Chattem, Inc. F1Q08 (Qtr End 02/29/08) Earnings Call Transcript

Chattem, Inc. (CHTT)

F1Q08 Earnings Call

April 8, 2008 9:00 am ET

Executives

Bob Bosworth - President and Chief Operating Officer

Zan Guerry - Chairman and Chief Executive Officer

Robert Long - Vice President of Finance

Analysts

Bill Chappell – Suntrust Robinson

Bill Leach – Neuberger

Doug Lane – Jefferies

Jon Andersen – William Blair

Jason Gere – Wachovia Capital Markets

Brian Delaney – Entrust

Christian Hoffman - Lehman Brothers

Kathleen Reed – Stanford Financial

Alice Longley – Buckingham Research

Karru Martinson – Deutsche Bank

Andrew Wolf – BB&T

Gary Giblen – Goldsmith & Harris

Presentation

Operator

Good day everyone and welcome to the Chattem First Quarter 2008 Earnings Conference Call. [Operator Instructions] Prior to today’s discussion the company has asked for a forward looking statement to be read. Statements concerning the company’s business outlook anticipating profitable sales or expenses and sales growth together with other statements made in the presentation but are not historical facts forward looking statements as the term is defined under Federal security laws.

It is possible that actual results may differ materially from the statements made in the presentation. All forward looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those projected including those described in the company’s filings with the Securities and Exchange Commission. A reconciliation of the non-GAAP financial measures contained in the presentation for the most comparable GAAP financial measures is contained in our earnings release for the fiscal first 2008 which can be found on the investor relations section of the company’s website at www.Chattem.com.

Now I would like to turn the call over to Chattem’s President and Chief Operating Officer Bob Bosworth.

Bob Bosworth

Good morning and welcome to the first quarter conference call for Chattem. We again very much appreciate your interest in Chattem and your participation in these calls. I’m joined today as I have been previously by Zan Guerry, Chairman and Chief Executive Officer and Robert Long our Vice President of Finance.

Today we are going to review the strong results for the first quarter ended February 29, 2008, and we’ll also provide an update on the positive outlook for the balance of this year. Before we start, however, a few important points regarding the call and the information to be provided. First, Zan will comment briefly on the performance of and the outlook for our brands and for our business. At the completion of Zan’s remarks I’ll provide some additional commentary on the results for the quarter and on updated guidance for 2008.

We’ll then conclude the presentation and open the floor for questions. We’ll limit the call to one hour out of respect to your time and to the extent there is specific questions regarding detailed line items on the financial statements provided in the release or to the extent your questions have not been answered and ask that you refer them to Catherine Baker whose number is listed in the press release. The third point would be in discussing earnings per share on this call all EPS data will be before PHAS123 charges and debt extinguishment charges both non-cash items and the one time charge related to the recall of Icy Hot Heat Therapy.

We believe this adjusted EPS information best reflects the operating performance of the company. Finally, in reference to guidance, we will be providing an updating earnings per share guidance for the year but as in the past we’ll not be providing quarterly guidance or revenue guidance. With all this said our goal remains to help everybody understand the manner in which we think about and approach our business and in that context I’ll turn it over now to our Chairman and Chief Executive Officer, Zan Guerry.

Zan Guerry

Good morning to everybody, we were informed that we had a 50% record crowd on the call this morning so we appreciate this increased interest in Chattem. We will try and raise our game as Kansas did last night to meet this record crowd this morning. You saw in our first quarter release today we had a very good quarter with adjusted earnings per share increasing 35% to $1.01. This is a solid start to the year in terms of reaching our overall earnings per share guidance of the upper end of the range of $4.00 to $4.20 per share.

As usual I will focus my discussion around the status and outlook of our major six brands. Big picture our large brands had a good first quarter in terms of consumer sales as measured by Nielsen. As mentioned in our last call the majority of our new product marketing activities occur from April to July this year so the next four months will be both very exciting and very important for the year. All our market research as well as early point of sale consumer data suggests it should be a very successful period.

Now let’s examine each of the six brands briefly. First both ACT and Cortizone had outstanding first quarter numbers. ACT continued the strong momentum that we started a year ago with the acquisition and sales jumped 42% from a year ago as measured by the last 13 weeks of Nielsen consumer sales. Cortizone increased 15% for the same 13 week period led by the new Intensive Healing Lotion which had an outstanding start for Cortizone.

For Gold Bond the 13 week consumer sales were up 7% however Gold Bond sales after a great December, January had slightly down sales for February, March which we don’t like for Gold Bond. We like nothing but strong up sales. This was due to two primary factors. In terms of the weather, January was extremely cold while February was a much warmer month and then even in the Northeast we continued with a lot of warmth in March. February, March Gold Bond sales were impacted negatively by the weather while December, January were impacted very positively.

Second, this year we purposely spent a little less marketing dollars in the February, March period anticipating our major April to June advertising for Gold Bond Restoring Lotion, our new launch in the lotion category. We will have record high advertising levels for Gold Bond Restoring Lotion for the next three months compared to no lotion advertising a year ago for the same period. We would anticipate much stronger Gold Bond numbers in the months ahead.

Icy Hot minus Heat Therapy was up 5% for the latest period and should benefit further from significant support in April through July for new Icy Hot PM Lotion and Icy Hot Patch. Selsun had its best performance in a number of periods by the early success of Selsun blue Naturals. We added a significant new flight of advertising in April and May for Selsun Natural responding to its early success. We would anticipate Selsun blue returning to growth over the near term.

Finally, Unisom 13 week sales were up 4% and again we look for more success from May, June advertising for the new Unisom Sleep Melt launch. Overall quite a good performance and an even better outlook for our major brands. Looking a little further out, recently we held a major two day conference with all of our marketing and sales people which focused on continued growth of our brands our to 2009, 2010. It was probably our best ever conference in terms of optimism and excitement going forward.

I think there were two key learning things that came out of that conference. First, we have a very good pipeline of products for 2009 perhaps even better than this year’s pipeline which is solid. Second, on a recent call I spoke to you about the fact that there was a study that suggested that a significant portion of advertising benefits accrued in the second and third year after an advertising campaign ran. This was never clearer than our recent conference as each of our sales managers focused on their key accounts and they in particular focused on improved distribution, improved shelf presence and improved moving brands from lower level of the shelf to mid level to high level.

