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Rocky Brands, Inc. (NASDAQ:RCKY)

Q3 2011 Earnings Conference Call

October 26, 2011 4:30 PM EST

Executives

Brendon Frey – ICR

David Sharp – President and CEO

Jim McDonald – CFO

Analysts

Reed Anderson – D.A. Davidson

Mitch Kummetz – Robert W. Baird

John Sullivan – Olstein Capital Management

Operator

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the Rocky Brands third quarter fiscal 2011 earnings conference call.

At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time for you to queue up for questions. (Operator Instructions). I would like to remind everyone that this conference call is being recorded.

And will now turn the conference over to Brendon Frey of ICR.

Brendon Frey

Thanks. Before we begin, please note that today’s discussion including the Q&A period may contain forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Such statements are based on information and assumptions available at this time and are subject to change, risks and uncertainties, which may cause actual results to differ materially. We assume no obligation to update such statements. For a complete discussion of the risks and uncertainties, please refer to today’s press release and reports filed with the Securities and Exchange Commission, including Rocky’s Form 10-K for the year ended December 31st, 2010.

And, I’ll now turn the call over to Mr. David Sharp, President and Chief Executive Officer of Rocky Brands.

David Sharp

Good afternoon and thanks for joining us. With me on the call is Jim McDonald, our Chief Financial Officer.

Overall, we were pleased with our third quarter results. We continued to experience increased demand for our Rocky-owned brands and our core western work and hunting categories. At the same time, our commercial military business, which was launched in 2010 and falls under our wholesale segment, more than doubled compared to the year-ago period. This helped to partially offset the significant decline in military segment sales and the loss of Dickies license business which in the third quarter of last year generated sales of $4.3 million and $2 million respectively, a total of $6.3 million.

Wholesale sales were modestly below our expectations. However, we feel that consumer demand is stronger than our results indicate. We believe many of our wholesale accounts have recently decided to operate with leaner inventory levels in response to a potential slowdown in the economy. Our performance in retail was evidenced by many key accounts that we monitor is solid, but reorders are not currently matching sell-throughs. Order rate should accelerate as the season unfolds and the weather becomes wetter and colder.

A few of the highlights from our wholesale division included our western boot segment sales increased 11% with growth coming from both the Durango and Rocky brands. We saw a good response to our women’s fashion product as well as our new little Durango kid’s line of boots. The growth of Rocky western products was driven by increased demand for our long range and original ride product lines at several key retailers.

The Georgia brand sales increased 8% on the strength of new product introductions and better inventory positions on core styles. Our hunting sales were up modestly in the third quarter and had recently picked up as the hunting season has gotten underway. And finally, our commercial military sales increased a 163% to $4.3 million in the third quarter.

As a clarification, our commercial military sales are those to on-based peers’ exchanges and off-based private sector retail stores to service uniformed service people. This high margin business is in contract to and should not be confused with our low-margin government contracts that we receive from time to time, which we report as our military segment.

We have two products in particular that appeal to the service people that they’re buying in increasing numbers. They are fully drainable boots we developed for the US Navy Seals and a hyper lightweight boot that soldiers like to wear on base and when they’re travelling in uniform. Soldiers are purchasing more and more of their own gear as the government is decentralizing its procurement matters. So we plan on this trend to continue into 2012.

Now, some comments on our retail division, where our operating performance improved dramatically in the third quarter. Our slightly lower sales volumes, we swung from a loss in the year-ago period to profitability on both higher gross margins and expense leverage. The number of accounts using our customized account websites grew by 15% and that enabled [ph] sales growth of 38% with that account population.

Also of note, our national account customers did 57% of their business online or direct in the third quarter, up from 41% last year. This has allowed us to significantly lower our expense base by reducing the number of mobile stores or trucks in operation. We now operate 42 trucks versus 63 last year at the end of this period. And now we’re operating just three stores compared to 14 in the third quarter of 2010. As accounts continue to seek out more cost savings, the interest level in our new web-based platform is increasing and we expect current trends to continue in 2012.

I’ll now turn the call over to Jim, who will review the financial details of the third quarter.

Jim McDonald

Thanks David. Net sales for the third quarter were $71 million compared to $74.8 million for the corresponding period a year-ago. Wholesale sales for the third quarter increased 1.4% to $60.2 million compared to $59.4 million last year. The sales increase was driven by 11% gain in our western category offset by a decline in our work category, due primarily to the discontinuation of our license agreement with Dickies at the end of 2010. We also experienced a significant increase in our commercial military business versus a year-ago.

Retail sales for the third quarter were $10.3 million compared to $11 million last year. Our military segment sales were $400,000 versus $4.3 million for the same period in 2010. The decrease in military sales was attributable to the completion of our initial order under our contract with the GSA before we started this year.

