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Zep, Inc. (NYSE:ZEP)

F1Q09 Earnings Call

January 12, 2009 8:30 am ET

Executives

Jill Gilmer - Assistant Corporate Secretary

John Morgan - Chairman, President, and CEO

Mark Bachmann - Executive Vice President and CFO

Analysts

Mike Sison – KeyBanc Capital Markets

Matt McCall - BB&T Capital Markets

Robert Felice - Gabelli & Company

Operator

(Operator Instructions) Welcome to Zep, Inc. Conference Call. I would like to introduce Jill Gilmer, Assistant Corporate Secretary.

Jill Gilmer

Thank you for joining Zep today for our First Quarter Fiscal 2009 Conference Call. Here with us today are John Morgan, Chairman, President, and CEO, Mark Bachmann, Executive Vice President and CFO, and other selected Zep officers.

I would like to remind everyone that certain information included in this conference call may contain forward looking statements that involve risks, uncertainties, and assumptions. If the risks or uncertainties ever materialize or the assumptions prove incorrect our results may differ materially from those expressed or implied by such forward looking statements.

All statements other than statements of historical facts could be deemed forward looking, including but not limited to any projections of financial information, any statements about historical results that may suggest trends for our business, any statements of the plans, strategies, and objectives of management for future operations, any statements of expectation or belief regarding future events including the economy, volume or cost trends and any statements of assumptions underlying any of the items mentioned.

For a description of the risks and uncertainties, please refer to the company’s filings with the Securities and Exchange Commission, including its Form 10-K and its 10-Q.

I will now turn the call over to John Morgan.

John Morgan

Let me first begin by telling you that although I’m very disappointed in our current financial performance I am extremely excited about the future of Zep and our ability to grow the business and create great shareholder value.

While our business was able to deliver strong financial performance throughout fiscal 2008 despite the implementation of our strategic initiatives and the fact that we now know the current recession began in early 2008, today the broader market is suffering from multiple headwinds as the depth of the financial crisis and global economic recession continues to widen. The deteriorating financial conditions leading to an intensifying credit crunch and a worsening recessionary environment significantly impacted our customers, our end market demand and our business during the first fiscal quarter.

Our fiscal first quarter proved to be more challenging than anyone could have planned for or expected. As you well know we are facing a new economic reality, operating in one of the most difficult economic periods in our history. While we have historically been less affected by economic downturns when compared to other companies and are certainly navigating better than many industries in today’s environment, the current recession is affecting virtually all of our market segments as can be seen in our first quarter financial results.

We reported a net loss for the first quarter of fiscal year 2009 of $1.5 million or $0.07 per diluted share versus $6.3 million or $0.30 earnings per diluted share reported in the same period of our prior year. The net loss included in the previously announced pre-tax restructuring charge of $1.9 million or $0.06 per diluted share related to further non-sales headcount reductions. Mark will further comment on the financial matters later in the call.

Despite these results I continue to believe in the recessionary resistant nature of our business model. Specifically when compared to other companies in the industry. While we happen to have just faced a quarter with a confluence of unusual economic challenges which came more rapidly than we could adjust for we were still profitable on an operating basis excluding special charges.

Let me take a minute to discuss the three major factors that impacted our business during the first quarter. First we experienced declining sales. We estimate that two thirds of the decline was driven by the economy and the balance was due to our own strategic initiatives which we believe are important to the long term growth of our business.

Second, the raw material costs remained very high despite the economic slowdown and declines in broader commodity costs. However, there is a timing issue with these lower costs flowing back into our results partly due to supplier’s reluctance to bring prices back in line and any decrease must work through our inventories before we see any P&L benefit.

Third, we had not expected the rapid decline in order rates and had not reduced our G&A costs as rapidly as we might have otherwise cut during difficult economic conditions and we are continuing to invest in the long term transformation of the business.

I would like to spend a few minutes discussing in more detail how the current environment is affecting our company with some of the steps we are taking to reduce our overhead cost structure and improve operating results. While we have previously articulated our expectations for inconsistent quarterly performance the broader economic conditions had a greater than expected impact on our business during the fiscal first quarter.

