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Zep, Inc. (NYSE:ZEP)

F2Q10 Earnings Call

April 8, 2010 9:00 am ET

Executives

Jill Gilmer – Assistant Corporate Secretary

John K. Morgan – Chairman, President, Chief Executive Officer

Mark R. Bachmann – Executive Vice President, Chief Financial Officer

Analysts

Matthew McCall - BB&T Capital Markets

Peter Cozzone - KeyBanc Capital Markets

Zahid Siddique - Gabelli and Company

Liam Burke - Janney Montgomery Scott LLC

Robert Felice - J. Goldman & Company

Operator

Good morning and welcome to the Zep, Inc.’s conference call. (Operator Instructions) Now I would like to introduce Jill Gilmer, Assistant Corporate Secretary. You may begin.

Jill Gilmer

Good morning and thank you for joining Zep Inc. today for our second quarter 2010 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 fact 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 statement 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 K. Morgan

Thank you, Jill. Good morning everyone. I’d like to welcome you to our second quarter 2010 earnings call. I’ll begin by commenting on our second quarter results as well as the highlights of our strategic growth initiatives, and will then ask Mark to provide a detailed overview of our financials. After Mark’s comments we will open the call for questions.

Despite the challenging macroeconomic environment, our results during the second quarter showed significant improvement when compared to the prior year. Most notably, we continue to make progress with our cost containment initiatives, long-term growth strategy and efforts to integrate Amrep. Although the economy continued to impact our customers and their demand for our products, we recorded $2 million in net income adjusted for acquisition related charges, or $0.09 per share during the quarter. These results represent a $2.3 million increase over the adjusted net income for the second quarter of fiscal 2009. Our results reflect the benefit from operating initiatives we implemented last year to reduce costs and improve productivity. Furthermore, revenues for the quarter were $127 million, representing an 11% increase over the year ago period. As a reminder, the second quarter is typically our weakest period, primarily due to the reduced number of selling days.

Overall, we were pleased with the year-over-year improvements in net income and the progress we’ve made with our strategic growth initiatives, despite the very difficult economic conditions. These improvements are a direct result of our recent cost containment efforts and efficient capital management strategies. First, our cost containment initiatives have served to drive our year-over-year earnings growth despite reduced sales volumes from the core business. And second, our financial discipline over the last two years has afforded us a very healthy balance sheet, which provided the necessary flexibility to acquire Amrep, which has already begun positively contributing to our results. Importantly, we produced these results without adversely impacting our long-term strategic growth plan as we’ve continued at the same pace to make key investments in the Zep professional product line as well as additions to our sales force and numerous investments to the marketing and our technical platforms.

In general, I believe our associates have done an excellent job of balance our short term initiatives which are managing costs and maintaining focus on the balance sheet strength, and allowing us to leverage operating profits to fund investments in the business that we believe are important to the long-term value of Zep, Inc. It is our intent to manage the business in this balanced fashion going forward. This includes managing expenses in a way that assumes we will not see near term economic recovery while also utilizing the strength of our cash flow to continue investing for the long-term.

And to briefly comment on the current economic landscape and its impact on Zep, while the rate of economic decline has slowed and in many verticals has stabilized, visibility regarding future improvements still remains limited. Needless to say, the performance of many of our end markets has remained a little softer than we would have liked. While we did see sequential improvement in certain end markets we serve, most major end markets relevant to Zep were down on a year-over-year basis. We continued to focus on our cost reduction efforts during the quarter, which has been an area of success over the past several quarters. I’m extremely proud of our associates’ effort to reduce and maintain our cost footprint and lower the breakeven point of the business in excess of 20%. That said, we will continue to look for ways to continuously manage our expenses and improve productivity that will benefit Zep in future periods, particularly as market conditions improve and we experience higher levels of demand.

Recently we have seen an increase in cost pressures from our raw material vendors and are now beginning to see higher costs in our purchases. We believe these increased raw material costs will begin to work their way into our financial results in the back half of 2010. To mitigate the impact of the cost increases we are evaluating new suppliers and, where necessary, we have announced a price increase on certain products. These price increases will go into effect in our third fiscal quarter. We’ve designed these increases to align with the timing of the increased costs in an effort to offset the impact of those inflation of raw materials used in our manufacturing process. Because these costs are driven by the price of commodities impacted by oil, ethylene, propylene and delimanine we believe that increased costs will have a similar impact on our competitors.

