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InterLine Brands, Inc. (NYSE:IBI)

F4Q08 Earnings Call

February 20, 2009 9:00 am ET

Executives

Michael J. Grebe – Chairman and Chief Executive Officer

Thomas J. Tossavainen – Chief Financial Officer, Principal Accounting

Kenneth D. Sweder – Chief Operating Officer

Analysts

Shannon O'Callaghan – Barclays

David Manthey – Robert W. Baird

Keith Hughes – SunTrust Robinson Humphrey

Matt McCall – BB&T Capital

Bob Franklin – Prudential Financial

Operator

At this time I would like to welcome everyone to the InterLine Brands fourth quarter and fiscal year 2008 conference call. (Operator Instructions) I would now like to turn the call over to Tom Tossavainen, Chief Financial Officer. Please go ahead Sir.

Tom Tossavainen

Good morning and welcome to the InterLine Brands earnings call for the fourth quarter and full year 2008. Joining me on today’s call is Michael Grebe, our Chairman and Chief Executive Officer and Ken Sweder our recently promoted Chief Operating Officer.

Mike will provide an overview of our fourth quarter full year 2008 performance as well as a discussion on current market conditions in the MRO space and the actions we have taken to improve our profitability through this challenging economic environment. Ken will then discuss recently announced operational initiatives and update you on our progress with respect to Project 20-20. Next I will review our financial results in more detail. Mike will then end with some closing remarks and then open the call to your questions.

Before beginning on today’s call let me remind you that some of the statements made today will be forward-looking and are made under Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected or implied due to a variety of factors. We may also discuss certain non-GAAP financial measures which are described in more detail in this morning’s release.

We refer you to InterLine Brand’s filing with the SEC for a more detailed discussion of the risks that could impact the company’s future operating results and financial conditions. These factors are also described in greater detail in the press release on the company’s website. I will now turn the call over to our Chairman and Chief Executive Officer, Michael Grebe.

Michael Grebe

Thanks Tom. Overall I am pleased with how our team has responded to the very challenging environment. In spite of headwinds outside our control we continue to manage the business prudently by adjusting our cost structure and maximizing cash flow generation.

During the fourth quarter we generated over $40 million in free cash flow, well ahead of the expectations we shared with you last quarter. Recall we said we would generate $30-40 million of free cash flow in the six months ended March 2009. We have already achieved the high end of that range in half the expected time, which is a true testament to our team’s focus and resolve.

We have also made significant progress in right-sizing our business to match current and expected demand. Including Project 20-20, our cost savings and efficiency announced last year, we have taken a total of $36 million in cost actions before considering related one-time expenses. In total we have announced two reductions in our workforce and continue to execute on other cost actions to improve our near-term profitability.

For example, we are managing our natural attrition by intentionally leaving certain vacated positions unfilled and by reducing positions at distribution centers as sales have declined. Bottom line, if you compare our current headcount to the beginning of last year we have reduced our total workforce by about 10% or 365 associates.

As Tom stated we are taking the appropriate steps to weather this very challenging environment but more importantly I am optimistic we will emerge a stronger, more profitable company long-term. Now let me share with you some of our performance highlights.

During the quarter we continued to see some degree of resilience in the sale of every day repair and maintenance products that make up the bulk of our multi-family housing business. In addition, we saw continued stability in sales of janitorial and sanitation products which makes up 25% of our revenue and is an important and growing area of our institutional business.

In general, these types of products tend to sell well regardless of the broader economic cycle. People don’t stop using soap and toilet paper or leave a broken sink unattended because of a troubled economy. To further leverage these stalwart products across our platform we launched one of the largest new product offerings in our history last September. We added over 7,000 SKU’s to our offering including electrical, HVAC, security and most importantly janitorial and sanitation products.

Since launching the MRO initiative we have accelerated our cross-selling efforts by adding over 200 of our existing sales professionals to our MRO roll out last month on top of the 130 assigned only five months ago. While we are still very early in this sales expansion and operating off of a small sales base initial results are encouraging. We have doubled February to date sales of our new MRO products through this additional sales team. As such we remain confident in our ability to gain additional wallet share over time by selling our wide range of institutional products to new and existing customers.

In today’s environment our customers have a renewed commitment to reducing costs which often translates to focusing on fewer vendors that can address a wider variety of their needs. We believe we are well positioned to benefit from this trend as a sole source provider of MR products and services. We have superior customer service and breadth of products to meet all of the MRO needs of our customers.

