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Executives

Allison Malkin – IR, Integrated Corporate Relations

Scott Beattie – Chairman, President and CEO

Joel Ronkin – EVP and General Manager, North America Fragrances

Steve Smith – EVP and CFO

Analysts

Bill Chappell – SunTrust

Joe Altobello – Oppenheimer

Arnie Ursaner – CJS Securities

Jason Gere – RBC Capital Markets

Reza Vahabzadeh – Barclays Capital

George Chalhoub – BTIG

Gary Giblen – Axiom Capital

Elizabeth Arden, Inc. (RDEN) F3Q09 (Qtr End 03/31/09) Earnings Call Transcript May 7, 2009 9:30 AM ET

Operator

Greetings and welcome to the Elizabeth Arden Third Quarter Fiscal 2009 Results Conference Call. (Operator instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Allison Malkin of ICR.

Thank you. Ms. Allison Malkin, you may now begin.

Allison Malkin

Thank you. Good morning. Thank you for joining us. Before we begin I’d like to remind you that some of the comments made on this call as either prepared remarks or in response to your questions may contain forward-looking statements that are made pursuant to the Safe Harbor provisions of the Securities Litigation Reform Act of 1995. Such information is subject to risks and uncertainties that could cause actual results to differ materially from the statements as described in the press release and in Elizabeth Arden’s most recent annual report on Form 10-K, filed with the SEC.

Also if any non-GAAP financial information is provided on this call, a reconciliation of the non-GAAP information to the most comparable financial measure is provided in our press release.

Also, I would like to now turn the call over to Scott Beattie, Chairman and CEO of Elizabeth Arden. Scott, please go ahead.

Scott Beattie

Thank you very much. Welcome everyone to our third quarter conference call. Joining me today is Joel Ronkin, our Executive Vice President of our North American Fragrance unit; Steve Smith, our Executive Vice President and Chief Financial Officer; and Marcey Becker, our Senior Vice President, Finance.

In terms of the agenda today, I will first provide a general overview of our Q3 performance. And then in addition to that, I will review our international business, which represents about 33% of our total business and an overview of our Elizabeth Arden department store business unit here in the US, which represents about 3% of our total business. I’ll also provide a summary of our key corporate initiatives and priorities and an update of how we are doing on those priorities.

Joel will provide a review of our North American Fragrance business unit, which represents about 65% of our total business. This unit includes our US department store fragrance business, our mass fragrance business, and Canada and Puerto Rico. Joel will discuss the retail performance of his business, as well as a review of the key business initiatives in his channel, as well as an overview of brand performance. Steve will provide a detailed review of key financial metrics, as well as a discussion of our cash flow year-to-date and an improvement in working capital.

In terms of our Q3 performance for the Elizabeth Arden department store business, we continue to be impacted by destocking in this channel of distribution. Our sales were down approximately 20% for Q3 versus our retail sales being down approximately 8%. This is being impacted by not only destocking of inventory, but also door closings within this channel of distribution.

With our retail sales down 80%, we are approximately performing at the rate of the category, although our fragrance component of our Elizabeth Arden department store businesses has been year-to-date performing much weaker than our skin care and color component of that business. This has changed quite dramatically with the launch of the Pretty Elizabeth Arden fragrance in the last month. In fact, so far this quarter we are up 1% in our Elizabeth Arden department store business.

The Pretty launch is performing extremely not only here in the US, but globally and it’s providing additional momentum in growth for the overall Elizabeth Arden brand on a global basis. In addition to this innovation, our Mineral Makeup innovation is performing extremely well and true in all the markets that has launched and we will continue to launch it through the fourth quarter.

It’s important to remember for our Elizabeth Arden department store business, but these numbers don’t include our Elizabeth Arden sales online, the sales of the Elizabeth Arden brand at the Red Door Spa, our military sales, and our travel retail sales here in the US for Elizabeth Arden. And generally those sales are contributing at a better rate than our department store business.

In terms of the international business, in total, the business year-to-date is down 9.8% and ex-currency, 3.5%. The Asia-Pacific region is performing very well. It’s actually up 4.4% year-to-date in constant rates and that’s been driven by the performance of our Greater China business, Domestic China, Taiwan, and Hong Kong. We continue to expand the doors and we are very successful in the Elizabeth Arden skin care lines.

We have improved our ranking in China competitively and we see strong growth continuing in China and Hong Kong and Taiwan for the remainder of this fiscal year and into next fiscal year. We are also seeing extremely strong growth in South Africa and we expect for the year, Asia-Pacific to increase by 6% in constant rates.

Europe is experiencing the similar economic issues as the US in terms of retailer destocking and the performance of the business is very similar to the US where we are at a retail sales level performing at or approximate to the category, but our sales are significantly below retail sales group.

In terms of year-to-date, Europe was flat in constant rates. The real difficulty and the reason for the reduced expectations for the fourth quarter is we’ve seen a dramatic deterioration of the travel retailer and distributor markets globally. This is a result of declining passenger traffic, distributors not wanting to take currency risk given we sell in US dollars, credit constraints amongst many of our distributors, many of which are small and entrepreneurial, and then in markets like Eastern Europe, Russia, Latin America where they are also experiencing credit constraints.

We’ve also seen a deterioration in our Japanese market and the Middle East. The travel retailer and distributor markets are very high margin businesses. There is limited infrastructure cost, so therefore it’s difficult to have a significant impact in terms of cost reductions to improve profitability.

And as you will recall, this business tends to be very volatile during the periods of SARS and post 9/11. We saw a tremendous decline in these businesses. They tend to rebound quite quickly as well. Although it’s very difficult right now, they have the visibility to determine when that will – rebound will occur, but I can assure you that our business in those channels is tracking at a similar rate to our competing beauty brands. Year-to-date, net sales for travel retail are down 22%.

In terms of our corporate initiatives, I’m extremely proud of the performance of our supply chain and reengineering initiatives that we’ve talked about in several conference calls, which began in fiscal ’08.