Gross profit in the third quarter was $25.6 million or 36% of sales compared to $27.2 million or 36.4% of sales for the same period last year. The 40-basis point decrease in gross margin was primarily attributable to an increase in product cost versus a year-ago.

Selling, general and administrative expenses were $18 million or 25.4% of sales for the third quarter of 2011, compared to $19.2 million or 25.6% of sales a year-ago. The decrease was primarily due to lower compensation expense.

Income from operation was $7.6 million or 10.6% of sales for the period compared to $8 million or 10.8% of sales in the prior year period.

Interest expense for the third quarter decreased to $300,000 versus $1 million in the third quarter of 2010. The decrease in interest expense was the result of lower interest rates on the new $70 million revolver credit facility we signed in October of last year.

Our effective tax rate for the third quarter of 2011 was 29.7% compared to 36% in the third quarter of 2010. For fiscal 2011, our effective tax rate is now estimated to be approximately 32.6%, compared to our previous estimate of 35%. The lower effective tax rate is a result of additional permanent capital investment, which we made in our Dominican Republic operation.

We reported net income of $5.2 million or $0.70 per diluted share versus net income of $4.7 million or $0.63 per diluted share a year-ago.

I’ll quickly touch on a few of the highlights from our year-to-date results. For the nine months period ended September 30th, 2011 wholesale sales excluding Dickies increased 8.3%, gross profit improved 230 basis points to 37.3%, with wholesale gross margins up 40 basis points and retail gross margins up 260 basis points. Interest expense was down $4 million. Net income improved $3.4 million and diluted EPS increased 51% to $1.07 per share compared to diluted EPS of $0.71 last year for the same period.

Turning to the balance sheet, our funded debt was $60.1 million at September 30th, 2011 versus $53.4 million at September 30th, 2010. Inventory increased 25.4% to $78.9 million at September 30th, 2011 compared to $62.9 million on the same date a year-ago. The increase in inventory is the result of an increased in cost per units as well as an increase in units. The increase in units was the result of lower than anticipated sales in the quarter. Inventory units are expected to be near prior year levels at the end of the year.

Lastly, as we announced in the earnings release, we have decided to terminate our Defined Benefit Pension Plan. The Defined Benefit Pension Plan is the predecessor to our current 401(k) program which was frozen at the end of 2005. The asset in the pension plan have underperformed expectations over the past several years and expense associated with this other performance as they capitalized on our balance sheet. This expense would have been recognized over the next 10 years. Therefore we made the decision to terminate the plan instead of letting the gap between the asset value and the commitments continue to widen and in turn increase the ultimate expense to be recognized. However, we’ll require that we take a one-time $3.2 million net of tax nonoperational charge in the fourth quarter to fund the remaining future commitments under the plan. In addition, by closing the plan, the company will save approximately $200,000 in annual maintenance fees.

I will now turn the call back to David, for this closing comments.

David Sharp

Thanks Jim. As I outlined on the last earnings call, we’ve identified a handful of key initiatives to grow our business outside our core, domestic, work, western and hunting categories. Many of these are longer-term plans, but let me update you on our continued progress.

The first of these involves the international markets. For 2011, we are now in pace to grow our sales outside the United States by 20% to roughly $10 million through direct operations in Canada and distributors in the European Union, Russia, and Central and South America. This comes on top of the 40% increase we delivered in 2010. We recently signed new distributors for the Rocky brand in Finland and for the Georgia brand in the United Arab Emirates, and we’re looking for other partners to fill out the map in the years ahead.

Another initiative is centered on extending our brands into new categories. We believe there are a number of logical extensions for both our brands and our proprietary technologies. This includes new industries for our work product, including more into our related professions where our proprietary split-resistant [inaudible] and unique comfort systems would benefit workers who are on their feet for the majority of their shifts.

We also think the broader outdoor market provides compelling growth opportunities for the Rocky brand. The hunting category represents a small percent of the multibillion dollar outdoor footwear industry and we are confident that many of the compelling benefits found in our hunting and military boots will appeal to hikers, campers and other non-hunting outdoor pursuits.

Finally, we are developing more fashion forward product under the Durango brand. So far this has been working well as evidenced this quarter with the reported increased sales. This line extension gives us entrees in new domestic channels of distribution in metropolitan areas and has appealed for our export markets. The fall of 2012, we have expanded the line and are looking forward to unveiling it at the FFANY New York Expo Show in early December. We’ve had a great reaction for the line from those retailers that have previewed it. They have commented positively regarding its fashion relevance and value. This is the first time in over a decade that we’re attending this market and we’re working hard on penetrating new channels of distribution with the brand.

