Checkpoint Systems Management Discusses Q3 2013 Results - Earnings Call Transcript

| About: Checkpoint Systems (CKP)

Checkpoint Systems (NYSE:CKP)

Q3 2013 Earnings Call

November 07, 2013 8:30 am ET


Annette Geraghty

George Babich - Chief Executive Officer, President and Director

Jeffrey O. Richard - Chief Financial Officer and Executive Vice President


Christopher Kapsch - Topeka Capital Markets Inc., Research Division

Jeffrey T. Kessler - Imperial Capital, LLC, Research Division

Christopher McGinnis - Sidoti & Company, LLC


Greetings and welcome to the Checkpoint Systems Third Quarter 2013 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Annette Geraghty, Investor Relations Specialist at Checkpoint Systems. Thank you, you may begin.

Annette Geraghty

Thank you, Donna. Good morning, and welcome to Checkpoint Systems' third quarter 2013 conference call. With me today are George Babich, President and Chief Executive Officer; and Jeff Richard, Executive Vice President and Chief Financial Officer.

Please note that unless otherwise stated, today’s discussion will be on Checkpoint’s continuing operations. Additionally, non-GAAP measures discussed on this call are defined and reconciled with GAAP on statements attached to our earnings release. The release is available on our Investor Relations website.

We remind you that during this call, we may make certain forward-looking statements. These are subject to the forward-looking statement included in today’s earnings release. A replay of this call and written transcript will be made available on our website following the call.

Now I will turn the call over to George.

George Babich

Thank you, Annette. Good morning, and thank you for joining us today. We appreciate you being with us and trust that you got an opportunity to read our third quarter earnings release issued after the market closed last evening. Normally, I'd begin the call with an overview of the third quarter performance. However, I'd like to start the call with what has happened since our last call to cause the reduction in our guidance. I will then go through the third quarter before turning the call over to Jeff to walk through the financials, our plans for additional cost savings and margin enhancement and our revised guidance. We'll then open the call up to questions, and I'll return with a closing statement.

So regarding our downward guidance -- a downward revision in our guidance, I'll begin by saying that no one is more disappointed than me and the entire management team. When I stepped into this role last year, I told you that one of my priorities was to improve our forecast accuracy. I told you that it was one of the 3 pillars of our cultural change was personal accountability. And while I can assure that the entire team is focused on delivering on our commitments, last night's announcement that we are lowering guidance means, by definition, that we failed on one of our most important objectives. Please trust me when I say that no one on this team takes this failure lightly. While there are reasons, there are no excuses.

So the downward revision is attributable to 4 factors, 3 of which I would call external and 1 of which I would call clearly internal. First, retailers lowering their same-store sales expectations. Since August, U.S.-based retailers have lowered same-store sales expectations for the second half of the year by more than 200 basis points. While it's difficult to predict precisely how these changes affect our business, invariably, declines in same-store sales lead to lower demand for our consumer labels, tickets, tags and Alpha products.

Second item are federal government-related issues. The sequester, the government shutdown and delays in resolving budget and debt issues in Washington have resulted in government and defense projects -- defense-related projects previously planned in the fourth quarter being delayed until 2014. This is having a significant impact on our normally steady RFID asset tracking business.

Third, the European economy. The faltering recovery in Europe continues to slow down customers' new store openings and remodeling projects which, in turn, impacts on our consumables RMS business in particular, as well as our EAS business.

Fourth, 4 incorrect management assumptions, 3 of which I'll characterize as impacting gross profit margins. Now the first one is that, clearly, we were overoptimistic on the timing to realize all of the Project LEAN cost of goods sold savings in the ALS business. Second, we underestimated the proportion of lower-margin new systems installations derived from recent market share gains, which will negatively impact EAS systems gross profit. Third, we incurred unexpected startup costs as we grow the RFID business, and these costs will negatively impact Merchandise Visibility gross profit. And fourth, we underestimated the continuation of foreign exchange translation and transaction losses.

We have immediately implemented a series of actions that, over the next year, are intended to improve our forecast accuracy and to recapture this operating income shortfall and keep us on our path to achieving our 2015 goals. The majority of these action plans center around process improvement as well as additional cost reductions.

With respect to those plans, when Jeff joined us at the end of May, I highlighted that his background in Lean Six Sigma is uniquely appropriate to drive the necessary process improvements in our business. He will share with you today his high-level plan for this next cost reduction effort.

So turning to the third quarter results. We are pleased -- while we are pleased with the market share gains that took place in the quarter as a result of new business won throughout the year, we were clearly disappointed with the declining gross profit margins. Several factors led to the decline, and I'll expand on those as we go through each business segment.

First, I'll cover revenue. Third quarter revenue was slightly ahead of expectations and 3.3% above last year. Merchandise Availability Solutions revenue, it's now referred to as MAS, it was formerly referred to as SMS, where -- so Merchandise Availability Solutions revenue was $117.2 million. Core MAS revenue, and that means excluding the Library and Asian CheckView business was $115.6 million, ahead of expectations and 5% ahead of last year. The main drivers were Alpha, where demand from key customers picked up after the second quarter shortfall and the 2 Merchandise Visibility chain-wide rollouts which more than doubled the revenue from last year's third quarter.

Revenue in the EAS systems business faced tough comparisons in the quarter versus last year when we were in the middle of 2 major European rollouts, but revenue was nicely above expectations in the quarter. EAS hard labels, hard tags and hard tag at source businesses were above expectations and in line with prior year.

Strong demand for RFID labels, largely attributed to Apparel Labeling Solutions revenue, beating our expectations and delivering a solid increase year-over-year.