The stability of our business model and revenue streams is predicated on the diversity of our customer and end markets we serve. As usually when orders from one market segment come under pressure orders from another remain strong or improve. Virtually each of our customer end markets experienced revenue declines this quarter.

Order rates declines continued to accelerate throughout the quarter. We believe that part of this is due to timing as some of our retail and industrial customers are unwilling to put cash on the shelves in the form of inventory given their concerns over the economy, efforts to improve their cash flow and their budget constraints. Volumes could come under even greater pressure if unemployment level increase or the economy continues to deteriorate.

Also, our newly established industrial distribution customers have been slow to place new orders. Although most are delaying orders they are committed to moving forward with us in 2009. We’ve been in communication with these customers to discuss the timing of potential orders and to identify areas where we can better serve important accounts. We remain very optimistic about moving into the important distribution channel.

Now let me shift gears to discuss some of the areas of the business we’re focusing on to improve our operating results. Specifically we are focused on reducing G&A expenses as well as improving our raw material sourcing strategy. We continue to keep a close eye on the economy and are prudently managing our costs to navigate the challenging environment and ensure we are positioned for long term success.

While we’ve already reduced our non-sales headcount by over 7% in an effort to further streamline our operating cost structure we made the decision to reduce non-sales headcount by an additional 5%. While never an easy decision we acted in the best interest of the business and our shareholders.

As I stated earlier we recognized the restructuring charge during the first fiscal quarter and we expect the reductions to be complete by the end of the fiscal year. Going forward we will continue to aggressively examine all alternatives to reduce costs in other areas as necessary. I’m confident that our people will do whatever it takes to manage through these difficult economic times and a number of these actions are already underway.

Another key concern for us that we are addressing is the rising cost of raw materials. All of you have seen the price of oil drop rapidly over the past few months. However, during the quarter our raw material input costs did not decline anywhere close to the same rate as the crude oil declines. This is due to the fact that a number of large suppliers have made the decision to cut production and costs within their own organizations in an effort to respond to lower demand and to maintain their current pricing as opposed to adjusting pricing to match falling commodity costs.

The difficult economy has created a challenging pricing environment for us and has limited our ability to further pass cost increases on to customers at this time. As a result our gross margins eroded during the first quarter. Further, given inventory levels and our current raw material prices we expect to face similar challenges in the current second quarter.

Given the severity of our raw material cost issue we have a number of actions underway both with existing suppliers as well as potential new suppliers. We expect to see significant improvements beginning in our fiscal third quarter. For example, we have already identified savings of an annual run rate of over $6 million that will begin affecting our business over the coming months.

While we will remain conservative, cautious, and prudent when managing our business through this difficult time we aren’t managing for just this cycle. Rather, we’re preparing ourselves for the growth and profit that we are expecting over the long term. Incrementally we invested approximately $1.5 million during the first quarter and I would like to update you on those strategic initiatives.

As a reminder, the transformation plan we announced following our spin off last year had three key components which included first, a focus on improving our core business to make future growth more valuable. Second, expanding our presence in the retail channel distribution. Finally, entering into the industrial distribution market which we believe exceeds $6 billion.

In the first area, our core business, which focuses on making our business better before bigger we have made good progress. During our fiscal first quarter we completed the decentralization of our business and we have recently begun to see the behavioral changes I had hoped for from having focused business leaders with P&L and balance sheet responsibility.

We continue to make progress with our demand shaping efforts. By the end of our fourth quarter 2008 we had completed the initial phase reducing 50% of our skus. Further demand shaping will now be done across geographies and by examining opportunities to further consolidate raw material usage.

On the revenue side we have completed our sales force restructuring and modified our growth model to begin recruiting experienced sales reps that have a proven track record. Our hiring strategy will include both former Zep sales representatives as well as targeting high quality reps from other companies. We’ve recently implanted this new hiring strategy and will take some time to attract these new sales representatives.

We are continuing to focus on our North American manufacturing and distribution strategy. While we have decided to delay the implementation of regionalized blending we expect to accelerate a logistics reconfiguration and have identified nine branches during the remainder of this fiscal year where we will consolidate inventory into fewer locations and open up one larger distribution center in the north eastern United States. We’re confident this will provide much and even better service to our customers and will do so at reduced operating costs.

