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Payless Shoesource Inc. (NYSE:PSS)

F2Q07 Earnings Call

August 29, 2007, 5:00 PM ET

Executives

James Grant - Director, IR

Ullrich E. Porzig - Sr. VP and CFO

Matthew E. Rubel - CEO and President

Analysts

John Shanley - Susquehanna

Jeffrey Stein - Keybanc Capital Markets

David Mann - Johnson Rice & Company

Jonathan Braatz - Kansas City Capital

Rob Wilson - Tiburon Research Group

Presentation

Operator

Ladies and gentlemen, thank you for standing by, and welcome to todays conference call. At this time, all lines are in listen-only mode. Later, there will be an opportunity for questions, and instructions will be given at that time. [Operator Instructions]. And as a reminder, today's conference is being recorded.

I would now like to turn the conference over to James Grant. Please go ahead sir.

James Grant - Director, Investor Relations

Good afternoon and welcome to Collective Brands Conference Call and the results of Payless ShoeSource's Second quarter of 2007. I am James Grant, Director of Investor Relations. Our call today will begin with Rick Porzig, Senior Vice President and Chief Financial Officer, followed by Matt Rubel, Chief Executive Officer and President. After we complete our prepared remarks, Matt and Rick will take your questions.

Our remarks today will contain forward-looking statements which are not historical facts and are subject to a number of risks and uncertainties. Actual results may differ materially. Please refer to today's press release for more information on risk factors.

And now, I would like to turn the call over to Rick.

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

Thanks, James, and good afternoon, everyone. Second quarter 2007 net earnings were $25 million or $0.38 per diluted share, down 23% versus the second quarter of 2006. However, this $0.10 per diluted share decline was impacted by the following.

Second quarter 2007 expenses related to the Companys distribution center initiative including the exit from one facility and the temporary redundancies between facilities. Those expenses totaled $3.6 million pretax or $0.04 per diluted share. Second quarter 2007 expenses related to the integration and planning of Stride Rite. Those expenses totaled $1.8 million pretax or $0.02 per diluted share.

Second quarter 2006 income related to Payless receipt of Visa Check/Mastermoney antitrust settlement proceeds and the income totaled $2.3 million pretax or $0.02 per diluted share. In second quarter 2006, income related to Payless insurance recoveries due to hurricane. The net incremental income over 2007 totaled $1.6 million pretax or $0.02 per diluted share.

Now, I would like to walk you through the second quarter 2007 financial statements and explain the drivers behind these results. Let's start with sales.

Second quarter sales totaled $699 million, a decrease of 1% over the second quarter of 2006. Same-store sales were down 1.4% for the second quarter of this year. Importantly, we did pick up market share during the quarter according to industry reports. So, we are very pleased with that achievement, in spite of overall sales performance.

Second quarter 2007 sales were unfavorably driven by the following factors. First, weak results in our sandal business which caused total unit sales to decline by 2%. And second, the later timings of the back-to-school to season. Certain key markets shifted there as school start dates a couple of weeks later. These factors were mostly offset by the following related favorable drivers. We converted a higher percentage of customers in our stores and sold more units per transaction. Athletic and casual footwear performed particularly well and average unit retails were up 1%.

Now on to gross margin. Gross margin was 34.4% of sales in the second quarter of 2007, down 20 basis points. The gross margin rate was driven principally by the following factors. Higher initial mark-on enhanced by more direct sourcing, mark-downs on most types of sandals, investments in our distribution center infrastructure and last years hurricane insurance recoveries. The latter two factors, as I quantified earlier are negatively impact the gross margin by a combined 73 basis points.

Selling, general and administrative expenses as a percent of sales was 28.7% in the second quarter of 2007 versus 24.7% last year, an increase of 130 basis points. The de-leverage was due primarily to lower sales of sandals rather than a growth in expenses. SG&A expenses for the quarter were $201 million, up 3.9% versus last year. The increase was primarily driven by higher payroll, last years antitrust settlement and the Stride Rite integration planning costs, principally professional services. The latter two factors, as I quantified earlier negatively impacted SG&A by combined 59 basis points.

We had net interest expense of $800,000 in the second quarter of 2007 versus net interest income of $700,000 in the same period last year. The change was driven by lower cash balances this year. As previously communicated, the Company financed the portion of its acquisition of Stride Rite with a $725 million term loan B at a variable rate of 8.3% over seven years. On August 24, 2007, Company entered into an interest rate swap arrangement for $540 million, which provides for a fixed interest rate of approximately 7.75%, portions of which mature on a series of dates over the next five years.