While we see opportunity to further reduce costs moving forward, we are continuing to shift our focus from cost reductions to identifying investment opportunities to build a stronger foundation from which to accelerate our revenue growth. Our strategic initiatives include a focus on improving our core sales and service organization, expanding our presence with complementary retailers, adding access to various market segments through distributors, identifying additional acquisition candidates and adding new innovative product lines. First, we continued to make progress on improving our Zep sales and service business, focusing specifically on enhancing the efficiency and capabilities of the business.

During the second half of 2009, we implemented a new hiring model designed to augment our sales force by recruiting and training experienced professionals. We believe these new associates will carry a substantially shorter payback period than those hired under the previous recruitment structure due to their potential to increase their base sales levels more quickly. For the second consecutive quarter we made noteworthy progress, increasing our sales headcount by 3% over the prior year. Additionally we have begun new investments in marketing, specifically in the areas of pricing and business transactions technology, in product management and in promotions, all designed to support our sales force.

We’ve also made progress with our continuing efforts to streamline our manufacturing and distribution network. During the quarter we consolidated two more facilities and are continuing to evaluate opportunities for further consolidation during calendar 2010. As a reminder, facility consolidations have historically resulted in improved customer service, reduced inventories and lower operating costs. To date we have consolidated more than 20 locations, dramatically improving our customer service while lowering operating expenses and capital requirements. Additionally, the Amrep acquisition provides us with opportunities to further consolidate facilities and enhance our logistics footprint as the initiative to consolidate our legacy facilities is nearing completion.

Next, I will shift to our second strategic growth initiative, expanding our retail market presence by making our products available to more customers through retail channels. We continue to experience success in growing our exposure to the retail market with our Zep Commercial, Enforcer and private branded lines with both existing and new retailers. Specifically, we’ve remained focused on expanding our presence in the $1.6 billion automotive after market, a market that has performed well during the most recent economic downturn. As you know, a little over a year ago we first began discussing our intention to target the automotive after market customer. As with any negotiation, it took some time to get our products on the shelves and begin selling through this channel. To this end we recently announced newly formed relationships with both AutoZone and Advance Auto Parts, the nation’s leading retailers of automotive replacement parts and accessories. These relationships provide Zep with yet one more avenue to distribute our industry leading products to the market. Additionally, Amrep has longstanding relationships with several automotive after market retailers which is expected to enhance our ability to further serve this market.

Next, we continue to pursue new distribution partnerships. With the benefit of the Amrep acquisition and their Misty, I-Chem and private brand product lines, our distributor sales organizations have begun collaborative selling efforts. Also, as we mentioned during our last call, the Zep Professional product line will be made available to W.W. Grainger’s customers through not only their website but now also through their catalog and branch network. Approximately 170 Zep Professional and Enforcer branded products were recently made available to customers of W.W. Grainger.

On the international front our efforts to expand our European presence continued during the quarter. Our European team is focused on continuing to grow their sales force headcount and integrate their operating platform.

We’re very pleased with the acquisition of Amrep. After the first three months, they are ahead of our internal projections and the integration efforts are on schedule. Importantly, the acquisition was accretive to earnings during the second quarter. Based upon my experience of integrating several acquisitions, I’m very impressed with the progress I’m seeing out of the joint Amrep, Zep integration teams. I’m also encouraged with the synergistic opportunities that they have identified and the progress they are making in realizing those synergies to achieve a run rate of benefits we expect by fiscal 2011. As a result of the analysis done by the integration teams, we have made the decision to move Zep’s aerosol production from our Atlanta location to Amrep’s Marietta, Georgia facility. Additionally, the teams identified cost savings and operating efficiencies for operations in Texas and, as a result, we will be consolidating Amrep’s Lancaster, Texas facility into other existing Zep plants. Further, we are consolidating Amrep’s Marietta distribution operation into our existing Atlanta distribution center. We’ve made progress in working with a multitude of suppliers to achieve additional savings and we expect the value of all synergies to be approximately $1.5 million in fiscal 2010, the benefit of which is to be [inaudible] by about 75% due to one time [inaudible] costs. The value is expected to reach an annualized run rate of approximately $5 million as we enter into fiscal 2011, which is an upward revision of our previous estimated range of $3 to $4 million.

