Zep F3Q08 (Qtr End 5/31/08) Earnings Call Transcript

Jul. 9.08 | About: Zep Inc. (ZEP)

Zep, Inc. (NYSE:ZEP)

F3Q08 Earnings Call

July 9, 2008 11:00 am ET

Executives

Jill Gilmer - Assistant Corporate Secretary

John K. Morgan - Chairman of the Board, President, Chief Executive Officer

Mark R. Bachmann - Chief Financial Officer, Executive Vice President

Analysts

 

Michael S. Sison - KeyBanc Capital Markets

Matthew S. McCall - BB&T Capital Markets

Robert Felice - Gabelli & Company

Richard Glass - Morgan Stanley

John Emrich - Ironworks Capital

Andrew Cash - Point Clearview Management

 

Operator

 

Good morning and welcome to the Zep Inc. conference call. On the call today will be John Morgan, Chairman, President and Chief Executive Officer; Mark Bachmann, Executive Vice President and Chief Financial Officer; and selected members of senior management. (Operator Instructions) Now I would like to introduce Jill Gilmer, Assistant Corporate Secretary. You may begin.

Jill Gilmer

Good morning and thank you for joining Zep today on our 2008 third quarter conference call. Here with us are John Morgan, Chairman, President and CEO; Mark Bachmann, Executive Vice President and CFO and other selected Zep officers. I would like to remind everyone that certain information included in this conference call may contain forward-looking statements that involve risk, uncertainties, and assumptions. If the risk or uncertainties ever materialize or the assumptions prove incorrect, our results may differ materially from those expressed or implied by such forward-looking statements. All statements other than statements of historical facts could be deemed forward-looking, including but not limited to any projections of financial information, any statements about historical results that may suggest trends for our business, any statements or the plans, strategies, and objectives of management for future operations, any statements of expectation or belief regarding future events, potential market, or market size, and any statements or assumptions underlying any of the items mentioned.

For a description of risks and uncertainties, please refer to the company’s filings with the Securities and Exchange Commission, including its Form 10-K and its recently filed 10-Q. Now I will turn the call over to John Morgan.

John K. Morgan

Thank you, Jill. Good morning. Thank you for joining us today. I’ll take a few minutes to comment on our third quarter results and the highlights of our strategic initiatives, and then I’ll ask Mark to provide a more detailed description and answer questions about our third quarter results.

There are a lot of moving parts which have -- summary for the quarter. I am very pleased with the progress our people have made on our previously announced initiatives. In addition, despite operating in a difficult economy, we generated very solid cash flow during the quarter. Continued increases in raw material cost put downward pressure on earnings as cost inflation slightly outpaced our ability to achieve price increases in a timely fashion. However, our solid cash flow once again demonstrated the recession resistant nature of our business.

We did announce another price increase early in our fourth quarter as our January increase was not sufficient. However, the most recent adjustment had no impact on the third quarter results.

Finally, the progress made on our strategic initiatives resulted in a restructuring charge in the quarter, which was greater than originally anticipated due to a more aggressive set of actions than were initially envisioned.

During the quarter, we reported net income of $200,000, or about $0.01 per diluted share, compared to $3.6 million or $0.17 per diluted share reported in the same quarter of the prior year. On an adjusted basis, which excludes $9.3 million in charges for restructuring and other special items taken in the quarter, the company generated adjusted net income of $6 million, or $0.28 per diluted share during the quarter. As compared to the adjusted $6.3 million, or $0.30 per diluted share reported in the year earlier period.

Now, at the risk of stating the obvious, the near-term economic environment remains very challenging, as very few economic indicators have shown signs of much strength an in particular, raw material cost inflation is at historic levels, making continued price increases necessary.

However, as many of you know, our business has historically shown a resistance to recessionary factors, as the demand for our products and in particular our cash flow generation has historically remained relatively stable. We believe that premise is still true for Zep and for most of our industry.

Our volumes this quarter did decline slightly following planned reductions in our sales capacity, as we instituted stricter performance standards and modified our new hiring practices. We also experienced continued softness with transportation related and home improvement customers. That said, as our strategic initiatives are implemented over the next several quarters, we expect unit volume growth.

To help offset a portion of the rising raw material costs, we continue to reduce our employment headcount as we become more productive. However, price increases were also necessary.

With regard to our key strategic initiatives, first I am pleased to report that during the quarter, we began implementing a number of key components of our demand shaping initiative, which is designed to reduce complexity in our business and enhance the customer’s overall experience with us. By doing so, we expect to reduce overall inventories and drive long-term margin improvement. The first step in the process is to rationalize our product offerings to simplify our portfolio.

We began the process during the quarter and are continuing to aggressively implement right now. During this process, we expect to eliminate 50% of our overall product offering in our North American INI business. Here are some examples; Zep was offering 34 different fragrances in our popular Meter Mist line of air fresheners. Some fragrances were confusingly similar and we believe we can fully meet customer’s need for variety while offering 12 unique fragrances.

In our hand care product line, we had more than 250 different stock keeping units for a variety of uses. We have reduced this line to less than 150 SKUs, yet we still satisfy virtually every customer application. Our customers have communicated an understanding of the need for these changes and their actions suggest they will support a streamlined product offering as they recognize the ultimate benefit to our customers as we simplify our business.

We may see some volume declines and additional liquidation cost in connection with continued demand shaping. Keep in mind, however, that this is consistent with the first phase of our transformation, wherein we are making the business better first and foremost. As we eliminate products, we are focused on relatively lower volume items and in the long-term, we expect margins to improve as we reduce our cost structure.