We saw a tremendous reduction in inventory this quarter. We started the quarter at approximately $390 million of inventory and ended the quarter at approximately $360 million. This is an extraordinary effort given the seasonal weakness of the third quarter for us and the extraordinary weak retail environment in which we operated in during the third quarter.

We are starting to see small signs of improvement at retail, particularly with our mass retailers in the US and as we move into the fourth quarter, we expect a continued reduction in inventory and we are very confident that we’ll hit our previously disclosed targets of $350 million to $370 million of inventory at the end of the year. Year-to-date, the reduction of inventories provided $48 million of positive cash flow contribution to our business.

In terms of the continued supply chain reengineering initiatives, we are migrating towards our shared services model. That will be completed by July 4th – or by July 1st, our first quarter of next fiscal year. In addition to that, as you will recall, we will be converting to J.D. Edwards enterprise application system. That will also begin the first quarter of ’10. Both of those projects are on schedule, on budget, and we expect to continue to see the improvements in our indirect overhead and operating efficiencies throughout our global enterprise.

To give you an example, which I discussed previously, the shared service model where we consolidate our financial accounting and accounts payable functions, we are going from 14 locations to four locations globally. Accounts payable, we are going from six locations globally to one and our order to cash function, we are going from multiple locations around the world to two primary locations and that will migrate during fiscal 2010.

As we move forward, we are also implementing our turnkey fragrance model, which will involve consolidating some of our existing contract fillers. As you will recall, we outsource all manufacturing of both fragrance, skin care and color. We are going through a process of consolidating vendors on a global basis. This will result in improvement in cost of goods. It will also contribute to a reduction of inventory that we hold on our books and we expect to see an improvement in the inventory investment each quarter going forward for the next several quarters through 2010 and 2011 on a year-over-year basis.

In terms of our outlook moving forward, both for the fourth quarter and into fiscal 2010, Joel will discuss the performance of his business for the past two quarters and some of the projections for Q4 moving forward, but I’d just like to comment, one of the things that we are seeing in our business on a global basis is our retails are performing much better than our replenishment of inventory.

This gap obviously is hard to predict when the narrowing of this gap will occur. But as we see a stabilization of consumer demand, we expect obviously to see replenishment increase and the most significant opportunity for this is in our US mass business, which Joel will go through in more detail.

I’d like to introduce Joel Ronkin to discuss our North American fragrance business.

Joel Ronkin

Thank you, Scott. As usual, I’m going to comment on the performance of our North American fragrances group for the quarter, what we are seeing currently from a retail standpoint, and comment on our future outlook including providing some commentary on our next holiday season.

Just as a reminder, North American fragrances group comprises about 60% to 65% of our overall net sales. It includes our department store fragrance business in the US. That’s the part of our US department store business where we sell all of our non-Arden branded fragrances. It includes our mass business, includes our dot-com business, as well as all of our business in Canada, as well as in Puerto Rico.

For the third quarter, our net sales in North American fragrances were up 5% and our operating profit was up healthy. It was 21% compared with the third quarter of fiscal 2008. Fiscal year-to-date, our net sales are down slightly, 1%, while operating profit has improved by about 7% due to higher gross margins.

Now turning to our department store fragrance business, we continue to benefit from the Liz Claiborne transaction. For the third quarter as compared to last year, net sales have increased significantly and operating profit has improved from a modest profit last year to solid profitability this year.

Now despite this difficult economic environment that we are in, fiscal year-to-date, our shipments to department stores and our operating profit in this business and channel have nearly doubled. And we are now one of the top fragrance suppliers to department store fragrance counters and you will recall this was one of the key reasons for the transaction with Liz was to give us more leverage in that channel.

Demand for our Juicy Couture and Viva La Juicy brands have been particularly strong and they had exceeded our expectations. In the department store channel, we’ve also see significant increases in gross margin as a result of the sale of higher margin products. Now at the same time, we have been cautious about spending in the current weak retail environment and where appropriate, especially during low traffic times, we trim some spend.

Retail sales at department store fragrance counters have declined about 7% this calendar year as compared with the prior year and our sales are broadly in line with category trends. As previously mentioned, Viva and Juicy have performed very well. Their rankings are number eight and number 21 respectively. And our Usher and our Rocawear brands have ranked well, both top 30 brands calendar year-to-date.

I wanted also to turn out to our mass business. And before we get started, I want to spend a moment underscoring what Scott was emphasizing, which is the difference that we are seeing between retail sales and net sales. In other words, the difference between our sell-through in stores and our shipments to accounts.

Now, since the beginning our retailers’ calendar year, this year, retail sales in the mass channel have been up 3% overall in the prestige fragrance category. Now, while up 3% in retail sales, we have been fortunate that retail sales at our brands have increased even more, up in average of 8% in those same accounts. Actually, in some accounts, we see them quite a bit above the 8% in some of our key accounts as we have increased our share substantially. So, the category is up 3% at retail, we are up 8% on average, and in some accounts, we are up even more.

Now while that sounds great, from a standpoint of net shipments, our shipments to our retailers, they have been down in the third quarter. Specifically, net sales in our North American mass business were down approximately 5% in the third quarter and that’s largely because mass retailers have not been replenishing as quickly as their retail sales trends. If you just do the math, the difference between the up 8% and the down 5% is 13%.

And some – in addition to not replenishing it quickly, we’ve also had to be careful with credit constraints at some of our smaller retailers and distributors in this environment, which is also impacting a bit our results.

Now, as far as Scott pointed out when will this change because at some point it has to, we are not sure. We certainly have planned for this destocking trend to continue in the fourth quarter, but at some point these replenishment orders will need to catch up with retail sales and we should see quite a bit of benefit from our increased retail sales and market share. And this is really an important point because before this year started, retail trends at mass were down and in 2009, we are seeing share being gained in this channel where we have such a high market share and retail sales being up.

How are we doing this? We are taking share by introducing new items and programs that are resonating with consumers. We are also seeing improved results because our gross margin in this business is expanding considerably by approximately 4% overall.

