Collective Brands Inc. F4Q07 (Qtr End 12/29/07) Earnings Call Transcript

Mar.11.08 | About: Collective Brands, (PSS)

Collective Brands, Inc. (NYSE:PSS)

F4Q07 Earnings Call

March 11, 2008 5:00 pm ET

Executives

James Grant - Director of Investor Relations

Matthew E. Rubel - Chief Executive Officer and President

Douglas Treff - Executive Vice President, Chief Administrative Officer

Analysts

Robert Samuels - J.P. Morgan

John Shanley - Susquehanna International Group

David Mann - Johnson Rice

Brad Cragin - Goldman Sachs

Nicole Jachobi – Liberation Investment Group

Operator

Ladies and gentleman, thank you for standing by. Welcome to the Collective Brands fourth quarter 2007 earnings conference call. (Operator Instructions) I would now like to turn the conference over to James Grant. Please go ahead.

James Grant

Good afternoon and welcome to Collective Brands' conference call for the financial results in the fourth quarter of fiscal year 2007. I’m James Grant, Director of Investor Relations. Our call today will begin with Doug Treff, Executive Vice President and Chief Administrative Officer, followed by Matt Rubel, Chief Executive Officer and President. Along with us today for the question-and-answer portion of our call is Rick Porzig, Senior Vice President and Chief Financial Officer. After we complete our prepared remarks, Matt, Doug, and Rick will take your questions.

Today’s remarks will contain non-GAAP financial measures. The financial measures are non-GAAP because they exclude purchase accounting due to the acquisition of Stride Rite. Management believes that these measures will help you to better understand underlying performance trends in our business. For reconciliation of these measures to their nearest GAAP measures, please see our press release that was issued earlier today and visit our website at collectivebrands.com and click on the Investor Relations and presentations and webcast links.

Also, our remarks today 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 financial press release for more information on risk factors and other factors that could impact forward-looking statements. And now I would like to turn the call over to Doug.

Douglas J. Treff

Thank you, James and good afternoon, everyone. In the next few minutes, I’ll walk through our fourth quarter 2007 and full year financial results. In the fourth quarter, we competed in a difficult economic environment, which impacted mainstream consumers significantly, resulting in lower traffic and lower fourth quarter results. Still, we ended the quarter well positioned for 2008.

Matt will speak to you about our strategy and the progress we are making in just a few minutes. Fourth quarter 2007 net sales were $77 million dollars, up 12% compared to the fourth quarter last year due to the acquisition of Stride Rite. The fourth quarter 2007 net loss was $46.6 million or 73 cents per diluted share and includes purchase accounting expense of $29 million dollars pretax or 42 cents per diluted share. The net loss excluding purchase accounting was 31 cents per diluted share.

Our fourth quarter earnings also included incremental interest expense of $14 million dollars pre tax or 14 cents per diluted share. On the debt incurred financed the acquisition of Stride Rite. In addition, the fourth quarter 2006 results additional profit related to the $36 million dollars of incremental sales related to the 53rd week.

For the full year 2007, Collective Brand sales were $3.04 billion, up 8.5% versus the prior year due to the addition of Stride Rite. Comparable store sales were down 1.9% for the full year. Net earnings for 2007 were $42.7 million dollars or 65 cents per diluted shared, compared to $122 million dollars in 2006. Excluding the impact of purchase accounting, net earnings for 2007 were $77.4 million dollars or $1.18 per diluted share.

So let’s talk about sales. Fourth quarter net sales were up 12.1%. Comparable store sales declined 6.8% on a calendar comparable basis. This was the result of lower traffic at Payless stores. In particular, sales of women’s dress and girl’s dress shoes were lower. The declines were offset in part for several favorable drivers of our strategy. Payless experienced strong sales in women’s casual and canvas footwear. This helped drive the 8% increase and average unit retail prices for the fourth quarter for Payless. In addition, our Payless International sales grew 3%, led by the Latin American retail business at over 20%. Double digit increases at Sperry Top-Sider and Saucony led the growth in Stride Rite wholesale.

Our gross margin rate for the fourth quarter of 2007 declined from last year. Still it’s important to note that the Payless merchandise margin increased again this quarter compared to last year, continuing its positive trend throughout 2007. This was the results of our efforts to increase direct sourcing of product and higher unit retail prices. In total, the Collective Brands’ gross margin rate was lower due to the lower comp store sales, which deleveraged fixed cost of sales such as occupancy cost and depreciation and amortization. Second, comparisons to the fourth quarter last year, which included a 53rd week of $36 million in sales that leveraged fixed costs. And third, our new distribution infrastructure, which net a freight savings, was $5 million dollars pretax or 60 basis points diluted.

SG&A. SG&A as a percent of sales, increased 40 basis points in the fourth quarter of 2007, an amount equal to $3 million dollars in acquisition-related expenses. The impact of the lower comparable store sales was offset by lower incentive compensation and reductions in certain other expenses. We took action during the last half of the year to curtail spending and make adjustments in response to the challenging business conditions. The result of these actions was the SG&A, excluding the acquisition-related expenses, remained at the same rate as a percentage of sales was last year. SG&A dollars were up due to the addition of Stride Rite offset in part by lower Payless SG&A from not incurring expenses tied to the 53rd week last year.

