Executives
Thomas J. Vacchiano Jr. - President and CEO
Lynn J. Lyall - Executive Vice President, Chief Financial Officer, and Secretary
Analysts
Charles Murphy - Sidoti & Company, LLC
James Ricchiuti - Needham & Company, LLC
Vincent DeVito – CIT
Steve Lemmer – Volt Capital
X-Rite, Incorporated (XRIT) Q1 2008 Earnings Call May 6, 2008 11:00 AM ET
Operator
Welcome to the X-Rite, Incorporated first quarter earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Thomas Vacchiano, Chief Executive Officer and Lynn Lyall, Chief Financial Officer of X-Rite, Incorporated.
Lynn J. Lyall
Welcome to the first quarter 2008 X-Rite Inc. earnings conference call. My name is Lynn Lyall, X-Rite’s CFO, and I along with Tom Vacchiano, X-Rite’s CEO, will conduct this call today.
Before we begin, I must discuss our normal Safe Harbor Statement. I have to caution you that the information we have released and will be discussing may contain forward-looking statements within the meaning of the private securities litigation reformat. Actual results may differ materially from those projected in the forward-looking statements due to a variety of factors, some of which may be beyond our control.
Factors that could cause such differences include the impact of our recent defaults under the company’s credit agreements, our ability to improve operations and realize cost savings, competitive and general economic conditions, our ability to access new markets and other risks described in the company’s filings with the SEC. The company undertakes no obligations to publicly update or revise any forward-looking statements whether as a result of new information, future events or for any other reason.
In addition to the results reported in accordance with generally accepted accounting principles or GAAP, X-Rite may provide certain information including EBITDA, which are considered non-GAAP financial measures. Management believes that these non-GAAP financial measures are useful to both management and its investors in their analysis for the company’s underlying business and operating performance.
Management also uses this information for operational planning and decision-making purposes. EBITDA is a non-GAAP financial measure used for covenant compliance testing under our credit agreements. Non-GAAP financial measures should not be considered a substitute for any GAAP measure. Additionally, non-GAAP financial measures as presented by X-Rite may not be comparable to similarly titled measures reported by other companies. A reconciliation of these items can be found as Exhibit 3 with today’s press release and on our website at www.xrite.com in the Investor Relations section.
We will move on now to the topics for the call today. Tom will start out by covering first, the discussion of our first quarter 2008 results including our major market categories and geographies and key business performance highlights. He will then cover an update on the progress and substance of our restructuring plans announced on April 3 and an update on the October 2007 acquisition of Pantone. I will then cover first, an update on our first quarter gross margin and operating expenses and then I will do an update on our Q1 balance sheet and key changes since 2007 year-end, including our liquidity position.
I will cover an explanation of the key defaults under our credit agreements including a reporting issue, a leverage level covenant and the recently announced termination of our interest rate swaths with Goldman Sachs. I will cover our first quarter performance relative to the four key financial covenants in our credit agreements and an update on our efforts to address the covenant non-compliance.
I will cover an explanation of the company’s proposal to increase the number of authorized common shares from 50 million to 100 million to be considered by our shareholders at our May 28 annual shareholders meeting and then finally, I will cover the company’s actions to date and process to address the challenges with our existing debt leverage and capital structure.
Tom will then come back to conclude by providing our performance guidance for 2008, which will include a range of sales, our balance of year expectations for restructuring and integration costs and restructuring savings, and a range of expected EBITDA. It will be per the definition in our credit agreements.
Finally, we will close by taking your questions. Before we begin our detailed discussions, I would like to cover a couple housekeeping matters. First, we now report our business in two segments with Pantone operating as a separate business unit. Specifically, the core X-Rite business will be reported as color measurement and Pantone as the color standards business. It is possible that we will back to one business segment in 2008 or 2009 since the core X-Rite business and Pantone are being integrated extensively in terms of operating systems, sales, marketing, etc.
In our call today, we will communicate pro forma sales by quarter in 2007 with X-Rite, Amazys and Pantone all included. In these numbers, we have eliminated inner company sales from X-Rite to Pantone from the beginning of 2007 up to the October 24, 2007 acquisition date for Pantone. We will not communicate pro forma EBITDA or other income related metrics by quarter in 2007 with Pantone results from the beginning of 2007 up to the October 2007 acquisition date added into the X-Rite results. As Pantone was a privately owned business prior to the acquisition, we believe that inclusion of 2007 expenses for pro forma purposes would not be meaningful. Pantone’s results are included in those of the company’s since the acquisition date.
Now, I send it back to Tom for his portion of the review.
Thomas J. Vacchiano, Jr.
Before addressing our Q1 performance highlights, I want to assure all the stakeholders in the company that management with our advisors is working diligently to successfully navigate to the current situation. We know the solution is rooted and continuing to improve on our historically strong business performance, which has traditionally generated substantial profitability and cash flow, while at the same time making smart decisions about our capital structure.
I would like to take a moment to review X-Rite’s rationale for the Amazys and Pantone acquisition. We believe that the business for color is expanding well beyond the traditional mission critical application to really anywhere where color is important. To take advantage of these new opportunities, we believe the scale, knowledge, technology and brand power of this combination of companies is very significant.
We are even more convinced today in the strategic value of this combination. These acquisitions extend our global reach across the largest customer base of anyone in our industry. It increases our market segment leadership to nearly every segment we play in. It provides significant cost synergies which were already being recognized in our P&L and it extends our ability to provide new product innovations through both exceptional market know-how as well as the biggest engineering spend in the industry. Our job is to consistently and effectively execute against the strategy.
