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Collective Brands, Inc. (NYSE:PSS)

Q1 2008 Earnings Call

June 4, 2008 5:00 pm ET

Executives

James Grant – Director IR

Matthew Rubel – President & CEO

Douglas Treff – Executive VP & CAO

Rick Porzig – Sr. VP & CFO

Analysts

Jeff Stein - Soleil Research

David Mann – Johnson Rice & Co.

Claire Gallacher - Caris & Company

John Shanley - Susquehanna Financial Group

Robert Wilson – Tiburon Research

Heather Boksen - Sidoti & Co.

Unidentified Analyst

Operator

Welcome to the Collective Brands’ first quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to your host, Mr. James Grant; please go ahead.

James Grant

Good afternoon and welcome to Collective Brands' conference call for the financial results on the first quarter of fiscal year 2008. I’m James Grant, Director of Investor Relations. On our call today we’ll begin with Doug Treff, Executive Vice President and Chief Administrative Officer, followed by Matt Rubel, Chairman, CEO and President. Also with us today for the question-and-answer portion of our call is Rick Porzig, Senior Vice President and Chief Financial Officer. After we complete our prepared remarks, Matt, Doug, and Rick will take your questions.

Today’s remarks will contain non-GAAP financial measures. The financial measures are non-GAAP because they exclude litigation and purchase accounting inventory step-up charges. Management believes that these measures will help you to better understand underlying performance trends in our business. For reconciliation of these measures to their nearest GAAP measures, please see our press release that was issued earlier today and visit our website at www.collectivebrands.com and click on the Investor Relations and Presentations and Webcast links.

Also our remarks today contain forward-looking statements which are not historical facts and are subject to a number of risks and uncertainties. Actual results may differ materially. Please refer to today’s financial press release for more information on risk factors and other factors that could impact forward-looking statements.

Now I would like to turn the call over to Doug.

Douglas Treff

Thank you James and good afternoon everyone. Over the next few minutes I will walk you through our first quarter 2008 operating results. We ended the first quarter with earnings that exceed last year’s excluding litigation expense and we are well positioned for the long-term in spite of the current economic environment which impacted mainstream consumers resulting in lower traffic at retail and comp sales. Matthew will speak to you about our strategic initiatives and the progress we are making in just a few minutes.

Our reported first quarter earnings per share were impacted by a charge related to loss contingencies associated with litigation and by the inventory step-up portion of purchase accounting charges. So excluding the litigation reserve, EPS was $0.67 and when you exclude the inventory step-up costs our EPS was $0.71. These we believe are the numbers that provide you with a better understanding of our underlying performance.

Let’s take a look at the financial drivers behind the earnings starting with sales. First quarter sales were up 28% due to the addition of Stride Rite. Comparable store sales declined 6.5%. This was the result of lower traffic and unit sales at Payless stores as well as an early Easter. In particular sales of women’s dress and children’s athletic shoes were lower. The declines were offset in part by several favorable drivers related to our strategy.

Payless experienced strong sales in women’s casual and canvas footwear and Payless branded sales were up significantly. This helped drive the 3% increase in average unit retail prices for the first quarter for Payless. In addition Payless international sales grew 14% led my Latin American retail business at over 20%. Double-digit increases at Sperry Top-Sider and Saucony let the growth at Stride Rite wholesale.

Our gross margin rate for the first quarter of 2008 declined from last year. Still it’s important to note that the Payless merchandise margin increased again this quarter compared to first quarter 2007 continuing its positive trend. This was the result of our ability to increase direct sourcing of product and to increase average unit retail prices. In total the Collective Brands gross margin rate declined due to four primary reasons: a $30 million litigation reserve which reduced the gross margin rate by 320 basis points; Stride Rite’s lower gross margin because of purchase accounting; the expense from inventory step-up negatively affected the rate by 40 basis points; lower comp store sales which deleveraged fixed cost of sales such as rent, occupancy and depreciation and amortization; and higher freight costs.

Our new distribution infrastructure in net of freight savings was accretive by over $3 million pre-tax in the first quarter of 2008 compared to the first quarter of 2007. This was due to severance costs recognized in the first quarter of 2007 related to the decision to close the Topeka distribution center. By the end of fiscal 2008 we believe the distribution center initiative will be approximately $7 million pre-tax accretive compared to fiscal 2007.

The first quarter gross margin rate decline was also partially offset by the integration synergies from combining our Asia based organization and leveraging merchandise and logistics programs which were $700,000 from cost of goods sold in the quarter.

SG&A as a percent of sales decreased 50 basis points in the first quarter of 2008. The improvement was primarily due to the impact of Stride Rite’s lower SG&A rate and Payless expense reductions such as incentive compensation. SG&A dollars were up due to the addition of Stride Rite. SG&A integration synergies were $1 million in the quarter. Some of the key factors included eliminating Stride Rite’s public company costs, consolidating a number of outside service provider contracts, eliminating staffing involved in duplicate activities. The combined synergies for gross margin and SG&A were $1.7 million in the first quarter, net of integration spending to realize the savings.