Just wanted to spend a moment mentioning a few of our other businesses. In Canada, we recently launched a new brand by Canadian designer Alfred Sung called Always. We are very pleased thus far with both the consumer and retailer reaction. Turning to our dot-com business, our e-Commerce business shows considerable strength. Shipment growth is 43% this past quarter compared to the prior fiscal quarter.

Now, turning to future months and years, we have a number of exciting launches on tap for the fall season, which should help drive sales growth in our department store channel. These launches include a new Juicy Couture brand called Couture-Couture [ph] that we are planning, as well as our retailers are planning to be the number one launch of the season. We also have important new launches from Usher and Mariah Carey. Thus far, we are very encouraged by retailer and trade reaction to these brands and you’ll start to see them on shelves in July, August, and September.

We also have a number of key initiatives with our mass retail partners, which are really aimed at improving the look and feel of the fragrance category to help drive retail sales as they are really seeing quite an opportunity to grow the fragrance category and gain share as consumer traffic grows considerably in their stores.

We recently discussed these initiatives with some of our largest chain drug and mass retail accounts at one of the biggest meetings of the year, it’s called the NACDS Annual Meeting. And this was a few weeks ago and found virtually across the board and a little bit surprisingly that these accounts were very optimistic both in terms of their businesses, as well as the ability to grow the beauty category and most importantly for us, the fragrance category in their stores. You’ll see these initiatives over the next six months to a year, which will include improved merchandising, fixturing, signage, and the use of an open sale environment.

So, when you couple those initiatives with the strength of our brand portfolio, this should lead to improved results going forward. Now, obviously we usually talk about the Britney brand and I wanted to mention it’s a good story. They continue to be a solid performer, these brands, in mass and mid-tier channels, as well as a strong business outside the US. It’s actually a stronger business, the Britney brands outside the US.

As far as retail sales, we have the same issue about retailer destocking on Britney brands as we do on other brands. The good news is this year retail sales in her brands are up 10% at mass and at some point that means it will equate to higher sell-in. Also, we are planning another Britney brand, which will leverage the recent success of her concert tour and album, launching this fall.

We’ve also been spending the last few months discussing our Christmas and holiday shipments for 2009, particularly with our mass retail accounts. We are pleased that despite the tough economic climate that our total sell-in offset is expected to be flat to modestly up versus last year despite the decline in economic conditions. Again, there are variances between accounts; some accounts were up more than others.

Why is it happening? Largely because the retailers are interested in delivering value to their consumers and we have brands and promotional programs that have resonated well on really being able to deliver value to their consumers. Now obviously, the big driver of growth next year, and we do expect growth in the North American fragrance business, will be from the sale of regular basic products, especially as the consumers continue to buy and the inventory destocking has to, at some point, turn.

Now finally, as this gap narrows between retailer and inventory replenishment, I think we can see significant improvement to total corporate sales and profitability as the size of our North American fragrances business is a considerable part of our business and very easy to leverage. It’s already very profitable and we do not have a lot of fixed costs.

So with that, I will turn it over to Steve Smith, our Chief Financial Officer.

Steve Smith

Thank you, Joel. I will discuss our third quarter results and provide some comments on our working capital and balance sheet. As we discussed on our last call, the Liz Claiborne transaction was completed on time, on budget, and we are no longer incurring any additional Claiborne related expenses.

This quarter, we did have about $2 million of expenses associated with the J.D. Edwards implementation and the reengineering project, all as expected. Adjusting for these charges on a year-to-date basis, gross margin was 42.6%, a 100 basis point improvement over last year. We’ve had robust margin improvement in our North American fragrance business due to increased sales and improved cost of goods.

This was offset primarily by lower net sales and our higher-margin international markets and the unfavorable impact of foreign currency translation, which further compressed the margins. On a full-year basis, our gross margins are expected to approximate 43%, an improvement of 80 basis points from last year’s 42.2%.

Excluding Claiborne restructuring and the reengineering related charges, SG&A expense as a percentage of net sales, was 35.9% versus 32.4% for the prior year. Liz Claiborne royalties, which is essentially how we financed that agreement, was 150 basis points of the increase and other direct expenses to support our brands accounted for another 150 basis points. The balance is primarily currency related.

These increases were offset by lower general and administrative expenses, which are down in absolute dollars including compensation expenses as we have been proactively managing our overhead and infrastructure to reduce those costs versus the prior year.

Turning to cash flow and our balance sheet, our target for free cash flow is zero to $10 million. That target was after CapEx of $45 million and $5 million for the Sovereign acquisition earn-out. And we are still comfortable with that range given our ability to manage our working capital and reduce CapEx requirements.

While operating cash flow of $12 million was $14 million lower than last year due to lower earnings, we’ve been very successful at improving our working capital management through inventory reductions. And as Scott mentioned earlier, this has contributed $48 million in cash year-to-date.

Inventory ended the quarter at $361 million, down from $390 million at the end of December. We’ve been very successful at proactively rebalancing our future inventory requirements with the excess we carried at the end of December and we will continue to aggressively continue to work this and other supply chain and logistic initiatives going forward.

We continue to target inventory at June 30th, 2009 at somewhere between $350 million and $370 million and continue to see inventory as a positive contributor to working capital on a year-over-year basis for several more quarters. As a result, looking ahead for the balance of calendar 2009, our peak inventory position and credit line balance should be lower, contributing to improved cash flow from operations.

Capital expenditures for the first nine months was $19 million. Our original budget for the full fiscal year was approximately $46 million, of which $14.5 million was for the J.D. Edwards and related IT investments and product tester units internationally. We’ve been successful at rolling out these tester units over a longer time horizon. And as a result, in total, we expect to either defer or cut approximately $18 million of our CapEx budget for fiscal ’09 and expect total CapEx this year to approximate to $28 million.

The credit facility had a balance at the end of March of $128 million compared to $146 million at the end of December and we had $55 million of availability at the end of March. It is important to note that while the credit facility is classified as short-term debt, it is because of its revolving in nature. It does not expire until December 31st, 2012.