As we turn our attention to growth in the future, we will be able to take advantage of this more attractive cost structure.

Another element of our demand shaping that we did execute in May was to significantly increase the minimum order size that we accept. This change will eliminate smaller transactions that take valuable time away from servicing our best customers. It also encourages some smaller customers to expand their spending with us or at least consolidate their individual transactions with Zep, thereby reducing both ours and their transaction volume.

While it will take some time for these initiatives to produce tangible results, the early signs are encouraging. For example, since May, the average order size increased 23% while the number of related transactions decreased 19%. This will allow us to reduce transaction related costs.

Next, our expansion into the $6.4 billion industrial distribution channel is progressing as planned. Our distribution sales team has been established. A branding strategy focusing on Zep Professional has come together. Our product line and packaging development is nearly complete and sales calls have begun. We are in various stages of discussions with a number of distributors in this target market and we like where these discussions are leading. As a reminder, we expect this channel to account for 10% to 15% of our total revenues within the next three years.

We also continue to implement lean in our manufacturing and distribution operations during the quarter. While we are still in the initial stages of our lean transformation, we are beginning to implement our near-term objectives and continue to identify ways to improve our manufacturing processes. Currently, we are focused on reconfiguring our production layout to take advantage of cellular designs which require less floor space, reduces overhead costs, and enhances our ability to produce a variety of products with fewer equipment changeovers.

In order to align product demand signals with our production efforts, we’ve begun the use of [ConVon], which replenishes inventory based upon customer demand. This scheduling method, along with our cellular designs, will reduce inventory and improve manufacturing productivity.

Our efforts on this front are showing good early results, as in the third quarter we reduced inventory days on hand by five days when compared to the third quarter of 2007. Continued inventory reduction will allow us to more effectively invest in the needed inventory build-up of our new Zep Professional product line.

For those of you familiar with the lean process, you know it takes time for this work to translate into significant cost savings but given the number of areas we have already identified for improvement, we are excited about the long-term potential that lean will create. Not only will this process help streamline our existing operations but the changes we are making will serve as a model as we build new manufacturing facilities.

Turning to [NAMADs], to date our initiative focused on our North American manufacturing distribution strategy has focused on strategy development, which is now basically complete. Analysis has now begun on site selection for regional blending capabilities. We are narrowing our focus to the exact states and communities for our new sites. As we enter into our fiscal 2009, we will be prepared for execution which again, I expect to take two to three years for final completion.

During the quarter, we completed the relocation of our corporate headquarters from our Riverside location to our seaboard location, which also houses our largest manufacturing site. Aside from the expected cost savings from centralizing our operations, we expect and are already seeing a number of other benefits from having our management team and corporate staff at the same location. While the costs associated with closing the corporate headquarters was considerable, it was absolutely the right thing to do for the future of this business.

As we’ve stated during previous conference calls, we have begun the transformation of our business this fiscal year to position the company for more profitable growth in the future. As you can see, the quarter featured meaningful advancements in our restructuring process. We are not only changing the way we do business but we are changing the culture to one that places a greater emphasis on profitability and cost containment first to prepare for profitable growth.

Our overarching goals can only be satisfied by providing a superior customer experience, which will be enhanced by our transformation process.

Now, I continue to expect inconsistent financial results as we move forward with our restructuring initiatives, particularly as we identify additional investments in the short-term that will drive margins and cash flow in the future. Taking that a step further, while we anticipate that our strategic initiatives will positively impact our business in the future, they have the potential to adversely impact our operating results in the next couple of quarters.

Overall, the way we do business at Zep is changing for the better and I have witnessed a dramatic change in our culture, as our valued employees are becoming more proactive, accountable, and are truly taking ownership of the transformation we are undergoing. They have adopted the new strategic direction of the company and are incorporating it into their daily work. I am very proud of what our people are accomplishing and our customers seem receptive to these changes as they are ultimately the ones most positively affected.

Now I will turn the call over to Mark for a review of the third quarter fiscal 2008 financial results. Mark.

Mark R. Bachmann

Thank you, John and good morning. Our third quarter revenues were $145.2 million, compared with $145.4 million reported in the year earlier period. Sales were positively impacted by currency and translation of $4.3 million on international sales, as well as a $2.1 million gain from higher selling prices following the price increases implemented earlier in the year. However, these gains were offset by $6.6 million related to a decline in volumes, which stem primarily from reduced selling capacity following our plan modifications to our hiring practices and stricter enforcement of our sales performance standards.

We are pleased with the 10% increase in our productivity, as measured by sales per employee. Additionally, the third quarter of fiscal 2008 included one less selling day than the year-ago period, which had a meaningful impact on our year-over-year revenue comparisons. We continue to be pleased with the growth in our European business, with our Green Lean product lines and with our food processing customers.

As John mentioned previously, our third quarter fiscal 2008 net income amounted to $200,000, or $0.01 per diluted share. On an adjusted basis, which excludes special items, Zep recorded adjusted net income of $6 million, or $0.28 per diluted share. This compares to adjusted net income of $6.3 million, or $0.30 per diluted share recorded in the year earlier period.

The decline in adjusted earnings per share can be attributed to higher raw material costs, investments related to ongoing strategic initiatives, and increased standalone public company expenses. As detailed in today’s earnings release, the current quarter special items included restructuring charges, which I will discuss further in a few minutes, and last year’s third quarter special items included the $5 million environmental charge.

Operating profit was $900,000 compared to $7.5 million in the third quarter of 2007. During the third quarter of 2008, we recorded a $9.3 million charge associated with restructuring and other initiatives which directly impacted operating profit.