If was very encouraging to see a lot of the improvements made in the merchandising of our brands and this was due to this multi-year growth that we’ve been experienced, this investment in advertising behind our brands and I think this will continue as we look at the advertising we are running this year will benefit distribution for next year and the years beyond. That was a very exciting conference. In conclusion, Warren Buffet said, “Short term the market is a voting machine, long term it’s a weighing machine.”

Bob and I we believe very much in weighing in, we like to weigh in with strong earnings per share growth and also very strong cash flow numbers at the same time focusing on the intrinsic value of our brands. Stepping back a moment 2005 was the first time we ever moved over $2.00 per share with earnings per share $2.09. Two thousand seven was probably our greatest year ever, we had a 72% jump to $3.36 beating $3.00 for the first time ever.

For 2008 we are looking for a 20% plus increase to over $4.00 per share for the first time ever. We are passing some very important milestones in terms of putting up strong earnings per share numbers and we plan to continue that same momentum for 2009 and beyond. In addition to those cash flow earnings per share numbers we have close to $1.00 in cash flow per share from tax savings. When you put that together you see an extremely strong cash flow picture which plays to our recent de-leveraging.

Overall Bob and I continue, as well as the entire Chattem team to be excited about these developments and excited about our momentum and very much looking forward to the next three or four months as its always exciting to watch your new products play out in the real world and we feel very good about them and we’ll look forward to reporting on their hope for successes on our next call. With that I’ll turn it over to Bob.

Bob Bosworth

As Zan has indicated and as was detailed in the earnings release made earlier this morning, the first quarter of fiscal ’08 was very strong from a variety of perspectives. Also it provides a platform for the continued growth of the company into the balance of 2008 and beyond. While the performance and the guidance are relatively self explanatory within the earnings release there are several comments that I’ll make before opening it up for questions.

First, in terms of total revenues, total revenues for the quarter did grow by 20% to $121 million from just over $100 million last year. This reflected the addition of the brands acquired from J&J for an additional month in 2008. Remembering that we acquired those brands in early January of 2007 and had a third month of performance of those brands this year.

Second, we had strong comparable period performances from ACT, Cortizone, Unisom, Gold Bond, Bull Frog, Aspercreme and Selsun, all those brands performed very well. Offsetting these increases were declines in Icy Hot Heat Therapy due to the recall. The continued reduction in Icy Hot Pro Therapy sales though that is waning in terms of importance, in terms of comparison. Finally, year over year declines in Dexatrim due to increased competition in the weight loss category.

It should be mentioned in reference to Dexatrim, it now appears that the brand, while down significantly from last year, has stabilized with retail movement as measured by Nielsen showing an increase in the four week period results growing from the February period to the March period. To put some of these numbers in perspective I just wanted to point out a couple of things. First the acquired brands in the aggregate grew by 37% in the January, February periods. Those two months are used to provide a meaningful comparison over the similar period last year.

Second, excluding the acquired brands and Icy Hot Pro Therapy the base business grew by 5% in the first quarter. We had very good factory performance there. Finally, while we aren’t trying to exclude everything, trying to put a perspective on growth opportunities, if Dexatrim and Icy Hot Heat Therapy were further excluded the base business would have grown by about 10%. From a factory sales perspective performance has been very good in the first quarter.

Moving adjusted earnings per share which we again believe is the most meaningful measure of our overall operating performance. Earnings per share for the quarter were $1.01 a 35% increase over the prior year period. These results were achieved in spite of the unanticipated operating loss of about $0.01 per share on Icy Hot Heat Therapy and we actually contemplated about a $0.01 per share contribution during this period which depressed total earnings per share by about a couple pennies to $1.01.

An important point that Zan has mentioned is that these earnings per share data exclude the cash tax shield related to the amortization of intangibles and the purchase bond has for tax purposes but not for book purposes. For the quarter this tax shield aggregated about $0.25 per share that is a very important number in terms of both cash flow and understanding the cash that the business does generate.

Moving to a third point, in addition to the good EPS performance we realized a 29% growth in adjusted EBITDA for the quarter to almost $39 million or over 32% of revenues. Importantly this is accomplished while providing strong advertising and promotion support for the brands with such expenditures increasing by almost $6 million to $34.5 million in the first quarter of 2008. In terms of the components of that earnings performance, just touching on several key issues.

First of all gross margin rose to 71.2% of revenues from 69.3% in the prior year reflecting as we have projected the impact of integrating Cortizone-10, Balmex and the packaging of Unisom into our Chattanooga operation. Also contributing to this to some extent was a shift in product mix. Second, advertising and promotion, as I mentioned rose by about $5.7 million and represented a slightly greater percentage of sales at 28.6% of revenues in 2008 then in the prior year. This reflects our commitment to support the brands very well during this exciting period of growth.

Finally, selling, general and administrative expenses while apparently slightly increased in 2008 as a percentage of total revenues to 12.8% from 12.3% last year. However, in the first quarter of 2007 SG&A expenses did not include certain platen and administrative costs that were paid to J&J under a transition services agreement with such expenses being reported on a separate line as acquisition expenses in the income statement.

Adjusted for this fact, SG&A expenses reflecting the leveraging of our infrastructure actually declined as a percentage of total revenues from 13.5% in the first quarter 2007 to 12.8% in the first quarter 2008. All of that is consistent with our expectations for the year. In terms of free cash flow, defined as operating cash flows less capital expenditures, was approximately $9 million in the first quarter of 2008 roughly equivalent to that achieved in the first quarter of fiscal 2007.

This free cash flow was impacted in both quarters by the timing of certain expenditures and the incurrence of those expenditures and is consistent with our expectation that free cash flow for the year will be in the targeted range of $90 to $100 million based on the achievement of earnings within our current guidance range. From a balance sheet perspective the free cash flow allowed total debt at the end of the quarter to dip under $500 million to $498 million with a total debt to EBITDA measured as trailing 12 months excluding the one time recall expense of 3.49 times. Again, consistent with our expectations.

Finally in the quarter and as disclosed in some detail previously we did initiate a recall of Icy Hot Heat Therapy which resulted in the $0.01 per share operating loss as compared with a $0.01 per share profit that we had planned. It did result in a one time charge of about $6 million pre-tax or $0.20 per share. This one time charge included returns from the tray inventory write-offs here in Chattanooga and various expenses associated with conducting the recall.

