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Kenneth Cole Productions Inc. (NYSE:KCP)

Q3 2010 Earnings Call

November 4, 2010 08:30 am ET

Executives

James Palczynski - IR

Jill Granoff - CEO

David Edelman - CFO and Treasurer

Analysts

Jeff Van Sinderen - B. Riley

Sam Poser - Sterne Agee

Janet Kloppenburg - JJK Research

Steve Marotta - CL King

Operator

Good day ladies and gentlemen, and welcome to the third quarter 2010 Kenneth Cole earnings conference call. My name is Gina and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. (Operator instructions). As a reminder, this call is being recorded for replay purposes. I would now like to turn the presentation over to your host for today’s call, Mr. James Palczynski. Please proceed.

James Palczynski

Good morning everyone. Before we’d get started, I’d just like to remind you of the company’s forward-looking statement language. The statements contained in today’s call that are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results might differ materially from those projected in such statements, due to a number of risks and uncertainties, including but not limited to demand and competition for the company’s products; the ability to enter into new product license agreements or to renew or replace existing product license agreements; changes in consumer preferences or fashion trends; delays in anticipated store openings and closings; and changes in the company’s relationship with retailers, licensees, vendors, and other resources. The forward-looking statements contained herein are also subject to other risks and uncertainties that are described in the company’s reports and registration statements as filed with the Securities and Exchange Commission.

Thank you. And with that out of the way, I would like to now like to introduce you to Jill Granoff, the company’s Chief Executive Officer.

Jill Granoff

Thank you, James. Good morning and thank you for joining us to review our third quarter 2010 results. With me today is David Edelman, our Chief Financial Officer.

We are very pleased to report strong performance in the third quarter as well as our fifth consecutive quarter of positive operating profit. We continue to demonstrate steady sustained improvement in the business. All of our operating segments posted solid results in the quarter despite a still challenging economic environment. We are seeing growth in each of the companies operating businesses and ongoing profit improvement. The progress is clear in both our third quarter and our year-to-date results demonstrating that our brands remain strong and that our products are resonating with consumers.

In terms of key initiatives we launched REACTION Men's Sportswear in the quarter and reached an agreement to bring our women's sportswear business in-house. We believe each of these moves will continue to drive growth and further improvement and profitability. In addition, we believe we are well positioned for the upcoming holiday season. I will talk about these developments and others in a moment, but first I would like to begin with a few highlights from the third quarter.

Our revenue performance was strong with each segment contributing to out growth. Total net revenues grew by 15% to $119 million. Our wholesale business grew 21%, consumer direct was up 8% and licensing grew by 11%. Our gross profits increased by 13% in the quarter to $51 million.

SG&A expense improved by 240 basis points as a result of our streamlining initiative and expense leverage. And our earnings per share climbed to $0.11 versus $0.01 last year exceeding our prior guidance of $0.08 to $0.10 per share.

Our balance sheet also remains strong. We continue to generate cash, with cash increasing to $70 million at the end of the third quarter, compared to $50 million at the end of last years third quarter.

Our inventory is clean and our year-to-date turns have improved. Although overall levels are up due primarily to the inventory build for new REACTION Men's Sportswear line and increased replenishment business. We also continue to operate with no long term debt. Now I would like to call your attention to our nine month comparisons which firmly show the turnaround in our business.

Year-to-date net revenues through the end of September had increased by 12% with double-digit growth in the company’s wholesale consumer direct and licensing business segments. Operating income has improved by $22 million versus the same period from 2009 and operating margin has improved by 710 basis points.

And earnings per share for the last nine months grew by $0.89 to $0.26 versus the year ago period lost of $0.63 per share. Much of our success is the result of a maintained focus on delivering great product. The holiday lines at Kenneth and the design team have created are compelling. This is true for our wholesale business as well as consumer direct.

In addition, our licensees are performing well in almost every category and they have developed some great holiday items. In wholesale as I mentioned sales growth has accelerated. This was driven by double digit growth in men’s and women’s footwear as well as by the launch of REACTION Men's Sportswear. I would also like to note that our gross margin was up for each brand in the third quarter.

Additionally, our backlog continues to be up double-digits and we are determined to build on this success. The launch of reaction men sportswear line is going well. As of last week, this exclusive business from Macy’s has been set in 210 doors. We are confident that we have the right product at the right price. While it’s still early we are optimistic about the potential of this initiative. Not only will it generate meaningful sale, it should also give a boost to the REACTION brand as a whole. We are already seeing increases in our REACTION Men’s footwear business as well as our REACTION Men’s licensed product portfolio.

