Heelys, Inc. F1Q08 (Qtr End 03/31/08) Earnings Call Transcript

May. 8.08 | About: Heelys, Inc. (HLYS)

Heelys, Inc. (NASDAQ:HLYS)

Q1 2008 Earnings Call

May 8, 2008 4:30 pm ET

Executives

Ralph Parks – Interim CEO

Mike Hessong - CFO

Don Carroll – Senior VP Marketing

Analysts

Mitch Kummetz – Robert W. Baird

Unidentified Analyst

Todd Brooks – Alydar Capital

[Ivan Swick] – Raymond James

Operator

Good afternoon ladies and gentlemen and welcome to the Heelys, Inc. first quarter fiscal 2008 earnings conference call. (Operator Instructions) Before we begin, I would like to remind everyone of the company’s Safe Harbor language. Please note that this call will include forward-looking statements within the meaning of the Securities laws. All forward-looking statements included in this call are based on information available to the company on the date of this call, the company's current expectations and various assumptions. The company believes that there is a reasonable basis for its expectations and beliefs, but they are inherently uncertain. The company may not realize its expectations and its beliefs may not prove correct.

For a list of important factors that could cause the company’s actual results to differ materially from the forward-looking statements in this call, please refer to the company’s public filings with the SEC, including the risk factors contained in the company’s Annual Report on Form 10-K. You are encouraged to read that section and all of the company’s other filings with the SEC. The company intends that all of its forward-looking statements in this call will be protected by the Safe Harbor provisions of the Securities Exchange Act of 1934.

The company undertakes no obligation to publicly update or revise any forward-looking statements as a result of new information, further events or otherwise. All subsequent written and oral forward-looking statements attributed to the company or persons acting on the company’s behalf are expressly qualified in their entirety by the cautionary statements contained throughout this call and the company’s public filings with the SEC.

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

Ralph Parks

Good afternoon everyone and thank you for joining us. With me today on today’s call is Mike Hessong, our Chief Financial Officer and Don Carroll, our Senior Vice President of Marketing.

Overall our first quarter results were pretty much in line with our internal projections. As everyone is probably aware the first few months of 2008 have proven to be a very difficult period at retail in the United States particularly for footwear and apparel. That said we did see some positive progress towards improving the average selling price at many of our accounts. Equally important retail sell-through during the first quarter remained solid which helped further reduce the level of inventory in the channel as we approach the summer and back-to-school season.

Overseas we remain confident about the prospects for our brand and products especially in Europe. While we did experience a slight shift in timing of deliveries which impacted quarter one performance we continue to expect international sales to be up double-digit in 2008. Strategically the first quarter included several important announcements that we believe have strengthened our market position, improved our operating platform and better positioned the company to capitalize on the many opportunities that still lie ahead.

First we established Heeling Sports Europe, Middle East, Africa, a subsidiary based in Brussels that will serve as our European headquarters. The office officially opened in February and since that time John O’Neil, our Vice President of International and his team have been extremely busy working more closely with our current distributors to enhance the awareness of the brand and increase consumer demand across the continent.

At the same time they’re evaluating new distributors and distribution opportunities for the company in under penetrated regions including the Balkans, Africa and the Middle East. Secondly we reached an agreement with our distribution partner for Germany and Austria and recently began selling direct in both countries. We opened a sales office in Munich, Germany and have hired a country manager for Germany and Austria. He’s spent more than a decade in the footwear and hard goods industry and has extensive sales and marketing experience with many well known brands in the space. We are confident that he is the right person to oversee the growth and development of our initial direct sales model in these countries.

We also reached an agreement with our distribution partner for France and Monaco and will begin selling direct in those countries this month. We have hired a manager for these countries and are opening a sales office in Annecy, France. We are pleased that we’ve been able to reach an agreement quickly with both of these distributors and are excited about the change that is being implemented.