As another example of how we are realigning our sales efforts to current market trends, we have recently expanded our corporate sales team in the Jan San area. We have redeployed several of our best sales leaders to this stable, institutional opportunity. Now that our AmSan integration efforts are behind us we have a truly national, unified platform from which to serve key national accounts. We believe over time we can increase our market share in this highly fragmented space.

That said our performance during the quarter was adversely impacted by a significantly lower demand environment driven by a continued macro economic headwind. Consumer spending, residential remodeling and new home construction obviously remain very weak which has continued to put pressure on our professional contractor and specialty distribution businesses. We do not anticipate an immediate improvement in these businesses. When those trends stabilize and start to improve we believe we are very well positioned for growth.

We are a formidable competitor in this fragmented market due to our strong customer relationships, diversified offerings, national footprint and unparalleled customer service. Some recent statistics also confirm new pressures on the multi-family housing market. During the fourth quarter vacancy rates rose and effective rents climbed. As a result, many of our multi-family housing customers have been forced to reign in their budgets particularly on major renovations and projects that are deemed discretionary.

We have felt this slow down most significantly in our renovations plus business which had one of its slowest quarters ever, down approximately 45%. In addition, major renovations and implementations in the institutional market such as upgrading a school or government building with hands free faucets have also slowed considerably. Taking all of this into consideration our results by markets served were as follows:

Our facilities end market was down 5.7% for the quarter and 0.3% for the year and was down 8.4% and 1.5% respectively on an average organic sales basis. Our professional contractor and specialty distribution businesses were down 14.6% and 5.5% for the quarter and down 12.1% and 6.6% for the year respectively. During the quarter we saw what I believe most other distributors saw, a significant change in demand from October through to December. To be specific, organic daily sales were down 5% in October, down 9.4% in November and then down 13.5% in December.

As I mentioned before we continue to take action to lower our cost structure and improve our free cash flow generation which we believe are the right moves in today’s environment. However, we remain committed to our vision for this business and will continue to take steps to improve our long-term position. One primary focal point for us in this regard is optimizing our distribution footprint. You may recall that last quarter Ken Sweder spoke about the comprehensive review of our distribution network he and Jim Spahn, our Vice President of Distribution were conducting. They have completed their initial review process and as announced in last month’s press release we are moving forward with a new plan to consolidate ten distribution centers in the next five months.

Bear in mind these consolidations are in addition to those included in Project 20-20. With these consolidations we have a great opportunity to reduce our fixed cost structure by $4 million annually once the consolidations are complete. We are highly confident we will improve our scale without sacrificing our excellent customer service or exiting any geographic markets. Streamlining our distribution network is the right decision regardless of present market conditions and we are very excited about the prospect of establishing a more profitable operating platform. We will execute this plan in an orderly fashion taking into consideration seasonality of demand and other market dynamics of course and by timing the consolidations with lease expirations to minimize associated costs.

I would now like to turn the call over to Ken Sweder who can discuss some of the implementation points of this exciting distribution initiative as well as provide an update on our progress with Project 20-20. Ken?

Ken Sweder

Thanks Mike. I would like to touch on three key areas this morning; distribution, Project 20-20 and inventory. First, as Mike mentioned we have completed our initial review of our distribution network. We are working in parallel to identify both short and long-term opportunities across our network with one goal; deliver product quickly, accurately and efficiently.

From a short-term perspective we are moving forward with our plan to close ten centers over the next five months which by the way represents 10% of our total distribution square footage. These ten sites specifically enable us to reduce duplicative coverage in certain regions and to opportunistically adjust and consolidate our network coincident with our lease expiration schedules.

Let me explain this further. Over the years of course InterLine has grown in part through acquisitions. In addition to all the necessary characteristics we look for in an acquisition, things like a compelling valuation, complementary products and services and strong customer relations, we also consider target geographic footprint. In most situations we are buying pre-existing distribution centers. Now, as you can imagine it is much more cost effective to convert a pre-existing distribution center to an InterLine site than to build a new distribution point from scratch. Therefore with this acquired growth necessarily comes some overlap where distribution points are in close proximity.