Now in consumer direct, we saw sales growth of 8% with comparable store sales up 6.7% and strong double-digit growth in our e-Commerce business. Success has been driven by women’s apparel, men’s apparel and men’s footwear. As we come into holiday, we are pleased with the product and assortment planning. This includes a good gift giving assortment in sweaters, small leather goods and other accessories such as watches and jewelry. As we talked about last quarter, we are continuing to work on improving our full price store chain by rationalizing our real estate portfolio. While the size of the business will shrink, we expect its profitability to improve significantly next year. We also continue to focus on e-Commerce as a key growth opportunity. As we anticipated in our call last quarter, we are now seeing great results from our new photography, enhanced functionality, our new REACTION micro-sites and the launch of mobile commerce.

Finally our licensing business continued to perform well growing by 11% versus last year’s third quarter. Our standout performers were men’s dress shirt, men’s and women’s outerwear, women’s sportswear and watches. We expect to see continued double-digit increases in our domestic licensing business. And with respect to our international business our results were good in a number of countries. However, these businesses are still generally small. That said, we believe the opportunities are large and we are continuing to look at a variety of deals to take advantage of our global potential.

I would like to address the transition of our women's sportswear business. As we announced a couple of weeks ago, we have reached an agreement with [Charles] to bring this business in house, effective June 2011. We are excited to be taking over this business which has been running at a $15 million level at wholesale. The line is currently distributed in over 400 domestic doors, including Nordstrom, Dillard's, Bloomingdale's and Lord & Taylor, as well as select international accounts. We believe there is significant potential to grow our women’s sportswear business in wholesale, consumer direct and internationally.

Thank you. And now, I would like to turn the call over to David for a more detailed review of our financials.

David Edelman

Thank you, Jill. Good morning everyone. This morning the company reported its results for the third quarter. As Jill mentioned, our business was a little better than expected for the revenues above guidance and earnings per share improving to $0.11 compared to $0.01 last year.

Consolidated net revenues were strong, up 14.7% to $119 million versus a $103.8 million in the third quarter of last year. Wholesale sales increased 21% to $62.5 million, driven by double-digit growth in footwear and the launch of Reaction Men's Sportswear. Consumer direct revenues increased by 8% to 45 million compared with 41.7 million in the third quarter of last year. This performance was driven by positive comps of 6.7% and by a strong double-digit increase in e-commerce.

We plan on opening four outlet stores and one new full price store in the fourth quarter. At the same time, we continue to expect to close at least seven unproductive stores by early next year.

Our licensing segment grew by 10.8% to $11.5 million, driven primarily by strong business and men's dress shirts, tailored clothing and dress furnishing categories, as well as outwear and women’s sportswear. Gross margin was 42.5% down 80 basis points compared with the third quarter of last year. This is the result of two factors: First, about two-thirds of the decrease is due to a shift in revenue mix because wholesale which carries the lowest gross margin of any segment grew fastest and therefore became a larger percentage of the business; secondly, the promotional activity in our outlets was at a slightly higher level than last year.

The slight decrease in margin was more than offset by continued SG&A leverage. SG&A as a percent of net revenues improved 240 basis points to 40.6% versus 43% in last year’s third quarter.

We continue to focus on expense management and on identifying opportunities to improve efficiency. Operating income in the quarter grew to 2.3 million versus 300,000 last year. This is a significant improvement and marks our fifth consecutive quarter of year-over-year operating profitability improvement. I will note that we continue to incur minimal tax expense due to the reversal and portion of company’s differed tax valuation allowance.

Net income grew to 2 million or $0.11 per diluted share versus a year ago quarter where we were just slightly over breakeven and reported $0.01 per share net income. Our balance sheet continues to be very strong. Cash and cash equivalents at the end of quarter were 69.8 million, 19.8 million greater than the 50 million we reported at this time last year. Our credit facility remains undrawn and we continue to operate with no debt.

Inventory at the end of quarter was 51.6 million. It is important to note that our Q3 inventory last year was artificially low, down 36% versus 2008. Keep in mind that on a two year basis our inventory at the end of the current quarter was down approximately 9%. As we mentioned on our last call, we are making increased investments in some categories where we believe there is opportunity for growth or the year ago inventory level was sufficient.

Additionally on those, that we added incremental inventory to support the new REACTION Men’s Sportswear business in over 200 Macy’s doors than more in transit inventory than we did at this time last year due to the planned shift in the timing of receipts and finally the five new stores to be opened during the fourth quarter. Excluding these items, our inventory is up 19% versus last year. Our inventories are current and we believe that appropriate levels should better service our growing replenishment business.