To date, our efforts have been primarily focused on integrating these three companies and achieving the cost synergies and fortunately, we have been tracking reasonably well against those projections. We acknowledge that sales synergies and new product innovation are yet to be delivered to the extent intended.
However, we are now clearly the leader in the complete value chain of color-based solutions from color inspiration to color measurement to color communications and color formulations. We really represent the full range of color-based management solutions. New product innovations like Color Monkey Photo and Color Monkey Design are just being launched with more new products in the pipeline. New OEM customer projects are in process that can take color management far beyond our traditional sales models. The potential is real.
That said we recognize that the financing models for the two acquisitions and the sales slowdown in our business in the first quarter, in a tough economic environment for 2008, has resulted in a challenging level of leverage on our balance sheet. Lynn will explain some of the specifics of our credit situation in a few minutes and our current efforts to address the leverage on the balance sheet, along with our 2008 business performance. These are two very important priorities for us.
I would now like to speak to our Q1 business performance and in the process, also outline our top priorities for the year. In this discussion, I will refer to sales results in Exhibit 1 and P&L results in Exhibit 2, which were sent out as a part of our press release. Our sales slowdown that we experienced really has become in view in Q1 2008 and it led to our April 3 press release reporting that we expected our sales would be down approximately 3% in Q1 2008 on a pro forma basis compared to Q1 2007.
X-Rite Q1 2008 actual sales results have come in at $65.9 million just at the top end of our estimate of $64 million to $66 million. Comparing Q1 2008 versus Q1 2007 pro forma combined sales results, X-Rite core business sales were down 3.2%, Pantone sales up approximately 1% or 0.9% and X-Rite and Pantone combined sales down 2.5% year over year on a comparable pro forma basis. Adjusting for currency effect, X-Rite and Pantone combined sales were down roughly 6.8% in the quarter versus prior year.
I would like to now address our sales performance by major market and product category as well as geography. After reported sales growth of 10% in the total year 2007, the imaging and media business unit or business segment fell off in Q1 2008 by approximately 7.3%. The fall off in sales growth was generally broad-based in the segment with OEM sales, the pressroom segment, the imaging sub segment, all struggling with flat to declining sales in the period.
The OEM sales rate was influenced by two things. First, a reported general slowdown in some of our large OEM partners as well as our own lack of success in earning new design wins for incremental projects as fast as expected. While we have some exciting projects in the pipeline, the timeline for revenue realization has been slow to materialize and something we are working on over the balance of 2008.
Our pressroom business appears to be suffering from accommodation of economic uncertainty, DRUPA timing which is the major pressroom show that occurs every four years beginning at the end of May and first week of June, and our new product innovation success rates.
We do see some cautious optimism by some of our major accounts surrounding DRUPA sales activities and we are of course, focused on addressing our new product realization issues to get a new product that we released recently with a faster adoption rate or getting new products into the market as quickly as possible. We are focused on addressing a number of the related issues with both small, medium and large accounts in the space.
The imaging or creative category of our business including selling into photography markets has also suffered a slowdown in this period. We believe that slowdown is primarily driven by new product releases and we believe that is the most important area we can address.
Fortunately at the end of March, we announced our new product family, TeleMonkey, which does directly address some exciting new products in both the photography space and the graphic arts designer space. Early reactions in April in the market for this product are very encouraging.
The industrial business continued to build on its momentum in 2007, where we began to show a low single digit growth over 2006. Q1 2008 sales growth was approximately 6% and driven by strong sales in both North America and Europe. It is difficult to predict however given economic uncertainties we face, if these growth rates will be sustained during the year.
In addition, our Asian sales performance for industrial solutions will be a key factor going forward as they suffered in Q1 because of the well-publicized safety issues around toys containing lead paint or lead content and food with various safety issues. These industries suffered and affected our industrial sales in Asia in the first quarter. A key new product introduction in the automotive phase later this summer, we do think will play an important role, not only in our growth later in the second half of 2008 in industrial, but even more so in 2009.
Our retail medical business also took a turn down from last year’s reported 6% growth over 2006. In Q1 2008, sales were down 12% versus the same period last year. This was driven exclusively by the retail business, as the medical business grew primarily based on our new dental program.
The retail segment suffered from a combination of a slowdown in new store openings and store refurbishment, a firmware bug which delayed shipment of our Matchstick products and the need for the next generation paint-matching system which was expected to be delivered later this year or early next year. We have solved the firmware problem with Matchstick and we have come up with some tactical programs to attract new paint matching opportunities. We do expect to struggle this year or much of the year anyway with very much growth in the retail segment.
Color standard segmental or Pantone sales did grow 0.9% in Q1 on a pro forma basis versus the same period last year. They enjoyed year-over-year growth in both their core standards products in graphic arts as well as fashion and apparel. Their color management instrument business or sub-segment business was down this year versus last year. That came together to represent a basically 1% growth year to year in the quarter for that business.
New products including Color Monkey Design are expected to help the color instrument or color management instrument part of Pantone’s business. We are more optimistic that Pantone can have better growth over the balance of the year than even our first quarter.
Geographically, we continue to have a mix of sales trends that are influenced by many factors. Americas sales were down for the quarter by 4.5% driven primarily by our retail business I just spoke about as well as our I&M performance. Europe was up about 4.5% in the period, but they were helped by our currency.
Asia was down 11% and this was heavily influenced by the safety issues I mentioned in both the toy and food industries which were an important part of our industrial market as well as a reduction in our printing business there, largely driven by a single large customer. Our geographic contribution in the quarter representing this makeup, Americas 36% total revenue, EMEA 46% of total revenue and Asia 18% of total revenue.
