drugstore.com, inc. Q3 2009 Earnings Call Transcript

Oct.20.09 | About: drugstore.com, inc. (DSCM)

drugstore.com, inc. (NASDAQ:DSCM)

Q3 2009 Earnings Call Transcript

October 20, 2009 4:30 pm ET

Executives

Brinlea Johnson – IR, The Blueshirt Group

Dawn Lepore – Chairman and CEO

Tracy Wright – VP and CFO

Analysts

Mark Argento – Craig-Hallum Capital

Shawn Milne – Janney Montgomery Scott

Operator

Good day, ladies and gentlemen, thank you for standing by. Welcome to the third quarter 2009 earnings call for drugstore.com conference call. (Operator instructions) This conference is being recorded today Tuesday, October 20th, 2009. I would now like to turn the conference over to our host, Ms. Brinlea Johnson of the Blueshirt Group. Please go ahead, ma’am.

Brinlea Johnson

Good afternoon. Welcome to the drugstore.com third quarter 2009 earnings call. With me today is Dawn Lepore, Chairman and Chief Executive Officer; Tracy Wright, Chief Finance Officer; and Rob Potter, Chief Accounting Officer. Before we get started, we would like to remind you that the information on this call may include forward-looking statements. Words such as "expect," "believe," "anticipate," and similar expressions, are intended to identify forward-looking statements, which involve risks and uncertainties that could cause drugstore.com’s actual results to differ materially from those discussed in the forward-looking statement. In particular, comments about drugstore.com’s anticipated future revenues, earnings and growth rate are forward-looking. Factors that could cause actual results to differ materially from anticipated results are detailed in our periodic filings with the SEC.

I would also like to point out that during the call, we do mention certain non-GAAP financial measures, which will be explained during the call. A reconciliation of these non-GAAP measures to most comparable GAAP measures can be found in our earnings press release, which is made available prior to today’s call. Finally, today’s call is being recorded and will be available for replay on drugstore.com’s Website at www.drugstore.com, under Corporate Information. In addition, the earnings press release for the third quarter 2009, including a summary of our financials and supplemental financial information disclosed on this call will also be available on our Website, also under Corporate Information.

With that, I will turn the call over to Dawn Lepore, Chairman and Chief Executive Officer.

Dawn Lepore

Thanks, Brinlea. Good afternoon everyone and thank you for joining us. Today, I am pleased to report a strong third quarter, posting double-digit revenue growth, our highest gross margins to date and record new customer growth. Here are a couple of quick highlights. Overall revenues were $96.8 million, up over 10% year-over-year. OTC revenue grew by an impressive 16.5%. Our prestige and total beauty business each grew 19%, in contrast to a continued decline in the industry. Vision sales increased approximately 11% over last year, also ahead of the industry. We had a record quarter of new customer addition, with 27% new customer growth overall, inclusive of contributions from strategic partners. Gross margins were our highest in company history at 29.3%, up 70 basis points year-over-year. We reduced operating expenses as a percent of net sales from the prior year by 310 basis points, and we delivered adjusted EBITDA of $3 million.

In summary, we surpassed our previous top and bottom line guidance and remain confident that we can continue to drive revenue growth and adjusted EBITDA. Before I delve into the details behind our accelerating OTC growth, let me first briefly update you on our other business segments. In the third quarter, our Vision business increased 11% year-over-year versus overall industry growth in the low-single digits. New customer growth was almost 11% for the quarter and baskets were up 4% year-over-year, as we offered effective promotions designed to incent greater volume purchases.

In pharmacy, Rx mail-order revenues this quarter were $8.2 million, down 25% over the prior-year quarter, due to the loss of the MSC business and to a lesser extent some economic impact on our lifestyle drug. Importantly, pharmacy gross margins were 21.5% this quarter, up 280 basis points year-over-year.

Now, let’s turn to OTC. As I mentioned, our overall OTC growth was 16.5%. Our base business was strong and our partnership continued to gain traction. I want to start with our base business. Our base OTC business grew almost 14%, up from 9% growth in the second quarter of 2009. We continue to drive our replenishment categories, but also benefited from an uptick in discretionary spending. In fact, there were three main drivers accounting for the accelerating growth. First, we posted a record number of new OTC customers in the third quarter. Overall, our new customers were up 30% in our OTC segment. Even without our partnership, we delivered 17% new customer growth in OTC, without increasing our cost for new customers. Our e-mail and marketing programs have been effective and the strength of our offers is driving improved conversion.

