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Executives

Brinlea Johnson – IR, The Blueshirt Group

Dawn Lepore – CEO and Chairman

Tracy Wright – VP and CFO

Analysts

Mark Argento – Craig-Hallum Capital

Lisa Rapuano – Lane Five Management

drugstore.com, inc. (DSCM) Q4 2008 Earnings Call Transcript February 4, 2009 5:00 PM ET

Operator

Ladies and gentlemen, thank you for standing by and welcome to the drugstore.com earnings 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 be given at that time. (Operator instructions) As a reminder, this call is being recorded today, Wednesday, February 4, 2009. I would now like to turn the conference over to Ms. Brinlea Johnson from the Blue Shirt Group. Go ahead.

Brinlea Johnson

Good afternoon. Welcome to the drugstore.com fourth quarter and fiscal year 2008 earnings call. With me today is Dawn Lepore, Chairman and Chief Executive Officer; and Tracy Wright, Chief Finance Officer; and Rob Potter, 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.com’s anticipated future revenues, earnings and growth rates are forward-looking. Factors that could cause actual results to differ materially from anticipated results are detailed in our periodic filings 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 most 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 fourth quarter and fiscal year 2008, including a summary of our financials and supplemental financial information discussed on this call, will be also available on our website, and also under Corporate Information.

With that, I’ll turn the call over to Dawn Lepore, Chairman and Chief Executive Officer.

Dawn Lepore

Thanks, Brinlea. Good afternoon, everyone, and thank you for joining us. Despite the more challenging economic environment, I’m pleased with our fourth quarter 2008 results. Specifically in the fourth quarter core OTC revenue grew over 6%, which compares to overall eCommerce decline of 4% reported by comScore during the same period.

Our Vision business increased 14.5% over last year to end the full year with 12% revenue growth, exceeding expectations. Despite a more competitive environment, gross margins were our second highest in company history at 28.5%. We delivered record adjusted EBITDA of $5.2 million, which more than doubled over the previous year period. Free cash flow was a record $5.4 million, and we generated net income of approximately $300,000. These results reinforce that we have a strong operating model and continued to execute in a highly competitive market.

There are three main points that I would like you to take away from today’s call. First, our OTC business continued to outperform eCommerce. And in fact, we expanded the gap between our growth rate and that of overall eCommerce. While we did not see the expected list from holiday sales, we continued to see strong demand for everyday OTC items such as vitamins and supplements, which were up 43%; skincare up 20%; and allergy and sinus products up 38%. Importantly, in a very challenging market, we were able to drive 8% new customer growth and 8% order growth year-over-year.

Second, a profitability initiative that we have put in place over the last few years have paid off, as they are enabling us to be more aggressive with promotion and help fuel growth in this market. The take rate on promotions was up 20% over last year, yet we still delivered improving contribution margins, positive cash flow generation, and record adjusted EBITDA.

And finally, we expect to drive continued growth and profitability on top of our core business with a number of new initiatives such as international, Rite Aid, Medco and new beauty partnerships. We believe all of these factors will have a long-term positive impact on our business, especially post recession.

Now let’s go over the fourth quarter details. For the fourth quarter, our OTC business grew over 6% year-over-year, below our target of 9% to 12%. Orders grew 8% in line with expectations. But we did not see the ordinary historical list in basket from holiday buying.

Looking in more detail at the quarter, before Thanksgiving, sales were up almost 10% and our baskets were up 2%, as expected. Starting in mid-November our baskets weakened dramatically in an unprecedented economic environment, ending down 80 basis points for the quarter with overall basket size down half a unit. Consumers were ordering, but they were just not adding the extra holiday items that they typically purchased in prior years.

During the quarter we ran a number of promotions, including free shipping, friends and family discounts, coupons and daily deals. That proved to be very successful. As I mentioned earlier, customers were more likely to take advantage of our promotions. And coupon usage grew considerably, more than doubling from last year.

While promotional activity obviously has an impact on margins, gross margins only decreased by 20 basis points this quarter. The savings from our profitability initiative effectively offset an impact of 150 basis points from the higher take rate on promotions.

Additionally this quarter our contribution margin increased by 100 basis points and contribution margin dollars increased by over 11%, as we effectively managed our variable cost. Our investment in our distribution center excellence program has paid of. And labor fulfillment cost per order has decreased over 20% year-over-year. In 2009, we will continue to balance the top and bottom line, managing our variable cost and using selective promotions to drive growth.