I would like to take a few moments to walk you through these special items, each of which was incurred in an effort to improve our long-term cost structure. First, we recorded a $4.5 million charge for employee severance related to the new organizational structure we announced last month. That will decentralize many functions of our business to establish decision-making and accountability closer to the customer.

Additionally, the expected reduction in transactions resulting from demand shaping will enable us to further right-size our cost structure. We expect the annualized savings from the actions in the most recent quarter to approximate $3.6 million and when combined with the actions taken in the second quarter, will total $5.8 million. We expect this to be at this annualized run-rate by the end of our second quarter in fiscal 2009.

Next, during the quarter we took a $3.3 million charge related to the consolidation of our corporate headquarters, which includes certain assumptions made regarding future revenue from sub-lease rentals. As a reminder, we expect $700,000 in identifiable annual cost savings from this consolidation, as well as many other benefits associated with having more of our Atlanta based resources at one location.

Lastly, we recorded a $1.5 million charge related to the write-down and disposal of discontinued inventory as a result of our product line rationalization initiative that John discussed earlier. This charge addresses the integration of our Selig product line into Zep and the first wave of reductions from the bottom half of our products in our North American INI product line.

As we continue the product line simplification, we may incur additional write-downs of inventory, particularly related to unique raw materials.

While it is too early to quantify the benefits from this product line simplification, we expect those will include manufacturing productivity, reduced inventory and warehousing space, and potential purchasing synergies.

In the future, we will likely incur additional restructuring expenses as we further reduce the complexity of our products and customer portfolio, realign our manufacturing and distribution operations to better serve our customers, exit certain leased properties, and take further actions necessary to streamline the business.

Another factor that adversely impacted our quarterly results was rising raw material costs. During the first five months of the calendar year, we witnessed a dramatic and broad-based increase in raw material prices -- in particular, energy related materials. This problem is not Zep specific as our industry and other industrial manufacturers are facing the same issues.

At the beginning of the calendar year, the company instituted price increases to offset the rapid price appreciation of these raw materials. However, during our fiscal third quarter, the unparalleled increase in raw material prices outpaced the pricing actions taken earlier in the year. As such, in an effort to offset this continued spike, during the month of June we instituted an average 7.5% price increase on industrial and institutional products in North America, and had communicated price increases to all of our retail customers.

If raw materials continue to increase, we will take the necessary pricing actions to manage our profitability.

Three other factors influence our operating cost during this quarter. One was a favorable insurance expense of approximately $2.6 million, stemming from a reduced headcount and favorable claims experience; two, continued investment in our strategic initiatives totaling $700,000; and thirdly, the costs associated with being a public company were $400,000 higher in the quarter than in last year’s comparable period.

The effective tax rate for the third quarter was 64.9%, compared with 44.2% in the same period last year. The effective tax rate in the third quarter of fiscal 2008 was negatively impacted by changes in our estimated pretax income resulting from the restructuring. The prior year’s comparable quarter’s tax rate was adversely affected by the non-deductible fine paid during the second quarter of fiscal 2007. The company anticipates its annual effective tax rate to be approximately 37%.

Despite operating in a challenging market environment, especially as it relates to rising raw material costs, we still generated $12.7 million in cash flow from operations during our fiscal third quarter. Contributing to the results was a continued focus on operating working capital management. As John mentioned, our focus on [combine or pull] is helping to drive the reduction in inventory.

During the quarter, we also reduced the company’s long-term debt obligation net of cash by $10 million. Our priorities for the use of cash are first, investments required to implement our strategies; secondly, to fund the stated quarterly dividend; and thirdly, to pay down our revolving long-term debt.

Now, turning to the results for the first nine months of the fiscal year, net sales were $421.9 million, up slightly compared to $413.3 million generated in the first nine months of fiscal 2007. For the first nine months of fiscal 2008, net income grew 21.2% to $8.4 million, up from the $6.9 million reported in the same period last year.

Earnings per share for the nine months were $0.39 per diluted share versus the $0.33 we recorded last year. Adjusting both periods for special items, EPS on an adjusted basis for the first nine months of 2008 have increased 18.5% to $0.69 compared to the $0.59 for the same period last year. Year-to-date cash flow from operations is $10.5 million, equal to last year. Our year-to-date capital expenditures totaled $5.1 million, an increase of $1.7 million from last year. We anticipate fiscal 2008 capital expenditures will range between $7 million and $8 million.

At this time, we would like to open up the call to questions. Operator.

Question-and-Answer Session

 

Operator

(Operator Instructions) We’ll go first to Mike Sison with KeyBanc.

Michael S. Sison - KeyBanc Capital Markets

Hey, guys. Nice quarter. I just wanted to better understand the demand environment that you are seeing here. So your [inaudible] 3% -- is that mostly from the product rationalization and your inclination is that your markets or demand is basically flattish?

John K. Morgan

Mike, I’ll ask Mark to comment. He’s probably got some specific data on that. In general, the market for our products is still -- I’ll just call it a pretty good market. If you think about our market share of this $15 billion market, our share is such that I don’t believe we should be dramatically impacted by the overall economic conditions. Now, having said that, there are puts and takes. You know, you can imagine when somebody pulls up to the gas station today and they fill up for $60 instead of $40, they might think twice about getting that car wash every time as opposed to every third or fourth time, and that has some impact, for example, on our car wash business.

On the other hand, in food areas we continue to see very solid demand, so while there are puts and takes within the various different sectors, overall it’s still a pretty good demand. I wouldn’t say it’s very, very rapid growth anymore than there is with GDP.

Mark, have you got some specifics on the areas where we were up and down?

