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Zep Inc. (NYSE:ZEP)

F1Q08 Earnings Call

January 10, 2008, 11:00 am ET

Executives

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

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

Jill Gilmer – Assistant Corporate Secretary

Analysts

John [Emoric] - Ironworks Capital

David [Woodyea] – Keeley Asset Management

Richard Glass – Morgan Stanley

David Beard - Morgens Waterfall

Dennis Delafield - Delafield Asset Management.

Operator

Good morning, and welcome to the Zep Inc. conference call. On the call today will be John Morgan, Chairman, President, and Chief Executive Officer; Mark Bachmann, Executive Vice President and Chief Financial Officer; and selected members of senior management. After today’s presentation there will bea question and answer session. (Operator instructions)

Today’s conference call is being recorded. If you have any objections you may disconnect at this time. Now I would like to introduce Jill Gilmer, Assistant Corporate Secretary, you may begin.

Jill Gilmer – Assistant Corporate Secretary

Good morning and thank you for joining Zep today on our 2008 first quarter conference call. Here with us are John Morgan, Chairman, President, and CEO; Mark Bachmann, Executive Vice President and CFO; and other selected Zep officers.

I would like to remind everyone that certain information included in this conference call may contain forward-looking statements that involve risks, uncertainties, and assumptions. If the risks or uncertainties ever materialize or if the assumptions prove incorrect, our results may differ materially from those expressed or implied by such forward-looking statements.

All statements, other than statements of historical fact, could be deemed forward-looking including but not limited to any projections of financial information; any statements about historical results that may suggest trends for our business; any statements of the planned strategies and objectives of management for future operations; any statements of expectations or belief regarding future events, potential markets or market size, technology developments, or enforceability of our intellectual property rights; and any statements of assumptions underlying any of the items mentioned. For a description of risks and uncertainties please refer to the company’s filings with the Securities and Exchange Commission, including its Form 10-K and its recently filed 10-Q.

Now I will turn the call over to John Morgan.

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

Thank you, Jill, and to all of our investors and employees welcome to the call. I will take just a moment to comment on our first quarter results and then I will ask Mark to take us a little deeper into a description of the first quarter.

For the first quarter our net sales were $143.6 million, a $6.7 million, or 4.9% growth over the previous year’s first quarter revenue of $136.9 million. Our diluted earnings per share were $0.30 versus the first quarter of last year’s diluted earnings per share which were $0.12. Favorable pricing and a positive impact from foreign currency exchange rates were the primary contributors to the increase in sales.

Overall, unit volume remained consistent with the first quarter of last year driven by increased shipments to our retail and international channels, but offset by declines in other areas. For example, during the quarter we did realize some volume decline due to a conscious decision to deemphasize certain lower margin customers, which is part of our long-term strategy to enhance margin growth.

I would characterize our first quarter as one with good results, but not yet great results. I am very pleased with the improvement when compared to last year and I would remind us all that our longer term objectives include obtaining margins which exceed those reported today.

Mark, why don’t you take us a little deeper into a description of the quarter and then before we open it up to questions I would like to comment on expectations for the future.

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

Thank you and good morning. As you mentioned, John, our overall revenue grew 4.9% and our actual earnings per share grew 150% when compared to our earnings per share in our first quarter of last year.

Pricing contributed $2.9 million in sales growth and foreign exchange rates added another $3.8 million. Our volumes were flat. We were pleased with our growth in certain areas including home centers, industrial distribution, international, food, and national accounts. We are also pleased with our customers’ response to our new GreenLink products, a line of 82 environmentally sustainable products.

During the quarter, gross profit increased $4.8 million or 6.1% to $83.4 million. Our gross profit margin increased to 58.1%, an improvement of 60 basis points over the previous year’s first quarter. Our improved gross profit was primarily due to the favorable pricing that supported revenue growth, although it was partially offset by higher raw material cost. To address this, we have initiated pricing actions of selected products, particularly those affected by adverse trend associated with energy related commodities. Our sourcing team continually monitors, addresses, and carefully manages our raw materials to minimize the financial consequences.

Operating profit dramatically improved during our first quarter reaching $10.8 million from the previous year’s $5.2 million. And operating profit margins increased 370 basis points to 7.5%. The operating profit and margin growth was realized predominantly from pricing and tighter control of our sales related expenses.

