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IKON Office Solutions Inc. F2Q08 (Qtr End 3/31/08) Earnings Call Transcript

May 02, 2008 | about stocks: IKN

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IKON Office Solutions Inc. (IKN)

F2Q08 (Qtr End 3/31/08) Earnings Call

April 24, 2008 10:00 am ET

Executives

Henry Miller - VP of Corporate Finance

Matt Espe - Chairman and CEO

Bob Woods - SVP and CFO

Analysts

Carol Sabbagha - Lehman Brothers

Shannon Cross - Cross Research

Woo Jin Ho - Merrill Lynch

Ananda Baruah - Banc Of America Securities

Matt Troy - Citigroup

Presentation

Operator

Greetings, ladies and gentlemen and welcome to the IKON second quarter fiscal 2008 Earnings Call. At this time all participants are in a listen-only mode. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Henry Miller, Vice President of Corporate Finance for IKON Office Solutions. Thank you. Mr. Miller, you may begin.

Henry Miller

Thank you, and good morning. Before we begin, we would like to caution you that the call we're about to conduct contains forward-looking statements within the meaning of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. References made during the call are based on management's current expectations or beliefs, and are subject to a number of factors and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. The company does not intend to update any forward-looking statements made during this call.

As a reminder, today's call is being recorded at the request of IKON. This call may not be rebroadcast or replayed, without the express prior written approval of IKON. Third-party transcriptions of the conference call have not been approved by IKON, and we take no responsibility for their accuracy.

The call today will be hosted by Matt Espe, IKON's Chairman and Chief Executive Officer, Bob Woods, Senior Vice President and Chief Financial Officer who will also be participating on the call.

At this point, I am going to turn the call over to Matt Espe, who will begin today's presentation on slide three.

Matt Espe

Thanks, Henry. Good morning everyone and welcome to the IKON Office Solutions second quarter 2008 earnings release conference call. Today we reported earnings per diluted share for the second quarter of fiscal 2008 of $0.24. This was at the high end of our improved outlook provided to you on April 10.

Total revenue for the quarter grew 1% to $1.1 billion, including a currency benefit of 1.4 points. Our revenue performance reflects bester than expected equipment sales, continued strong growth in Managed & Professional Services, and flat customer service and supplies revenue. Clearly we are gaining traction from the actions we took to improve our financial performance. We worked with our vendor to reinstate the long-standing promotional program that was substantially reduced in our first quarter.

We adjusted our color office pricing strategy to be more competitive. We took actions to improve our sales productivity and we are on track to the achieve a $25 million in savings in fiscal 2008 from our spending reduction plan we announced in January.

Before I discuss our revenue performance in more detail, let me stress that while we are encouraged by our second quarter performance, we recognize it is just a first step. We expect to continue to improve sales productivity and deliver on our spending reduction objectives.

However given the uncertain economic outlook we are maintaining our fiscal 2008 earnings per share guidance of $0.92 to $0.98 excluding any nonrecurring items. I will discuss our outlook in more detail at the close of the call. I am proud of our strong execution in the second quarter.

Let me outline five specific examples. First; we successfully implemented our new organization IKON US combining our US sales and operations team. This move completed the evolution of our corporate structure, into three operating business units, US, Canada, and Europe.

Jeff Hinkling, President of IKON US, and Mark Bottini, our Vice President of US Field Sales did a remarkable job of leading this transition and focusing the team evidenced by the improved equipment sales. Clearly this new team is off to a terrific start.

Second; we increased our color mix in the second quarter to 40% of our US equipment revenue up substantially from the prior year and from our first quarter.

Third; we strengthened our product portfolio. In particular we successfully launched the Canon C6000 product line in color production. In addition we launched the Ricoh MPC6000 and MPC7500 products which enhanced our color office product portfolio with increased output speeds.

Fourth; Europe again performed well, growing total revenue 10% year-over-year and at 5% at constant currency. Note this was their seventh consecutive quarter of year-over-year revenue growth at constant currency.

And fifth; as planned, we reduced our inventory by $89 million a significant improvement from December 31, 2007. This was a noteworthy accomplishment given our improved equipment performance and contributed to the generation of $77 million in cash from operations in our quarter.

Now please turn to slide four, and I will review equipment revenue for the quarter.

In the second quarter, equipment revenue was $455 million, flat compared with the prior year. Looking at key product segments of the US equipment market, revenue declined in both the black and white office and production segments and was partially offset by growth in color production and color office segments. Color equipment revenue increased 6% with placements up 8%.

