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Heelys, Inc. (NASDAQ:HLYS)

Q4 2007 Earnings Call

March 4, 2008 4:30 pm ET

Executives

Ralph Parks – interim Chief Executive Officer

Mike Hessong - CFO

Analysts

Mitch Kummetz - Robert W. Baird

Robert Samuels – JP Morgan

John Carrick - Principal Global Investor

Operator

Welcome to the Heelys, Inc. fourth quarter and fiscal 2007 year end earnings conference call. (Operator Instructions) Before we begin, I would like to remind everyone of the company’s Safe Harbor language.

Please note that this call will include forward-looking statements within the meaning of

the securities laws. All forward-looking statements included in this call are based on information available to the company on the date of this call, the company's current expectations and various assumptions. The company believes that there is a reasonable basis for its expectations and beliefs, but they are inherently uncertain. The company may not realize its expectations and its beliefs may not prove correct.

For a list of important factors that could cause the company’s actual results to differ materially from the forward-looking statements in this call, please refer to the company’s public filings with the SEC, including the risk factors contained in the company’s annual report on Form 10-K. You are encouraged to read that section and all of the company’s other filings with the SEC.

The company intends that all of its forward-looking statements in this call will be protected by the Safe Harbor provision of the Securities Exchange Act of 1934. The company undertakes no obligation to publicly update or revise any forward-looking statements as a result of new information, future events or otherwise. All subsequent written and oral forward-looking statements attributed to the company or persons acting on the company’s behalf are expressly qualified in their entirety by the cautionary statements contained throughout this call and the company’s public filings with the SEC.

I would now like to turn the conference over to the interim Chief Executive Officer, Mr. Ralph Parks. Please go ahead, sir.

Ralph Parks

Thank you, operator and thank you everyone for joining us today to review our fourth quarter and full year results. With me on the call today is Mike Hessong, our Chief Financial Officer.

Let me begin by just saying that I’m very pleased to be here serving as the interim CEO. The board of directors has retained Korn/Ferry to conduct its search for a permanent Chief Executive Officer and that’s been underway for several weeks now. In the meantime, I want to stress that the entire organization led by myself, Mike and the rest of the management team are very, very focused on running the company and executing our business plan.

Now to our recent performance. While Mike will go into the detail about our financial results in a moment, the fourth quarter was obviously a challenging time for the company. From a sales and earning standpoint and from an inventory perspective though, we are very pleased at how our retail partners ended the year with lower levels than they originally expected, as their sell-through rates accelerated over the holiday selling period.

The downside to that is that during this holiday selling period, the inventory reductions were driven by greater promotional pricing, including much deeper discounting at one retailer that we would have preferred not to have been that promotional. While the latter was done without our support and no expense to us, many of our customers had to follow suit and therefore that caused increased assistance from us. We’re starting to see a return to more normalized pricing and we’re encouraging our accounts to be back at full retail for the back-to-school season.

On a more positive note, we did witness higher selling prices at Shoe Carnival and Famous Footwear where the brand was just introduced in November. Importantly, the momentum at both of these national chains has carried over into the new year, and we believe that underscores that the demand for our wheeled footwear remains healthy among our targeted demographic.

Looking overseas, we continue to see healthy demand from our wheeled footwear throughout much of Europe. International net sales for the year increased approximately 13% to $30.5 million driven by meaningful gains in key markets such as the UK, Germany, Spain, France and Belgium. We recently opened our new sales and marketing office in Belgium which will serve as the headquarters for our European operations. John O’Neill, our Vice President of International, and his team will be based there and will focus on expanding opportunities by working more closely with our distributors to improve the marketing and advertising campaigns and delivering a cohesive brand message across the continent and increase our door count.

In Asia we opened our new sourcing office in Qingdao, China, led by Will Albers, our Vice President of Sourcing, and his staff. By taking this important component of our business in-house and having our representatives on the ground dealing directly with the manufacturing partners, we believe that we will be able to negotiate better pricing, maintain quality control and help streamline the product development process without the expense of a sourcing agent.

