Zep, Inc. F4Q09 (Qtr End 08/31/09) Earnings Call Transcript

Oct.15.09 | About: Zep Inc. (ZEP)

Zep, Inc. (NYSE:ZEP)

F4Q09 Earnings Call

October 15, 2009 9:00 am ET

Executives

Jill Gilmer - Assistant Corporate Secretary

John Morgan - Chairman, President, and CEO

Mark Bachmann - Executive Vice President and CFO

Analysts

Mike Sison – KeyBanc

Zahid Siddique - Gabelli & Company

Andrew Cash - Point Clearview Management

Sean Connor – BB&T Capital Markets

Robert Felice – J. Goldman & Company

Operator

(Operator Instructions) Welcome to Zep, Inc. Conference Call. Now I would like to introduce Jill Gilmer, Assistant Corporate Secretary.

Jill Gilmer

Thank you for joining Zep today for our Fourth Quarter and Fiscal 2009 Conference Call. Here with us today are John Morgan, Chairman, President, and CEO, Mark Bachmann, Executive Vice President and CFO, and other selected Zep officers.

I would like to remind everyone that certain information included in this conference call may contain forward looking statements that involve risks, uncertainties, and assumptions. If the risks or uncertainties ever materialize or the assumptions prove incorrect our results may differ materially from those expressed or implied by such forward looking statements.

All statements other than statements of historical facts could be deemed forward looking, including but not limited to any projections of financial information, any statements about historical results that may suggest trends for our business, any statements of the plans, strategies, and objectives of management for future operations, any statements of expectation or belief regarding future events, potential market or market size and any statements of assumptions underlying any of the items mentioned.

For a description of the risks and uncertainties, please refer to the company’s filings with the Securities and Exchange Commission, including its Form 10-K and its 10-Q.

Now I will turn the call over to John Morgan.

John Morgan

I’d like to welcome you to our fourth quarter and fiscal year 2009 earnings call. I’ll first comment on our quarterly and full year results as well as the highlights of our strategic growth initiatives then I’ll ask Mark to provide a detailed description of our financial results and lastly we’ll open up the call for questions.

Fiscal 2009 proved to be a year of meaningful progress. Although our company faced a number of challenges as the economy slipped deeper into recession, unemployment rates increased dramatically, raw material prices continued to escalate and consumer confidence declined to levels not seen in decades. Zep was able to respond decisively and deliver respectable financial results and noteworthy operational improvements.

Given these challenges, I’m especially proud of our results and what our associates were able to accomplish. The competitive spirits of our associates coupled with their energy, experience, focus on teamwork, and commitment to excellence clearly benefited Zep and its shareholders. The progress we made and the results achieved during 2009 are due primarily to our associates. Our company would not be in such a strong financial position or operational position without their dedication.

During the fourth quarter we delivered solid financial results as we built on the positive momentum and progress achieved during our third quarter. We reported net income of $6.3 million for the fiscal fourth quarter compared to net income of $8 million in the year earlier period. For the year ended August 31, 2009, the company reported net income of $9.3 million compared to $16.3 million reported in 2008.

Driven by our cost containment and working capital management efforts the company’s net cash provided by operating activities totaled $22.9 million during the quarter, a $7 million or 44% improvement compared to the same period in 2008. Our operating activities provided $30.4 million in cash during fiscal year 2009 compared with $26.4 million in 2008.

When taking into consideration the state of the economy during 2009 we are pleased with the cash generated during the fourth quarter and the fiscal year. Our cash flow allowed us to pay down a significant portion of debt which further strengthened our balance sheet and will provide us the opportunity to leverage our capital structure to grow acquisitively as well as to fund internal growth initiatives.

While we remained mindful of our long term strategy and position in the market during 2009 we increased our focus on proving our business model and streamlining our cost structure. We took bold steps to reduce costs, develop new green products, adopt a culture of entrepreneurialism and improve profitability that not only helped us navigate a challenging market but also provided us with greater earnings leverage when volumes improve.

Unfortunately we were still operating in a depressed market environment as our average daily sales were down 13.5% in the fourth fiscal quarter as compared to the year earlier period. However, this compares favorably to the 15% sales decline we recorded in the third quarter as a result of strong sales growth to our retail customers.

While we are not certain that this represents a bottoming of volume declines we do have a more favorable outlook on near term expectations as we have seen some stabilization in end market demand and some traction from our revenue growth initiatives. While it appears as though we are bouncing along the bottom of the current recession and economic indicators have shown a considerable level of stabilization, we are going to continue to manage the business in a way that is not predicated upon a near term recovery.