Before I turn to guidance, I’d like to provide an update on rising sourcing costs. While we are seeing some pricing increases in raw materials and freight, we believe we can mitigate these by consolidating factories, utilizing new sources of supply and reducing agencies to the use of our own China sourcing office.

Now with respect to guidance for the fourth quarter. I am pleased to report that the fourth quarter has started off well. Our comps have accelerated from third quarter level and we anticipate total revenue growth in the quarter of 10 to 12%. While the significance of consumer direct sales in the fourth quarter makes it the most difficult to forecast, based on current business trends we are comfortable with the $0.31 per share consensus estimate, excluding anticipated non-recurring costs principally associated with the store closing.

In addition as I spoke about last quarter on those that included in the fourth quarter SG&A is approximately 4.4 million of incremental expense versus last year as we continue to accrue for our pay for performance bonus plan and increase our marketing spend to support expected sales growth including the new REACTION Men’s Sportswear business.

Thank you. And I’d now like to turn the call back to Jill for some closing comments.

Jill Granoff

Thank you, David. As we move forward, our brands and product initiatives remain top priority. This focus has clearly been paying off as you can see in the year-to-date sales growth and margin improvement. There is an opportunity to capture more share of wallet from customers seeking modern designer fashion at accessible price points and we intend to capitalize on it.

At the same time, we are going to maintain our operating discipline, our streamlining and our pay-for-performance compensation plan have been powerful tools in this regard. In every area we will vigilant on expenses and allocate our capital carefully.

We have made good progress over the course of this year. Throughout the year consumer confidence has been low, unemployment has been high and the credit market has been tight. Despite these challenging conditions, as we said we could, we have continued to take market share and grow the business at a double-digit rate. We believe we can continue that trend as we move through holiday and into fiscal 2011. There is no question in our mind that the long-term potential of this brand and business is exceptional.

Thank you for your support, and operator, I think we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of Jeff Van Sinderen from B. Riley. Please go ahead.

Jeff Van Sinderen - B. Riley

Congratulations on the quarter and the momentum that appears to be building in your business. Maybe you can just share a little bit about the decision to bring the women's business, the women's sportswear business in house and how you are approaching that and we should expect there may be how much that will also impact your licensing revenue?

Jill Granoff

Sure. As we said on many of our prior calls, our women’s apparel has been one of our best performing categories. It’s performed well in our own retail stores and it’s performed well at wholesale. As you may know Jeff, we actually have an in-house team today that handles designs, merchandizing and sourcing for the women’s apparel product that’s sold through our own stores.

So, we really felt that this was an opportunity to create one integrated line and to leverage our existing capabilities. And we believe that this will be accretive off the back because we already have a lot of the capabilities in-house.

Jeff Van Sinderen - B. Riley

And it basically is going to continue in the same channel of distribution, is that right?

Jill Granoff

Yes. Today it is a $50 million business at wholesale. It is sold in Nordstrom, Dillard, Lord & Taylor, Bloomingdale, Bells, (inaudible), et cetera, and we intend to keep it in those same channels of distribution. We think there is opportunity to grow in some of those stores as well, and we also have the resources to invest to facilitate that growth.

Jeff Van Sinderen - B. Riley

So when will we be able to say that it’s actually your business versus the licensees business?

Jill Granoff

We are taking the business in-house for fall 2011.

Jeff Van Sinderen - B. Riley

And then, maybe you can also give us a little more color, I know you gave some comments in your prepared remarks on the men’s apparel launch and what we should there, I know it’s still early, but any other color would be helpful.

Jill Granoff

Sure. It is very early Jeff, I mean setting 210 doors as you can imagine is a big undertaking and actually the last store was set just last week, but we did launch Herald Square for Labor Day weekend, it’s something that that Macy's requested and performance in that store has been very good. We are certainly excited about the potential and what we are seeing is that the EDV product, every day value product is actually performing best which is terrific news, because that is all replenishment business. And by category what we are seeing is great results in our suit separate, some of our long-sleep wovens and slub tees, and then we’re still seeing a little bit of softness in outerwear and sweaters as is just about everyone because of the warm weather.

Jeff Van Sinderen - B. Riley

And then finally, since everybody seems to be focused on sourcing cost pressures these days, it sounds like you feel you can offset some of the pressures, the in-hand pressures, maybe you can just clarify that a little bit for us.

David Edelman

Yes, we are seeing rising freight costs and raw material prices, but we have the ability with our sourcing office that’s in china, and also I think we talked about Peter Charles who joined us about a year ago, some of the changes that he’s been able to make. We think we can offset most of the increases in the near term.

Operator

Your next question comes from the line of Sam Poser with Sterne Agee. Please go ahead.