Mark R. Bachmann

Well, one point I would like to point out is that the one less selling day did have an impact on volume, and so that probably contributed to 25% to 30% of that overall volume decline. As we indicated and John mentioned, transportation and home improvement sectors were soft and that’s pretty indicative of what’s happening in the marketplace. And we were pleased with the food processing, as well as growth in government and schools and hospitality.

John K. Morgan

And Mike, just one last thought -- I don’t think that -- you asked specifically about product rationalization. I don’t think much of that came from rationalization of the product line at this point in time because of the nature of the products that we are taking out at this point in time. However, to Mark’s point, we have reduced our selling capacity somewhat as we’ve toughened up our performance standards in our rep force. And that has to have some impact.

Michael S. Sison - KeyBanc Capital Markets

Okay, so going forward the volume implications from the product rationalization should be bigger?

John K. Morgan

Well, what we’ve said in the past is that we think with all the various different initiatives underway, including the product rationalization and the simplification process, that we think at risk for the business is revenue ranging from $5 million to $20 million at the top. And I’m just going to stick with that for right now, and from a planning standpoint here, what we’re doing is we’re focusing on the cost adjustments necessary to deal with any revenue declines that might be experienced as we go through that transformation process.

Now, when we come out at the other end of this, I think I may have mentioned in the prepared statements here in the conference call by the time we get into our Q2 and Q3 of next fiscal year, which begins September 1st, we’re starting to get into that period of time where I would expect some of those initiatives to be bringing new business, new revenue in which should have an offsetting or more than offsetting effect of some of those areas where I think there will be some declines.

Michael S. Sison - KeyBanc Capital Markets

So assuming the markets remain stable heading into 2009, you should start to see an inflection point in volume maybe sometime in the second, third, or fourth quarter?

John K. Morgan

That’s my expectation.

Michael S. Sison - KeyBanc Capital Markets

Okay. Then Mark, the price increases -- well, year-to-date your raw materials were up about $6 million or so. It looks like pricing was up a little bit more than that, so you’ve actually kept pace year-to-date with raw materials?

Mark R. Bachmann

That is correct, year-to-date but if I can call your attention to the rapid increase in the last couple of months.

Michael S. Sison - KeyBanc Capital Markets

Right, so if the price increases that you have initiated stick, you would keep pace again going forward?

Mark R. Bachmann

Yeah, and we would continue to evaluate closely the raw material costs and our pricing actions, as well as taking other actions, as John mentioned, to our cost structure to minimize the impact that we’d have to pass on to our customers.

Michael S. Sison - KeyBanc Capital Markets

Right, and so the raw material increases you are seeing are pretty big, like 20%, 25% if I did the math?

Mark R. Bachmann

They are quite significant and you can go to some of the raw inputs and you see in terms of some of the crude oil things that are related to that, benzyne, ethylene, gasoline, and the like, they are all up significantly on a month-over-month level and a quarter over quarter basis.

Michael S. Sison - KeyBanc Capital Markets

And your assumption is to raise prices at 7.5% assumes more price increases to you as the next six months come along? Meaning your compensating for potential for more increases down the road from raw materials?

Mark R. Bachmann

We have some estimates in there but once again, it depends on where the crude oil and other commodities -- you know, we’re not only affected by crude oil but by steel, we’re affected by crops and commodities such as corn and soybeans as well, so it’s pretty broad-based and really depends on what the inflation impact is across a wide array of raw materials.

John K. Morgan

Mike, let me just pile on and tell you -- we’re in an environment, I suppose it’s probably very similar to many others, not only in our industry but other industries, we’re in an environment now where we can’t afford to look at raw material increases that might occur every six months or every year. We’re looking at it weekly and monthly at this point in time, so we’ll just have to make the necessary adjustments as we see what happens.

It’s frustratingly difficult to predict at this moment in time.

Michael S. Sison - KeyBanc Capital Markets

No, I understand and last question; when you think about -- I think you outlined it to a degree but the amount of cost savings you think you can generate in ’09 based on what you’ve accomplished thus far?

Mark R. Bachmann

Well, we’ve outlined that the restructuring initiatives between the reduction in headcount and the closure of our manufacturing or our office location, the combined between those two should be $6.5 million on an annualized run-rate.

Michael S. Sison - KeyBanc Capital Markets

As we head into ’09?

Mark R. Bachmann

Well, when we’re -- we should be at that full annualized rate by the end of the second quarter of fiscal 2009.

Michael S. Sison - KeyBanc Capital Markets

Okay. Great. I’ll get back in queue. Thanks.

Operator

We’ll take our next question from

Matthew S. McCall - BB&T Capital Markets

Did you talk about the -- I think you kind of inferred that the cost environment did outpace your pricing environment. What was the delta or the price that you pushed through, what was the delta that you recognized in Q3?

Mark R. Bachmann

Our costs had increased by -- what was it, about $4 million I believe we had in the --

Matthew S. McCall - BB&T Capital Markets

I’m sorry, if you said it, I missed it, so --

Mark R. Bachmann

It was about $3 million, we had an increase in overall cost. Part of it was due to the write-down of raw materials, and we had pricing of about $2.1 million, so it was about $900,000 of a net delta in the third quarter.

Matthew S. McCall - BB&T Capital Markets

And I think -- so obviously that was a portion of the hit to your gross margin in the quarter. As we look forward to Q4, you’ve had 100 basis points of pressure Q2 over Q2. You’ve had now closer to almost 300 -- or I’m sorry, 200 basis points Q3 versus Q3. Are we back to a level -- I know there are a lot of moving parts, as you’ve said, but are we back to a level where we start to see some stabilization on a year-over-year basis? Or I think you did 57.5% in Q4 of last year, or are we talking about levels still in the 56.5 range like Q3? I’m trying to get a handle on what that -- I know you put through some incremental pricing. It sounds like it’s still dynamic but based on what we know today, are we going to see stabilization either at current levels or versus the prior year?

