Sonic Innovations, Inc. Q1 2008 Earnings Call Transcript

Sonic Innovations, Inc. (SNCI)

Q1 2008 Earnings Call Transcript

May 1, 2008 5:00 pm ET

Executives

Mike Halloran – VP and CFO

Sam Westover – Chairman, President and CEO

John Kroeller [ph] – Piper Jaffray

Ethan [ph] – Natixis Bleichroeder

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2008 Sonic Innovations Earnings Conference Call. My name is Nakita and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Mike Halloran, Chief Financial Officer of Sonic Innovations. Please proceed, sir.

Mike Halloran

Thank you, Nakita. Good afternoon and welcome to the Sonic Innovations first quarter 2008 conference call. Before moving into a review of the first quarter and our thoughts on the future, I would like to remind everyone that during the course of this conference call, we will offer projections and forward-looking statements regarding future events and the future financial performance of Sonic Innovations. I wish to caution you these statements are just predictions and the actual events or results may differ materially and adversely. I refer you to the documents we filed from time to time with the Securities and Exchange Commission and specifically, the section entitled, "Factors That May Affect Future Performance," included in Part 1, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2007, which identifies important factors that could cause our actual results to differ materially and adversely from those contained in our projections and forward-looking statements.

With that Safe Harbor statement, let me turn the call over to our President and CEO, Sam Westover.

Sam Westover

Thank you, Mike. Good afternoon and welcome to our earnings call. I have been looking forward to this call to be able to show how well our vertical integration initiative has been progressing. First, let's talk about the overall highlights.

Revenue was up 10% in a market that is shrinking 5% at least in March. Gross margin improved from 61% to 64%. This was our best first quarter revenue and gross margin in the Company's history. Let's talk about how our strategy is doing. For a discussion, let's divide the Company into two parts, Company A and Company B. Company A is the venerable, original Sonic Innovations. Company B is the new, vertically integrated operation.

As we have been discussing for the last year or two, our focus has been on developing a vertically integrated operation. These efforts have been very successful and are yielding significantly above-market returns. In the first quarter of this year, 62% of our revenue was from Company B, the vertically integrated operation. A year ago, that number was 49%. In the first quarter, Company B's revenue grew 39% with same-store growth of 23% and operating income increased 50%. So let me say that again. Revenue grew 39% and operating income grew 50%. We are very pleased with the results of our strategy.

We are continuing to make acquisitions. Since our last call, we have acquired $4.2 million in retail revenue. There has been no change in our pricing discipline.

Now let's talk about Company A. We have some work to do here. Our costs are too high and we have some unprofitable business. We are going to be consolidating some of these operations for efficiency. We have also seen some pressure from the economic environment, which we discussed last quarter. This year, we will be eliminating $5.3 million of annualized expenses from Company A. To achieve this, we will be taking a restructuring charge of approximately $3.8 million, $1.3 million of which is non-cash, over the next two or three quarters. We have already booked $565,000 of that amount in the first quarter.

In the old days, we would have taken the entire $3.8 million at once, but under the new accounting rules, we will be recognizing it throughout the year. Most of the charge will be in the second quarter. And these restructuring actions are well underway. By the third and fourth quarter of this year, these charges will be behind us and the corresponding $5.3 million of expenses will be gone. Not all of the $5.3 million will drop to the bottom line because there will be a decline in unprofitable revenue associated with the consolidation of operations. We expect an annualized net positive effect of $3 million plus in operating income.

Late in the first quarter, we launched a new product called ion 400. Ion 400, the newest member of the ion family of products, adds hands-free automatic features to the market's smallest micro BTE. In addition, ion 400 provides excellent moisture resistance. In laboratory testing, ion 400 outperformed all competitive products tested when subjected to extreme moisture and humidity conditions. Ion 400 also offers voice alerts, automatic and adaptive directionality, and a robust adaptive feedback management system.

In April, we launched another product called Velocity mini. The new Velocity mini BTE is the smallest full-featured BTE on the market. The mini BTE extends the premium features found in Velocity into a form factor that offers both open ear and standard fittings, a powerful fitting range, and extendable functionality such as Bluetooth and direct audio import support.