As volume growth returns we expect to realize significant financial leverage due to our efforts to improve productivity and streamline the business. Again, from a day to day management standpoint until we have greater confidence that the external markets are recovering we are going to continue to be very cautious regarding spending in our current business.

While raw materials continued to impact our results our sourcing teams have done a fantastic job of reducing spend in this area. Additionally, I’d like to thank our strategic supplies that have worked with us to find various ways to help reduce costs. We appreciate their willingness to support Zep. These partners have been the benefactor of taking on a larger share of our purchases and we look forward to working with them in an even greater capacity going forward.

On the legal front, we previously disclosed our intent to incur higher costs associated with enforcing certain protective covenants and to bring action against companies whom we believe have unlawfully interfered with our business. We are pleased with an agreement reached with Kimball Midwest which had been filed in Federal Court in Ohio and with terms that are favorable to Zep. We expect to incur further expense as we are in the process of pursuing similar actions against other companies and former sales reps who we believe have violated our agreements.

Since our inception, we have focused on three key tenants:

- Integrity

- Decentralization

- Relentless Execution

The foundation of our company is based upon our integrity. Specifically how we manage our business and our customer relationships. Integrity garners the utmost respect from customers and throughout our transformation we have remained focused on improving the quality of our customer base while demanding honesty and truthfulness of our associates. Moreover, as we commenced our efforts to build our sales representative headcount we have focused on not only attracting successful and experienced representatives but also those that have a track record of quality customer service.

As we move forward with our transformation initiatives a key component of this strategy is decentralizing and streamlining our business to bring service and other capabilities closer to the end customer. The tenant of decentralization is grounded in the idea that we needed to make our business better before bigger and create an entrepreneurial culture. Our efforts thus far have begun to bear fruit as we have taken more and more costs and inefficiencies out of the business while also putting more decision making authority in the hands of our business leaders. This process has led to a dramatic shift in our organizational structure which we expect to continue having a positive impact in the future.

The third tenant is relentless execution in all areas of our business. Our associates acted swiftly and strategically in the face of the recessionary environment and have found innovative ways to improve our cost structure. These actions were intended to reduce the company’s cost footprint and we are confident that our ongoing cost reduction efforts will strengthen our financial position even further.

Overall our success is deeply rooted in our long term strategic growth that focuses on expanding margins and growing share with new and existing customers. We expect this strategy to strengthen Zep’s position as a leading provider of innovative, environmentally sustainable cleaning and maintenance solutions for commercial and industrial customers.

Our long term growth strategy has five key components:

Simplifying and improving the core

Expanding our retail presence

Entering industrial distribution

Growing our international business

Becoming acquisitive

Despite economic challenges we continue to make significant progress with our strategic transformation initiatives during the quarter as well as the year and have positioned Zep to enter 2010 a much stronger company.

During 2009 we focused a majority of our efforts on improving our core business. This includes rationalizing our product offering, implementing lean methodologies, expanding and leveraging our sales force capabilities, and reducing our cost footprint. We made terrific progress on this front and as we move forward into 2010 we will look to sustain our gains and continue to make incremental improvements.

Specifically in our core business we consolidated 11 locations during 2009, recently consolidated another location into our Allentown facility and plan to consolidate at least three more locations during fiscal 2010. Having our business decentralized will help ensure these consolidations are smooth for customers and result in improved customer service with lower capital requirements.

Secondly, we have begun expanding our sales rep base through the use of a redesigned hiring model which is offsetting normal attrition and bringing more qualified sales professionals to Zep. Additionally, to complement our direct sales model we have developed an inside sales capability across the United State to more fully meet the needs of our smaller customers. Zep’s ability to leverage its technical resources in delivering a superior customer experience has always been a positive differentiator the company.

One recent example is the expansion of our GreenLink and EnviroEdge product lines. With these products we are well positioned to offer customers a full range of environmentally friendly cleaning and maintenance solutions and can facilitate compliance in lead certified spaces. Our focus on green products has increased over the past few years and we look forward to continuing to leverage our unique capabilities to ensure Zep remains the preferred provider of green products.

Given the progress we made this past year in improving the core we are now able to focus more of our time and energy towards the other four components of our long term growth strategy. In fiscal 2009 we made significant progress penetrating a broader cross section of retail segments with our Zep Commercial and our Enforcer product lines. We continue to work collaboratively with our retail customers to build successful merchandising programs at the store level. Our Zep Commercial line is reaching a broad customer base through exposure at The Home Depot and in 2009 we increased our brand awareness by offering products at complementary retailers.