Beauty, both mass and prestige, was impacted by the overall economy, as overall Beauty sales grew approximately 9% year-over-year with Beauty.com growing at the same rate. While below our expectations and previous growth in beauty, our 9% growth does compare very favorably to the industry, as NPD reported the prestige beauty business experience a 7% decline for the quarter. Despite the fact that we are outperforming the industry, our Beauty.com growth this quarter was a bit disappointing, as we had originally forecasted growth of approximately 20%.

Because beauty is such an important piece of our business, I want to walk through a couple of factors that impacted sales growth. While we are highly focused on Beauty.com, we are also focused on growing our overall beauty business. At the request of select vendors, we have copied a few prestige brands with more mass appeal onto drugstore.com. This means that some items are available on both Beauty.com and drugstore.com. And the revenue is split between the two sites.

The combined sales are now reported in our total beauty number. The result is more total beauty sales, but this reduces Beauty.com growth by one to two points. The majority of the impact on beauty sales is the economy, some of which is non-recurring and related to holiday. For example, Oprah Winfrey did not do her holiday favorite things list, which typically had boosted sale.

In addition to changes in holiday spending, we are seeing an ongoing impact on the recession. While hard to specifically quantify our estimate is that the overall economy is negatively impacting us by 5% to 10%. But we are still confident that we can grow Beauty.com in the 10% to 20% range in 2009, and as importantly, lay the groundwork for accelerated growth post recession by adding major brands and new customers.

In our Vision business, we continue to see it exceed our expectations, posting 14.5% growth, an increase in contribution margin dollars by 16% from the fourth quarter of 2007. New orders for vision were up 26%, as we continued to attract new customers to our product offering. Additionally, our marketing programs are proving highly effective at driving customers to purchase annual supplies, resulting in larger vision baskets, which were up 11% in the period. Looking ahead for 2009, we expect to grow vision in the high-single to low-double digit range.

Moving to pharmacy, Rx mail-order revenues decreased 25% while contribution margin dollars improved 8% over last year. We expect mail-order pharmacy revenues to continue to decline by approximately 30% in the first quarter due primarily to the acquisition of one of our PBM partners, Medical Services Company, by Express Script.

Summing up the fourth quarter, we continued to drive solid growth in our business. This quarter we accelerated select promotional activity and we were able to compete aggressively in the market. There is no doubt that this is an incredibly challenging environment. Our OTC basics, beauty and vision businesses are performing well ahead of eCommerce.

Let’s turn to 2009. In the past, we’ve provided full year guidance on each fourth quarter call. But due to the uncertain economic environment, I only feel comfortable looking at the current trends in our business and issuing first quarter guidance. As we mentioned earlier, we’ve had a strong start to the quarter with January growth in the teens, driven by FSA, drugstore dollars and the fact that January is always a big basics months, as people act on their immediate [ph] revolutions.

While we do not expect our OTC growth to remain in the teens, we think the strong start to the year is evidence that our OTC basics and beauty businesses are compelling. In addition to growth in our core business, we have a number of key initiatives that we believe will drive growth and leverage our current infrastructure.

In November we announced a strategic alliance with Medco Health Solutions, the nation’s leading pharmacy benefit manager serving over 60 million lives. We are building an integrated online OTC store, which they will be able to offer to their members. Development is underway, and we expect to launch in the second quarter. At this time, it is too early to forecast any specific growth rate from this partnership. So we will provide more detail when we have some actual numbers under our belt.

We also successfully launched our new online store with Rite Aid in December. Rite Aid is now beginning to market the convenience of online shopping, and we are confident that the store will provide a compelling online experience for Rite Aid customers. Given that it’s early in the partnership, it’s very hard to estimate the revenue. So we are not forecasting a significant list of revenue from this partnership in the first quarter.

We have also expanded with the launch of our international site to our partnership with E4X. We now have access to an entirely new market of 500 million customers in 34 countries. While revenues are not yet material, initial results are promising with over 70% of sales from Canada and the United Kingdom.

The other growth strategy that continues to be critical is beauty. Part of the prestige beauty growth will come from adding vigor new brands. As the overall beauty market is weakened by the economy, we are seeing heightened interest from premier brands that see our growth and are looking to find alternative distribution channels. Looking at 2009, we are optimistic we can add approximately 30 new brands, including large department store brands.