We had a fourth quarter operating loss of $6 million dollars, excluding purchase accounting. The operating loss including purchase accounting was $35 million. Net interest, we had an increase of $18 million dollars in net interest expense in the fourth quarter of 2007. The change was due to financing the acquisition to Stride Rite and Collective Licensing.

Our full year 2007 effective tax rate of 14.6% was favorably driven by the impact of purchase accounting, higher interest expense, and lower pretax income in higher tax jurisdictions compared to 2006. Minority interest represents the 40% share of earnings due to Payless joint venture partners in Latin America. Fourth quarter 2007 minority interest was up $800,000 versus the prior year due to the stronger results in the Payless Latin American business.

Now onto the balance sheet. During 2007, we recapitalized the company to acquire Stride Rite and Collective Licensing. The recapitalization improved our capital efficiency and lowered our cost of capital. As a result, we ended the year with lower cash and higher debt positions. Cash at yearend was $233 million dollars compared to $461 million last year. Total debt increased to $922 million from $202 million and net debt at the end of 2007 was $690 million dollars compared to a net cash position last year of $259 million.

Inventory. Our collective brand inventory was $470 million at the end of 2007, up $108 million compared to 2006, due to the addition of $155 million of Stride Rite inventory. Payless inventory was 12% lower at the end of the year. Inventories in Payless stores were down 7% and other inventories were lower due to more efficiently managing our supply chain, including raw materials.

Regarding fixed assets, our capital expenditures for fiscal 2007 were $167 million dollars, $49 million higher than 2006, due to $36 million dollars in plan investments in the company’s supply chain that will improve its efficiency and effectiveness and $12 million dollars related to the rollout of new point of sale registers to North American Payless stores.

Cash flow. We continue to generate strong cash flow from operating activities for the year of $193 million dollars. The company demonstrated its ability to generate health cash flows despite the challenging footwear retailing environment. [Abaete] excluding purchase accounting for the year was $257 million dollars. This was flat compared to 2006. Stride Rite’s contribution to cash flow was positive and consistent with our expectations given the last half of the year as seasonally lower than the first half.

During the fourth quarter of 2007, we repurchased 1.8 million shares for $27 million dollars at an average price of $15.18 under our stock repurchase program. For the full year, we repurchased $2.4 million shares.

Next, I’ll direct my comments to the cost synergies related to the Stride Rite integration and the progress we continue to make. The cost synergies continue to be developed and they will be significant. We are reiterating our guidance for cost synergy expectations for the next three years. These savings amounts are net of investments required to achieve the savings. In 2008, we expect to achieve more than $5 million dollars in pretax synergies over the base year of 2007. In 2009, we expect to achieve synergies of $15 million dollars or more versus the base year of 2007. This represents $10 million dollars more in synergies than in 2008. In 2010, we anticipate synergies at $25 million dollars or more versus the base year of 2007. $10 million dollars of this will be incremental over 2009.

Overall, the operating results generated by Stride Rite are building a stronger Collective Brands and will help fund additional future growth opportunities concurrent with our growth strategies at Payless and Collective Licensing.

Regarding the Collective Brands’ financial outlook, it’s important to note as investors analyze our business that the seasonality of our business in the future is anticipated to be consistent with the seasonality of our business prior to the acquisition of Stride Rite and Collective Licensing. That is, to say, we still expect first quarter to be the highest sales and operating profit quarter followed closely by the second and third quarters and the lowest sales and operating profits in the fourth quarter. This is driven by the seasonal retail store trap and wholesale shopping patterns for our products.

Collective Brands anticipates an operating profit growth rate in the mid-teens over time on a base of $192 million dollars in adjusted operating profit in fiscal 2007 before purchasing accounting expense. Adjusted operating profit is the sum total of Payless and Stride Rite operating profit as if Stride Rite were in Collective Brands results throughout 2007. This long-term goal is predicated on low single digit comparable store sales growth. In the next six to nine months, the company anticipates the comparable store sales growth may be below its long-term goal. Collective Brands intends to mitigate the anticipated year term sales environment with prudent inventory control and expense management.

During 2008, the pretax purchase accounting expense is anticipated to be approximately $22 million dollars. The company anticipates approximately $9 million dollars in the first quarter of 2008, approximately $4 million of which is due to the flow through of inventory recorded as fair value. By the end of the first quarter of 2008, the flow through of inventory recorded at fair value is expected to the fully recognized in the income statement. Approximately $13 million dollars of the pretax purchase accounting expense will be incurred readably over the second, third, and fourth quarters of the year.

Excluding the impact of purchase accounting, the Stride Rite acquisition is expected to be accretive to earnings in 2008. As Stride Rite’s operating earnings contribution, including synergies, 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 2008 on a GAAP basis.

Capital expenditures in 2008 are expected to total approximately $145 million dollars. The 2008 effective tax rate is expected to be approximately 30% on a GAAP basis, excluding discreet events.

Depreciation and amortization in 2008 is expected to total approximately $145 million dollars due to greater investments and supply chain and stores in recent years as well as the 2007 acquisition of Stride Rite.

Now, I’ll turn the call over to Matt.

Now I will turn the call over to Matt.

