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Spartan Stores Inc. (NASDAQ:SPTN)

F3Q09 (Qtr End 01/03/09) Earnings Call.

February 05, 2009, 9:00 AM ET

Executives

Dennis Eidson - President, CEO and COO

Dave Staples - EVP and CFO

Analysts

Karen Short - FBR Capital

Sarah Lester - Sidoti & Company

Presentation

Operator

Good day and welcome to the Spartan Stores, Incorporated conference call. (Operator Instructions)

Ladies and gentlemen, I must remind you that comments made by management during today’s call will contain forward-looking statements. These forward-looking statements discuss plans, expectations, estimates and projections that involve significant risks and uncertainties. Actual results may differ materially from the results discussed in these forward-looking statements.

Internal and external factors that might cause such a difference include among others, competitive pressures among food retail and distribution companies, the uncertainties inherent in implementing strategic plans in general economic and market conditions. Additional information about risk factors and the uncertainties associated with our forward-looking statements can be found in the companies’ earnings announcement annual report on Form 10-K and the companies other filings with the SEC.

Because of these risks and uncertainties investors should not place undue reliance on forward-looking statements. Spartan Stores disclaims any intention or obligation to update or revise any forward-looking statements.

It is now my pleasure to turn the conference over to Dennis Eidson. Please go ahead, sir.

Dennis Eidson

Good morning, everyone, and thank you for joining our fiscal 2009 third quarter earnings conference call. With me this morning are members of our team including EVP and CFO Dave Staples; EVP of Retail Operations Ted Adornato; EVP of Merchandizing, Alan Hartline; EVP of Supply Chain, Derek Jones; and EVP and General Counsel, Alex DeYonker.

This morning I will begin by providing you with a brief overview of our third quarter financial results and business progress. Dave will then give you a more detailed view of our third quarter financial results, as well as our financial outlook for the remainder of the fiscal year. I will rejoin the call following Dave’s remarks to provide you with an overview of our business plans for the last quarter of our fiscal year.

I will start by stating that we are very pleased to continue our long track record of operating earnings improvement. Particularly in this challenging and recessionary economic environment or consumers have become even more value conscious. As many of you realize, we have had a consumer centric business strategy for many years. This fundamental strategy has served us well. But it's been particularly effective during this weak economic cycle.

Our over urging focus on the consumer provides us with key inside of our purchasing behavior and the flexibility to quickly shift our marketing and merchandising strategies in a manner that delivers even more value to our customers.

For example, during the quarter we launched our $4 generic prescription program in our West-Michigan market, and offered consumers exciting deep discount fuel promotions. Both of these programs have been very well received by our consumers.

In addition, we've worked diligently over the years to develop a premier private label program, which offers customers more than 3,000 corporate brand products. These product offerings are serving us particularly well, as the consumer shifts towards the more value orientation.

Turning to the third quarter financial results, we're pleased that our solid operating earnings and retail comp store sales growth continued. This quarter marks our tenth consecutive quarter of retail sales growth and 12th consecutive quarter of double-digit operating earnings growth, demonstrating our sustained growth and profitability in a competitive environment and through the economic recession that began earlier in the fiscal year. The benefits of our capital investment program and consumer centric strategies were evident as retail comp store sales improved by 3.3%, excluding fuel.

During the quarter, we also completed one major remodel project and held that store grand reopening. Consumer response at the newly remodel stores has been very good and is leading our preliminary performance expectations. On a fiscal year-to-date basis, we have now completed six major store remodels and are very pleased with the sales trends and performance of these remodel stores as well as those that were remodeled last year.

During the last week of the third quarter, we completed the acquisition of 17 VG's Food and Pharmacy stores. Although only five days of the operations were included in our third quarter results, the ongoing results are inline with our initial expectations. Really enthused about these stores because they provide us with the quality operation in a new retail market. I will remind you that more than 30 million in capital investments were made to these stores during the past five years, and this prior investment fully allow us to be more targeted with our future capital investments and to focus on only the opportunities that will generate the best investment returns.