When comparing our traffic to others, we are doing quite well. For example, looking at a year-over-year comparison, in the fourth quarter Beauty.com traffic grew 9% in November and declined slightly minus 3% in December. In contrast, as reported by comScore, the forward [ph] dot-com traffic was down 13% in November and down 15% in December.

As we have discussed, the margins on Beauty.com are higher than other categories. In fact, new Beauty.com customers delivery over 100% more contribution margin dollars than drugstore OTC customers. Even more important, our best customers are the customers that shop on both Beauty.com and drugstore.com. They have higher retention and frequency than our drugstore-only customers. And they have over 60% more revenue than a Beauty.com-only customer and over twice as much average revenue than a drugstore.com-only customer.

Based on these numbers, you can see why we continue to focus on getting new Beauty.com customers as well as cross-selling across Beauty.com and drugstore.com. Our goal is to emerge from this downturn with an even stronger beauty business, including expanded premier partnerships, increased awareness and a larger customer base.

To summarize, we are confident in our long-term strategy and our future success. When I look back on the year as a whole, it was a challenging year, but there were some notable accomplishments. OTC revenues grew by over 11%. Beauty.com was up 28% despite a 3.3% decline in the prestige beauty industry. Gross margins increased by 130 basis points. EBITDA more than doubled year-over-year. And we generated positive free cash flow.

In the current environment, we believe consumers are being smart and frugal, but they continue to purchase their health and beauty products on a regular basis and are looking for the value and bargains that can be found at drugstore.com. A profitability initiative has led to strong cash generation and a better business model. While there is no question that we are seeing an impact from the slowdown in the economy, we are encouraged by the positive momentum we are seeing at the start of 2009 and the prospect for our new initiative to contribute to revenues during the year.

As I’m very mindful of profitability, we will also continue to closely examine every expenditure and costs to ensure we drive maximum dollars to our bottom line. With this in mind, we have reduced our planned capital expenditure to a projected range of $7.5 million to $9.0 million and instituted a hiring freeze for the coming year. We believe that we have the business model, the customer base, and the product assortment to do much better than most in this environment. And we are dedicated to making that happen. As always, we will remain laser-focused on generating free cash flow and strong EBITDA.

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

Tracy Wright

Thanks, Dawn. Over the next few minutes, I’ll walk you through some of the fourth quarter and year-end key metrics and then provide first quarter 2009 guidance. Before I begin, please note that all comparisons with last quarter and last year’s numbers exclude the local pickup pharmacy business, which as of September 4, 2008 we now report as discontinued operation.

Fourth quarter net sales were $93.9 million, bringing the full year 2008 sales to $366.6 million, up 8% year-over-year. OTC continues to be a key driver of our business, as OTC net sales grew by over 6% to $69.8 million or approximately 74% of total sales in the fourth quarter. For the full year, OTC sales increased over 11% from 2007 to $160.8 million.

In the fourth quarter, vision sales improved by 14.5% year-over-year to $14.6 million. For the full year, vision sales increased almost 12% to $61.4 million. And in the fourth quarter mail-order pharmacy net sales decreased to $9.6 million, bringing the full year 2008 sales to $44.4 million.

Overall average net sales per order in the fourth quarter were $67. On a segment basis, average net sales per order were $58 in our OTC segment, up almost 11% to $112 in the vision segment, and were $156 for mail-order pharmacy. Net sales from repeat customers represented 76% of totals sales in the fourth quarter. And new customers increased over 8% year-over-year to 406,000, bringing our total life-to-date customer base to 9.8 million unique customers. Our trailing 12-month active customer base grew by 9% year-over-year to 2.6 million.

Now I'll move on to gross margin. Gross margin was 28.5% in the fourth quarter, our second highest gross margin in company history, up 50 basis points over the prior year period. Gross margins benefited from our profitability initiatives as well as an improving sales mix. Our strong gross margin contributed to over 11% year-over-year growth in contribution margin dollars to $19.5 million. Full year of 2008 gross margins were up 130 basis points to 28.1% and contribution margin dollars for the year grew 18% to $73 million.

Moving on to expenses. And please keep in mind that figures as a percentage of net sales are calculated on a lower revenue base due to the change in accounting for LPU. Marketing and sales expense for the fourth quarter was $9.1 million or 9.7% of net sales compared to 9% in the third quarter of 2008 and 9.2% of net sales in the fourth quarter of last year. The year-over-year increase in marketing and sales expense as a percentage of sales is largely due to an increase in the mix of new customers as well as in increase in stock-based compensation expense.

