Schawk, Inc. Q4 2007 Earnings Call Transcript

Schawk, Inc. (SGK)

Q4 2007 Earnings Call

April 4, 2008 11:00 am ET

Executives

Philip Kranz - Investor Relations, Dresner Corporate Services

David A. Schawk - President and Chief Executive Officer

James J. Patterson - Senior Vice President and Chief Financial Officer

A. Alex Sarkisian, Esq. – Executive Vice President and Chief Operating Officer

Analysts

Casey Flavin - CJS Securities

Ryan Kelly - Robert W. Baird

Myron Kaplan

Presentation

Operator

Welcome to the fourth quarter 2007 Schawk earnings conference call. (Operator Instructions) I would now like to turn the call over to Philip Kranz.

Philip Kranz

Earlier today, a press release was distributed outlining the results for the fourth quarter 2007. If anyone has not received the release, please contact us at 312-726-3600, and we’ll provide you with another copy.

Joining us today from the management of Schawk is David Schawk, President and Chief Executive Officer; Alex Sarkisian, Executive Vice President and Chief Operating Officer; and Jim Patterson, Senior Vice President and Chief Financial Officer. The management team will begin with an overview of the results and then we will open the call to your questions.

Before we begin, however, I would like to remind participants that this conference call may contain certain forward-looking statements that are subject to the Safe Harbor disclaimer found in today’s press release.

I’d like to turn the call over to David.

David A. Schawk

While 2007 was a year of significant accomplishments for our operations, we have seen a number of accounting-related challenges. To start with the challenges, we have determined that certain errors in our internal practices of accounting have required us to make various non-recurring adjustments, causing the most impact occurred at our digital solutions business, which represents about 2% of our revenues, and in the area of IT and software.

The cumulative effect of these accounting errors required us to restate our financial statements for the 2006 and 2005 fiscal years, as well as for each of the first three quarters of ‘07. For the 2007 fiscal year period results were adjusted by a price of $0.04 per share for the first three quarters of the year. For the 2006 fiscal period, the earnings per share [inaudible] were $0.98 versus $1.08 as previously reported.

For the fiscal 2007 fiscal year period, restated earnings per share for continuing operations were $1.06 versus $1.10, which was reported. We continue to work with our external auditors to address the related material weaknesses in our internal controls.

As you’ve heard me say while discussing other areas, our goal is always to right any errors or weaknesses we have as quickly as possible, and this is no exception. Our executive management team and I want to assure you that we will take the steps necessary to resolve these issues, and we’ll work to ensure that our accounting and IT functions reflect the level required of a $550 million global organization.

Of all these accounting-related items, internal control weaknesses represent significant challenges. Our operations showed good solid performance in the fourth quarter, and along with the efficiencies we put in place throughout the year resulted in record operating profit for the full year 2007, even though the markets we serve experienced a difficult year.

In 2007, we completed and integrated the three acquisitions, increased our service offerings and geographic footprint, and we saw a good expansion in our consumer products packaging accounts.

In addition, by leveraging the cost reduction efforts completed in 2007, we have positioned Schawk to deliver sustained margin improvement in 2008 and beyond. Alongside the acquisitions we made in 2007, we also had a number of strong new business wins and were able to grow our business organically.

Finally, we dramatically reduced our debt by $32.6 million in 2007, due to our generation of operating cash flow of $69.8 million in 2007 versus $28 million in 2006. As you will recall, we had a very slow third quarter in our U.S. operations in 2007.

As we anticipated in the fourth quarter, many of the projects we had been on hold came through. And in fact, consumer products packaging accounts increased 10.6% in the fourth quarter over the previous year. However, the entertainment business continues to be a drag on the top and bottom line, and our advertising agencies’ accounts were soft during the fourth quarter.

Our packaging business worldwide was up 8.3% in 2007. Higher-end branded products were under consumer pressure while corporate brands had gains. While the rising fuel costs continue to impact global economies, new product introduction and customized products coupled with aggressive marketing programs are ways clients are driving growth.