Our operating profit in the first quarter was $41 million. Excluding the impact of the litigation charge and inventory step-up costs which have now fully flowed through the income statement operating profit was $75 million. First quarter adjusted EBITDA was $110 million. Adjusted EBITDA excludes the charges for litigation and purchase accounting inventory step-up. The $110 million of adjusted EBITDA showed the cash flow generating ability of our business model in the midst of difficult economic climate.

We had an increase of $17 million in net interest expense in the first quarter of 2008. The change was due to financing the acquisition of Stride Rite. The income tax rate for the first quarter of 2008 was 10% including discrete items of $1 million compared to a rate of 32% for the first quarter last year. The effective tax rate for the full year is expected to be approximately 16% compared to previous guidance of 30%. The improvement in the rate for the first quarter versus the same quarter last year, and for the full year 2008 effective tax rate versus prior guidance is primarily due to a lower percentage of earnings in high tax jurisdictions and a higher percentage of earnings in lower tax jurisdictions together with inherent tax efficiencies gained through the Stride Rite acquisition.

These tax efficiencies are expected to have a long-term favorable impact to cash flow. Now on to the balance sheet. During 2007 we recapitalized the company to acquire Stride Rite and Collective Licensing. As a result we ended first quarter 2008 with lower cash and higher debt positions. Cash at quarter-end was $231 million compared to $321 million last year. Total debt increased to $921 million from $202 million. Net debt at the end of the quarter was $690 million compared to a net cash position last year of $119 million. We intend to use our cash to maintain liquidity in the current environment.

Collective Brands inventory was $481 million at the end of the first quarter, up $100 million compared to the first quarter last year due to the addition of $131 million of Stride Rite inventory. Payless inventory was 8% lower at the end of the quarter. Inventories in Payless stores were down 10%. The percentage of aged inventory on the Payless balance sheet at the end of the first quarter was slightly below last year and lower then the average over the past three years in the first quarter reflecting a clean inventory position and effective margin management.

Looking at the cash flow statement, cash flow from operations increased to $45 million during the first quarter versus $21 million last year due primarily to changes in working capital. Regarding fixed assets, our capital expenditures for the first quarter 2008 were $43 million, down $13 million compared to the same period last year. The decline was due primarily to investments last year in new POS registers and inventory scanning devices for the stores and lower expenditures this year on supply chain and new and remodeled stores.

We have lowered our full-year 2008 capital expenditure estimate to approximately $130 million, down from a previous estimate of $145 million. We are being prudent to manage our capital spending in order to optimize free cash flow and make sure our investments are being made in high return opportunities.

Before getting to our financial outlook just a few words on litigation, on May 5th, 2008, a jury returned a verdict against us in the aggregate amount of $305 million in connection with our litigation with adidas. We believe that the verdict was excessive, unjustified, and the product of legal error. We are expeditiously taking steps to protect our legal rights but there can be no assurances that our efforts will be successful. During the quarter we recorded a $30 million pre-tax loss contingency reserve in connection with our litigation. Although the likelihood of further losses and the ultimate amount of any such losses are not reasonably determinable at this time, the actual resolution of litigation may result in a reversal of the loss or in further losses which could be material. As a matter of policy we are not commenting on litigation beyond the disclosures we have already made.

Regarding the Collective Brands financial outlook, Collective Brands anticipates an operating profit growth rate in the mid-teens over time. This long-term goal is predicated on low single-digit comparable store sales growth. In the next three to six months the company anticipates a comparable store sales growth may be below its long-term goal. Collective Brands intends to mitigate the anticipated near-term sales environment with prudent inventory control and expense management. Excluding the impact of purchase accounting the Stride Rite acquisition is expected to be accretive to earnings in 2008 as Stride Rite’s operating profit contribution including synergies is expected to exceed the incremental interest expense. Due to the impact of purchase accounting the Stride Rite acquisition is not expected to be earnings per share accretive in 2008 on a GAAP basis.

The 2008 effective tax rate is expected to be approximately 16% excluding discrete events associated with the resolution of outstanding tax audits. We have lowered our capital expenditure forecast in 2008 to approximately $130 million. Depreciation and amortization in 2008 is expected to total approximately $145 million due to greater investments in supply chain and stores in recent years as well as the acquisition of Stride Rite.

Now I’ll turn the call over to Matthew.

Matthew Rubel

Collective Brands delivered first quarter 2008 operating results that demonstrate the advantages of our new business model that emphasizes the diversity of our product offerings, geographies and channels of distribution. I’d like to highlight these advantages as I make a few remarks about our brands and the environment in which we’ve been operating. I will make these comments by addressing our businesses and exclude the impact of the litigation charge.