We also strengthened our senior management team with the appointment of Don Carroll as our Senior Vice President of Marketing. Don comes to Heelys with more than 20 years of experience in marketing and product development, including eight years at Radio Shack where he served as Chief Marketing and Brand Officer during his tenure; and six years at Ogilvy & Mather, a global advertising, marketing and public relations firm. Don has been here just a short two months and has already had a noticeable impact on the direction of our upcoming marketing and advertising programs for 2008.

Staying on marketing and advertising, in February we completed shooting our new commercial and are pleased with the initial footage. When it airs on regional and national cable stations such as Nickelodeon and Cartoon Network later this month, consumers will definitely see a more energized, upbeat brand message that better highlights the fun and excitement of our wheeled footwear than in previous campaigns.

Other recent marketing highlights include the Broadway debut of Heelys in the musical production of Disney’s The Little Mermaid, our cross promotion with the DVD release of High School Musical II and our ongoing participation in the Disney’s Wide World of Sports Endurance Series.

Strategically we were successful in our court battle against a company selling knockoffs through several mall-based kiosks in the Dallas, Texas area. We believe the courts’ decision confirms our strong patent position and unique status in the marketplace which we will continue to aggressively protect.

Finally, in light of our recent financial performance, we are very pleased to have ended 2007 with more than $98 million in cash on our balance sheet and no debt.

I’ll now turn the call over to Mike, who will review the financials and then I’ll return to discuss our strategy for 2008.

Mike Hessong

Thank you, Ralph. Net sales for the fourth quarter were $9.8 million, compared to net sales of $71.1 million in the fourth quarter of 2006. Due to the promotional pricing and inventory situation that Ralph has discussed, it’s important to note that our top line was negatively impacted by approximately $3 million related to an increase in our reserve for marketing discretionary fund assistance and approximately $2.7 million for an increase in our returns reserve both related to domestic net sales. After you eliminate this impact, our net sales for the fourth quarter were $15.5 million. In the quarter domestic net sales were $10.2 million prior to these adjustments, and international net sales were $5.3 million.

Gross profit for the fourth quarter was a negative $1.7 million, compared to gross profit of $25.1 million or 35.3 % of net sales in the fourth quarter of 2006. Included in this year’s fourth quarter gross profit is a charge of $1.5 million related to the writedown of certain inventory on our balance sheet; a charge of approximately $3 million related to an increase in our MDF reserve as we discussed previously; and a net charge of $1.7 million related to an increase in our returns reserve. The gross profit for the fourth quarter prior to these adjustments was $4.5 million or 29%.

Total SG&A for the fourth quarter was $7.2 million compared to $7.1 million in the corresponding period last year. We incurred a loss from operations for the quarter of $8.9 million versus income from operations of $18 million or 25.3% of net sales last year. After you adjust for the charges I mentioned previously, the loss from operations for the quarter was $2.8 million.

Our net loss for the quarter was $5.5 million or $0.20 per diluted share, compared to net income of $11.5 million or $0.44 per diluted share in the fourth quarter of 2006. Excluding the impact on sales and gross margins from the aforementioned additional expenses, we incurred a net loss of $1.2 million or $0.04 per diluted share in the fourth quarter of 2007.

If you look at full year, net sales were $183.5 million compared to net sales of $188.2 million in 2006. For the year, domestic net sales were $153 million, international net sales were $30.5 million. Excluding the impact from the returns in marketing assistance in the fourth quarter, net sales would have been $189.1 million, up slightly versus the year before.

Gross profit for fiscal 2007 was $58.1 million or 31.6 % of net sales compared to $65.5 million or 34.9% of net sales in fiscal 2006. Total SG&A for the full year was $26.1 million or 14.2% of net sales, compared to $20.1 million or 10.7% of net sales a year ago, with the increases coming primarily in marketing and public company costs.

Income from operations was [$30 million] or 17.4% of net sales versus income from operations of $45.6 million or 24.2% of net sales last year. Net income was $22.3 million or $0.79 per diluted share in fiscal year 2007 compared $29.2 million or $1.16 per diluted share in fiscal 2006.

With regard to our balance sheet at December 31, 2007 we had cash and cash equivalents equal to $98.8 million. This compares to $89.4 million at September 30, 2007 and $54.2 million at December 31, 2006. We ended fiscal ’07 with inventories of $15 million, which includes a returns reserve of $1.1 million compared to inventories of $6.1 million at the end of fiscal 2006.