Our color mix in the second quarter increased to 40% of equipment revenue, up from 37% in the second quarter last year and 38% in our first quarter of fiscal 2008. Color office revenue grew 1%, on placement growth of 9%. These results were driven primarily by the actions I discussed earlier.

We built momentum through the quarter and finished strongly with placement growth of 13% in March. Color production revenue grew 18% while placements declined 3%. Our revenue growth reflected continued strong sales of the Canon C7000, with 56 machines placed in the quarter. We also successfully launched the new Canon C6000 and placed 10 machines. The primary reason for the decline in placements was lower sales of the Canon imagePRESS C1.

Now recall this product's availability was delayed in our first quarter of last year. This contributed to strong sales in our second and third quarters last year, so that said, we continued to generate solid sales of the C1 in our second quarter fiscal 2008.

Black and white office revenue declined 7%, with placements down 10. These results were due to the continued pricing pressures across all segments inline with the market, and the continued shift to Color Office. In addition, the migration of lower priced A4 units continued with placement growth in excess of 30%.

Black and white production revenue declined 5%, with placements down 9%. These declines were driven by increased competition and light production. Strong sales of the IKON Print Center Pro 1050 drove mid production revenue, and placement growth. Heavy production revenue and placements grew, due to strong sales of used equipment.

And in Europe we continued to generate strong results. Equipment revenue grew 15% year-over-year at constant currency as a result of strong performance in the UK and Germany. And as reported Europe's equipment revenue grew 22%. So in summary, we made lots of progress on our execution. And we exited the quarter with terrific momentum.

Customer service and supplies revenue was $344 million flat when compared with the prior year. North American customer service and supplies revenue declined 3% in the second quarter. This performance was driven by lower total page volume, a decline in analog copier machines in the field or MIF and a decline in digital MIF.

Now with in total page volume, declining pages from Analog Devices and black and white office products, were partially offset by continued strong page growth from color devices. Pages made on color devices now represent 10% of our total pages. Looking at customer service and supplies copier MIF in North America, analog MIF declined as expected, now representing only 7% of our total MIF.

Digital MIF declined 1% with strong growth in color. In addition, as we expanded our service offerings with our existing customer base some customer service and supplies revenue and MIF migrated to On-Site Managed Services. So total North American digital MIF, including On-Site Managed Services increased 2% year-to-year.

In Europe customer service and supplies revenue grew 9% at constant currency, due to an increase in color page volume and strong color placement growth. As reported, Europe's customer service and supplies revenue grew 16%.

Now please turn to slide six. Total Managed & Professional Services revenue grew 6% to $211 million. On-site Managed Services revenue which represents about two-thirds of the Total Managed & Professional Services grew 7% due to continued expansion of existing accounts and the cumulative effect of net new site additions.

Off-site Managed Services revenue increased 3% primarily as a result of a large electronic document discovery project in the quarter. Professional services revenue grew 9% in the second quarter due to growth in consulting, support and maintenance services, and equipment related services.

I will review our outlook for the third quarter and all of fiscal 2008 in a few minutes. But please now turn to slide seven and Bob will discuss our second quarter results in more detail.

Bob Woods

Thank you, Matt and good morning everyone. For the second quarter of fiscal 2008, earnings per diluted share were $0.24. Gross margin for the quarter was 33.1%, an increase of 30 basis points from the second quarter last year. I will review gross margins in more detail on slide eight.

Selling and Administrative expenses were $299 million up $6 million year-over-year, primarily due to higher selling related compensation expenses and currency and it was partially offset by lower administrative expenses. For the quarter our S&A expense-to-revenue ratio was 28.2% up from 27.9% last year, but a 140 basis point improvement from the first quarter. Let me provide you an update on our spending reduction plans we announced in January.

During the quarter we reduced headcount by more than 350 in the United States. We also lowered executive bonuses and reduced spending in IT, travel and other corporate activities. Overall we are on track to achieve $25 million in savings in fiscal 2008 with the majority of these savings coming in the second half of the year. As a result we still expect our expense-to-revenue ratio to be approximately 28% for the full year.

Operating income was $52 million or 4.9% of revenue in the second quarter, essentially equal to the prior year, but a $14 million increase from the first quarter of this fiscal year. Interest expense, net of interest income increased $7 million year-over-year to $16 million due to our share repurchase related activity in the first quarter.

