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Executives

Melissa McKay – IR

Martin Hanaka – Chairman and CEO

Sue Gove – EVP, COO and CFO

Analysts

Jennifer Davis – Lazard Capital Markets

Derek Leckow – Barrington Research

Alex Silverman – Special Situations Fund

Casey Alexander – Gilford Securities

Golfsmith International Holdings, Inc. (GOLF) Q3 2010 Earnings Call Transcript October 27, 2010 9:00 AM ET

Operator

Good day, everyone, and welcome to the Golfsmith International Holdings Incorporated third quarter 2010 earnings conference call. One note that today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to Melissa McKay of ICR. Please go ahead.

Melissa McKay

Good morning, everyone. Thank you for joining us today to discuss Golfsmith's third quarter fiscal 2010 results. As a reminder, our presentation includes and responses to various questions may include forward-looking statements about the company's financial results and about future plans and objectives.

Any such statements are subject to risks and uncertainties, which could cause the actual results and implementation of the company's plans and operations to vary materially. These risks are discussed in the company's Annual Report on Form 10-K, fiscal 2009, filed with the SEC.

We issued a press release this morning. If you have not received a copy, you can find it on our website or by calling Investor Relations at 203-682-8200. Presenting on the call today, we have Golfsmith's Chairman and CEO, Martin Hanaka, as well as Chief Operating Officer and Chief Financial Officer, Sue Gove.

With that, I will turn the call over to Marty.

Martin Hanaka

Good morning. Thank you all for your time and interest in Golfsmith. Today I’m going to first present a synopsis of Q3 and then a summary of major trends, both positive and negative in our business. Sue will then cover our financials in detail, and I will close with some forward-looking direction. Obviously, we are interested in any questions you might have.

Q3 started off strongly for us. July was our best month of the quarter, August was down slightly, and September offset our July gains basically. It was largely due to a two-week Labor Day promotion that we did not repeat. With our lowest margin offer of the entire year last year, we decided not to anniversary it and cost us on the top line. Soft goods were our strongest category followed by clubs. And club making was our weakest area. We were down about 10%, a trend – it's a multi-year trend that continued.

California, in general, was our weakest region, and Southern California, in particular, our weakest market in the company. We had strong performances in Texas, Atlanta, Phoenix, and generally in the Midwest. Traffic was down consistently in each period between roughly 3% to 6%, and that is roughly equivalent to rounds played decrease, which we experienced nationally. And year-to-date, rounds played are down almost 4%.

There is good news, however. Our conversion is up nicely. Our average order value is up nicely as well. It underscored the real progress that we are making in building our selling culture. We have seen real, positive share gains. We are essentially 6% better than the industry. If we look at the eight categories that Golf Datatech covers, we have really did some (inaudible), particularly in irons where we are up 9% better than the market. Wedges, putters, and shoes are other strong categories. And that also speaks to the fact that our custom fitting initiative is really gaining traction with the customer.

Our direct business is growing, and this may be the best thing within our numbers. It’s the first time we’ve had an overall net gain in our direct business since Q4 2006. We are up 6% in our direct business. So our web demand is really now more than offsetting the clubmaking decline and the natural shift away from catalog shopping.

Another good guy is our proprietary mix is up 70 basis points of total, and as I said, custom fitting has improved nicely. Some major trends. First of all, the consolidation continues. This is not just mom-and-pop stores anymore. Our largest major competitors closed 12 doors, nine of which directly compete against us. We think they will be accretive next year. Sue will talk more to that. But beginning now, these stores are getting room clean. We should see a direct benefit to Golfsmith.

The web is showing real momentum. We’ve had double-digit demand increases for several months now. It’s a definite trend. As Steve Larkin said, she has really taken hold. And we are encouraged by some launches that are coming down the pike, most notably, Web 2.0, which is in the market. Callaway Octave, which comes up very soon, and there is huge buzz around the Titleist Suzen [ph] watch. So hopefully, that will generate more demand.

With those opening comments, I’d now like to turn it over to Sue. Sue?

Sue Gove

Okay. Thank you, Marty. Good morning, everyone. For the third quarter, net revenues increased 3% to $93.3 million compared to $90.6 million in the third quarter of 2009. The increase was primarily driven by new stores and the 5.8% increase in net revenues in the direct-to-consumer channel Marty mentioned, partially offset by a 1.7% decrease in comparable store revenues.