Matthew E. Rubel

Thanks, Doug, I’d like to begin with a few remarks about the fourth quarter of 2007 focusing on Payless domestic as well as the current environment in which we’ve been operating.

Consumers tend to be resilient in the face of a single challenge, but the core Payless customer, the premium mass or value-typed customer, has been particularly impacted by the multiple economic challenges many consumers face today. This led to lower traffic at Payless. We expect low year-over-year traffic for at least the next six to nine months. The value channel of footwear was slower than other footwear sectors in 2007; however, according to industry data, we gained market share relative to other players in the value channel. Our share gain, we believe is a result of our strategy and would not have happened if we were still competing only on price as we did just a few years ago.

Currently, our focus is to manage inventory and expenses very carefully so we can be as flexible as possible in the current environment and while we remain cautious about the overall environment, our corporate strategy at Collective Brands is a solid one, one which is working. Our diversity in price points, brands, selling channels and geography underscores the rationale behind our acquisitions. We’re seeing strong performance in certain wholesale brands and our international businesses. This, along with a solid core, is driving cash flow and validating our strategy.

2007 was a transformational year. The acquisitions of Collective Licensing and Stride Rite changed the face of our business and pointed us to drive higher long-term earnings growth through multiple platforms that connect with consumers to retail, wholesale, licensing, and e-commerce. We are working to leverage this hybrid business model to take advantage of growth opportunities.

At Collective Brands, our mission is to become the leader and bringing compelling lifestyle performance and fashion brands for footwear and related accessories to consumers worldwide. Our strategy will have four strategic themes. Consumer connection is number one. The touch points and insights being critical. Two, powerful brands. Three, operational excellence. And four, growth that is organic, synergistic, and acquired. The financial outcomes from this mission are clear in our planning and should become clear to everyone over time. The business model has higher margins which generate high returns for our company and for its shareholders. The model is less capital intensive, so we increase our return on invested capital. The hybrid model has greater liquidity, greater cash flow, and synergistic opportunities to deploy cash more effectively, and while the transformation is taking place in a difficult economic environment, I believe that our performance in 2007 provides insight into our future growth potential when our synergies increase and consumer spending picks up.

With that as background, let me review five of our 2007 accomplishments, which lay the groundwork to create future shareholder value. One, that house of brands. With the addition of the Stride Rite group and Collective Licensing, we have built a more formidable portfolio of brands in Payless. We strengthened our house of brands by growing the most profitable and high impact junior brands we own, rationalizing other brands that no longer made business sense for us, and working with coveted designers to bring new designer brands to Payless on an exclusive basis. With Stride Rite group, we have added a portfolio of brands that serves the premium market with brands such as Saucony, Sperry Top-Sider, Keds, Stride Rite, and Robeez. As a result, at Collective Brands, we now have a strong brand that are positioned well in both the math and the premium markets. Two, acquisition integration. I am pleased with the progress of our Stride Rite integration and its operating results. We continue to move forward with multiple integration projects in raw materials, consolidating of factories, efficiencies and logistics, and other opportunities. We are on-track to deliver the integration savings in 2008 and future years that we reiterated in our press release today. Three, people. We continue to add and build strong leaders to Collective Brands. At the most senior level, we have a formidable team and great talent, talent in Stride Rite CEO Gregg Ribatt, Collective Licensing CEO; Bruce Pettet, our Executive Vice President of Supply Chain, Darrel J. Pavelka; our Chief Administrative Officer; Doug Treff, and General Counsel; Michael J. Massey, who also oversees international business development. Four, supply chain. We made significant progress in 2007 to integrate and optimize our global supply chain strategy by opening a distribution center in Redlands, California and beginning construction on another one in Brookville, Ohio. And earlier today, we announced in a news release, that we are taking steps to further integrate our global supply chain, increasing efficiency and decreasing costs. We will close two DCs in North America within the next 15 months and consolidate their functions into other DCs. These moves are important steps in realizing the operational and backend efficiencies of Collective Brands. In addition, in 2007, we expanded our direct sourcing capability and staffed our New York design office. Five, store formats. We successfully concluded our development, testing, and refining of our Payless store prototype. The hot zone format will be our design for all future new, relocated, and remodeled stores. Since the start of calendar 2008, hot zone stores have shown demonstratable sales lifts versus their district, control groups, including the retro fitted stores in which we added backup five foot sections. At Stride Rite Kids, we will open up a new format in New York City for back-to-school. It will carry all Stride Rite children’s group brands and capture customers from zero to ten with its own house of brands.

So in the face of head winds, we’ve made substantial strategic progress in 2007. As we compete for consumer dollars in 2008 against both competitors and share of wallet, we need to do even more to achieve relative success and gain market share. We believe we can compete successfully in 2008 through a number of key strategies. We will stay true to our successful merchandising strategies and maintain the right balance of our opening price point offerings while communicating to customers to refined marketing a clear message that Payless is the destination for the best value based on price, quality, fashion offerings, and brand trust in the footwear industry.

We have kept our inventories clean. Our in-store inventory levels in Payless at yearend were down 7% from a year ago. As a result, we have fresh goods heading into the pre-Easter season. In 2008, Payless will continue to profitably built upon its house of brands positioning by emphasizing freshness in existing programs and adding new programs.