John K. Morgan

I’m going to let Mark pull out some data here, give him just a minute to pull that out but Matt, my expectation is that we are reaching sort of a stable level, if you will, of increase from a dollar standpoint. It’s still possible that you’ll see some gross margin percent degradation as we try to recover the dollar increases in raw materials with our price increases. But I have a high level of confidence that the price increases we announced in June will offset those dollar increases that are coming into our spending in this fourth quarter.

Mark, do you have anything to add to that?

Mark R. Bachmann

I concur with that, John.

Matthew S. McCall - BB&T Capital Markets

Okay, and just to make sure I understand, seasonally it looks like Q4 gets a little bit stronger, so when you’re talking about dollars, you’re talking about on a comparable top line Q3 to Q3, so we’re at $63 million in cost of goods and your costs are going to go up X based on inflation but they will also go up because your volume should be higher. So I guess I’m getting lost a little bit there on what you mean from an absolute dollar basis.

Mark R. Bachmann

Well, let me jump in here -- in terms of the dollars increased, you know, on a same level of volume, we would expect that our pricing would offset our dollar increase in costs, okay? So that the margins that we saw in the third quarter probably as we go into the fourth, you know, as John said there still could be some downward pressure on those overall gross margins but we believe that we will offset the dollar increase.

Matthew S. McCall - BB&T Capital Markets

Okay. And John, you talked about the -- you continue to talk about the expectations for inconsistent results in the near term; specifically, you talked about the next couple of quarters being adversely impacted by near-term spending. Should we -- bear with me -- I think in the past you’ve talked about the second half representing about 60% of your earnings and the first half, 40%. Are we still on track to -- I’m trying to get an order of magnitude for Q4 on the earnings line, what’s expected from a pressure standpoint.

John K. Morgan

Well, again I’ll Mark pull a forecast out here and comment on based upon what he already has or has not publicly disclosed, but I don’t think at this point in time there’s as much expectation on our part that the sort of seasonality, if you will, of our volume and our cash flow generation in particular will have changed materially this year compared to our history.

I see Mark’s pulled out his calculator so I’ll let him to add on.

Mark R. Bachmann

I think relative to the second half of the year, what we have stated and still believe, it’s stronger than the first half of the year in terms of the profitability relative to the sales in the second half and we would still expect that to be the case.

What we had said what’s driving the top line is just -- and we are sensitive to the number of available selling days, and there’s just more selling days in the second half of our fiscal year than the first half of our fiscal year.

Matthew S. McCall - BB&T Capital Markets

Okay, okay, that’s helpful. And then maybe one additional question on the distribution strategy, or entering distribution -- it sounds like you said various stages of talks. Can you provide any other color on or detail on the types of customers and maybe where you are expecting the most near-term success there?

John K. Morgan

Yes. If you think about, and I’m going to sound a little evasive here because we are at those stages where I have a high level of confidence that we’ll have some distribution arrangements in the future, but we haven’t entered into conversations about the timing and the nature of what we say publicly about all that with those we’re in negotiations with.

Having said that, if you think about some of our core capabilities and things we’re trying to bring to market, we think the segments that are important to us are areas such as maintenance and repair operations, areas such as [Jansan], a food area is an area where we are particularly skilled. We’ve got some very interesting plumbing products. We’ve got some very interesting products for the electrical industry. There’s of course some very interesting products in the automotive industry and so those are some of the segments that we are interested in. The fact is what we have is a situation where about $6 billion worth of sales go through distribution because there are a number of customers that for whatever reason prefer the kind of services that they can obtain from the distribution model, from the industrial distribution model.

And so we’re actually having conversations with folks from a variety of those various different verticals, as highlighted in the examples I just gave. And as you would expect, we are having varying degrees of success or optimism in those conversations but I’m not seeing anything that would cause me to back off of a belief that that ought to be 10% to 15% of our revenues in the next two to three years.

Matthew S. McCall - BB&T Capital Markets

Okay, that’s fair. The final question, you talked about the decentralization, and I know you’ve talked about it in the past and having blending, regional blending facilities, remind me, a lot of time these -- this utilization is actually associated with increased levels of costs. Help me understand the puts and the takes there. You are going to increase your service levels but potentially have higher levels of costs. How should we look at the net impact to your margins from those efforts?

John K. Morgan

Again, I’ll let Mark comment on the specific number, since I don’t do math in public, but let me just talk conceptually about this a minute. It’s not my belief that what we are talking about brings increased levels of cost into our business. It’s my belief that we’ll bring reduced levels of cost into our business and Mark I’m sure will refer to the long-term financial goals that we’ve already spelled out with regard to that.

Here’s the issue -- from the standpoint of manufacturing and logistics, our business and our industry is somewhat logistics intensive. We’re moving a lot of product across North America, as an example, and it’s not a terribly capital intensive business. So to set up some blending in closer proximity to our customers can have the impact of allowing us to reduce our overall finished goods inventory levels in that region. It can have the impact of reducing our logistics costs associated with serving that region and those improvements in our performance I believe should be -- should more than offset the costs associated with setting up those operations in those locations.

Furthermore, we’re not working from a total clean sheet of paper in that we’ve got some capabilities in some regions that we can expand upon, so it’s not my expectation that it’s fully and completely greenfield.