Thus in the period we saw earnings and cash flow increase this quarter as a result of growth in several areas of the company. Sales for Stride Rite wholesale increased both in the US and overseas as did sales for Payless international. Our diversity and price point’s brands, selling channels and geographies contributed to our results and confirms the rationale behind our acquisitions. At the same time the core Payless domestic customer continued to be impacted by the multiple economic challenges facing many consumers today.

This along with an early Easter contributed to lower traffic in our stores at Payless that led to lower comparable store sales. In addition the competitive environment was more promotional this year then last year. And while we remain cautious about the overall environment the underlying results from operations demonstrates that our strategy at Collective Brands is working. We had a number of successes which strengthened our competitive position, improved our operating performance and led to high cash flows.

Let me summarize some of those successes during the quarter. Stride Rite group sales were up 5% on pro forma basis. This continues to validate our acquisition and the opportunities for growth that these brands represent. We are now servicing a broader variety of customer segments with more diverse products through different points of distribution therefore building a stronger company. Growth in the Stride Rite wholesale segment was led by Sperry Top-Sider and Saucony.

Collective Brands international results also improved. First quarter Payless international segment sales increased driven by double-digit percentage gains in Latin America. At Stride Rite international sales were up nearly 19% on a pro forma basis to last year. This growth illustrates why we are investing relatively greater amounts of resources in our international activities where we typically generate higher returns. We also adjusted merchandise receipts and flow to more affectively manage our inventory and meet customer needs. At Payless we flowed sandals later, closed [inaudible] when customers were buying as customers have moved more toward a wear-now philosophy.

This decision to shift the flow of sandals later in the spring season improved inventory turnover. This helped us deliver fresh fashion and on-trend product while lowering our lot count at the same time. These moves helped to drive Payless merchandise margins higher even in the current operating environment. We affectively controlled our operating expenses by eliminating open positions, managing discretionary spending and realizing integration savings. We were able to improve customer satisfaction scores while reallocating store payroll hours. In fact, customer satisfaction scores increased by seven percentage points in the first quarter compared to a year ago.

Finally we generated stronger cash flows during the quarter. Adjusted EBITDA reached $110 million. This is the result of our combined successes produced by a hybrid business model that offers diversity in price points, brands, selling channels and geographies. We will continue to use cash flows from mature businesses to accelerate growth opportunities that our retail, wholesale and licensing platforms provide.

All of these first quarter achievements demonstrate the validity of our strategies that are intended to produce growing cash flows and high return on invested capital. Now that I’ve highlighted some of the successes in the first quarter, I will address more specifically the Collective Brands strategies to become the leader in bringing compelling lifestyle, performance and fashion brands for footwear and related accessories to consumers worldwide. These strategic themes include consumer connections, powerful brands, operational excellence and dynamic growth.

I’ll start with consumer connections, consumer connections is the strategy designed to meet our customers’ various needs and desires, anticipate the trends that influence them, increase the relevance of our products to their lives and create outstanding customer experiences for them. In the first quarter we kept our inventory clean to ensure a fresh flow of on-trend product at Payless while insuring assortments were balanced by customer-type, category and price point. We focused thoughtfully on designs for the expressive customer who defines value by much more then just price. She’s looking for compelling products that meet her very desires for style, performance and quality.

According to our latest attitude and usage survey, the expressive customer is responding to our assortments. In the most recent quarter loyalty amongst expressive consumers was higher then at any time during the past five quarters. First quarter conversion increased slightly indicating that when customers came into Payless stores they purchased more frequently. This was a function of on-trend product and Payless store associates providing a better customer experience as measured by customer satisfaction scores increasing seven percentage points over last year.

At the same time average unit retails increased 3% and units per transaction were higher as customers responded favorably to certain on-trend style as well as highly promotional product. Our newest Payless Hot Zone store format is inspiring fun fashion possibilities in footwear and accessories for our customers. In addition these stores are delivering results consistent with our long-term return on investment expectations. They are also experiencing customer conversion rates higher then the chain average.

As a result the Hot Zone format will be the standard for future new stores. We ended the quarter with 507 Hot Zone stores, up 215 stores from the end of the first quarter 2007. About 11% of the Payless chain has been refreshed in the last two years. The Payless Possibilities co-branded Visa card is another example of focusing on customer needs. We launched the program in five metro areas beginning last month. Early results are positive and above planned. As results to meet or surpass expectations we anticipate extending the program’s availability. The features and benefits the cardholders realize including receiving a free pair of shoes after their first purchase, and accumulating points on all their card purchases. Points are redeemable for discounts on their next Payless purchase. We anticipate the card will be an effective customer affinity tool; something Payless has never had before.