Next we settled our lawsuit with Elan-Polo over patent and trademark infringements. Under the terms of the agreement we received approximately $750,000 from Elan-Polo and will receive additional payments of $650,000 over the next three years. At the same time we entered into a three-year strategic licensing agreement which will allow Elan-Polo to sell a certain style of skate shoes to a select list of retailers in the United States and Canada. This deal is important because it accomplishes several things. First and foremost it gives us control over the distribution of the lower end product, second it introduces us to a whole new channel of distribution and the sourcing requirements that come along with this channel. Thirdly it provides an incremental royalty revenue stream that will benefit our bottom line. While it’s early in this relationship we believe our license agreement with Elan-Polo could evolve into a more strategic partnership over the longer term.

Finally, we appointed Jerry Edwards to the Board of Directors. Jerry brings with him a great deal of valuable experience particularly from his tenure as President and CEO at Pearl Izumi where he oversaw the dramatic turnaround of that business. We are pleased to welcome Jerry to the Board and look forward to his input and direction.

Before I turn the call over to Mike I want to quickly share some of the feedback that I have received from retailers during my many meetings over the past several months. I think it’s important for our shareholders to hear what accounts are saying about the brand and about the product. While most of our retail customers did not make acceptable margins off our product in 2007 they are looking for this to improve in the second half of ’08 because of more manageable inventory levels and higher selling prices.

They have been very pleased with the new styles for these seasons as well as the pre-line we’ve shown them for spring ’09 and believe these styles will be well received by the consumer. Most of our retailers have been very supportive and have begun to place future orders earlier than I originally anticipated. Ultimately the end consumer will determine the appropriate inventory level and with that in mind we are encouraging each retailer to only book and order what they feel they can sell during the back-to-school season and then fill in with at-once orders.

I would expect to see more future orders for holiday. While the sales levels may not match those of 2006 and 2007 there is still a healthy consumer demand for Heelys product. We’re also seeing many retailers beginning to increase the average selling price back closer to more normalized levels. One retailer is selling new product at $69.99 and has two of our shoes in their top ten SKUs in the children’s department.

With that I’ll turn the call over to Mike and then come back with some closing comments.

Mike Hessong

Thank you Ralph. Net sales for the first quarter were $13.1 million compared to net sales of $49.4 million in the first quarter of 2007. Gross profit for the first quarter was $2.8 million or 21.5% of net sales compared to gross profit of $17.5 million or 35.4% of net sales in the first quarter of 2007. Most of this decrease was in domestic gross margin due to lower sales, lower average selling prices as we worked to sell off inventory from past seasons, an increase in our inventory reserve and higher fixed distribution costs.

Total SG&A for the first quarter was $6.1 million compared to $5.2 million in the corresponding period last year. This amount included approximately $900,000 associated with the transition of our CEO during the quarter. We incurred a loss from operations for the quarter of $3.3 million versus income from operations of $12.2 million last year. Our net loss for the quarter was $1 million or $0.04 per diluted share compared to net income of $8.5 million or $0.30 per diluted share in the first quarter of 2007. Excluding the transition cost that I mentioned above, our net loss for the quarter was $0.02 per diluted share.

With regard to our balance sheet, at March 31, 2008 we had cash equal to $100.8 million. This compares to $69.1 million at March 31, 2007 and $98.8 million at 12/31/2007. We ended the first quarter with inventories of $12.2 million which includes a returns reserve of approximately $600,000 compared to inventories of $10.3 million at March 31, 2007 and $15 million at December 31, 2007.

As we previously mentioned in our Q4 call in March and as Ralph has reiterated today we have seen a shift to more of an at-once business and expect to see this continue throughout 2008. That factor combined with the challenging retail environment provides us less visibility into future sales. We still expect domestic sales to increase sequentially each quarter throughout the year but do be down in total in 2008 and while we will see growth in our international sales it will not be enough to offset this decrease. In addition we expect to see similar margin pressure during Q2 as we continue to move product from past seasons. We should start to see a return to more normalized margins in the second half as we sell primarily new in-season product. We also expect to be cash neutral for the year.