We now have a great opportunity to rationalize our infrastructure and improve our operating leverage without sacrificing the customer proximity and intimacy for which we are known. To use one concrete example, with the AmSan integrating and everyone on one system we will close one large warehouse in South Florida and transition much of this inventory to another site that sits less than five miles away. Under the same rationale, we continue to execute our longer-term strategic distribution projects related to Project 20-20.

Two large regional consolidations are still slated for 2009. As you can imagine these remain subject to finding the right space, the right economics and ensuring that these consolidations align with the longer-term distribution plans we have under development. We will definitely keep you posted on our progress throughout the year.

Whether it is a strategic project or something more opportunistic I just want to remind everyone that these consolidations do not signal our exit from any markets and come in conjunction with ongoing transitions to a network of fewer, but larger, regional distribution centers or RDC’s. These RDC’s afford us with operating leverage in the form of improved customer fill rates and inventory turns and a lower cost per square foot.

Next, we have completed the closure of the ten professional contractor centers we identified last year. Importantly with our related sales retention initiatives surrounding these closures we have been able to retain the vast majority of sales through these centers which has exceeded expectations and increased our net savings. Let me close my comments on our distribution footprint by saying we do believe that additional consolidation opportunities exist beyond those already identified and we will continue to examine our infrastructure needs and geographic footprint going forward.

Now I would like to update you on two of the remaining aspects of Project 20-20. Tom will update you on our debt and collections initiatives. From a headcount perspective, following up on Mike’s comments, we are now realizing the full $10 million annual run rate of benefit from our actions taken last August and for our original estimate. We are also making solid progress towards improving and streamlining our customer service centers. Recall we upgraded our telecommunications systems to both reduce call waiting and to provide look-ahead call routing which enables us to further optimize our knowledge resources and make more efficient call centers.

While full benefits will not be realized in 2010, we remain on track to realize the original savings goals. Finally, I would like to discuss our progress regarding inventory investments and efficiencies.

As previously mentioned we increased inventory during the third quarter to plan strategic actions including our National Distribution Center West ramp up, the institutional MRO product roll out and final AmSan information systems conversions. I am extremely proud of our team on the progress we have made all of these fronts especially against the back of a challenging operating environment. We reduced inventory by $20 million in the fourth quarter without any impact to our service levels.

Equally as important we continue to manage, control and tighten our supply chain in this challenging economic climate. Also, as you would expect, given lower sales levels we do anticipate another sequential reduction in our inventory levels in the first quarter of 2009.

With that I would like to turn the call over to Tom.

Thomas Tossavainen

Thanks Ken. In the fourth quarter of 2008 we had net sales of $277.6 million, a 7.5% decline compared to the prior-year quarter. For the full year 2008 InterLine reported sales of $1.2 billion, a decline of 3.5% versus the prior year. In the third quarter of 2008 we announced the acquisition of Eagle Maintenance Supply which expanded our footprint in the Northeastern United States and bolstered our Jan San offering. Excluding this acquisition, organic sales declined 9.3% in the fourth quarter and 4.3% for the full year.

As a percentage of total sales our end market break down is as follows: 67% from facility maintenance, 20% from professional contractors and 13% from specialty distribution. Gross margins for the fourth quarter of 2008 were 37%, a decline of 240 basis points versus the prior year quarter. The prior year quarter which was our highest gross margin ever at 39.4%. For the full year gross margins were 37.6%, a 60 basis point decline from 2007.

There are a number of puts and takes that go into our gross margins especially as it pertains to our sales and product mix. We saw three main factors contributing to gross margin compression in the fourth quarter 2008. First, the economy has forced customers to limit MRO spending and we saw additional pressures in pricing to respond to waning demand. Second, our successful effort to lower inventory and significantly improve our cash flow put some pressure on our gross margins. The combination of lower sales and lower inventory purchases resulted in lower gross profit dollars associated with our supplier programs such as payment discount and volume aids to purchase rebates.

This impacted our gross margin by approximately 60 basis points and was not unexpected. Conversely, the fourth quarter last year gross margin was 70 basis points higher than the prior year period at 39.4% as we made some very opportunistic purchases last year to maximize profitability and expand our gross margin through these efforts.

The third contributing factor is our continued ramp up of the West Coast NDC which started operation in July but only reached full operations in the fourth quarter. During this ramp up period we did not expect to break even right away and as such our gross margin was impacted by roughly 25 basis points.

