Zep Management Discusses Q2 2013 Results - Earnings Call Transcript

Apr. 9.13 | About: Zep Inc. (ZEP)

Zep (NYSE:ZEP)

Q2 2013 Earnings Call

April 09, 2013 8:30 am ET

Executives

Don De Laria - Vice President of Investor Relations & Communications

John K. Morgan - Chairman, Chief Executive Officer and President

Mark R. Bachmann - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Robert Labick - CJS Securities, Inc.

Matthew Schon McCall - BB&T Capital Markets, Research Division

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Zahid Siddique - Gabelli & Company, Inc.

Operator

Good day, ladies and gentlemen, and welcome to the Zep Inc. Second Quarter Fiscal 2013 Earnings Conference Call. [Operator Instructions] As a reminder, ladies and gentlemen, this conference is being recorded.

I'd now like to introduce your host, Don De Laria.

Don De Laria

Good morning, and thank you for joining Zep Inc. today for our second quarter fiscal 2013 conference call. Before I begin today's call, I'd like to remind participants that our earnings call format includes an online presentation to augment our comments. You can access this presentation, as well as this quarter's earnings press release, online at www.zepinc.com in our Investors section under Webcasts and Presentations.

Included within this quarter's earnings press release is a reconciliation of any non-GAAP measures, that may have been referenced throughout this presentation, to their nearest GAAP measure. This conference call contains forward-looking statements within the meaning of Section 27A of the Securities Exchange Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended. All statements other than statements of historical facts communicated during this conference call may constitute forward-looking statements.

These forward-looking statements involve risks and uncertainties. Important factors that can cause actual results to differ materially from the company's expectations are disclosed in the risk factors contained in the company's annual report on Form 10-K dated November 8, 2012. All forward-looking statements are expressly qualified in their entirety by such factors.

Here with us today are John Morgan, Chairman, President and Chief Executive Officer; Mark Bachmann, Executive Vice President and Chief Financial Officer; and other selected Zep officers. I would now like to turn the call over to Mr. John Morgan.

John K. Morgan

Thank you, Don, and welcome, everyone, to our second quarter earnings call. I'll start by discussing the highlights of the quarter, including updates on key initiatives, and then Mark will follow with a review of financial results. And as always, we'll conclude the call with your questions.

Let me begin by saying I'm pleased with the overall performance during the quarter. At the start of the quarter, our associates were challenged with the task of integrating Zep Vehicle Care at the same time we were implementing a new ERP solution to better manage the North American sales and service channel and the supply chain. I'm very pleased to report that our team has delivered and that both projects are on track to achieve the benefits we expected at the outset.

During the quarter, we completed Phase 1 of the Zep Vehicle Care integration, which combined the talents of professionals from our Zep Sales & Service organization with professionals from our recently acquired Vehicle Care division of Ecolab to create a platform to focus exclusively on car, truck and fleet wash. Now as the recognized industry leader with the largest team of Sales & Service associates and distributors in the nation, we've created a platform with a 10% share of the vehicle wash market, a 20% share in full-service carwashes and a 35% share in convenience store chain carwashes. On a combined basis, our team calls on over 10,000 customer sites that wash over 1 million vehicles daily. I'm proud of the way our associates have come together to form Zep Vehicle Care. We continue to expect that Zep Vehicle Care will positively impact fiscal 2014 earnings by $0.08 to $0.10 per share.

Also during the quarter, we completed the largest phase of our ERP solutions implementation. This greatly enhances our ability to serve customers and to improve productivity with real-time information provided by a fully integrated system. It is common for ERP implementations of this magnitude to create temporary distractions, which we will discuss in detail a little bit later, but I'm pleased to report that the heavy lifting is complete, and we are beginning to focus on fine-tuning the system. Among other benefits, we expect the new ERP system will provide access to timely and accurate information about our business, thereby improving delivery cycle times and improving inventory management.