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

Ralph Parks

Thank you Mike. Our strategy for 2008 is to be proactive but also patient. To be successful we need to continue to drive consumer demand and to make sure our retail customers are [promptable] with our product while managing the business to the correct levels of demand. The explosive popularity of our brand combined with a massive slowdown in consumer spending trends in footwear and other categories caused an over-inventoried situation last year that we are slowly but steadily recovering from.

The first step was to work down the inventory levels in the retail channel which we have essentially done. Once this occurs this lessens the need to discount and allows the retailers to slowly raise retail prices back up to a full rate. This then allows retailers to capture a full margin on sales which leads to a greater willingness to place future orders and expand their Heelys business again.

While the visibility remains limited our hope is that the business will be operating again under full prices, margins and bookings sometime toward to the latter part of the year. Of course some of this is also dependent upon the health of the overall economy. As long as the environment remains soft there will be a continued reluctance by retailers to place significant pre-orders of any kind and stores will continue to do more business on an at–once basis.

The good news is that our brand recognition and sell-through rates remain healthy. In addition our strong patent protection allows better control over the market and limits competitive products. So the whole situation becomes finding the proper balance between supply and demand and the natural growth for the business. There are things we can do to keep improving our product offering and brand message. To that point we have developed more style-right product that incorporates more skate silhouettes, more color and graphic design imagery and more low profile and vulcanized styles.

The feedback on the back-to-school product line has been very positive. On the marketing side our new Senior Vice President of Marketing, Don Carroll, has developed a more integrated marketing communication strategy. The strategy builds on our existing use of TV but with a new, more demonstrative creative execution. In addition new elements to the mix will include radio, public relations, online and product placement. By effectively changing our mix Heelys both extends the campaign’s reach and frequency among kids and parents. This broadening of our target to include parents is an important shift that compliments the buying process for our products.

From a diversification perspective we continue to believe it’s important to develop non-wheeled footwear. We are showing the retailers our new styles in the sidewalk sports category and they believe we’re making advances in creating styles that have the opportunity to sell well at retail. This is going to take some time but we’re excited about the category and think we can be successful. We’ll continue to develop sidewalk sports product internally but with over $100 million in cash and no debt on the balance sheet we’re in a position to evaluate acquisitions or formulate strategic alliances.

Finally with regards to the CEO position we are in the process of searching for the right candidate and hope to have something more to report in the upcoming weeks. We feel confident that our selection will possess the leadership characteristics necessary to strategically take this company forward and implement the growth opportunities required to continue to be a successful company.

We are now ready to open the call up to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Mitch Kummetz – Robert W. Baird

Mitch Kummetz – Robert W. Baird

Mike could you tell me what sales came in US versus international for the quarter?

Mike Hessong

US sales for the quarter were $5.6 million and international was $7.6 million.

Mitch Kummetz – Robert W. Baird

So international was still down in the first quarter year-over-year, you’re expecting a double-digit increase there, when would you expect to see year-over-year improvement in that business and see some growth coming out of it to get to double-digits for the year?

Mike Hessong

Well I think we’ll start to make up that in the second quarter. Some of that was timing of deliveries at the end of the first quarter that made it into April instead into March. I think we’ll start to make up some of that ground in Q2 but it will continue to build momentum as John carries out his strategy in Europe.

Mitch Kummetz – Robert W. Baird

Okay and how much was the shift in deliveries out of Q1 into Q2?

Mike Hessong

There were a couple of million dollars. I don’t have the exact dollar amount here but it was a couple of million dollars in deliveries.

Mitch Kummetz – Robert W. Baird

And why did that occur?

Mike Hessong

It was just the timing of when the shipments are going to leave the factory.

Mitch Kummetz – Robert W. Baird

Was it in any particular markets?

Mike Hessong

No, no particular market. Again they’re not as worried about cut-off so --

Mitch Kummetz – Robert W. Baird

And then Ralph could you just elaborate a little bit more on – you made a comment that inventory levels are coming down at retail and pricing is starting to improve. I don’t know to what extent you could elaborate on that or maybe talk about some of the metrics that you’re looking at that gives you that sense.