Second, we have a high number of replenishment categories in everyday item, which represented over 80% of OTC sales. This quarter, traditional cosmetics were up 65%. Vitamins and supplements were up 35%. Pet products grew 35% and oral care was up 30% [ph]. Additionally due to flu season, products such as Vitamin C and hand sanitizers were very strong. And finally, we saw a pickup in discretionary spending on both drugstore.com and Beauty.com. Although it is still too early to definitively gauge change in consumer behavior, we are encouraged by what we are seeing with increased sales on discretionary products such as electronic toothbrushes and electric shavers. Our beauty growth was very strong in the third quarter. Both prestige beauty and total beauty reaccelerated and were up 19% year-over-year. This compares to an NTD reported decline in the prestige beauty industry of 7%. Inclusive of the fourth quarter, we expect our prestige beauty business to grow 15% to 20% in 2009.

In Beauty.com, we continue to focus on adding new brands. During the quarter, we added (inaudible) and Boots No7. Hair essentials continues to do well and is one of our top color brand. Our gift with purchase offers was very effective overall and specifically the beauty bag that we offered in the third quarter was one of our most successful to date. In addition to the strength in our base business, our partnerships continued to gain traction, contributing 3 points of OTC growth this quarter. As most of you know, last quarter, we successfully launched a new Medco Health store, Medcohealthstore.com. Our partnership site leveraged our infrastructure and competitive strength in merchandising, marketing, fulfillment, and customer care. We expect the growth from these sites to continue to accelerate in 2010.

Another growth initiative is our microsite strategy. Our microsites are an additional format for us to provide health, beauty and wellness products to customers specialized for this specific category. We focus on higher margin categories and offer different targeted marketing programs to help drive sales. We can even tailor our shipping policy, prices and promotions to each site. In August, we successfully launched our first microsite SexualWellBeing.com. This site offers over 2,000 SKUs and our grand opening marketing program gives customers 20% off purchases of $49 or more. The launch and performance of the site is going according to plan and throughout November and December, we will increase our search and affiliate marketing.

During the fourth quarter, we will also launch our second microsite, followed by five to eight microsite launches in 2010. All of these sites will focus on attractive product categories with high margin. In summary, we had an impressive third quarter, with double digit revenue growth for the overall company, accelerated revenue growth in our OTC and beauty business, and record gross margins. I am especially encouraged by our new customer growth, both internally and through our partnership. We are clearly making progress on our strategic initiatives and we continue to actively pursue new partnerships and growth opportunities.

With that, I will turn the call over to Tracy, our Chief Finance Officer for the financials.

Tracy Wright

Over the next few minutes, I will walk you through some of the third quarter key metrics and then provide fourth quarter 2009 guidance. Third quarter 2009 net sales were $96.8 million, up 10% year-over-year. Looking at each one of our business segments on a year-over-year basis, OTC net sales grew by 16.5% to $71.3 million. Vision sales improved by 11% to $17.2 million, and mail-order pharmacy net sales inclusive of wholesale orders declined by 25% to $8.2 million.

Overall, average net sales per order were $67, down 4% both sequentially and year-over-year, primarily due to a lower mix of mail-order pharmacy sales. On a segment basis, average net sales were $57 in our OTC segment, $118 in the Vision segment, and $163 for mail-order pharmacy. In the third quarter, net sales from repeat customers represented 77% of total sales. And overall new customers inclusive of our strategic partnership increased an impressive 27% year-over-year to 412,000, bringing our total life-to-date customer base to 11.1 million unique customers. Our trailing 12-month active customer base grew by 14% year-over-year to 2.9 million.

Now, I will move on to gross margin. In the third quarter of 2009, we achieved record gross margins of 29.3%, up 70 basis points over the prior-year period, due to the increasing mix of OTC and a 280 basis points improvement in mail-order pharmacy margin. Gross margin expansion was the main driver of year-over-year growth in contribution margin dollars, which increased 15% to $20.4 million.