Our income tax provision was $12.7 million in the second quarter of 2007 versus $17.3 million in the prior year period. The lower tax provision was due in part to lower pretax earnings. Our effective income tax rate of 32.8% on continuing operations was down compared to 34% last year due primarily to reinstating of certain federal employment tax credits and a decrease in the effective tax rate related to our international operations. The full year effective tax rate on continuing operations, including discrete events known at this time is projected to be approximately 33%.

Minority interest represents a 40% share earnings due to our joint venture partners in Latin America. Second quarter 2007 monitory interest was $1.3 million compared to $600,000 in the same period last year. The increase was due to our stronger results in our Latin American business.

Second quarter net earnings from continuing operations were $24.7 million this year versus $33 million last year. Our cash and short-term investments at quarter-end were at $327 million, down $114 million or 26% over the previous year. The decrease was due primarily to the first quarter 2007 acquisition of Collective Licensing International.

Our total inventory at the end of the second quarter 2007 was $370 million compared to $351 million at the end of the second quarter of 2006. Inventory quality at quarter end was better because aged unit as a percent of total inventory was lower. The increase in inventory was driven primarily by the following factors. We had greater investments in strong performing product categories for fall, merchandised mix shift towards our footwear at higher average cost linked to higher average retail in the initial mark-on, and an increase in longer lead time raw material commitments associated with a higher percentage of products sourced directly by Payless.

Regarding our fixed assets, our capital expenditures through the first half of fiscal 2007 totaled $93 million, up $40 million from the same period last year. The increase was due primarily to greater investments in the Companys supply chain and Payless stores. Collective Brands capital expenditures for fiscal 2007 are expected to total about $175 million. This higher level of investment is driven predominately by our new distribution center initiative. We will also continue to invest meaningfully in our retail store base to improve our customers shopping experience.

And as for share repurchases, during the second quarter of 2007, we repurchased 141,000 shares for $4.6 million during under our stock repurchase program in accordance with our debt covenants. We may repurchase approximately $32 million more of our stock at this time. This limit will continue to adjust quarterly based on our net earnings.

Regarding the Collective Brands financial outlook, Collective Brands is expected to have strong pro forma financials, excluding the impact of purchase accounting. The acquisition is expected to be accretive to earnings per share in 2008, as the Stride Rite unit's earnings contribution is expected to exceed the incremental interest expense. Due to the impact of purchase accounting, the Stride Rite acquisition is not expected to be earnings per share accretive in fiscal year 2008 on a GAAP basis. Excluding the purchase accounting, the 2006 to 2009 compound annual growth rate in operating profit is expected to be in the mid to upper teens. Including purchase accounting, the 2006 to 2009 compound annual growth rate in operating profit is expected to be in the low teens on a GAAP basis.

And now, I will turn the call over to Matt Rubel.

Matthew E. Rubel - Chief Executive Officer and President

Thanks, Rick and good afternoon everyone. Today, its my pleasure to address the investment community for the first time representing our new Company Collective Brands. Collective Brands is a global footwear, accessory and lifestyle brand company that reaches customers through multiple price points and multiple selling channels, such as retail, wholesale, licensing, and e-commerce.

Later in my remarks, I will address some of the strategies we are pursuing related to our recently acquired Stride Rite unit and the corresponding impact on our new company, Collective Brands. But first, I will provide you with some commentary on recent Payless performance and how we are progressing on the Payless strategy.

While our second quarter results underperformed our expectations, we are pleased that according to the survey prepared by the footwear distributors and retailers of America, we were successful in continuing the grow market share. I will also mention that while on a fiscal basis, our comp store sales were down 1.4%, on a calendar basis which reflects how our customers shop, our comp store sales were flat to last year. Again, this performance was due to sales of sandals, which made up 36% of the sales in the second quarter of 2007. Importantly, we continue to see that our merchandise and core strategies are resonating with consumers. This was evidenced by the improvement in several important sales metrics in the second quarter. We converted a higher percentage of customers with more units per transaction and at a higher average retail. This encourages us that our merchandising strategies are positioning Payless to continue to build market share.

So, now I would now like to update you on some of our more important initiatives and achievements, which I believe will provide additional confidence that we are well positioned to capitalize on growing market segments in both the short and long-term. Lets go through each of the four cornerstones of the Payless strategy, starting first with on trend, targeted product.

We recently received results back from our periodic womens attitude and usage survey, and the results offered a lot of compelling evidence that we did improve our standing among customers as being more on trend. We saw a 300 basis point improvement over last year on the perception that Payless almost always has the styles you are looking for. And we saw a 200 basis point improvement over the same period on the perception that Payless has current fashion styles at the same time or better than department stores. Other attributes consistent with being on trend, improved as well. Payless is a store you go to first when you are looking for whats new in shoes and Payless is a store you really enjoy shopping for shoes.