Now I'd like to discuss a few financial highlights. Revenue in the first quarter was up more than 7%, exceeding $163 million. Our gross profit margin grew by 260 basis points, exceeding 47%, and diluted earnings per share grew by more than 9% to $0.12 per share. I also want to point out that EBITDA for the second quarter increased $3 million or 34% to nearly $12 million, and our EBITDA margin increased approximately 140 basis points. As is typical in the second quarter, we use cash, and this quarter, the cash usage totaled $11.5 million.

We're making progress with respect to organic growth in a number of areas of our business. I'm particularly pleased with the investments we continue to make in retail and distribution. These teams grew average daily sales by 4.6% in the quarter, overwhelmingly led by growth in the retail channel. We have made great progress in expanding our sales of our Zep Commercial brand of products. Mark will take you through more detail and a breakdown of the revenue here in just a moment.

Our North American strategy is founded on developing products for select key end markets that we believe have attractive characteristics and areas where we believe we have a winning value proposition. We believe it is appropriate for us to make our products available to customers through the channels of their choosing. While there has been and will continue to be shifting demographics in the market, as a broad-based manufacturer with significant brand equity, we believe our approach contributes to consistent cash flow, safety through diversification and growth opportunity.

Over the quarter, we experienced the puts and takes that such a strategy will experience. As we would expect it, vehicle wash was up sizeably, primarily as a result of the acquisition we previously discussed. Also, in the automotive aftermarket area, we achieved strong growth in the retail channel, which was driven by new products and promotional activity. All told, the transportation sector of our business now represents more than 1/2 of our total sales. Our industrial/MRO sales were up nicely due to growth with large national distributors. When combined with transportation, these 2 categories now represent more than 60% of our business.

In janitorial products, we once again experienced very strong growth in the retail channel. Our team was comping against a very strong Q2 last year, so I was particularly pleased to see continued growth this year. Sales through Jan/San distributors, however, declined as has now been the case for several months. Our Jan/San plumbing and automotive products are now sold in over 10,000 retail locations, so we are finally beginning to see some smoothing effect from the benefits of scale and diversification in retail.

Another bright spot continues to be the sales of our food processing products, which are serviced through the sales and service channel. The team is continuing to experience growth in average daily sales primarily from deeper penetration of existing accounts. Sales & Service overall as a channel, however, experienced declines as the organization was impacted by ERP-related disruptions, which were overwhelmingly felt in the month of December. While we are not yet as proficient with the new systems as we were with our legacy system, we do not expect any further major disruptions to the top line of the business due to business systems. The sales model continues to be critical to success in markets such as energy and food processing, and we continue to see gains in both markets. Finally, and as you might expect, sales to governments and schools continue to be impacted by reduced spending, and while we see some improvement in local governments, we expect federal spending to be tight in the near future.

Before concluding with a review of our near-term priorities, I want to take a moment to expand on this strategy. We have a clear understanding of our competitive position and are focusing our efforts where our capabilities create value. We start by focusing on key markets like transportation, industrial maintenance and repair operations and food service where the demographics are in our favor and where we can win. Our multichannel distribution capability provides a unique opportunity to serve our customers when and how they want to buy, and our acquisition strategy further expands market access in key end markets. Building volume creates a significant opportunity to further leverage our existing manufacturing and logistics infrastructure while also driving economies of scale for purchasing and administration. These activities ultimately lead us to generate organic growth in selected strategic platforms.

I want to conclude by emphasizing the progress we've made in just the past 3 months. By launching the most significant change in our information technology capabilities in our history, we've made significant progress on integrating the Zep Vehicle Care business and continue to grow our business in a number of key end markets. As we discussed last quarter, we will continue to focus on generating cash from our recent investments. We will utilize this cash generation to pay down debt and delever the balance sheet while delivering the free cash flow one would expect of a business of our brand equity, stability and opportunity.

And with that, Mark, let me turn the call over to you to begin to review financial details.