From an expense perspective SG&A expenses for the quarter were $82.4 million, down $2.6 million or 3% from the same period last year. Our costs in the quarter included $630,000 or just over $0.01 per diluted share of costs related to pro center closings. Excluding these costs SG&A expenses were 29.4% of sales, off 115 basis points from the fourth quarter last year. Our August 2008 reduction in force had a $0.03 per share favorable impact during the fourth quarter and helped us keep payroll related costs as a percentage of sales in line with the prior year.

The 115 basis point increase in SG&A costs as a percentage of sales over the prior year was driven primarily by 65 basis points of higher bad debt provisions and approximately 50 basis points in rent and related occupancy expenses on a lower sales base. For the full year 2008 SG&A expenses were $343.8 million, or 28.8% of sales. Our 2008 SG&A expense included $4.3 million or $0.08 per share in one-time employee separation costs, professional contractor showroom closing costs and costs associated with the consolidation of our Auburn and Richmond distribution centers and the opening of our West Coast NDC.

Adjusting for these costs, SG&A expenses for the year were $339.4 million or 28.4% of sales, up 50 basis points from the prior year. This increase in SG&A costs as a percentage of sales for the year was related to a combination of 20 basis points in higher bad debt provision and 40 basis points in rent and related occupancy expenses on a lower sales base.

Our operating income in the fourth quarter 2007 [sic] was $15.9 million or 5.7% of sales compared to 9.8% in the prior year quarter and for the full year 2008 operating income was $89 million or 7.4% of sales compared to 9.2% for the full year 2007. Interest expense was $6.7 million in the quarter down 15.4% from the prior year quarter primarily as a result of lower interest rates. For the full year 2008 interest expense was $28.5 million down 16% from $33.9 million in 2007.

Conversely interest and other income were down approximately $1 million from the prior year period predominately on lower interest income yields.

In December 2008 we opportunistically used $10 million of cash to repurchase $12.9 million of our senior subordinated notes at a discount which after expenses resulted in a net gain of $2.8 million or $0.05 per share in the fourth quarter. Taking all of this into account net income was $10.2 million or $0.22 per diluted share for the fourth quarter 2008 compared to $13.6 million or $0.41 per diluted share for the prior-year quarter.

For the full year 2008 net income was $40.8 million or $1.25 per diluted share compared to $51 million or $1.56 per diluted share in 2007. Let me now move onto the balance sheet.

Driven by strong fourth quarter cash flow generation, as of December 26, 2008 we had $62.7 million in cash and cash equivalents on the balance sheet. With respect to accounts receivable our traditional measure of average DSO with a rolling five-quarter average has increased by one day over the prior year and is currently 48 days at the end of 2008. Conversely, on a spot basis DSO levels have improved but we believe this is primarily due to a lower sales environment. We continue to take a very cautious stance which we believe is prudent given the high risk environment we operate in today and accordingly we have increased our provision for bad debt to 8% of gross receivables at the end of 2008 from 4.5% at the end of 2007.

You may recall that as part of our Project 20-20 initiative we were implementing a new credit and collections technology solution. This solution is designed to significantly improve our credit and collection processes and productivity over time. We are excited about being able to use this tool during these challenging times now that it has been fully implemented across all of our brands.

Turning now to cash flow, during the fourth quarter we generated $42.1 million in cash from operating activities and allocated $1.9 million to capital expenditures. This resulted in $40.2 million of free cash flow for the quarter which, as Mike mentioned earlier, is a tremendous achievement that put is in the high end of our previously stated expectations.

Heading into the first quarter of 2009 we are confident in our liquidity position, have a strong cash balance entering the year and we have significant increases since then. We also expect another strong cash flow quarter due in part to the seasonal strength in cash flow that typically comes in the first quarter.

As I mentioned before we opportunistically repurchased $12.9 million of our senior supported notes in December 2008. Since year end we also bought back an additional $25 million of our bonds bringing our total debt extinguishment to approximately $48 million since December.

To provide you some color on our debt maturities we have a revolver which we currently do not use that matures in June 2012, $215 million of bank debt that matures in June 2013 and now $162 million in bonds or senior subordinated notes that mature in June 2014. So we are very pleased that we have no foreseeable need to access the debt markets in the near future.