In our distribution business, third quarter sales decline modestly due to a lower sales volume in our nominally profitable pharmacy distribution program, and the elimination of the sales to the acquire VG stores. The pharmacy program is provided principally as a value added service to our distribution customers and some have chosen the exit program. Despite the slight sales decline operating earnings in the segment increased for the 13 consecutive quarter. During the quarter, we substantially completed the grocery warehouse re-ranking project, and expect to begin benefiting from greater operating efficiency by the fiscal year end.

With that overview, I will turn the call over to Dave Staples for a detailed review of our third quarter financial results, Dave?

Dave Staples

Thank you, Dennis and good morning everyone. I will now provide you some additional details about our third quarter financial results and review our performance outlook for the remainder of the fiscal year. Consolidated net sales for the 16 week third quarter were $781.9 million compared with $787.8 million in the year ago quarter. Retail segment sales increased in the quarter due to a 3.3% growth in comparable store sales that were offset by lower sales related to our marginally profitable pharmacy distribution program and the elimination of the distribution sales to acquire VG Stores.

Gross margin for the third quarter increase 60 basis points to 20.1% from 19.5% in last years quarter. Despite significantly higher LIFO inventory charges this year. Improvement in the margin rate was due mainly to higher mix of sales from higher profit retail sales and improved margins in our retail segment.

As a percentage of sales, third quarter operating expenses increased to 17.8% from 17.6% in the same period last year. The increase was attributable primarily to the sales mix changed just mentioned.

Third quarter operating earnings improve by double-digits for the 12 consecutive quarter to $17.9 million, an increase of 17.4% from the $15.2 million reported in the same period last year. The improvement was the result of higher retail sales in better margins in our retail segment.

Third quarter earnings from continuing operations reach $8.7 million or $0.40 per diluted share compared with adjusted earnings from continuing operations of $7.5 million or $0.35 per diluted share last year representing 15.5% increase. The adjustment number excludes $2.7 million nonrecurring tax credit mentioned in our press release. Including the tax credit last years third quarter earnings from continuing operations were $10.3 million or $0.47 per diluted share.

Net earnings for the third quarter were $8.9 million or $0.41 per diluted share compared with an adjusted $7.9 million or $0.36 per diluted share in the year ago period, representing a 13.5% increase. Again this rapid number excludes the effects of tax credit. Net earnings including the tax credit were $10.6 million or $0.49 per diluted share. Net earnings include earnings from discontinued operations of $200,000 or $0.01 per diluted share compared with $300,000 or $0.02 per diluted share last year.

Turning to our business segments, third quarter distribution sales were $397.9 million compared with $410.7 million in the same period last year. As previously mentioned the sales decline was related to lower volumes in our Pharmacy program which totaled approximately $9.1 million in the quarter. And the elimination of distribution sales to our acquired VG Stores which totaled approximately $2.6 million. As demonstrated it’s important to understand that the pharmacy distribution program is marginally profitable and provided mainly as a value added service to our distribution customer. Distribution operating earnings improved to $11.1 million from $10.9 million in the same period last year. You may recall that we had a significant increase of nearly 49% in operating earnings in the third quarter last year due to new business.

The third quarter improvement was due mainly their continued expense control that was partially offset by a $700,000 increase in the LIFO inventory charge. Third quarter retail sales increased 1.8% to $384 million from $377.1 million in the same period last year. The improvement was due the 3.3% increase in comparable store sales excluding fuel which is driven mainly by our capital improvements and value oriented promotional program.

In addition, we have five days of sales from our 17 acquired VG stores which totaled $5.1 million. The sales improvements were partially offset, however, by loss retail sales from four stores that were sold to distribution customers, since the third quarter of last year. The closing of one retail store in the first quarter and lower fuel sale due to the decline in retail pump prices.