With respect to covenant compliance, the only financial maintenance covenant we have is a fixed charge coverage ratio of 1.1 to 1, which only applies when our average availability is less than $35 million or $25 million between June and November. Our availability at March 31st, 2009 was $55 million and expected to be – and we expect it to be higher at the end of June. The only other debt outstanding is our 7.75% senior subordinated notes, which do not mature until January 2014 and these bonds have no maintenance covenants.

Lastly, I’d like to just briefly comment on the anomaly between our adjusted loss for the quarter of $0.19 a share and the reported loss of $0.13 per share. This is due to a significant difference between our effective tax rate in the US, which is higher versus our international operations. And in the US, we had pretax losses due to our special charges and interest cost as compared to the tax rate that was applied to our foreign operations.

And with that, I will turn it back to Scott.

Scott Beattie

Thank you very much, Steve. Before we open the call up for questions, I just wanted to talk a little bit about the frustration with the lack of financial visibility in terms of our guidance this year. Obviously, it’s frustrating to us and frustrating to our investor community and we are very well aware of it.

And – but I would like to just kind of give an explanation of where that lack of visibility comes from. As Steve and Joel have outlined, the disconnect that we are experiencing between retail sales and replenishment has been something that’s been very difficult, the struggle within our North American business and being able to have a strong confidence in when that gap between retail sales and replenishment will narrow.

When it does, we will see quite a substantial pickup in both revenue and profitability in our North American business. And as Joel said, it’s already a prime profit generator of our overall corporate business.

The other challenge that we have is the lack of operating leverage in our international business and it’s a very high margin business for us including the travel retail business. And a relatively small movement in either the currency or sales has a big impact on profitability.

And so, as a result of that – again as I said, a small movement in net sales or small movement in currency and certainly a movement in both of those in our travel retail component of that business, which has traditionally been about 20% of the total sales of international, creates the swing in profitability and contribution. And as Steve mentioned, that has been the primary offset to gross margin and profitability for this quarter and what we expect in the fourth quarter.

But I would like to just give everyone a very strong degree of confidence in our overall business and brand portfolio. We have a very sound business strategy. Our outsource model where we outsource manufacturing, information technology, and the implementation of our global J.D. Edwards enterprise application, and our migration to a shared service model is showing that we can contain our indirect cost and overtime, leverage those as we see sales and replenishment improve.

Our multi-channel distribution strategy has positioned us in an ideal strategic position, particularly for our fragrance portfolio as we are seeing more and more customers trade-down to value-based retailers. And we have strong global brands in growth. In terms of product innovation, the Viva La Juicy launch was the number one last year. So far this year, the Pretty launch is the number one launch in the spring of this year, and our Mineral Makeup is doing tremendously well on a global basis.

We have shown year after year that we – our organization is capable of developing world-class leading product innovation and development and globally driving the performance of our brands. And finally, we have an outstanding group of management and people within our organization. We continue to upgrade our organization globally and we’ve never been in a stronger position in terms of the performance of our operation.

Now, much of this is not showing up currently and falling to the bottom line in terms of the performance of the business, but as the economy slowly improves, we will see the improvements that we put in place over the last two years accruing to the performance of our business.

So on that note, I would like to open it up to any questions investors have.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question is coming from Bill Chappell of SunTrust.

Bill Chappell – SunTrust

Good morning.

Scott Beattie

Good morning.

Bill Chappell – SunTrust

I guess, can you talk a little bit about inter-quarter trends both for the North American retail business and the travel retail business? I mean, was it pretty similar throughout the quarter, did it start to improve towards the end of the quarter and any kind of update on what you’ve seen in April?

Scott Beattie

I’ll comment on the travel retail and will let Joel comment on the US North American fragrance business. In terms of travel retail, we’ve seen an additional step-down in that business in the most recent few weeks. I mean, obviously the swine flu outbreak and the continued reduction of airplane flights, I think in March we were down 11%, we were down again in April.

So, we are seeing continued reduction in travel, business travel, overall air flights globally, and then this swine flu obviously starting to have an impact. And so, as we look forward into the fourth quarter, we are just being very cautious in terms of the performance of that business going forward. And as I mentioned in my remarks, it’s very difficult in this environment to be able to predict any kind of improvement in that channel.

I’ll let Joel talk about the retail environment.

Joel Ronkin

Yes, Bill, we did see a shift actually. Probably at the end of January we started to see a pickup that was markedly different than January. And February and March have been strong months, stronger than January, and we see that continuing into April in the mass channels.

In department stores, it’s been pretty much the same, but maybe slightly better than we are expecting from a retail standpoint, but as we’ve mentioned many times, we are not seeing a huge pickup in terms of – in department stores and we are seeing actually the opposite in mass business in terms of net sell-in.

Bill Chappell – SunTrust

Got it. And then in terms of just the overall category decline, is it just consumers are not gifting these products, are you seeing a trade down to smaller sizes?

Scott Beattie

Bill, there is not a category decline actually. I mean – as Joel went through and then we wanted to be very clear and precise about this, the fragrance category decline at mass is up 3%. We are actually up 8% this past quarter in the fragrance category and then some of our largest accounts were up quite a bit more than that.

As Joel mentioned, some of our smaller accounts are being very cautious about selling. So, it’s not a category issue, the categories are actually doing better in Q3 than the trends in Q2 or even Q1 from that. So, that’s positive for us.

And as Joel went through, there is a number of initiatives with all of our major drug store chains, our mass volume retailers, our mid-tier retailers, and our department store retailers to continue to grow and improve the beauty category and the fragrance category. So, it’s not a category issue per se in fragrances.

Bill Chappell – SunTrust

Okay. And then just one last one. I’m amazed we are still seeing positive things about Britney Spears and the whole launch, but that’s – when you talk about new launches for the fall, are they the same amount, less, more new launches versus the 2009 holiday season and then how is that affecting kind of the initial shipments?