And finally, lower demand from the European retailers led to merchandise -- Retail Merchandising Solutions revenue being not only lower than last year's 3 quarter -- third quarter, but below expectations as well. Uncertainty surrounding meaningful economic recovery in Europe continues to hinder on our plans for this business.

Now turning to gross profit and segment margins. As I mentioned, gross profit was above prior year but significantly below expectations. Core Merchandise Availability Solutions gross profit was below expectations. The shortfall was due largely to a higher mix of lower margin, new EAS systems installations as a result of our recent market share gains where, by the way, the offsetting mix of higher-margin labels business will be realized in 2014 and beyond. MAS gross profit margins were also negatively impacted due to our Merchandise Visibility business where we expect -- excuse me, which were below expectations and where we experienced inefficiencies, unanticipated startup costs and continued investment in pilot programs. Partially offsetting those declines was a notable improvement in the Alpha margins due to higher volumes and manufacturing efficiencies.

Turning to the ALS business. Although overall I'm pleased with the progress against the Lean restructuring initiatives, which drove ALS margins significantly higher than last year's third quarter, margins came in lower than we expected due to program timing.

Finally, RMS gross profit was well below expectations and last year due to pricing pressure, lower volumes and related overhead under absorptions.

Turning to our operating expenses and operating income performance. Our operating expenses were better than expected due to a management incentive compensation accrual adjustment. As a result, pro forma operating income was $14.9 million, $7.5 million above last year's $7.4 million. Excluding the $700,000 negative impact of foreign exchange translation losses, operating income was slightly above our expectations for the third quarter.

Unfortunately, foreign exchange transaction losses drove pro forma earnings per share below expectations, although above last year's third quarter.

At this time, I'll turn the call over to Jeff to go through the financial statements.

Jeffrey O. Richard

Great. Thanks, George. Good morning, everybody. As a reminder, all of my references will relate to the third quarter activity from continuing operations, unless I state otherwise. Continuing operations exclude the results of the U.S.- and Canada-based CheckView business, which was sold on April 29, 2013.

The third quarter revenue was $174.5 million, an increase of $5.7 million or 3.3% year-over-year, increased largely as a result of continuing market share gains and strong sales in the Alpha and RFID business. Year-over-year differences in foreign currency exchange rates accounted for $0.4 million or 0.2% increase in revenues.

Gross profit was $70.3 million, above prior year by $1.6 million. Gross profit margins in the quarter were 40.3% compared with 40.7% last year, which was lower than we had expected. The strong showing from Alpha and the RFID business, together with rigorous expense control throughout the quarter, helped to make up for the margin decline resulting in a $7.5 million increase in non-GAAP operating income year-over-year, which was slightly ahead of our expectations.

Now let me break this down into more detail by segment. But first, let me discuss the change in our segment reporting that began with the third quarter 2013. So while we've historically reported our results of operations in 3 segments: Shrink Management Solutions, Apparel Labeling Solutions and Retail Merchandising Solutions, during the third quarter 2013, we adjusted the product allocation between our SMS and ALS segments, renaming the SMS segment to Merchandise Availability Solutions, and began reporting our segment as Merchandise Availability Solutions, or AMS; Apparel Labeling Solutions, or ALS; and Retail Merchandising Solutions, or RMS.

All of our preoperative amount have been recast to reflect this change. We issued a separate 8-K this morning that details the historic segment income statement information and recast for this change in the reporting.

ALS now includes the results of our RFID label business, which were previously reported in SMS, coupled with our data management platform and network of service bureaus that manage the printing of variable information on our apparel labels and tags. This change aligns us with refined ALS strategy to be a leading supplier of apparel label solutions with expertise in intelligent apparel labels for item level tracking and loss prevention.

Now our AMS segment, which is focused on loss prevention and merchandise visibility, includes electronic article surveillance or EAS system, EAS consumables, Alpha, high theft solutions, RFID systems and software in non-U.S.- and Canada-based CheckView. There were no changes in the RMS segment, which includes the handheld labeling and retail display systems.

So now let's move to talk about the segment results. So Merchandise Availability Solutions revenue increased 3.1% to $117.2 million despite declines in the EAS systems when compared with last year's third quarter, when we benefited sizably from deployments in the U.S. and Europe. This was more than offset by our increases in Alpha and Merchandise Visibility business, 21.9% and 125.7%, respectively.

Alpha revenue increased in the third quarter of 2013 as compared to the third quarter of 2012 primarily due to increased sales in the U.S. resulting from strong demand from key customers after a shortfall in the second quarter 2013.

Merchandise Visibility revenues increased in third quarter of 2013 as compared to the third quarter of 2012 primarily due to a substantial rollout with RFID-enabled technology in the U.S. and a smaller-scale rollout in Europe. We expect RFID revenues to continue on their forecasted path for strong growth as a result of the conversion of certain current pilots into installation contracts, and the expansion of certain installation contracts into additional stores. Some of the anticipated RFID growth for the remainder of 2013 will be delayed to early 2014.

Gross profit margin for the segment declined from 46.1% in 2012 third quarter to 44.1%. We incurred extra cost during the quarter in connection with growing our MV business. In addition, EAS systems continue to be pressured by a greater-than-expected mix of lower-margin new installation. Offsetting these margin declines, the Alpha margins increased due to higher volumes and favorable manufacturing variances.

Now to ALS. Apparel Label Solutions revenue increased 6.7% to $45.5 million. Strong demand for RFID labels fueled the increase, more than offsetting the loss of revenue resulting from exiting our Sri Lanka business. Gross profit margin for the segment increased from 24.3% in 2012 third quarter to 32.4%.