Moving on to expenses, we showed solid improvement in reducing year-over-year expenses as a percentage of sales due to a higher mix of customers from our lower cost partnerships, as well as fixed costs spread across a higher revenue base. Marketing and sales expense for the third quarter was $8.9 million, or 9.1% of net sales, and was essentially flat with the second quarter of 2009 in the prior-year period. Marketing and sales expense per new customer decreased in the third quarter to $21.50, from $23 in the second quarter of 2009 and $24 in the prior-year period. The sequential and year-over-year improvement is driven by the significant increase in the number of new customers as well as an increase in the percentage of base OTC orders acquired through free channels.

For the third quarter of 2009, fulfillment and order processing expense was $11.1 million or 11.4% of net sales, an increase from 10.8% in the second quarter of 2009, but an improvement of 110 basis points from 12.5% in the third quarter of 2008. The sequential increase is due to Q2 having benefited from higher revenue associated with pharmacy wholesale orders as well as typical Q3 seasonality inherent in our labor costs. Technology and content expense for the third quarter of 2009 was $6.2 million or 6.4% of net sales, an increase from 6% in the second quarter of 2009, but an improvement of 40 basis points from 6.8% in the third quarter of the prior year. The sequential increase was due to Q2 having benefited from higher revenue associated with the pharmacy wholesale orders. The year-over-year improvement is driven by a higher revenue base, partially offset by an increase in depreciation expense.

General and Administrative expense was $3.8 million or 3.9% of net sales, down 30 basis points sequentially and down 160 basis points year-over-year. The sequential decrease was due to a reduction in consulting costs incurred in the second quarter. The year-over-year improvement is driven by a reduction in consulting costs associated with our profitability spent, a higher revenue base and a reduction in non-cash stock-based compensation expense. For the third quarter, non-cash stock-based compensation expense was $1.4 million and depreciation expense was $3.2 million.

Looking ahead to the fourth quarter of 2009, we expect non-cash stock-based compensation expense to be $1.75 million and depreciation expense to be $3.5 million. On a GAAP basis, the company reported a net loss of $1.6 million or $0.02 per share compared to net income of $1 million in the second quarter of 2009, which included $3 million of income from our discontinued local pickup or LPU business. This compares to a net loss of $3.6 million or $0.04 per share in the third quarter of 2008, which included $1.1 million of income from our LPU business. We reported adjusted EBITDA of $3 million, a year-over-year increase of $2.8 million, excluding the adjusted EBITDA generated from our discontinued LPU business in the prior year. Third quarter 2008 adjusted EBITDA results included $3.4 million in contribution from LPU. We ended the third quarter with an employee base of approximately 870 FTEs. CapEx for the quarter inclusive of capitalized labor associated with internally developed software projects was approximately $2.1 million, a decrease of 28% from the prior-year period. We ended Q3 with a strong balance sheet and $37.4 million in cash, cash equivalents and marketable securities.

Free cash flow for the trailing 12 months was $7.2 million, down from $7.5 million in the prior quarter, as we increased inventory in preparation for the holiday season. With that as a review of third quarter results, we will move on to our outlook for the fourth quarter of 2009.

As a reminder, fiscal year 2009, which is a 53-week fiscal year, with the fourth quarter representing a 14-week period. The company is targeting fourth quarter net sales in the range of $107 million to $110 million. Net loss of $1.8 million to $2.8 million and adjusted EBITDA in the range of $2.5 million to $3.5 million. We will now move on to Q&A. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Mark Argento with Craig-Hallum Capital. Please go ahead.

Mark Argento – Craig-Hallum Capital

Yes, good afternoon.

Dawn Lepore

Hi Mark.

Tracy Wright

Hi Mark.

Mark Argento – Craig-Hallum Capital

First off, a question around the Medco relationship, how is that tracking versus your expectations, and is all the sales that you are booking for – with that relationship, is that in the OTC segment alone or are you doing some stuff with the Vision business as well in regards to the relationship with Medco?

Dawn Lepore

I will – let me take a piece of that and then Tracy can chime in. So, Medco is going according to plan. We continue to be very pleased with them as a partner, and we are – it is in the OTC segment. And Tracy can go over exactly how we are booking those sales.

Tracy Wright

So, all of the revenue is OTC related. So, it’s reported within that 16.5% growth, and then we report only the expenses similar to how we report fulfillment and labor. The only difference is that we booked the royalty back to Medco in our sales and marketing line.