As Marty stated, we are pleased to see solid evidence from industry data sources of market share gains, which gives us confidence we are doing the right thing. Our conversion accelerated sequentially in the quarter, with improvements across all regions. In addition, we are extremely pleased with the increased momentum in our direct-to-consumer business. We see a lot of opportunity in the channel from both a marketing perspective and an incremental sales driver.

Gross margin for the second quarter increased 10 basis points to 34.4% as compared to 34.3% for the same period last year. The gross margin improvement was driven primarily by a 40 basis point increase associated with improved sales performance of higher margin category and a 20 basis point increase due to a decrease in shrink expense resulting from improvement in the current year physical inventory results. This was partially offset by a decline in vendor allowances, which were shifted to offset direct advertising cost this year.

SG&A expense for the quarter increased 6.9% to $31.5 million versus $29.5 million in the same quarter last year. As a percentage of net revenue, SG&A expense increased to 33.8% versus 32.6% in the prior year. The increase in SG&A dollars was primarily due to the four new store expenses and higher advertising spend associated with increased direct mailings.

Store free opening and closing expenses were $262,000 in the third quarter of 2010 compared to $144,000 in the third quarter last year. We closed two stores during the quarter. We also recorded $1.3 million in asset impairment and lease termination charges during the third quarter associated with store closures.

Operating loss was $1.1 million for the third quarter compared to $1.4 million income in the third quarter last year. We’ve recorded an income tax benefit of $230,000 on pretax loss of approximately $1.4 million. This compared to an income tax provision of approximately $52,000 on pretax income of approximately $1.2 million in last year’s third quarter.

Net loss totaled $1.1 million or $0.07 per share. This compares with net income of $1.1 million or $0.07 per diluted share in the third quarter last year. Excluding the store closings and lease termination charges, net income for the third quarter of this year would have been $500,000 or $0.03 per diluted share. Excluding litigation settlement charges recorded in last year’s third quarter in the amount of $400,000, net income in the third quarter of last year would have been $1.5 million or $0.09 per diluted share.

As of October 2, 2010, the end of the quarter total inventories were $80.7 million compared to $79.1 million for the prior year. Average store inventory remained flat as compared with last year, following significant reductions in prior quarters.

We had approximately $42.6 million of outstanding borrowings under our credit facility and borrowing availability of $18.4 million. This compares to $33.7 million of outstanding borrowing under the credit facility and $22.5 million of borrowing availability last year. We continue to move forward with operating initiatives. We have carefully evaluated our store portfolio and closed unprofitable stores. Combined these store operations were a $0.03 drag on earnings, which will be accretive for next year.

We have revised our target now and we will be opening five new stores next year. We have two of those new leases that are signed to date that we will be opening in the first quarter. We expect to complete our Oracle ERP system implementation in the first quarter of next year. The new system will enhance our decision-making capabilities and provide the foundation for new merchandising systems.

Overall, we feel good about the progress on our strategies. Our continual gain in market share assures us that our initiatives are yielding results, and we continue to build on that momentum. We are encouraged by the progress we’ve made. Despite the headwinds of the difficult industry trends, we remain confident that we are moving the business in the right direction.

I’d now like to turn it back to Marty for question-and-answer.

Martin Hanaka

Great. Thanks, Sue. Before the Qs, just a couple comments. We are planning 2011 with the following priorities. Number one, Sue mentioned new stores. We originally thought of seven. We moderated that back to five that we can find quality sites. That means really healthy overall mix of stores, given the recent closures. Really going to grow the web aggressively next year.

This trend that we are experiencing, we see continuing beyond selection, which means assortment and technology, which has to do with speed and our card availability, marketing around search and social media, and finally, service, which really is based on inventories, particularly essentially located inventory. We really see that that’s continuing to grow aggressively. We see mid-to-low single-digit kind of comp growth.

We are making some exclusive assortment of buying changes, which would really fuel our proprietary mix and apparel shift that we think continue our strongest category overall, including a better floor planning. And then finally, continued focus on improving our traffic, because we know if we can drive traffic with every marketing spend with the progress we’re making, our selling culture, conversion AO will certainly – average order value will certainly follow, and we are going to link our pay plans to guarantee execution of these areas. So those are the comments. Please, your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We will go first to Todd Slater with Lazard Capital Markets.

Jennifer Davis – Lazard Capital Markets

Hi. Congratulations, guys, on actually a good quarter in a bad environment.

Martin Hanaka

Thank you.