Lastly, we remain focused on growing our business with additional acquisitions. We are currently in [inaudible] in a wide variety of acquisitions of various sizes across several end markets. Acquisitive growth has always been a component of our long-term strategy and the success of the recent Amrep acquisition has been encouraging, reinforcing my belief in our ability to integrate acquisitions. We remain active in our pursuit of potential acquisition opportunities. We are focused on companies that fit our business model and expand our access to market through different platforms and customers. It is our intention to identify and acquire businesses that generate annual revenues between $50 and $150 million. Although not a primary focus, the company may opportunistically acquire smaller businesses if they can be easily folded into an existing platform. This effort will expand our access to market and is anticipated to accelerate sales growth in the distribution, retail and international markets. Importantly, our ability to target acquisition opportunities is predicated upon consistently improving our balance sheet by generating strong free cash flow and paying down debt.

Now let me ask Mark to provide additional financial perspective on the second quarter.

Mark R. Bachmann

Good morning. Our second quarter revenues were $127 million compared to the $115 million reported in the year earlier period. Revenues recognized in January and February from the Amrep acquisition accounted for $18 million of the increase. Additionally, foreign currency favorably impacted revenue by $3 million. Sales, however, were adversely impacted by a decline in volumes of approximately 7% compared to the prior year, primarily in the North American I&I market.

We reported an operating profit of $1.6 million during the quarter compared to an operating loss in the second quarter of 2009 of $1 million. Our second quarter reported net income grew to $738,000 or a $0.03 per diluted share versus a loss of $942,000 or $0.04 per diluted share reported in the prior year. However, we believe the more appropriate comparison is to exclude the charges associated with the Amrep acquisition and restructuring charges from the reported results which would have yielded $0.09 per diluted share this year versus a loss of $0.01 per share last year. The company consumed $3 million in cash from operating activities during the quarter. This represents an increased use of cash of $4 million when compared to the second quarter of fiscal 2009. The increased use of cash is primarily due to the deferral of $6 to $7 million of payments that historically were paid in the company’s first fiscal quarter.

Year-to-date, the company has generated cash flow from operations of $4 million, an improvement of $14 million compared to the first six months of fiscal 2009. We were pleased with our ability to generate this level of cash, which was largely driven by the substantial improvement in year-over-year operating profit.

Now let me take a few moments and discuss the impact our end markets performance had on our operating results for the quarter. Although economic indicators improved during our second quarter, the pace of progress remains slow. During our second quarter, we experienced continued decline in the majority of our key industrial and institutional end markets. Several of our largest, direct sales verticals including industrial manufacturing, automobile servicing and vehicle wash continue to show double digit declines versus last year, although all of these end markets modestly improved on a sequential basis.

For the fifth consecutive quarter we saw increased sales to retailers and remain encouraged by the growth in this channel. We were also very pleased with the growth realized in our new channel served by Amrep, evidencing the strategic importance of the acquisition. Gross profit margin declined 415 basis points from a year ago to 47.1%. This was primarily attributable to the mix effect of the Amrep acquisition and increased manufacturing costs. This decline in gross profit margin was partially offset by a 160 basis point reduction in the cost of raw materials.

Let me take a minute and elaborate on Amrep’s margin structure. That business has lower gross profit margins and significantly lower selling, distribution and administrative expenses, yielding a better EBITDA margin than Zep. We continue to be pleased with the progress in realizing reductions in our operating expenses. Excluding [inaudible] fees related to the acquisition of Amrep, and restructuring expenses incurred in the prior year, we lowered selling, distribution and administrative expenses by 640 basis points from a year ago due to the mix effect of the Amrep acquisition, reduction in non sales employees, and the carryover of our enterprise wide cost containment initiatives implemented during 2009. While we continue to benefit from lower operating costs, as a reminder a portion of our cost reductions were temporary and began to move back into our cost structure during the second quarter. To be specific, approximately $2.8 million on an annualized basis will be incurred by the business. During the quarter we reinstated matching in our deferred compensation programs and made compensation adjustments across our company.

