margin under 45%. This is a model that’s not viable in terms of revenue base and cost structure. I’m wondering number one where do you get the cash to pay your contribution to corporate overhead. Number two, with losses being 9 out of 10 quarters, how much longer can you go before you violate some of the debt covenants, and then finally, is there any plan that at this level of revenues you’ve got to get your cost structure down $15 million or $20 million. I don’t know how you do that. Could you discuss these problems?

Bruce G. Crain

Let me talk generally and then I’ll have Tony talk a couple specifics on covenants and stuff. We are very cognizant of the business model and the structure and the costs. We’re also very cognizant at the end of the day, a tremendous amount of economics of gift is driven by top line and we are missing the top line. So as I said in my remarks, we’re focused very much on trying to drive top line and introducing a lot of new product but recognizing that we can’t count on top line showing up. We do not have a Shining Stars equivalent in the near term that we see or the one that we’re experiencing right now. The cost structure is fundamentally what we need to go after and we’re doing a lot of work against that on the SG&A front.

On the gross margin front, we’re actually... there’s some reasonably okay things going on in gross margin but it really isn’t an SG&A overhead issue and it is a top line issue. We should remind everybody though, also when we talk about our gift business, within the gift P&L and numbers you are also seeing a lot of our corporate cost structure which is reported through our gift segment numbers and they enjoy some pick up from the I&J side. If you read our debt covenants in there, there’s a $3.5 million contribution on an annual basis from our most recent refinancing that comes over from I&J but everything else is supported. All the other corporate charges are supported within the gift segment.

Tony, do you want to talk a little about the covenants?

Anthony P. Cappiello

So all the overheads are in there. Over the next 12 months we have adequate funding and ability to continue to do what we need to do to continue to resize this business. We continue with strong asset management and cash management and we have the capabilities in those borrowing facilities right now to get us through at least the next 12 months.

Bruce G. Crain

Specifically, Arnie, the major facility on the gift area is an asset based lending facility that we have through B of A that covers the US and Canada and why don’t you just talk to the covenants on that, Tony? It’s a very simple...

Anthony P. Cappiello

Well very limited covenants, I mean, really it’s a $25 million facility and there is a $3.5 million hold back subject to some level of covenants of profitability but without that [inaudible] $21 million facility all up and right now we’re borrowed to the tune of about $7 million on that facility.

Bruce G. Crain

Arnie, did that get at your questions? We clearly need to and have underway a lot of issues on cost structure and I am absolutely to going to build a business model looking forward that counts on sales to take care of that cost structure.

Arnold Brief – Goldsmith & Harris

You’re in essence telling us, let me see if I interpret what you’re saying properly. You’re basically telling us there’s another significant tight restructuring program in the works in the near future.

Bruce G. Crain

I wouldn’t say that. We’re using all the tools that are out there. We’re using attrition and we’re using a lot of other things. We’re restructuring some of our costs from fixed into more of a variable approach to it as we structure some of our... a lot of our... yes, there are a lot people in the business but a lot of that people structure is sales people and so we’re doing a lot of work on our comp programs to build more incentives into that and variable cost structure around that.

So we’re trying to convert a lot of our cost structures to things that have more variability. We also have a variety of things that are coming up whether it’s leases and other things that we think will cycle into lower cost facilities and things like that over time. So we’re looking every line item at a very detailed level but we have not put out any messaging of any significant PIP program or anything like that.

Arnold Brief – Goldsmith & Harris

The disparity between the gross profits at this level of sales and your SG&A isn’t a fine tuning job. I don’t recall the exact numbers but it’s probably at least $15 million gap in there.

Bruce G. Crain

Do recall that in our numbers year-to-date we have a fair amount of one-time charges that are non-cash.

Arnold Brief – Goldsmith & Harris

I’m excluding all that.

Bruce G. Crain

Look Arnie, the thing I can say is we’re going to stay in touch with you in various calls and other things as we work through it but we’re well aware of the parts and are working hard on each part of it. It’s not fine tuning. There are some significant things we recognize, some of which we have underway and other things that will need to be forthcoming. We’re right now in the middle of building our business plans for next year.

Arnold Brief – Goldsmith & Harris

Babies R Us announced in the summer a new exclusive agreement with Amy Coe and I’m wondering... the product line seemed very similar, cribs and bedding and what have you. Two questions in relation to that. One, has it had any impact on your shelf space at Babies R Us and two, do you see this as a longer term trend where retailers are trying to differentiate themselves more in developing some of these exclusive agreements?

Bruce G. Crain

I’m not going to speak to the specifics of that one, but there are... Yes, these exclusives, designer-led things, are in the market. There are... We’ve participated in some over time and some have come and gone. Our focus at BRU today is a combination of our own brands and several things that we do with licensed brands. So if you just bear with me for a second, we’ve got our four businesses with a lot of activity going on there and so if you take CoCaLo, it’s almost exclusively CoCaLo branded product in there. If you take our Kids Line World, they’re in there with Carters product, they’re in there with Kids Line product.