Ralph Parks

Well I’ve just been out travelling and in a lot of retailers’ offices and meeting with them and speaking with them and I know that their inventory levels are coming down substantially from what they were at the beginning of the year. And we’ve been encouraging the retailers to look at the new product and start working their prices back up. And if you look at Sunday’s circulars for an example, you’ll see two of our key retailers that we consistently running $39.99 on most every Sunday but for like the last one of them – for the last about six weeks has been $49.99 and the other one the last three weeks has been $49.99 and then speaking with some retailers I know that some of the new product they had out there for $69.99 that’s selling – their pushers are anywhere from 5% top 7.5% on a pretty regular weekly basis, which is pretty strong.

Mitch Kummetz – Robert W. Baird

Do you now feel like the inventory at retail is aligned with the demand that’s out there for the product or is there still more room to go and if so when do you think you’ll get there?

Ralph Parks

I think there’s still a little bit of room to go still, so much better than what it was that we’re extremely pleased and excited about that but there’s still some more to go and our goal and our desire is that when we end back-to-school the retailers are going to be in a healthy position in inventory and our desires that they have nice sales for June, July, August but that we plan it correctly and their inventory levels are where they should be so that opens up for receiving the new product for holiday which of course is the best selling season.

Mitch Kummetz – Robert W. Baird

Could you maybe speak to what you’re seeing in terms of the presentation of your product at retail, its seems to me that we’re seeing less of it or fewer – it seems like you go back even as retailers were sitting on inventory there were still presenting it as a collection and we’re seeing the last of that now and I’m wondering as you think about the business going into the back half do you think that retailers on average are just going to be carrying fewer SKUs of the product or how do you think they’ll be positioning it in terms of presenting it at retail?

Ralph Parks

Well I’m sure they’ll have a fewer SKUs than LY. I really haven’t looked at it by individual account by the number of SKUs quite honestly. But they will not place as deep as they did last year at this time and rightly so. But I think what you’re seeing right now is in the process of cleaning up there’s a lot of odds and ends still left out there and there’s some shoes that have been out there for two years period of time that they’re so broken in sizes right now because the new product is just now – the end of May and June, the new back-to-school product will start arriving. So there really hasn’t been the new product hitting the stores except for just a couple of situations where there were some special make-ups. And so you’re seeing a lot of broken sizes and that is really one of the exciting things that we see is the retailers stabilize the prices of some of the existing carry-over and even though they’ve got broken sizes we’re still seeing nice pushes on a week to week basis. So I think the retailers are excited about what’s going to be delivering for back-to-school. We’re excited just to see how the sales come through and we believe that it will be positive and – but I really want them to come out of back-to-school clean with their inventory so that they’re open and not disappointed in the amount of inventory they’re carrying over.

Mitch Kummetz – Robert W. Baird

Mike you made the comment on margins, you’re expecting similar pressure in the second quarter, are you specifically speaking to the gross margin, because I would think that with higher volume in Q2 then Q1 you could probably do a better job on the SG&A maybe seeing that improve on a percentage of sales basis.

Mike Hessong

Yes, I was definitely referring to the gross margin and for the same reasons that we mentioned earlier that put pressure on it in Q1. We’re still going to be selling some product at lower prices. We move through, we still have some fixed costs. I think it will be better than it was in Q1 but I still think there will be pressure compared to prior quarters.

Operator

Your next question comes from the line of Unidentified Analyst

Unidentified Analyst

Could you tell us a little bit more about Europe and what’s happening there, is there specific countries that are growing and how does that ramp up compared to the ramp up that you experienced in the United States a couple of years ago?