The sale of the stores and store closing reduced sale by approximately $9 million for the quarter. One of the store sales occurred late in December. There was a smaller acquired Felpausch store that had annual sales of approximately $3.5 million. Third quarter operating earnings in the segment increased 58% to $6.8 million from $4.3 million in the same period of last year. The improvement was primarily the result of higher comparable store sales, better gross profit margins and improved profitably in our fuel center operations.

Additionally, retail store opening and remodel activity cost were approximately $400,000 compared with approximately $1.3 million in the same period last year. Total long-term debt including term maturities in capital re-fabrication increased to $241.3 million as of January 3 from $154.4 million at March 29, 2008. The increase filings was a result of our VG's acquisition.

As noted in our press release, we also executed an interest rate swap agreement affectively fixing the interest rate at approximately 3.3% on $45 million of the incremental borrowings.

As a result, we now have approximately $155 million of our outstanding long-term debt with an effective fix interest rate of below 3.4%, and we expect the pay down approximately $10 million of the outstanding floating rate long-term debt by the end of the fiscal year. Although our debt level increased because of the acquisition our balance sheet remains healthy, with our long-term debt-to-capital ratio of approximately 0.5 to 1 and we still have more than $100 million of borrowing availability under existing credit facility.

Year-to-date cash generated from operating activities more than doubled to $46.8 million from $19.8 million in the same period of last year, due to improved earnings and the cycling of new distribution business secured last year which in a short-term increased our working capital requirement.

I will now cover our outlook for the remainder of fiscal 2009. We expect comparable retail store sales to increase in the lower single-digits during the remainder of fiscal. But below our third quarter results due to the cycling of sales from stores remodeled last year. This year’s fourth quarter will additionally be negatively effected by the shift in Easter holiday in the fiscal 2010 first quarter. Easter holiday contributed approximately 1% to comparable store sales in last year’s fourth quarter. As a reminder, there is no Easter holiday included in fiscal 2009.

For the remainder of fiscal 2009 we expect to invest capital and complete two major store remodels near the end of the fourth quarter. Major store relocation project and begin construction of a relocated grand store. Additional store opening and remodel activity costs are expected to be approximately $1 million in the fourth quarter.

In the distribution segment, we expect our third quarter sales trying to continue into the fourth quarter because of the effect of the pharmacy distribution program and elimination of distribution sales to acquired VG Stores. Distribution sales to customers that [acted] at our pharmacy distribution program were approximately $6.9 million in last year’s fourth quarter and approximately $29 million on an annualized basis.

We continue to expect year-over-year operating earnings growth in this segment as we focus on efficiency improvements, cost controls and procurement and merchandizing opportunities. We expect total capital expenditures for fiscal 2009 to range from $58 million to $60 million with deprecation and amortization expense ranging from $26 million to $29 million and interest expense to be approximately $11 million.

Our VG’s acquisition should add approximately $300 million to our annual retail sales but add approximately $150 million total net annual sales because of the former distribution customer their distribution sales are eliminated. Distribution sales for these stores totaled approximately $35 million in last year’s fourth quarter. We continue to expect the transaction to be slightly dilutive in the fourth quarter due to transition costs and the elimination of the related fourth quarter distribution profits for our base inventory shipments to these stores. We then expect the transaction to be modestly accretive in fiscal 2010 and increasingly so thereafter as acquisition synergies are realized.

I will now turn the call back to Dennis for his closing remarks, Dennis.

Dennis Eidson

Thanks Dave. We are very pleased with our consistent performance during this troubled economic period. Our consumer centric strategy has been the bedrock of that consistent performance that has positioned us particularly well. As a consumer gravitates back to meals at home or trades down in his more discriminate in their shopping choices.

With the introduction of our $4 generic prescription and discounted fuel programs, we are taking even stronger actions to further enhance our value proposition with consumers. Our robust private label program and targeted commercial programs features that have been effective in building loyalty and attracting new shoppers.