I should also point out that this quarter’s earnings were impacted by purchase accounting associated with the Amrep acquisition. Specifically, we were required to record a one time adjustment of $850,000 in order to stay acquired finished good inventory on our balance sheet at its estimated fair value. The offset to this initial valuation adjustment decreased goodwill. Approximately $525,000 of the inventory with this higher carrying value was sold in the second quarter, which adversely impacted gross profit. The majority of the remainder of this inventory is expected to sell during our third fiscal quarter, after which time the mark up of the acquired finished good inventory is not expected to materially impact our operating results.

Also, our balance sheet includes an additional $35 million in definite, lived, intangible and fixed assets after applying purchase accounting rules to assets acquired from Amrep. The majority of this value is attributable to Amrep’s longstanding customer relationships and proprietary formulations. As a result, we recognized approximately $400,000 of higher depreciation and amortization expense this quarter. Going forward, depreciation and amortization expense associated with the increased value of acquired fixed and intangible assets is projected to total $2.2 million on an annual basis.

The effective tax rate for the second quarter of fiscal 2010 was 24.7% due to a one time discrete tax item, and it is anticipated to range between 37.5% and 38.5% for the fiscal year 2010.

Now let me shift to our debt structure. As of February 28, 2010, borrowings under our revolving credit facility totaled $83 million, with approximately $14 million remaining un-drawn on our revolving credit facility. Our revolving credit facility extends to October, 2012, and we have no significant debt coming due in the next 30 months. As a reminder, during our first quarter we executed a three year loan and security agreement that allows for borrowings up to $40 million. As of February 28, 2010, we had drawn $15 million against this agreement and had a receivables borrowing base that provided for an additional $16 million of loan capacity. Further, we continue to be in full compliance with all of our debt covenants. We believe liquidity is extremely important to operating a business in this market, and we will therefore remain prudent in managing our balance sheet.

In the second quarter our capital expenditures were $3 million. We estimate that we could spend $11 to $13 million in capital in fiscal 2010 to support our strategic initiatives. Based on our cash on hand, financing arrangement and current projections of cash flow from operations, it is our belief that we will be able to meet all the liquidity needs of our existing business over the next 12 months. Our debt to capital ratio, net of cash, is just under 44% as of the end of our second quarter.

While we continue to maintain our policy of not providing specific guidance, we will comment on our high level expectations for the remainder of fiscal 2010. It is important to note that we are managing this business assuming no near term economic recovery. The significance of this assumption is the implication that our institutional and industrial direct sales over the next few quarters would continue facing pressure. We will remain vigilant in managing our overhead costs; however, we believe it is in our shareholders best interest to continue to invest in growth initiatives for the long-term health of the business, as we have done recently. The Amrep acquisition is important in that it replaces the revenues and earnings lost primarily as a result of the recession.

Looking forward to the remainder of the fiscal year, we expect to benefit from continued accretion from Amrep and earnings for Zep in total, excluding further restructuring charges, could slightly exceed those results achieved prior to the recession. At this time we would like to open up the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew McCall - BB&T Capital Markets.

Matthew McCall - BB&T Capital Markets

Mark, just jotting down those numbers. Prior to the recession, are you referencing the $0.28 and $0.37 that you did in the back half of fiscal ’08? Is that the right reference point?

Mark R. Bachmann

Yes.

Matthew McCall - BB&T Capital Markets

And in your guidance or in that commentary you talked about continued pressure on the direct business. So your volume down 7%, your reps are up 3%, does that indicate, can we do the easy math and say that maybe more like a same store number was or a same rep sales number was down about 10%? Or is it not that easy?

Mark R. Bachmann

Well, one of the things that you need to realize is that as you’re bringing on new reps in any organization, their productivity builds over time. So relative productivity of the new reps versus the existing reps has some impact as to what overall volume growth can be.

Matthew McCall - BB&T Capital Markets

Has the initial view of their progress been, and I know this only started last year, but has it been what you would hope? I know it’s a difficult environment, but any commentary on how the progress of the new hiring model has been?