Payless will utilize cost efficient direct marketing a lot more in 2008, leveraging the 21 million phone numbers that we have collected in 2007. In 2007, this tool was not used as a meaningful marketing tool.

Our international diversity is both a competitive advantage in today’s market and a key driver of our business for the long-term. In 2008, Collective Brands will continue to diversity through new channels and geographies. We will expand internationally by building platforms for future growth in Columbia and other Latin American locations, Western Europe and other locations where financial returns meet our expectations.

And finally, we will be highly competitive in 2008 by the way in which we manage cost increases coming out of China. On a relative basis, we know we’re doling better than the average company using contract manufacturing in China. From a long-term perspective, we’re working with our factory partners on opportunities for production inland and north in China, as well as other countries such as Indonesia, India, and expanding our existing presence in Vietnam. We are able to manage costs by using a number of tools at our disposal, such as more direct sourcing, the consolidation of raw material suppliers, and the consolidation of factories.

So in the context of the Payless strategy, let’s take a more detailed look at our Q4 in fiscal 2007 accomplishments, which we believe position Payless well for the future. With regard to on-trend targeted product, in its quarterly attitude and usage survey, Payless scored 700 basis points higher at the end of 2007 on the question - is Payless a store you go to first for what’s new in shoes? Among women, comfort, and style measures as trending upward at Payless as well. The same study also indicated that Payless improved relative to its competition in 2007 in key attributes, including product availability, product quality, having trend right product, being a brand that they feel good about, and being a store that they enjoy shopping for shoes.

For effective brand marketing, Payless increased its brand penetration in the fourth quarter of 2007 and improved its brand productivity. Branded footwear sales rose to 47% of overall sales versus 30% the prior year, and importantly, brands produced 26% more gross profit dollars per five foot section in the fourth quarter of 2007 versus the year ago period.

Also, at the end of 2007, we soft launched our Dexter branded program as the branded alternative for the traditional updated customer in both men’s and women’s. It started in the fall in a few hundred stores and today Dexter is in all stores supported with marketing.

Also supporting the Payless brand strategy in 2007 were new collections in our designer lines, which added to Abaete. We had Lela Rose and alice + olivia come into the pack.

We are also executing well on our strategy of providing a great shopping experience. Payless customer satisfaction scores indexed four percentage points higher in Q4 2007 versus Q4 2006. Our full year conversion rate, the percentage of customers who buy when they visit the store increased ten basis points and according to an industry research service, Stride Rite and Payless were number one and two, respectively, in customer service amongst footwear specialty retailers.

We also improved the customer shopping experience in 2007 through technology. We rolled out labor scheduling, new point of sale terminals, and in-aisle scanners in most of our Payless stores worldwide.

As for supply chain efficiency, in addition to the strategy developments announced today, we continue to drive our direct sourcing in the fourth quarter of 2007. Direct sourcing improves our merchandise margin rate and approximately 61% of our product was sourced directly in the fourth quarter of 2007. This compares to 53% in the previous year.

During 2007, we also began operating our New York based design center, which is adding expertise in the design process and enabling us to source distinct product directly and at a lower cost. The New York design center team is also working in partnership with design teams from the brands at Stride Rite to add value across our organization.

Now turning to Stride Rite, we continue to be very pleased with the progress of the acquisition integration. Doug talked about the cost synergy. From a cultural perspective, I’m pleased with the teams and their passion for their products and from a growth perspective, the Stride Rite portfolio is generally executing both as a wholesale and a retail business and both of those had Q4 sales increases compared to the same period last year.

In wholesale, overall backlogs were up significantly for the first half of 2008, compared to the first half of 2007.

Sperry Top-Sider continues to perform very well, due to the expansion of its women’s business and all year-round line. Vulcanized and nautical casual products have been particularly strong as well. Footwear Plus named Sperry Top-Sider vendor of the year in the nautical category.

Saucony is gaining momentum and has increased its market share in the specialty run channel due to new product, such as the Hurricane 10, design improvements across the entire line, and strategic expansion of its distribution channels. Earlier this year, the Independent Running Retailers Association named Saucony vendor of the year and recognized its Omni Fix as shoe of the year. In addition, Saucony launched, successfully I might add, its apparel line into the run specialty trade channel just a couple of months ago.

Keds and Stride Rite kids’ wholesale businesses have partially offset the Q4 wholesale segment gains, but the teams in those brands are making the right investments to improve the businesses long-term. For example, Stride Rite introduced Stride Rite Kids group, introduced Robeez Treds into the marketplace as their first toddler indoor-outdoor offering. Its initial selling is strong and above plan.

In retail, Stride Rite comp sales and mall-base traffic were down, but total sales were up 2% in the fourth quarter. The result is good given the environment in which footwear retailers are competing. The Stride Rite retail performance is a testament to the kind of loyalty and trust the team has built with its customer base. Stride Rite is taking the right steps to position the Stride Rite stores, emphasizing the elements that make it a destination for children’s shoes and driving forward its strategy to both attractive customer base and keep them as customers for a longer period of time. As an example, Stride Rite is broadening its licensing agreements and the team is encouraged by the continued strong performance of its Super Ball license program.