In fact, during the fourth quarter we launched hour first ever Spartan brand fresh chicken program. This program will bring better value to our consumers while expanding the breadth of our products to include another center of the plate offering. We will continue to analyze and closely monitor consumer buying patterns and make adjustments to our marketing and merchandising strategies accordingly, while maintaining our focus on profit growth and performance objectives. In the remainder of the year, we will focus on the integration of our VG’s retail acquisition to capture the expected operational synergies and continue executing our capital investment program across our store base.

As I mentioned in our last call the majority of VG stores, our service and product focused well run have great associates and have successfully competed with national and regional chains for many years. Their fresh product offering is outstanding and helps tremendously to differentiate the chain from others as well as their service and quality.

In addition to these stores we have more work remaining to fully integrate our Felpausch retail stores. We continue to improve their facilities and we find their marketing, merchandising and promotional programs. We are looking for additional opportunities to enhance our value preposition in order to more fully realize their performance potential.

In the fourth quarter, we have completed the relocation of one of these Felpausch stores and we will complete a major remodel of another till the end of the quarter. Both locations will be re-branded as family fare. The relocated store opened on January 19th and is being well received by the community. By the end of the quarter, we will have just a handful of remaining Felpausch stores where we believe significant capital expenditures are still required along which we are bettering.

As Dave mentioned, under our capital program we also expect to complete one additional major store remodel of our Glen's banner, late in the fourth quarter, and have begun constructing a new Glen store. The new store will replace an existing Glen's location in Manistee, Michigan.

In our distribution segment, we are continually engaged in seeking new customers and in exploring opportunities to expand sales with our existing customers. In addition, we constantly evaluate our supply chain to determine where service capabilities and operational efficiencies can be improved. Although, we're putting the finishing touches on our grocery warehouse re-ranking project, a number of operational improvement opportunities remain. Our warehouse throughput and inventory management initiatives are ongoing and will help gradually improve our service quality and operational efficiencies.

I want to conclude my remarks by thanking all of our hard-working associates for their efforts during these difficult times, as well as thank our distribution and retail customers for their continued support. I believe our discipline team work and focus on financial structure has positioned us to be able to take advantage of VG’s opportunity and that it will continue to provide us with the flexibility to take advantage of other strategic opportunities as they become available.

We will now open the call for your questions.

Question-and-Answer-Session

Operator

(Operator Instructions) We will go first to the side of Karen Short with FBR Capital. Your line is open. Please go ahead.

Karen Short - FBR Capital

Hi, great quarter.

Dennis Eidson

Thank you.

Karen Short - FBR Capital

A couple questions, I guess start with retail. Retail in the competitive environment in general, I just wondering if you could give us some color around what you are seeing in the competitive environment, are there any competitors that are feeling some pain particularly? And what you are seeing in terms of your market share? And then, I guess, the second question on the retailers. Can you maybe just go in there little more color on what is driving the improvement in EBITDA margins to retail, and where do you think it could go?

Dennis Eidson

Sure. From -- on the competitive fronts, as you know notwithstanding the five weeks we have owned the VG’s brand. Our primary competitors that are corporately own stores our super centers it's either Super Wal-Mart or Meyer. And I would say that the competitive environment hasn’t changed dramatically. I think we’re all searching for ways to really add more value to the consumer, and I think maybe you had a little bit of lag up on some of the things we have done and particularly is it relates to strength our private label program. We use Nielsen to track market share and there is good and bad the ugly when you are using syndicated data, I'd suggest that the numbers would tell us that we are building market share in our corporate retail geography, and we feel pretty good about that.

In terms of the EBITDA, obviously the comp sales store growth certainly that did not hurt but I would tell you that we have a reluctant focus on our SG&A lines as well. And I think that the team here is done an outstanding job of squeezing cost out of the system without impacting the consumer, and I think that's been big driver as well. But we're I know it’s a tough environment but we are feeling pretty good about where we are.

Karen Short - FBR Capital

Okay, do you have some color on private label penetration and what it increased by I guess sequentially at both distribution and retail?