Due to Project LEAN, we are continuing to see the positive gross margin impacts, most notably from the business rationalization, improved efficiencies in inventory management. While these represent a sizable uptick, we fully expect further margin improvement once the full scope of our restructuring program is complete.

Now to our RMS. Retail Merchandising Solutions revenues decreased 5.8% to $11.8 million, and resulted lower volumes caused margins to decrease from 46.9% in 2012 third quarter to 32.2%. The decline in revenues is due to the slow economic recovery in Europe, causing our customers in this business to postpone their plans for new store openings or refurbishments. This inevitably impacts our overall business. The margin reduction is attributed to overhead under absorption and increased inventory costs related to volume reductions and increasing competition impacting average selling prices.

On the SG&A expenses. Expenses for the third quarter decreased 10.4% for $56.9 million in 2012 to $51 million, reflecting further progress in our enhanced global restructuring programs and reductions also in the performance incentive compensation, as well as less amortization expense in 2013 due to a fully amortized intangible asset. Foreign currency translation increased SG&A expenses by approximately $0.4 million. Offsetting these savings were increases in long-term incentive compensation, increased business development and marketing efforts and external legal and tax services.

Now I'm going to provide an update on our restructuring program. We expect that the Expanded Global Restructuring Plan will generate approximately $102 million in savings in cost of goods sold and SG&A expense when the plans are fully implemented by the end of the first quarter of 2014. These restructuring initiatives lowered costs in the third quarter by an additional $10 million when compared with reductions achieved through the third quarter of 2012 with $6.9 million of that attributed to SG&A cost reduction actions. To date, $88 million of the cost reductions have been realized, of which $62.4 million reduced SG&A expenses.

Restructuring expenses in the third quarter were $0.9 million. To date, the Expanded Global Restructuring Plan has recorded $70.5 million in expense including $46.7 million in severance and other employee related charges, $8.8 million in other restructuring costs, as well as $15 million in non-cash asset impairments associated with facilities rationalization and closures.

These programs will impact approximately 2,500 positions with 2,495 positions eliminated through the end of the third quarter. While we are firmly committed to achieving the overall savings targets, the Expanded Global Restructuring Plan has a wide ranging scope in which some details may change as we continue to execute specific programs. Delivering the $102 million in savings is expected to cost between $71 million and $73 million.

Turning to GAAP income taxes, the effective tax rate for the third quarter of 2013 was 26.8% as compared to a negative 577.2% for the third quarter of 2012.

The third quarter of 2013 effective tax rate was impacted by the mix of income among subsidiaries. The effective tax rate for the third quarter of 2012 was negative as we had losses in countries with valuation allowances that did not result in tax benefit. The third quarter of 2012 effective tax rate also included the impact of mix of income among subsidiaries and goodwill impairment charges that did not receive an income tax benefit.

Now regarding EPS. Non-GAAP diluted earnings per share for the third quarter of 2013 was $0.22 versus a loss of $0.01 in the same period in 2012. Foreign currency transaction and revaluation losses for the third quarter of 2013 were $1.1 million, reducing our EPS by approximately $0.03 in the quarter. This unfavorable variance is primarily attributed to U.S. dollar and euro inter-period currency fluctuations versus currencies in our operations in several emerging markets where central banks prohibit participation in our intercompany netting system, and where it is either impossible or cost-prohibitive to effectively hedge certain of our foreign exchange exposures. Where hedging is possible and the cost is practical, our practice is to hedge at least 75% of our net exposure.

Now moving on to cash flow and our debt. Cash flow used in operations was $21 million -- $21.2 million in the quarter compared with $10.6 million provided by operations in the third quarter of 2012. Capital expenditures in the third quarter were $2.6 million. Free cash flow in the third quarter of 2013 was negative $23.8 million compared to $8.6 million in the third quarter of 2012.

We repaid $7 million in debt during the third quarter, total debt at the quarter-end was $89.2 million compared to $113.3 million as of December 30, 2012. Due to the July 2014 pending maturity of our revolving credit facility, we've reclassified this debt to short-term on our balance sheet during the third quarter of 2013. We are currently in refinancing discussions with a group of both existing and new lenders.

We finished the third quarter well within our original financial covenant ratios. We expect to remain in compliance with the original debt covenants next quarter.

Following 2 consecutive quarters of compliance with these original covenants, we revert back to the original terms of the debt agreements. This will release restrictions on our permitted borrowings and provide us with a lower cost of borrowing.

Now let's talk about additional cost savings and margin improvement projects. During the third quarter, I toured manufacturing sites in Asia, Europe and North America and in the course of these visits, met with many of our operations and finance leaders. The information they shared has been very useful in helping me frame up additional cost savings and margin improvement opportunities. At this time, there are several likely areas to target including supply chain optimization, our facilities' footprint, additional manufacturing enhancements, various corporate activities and audit tax and other general administrative expenses. We expect these initiatives to generate $10 million to $15 million of savings by the end of 2014 with an annualized benefit of $15 million to $20 million. This will be in addition to the $102 million in savings from the global restructuring plan, which we expect to realize by the end of Q1 2014.

Now to 2013 guidance. As highlighted in our earnings release, we are lowering our guidance for 2013 as a result of several factors. Those impacting revenue include delays in federal government-related projects, a lowering of the U.S. retail or same-store sales, and the slow uncertain recovery in most of our European countries which we do business. These factors will also affect margins as we will -- as will the higher mix of lower-margin systems installation and delay in realizing the full benefit from restructuring in the ALS.