Importantly, this is an important factor, from a brand perspective the recall does not appear to have negatively impacted the overall Icy Hot Brand as it did experience an increase in the first quarter and has continued to perform well into the second quarter both from a retail and from a factory perspective. Overall the first quarter was a very strong quarter for us. As we consider those results and the momentum of the business, Zan talked about some of the initiatives we have coming up in the second quarter and into the third quarter.

We are maintaining the guidance range of $4.00 to $4.20 per share trending toward the upper end of the range. The $4.00 to $4.20 would reflect a 19% to 25% increase over the adjusted earnings per share of $3.36 achieved in 2007. For purposes of clarity, if somewhat repetitive this EPS data excludes a debt extinguishment charge this past 123R charges both of which are non-cash, and the one time charge related to the recall of $0.20 per share.

Its also again important to note and we repeat this many times that this guidance excludes the cash tax shield of about $19.7 million or $1.00 per share for the full year 2008. This guidance reflects the continued growth of our key brands, the success of our new product launches. We will continue to show improvements in gross margin. We have said that our target is the historical levels 70% to 72% which we have achieved in the first quarter and expect to continue to see through the balance of the year.

We will continue to support the brands, we are going to increase absolute dollar investment in advertising and promotion significantly and such expenses will be in the historical range of 26% to 28% total revenues. Some continued SG&A leverage will be evident, we see SG&A at about 13% of total revenues for the year. A couple of other points, the income tax rate is expected to be in the 35.5% to 36% range and we do expect to de-lever through the generation of between $90 to $100 million in cash over the course of the year. This would reduce our debt to EBITDA ratio well below three times excluding any acquisitions or share repurchases that we might make.

Finally, there a couple other issues that have come up repeatedly that I’d just like to touch on that affect our industry in general. First, we have not been generally subject to recessionary pressures as our key products are not discretionary purchases for the most part and are not very big dollar items. When you are treating pain and itch and a variety of other maladies the products are needed and consequently not subject to the recessionary pressures in general.

The second point is we have been able to mitigate increases in purchase material and freight costs through careful management of those costs and through very selective price increases effective April 18^th we have taken increases of about 5% to 5.5% on volume representing about 15% of our overall volume. None of that was reflected obviously in the first quarter as they go into effect in the second quarter.

In summary, the first quarter has been very good from a business perspective, provides an excellent foundation for the balance of 2008 and as Zan said some of the meetings we’ve had recently with our sales and marketing people and with our product development people give us a lot of opportunism for the year and beyond as well. With that I will turn it over to the operator to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from the line of Bill Chappell with Suntrust Robinson.

Bill Chappell – Suntrust Robinson

First, not as related to the quarter, but on the acquisition landscape we saw last week Orajel go for about 13 time EBITDA and I guess a couple months ago Burt’s Bees for 16 or 17 times. Is there a concern that good properties are pricing you out of the market and maybe the focus will just be on internal growth for the next two, three, four quarters or are you seeing other opportunities out there that might fall within what you are willing to pay?

Zan Guerry

Each acquisition is unto itself and so you will see a few acquisitions that if you find one buyer who wants it bad enough you just see an occasional high multiple. I think that that’s not always indicative of what some of the numbers are in the hands of the acquirer. We are not seeing a big problem with over pricing of properties in general and we do evaluate each brand on its own merit. I think that Burt’s Bees did not fit our strategy at all so that was easy.

As you mentioned Orajel is something we did look at seriously. It doesn’t fit our advertising driven line extension philosophy too well and there are a lot of small brands that we’ve got so much going on with our large brands we felt that it might swamp our operations. We look at all these properties but we are not concerned that there will be one that comes along that fits our game plan better.

Bill Chappell – Suntrust Robinson

On the core business, if we look at the Nielsen numbers recently for the March quarter it looked like there was a little bit of a slow down. Can you talk about, are you seeing any change at retail, be it a channel shift to Wal-Mart or other channels or change in time in terms of the consumer environment and what you see on the horizon.

Zan Guerry

No, I think this was, as we looked at March Nielsen, our people spent probably more time digging in even more than you want to know the numbers are really good or not as good. I think the thing that were unusual factors, the biggest was the Gold Bond we had a major coupon drop a year ago, we had big advertising a year ago. This year we are very excited about this restoring line, so we funnel more money into April, May and June.

We had some outstandingly cold weather this December, January, where Gold Bond was very strong. That moved against us so Gold Bond, was, if you looked and said what surprised us a little bit that would probably be the only one that I would say, “Wow!” that surprised us a little bit. As I indicated that was very temporary as we move into strong advertising and we get restoring on the shelf. Icy Hot is a little confusing because you have the Heat Therapy issue as people look at Nielsen but overall as I indicated in my remarks the more we dug the better we felt.

I didn’t say a lot about competition but when we look at Nielsen we look at how do we do against a year ago, how did we do against the prior period, how are we doing versus competition and sort of blanketly we are doing quite significantly better than some of our main competitors as you look at the Cortaid and Ben Gay and Therma Care of the world. We do pretty well.

Bill Chappell – Suntrust Robinson

One final question on the Heat Therapy recall, your guidance is maintained and that’s despite, it excludes the recall costs but you are also losing some of the $0.05 or $0.10 of what you would have had if it was still on the shelves?

Zan Guerry

We are losing some. We did have to hustle and adjust some advertising. We moved some advertising behind PM and fortunately as you heard, ACT is performing outstanding, Cortizone is performing outstanding. Gold Bond, we think as the year goes, we’ve got some pretty good brands that’s one of the reasons why when we tell you we like to plan a little conservative we need room because you do get a surprise. We are confident as we said we’ll be in the upper range even taking that challenge as you indicated.

Bob Bosworth

To elaborate on that, you had said the $0.05 to $0.10 range. Because it was in the relatively early stages of development of the product, it had only been on the market for a year, it would have been toward the lower end of that range in terms of the impact for the entire year.

Operator

The next question comes from the line of Bill Leach with Neuberger.

Bill Leach – Neuberger

I want to make sure I heard your comments correctly. You are basically projecting a gross margin of about 72% for the year, is that correct?