Mark R. Bachmann

Thank you, John, and good morning, everyone. Revenues in the first (sic) [second] quarter were $163.4 million, up $11.7 million or 7.7% compared to last year's results. The effects of favorable pricing of $2 million and foreign exchange of $300,000 were partially offset by a $600,000 volume decline, resulting in organic growth of approximately 1.1% on a constant selling day basis. Revenue was impacted by $2.4 million from 1 less selling day during the quarter, given that last year was a leap year.

Additionally, revenue was negatively impacted by an estimated $5 million in the month of December, resulting from the disruption associated with our recent ERP implementation. This impact is consistent with our comments on our first quarter earnings call regarding the potential disruption from the ERP implementation and its impact to operating earnings. It is important to note that disruptions of this sort are common with new technology, and we have substantially returned the functionality of our processes to their pre-conversion capability. Separately, acquired revenue added $17.4 million or 11.5% to net sales, contributing to a growth rate in total revenues of 7.7%.

Turning to gross profit. Second quarter gross profit was $77.4 million, $9.4 million higher than the comparable quarter of fiscal 2012. Our gross profit margin increased 260 basis points to 47.4%. Approximately 1/2 of this 260-basis-point improvement in gross profit margin is attributable to the inclusion of Zep Vehicle Care within our second quarter results, that was partially offset by other channel mix. The remaining improvement is primarily due to the favorable true-up associated with distributor marketing programs which affected sales. On a sequential basis, gross profit as a percentage of sales remained flat for the first quarter as the true-up of distributor marketing programs were virtually offset by unfavorable manufacturing absorption, which is typical of our second quarter. I am pleased to update you on our estimate for full year gross margin, which we now believe will be in the range of 47% to 49%.

During our second quarter, we generated $11.8 million of EBITDA, representing a $3 million increase over the prior year. Our EBITDA margin of 7.3% represented a 140-basis-point improvement compared to last year. It is important to note that our EBITDA margin in the current quarter benefited from the recent acquisition of the Vehicle Care business, which accounted for 40 basis points of improvement, and from a $1.3 million adjustment to an acquisition earn-out reserve. This was partially offset by $1.6 million of acquisition and integration costs related to both the Vehicle Care transaction and last year's U.K. acquisitions.

Our effective tax rate for the second quarter was 32.2% compared to 38.5% in the second quarter of 2012 resulting from lower permanent items and a discrete benefit related to the US-based research and development tax credit law change, which was retroactive to January 1, 2012. We would expect a much smaller benefit in the second half, and now expect our full year tax rate to be in the range of 36% to 37%.

Net income for the second quarter increased almost 15% to $2.8 million, bringing EPS to $0.12 compared to $0.11 last year. Free cash flow during the second quarter, defined as cash flow from operations less net capital expenditures, was a cash usage of $11.5 million during the quarter compared to a cash usage of $3.3 million in the prior year. The disruption associated with our new ERP system resulted in increases in operating working capital due in part to a temporary delay in collections and increased inventory levels. We have substantially returned the functionality of our operating working capital related processes to their pre-December 1 capability. We will utilize our new systems and processes to improve our current net trade cycle.

Capital expenditures for the second quarter were $2.6 million, which represented a decrease of approximately $1.2 million compared to last year. We now expect that total capital spending in fiscal 2013 to range between $14 million and $15 million, which includes investments related to the Vehicle Care business. Now that the most significant impact on free cash flow is behind us with last year's investments, we expect to return to historic levels of free cash flow generation, which has hovered around 4.5% of sales for the full year.

Our net debt position at the end of the quarter was approximately $260 million. We remain in compliance with our debt covenants during the period, finishing the quarter with a debt-to-EBITDA ratio of 3.89x and a fixed charge coverage ratio of 1.98x, each of which are in line with our expectations. We continue to believe that we will be able to operate this business within the current covenants and delever by approximately 0.5 turn by the end of the first fiscal quarter of 2014.

In closing, let me highlight our 2 key priorities for the immediate future. First, we will continue to integrate Zep Vehicle Care and expect to discontinue utilizing services under the Transition Services Agreement by the end of the calendar year. Second, we will focus on generating free cash flow to reduce debt.