Becoming more targeted and on trend was evident not only in customer survey results, but also with the point of sale. We saw strong second quarter sales in athletics, in branded footwear, and to the important junior customer. We continue to have a very balanced approach to merchandising that's well segmented by customer type and by end users.

In the third quarter, you will see more focus on our stores on our most important merchandise ideas. For example, compared to last year at this time, there is a greater commitment to casual footwear for all customer types, classic, updated, junior, and fashion, particularly in flats and canvas. We have also put greater emphasis on fall transitional footwear and are focused more on wear-now product. Our fall assortments are well segmented by price, enabling us to target looks to our customers across a variety of price points.

Moving on to effective brand marketing. Again, consumer surveys indicate that our brand awareness and the effectiveness of our brand marketing are improving also. According to customers, Payless has brands you can trust at a rate of 100 basis points higher versus last year. Brands now make up 44% of our footwear sales in the second quarter of 2007, up from 30% in the year ago period. The growth in brands was led by strong performances in Airwalk and American Eagle footwear lines.

Brands have higher average unit retails and higher gross margin return on inventory investment versus non-brands. Their higher productivity per five foot section is a key metric reinforcing our efforts to drive the House of Brands strategy in our Payless stores. We will continue to grow our mix of brands, and as I've stated before, we intend to transition Payless stores to about 70% to 80% branded over time.

Some of the newest brand programs, we are launching include Hannah Montana, which just arrived in the store. Dexter and Lela Rose for Payless. Our first Hannah Montana line made in partnership with Disney and exclusive to Payless will hit all stores next month with footwear and accessories.

Dexter branded footwear will launch early in the fourth quarter in about 600 stores. The Dexter line for which we are the exclusive retailer, addresses the traditional and updated customers' segment in both men's and in women's. The Lela Rose for Payless collection features classics with a twist for women and is now being sold in over 400 stores. The results of our branded programs validate our strategy and demonstrate that we have additional sales and gross margin expansion opportunities ahead.

Now on to our strategy component of creating a great shopping experience. During the second quarter, we enhanced our customer shopping experience at Payless in different ways. We continued improving our store environment and building the Payless brand image by adding 42 new hot zones and two new fashion labs formats during the quarter. This brought us to a total of 334 hot zones and just 15 fashion labs at quarter end. Virtually all of our Payless store openings are in the hot zone format.

From a qualitative perspective, customers indicate that they like hot zone changes. Customer satisfaction scores on hot zone stores in the second quarter were 160 basis points higher than the company average. We have made significant investments in our new format and have value engineered them and we will be rolling these changes forward in order to generate an even higher financial return.

Further contributing to our improved shopping experience during the third quarter, we will complete our North American rollout of more technically advanced point of sale terminals and inventory scanning devices. We will also continue the rollout of our new labor scheduling system in the third quarter and extend it to all U. S. stores by the end of fiscal 2007.

Next, I would like to address our final strategy component, Efficient Operations. Our new western distribution center is up and shipping on time, under budget. Last month we went live with case back shipment and then in early August we began shipping single pair replenishment to 180 stores. Today we are shipping at over 98% efficiency. This is an amazing accomplishment, and a huge win for our supply chain team and an indication of our operational achievements happening across our Company.

The success of our new distribution center is an example of this organization's ability to succeed at implementing large initiatives with critical implications for how we serve our customers. The team has to be congratulated for driving our strategy component of Efficient Operations.

Through the Redlands California DC, we are getting closer to our stores and customer base, improving our speed to market and reducing transportation costs. Together with our Ohio based faculty that will be opening next year, this DC initiative is projected to produce a payback well in excess of our investment requirement. The DCs represent a prudent investment, which will build significant, sustainable advantage as a key component of our business model.

We are also supporting our Efficient Operations strategy by increasing the proportion of our products that are designed, developed and sourced directly through our own, internal sourcing capabilities. Direct sourcing helps drive our merchandised margin rates. Approximately 60% of our products were sourced directly in the second quarter of 2007. This compares to 51% from the previous year. While direct sourcing has room to grow, an important part of our business model it to bring creativity, not just from internal resources, but from external resources as well. We are committed to continuing to work with our network of core third party agents, who can help us build our business over time.

Now having finished my remarks on executing the Payless strategy, I would like to turn my remarks to our newly acquired Stride Rite business unit. The acquisition closed just 12 days ago on August 17 and we were very hard at work, setting long-term strategic direction while moving aggressively to improve business operations. We are planning and beginning to implement a broad range of integration initiatives. In fact Rick and I are doing this conference call today in New England, because were with the teams of Stride Rite for a significant, strategic and financial planning off-site meeting. Over the next few months we will develop detailed plans to fully maximize the value for the newly expanded brand portfolio we have built in the process of creating Collective brands. The integration of Collective Brands operating unit will be about capitalizing on growth opportunities, aggressively pursuing cost energies and operating with more efficient processes. Ill address each one of these areas starting with growth opportunities.