Consistent with our goal of increasing our retail presence in previously untapped markets, Zep has also targeted automotive after market space. A great example is the progress we’ve made in our recently announced agreement with Advance Auto Parts, with a nationwide presence of more then 3,400 stores Advance Auto will now offer a line of Zep Commercial products. While we don’t expect this agreement to have an immediate impact on our earnings results we do believe expanding our retail presence will drive long term growth and will enhance our value proposition and our brand awareness.

We made noteworthy progress during the year in working towards entering the industrial distribution market as we partnered with six world class distributors and signed agreements with 70 local and regional distributors to market our Zep Professional product line during 2009. While we remain very enthusiastic and optimistic about the long term prospects of this initiative sales to some distributors have ramped up more slowly as some of our partners are only willing to add inventory at a particular rate given the current economy. Strategies are currently underway to continuously improve our customer reach in this market.

We will also look to expand our international business specifically we are focusing on driving our core Italian operations integrating our entire European business and then expanding geographically there.

Finally, as we mentioned during our last earnings call we will look to grow acquisitively going forward. Acquisitions have always been a part of our long term growth strategy but our more immediate plans for M&A activity were impacted by adverse economic conditions experienced during fiscal 2009. While we continue to stay on top of potential opportunities we maintained a very conservative stance with regard to capital allocation.

However, we have revisited our acquisition strategy given our consistent cash flow generation and overall liquidity. We intend to leverage our improved capital structure by acting on appropriate acquisition opportunities that will not only expand our access to market but will also accelerate the sales growth in industrial distribution, retail and the international markets.

With that I’d like to now turn the call over to Mark Bachmann.

Mark Bachmann

Our fourth quarter revenues were $134 million compared to the $153 million reported in the year earlier period. Sales were adversely impacted by a decline in volumes of approximately 12% compared to the prior year quarter as the recessionary environment continued to adversely impact our customers and various end markets during the quarter. We continue to believe that approximately 70% of this volume decline was attributable to the economy and the remaining 30% is related to our strategic initiatives implemented last year.

Unfavorable foreign currency translation on international sales contributed $2.8 million of the decline. Offsetting this shortfall was the affect of higher selling prices of $2.9 million. As John mentioned previously, our fourth quarter net income grew sequentially to $6.3 million or $0.30 per diluted share versus a profit of $8 million or $0.37 per diluted share reported in the prior year. Included in the fourth quarter of 2009 were $400,000 or $0.01 per diluted share of additional restructuring charges associated with facility consolidation and severances.

We reported a profit from operations of $11 million during our fiscal fourth quarter compared to an operating profit of $13.5 million in our fourth quarter of 2008. Despite the continued macro economic headwinds the company generated positive cash flow from operations of $22.9 million during the fourth quarter and we expect to continue generating strong cash flow on an annual basis going forward.

Shifting gears let me take a few moments to discuss the impact our market segment performance had on our operating results for the quarter. During the fourth quarter we continued to realize sales growth in our retail channel due to successful merchandising programs with a variety of retailers. However, we experienced significant declines in transportation and industrial manufacturing end markets with more modest declines in food end markets and government and schools. Many of these top categories have been affected by ongoing negative trends. For example, rising unemployment and continued low levels of industrial growth as measured by goods orders, production utilization and automotive sales.

Gross profit margins were 53.4% for the fourth quarter of 2009 versus 55.6% last year. While raw material costs still increased they were completely offset by higher selling prices. The decline in our gross profit margins were attributable to the higher mix of retail and distribution sales of approximately 120 basis points and the impact of less overhead absorption due to the lower finished good inventory levels which approximated 130 basis points of the gross profit margin decline.

Operating expenses were favorably impacted by the multiple efforts to streamline and reduce the cost structure. Operating expenses as a percentage of sales were 44.9% this quarter excluding the restructuring charge versus 46.7% last year.

Now turning to the results for fiscal 2009. Net sales were $501 million in fiscal 2009 compared with $575 million in the prior year representing a decrease of 12.8%. We realized higher selling prices that contributed an additional $18 million in sales in fiscal 2009 which was virtually offset by $16 million of unfavorable foreign exchange.

For fiscal 2009 net income was $9.3 million or $0.43 per diluted share compared to $16.3 million of net income or $0.77 per diluted share reported in the prior year. Pre-tax charges related to restructuring and other special items totaled $3.4 million or $0.10 per diluted share this year and $10 million or $0.30 per diluted share last year. The effective tax rate for the total year was 39% compared with 37.2% in the same period last year due to the mix of income in various tax jurisdictions. We anticipate the tax rate will range between 38% and 39% next year.