Mark Argento – Craig-Hallum Capital

So you booked the gross – the gross revenue contribution in the OTC line and then the marketing, you basically net that back against sales and marketing?

Tracy Wright

Exactly.

Mark Argento – Craig-Hallum Capital

And the additional microsites, could you just walk us through the timing, do you expect to have any of these launches by the end of this year? And what are your targets there?

Dawn Lepore

So, we are going to launch one more this year, and then we have a list, frankly of eight next year. We don’t know if we will be able to do all eight, we may only be able to do five or so of those. They will be spread out throughout the year, there is a couple of them that we feel should be done in the first quarter. Anything to do with resolutions, vitamins, that’s the time of the year that we want to launch those sites. Obviously, if we were to launch an allergy site, we would want that to be launched for allergy season. Those are the things we take into account as we come up with our list and our timing for each of the sites. But I would say somewhere between five and eight next year and look for one more this quarter.

Mark Argento – Craig-Hallum Capital

Sure. And then in terms of the competitive environment, I know recently Walmart.com started to get a little bit more active in the OTC segment. Have you seen that increase competitive threat, any kind of impact to your business at all, any thoughts there?

Dawn Lepore

You know, we certainly haven’t seen any immediate impact to the business. One thing to remember about Wal-Mart is it’s a different demographic. So, we have a fairly affluent demographic. So, it’s I think they are going after a different demographic. Tell me, Mark, one thing you can say is that as people enter the space, it certainly validates the space. Now, I would certainly love to have the space to myself and I don’t have any complication, but obviously this is a good space given the number of people who are getting into it. But, you know, we are not trying to be the Amazon or Wal-Mart of e-commerce. We have a great value proposition. We have been shopping their site, looking at their prices, comparing them to ours, we compare very favorably. We are not always the cheapest, but we are very close, plus we have drugstore dollars, we have free shipping. We are the leader in health, beauty and wellness and we are focused on remaining the leader, and so we have not seen any immediate impact from them entering the space, and they have actually been out there for a while. They are just putting more focus on it.

Mark Argento – Craig-Hallum Capital

Last question, in terms of gross margins, I know you guys continue to make a lot of progress in the gross margin line. That’s something like you could see continue to improve up over that 30% level as more microsites come online, hopefully driving higher margins there?

Dawn Lepore

Mix, and once again, I am going to add a few comments and let Tracy weigh in. Definitely as beauty increases, as we increase microsites that are higher margin products, those helps the margin as well. On the flip side, some of the partnerships sites may be slightly lower margin just based on the types of products that they are selling. If they are not selling Beauty.com. So Tracy, why don’t you add your $0.02 about margin?

Tracy Wright

Sure. It’s difficult to say what the overall margin of the business is going to look like, Mark, because right now as we have talked about, the partnerships could vary in terms of their percentage. What I will do is just break it out into two separate pieces if that helps for you. Our base OTC business and I am just going to focus on OTC margins at the moment, they were about 31.6% in the third quarter, that was actually up 40 basis points year-over-year. But we had our partnership revenue now included in that total OTC number, and the margins for partnership are somewhere between 25% to 30%. So, you can see we will probably continue to make modest improvements in the margin of our base OTC business, because of the higher mix of beauty, because of continued focus on improving the profitability of that segment. But if partnerships become an increasing mix of our overall OTC revenues, we are going to see pressure on that margin just because of the lower gross margin associated with that partnership business.

Mark Argento – Craig-Hallum Capital

The partnership margins a little lower, the type of products that they are buying, or is there a different set of prices on the Medco side?

Tracy Wright

It’s mostly the product. So, they don’t – Beauty.com and some of the higher margins, SexualWellBeing, those kinds of things, which tend to be higher margins. So, it’s the focus in terms of the products that they have in the site.

Mark Argento – Craig-Hallum Capital

Thanks, and good work on the quarter.

Tracy Wright

Thanks Mark.

Dawn Lepore

Thanks Mark.

Operator

(Operator instructions) Our next question comes from the line of Shawn Milne with Janney Montgomery Scott. Please go ahead.

Shawn Milne – Janney Montgomery Scott

Thank you and good afternoon and very good job, tremendous quarter.

Tracy Wright

Thank you, Shawn.

Dawn Lepore

Thanks Shawn.