Bob Bosworth

What I specifically said was we were going to see in the range of 70% to 72%, that we had been in the 71.2% range for the first quarter and anticipated some improvement over that.

Bill Leach – Neuberger

For the year?

Bob Bosworth

Yes.

Bill Leach – Neuberger

The SG&A you mentioned it included the transition fee that J&J set on extraordinary costs, is that going away?

Bob Bosworth

No, actually the way to look at that acquisition expense which was categorized there because it was part of the transition services agreement with J&J is that really was freight, distribution and administrative costs all of which would have normally been carried in the SG&A line. To get an accurate picture for 2007 you need to add SG&A plus that acquisition services line. Now those services are fully incorporated into Chattem and included in our SG&A line.

Bill Leach – Neuberger

What’s the thoughts of bring ACT in-house to improve the margins for that product?

Bob Bosworth

Two comments regarding that, first of all as I think everybody knows the existing contract with ABGI runs out in 2009. Our intent was to evaluate closely bringing that in-house because we have always been able to achieve increased margins by doing that. I also indicated that there was a fairly significant capital expenditure that went with it. We are evaluating that. One thing that probably pushes it off a little bit is ACT is growing so rapidly that we need to take a look at efficiently sizing any facility that we might want to construct and also evaluate the supply capabilities of our supplier partners. This growth that we are going through is causing us to step back and make sure we sized it appropriately.

Operator

The next question comes from the line of Doug Lane of Jefferies.

Doug Lane – Jefferies

Turning to international, a couple of things, are you stopping the reporting of the royalty income from Selsun internationally? Broadly, can you talk to the large gain in the international business this quarter?

Bob Bosworth

Two comments there, first the royalty is something that phases out as we certain of those operations into our own business. That is going to become deminimus. The second question which is why the increase in volume internationally, there are a couple things that come into play there. One, there was some benefit associated with exchange rates in terms of revenues that might have been between $500,000 and $1 million in terms of foreign exchange rate changes.

Second, which is more positive we do have ACT internationally which we acquired last year which is in the first quarter. The second thing is our Latin American business is doing very well. We’ve made a commitment to growing our big brands in Spanish language packaging in key countries in Latin America. As a result we are seeing a growth in those areas particularly Selsun, Icy Hot brands specifically.

Doug Lane – Jefferies

Turning to the domestic business with the Heat Therapy being the featured new product a year ago the comparisons I imagine while not as tough in future months as they were in March as still difficult from an expectation standpoint. How long do you figure the Icy Hot franchise will be in negative territory year over year including Heat Therapy?

Zan Guerry

We haven’t been looking at it including Heat Therapy. We’ll give you a better answer on that absent Heat Therapy as I said we are up 5%, we’ve got Icy Hot PM Patch and Lotion going pretty well. That’s obviously going to have to do very well to begin to offset, which was a fairly significant loss. It’s a good question, it will begin to, and if PM performs well it should be getting back in pretty good shape fairly quickly. We are growing again the highest number for Icy Hot right now a year ago and then it goes back to numbers that aren’t too far off of where Icy Hot is today and if PM grows we could by June or July be at least flat if not in the positive territory.

Doug Lane – Jefferies

That’s helpful. I’m trying to see how that plays out throughout the rest of the year.

Zan Guerry

A couple of our items for next year, Icy Hot has benefited globally from Patches, Big Patches, Vanishing Scent, Heat Therapy and now PM. We’ve got some above average excitement on Icy Hot for next year. We are not forever out of the Heat Therapy game. We feel very good about next year for Icy Hot.

Doug Lane – Jefferies

In the two weeks since the March Nielsen have you seen a pick up in Gold Bond at the scanner data that you get?

Zan Guerry

At the scanner data for the latest, yes we did. We saw, which was the first of Restoring we saw some pretty encouraging numbers. That’s one week so I don’t want you to bank those. You take that week. Yes we are seeing some response on Gold Bond.

Doug Lane – Jefferies

That was the first week the advertising turned on for Ultimate Restoring, right?

Zan Guerry

Yes, and we are gaining distribution on Restoring. A number of these products are in the middle of the have distribution, some are gaining, Sleep Melt is gaining, Intensive Healing got it very early, the PM lotion. Each account they have different planograms. We should be continuing not only advertising but benefiting from increased distribution for most of the new products.

Doug Lane – Jefferies

You sighted Bull Frog as a particularly strong brand in the quarter, was that a timing of shipments thing or are you expecting a strong year for Bull Frog this year?

Bob Bosworth

It is principally a timing and shipment.

Zan Guerry

We expect a good year from Bull Frog but we don’t have any spectacular new news. We’ve got some good accounts, some good distribution so we are optimistic about Bull Frog but nothing dramatic.

Bob Bosworth

To put it into perspective, it might be a little bit more than one percentage point of the increase that came from Bull Frog in the first quarter.

Operator

The next question comes from the line of Jon Andersen from William Blair.

Jon Andersen – William Blair

You mentioned a couple minutes ago that you didn’t necessarily consider you out of the Heat business. Have you put some additional thought into possible re-launch of a heat product down the road? Can you give us any color on that?

Zan Guerry

We put a great deal of thought into the whole heat therapy question and we are continuing to put a great deal of thought in that and it is a very complicated area. Simplistically human beings can burn themselves with anything you give them hot, including coffee and hot showers and other things. This was a tricky, what we saw was one out of 100,000 numbers and so we are assessing that aggressively we are looking at what we think would be significantly reduced side effect issues while trying to maintain efficacy. It is one of our top three or four priorities because it was the hottest brand in the category while it was out there.

Bob Bosworth

We would be, as we consider this, we do a lot of work internally with it and we work with the FDA as we consider the re-launch of the product.

Jon Andersen – William Blair

One other quick question on ACT, the growth there has been particularly strong as you mentioned and I’m wondering if you can help us understand what’s driving that. Is it expanded distribution; is it the new 32 ounce bottle and what your expectations for that brand are going forward? Is it sustainable as the year unfolds?

Zan Guerry

Globally ACT was one of those undiscovered things where it had not ever even been advertised. It had this great dentist following, this great heritage and so it was a gem. If you go way back to Neutrogena before it exploded with advertising so Johnson & Johnson did a wonderful job a getting it public and starting it with the Restoring and we are continuing with that story. I think we fine tuned it, people want to make dental problems, cavities, root canals all of those people want harder enamel, want stronger teeth, we’ve got a great position and we are just pounding the advertising message home which is what we do best.