Capital expenditures for the total year were $7.5 million a decrease of $1.7 million from last year. These expenditures were primarily used to consolidate branches, reduce our cost structure, enhance information technology, and improve manufacturing capabilities. We anticipate fiscal 2010 capital expenditures will range between $11 and $13 million.

During fiscal 2009 the company generated $30.4 million in cash flow from operations, once again demonstrating the recession resistant nature of this business. This is a very important achievement considering the number of strategic initiatives undertaken during the year along with the challenging economic environment.

Our significant cash flow generation allowed us to reduce our net debt position by $20.6 million or 46% during the year with total debt outstanding of $40.7 million at year end. We believe our focus on free cash flow and paying down debt is important especially in today’s economic landscape. Additionally, we plan to leverage our cash flows and strong capital structure to acquisitively grow our business as John mentioned earlier.

Although raw material costs continued to adversely impact our business during the quarter the rate of increase has slowed considerably. To provide an historical perspective year over year raw material costs increased $8.3 million in the first quarter, $6 million in the second quarter, $4.4 million in the third quarter and $900,000 in the fourth quarter. As you can see, material costs are moving in the right direction. Improving raw material cost have been a direct result of our efforts to aggressively renegotiate supply agreements and rationalize our supplier relationships.

We continued to see the benefits of our sourcing efforts in our P&L during our fourth quarter and expect the benefits of these efforts to continue to positively impact our operating results in fiscal 2010.

Now let me provide some additional details regarding our debt structure. As of August 31, 2009, borrowings under our revolving credit facility totaled $33.5 million leaving approximately $64 million available under our revolving credit facility. We are also in the enviable position that our revolving credit facility extends to 2012 and we have no significant debt coming due in the next two years. Further, we are in full compliance with all of our debt covenants.

Our debt to capital ratio net of cash was 18% as of the end of our fourth quarter. We believe liquidity continues to be extremely important to operating a business in this market and will therefore remain prudent in our approach to liquidity. As described in yesterday’s press release, we just executed a three year loan and security agreement for up to $40 million which replaced a similar facility that expired last year. We believe our strength and capital position coupled with the businesses sustainable lower break even point affords us financial capacity and confidence as we reinvigorate our plans for acquisitions.

We also announced in the press release yesterday that we filed a universal shelf registration statement with the Securities and Exchange Commission that will allow the company to raise through one or more offerings up to an aggregate of $200 million through the sale of equity, debt, and certain other types of securities described in the registration statement. The shelf registration statement has not yet become effective with the SEC. At this time we have no immediate plans to issue securities under the shelf registration statement and will have no further comment. We refer you to yesterday’s press release or S-3 filed with the SEC for additional information.

Let me conclude by saying we made tremendous strides to improve the company’s cost structure and balance sheet and are well positioned to enter into 2010. We would expect to have a decrease in revenues in the first quarter compared to last year as the downturn in the economic conditions had not fully begun to impact our business until our second fiscal quarter. We continue to expect to be profitable in each quarter of fiscal 2010, although it is unclear at this time whether our profits will fully return to fiscal 2008 absolute levels due to the lower revenue base.

At this time we’d like to open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mike Sison – KeyBanc

Mike Sison – KeyBanc

I wanted to think about this acquisition strategy with the shelf. Could you maybe give us a little bit of understanding of what type of businesses our out there at this point in time, many geographic regions, maybe your appetite in terms of size, and maybe quickly how are you going to go through and pick one? What would be the criteria in pulling the trigger for one of these?

John Morgan

Let me characterize it and invite Mark to interrupt at any point. Mark’s actually leading an enterprise wide project here to get that pipeline filled in looking into acquisition opportunities. Let me first say that my comments are unrelated to the shelf registration as Mark mentioned that’s not yet effective with the SEC so we can’t comment on that at all. In terms of our overall acquisition strategy we’ve got, in terms of our existing capabilities and resources, terrific manufacturing capabilities, product capabilities, financial resources, good logistics network that’s becoming more and more lean.

As we think about how we leverage those resources to grow acquisitively we’re really interested mostly in expanding our access to market, followed secondarily we would be interested in some manufacturing capacity in some geographies where we don’t have it today close to our customers. Those are our two priorities.

On that first part we’re looking at revenue businesses that would range in the $50 to $150 million range. I am willing to take a look at some smaller opportunities if we consider them to be very similar to any of our current businesses and tuck in quite easily. I’m much more interested in expanding our access to industrial distribution with other capabilities, especially if it comes with the product lines and brands that expand our brand portfolio in a way that’s interesting to our customer base.