Sam Poser - Sterne Agee

I got a whole bunch of questions. Number one, what is your current store count and what did you open and close in the quarter?

David Edelman

We have 109 stores, and we didn’t actually open or close any stores during the quarter.

Sam Poser - Sterne Agee

And then, if you're planning on opening five in Q4 and can you give us an idea of what you plan to close in the fourth quarter? I know you said you're closing stores soon, but…

David Edelman

We think we'll close at least seven stores most of them are some of the larger unproductive boxes.

Sam Poser - Sterne Agee

And is that in Q4 or will that fall into the first quarter as well?

David Edelman

It will be at the end of the year and roll into early Q1.

Sam Poser - Sterne Agee

Okay. And then you talked about the sourcing costs, as you built your REACTION Sportswear business at Macy's, and that's going to roll out to more stores next year from what I understand, and you priced it accordingly. Would the prices, and especially in apparel going up towards the end of next year, how are you planning on maintaining the value strategy there? Are you going to have to raise prices? You're working with Li & Fung I believe, so what kind of advantages are they giving you and so on and so forth?

Jill Granoff

Well actually we are working with W.E. Connor today to source our line and what we have done in order to really preserve margin based on the out-the-door prices, it’s really critical, we've developed the product based on the out-the-door prices. We have sourced this line entirely outside of China. So the line was sourced from India, Vietnam, Indonesia and Bangladesh and that is what has enabled us to the targeted margins that we set out.

Sam Poser - Sterne Agee

And then when you're looking at the women's apparel business, you already have the majority of that in place right now from what I understand as far as the infrastructure to get it done, how does the women's apparel business of that $50 million, how does that break down by quarter in the actual dollar so we can at least try to model the sales into next year?

David Edelman

You know what Sam, we are really not going out beyond any guidance for Q4. It’s a $50 million and we take it over after six months.

Sam Poser - Sterne Agee

I mean is it 50-50 front half, back half, I mean is that a good way to look at it. I just want to have some idea. I realized we are not going to come out of the royalty income in the front half of the year, and you’re going to have more revenues towards the back half.

David Edelman

You won’t be far off using that assumption.

Operator

Your next question comes from the line of Janet Kloppenburg with JJK Research. Please go ahead.

Janet Kloppenburg - JJK Research

I wanted to just touch based on a couple of things, the REACTION footwear business, was it showing in both men’s and women’s, Jill?

Jill Granoff

Yes, it was.

Janet Kloppenburg - JJK Research

And you were happy with the performance, and could you talk a little bit about some of the newness there and what the reaction, no pun intended, was to that. And if order trends continue to be strong with the department store is for that plan going forward?

Jill Granoff

I mean we are seeing double-digit growth in both men’s and women’s footwear in the quarter which was terrific news. On the men’s side we have a very well rounded assortment. We are seeing some nice momentum in Oxford and in Boots, but also we still maintain a nice Lofer program and also at leisure footwear. So, we feel that the assortment is well rounded, it is priced right and we have a very high percentage as well of EDI or replenishment inventory in REACTION Sportswear and that is what helps to show the momentum. It’s a good double digit EDI replenishment business within REACTION footwear.

And then on women’s side, clearly we continue to do well with our glam construction. I think we are known for this sandal, which also sells year around. It has a comfort foot bed with embellished uppers at a very attractive price point, but also we are doing well with wedges and clearly boot sales are starting to pick up now that the weather is getting colder.

Janet Kloppenburg - JJK Research

I also wanted to just ask a question about the pricing. Other footwear manufacturers are saying that there will definitively be price increases in the spring. So, I guess I'm hearing from you guys that you can hold prices for next spring, and are you not yet ready to comment on the fall season?

Jill Granoff

We are not yet ready to comment on the fall season, so you are correct in that and as we’ve talked about previously we still believe the customer is seeking value and we are going to try to hold our prices. As David had mentioned we do have opportunities to mitigate some of the cost increases, by consolidating some of our factory base and also doing more development through our own China office. So, for spring we are really looking to hold prices.

Operator

Your next question comes from the line of Steve Marotta with CL King. Please go ahead.

Steve Marotta - CL King

A couple of quick questions. You mentioned on the call last quarter that the five-to-ten stores are expected to close, we’ll save about $0.15 to $0.20 but I believe a bulk of that is the Rock Center store. Can you update on the progress with that particular unit?

Jill Granoff

Sure. Basically what has transpired since the last call is that we have reached an agreement with the landlord to close the mezzanine level or the second floor of the store at the end of the year, and as you may know it’s a 17,000 square foot store with 12,000 square feet upstairs. So, we have reached an agreement to close that, that will obviously result in rent and can saving and we are in continued discussions with regards to the first floor and as soon as we have closure son our plans for the first floor we will share that with you when we are ready.