Our second initiative is broadening our access to the retail market. We continue to focus on penetrating a broader section of our retail segment with our Zep Commercial and Enforcer product lines. Our Zep Commercial products are currently available at The Home Depot and at various hardware retailers such as True Value. While these relationships have served to increase our end customer reach and brand name recognition we are in discussions with additional retailers that serve fundamentally different markets such as the automotive after market.

Additionally, we continue to focus on growing our industrial distribution business. As you’ll recall we previously announced the signing of five distribution partnerships with world class business partners. As we discussed at the time of that announcement these relationships are not expected to generate meaningful revenue right away particularly in light of todays market conditions but will certainly provide a long term growth avenue for this company. Recently we were able to sign one more distributor partner, The United Group which serves the janitorial and sanitation markets.

In all areas of business we continue to invest in the development of Green products. While we have been pleased with customer acceptance of our Green Link product line we believe additional market penetration opportunities exist. We currently offer about 100 environmentally responsible products and are focused on continuing to expand this product line going forward.

While we continue to make important progress on our strategic initiatives the current economic climate has caused us to postpone some items particularly those that have higher cash costs. For example, while we had begun analyzing some potential acquisition opportunities the current environment has caused us to put this on hold. We are always looking to improve our long term operations and product offering by acquisitively growing our business. We believe attractive opportunities still exist. However, the most prudent course of action is to wait for the economic volatility to subside.

Lastly, it is important for us to support our Zep reps as they work to aggressively compete everyday. Unfortunately over the last year some of our former sales reps have broken their non-compete agreements with Zep and have decided to join competitors. At this point we have filed law suits against one competitor and six former sales representatives in support of our business and to enhance our own reps abilities to compete. Again, we will support and defend our people to do all it takes to help them compete effectively everyday.

We achieved a number of important milestones this quarter and are focused on moving past a period in our history that can only be characterized as challenging. Even in this challenging period we continue to stay focused on our strategic initiatives that will further diversify our customer base, streamline our operations and decentralize our managerial capabilities. Zep is a company with a proud history and a strong heritage and while we still have a lot of work ahead of us we are confident in the long term prospects for the business.

With that I’ll now turn the call over to Mark for a review of the first quarter financial results.

Mark Bachmann

Our first quarter revenues were $129.2 million compared to $143.6 million reported in the year earlier period. Sales were adversely impacted by a decline in volumes of approximately $16.2 million as the recessionary environment has negatively impacted our customers. We estimate that about two thirds or $10 million of this decline is attributable to the economic slowdown.

Further contributing to the volume decline were some of our strategic initiatives which reduced selling, headcount and changed sales policies that we estimate were responsible for $5.5 million of the volume deterioration. Unfavorable foreign currency translation on international sales contributed $3.4 million of the decline offsetting this shortfall was the affect of higher selling prices of $5.2 million.

As John mentioned previously our first quarter net income fell to a loss of $1.5 million or $0.07 per diluted share versus a $6.3 million or $0.30 earnings per diluted share reported in the same period of the prior year. We reported an operating loss of $800,000 compared to an operating profit of $10.8 million in the first quarter of fiscal 2008. Excluding the impact of the $1.9 million restructuring charge Zep generated operating profit of $1.1 million during the first quarter of fiscal 2009. The earnings shortfall was caused completely by the decline in volumes and gross profit margins.

Let me take a few moments and discuss the impact our market segment performance had on our operating results for the quarter. During the first quarter we recognized the decline across most of our market segments. In the US which represents more than 75% of our worldwide sales we participate in six main industry verticals. Of the six, in order of magnitude; transportation, retail, industrial manufacturing, and food are the most important. Combined these four verticals represent approximately 70% of our US revenues. Each of these has been affected by growing negative economic trends.

For instance, broader US market is experiencing falling consumer confidence, decreasing passenger miles driven, collapsing vehicle sales, declining retail home improvement sales, deteriorating labor market, and weakening industrial production. As a result, our retail customers recorded lower sales during our first quarter as consumer trim spending in the wake of recessionary environment.

Our customer base regardless of the end market they serve are being more conservative about their inventories in reaction to the economic environment. We anticipate that some of our retailers will be slightly increasing inventory levels in the coming months in preparation for the seasonality of their business.