John K. Morgan

Matt, it’s been encouraging. You know the biggest single factor in the long-term with the new reps is actually turnover. So the key to them having early success, especially relative to the old model, is that our projection is it reduces the overall turnover which has the biggest impact on the economic viability of investments in the new rep model. So the early indications are they’re more productive early than the old model. Early indications are the turnover is less with the new reps. It’s too early, in my estimation, to declare victory on the turnover. It just takes too long to peel that out. So while the math is not as exactly as pure as what you’re describing, it’s pretty darn close.

Matthew McCall - BB&T Capital Markets

I guess I just read the language in the release, when I saw the $1.5 million savings and I compared that to the initial savings I thought we were talking about fiscal year ’10, I thought we were originally talking about $3 to $4. Now it sounds like that $3 to $4 is more like $5, so I guess two parts to the question. Sounds like the accretion is in line with the expectations. Where did the extra? Is it that you’re pulling ahead projected savings and the initial total projection of $7 million is unchanged or are you finding incremental savings that would make that $7 million go higher?

John K. Morgan

Yes, let me first be clear about the $1.5 million and the $3 to $4. Sorry for the confusion. The $3 to $4 estimate was the run rate we expected as we got into fiscal ’11, which of course begins in September. Let me back up then to the $1.5 million. The $1.5 million expectation of gross benefit from synergy was what we expect for the balance of our fiscal 2010. Now the $3 to $4, we’ve revised that estimate up to in the neighborhood of $5, and that’s because of success we’re finding, particularly on the cost side of the equation as the integration teams are digging deeper than we were able to do pre-acquisition.

Matthew McCall - BB&T Capital Markets

So that $7 million total could go up $1 million to $1.5 million.

John K. Morgan

Here’s what I want you to think about it. In fiscal ’11, we are expecting the benefit of synergy from the acquisition to be in the neighborhood of $5 million, in our fiscal ’11. Okay? In the total of fiscal 2010, we are expecting the benefit of gross synergy from the acquisition to be $1.5 million. That is going to be partially offset by the requirement to take some restructuring charges associated with the changes. Mark, you’ve got some further.

Mark R. Bachmann

Yes, and just to elaborate a little further, Matt, the $7 million is what we said last quarter was after 24 months what we would anticipate the run rate to be. And we have not revised that number.

Matthew McCall - BB&T Capital Markets

You went through numerous sales and service investments and talked about numerous marketing initiatives and selling initiatives. Is there any number that you could put to that incremental cost or expense year-over-year?

John K. Morgan

It would not be incremental, Matt. In the economics of the business it’s about $2.5 million a quarter we’re investing back in the business in the form of expenses that we think are important to the long-term growth. I guess I could say I’m disappointed with the results from those investments in the short term. When I look at the individual end markets that we serve that are most relevant to Zep, you know those end markets frankly are still getting hammered. And areas that are more robust in the economy, unfortunately Zep’s not a significant player in those areas. So the short answer is that we began these investments about a year ago, at the $2 to $2.5 million a quarter rate, while in other areas of the business we were taking costs out. So from an incremental standpoint you should not assume that there are additional investments, but we are continuing at that $2.5 million run rate.

Matthew McCall - BB&T Capital Markets

I heard a new word on the call, delimanine I think you might have said. I’m hoping I wrote that down the right way, but I haven’t heard that one before and I don’t have that one in my cost model and maybe I’ve just missed it through the years, but the question is I guess related to the raw materials and the addition of Amrep. Are there new costs that we need to start monitoring to get a better handle on your inputs with the addition of Amrep?

John K. Morgan

No. The delimanine is extracted from oranges and we utilize that delimanine in some solvent based type products that are used in cleaners and degreasers, and the freeze in Florida affected the cost of oranges, so that’s where that comes from.

Operator

Your next question comes from Peter Cozzone - KeyBanc Capital Markets

Peter Cozzone - KeyBanc Capital Markets

I was just hoping you could give us maybe a little bit more color on your outlook for the remainder of fiscal 2010. I know on your last call you had stated that you expected some benefit from volume recovery as the year unfolded. Is that outlook still maintained and if so is that a function of favorable year-over-year comps or do you expect any underlying demand improvement?