Now I would like to turn to our key priorities for the company in 2008. Obviously addressing our financial leverage situation is an important one and Lynn is going to speak to that specifically. We obviously need to execute our restructuring plans to meet or exceed our estimated cost savings. We are ramping up our new product innovation and new product launch scheduled this year.
We obviously need to ignite our sales and outbound marketing performance to keep our growth engine going in a better direction. We are working on driving efficiencies in our supply chain and manufacturing model to both reduce cost as well as improve our asset utilization and inventory turn. We are also working on a number of new programs already put in place or starting to be put in place in the area of improving our cash and working capital management.
Then finally, we of course need to retain and support our high-performance team because at the end of the day without their knowledge and passion, we will not be able to achieve either our short-term or long-term strategy. With two large acquisitions in the last two years, restructuring costs and restructuring synergies have been a major topic of both our work focus and our communications to our investment community. As we have communicated on our last earnings call, adjusting for currency impact, we have achieved the Amazys acquisition cost synergies by the end of 2007 that were expected by mid 2009, roughly $25 million.
We have also communicated that the cost synergies related to the Pantone acquisition are expected to be approximately $6 million and would be achieved in the 2008-2009 timeframe. Due to the overlapping business integrations and because the companies announced a much larger restructuring plan on April 3 of this year in response to our business slowdown, we are treating our restructuring plans as [spongeable] costs in terms of their execution and will communicate going forward in terms of a total company restructuring cost target and total company restructuring savings. We identify our potential restructuring savings by comparing our budget before and the budget after with the restructuring actions therefore will be able to clearly identify and track our progress. On April 3, we announced a total of $23 million of restructuring cost savings expected to be realized from Q2 2008 through Q1 2009 including $7 million of previously announced synergies from Pantone and Amazys.
To be more specific, we are expecting to realize $18 million of incremental cost savings in the next 3 quarters of 2008, Q2, Q3, Q4 and a total of $23 million of cost synergies including Q1 of 2009. I will communicate how this affects and how it is influenced in our 2008 guidance, EBITDA guidance in a few minutes.
Per Exhibit 2 attached to the press release, we had restructuring integration costs of $1.4 million in the first quarter of 2008 and we expect an additional $5 million to $6 million of restructuring integration costs in the balance of 2008, most of which was recognized in Q2 2008.
Regarding this latest restructuring plan with $23 million of annualized cost savings, approximately 70% of those cost savings are head count and head count related and were substantially triggered and executed in the first couple weeks of April. This restructuring plan was designed and executed with a high sensitivity to our R&D efforts and our sales efforts which we believe are vital not only to our short term prospects but our longer term prospects for the business. There will be some narrowing of focus of course in our sales, marketing and R&D efforts, but we do not feel it will be a material impact on our short-term sales efforts.
As we successfully address both our existing business performance issues and capital structure challenges, we will revisit programs that will have sort of a medium to longer-term effect on our overall business. The Amazys integration with X-Rite has totally been challenged to achieve the alignment and focus we needed in our product development process. That said, much of the background work in organization, process and technology choices has been placed and is started to yield tangible results.
The Color Monkey release at the end of March is one example where we have a very high level of new product innovation and are excited about future sales prospects. On the sales and marketing front, we just announced some important organization and leadership changes we believe will work well for us in 2008 and beyond. We have put selected top performers from our core color business and Pantone business into key new positions and responsibilities for our channel sales, medical and dental sales and retail sales and OEM sales.
We have also named a number of key employees to lead and provide new leadership positions in our worldwide outbound market organizations and they will be focused on expanding market awareness, creating market excitement and creating more market demands in support of our sales efforts.
Of course, most importantly, sales organizations thrive on new product innovations. Here, we will continue to build on a number of new product announcements that we believe will clearly energize our sales force looking out over the next 2, 3 or 4 quarters and beyond. On the supply chain and manufacturing front, we have advanced on a number of initiatives around plant consolidation, outsource design and manufacturing, but we realize we have more to do.
Teams are currently working on or being formed to work on expanding to achieve fully the kinds of efficiencies and effectiveness that we look for both in our announcement with the Amazys integration as well as the Pantone integration. An example of one such initiative is a team that we put in place to completely reinvent our global freight and distribution model, where we hope to achieve as much as one full point of gross margin improvement over the coming twelve months.
We have also recognized that we can improve our inventory turnover which will benefit both our cost model and our cash flow model and a team has aggressively begun work in this area. We expect to show measurable progress quarter to quarter over the next 3 to 4 quarters on our inventory turned and our cash employed in the area of asset management.
Of course to achieve our 2008 plans and beyond, we need to retain and support our talented employee workforce. Fortunately, X-Rite is blessed with a workforce that has demonstrated a passion for our customers and the business of color has been tremendously loyal over the last many years and has broadly expressed their ongoing belief in our company.
While change does create anxiety in the workforce, it also creates opportunity. In the last few months, we have had a number of exceptional performers in our business take on new or expanded responsibilities and bring a level of energy and imagination to our company and our colleagues, which is really helping out the situation.
I would now like to pass the call back to Lynn.
Lynn J. Lyall
I am going to discuss a range of topics related to the company’s financial condition, liquidity, working capital management, the credit agreements with our first and second lien lenders and the company’s efforts to reduce the financial leverage on the balance sheet. Before doing this, I want to complete the discussion of the first quarter income statement with the review quickly of the gross margin and operating expenses.