Before I turn the call back over to Mike I’d like to spend a minute going over the anticipated cost savings from our recently announced initiatives and the previously announced savings associated with Project 20-20. In total we expect a $0.31 per share net benefit for the full year 2009. That includes a $0.02 per share net benefit in the first quarter 2009 and $0.08 per share in the second quarter with the balance coming in the second half of the year. So as you can see we have acted decisively to adjust our operating cost structure in what is clearly a challenging environment.

At this time I would like to turn the call back to Mike to discuss our business outlook.

Michael Grebe

As we look ahead we see continued but varying levels of resistance in each of our core end markets. However, we are confident we have taken the right steps to prepare the company for a difficult environment in 2009. We have taken action to broaden our product portfolio to better serve new and existing markets. We continue to further align our sales efforts strategically with the dynamics of the market and we continue to streamline our operations and rationalize our cost structure all while keeping a keen eye on our liquidity levels and cash flow.

However, given the current uncertainty in the global economy and the specific end markets we serve it is particularly difficult to provide our customary financial targets with a high degree of confidence. Therefore, we are suspending guidance at this time. In an effort to provide as much visibility as possible, I would like to relay what we are seeing quarter to date.

On an average organic daily sales basis January was slightly worse than December but February to date is better than both January and February in terms of year-over-year sales decline. This type of trend was generally true across all three of our key end markets. With respect to 2009 free cash flow, I want to highlight again we have been successful as a company over time in generating strong cash flow under difficult market conditions. We feel very good about our ability to generate strong cash flow despite the current economic challenges in the marketplace.

We generated $35 million in free cash flow from operations in 2008 and like many distributors we tend to generate more free cash flow when sales slow down a bit since working capital consumes cash for a distribution company in a high growth environment. So we expect to generate at least the same level of free cash flow in 2009 if not more.

Since we have focused our efforts on several important cost actions let me repeat what we just reviewed in terms of expectations in terms of cost savings actions in 2009. If you add all of our cost actions together we expect $0.31 per share net benefit for the full year 2009. While we have made very good progress on our cost inefficiency initiatives we are by no means done. Additional opportunities above and beyond the areas we have discussed here, across all facets of our business continue to be under close review. Again, we are committed to getting both short and long-term efficiencies during this challenging period.

Finally, while we have put plans in motion to align the business with market demand let me take a minute to remind you all of what we will not be doing. We will not focus on short-term financial targets to the detriment of our long-term sustainability. We will remain focused on managing our costs prudently and generating cash flow to support the business during this challenging period. We will not panic and make short sighted decisions that hinder our long-term progress.

We will leverage our past experiences operating in difficult environments to make proactive decisions that benefit the business and finally and most importantly we will not sacrifice any aspect of our customer experience. We have a strong underlying business and are confident in our fundamentals and strategies. I believe we are doing what is necessary to navigate the current environment while we continue to build a more efficient and profitable company for the long-term and for our shareholders.

With that I will now turn the call back to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Shannon O'Callaghan – Barclays.

Shannon O'Callaghan – Barclays

Can you maybe give a little more flavor on this monthly trend you are talking about with things getting worse in January but then February looking a little better? Can you fill that out in terms of what you are hearing from your customer base? Is this a kind of stabilization you can have some confidence in or what do you make of it?

Michael Grebe

Obviously this is a period very limited visibility and I think I speak for a lot of CEO’s when I say that it has been quite some time since we have seen a period like this. I guess to maybe just put specific numbers on those figures that I gave you; I mentioned that December was down 13.5% on an organic basis. January was down 14.1% on a year-over-year basis and February so far month to date is down 11.1%. So it is nice to see numbers moving slightly in the right direction. It is still hard for us to determine the long-term trends there. Obviously we like the fact that it is picking up. Typically we would see more sales come at the end of the month than the middle of the month. We are still hopeful that February will end even stronger.

I guess if you think about what we sell to our customers as we have always said it is common, every day repair parts and typically customers can reign in hard for a period but at some point these are properties they own and need to be maintained. There are studies out there that show it is equally dangerous to under invest in a property than it is to over invest. We would like to think some level of stability might be coming back. As I said earlier we are clearly seeing larger renovation projects being put on hold, being stopped and so forth and we are not at this stage thinking those are going to snap back very quickly. So hard for us to really discern a long-term trend. All we know is we have pointed our sales professionals in the right direction, keeping them focused in on the initiatives we can execute on and hopefully gain market share during a tough period.