Now we'd like to open up the call to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Robert Labick of CJS Securities.

Robert Labick - CJS Securities, Inc.

I wanted to start on the retail side. I think you just said -- you reported you're in about 10,000 stores, maybe up from 7000 before. Can you talk a little bit about how -- maybe it's too early but sell-throughs going there and how you're getting these new customers and where you see the retail channel going over the next few years?

John K. Morgan

I think you're right. I think it is, frankly, too early to fully understand the sell-through because at the same time that we're rolling out various different programs in retail, we're going through, in some cases, seasonal promotions and BOGOs and that type of thing. And so it's not an area where we have the history and experience to be able to accurately answer your question. That having been said, the focus has been to take our primary brand that we sell through retail the Zep Commercial product, and in some instances combine that with our private brand capabilities and to take a complete package to retail. And in particular, what we're focused on is the feedback we've gotten from our customers over the years is that they like the efficacy of the product, the brand is a trusted brand, it's something that they understand, a product will do what it says it does, but they want it to be more broadly available. And our focus, the final thing I would say about this, our focus is really remains on the professional user of the product, not the, I'll say, typical homeowner. And we recognize, of course, that homeowners can buy our product because it's in that environment, but the majority of our sales, as measured by store intercepts when we evaluate who's actually buying our product, is really the professional user. And so my expectation is that demand for the product in general in retail will continue to grow as the demographics improve and as the channel shift continues to occur because of the speed and convenience available through the retail channels and so that's been the focus. Does that answer your question, Robert?

Robert Labick - CJS Securities, Inc.

Sure, yes. Just to follow up on that. You've had nice success there, and I think that, generally speaking, gross margins may be a little lower even though operating margin is equal to or better through retail, but you also increased your gross margin guidance for the year. So maybe you could talk a little bit about the drivers behind the higher gross margin for the year, please.

John K. Morgan

Mark, why don't you take that?

Mark R. Bachmann

Yes. So Bob, the increase in overall guidance on the gross margin is our expected manufacturing absorption for the balance of the year, as well as the benefits we expect from the -- adding Zep Vehicle Care to the business.

Robert Labick - CJS Securities, Inc.

Okay, great. And then last one, I'll get back in queue. You mentioned certainly the ERP implementation and the cash flow collections in the quarter. Have you recouped all of that -- those receivables at this point? Or are those expected to flow back in over the course of the year? Or how is that playing out?

John K. Morgan

We have not fully recouped all of that yet, but we do expect that to come back in over the course of the second half of our fiscal year.

Operator

Our next question comes from Matt McCall of BB&T Capital Markets.

Matthew Schon McCall - BB&T Capital Markets, Research Division

Let me follow up on that last question about gross margin. Mark, you said that part of that was due to manufacturing absorption. So if you're taking that guidance up, is it that absorption is looking better or that growth is looking better?

Mark R. Bachmann

It's really a combination when you look at the increased sales in the back half of our fiscal year and being able to more fully absorb our manufacturing costs.

Matthew Schon McCall - BB&T Capital Markets, Research Division

All right. So it sounds like maybe more growth is there. Is there anything on the absorption side that you maybe learned from the acquisition that's changed that calculation or the assumptions in your -- in what would be the normal fixed cost absorption?

Mark R. Bachmann

No, no. And as we indicated, Matt, in -- with the second quarter, more than 1/2 of our increase, about 130 basis points in the second quarter, was due to the addition of the Vehicle Care business to our results for the quarter.

Matthew Schon McCall - BB&T Capital Markets, Research Division

Okay, okay. And I apologize [indiscernible] -- yes, sir.