Joel Ronkin

Well, we have a very healthy group of launches for the fall compared to what we expected to be out there in the channel for department stores, we expected it to be a little bit less. And I think department store is going to be more conservative in terms of taking brands that they think are just going to be the big brands rather than every brand.

In terms of mass, I would say it will be consistent with last year, which we had a considerable number of brands cascading into that market in the fall and I think if anything, the quality of the brands continue to get better in this economic environment as more and more brands are made available for that channel both from our sales, as well as from our distribution partners.

Bill Chappell – SunTrust

Great. Thank you.

Operator

Thank you. Our next question is coming from Joe Altobello of Oppenheimer.

Joe Altobello – Oppenheimer

Thanks. Good morning, guys. First question I guess is for Joel, just to make sure that I heard this right. The North American fragrance business was up 5% in the quarter, but it would have been down 7% if you exclude the Liz brands?

Joel Ronkin

No. What I said was retail sales in department stores were down 7% and our sales are about the same in department stores in terms of sales.

Joe Altobello – Oppenheimer

Okay. So, if we did back out the Liz brands, what would the North American fragrance business have done?

Joel Ronkin

I don’t have those numbers.

Joe Altobello – Oppenheimer

But it would have been down?

Scott Beattie

The department store piece probably would have been down a little bit more just because of the success of Viva La Juicy and the continued support of that brand, but it’s difficult because apples-and-oranges, we’ve got new launches going into that channel and so on.

So, we don’t – it’s all co-mingled. I think the key takeaway here is that as Joel mentioned, is that the combined Liz Claiborne-Elizabeth Arden fragrance portfolio at the fragrance bar has given us substantial improvement in operating leverage. So, it’s a much more – it’s a stronger business with better in-store execution and more predictable profitability contribution, and improved market share, we are now top five vendors in the fragrance category and department stores.

Joel Ronkin

Joe, one thing you need to remember. I think we’ve talked about this before as far as breaking out Claiborne sales. It’s very difficult because we were the distributor of their brands in mass before this transaction.

Joe Altobello – Oppenheimer

Right.

Joel Ronkin

And so, in most cases, it was a situation of us just being going from a distributor margin to an owned margin. You don’t pick up sales, but you pick up margin. And what I think mentioned, where even though fiscal year-to-date our sales in North American fragrance are flat, our operating profit has improved by about 7% due to higher gross margins. Part of that is because of that owned – going to an owner margin rather than distributor margin.

Joe Altobello – Oppenheimer

You pick up the department store piece?

Joel Ronkin

You do.

Joel Ronkin

Yes, it is right. You pick up the department store sales.

Joe Altobello – Oppenheimer

Okay.

Joel Ronkin

That’s correct.

Joe Altobello – Oppenheimer

Okay. In terms of 2010, obviously it’s a little bit early because you guys will probably give us more guidance I would imagine on the next call. But if you could talk about that directionally for a second, it sounds like you are expecting North American fragrance sales to be up next year. International, who knows at this point?

But in terms of what’s going on in the margin line, obviously travel retailer and distributor sales are weak and that’s a high-margin business for you, but you’ve got some cost savings, supply chain reengineering projects going on. So, how should we think about margins next year and specifically, should we expect a nice step-down in SG&A next year?

Scott Beattie

Maybe I’d answer that question a little bit differently. Let me give you the variables that will determine the performance of our 2010, the key variables that are going to determine the performance of our business in 2010. The first primary variable is going to be the closing of the gap between retail sell-through and replenishment, particularly in our North American fragrance business, and as Joel mentioned and particularly in our basic inventory replenishment.

We’ve had – we’ve got a pretty good visibility going forward in what our promotional business will look like in the fall and that’s flat to modestly up depending on the customers. So, it’s all going to depend on the – closing that gap between retail sell-through and replenishment at our largest mass retail account. That is the first and most impactful variable in terms of improved sales and profitability. The second one will be the movement of currency. Currency has a big impact obviously on the profitability and gross margin and as well as our SG&A costs in our international business.

The third is going to be an improvement in the same retail to replenishment performance of our overall international business. As I mentioned earlier, we suffer from weak operating leverage in our international piece. So, when the travel retail business that has very high margins, gross margin contributions and very low SG&A deteriorates to the extent that it does, it has a very material impact on our international gross margins and our international profitability.

And when you combine that with the strength of the US dollar because most of our products are manufactured here in the US and distributed internationally and the overall operating leverage of international, that provides compression of gross margin and profitability in international. So, the key variables for us in sales growth and profitability growth for international are the improvement of travel retail and the currency assumptions.

Joe Altobello – Oppenheimer

Okay. So, I guess my question is would you guys expect to see the efficiency improvements that are ongoing now show us through [ph] and fiscal 2010, assuming everything else stays the same?

Scott Beattie

Yes, we do. We’re not only seeing those in our SG&A line and I think Steve in his remarks emphasized that. If you look at the year-to-date performance of SG&A once you net out the Liz Claiborne royalty, which is really how we are paying for the Liz Claiborne brand over the long term, and absolute dollars, it’s down year-over-year and as we move forward, we are going to continue to see constrained indirect cost increases.

In addition to that, we are going to see almost a $55 million reduction in inventory by the end of this fiscal year and as I mentioned in my remarks, we’ll see a continued reduction in inventory on a year-over-year comparative basis right through 2010. So, we are going to see the benefits of these reengineering on our SG&A line and then on our working capital and particularly, inventory line.

Steve Smith

Our G&A expenses, when you net out those items that Scott mentioned on a percentage basis, are flat year-on-year. So, with declining sales they have to been down on absolute dollars. And most of those costs are either US dollar based or Swiss franc based and the Swiss franc has not deteriorated to the extent of other currencies.

Joe Altobello – Oppenheimer

Okay. Perfect. Thank you.

Operator

Thank you. Your next question is coming from Arnie Ursaner of CJS Securities.