Shannon O'Callaghan – Barclays

What about the point on inventory? You started to take inventories down but you said you are not done. Is there a certain inventory turn level you are targeting to get to or how are you thinking about it?

Thomas Tossavainen

Let me walk you through some of the things in terms of some of the specific dollars we focused on in the third and fourth quarter and then I will give you a look ahead. Recall that in earlier releases we talked about some investments very specific NDC West was $12 million. $3 million to support some of the final AmSan conversions and $3 million to support the new MRO product offering. With the $20 million reduction again we feel very good about that and the fact it had no impact on our book rates given that the current sales landscape will show another sequential reduction similar to at least $8 million in the first quarter 2009. I will tell you we do particularly in this economic environment see fill rates as a strategic weapon and having great fill rates is certainly a source of advantage.

We are very, very focused on it and we will continue to work on inventory methodically and prudently as we did in the fourth quarter but now against this more challenging sales climate. Again, I do want to reiterate that it is very important we will use this economic situation to further tighten our global supply chain. So from Asia back over to the United States I should note we are having a lot of success across this dimension as well.

Again, following Mike’s comments we are still very excited to support growth initiatives. Things like the institutional products. Again we are seeing more and more traction there as we roll out to a larger sales base. In summary, we do feel good about our progress to date but that being said we also remain very focused on continued management of our supply chain and inventory levels so that we can bring things down in a very thoughtful and proactive fashion.

Shannon O'Callaghan – Barclays

On the bad debt, what are you seeing develop in terms of where that is tracking? Just a little more color there and also historically in the last down cycle where did bad debt typically trend to?

Michael Grebe

As the year progressed we highlighted on our call we have seen a progressive slow down in customer sales and payments alike. This trend continued and in fact increased in the fourth quarter especially in the month of December. Our traditional measure of DSO’s we were saying the five quarter average has increased a day. Even though spot rates tend to say they are better on a year-over-year basis but again I think that is just the weaker sales environment we are functioning in versus improved payment patterns.

Today’s economic environment I think while payments are slowed down we have increased reserve levels to try to address that potential increase in risk. We think that is the prudent thing to do right now and I think we are investing for the risk environment appropriately. In terms of color on terms of where we have been in the past this is higher rates than we have had in the past. In the 2003 time frame we saw a relative type of slow down but we reserved at a higher rate than we saw back then.

Operator

The next question comes from David Manthey – Robert W. Baird.

David Manthey – Robert W. Baird

I was wondering could you talk about inventory levels that are held at your customers by segment? I don’t know to what extent your customers are carrying some level of safety stock and then replenishing that and they are in the process of de-stocking right now. Could you talk a bit about any kind of rebalancing you are seeing in the market that might have made December and January look even worse?

Michael Grebe

Sure. Pretty tough for us to gauge customer inventory. It depends on the end market but if you think about an apartment complex, for example, the typical maintenance area for an apartment complex or storage area might be 100 square feet or 200 square feet and might have a couple thousand dollars maybe of inventory in it some of which might go back a few years I would suspect. There isn’t typically a lot of inventory at an apartment complex or even within a hospital with some of our institutional customers. Clearly we have heard from some customers a lot in the December and January timeframe with commentary like I have been told not to order. I have been told not to order this week. Usually followed by I’m not sure I know what that means. We think there is clearly some de-stocking going on at the customer level. I would also say in the pro contractor arena we are often hearing customers say I am buying for a job or I am buying job by job. I’m not buying for inventory. I think that goes to what Ken said very ably that in this period we want to make sure we maintain the right inventory levels so that we can use fill rates as a strategic weapon. In scenarios like that what that often means is that if you don’t have the product right now you aren’t going to get the order. The customer is not going to wait 3-4 days because they can’t afford a back order type situation.

We are very pleased with the inventory reductions we made while still maintaining fill rates. I would say to sum that up our typical customer doesn’t have $100,000 of inventory in their shop. Typically what we are hearing is there has been some de-stocking and it is hard for us to tell how far that has gone or when that will end.

David Manthey – Robert W. Baird

The second question relates primarily to the Jan San business but also maybe facilities maintenance in general, are you seeing any kind of secular shift from in-house DIY Jan San and maintenance to more of an outsourced situation? Could you talk about your relative value proposition to each of those potential customers?