Despite these challenges we still believe that the diversification across numerous segments is a long term positive for our business. It is very unusual when all of our four main verticals are down. As John described earlier this quarter we realized the full impact of the sharp increases in raw material costs year over year as we were unable to fully recover the increased costs with higher pricing in the market place. Our cost containment strategies were only able to mitigate a small portion of the gross profit shortfall.

It should be noted that we invested $1.5 million this quarter to support our long term strategic initiatives and incurred $900,000 in higher costs associated with being a public company. The effective tax rate for the quarter was 37% compared with 35.8% in the same period last year. The company anticipates the annual effective tax rate between 36.5% and 37.5% for fiscal 2009.

Cash flow from operations consumed $11 million or $5.5 million higher than cash flow consumed last year. Historically we consume cash in the first quarter as certain liabilities are typically paid during this period of each fiscal year. The increased usage was directly related to our lower operating earnings as the company’s working capital decreased by more than $6 million.

Capital expenditures for the quarter totaled $2 million an increase of $600,000 from the year earlier period. These expenditures were used to consolidate our Atlanta based office personnel, enhance information technology and capital to maintain our facilities. Now we anticipate fiscal 2009 capital expenditures will range between $8 and $10 million compare to our previous estimates of $14 million. We expect to closely manage capital spending in this economy.

Given the markets current focus on debt we wanted to provide some additional details regarding our debt structure. As of November 30, 2008, our outstanding debt was $66.5 million with approximately $38 million remaining un-drawn on our revolving credit facility. We are in full compliance with our debt covenants.

As a reminder, we are a dividend paying company and we declared a quarterly dividend of $0.04 on January 9. Our liquidity standing remains strong and we remain in a good position to manage our day to day operations and continue to make further investments in the business. Our debt to capital ratio net of cash is just over 39%.

While it is our policy not to provide annual or quarterly guidance, given the first quarter results, high raw material prices and the current economic forecast we felt it was appropriate to provide some perspective on the remainder of our fiscal year. We continue to anticipate inconsistent quarterly financial results as we manage through this difficult environment and continue to make progress with our restructuring initiatives.

Given that we have very limited visibility US recession is intensifying we would anticipate that essentially all of our profit would occur in the second half of the fiscal year. Further, it is likely that our operating results for each quarter of the fiscal year 2009 will be significantly below those achieved in fiscal year 2008. While the economic challenges may dampen short term results we remain committed to our long term financial objectives we set out over a year ago and we remain confident in the longer term prospects for this business.

At this time we would like to open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mike Sison – KeyBanc Capital Markets

Mike Sison – KeyBanc Capital Markets

In terms of demand here in the September, November quarter we had thought historically that to some degree cleaning chemicals, industrial maintenances a little bit less cyclical to a degree. We’ve heard other industrial companies that some of their customers idled plants, temporary shut downs. How much of the weak demand you saw was caused by that type of event?

John Morgan

We think that in the neighborhood of two thirds of our weakness in revenue was caused by economic events the majority of which is just the type of thing you described. Automobile dealerships are important for us. A number of them closed their doors. Industrial production is important to us; we’re a significant player in industrial maintenance, chemicals and supplies. Industrial production was cut, production days were cut back, and budgets were constrained.

What happened, I talked to folks from lots of different companies and lots of different industries over the last two or three months, as I’m sure all of you have. I continue to hear folks refer to things like it seemed like in early October their order rates spigot shut off. What’s happened is an awful lot of industries have constrained their budgets and curtailed operations. Those are our customers. We have seen that across the board.

The one area that we did not see as dramatic a decline in our business as other areas was really food. In the industry as you would expect things like healthcare did not experience quite as dramatic a decline. Unfortunately we’re not a very significant player in healthcare. We participate there but it’s not a large portion of our business so we didn’t get a lot of lift there. This is probably the first time that we can recall we’ve seen it so broad based.

Mike Sison – KeyBanc Capital Markets

I’ve heard pretty consistently from several that December was really the worst of the calendar fourth quarter. When you think about your 11% volume declines has it gotten worse generally speaking since then?