Our revised guidance assumes current market conditions, current customers' orders and commitments and the continuation of current FX rates. The net revenues are expected to be in the range of $680 million to $695 million. Prior guidance was a range of $685 million to $700 million. Gross profit margins are expected in the range of 39.0% to 39.7%. Prior guidance was in the range of 40.9% to 41.6%. Operating expenses are expected to be in the range of $232 million to $237 million. Prior guidance was in the range of $233 million to $239 million. Non-GAAP operating income is expected to be $33 million to $39 million. Prior guidance was in the range of $47 million to $52 million. Full year non-GAAP effective tax rate is expected to be approximately 26% to 28%, which is unchanged from prior guidance. Non-GAAP diluted net earnings per share attributed to Checkpoint Systems are expected to be in the range of $0.40 to $0.50. Prior guidance was in the range of $0.65 to $0.75.

Given the significant working capital investments that were made in the third quarter of 2013, and that will continue to be made in order to support the significant upcoming market share gains, we are withdrawing free cash flow guidance. Prior guidance was $50 million to $60 million.

Adjusted EBITDA is expected to be in the range of $66 million to $73 million. Now this is the first time that we are providing adjusted EBITDA guidance. We believe this is the most effective and commonly used metric to measure our performance and valuations. We will report this non-GAAP metric every quarter going forward.

Now I'll turn the call back over to George.

George Babich

Okay. Thanks, Jeff. At this time, I'll turn the call back to the operator and -- to open the call up to questions, and once we finish with the Q&A, I'll return for a brief closing remarks.

With that, Donna?

Question-and-Answer Session


[Operator Instructions] Our first question is coming from Chris Kapsch of Topeka Capital Markets.

Christopher Kapsch - Topeka Capital Markets Inc., Research Division

A couple of questions. Just one, focus on the margins in the new MAS segment as reported. I think you mentioned sort of a rebound in Alpha sales which, along with their margins, sort of bolstered gross margins or should have bolstered gross margins. But the less-than-expected margins in that business sounds attributable to unexpected costs associated with systems rollouts. In the last sort of -- the first half of this year and even the latter part of last year, you had a number of EAS installs which, presumably, are a prelude to higher-margin consumable sales, but it doesn't look like that's flowing through. So I'm just wondering if after -- do you expect after some stabilization of some of these costs associated with system rollouts that the margin benefit from those higher-margin consumables will flow through as expected? And when would we expect to see that sort of margin profile emerge?

George Babich

Okay. Chris, this is George. So you're absolutely right. We did have some big wins, 2 in Europe, Tesco, and then a 1,100-plus hard discount retailer where we did systems installations late last year and into this year. And as you know, and as you just alluded to, that means, usually, that we record the lower-margin system installation at the front end with the labels coming at the back end. Now on top of that, what happened in the quarter was that we continued to install more stores with those 2 European customers than we had anticipated and that put pressure on our systems margins. The labels piece of it does follow with these contracts that we have and the benefits do flow through in our labels business. EAS labels business is up nicely this year, forecasted to be up mid single-digits with somewhere in maybe the 500 basis points improvement in margins. So we're beginning to see that happen. So in the third quarter, that's kind of what has taken place in the systems area. And then the same thing is repeating itself in the fourth quarter, it's actually accelerating a little bit because this Family Dollar contract is a massive rollout for us. We will have, out of their 8,000 stores, 2,300 of them installed by the end of the year. And so, heavy pressure on margins and on the balance installed by the end of 2014. But we will begin to see the labels rolling through as well. So in 2014, you'll be getting the benefit of that and, clearly, into 2015 and beyond, that will be the heaviest mix of that long-term relationship that we have with them. So there is that lag. As you've spoken, as we gain market share, which is a good thing, but unfortunately in the short run, we feel this pressure and we did not completely understand the impact for Q3, and we have adjusted Q4 accordingly to reflect that. So that's the MAS systems piece. The other piece of the MAS margins that we mentioned that didn't go as expected has to do with our Merchandise Visibility business. That business, as you know, we more than doubled despite the fact that we lost a substantial asset tracking business with 3 different government-related customers that's been postponed or delayed to 2014. So we've been able to make up for that shortfall in the revenue. Unfortunately though, with lower margin RFID labels and the RFID labels business was a huge success for us. This year, we will produce more than 5x this year that what we produce in the history of this company. So we were ramping up rapidly. We didn't expect it when the contract was signed in May or June and when we built the forecast in June and July that we would have these RFID labels. So we were scrambling to put printers in, in the 4 or 5 different plants on 3 different continents around the world to be able to deliver these labels. And they're not all the same type of label. With 1 customer, it's a pocket tag, so there's particularly difficult technical issues with ink and fabrics and that sort of thing, and we've delivered -- we had some issues, but we were able to recover and satisfy the customer and delivered a massive amount of those. And with our other customer, which we announced last night in the U.S., that was a completely different type of RFID label that required a whole different set of technical capabilities. And in that business, we did not expect to have anywhere near the volume that we ended up getting and were able to produce in Q3 for the tag up of the stores, the tag up of the DCs and to get labels into their systems. So along with it came some inefficiencies, some costs that we didn't expect and hadn't put into our previous forecast for Q3. It caused additional margin pressure in MAS as well. So those are the 2 big factors, both of them stemming from market share gains, and we just need to do a better job of anticipating what could happen and making it certain that our forecasting reflects it.