During the quarter we reduced our selling, distribution, and administrative expenses by $600,000. The savings came from changes in our yearly first quarter sales meeting format and through improvements related to the hiring of our sale reps, but these improvements were partially offset by our on-going costs associated with being a public company.

Our first quarter achieved 158% increase in net income to $6.3 million or $0.30 per diluted share, versus the $2.4 million or $0.12 per diluted share reported inthe prior year. Operating profit improvement and a decrease in our effective tax rate drove the net income growth.

Our first quarter tax rate was 35.8% down from 37.7% we realized inthe prior year, which was effected by a non-deductable item related to the environmental legal charge we incurred last year. Going forward we anticipate our effective tax rate to be approximately 37%.

Historically we consume cash inthe first quarter as certain liabilities are typically paid during this period of each fiscal year. This year due to our increased profits we consumed only $6.8 million in cash, which was $3.3 million less than the prior year. Our working capital management continued to make progress reducing our net trade cycle by two days.

While we are pleased with our first quarter numbers, we realize that there is vast room for improvement and we are using this fiscal year to transform and position the company for better and more profitable growth inthe future. We anticipate inconsistent results as we undertake various restructuring initiatives in order to streamline and improve our operations, but over the coming quarters as our strategic initiatives are implemented we will improve our margins and working capital turns. On a long-term basis we will expand our focus to consolidating revenue growth.

John, you wanted to comment on future expectations before we go to questions.

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

I do, thank you, Mark. First, I would like to point out that our business does have a historic seasonal trend. The second quarter is traditionally our weakest. Our second fiscal half tends to outpace our first fiscal half of the year. We further expect to seean impact in our second quarter revenues this year as our retail customers undertake inventory reduction initiatives atthe end of their fiscal years.

So while I expect our second quarter to continue to be our weakness, I do expect that our second half will generate greater earnings than our first half. And that is similar to our historical earnings patterns that are outlined in our 10-K.

While ithas only been six weeks since our last conference call, I am pleased to say that we have made good progress inthe early stages of implementing our strategic plans. Inthe past several months, we have sharpened our focus on thekey initiatives to make this a much better business.

As of October 31, when we became a public company our role changed. Now we have aggressively begun to pursue and implement our dynamic profitable growth-driven plans that will produce near and long term results and support a strong financial improvement, particularly in sales and margins and return on invested capital, thereby creating significant shareholder value.

We have started to utilize the lean implementation tools and as one would expect the results are first beginning to show up in increased capacity and better service. For example, during the past ten weeks we have shift to our largest customers with absolutely record service and product quality. Our Chief Supply Chain Officer, Cedric Brown, and his team have gotten off to a great start. Within the next six months they will begin implementation of a new plan for our North American supply chain footprint. I expect it to result in products being made available more rapidly and reliably while reducing logistical cost.

In the next 60 days, Bill Holl, our Executive Vice President, and Chief Commercial Officer, and his team will be presenting their final plan for demand shaping our business. I expect implementation to begin immediately and anticipate that from this we will eliminate a number of unprofitable products as well as discontinue doing business with a number of low profit customers. Bill will also be presenting a plan to expand into the $6.4 billion industrial distribution channel by establishing a network of distributors to serve market segments where we are not selling today. Our goal is to have 10-15% of our total revenues coming from new channels of distribution within the next three years.

Finally, I continue to be very pleased with our compliance focus including our environmental compliance and our voluntary remediation. Our long-term goals in terms of revenue growth, EBIT margins, earnings per share growth, and return on invested capital were discussed during our November 29th 2007 conference call and those remain unchanged. Our strategic initiatives, discussion as well as our comments on this quarter, are archived for your convenience on (zepinc.com).

We are very optimistic about the future and we are very pleased with the team that we have in place to transform this business. And now we would like to take your questions, so Katie if you would open up the line for questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And we take our first question from John [Emoric] with Ironworks Capital.

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

Hi, John.

John [Emoric] - Ironworks Capital

Hi, how are you doing?

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

Good, thank you.

John [Emoric] - Ironworks Capital

Just a couple of clarification questions, the $8 million that you spent over the year on the transformation of the business. Would that bein the fiscal year, so therefore, over the next three quarters or just over the calendar year of ’08? I know that’s a kind of goofy fine-tuning question but just wondering how…

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

That’s fine. John, I think that you are referring to that which we had previously disclosed as a restructuring charge that we would anticipate at some point in time inthe future. Is that correct?

John [Emoric] - Ironworks Capital

I think that’s right.