John Morgan

Somewhat. I don’t what to sound overly optimistic but in January we have seen the rates begin to recover somewhat. December was still a very tough month. It’s a little early for us to declare that we’ve turned the corner on things picking back up but we have held on to an expectation that as we got into calendar 2009 that some budgets might free up a little bit. We’re going to have to watch that over the next few weeks and see. We’re managing the business and making the changes to the business assuming that things are not going to get better anytime soon.

Mike Sison – KeyBanc Capital Markets

In terms of raw materials, what are you expecting for the increase in the second, third and fourth quarters and maybe give us a little bit of help on how you buy in terms of contracts, are you stuck with a price for a couple months then they start to come down is there a lag that you have in your contracts that’s causing you to pay the higher prices when spot prices have come down quite a bit across the board?

Mark Bachmann

Let me remind you that about two thirds of our sourcing costs come in the form of chemicals. Most of those are not under long term contracts or under price commitments. As the price in the market increased last year those flowed through to us. As John mentioned in his comments some of the upstream suppliers and manufacturers seemingly are holding on to the price increases that they passed along earlier in the year.

As we said, we expect that the continued high prices to continue as it works through our inventory in our second quarter and that we would expect to see that annualized run rate hit us in the third quarter by the time our inventories turn since we’re on FIFO and we already have commitments from a number of our pre-existing suppliers and we’ve also engaged with some new suppliers to achieve these savings.

Mike Sison – KeyBanc Capital Markets

The price increases that you’ve achieved you should keep those and then by the third quarter as the lower prices flow through if you will, you would break even, or close the gap between raw materials and pricing then in the fourth quarter and beyond you would have a plus, pricing would be above raw materials that would be a positive for you heading into 2010?

Mark Bachmann

As we said when you look at the impact that the gross margin had down to 52.5% this quarter from the mid 55% over the last previous three quarters we’ll be able to claw some of that back with what we announced in terms of the $6 million worth of annualized savings. We’re working on clawing the rest of it back through the remainder of this year and into next year.

Operator

Your next question comes from Matt McCall - BB&T Capital Markets

Matt McCall - BB&T Capital Markets

You said that you’ve seen rates beginning to recover; I know that wasn’t an aggressive improvement but help me understand you talked about orders deteriorating throughout the quarter, what were order trends like in October versus December, if you don’t want to give numbers maybe relative to the 11% sales decline that you reported.

John Morgan

We were not down, at our 11% decline, I’m going to go from memory while Mark’s looking for some data here. We were not down at that rate in September. We were down approximately that rate in October and the rate got a little worse in November. We saw an accelerating rate of decline as our quarter went on. The reason Mark’s commenting about our second half, December wasn’t much better. You’re right, it wasn’t a glowing endorsement of volumes in the current period talking about January but we have seen some improvement here recently.

We don’t know how much of that is getting in the new budget years and things like that. We frankly expect things to slowly improve, however, given the uncertainty in the economy we’ve decided that we really have to manage the business for the foreseeable future assuming things are not going to improve. The changes that we have underway and the things that we’re talking to our team here about today and tomorrow in various town hall meetings are further cost reductions necessary to manage through order rate declines like what we’ve recently experienced.

If things turn around in the economy a little bit better than that then that’s going to be good for us. We’re going to manage for that kind of expectation. Does that clarify?

Matt McCall - BB&T Capital Markets

I think I said October versus December but, the 10% of the top 11% was a volume number we calculated December I can assume that if things got worse that December was probably worse than that 11% is that a safe assumption?

John Morgan

Yes, that’s correct.

Matt McCall - BB&T Capital Markets

Order magnitude of 1.5 times, something like that is that a good ballpark?

John Morgan

I think that’s very similar to what we’re seeing in the industry with us yes.

Matt McCall - BB&T Capital Markets

You spoke about the $6 million in savings from raw materials you expect. Just to clarify I think the previous question you said you made some moves, is that assuming current pricing levels? Explain that $6 million of savings and when it should show up.