Jennifer Davis – Lazard Capital Markets

Sorry. It’s Jennifer for Todd. I should have said that first. A couple of questions. First, on the advertising spend, it looks like that that drove direct sales. But I was wondering if you could elaborate a little bit on what you are doing to improve traffic to the stores. And then secondly, could you talk about the nine markets where the PGA stores are closing, kind of the timing of that, because I assume that you will see kind of a hit as they clear. But then, once those stores close, that should benefit you. So if you could just kind of talk about the timing of those closures. Thanks.

Martin Hanaka

By all means. Number one, what we did is, in the quarter, we had more spend on catalog, particularly on acquisition and reactivation. And that spend really didn’t give us the top line results we had expected. And frankly, we did have two other extra spends on the retail side of the business. And while we are really pleased with the share gains in all eight categories that are tracked, we’ve had really meaningful increases. But it didn’t give us the absolute top line we wanted. So we didn’t get the fruit of those labors.

So we are reevaluating how we are going to spend those dollars going forward. And we are in a real quiet time of the year right now. You don’t see us spending money in retail until really December. The markets that are closer from Galaxy, not PGA, and those stores close anywhere from the Sunday after the Thursday earnings call from Dick’s this week. And frankly, those – that closings haven’t affected us in a negative way, because some close immediately, we get a benefit; and some, they really drove very hard and eye witnessed 50 pallets coming off of trucks from their central warehouse two weeks into the closing offer.

And so we were disrupted a little bit as they cleared out inventory. But at the end of the day, beginning now, every one of those locations will be a net positive for Golfsmith. We have no other negatives that we are looking forward to. It should all be positive. And those markets were Dallas, Phoenix, Austin, Texas, one in Chicago, two in Houston. So, right across the board, we see benefit to Golfsmith shareholders.

Jennifer Davis – Lazard Capital Markets

Great. Thanks. Good luck.

Martin Hanaka

Thank you.

Operator

Next we’ll here from Derek Leckow with Barrington Research.

Derek Leckow – Barrington Research

Thank you. Good morning.

Martin Hanaka

Good morning.

Derek Leckow – Barrington Research

Hey, Marty. The selling, general and administrative expenses that we’re modeling was a bit – we're modeling has been lower. I think you called out there were some spending in a couple categories. Can you help me understand what that was? And are we going to see that revert in the following quarter? Was it spending that was pulled ahead or –?

Martin Hanaka

Yes. I’ll talk about advertising. Sue can elaborate further. But – as we got into second quarter, it was clear that we were being outspent by a margin from some of our big competitors. So we’ve put in, beginning of the second quarter, extra efforts and extra Memorial Day effort, extra pages in June, and then we added an extra effort in July and August. And frankly, again, on an absolute basis, we are disappointed. And the answer is no, you’re not going to see us spend at those levels going forward. We are finishing out ’11 plan right now, and you’re going to see us leverage advertising next year. And you’re going to see us with a more stratified approach market-by-market. And therefore, you won’t see that continue. There are other SG&A spends. I’ll let Sue again to elaborate a little more. Sue?

Sue Gove

Right. The other piece of the increase in SG&A, as I mentioned, Derek, was on new stores. The new stores expenses are reflected in the SG&A. And unfortunately, overall, we are not seeing the leverage because the new stores revenues are being offset by the comp decrease that we have. So, from a comp base-to-base expense, expenses are down slightly. We are continuing to see the benefit of the initiatives that we have in place to continue to control our costs. But I think the key point is that we are not seeing leverage on the SG&A rate.

Derek Leckow – Barrington Research

Were the incremental expenses approximately $3 million? Is that about what it was?

Sue Gove

That’s right, between new stores and advertising.

Derek Leckow – Barrington Research

And advertising would include the additional pages in the catalog or is that a separate category?

Sue Gove

No, that includes that.

Derek Leckow – Barrington Research

That includes it?

Sue Gove

Yes.

Derek Leckow – Barrington Research

What was the sort of catalog circulation or page count increase in the period?

Martin Hanaka

It really had more to do with an extra vehicle.

Derek Leckow – Barrington Research

An extra drop? Okay.

Martin Hanaka

Yes, an extra drop.

Derek Leckow – Barrington Research

And – okay. And then, you also mentioned (inaudible) cost savings with regard to some stores that were closed, and just wondered if you look at your portfolio of stores, how many more are there that are unprofitable that you think might be a candidate for closure?

Sue Gove

Derek, at this point, we have a couple of stores that are marginally unprofitable, but they are improving with the initiatives that we have in place. So, at the current time, we do not expect any further impairment.