Christopher Kapsch - Topeka Capital Markets Inc., Research Division

George, just on the notion that you got some market share gains, you got some nice project installs. And then you'd -- it sounds like you sort of effectively had to scramble in order to satisfy the timelines associated with those projects and the customers' expectations. Two things. One, when do you expect these costs, these sort of extra burdensome costs to sort of settle out? And two, were you able to accomplish the install to the satisfaction of your customers in terms of them meeting their deadlines and expectations in terms of the rollouts?

George Babich

Yes. Well, as I've said, I told you and others many times, we have 3 pillars to the cultural change. One is innovation leaders in the market. Two is provide the best customer service out there -- it's an absolute paramount priority of ours. And then, of course, personal accountability, which we talked about -- I've talked about earlier. But on the customer front, we did everything to meet their requirements. We installed more than 1,100 stores in 100 days with RFID and provided all of these RFID labels to them in that timeframe because they had a hard stop prior to their holiday selling season, in getting their stores ready. So that, we incurred additional field service costs, installation costs and also pressure, what we call systems margins. I think, as you know, our "EAS system-ing" is both the hardware that we sell and the cost -- the revenue and costs associated with installing that hardware. So in order to meet that demand and not let our customer down, we incurred many more costs than we expected. But we did accomplish it despite the expectation for much lower label revenue tags. I think their initial -- what we initially went in thinking we're going to produce in the way of tags increased by, I believe, fivefold throughout the quarter, and we had to satisfy the customer. So the customer is very pleased with how that whole thing took place. And it's some of the startup costs associated with a new business, some of the costs associated with rapidly ramping up for the customer and it hurt us in the quarter. Now fortunately, we're able to offset it with operating expense reductions and still deliver operating income in the quarter ahead of our expectations, but our margins suffered in the quarter. And I believe because of the massive rollout is done for that project, I believe these startup costs are behind us, some of the inventory issues that we resolved are behind us -- or that we incurred are behind us. And yes, so, I think we will return to a more normalized level going forward. The question for this business, called MV overall, is when does the significant amount of asset tracking business get back into the pipeline because it's a very high margin business for us relative to the RFID tags. So we're doing very well, much better than expected on tags but -- driving our revenue, but it has -- puts pressure on our margins.

Christopher Kapsch - Topeka Capital Markets Inc., Research Division

Okay. Could I -- just a quick couple of thoughts for Jeff. One, like your revised guidance, Jeff, you're coming at, say, the low end of that revised EBITDA guidance range, which you just -- I guess, it's not really revised, I guess you established adjusted EBITDA guidance for the first time. But if you come at the low-end of that, would you still be in compliance with the legacy covenants? And when, assuming you are, when would you get the benefits from reverting to the prior interest expense?

Jeffrey O. Richard

Yes. No, we'd be fine. We're -- we came out of the covenant this quarter. We'll be fine next quarter. If you could think about it, the thing that's hurting us on that is just the legacy restructuring costs that we couldn't carve out of the calculation for the bank deal. So as those drop off, I mean, we'll be well under the covenants, so fourth quarter will not be an issue at all. So we'll revert back to taking the handcuffs off and getting better rates. That assumes if we -- that's assuming we haven't landed a new bank deal at the time, which we're working on right now.

Christopher Kapsch - Topeka Capital Markets Inc., Research Division

Got you. Then George's final -- one of his last comments was showing that you have this inventory issue behind. But the snapshot of the balance sheet, obviously, or the cash flow as of at the end of the third quarter, big investment in working capital inventory. So I'm just wondering if you say you have that issue behind, is that to suggest that there was a big build in inventory that's already sort of reconciled itself thus far into the fourth quarter or you have good enough visibility into demand that's going to chew through that inventory? I'm just trying to get more comfortable with the sudden drawdown in cash flow because of the inventory spike, if you will, throughout the third quarter.

George Babich

Yes. 2 different issues. One, the inventory-related issues that we experienced with the RFID rollout is what I'm referring to that are behind us. The inventory build that you see on the balance sheet is related primarily to the Family Dollar rollout. As I said, we'll have -- we're going to do, between now and the end of the year, 1,300 more stores and then we'll do the balance of the 8,000 stores. And we've done 1,000, up in 2,000 at this point. So we're 2,300 by the end of the year. But we're building inventory so that next year going into the -- beginning in the first quarter, which is very unusual for us actually, we'll be releasing a lot of inventory for those installs systems as well as for labels. In fact, we're running at -- we're running all-out on labels right now. We are at maximum capacity. We'll set a record in the fourth quarter at over 1 billion labels being produced in the fourth quarter. And in fact, not be able to deliver everything that's been ordered, another good problem, if you will. We're also going to set a record on hard tags that we're producing. So we're building inventory for these market share gains and they'll be released to all current and good inventory. I'd say one area that we're keeping our eye on is -- we placed bets on Alpha inventories because of long supply chain and -- but it's not a significant amount. What you see on the balance is related to these market share gains.