John Morgan

This is such an important part of our business let me be very clear about that. If you look at our current pricing levels that is the pricing levels at which we purchase raw materials in our first quarter that we just announced. The $6 million savings that we’re referring to are identified annualized savings from those purchase prices on a rate basis. Those are identified savings, let me parenthetically tell you obviously people here are working very hard to take that number much higher than $6 million but we have identified $6 million, we have commitments on $6 million.

That takes a bit of time to work through our inventory since we’re on a FIFO but we believe that will be coming into our results at the full run rate of the annualized $6 million by the time we hit Q3 which begins March 1. Obviously we’re beginning to see as inventories turn some of those savings come into our results in the current period but it won’t be up to the full run rate until we hit Q3. Does that make sense?

Matt McCall - BB&T Capital Markets

It does, thank you for that clarification. You talked about some of the headcount reductions and some of the other measures you’re taking to save on your costs, reduce your costs, some of those actions took place in Q4 I believe, and maybe it was after Q4. What was the savings, if any, in Q4, what is expected to be in Q1 and after Q2 when you complete the next round what’s the expected savings?

John Morgan

When you say Q4 I assume you’re talking about calendar Q4?

Matt McCall - BB&T Capital Markets

I’m talking about your fiscal Q1. I keep getting my dates mixed up.

John Morgan

Our fiscal Q1 we did not realize any significant savings from those reductions. We were slow to believe that the order rate declines would continue for any sustained period of time. We began the plans for those reductions as we got later into our Q1. When we got literally into the last week or so of Q1 we began reductions, continued reductions in the month of December, are continuing some reductions in January and frankly because some of those reductions are related to the consolidation of branches some of them will go on in through our fiscal year.

We’ll have a large portion of that completed by the time we get done with our Q2. This is an area that we owe it to our people to have a more explicit conversation about exactly the actions that we’re taking which were on the docket to do today and tomorrow. We’ve identified some significant savings. We’re also going to do some things that can have an immediate impact.

We’ll be talking to our employees today and tomorrow for example about the fact that I intend to take a 20% cut in my compensation. My staff has agreed to take some cuts up to about 13% and we’re taking other actions such as that because of immediate favorable impact that we have in those areas which helps get us through other further reductions.

Mark Bachmann

With respect to the $1.9 million restructuring charge and the people that it affects it’s related to severance. As we exit the year, as John said, because of the people who will be affected in some of the locations that will be consolidating those branch locations we anticipate exiting the year in an annualized run rate of $3 million savings associated with the $1.9 million restructuring charge.

Matt McCall - BB&T Capital Markets

Three million dollars of savings exiting the fiscal year and what portion of that savings comes from headcount reductions and what from branch closures?

Mark Bachmann

When you talk about the branch closures and the labor savings associated with that, that might be about a third of that, about $1 million and two thirds are from other headcount reductions in the organization.

Matt McCall - BB&T Capital Markets

You mentioned the six reps and the non-compete I assume that those were folks that were not let go, correct me if I’m wrong, that non-competes don’t apply if you’re let go. Are you running into any issues in hiring folks with those non-competes?

John Morgan

Some of those are people that we let go. We do have some agreements in place where non-competes are still enforceable even if we’ve let them go where they have left for performance or other reasons. We intend to enforce those no competes. On the hiring side there are some situations where we’ll have to stay hands off because they have entered into no competes. We do honor other peoples no competes. We’ll have to be mindful of that. We believe that there are experienced and successful reps that have relevant experience.

An example, in our Midwest territory we hired five reps in the last 10 days, four of whom have relevant experience and we’ve already seen their performance hitting our order rates. Each of them are in situations where they did not have no competes. This is not a panacea as you know it takes longer to energize the top line by adding reps. The most significant thing about this that I really want to clarify is that post spin off we wanted to focus on how we could really grow our traditional Zep rep business since that’s an area that we need to continue to invest in.

We needed to repair a number of structural things relative to the business to make future growth more profitable. Bill Holl and his team over the last year have undertaken to accomplish that and I’d say they’re overwhelmingly complete with that and even if we weren’t going through the current times we would now be back in the mode of adding Zep reps but instead of the old model of less experience and a long lead time to train we’re focused on more experienced reps.

The reason I wanted to highlight that today is I want to be clear that we are from a financial perspective still in a position to be able to make those investments at this point in time. Sorry for the long winded answer but its such an important part of our business I want to be clear.