In conclusion, I’m very proud of the entire Collective Brands organization. In 2007, they worked hard and worked effectively through a lot of change under tough circumstances, but I believe it made us a stronger company, one that is well positioned to compete effectively in 2008, and well beyond to build and deliver value for our customers and for our shareholders.

Thank you for your time and now we’ll take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Robert Samuels from J.P. Morgan. Please go ahead.

Robert Samuels - Morgan Stanley

Hi. Good afternoon, guys. Matt, can you provide just a little bit more color by segment within the Payless stores and then maybe talk about any trends that you are particularly excited about that could potentially impact sales for the spring season.

Matthew E. Rubel

We don’t break out the categories bit by bit, so it’s a little bit hard to get into that, but I will tell you that we are seeing the casual business continue to be very strong, you know, flats and ballet shoes, mocs, inspirations around nautical. We do continue to see diversified things in canvas working well. So not necessarily your old solid twin core, but we are seeing diversified patterns. Sometimes even up on a wedge working well in that category. We’re seeing the play area of kids, which would equate to the casual portion of what you see in other areas doing well also and for us, we are seeing our junior segment continue to trend very nicely.

Robert Samuels - Morgan Stanley

Are you seeing any trade down within the stores from your hiring consumer coming in and possibly helping to offset some weakness on the lower end?

Matthew E. Rubel

The data that I alluded to about the value channel not doing well in the fourth quarter was pretty substantial. It’s out there, it’s in NPD, and you would see though that within that channel when you adjust especially for store rollouts that we did materially better than everyone else in that channel. So is our hypothesis that we have picked up much more from the middle than in fact some of the other players in the value channel. We are doing an attrition study and to kind of understand movement through the channel and the initial results, although I haven’t gotten into the detail so I don’t want to overstate it, is that we’re not losing to our competition. It’s just people are buying fewer shoes right now and coming in the stores a little bit less.

Robert Samuels - Morgan Stanley

Okay great. You touched a little bit on what you’re seeing in terms of cost coming out of China. Have you any way to quantify that at all just in terms of what you’re seeing over the last couple of months?

Matthew E. Rubel

The answer is yes we quantify it. I don’t find it productive to quantify it publicly and the reason why I don’t is that what our price increases are or will be versus competitive. It’s just something we know what ours are. We get general data about what other people are and we want to be able to manage appropriately. We have really been thoughtful about a clear good better-best strategy to make sure we’re mining all price zones and at the same time there will be price increases. We will not get as much leverage as we have the last two years out of cost of goods, but there will still be maybe some leverage to be had. Although we’re going to see that slowing.

Robert Samuels - Morgan Stanley

Thanks very much.

Operator

Next we go to the line of John Shanley with Susquehanna International Group. Please go ahead.

John Shanley - Susquehanna International Group

Thank you and good evening, guys. Matt, in the press release, the notation was that the company is now expecting operating growth rate in the mid-teens over time versus the high teens rate that you previously provided us guidance with. Can you give us an idea of the primary reasons for the lower guidance rate and also what does over time mean? Is that measured in quarters or is that measured in years?

Matthew E. Rubel

Years. It’s measured in years and I think we also said mid to high teens. So I don’t think there’s a material change. I think we’re level setting you off of where we ended up on an adjusted basis with the two larger companies coming together off of that 192 number. I think we’re also very clear that in the near term, meaning the next six to nine months, that we do see a much more difficult environment and, in fact, meeting that low single digit expectation is not something that we foresee happening in the next six to nine months.

John Shanley - Susquehanna International Group

It could be that in the single digit range. Is that what you’re basically guiding us?

Matthew E. Rubel

I’m not giving guidance other than to say that over time our business plan show that we’re going to get to mid teens, John, so that’s really as far as we’re going to go. I think we’ve given you a lot more information than ever before and in this environment to get any more specific than that wouldn’t be productive for you or for me.

John Shanley - Susquehanna International Group

Okay, I can appreciate that. I wonder if you can give us a little bit more details on the performance of the major components of the Stride Rite operation, specifically Keds and Stride Rite wholesale based on the bookings and the pre-lines that the brands have done. How do those brands stack up in terms of where they are now versus where they may have been at this time last year?