Arnie Ursaner – CJS Securities

Hi, good morning, Scott. I want to try to focus a little bit on the replenishment issue and maybe if you can help us understand your business a little, it might help. Can you give us a feel for the order pattern you would typically get from a retailer, meaning from the time they place an order, when do they normally want the goods shipped and are you seeing changes in that order pattern where perhaps they are holding out placing the orders, but then want the product shipped more rapidly? Can you give us a feel for the timeframe of that?

Scott Beattie

Well, the majority of our orders are received through EDI, electronic data interchange. So, we receive – I’ll talk about the North American fragrance business. We receive orders from most of our major mass retailers and department store retailers on a weekly basis. And as that – those replenishment orders are based to some degree on retail sell-through, but also in the controls that they put on over their own inventory management.

And so as a result, what we track is replenishment on a weekly basis. So, we do have visibility on the orders, in some accounts, on a daily basis and others, weekly. So it’s – I think that answers your question.

Arnie Ursaner – CJS Securities

Well, I guess I’m trying to get a feel. If you are doing it on an EDI, then you have a pretty good sense of what your customer inventory is as well. Wouldn’t that be correct?

Joel Ronkin

Yes, we do. We – for all of our big accounts, we have – we know exactly our inventory both from a – because for the category captain, as well as just knowing our own – every major customer knows their own inventory to all the mass accounts. And so, you see what the inventory is.

What you – what we can’t predict with and was not been able to predict is exactly how many weeks on hand the customer is willing to keep it anytime because we are seeing retail sales that we expected – if you sold a 100 units of a particular item, we would ordinarily expect based on constant weeks of supply to sell a 100 more if you were in a normal non-seasonal sales pattern, but we are not seeing that in some cases, in fact in most cases. Instead of buying 100, they’re may be buying 80 or 70.

Arnie Ursaner – CJS Securities

Would it be fair to say if there is a generalization that your customers (inaudible) slightly under-stock right now of inventory?

Joel Ronkin

It depends. I would think that there – some of our biggest accounts are under inventory right now.

Arnie Ursaner – CJS Securities

Okay. And going to back to Liz for a second, I just want to be clear. When you mark up the inventory, when you acquired the brands rather than just distribute them, you essentially mark them up at no margin. Is that process behind us and has it impacted Q3 and how might it impact Q4?

Steve Smith

The process is essentially behind us. The markup occurred within cost of goods based upon how we bought those goods versus manufacture costs. That process is now behind us and we saw some benefits in Q3 and we will continue to see benefit going forward.

Arnie Ursaner – CJS Securities

Okay. And again, I know you’ve been asked various questions on the SG&A may impact cost of goods as well. Advertising – I’m assuming the cost of advertising on TV going into the upcoming holiday season is lower than it’s been; it sounds like much easier to buy space. And that is obviously one of the key expenditures you have within your category. Can you comment about what you are seeing in the cost of advertising expenditure?

Scott Beattie

Well, Arnie, you are absolutely right. I mean, particularly in traditional advertising, the publishing industry, the TV industry, and so on, but the effectiveness of some of that advertising in terms of circulation or impressions has also declined to some degree. And we’ve always, as an organization, been very creative at using alternative forms of media to promote new products and new launches.

So, although we will get a benefit from a reduction in terms of the costs of those kind of advertising, we have been sort of rebalancing some of our spend into other kinds of vehicles and – which are generally more effective. So, the point is right on and frankly, it’s too early right now to give any definitive idea on that because as you know, we are putting together our ’10 budgets and brand development and marketing plans now for the fall season.

Arnie Ursaner – CJS Securities

Two more quick questions if I can. If you were to – based on the cost reductions you’ve already implemented this year and maybe some you’ll do in Q4, rationalizing all your facilities and back-office expenses, what sort of cost savings should we look for in 2010 based on the actions you’ve already taken or will take in ’09?

Scott Beattie

It’s premature to answer that question. I mean, we are very satisfied. The frustration I guess we all have in the management team is we can see all of the operating improvements and the structural improvements that we are making to our business whether it’s in supply chain, logistics, the effectiveness of our information technology and so on, it’s just not showing up yet and the benefits of that are being muted obviously by the declines in volume too.

So, I think when we come back in August, obviously we’ll be providing an outlook for 2010, we’ll have a much clear view of the fall season. We’ll hopefully see this sort of gentle modest improvement in consumer demand that we are seeing over the last month or so and we’ll have a better idea of how to provide guidance on that question.

Arnie Ursaner – CJS Securities

And I’ll try one more quick question. I know you’ve been in a test with a major US retailer of a different – of a major mass retailer where you can’t disclose their name, but it’s been a very interesting test program you’ve been running. When do you expect to be able to say more about the outcome of that test and their likelihood of expanding it?

Joel Ronkin

I think I know the test you are referring to. And the good news is that it is being expanded. It’s a big retailer and I think you’ll see it in about 20% of their doors over the next year and sales are up considerably in those doors. And so, obviously that will be a big driver in the North American fragrances business going forward.

Arnie Ursaner – CJS Securities

And you’d be able to say more about that hopefully in August?

Joel Ronkin

Yes, we still – we won’t be able to talk about the retailer by name, but it will be embedded in our guidance and we will talk about the success of the actual initiative.

Arnie Ursaner – CJS Securities

Thank you very much.

Operator

Thank you. Our next question is coming from Jason Gere of RBC Capital Markets.

Jason Gere – RBC Capital Markets

Good morning. I just have two follow-up questions from earlier questions and then just a separate one. With Liz, I know you don’t want to call out what the sales were in the quarter, but are you still comfortable with at least $120 million to $130 million of incremental sales for the fiscal year?

Joel Ronkin

That seems about right.

Jason Gere – RBC Capital Markets

Okay. And then, the second question really goes back to talking about SG&A. And I was just wondering if you could just talk about your – how – I guess how well the sales productivity has been. Certainly in these tougher times you have to go a little bit leaner.

So, I’m just wondering if you could talk maybe about your confidence with maybe in a leaner operating structure once you start to see some of the shipment trends kind of balance out to kind of to the sell-through that you are seeing and maybe this is six months down the road?