Operator

Your next question comes from Robert Felice - Gabelli & Company

Robert Felice - Gabelli & Company

You had mentioned that all of your profit this year will come in the second half. As we look to 2Q should we expect results to be similar to 1Q, should we expect that as the raw material costs remain high, December was probably the worst month that you saw so far that things will get worse. Some clarification on 2Q relative to 1Q and the full year.

John Morgan

December was a tough month compared to October and November. That means we need to do well in January and February to claw back some of December in order to have a Q2 that is similar to Q1. That’s why Mark is characterizing that we think essentially all of our profits come in the second half of the fiscal year. While our current results I know is not the inflection point that either you or I were hoping for I do believe that as we then get into Q3 with these cost savings that are underway and with a little bit of volume we begin to see things recover.

Robert Felice - Gabelli & Company

You mentioned that two thirds of the volume decline was due to end market. Of that, I know its probably going to be difficult to quantify how much of that would you say was due to facilities on the part of customers being idled during the quarter due to inventory de-stocking. What’s pure end market demand versus volatility during the quarter?

John Morgan

We have debated and analyzed the heck out of that in the last few weeks as you can imagine. I can safely say that we’re not certain. We have talked to a lot of folks, customers and reps and of course we have evidence of both like you’ve described. I really don’t know the answer to your question. I guess it is my speculation that a significant portion I’ll call it half is related to people just being so uncertain about the economy that they are squeezing down their inventories including maintenance chemicals on their shelves.

We certainly know that in the retail side of our business a lot of it is a reduction of inventory on the shelves, the majority of it in fact. In our I&I business we’re not certain. In terms of the upstart of our industrial distributor model it’s obviously all as a result of not wanting to go ahead and build inventory going into the end of their calendar year and fiscal years. I would expect for that to recover as we get into this early calendar.

Mark Bachmann

There are many factors that we believe influence our business. Employment levels in the industrial space we certainly believe are one of them. As the jobs report came out last week, which obviously shows a significant loss of jobs in the last three, four months of this calendar year would suggest that that’s not inventory so much as sheer industrial production that is being reduced in the marketplace. If you look at the sectors who are experiencing the highest levels of unemployment; construction, manufacturing, some of those are at the top which are some of the industries in which we serve.

Robert Felice - Gabelli & Company

As you adjust the business for the medium term should I assume that first quarter volumes are the run rate that you’re kind of assuming continue?

John Morgan

That’s well characterized. Our situation is because we cannot answer accurately the question you asked and its obviously a critical question we believe the prudent thing for us to do is to attack our operations with the assumption that this is a new economic reality. We have to do the things necessary to size our business to be able to operate at the new levels. That’s the assumption we’re making.

Robert Felice - Gabelli & Company

In your prepared remarks you had mentioned some changes to your strategy and obviously this environment creates a heightened state of operational risk for all companies but has got a number of moving parts in terms of the ongoing transformation. Any other areas where you’ve kind of reassessed the risk of moving forward and altered your approach.

John Morgan

Yes, when we talk about the risk of moving forward in particular we’re interested in those areas that consume cash in the short term or would divert our internal resources to areas of longer term benefit when we need them focused on things in the short term instead right now. For example, some of our systems implementation from a computer systems standpoint we would anticipate sliding that out somewhat to delay some of that spending.

Those are the primary things, the things that we don’t believe we have to touch at this point in time we believe we can continue to do the sales rep hiring that I referred to earlier. We want to obviously continue our investments in new product development. We introduced a number of new products at our sales meetings over the last 60 days, I guess now its 90 days. That’s important to the future of the business and we want to continue that. The two primary areas for delay are the manufacturing blending portion and our internal systems investments.

Operator

Your next question comes from Mike Sison – KeyBanc Capital Markets

Mike Sison – KeyBanc Capital Markets

In terms of a follow up, when you think about the second half of the year noting when you’ll see some profitability do you need to have volume to generate profitability in the second half?

John Morgan

We do.

Mike Sison – KeyBanc Capital Markets

You’re assuming to some degree that maybe the product rationalization efforts anniversary and things get a little bit better?