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

Yes, I think that’s right. We have not taken any of restructuring charge in this first quarter.

John [Emoric] - Ironworks Capital

Right.

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

We continue to anticipate that we will take a restructuring charge and as we have previously disclosed, I believe, we had said that would be inthe range of, Mark, of $5-8 million? Is that correct?

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

That’s correct.

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

And we would anticipate those expenditures, once announced would occur over a period of time, 12 to 18 months.

John [Emoric] - Ironworks Capital

Okay, so you take the charge and then the cash expenditures would be over the 12 to 18 months following.

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

That’s correct and some may reach out as far as 24, but overwhelmingly it’s in that 18 month period.

John [Emoric] - Ironworks Capital

Okay, that’s helpful. And then in addition to above the more recent trends in CAPEX, maybe a $10-15 million year? I’m going kind of from memory here.

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

Yes, and again, Mark, correct me if I am wrong. But our sort of let’s say “maintenance level” of CAPEX for this business is between $5 and $6 million. We said that we would expect our capital expenditures this year to bein the $11-12 million range. That includes the maintenance levels of CAPEX plus expenditures that we would intend to make (NYSE:A) on SAP financial systems that we are installing, and also on some things that we think will be necessary in the supply chain to get some blending close to customers.

John [Emoric] - Ironworks Capital

And then lastly do you suspect that you will be able to, I know that you are going to continue paying it. But will you be paying the dividend out of free cash flow or after all of these expenditures or will you have to borrow a little bit to do it.

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

Mark?

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

We expect to be able to generate free cash flow to pay the dividend.

John [Emoric] - Ironworks Capital

Okay. Thank you very much.

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

Thank you, John.

Operator

(Operator instructions) And we will go next to David [Woodyea], with Keeley Asset Management.

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

Hi, David.

David [Woodyea] – Keeley Asset Management

Hi. You made reference to phasing out some low profit customers. Could you give us a little, or at least an educated guess as to how much that might affect the sales? And would you comment on whether this effort is going to be increasing in the future or whether you have already taken the action that you think that you need to?

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

The impact on revenue in our first quarter would, in that area would have been between $1 and $2 million. And I would say we are just getting started. I don’t have absolute clarity, frankly, at the degree to which we’ll benefit from that inthe future. That report out that I referred to earlier, which we call “Demand Shaping” over the next 60 days will really bring clarity to that.

But clearly we area business that hasa number of products that are late in their product life cycle. And a number of customers that have come on that are small customers buying less important products. And we need to attack that, so I would say that we really just got started on that.

David [Woodyea] – Keeley Asset Management

Okay if I could just ask a quick question, I know that I don’t have to ask, but I noticed on the press release a different person is mentioned as the company contact. Clarify who is really running Investor Relations.

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

This is Mark Bachmann. Investor Relations is my responsibility and we have other people who are assisting, Cathy Frost, who is mentioned down there is assisting us in that effort.

David [Woodyea] – Keeley Asset Management

Okay, thank you very much.

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

Thank you, David.

Operator

We will go next to Richard Glass with Morgan Stanley.

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

Hi, Richard.

Richard Glass – Morgan Stanley

Hi, guys, nice number here.

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

Thank you.

Richard Glass – Morgan Stanley

A good start, we will call it. Can you guys give us any more insight into what the restructuring charge that $5-8 million that you talked about is going towards? And if you can’t really tell us what it’s going towards, can you at least tell us how you look atthe expected payback period or the IRR’s for those sorts of spending?

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

Rich, let’s just assume $8 million since we have set a range of $5-8 million at this point in time and talk from that point. Without breaking it down to each category individually, some of those costs would be related to the things that we needed to do inthe supply chain. To consolidate some of our operations and take some operations closer to our customers to reduce logistical cost, increase service and so forth. And that’s a good bit of that.

Other costs in there would be associated with the consolidation of operations inthe Atlanta area. For example, we’ve announced to employees that we are going to close the corporate office atthe Riverside location. Myself, and my staff for example, have in the last few weeks moved to our Seaboard location where our primary factory is located, and we are closing that corporate office. There is an impaired asset of lease there so.

And then the third thing is there’s some cost associated with the demand shaping. So it’s those three primary categories. If you assume those expenditures take place over the next 12 to 18 months while some items might have a payback of greater than a year, others I would expect much less than a year. And so frankly, I would expect paybacks of year or slightly more on the total amount.

Richard Glass – Morgan Stanley

All right, great, it sounds good. Thanks.