The Stride Rite Childrens Group has done a great job at putting together an assortment of brands. We will work on a strategy, which enables them to platform the retail and wholesale divisions of this Group as the provider of the greatest assortment of premium childrens footwear. We envision opportunities to grow the Stride Rite business by extending the duration of customer relationship. We intend to do this by making the Stride Rite Childrens Group and Robeez relevant for our customers over a longer period of their childrens lives. We will extend the Stride Rite Childrens Group to merchandise and market up to a 10 year old customer and strengthen Stride Rite as a house of kids brand.

One way for example that we can attract an older child is through the introduction of skates. Stride Rite has done a great job of appealing to younger children and we want to extend that relationship by building authenticity in the Skate category. In Airwalk, we own one of the top two skate brands in America through our purchase of Collective Licensing International. In the spring of 2008, Stride Rite Stores will launch as Airwalk Branded limited Edition Skate Shoe Collection endorsed by skate-boarder Andy McDonald. This will fill a void in action sports in their stores. This might also become a wholesale opportunity for the Childrens Group.

Over the past couple of years the leadership team at Sperry really took this brand to the next level and grew sales in Sperry by over 20% per year. The growth has been mostly in men's. As of today this high growth brand is about 3:1 mens versus women. We believe this brand has the potential for explosive womens growth which over time can make the womens business greater than the men's. Sperry has had great results and still can be further developed by welding its womens merchandising design and organizational capabilities. We also expect to drive creativity through the sharing of ideas across Collective Brands design Team and eventually build the brand beyond footwear.

In Keds, over the past couple of years the leadership team has successfully repositioned brands to be more relevant and useful. We intend to build on that momentum, while addressing all consumer opportunities available with this iconic brand. Marketing efforts which have targeted 18 year old women have been effective at creating the image of a more useful brand. Adjusting the target up to a 24 year old, is likely to better attract a 40 year old in addition to that 18 year old that is now attracted to Keds. 24 year old after all an age that many of us aspire to be in our own lifestyle. We will also broaden the appeal of the Keds brand beyond just canvass and vulcanized styles by adding new classification and innovative comfort features.

With Saucony the domestic and international growth opportunity is focused on creating and delivering authentic technical running products through the specialty running channel. The team has done a terrific job of creating an innovative technically superior product line. We will remain consistent in our approach to this classic brand which is third in market share now in this channel of authentic running. And we will also use this channel to platform and build the brand, both in footwear and in apparel.

The Hind brand which was one of the originators of compression technology in the athletic apparel arena will move from the Saucony Group into our Collective licensing unit and become licensing platform forum. Were also happy with our Tommy Hilfiger footwear business and discussions are taking place to extend our license.

And for a final example of growth opportunity, we are likely to test new retail concept especially in the Childrens area.

Moving on to cost energy example, we have developed meaningful insights into all aspects of Stride Rites business over the past few months. We formed 11 integration planning teams in areas such as Human Resources, Finance, Sourcing, Logistics, IT, Retail Operations and others. These teams have identified a broad range of synergies and resulting profit improvement opportunities and these teams are hard at work at developing the detailed plans to fully exploit our scale and evolving business model. These synergistic opportunities will be fully operationalized by the end of 2010.

In the supply chain, we are already beginning to leverage Payless than scale. There are opportunities to save on raw materials, manufacturing cost, container shipping costs and in-bound freight as examples. We have already begun to renegotiate some Stride Rite shipping contracts. The supply chain is likely to be our single greatest source of synergistic savings over the next few years.

In finance, there are a number of processes that can be combined and efficiencies enhanced. Examples include regulatory and compliance activities, board of director costs, auditors, insurance, treasury, tax and loss prevention. These are merely examples of an output of a comprehensive integration planning process that has touched all the major functional areas of our Company. When we estimate our combined cost saving opportunities for the three year period 2008 to 2010, we believe that we can achieve cumulative cost energies in the range of $40 million to $50 million, the majority of which will be realized in the latter half of that period.

The success of that integration will be driven not only by specific quantifiable growth and synergistic opportunities, but also the qualitative factors of improving operating processes. Though not as easy to measure, these soft benefits are also extremely important. For example, were installing processes to ensure alignment and consistency for how we develop and source products. Given the scale of Collective Brands, we source some 220 million pairs annually, consistent and simplified processes can save a lot of time and ultimately provide additional financial benefits.