Scott Beattie

I think the business unit that’s most affected by what you are describing is the fragrance department store piece.

Jason Gere – RBC Capital Markets

Correct.

Scott Beattie

And the ability – as Joel mentioned, the ability of consolidating both our brands and the Liz Claiborne brands and organizations into one unit. Last summer, we sort of rationalized that cost structure so that we doubled approximately the size of the business and didn’t add a significant amount of cost.

Joel alluded to that in this weak environment, we’ve been very cautious in terms of in-store modeling and execution just because there hasn’t been the traffic to kind of justify the expenditure. What I would see going forward is as that – is that business continues or starts to improve in terms of overall retail sales, we have the levers to add more in-store support and sales support, which can then sort of build on the retail momentum.

Jason Gere – RBC Capital Markets

Okay. And then would this – and I know the department store obviously is a small piece of the total pie at Arden, but would this be embedded into kind of your commentary just about SG&A getting leaner? That would be all encompassed into that commentary you made maybe about five minutes ago?

Scott Beattie

Yes.

Jason Gere – RBC Capital Markets

Okay. And then just the last question, I was just wondering – we are thinking about inventory at retail right now and it’s been great that you guys are taking share at this point. Can you just talk about – thinking about SKU rationalization, you guys have the strength of the Liz business now in the portfolio? Can you talk about maybe some of your other owned brands or even some of the brands you are distributing? How do you think about that going forward? Well, obviously there is not going to be a lot more products on the shelf and you obviously want to make sure you have the best products out there. Thank you.

Scott Beattie

I mean in terms of the SKU rationalization, as you know, the – there are a number of mass fragrance SKUs at planogram in mass retail channel that have performed less efficiently if you will than the – what we bring in terms of new prestige fragrance brands. So, there is always the opportunity to steal market share from those specific brands, and Joel can comment on the other part of the question.

Joel Ronkin

Yes, you need to remember that first of all there has been a SKU rationalization on our category for quite a while and fragrance is a little bit different in some other categories in that – generally, you are not going to move between one fragrance to another if you like a certain fragrance for a variety of matters and I think our retailers understand that.

What we are seeing is that our brands are holding their own, if not taking more share, and some other lesser brands are going away. That doesn’t mean we don’t from time to time lose brands that we own or distribute from the planogram. That being said, overall we are gaining more than we are losing even though SKU count is going down a bit.

And in some cases, we have some tests going on with some of our retailers where SKU count went down 10% and sales are up 20% because what matters is – are the big brands and you can focus on them. We are using some of the space to highlight the key brands and key launches and what we are seeing is overall, sales are going up, inventory is going down for our retailers, and we are turning it much quicker. So, that’s all good things.

Jason Gere – RBC Capital Markets

Okay. I know that, you answered it exactly. Thank you.

Operator

Thank you. Our next question is coming from Reza Vahabzadeh of Barclays Capital.

Reza Vahabzadeh – Barclays Capital

Good morning, Reza Vahabzadeh from Barclays. Just on the inventory issue, if we were comparing inventory at retail sort of this year versus last year, can you give us an order of magnitude of how much lower they are?

Joel Ronkin

It’s sold across the board, that will be hard. I know I just looked at one particular retailer that’s large and it was down 16%. But we are really – I mean, I haven’t looked at every single retailer and there are wide variances between accounts.

Scott Beattie

I think the point that people should remember, this isn’t unique to the fragrance category or even the beauty category. It’s rated store-wide and economy-wide and global, you are seeing a tremendous destocking of inventory through retail channels of distribution. And as a result of weak consumer demand, slower traffic, and sort of a movement towards using reduced inventory to generate cash flow and liquidity for retailers across the globe. It’s a phenomenon that affects just about everyone selling to the consumer.

Reza Vahabzadeh – Barclays Capital

No, I hear you. I’m just trying to gauge once things normalize how much of an upside there is here.

Scott Beattie

Well, I think the way to look at that is and what we wanted Joel to go through very clearly is, if you look at mass business, which is a large segment of our overall business, our North American fragrance business, we’ve got – we are up 8% and then the replenishment is down 5%. So that 13% gap is really the opportunity and that’s at a seasonally weak point of the year for fragrance.

Reza Vahabzadeh – Barclays Capital

Right.

Scott Beattie

So, obviously that gap will decline and we are seeing in some retailers it’s starting to decline. You saw today Wal-Mart’s retail sales were very strong, much above expectations and we are seeing that across some of our other retailers right now. So, it’s a matter of when they get confident enough to start closing that gap.

Joel Ronkin

And one of the things we are also seeing in some of our retailers and Wal-Mart has been publicly talking about this, they are seeing increased foot traffic in their stores. New consumers, around 20% of their consumers I think, are coming in that weren’t coming into their stores before. And obviously with the market shares we have at those accounts like Wal-Mart and Target and the drug stores, we’ve been in those environments. So, that’s a good thing for new consumers to be going into those channels and it’s starting to show in the results.

Reza Vahabzadeh – Barclays Capital

Right. Turning to gross margins, they were remarkably stable this quarter on a year-over-year basis. Is that likely to persist or even improve in the fourth quarter and then into the next year?

Scott Beattie

As Steve outlined in his remarks, we saw a very significant improvement in gross margins in our US business, but internationally it was offset because of the currency impact, as well as the decline of our travel retail business, which is a very high gross margin contributor.

So, the key variable as we look forward, we are very confident that we are on the right track in terms of driving gross margins in our North American business. The key variable for continued significant improvement in gross margin for 2010 and beyond is going to be the currency impact on cost of goods and sales and then the improvement again on the travel retail business in international.

Reza Vahabzadeh – Barclays Capital

Got it. And then turning to free cash flow, this year obviously is not a stellar year on the free cash flow front. But next year could be, whether or not working capital is as good as you are saying, it does look like free cash flow can be pretty solid next year. I’m just wondering what’s your thought process is in use of free cash flow, whether it’s acquisitions, share repurchases, or debt repayment.