Our adjusted gross margin excluding certain Pantone acquisition-related purchase price adjustments and integration costs was 59.8% in Q1 and it was comprised of 57.7% for the color measurement segment or X-Rite without Pantone and 69.5% for the Pantone segment. The Pantone segment was aided by product mix and we do not expect gross margin to continue at this level for the full year.
The gross margin for the X-Rite segment was hampered by the soft first quarter volume and product category mix. We are not satisfied with our X-Rite gross margin performance; we have plans underway to improve that gross margin including pricing actions and improved cost management. We expect the product mix also to adjust back somewhat for the full year.
Operating expenses in the first quarter, excluding the restructuring costs while negatively affected by foreign exchange rates, were $800,000 lower than Quarter 4 of 2007. They would have been approximately $2 million lower than the fourth quarter of 2007 if we had compared against our pro forma combined operative census with Pantone included for all the fourth quarter of 2007.
The restructuring announced on April 3 is expected to impact our EBITDA results starting in Quarter 2. The restructuring costs will offset some of the cost-saving benefits in operating income but they will not burden EBITDA per the definition or credit agreements since restructuring costs are an add-back item.
Now I would like to go back to the topic I referred to a moment ago. First, I will start with a discussion with key items on our balance sheet and key changes since 2007 year-end. Cash decreased from $20.3 million at 2007 year-end to $18.4 million at the end of the first quarter.
Our borrowings with the first and second lien lenders increased $9.8 million during the quarter from $389.7 million at 2007 year-end to $399.5 million at the end of the first quarter. Pursuant to GAAP accounting, all of the debt with our first and second lien lenders is being shown in our 10-Q for the first quarter as a current liability at the end of the first quarter, due to the covenant defaults that occurred relative to this debt during the quarter. This GAAP accounting treatment will continue as long as there exists defaults that could lead to this debt become due within the next twelve months.
For the first quarter, EBITDA as defined in the credit agreements was $13.2 million. We have included a reconciliation of net income to EBITDA per the credit agreement for Quarter 4 of 2007 and the first quarter of 2008 with Exhibit 3, which was attached to today’s press release. Despite $13.2 million of EBITDA in Q1, our cash balances decreased $1.9 million during the quarter and we borrowed an additional $9.8 million under the first lien line of credit. These three items in total called for an explanation of where $25 million of cash outflow occurred during the quarter.
The key cash outflow items comprising the $25 million use of cash were capital expenditures and capitalized software costs of $2.2 million, restructuring and integration payments of $2.6 million, interest payments, $9.8 million and investments in key working capital items of approximately $13.8 million.
Similar to previous years, X-Rite’s largest sales quarter is Quarter 4. The impact in the subsequent first quarter is a cash outflow with declines in accounts payable, accrued payroll and benefit plans, which is largely year-end bonuses, sales commissions, and other accrued liabilities. These items explain the most of the $13.8 million cash outflow in Quarter 1 and due to key working capital items. In addition, accounts receivable actually declined $1.9 million during the quarter and inventories net of the Pantone purchase price accounting increased $5.6 million during the quarter despite soft sales.
The declining U.S. dollar relative to the Euro and the Swiss franc added $2.8 million of accounts receivable and $2.3 million of inventories during the quarter. Improved working capital management is one of our key priorities in the company. The company has been consistent with 57 days to 60 days of accounts receivable globally and we are working hard to avoid any slippage of those receivables in a more challenging economic environment.
To date, the company has paid its vendors with net 30-day terms and we have started in April to work with our vendors globally to get our accounts payable terms in line with our receivable terms. In April, we are beginning to have success with these efforts with our vendors. As Tom has explained, another of our top priorities is to improve our supply chain efficiencies and coordination.
Next, I will try to explain the key default conditions with our first and second lien lenders that occurred during the first quarter and the status of our current ability to draw down in the first lien line of credit. The company has not defaulted in any payment obligation for the first and second lien lenders. The company is required within 45 days after each year end to supply the budget for the following year with a quarterly income statement, balance sheet, cash flow statement, statement of changes of equity and a signed certificate showing compliance in all 4 quarters with each of the 4 financial covenants which I will explain shortly.
The supply of this budget was not done triggering a default with the first and second lien credit agreements. By the time the company could finalize their budget and assess its first quarter performance, it became apparent that noncompliance with one or more of the financial covenants sometime during 2008 was possible.
Therefore, the company could provide a 2008 budget but could not meet the requirements of the compliance certificate. The company is obligated under the credit agreements to enter into interest rate swath agreements to fix the interest rates on 50% or more of the company’s total indebtedness.
The company chose in December 2007 to add four swath contracts to three previous swath contracts related to the 2006 Amazys financing and fixed the interest rates on approximately 87% of the company’s total indebtedness. The swath agreement with Goldman Sachs gives Goldman Sachs the right to terminate these agreements and demand payments for any related liability if the company credit rating declines. Our credit rating declined one notch in March.
As we are closing the books for the first quarter, we received word that Goldman Sachs was considering its right for early termination and demanding payment. This termination of the swath contracts essentially creates a liability for the present value of the difference in the fixed interest rates and the floating interest rates as LIBOR had decreased since the contracts were entered into. After discussions with Goldman Sachs, the company terminated the swath contracts and fixed its liability at $12.1 million.
The termination of the Goldman Sachs swath contracts creates the second major default under the credit agreement. We are currently in discussions with the lead banks on the first main credit agreement to enter into arrangements that will satisfy the requirement to hedge the interest rates on 50% of the company’s total indebtedness.