This all bodes extremely well for Schawk. With our diversified offerings and agility, we believe Schawk will succeed even in the unsteady economic times that we are now facing.

We remain extremely confident in our operations and in the ability of this organization to win global opportunities that no one else in the industry could handle. We will continue to work to increase shareholder value by following our strategic plan and increasing our global service offering.

We are committed to continue leading our industry while delivering the greatest value to our clients around the globe everyday. Additionally, we will continue to make the tough decisions of consolidating, improving technology, and right sizing our workforce.

Now, I’d like to turn the call over to Jim, and he’ll review the numbers in more detail.

James J. Patterson

First, I would like to address the accounting issues. Software capitalization, there’s actually two issues related to software capitalization. Software for internal use is the first issue.

Software for internal use includes our accounting and human resources system, our costing system, our shop floor system, our data warehouse, as well as other systems. These systems all require development to accommodate changes in our business and to add new features.

We capitalized these development activities and in the vast majority of cases, the capitalization was appropriate. In certain instances, however, we did not have adequate documentation for our development activities and these expenditures have been written-off.

In other instances, the development project did not qualify for capitalization because it did not provide a significant enough future benefit where the development activity was determined to be a minor enhancement as opposed to a major enhancement, and as a result, these items had to be expensed.

In connection with our review of the capitalization of certain costs related to the development of the software, we recorded an additional expense of $0.5 million in 2007, and all these numbers are net of the reversal of the depreciation related to this issue. The impact on the results for 2007 was $0.5 million pre-tax for the first three quarters of 2007.

In 2006, the impact was $1.4 million, and in 2005, the impact was $1.8 million. In the first quarter of 2008, we have put into place procedures to make sure that all software development costs are reviewed for compliance with Generally Accepted Accounting Principles.

As a result of the write-off of the previous capitalized amounts in 2005, 2006, and 2007, there will be lower depreciation in 2008. However, there will also be more expense for those items that don’t qualify for capitalization. At this time, we expect the net of those two items to be insignificant to our results.

The next item under software is software for sale to third parties. So, separate and apart from our internal use software, which I just addressed, we have a digital solutions business that develops software for sale to third party customers. This business is less than 2% of Schawk’s revenues.

As you recall, in our third quarter earnings release, we disclosed a pre-tax charge of $4.2 million to write-off costs for internally developed software for sale to third parties that had previously been capitalized. These costs did not meet the strict requirements of Statement of Financial Accounting Standard No. 86, and under these rules, it’s very difficult to qualify for capitalization on development of software for sale to third parties. As a result, all these development costs are being expensed at the present time.

In 2007, the effect is $1.1 million. In 2006, the effect is $1.5 million, in 2005, the effect was $0.3 million, and these are pre-tax amounts. The balance of the $1.3 million of the overall charge of $4.2 million will be reflected as an adjustment to opening retained earnings in 2005. As we disclosed earlier, we expect the impact in 2008 to be approximately $0.03 per share for additional development expenses as compared to prior years.

Now, in terms of revenue recognition, we have an issue with our software revenue recognition. We determined that the software solutions business, which again represents less than 2% of our company’s revenue, was not recognizing revenues and costs in accordance with the Generally Accepted Accounting Principles. The revenues and costs should have been deferred as opposed to recognizing them currently.

All the revenue and costs involved will be recognized in the periods we stated, 2005, 2006, 2007, as well as in the periods after December 31, 2007. The impact on the revenues will be as follows: for the first three quarters of 2007, a reduction of $0.7 million; in 2006, similarly another reduction of $0.7 million; and in 2005, it’s an increase in revenue of $0.2 million.

The impact on pre-tax income in each of the three years will be as follows: the first three quarters of 2007, a negative impact of $0.5 million; 2006, a negative impact of $0.4 million; and in 2005, a positive impact of $0.1 million.