We recently completed previewing our new back-to-school line for our accounts and we can say the feedback was positive. However, as a result of the challenging retail and economic environment and general uncertainty in the marketplace, our retailers are being much more cautious with their future orders. Therefore, we will be relying much more heavily on at-once business in 2008, which obviously makes it more difficult to forecast our sales.

Right now, we are planning our domestic business to be down for the year with sales volumes increasing sequentially as we approach back-to-school and the holiday selling season. We’re expecting our international business to be up nicely, driven by a growth in Europe; however, not enough to offset the expected decline in the US. Furthermore, we anticipate margins will remain under pressure during the first half of the year as retail price points slowly work their way back up closer to our historical levels.

With that, I’ll turn the call back to Ralph for his closing comments.

Ralph Parks

Thank you, Mike. Let me just conclude by touching on some strategic objectives for 2008. First and foremost, we’ll continue to work very closely with our retail partners in finding the right assortment, the right product flow and inventory levels to maximize gross margin dollars for the customer and for Heelys. As Mike just mentioned, retailers are looking to limit their future orders, choosing rather to chase demand with in-season reorders. As a result, we have less visibility than in the past.

Product development and marketing remain key areas of focus for us this year. On the product development side, we’re launching a wider assortment of styles and trend right product. Graphic based designs, balkanized soles, skate silhouettes are all important trends in the market that should allow us to appeal to a wider customer base and capture both the fashion conscious and the skater kids.

On the marketing and advertising side, we’ll look to leverage Don’s experience to help broaden awareness of Heelys in order to attract new consumers to the franchise and drive repeat business. This will be done through a combination of television, print ads, sponsorship, point of purchase materials, and cross promotions. We’ll also look to capitalize on our growing relationship with Disney, utilizing their multiple brands to further promote our brand and products.

On a category basis, we’ll continue to diversify the business around non-wheeled footwear, apparel and accessories. In non-wheeled footwear, we have redirected our focus from gamer to a line of sidewalk sports shoes for kids which we believe is a larger market opportunity. These shoes contain an aggressive no slip bottom called MaxTrax that really sticks to the pavement, to coaster boards, skateboards, bikes and scooters. The line features a grippy bottom outsole with both athletic inspired and traditional skate designs. With the growing popularity of wheeled and sidewalk sports, we think this could be an interesting niche in the marketplace.

International, particularly Europe, continues to be a significant opportunity and area of focus. As mentioned, we recently opened our headquarters in Belgium and will use this initiative to drive growth throughout the European Union. We’ve increased capacity with our third party operator for additional warehousing in anticipation of the growth we’re expecting throughout the region in the years ahead.

Regarding acquisitions, our strong balance sheet and cash position allows us the opportunity to evaluate potential acquisitions. Our primary focus will be in the footwear space given our core competencies around product development, sourcing and distribution.

In closing, I’d like to thank our employees for their hard work and dedication, and our shareholders for their support through this challenging period. Our organization is committed to improving the business and maximizing the strong brand equity we have created.

Operator, that concludes our presentation. I would open it up to you for questions.

Question-and-Answer Session

Operator

Thank you, Mr. Parks. (Operator instructions). Our first question comes from Mitch Kummetz - Robert W. Baird.

Mitch Kummetz - Robert W. Baird

Thanks. I have got a few questions. Let me start with the outlook for ’08. You guys obviously aren’t providing any official guidance but Mike, you did mention a few things starting with the top line expectations. I just want to make sure I’ve got this right. You expect domestic to be down, but increasing sequentially over the course of the year, and international up but not offsetting the US. What are you thinking for the year as a whole? Do you expect business to be down 10, 20? Can you give us some sense as to what that gets us to when you factor in those considerations?

Mike Hessong

Yeah I think Mitch, you’re assumptions or what you heard was correct. With the lack of visibility that we have and the period we’ve come through we’re hesitant to put a target or a number around what the total year is going to be. So we’re not prepared to do that at this time. We will continue to provide updates as the year goes along.