Jeffrey O. Richard

Yes. And I'll add, too. So when I look at free cash flow for the quarter, we obviously have done a lot of digging the big chunks; our inventory, and then you see the AR as well on this cash flow statement moving from Q2 to Q3. And when you dig down in the inventory, the question is, is that all good inventory? Is there a problem in that inventory number? And you look at our turns, there's always improvement, there will be more improvement. But year-over-year, the turns have gone from, I think, it was -- last year, it was 116 and now it's 97. You look at the aging of that inventory, it's just -- it's what George said, we have cranked up our plants, full capacity. And we did take a little bet on Family Dollar and built ahead of time because, as you know, one of the things kind of that bothered me since I've been here is we spend a lot on airfreight. And we just didn't want to airfreight a bunch of stuff in to get this Family Dollar rolling. So as a management team, we held hands and said, "Let's start building ahead of time." And that has paid off. So we haven't eliminated airfreight totally, but boy, it's a lot less than what it could have been or what it -- yes, it could have been. So the inventory will bleed out. What you see -- and normally, this time of year it grows anyway, it's a cyclical business and you would see a drop-down into Q1 and you'll see a drop -- I would caution to say that because of -- it's not like we're completing the Family Dollar in the fourth quarter, we're going to continue, as George said, throughout the year. So the drop probably won't be as low as it had been in the past just because these 2 big deals that we've just announced will continue. I mean, our plans will continue to be full out throughout Q1. And on AR side, I'd say, digging down into that in detail, again, it's like the snake swallowing the mouse, a big chunk of the increase is in current. So our aging is actually better than it has been. It's been getting better. We've been doing a lot of work there in process improvement. We're getting better. Our days outstanding year-over-year, they're 83 now, they were 97 last year. So when I look at overdue AR, it's better. So it's all sitting in current, we just need to convert it to cash, continue to do a good job of collecting. And so, that's just a temporary blip there as well. But good questions because that's, obviously, one of the things that I would ask.


Our next question is coming from Jeff Kessler of Imperial Capital.

Jeffrey T. Kessler - Imperial Capital, LLC, Research Division

I want to follow up on the cash flow question because I do think it is -- it's one of the big investment drivers in the stock. With regard to what you would consider to be a normalized level of working capital relative to revenue, realizing that you're going to still have inflows from the current contracts and, hopefully, you'll get more contracts. Is there a point in 2014 at which you believe you can begin to, let's say, annualize the cash flow numbers so that we can be -- you can start giving out not just projections on where cash flow was going to be in the next quarter or 2, but give us some idea of comfort on where 2015 is going to come out? I mean, do you see a point at which the systems that you're putting on and the inventory and working capital you're putting on begin to come into balance with the revenues and the recurring revenues that you're getting out of what you're investing into now?

George Babich

Well, I guess if I understand the question right -- this is George, and maybe Jeff and I can both chime in on this. This is a really big contract. This is the biggest contract on the history of the company that we signed with Family Dollar. So if my biggest problem is that we signed an even bigger one, I'm okay with that. But to your point, they don't come along everyday. So this is kind of unusual situation on the inventory build. And on the receivable side, it really was a very strong -- it was September that drove our receivables so high. And so, I think there's 2 different issues on the cash. One is that this inventory thing will slowly bleed down. We're going to collect a lot of cash in Q1 in particular. So we'll be sitting on a lot more cash at that point in time as we collect these receivables. So there is going to be a normalization. The receivables issue is an internal process issue that is on the balance sheet at the point in time, at the end of the quarter, because the billing primarily takes place at the end of the last week or 2 of each quarter. And it's something that we need to spread out. And that's something Jeff's going to be working on so that it -- that we're collecting it on a more regular basis. But when we look at -- kind of when we look at, because of these big builds and their big projects, it's lumpy in the business, it's really hard, Jeff, to give you a good answer, but I can -- on how it normalizes. But we do kind of look at the metrics and make sure that we're -- like Jeff said, we're getting better on our receivables, days of sales outstanding, and our inventory turns, okay? And if we're good there, we keep moving that in the right direction, then that means we've got -- we've tied up this cash in a healthy way on the balance sheet. So we're starting to look at our cash flow as more of an EBITDA less CapEx. And we're -- the EBITDA through the first 3 quarters of this year is $45 million. Last year, it was $24 million, so up about 90%. CapEx is about the same for the year. We expect to be up substantially over last year. CapEx will only be $12 million. We're looking at it that way but to ensure that we're continuing to generate operating cash flow and manage our CapEx and then manage those metrics on the balance sheet. So hopefully, that gives you an idea of the challenge that we faced because we have these customers in the pipeline and, like what happened with the RFID rollout in the third quarter, it just was well beyond what we expected in the third quarter and -- or Family Dollar -- they're just very lumpy. And I've talked to you guys about this before, sometimes we missed quarters in a positive way, sometimes we missed some in a negative way, I'll always try to be transparent. I've said this, every time I've spoken with you or investors, that it's very difficult for us to give guidance, especially quarterly guidance. And I'll just -- we'll be transparent about what's going well and what's not, but the long-term view is what we're staying focused on.

Jeffrey T. Kessler - Imperial Capital, LLC, Research Division

Okay, great. Look, you have 2 or 3 new systems out there in terms of antenna systems. Are you able to -- are you being asked to put in uniform systems at the stores? Or is there -- how much customization is going on? Are you being asked to put in some stand-up systems, some up -- some in the floor systems? I mean, is this -- is the lack of uniformity, I should say, creating some inefficiencies in your installation process?

George Babich

No, I don't think it is. We -- for the most part, you think of Family Dollar, it's a pretty standard set. They are plug-and-play capabilities. If they want to add different capabilities, we just open up the side and plug it in, that's not an issue. We are -- with different verticals moving more towards the new, we think industry-leading in-floor antenna and the industry-leading overhead antenna, but completely different verticals, and when we do get those customers, it is usually the same system that's put in within that chain, within that vertical. So now it does change by chain and vertical, but within the -- it's usually the same.

Jeffrey T. Kessler - Imperial Capital, LLC, Research Division

Okay. Could you explain a little bit about the U.S. federal asset tracking projects that you're involved with? If you're able to, give us some details on what those projects are, the size of them or at least the nature of them.