Certain revenues and associated costs will be deferred on the December 31, 2007 balance sheet, and these amounts are expected to generate approximately $2.0 million of pre-tax income in 2008 and future years. In the restatement process, we will be recording all the adjustments that I have just described in 2005, 2006, and 2007.

In addition to these matters, there were other adjustments previously considered to be immaterial that will also be recorded in the restated financial statements. All of these adjustments are reflected in the earnings per share amounts that David Schawk just referred to.

The accounting errors noted above and other findings in 2007 have resulted in findings of material weakness in internal control in the areas of software development, revenue recognition, income taxes and energy level controls. As David Schawk noted, we are determined to eliminate these material weaknesses by the end of 2008.

As the Chief Financial Officer, I take full responsibility for all of the accounting errors and material weaknesses in internal control. We will take necessary steps to implement procedures and controls to prevent these errors from occurring in the future. Now I would like to turn to the financials.

As noted in the press release, we are currently preparing our restated financial statements, and we’ll include them in our annual report on Form 10-K that we anticipate filing later this month. Our external auditors will be reviewing our restated financial statements and our 10-K, and as such, they have not yet completed their audit procedures.

Comparing the fourth quarter of 2007 with the fourth quarter 2006, our sales were up 0.9%, comprised of higher consumer products packaging sales, as David mentioned, lower advertising retail sales and lower entertainment sales. Excluding the loss of a large retail account we disclosed earlier in the year, our advertising retail accounts were essentially flat compared to the prior year fourth quarter.

The increase in consumer products packaging revenue in the quarter was a result of the combination of acquisitions and internal growth. Consumer products packaging accounts represent approximately two-thirds of our total revenue. So this part of our business has the largest impact on both our revenues and our profits.

Advertising and retail accounts represent approximately 25% of our total revenue. Retail accounts were up for the quarter as our business benefited from an increase in holiday advertising. Additionally, the ad agency business, which is the magazine ad work that we do, was softened overall in the fourth quarter due in part to a reduction in print advertising of the clients that we serve.

On the operating income line, we had operating income of $16.1 million in the quarter versus $14.4 million in the previous year’s fourth quarter, an increase of 12.1%. Most of that growth was attributable to the turnaround in the European operations and the stronger consumer products packaging revenues which drives higher operating profit.

Excluding certain items that we’ve enumerated in our non-GAAP table and the release operating income was $16.9 million compared to $12.8 million, an increase of 31.9%.

Moving to interest expense, we continue to drive down our interest expenses as we have for the past two years. Fourth quarter interest expense was down 17.5%, as we continued to use our strong cash flows to reduce our debt.

Effective tax rate was 51.8% in the quarter as compared to 45.8% in the prior year fourth quarter as a result of recording valuation allowances on certain tax receivables, and an increase in our tax reserves. Lastly, for the quarter, our income before taxes was $14.1 million, an increase of 18.2% compared with the prior year fourth quarter.

For the full year, sales were slightly below prior year. Excluding the loss of the retail account in the first quarter of 2007, sales were up approximately 2%. Consumer products packaging accounts were up 8.3% year-over-year, with 2.7% of that growth from acquisitions, and 5% from organic growth with the remainder being from foreign currency translation.

Advertising and retail accounts were down 13.5% for the year, but only 7.8% excluding the retailer that we spoke about earlier. Retailers reduced their spending in the first nine months of 2007, contributing to the decline in revenue. This trend reversed itself in the fourth quarter, as retailers spent more on holiday advertising than in the prior year fourth quarter. Advertising agency accounts, however, were soft for all of 2007, due in part to a decline in ad pages.

I would like to just mention on the balance sheet, the biggest change to the balance sheet really in two areas, the reduction in our accounts receivable from our strong collection efforts in 2007, and the decrease in our debt by $32.6 million during the year. Our debt to equity has been decreased to 36.3% at the end of ‘07 and our debt to total capital is 26.6%. The company is well positioned to finance its growth in 2008 between operating cash flow and $78 million of availability on our revolving credit facility.