At the Stride Rite group, Saucony continues to be recognized for outstanding product that meets and exceeds the needs of the running consumer. Saucony Pro Grid Triumph 5 was selected as the United Kingdom’s Shoe of the Year by Runners World Magazine, the worldwide authority on running. This latest honor continues the impressive series of recognition received by the Saucony team for their industry-leading product innovation. Clearly we are on the offense.

Now onto Collective Brands strategic theme of powerful brands. Our second strategic theme is powerful brands. We are building a diverse portfolio of leadership brands that forge connections with target consumers. The Stride Rite group contains strong brands as evidenced by the operating results in the wholesale segment led by Saucony and Sperry Top-Sider. Saucony achieved double-digit sales increases on a pro forma basis in the first quarter and continued to gain market share in the running channel. We have recently built important partnerships and undertaken other actions that will extend the Saucony brand.

Saucony also recently signed US Olympic Marathoner Magdelena Lewy Boulet to a multi year endorsement contract. Lewy Boulet earned a spot on the US Olympic team by placing second in the 2008 US Women’s Olympic Marathon trials held in Boston just this April. The Saucony team launched a new website during the first quarter and we successfully launched a Saucony apparel line in the run specialty channel. We complimented innovative footwear for the technical runner with apparel performance fabrics designed for runners looking for lifestyle product with technical features as well as technical running product. This highly differentiated approach builds off of Saucony’s core heritage of performance and innovation with great design to serve the running consumer on the track or off.

Sperry Top-Sider also generated double-digit growth in the first quarter. The strong performance continues to be driven by the fast growing women’s category and the boat shoe business. Sperry Top-Sider continues to be the leading name in boat shoes, a category of footwear that continues to perform well. We are launching a new advertising campaign that clarifies the Sperry Top-Sider brand positioning to enable it to expand it into multiple footwear product categories. The campaign uses tailored imagery to convey a performance message or a fashion and style message depending on the target consumer and the media forum.

The Stride Rite children’s group also contributed to the growth in the wholesale business segment in the first quarter. The team recaptured market share in the first quarter of 2008 by expanding distribution amongst its wholesale account base particularly with high-end department stores. Payless also continues to see a greater mix of branded sales as well. They have a higher productivity due to faster turns compared to house labels. Brands drove significantly higher gross margin dollars per five foot section during the quarter. Brands accounted for 50% of the Payless footwear sales in the first quarter compared to 38% for the same period last year. We expect brands will become 70% to 80% of our footwear portfolio over time.

A small but growing part of the Payless brand portfolio is our designer lines. I am thrilled to report that we have signed a new multi year agreement with fashion designer Lela Rose to continue designing Lela Rose for Payless, an exclusive line of women’s and infant’s shoes as well as handbags. Lela’s classics with a twist collection are available in nearly 500 Payless stores. We are expanding our alliance further with the launch of a special occasion dyeable line of shoes under the label Unforgettable Moments by Lela Rose. This new designer label will feature several core classic styles as well as refreshed seasonal silhouettes capturing the latest trend details which can be dyed in 64 colors. The Unforgettable Moments by Lela Rose line will be available in about 2,400 stores starting early next year.

Another important initiative beginning soon is our recently announced Nickelodeon programs. The Stride Rite children’s group entered into an agreement with Nickelodeon to create a new line of children’s shoes known as [Nick Slimers] due in stores next month in time for back-to-school. And Payless and Nickelodeon have teamed up with a direct to retail agreement to produce a new line of Blue’s Clues footwear due in Payless this November. This direct to retail arrangement is similar to the one that we have with Disney whereby we co-design exclusive footwear for Payless. This presents both sales and gross margin expansion opportunities.

Collective Licensing international, they are undertaking some exciting brand development efforts. We have recently signed licensing agreements for our Airwalk and Vision Street Wear brands with new and existing licensees. The two most significant deals are international. CLI recently locked up separate multi year deals for the use of Airwalk brand licensees in Mexico and Indonesia. In Indonesia sell-through has been very strong and our partner plans on increasing their commitment to marketing and category expansion.

Another example is our agreement with US based Junk Food. Now this is a boutique apparel supplier for use of the Vision Street Wear brand. Junk Food is well positioned to give the brand preeminent positioning amongst early adopters and trend-setting consumers. Collective licensing continues to develop promising opportunities in its licensing pipeline worldwide. Some build brand and some build business.

The third of the four Collective Brands strategic themes is operational excellence. This strategic theme is about developing capabilities, leveraging technologies and delivering solutions. We are driving operational excellence by increasing the percentage of our footwear portfolio that we source directly through our own vertically integrated sourcing organization resources. Direct sourcing improves our merchandise margin rate and 62% of our product was sourced directly in the first quarter of 2008. This compares to 56% in the prior year. Coupled with other gross margin expansion drivers like the use of preferred material suppliers, factory consolidation and other integration efforts, we believe direct sourcing will help drive Collective Brands merchandise margin higher offsetting in part the product cost increases coming out of China. This team deserves a tremendous congratulations.