Likewise, we have the same appetite in the retail space. As you know, in retail we focus on the customer who wants to buy what the pro buys, that’s the reason we work with such organizations as The Home Depot who are really very effective at reaching out to customers such as that. We would like to expand that business, we’ve got a great leadership team there and we’d like to find ways to bring them additional brand capabilities to reach further into retail.

Third, over the last couple of years we’ve really been fortunate to have and build on and strengthen the team that we have in Europe previously that had been operated internally as a variety of different businesses, those are now pulled under single leadership team into a single platform and we want to continue to add scale to that business where we think it would be beneficial especially moving into Eastern Europe. Those are the three areas of focus.

Mike Sison – KeyBanc

In terms of hurdle rates is there a general rule of thumb you want it to be, accretive to earnings in the first year, accretive to cash flow, accretive to returns, any thought process there?

John Morgan

We’d like it to be accretive to earnings in the first year. I’d be willing to look at something that’s not accretive until the second year if it’s just the right candidate. We’re interested in it being accretive to earnings in the first year and we’re not interested in any fixer uppers if you will. We think that we’re much better served to find product capabilities and the brands that are already successful and interesting to our customers and to customers in verticals where we don’t focus a great deal yet today where we can bring our operating platform in ways to help them. We’re interested in looking at good quality businesses.

Mike Sison – KeyBanc

In terms of your leverage, when you take a look at 2009 your sales volume declines were roughly $76 million. If you were able to recoup that $76 million over time can you give us some help in terms of what the leverage is, is there a certain incremental margin we can apply to that or how much of that comes back straight to the bottom line?

John Morgan

As you know, what we had disclosed previously is some of the cost out activities that we drove in the business last year were temporary in nature, however most all of the cost out activities were designed to fundamentally reduce the break even of the business in a sustainable way.

Mark Bachmann

On the break even we probably reduced the break even point greater than 10% this past year. We would expect that contribution rate would probably be in the 30% to 33% range to fall through in that we’ve taken the fixed costs out, as John mentioned, and believe we still have the manufacturing capabilities to support that kind of volume growth.

Operator

Your next question comes from Zahid Siddique - Gabelli & Company

Zahid Siddique - Gabelli & Company

Could you provide a little bit more color on the various end markets? I know you touched on it briefly but just some more color on the various end markets are doing.

John Morgan

It’s an interesting question; the end markets are quite mixed. Let me just focus on the end markets actually where we focus the most, are probably the most relevant here. One of our largest end markets or verticals that we serve is in the transportation area. In the transportation area that includes, of course, things like car dealerships which are an important part of our business, that’s been a little bit difficult over the last year as you might expect, vehicle wash, airline, trucking and so forth. That’s an important part of our business. That has I would say stabilized but its just bouncing at the bottom. As you know from the broader economic indicators there’s no major turn around in the transportation sector, certainly in North America.

Food is another important area for us, food processing and food preparation. That’s been a relatively stable market. We anticipate that that will continue to be a relatively stable market. Apparently we still like to eat and so that’s been a pretty good business for us. In fact, in food processing the focus is on the at home markets, that’s been a pretty good market segment.

Of course products in the construction area that has been very difficult to come by over the last year. Residential construction has somewhat increased, still bouncing along a bottom but as you know from the broader indicators has increased somewhat. Non-residential construction has been very difficult.

Government markets have been pretty robust over the last year. We anticipate that that will continue in the coming year and that’s an important business for us.

Mark Bachmann

The only other area that has a significant impact relative to our sales is the general and industrial manufacturing segment. I think everybody knows industrial production is way off and continues to be off relative to production utilization. Those trends continue to be down.

John Morgan

I would mention one more, not because it’s a significant part of our business today but because its an area of focus for us and we’re getting some early entrances into that and that’s the automotive after market, that might be a subset of transportation but the automotive after market over the last year has been pretty stable as people continue to maintenance existing vehicles.

The retail space we’re in of course has been relatively flat overall but that’s been a very good market for us as many retailers are increasing their focus on cleaning and maintenance products.

Zahid Siddique - Gabelli & Company

With regards to the compensation of the sales team, you talked about some sort of a redesign of that process; I wanted to understand your sales force compensation a little bit better if you could elaborate on that.

John Morgan

We don’t disclose what our compensation structure for our sales force is. In specific terms I will say it’s overwhelmingly a commission based sales force. We have a terrific sales force that’s dedicated to Zep, they don’t represent other lines and they’re overwhelmingly commissioned and of course very different bonus and sales incentives and that type of thing.