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

Thank you.

Operator

Thank you. Our next question will come from David Beard with Morgens Waterfall.

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

Hi, David.

David Beard - Morgens Waterfall

Hi, good morning. Most of my questions have been answered but could you just walk me through your working capital needs just as your operating cash flow is negative in the first quarter of ’08, although an improvement from the year before. Can you just walk me through the need of where the capital needs is coming from? Thanks.

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

I’m going to ask Mark to take us through that which is a pretty inconsistent pattern as the fiscal year goes on. So, Mark, maybe you could take us through that?

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

Yes, I will. Clearly there with roughly 53% of our revenue inthe second half of the year you’ll see a building and some seasonality relative to the receivables moving, obviously with the revenue over the course of the year.

Inventories have, historically, built over the, in terms of days on hand of inventory, they tend to build up over the first four or five months and then decline for the rest of the year. So that is pretty much our historic patterns.

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

I would say, David, and again I apologize I don’t have absolute clarity on this. But it’s been my experience that as we undertake demand shaping and become more aggressive at that, and of course our lean initiatives. One of the things that I would, frankly, expect to see is us able to change our pattern of working capital demands on the business and see the demand to come down as time goes on. And so, I’m confident that when we are having this conference call for our second quarter in April that we will talk a lot more about what our expectations are there.

David Beard - Morgens Waterfall

Okay, good, thank you.

Operator

Thank you. (Operator instructions) We will take our next question from Dennis Delafield with Delafield Asset Management.

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

Good morning, Dennis.

Dennis Delafield - Delafield Asset Management

Good morning, John. Would you just, I just came in and I don’t have any specs or anything in front of me. Would you remind me of how much the second quarter normally seasonally drops off and can you give me any indication of how much the profitability would drop off. Would you expect to dip into the red or what we might expect?

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

Dennis, this is Mark. If you look over the last two years that were inthe 10-K, anywhere between 7 and 10 or so percentage of the total year’s net income is derived inthe second quarter. And low 20% kinds of percentage of revenue in that quarter.

Dennis Delafield - Delafield Asset Management

20% of revenue in that quarter?

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

Yes.

Dennis Delafield - Delafield Asset Management

Okay, that should help. I’ve got all of my sheets close in the room. I just wanted to speak. And you are expecting that this year to follow that normal pattern.

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

We are not giving quarterly guidance. Dennis, what we are saying is we expect and what we are trying to communicate to folks who may not have tracked that or knows that on a stand-alone basis, we do have the seasonal pattern and so we are just making people aware of what our seasonal patterns have historically been. But we are not giving specific guidance as to what this second or third quarters will be.

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

Dennis, you have watched Zep for quite some time and it would probably be useful to pull those patterns from that 10-K, and we expect those to be similar.

Now, let’s do remind everybody that all of our discussion there is net of anything we might do relative to restructuring charge we are trying to firm up at this point in time.

Dennis Delafield - Delafield Asset Management

Of course, good, thank you.

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

Thank you, Dennis.

Operator

Thank you. We will take a follow-up question from John [Emoric] with Ironworks Capital.

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

John?

John [Emoric] - Ironworks Capital

Yes, thanks. The share count was a little lower than I had in my model. I don’t know what the growth is going to be just from options plans growing. And I know that you have got the new plans as any new company would. Anything that you can tell us about on the sequential or the average share count for the year that I might want to put in my model? Relative to what we just showed, say in November?

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

John, it’s Mark, probably one of the reasons that it’s a bit lower than what people might have anticipated was that prior to the distribution, Acuity Brands was repurchasing shares as they announced in their earnings call earlier this week. We did have some options grants that we have disclosed inthe first quarter and there weren’t as many grants that were transferred from Acuity Brands. And so, but in terms of giving you guidance for the number of shares…

John [Emoric] - Ironworks Capital

I guess that net and number of shares, you wouldn’t expect that to materially change in the near future.

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

No.

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

Yes, the grants are incorporated in this number that we saw today.

John [Emoric] - Ironworks Capital

Oh, yes, okay, great. Thanks.

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

Okay.

Operator

Thank you. And with no further questions inthe queue I would like to turn the conference back to Mr. John Morgan for any additional or closing comments.

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

Thank you, Katie, and thank you everybody for taking the time to dial in. We look forward to speaking with you in April. Have a good day.

Operator

This concludes today’s conference. We thank you for your participation. You may now disconnect.

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