John K. Morgan

Let me sort of characterize what we’re seeing in the market and then ask Mark to be a little more specific here. On the last call we talked about expecting to see some lift in the core business from the economy in the second half of the year, and as we’re getting closer and closer and frankly now in that period of time, in the market segments most relevant to Zep unfortunately we’re not seeing any significant turnaround in the economy. So while we’re seeing some modest sequential improvements, and even in our current order rates that you would look at, you know, sort of today if you would, we’re seeing some modest improvement but the rumors of great turnaround being in certain areas of the economy are exaggerated. You know, the industrial areas, the vehicle wash areas, another area that we serve are municipalities, you know government spending is important in our business, but municipalities and states are still in serious financial difficulty and cutting back a good bit. So the areas that we had hoped would begin to show a little bit more robust turnaround in our second half, we’re frankly not expecting that.

Now, other areas we’re seeing benefit such as in retail, in automotive after market retail, in the auto OE’s that are served by Amrep and so forth we’re seeing some lift. Now, Mark, you’ve turned that into some more specific thoughts. Would you like to comment on that?

Mark R. Bachmann

Well as we’ve indicated the addition of Amrep fills the gap that was created by the recession over the last 12 to 18 months. So we will benefit in total, and we’re looking at the business in total. We will clearly benefit from the addition of Amrep and will bring us back to or exceed on the top line the net sales occurred prior to the recession, and then on the bottom line as we said should slightly exceed the earnings levels prior to the recession.

Peter Cozzone - KeyBanc Capital Markets

In terms of raw materials, I know we’ve seen significant sequential rise here in March thus far, and could you maybe quantify what you’re seeing sequentially and maybe the impact going forward here? And how confident are you that you can get pricing through to offset the inflation there?

John K. Morgan

Let me comment on the cost to price relationship and our confidence there, based upon our history, and while Mark pulls some data here on the sequential impact. We have in the past had very good success at passing on cost increases if they are the cost of raw materials that are generally affecting the industry as a result of the fact that they’re commodity based cost increases. We have, during the very, very rapid inflationary period and in the recent past in the last two or three years, you may recall that we had difficulty passing on anything more than just the increase on a dollar basis. Our pricing structure and our price increase that we are currently going through is designed to retain margins on our products that are affected. And what I don’t know, and we have no history of, is our ability to retain the actual margin percent. But we have a great deal of history that suggests that we are very successful in recapturing the dollar impact of raw materials. So there’s a modest difference between those two, and we’re managing to retain margin on those specific products that are affected by those commodities. Mark, do you want to give some perspective on the magnitude of this?

Mark R. Bachmann

Yes. I mean, if you look at any of the individual commodities, you’ve seen particularly over the last three months some pretty significant increases in a number of commodities like ethylene and propylene as we have mentioned, and [dilamadine] are all up significantly. As you look at what that impact is on our overall cost structure, you know, our cost in materials could rise in the mid to upper single digit increases as a percentage.

Peter Cozzone - KeyBanc Capital Markets

I believe in the past your goals for the distribution channel is 10% to 15% of total sales. Can you maybe update us on where that currently stands and if you believe that goal is still obtainable?

John K. Morgan

Again, while Mark’s getting the data out here for you, let me characterize that 10% to 15%. The discussion around 10% to 15% was frankly designed to be very clear about the fact that we believed that we could realize some organic growth with existing capabilities by moving some new brands into distribution, but that we did not believe that it was realistic to assume that we would achieve that kind of level without acquisitive growth that would accelerate, moving access into different channels of distribution. And so the Amrep acquisition is an important part of that overall strategy of having product lines, brands and sales force that focuses on distributor sales. So we’re going to continue to talk about this in aggregate. It’s no longer just of course the Zep Professional product line, which was our internal green field approach here. But we’ve got in addition acquisitive growth in this area. And so Mark, when you combine it all what do we like today?

Mark R. Bachmann

Well, on a pro forma basis we would estimate that we would be in that 15%, 16% of our revenues would come in that area. Obviously in the second quarter we weren’t quite there because we only had two months of Amrep as opposed to the full three months.