We are leveraging our technology platform that was developed for our Payless stores in the US, Puerto Rico and Canada for use in our Latin American Payless stores. We are beginning the upgrades of our point of sale system this year in our Latin American stores and will complete the rollout in 2009. Store sales volumes are much higher on average in Central and South American markets compared to the US. Therefore the investment in new point of sale registers will allow us to better serve our growing customer base there. The new systems will speed customers through stores more quickly, enable stores to price product more efficiently and provide more timely communication to stores on important programs.

We are also improving productivity and lowering costs through the implementation of the dual US distribution center strategy. This strategy will place two distribution centers closer to our largest markets on the East and West Coasts. In addition we will integrate two Stride Rite group distribution centers into these facilities resulting in greater efficiency and lower transportation costs to stores and customers. Our Western distribution center is now supporting the inventory needs of approximately 1,400 stores with plans to serve 1,800 stores by year-end. Productivity is now at levels that will handle peak volumes during the year. We expect to begin flowing product through the Brookville, Ohio facility around year-end.

In the first quarter we also launched a test of traffic counters in Stride Rite retail stores. We intend to rollout the counters to all stores within the next 24 months. This capability will enable us to manage store performance and customer conversion more effectively as been demonstrated at our Payless retail stores.

The last strategic theme that I’d like to update you on is dynamic growth. Dynamic growth includes fully extending the reach of our brand platforms across global markets expanding the reach of our brands into other relevant categories from the core base of footwear and building out delivery channels for our brands in wholesale, retail, licensing and e-commerce as well as consumer direct. Payless is extending its brand internationally this year into Columbia. We expect to open our first stores in Bogota this summer. The size, health and growth of the Columbian economy, one of the largest in Latin America are factors that made our entry into the country attractive. Combined with our success in other Latin American countries we are excited about this opportunity to extend our brand, serve new customers and generate strong investment returns.

We are also looking to extend the reach of our brands as we consider other international opportunities for Collective Brands. At Payless we’re evaluating licensing, franchising and/or wholesale opportunities in the Middle East and other developing economies. Payless has had success in developing economies and this initiative provides the potential to realize good investment returns through less capital intensive business models.

At the Stride Rite group we are investing in our European operations, our people and our distribution centers to support the strong growth that we are experiencing in several of our brands on that continent. Ultimately we plan to streamline certain functions into a comprehensive European headquarters to provide the necessary sample creation, distribution, sales and systems capabilities for our growing brands. At Collective licensing we are using the Airwalk brand to grow our footprint internationally and in categories beyond footwear.

In summary we’ve made progress during the first quarter on our mission to become the leader in bringing compelling lifestyle performance and fashion brands for footwear and related accessories to consumers worldwide. Our results in the first quarter excluding the litigation charge showed higher earnings and stronger cash flows then a year ago, highlighting the growth opportunities within our current brands.

I along with 31,000 other dedicated associates share a pride in the brands that we have built and are committed to executing the strategies to build a great company. I want to thank each of them for their effort and dedication to our company, especially during these challenging times. The economy will come back but until it does, we will manage our brands, our inventory and our expenses to make sure we are focused on meeting the needs and exceeding the desires of our various customers. We will continue to offer diversity to our consumers in price points, brands, selling channels and geographies. This hybrid model makes us a stronger, more resilient company with greater opportunity to create value for our shareholders.

Thank you for your time. We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jeff Stein - Soleil Research

Jeff Stein - Soleil Research

I know you don’t want to talk about the legal situation but I’m just curious, can you just give us some sense in terms of how you came up with the $30 million provision? What does that represent?

Douglas Treff

What we did, we have to follow FAS 5 and FIN 14 and I know those are technical accounting types of things but they govern how you go about determining probability and estimability of loss contingencies meaning if there is a potential loss out there, so we evaluated that there is a probability and then we sought to establish an estimate for that. We determined that there was in fact probability and the estimability were required to provide an estimate of a range—the minimum of a range and so that’s what the $30 million represents is that estimate.

Jeff Stein - Soleil Research

I’m wondering if you could comment on the performance of Dexter during the first quarter, is that meeting your plan and it also appears secondarily that the athletic category is beginning to gain some momentum nationwide and I’m wondering do you have an answer for that? It seems that your athletic penetration is below that of some of the other family footwear chains and do you have any strategy to try to capitalize on what might be a growing trend for athletics?

Matthew Rubel

First of all on the Dexter brand, the men’s business has met or exceeded our expectations and we’re seeing great consumer feedback and great take-away. The women’s side of the business, we actually got off to a little bit slower start. I think that we were too traditional in our product assortments. As we flowed product later in the quarter and became more expressive with that product moving it more into an updated zone as opposed to traditional, we got tremendous velocities and started to see some of the Dexter product move into our top 15 lots. So we believe we have found the design vocabulary for women’s going forward, men’s we knocked it right out immediately and also interestingly enough, especially on the boy’s side of the business which is an added plus, we are seeing some very positive results in Dexter in boy’s.