Despite facing a competitive environment in the fourth quarter, marketing and sales expense per new customer decreased to $22. This compared to $24 in the third quarter of 2008 and remained flat with the prior year period. For the fourth quarter of 2008, fulfillment and order processing expense was $10.5 million or 11.1% of net sales, down from 12.5% in the third quarter of 2008 and 11.9% in the fourth quarter of 2007. The 140 basis point sequential decrease in fulfillment as a percentage of sales was largely driven by a reduction in consulting spend in connection with our profitability initiatives, a reduction in labor fulfillment cost per order, and fixed costs spread across a higher revenue base. The 80 basis point year-over-year decrease was driven almost entirely by the reduction in labor fulfillment cost per order as a result of our successful operational excellence program implemented earlier this year.

Technology and content expense for the fourth quarter of 2008 was $6.1 million or 6.5% of net sales versus 6.9% in the third quarter of 2008 and 4.8% in the fourth quarter of 2007. The 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 $3.9 million or 4.1% of net sales, down 280 basis points from the prior year period, as the fourth quarter of 2007 included a New Jersey sales tax charge of $2.5 million. For the fourth quarter, non-cash stock-based compensation expense was $1.8 million and depreciation expense was $3 million. For the full year of 2008, non-cash stock-based compensation expense was $7.6 million and depreciation expense was $10.9 million.

Looking ahead to the first quarter of 2009, we expect non-cash stock-based compensation expense to be $1.7 million and depreciation expense to be $3.3 million. On a GAAP basis, the company reported a net income of $289,000 or zero cents per share compared to a net loss of $2.3 million or $0.02 per share in the prior year period. For fiscal year 2008, net loss was $8.3 million, including $3.4 million in non-cash marketing expense, $3.2 million related to consulting services, and $7.6 million in non-cash stock-based compensation expense.

Our adjusted EBITDA was a record $5.2 million, an improvement of more than 243% from the fourth quarter of 2007. Fiscal year 2008 adjusted EBITDA more than doubled from $6.6 million in the previous year to $13.9 million. We ended the fourth quarter with an employee base of approximately 870 FTEs. We generated free cash flow of $5.4 million in the fourth quarter, up $8.2 million from last year. For the year we generated $680,000 in free cash flow, up $7.2 million from the year.

CapEx for the quarter, inclusive of capitalized labor associated with internally developed software projects, was approximately $2.1 million, and for the year was $13.2 million. As Dawn mentioned, we plan to reduce our 2009 CapEx spending to approximately $7.5 million to $9.0 million, which at the midpoint represents a decrease of almost 40% year-over-year. We ended Q4 with a strong balance sheet and approximately $38 million in cash, cash equivalents, and marketable securities.

With that as a review of fourth quarter and fiscal year results, we'll move on to our outlook for the first quarter of 2009. While the environment remains challenging, we have had a strong start to the first quarter. We expect gross margin to be solid in the range of 28.0% to 28.5% with a continued high take rate on promotions. In addition, we have some expenses such as FICA and other payroll items that kick back in the first quarter. Given all these factors, the company is targeting net sales in the range of $93 million to $97 million based on year-over-year OTC growth between 6% to 10% and Beauty.com growth in the mid-teens. The company is targeting net loss in the range of $2 million to breakeven and adjusted EBITDA in the range of $3 million to $5 million.

We will now move on to Q&A. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) First question comes from the line of Mark Argento Craig-Hallum Capital. Please go ahead.

Mark Argento – Craig-Hallum Capital

Yes, good afternoon.

Dawn Lepore

Hi, Mark.

Mark Argento – Craig-Hallum Capital

Hi, hi. Sorry I’m out of the office here (inaudible) I apologize. But I just wanted to ask you a couple of questions regarding kind of the behavior you see from the customers. You said that the basket side is down for the last quarter. Could you talk about what you are seeing in terms of basket size so far this year? And then also could you just touch on – I know you did some econometrics work last year, and if you had seen any real return on that work that you guys did last year?