It’s basically that and we’ve got the 33 ounces is becoming a much more meaningful. As we look forward to one of the biggest things that can help the remainder of the year is even further distribution gains on the 33 ounce. We are looking at ACT at this stage much like we looked at Gold Bond maybe five years ago as probably our number one growth provider over the next two to three years. With think the ACT name somewhat similar to Gold Bond, not quite as reasonable but has lots of legs and lots of ways to expand. Some ways maybe even better than Orajel.

Operator

The next question comes from the line of Jason Gere from Wachovia Capital Markets.

Jason Gere – Wachovia Capital Markets

One reconciliation question, the 13 week consumption data that you provided does that include Wal-Mart and Club stores or was that the Nielsen numbers without it?

Zan Guerry

That does not include the club stores; it does include Wal-Mart.

Jason Gere – Wachovia Capital Markets

Can you talk a little bit about the channels right now what you are seeing with the club stores certainly seems like there is more product on the shelf there and certainly with the Nielsen number come out there is always some uncertainty because it doesn’t include Wal-Mart, it doesn’t include Club and obviously we assume those numbers are better. Maybe the last two months can you talk about Wal-Mart and the Club stores and what we were seeing there relative to food and drug and target?

Bob Bosworth

Wal-Mart, those numbers that he quoted included the Wal-Mart data and it continues to be in that 30% plus percent of our total volume. A couple places where we are making in-roads that we haven’t done as well in previously are the Club stores particularly when you look at Costco and Sam’s in our volume and that’s not measured by Nielsen or by the Wal-Mart data. It is up significantly over last year from the factory perspective. We are seeing some real improvement there. You probably have seen Gold Bond in some of those stores. As we get bigger brands like Gold Bond or like ACT or Cortizone we’ll be able to penetrate that channel better.

We also have been able to make some in-roads in a couple of other areas in the Dollar Stores we gotten some increased distribution there. That was more second quarter and on distribution gain. That was a non-measured channel as well. Finally we’ve been achieving some pretty good growth in the military exchanges and commissaries where our products become more generally used than very narrow we are able to gain some distribution and volume there as well. We are getting some increase channel distribution there which we don’t think significantly impacts or cannibalize existing drug, food and that.

Jason Gere – Wachovia Capital Markets

With the inventories that came in in the quarter is actually lighter than I thought and it was down sequentially from year end. Can you talk about where you stand right now, how you feel about your inventory levels and especially with expectations for some stronger shipment trends as the year progresses?

Bob Bosworth

A couple points that I would make, first we should recognize that we did take an inventory reserve that brought that inventory down a little bit. Inventory reserve against Icy Hot Heat Therapy so that number would have been excluded from the February quarter. We should see, some of our new products are shipping later in the year and generally we’ll have a run up early in the first quarter which will tail off as we move through the balance of the year with new product shipping a little bit later we should see a decline in inventory levels over the next period.

Jason Gere – Wachovia Capital Markets

The last question, really more on the advertising, what we have been hearing for the last couple months is some of the rates going up. You guys have for cable you have a very unique advertising program with your 10 or 15 second ads. Can you talk about is there any change in the number of impressions that you are expecting with the step up in advertising for the rest of the year?

Zan Guerry

Our impressions are very solid. We see minimal change in there. We also have a lot of flexibility to respond and because we are in a lot of different media types we can move from cable, unwired, syndication, so we have a lot of flexibilities. We are in pretty good shape.

Operator

The next question comes from the line of Brian Delaney from Entrust.

Brian Delaney – Entrust

Is it possible to help me out, when I’m looking at the domestic business the absolute $17 million increase year on year how much of that $17 million is the acquired, the J&J brand?

Zan Guerry

The base business when you include, this is going to be rough numbers, is going to be relatively flat. The preponderance of that increase is going to come from the acquired brands between organic growth of those businesses plus the inclusion of the third month. That was in the base business. What you’ll find is there are a couple of big declines which would be Icy Hot Heat Therapy and Dexatrim in particular also a little bit of Pro Therapy in there that held down any growth that we would have achieved. I think the number that I quoted was, if you exclude Pro Therapy the growth from the base business was about 5% in the quarter. A long answer to a short question but we can go through that some more if you’d like to offline.

Brian Delaney – Entrust

The base business being flat does that also include, I want to make sure, earlier you said Bull Frog was a percent of the comp from a timing perspective or did I misunderstand the explanation to an earlier question?

Bob Bosworth

That’s about right. We had, offsetting that, as I said there are three brands, its important to note, Dexatrim, Pro Therapy and Heat Therapy all experienced significant declines from the prior year. Importantly those three brands are, particularly Pro Therapy and Heat Therapy were not among the most profitable businesses we had and Dexatrim also was a relatively lower profit kind of business. We lost volume there we weren’t losing the kind of income that you might expect.

Brian Delaney – Entrust

I know you don’t give revenue guidance but conceptually now this being the last quarter with the J&J the year on year benefit from J&J and the base business being relatively flat the EPS guidance is that predicated on the base business being flat throughout the year or how should we think about that in the context of your longer term goals of mid to upper single digit organic growth rates?

Bob Bosworth

We do not provide revenue guidance. Our overall goal over a period of time is mid to upper single digits revenue growth. Our earnings guidance is predicated on being within that range.

Operator

The next question comes from the line of Christian Hoffman from Lehman Brothers.

Christian Hoffman - Lehman Brothers

I wondering if you guys could comment on the M&A front. Have you seen an increase in activity?

Zan Guerry

I think generally we have seen an increase. It’s not like it goes from 50 to 80 or anything like that. The deals are still very selective, in particular the ones that we look at. I would say we have looked at a few more properties than normal during this period. Given the growth opportunity we are always very focused on making smart acquisitions. We have a variety of criteria which are fairly hard for brands to achieve and we’ve stayed with that strategy and I think it serves us well. We have not seen an increase. We’ve not lost any brand that we thought was a Chattem kind of brand. We’ve look at some but at this stage its not property that we felt were correct for us at this time.

Bob Bosworth

That buy side, when you look at who the other buyers are, the other significant change that we’ve seen in the M&A world is that the competitors of these businesses tend to be strategic as opposed to private equity guys or financial players.