On the athletic side of the business we continue to build our Champion business as well as Airwalk so we do have two core businesses. Also our Dunkman product that we have is something that we are working on expanding as well. We are looking for an additional athletic brand. There is nothing that we have to announce at this point in time but there are some different ways that we are looking to skin that cat because we do believe it is a growth opportunity. It must be done through a brand. We have increased—now that we have access to certain understanding on technology we have increased our design efforts and our innovation efforts in bringing technology into athletics. And you will start to see that actually in the fall season within the existing brands that we do own.

Operator

Your next question comes from the line of David Mann – Johnson Rice

David Mann – Johnson Rice

On the gross margin can you talk a little bit about how Payless performed, perhaps quantify how much that was down and how Stride Rite performed on a pro forma basis.

Matthew Rubel

I think you didn’t—must not have heard what we said because actually Payless gross merchandise margin was up and I’ll let Douglas walk you through that.

Douglas Treff

The Payless merchandise margin actually increased compared to last year and again that was a function of the direct sourcing, a function of the average unit retails.

David Mann – Johnson Rice

What I was more asking about is if we looked at Payless compared to last year with all the other components of cost in there how that might have performed.

Douglas Treff

We don’t breakout specifically the Payless gross margin; we show our segments which show sales and operating profit. In terms of—we broke out the two pieced to be able to explain the merchandise margin and the deleveraging. So there was some negative impact related to the sales decline due to the impact of higher rents.

David Mann – Johnson Rice

And should we assume that the negative impact was greater or meaningfully greater then the merchandise margin improvement?

Douglas Treff

We don’t disclose that, we don’t break it out specifically that way.

David Mann – Johnson Rice

On the backlog at the Stride Rite wholesale business, I think coming into the first quarter that was up perhaps 10% or so, can you just give us some color on how backlog is looking right now?

Matthew Rubel

Again we’re not releasing backlog results but they continue to be very strong. With again being led by Sperry and by Saucony but also starting to see gained improvement in the international as well as in the Stride Rite business. Those are strong. It’s up basically high single-digits.

David Mann – Johnson Rice

You highlighted your focus on some of your growing parts of your business, when you look at the US store base, I think you have as many as 1,000 stores coming up for lease renewal, given that having a lot of stores in close proximity was necessary in the past, it seems like that’s a whole lot less important now when you’ve got a much more differentiated product. Can you just talk a little bit about how you look at that opportunity to shrink the US store base given the ability to recapture some of those sales and free up working capital and focus on some of your growing businesses?

Matthew Rubel

Its difficult to answer exactly other then to say that what we are doing in our store development group is we have put together a whole new way of analyzing where our customers are coming from. About a year ago I told you we were putting in a customer relationship management program and ultimately building a database. We now have a database that has over 25 million names in it. We are able to append those to understand where those people actually live. So in knowing where those people live and what store they shop in, we’re able to better understand how the marketplace traffic is moving and where they’re coming from. And our real estate and store development leadership team is putting together a plan, market by market, which will enable us to go in and more clearly optimize locations and understand transfer sales and where is the right place to locate a store. So we do believe over time that we will be able to pull as much sales out of a market with less use of capital so that is something we are working toward.

I will say though that one of Payless’ especially during this time of energy challenge is that we are in the neighborhoods and we are convenient and so people find it easy to get jobs with us because we’re in the neighborhood and people find it easy to shop with us. So in no way, shape or form do we want to make a material change in anything that we would do to lose that competitive advantage? But your question is correct on many levels. Your 1,000 store per number if you’re saying that’s per year, that’s incorrect.

David Mann – Johnson Rice

I was just pointing out it seemed like that was the number for this year.

Matthew Rubel

No that’s incorrect. That’s high but we do have a substantial amount every year. It might be 20%, 700 or 800 stores per year where lease renewals do come up, not 1,000 though.

Operator

Your next question comes from the line of Claire Gallacher - Caris & Company

Claire Gallacher - Caris & Company

My question has to do with the Stride Rite wholesale business, it seems like this really is the bright spot if you’re looking just within the US border, I was wondering if you could talk generally about the performance in department stores versus specialty stores, if you’re seeing strength in one area versus another.