Mitch Kummetz - Robert W. Baird

Are you thinking that Q4 ’07 will end up being a trough quarter? I mean when you say domestic increasing somewhat sequentially, are you thinking that Q1 will be stronger than Q4 of ’07?

Mike Hessong

We’re expecting it to continue to increase through the year. We do think Q4 was the toughest quarter. We’re not putting a number on what Q1 is going to be, and I can let Ralph answer some of this. We’re starting to see some progress in the marketplace based on the customer conversations that we’re having.

Mitch Kummetz - Robert W. Baird

Maybe Ralph can address it. Ralph, you’ve been there at least for a short time as the interim CEO. Can you talk little bit about feedback that you’re getting from accounts as you’re talking to them? What is end-use demand looking like? You did mention that retailers are now at lower levels of inventory than expected. I don’t know if there is any way to quantify that, but can you at least kind of qualify it with some comments there?

Ralph Parks

Yes Mitch, I’d be glad to. First of all, I have spent most of my time since I’ve been here out traveling, visiting face to face with as many of the customers as possible. I’ve been on their side of the table more than I’ve been on our side of the table so I know how they feel about things.

Sales actually came through holiday much stronger than what it looked like they were going to come through for the retailers as they were ending back-to-school and of course they saw the amount of inventory they had and it scared everyone, and rightly so, to some extent. But one particular retailer broke price and that created a lot of havoc in the marketplace.

But sales were much stronger than what they had anticipated. Yes, they lost margin dollars on it, did not make what they had planned to make, so we have to work with them in that area. But the sales have continued right on into January/February. I know from speaking with many of the retailers, their sales are much greater right now than what they thought -- they just never dreamed that they would be selling the pairs right now that they're selling and the push against inventory would be as strong as it is.

So we’re seeing some at-once orders come in. They’re still not to the point that they’re going to place a lot of futures with us. They’re going to put the pressure on us to make sure that we buy the right SKUs and the right colors and styles and sizes and service them through back-to-school and I think we’ll see futures for a holiday. I don’t think we will through back-to-school. When you look at the deliveries for back-to-school and then deliveries for fourth quarter, I think we’ll be in pretty good shape.

Mitch Kummetz - Robert W. Baird

How are you guys reserving for ’08 if the inventory situation or retail looks to be improving are you not reserving as much in the first quarter as you were in the fourth?

Mike Hessong

We assessed it at year end and so we wanted to make sure any of the assistance that we’re doing or any reserve against our own inventory is really an ’07 matter. We wanted to make sure we were properly accrued at year end. I think based on the progress we’re seeing in Q1, we don’t expect any material changes in reserves in the first quarter.

Mitch Kummetz - Robert W. Baird

On the SG&A side, it came in a little higher than I would have expected in the quarter given the sales level that you were at. I know you guys run a pretty lean operation, I don’t know how much wiggle room you have in terms of cutting costs. How should we be thinking about that line item in ’08? If the sales were to come down as I believe you’re saying, should be expecting SG&A to drop too in absolute terms or is that not going to happen?

Mike Hessong

I think a couple of things there Mitch. We had said that we were going to spend more in the fourth quarter on marketing and we did so, not only the marketing that we spent on our own on TV but also the co-op advertising that we did for our customers. We purposely did that. We think that helped to continue to drive sell-through and move units through at retail, so we think it was the right decision.

I think when you look at 2008, there are variable costs. We are a lean organization. We’ve got to balance saving money for the bottom line versus continuing to drive the long-term growth of the brand; so I don’t see us backing off from a marketing standpoint or even a product development standpoint, but there will be other areas where we can sharpen our costs if necessary and of course, you’ll learn a lot more as the year goes along on how you can best spend that money.

Mitch Kummetz - Robert W. Baird

Inventory on your end, how clean is it? It’s up year over year by a pretty good margin. Can you just comment on that?

Ralph Parks

I’ll jump in there and then I’ll let Mike follow up behind me on it. I can tell you, the inventory that we ended the year was higher than what we would have liked, but because of the futures not being out there and the retailers using at-once orders to fill their needs, our inventory has come down dramatically. We’re in actually pretty good shape with our inventory right now.