We also intend to put more rigorous discipline about how we plan our product line calendar. The seasonal merchandise planning rhythm that has been implemented at Payless has significantly helped in bringing Payless products to market more efficiently and timely. We believe a similar process will add corresponding value at Stride Rite. And very importantly, we intend to invest meaningful in information technology to bring all the units of Collective Brands up to a consistent of high level of operational performance and to support our overall integration process.

We believe the financial implications of this business combination are very, very promising. Collective Brands was created in order to capitalize on key industry growth plan such as brands, children's markets and casual footwear. We possess growing competitive advantages such as channel diversification, the ability to address a broad range of price points and customer segment and a highly efficient supply chain all supported by significant scale, leverage and customer centric infrastructure.

Collective Brands stands ready to deliver long term share holder value by leveraging its core competencies of each of its business unit, its great people in combination with building the value of our brand portfolio to inspire even greater possibilities in the years to come.

That concludes our prepared remarks. Now Ill open it up for your questions.

Question and Answer

Operator

[Operators instruction]

And our first question comes from John Shanley with Susquehanna. Please go ahead.

John Shanley Susquehanna

Thank you, and good afternoon, folks. Matt or Rick, the comment in the press release that the '06 to '09 compounded annual growth rate in operating profits is expectedly in the mid to upper teens is considerably less robust than the forecast that Rick gave us when the Stride Rite deal was first announced back in late May. Whats changed to lower your expectations in terms of the Companys full earnings capacity?

Matthew E. Rubel - Chief Executive Officer and President

I guess, I'd say, John, Im going to take that because its ultimately my call on what that guidance number is. When I really sat down and looked at the 20%, we might be able to get there. But Im looking at it a little more conservatively just given the general market conditions and also just want to make sure that all of our significant assumptions about Collective Brands are intact. The basic premise of the acquisition and the synergies we see there, are there. Im just being a little bit conservative.

John Shanley Susquehanna

Are you more conservative on the Payless operation or the wholesale brand component of the Company, Rick?

Matthew E. Rubel - Chief Executive Officer and President

Ill take that one. I mean, it would be an equal it would be an equal kind of thing. Im just trying to take in the whole thing based on how the whole marketplace is right now, just kind of took everything and made it a little bit more conservative. But no actually, we are actually up here in New England working with the Stride Rite team and spent the last two days, and have one more day to go, going brand by brand through them and quite honestly, the opportunities are terrific. But we just want to organize them, get after them and make sure that we give you something that we can deliver on every quarter.

John Shanley Susquehanna

Okay, fair enough. Matt, the cost of purchase accounting comment that was also in the press release, how much is that or can you clarify why that is going to make the Stride Rite operation non-accretive to earnings in the fiscal 08 period?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

As you know, John those are non-cash charges and we are still waiting valuation from consultants and things like that, so its premature to give you a specific number. But the order of magnitude is such that it would make on a GAAP basis, would not make accretive.

John Shanley Susquehanna

Okay, all right. Also, Matt, looking at the upcoming third and fourth quarter, you are up against some pretty tough comps, 5.2 in the third quarter and 6.8 in the fourth quarter. Are you feeling optimistic that the sales results in the Payless division can exceed those kinds of strong numbers from the year ago period?

Matthew E. Rubel - Chief Executive Officer and President

I guess we were waiting for this question, from whoever. And the best way to answer that is we feel really good about the strategy and feel as though we have got we have got the right merchandise and the right set up to get the business growing. I think an interesting thing if you look back at, we tried to give you some insight at the end of Q1 about what was going on with the sandals, and yet we still had a growth in average price. And if you look at our gross margin without some of the one time hits we actually still grew gross margins. So we feel very confident on our strategy.

John Shanley Susquehanna

Okay, last question I have is, can you walk us through the current back to school season? Were you pretty much on plan with your Payless business in terms of expectations and are you fairly optimistic that the balance of the back to school season will

Matthew E. Rubel - Chief Executive Officer and President

John, you're terrific, but you know I dont give guidance on a quarterly basis in that manner, other than to say that we feel confident in our strategy and the assortment.

John Shanley Susquehanna

Okay, well maybe you can give us an idea of whether the numbers that came in towards the later part of the second quarter showed signs of improvement over the comp results for the overall quarter.

Matthew E. Rubel - Chief Executive Officer and President

As our mix changed, where we had sandal business and the other businesses starting to take over, we saw a change in our overall trend.

John Shanley Susquehanna

In a positive way, I assume, right?

Matthew E. Rubel - Chief Executive Officer and President

Yes, correct.

John Shanley Susquehanna

Thank you very much. I appreciate it.

Operator

We will go next to Jeffrey Stein with Keybanc Capital. Please go ahead.