During the second half of this year, we will be releasing between four and seven products. Most of these will be targeted at the new economy. If we continue to see slow growth, we believe that more consumers will be looking for lower priced alternatives. We will launch products that respond to this need. We also have three or four products that are planned for spring release 2009. During the next 12 months, we will be releasing between 7 and 11 new products and we know that new products drive sales.

So, in summary, our vertical integration strategy is working and generating significantly above market returns. Our consolidation of other operations and elimination of unprofitable business will produce strong bottom-line results. Our product offering has never been stronger and we will be launching new products to target the consumer of today's uncertain economy.

After Mike goes through the details of the financials, we will open the call for questions. Mike?

Mike Halloran

Thank you, Sam. Before I get into the numbers for the first quarter, I would like to remind everyone that we sold Tympany, our auditory testing equipment division, in the first quarter of 2007 to a group of independent investors. Accordingly, we have reflected this division as a discontinued operation in our financial reporting. From here forward, my commentary refers to our hearing aid business, in other words, our continuing operations.

As Sam mentioned, we started a consolidation program in Q1 and it will accelerate in Q2 and is expected to be complete in Q3 2008. We plan to eliminate approximately 45 positions or approximately 7% of our workforce from primarily three locations in the Company. The expected costs are $2.5 million in cash charges and $1.3 million in non-cash charges, less than a one-year payback based on the Q4 2007 and Q1 2008 results of these three operations.

I want to highlight the financial impact to the Company in Q1 2008 had the consolidation been completed last year. In Q1 2008, net sales would have been $1.3 million lower; gross profit would have been $0.6 million lower; and our operating expenses would have been $1.4 million lower, resulting in a net improvement of approximately $800,000. These results would have increased earnings per share by $0.03 in Q1 2008, clearly material for a company which has earned $0.03 in its best year. After we had completed the consolidation activities, I believe the Company will be better positioned with significantly less risk.

I expect the second half of 2008 to be very good for the Company and it will show that we can achieve our forecast, excluding one-time items for net income. Sales are expected to be $140 million in 2008, which is approximately $5 million lower from our previous guidance, all as a result of this consolidation and the elimination of unprofitable businesses. The second quarter sales and operating profit is expected to improve over the first quarter of 2008, with the exception of costs associated with our annual AAA convention of about $900,000. Q3 and Q4 will produce substantial earnings improvements.

I will now go through the first quarter in more detail. Net sales in the first quarter 2008 were $31.9 million, up 10% from first quarter 2007 net sales of $29 million. Operations where we are vertically integrated did extremely well, as Sam indicated, having sales growth of 39%, demonstrating the Company's vertical integration strategy is starting to produce the financial results we expect.

By segment, North America first quarter sales of $11.9 million increased $1 million or 9%. We have begun to put new programs in place and plan to launch more products in the third quarter to address the mid- and low-price segments of this market. European sales of $13.1 million increased 3% over 2007 first quarter sales of $12.7 million. We expect our European growth rate to improve after our consolidation activities since we will be eliminating some unprofitable, slow-growing businesses. Rest of world sales of $6.9 million in the first quarter of 2008 were up $1.5 million or 28% from 2007 net sales of $5.4 million. This was a record first quarter sales.

As a preview to Q2 2008 sales, April ended at approximately $12.4 million, which includes approximately $800,000, which we budgeted and anticipated in Q1 2008, but was delayed due to the Easter holiday, and we would expect – we have that coming through in April.

I am pleased with the first quarter gross margin of 64%. There are a number of significant items that helped improve this margin over first quarter 2007, including the effect of the weakening US dollar, cost savings from moving some production offshore, increased vertical integration, and our focus on improving product quality, which lowers our return rates and warranty costs.

Selling, general, and administrative expense in the first quarter 2008 of $18.2 million was up $3.5 million from last year's first quarter level. SG&A expense increased mainly due to $1.9 million growth for the vertical integration, including acquisitions and integration costs, $1.2 million for foreign currency, and an increase of $0.4 million in other areas. We continue to make efforts to control costs and we will continue to do this and particularly with the elimination of 45 positions and the unprofitable business that we have mentioned earlier.

First quarter 2008 consolidation costs of $0.6 million are employee-related severance costs. In the rest of 2008, we expect restructuring costs of $1.9 million of cash charges and $1.3 million in non-cash charges. The non-cash charges primarily relate to goodwill associated with our UK operation.