Our effective tax rate for the second quarter was 36% up from 28% in the prior year. For the third quarter we anticipate our tax rate to be less than 24%. For the full fiscal year 2008 we still expect our tax rate to be approximately 33%. And as we have mentioned in the past our tax rate will rise over time to our structural tax rate of about 36%.

At the end of the quarter, actual shares outstanding were 94 million shares, a 25% reduction year-over-year driven by our share repurchase program. For the quarter, our weighted average fully diluted shares were also 94 million, essentially equal to actual shares outstanding as there was little dilution. Given the recent increase in our share price we expect weighted average fully diluted shares to exceed the actual shares outstanding for the remainder of fiscal 2008. We anticipate weighted average fully diluted shares for all of fiscal 2008 to range from 99 to 100 million shares.

Now please turn to slide eight, and I will review gross profit. Gross profit margin in the second quarter increased from 31.1% to 32.8% a year ago, primarily driven by improvements in equipment and Managed & Professional Services, which were partially offset by lower customer services and supplies margin.

The equipment margin improved driven by higher average selling prices and a higher mix of used equipment. We realized higher average selling prices as we moved to an increased mix of high end color machines and improved revenue realization on lease transactions as interest rates declined substantially this quarter. We expect our equipment margin in the third quarter to be approximately 25%.

Customer service and supplies margin decreased primarily due to North America, where cost declines did not keep pace with revenue. Managed & Professional Services margin improved, primarily due to strong professional services revenue on relatively fixed costs and continued contract profitability growth in On-site Managed Services.

Now please to slide nine and I will discuss cash flow. For the first six months of fiscal 2008, we generated $61 million of cash from operations compared to a use of $11 million in the first half of fiscal 2007. During the first six months of this year, we generated $19 million in cash by reducing inventory driven by the second quarter reduction of $89 million. As we said we would in January, we substantially sold through the large inventory purchase made in the first quarter.

For the fiscal year we still expect to generate a $15 million net working capital improvement from inventory and accounts payable. For the first six months of the year, accounts receivable used $30 million of cash driven by strong equipment sales at the end of the second quarter. Other cash flow, which is the net of the remaining non-cash items and changes in our assets and liabilities, was $13 million, an improvement over the prior year and was due to lower bonus and tax payments in fiscal 2008 and the timing of payments related to other liabilities versus the prior year, such as the timing of payroll disbursements.

Net capital expenditures were $24 million in the first half of fiscal 2008, resulting in free cash flow of $37 million. Free cash flow improved $68 million year-over-year. We continue to expect free cash flow to range from $80 to $110 million for fiscal 2008.

During the balance of fiscal 2008, we expect to repurchase $25 million of our shares.

Now please turn to slide ten; and I will cover our balance sheet. Cash on the balance sheet increased $61 million to $203 million in the second quarter. As I mentioned earlier, inventory declined $89 million to $268 million at March 31, 2008. Consistent with this decrease in inventory accounts payable declined $66 million, to $242 million. Our debt to capital ratio was 41% at March 31, 2008, unchanged from December 31.

In the near term, we expect to repurchase our shares and pay dividends within the covenants of our existing debt agreements and to deploy our remaining available cash to reduce debt. In early April we notified holders of our 2012 notes that we will redeem $50 million of these notes. We expect to incur a $1.7 million pre-tax loss on the extinguishment of this debt in the third quarter as a result of this partial redemption.

Now please turn to slide 11; I will turn the call over to Matt to discuss our outlook for fiscal 2008, and for the third quarter.

Matt Espe

Thanks Bob. As I mentioned earlier we continue to expect our earnings per share in fiscal 2008 to range from $0.92 to $0.98 excluding any nonrecurring items. In addition for fiscal 2008 we expect total revenue to be flat year-over-year and expense-to-revenue ratio of about 28%, and an operating income margin of about 5%.

Now for the third quarter; we expect earnings per diluted share to range from $0.29 to $0.32 excluding nonrecurring items. Our management team is intensely focused on continuing to improve sales productivity, increased placements of color machines, grow our annuity streams, improve working capital and reduce costs and expenses.

Before I close; I would like to thank all of our employees personally for their hard work and contributions in our second quarter. Everyone rallied together. We asked our employees to take more ownership and responsibility and help us drive the company forward in a challenging operating environment. And they responded with dedication, and delivered solid results for our customers, and our shareholders.

In closing; we are proud of our second quarter execution. We successfully implemented the IKON US organizational structure. We improved equipment revenue and gross profit. We increased our color mix as a percent of equipment revenue. We strengthened our product portfolio. We reduced inventory and generated strong cash flow and we built momentum through the quarter.