Jeffrey Stein Keybanc Capital Markets

I was wondering if you could help us understand how Stride Rite is going to impact the back half of the year. And also on the purchase accounting adjustments, is this just going to be a one time hit to results in next year or do they amortize over a period of time.

Matthew E. Rubel - Chief Executive Officer and President

In terms of the purchase accounting adjustments, they will, some of them will carry on for several years.

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

In a decreasing, to a decreasing degree.

Jeffrey Stein Keybanc Capital Markets

You dont, Rick, you dont know what the magnitude of those charges are going to be at this point?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

I dont have the exact numbers. We happen to have some preliminary estimates that we've used throughout in modeling but those are all subject to a final review by our outside consultants, and we havent got that yet. So we should have a better idea by the end of the third quarter.

Jeffrey Stein Keybanc Capital Markets

Do you have any thoughts on how accretive Stride Rite may be on a non GAAP basis next year?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

I think that I already indicated that it would be accretive on a non-GAAP basis.

Jeffrey Stein Keybanc Capital Markets

Right, I said, the question was how accretive it might be?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

We haven't really disclosed that how accretive it would be at this point.

Jeffrey Stein Keybanc Capital Markets

Okay. Can you talk a little bit about the, I mean, I was wondering about the sandal business and what kind of impact, I would call excess mark downs above and beyond what you had anticipated, may have had on the gross margin in the quarter?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

Well thats fairly material, in terms of the excess mark down that we both took and realized and accrued for in the quarter.

Matthew E. Rubel - Chief Executive Officer and President

So, but our initial mark downs was in excess of the additional mark downs we ended up having to take.

Jeffrey Stein Keybanc Capital Markets

And Matt, you mentioned in terms of taking a look at some of the opportunities at Stride Rite, you talked about introducing Airwalk I believe, into the Stride Rite stores and Im kind of curious, I was under the impression that you were intending to keep kind of the brands within Payless exclusive to Payless and in turn, the Stride Rite brands exclusive. Have you changed your thinking process on this, or am I just misunderstanding?

Matthew E. Rubel - Chief Executive Officer and President

Well, Airwalk actually has never been exclusive just to Payless. It's actually in skate shops both in the US and in Canada. It's actually in some mid-tier distribution and has been for quite a number of years. So, and the reason it's number one in Canada is because it actually has our distribution and others. I would not sell any of our brands or allow our brands to go to distribution at our level or below our level, but something that positions it up and moves the brand up market, I would very much be in favor of.

Jeffrey Stein Keybanc Capital Markets

Okay. And last question, and on the back of the Stride Rite question. With respect to how should we think about this business in terms of how it will impact the back half of 2007?

Matthew E. Rubel - Chief Executive Officer and President

Well, I mean you're going to have to I mean, Ill let Rick talk to you in a second, but I mean youre going to have to look at it on a there will be purchase accounting charges that will come through. But our projections for the Payless business model remain the same. So were not changing that. And the base projections that the Stride Rite people had given you prior to the transaction, those remain in place as well. There may be some integration charges here and there but pretty much we remain on what weve called out before.

Jeffrey Stein Keybanc Capital Markets

Thanks.

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

Yes, there wont be any significant synergies this year but we should be able to come pretty close to covering the additional interest expense, except for integration costs that we might incur.

Jeffrey Stein Keybanc Capital Markets

Thanks.

Operator

Thank you. Our next question will come from David Mann with Johnson Rice. Please go ahead.

David Mann - Johnson Rice & Company

Yes, thank you. In terms of cash flow from the deal, in the past we talked about the ability to return to pre-transaction debt leverage in two to three years. But I didnt see that comment in the release today. Do you still feel that way?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

Yes.

David Mann - Johnson Rice & Company

And in terms of your initial thoughts when you purchased, or when you agreed to purchase Stride Rite, how did the final debt cost compare to your initial assumptions?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

It actually came down slightly.

Matthew E. Rubel - Chief Executive Officer and President

Well, I mean, I guess we had different ways we were looking at that, and we had three scenarios. There was a scenario A which came off the table. So that one might have been a little bit lower cost financing, but we took that off the table. So of the financing things like-to-like, we ended up slightly lower to about where we thought we would be.

David Mann - Johnson Rice & Company

Okay. So, the turmoil in the debt market doesnt seem like that had much impact on your forward guidance.

Matthew E. Rubel - Chief Executive Officer and President

You'd have to speak to our bankers and our group, who were up about eight days in a row, about 24 hours a day, to get it done. So it had some personal impact but no business, no long-term, lasting business impact.