Mike Hessong

I think the other thing I would add to that, Mitch, too is that even with the higher balance at year end, most of that was fresh product. We weren’t carrying a lot of older styles. We accepted, as we had mentioned, some cancellations in the back half of ’07, so it was new stuff, and so when you look at the aging of the inventory it’s in pretty good shape. So it does give us more of a better position to react to at-once demand and we feel good about it.

Mitch Kummetz - Robert W. Baird

What is your CapEx expectation for ’08?

Mike Hessong

It was just over $1 million in 2007. I would expect it to be around that number, maybe down slightly, although with the continued expansion in Europe, there would be some additional cost there as well, but I think it’s still probably in the high six figures.

Operator

And the next question comes from Robert Samuels - JP Morgan.

Robert Samuels - JP Morgan

Have you had any other major accounts in the US drop you from their stores?

Ralph Parks

No. Everyone that I have met with wants the product, needs the product, the customers, the end-use consumers asking for the product and other than the one that you're aware of, everyone is going forward with us.

Robert Samuels - JP Morgan

Can you talk about what sort of impact the addition of Famous and Shoe Carnival had during the quarter? Are you currently in all of their doors?

Ralph Parks

No. They just brought it in like November-early December, not that many doors. They're doing well. They plan to continue to grow with us. They serve a family footwear niche. You’ve got your mall-based retailers that serve a niche and then you’ve got your sporting goods stores. There are really three different channels and they're all important to us. Famous and Shoe Carnival are doing a great job with our product, the way they're showing the product, and the price points that they're selling the product at. But it’s not something that they're doing in all stores or anything like that.

Robert Samuels - JP Morgan

Are you going into more stores with them; can you give us a number there?

Ralph Parks

I don’t have a number. We will add some stores, but it won’t be real dramatic.

Robert Samuels - JP Morgan

Got it. And then finally, any quick comment on accessory or apparel sales during the quarter and just how that’s going.

Ralph Parks

Apparel we’re still working with that. That’s a very slow process, and it takes a lot of time, and we’ve got to continue to work on that. It’s very insignificant at this very moment. On accessories, we continue to do an extremely strong job with wheels, replacements and so forth. With the safety gear, helmets, knee pads, elbow pads, we do well with it, not as well as we would like, but we try to make sure that every retailer has that product in stock to offer it to the consumer.

Operator

(Operator Instructions) We’ll take our next question from John Carrick - Principal Global Investor.

John Carrick - Principal Global Investor

Good afternoon. With the lack of visibility on futures orders and it becoming more of an at-once business now, how does that impact your ability to go back to your suppliers and get improvement in pricing, because I’m sure they're going to want to have some sort of contracted run. How does that impact your ability to get further pricing concessions?

Ralph Parks

We already have our process worked out with our factories, and we have great relationships with them and quite honestly, they just want to make sure that we’re continuing to do business with them and continue to manufacture in their facility, and pricing has not been a problem for us.

John Carrick - Principal Global Investor

How many factories, or how many different suppliers are you using?

Ralph Parks

Three, I believe, isn't it?

Mike Hessong

Yeah, I think it’s currently three. We still have the ability with the number of shoe manufacturers over there to ramp up pretty quickly.

John Carrick - Principal Global Investor

We’ve been hearing talk about increased pricing for footwear and apparel and stuff coming out of China. Have you been able to kind of hold those pricing increases down?

Ralph Parks

So far we have and part of our strategic initiative was to get our office set up over there, and Will Albers and his team are doing an outstanding job for us, and when you're doing that yourself and you're not having to pay the commission to the sourcing agent, you can really leverage a lot of things.

John Carrick - Principal Global Investor

Then on the fourth quarter results, were almost all of those MDF reserves against domestic business, or was there any set up against international?

Mike Hessong

Yes, it was all domestic business. There were none for international.

Operator

That concludes the question-and-answer session today. At this time, I would like to turn the conference back over to Mr. Ralph Parks for any additional or closing remarks.

Ralph Parks

I just want to thank everyone for being on the call today. Thank you for your questions. Thank you for your attention to Heelys and we look forward to presenting better results on our next call. Thank you.

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