As regard the decentralization, it’s also -- it’s not just about logistics and manufacturing. It’s about the organization as a whole. I am of the view that when you decentralize the business, organizing around smaller, more manageable, simpler businesses with people close to customers with greater accountability and greater authority, they will make better choices and better decisions about the business day in and day out than, for example, what I could make here from some corporate office, as evidenced by the fact that we believe that we will get through over the next two quarters this decentralization process from an organizational structure standpoint and, in spite of the leadership talent that has to be put in those decentralized locations, we’ll still end up reducing headcount some hundred people.

And so Mark, I’ll let you add flavor to that from a standpoint of what you’re forecasting in terms of the benefits but Matt, I’m just not of the view that we’ll add cost in going through that. We’ll actually take cost out.

Mark R. Bachmann

The only thing I would add to that, John, with respect to the [NAMAD] strategy as well we’ll be adding manufacturing capabilities. We also believe that we’ll be able to reduce our distribution footprint that will take fixed costs out of our cost structure as well. Additionally, those manufacturing sites will gain the benefit of our learnings from the lean perspective and we believe that we’d be able to set up more efficient cellular manufacturing and it would be more productive going forward.

Matthew S. McCall - BB&T Capital Markets

Okay. That’s all very helpful and I know I said last question, but I have one more; can you give me an update on -- it sounds like there was some weakness in the retail segment in the quarter. Can you give us an idea of where that stands as maybe a percent of sales, or what the year-over-year trend was like from a revenue perspective in your retail segment?

Mark R. Bachmann

Retail I think in the third quarter represented in that 15% to 17% of our total revenues, which was pretty consistent with our overall business and where it’s been in the past year. And I think the trends with particularly home improvement are pretty well known with housing and starts being down.

Matthew S. McCall - BB&T Capital Markets

Okay. All right, thank you, all.

Operator

We will go next to Robert Felice with Gabelli & Company.

Robert Felice - Gabelli & Company

Most of my questions have been answered, just a couple more; it seems like you are starting to make good progress on the demand shaping front. How long will it take before that initiative is fully implemented or finished? And then also, you mentioned the $5 million to $20 million that’s at risk and I know, John, you’ve also said in the past that you are going to work to convert some of that business to alternate product. How is that effort coming along? And I don’t know if it’s too early to tell yet but where are you tracking in the range of that $5 million to $20 million?

John K. Morgan

Robert, that’s a great question. The demand shaping initiative, as we currently full envision it, I believe the work associated with that will be complete by the time we get to the end of the calendar year. And then you begin to see -- let’s be clear about what happens; through demand shaping, it brings a simplification to a variety of processes in the business. In order for demand shaping to the be valuable to us, we have to take cost out of our business in those areas that have been simplified as a result of the demand shaping effort.

The example I would use from Q2 with transaction volume being down 19%, you can imagine in any organization there are areas of the business where your activity level -- that is, your demand for human resources, is affected by the actual transactions you are processing in the course of the day.

So I would expect then, as the demand shaping process is complete, that then you end up with another quarter or so to have to go through to then take resulting cost out. Understand what we are doing here is we are focusing on taking work out before we take resultant headcount out as opposed to just coming in and taking headcount out and hoping the work comes out.

And so quite frankly, it takes an extra quarter or so to get through the process but I think you end up providing a lot better experience for your customers in handling it that way.

As regards trying to move customers to alternate products or products that provide the same function, I’m just very pleased with what I’m seeing. We had a report out here not long ago on that and I have -- I just have a very, very high level of optimism in terms of our ability to service our existing customers not only as effectively but actually a heck of a lot better, as you simplify the business. And so I’m not really concerned too much about that portion of demand shaping and the impact it has on revenue. All of the other moving parts still have some impact on generating some risk to that overall top line, and so I’m still sticking with my view and internally preparing for what happens if we realize a decline in revenue in that range that we talked about. But on the product line portion itself, I’m very optimistic about recovering that.

Robert Felice - Gabelli & Company

So it sounds like you are tracking more toward the five as opposed to the 20.

John K. Morgan

Well you know, given the deadlines associated with the various different initiatives that are underway, I really don’t want to take a view on it yet. In the coming weeks and months, we have a number of gating factors and dates in our various different projects internally that we’ve not disclosed. And until we get past those dates and those deadlines and see what the customer and rep market reaction is, I don’t want to narrow that range.

Robert Felice - Gabelli & Company

Okay, and then also, I know that long-term, John, you are targeting annualized EBIT margin improvement of about 50 basis points. But it seems to me that with a number of the actions that you are taking, we should probably at some point, and it sounds like that some point, it looks like it’s going to fall mid-year ’09, we should probably expect to see a step change in margins with all of the cost that is coming out. So I guess I was hoping you could comment on that and kind of the margin improvement expectations as we look out over the next 12 months or so.

John K. Morgan

Robert, there you go again. As you know, we’re going to go ahead and stick with at this point in time what we’ve articulated in terms of the annualized rate of improvement on a long-term basis. And then as we take a finer view, if you will, of the outcome of these various different initiatives, we absolutely will update our thinking on those objectives as we have better data.

What I’m leaving room for in those goals is the fact that we are making investments back into the business at the same time that we are improving those margins. For example, our distributor selling effort, we’re fully funding that as an expense and that’s just one of the expenses associated with all the various different moving parts of these initiatives. So I’m not ready to say, Robert, at this point in time that when you get into the middle of fiscal ’09, you would expect a step level improvement at the margins. But I am ready to say that by the time you get to the center of, middle of fiscal ’09, we’ll have I think awfully good data with which to update our expectations about those long-term goals.