R&D expense in the first quarter 2008 was $2.2 million, down a fraction over the first quarter of 2007. We expect research and development to increase to approximately $2.3 million to $2.4 million per quarter in the balance of 2008.

Operating loss was $0.6 million for the first quarter of 2008 compared with an operating gain of $0.7 million in the comparable quarter in 2007. Three things drove this change- the severance costs of $0.6 million, softening in North America wholesale sales, primarily resulting from the downturn in the economy, as we discussed last quarter, and European operations that are subject to our consolidation activities. Partially offsetting this is the improvement in those geographies where we are vertically integrated.

Other income was approximately $0.3 million in the first quarter of 2008 compared to $0.2 million in the first quarter of 2007. Q1 2008 was impacted by foreign currency translation gains on our inter-company balances.

We had income tax expense of $0.3 million in the first quarter of 2008 and the first quarter of 2007. I would expect our income tax provision to be roughly $300,000 to $400,000 every quarter in 2008 because the foreign locations driving the tax are profitable and we use a transfer pricing method based on net sales. We have a reserve against deferred tax assets in our Australian operation of approximately $1.0 million, which based on our projections will be reversing sometime in 2008 and most likely the third or fourth quarter.

Our net operating loss carry-forwards are approximately $21.4 million in the US and $13.8 million in the balance of the world. Our loss for the quarter was $0.5 million and excluding severance charges was a slight gain.

The consolidation and the elimination of unprofitable business will improve our forecasting accuracy because of the volatility in those locations subject to our consolidation program. Accordingly, we are lowering the risk profile of the Company and expect to be more consistent in delivering profits and increasing earnings per share. The one exception to this is the North American wholesale division, which requires a heavy investment in fixed costs, thus a small increase or decrease in sales has a big impact on our operating profit.

The good news is our return on our recently acquired investment in vertical integration is yielding positive results. We lowered costs. And the key to driving higher profits in the future will be our ability to increase sales.

Basic weighted average shares outstanding were 26.8 million in 2008 versus 26.1 million in 2007.

Briefly turning to the balance sheet, as of March 31, 2008, cash and marketable securities totaled $14.1 million. Cash flow utilization from operations was approximately $0.6 million in the first quarter 2006 (sic). We reduced our inventory from December 2007 and anticipate this reduction to continue due to a new inventory management approach that we launched recently. New product launches will offset our operational improvements to drive inventory down. Accounts receivable grew this quarter after factoring out foreign currency. And I expect to decrease accounts receivable in the future from additional operational improvements, but offsetting this, of course, will be the increase in sales.

The significant cash outlays in this quarter were large deposits for the AAA show, which was held in the first week in April, of approximately $0.9 million, and $4.3 million for acquisition-related payments, and $1.1 million for customer advances, and finally fixed asset purchases of $600,000. We have not drawn on our $6.0 million line of credit. And we have restricted cash of approximately $5.2 million, which we are negotiating with the bank to free up. Accordingly, we believe we have sufficient cash resources for 2008.

At this time, we would like to – Nakita, we would like to turn it over for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of John Kroeller [ph] of Piper Jaffray. Please proceed, sir.

John Kroeller – Piper Jaffray

Hi. This is John in for Mark Mullikin. He needed to step away for one second. A couple of quick questions here. I'm sorry if I missed this in the call, but did you say what the impact of foreign currency was on the quarter?

Mike Halloran

We did not. You are talking on the sales line?

John Kroeller – Piper Jaffray

Yes, yes, exactly.

Mike Halloran

Yes, the total foreign currency on the sales line was 9%.

John Kroeller – Piper Jaffray

9%, great. And then a quick question here on the European business, you guys were having pretty good growth rates over the last year. Just kind of wondering, the softness, obviously, you said is from unprofitable businesses. Is this more of a recent occurrence? Or is this something that's been kind of hanging around for a little bit?

Sam Westover

Well, it's been mixed. We have got some customers in Europe that are growing, positive, profitable. And then we have some others that aren't. So we think it's important to take a good, hard look at that. And even though it's painful to do this, to walk away from business if' it's not profitable, you need to do it. And not only that, but we have had as an initiative since the beginning of the year to consolidate our European operations. If you look back, historically, the Sonic business grew by acquisition. And that meant that every acquisition had its own infrastructure. That really didn't make sense. So we are in the process of consolidating that into a more cohesive management structure. And as part of that, we will be able to reduce our costs substantially.