The only exception to that is that as we bring in new reps a lot of times we’ll do the things necessary to assist them coming into the business. It’s an important point you bring up because our Zep rep hiring has increased substantially in the last several months. That’s an important driver to our core sales and service model. The primary difference that we’re referring to is that for a number of years we hired inexperienced reps that we taught not only chemistry but how to sell. We’ve increased our focus on bringing in reps that have much more sales experience and we can easily teach products and chemistry.

The thing that really helps the economics of the hiring model is the ramp up rate and the reduced turnover from the previous model, that’s the primarily. I hope that gives you enough of a flavor. I’m sorry I don’t like to disclose our comp structure as far as our competitors.

Zahid Siddique - Gabelli & Company

What’s the number of reps currently that you have?

John Morgan

We’ve decided not to disclose that for the same reason.

Operator

Your next question comes from Andrew Cash - Point Clearview Management

Andrew Cash - Point Clearview Management

What percentage of the sales now are moving through third party distributors, if you could compare that to year ago and what do you think it will be at the end of another year without the help of any acquisitions?

John Morgan

I’m going to ask Mark to pull out the specific information.

Andrew Cash - Point Clearview Management

Just roughly, it’s not necessary exact.

John Morgan

Let me comment on what we expect and ask Mark to pull out the facts. We’re still focused on the industrial distribution sales being 10% to 15% of our total sales in the coming three years. Of course we’ll have to grow that disproportionate to the growth in the other business to achieve that. In addition, I would remind you that all of our retail sales are through retail distributors which is third party distribution.

Mark Bachmann

In the fourth quarter the sales through industrial distribution reached 2% it had been less than that prior to that. Our retail growth over the last couple of quarters and this last quarter our sales to retailers approached 19% for overall.

Andrew Cash - Point Clearview Management

Is the reason for such a potentially large acquisition tied to the drive increased in industrial distribution through third parties because you really can’t get it on your own organically is that part of the reason for such a large acquisition?

John Morgan

It is and actually it’s the acceleration. I think ultimately we could get it on our organically but as you know that just takes forever. We want to accelerate that process and build that platform furthermore in terms of general management we want more products and brands so that they’re complimentary. As that grows we want to manage that conflict effectively.

Let me take you back just a minute to the broader market. This $15 to $16 billion North American market, just as a reminder, about 80% of that market goes through some form of distribution either retail or industrial distribution and about 20% of the market is sold direct to the end user by the manufacturer, especially in those areas where some high degree of technical support is necessary. The business has traditionally focused on really only 20% of the market. The other dynamic here is not only we want to accelerate this initiative but the initiative is focused on moving us into a larger portion of the market where the growth potential is much greater.

Andrew Cash - Point Clearview Management

Assuming the shelf goes through could you give us a rough idea of what sort of bang for your buck you might get in terms of an acquisition? Would you be paying roughly one time sales or some multiple greater than one time sales? In terms of rough ballpark.

John Morgan

I’d rather not, for obvious reasons. We’re in conversations with a number of people as we start to build information and build a pipeline and this is probably not a very good venue for me to get into that.

Andrew Cash - Point Clearview Management

On the one hand I hope you don’t bite off more than you can chew, on the other hand I’d like you to do something really big because you’ll have more to work with.

John Morgan

Sounds like our thinking is totally aligned.

Operator

Your next question comes from Mike Sison – KeyBanc

Mike Sison – KeyBanc

Back to the leverage question, I’m curious what the total sales volume potential is, meaning that you were down $76 million you like de-bottlenecked here or there. What is the peak or full capacity type of sales that you could recover or grow into over time?

John Morgan

If you start with Mark’s characterization of the benefit of revenue growth we think that at our current cost structure about a third falls through. To your point, it’s a pretty important part of our future. When we went through the various different steps of transformation over the last 12 to 18 months we lost revenue about a third of which is of our own doing and about two thirds of which were due to the economic factors. The third of which was due essentially to our own doing I don’t think comes back anytime quickly because some of that was just not good business. The two thirds that is driven by economic factors quite frankly your guess is as good as mine on that.

In terms of our capacity and capabilities we could easily handle from an operations and logistics standpoint a recovery of all of that lost volume plus a good bit. We are one shift chemical operation with a great team and ability to ramp up further output. I really like the work that our team has done over the last year in terms of the consolidation of suppliers in that we’re working with some awfully good suppliers that have the capability to ramp up with us.