George Babich

Yes. When we acquired the OAT software suite back in, I think, '08, that's what the business they were in, and our engineers were able to take that technology of asset tracking of major components for the aerospace industry, of the defense industry for -- we announced, if you recall, the asset tracking contract with the VA, to track medical devices within the hospitals, we took that software and then eventually, got it -- developed it into the item level software that's used in retail today. So it's our legacy business, usually a Steady Eddy legacy business. We -- there were just issues that we did not -- we were not made aware of until into October, middle of October, related to the sequester, the shutdown or the uncertainty, whatever. And 3 major projects more than 10% or 15% of the revenue for the entire business was delayed into next year. And we - as I said, it's a good margin business, it's certainly better than the consumable RFID label business, we were able to recapture some of the lost revenue but on a lower margin. We think because it's legacy contracts, we think that once things are resolved in Washington, we believe that those projects will be restarted, and hopefully that's in 2014.

Jeffrey T. Kessler - Imperial Capital, LLC, Research Division

Okay. And one final question, that is, do you think any of your margin pressure with regard to volume in Europe or whatever or other margin pressure aside from the installation, of the large installations you're talking about is due to, what we'll call, defensive measures from your competitors to either from pricing or from the presentations they're making to customers to try to -- that effectively take the price, the overall cost of installation, up for you on projects that you have won? In other words, has -- have any defensive measures cost you margin points in Europe or in United States on new installations?

George Babich

I would say on -- there's always that battle, okay, with -- when we did a swap-out of Tesco from the AM technology to ours, certainly, it had to be attractive to them especially. In the beginning, when we did the swap-out of Family Dollar, 8,000 stores from AM to our RF technology, that -- there's always -- retailers are notorious for driving prices down. It's a mature market. We are at the point now of trying to increase market share and that always comes at a cost, so there is a continuing, long-term price pressure in this business. And one of the reasons why Jeff joined us is because of his focus on process improvement so that we can -- in the past, we've been able to offset that price pressure with massive restructurings and consolidation of manufacturing from the Caribbean into Asia, big projects like that. We're now down to get -- we need to get more sophisticated to continue to drive cost out, to continue to combat this -- the pricing pressure, the mature market, very competitive markets. So that is absolutely a piece of it. We -- and in our R&D efforts, we're always taking cost out of our systems, et cetera. But I'd say, to gain market share, there's always that pricing pressure. Now I will tell you that we have a very rigorous, for lack of a better term, discounted cash flow model to make sure that while we might be getting lower margins in the beginning with the systems that by the time we realize all of the labels business, that we have a substantial return on investment for these -- it's appropriate for our shareholders.

Jeffrey O. Richard

Yes. I'd add, Jeff, on that. As you and I have talked, I mean the -- a big part of my focus, one of the big Lean projects, Six Sigma projects that we have stood up now. We've been working on it for 3 months. Thus far, it's really bringing a deeper view of profitability into the business both by product line, by customer that has been hard to see, if not able to see, in the past. And part of this, once you start learning about profitability of things, you can really start making different decisions. And so we're also, as part of that project, looking at just our -- the process of value-based selling, customer segmentation, look -- we're kind of relooking at our price model, that kind of thing, to fine-tune and get better mix, bring all of that in the back [ph] when we're sitting in front of a potential business. And I think that's going to pay off for us as well. So I think that's something to look forward to. We're not finished with that project yet, but we will.

George Babich

Jeff, before -- I'll make one last comment before we take one more call and then we can catch up with you later. So I think it's important, as we said earlier, our systems margins are down. A lot of it was -- there's field services installations that rapidly deploy what we did with this RFID business here in the U.S. But as I said, our labels margins are up, that's a combination of some price pressure with a lot of cost savings and, to Jeff's point, mix management. They're up year-over-year about 500 basis points. And our Alpha margins are up and revenues are up, same thing, mix. And now we're focused on cost reductions. Where we got hurt in margins beside systems, obviously, in MV where I talked about the inefficiencies of the rapid rollout, also in ALS where we didn't realize all of the Lean cost-savings initiatives but that's a delay, we just took on so many projects there. So that's a delay. We believe that there is still fairly substantial margin improvement that we'll experience next year in ALS as we finish those projects. And then, of course, there's no doubt about it that RMS business is under pressure, pricing pressure in that tough European economy that we deal in with a low value technology, if you will. So hopefully that gives you -- that answers your questions. And if I could, we can catch up with you later. I want to take one more call.


Our last question today is coming from Chris McGinnis of Sidoti & Company.

Christopher McGinnis - Sidoti & Company, LLC

I guess 2 questions. I know the call is running late obviously. But one, just on the consumables side of the business. You did talk about some pricing pressure. Is that due to the influx of the RFID tags into the system?

George Babich

Well, in our overall margins, yes. Because that RFID tag clearly is a lower margin product for us where we -- it's a generic technology. We don't add substantial value other the variable data printing that we do on top of the tag, unlike our EAS labels business where we have value-added products that differentiates us on the marketplace. So we're growing the labels for EAS, we're growing that business, and expanding those margins. But we're growing so fast in ALS right now with the RFID tags, which are lower margin, but that unfavorable mix of that lower margin product is weighing on our margins in the quarter, in particular, okay. But -- and I think it'll -- even with that, we expect more margin expansion in both EAS labels and, in particular, in ALS tickets and tags, including the RFID piece, as we move into 2014. Third quarter this year was especially difficult because we just had a massive influx that we didn't expect of the lower margin RFID tags.