Matthew E. Rubel

Well I mean I guess your question kind of said the major ones and then you said Keds. Keds is actually the fourth out of five brands that we would have in terms of size and scope, so I would first start off with our Saucony brand, which is the biggest overall brand and Stride Rite Kids when you include retail as well, but I’d say the Saucony brand is increasing double digit. Their bookings are substantially ahead. They’re getting diversified sell through across all of their new product launches. I mean virtually I would say they’re really hitting on great innovation. They’ve been recognized by the industry. I think the leadership team there is doing an outstanding job of focusing on hugging the running channel and really doing all it takes to make sure they understand that consumer really well. The launch of apparel has been successful, limited and small, but successful. They’ve transitioned from Hind over to Saucony and have done a great job and the reception on the fall product is even better than Spring. So Saucony, all things are really moving forward quite well with an aligned and thoughtful and well managed team there. In terms of Sperry, we’re in the midst of a marketplace which is very accepting to that category, but at the same time, I think they’ve done a terrific job getting beyond the boat shoe, which is still a material part of their business and driving a big part of their growth. They’ve gotten into lifestyle products. They’ve done specialized products with other upscale retailers and with different brand affiliations coming through. They have a diversified distribution, which I think serves them very, very well and their bookings are up high double digits and their sell through rates continue. They also have put more resources against women’s and are still looking to add even more resources against women’s and have some new marketing initiatives, which are just starting to hit now and will go into next year. So both of those brands are really, really performing much better actually than one could hope. In terms of Stride Rite group, the Robeez business has been good and their launch of Treds as I said was excellent. Bookings at wholesale for the Stride Rite Kids group is up very nicely now. So they made their turnaround from the fourth quarter and what they’ve done with some of the marketing and product innovation, what they’re doing with Boogie Board and what they’re doing with Super Ball is very well accepted. So I think those three businesses, even though the Stride Rite retail business has its challenge as all retail footwear segments do, they’re leading with product innovation, they’re leading with hugging their customers, and really focusing in on category expansion very thoughtfully and innovation. So really, really thrilled there. The Keds business continues to be challenged in some areas. We are seeing some good sell through on some new product and some high wedges and things like that, but I still think we have to find a really clarified strategy there to really give sustainable growth in the U.S. Internationally, Keds is doing terrific. So that kind of gives you a quick look at the business at Stride Rite.

John Shanley - Susquehanna International Group

That’s very helpful, Matt. I appreciate it. What’s the game plan in terms of rolling out additional Stride Rite retail stores? Is it on hold or are you still looking to aggressively roll out additional units or going forward?

Matthew E. Rubel

We still have about 20-23 stores planned for this year. So continuing to do that and that will be first quality as well as some outlet stores. They are working on a new store format, which will be unveiled in New York for back-to-school, which we’ll be able to really work a little bit harder at getting that six to ten-year-old engaged in the store. So I think with the Jeff Kasimson launch as well as with some of the Saucony kid’s products, Sperry kid’s products, Keds kid’s product, and other brands that they bring into that store to compliment the Stride Rite, I think they will make a great premium house of brands under the Stride Rite retail umbrella. So you’ll see a new format as well as continued rollout of what we have.

John Shanley - Susquehanna International Group

That’s great to hear. Last question I have is going back historically and obviously this is a number of years ago, but has Payless benefited as the economy has taken a dip to the recessionary climate?

Matthew E. Rubel

John, I’ll make this your last one, because I got to get to other people, but the answer is from time to time we’ve seen some things work out and other than this kind of a recession or this kind of a pull-back, so it hasn’t been consumer led in the same way. When you see store traffic dropping out there in the malls and freestanding stores double digit and you know that’s what’s happening in competition and across the board. Less people coming in the stores is not good. We are very maniacally working on conversion. We’re getting great customer service scores and when we get product in the store, we’re seeing our conversion hold, which means the customer likes our offer. We just got to get more customers in the store and that’s not a Payless issue, that’s a marketplace issue. Let’s go onto the next caller.

Operator

Next we will go to the line of David Mann from Johnson Rice. Please go ahead.

David Mann - Johnson Rice

Yes, thank you. First question was on gross margin. It was worse than the guidance you gave us. Curious was that all due to the leveraging effect from the comp decline or it looks like you had less of a year-over-year gain in direct sourcing. So I didn’t know if there were some other components which maybe didn’t perform as well as you thought.

Matthew E. Rubel

We don’t give guidance, so I’m not sure what that meant. Our merchandise margin was up year on year at Payless and I’ll let Doug walk through, but it was mostly de-leveraging of other cost of goods.

Douglas Treff

Yeah, that really is the driver was the comparable store sales decline at 6.8% was the primary effect there. That was the most significant factor. I mentioned also the distribution center costs that had a 60 basis point dilute of effect, but it was primarily the de-leveraging related to that had an effect on occupancy costs and DNA.

David Mann - Johnson Rice

Okay. Matt, I was just referring to what you had in your last release about one third of the 500 or 600 basis point decline in gross margin that you expected. My other question was on the long-term guidance that you were commenting on with I think John Shamley’s question. The mid to high teens that you talked about was tied into the time period from ’06 to ’09 and now you’re sort of talking off of a base of ’07, which looks lower than the growth rate. More like a high single digit growth rate from the ’06 time period. So is there anything else that’s changed other than the current environment, you know, about the acquisition about your business model that would sort of explain that change in guidance?

Matthew E. Rubel

No, there isn’t, David. We wanted to do a couple of things. One, we wanted to make sure that we level set based upon the current situation we’re in today. The current retailing environment consistent with the strategies that we have in place to grow at a strong rate in future years. That was the primary thing. The other thing we wanted to do was we wanted to be able to provide you with more information related to full year performance. That’s why we provided the adjusted operating profit in 2007 of $192 million dollars so you could begin to think about what that bases. So instead of working off of 2006 numbers, you’re working off of the 2007 numbers, and really begin to see how the company begins to form versus the most recent period.

David Mann - Johnson Rice

That’s very helpful. Last question, use of free cash flow. If you can update what you’re thinking there with the numbers you put out there, it’s not unreasonable to think that you’d have $100 million dollars or so of free cash flow this year. Can you sort of balance between growth projects, debt reduction, and more buy back. How you expect to proceed?