Operator, we’re now ready to take questions.

Question-and-Answer Session

Operator

Thank you. We will now be conducting our question-and-answer session. (Operator Instructions). Our first question is coming from the line of Mr. Reed Anderson with D.A. Davidson. Your line is now open. You may proceed with your question.

Reed Anderson – D.A. Davidson

Thank you, good afternoon. I have a few questions. David, let’s start just kind of talking about on the western business. I wondered if you might just provide a little more color there, because that has really continued to be one of your strongest areas. I’m just curious if you think that’s almost entirely driven by a lot of the new product that you’re putting out there or is it also just where that product is distributed. And I’m just thinking of particularly in some – one will say rural markets, but that the rural economy is very strong and to the extent that there might be a customer who would buy a pair of boots if that’s a factor. But if you could just provide some more color on why that’s been so strong please.

David Sharp

Well, with respect to the Rocky Brands, the product is really heavily focused on work applications. And we’ve gained a lot of shelf space in traditional western stores and farm and ranch stores. So yes, I think it does appeal for that rural customer and that’s certainly who we’re targeting with it. With respect to the Durango brand, a lot of the growth is coming from traditional western distribution, but with a more fashion product that is not strictly western product.

Reed Anderson – D.A. Davidson

Okay, that’s helpful, thank you. There is another question I had just on sales trends. You had said, typically wholesale just a little bit less than you thought. I mean I got to believe weather was a negative – I mean it’s been very warm, not a lot of moisture particularly in a lot of the upper Midwest, people that are out hunting and things like that, I mean that’s got to be deferred. Do you think that was a factor? You said order, reorders have not followed sell-throughs. Do you think that weather was a factor?

David Sharp

Yes, weather – we have businesses that are affected by weather. There is no doubt. And I think that the weather was more favorable in the third quarter of last year than it was this year. And as the weather is starting to change, we are seeing our hunting business, our insulated work boot business picking up. We also had two large programs of large retailers where we’ve had good sell-through, where I think the retails were concerned about their inventory levels throughout that whole business, not particularly in footwear or with our products, and we didn’t get the fill-ins that we frankly deserved. But we’re actually seeing those improve right now as the weather is changing.

Reed Anderson – D.A. Davidson

That’s great. And then one last one. Jim, you did say obviously in inventory growth that it was both units and costs. I’m just curious, could you just give us a sense of how much – how much higher product cost is baked into that inventory growth, just a ballpark?

Jim McDonald

About – of the increased we had of 16 million. About – a little bit about 55% of that is related to increased product cost and 45% is related to increase in units.

Reed Anderson – D.A. Davidson

Okay, that’s great. Thank you. Best of luck.

David Sharp

Thank you.

Operator

Our next question is coming from the line of Mr. Mitch Kummetz with Robert W. Baird. Your line is now open. You may proceed with your question.

Mitch Kummetz – Robert W. Baird

Yes, thank you. Let me just start on the Q3 shortfall. How much was the shortfall relative to your expectations?

David Sharp

Approximately $2 million to $3 million in wholesale.

Mitch Kummetz – Robert W. Baird

Okay.

David Sharp

We were right on target really with our retail businesses as we remake that. And then, of course, we had the main shortfall in military, but we expected that.

Mitch Kummetz – Robert W. Baird

Okay. So with the expectation of reorders accelerating as we go through the year, how much of that $2 million to $3 million do you think you make up? You think you make all of it up or is there piece that you have to close out?

David Sharp

Yes. I think as we just discussed with Reed, we – it’s the weather patterns for most of the year in the fourth quarter than they were last year. And on a comp basis we should do better. We’re getting great sell-through reports from our retailers, we have a lot of new product in the pipeline where we’ve taken a good hard look at this inventory. it’s heavier that we’d like it right now, but we do still very confident that we’ll be – we’ll have the inventory down to pretty much where it was at the end of last year at the end of this year. And – but that’s without promoting it heavily.

Mitch Kummetz – Robert W. Baird

Okay. And inventory looks to be up about $16 million year over year, so just a couple of million from – or maybe a little bit less than that from this shortfall in the quarter.

David Sharp

Well, that’s the major.

Jim McDonald

Yes, it would be about couple of million. That’s about right, yes.

Mitch Kummetz – Robert W. Baird

Okay. And then you guys have talked a lot about the commercial military business, it sounds like it’s trending very well. Is there anyway you can give us just a sense as to how big that business is and what the growth – did you say what the growth rate is on that business?

David Sharp

In the quarter it was around – I think it’s 40%, we reported 40%. And we think we can –

Jim McDonald

Actually, it was up 200% some I think. But for the year so far it’s more than doubled.

David Sharp

Yes.