John Morgan

I’m going to ask Mark to comment here. Let me say that we have a number of areas of our business where not only do we expect some modest recovery in the economy but we have some otherwise seasonality and we have some look into some of the initiatives that are underway in our various different sales initiatives. We have in our internal forecast some expectation for some increasing volume.

From a cost structure standpoint we none the less don’t believe we should depend on that and so we’re taking the actions necessary to reduce costs and to operate as a smaller company basically as a 5% to 10% smaller company. That’s our internal focus and the way we think about how we need to structure our costs we need to be prepared to operate as a 5% to 10% smaller company instead of that $575 million company we have been for some time.

Mark Bachmann

There is natural seasonality in our business in terms of the back half of the year having more selling days and typically stronger for us. We would expect on an absolute basis that the quarterly revenues in the back half would be greater than the first half. As John said, we’re planning that we’ll have reduced sales throughout the year on a quarterly basis.

Mike Sison – KeyBanc Capital Markets

Reduced sales on a year over year basis?

Mark Bachmann

On a year over year but probably also when you look at it on a quarterly basis.

Mike Sison – KeyBanc Capital Markets

The concept heading into the second half of the year is that sequentially sales get better which puts you back in the black then you’ll execute well on the cost savings you get a little bit plus on raw materials then depending on how the economy shapes up will sort determine whether it gets you back into what profitability levels you had the prior year or if it remains down year over year on a gross margin basis.

Mark Bachmann

You summarized it well.

Mike Sison – KeyBanc Capital Markets

When you think about longer term certainly you’re going to be leaner, you’re certainly going to have a better cost structure as you head into 2010 and 2011, its certainly premature at this point to think about the earnings in 2010 but can you help us think about what level of earnings you should get back to once demand here picks back up and gets to a normal state hopefully sometime down the road?

John Morgan

I’m not prepared to do that. The prudent thing for us to do is as we get into our next quarterly call as we have a better look at a number of things we have underway and as we’re talking to employees about this week, I think we’ll probably be better prepared to characterize that. Generally speaking without putting numbers to it I’m might optimistic about the future. We’re not letting a good crisis go to waste. We are accelerating some of the actions that we would have otherwise taken in the continual transformation of the business. I believe its going to make us a leaner organization.

While some of the costs that we will take out could come back in because of the variable nature of them, some programs that we will end for employees, we will reinstitute when things are better. A lot of our costs we’re taking out will be essentially permanent structural changes to the business. I think that we’ll get significant leverage out of that, that’s what I hear in your question.

I do believe that as we get on out past this fiscal year we will get significant leverage in that. I do believe that we’re the kind of consistent cash flow generating business that it puts us in a position to get back into our thinking about acquisition due to add to the platform. To be specific about that in terms of ’10 and ’11 I’m just not prepared to do that.

Mike Sison – KeyBanc Capital Markets

If you were able to recoup the volume declines due to the market weakness this year and your raw material situation is going to look better, there’s really no reason why you wouldn’t be able to get to earnings levels that you achieved in 2008 assuming you get the volumes back right?

John Morgan

It takes that volume return. The important caveat you placed on this is that we recover raw material costs structures that are necessary because we need to get that gross margin back to an historic level and that’s what we’re focused on. That having been said, volume in the short term in this business falls through at a pretty good rate. I think you characterized it accurately.

Operator

There are no further questions at this time. I would like to turn the conference back over to Mr. John Morgan for closing comments.

John Morgan

As you heard, despite the progress and implementation of our strategic initiatives we are disappointed with our operating results for the quarter and we realize that there is clearly work to be done. We are balancing the short term needs to reduce costs and conserve cash with our desire to focus on our strategic initiatives which we believe will position the company for sustained growth and profitability over the long term.

Moreover, we believe the steps we are taking to right size our workforce and cost structure improve our raw material sourcing and add high quality sales reps will help us navigate through this challenging environment and come out of this recession well positioned relative to our competitors. Thank you for your participation today. Mark and I look forward to speaking with you on the second quarter conference call.

Operator

That does conclude today’s conference thank you for your participation you may disconnect at this time.

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Source: Zep, Inc. F1Q09 (Qtr End 11/30/08) Earnings Call Transcript
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