Matthew E. Rubel

Well first of all, I think you’re very astute in the way you’re looking at it in that this entity is a tremendous cash flow generator. So what we are really trying to do is to deploy cash flow into the highest return, opportunities to drive growth for the long term. Now, what does that mean? I mean we have a CapEx statement of what we’re doing. We’re finishing off the supply chain. We have stores that we’re both going to have new stores as well as refurbished, and we’re also continuing to invest in the Stride Rite group and have more than enough CapEx allocated to that. As it relates to the balance sheet and how we’re going to deal with the balance sheet, I think there are many options that are before us that we have to wait and see how they unfold in the debt markets and in share buy backs and other things like that. We are open to making a more efficient use of capital through any of those means, but I think right now to call anything out specifically would be a little premature. I do say also, notice that we did buy back in the fourth quarter a substantial amount at a little over $15 so we will go back under scenarios and buy significant amount of shares back when our basket is open and it will not be open for the next three months.

David Mann - Johnson Rice

But previously you talked about debt reduction, is there any change in that prior commentary of how you expect debt…to flow?

Matthew E. Rubel

You tell me what it is that you’re…

David Mann - Johnson Rice

In the original guidance, when you bought Stride Rite, you talked about a certain pay down schedule.

Matthew E. Rubel

We’ll continue to pay down debt when we see it appropriate, but we don’t have to.

David Mann - Johnson Rice

Yes, thank you. First question was on gross margin. It was worse than the guidance you gave us. Curious was that all due to the leveraging effect from the comp decline or it looks like you had less of a year-over-year gain in direct sourcing. So I didn’t know if there were some other components which maybe didn’t perform as well as you thought.

Matthew E. Rubel

One other factor, David, is that given the current environment, it’s prudent for us to make sure that we have cash flexibility for the growth projects that we have for debt reduction for share repurchase, but given the current credit environment, it’s prudent to have flexibility that we have in the company.

David Mann - Johnson Rice

Good luck with the rest of the year.

Matthew E. Rubel

Thank you.

Operator

Next we go to the line of Brad Cragin from Goldman Sachs. Please go ahead.

Brad Cragin - Goldman Sachs

I was wondering if you could talk about whether or not you’re adjusting your price point mix at all given the current economic environment?

Matthew E. Rubel

Yeah, we are, but I would say it’s really about creating price zones. So as when we were talking about China, prices are going up. So that’s another factor that is real. So we will not reduce our gross margins on an overall basis. So we are not looking at that and when we actually look at what items sell, the lower price point items aren’t selling at greater velocities. It is, in fact, an item which has great value which may have a markdown attached to it which is selling at strong velocity, but it has to be on-trend and of great value. So being opening price point, we’re not necessarily seeing it and, in fact, through our attrition study, the money matters consumer, because we actually have them segmented into these different ones, that’s the one that’s pulling back most, which is why you’ve seen an impact in the rest of the value channel much greater than ours. So for us to make too much of an offer for that money matters consumer more than we have in the past could, in fact, be a strategic flaw and something that we will not do. We’ll still have things for them, but we’re not going to increase our offer at that range.

Brad Cragin - Goldman Sachs

Okay, it makes sense. You guys truly have a lot of opportunities on the expense front. Just so I don’t misinterpret what you guys are talking about for your outlook. When you say comps may trend below the long-term plan in the next six to nine months, are you implying as well that that operating profit gross might trend below that over that time period as well?

Matthew E. Rubel

We’re not giving you annual guidance and that’s the best way that I can do it, but we’re trying to also let you know that the environment out there today is tough and that traffic as you know, because you cover retail quite a bit, and it’s something that we got to get the customers in the doors. So if we look at it and we model it out over time, we’ve got all the tools and the pick-up share and this is a cycle. We will go through the cycle and then on the other end we will start to grow again and so we look at things really over time, it’s generally about a three-year horizon the way I look at over time.

Brad Cragin - Goldman Sachs

Okay. Then just finally, on CapEx, I believe you guys are talking bout $145 million in spending in ’08. That seems to be down from what you guys were talking about back at the September meeting. Are the initiatives that you guys are pursuing simply less costly at this point?

Matthew E. Rubel

Brad, what we’re really doing is we’re one closer to the year, actually we’re starting in the year, but also we want to be very careful related to the cash flow. We want to manage expenses as carefully as we’re managing inventory. So we’re looking at each of those. We will bring it down, the distribution expenses will cost less than they did in 2007. So that’s a primary contributor.

Operator

And next we go to the line of Sam Poser from Sterne Agee. Please go ahead.

Sam Poser - Sterne Agee

Good evening. If I could just follow up one more time on the pricing. When you say that you will not reduce margins, are you talking about your initial margins, because don’t you face the risk of you’re maintaining the initials, but the customer may not go with you up to a certain extent?

Matthew E. Rubel

We don’t release initial margins. We only kind of look at our maintained mark-up over time. So our mark down cadence to our mark up cadence isn’t something that we really release.