Steve Marotta - CL King

The SG&A cost associated with bringing women to the sportswear in-house, I realize you commented that the design and merchandise teams are currently there. Are there any incremental expenses that you expect by bringing this in, or is the entire infrastructure in your mind in place?

David Edelman

No we are going to have on some support steps, from mostly that’s the front end of the business.

Jill Granoff

It’s really in the sales arena because as I said we had designed merchandise and in sourcing we will need to add some support in those areas, the business expands but the primary addition will be in terms of our sales team and building a showroom.

Steve Marotta - CL King

Can you quantify that?

Jill Granoff

Not at the present time.

Steve Marotta - CL King

And can you comment, I realize that the licensing will roll off in the back half. Can you quantify what that annualized stream is?

David Edelman

You know we don’t comment on any specific license but it’s a $50 million and our royalty rates range anywhere from four to 12% on licensees. So, you can…

Jill Granoff

And in the model we feel that this is a accretive, which I think is the key point, because if you think about the fact of we can earn a double-digit rate of return on the sales versus a single digit royalty rate obviously there will be incremental profit that floats to the bottom line.

Steve Marotta - CL King

David, you commented on $4.4 million in SG&A costs in the prepared text. Can you quickly go over that again, I missed it whether it was last year or this year.

David Edelman

I just wanted to make sure that as we gone in leverage over the last several quarters that our absolute dollars are going to start going up as there were some of the incremental spend. So, one of those larger expenses is a paper performance bonus. So, last year the company was loosing money we did not pay bonuses and this year we are on pay suit to pay a bonus. So, we are paying accruing for bonuses which is going to hit a good part of the fourth quarter, as well as an increased marketing spend to support our sales growth and also the new men’s Reaction sportswear line.

Steve Marotta - CL King

And that can equal, you’d expect 4.4 million.

David Edelman

That is $4.4 million incremental spend over last year’s fourth quarter.

Steve Marotta - CL King

Lastly, the promotional environment you mentioned that you feel that your inventory is clean at the current time, you did mention a little bit of promotional activity in the third quarter we’d put some pressure on gross margin. I just want to be clear that the item that might not have sold well and that had been promoted are completely out of the inventory and you are currently in a less promotional stance than you may have been in the third quarter. Did I read that right during the prepared text?

David Edelman

Not exactly. Our inventory is very clean, it is actually improved year-over-year. Most of our stuff is in transit or the stuff that just came in the last couple of weeks in September. We are just saying the actual environment is more promotional and the customer is demanding more so we have been a little bit higher on our mark downs.

Jill Granoff

In the outlet channel.

Steve Marotta - CL King

So you’re saying that’s a similar cadence currently as there was to the third quarter?

David Edelman

In my guidance, it’s the same cadence, yes.

Operator

Your next question is a follow up question from Sam Poser from Sterne Age. Please go ahead.

Sam Poser - Sterne Agee

David, I just missed what you just said about the SG&A. How should we look at that in the fourth quarter?

David Edelman

That our absolute dollars is going to go up. We are still looking to be flat to have some slight leverage, but the differencing being that the two components that are taking away the leverage that we’ve seen over last few quarters are an increase in marketing spend and an accrual for our pay-for-performance bonus.

Sam Poser - Sterne Agee

And the pay-for-performance bonus is about $4.5 million?

David Edelman

The two items together are 4 million.

Sam Poser - Sterne Agee

And Jill, you commented that the retail business, you commented that women's and men's apparel and men's footwear was good, what is the status of women's New York footwear these days with the 9-to-5 and all that, that didn't seem to come up in conversation?

Jill Granoff

Yes, I mean we are seeing double-digit growth in 9-to-5 which is great, but as you know it’s off of a small base as we keep the line exclusive and proprietary, the line is sold in our full price stores and online, and also in better distribution like Nordstrom and Bloomingdale. So, we are seeing growth, but again a top of a small base, the key is that the focus has been on the core pump, and going forward we will be surrounding that or looking to surround that with some key fashion items which should really then help us continue the momentum and roll out distribution for next year.

Operator

(Operators Instructions). There are no additional questions at this time. I would like to turn it back to management for closing remarks.

Jill Granoff

Thank you. Kenneth and I sincerely appreciate the hard work and dedication of our associates as we have said many, many times. They are the foundation of our business. We also want to thank our customers for their ongoing loyalty and our shareholders for their ongoing support. Thank you again, and have a great day.

Operator

Thank you all for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.

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