Zan Guerry

The previous question asked about sales growth. We like to give conservative numbers because predicting success of new products is fairly hazardous. Having said that, globally when we step back and we look at the big brands and the big categories, ACT I commented on it earlier, over the next three years we see big potential there if we do it correct. We think Gold Bond still has a lot of headway to make in the lotion category and we’ve got a couple other categories in mind.

We think this whole arthritis pain category where Icy Hot is the leader is a big thing. We think this whole itchy skin, dry skin, where Cortizone is a lot of people, the older people not sleeping. We’ve got some big goals for some of these brands. If we can add ACT or Gold Bond $30 or $40 million in new sales and pay nothing for it why go pay $150 million to acquire a $30 million or $40 million brand. We are focused and we’ve got so many good opportunities that we are being a little more focused on growing our existing business.

We are also aware of the financial climate and we love our cash flow and we like our flexibility to respond no matter what the environment. We are pretty content where we are right at this moment.

Christian Hoffman - Lehman Brothers

Is there any chance we might see some increase share repurchase activity, I noticed they were relatively modest in the first quarter?

Zan Guerry

We look at our share repurchase and our balance sheet as a strategic resource. Globally our goal is not to see how many shares we can buy back but as you’ve seen if the market responds irrationally to what we think are very strong numbers. We were beginning to get our stock purchasing power out not too long ago as we began to look at the trends. It’s not a pound on the table goal it is a flexible tool we’ll use to respond to what we think are inappropriate pricing of our value.

Bob Bosworth

I also think, the question has been asked several times as capacity. We have under the senior subordinated notes a little bit over $100 million in stock repurchase capability.

Christian Hoffman - Lehman Brothers

Are there likely to be any more charges from Heat Therapy or are they mostly incurred in this first quarter?

Bob Bosworth

Our expectation is that what we’ve accrued in the first quarter which related to inventory trade and various expenses should cover any charges that we would incur. We don’t believe it would be material to the overall financial statement.

Operator

The next question comes from the line of Kathleen Reed from Stanford Financial.

Kathleen Reed – Stanford Financial

Can you talk a little bit further about your A&P spending as a percent of sales back to the mid 28% range is the highest is the past four quarters? Can you talk a little bit about if that was due mainly to all the new product launches? Since you are going to have more advertising turning on in the April, May, and June period although I think that you accrue for advertising as well. What kind of flow can we expect to see for advertising and then if it should be a little bit less in your back half of the year? Along with that, at least down here, I’m hearing a lot of radio ads for many of your products and I wondered if that was an avenue that you are increasing your spending on as well?

Bob Bosworth

Let me address the arithmetic of the 28% backing off a little bit in the back half of the year which will in fact take place. First of all advertising is accrued during the year. Actual advertising expense, what we call working advertising which is the radio, TV that you see or hear. In the first quarter there are some expenses that aren’t accrued and are expenses we incur them according to GAAP. First of all we have television and radio production costs but the minute we run the first commercial we have to expense that amount. That’s a very significant charge in the first quarter.

The second is, for example, this year in particular we have pretty heavy sampling expenses for Gold Bond. A disproportionate amount of our sampling comes in the first quarter in an effort to drive product sales in the second quarter and beyond. Those are expensed as you distribute those samples. Overall there are some fixed expenses that take place in the first quarter that will drive that number up higher. One other thing that, excuse it a little bit, Icy Hot Heat Therapy we accelerated the expense which we had been accruing into the first quarter.

As you look at the balance of the year it should move into the 26% to 28% range that we spoke about. It should not remain at the 28.5%.

Zan Guerry

We viewed that on the radio question we are not increasing the use of radio maybe just we use it. It is not a major form of our advertising which is primarily TV.

Kathleen Reed – Stanford Financial

When you gave out your Nielsen numbers for the 13 week period you mentioned that Selsun, I don’t think you actually gave if it was up or down, I think you said you hoped it returned to being up going forward. Could you give us the actual number for the Selsun blue for the latest period?

Zan Guerry

You are exactly right, as we look at it ourselves, Selsun blue Naturals goes under Selsun blue’s name. Selsun salon is kind of messing around the data. If you look at Selsun counting the whole Selsun franchise counting Selsun Salon we were down just a little bit for that period. The smallest decline we’ve seen in six periods as I indicated. If you look at Selsun blue franchise counting Selsun blue and Naturals that was up 12%. I didn’t give a number because slightly down is accurate, we will begin to see much easier comparisons against Selsun Salon so I think 12% for Selsun blue and Naturals is probably more indicative of where this thing is going to trend assuming Naturals keeps its momentum.

Kathleen Reed – Stanford Financial

I’ve been seeing a new product by the Listerine Fluoride Rinse for children that I guess you can rinse and then actually see particles when the kids spit in the sink. I wondered, it looks like your ACT is showing such terrific growth but the majority of your ads for ACT are targeting adults. I’m wondering if you had any comments on this new J&J product or if you think that the bulk of your new growth for ACT is in the adult business and if you have any comments.

Zan Guerry

I think you are accurate; the largest growth has been in and probably will be in the adult business. Having said that, the kids business is doing quite well. What we would call the rinse business is up 15%, 18%, not quite as much as the 80% for Restoring but pretty good numbers. We had a lot of dental programs that are not advertising but sampling programs, dental heritage and we think with the kids that’s probably a better way to market that brand. We are actually looking at increasing that program for next year. We want to get them early and now we can take them forever.

Operator

The next question comes from the line of Alice Longley from Buckingham Research.

Alice Longley – Buckingham Research

I want to go back to the sales line. You said the acquired brands in January and February were up 37%. If you put the acquired brands results in December when you didn’t own them in the year ago number how much would your sales have been up. Maybe that’s the best way to look at organic growth; you’ve got those products now. In other words, your sales were up 20%, how much would they have been up if you had the acquired brands in December so that we have a full quarter of those acquired brands in the year ago numbers.

Zan Guerry

There are a variety of ways to look at the acquired brands. One of the things I always go back to is Nielsen, that’s eventually Nielsen sales let’s consumers take it away and factory sales has to be equal over time. The one fact we have which compares when J&J had it and when we had it etcetera is for this period you are talking about the total J&J brands are up about 30% in total. That’s apples to apples because it’s all consumer sales from December, January, February and March. That’s indicative of where we are going.