David Mann - Johnson Rice & Company

Okay. And then in the past, youve also talked about a Payless outlook of low single-digit store-for-store sales and mid-teens EPS growth. Is that still the view that you have? And is that consistent with what you said this morning this afternoon?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

Yes. From the Payless side of the business that would still be the case.

Matthew E. Rubel - Chief Executive Officer and President

And so, therefore if you take the guidance of mid to upper teens number without the purchase accounting impact, that would imply of course that the Stride Rite group would be growing at a rate higher than that.

David Mann - Johnson Rice & Company

Okay. On the distribution costs impact in the quarter that was less than I think you intimated for the first half on the last conference call. Can you just reconcile why it was lower in Q2 and what you expect for the year?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

For the year, I think, if my memory serves me right, we had guided somewhere around say, I think $0.20 to $0.21 impact. And that's still our expectation. And the improvements in the second quarter and maybe the are I think what we had in the original assumptions.

David Mann - Johnson Rice & Company

I think the comment was, it was going to be more than half of it in the first half.

Matthew E. Rubel - Chief Executive Officer and President

Yes, why we get back to you offline on that and.

David Mann - Johnson Rice & Company

And then understood let me ask just one last question on when you look at some of the regional performance in terms of California and Florida which are getting lot of attention, are you seeing any specific regional weakness there or any other regional trends that you'd like to call out?

Matthew E. Rubel - Chief Executive Officer and President

Well, I think that it's no news to anyone who follows retail, especially of retailers who experienced back-to-school that back-to-school was switched in many states late in the spring. They made the call late in the spring to change the dates and move them later. And that has a very direct correlation on when you spike in certain categories of your business. So, moving those out two or three weeks took the curve and moved it out. We do see the curve happening now and so it's definitely there. But Texas was a problem and came on later. They also had a tax free movement, and the same thing in Florida. The good news is, is that in Florida we actually see it finally starting to stabilize in the post back-to-school time period or during that time period, because it's been ever since a couple years ago and the hurricanes, it's actually had a two*year challenging run, as I think is public knowledge based on just tax collections and things like that for these states in general.

David Mann - Johnson Rice & Company

And California?

Matthew E. Rubel - Chief Executive Officer and President

California, we are not seeing material issues there.

David Mann - Johnson Rice & Company

Very good. Thank you.

Matthew E. Rubel - Chief Executive Officer and President

All right. Let me clarify, in terms of leverage ratio, David, what I was referring to was that on a lease adjusted basis, our leverage ratios would be back to what they were prior to the acquisition.

David Mann - Johnson Rice & Company

Okay. Thank you.

Company speaker

All right.

Operator

Your next question is from Jon Braatz with Kansas City Capital. Please go ahead.

Jonathan Braatz - Kansas City Capital

Good afternoon guys. Couple of questions. First of all, more specifically, Matt, when you talk you about getting back to the capital structure ratio that we saw prior to the acquisition, what type of levels of CapEx would you anticipate combined with the Stride Rite acquisition. I know you have brought $175 million this year but how does that look as you go forward two or three years?

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

Its pretty level going forward. There will be somewhat of a decrease next year because of our supply chain initiative, those costs won't recur. So, it'll be a step function down, and then it will stay relatively flat after that.

Jonathan Braatz - Kansas City Capital

Okay. How much might be will there be much devoted to Stride Rite, so to speak?

Matthew E. Rubel - Chief Executive Officer and President

Well, in relationship to our total, they're primarily a wholesale business, so their CapEx is materially less than ours. And

Jonathan Braatz - Kansas City Capital

I was assuming maybe you talked about the new stores and so on.

Matthew E. Rubel - Chief Executive Officer and President

Jon, I think that probably they spent about $13 million in CapEx last year.

Jonathan Braatz - Kansas City Capital

Okay.

Matthew E. Rubel - Chief Executive Officer and President

And so, as we discover either opportunities for one of the retail concepts to roll out more, there may be some, but next year's really a period of testing.

Jonathan Braatz - Kansas City Capital

Okay.

Matthew E. Rubel - Chief Executive Officer and President

So, it wouldn't be anything that's a material change and we'll just deploy some of the CapEx into some of the IT initiatives needed.

Jonathan Braatz - Kansas City Capital

Okay. Matt, you spoke about maybe cumulatively $40 million to $50 million in synergies from the acquisition, but obviously you acquired Stride Rite for the top line in improving the growth aspect of the company and managing and leveraging the brands. Do you want to give us a number or an expectation of what you think you can do with this top line, or a number that you would be disappointed that you didnt achieve in terms of accelerating the growth of those of that Company?