Ralph Parks

Well the brand is becoming more and more important throughout Europe. We’re going to manage that demand for the brand and we’re going to make absolutely sure that we do not over expose or over inventory our distributors or the retailers. But with us bringing Germany and Austria in-house, we have more control over how the brand is going to be presented. We have more control over what retailers will carry the brand. What levels they’ll have and our plan is to service those retailers to make sure that they don’t have to over inventory their stores. They can depend on us to have some at-once product for them. And I think that’s extremely important to grow the business but to grow it in a safe situation and not put all the risk on them and they end up over inventoried in their stores. Same thing with France and Monaco. John has had this experience with other companies and he’s true professional at what he’s doing and our opportunities over there are extremely strong. And I just travelled, I was in China visiting our factories and I met with him with one of our distributors in Asia and things are going extremely well there also. So the influence of Heelys, the brand is still extremely strong in the United States and that influence is still moving over to Europe and Asia.

Unidentified Analyst

Do you find that new skate products that come out like the rib stick or the wave board, do you find that they compete directly with you or are they more like complementary?

Ralph Parks

I would say it’s more complementary. I don’t see a competition thing there whatsoever.

Unidentified Analyst

And what about like skateboards, do kids who buy [Heelys] do they also buy skateboards or are they substitutes?

Ralph Parks

Well we have people here in the office that have young children and those children have Heelys shoes and they also have skateboards and they also have rip sticks and wave boards. It’s a different activity and they use different shoes for different times but it’s not something that’s going cut into a sale of a Heelys shoe because they choose to buy a skateboard versus a Heelys because we have our plug. They can wear the shoe as a regular shoe and our new upper patterns look extremely fashion-forward and I know some of the retailers really believe that with the plug in the shoe that with the patterns that we have today it lends itself to selling more for just wearing it with the plug.

Unidentified Analyst

How’s the retail environment in Europe right now?

Ralph Parks

I think its tough over there just like its tough here from everything I could hear but they’re enjoying the euro being up. I was just at our National Sporting Goods Association Conference and speaking with a couple of people that are from Munich [Isto] that I’ve known for years and asking them that question and its still difficult over there also.

Unidentified Analyst

You mentioned distributing in Europe directly, what kind of margin improvement would you expect from cutting out the middle man?

Mike Hessong

Well I think there are a couple of things going on there. Obviously our average price is going to go up because we’re going to be selling to the retailer. We also continue at our cost but we’re going to have more inventory carrying costs and distribution cost then we’ve encountered before so I’d expect to see our gross margins improve. We’re going to have a mix for awhile of selling direct and distribution business but we’re also going to have marketing expenses, G&A costs and stuff that we haven’t had before. So the real focus on this is to try to drive distribution and top line sales growth in Europe and spread in a controlled manner.

Operator

Your next question comes from the line of Todd Brooks – Alydar Capital

Todd Brooks – Alydar Capital

With the shift to more of an at-once model for this back-to-school how should we think about the inventory build that we should be seeing on the balance sheet in Q2?

Ralph Parks

Well we have at-once but its going to be the smaller retailers quite honestly. We’re replacing orders for product for us to have at-once and we started getting in more futures than what we anticipated and we actually moved some of the at-once orders to the future orders to replace that so we wouldn’t have a carry over of inventory. So really where the at-once is going to be for the smaller retailers and then for the fill-ins from the major guys and – our inventory level is not going to be substantial, I honestly do not know and Mike you would help me there what the inventory level was at the end of August last year in the DC versus what it might be this year.

Mike Hessong

I think what you’ll see is that you’ll see a slight build back up here during Q2 versus where we ended 3/31 because you’re at the beginning of the back-to-school season, we’re bringing most of that product in in June, some of it will wait to come in on a second wave in July, so you’ll see it go up at June 30 as we start the season. You’ll see it go back down in Q3 as we sell through it and where we haven’t brought in holiday product. The dynamics of last year make it a little more difficult to compare to this year but what I think you’ll see is it go back down at 9/30. The goal would be obviously to end the year at a much lower inventory level because we will be through the holiday season and we’ll be ready to bring in fresh new product for spring 2009.