As a reminder; our Annual Investor Conference will be held at the Park Central Hotel in New York on May 14 and we look forward to seeing you all there. Thank you very much.

And at this time we will be happy to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from Carol Sabbagha with Lehman Brothers. Please state your question.

Carol Sabbagha - Lehman Brothers

Good morning. Thanks. Sort of quick question on the economy here in the US. What did you see in the quarter? Other companies in the sector are talking about weakness as the quarter progressed so the latter part was worse than the beginning part. Just your view of that and where you think it's going to go going forward?

Matt Espe

Good morning Carol. When we started our fiscal year in our first quarter we talked about getting ready for and planning for a challenging environment. It's proven to be challenging. We see it I guess in two ways.

Number one; we see the same trends in the second quarter that we saw in the first quarter, in terms of the lengthening sales cycles on large deals. So when we are talking about national account or major account deals, those sales cycles are extended as they were in our first quarter.

And I guess the second thing we look at as an indicator of the economy, is a slight decrease in output on our machines. So page volume down slightly. So those two things will tell us that the challenging environment we expected to see, we are in fact seeing.

Carol Sabbagha - Lehman Brothers

And my other question is, since the last time we had this call there has been some distributor consolidation in the industry. What is your current view right now on the landscape?

Matt Espe

Well, obviously, Konica buying Danke is a bit of news. We expect Danke to be a stronger competitor with the Konica investment. Konica continues to be a valued supplier and partner to us. So we think that we are uniquely positioned now as the only or at least the largest and strongest independent distributor.

Carol Sabbagha - Lehman Brothers

Does this bring your relationship with Canon any closer?

Matt Espe

Yes. We have a ongoing strong relationship with Canon anyway. And clearly, some of the channel dynamics can result in us even improving our integration.

Carol Sabbagha - Lehman Brothers

Do you think you can leverage your unique position right now for better pricing from Canon going forward?

Matt Espe

Well, I wouldn't want to comment specifically on discussions we have going on with Canon with respect to pricing. But I would tell you that the commercial integration between us and Canon, frankly between us and Ricoh are stronger than ever.

Carol Sabbagha - Lehman Brothers

Okay. Thank you very much.

Matt Espe

You are welcome. Thanks.

Operator

Thank you. Our next question comes from Shannon Cross with Cross Research. Please state your question.

Shannon Cross - Cross Research

Hi, good morning.

Matt Espe

Good morning.

Shannon Cross - Cross Research

I am just curious Matt, when you sort of look at how the most recent quarter came out, relative to your expectations obviously it was above. I mean is this sort of the perfect storm in a positive way that happened? Or how should we think about it? I know you are being conservative on the remainder of the year, but I am just kind of curious as to how much of this was kind of potential as we exited last quarter and then it came through during the second or any color you can give us in terms of your visibility in that?

Matt Espe

I think that's a good question. I mean the way I think about it is I am stuck looking back really, Shannon really looking at the first half. We cited a couple of things that caused most of our issues in the US on the equipment side in Q1. We said that we would correct those and get working hard in Q2. And I would point to Jeff Hinkling and Mark Bottini's leadership as critical in driving the equipment revenue results that we saw in Q2.

The execution in the field was crisp. The focus was outstanding. And the morale was very, very high. So I think we really did an about face, and delivered a stronger than expected equipment revenue in the US. Europe continued as you heard us say continued to be very strong. Managed & Professional Services continued to grow. So for us, the thing that sort of helped us overdrive the second quarter was better than expected equipment revenue particularly in the US.

Shannon Cross - Cross Research

Okay. And then you talked a bit about seeing a slight decrease in output on devices. Was that toward color or mono? I am just kind of curious. I mean there is this expectation or at least historically has been that when the economy turns south people stop printing in color. I am not sure we've seen that, but I am just curious as to anything you can give us there?

Matt Espe

The dynamics continue to be strong growth in color output. And most of the slowdown we experienced is in office black and white.

Shannon Cross - Cross Research

Okay. Great. And I am not sure what you can say about it, but any comments you can make on your activist shareholder or non-activist shareholder depending on where you are in the relationship and since you sort of changed your expectations for share repurchase and what have you?

Matt Espe

We talk with all of our shareholders frequently and along. We obviously wouldn't comment on any specific conversations we have had with any of them.

Shannon Cross - Cross Research

Okay. Thank you very much.