Operator

Your next question comes from Zahid Siddique - Gabelli and Company.

Zahid Siddique - Gabelli and Company

My first question is with regard to the markets that you mentioned are somewhat weaker, what percentage of your revenues are made up by those markets? I just wanted to get a sense. You said retail is better but some markets, auto wash, is weak. So what percentage of revenue are the weaker markets?

John K. Morgan

We don’t give the overall percentages, Zahid, but in order of importance the transportation is our largest end market. That in our mind consists of both auto servicing as well as vehicle wash. Our second most important category would be to the contractors and homeowners that might shop at the do-it-yourself and hardware outlets. The third most important area would be industrial manufacturers, constructions, that entire segment. And then food would be the fourth and then government would be the fifth. And what we’ve said is, you know, in the U.S. market, which is about 75% of our overall sales, what I just described the top four represent 70% to 80% of all U.S. sales. And U.S. sales are about as I said 75% of the overall market.

Zahid Siddique - Gabelli and Company

Now you made a remark about the next two quarters. If I got it right the ending EPS would be comparable to the recession. Could you just clarify that once again?

John K. Morgan

Yes, and what I said is for the remainder we don’t give guidance and we certainly don’t boil it down into quarterly expectations. But if you looked, and one of the previous questions referred to fiscal ’08, but if you look to either fiscal ’08 or fiscal ’07 and you look at the back half of the earnings when you adjust for restructuring items in both years, they were about $0.65. And what we said is that in total, excluding restructuring, we should slightly exceed those levels of earnings.

Zahid Siddique - Gabelli and Company

Over the next two quarters.

John K. Morgan

Yes.

Operator

Your next question comes from Liam Burke - Janney Montgomery Scott LLC.

Liam Burke - Janney Montgomery Scott LLC

On the acquisition, you mentioned the size of what your targets are. Are you seeing opportunities that are being offset by people wanting too much or companies that just don’t fit the bill? What is the status of some of the acquisitions you’re looking at in general?

John K. Morgan

Well, frankly most of the things we’re interested in are not necessarily businesses that are out shopping themselves. So we’re pro-active in making contact and talking with folks about their interest in partnering up and where we think we might be stronger as a combination. And we’re seeing, there are a few businesses starting to come available, a few properties that come available through the auction process. I’m not terribly optimistic about acquiring businesses that come to us through the auction process from a valuation standpoint. And so I think this is going to be a long, slow, continuous process. We are not seeing a flurry of activity of businesses beginning to market themselves. Further, we’re in an industry that is overwhelmingly mid-size private companies or private equity held. The thing we like, of course, about the fact that they’re private equity held is that equity investors are looking to monetize those investments on some scheduled basis, so it’s a little early to characterize what I think about sort of valuations if you will, and I would say that the activity level is not robust yet. It appears to me as though there is still a little bit of a wait and see mode from a lot of folks wondering what the value of the businesses might look like as the economy improves. That notwithstanding we’ve got our pipeline list, and we’re reaching out to people and expressing interest. And you know the drill. We’ll just have to see where it goes.

Operator

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

Robert Felice - J. Goldman & Company

Just a couple of quick questions. I guess first I was hoping you could delve a little deeper into this specific investment you mentioned you’re making in your European business. And then, John, I think I’ve asked you this before but I’ll ask it again, if I think back a couple of years ago to the spinoff of Zep, the future of the European business as it pertained to Zep in its entirety was in question, and since then that business has performed quite well. So I was hoping you could kind of walk us through what’s different now versus then, the investments you’re making and the outlook for that business.

John K. Morgan

Good questions. Good to hear you again. Specifically the primary investments we made in the European business in the current business platform is expansion of the sales force in southern Europe. The second thing is there’s a lot of work going on behind the scenes through rationalized product line across Europe. We’ve had historically a product line in northern Europe and a product line in southern Europe, which are different from one another, adding complication to the supply chain. So our leader of that business there, Alessandro Brighenti who resides in Italy, now has responsibility for all of Europe. That was different, too, from two or three years ago where we had multiple smaller business units, if you will, within Europe. We now have that all under common leadership of one individual and his team. He’s recently put some investments in supply chain, putting a director of supply chain for all of Europe on his staff and they’re beginning the process of rationalizing product lines and operations to simplify the product line. So the things we talked about that the core business had begun a couple of years ago, two-and-a-half years ago in the U.S., Alessandro is now grappling with that same process for Europe, albeit on a little bit smaller scale. But he’s getting some good traction with that.