Derek Leckow – Barrington Research

Okay. So we’ve kind of reached a threshold here that were some stores that are future stores that are going to be performing better?

Martin Hanaka

Yes, absolutely. We have much healthier base. And you’re going to see a wholesale event from us.

Derek Leckow – Barrington Research

And then if I look at my two – Q1 and Q4 for next year, are we going to expect to see that reflected in the improvement there in terms of the operating losses that we should expect?

Martin Hanaka

Yes, we definitely feel you should see us return to profitability and improvement in every quarter next year.

Derek Leckow – Barrington Research

So you’re going to –

Martin Hanaka

Following [ph] some change in demand, some unusual event, we definitely feel we will continue to take share, capitalize on these competitors’ closings in the overall consolidation, and be better operators of the business.

Derek Leckow – Barrington Research

Well, that’s a huge swing from year-to-year, Marty. I mean, if you guys can do – this year I’ve got you losing like $9 million in those outside quarters. Is that what you’re saying?

Martin Hanaka

No, not in every quarter. You will see improvement in every quarter.

Derek Leckow – Barrington Research

Oh, okay, got it. Got it.

Martin Hanaka

Yes.

Derek Leckow – Barrington Research

No breakeven. Okay.

Martin Hanaka

That’s right.

Derek Leckow – Barrington Research

Thanks a lot.

Martin Hanaka

Yes, that would be a – from your lips to God’s ears, right?

Derek Leckow – Barrington Research

Yes. Okay. Thanks a lot. Appreciate it.

Martin Hanaka

Yes, sir. Thank you.

Operator

(Operator instructions) From Special Situations Fund, we’ll move on to Alex Silverman.

Alex Silverman – Special Situations Fund

Hey, good morning. My –

Martin Hanaka

Good morning.

Alex Silverman – Special Situations Fund

My question was answered. Thank you very much.

Martin Hanaka

Thank you.

Operator

And we’ll move on to Casey Alexander from Gilford Securities.

Casey Alexander – Gilford Securities

Hi, good morning.

Martin Hanaka

Good morning.

Casey Alexander – Gilford Securities

Just real quick, it seems like you’re a little further out on your credit line than normal at this time of year. Your cash is a little lower than normal at this time of year. And you should be at the better portion of the cash conversion cycle. Should we be a little concerned about your ability to get the right inventory in the stores going into the New Year?

Martin Hanaka

No, not at all.

Sue Gove

No. Just to add to that, we are, as you noted, at a higher debt level than we were last year and at slightly lower level in our borrowing capacity. A combination of a couple things; one, the new stores openings, funding the inventory for those new stores. And in addition, some inventory that we brought in in the second quarter that there again are some timing differences. So you see our payables balance is actually slightly lower. So there are some timing differences, but we feel confident in our borrowing situation and where we will end the fiscal year.

Casey Alexander – Gilford Securities

Okay. Look, I know it’s always the dangerous prospect, taking a snapshot of a balance sheet when the train is moving. So, secondly, could you give us some sense of where we are at in kind of the promotional environment as you see it from various competitors out there?

Martin Hanaka

Yes. I was going to close with that. It’s a much more rational marketplace with the exception of Southern California where the economy has been very difficult and rounds played are down basically 4%, 5% consistently. So, other than that, part of the world, that’s pretty rational plays. Everyone is pretty quiet right now. And we’ve got a lot of new exciting products coming. So that means full price sales, which is what we live on. We don’t live on a $149 two-year old driver. So it’s not a challenge at this point in time.

Casey Alexander – Gilford Securities

Okay. Great. Thank you.

Martin Hanaka

Thank you.

Operator

(Operator instructions)

Martin Hanaka

Okay. We’ll close then, operator?

Operator

Certainly.

Martin Hanaka

Okay. 2009 was about survival. It’s a very difficult marketplace in this year. While we’re missing our top-line because of the marketplace, frankly, we’re really in a stabilized position. So we look forward to 2011. We think it will be of a meaningful profit improvement. We’ve got a healthier store base. We’re carefully opening new stores. We’re taking shares, and competition is less aggressive than we’ve seen. So we think that makes for a good set of environmental conditions. Q4 is off to a strong start. Hopefully, this will continue and we’ll begin to realize the return to profitability. Our team is fully committed to making that happen. Again, thank you for your time and interest in Golfsmith. Good day.

Operator

Ladies and gentlemen, that does conclude today’s conference. We thank you for your participation.

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