Christopher McGinnis - Sidoti & Company, LLC

All right. So there's no deterioration in the pricing on EAS side of moveable [ph] business?

George Babich

No, I said there is always pricing pressure there, but we've been able to offset it through mix, bringing in new tags that come in with a higher value-add and with a higher price, as well as cost reductions, real, real strong cost reduction initiatives. But there is ASP pressure in our EAS labels business. Despite that, we've been able to increase the margins handsomely.

Christopher McGinnis - Sidoti & Company, LLC

Sure. And then, just really 2 quick questions. One, just on the delays on the RFID, is that just government-related or is there also on the retail side?

George Babich

The retail side has been a home run this year. Absolute home run. We -- as I've said, we've been able to double the RFID business without the government business. So we've been pleasantly surprised on the topline -- a little unfavorable mix. But no delay, no unpleasant surprises in the retail RFID business.

Christopher McGinnis - Sidoti & Company, LLC

And then just, Jeff, just quickly on CapEx spending. I know that due to the debt agreement, there's a -- just on CapEx, it's limited. Can you just maybe walk us through maintenance CapEx, what the company needs under your -- in your view and then maybe growth opportunities? And does that grow once the $20 million restriction goes away?

Jeffrey O. Richard

Yes, good question. Yes, this business is unique in that it's just not a big CapEx business. I think the maintenance CapEx is probably $10 million to $12 million. We'll probably hit roughly that this year. So we're not really -- we're not constrained by the bank on the spending. So we're not saving up a bunch of CapEx and blow it out next year. It's -- and that's why we're looking -- when you look at EBITDA minus CapEx, it's -- that makes a lot of sense for this business, the way -- the way I look at businesses, and that's part of the reason why we're starting to focus on EBITDA here and will in the future. But yes -- but so, yes, not a lot of things going on in CapEx.

George Babich

Chris, I'd add that we had to add a significant number of printers like, as I said, on 3 continents to ramp up, to increase our RFID label production by fivefold, and that's included within this year's CapEx. We've also included within this year's CapEx expectations and investment in a new etching plant in China for our EAS labels business, so there is a -- so we kind of consider that just normal maintenance, but this is kind of a normal level. We have not put any constraints on CapEx this year whatsoever. Where we need it, where it can help us, the efficiencies or volume, revenue or whatever, we're spending it .


I will now turn the floor back over to management for any additional or closing comments.

George Babich

Okay. Thanks, Donna. This is George. In closing, I want to assure everyone on the call that we remain laser-focused on the long-term view by gaining share in the EAS systems market, continuing to grow our EAS labels business and our Alpha high test solutions business and capitalizing on the emergence of the RFID market with our MV solutions. We were very pleased to have been selected by Family Dollar to partner with them to provide Merchandise Availability Solutions throughout their chain. By providing -- or excuse me, by replacing their current AM technology with our RF technology for their EAS, Anti-Theft solution, Family Dollar will improve theft protection and more accurate -- and realize more accurate detection systems and, at the same time, lower their overall EAS operating cost. In addition, they'll have access to several other technologies with our systems, including people-counting, remote diagnostics, metal detection to prevent organized retail crime to name a few. We look forward to expanding that relationship by providing our industry-leading source tagging capability and our Alpha solutions to further protect and improve protection inventory accuracy and profitability. And as I've said earlier, this will be the largest deployment in North American checkpoints history and it'll be one the fastest ones ever, so we're really excited about that. In addition, as we announced yesterday, since August, we did complete the deployment of our RFID solutions in all of more than 1,000 retail stores of a leading North American retail chain. The retailer selected us based upon many criteria, including our performance during a pilot on a significant number of stores over the past 18 months to 2 years, and our capability to scale up deployments of hundreds of stores per week. Our software architecture and licensed technology also minimize the risk of RFID patent licensing litigation, which enabled the retailer to achieve a rapid return on investment. Both parties are very pleased with this deployment. And because the retailer views this RFID implementation as a competitive advantage, it's asked -- it's chosen to remain anonymous at this time, and we respect those wishes. Turning to 2014, we expect that we'll launch a number of new products, as we always do. We have now, I believe, a stronger pipeline, some of it potential game-changing in each of our core businesses, and several of these solutions will be commercialized next year. I'm delighted with the progress that's being made in the R&D group this year. Checkpoint has historically been and should always strive to be a leading innovator within its core markets. We will also continue to strive to be the best customer advocate in our markets by providing the best possible customer service available. As I've said many times before, because we depend on large projects for large retailers in a highly cyclical market, in which most of our customers and our revenues come in the third and fourth quarters of the year, we'll always be challenged to deliver predictable quarterly results. However, along the way, quarter by quarter, we will be transparent with you on the timing of projects unexpectedly, either positively or negatively, impacts us on a given quarter or even a year. And importantly, as Jeff said, we remain to committed -- we remain committed to improving our forecast and full year guidance accuracy. As I've said earlier, we remain committed to recapturing the 2013 operating income shortfall in order to stay on track with our 2015 goals of improved profitability, free cash flow and a stronger balance sheet. And given the current market conditions, we expect next year to be relatively low growth with improved gross profit margins across the businesses, lower SG&A and interest expense driving our profit growth. We're currently in the middle of a budget process and we'll update you further on 2014 in our fourth quarter call. As always, I'd like to thank all of my checkpoint colleagues worldwide for their continued efforts this past quarter as we continue to create the new Checkpoint. Thank you, and have a great day.


Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may disconnect your lines at this time, and have a wonderful day.

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