Robert Felice - Gabelli & Company

Okay, well I mean, when I looked at the mid ’09 mark, you said you will be at the run-rate, you know, $6 million in savings from some of the restructuring activities, the demand shaping will have finished and you will have had that extra quarter or two to take out some of the cost there. So I mean, it does seem like excluding some major step-up in investment spend that perhaps we do get to some kind of change at that juncture.

John K. Morgan

It’s hard to disagree with what you just described, especially when you say barring some step-up in investment, and that’s what we’re not ready to disclose at this point in time.

Robert Felice - Gabelli & Company

Okay, and then I guess additionally, I noticed you lowered your CapEx budget from the year, $7 million to $8 million versus previous $8 million to $10 million. Is that a timing issue or a reflection of what’s going on in the economic environment? Just some color there.

John K. Morgan

It’s more of a timing issue and I would expect that the difference would probably roll over into the next fiscal year.

Robert Felice - Gabelli & Company

Okay, so as I look to fiscal year ’09, I should expect that to step up to that $10 million to $12 million, which you previously talked about?

John K. Morgan

We have said that we would expect that the -- we would be spending $12 million a year for the next several years to implement these plans, so any deferral that we’ve had this year will probably roll over on top that and we’re in the midst of finalizing our plans for the next fiscal year, and we’ll be able to bring greater clarity in the coming months on that.

Robert Felice - Gabelli & Company

Okay, but it could be a little higher than the 12?

John K. Morgan

Yes.

Robert Felice - Gabelli & Company

Okay, and then I guess lastly, a broad-based question; John, as you expand in the distribution channel and we think about Zep's overall sensitivity to the economic environment, does expanding in the distribution channel decrease the recession resistant nature of the business? I mean, you are going to increase your exposure on the retail side, so as we think about the company’s exposure over the cycle, does that change at all?

John K. Morgan

That’s a great question, Robert. I think that in the short run, it does not and the primary reason is the verticals we’re focused on in the initial stages are verticals, are market segments that we think we are particularly well-suited to service based upon our product formulation capabilities, our brand equity and so forth that currently exists. It’s just that we’re focused on customers who choose to be served by distribution as opposed to that high touch model that we have.

Now as time goes on and as we take that distributor capability and begin to try to reach out to other verticals, I would absolutely expect that it would have a further I’ll call it diversification effect, diversification impact and adds even further stability to the business. So yes, [out on a] long-term but I wouldn’t want to set the expectation that in the next 12 months, for example, that it would add a great diversity in terms of the end markets.

I think it does add diversity to our business in terms of the way markets are served and that’s always been [official] from a stability standpoint.

Robert Felice - Gabelli & Company

Okay, but not substantial enough to have any real impact in the current environment?

John K. Morgan

Yeah, no, I don’t think so. I don’t think in a window of time that you are talking about, I don’t think so.

Robert Felice - Gabelli & Company

Okay, great. Thanks for taking my questions.

Operator

We’ll go next to Richard Glass at Morgan Stanley.

Richard Glass - Morgan Stanley

Nice quarter, considering the environment. Can you guys give us any information on what’s happening with the size of your sales force? If not exact numbers, kind of where you are and where you are headed a little bit?

John K. Morgan

I’m going to let Mark comment there as well primarily, Rich, because I don’t know precisely -- I can’t remember off the top of my head precisely what we disclosed about that. We have decided primarily as a result of the competitive environment and the fact that our primary competitors are a whole host of private companies and I’m not particularly interested in disclosing our future state after a lot of this transformation is complete. We have decided to discontinue the practice of talking about specifically sales force headcount in our INI business, but instead are talking about overall company headcount and productivity in total.

It has -- the sales force has declined, as has the other -- various other management positions and I would expect that to continue somewhat for some period of time, as we are going through this change in the way we hire new reps and put in place the performance expectations that I think we’ve talked about in the past.

Mark, I’m going to let you add some color to that.

Mark R. Bachmann

I would say that the change in our hiring practices as we are moving forward, the more significant impact on that headcount is on the -- in the lower tenure bands of our organization. We’ve seen great stability in our overall tenure. The average tenure of our sales force is about 12 years and those folks who have been with us for more than five years, that’s a pretty stable group of reps and high performing and one of the reasons why we are able to get the productivity improvements the way we are.

The other piece is that, to the extent that the -- our change in hiring practices and the fact that, as John mentioned, the sales force has contracted a bit, has had impact on the top line, we believe that we have more than offset it with cost reductions from our recruiting and development of those same individuals.

John K. Morgan

The other thing I would add, Rich, and I know -- I apologize we’re not being as helpful as you’d like, but the other thing I would say is the -- we have not lost, nor do we expect to lose, reps from our top performing rep group.

Richard Glass - Morgan Stanley

All right, so I guess it sounds like you’re doing the right things at the sales force and I guess I’m after directionally more than specifics. I understand your viewpoint there. Where I’m headed with this though is in terms of the North American INI business, average order size up 23% and the number of transactions only down 19%, would that -- if you hadn’t had any sales force dislocation in there, would that number of transactions have looked better or do you feel like that’s an apples-to-apples? Obviously if you are moving people around and there’s new relationships where there used to be old relationships, things on the transaction side could flip as well, is my thinking here.

John K. Morgan

I’m not sure. It’s not 100% clear to us at this moment in time why the difference between the 23 and the 19. We know factually it is correct. I believe there is some phase-in associated in all of that that I’ll be very interested in reporting in our Q4 what we saw happen there and I’ll have a lot better read on that at that point in time.