John K. Morgan

Given the nature of your question, let me be specific. Mark, correct me if I'm wrong here. Part of the growth that you would experience affecting absorption in the second half has to do with the seasonality of our business. So I don't want you to walk away from here with the impression that we think that the top is going to come out of the -- the top line drivers of demand in the industry and our business over the next 6 to 12 months, we still expect the external environment to be difficult in general. So we're talking about estimates for the balance of the fiscal year, which have a bit of a benefit in the second half of our fiscal year because of mix of our business from a seasonality standpoint.

Mark R. Bachmann

And I would just add that we always have more selling days in the second half of the fiscal year than we do in the first half of the fiscal year. And then, our second quarter is always the fewest number of selling days in any given quarter.

John K. Morgan

Does that help?

Matthew Schon McCall - BB&T Capital Markets, Research Division

Yes, sir. And then, Mark, I was cut off and hopped right back on, and you were -- I think you were talking about $5 million of ERP impact in the quarter. Is that correct? I'm just trying to reconcile that number with the $1.6 million of acquisition and integration cost. I think they're totally separate. Is that correct?

Mark R. Bachmann

Yes, they're different. The $5 million is our estimated impact to sales in the month of December, primarily in our Sales & Service business, which was where the implementation took place so that's a sales number. And the $1.6 million of acquisition and integration cost is an EBIT number.

Matthew Schon McCall - BB&T Capital Markets, Research Division

Okay. They're separate topics?

Mark R. Bachmann

Yes.

Matthew Schon McCall - BB&T Capital Markets, Research Division

Okay. And then you talked about federal government impact. Can you give us any quantification of what the pressure has been like and what you expect it to be like?

John K. Morgan

We -- the truth is it's hard to tell exactly because we don't know about the tertiary effects. We know what our sales to governments are, of course, but we don't fully understand the tertiary effects of our customers who are suppliers to the federal government. That having been said, this well-known concern around sequester, it would be our thought that in our second quarter, that should not have had much of an impact, if at all, in Q2. I'm a little more concerned about it for the future than I am of in Q2.

Matthew Schon McCall - BB&T Capital Markets, Research Division

Okay. And then back on the seasonality, I think in the past you've talked about some percentages. Just given the shift in the mix from acquisitions, have you provided an up-to-date view on what your back half should look like versus your first half of the year?

Mark R. Bachmann

Well, I mean, we always -- from a sales perspective, we've always generated more than 50% in the back half of the year. I mean, so you can look historically in there. I don't think there's anything that will change there. You just need to adjust for the fact that you will have Vehicle Care in the back half and we didn't have it in the first quarter of this fiscal year.

Matthew Schon McCall - BB&T Capital Markets, Research Division

Okay, so no real change there. And then final one, Mark, you talked about the $1.3 million adjustment to an earn-out. Just trying to make sure I understand. What -- you talked about it, I think, when you were referencing EBITDA. If I take the $1.6 million acquisition integration, do I need to offset that by the $1.3 million of the adjustment to earn-out to get to a cleaner operating income number? Or that was [indiscernible]?

Mark R. Bachmann

That's correct. They're 2 separate factors. And we reduced the reserve for the earn-out, and we incurred the acquisition integration, so the 2 would offset each other.

Operator

Our next question comes from Mike Sison of KeyBanc.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

The $5 million in sales disruption you had in ERP for the quarter, does that linger on for the next couple of quarters? Or is that solved, if you will?

John K. Morgan

We think that's behind us.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Okay. And then, so when you think about your same-store sales, I think you mentioned, with all the puts and takes, it's running about 1%. Is that sort of the -- is that the right run rate to think about where it sort of shows that the organic growth initiatives will show in, in the next couple of quarters?