Mitch Kummetz – Robert W. Baird

Okay.

David Sharp

We did a 163% in the quarter. So we believe that we can sustain that kind of growth into next year.

Mitch Kummetz – Robert W. Baird

Okay. I’m guessing that’s going off of a pretty small base and continues to be a pretty small base. Again, is there anyway you can kind of give us a sense of magnitude how significant that is for your overall growth?

Jim McDonald

Well, we’re – year-to-date we’re at $14 million on that business versus about $6 million last year.

Mitch Kummetz – Robert W. Baird

Okay. That’s very helpful. On your overall wholesale business, I know you’re still lapping Dickies and I know that was a drag on the sales, could you say what wholesale was ex-Dickies on the quarter?

Jim McDonald

Ex-Dickies we’re up about 5% in wholesale. We did $2 million last year in the sales of Dickies products last year.

Mitch Kummetz – Robert W. Baird

What was Dickies in Q4 last year? I can’t remember exactly when that was terminated.

Jim McDonald

It was about the same of $2 million, it maybe a little bit more than $2 million.

Mitch Kummetz – Robert W. Baird

All right. Let me see, I might have another one or two. On the stores, I think you said you have three now and there was a 14 last year. I didn’t quite get that number.

Jim McDonald

That is correct, yes.

Mitch Kummetz – Robert W. Baird

Okay, good. And then – I wanted to ask you this question Jim, gross margins by segment, wholesale, retail, military on the quarter.

Jim McDonald

Sure. Wholesale was 35%. Hold on one second. Wholesale was 34.3%.

Mitch Kummetz – Robert W. Baird

Okay.

Jim McDonald

Retail was 47.1% and military was 13.3%.

Mitch Kummetz – Robert W. Baird

Okay, 13.3%. And then on the SG&A with the headcount reduction, how much of an impact was that on SG&A and what’s – and how does that play out on a go-forward basis? I mean, I guess, you continue to benefit from that then, right?

Jim McDonald

Yes, I think we do. We had a – it was about $600,000 in the quarter and we’ll continue to benefit prefer than that. But we are – as we try to grow, we are trying to reallocate some of those resources that we’ve had into things that will help us grow the top line. We were just shipping around. But we’ll [inaudible] maybe not to the magnitude – certainly not to the magnitude we’ve had in the past.

Mitch Kummetz – Robert W. Baird

Got it, okay. And then lastly, I mean on the interest expense, I think your guidance had been $1.5 million, but I mean – it’s like you’re continuing to trend below that for the year. I mean, should we be thinking something more in the neighborhood of $1 million or –?

Jim McDonald

Yes, I think the interest expense for the quarter was $250,000. I would expect fourth quarter to be similar to that. Our partners are starting to – they peaked and they’re starting to go down, so I would say that we’ll – we should be relatively similar to that probably in the fourth quarter.

Mitch Kummetz – Robert W. Baird

Great. All right, guys, thanks a lot. Good luck.

Jim McDonald

Thanks Mitch.

Operator

Thank you. (Operator Instructions). Our next question is coming from the line of John Sullivan with Olstein Capital Management. Your line is now open. You may proceed with your question.

John Sullivan – Olstein Capital Management

Hi, I just wanted to circle back real quick on the inventories here. So you said that sales are maybe a couple of million short which might – which would – it looks like it would have taken care of the sequential increase. But on the year over year being up 25%, you guys – it sounds like you alluded to not having to promote heavily in the fourth quarter to work it down, is that you’re just doing quite a bit less production to offset?

David Sharp

Yes, that’s correct. Less production and less sourcing.

John Sullivan – Olstein Capital Management

Okay, okay. And just if my math is correct, the inventory is being kind of keeping the cash flow at bay this year so far, but is that something we should be looking at to reverse in Q4?

Jim McDonald

Yes, I think that – I think as the – obviously as the inventory comes down, we’re going to push that all into the cash and reduce our low balance. The other thing that’s affecting us this year as you compare it to last year is that our – last year we did $17 million in military business, four of it in the third quarter. Well that – those sales had very short terms on them and they turned out receivables pretty quickly, they certainly in comparison to our wholesale business and our retail business. So that’s just delaying the cash flow a little bit here as we turn those receivables into cash.

John Sullivan – Olstein Capital Management

Okay. Great, thank you.

Operator

Thank you. At this time, there are no further questions. I’d like to turn the floor back over to management for any closing comments.

David Sharp

Okay, thank you, for joining us on the call. We’ll continue to work hard and talk to you in another 90 days.

Operator

Ladies and gentlemen, this does conclude tonight’s teleconference. You may disconnect your lines at this time. Thank you very much for your participation and have a wonderful evening.

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