Directionally with the sales force, Rich, I think what you can expect is some continued declines, particularly in our lesser performing areas in the coming weeks and months. Then I believe you can expect that that will be followed by our various different INI sales region management beginning to get back into the mode of increasing sales force headcount. But instead of bringing inexperienced reps in at a very low rate of pay and rate of performance, our focus is to bring more experienced reps in that we think can build a book of business more quickly, be more successful, and I’m willing to pay for that.

And so I would expect that as we get on into or early in our fiscal ’09, which as a reminder for everybody, starts September 1st, we would be starting to bring new reps back into the business.

So directionally, that’s the focus.

Richard Glass - Morgan Stanley

Okay. The last thing I wanted to do was just clarify -- you guys said you invested $0.7 million in consulting and other investments in support of your strategic initiatives. Those were expense, those weren’t part of the charge?

John K. Morgan

Those were expense.

Richard Glass - Morgan Stanley

Okay. All right, thank you. Keep it up.

Operator

We’ll take our next question from John Emrich with Ironworks Capital.

John Emrich - Ironworks Capital

Thanks. Can you just review or go back over and clarify the insurance recovery comment? I missed it and what I’m trying to figure out is number one, where it is; number two, does it represent a one-time reversal or contra account, if you will? Or is it in fact a new lower base of expense because of improvements? Or maybe it’s a combination of those things but I just kind of missed that.

Mark R. Bachmann

I’ll respond to that -- it actually is a combination of both in terms of needing to provide the adequate reserves for future liabilities as we project out, so that’s a one-time adjustment, if you will, to our reserves and we threw those up in each quarter as we look out. But then it does suggest that the ongoing rate of expense for insurance is improving.

John Emrich - Ironworks Capital

But was it a -- was the number you gave out, which was a seven-figure number, I think, was it just an amount that was an expense lower than prior year expense, or was it actually an inflow, a reversal, if you will?

Mark R. Bachmann

It was from an expense standpoint, it’s a year-over-year change. Last year’s third quarter, there had to be a -- we had a supplement, an add-in, additional, particularly property and casualty insurance last year. So it’s really reflecting a year-over-year change. This one was both the combination of medical insurance as well as property and casualty that were both favorable on a year-over-year basis.

John Emrich - Ironworks Capital

And those were all represented in SG&A?

Mark R. Bachmann

Yes, they are. There is some of it that relates to our manufacturing organization that would actually find itself in the gross margin.

John Emrich - Ironworks Capital

Super. Thank you very much.

Operator

Our next question comes from Andrew Cash with Point Clearview Management.

Andrew Cash - Point Clearview Management

As you roll out your new distribution partnerships, do you expect that Zep might be able to increase it overall business with its existing home improvement channel? You know, thinking longer term over the next few years?

John K. Morgan

Well, we do. Let me sort of bifurcate distribution, if you will, into the industrial and institution distributors versus sort of retail. The primary rollout of the expansion into distribution where we talk about the market being $6.4 billion is really mostly related to the INI, the industrial and institutional -- industrial distributors, those that serve maintenance and repair operations and the like.

Over on the retail side, actually the retail market for our type of product is about another $6 billion, so the combination of the two would be about $12 billion. Today, as you know, about 15% of our revenues goes through the retail channel. That’s overwhelmingly home improvement and hardware.

Now, in the home improvement and hardware, we do believe there’s opportunity for expansion there, albeit at a lower rate than what we’ve described in the industrial distribution because of our current satisfactory position in there and therefore the available target market to us. In particular, I’m going to further bifurcate that retail market and say that there are retailers that serve the typical consumer and then there are retailers that in addition to serving the consumer, serves consumers who want to buy what the pro buys, or retailers who serve small contractors, small businesses and that type of thing. Some of the home improvement, you know, big box stores, for example, would fall into that category, whereas say a food chain would fall into the former category.

You won’t see us anytime soon with our current capabilities go into that retail packaged goods consumer business. That’s not a core competency of ours. However, focusing on those retailers that serve the consumer who wants to buy what the pro buys, that is an area of opportunity for us.

 

Andrew Cash - Point Clearview Management

So you think the big box home improvement channel can actually improve in overall sales as you link up with these new distributors?

John K. Morgan

Again, I’m going to separate those things. The linking up with the new distributors and the focus that we’ve talked about in the past has really nothing to do with our retail business.

Andrew Cash - Point Clearview Management

I was just concerned about perhaps you may increase your business 10% to 15% with your new partners, yet you may lose some business with your current big box retailers.

John K. Morgan

I don’t believe our initiative related to industrial distributors will negatively impact our retail business. What could impact our retail business is if we went and did something dumb inside of the retail space that affected our existing retail relationships. We don’t plan to go do anything dumb.

Andrew Cash - Point Clearview Management

Okay. Thanks a lot and thanks for doing a terrific job.

Operator

There are no more questions at this time. I would like to turn the conference back over to Mr. John Morgan for any closing comments.

John K. Morgan

Well, thank you and while we are pleased with the implementation and progress of our strategic initiatives and restructuring efforts to date, we know there is still much work to be done. However, as I’ve stated previously, we are committed to our long-term growth and profitability plan which will transform our business into a stronger, more profitable foundation from which to grow. As we institute these changes, our competitive focus remains unchanged. We continue to hold a leading industry position, maintain strong customer relationships, and have a product offering that is unmatched in the markets we serve. We are focused on the task at hand and I am confident that our team at Zep will continue to generate improving shareholder value and continue to provide a superior customer experience.

Thank you all for your continued support.

Operator

And that does conclude today’s conference. We appreciate your participation and you may now disconnect.

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