Again, I want to emphasize the strong cash flow for the full year 2007. The biggest contributor to that increased cash flow was the collections of receivables, which improved $24.8 million as compared to the prior year.

I’d like to turn the call back to Dave.

David A. Schawk

Well, clearly 2007 was both significant in our operating accomplishments, while extremely frustrating administratively. As a large shareholder and speaking on behalf of my family’s major position in Schawk, we are extremely optimistic despite the challenges with respect to the accounting matters and material weaknesses discussed this morning.

I, along with my executive management team, are fully committed to continuing to improve our growth and operating performance, while resolving these accounting and SOX matters, and will take the appropriate steps necessary to do so.

With that I’d like to open up for questions.

Question-and-Answer Session

Operator

Your first question comes from Casey Flavin - CJS Securities.

Casey Flavin - CJS Securities

Could you please just touch on the steps that you plan to take to improve the accounting controls, and how that might impact SG&A going forward?

David A. Schawk

We are going to have to add additional personnel, as well as making the changes necessary for remediation of the material weaknesses. So we’re going to be certainly looking at helping getting us consultants, as well as getting additional internal staff.

Casey Flavin - CJS Securities

Regarding the trends in your various account segments it appears that retail is becoming less of a drag while entertainment is actually heading the other direction, and consumer packaging really bounced back or rebounded nicely in the quarter. Could you just give us a sense of what the trends you are seeing there from your various customers, and what your strategic outlook is for the entertainment business?

A. Alex Sarkisian, Esq.

The entertainment side first, this is economy-driven. There is less discretionary income, so folks are pulling back, and as a result we’ve seen some delays in releases. And as a result, the entertainment industry is softening a little bit.

To your point, from a retail standpoint, we see both in the grocery retail, there’s a lot of movement into corporate brands, and those retailers, those groceries are getting better control over what we used to call private label products that are now being referred to as corporate brands, and there’s a lot of that going on. We’re doing a lot of, not only pre-press and pre-media, but we’re also doing design in that area, and that’s been a very successful opportunity for us.

On the non-food side, there’s a real push. They’re trying to get people into the stores, and they’re doing more promotions and advertising and that for our retail business is good news.

As to the consumer products packaging work, the trends that we’ve been talking about with demographics, and experiential consumption and sustainable packaging, those are all really great drivers for us. And we are very, very well positioned, again, from design through pre-media on a global basis; these are global phenomenon.

We’ve got aging demographic situations and people are more concerned about health and wellness, and you’ve seen most of the new product development is coming in those areas. So those are really positive opportunities for us, and we believe that we’re very well positioned to have that.

And while some of our clients are pulling in their horns a little bit and being more cost focused, most others are starting to drive their marketing. So we anticipate through 2008 that we’ll see that starting to rise through the year.

Casey Flavin - CJS Securities

The acquisitions you made recently in ‘07 give you a nice opportunity for growth in the design business. Can you just give us a sense of the activity you’re seeing there and your expectation for those three businesses and just the design segment in general, in fiscal ‘08?

A. Alex Sarkisian, Esq.

Yes, what we saw, what we have seen, we’ve talked about some of the in-store activities, and store within a store, and anybody who goes into any of the retail stores, whether pharmacies or groceries, are seeing a lot of that. That was one of our targeted areas, and that’s been rewarding for us.

The others were more international in nature to complete or move towards the completion of our global strategy for having better coverage, particularly in the Asia-Pac and Australia regions.

And so, we think that, again, is giving us better coverage and that’s one of those things that is forward thinking, and we’re starting to see some rewards on that. We’re making global pitches from the design standpoint now, and that’s getting some good wind behind it. So we’re looking forward to continuing success through 2008 in that regard.

Casey Flavin - CJS Securities

It sounds like you’re making some progress in both Europe and Asia. Can you just give us a little bit of an update there, and are there any major global contract wins that you can highlight at all in the quarter?