If you take our LaJobi world, we’ve got our own branded stuff in there, we’re also in there with Serta and with Graco at lower price points and with Sassy, we’re in there with a lot of Sassy branded products and then select brands like LeapFrog. So we think there is a role of other well-known brands but where it comes to the more design led ones, we are more focused on our own brands doing that than some of the partnerships when it’s very design led type things. But we are very open minded and continue to look at all of those programs.

Arnold Brief – Goldsmith & Harris

Would you indicate whether or not that cost you any shelf space, that agreement with Amy Coe?

Bruce G. Crain

I don’t have a quick answer for you, Arnie on that. I can dig up one and try to get back to folks.

Arnold Brief – Goldsmith & Harris

Let me just ask one more question and then I’ll get back in line. In conversations with you as well as listening to the Carter conference calls, in your call today you talked about the stability and lack of demand for baby products is not seasonal and not very cyclical. Conversely, we do know that at any given point in time retailers can get very scared and cut inventories and you sort of discussed that today. It’s interesting to note that again Babies R Us had higher sales for their first six months and lower inventories which is right in line with what we’ve just outlined here.

Given what’s going on in the economy, it seems to me that further cuts in retail inventories are possible in the fourth quarter leading maybe to some disappointment in the fourth quarter for the infant and juvenile. However, as you look into ’09, again if demand is reasonably stable and growing, and inventories have been reduced, it seems to me that the outlook for ’09 is actually stronger because these inventories are going to have to be rebuilt as demand continues to grow. Would you comment on that concept?

Bruce G. Crain

Arnie, I think you’re observing the same things that we’re observing and tracking very closely account by account. There clearly are inventory adjustments going on. In many cases I think we’re feeling reasonably okay that most cases these are postponements of programs that we’re maintaining placements and people are ratcheting their open to buy dollars down. I do think they have any unprecedented sort of approach that they’re taking on their holiday season this year as they try to think about their inventories relative to what’s moving on a holiday standpoint.

I think the thing that to your comment or to your question specifically, the one thing that we would miss through postponements is the cycle that we get through that inventory. Obviously that’s one sell through that you would miss even if you eventually get the program in, so I think we feel reasonably okay looking into next year that we will get the placements, what the velocity is off the shelf we’re cautious on, we’re managing our own supply chain carefully on that, but we do miss one turn by missing one of the cycles here to the extent that people do postpone programs.

But I go back to my comments of earlier, we feel like this is a category of product where the consumer does behave differently than in more discretionary oriented product.

Arnold Brief – Goldsmith & Harris

Do you see that cycle really hitting more in the fourth quarter or hitting in ’09 in terms of the order picture that you’re looking at?

Bruce G. Crain

Account by account we’re seeing different actions being taken by retailers right now for sure. Again, we’re now just building our plans going into next year. For the most part, if your question is what’s going to happen in Q4 of next year, we have not done that level of analysis right now, but clearly there has been some pull back during this quarter that we’re in now and we’ll see how that cycles into next year. I mean, I think that goes to how long whatever level of recession we have and things like that. I can’t give you a quarter by quarter answer at this point.

Arnold Brief – Goldsmith & Harris

Carters mentioned in their third quarter that they thought cost pressures from China were ameliorating a little bit. Are you seeing some of that?

Bruce G. Crain

As I said, all of our teams are just back from Asia. We’ve got people over there a lot. We are seeing some things because of freight costs, petroleum lead things in various resins and plastics, but there are several other issues that are really big over there, plus rebates in particular. As some people on this call would know, the Chinese government used to have a fairly significant amount of rebate structure that went to the factories and it backed off on a lot of that over the last year and have now re-instituted those which is very favorable to the factories. So there are some positive things going on. But what’s happening I think is the currency trends continue to go against US dollar buyers and now you’ve got this other issue going on with a variety of testing and regulatory stuff that is really sort of another headwind that’s hitting these factories.

So yes, I think there’s some positives, but there’s some other things going on too. Again, we think our scale and our people on the ground, we’re trying to be in the best position possible over there now.

Operator

There are no further questions. Please continue with any closing comments.

Bruce G. Crain

Look folks, thanks for your time today. I hope the overview of the results as well as some of our plans for the rest of ’08 and ’09 give you some useful insights. I look forward to updating you on Q4 as we did dig through and work through this tough environment. Thanks a lot.

Operator

Ladies and gentlemen, that does conclude our conference call for today. You may all disconnect and thank you for participating.

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Source: Russ Berrie & Co., Inc. Q3 2008 Earnings Call Transcript
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