Alice Longley – Buckingham Research

If their sales were up 30% through those three months and your other brands all in including the Pro Therapy, etcetera were sort of flat, if you do a weighted average how much would you have been up as a whole company?

Zan Guerry

As Bob mentioned we got a Heat Therapy number in here which has a significant impact on the thing. We have Pro Therapy; we have Dexatrim so we have a lot of things moving. The good news is the bigger brands are generally all moving positive and as Bob indicated the ones we actually net are probably between Pro Therapy, Heat Therapy and Dexatrim we barely made any money on those. Those are impacting the overall consumer sale. We can spend time, Heat Therapy alone, which we didn’t make any money on last year takes Icy Hot from an up 6% to a down 11% in March. That’s a pretty big swing when you start factoring that into the Nielsen’s.

Alice Longley – Buckingham Research

I’m just trying to imply that your sales overall were probably really good for the quarter if you include all the acquired brands in there for the full quarter.

Zan Guerry

We’ll go with that implication.

Bob Bosworth

I’ll give you a frame of reference. Let’s not mix Nielsen and factories. Zan was talking about Nielsen was up, if you look at factory results and assume, I don’t have December numbers for the J&J business but assume it was pro-rated during the year. We would have what amounted to a 10% plus increase in our overall business.

Alice Longley – Buckingham Research

That includes Heat Therapy and Pro Therapy.

Bob Bosworth

That includes everything.

Alice Longley – Buckingham Research

It sounds like your sales growth is running 10% all in, right?

Zan Guerry

That’s factory.

Alice Longley – Buckingham Research

My other question is about the timing of your innovations. You’ve made it clear that you’re advertising behind a lot of your innovations in Gold Bond and Icy Hot and Cortizone it’s weighted to the April to July period and yet I think you’ve told us and there is some evidence that these products are sort of seasonally weighted to the winter months. I was wondering why you kept the focus on the advertising in months where we are getting warm.

Zan Guerry

Part of it is driven by trade planograms and other things. Some of the big investments are not seasonal. Let’s take Gold Bond Restoring. Women want to restore their skin year round. Healing we do think is a seasonal thing, we hope Restoring becomes a stable year round. We don’t view that as seasonal. Unisom sleep would not fit in the seasonal category, Arthritis, which is targeted by the Icy Hot PM would not be in the seasonal can. Cortizone can have different seasons but to a large extent the summer season is a big season.

The one that you could have a slight question about is the Dandruff category skews a little bit but its still a year round business and we think Selsun blue Naturals being a daily product hopefully will be more year round, more daily than maybe a Selsun blue. We feel pretty good about the timing of our advertising with the message we are trying to get out there.

Operator

The next question comes from the line of Karru Martinson from Deutsche Bank.

Karru Martinson – Deutsche Bank

If I was to summarize your priorities for free cash flow we’d be looking at debt repayments first, share buy backs, then it sounded like acquisitions more of when the opportunity arises. Correct?

Zan Guerry

We are a growth company, acquisitions always has the priority so that’s our first choice is to do that. We can’t plan that and I think what I indicated we’ve always been very disciplined by ours. We are maybe even 10% more disciplined in this environment. You give us a good brand that fits our model and that is by far in a way our first choice and then the debt repayment vis-à-vis stock repurchase is really a capital market.

We have a range of debt coverage ratio that we feel comfortable operating in at this stage. As you’ve heard we are on a great trend to taking debt to EBITDA 103 by the end of this year. As far as business as usual tomorrow absent nothing changing we’ll do that the remainder of the year. I hope an acquisition looks like one of these, typically you don’t see a big package of brands like J&J. I’d love to see one or two brands of a $20 to $50 million size come along and we would jump all over them.

Karru Martinson – Deutsche Bank

What are your expectations for the cash interest benefit from the decline and libor for the upcoming year?

Bob Bosworth

We at this point in time, if you look at the preponderance of our capital structure with the senior subordinated now is to two converts which both had very low cash interest rates. Both had no relationship to libor. When we entered into the agreement when we bought J&J we weren’t going to take financial risk on top of operating risk. We have a swap that effectively fixes our rates at libor five plus the spread.

Karru Martinson – Deutsche Bank

Not viewing these as discretionary products in a recession do you see your customer trading down in a recessionary period?

Zan Guerry

We spend a lot of time on that and the interest, no, we do see categories fortunate we don’t compete in where you could make a little argument that you are seeing some of that but its almost category by category OTC’s tend to have a higher private label than cosmetic and toiletries. You might see a category such as vitamins and internal analgesics neither of which we are really in would be ones that might be impacted that way. We are not seeing much of that.

Karru Martinson – Deutsche Bank

What is your expectation for gross margins in your historical range, what are you seeing on the raw material side for packaging and everything else?

Bob Bosworth

We have seen increases in certain categories particularly, not surprisingly, petroleum based product, resins, those kings of things, then we’ve seen it in freight costs too as fuel surcharges have risen. What we’ve been able to do through, creative things for example, consolidating freight with truck load carriers while we may not have done that before negotiation with our suppliers and looking at alternative suppliers to keep those cost increases under control. Through price increases which I mentioned offsetting those increases that we have gotten. We are comfortable with our ability to maintain our gross margins.

Operator

The next question comes from the line of Andrew Wolf from BB&T.

Andrew Wolf – BB&T

I wanted to ask you regarding the recall of the Icy Hot Heat Therapy, antidotically doesn’t look like it is in the numbers, what’s your sense has it had any impact on the brand equity of the core Icy Hot brand and related to that what are you guys contemplating above potentially re-launching it? It seemed like it was very successful prior to its recall.

Zan Guerry

We’ve seen no evidence of it impacting the franchise. As I indicated earlier it’s a tricky situation I spent some time with our market research people and we put it on 500 people and saw nothing other than great results. What we are dealing with is one out of 100,000 find some way to usually don’t use it correctly and get some degree of heat issues. It’s hard to screen for that. We are evaluating that very carefully. We want to get back in the game. We were, as you say, successful and that’s just a tricky regulatory thing.

We are working diligently on a product that hopefully optimizes benefit for the consumer and what you saw was our product had the best benefit for the consumer while balancing this undetectable chance of somebody getting some type of burn from leaving the heat, sleeping with the heat on. A lot of people we found probably didn’t know how to take the adhesive off very well which kind of surprised us. We saw none of that. We are looking at all those variables as rapidly as possible.