Along with finalizing our financial results for the first quarter in April, we also finalized our first quarter covenant calculations. With today’s press release, we included Exhibit 4, which summarizes the first and second lien covenant calculations for the first quarter. I should point out that Exhibit 4 includes stipulated amounts for adjusted EBITDA for the second quarter and third quarter of 2007, since some of the ratios are twelve-month trailing ratios and the covenants are first tested with the first quarter of 2008. Also, there is a formula for annualizing cash interest during the first twelve months since the Pantone acquisition.
Lastly, I should also point out that per the credit agreements, the mortgage liability and interest expense related to X-Rite’s former headquarters building, which is being marketed for sale, were excluded from the definition of total debt and cash interest expense. For the first quarter, the company satisfied the four financial covenants with the first and second lien lenders with the exception of the leverage ratio under the first lien credit agreement. For Q1, our leverage ratio was 6.47 and the required first lien leverage ratio was no greater than six.
I should also point out, given our current outlook for the balance of 2008 and given the increasingly challenging covenant ratios in the balance of 2008, it is possible there would be additional financial covenant noncompliance in future quarters unless the covenants are amended. Therefore, we have a top priority now to amend our credit agreements including the required covenants. We are also exploring alternatives to manage the company’s financial leverage.
At the end of the first quarter, the company had a $14.8 million unused first lien line of credit. As a result of the covenant defaults, any and all requests for further draw down of this line of credit must be approved by first and second lien lenders.
The following is the current status of the company’s efforts to amend our credit agreements and reduce the financial leverage on the company’s balance sheet: first, the company has engaged RBC Capital Markets as a financial advisor to assist with our efforts to explore options to reduce the financial leverage on the balance sheet. We and our advisors are deep into discussions with our lenders.
While the amounts cannot be gauged at this time, we are expecting incremental fees, incremental interest charges, though we also recognize that the credit markets are more expensive now than when these credit agreements were entered into in the fall of 2007. As I stated earlier, any incremental fees are not included yet in our EBITDA guidance since we do not know the amount or nature of these fees.
Currently, the company has 17.4 million shares of common stock that are authorized but not issued. The company is requesting the shareholders to approve an increase in the number of authorized shares of common stock from 50 million to 100 million at the May 28 annual shareholders meeting.
The additional shares will be available for issuance from time to time including for raising capital though the sale of common stock with convertible securities in connection with a stock split or dividend as consideration in connection with acquisitions and for attracting and retaining valuable employees and directors by issuing additional equity-based awards.
While the company is currently considering the company’s capital structure and various financing alternatives, which may involve issuance of common stock or convertible securities, the company has no formal commitments to issue any additional shares at this time. The company will determine whether, when, and on what terms the issuance of shares may be warranted in connection with any of those purposes.
Any share issuance or other transaction will be conducted in accordance with applicable legal and regulatory requirements including approval by the shareholders where required. In terms of timing, we are hopeful that forbearance agreements can be in place with both our first and second lien lenders in the very near future and that our shareholders will authorize the increase in the number of common shares at the May 28 shareholder meeting.
We are also hopeful that we can agree on the best solution to reduce the company’s financial leverage during May and if shareholder approval is required, seek shareholder approval at a meeting subsequent to the May 28 meeting.
Tom, I will give it back to you for the 2008 performance guidance.
Thomas J. Vacchiano, Jr.
Specifically, there are three areas where we will provide guidance, 2008 sales, balance of year restructuring savings and restructuring costs, and 2008 EBITDA for the definition in our credit agreement and as defined in Exhibit 2 for our Q4 2007/Q1 2008 results attached to the press release.
In terms of 2008 sales or revenue outlook, we remain cautious about our growth given the various integration dynamics we are dealing with and a difficult economic climate. Some of our businesses do have exposure to various consumer-end markets and all businesses directly or indirectly seem to be impacted by the difficult global credit market and economic situations. We are trying to be cautious and conservative in our outlook.
Our 2007 pro forma combined sales for X-Rite and Pantone were approximately $283 million. For 2008, we are currently seeing a sales range of $272 million, which would represent a 4% decline versus prior year on a pro forma basis and $286 million, which would be up approximately 1% versus a prior year on a pro forma basis. While we are enthusiastic about some of the new products we are launching this year, we believe it is important to remain cautious given the uncertain market conditions.
In discussing with many of our dealers, OEM’ and partners, everyone seems to be taking a cautious perspective. This sales guidance is subject to the assumption that we will not experience material sales disruption, which is very difficult to quantify due to the negative publicity of our current credit situation. I have communicated a few minutes ago that we are expecting $18 million of restructuring savings in the next three quarters for 2, 3 and 4 of 2008, for a total of $23 million when including Q1 2009. I have also communicated that we expect to incur approximately $5 million to $6 million of restructuring integration costs much of which will be seen in Q2 of this year.
Remember that restructuring costs are an add-back item per our EBITDA definition with our credit agreement. I should caution for purposes of this restructuring guidance for purposes of EBITDA guidance - that I will discuss next - it is too early to gauge the amount of incremental costs, X-Rite’s financing cost, advisor fees, legal fees, etc. that we will be obligated to pay related to the current negotiation and situation with our first and second lien lenders, and of course the work we will do to try to address the level of leverage we have on our balance sheets. Depending on the nature of the fees, they may or may not impact our EBITDA results for 2008 since they may or may not be add backs. For now, guidance for restructuring cost and savings and for EBITDA excludes costs related to any financing discussions or any change in the company’s financial structure.