Todd Brooks – Alydar Capital

On the sourcing and product costs side, what are you seeing kind of on a cost prepared trend for back-to-school and then what are you looking at in ’09 just from an inflationary standpoint?

Ralph Parks

I just back from China a few weeks ago, as you know we opened a sourcing office in Qingdao and we use two factories there in the Qingdao area and another in Indonesia. By us going to our own office versus historically we’ve used an agent, we are actually still seeing some class cost reductions presently. We think that will hold possibly through holiday but we will have some increases come spring ’09 but we’re very fortunate where we are and the movement that we made in setting that office up that its not going to hit us as dramatically as it will be and has hit some other manufacturers.

Todd Brooks – Alydar Capital

And as you start to look out to ’09 I know kind of the core brown shoe producers are talking about 10% cost increases, with your own office in place, do you sense a magnitude for how much you think cost prepare may be up in ’09?

Ralph Parks

Well I would agree with what you just said as far as everybody saying 10%. I’ve talked to people that say anywhere from 10% to 13% to 15%. We will probably ’09 – not positive at this time, we’re still pricing some of the materials and so forth we’re probably going to be pretty close to that 10% range ourselves.

Todd Brooks – Alydar Capital

Okay and then with such iconic price points would the $59.99, $69.99, what’s the thought about what you do as far as the ability to pass increased costs through, are there efficiencies that you look to get internally to offset the cost increases next year?

Ralph Parks

We’ve got to look at every avenue. Some of it will have to be passed on, some of it – I think there’s things that we can do that doesn’t affect the shoe. There may be something that we can do with our boxes, our packaging. We’re looking at everything right now.

Todd Brooks – Alydar Capital

Okay and then to follow-up on the switch to direct distribution from using distributors, I guess there were two countries that you went to direct in Q1--?

Ralph Parks

Not really, Q1 we just did in April we just got Germany and Austria completed. And May, just this first of May we got France and Monaco.

Todd Brooks – Alydar Capital

Okay so the way it seems like you’re talking about, its relatively margin rate neutral but if you look at what it means on the revenue side, kind of what’s the additional revenue prepare that you realize with direct distribution versus going through a distributor?

Mike Hessong

Well part of that is one of our goals in going direct too is to also try to get the price point as competitive as possible. Like in Europe we’ve been very expensive over there and we think by eliminating the distributor in these countries, we want to pick up extra margin but we also want to keep the price points in check. So I think its going to depend on the country and where we eventually land on the pricing. It’s still a little premature to quote an exact number for these.

Operator

Your final question comes from the line of [Ivan Schwick] – Raymond James

[Ivan Schwick] – Raymond James

In your earlier prepared remarks you mentioned a $100 million you had on the balance sheet and that you were in a position to look at acquisitions or licensing’s, my question is this, what’s the likelihood say in the next six months, particularly with the economy the way it is, I would assume there’s more opportunities than in normal times for attractive acquisitions, of a meaningful one happening to the company for cash?

Ralph Parks

Well not only at this point are we looking, we have consistently been looking for at least the past year plus. But we are very aggressively looking but we have some pretty rigid requirements that we expect the deal to have and in this economy and what’s taking place right now, we just believe that those that are patient and do their due diligence will be successful.

Operator

There appears to be no further questions at this time, I’ll turn the call back over to Mr. Parks for any closing remarks.

Ralph Parks

I want to thank everyone for having interest in Heelys and being on the call today. I want you to feel comfortable that we are doing everything that we can to run this business very profitably. We will control the inventory flow. We will control the inventories out at retail level and continue to build the brand. But it’s an exciting business. It’s a solid brand. I know a lot of people felt that after what took place last year with all the pricing that went on and the huge amounts of inventory that the brand was probably done and gone and that’s not the case. It’s very, very attractive to the six to 14-year old consumer; they want it and it’s up to us to make sure that we develop the right product and that we put it in the right retail stores in the right quantities to drive the business. But I thank you for being patient with us and we look forward to better things in the future. Thank you.

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