Matthew Rubel

I think the beauty of the Stride Rite group is that no one customer offers purchases more then 4.5% of the merchandise from the total group. And so one of the things that—and we also have mixed genders, we go male female, we go kids, so it’s an incredibly diversified group kind of moving into many things. The answer that I would give you is just to say that in Saucony it’s the running channel, but we’re also seeing strength for Saucony outside of that. But its core channel in the US as the running channel. And in Sperry Top-Sider they’re actually seeing it across the board but what they are also doing is they also are reducing distribution as their brand has momentum from some of the more mainstream accounts building a more premium portfolio of distribution and we are seeing growth in that whether it’s a performance channel like marine or whether its in a department store or a specialty store. We’re seeing it across the board in Sperry Top-Sider. In the Stride Rite children’s group one of the great things is to see the Stride Rite core brands growing again and picking up market share again in its wholesale business. I think that some of our wholesale customers have seen that as they’re customers really go to the go-to brand for children under the age of seven the Stride Rite is that, but we are seeing growth in both our licensed partners as well as in department stores.

Operator

Your next question comes from the line of John Shanley - Susquehanna Financial Group

John Shanley - Susquehanna Financial Group

I wonder if you can talk a little bit about some of your sourcing costs particularly coming out of China. Are you anticipating much of a price increase as you look at your spring 2009 selling season and is there much of a differentiation between the margins, product margins that you’re getting from the direct source goods versus goods you may have sourced in the past through either [jobbers] or distributions?

Matthew Rubel

Yes we are getting price increases out of Asia and it is, it’s quite a battle out there. There are multiple issues that we’re dealing with. Anywhere from container rates to diesel to actual devaluation of the dollar and the purchasing power of the dollar because we’re a dollar denominated industry to actually seeing the labor rates go up in certain areas of China as some of the social costs are added in to those businesses. So the answer is yes, they are up mid to high single-digits. We are able to combat that, now you might have some brands that are up, some zone that’s up double-digit and other one where you’re only up 2% or 3% but in aggregate that’s about where it would end up being. We are able to combat that somewhat through our purchasing power, through use of our core factory base, through moving further into China into regions that are more diverse. We also are increasing our sourcing in Vietnam. We have a sourcing team based out of Asia that has put together a terrific strategy for diversification but that diversification is only going to get us so far. We need a stronger dollar and I think that will start to help to mitigate some of this that’s happened. And what I think is more of a step variable function. I don’t think it going to just be linear and keep moving up like this. I think its kind of a step function here this year and then I think we will see a leveling out.

John Shanley - Susquehanna Financial Group

Is it likely you’re going to see retail price points come up to basically offset at least some of those sourcing costs?

Matthew Rubel

I would say it would be hard to avoid having price increases as a part of this. So yes there will be price increases and we’re—on every brand studying it very closely. We’re looking at marketplace pricing, competitive situations, and really being very, very thoughtful about it category by category.

John Shanley - Susquehanna Financial Group

And the question about the differentiation between the direct source and --

Matthew Rubel

We don’t give out the actual margin but the answer is yes. We are able to both eliminate the agents’ fee in some cases although we value agents and continue to see them as a part of our ongoing business model in the very long-term so we don’t see that as a short-term thing. We believe they will always be a part because they bring great creativity and resourcefulness to us. We have narrowed down to those who we value most in the areas, although we’re always looking for new ones to bring us new ideas. And also sometimes those factories don’t--that the agents use don’t provide us with the aggregate purchasing power to get the best price on a shoe. So the answer is yes, we still have opportunities as well as what we’re doing on materials and consolidation with that as well.

John Shanley - Susquehanna Financial Group

You gave us a pretty good indication of most of the Stride Rite components in terms of how well they’re doing; I didn’t hear you mention anything about Keds. Can you talk about that brand and whether it’s meeting your expectations and what the—has there been much of a change in terms of the sales trends of business over the last quarter?

Matthew Rubel

No it’s not meeting our expectations in the US, its falling below our expectations and it’s actually the drag on the wholesale business in the US for the Stride Rite group. And that’s primarily impacted by some of the performances that you’ve seen from mainstream retailers so its performed in-line with those mainstream retailers but those mainstream retailers have had very significant comp store challenges. So yes, Keds in the US is having a challenge. Actually in Europe it’s exceeding our expectations and doing quite well. Much smaller business. And also we do have the Grasshopper brand which is not talked about that much. It’s a part of the Keds group and the Grasshopper brand is showing growth and it’s for a more mature woman. It’s a very small business but it’s very profitable and starting to show nice growth.

John Shanley - Susquehanna Financial Group

Also looking at the retail part of the business, can you give us an indication of how shopper traffic levels and comps performed as the quarter progressed at both the Stride Rite retail as well as the Payless stores?

Matthew Rubel

Because we only release sales results quarterly its not something that I could go into month by month other then to say that it was very inconsistent. You could not get a rhythm to things. You could be in the same promotion with the same product one day and two days later the sales trend could drop off dramatically even with the same weather. So it’s fairly inconsistent out there and I know talking to other retailers because we are in contact with them both because we know them and because we sell to them, it’s pretty much consistent.

John Shanley - Susquehanna Financial Group

Is that true with the shopper traffic levels as well?

Matthew Rubel

Yes, they’re down and basically as we went through on Payless conversion was slightly up so that shows that when we get them in there, we’re doing fine. It’s just they’re not out.