Sam Poser - Sterne Agee

I understand, but the question is your maintained margin, the margin you’re going to maintain, you’re going to be raising prices. What level of concern do you have if let’s say you broke through, you know, go from $29-$31 dollars or $19-$21 over some of those…

Douglas Treff

But you know, the interesting thing is first of all we’ve already done that. So we’ve already broken through the $19 dollar mark to the $22.99 mark or to the $21.99 mark and we’ve already broken from the $29.99 mark to the $32.00 mark and it really comes down to relative to competition. The white space that we look at is where we’re priced relative to competition. We have a competitive shopping scenario, so we see what other people price at. We look at the FSI’s every week and what everybody is marking down at. So we have a very methodical way of understanding where we are relative to our competition and how far we need to be different than them. All of us are sourcing out of China. All of us have the same issue. So the movement that we’ve seen to date is relatively the same. There’s nothing that one can do about that marketplace shift.

Sam Poser - Sterne Agee

You’re doing a great job over the last few years updating the fashion element. That’s been the divider between you and some of the other valued players. Are you going to increase a little fashion in the stores at a time like this?

Douglas Treff

Well actually it’s great question, Sam. We’re not going to increase our fashion, because what we do is we try to make what we think is the right mix for the consumer, whether it’s classic, it’s updated, it’s junior, or it’s fashion, and how we do that by zone at what point in time, but if the spirit of the question is are we going to pull back and become more classic? You know, pull back, pull our wings in any way, shape or form? The answer is we’ve just launched a new ad campaign around “I love shoes.” We own the mark “I love shoes.” We’re going to make a big deal out of that and we’re going to make our in-store elements more exciting. We’re going to amp up the innovation that we see and that we’re working on with our designer product and our designer launches. We’re adding more comfort features to our shoes. So we’re going to increase our quality and we’re going to call out a point of difference more, but are we going to become a higher percentage fashion than we have been? No, because we try to map that to the right percentages for the marketplace.

Sam Poser - Sterne Agee

I was actually asking you the spreading wings way, not the pull… You mentioned also that MPD was showing that you were really getting your share of the business and the value piece of it.

Douglas Treff

Yes, against our value channel competitors.

Sam Poser - Sterne Agee

Is the pie itself bigger than it was or smaller a year ago?

Douglas Treff

It shrunk.

Sam Poser - Sterne Agee

By what degree?

Douglas Treff

I’ll let you get MPD. I don’t think I should quote their stuff over the phone. We’ll take another caller and that’ll be the last question.

Operator

From the line of Nicole Jachobi from Liberation Investment Group. Please go ahead.

Nicole Jachobi – Liberation Investment Group

Hi. Thank you. I want to follow up a little bit on some of the long-term guidance that you were giving. When we look back, I want to confirm if my understanding this correctly, when we look back at the investor day presentation, we were looking at an ’09 operating income range of $326 to $370 million and an ’06 operating process base of $218. Now if I’m understanding this correctly, we’re looking at a base in ’07 of $192 with the mid teens, which I take means 14 to 16%, which gets you to ’09 of about $250 to $260 million. Is this the right way to think about it or are these not apples to apples kinds of numbers?

Matthew E. Rubel

I’ll caution you that the $192 million dollars of adjusted operating profit and we were clear in the guidance here, that this is based upon the full year. We are level setting, what we are saying is not anything specific related to 2008. We’re saying over time. We’re saying that there could be risks associated with lower sales than the longer term guidance related to the next six to nine months. So in totality, I’m not affirming what you’re saying. I’m just saying that the $192 million dollars is the right place to start. Mid teens over the longer term is the right way to look at it and given where we are today, this is refresh and a new level set compared to last September.

Nicole Jachobi – Liberation Investment Group

Okay, well let me just ask one more question related to that. In the investor day, you did refer to that timeframe, the ’06 to ’09 timeframe as long-term guidance. So is ’09 the wrong year to look at or are you really looking at a three year ish, you know, plus or minus, I’m assuming type of timeframe.

Matthew E. Rubel

That three year timeframe is the right timeframe that we’re looking at.

Nicole Jachobi – Liberation Investment Group

Okay. Related again to the price increases that you plan on taking and the potential reduction of gross margin leverage you’ll get due to the increased cost coming out of China. Is this dynamic taken into account in your long-term thinking about this or are you expecting something to change with respect to the cost out of China?

Matthew E. Rubel

We’ve actually tweaked our model a little bit differently, to not quite expect as much gross margin expansion, because of the changes in China. So we’re really drilling in on some operating expenses and some other things to make that difference come to fruition. So if things even out there and if the marketplace picks up, we may be able to re-leverage it, but I think at this point we will say that we won’t get as much gross margin expansion as we have in the past.

Nicole Jachobi – Liberation Investment Group

So when you’re talking about your longer term guidance, you’re not expecting necessarily for the cost reductions and whatnot from China?

Matthew E. Rubel

Cost reductions?

Nicole Jachobi – Liberation Investment Group

Not cost reductions, or lack of increases versus what we’re expecting for this year.

Matthew E. Rubel

I’m not sure how to answer the question other than to say to go back to what I was saying which is we’re not modeling in continued material gross margin expansion and so, therefore, within the comp store number, within the other number, we obviously have to after expenses and do some other things and that’s what we’re working very hard on. So if the other number backs later on, that’ll be a bonus.

Nicole Jachobi – Liberation Investment Group

Okay, great. Thank you.

Matthew E. Rubel

Thank you, guys, very much. Appreciate it and that’ll be it for today.

Operator

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