Dawn Lepore

Okay. So first in terms of baskets, we took everything that we learned in the fourth quarter and we did factor that in our guidance in the first quarter. But specifically on baskets, they are still not growing, but they are not decreasing as much as they were in the fourth quarter so far. That’s what we are seeing. In terms of the econometrician work, we did use the econometricians to look at pricing and we have seen an impact from that. That actually is one of the reasons that we are able to increase our promotions a bit in the fourth quarter and still have very good gross margins. And we will continue to work with them this year. We are not going to spend a huge amount of money with them. However, they continue to tweak their models based on the changing consumer behavior as consumers get even more price sensitive. And we will continue to look the way [ph] price as we can, lower and raise prices to make sure that we are maximizing the top line and bottom line.

Mark Argento – Craig-Hallum Capital

Okay. And could you talk a little bit about what was working in the quarter? It looks like the up-sell was a little difficult. People were taking kind of the staple products but not a lot of it giving type things. Were you happy with the way you merchandised the site or anything that you think you could have done differently?

Dawn Lepore

That’s a great question, Mark. I mean, obviously I think we always feel like we can do things better and better. I would never say we are perfect. However, I will tell you that the fourth quarter of 2008, I felt as a company we executed extremely well. We did great on inventory. We are not left with a lot of products. I do think the site looks nice. I think our daily deals and our promotions were good. We went into it knowing that this was going to be a tougher holiday season. We executed like crazy. We watched every detail of the business every day. And I do feel like the fourth quarter was a very good performance by the company, quite honestly.

Mark Argento – Craig-Hallum Capital

Last question, I know you didn’t provide guidance for the full fiscal year given the environment. I know you guys have just decelerated [ph] down some of your employee incentives and bonuses. Could you just give us a little bit of an idea of what – to trigger bonuses or any of the incentive comp, what that expectations are built into that so we can kind of triangulate that’s what we should be expecting in terms of better performance for ’09?

Dawn Lepore

Well, that’s – you’re quite clever and so really good way of asking for guidance without giving guidance, Mark. So I won’t comment specifically. We have a bonus matrix. The matrix, we have to deliver both top line and bottom line in order to get a bonus. It’s a sliding scale bonus. In other words, it’s not a zero or 100%. We paid appropriately in 2008. We didn’t earn 100% bonus, but we felt we are into the appropriate bonus based on the matrix. And we are in the process of building that matrix for 2009. But it definitely looks at both top line and bottom line. So all employees are incented to maximize both. We can’t just grow the top line and not have profitable growth. We also can’t just deliver bottom line without top line. And I’m trying to be more specific.

Mark Argento – Craig-Hallum Capital

No, I thought to give it a shot. Appreciate it.

Dawn Lepore

Good thought though.

Mark Argento – Craig-Hallum Capital

Thanks.

Operator

(Operator instructions) Our next question comes from the line of Lisa Rapuano from Lane Five Management. Go ahead.

Lisa Rapuano – Lane Five Management

Hi. I just had a question about the Rite Aid deal. You said that the website came up in December and it’s too early to look about revenues. But I was wondering if you could talk a little bit about any observations you might have about people that were previously ordering from – directly from the site moving to the Rite Aid site, or any sort of color you might have on how behavior might have changed since the transition?

Dawn Lepore

Thanks, Lisa. We haven’t seen – we don’t have quite enough time yet. The site was launched in December. Prior to that, if you went to riteaid.com and wanted to shop for OTC, you went directly to the drugstore site. In December we’ve launched the Rite Aid branded site. And we are not seeing customers who used to order on drugstore ordering on Rite Aid to date. We are definitely excited about the plans Rite Aid has in place to market, but we just haven’t – we don’t have enough information yet or an update to be able to talk specifically about behavior. It’s performing as we expected it to, and we just need to see how the first couple of months go before we can really talk about what revenue lift we think we would get from that site.

Lisa Rapuano – Lane Five Management

Okay. And just because I’m new to this, can you clarify – in your Q1 guidance or as you look at ’09, can you just clarify exactly how the payment that Rite Aid is giving you fits into the whole picture?

Dawn Lepore

It is included in our EBITDA number. So we will get – we are getting about $1 million a month for the first quarter. So it’s about $3 million of the EBITDA for the first quarter.

Lisa Rapuano – Lane Five Management

Okay, thanks.

Operator

(Operator instructions) (inaudible) that we have no further questions. Continue with any closing remarks that you may have.

Dawn Lepore

I just wanted to thank everybody for participating and joining us today. We are very excited about the year ahead despite the challenging environment and look forward to keeping you updated. Thanks very much.

Operator

And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.

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