I’m really not concerned about our infrastructure capability in that regard and most of our capacity demand to support increase would be variable costs in nature. I don’t really see us having any significant fixed cost increases to be able to support increased volume. Therefore, back to your point, that makes that revenue fall through very important to this business.

Mike Sison – KeyBanc

When you think about some of the organic growth initiatives that you suggested can you talk about how much of that should flow into 2010, is there a certain volume growth number that you can share with us that is indicative of those internal initiatives alone?

John Morgan

I’m not prepared to do that. I’m not prepared to provide that right now.

Mike Sison – KeyBanc

You have a number?

John Morgan

We certainly have our internal plans that we haven’t disclosed. We certainly feel like even in this economy we should be able to grow organically.

Mike Sison – KeyBanc

Can you talk about some of the two or three major areas where you’re focusing on and where you think gain more traction sooner than later?

John Morgan

You’re hitting on an important point. When it comes to organic growth not only does it sometimes take longer its frankly harder for me to predict. Maybe others are better predicting that. The three or four things that we’re most heavily focused on and investing in is expansion of our own Zep rep sales force. That is an expensive, time consuming proposition but it’s critical to the continued growth of our core business. We reinitiated that several months ago and we’ve continued on into our fiscal 2010 and while we’re not disclosing rep headcount for competitive reasons we just had our best recruiting month in September as we continue to add experienced reps to that Zep sales and service force. That’s the most important initiative.

We’re augmenting that with the continued expansion of inside sales organizations because we’re finding that as our outside sales reps become increasingly successful it becomes more and more difficult for us to service the smaller clients as effectively as we like to. We’re investing in inside sales organizations to continue to support not only the maintenance but the growth in sales with literally thousands of smaller clients that in our history sometimes we lost because of a lack of focus in that area.

The third area is in our retail area. We’ve continued to focus on building that organization, adding merchandising capabilities, marketing capabilities. We constituted a retail business here over the last year, hired a terrific lady who is the president of that business now with great experience and they’re focused on, first and foremost, supporting and merchandising with our existing retail base and then secondly bringing new products, new formulas not only to those existing customers but other retailers. Specifically we’re focused on taking Zep Commercial products to retailers that we view to be complementary to our relation with The Home Depot. That seems to be going very well and very pleased with that.

The other thing I would say is that in the industrial distribution space we have received word recently that in the spring of 2010 we will take Zep Professional into the W.W. Grainger catalog. We really have a high regard for that organization, we love their brand, and they’re very professional organization bringing high quality solutions to the customers. Our experiments with one another over the last year we’ve both been very pleased and see great growth opportunity there. That’s getting a little late frankly in our fiscal 2010 but certainly as we get into spring of 2010 we see that as an important initiative.

Before you even ask the question, of course I don’t want to speculate on a customer by customer basis exactly what the volumes would look like so it would be terribly unfair to Grainger if I were to disclose what we think that volume would look like.

Mike Sison – KeyBanc

In terms of gross margins could you help us get an understanding what levels they will track over time? They were high in the first half, they started to dip in the second half and they are up quite a bit year over year which is good. Maybe a better feel of how that is going to shape up over the next couple of years. Is this the right level that you want to keep it at?

Mark Bachmann

The first half of fiscal ’09 actually our gross margins were impacted significantly by the rapid increases in raw material costs that happened during calendar 2008 that with time flowed into our P&L. They started to, as we said, they dissipated over the course of the year as I described in my earlier comments. We’ve started to see our gross profit margins return and they were 53.4% this last quarter.

Noteworthy is that one of the things that was impacting our gross profit margin was the lower overhead absorption because our finished goods inventories came down and that was worth 130 basis points. If you added that because that’s really a one time thing you’re getting up to almost 55%. Over time we got the kinds of savings we were anticipating in our sourcing.

We had communicated previously that we believed we would get $10 to $11 million worth of sourcing savings. Our purchases now and things that we are making are coming in at those lower levels. Of recent past we’ve sort of seen that stabilize. Granted some things are going up again like propylene and so forth we’re seeing some other benefits there. They’re netting off as we go forward.

As we think about the next couple of years that greater percentage of growth that would come out of industrial distribution or retail will continue to have a downward pressure on gross profit margins but as I’ve said in previous discussions that our EBIT margins would expect to improve from that mix shift. This last quarter the mix impact was 120 basis points. Hopefully that gives you a little better flavor.