David A. Schawk

Europe, we’re actually continuing to improve not only operation, but now we’re starting to win some additional businesses. We’ve talked about in the past, we first had to right size the business, improve the quality, improve the output, improve the timing, and now we’re starting to go out and win additional business.

And that’s helping obviously drive the top and bottom line there, since we have made all of those cost adjustments back in 2005, 2006. Europe is going well, and Asia is going well as well. So overall, I’m pretty pleased.

A. Alex Sarkisian, Esq.

We don’t really like to talk too much about specific client wins and so on, but one thing that I will tell you and I think we talked about some of this strategically from in the past, but we did have a client that has asked us to set up an operation for them in Poland, and we have done that. We’re pretty excited about that, and that’s really our first step into the Eastern block, which is an area that’s being targeted by global CPGs as a real growth opportunity and a growth area.

It’s going to start small for us, but that’s an area that we will be targeting over the next 12 to 18 months, and we like to start with a little bit of business as opposed to just doing it as a straightaway greenfield, and so that strategy has worked for us in the past. That’s how we built Asia, and we look forward to employing the same strategy in Europe.

Casey Flavin - CJS Securities

Can I assume that the pick up in your international business is partially the result of the pick up from business from that major key client that pulled back in the last quarter, or is this independent of that?

A. Alex Sarkisian, Esq.

I think it’s across the board.

Casey Flavin - CJS Securities

So they did come back and increase their activity?

A. Alex Sarkisian, Esq.

Yes.

Operator

Your next question comes from Ryan Kelly - Robert W. Baird.

Ryan Kelly - Robert W. Baird

You talked a little bit about the advertising, retail and entertainment businesses. How important are they to you longer term and do you still consider them core to your strategy?

A. Alex Sarkisian, Esq.

Well, we re-evaluate those smaller businesses on a regular basis, Ryan. And at this point, I should point out that, as I mentioned, I think those groups that were focused exclusively on entertainment we have diversified those a little bit in terms of the target areas, and we’ve had some success with that, particularly on the retail side. And so we are looking to see how the success is in that area. They are part of our strategy.

It’s tough to talk about core strategy and non-core strategy. It’s part of our overall strategy at this point. But it’s absolutely mandatory that we maintain our agility, and to the extent that that helps us with agility, we will continue it. To the extent that it doesn’t, we will take steps to address it.

Ryan Kelly - Robert W. Baird

Can you talk little bit about the acquisition that you’ve decided not to pursue in Q4 and why you decided not to pursue it?

A. Alex Sarkisian, Esq.

There are number of reasons. I don’t want to get into too much specificity on it, because you never know when things are going to come back. But we look at it and the acquisition target looked at it, and it became evident that that maybe the timing wasn’t right to go forward, and so we pulled back. It would have been a significant acquisition, it would have been consistent with our strategy, and that’s about all I can say to that right now.

Ryan Kelly - Robert W. Baird

Can you give any commentary related to Q1, how business trends have been there?

A. Alex Sarkisian, Esq.

It’s still early. We don’t all have of our numbers in. Our plan for the first quarter was going to be lighter for any number of reasons. We looked at the economy a little bit, it was obviously going to be choppy, and so we were conservative in our internal plans. I can tell you that from an internal plan standpoint, through February, we are a tick ahead of our internal plan. And at this point, that’s about all I can mention.

Operator

Your next question comes from Myron Kaplan.

Myron Kaplan

In case the entertainment business doesn’t recover, do you have any fail-safe remedy?

A. Alex Sarkisian, Esq.

I think that we remediated a lot of that in terms of some of the areas that we’ve expanded into. But again, we are not hesitant to expand or contract where it’s appropriate.

Myron Kaplan

So you’ll take action as required.

A. Alex Sarkisian, Esq.

Yes.

Operator

There are no further questions in the queue.

A. Alex Sarkisian, Esq.

I want to thank everybody for calling in, and assure everybody we’re very pleased with our operating issues, and we will get these other items corrected through this year. Thank you very much.

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