Shawn Milne – Janney Montgomery Scott

You know, just in terms of the revenue acceleration, I think you actually gave enough components here to, if I do in the math right, it looks like if Medco is really the key partnership, and now it looks like Medco added about $2 million in the top line in the quarter, does that amount make sense?

Dawn Lepore

You know, we are not breaking out Medco from Rite Aid, but certainly you can do your math based on the information that we have given you.

Shawn Milne – Janney Montgomery Scott

Okay, and then given that there was such a reacceleration in the quarter, and my understanding was they were still in the early stages of marketing, can you give us an update on the progress they have made, in terms of building that customer base in the e-mail marketing campaign and how you see that progressing in Q4?

Dawn Lepore

No, we are not commenting specifically on Medco, Shawn. They are – you know, I can tell you, they are very focused on marketing. If you are a Medco member, you are probably seeing some of their marketing and they are doing everything from e-mail to inbox to pop-ups, what you would expect as you are launching a new site. So, we are really pleased with them as a partner. Unfortunately, I just can’t comment specifically on what they are doing, but I would tell you is that we are pleased with the progress. It continues to track as we expected it to track and when we talk about 2010, we will obviously talk about how we are thinking about Medco as a part of that.

Shawn Milne – Janney Montgomery Scott

Okay, great. And it looks like, Tracy, in terms of the guidance, again a nice reacceleration going into the fourth quarter, the comp does get a little bit easier, then you get more kick-in from the partnerships and the core business remains very solid. But as you flow that through down to the EBITDA line, are you being a bit conservative on the EBITDA guidance or there is something there in terms of the incremental EBITDA that you are getting that leads you to believe that the profitability won’t be quite as strong?

Tracy Wright

There’s one primary difference in kind of the EBITDA percentage between Q3 and Q4 and that is that we typically spend a higher percentage on advertising and promo expense, because we are out fishing when the customers are buying product. So, we typically see what we have seen historically is about a one point delta between Q3 and Q4, and advertising and promo expense, that’s the variable portion of our sales and marketing as a percentage of sales. And so, we benefit from that new customer acquisition investment in the first quarter and beyond.

Dawn Lepore

You know, Shawn, it’s Dawn. We have always (inaudible) more in the fourth quarter, I mean prudently so, but we are slightly more promotional and we are also spending marketing dollars, because people are out there shopping and we want to take advantage of that and get those active customers.

Shawn Milne – Janney Montgomery Scott

So, can you characterize the guidance, again, if you take out the partnerships and some of the new growth drivers, if you are assuming the core business, or maybe, ask you this way. Are you assuming that core business grows like it did in the year-over-year – in the third quarter? You are loading your expenses and not really giving yourself much more benefit on the top line in the guidance?

Dawn Lepore

Not quite sure I completely followed your question, but if your question is, is the fourth quarter base business is our guidance assuming a consistent growth rate as the third quarter, that answer is yes. And we have also told, said you that Beauty.com will grow 15% to 20% for the year. So, you have got the growth rate for the first three quarters, so you can calculate that as well.

Shawn Milne – Janney Montgomery Scott

Right. And then just lastly, just to clarify because there was some questions about margin and the new partnership, but clearly, given the fact you are not spending any marketing dollars, the EBITDA margin of this partnership is very profitable.

Dawn Lepore

Yes, I mean, they are good orders and good customers. It’s simply that we are not – those partnerships, especially Medco does not have some of the higher margin categories on it. So, the gross margin will be slightly lower.

Shawn Milne – Janney Montgomery Scott

That’s okay. Keep cutting those kinds of deals and drive your cash flow. Thank you.

Dawn Lepore

That’s our goal. Thank you.

Tracy Wright

Thanks, Shawn.

Operator

Thank you. I assume there are no further questions at this time. I would like to turn it back to Ms. Dawn Lepore. Please continue.

Dawn Lepore

Thank you very much for joining us today. We look forward to keeping you updated on our progress.

Operator

Ladies and gentlemen, this concludes the third quarter 2009 earnings call for drugstore.com. If you like to listen to a replay of today’s conference, please dial 1-800-406-7325 and for international participants 1-303-590-3030 and entering the access code 4166337 followed by the pound sign. The replay will be available until October 24th, 2009. ATT would like to thank you for your participation. You may now disconnect.

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