So the biggest single difference that you asked about in my view was once the dust settled from the spinoff and we had a chance to really more thoroughly analyze the European business and the European market, we concluded that it’s an interesting market and a good business. We needed to align the leadership team, get the right leaders in place, and make a firm declaration that it’s important to us and support those folks in doing the things that they are now doing. And they’re just simply getting some traction from that. So you know we like the size and the nature of the European market. Ultimately, frankly, I would like to find a platform to add either in Germany or in Austria that would assist us, not only in that market but in moving further east into Eastern Europe where there’s some developing economies. We think that would be helpful to us and we’ll support those folks with that. So that’s really what’s been happening there.

The one last thing I would say is was we did sign an updated agreement with a business known as Zep France and they’re now a distributor of Zep branded product for the French market, and that’s with the license agreement and a supply agreement from us. That previously had been a business that was owned by Zep and is now owned by an independent group there.

Robert Felice - J. Goldman & Company

Well, it sounds like the bulk of the actions you’re taking really simplify the operating structure and drive overall margin improvement in that area. Could you give us a sense as to the magnitude of the cost savings or margin expansion we should see as a result of these efforts over the next 6, 12, 24 months?

John K. Morgan

You know I’m inclined to continue to aggregate the impact of all of our various different initiatives as opposed to carving out just one business or one geography and detailing that. But I would characterize it, you’re right, what we’ve asked the folks to do there is to think about much likely we said overall business, simplify the core first, improve the operating business which gives us a confidence in the business which in our view will move them to a position where we think they’ve earned the right to grow. In this business we think you need to earn that right. So that business had some work to do to demonstrate that they’ve earned the right to grow, and they’re making progress on that. But I don’t want to get into the business of taking the multitude of initiatives that we have throughout the business and trying to depict each of those.

Robert Felice - J. Goldman & Company

Flipping gears to the acquisition front, as you think about the range of potential acquisitions out there do you feel comfortable with the available liquidity that Zep has or do you think that, given certain opportunities, you might have to access the capital markets?

John K. Morgan

For what we’re looking at today, I feel comfortable that we have access, at this moment in time, you know Mark has done a good bit of work here in the last several weeks looking at the availability of capital and the kinds of things that could be done if we restructure our capital from a debt standpoint. And Mark’s got sufficient access to capital to do the things that we’re looking at. I would not want to discount, however, the possibility of accessing the capital market. You’ll recall that we did file a $200 million shelf and we’ll keep that in force, and with the right opportunities if it’s good for our existing shareholder base, I would absolutely access the capital markets. But there’s nothing imminent.

Operator

With no further questions this does conclude today’s question-and-answer session. For any additional or closing remarks, I’d like to turn the conference back over to Mr. John Morgan.

John K. Morgan

Great. Thank you for your questions. In conclusion let me say again that we are pleased with the progress we made on our strategic transformation, the integration of Amrep and the financial results we were able to achieve for the quarter. We are pleased with our efforts to reduce the breakeven point of our business. While the cost reduction aspect of our business is beginning to slow, we are excited about the implementation of initiative design to drive sales growth over the long-term. Clearly we believe the combination of the cost reduction initiatives coupled with the initiatives to increase revenue will positively impact our business for many years to come. As I’ve mentioned during previous calls, we believe we have taken unnecessary costs out of the business that will not return as the market rebounds, ultimately positioning Zep for higher margins and cash flow in the future. Importantly, we are building a platform for longer term growth and shareholder value creation. Thank you for your participation today. Mark and I look forward to speaking with you on our third quarter conference call.

Operator

Again ladies and gentlemen, this does conclude today’s conference call. Thank you for your participation.

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Source: Zep, Inc. F2Q10 (Qtr End 02/28/10) Earnings Call Transcript
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