Operator

Your next question comes from Sean Connor – BB&T Capital Markets

Sean Connor – BB&T Capital Markets

You guys referenced the 11 consolidations this fiscal year. I’m trying to get an idea of how much of the savings is currently in Q4 versus what we can see incrementally from those actions in the first part of this next fiscal year. As you look at the three additional that you’ve sited for fiscal ’10 is there an estimated savings level that we could build in for that or expect? An idea of what that would mean to the SG&A line.

John Morgan

Let me comment generally on one thing with respect to that. As you pointed out we’ve taken those actions throughout the fiscal year so we’ve not yet lapped some of the benefits and we would expect some of that to continue on into certainly the first part of fiscal 2010. The thing that I’m always mindful of as well is as we continue to take further costs out and continue to improve our ability to service customers with lower levels of inventories through this consolidation effort that also provides a little bit of expense headroom for some increased investment into some organic revenue growth opportunities.

I’m certain we’re prepared here to characterize the cost out on the platform, I’ll ask Mark to comment on that in a minute, but I’m not prepared yet to depict specifically how much of that we’ll take and invest back into the business but of course one of the things I’ve been looking to do over this year is as we take costs out, take a portion of that back into revenue growth investment. That’s my caution about thinking about us taking 100% of those savings in the future and to the bottom line because I think we need to be focused on some revenue growth investments as well.

Mark Bachmann

A lot of the consolidations had already taken place or early in the fourth quarter so that most of the benefits from the actions that we had taken this year would have translated into the fourth quarter results. As we’ve said before there’s a lot of moving parts and we’re not prepared to specifically or be as granular of what the benefits will be from further consolidations. I would say the biggest ones for the most part have already been behind us.

What I will say is on fixed costs that we had identified what we were targeting to get out by the time when we said $10 million by the time we exited fiscal 2010 and we achieved that. To John’s point, now as we will benefit from some additional savings we’re looking to reinvest that to grow organically.

Operator

Your next question comes from Robert Felice – J. Goldman & Company

Robert Felice – J. Goldman & Company

You mentioned 120 basis points of gross margin compression due to the decision to lower production rates this quarter and cut inventory. Is that process complete? If not, to what extent do you expect it to persist as we look to fiscal 2010?

Mark Bachmann

We had said our biggest opportunity in working capital is our inventories. We’re quite pleased with the efforts achieved over this last year to reduce our days on hand of inventory. It came through a multiple of means as we’ve discussed before between the consolidation of our branches, through the SKU reductions and demand shaping that we’ve done by some of the improvements we’ve made in our manufacturing processing using lean techniques and so forth. There have been a number of different things that have contributed to that.

Having said that, we would expect that we would continue to drive further inventory out over the coming year but not prepared to tell you exactly how much. I would say that we exceeded our internal expectations this last year about how much we were able to achieve in this past year.

John Morgan

For your further edification I would just say that as we bring down inventories further in the future I don’t expect or demand that they come down at the same rate that they came down over this last six months because we have more work to do in our operating platform to be able to effectively service customers at a lower inventory level. From a modeling perspective I think that that big step that we took in the last few months is behind us for the foreseeable future.

Robert Felice – J. Goldman & Company

It sounds like any impact should occur at a diminished rate going forward?

John Morgan

Yes.

Robert Felice – J. Goldman & Company

You mentioned that you lowered the overall break even point for the business. To that end I’m hoping you could help me understand that the magnitude of the volume improvement or revenue improvement it would take to get you back to fiscal ’08 levels of profitability? Overall I’m trying to get my hands around what the new incremental contribution margin is per dollar earned.

John Morgan

My rule of thumb is about a third of revenue increase should fall through now given the lowered break even of the business.

Mark Bachmann

We’re probably looking at a 5% or 7% increase in volume would bring back that level of profits to the ’08 levels.

Operator

At this time we have no further question. I’d like to turn the conference back over to Mr. Morgan for any additional or closing remarks.

John Morgan

In conclusion let me say that when taking into consideration the recent economic environment and global recessionary environment we are very pleased with the financial results generated during our fourth fiscal quarter and our fiscal 2009. Truly the resiliency of our business model, cost actions taken during the year, and the efforts of our talented associated helped us not only manage through the current economic turmoil but also positions us for long term growth and shareholder value creation.

While we remain cautious of the current economic climate we have seen some stabilization in end market demand and maintain the flexibility to properly service our customers as well as expand as the market eventually rebounds. Further, our strong capital structure and current borrowing capacity provides the needed liquidity to not only manage through the current economic slowdown but also acquisitively grow our business.

Thank you for your participation today. Mark and I look forward to speaking with you on the first quarter conference call.

Operator

That does conclude today’s conference. Thank you for your participation.

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