Matt Espe

You bet. Thanks, Shannon.

Operator

Our next question comes from Woo Jin Ho with Merrill Lynch. Please state your question.

Woo Jin Ho - Merrill Lynch

Hi, good morning. Just a couple for me. Just a question on the pricing environment ASP has trended higher on the equipment side which helped on the gross margin. Obviously the production color has been helping out a bit. How should we think about the ASP and the gross margin going forward? Especially given the tough pricing environment?

Matt Espe

A couple of thoughts Woo Jin. First of all in general I mean ASPs across the board are going to be down, and range between sort of 5% and 10%. Our dynamics are different because of mix. As you pointed out we had a very strong color production quarter with 56 7000 placed, and 10 6000s, the 550 and the 650 continue to be strong. So we're clearly seeing some benefit from strong placement activity in color production. So I think we'll a little bit of a positive mix effect in our results. The margin improvement that we've seen is really a function of kind of three things.

We had lease rates decline in the quarter. We kept some of that, didn't pass along all of that along to the customers. Secondly; our used mix improved over the first quarter. And thirdly; our deal mix favored small and medium deals to large deals.

Woo Jin Ho - Merrill Lynch

Got it. Okay. Can you provide an update on the progress in the graphics arts and the graphic communication markets up to now, the color production equipment that has been placed on the implant where do we stand today?

Matt Espe

Yeah, good question. Most of our placements experience year-to-date has been an implant or in the industrial space as expected. The guards are out building pipeline in commercial print, and we expect that those deals will close and help drive our growth as we go through the balance of the year.

Woo Jin Ho - Merrill Lynch

So what percentage of the 66 placements were in graphic arts?

Matt Espe

I don't think we ever disclosed that Woo Jin.

Woo Jin Ho - Merrill Lynch

Okay. Just to drill down a little bit on the Konica Minolta Danke acquisition does that pending merger change your relationship in terms of your distribution of Konica Minolta machines through the IKON channel at all?

Matt Espe

Too early to speculate. We have no plans to change the nature of our relationship with Konica Minolta yet.

Woo Jin Ho - Merrill Lynch

Okay. And lastly on the cost side, and this may be something you may come up more on the Investor Meeting in a couple of weeks. Clearly you are focused on cost management, and you are making progress on the restructuring that you took in the quarter. However longer term it seems that much of the low hanging fruit is behind you. I mean what are some of the strategies to help further improve gross margin as well as expand operating margins going forward?

Matt Espe

Well, I mean I think part of it, and I will turn it over to Bob here in a second, I am not sure we would agree that all of the low-hanging fruit is done. I mean I think we find opportunities every day to continue to drive costs and spending out of the company. The gross margin improvement or stabilization going forward really is a function of building a more reliable annuity stream. So it is expansion of Managed Services, expansion of Professional Services, and the correction in the revenue from after market or customer service. Bob?

Bob Woods

I would also point to our one platform integration going forward. We very quietly and very successfully have moved over two-thirds of the company to our one platform, meaning a single operating platform. The balance will move in the month of May. So by the end of May we will have the entire company on one platform which will allow us to drive efficiencies across the company. And as we pointed out in last year's Investor Conference, and we will refresh in this year's Investor Conference, that alone drives significant savings in the company.

We are also looking at our integration with vendors, in terms of supply chain how we can get tighter with that. So that from our standpoint we have a cheaper cost to serve throughout the whole supply chain including what inventories the vendors may be holding.

Woo Jin Ho - Merrill Lynch

Great. Thank you.

Matt Espe

Thanks.

Operator

Our next question comes from Ananda Baruah with Banc Of America Securities. Please state your question.

Ananda Baruah - Banc Of America Securities

Hi, guys. Thanks for taking the question. If we could just jump across the pond so to speak, over to Europe, pretty consistent tone coming from sort of all you folks in the print industry as well as sort of hardware vendors to a larger extent, with broader portfolios, US enterprise weaker, US SMB okay, Europe okay, kind of across the board. But as you move through the quarter in Europe what did the linearity look like, both on the enterprise side, and on the SMB side, and then do you get any sense that there maybe is some give starting to show up in the European demand?

Matt Espe

We haven't seen any signs of softening in demand. We've had very solid progress in Germany for the last year, year and a half. The UK is another center of gravity for us.

And the leadership team in the UK has done a very nice job building its mid-market, what we would call mid-market SMB business. And we think that that has been contributing to significantly improving their results for the past several quarters.