At the present time, we expect X-Rite’s 2008 EBITDA for the definition in our credit agreement to range between $60 million and $68 million for the fiscal 2008 year. I would like to close by restating our key 2008 priorities. We are focused very much on addressing our financial leverage. We are focused very much in executing our restructuring plans to equal or exceed the commitments we have made to the markets and to our bankers and lenders. We are working very much in ramping up our new product innovation pipelines and releasing new products this year. We are working with our outbound sales organizations and our worldwide outbound marketing organizations to keep the energy and excitement up out in the marketplace, to keep our sales going in the best possible way in a difficult economic environment.
As we mentioned, we are working to drive more efficiency and more costs out of our manufacturing supply chains model and turn our assets more quickly to support our cash management goal. We are obviously working with the financial organization on payables, receivables and other actions to improve our cash flow. Finally, we are working to retain and support our high performance team so that they continue to exercise the possibilities with their know-how and their passion to serve our customers and help us address the opportunities we see in 2008 and beyond.
In closing, I would like to remind everyone that X-Rite’s position as the leading global provider of color management solutions remains intact. Our business model is strong and our strategy is compelling. We fully expect to work our way through our current issues and we appreciate your support to join us in this ride.
Now, I think we will stop and take questions.
Question-and-Answer Session
Operator
(Operator Instructions) Our first question comes from Chuck Murphy - Sidoti & Company.
Charles Murphy - Sidoti & Company, LLC
Could you elaborate a little bit, any impact you are seeing on your ability to execute due to the debt levels and as you mentioned in the press release, the negative publicity?
Thomas J. Vacchiano, Jr.
I will tell you that so far while there have been many dialogues with varying degrees of sales management and executive management with small, medium and large customers; we have not seen what we would consider a dramatic or material fall off in business as a result of the situation.
I know personally I have talked to a number of our largest accounts. They are obviously concerned that we get our balance sheet and capital structure sorted out as quickly as possible with our lenders, but there is a strong degree of support and loyalty based on our scale and our historical performance of strong gross margins, strong operating margins and strong cash flow. I think there is a willingness and a wanting to believe in us, support us, and help us get through this process.
I would think that is also not only true for dealers, partners, OEMs and customers, but even from the employees’ standpoint, there is just a huge amount of support of people feeling the pain of course, but wanting to do what they can to get us through this storm. I think most people believe as we get through this storm, we have such a strong market position. We have such a historically strong business model and the opportunity for the business of color is expanding, growing and changing. I think most of the constituencies we talk to believe in us and the opportunity and want to help us be successful.
Lynn J. Lyall
Our vendors have also been very helpful in the U.S. in particular. We have been successful in the last month taking almost every single vendor from net 30 to net 60. They were quite willing to work with us and understood the situation and conflict we had between our receivables and payables. It is a little more lengthy process and a little more challenging in Europe, but in the U.S., we have made a huge headway on that front as well.
Charles Murphy - Sidoti & Company, LLC
Just to kind of go through again your general feelings on the sales trends. I know you gave us a lot of information. If you kind of had to pinpoint an area that is particularly slow right now, which would it be?
Thomas J. Vacchiano, Jr.
The things we are concerned most about when you talk about a slow down in the global economy are big accounts. The guys through the big retailers in North America that account for a pretty substantial part of our business as you know and whether or not that business will soften by 5% or 10% or more, then the large OEMs that we count on. In fact, we are tracking their business whether they are big press manufacturers like Heidelberg or Komori or whether they are technology partners like EFI, Hewlett Packard and so on. We are talking to them on a regular basis to try and get a sense for how their business is going. It is the big guys that can hit you with $1 million or $2 million in a quarter and for us $1 million or $2 million down in a quarter is material.
Charles Murphy - Sidoti & Company, LLC
I guess to put it bluntly, they probably do not have a whole lot more options on where else they can go to get this type of equipment, right? They may not need it necessarily now but they are going to need it at some point in the future.
Thomas J. Vacchiano, Jr.
I will tell you that we do not believe we have lost any market share. We do not think this is about market share. We think this is about a temporary contraction associated with some pretty ugly market conditions in various areas. I am unaware of any material loss that we have had to a competitor.
Charles Murphy - Sidoti & Company, LLC
Can you give us an update on where you stand in selling the former headquarters?
Thomas J. Vacchiano, Jr.
As I think we have talked about before, we signed what was loosely called a Purchase and Sale Agreement back in December. It was really an option to buy which gave the developer the opportunity to do due diligence over a course of 120 days, which actually ended just the first week of May. Also, reviewed our ability to get the town council or city government to approve the various elements of the development plan so that it met needs of the county.
Then, actually gave them an opportunity for an additional twelve months to then line up the various retail stores and other companies that would come into the development. Last week, there was a milestone for that company to start putting more money into the program. They actually asked us last week if they could sort of rework the purchasing sale and options, which basically meant they wanted to take more time because of the slowdown in economic situations and not pay us what they were committed to pay us too.
Because of what we have had some interest by some other people in the property, in fact we have received just in the last couple weeks - I would say a draft letter of intent for some other interested parties. We decided to hold the line on the first vendor. They have been executed – a sort of a cancellation – of their original purchase and sale option in December. Now quite frankly, we are looking at some other options including this option going back to the table and renegotiating what we think will be a more timely and better option by having more than one person locked in with a twelve-month window.
Operator
Your next question comes from James Ricchiuti - Needham & Company, LLC.
James Ricchiuti - Needham & Company, LLC
The cost savings you guys have talked about, the $18 million or so, can you give us some sense as to how we should think about that in terms of those areas of line items. It looks like you are still going to be spending a fair amount in engineering.