Matthew E. Rubel - Chief Executive Officer and President

Jon, I appreciate the question, and I think you are going have to give me a chance and I will actually be a little more clarified about that, some time in the first quarter, at the end of the first quarter of next year. We are going through, we are here with the Stride Rite team for three days. We are getting them to get on to a very specific strategic planning process, which has financials with it and really trying to place that up, so that when I give you a number, its not my dream or my wish, but its a well architected plan, the same way that we did that with Payless.

Jonathan Braatz - Kansas City Capital

Okay. All right. Matt, thank you very much.

Matthew E. Rubel - Chief Executive Officer and President

Thank you, John.

Operator

Thank you. We will now go to Rob Wilson with Tiburon Research Group. Please go ahead.

Rob Wilson - Tiburon Research Group

Yes. Thank you. Matt, you mentioned that sandals was at 36% of sales in the quarter?

Matthew E. Rubel - Chief Executive Officer and President

Thats correct.

Rob Wilson - Tiburon Research Group

And, what is that generally for a full year?

Matthew E. Rubel - Chief Executive Officer and President

I dont have that number in front of me, but again James can give you that number offline.

Rob Wilson - Tiburon Research Group

Okay. I guess when I look at the sandals business, I guess, you had some heavy markdowns in 2005, and I guess we have now followed that up in 2007, with some heavy markdowns. Can you guys have success financially without success in the sandals business?

Matthew E. Rubel - Chief Executive Officer and President

Rob, its a good question and the answer is yes. And I think that what we have to do is build out these brands across all classifications, the way we are doing it. And as we do that, and dont become dependant on one category, which has been something rather specific to Payless over the years that we can do. I mean one of the reasons we focus on the casual business in the third quarter is because historically if you go back many, many years that was actually a very profitable business for Payless and Payless didnt even its businesses out. So, we have teams that we've kind of put on how to manage each classification by quarter, by zone, and feel as though we are coming up with a very balanced approach on how to do that.

And so, if the question is, can we do business in Q2 without sandals, the answer is yes. I mean I can even I dont want a get overly specific, so I will kind of use a number. Say if we are just taking $30 million in receipts and moved them and cut them by half and moved half of them into another product category, we would have had a very, very solid quarter. And so its really kind of modulating to finding the right thing. But our success in both Airwalk and American Eagle, as well as Champion is showing that our productivity per five foot section in these brands is much higher than our private brands. And so as we move to that 70%, 80% ratio, I think you can see more consistency as well as continued leverage.

Rob Wilson - Tiburon Research Group

So, I guess what you were saying as we should look for the sales mix of sandals to come down in future years?

Matthew E. Rubel - Chief Executive Officer and President

Slightly. Its got to be slightly. I think we planned it higher. So we have gone back and done a ten year mapping, taking out stuff, so we are actually working to come up with what is right percentage. And again it does it is impacted by both where Easter falls and what happens at Easter. This was an extraordinarily challenging Easter for everybody in the footwear industry in retail, and so we ended up with a very large overhang of dress sandals that were opened up. Next year we wont have that problem, Easter is early. So, we wont be buying sandals for that time period. So, that will, in and of itself take it down. But one of the promising things is actually our beach wall during this time period was incredibly successful and remains successful.

Rob Wilson - Tiburon Research Group

Okay. Could you speak also to the trends in accessories, I dont believe I heard you mention accessories as a success this quarter. Maybe what sort of initiatives you have in play there as well.

Matthew E. Rubel - Chief Executive Officer and President

Yes. Well, we actually are having some very solid success on some tests, both in the jewelry area and in the sunglass area where we have done a test a quiet test and fixturing program as well as inventorying up those two areas and are seeing in excess of 20% and 30% lifts in those stores. Now those businesses are small, but those are very profitable businesses and lead to a higher average transaction.

In addition, our handbag business, we have found two very key platforms to our handbag business, one which would be the status area that we do with our Minicci product as well as the American Eagle product has been very successful. We also have some matchables that do well also. But, so we do have some platforms there. And our hosiery business has continued to be solid.

Rob Wilson - Tiburon Research Group

And one final question. Maybe Rick, if you can give us, so we're all very clear whats going to happen to the balance sheet and what its going to look like at the end of Q3, maybe some sense for what the debt levels will look like and the cash balances. And thats my final question. Thank you.

Ullrich E. Porzig - Senior Vice President and Chief Financial Officer

Okay, the debt levels will basically be flat with our announcements, once you take into account the additional debt that we just took on, and thats the $725 million of debt. Beyond that, the other items will basically be flat.

Rob Wilson - Tiburon Research Group

Okay, thank you.

Operator

Thank you, and ladies and gentlemen, that does conclude our Q-and-A session for today.

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Source: Payless Shoesource Inc. F2Q07 (Qtr End 8/4/07) Earnings Call Transcript
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