John Shanley - Susquehanna Financial Group

Are you getting any kind of response to date on the rebate checks? Are you seeing any impact at all from that particular customer who may be coming in with a little bit more spending power in their back pocket?

Matthew Rubel

I don’t have an answer to that. There’s no way that we can really track that and those things are coming out over such an extended period of time that it’s very difficult. The thing I can tell you is that we are seeing a greater degradation in sales the two or three days prior to payday then we had in the past and we are seeing a higher relative jump when payday comes. So people are living paycheck to paycheck.

John Shanley - Susquehanna Financial Group

I want to know if there are any insurance policies in effect that could cover some of the cost of the adidas litigation, is there a possibility that part of that $305 million could be picked up by insurance coverage?

Douglas Treff

We have multiple layers of insurance that are potentially relevant to the claims in the case. The jury’s verdict raises as you can appreciate, a number of complicated issues so we’re not really in a position to discuss those publically.

John Shanley - Susquehanna Financial Group

But there are insurance policies of some degree in effect?

Douglas Treff

There are insurance policies in place and we have multiple layers of insurance.

Operator

Your next question comes from the line of Robert Wilson – Tiburon Research

Robert Wilson – Tiburon Research

I was wondering if we could drill into merchandise margin a little bit more given that you had such a large comp decline, I could only assume that occupancy materially deleveraged therefore should I be left with the impression that merchandise margin materially increased at Payless? Could you give us some sense of how much merchandise margin increased?

Douglas Treff

I can’t give you a sense of how much it increased but I did give you some factors and one of the factors that in addition to the rent relationship, I also indicated that the distribution center costs which are part of our gross margin, those were down this year compared to last year related to the distribution centers. So I did touch on that. So that played a roll; that was a factor as well.

Robert Wilson – Tiburon Research

You’ve also, I think women’s casuals have outperformed for many quarters in a row, I’m just curious if you’ve been adjusting the mix of your product towards more casual styles versus dressy or men’s or has there been any change in the mix of your product over the last year?

Matthew Ruben

Yes actually there has been. We have increased the mix of casuals because we’ve seen the sell-through rates and the GM ROI higher and also it enables you to move through certain season changes more effectively. So the answer is yes. As we mentioned we flowed sandals later which meant that we flowed more casual product during that transition time period and it was successful. I think one of the things also to note is that when you heard Payless inventory per store was down 10%. That’s fairly material and yet we were at a 6.5% comp store decline and we had an increase in our gross margin, in our merchandise margin. So overall we had a pretty well managed first quarter and considering the overall environment we walked away feeling pretty good, generated a lot of cash and showed that we have a good free cash flow machine here.

Robert Wilson – Tiburon Research

It’s fair to say that casual shoes have a higher merchandise margin then dressy or men’s?

Matthew Rubel

No that’s not what I said. I said they have a higher GM ROI then sandals is what I was saying so in other words that gross margin return on investment which is a component of the actual dollars given, the percentage as well as the turns, so it’s a mathematical formula that basically means how much gross margin you’re bringing into a store at a given point in time.

Robert Wilson – Tiburon Research

So casual shoes have a merchandise margin equal to the other categories?

Matthew Rubel

We don’t give out merchandise margin by category.

Operator

Your next question comes from the line of Heather Boksen - Sidoti & Co.

Heather Boksen - Sidoti & Co.

You kind of touched on it a little but with inventories down 10% on a per store basis at the end of the quarter, should we looking going forward at least through the remainder of this year for similar inventory declines? Are you going to plan inventory? Can we expect that you’ll plan that conservatively going forward?

Matthew Rubel

No, there were two pieces of why that happened. One was tight management and later flow of sandals, the other was the very early Easter against the later Easter. So you naturally had higher inventories the year before because of a later Easter. So next year you will also have probably a change in inventory levels toward the end of the quarter because Easter falls later again. So that’s a piece of it. But no they won’t be planned down that conservatively. We are very cautious in our overall top line. We’ve left room for ample markdowns and we really are looking at it on a units per store basis as well. So we’re just trying to keep it fresh and make sure we have good receipt flow.

Operator

Your next question comes from the line of Unidentified Analyst

Unidentified Analyst

Just a question about just some debt level guidance for say a year out, any cash flow left to pay down some debt balances?

Matthew Rubel

I’ll just say that we want to first deal with our litigation issues and see where that all ends up so beyond that though I would say that we should have free cash flow and that free cash flow would be used to either pay down debt—pay down debt would be one of our top things. We can look at share repurchase, there are all sorts of other things but I would say that paying down debt would be a part of one of our models that we’re looking at.

Matthew Rubel

Thank you very much; appreciate it. I think that does it.

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Source: Collective Brands, Inc. F1Q08 (Qtr End 05/03/08) Earnings Call Transcript
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