Michael Grebe

In the Jan San space the outsource entity that usually goes to is usually what is referred to as a BSC or Building Service Cleaner or contractor. We have a fair amount of great customers that fall into that category. I would say we have an equal value proposition or as good a value proposition for both the in-house team and for someone that is using a BSC. I have not personally seen any recent trends, or seen any recent data meaning what is happening in December or January with respect to BSC’s. That has been a very growing portion of the market over the past few years. The last statistics I have seen was showing that is slowing down a bit. Obviously lots of things have changed over the past 2-3 months so that may be a little bit different.

I also would add that in the Jan San space we have a very strong private label component in that space and that tends to be a great value add for someone that is a building service contractor that we are able to provide them with a product at the right price point to assist them in their relationship with their end customer. I think we are in pretty good shape on both those counts.

Operator

The next question comes from Keith Hughes – SunTrust Robinson Humphrey.

Keith Hughes – SunTrust Robinson Humphrey

You had talked about the pressure on the gross margin. You said something about pricing representing a fair amount of the compression. Was this just bringing down prices to compete with competitors or their axing the pricing? What specifically was going on there?

Michael Grebe

I think that is a mix of a number of things. Certainly we did see some pricing pressure. That coupled with the record comp in Q4 2007, inventory reduction that Tom took us through plus the West Coast NDC ramp up. Let me also take that and look forward. I think certainly we can’t predict issues like mix or competitive intensity but we do see some potential positives on the horizon. For one example after increasing in the first half of 2008 we are seeing some product price moderation particularly in Asia and some commodity driven product price reductions. So I don’t think we can quote you a specific number. We do expect to see some of this benefit beginning in the second quarter given the length of the supply chain.

I guess also one other thing is as commodities moderate at lower price levels we would expect our margins on those items to increase from where they were in the fourth quarter. Third, we of course continue to look for ways to reduce our product costs. We feel that with our local knowledge of the Asia market we can continue to capitalize on advantageous overseas product sourcing opportunities. Case in point we have over 40 people in our two sourcing offices in China. A lot of solid, long-term supplier relationships there and I think this allows us to redirect product flows across the globe quickly and efficiently. Finally, with that we can talk a little bit about merchandising. That team was highly focused on ensuring we have the right product cost structure and one that is very competitive and capitalizes on our scale.

Certainly we also have that team focused on allowing us to kind of manage our product price changes relative to our catalog commitments. I guess now with all that said clearly we are in unprecedented times so our deep merchandising experience shows that during times like these raw material and supplier prices as well as demand all can move quickly. So a challenging period…

Keith Hughes – SunTrust Robinson Humphrey

There is not a lot of commodity product. You sell a lot more manufactured goods so I guess my question is really this early in the down cycle on some of your businesses it would seem as though if you are buying more cheaply out of Asia so are your competitors and the price for everyone would continue, the finished price for some of your customers, will continue to go down.

Michael Grebe

Certainly. That is a possibility that we could see more and more deflation throughout 2009.

Keith Hughes – SunTrust Robinson Humphrey

Is there a specific sector or a specific product category this is more prevalent in the fourth quarter?

Michael Grebe

Certainly anything that is tied to a commodity. For example, things that have higher copper components are one example so it is those things that manifest themselves in areas like plumbing.

Keith Hughes – SunTrust Robinson Humphrey

I meant more is it facilities maintenance, is it specialty distributor, more the MRO? Anything like that?

Michael Grebe

I’m not sure I can call out for you any one specific segment. Certainly everyone is very price sensitive right now. Again we see those issues across the board and nothing per se unique to any one segment or sub-segment.

Keith Hughes – SunTrust Robinson Humphrey

You had talked in the prepared comments within facilities maintenance of stability within the MRO and the Jan San business. That would imply there was a significant decline within the apartment business. Am I reading those comments correctly?

Michael Grebe

The area within facilities maintenance that was impacted the most, as an example where the renovations portion of that business. Renovations plus which is a division within that facilities maintenance group we report on or provide sales numbers for, as I said that was down 45% and that business typically goes after very large scale projects that are renovating 10-15 apartment units or perhaps a whole apartment complex. Still within our regular Wilmar brand that you are very familiar with there is still a fair amount of renovations that are included in there, we just can’t identify them as such because they tend of be one off or two off. That portion of the business again has been impacted dramatically. The kind of every day repair and maintenance and faucets, ice melt, those types of products that field is very steady for us. Anything that involves a renovation or a major upgrade has been dramatically impacted.