Scott Beattie

Well, at this point in time I think we all agree with you that next year will – their free cash flow will be strong and we are very confident with the momentum we have in our supply chain reengineering and our turnkey fragrance initiatives, which will drive inventory down.

But I – at this point it’s premature to give specific – any elaboration on where we would apply it. In the short term, we will apply to pay down our operating line and improve our liquidity. We are seeing opportunities on specific fragrance brands and additional opportunities in international to expand our fragrance business and that’s a priority for us. We clearly want to expand our fragrance footprint in Europe.

Reza Vahabzadeh – Barclays Capital

But we are talking about bolt-on acquisitions here, right, the Liz Claiborne type size?

Scott Beattie

Well, it could be new licenses, it could be selective bolt-on acquisitions as you call them, or just reinvesting some of that cash flow to drive our existing brand performance in the international marketplace.

Reza Vahabzadeh – Barclays Capital

Got it. Thank you.

Operator

Thank you. Your next question is coming from Analyst George Chalhoub of BTIG.

George Chalhoub – BTIG

Good morning. I’m looking at the inventory levels and you ended the quarter at about $362 million – $361 million. In the new guidance, you basically say you are still on target to finish inventory levels at somewhere between $350 million and $370 million?

Steve Smith

That’s correct.

George Chalhoub – BTIG

So, does that Steve, mean that the channel’s inventories could be up $10 million?

Steve Smith

Well, as we head into the summer period, we are also building for our Christmas season and for launches that occur late summer, early fall.

George Chalhoub – BTIG

Right.

Steve Smith

So, it’s not unusual for inventories to build up between March and June.

George Chalhoub – BTIG

Right. So, there is a chance that – and you kind of basically see what happens over the course of the next couple of months and there is a chance that you maybe able to lower inventories if you are able to – if the sell-in, let’s call if that is not as strong as you expect it to be and take advantage of free cash flow generation. Now the flipside of that is it turns out to be better than expected, you may need to ramp up a little bit and that could be the swing between the $350 million, the plus $10 million, the minus $10 million in inventories by the end of the year?

Scott Beattie

Well, I don’t – George, the lead time on producing inventories are a little longer than a couple of months. So, I can tell you that our inventories are down again this month and to Steve’s point, typically what we will see in June is a buildup of some of the with inventory we call, the components that we use for gift sets and the initial build of our gift sets for the fall season, as well as some additional inventory investment for fall launches because we typically ship that to trade in early July. So, there is a – there will be a tough buildup that we have planned for inventory based on the August kind of launch program and our set manufacturing initiatives for the fall season.

George Chalhoub – BTIG

Okay. So Scott, does that mean that the potential cash flow generation, call it from working capital, maybe coming from better DSOs then if inventories don’t even go up a little bit, I mean because in your remarks –?

Scott Beattie

No, the inventories will still be down year-on-year. We ended June last year, I think with $408 million [ph] of inventory.

George Chalhoub – BTIG

Right.

Scott Beattie

So, year-on-year, we expect the June period to be down, we expect the September period to be down, so on and so forth as we move forward through the rest of calendar 2009.

George Chalhoub – BTIG

Okay. One last question on the SG&A. The SG&A – the currency impact on the SG&A, doesn’t that help you a little bit in terms of the SG&A paid in the international operations? Does that not offset some of the gross margin production you are seeing from the foreign currency negative impact?

Joel Ronkin

We have a natural hedge in some of our affiliate markets like the UK for example where that helps. But most of our SG&A costs, as Steve mentioned before, are in Swiss francs. So – and the Swiss franc has been much more stable currency vis-à-vis the currencies like the euro and the pound and many of the other currencies around the world, which have significantly devalued against both the franc and the US dollar.

George Chalhoub – BTIG

Right. Okay, great. Thank you very much.

Operator

Thank you. Our last question is coming from Gary Giblen of Axiom Capital.

Gary Giblen – Axiom Capital

Hi, good morning everybody. I wondered if you could comment on the factors that led to the success of Pretty.

Scott Beattie

Sorry, what was that question?

Gary Giblen – Axiom Capital

The entry of Pretty has been unusually successful. So, what were – were there any new marketing techniques or anything that you would attribute that to?

Scott Beattie

No, I don’t think – I think it’s just a credit to the innovation teams that we have I mentioned just before the question period is that we’ve not had any better quality innovation in the history of the company than we’ve had over the last couple of years. And we have extraordinarily talented people in marketing and product development and innovation and supply chain and so on.

If you look Viva La Juicy as I mentioned, it was the number one launch last fall. Pretty is the number one launch so far this year. Mineral Makeup is doing extremely well. And we continue to have very high level of confidence from our retailers in the quality of the innovation.

As Joel mentioned, the new Juicy Couture launch in the fall, the retailers are planning it as the number one launch; they are giving us tremendous resources in-store to launch the product. We’ve got a very successful launch of Mariah Carey on a global basis. So, it’s really a core capability of our organization.

Gary Giblen – Axiom Capital

Understood. And what’s the market share trend for PREVAGE? How is that doing?

Scott Beattie

It depends – on a global basis, it’s very difficult to get at those kinds of numbers. What I would say is we – what we track is a three pillars within our skin care franchise, PREVAGE, Ceramide, and Intervene. And if you look at it sort of on a global ranking, we are performing at or slightly above the category performance.

PREVAGE has done well in certain markets and hasn’t penetrated to the level we would expect in other markets. Part of that is the price point, part of that is the ability for us to articulate the technology in the story and that we need to get better and more consistent with that across the globe, but I’m very satisfied with the three pillar – the performance of our three pillars in skin care.

Gary Giblen – Axiom Capital

Okay, that’s helpful. Thank you, Scott.

Operator

Thank you. That concludes today’s Q&A session. I’d like to hand the floor back over to management for any closing comments.

Scott Beattie

Thanks very much, operator. Thanks everyone for joining us today.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Elizabeth Arden, Inc. F3Q09 (Qtr End 03/31/09) Earnings Call Transcript
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