Dennis Eidson

Yes, we do. On the corporate retail side, in the quarter, again this is AC Nielsen data in units, in the quarter we were in 26.4% penetration, and that compares to 23.7% a year ago, so significant lift. And 26.4% compares to the U.S. average 23.36%, so again the nice lift for the U.S. On the distribution side, we are taking corporate number here, see for the quarter were at a 21.63%.

Karen Short - FBR Capital

Okay.

Dennis Eidson

That compares to a 22.12% the year ago, so 150 point lift. So as if historically been the case, our distribution customers lag up a bit but their trend is robust.

Karen Short - FBR Capital

Okay. What is the year-over-year delta in gas prices, do you just average price at the pump I do not know if you know at the top of your head.

Dennis Eidson

I think it was down somewhere around 15% to 20%.

Karen Short - FBR Capital

Okay. Okay, and then just switching gears to inflation versus deflation, I mean, there is obviously a lot of talk about the potential for deflation and it's seems consistently retailers seem to be paying that some categories will see deflation in that overall we won't see deflation. But I just sort want if you can talk little bit about what that environment or do to your business model in general if we were to enter the deflationary environments?

Dennis Eidson

First of all, I agree with you, with your assessment about all this inflation, deflation. And we are seeing some deflation on commodity items, cheese from Kraft. I think we have had some oil, some flour, some coffee. But the processed foods we're not seeing that; I think that the increases we got are due going to be pretty sticky for the CPG companies. We are working hard to try and get them to spend some of that money back with us. And then I think it may end up manifesting itself in more promotional spending.

Our business model as it relates to, if there were deflation and we are not really seeing significant deflation. I want to make that clear. Actually in the quarter, we saw modestly robust inflation. As a distribution entity, our center store, frozen, dairy, we have a cost-plus model that has a variable component and a fixed component. So the fixed component, the cent per case charge, really is a hedge against us getting hurt in a deflationary environment. As it related to retail, I think which historically happen is, as retails have gone up in an inflationary period, generally speaking there is a little bit of stickiness on them coming down when that inflation subsides. So, I don’t think the impact will be significant in either segment.

Karen Short - FBR Capital

Okay, great. I’ll get back in the queue. Thanks a lot.

Dennis Eidson

Thank, Karen.

Operator

Thank you. (Operator Instructions) We will go next to the side of Sarah Lester with Sidoti & Company. Your line is open. Please go ahead.

Sarah Lester - Sidoti & Company

Good morning.

Dennis Eidson

Good morning.

Sarah Lester - Sidoti & Company

I was wondering if you could talk about in the retail segment, how much of the operating margin improvement was from the improvement in fuel margin?

Dennis Eidson

Sarah, we don’t break out our segments, but it was maybe a third or so.

Sarah Lester - Sidoti & Company

Okay. Then just a small question. The Peanut butter recall, I would expect that to not impact you too much. But could you talk about that briefly?

Dennis Eidson

We are living through it like every other retailer. I was just remarking yesterday, I just felt that of all the recall that gone through, this one has prolonged itself relative to the number of items that have come out. It seems like every day there is another SKU or two that we are being notified we have the pull. We certainly don’t feel comfortable about it and the consumer trust us as a retailer, food retailer with their health and well-being, and I think we have an obligation as an industry to really do a better job in this area. Fortunately, we have had very, very little fall out in our private label program. We’ve had three candy items that we had to pull. So, I don’t know if that answer your question but -.

Sarah Lester - Sidoti & Company

Yes, that's all I have. Thank you.

Operator

Thank you. (Operator Instructions) It does appear that we have no further question in the queue at this time.

Dennis Eidson

Okay, well if there are no more questions we will conclude the call. On behalf of Dave Staples and everyone on this Spartan team, I thank you for joining our call today and we look forward to discussing our fourth quarter and fiscal year results with you during our next conference call. Thank you.

Operator

This does conclude today’s teleconference. Thank you for your participation. You may disconnect at any time, and have a wonderful day.

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