Andrew Wolf – BB&T

One quick follow up, I did join the call late so I apologize if you might have answered this. What is the internal sales growth if you also take out the Dexatrim? I know you are giving 5% excluding Pro Therapy. Last quarter you had that number with Dexatrim as well.

Bob Bosworth

We have covered that in the call previously, if you give us a call afterwards we’ll take you through that.

Andrew Wolf – BB&T

The related follow up is you are now saying Dexatrim has flattened out and Pro Therapy is deminimus so going forward we shouldn’t look for much in the way of adjusted?

Bob Bosworth

Let me make that clear, that probably requires some explanation. Pro Therapy is going to dissipate and the comparisons are going to dissipate over time. Dexatrim, this is important to make absolutely clear, we will still see year over year declines in Dexatrim because Alli was not launched until May or June of this year. What I said was form the Nielsen perspective in a period over period from February to March it has flattened out. We will still see some negative comparisons from a factory sales perspective.

Operator

The next question comes from the line of Gary Giblen from Goldsmith & Harris.

Gary Giblen – Goldsmith & Harris

I respect the fact that you don’t give quarterly guidance but probably a lot of the institutional investor community is wondering ballpark on the second quarter. I would put it out to you if you can answer it give $1.04 of earnings estimated on a consensus $119 million in sales. Does that look good or what’s your color on the second quarter to the extent you can possibly say it.

Bob Bosworth

We’ve had this discussion. We do not give quarterly guidance and the minute we step back into affirming or denying quarterly numbers we are back in the quarterly guidance world. We really think it needs to be looked at over a longer period of time and that a year is an appropriate time to take a look at it. The second thing I would say is, as Zan mentioned we are looking for the Nielsen results as the new products come in to be very good for the second quarter as we put incremental spending behind it. We feel good about the business for the balance of the year. We are not going to provide quarterly guidance.

Gary Giblen – Goldsmith & Harris

My only other question is to date it looks like some of the major new products haven’t achieved distribution in some of the major retail chains. Is that still going to happen or are there some products that aren’t making the distribution cuts?

Zan Guerry

We have excellent distribution on all of our products. We went over that at our meeting yesterday. There are a couple of items that are, we’ve got so many different accounts, so many different launches but as an overview we are in extremely good shape. Sleep Melt did not start shipping until much later so you won’t see Sleep Melt out there for a little while. Cortizone Intensive Healing you should be seeing everywhere.

The Icy Hot products you should be seeing everywhere. Restoring is moving, it is in the right place. Other than the Unisom our distribution gains have been very good this year. We are very pleased with that and we’ve picked up interestingly we regained some distribution in a couple key accounts. We got things moved to better places so we feel very good about that.

Bob Bosworth

There are a couple things that you’ll see we’ve talked about this previously but the ACT 33 ounce has picked up a couple of key distribution points over the last couple of months. That should be also out there.

Gary Giblen – Goldsmith & Harris

I noted Aspercreme PM is not yet at Wal-Mart, I don’t know if it will be. Naturals is not at CVS so those seem surprising but I don’t know if those are going to be.

Zan Guerry

You are always as many products and as many things, if those are the only two distribution voids you’ve found that’s great. In particular we did have some accounts, our focus on the Aspercreme which I didn’t mentioned our big fix it’s maybe a number seven product, strong product, it had growth for the first time and that was coming off Aspercreme Heat. I think the heat product is at this stage ahead, in terms of distribution and advertising focus that’s the one that we are doing.

That one does have very good distribution. CVS with Selsun I think you are accurate. There are a couple of accounts it’s a little different brands have different timing. We keep the sheet of all that which is basically all green which means in there or shipping there and you are right CVS is the only account where Selsun Naturals is not currently in right now. Selsun Naturals was everywhere and…

Bob Bosworth

One of the Aspercreme lines, the lotion is in partial distribution within Wal-Mart. That will occasionally have them in higher movement stores. When you look at Selsun Naturals we always like to fill distribution voids. It is pretty startling but its good news that even at this early stage the Selsun blue Naturals are moving more rapidly sku by sku basis than any of the salon skus did. We are seeing a lot of success and hopefully can fill that distribution gap.

Operator

You have a follow up question coming from the line of Brian Delaney from Entrust.

Brian Delaney – Entrust

In last years quarter what was the total absolute amount of the J&J revenues embedded in the $100 million?

Bob Bosworth

One way to look at it, its roughly $20 million.

Brian Delaney – Entrust

The extra month, then I could back into what the extra month was worth this year on the year on year change based on that and what that business grew the $20 million is what grew the 37% is that the right way to think about it?

Bob Bosworth

Let me explain the right way to think about it. If you take the two months that were comparable, which would be January and February this year versus January and February last year. The aggregate of the brands were up 37%, those brands were up 37%. That’s one way to judge the success of the business year over year. Roughly speaking if you look at that 12^th month if you take $115 million and divide it by 12 you get roughly $10 million that you would have expected last year in the December period and it would have been up a little bit on that this year. Overall very good performance for the entire brands.

Brian Delaney – Entrust

Someone had asked the total business and factory up 10% and that includes the Icy Hot Heat Therapy, it includes the results from Icy Hot Pro, is that accurate because then I can’t get to…

Bob Bosworth

Why don’t we take this offline, the reality is what we said, acquired brands are up substantially over this time frame. If you take out Pro Therapy only from the base business it’s up about 5% and if you take out Pro Therapy and Dexatrim and Heat Therapy you get the 10% growth on the businesses on which we are currently focused. Those are the way those numbers work.

Brian Delaney – Entrust

Ten percent run rate is how we should think about the business prospectively?

Bob Bosworth

Leaving aside Pro Therapy, Heat Therapy and Dexatrim that is an accurate statement. Those brands, as I mentioned before aren’t making a lot of money but we are still going to have those comparisons to deal with in the out quarters particularly as it relates to Dexatrim.

Operator

We have no further questions. I would like to turn the call back over to Zan Guerry.

Zan Guerry

Thank you all for taking the time and we look forward to speaking with you the second quarter next time.

Operator

This concludes the presentation for today ladies and gentlemen you may now disconnect.

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