John K. Morgan

The expectation that we have is that the top line will really not benefit much, if at all, from the external environment. We don't -- I'm not as optimistic about the general economic conditions in aggregate in North America as I hear some prognosticators describe. Small business sentiment is still not great, and while corporate profits continue to climb substantially, the rate of improvement in large business is pretty substantial, the rate of improvement in small business is really de minimis. And a lot of our -- and of course, employment levels affect our business. So I don't -- I wouldn't put anything more into our thinking then than that 1% that you alluded to. Having said that, here in the next few months, here in our business, now that we've made so many acquisitions in the last 30 months and now that we have put some leverage on the balance sheet to get that done, I think our focus for the immediate future needs to be to delever the balance sheet, to focus somewhat on taking some of the complexity out of the business that we've added as a result of all the acquisitions. And so we're really not laying much at the feet of top line revenue growth in the coming 3 or 4 quarters as we think about the business going forward.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Okay. And the sales run rate you're seeing for the Ecolab business that you just bought, that $17 million, is that about a good run rate for the next couple of quarters?

Mark R. Bachmann

Well, what we had shown in the pro forma is that on a trailing 12-month basis, they did approximately $66 million worth of overall revenue, and there is not a lot of seasonality in that business.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Got it. John, when you think about -- just back to the guidance for gross margin, 47% to 49%. To hit the high end of that range, your third and fourth quarter would have to be pretty significant to average to full year of 49%. So if that was to happen, it doesn't sound like the volume is going to help you and the external environment to get there. Is it really just within your control to get to that higher end, to average that for the full year?

John K. Morgan

Well, I do think the volume helps somewhat insomuch as there's seasonality in our business, where greater than 50% of our revenue is generated in the second -- in the back half of our fiscal year. And so we get some benefit of volume and of course, absorption in the second half of the year so that is a contributor. I think beyond that factor, you're right, it's really -- it really lays at the feet of mix and execution on our part.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

And longer term, what do you think the growth rate from the new vehicle wash -- sort of the bigger vehicle wash business you put together can generate over time?

John K. Morgan

That's a great question, and quite honestly, I'm not prepared to answer that at this point in time.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Okay. Last question, Mark, SG&A for the full year? The quarterly run rate is -- they're the same as you saw in the last couple of quarters?

Mark R. Bachmann

Well, I mean, you have clearly a higher gross margin as a benefit of the Vehicle Care acquisition, but it also does add additional selling and administrative expenses or distribution expenses with that. So I'm not sure if your comment is on an absolute basis or margin percent basis.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Kind of percent and sales basis, is that about the right run rate?

Mark R. Bachmann

Yes, I mean, certainly, from where we've experienced it, it would -- there should be major changes. I mean, we do get some benefit, once again, of the higher back half sales over what is considered fixed cost. So you do get some better leverage or absorption on some of your fixed costs there.

Operator

[Operator Instructions] Our next question comes from Zahid Siddique of Gabelli & Company.

Zahid Siddique - Gabelli & Company, Inc.

Most of my questions have been answered, but just a couple of small questions. One is on depreciation and amortization, I know you did went from $3.5 million to $5.5 million sequentially. I assume that's coming from the Ecolab acquisition. So my question is, is $5.5 million a quarter is the number we should be looking at?

Mark R. Bachmann

Yes, that's right. The Ecolab acquisition accounting will add about, on an annual basis, about a little more than $4 million in amortization expense per year.

Zahid Siddique - Gabelli & Company, Inc.

And about the same for depreciation?

Mark R. Bachmann

Well, the depreciation, I think what you saw in the second quarter is when we began to depreciate SAP, that has an impact of $2 million on an annual basis for that. So both of those were reflected in the second quarter and should reflect an ongoing run rate.

Zahid Siddique - Gabelli & Company, Inc.

Okay. And then I noted your net debt went up slightly, maybe by about $10 million. Anything there?

Mark R. Bachmann

So that was driven largely by increases in operating working capital, both in receivables and in inventory. And as we noted, there were some disruptions associated with the ERP implementation in a portion of our business. But we would expect those to come back in line by the end of our fiscal year.

Operator

Mr. Morgan, I'm not showing any further questions at this time. Please proceed with any further remarks.

John K. Morgan

Well, thank you very much. And I want to thank everybody for joining us on the call today, and we, of course, will look forward to reporting our progress with you sometime in early July time frame. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference, and you may now disconnect. Everyone, have a wonderful day.

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