Lynn J. Lyall
The breakout is reasonably balanced between sales marketing R&G and G&A. I am not going to give you very specific numbers today. We may decide to do that in our next call. I will tell you that about 70% is head count and head count related and most of that action is tangible, it has been executed and we know that we are going to see a good portion of our $18 million as early as Q2 as of course Q3 will be a really big impact as well.
We are very confident that we are going to deliver against that $18 million as we have in cost synergy savings over the course of the last 18 months. You will see a mix of sales marketing R&G and G&A for that $18 million and cost of goods sold. Absolutely.
James Ricchiuti - Needham & Company, LLC
Lynn, I believe you gave a gross margin percentage for the color measurement business. I wonder if you could just repeat that.
Thomas J. Vacchiano, Jr.
We did. It was around 7.7%, it was roughly 58% which is down a little bit from our expectations. That included drivers including volume. Our first quarter volume was one of the lowest volumes for our color measurement business we have had in the last 5 quarters. Volume affects us because of our plant, PP&E and when you have volume, we have an effect in terms of absorption in the first quarter. That always helps us in the fourth quarter, hurts us in low-volume quarters.
We also had some mix issues. For example, retail, particularly retail paint matching systems, is a very good business for us from a gross margin standpoint. That was off quite a bit versus prior year. We also had in Q1 last year some exceptional non-recurring engineering payments in the first quarter last year, which we had some this year but they were not nearly as good. That comes through the gross margins at very high gross margins. Those are the three biggest elements for our gross.
Lynn J. Lyall
Lastly, the currency [inaudible] helped us on the sales side this year against the Europe currency. It hurts us on all the cost sides. It even hurts us in the cost of goods sold.
James Ricchiuti - Needham & Company, LLC
Tom, in the past couple of quarters, you have actually had some decent strength in the retail paint matching business in Europe. It looks like that might have slowed as well in the quarter.
Thomas J. Vacchiano, Jr.
Well, it did slip because of the firmware problem with the Matchstick. The Matchstick sales have been just wonderful for the last 5 or 6 quarters in Europe primarily. We think that business is going to continue to be a growth driver but we unfortunately could not ship what we expected to ship in March because of a firmware problem. We have resolved the problem and we do expect our Matchstick sales in the second quarter to be better.
Operator
Our next question comes from Vincent DeVito - CIT.
Vincent DeVito – CIT
Can you tell us the current inventory on hand and have you done any count or is there any obsolescence or write downs that we should expect?
Thomas J. Vacchiano, Jr.
The current turns that we have are reasonably poor. We have set up a program in which we are going after a reduction in gross inventory and net inventory from our Q1 market position of between $7 million and $9 million. We have a quarterly target for that.
Basically, we see that we can get that $7 million to $9 million of gross and net inventory reduction in all three areas, finished goods because of some changes we are going to take in the area of our global distribution models, work in process inventory because we are going to change some of our manufacturing processes as well as some practices in raw materials based on some new approaches we are going to take with our forecast demand and stocking levels.
We are going after $7 million to $9 million this year, both which will affect gross and net. Perhaps we have even more opportunities as we start clearing the program. I am unaware today of any specific new OEM risk. Most of the inventory buildup occurred in Q4 and Q1 and because of that, those would be inventory that would be relatively fresh products since a lot of it came in through Q4 and Q1.
We do continually review our excess and obsolete every quarter. We did a physical in [Reagenstorf] back in the October/November timeframe. We did some clearing of excess and obsolete inventory at that time. We will continue to stay diligent on looking at inventory turns by product and by category to make sure we deal with that as quickly as practical.
Vincent DeVito – CIT
When you look at that $7 million to $9 million target, are you reducing pricing on product or is that how you plan on achieving that?
Thomas J. Vacchiano, Jr.
No, it is pretty straightforward. Basically, a part of it is looking at what our safety stocks need to be and what they are today and simply backing down on our manufacturing and purchasing for certain products. The second thing that we are doing is we are actually changing our models so we bring in less stock earlier so we have actually a shorter band between something coming in the door and something going out the door in terms of raw, ripped and finished. Those are the two major initiatives we have underway to maturely reduce our gross and net inventory.
Vincent DeVito – CIT
What was the balance currently? I know it was 62 at year-end. What is it today?
Lynn J. Lyall
The inventory at Q1 was – I am going to exclude the Pantone purchase price accounting number – that is 8,972,000 if you take that out, the inventory at the end of the first quarter was $54,646,000.
Vincent DeVito – CIT
I think you commented there was $14 million, approximately $14 million invested in working capital.
Thomas J. Vacchiano, Jr.
When I was saying that, I was selecting key operating elements of working capital. I was excluding things like anything that is tax-related, financing related, deferred financing costs, items like that. I was basically taking our receivables, our inventory, our prepaids and other current assets, our payables and with the accrued items, liabilities, I was basically taking our payroll and benefits and other. I was ignoring anything taxes, derivative financial instruments, interest, and things like that.
Those other five or six items I mentioned, that is really what is behind the working capital ship. That is really where the cash flow…you either benefit or you get hurt by it.
Vincent DeVito – CIT
Do you see working capital needs on a go-forward basis?
Thomas J. Vacchiano, Jr.
I see an opportunity with payables and we are already starting to get it, since the first quarter. Our cash is up. I will not get into specific numbers but our cash is increasing. Our payables are increasing. It is a little difficult to compare it against our year-end numbers because they already held everything at year-end every year for some checks runs and stuff to a little cosmetics I’m sure at the end of the year.
At the end of the quarter, we started in the last week or two of March, to really manage our accounts payable much more aggressively. We have continued through April so the cash has increased since the end of the quarter. Payables is increasing. We are hoping there is some real benefits on that side.