John Kroeller – Piper Jaffray

Okay, great. And you guys on the last call mentioned putting up ten de novo stores this year. Just wondering if you have any update on that, any progress in there?

Sam Westover

Sure. Well, let's see. I know we have opened one. Have we opened the second one yet? It's almost – pretty close.

Mike Halloran

I think it will tomorrow.

Sam Westover

Tomorrow, okay. So we will have two open here very quickly. And we have got three more that are in various stages of construction right now. So over the next two months, we will probably open a couple more.

John Kroeller – Piper Jaffray

Okay. And any idea where they are located that you can pass along to us?

Sam Westover

Where they're located?

Mike Halloran

It's all part of our global vertical integration strategy. So we – it's not really important and we don't usually talk about the specific geographies, just to avoid channel conflict issues.

John Kroeller – Piper Jaffray

Got you. And then one last quick question, you talked about new product innovations for – in a softening economy products that are targeted towards lower – mid- and lower- price ranges.

Sam Westover

Yes.

John Kroeller – Piper Jaffray

The like features of this and really more at the margins, with these lower priced products, are you – how's that going to affect your margin as you progress through the year and more so into 2009?

Sam Westover

Well, our hope is that it will increase our revenue and decrease our margin a little bit and increase our operating income. So if a customer is looking for a certain product in the right price range and they don't buy it from you, obviously your ASP is zero. So we would rather have a smaller margin on a piece of business than no margin at all. And we are pretty excited about these new products. We have a full range of products, but they really need to be tuned to today's specific needs. So we will be announcing those within the next couple of months.

John Kroeller – Piper Jaffray

Great. Thank you very much.

Operator

(Operator instructions) Your next question comes from the line of Joshua Zable of Natixis. Please proceed.

Ethan – Natixis Bleichroeder

Hey, guys, good evening, this is Ethan [ph] on for Josh.

Sam Westover

Hi there.

Ethan – Natixis Bleichroeder

I just want to thank you for taking my questions and also congratulate you on putting up some good growth in a difficult market.

Sam Westover

Thank you.

Mike Halloran

Thank you.

Ethan – Natixis Bleichroeder

Yes, absolutely. The first question that I had was just if you guys have seen any trends in April so far, just in the North America market?

Sam Westover

April in North America looks a little bit better. It's still not robust. It's – the market is a little bit soft. And in the month of March, the whole industry showed a 5% decline over the March of the prior year. So I think some of our competitors are starting to process the realities through their systems and it's showing up in the numbers that are being reported through our industry association. I think we probably saw it a little bit earlier than they did, for whatever reason. But we – it looks a little bit better. And I think the – also the news is getting a little bit better as well. You can judge how our customers are responding by what you hear on the evening news. And I don't think it's quite as negative as it was a few months ago. So that softening, I think that might help consumer confidence a little bit. We know that this will turn around. It just hasn't gotten back to where it was last year about the same time.

Ethan – Natixis Bleichroeder

Okay, great. Thanks. And just a follow-up question kind of along the same lines, basically, with some of the weakness in the North American market if you are looking at potential acquisitions, is – do they look cheaper as a result of this?

Sam Westover

We haven't seen them look cheaper, but they are not more expensive either. And it's a little bit like selling your house. If your house was worth a big number last year, you really don't want to sell it for a low number this year, even if everybody's telling you that that makes economic sense. So – and really the numbers that we are willing to pay work for us. They are – they give us a fantastic return. And if there are more people that are willing to sell at those numbers, that's a good thing.

Ethan – Natixis Bleichroeder

Okay, thanks guys. Appreciate it.

Mike Halloran

Thanks, Ethan.

Operator

It appears there are no further questions at this time. I will now turn the call over to Mr. Sam Westover for closing remarks.

Sam Westover

Thank you. I would like to thank all of you for your interest in Sonic Innovations. We are demonstrating consistent revenue growth and margin expansion. Our cost-cutting efforts will position us for strong future earnings performance. Our strategy is to produce great products, deliver outstanding quality, and customer service, and expand distribution. We will look forward to updating you further on our progress in July. I wish you all a good day.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

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