Operator

The next question comes from Matt McCall – BB&T Capital.

Matt McCall – BB&T Capital

Mike I think in your comments you said that you right-sized the business to match current and expected demand. As we look out I guess the question is about the expected demand. As we look out to 2009 if we assume the current kind of run rate obviously that is going to be year-over-year pain but is there some margin expectations or margin improvement? I know there is $0.31 out there. I assume you said to match expected demand you have some kind of idea what you expect that to be or are we looking at kind of a take this run rate and carry it forward for the full year and average it out? How should we look at that? It is not a guidance question I’m just trying to understand what the cost structure looks like.

Michael Grebe

In terms of how we have tried to match costs to revenues I guess the way we have tried to manage the business here is to assume no material change in trajectory at the revenue line for the year. We feel that if we take that approach, manage our costs very, very tightly and manage our initiatives very tightly and revenue is an upside surprise then that will be a good problem to have. That will be a high class situation to have. That is kind of the way we are thinking of that. We are not expecting any of our core end markets to improve dramatically and we feel that if that happens and we put those cost initiatives in place we have got the right structure for that business and when the markets return we are going to see our operating margins return to historic levels and go past. That is our objective. That is clearly where we want to be.

Matt McCall – BB&T Capital

The commentary about January and February comps that is helpful. Is there anything in the year-ago comparisons we should note looking at December versus January versus February? Do they get easier or harder? I know it is not a huge delta between the 11% and the 14% trends but anything in the year-over-year comps that would be even more telling?

Michael Grebe

The only thing I would call out Matt and I suspect every other distributor is thinking the same thing is where Christmas and New Year’s fell this year had a dramatic impact on a year-over-year basis in December and January. Our fiscal year ended in between Christmas and New Year’s so the way that holiday fell in January impacted us a little bit as well because people tend to take off more days or more time depending on what period that is. I’m not sure there is anything dramatic there I would cite on a year-over-year basis. When I cited those numbers those are really adjusting for days and so forth. I think we are in pretty good shape.

Matt McCall – BB&T Capital

When you say average organic down 14% just for that calendar this year?

Michael Grebe

That’s correct.

Matt McCall – BB&T Capital

On the free cash flow if I wrote it down correctly at least as good as this year and I think the number you used was $38 million. You had a strong Q1. Top in your mind is the expected seasonal pattern it sounds like there is going to be more of a usage as we go through the end of the year?

Michael Grebe

Just to clarify what I think I said was that we generated $35 million in free cash flow in 2008. We expect that to be at least as much or more in 2009. Generally speaking the Q1 and Q4 are cash generating quarters for us. Q2 and Q3 are mild users, flat to a use of cash. So that is the normal pattern for us.

Operator

The next question comes from Bob Franklin – Prudential Financial.

Bob Franklin – Prudential Financial

Could you repeat the number of bonds you said you bought back in the first quarter? I want to make sure I got that right.

Thomas Tossavainen

We bought back $25 million in the first quarter thus far.

Bob Franklin – Prudential Financial

That is face amount?

Thomas Tossavainen

That is correct.

Bob Franklin – Prudential Financial

What is the average price you paid for that?

Thomas Tossavainen

On average we paid 95 on that.

Bob Franklin – Prudential Financial

Your term debt, there is scheduled amortization on that isn’t there?

Thomas Tossavainen

We have $215 million in term debt and our amortization is very low. It is $1.28 million a year.

Bob Franklin – Prudential Financial

Are there restrictions on how much more of the bonds you can buy back? Does the term debt restrict that?

Thomas Tossavainen

We have some baskets of capability to buy some more bonds. We have a $25-35 million basket give or take.

Bob Franklin – Prudential Financial

That is still available?

Thomas Tossavainen

That is in total.

Bob Franklin – Prudential Financial

Now I’m confused. If you bought back about $12 million in the fourth quarter and $25 million this quarter are you bumping up against the basket?

Thomas Tossavainen

No, on an annual basis we can buy back $25 million in addition to another $10 million.

Operator

There are no further questions at this time.

Michael Grebe

Again thank you for attending the call. We appreciate the support and that’s the end of our call.

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Source: InterLine Brands, Inc. F4Q08 (Qtr End 12/26/08) Earnings Call Transcript
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