The other major item is receivables. Actually, the company is not too bad relative to its terms globally. The challenge is to hold it and then try to improve it somewhat. Receivables are pretty well managed. It is the payables and inventory that is where the opportunity areas are in the company.
Vincent DeVito – CIT
The $18 million in restructuring savings is inclusive in your EBITDA guidance, correct?
Thomas J. Vacchiano, Jr.
Correct.
Operator
Our next question comes from Steve Lemmer - Volt Capital.
Steve Lemmer – Volt Capital
First of all, what is the status of the payment you need to make Goldman with regards to the cancellation of the swath? Was that done after the first quarter was over and if it was, was that funded out of cash? What is the basic status of that?
Thomas J. Vacchiano, Jr.
There is no funding. The funding… basically the liability has been demanded for payment. We basically have a liability that is sitting there. We are working on talking with them to agree a payment plan. At the same time, we are working with our first lien to replace those interest rates swaths whether we will probably do some time of interest rate cap, something much more affordable, we think better-fitting for our current situation. We can meet effectively that requirement under the credit agreements, but as it stands, that liability is out there and will be resolved in the context of the company’s broader financing efforts here going forward.
Steve Lemmer – Volt Capital
So there is no imminent need to make cash payment on that, it is something that basically as you restructure, the whole balance sheet will resolve itself with that? Is that correct?
Lynn J. Lyall
Just as we are working with the first and the second lien, we are working with the Goldman Group as well to come up with a program that works for all parties.
Steve Lemmer – Volt Capital
Then, also with respect to the guidance that you gave, it looks like the guidance you gave would put at least one adjusted EBITDA covenant if not also the interest coverage covenant in default by the end of the year. How are we to look at that, that the guidance is essentially -- it seems more imperative than ever that the debt gets restructured with the guidance puts in a worse position?
Thomas J. Vacchiano, Jr.
I think you are exactly right. You are seeing the specifics behind our comment that we believe there is a strong likelihood that we would violate another covenant. In particular, the two that are challenging at the leverage ratio are total debts by EBITDA. The interest coverage number is fine for the year and today, we do not see any problems with capital expenditures.
It is those two primary ones, the leverage in EBITDA and then if you take the top-end of our range at $68 million, that comes short of the number which I believe is $72.5 million. I would have to look at that schedule by the end of 2008. Coming back to the imperative that in the discussions with our first and second liens and any type of consideration on de-leveraging the balance sheet, we have to resolve those covenants as well.
Steve Lemmer – Volt Capital
You did mention you hoped to increase your authorized shares. Is that the direction you guys are leaning as far as re-capitalization issuing more equity or are you prepared to comment on that at all?
Thomas J. Vacchiano, Jr.
Let me just say that we are working with our first and second lien lenders to obviously revise our covenants as a part of the solution. We also recognize that the degree of leverage that we have on the balance sheet today and in today’s situation, is not healthy.
We are pursuing both with our lenders instead of new covenants and we are also reviewing with our financial advisors, RBC Capital. The appropriate actions that we should be reviewing and taking with our board and with our shareholders to make sure we have a capital structure that is sensible both in the shorter term as well as in the medium to longer term.
Operator
Our next question comes from James Ricchiuti - Needham & Company.
James Ricchiuti - Needham & Company, LLC
Tom, I just wanted to go back to the full-year guidance that you are giving. Can you give us a sense as to how you are thinking about some of these markets? It does not appear that there is much of a recovery in sight in parts of the graphic arts business. It looks like there is quite a bit of caution out there, nor is there much reason to see the retail portion of the business turning. I wonder if you can just comment on how you are thinking about that full-year guidance that you gave.
Thomas J. Vacchiano, Jr.
As you saw, we are minus 4% to plus 1%. We are now 4.5 months into the picture. We are talking to lots of customers, dealers and partners. We are looking at big projects. We are really trying to get a sense for what DRUPA might do in the pressroom in the imaging and media space and as I said earlier, there is some cautious optimism about maybe getting a bump from the DRUPA program which would help us is Q3 and Q4.
What we have tried to do is balance the ups and downs. We looked at the big accounts and we looked at our large OEM project. We tried to come into a place where we felt that we – unless there is some unexpected additional big issue in the marketplace - we tried to come to a place where we felt reasonably comfortable that we could land. Even within the retail space, we think there are some projects that will still go this year.
If you look at the pressroom area, there is still some enthusiasm. Even though the number of presses might slow down, we think the attachment rate for example of our color control system in a slow market could actually bump up. We are counting on the ability to increase our attachment rates, which could be good in the pressroom space. We are excited about the new Color Monkey product and so far, that is generating a lot of excitement and that could help us in the creative side for designers and photographers.
Also, we are taking some pricing actions, selective pricing actions which could also offset some of the downs by increasing prices from 1% or 2% in some cases to maybe 3%, 4% or 5% in other cases. There are tactical items and new product actions that we are taking to try to protect that top line. We are confident that if we can protect the top line, we know how to manage cost and expenses. We can then have a better story on the even or the bottom line.
Thomas J. Vacchiano, Jr.
I think that is the conclusion of all the questions on the line. Again, I would just like to close by thanking all of you for participating and your support of our company. I know that the last several months, particularly the last couple of weeks, have been very challenging for you and for us.
I would just remind you that the market position that X-Rite has is a strong one. The opportunity for the business of color is quite strong and that we believe very much in the business. We are working very hard to get us through this difficult period and begin to achieve a potential that we have all talked about now for several quarters. Thank you all very much. I look forward to talking to you soon.
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