Heelys Q2 2008 Earnings Call Transcript

| About: Heelys, Inc. (HLYS)

Heelys, Inc. (NASDAQ:HLYS)

Q2 2008 Earnings Call

August 7, 2008 5:00 pm ET

Executives

Donald K. Carroll – President & Chief Executive Officer

Lisa K. Peterson - Chief Financial Officer & Senior Vice President

John Benton Price - Vice President, Product

Analysts

Kevin Kim – Robert W. Baird & Co., Inc.

[Dimitri Cornasofskia – First Wilshire Securities]

[Scott – First Wilshire Securities]

Operator

Good afternoon ladies and gentlemen and thank you for standing by. Welcome to the Heelys, Inc. second quarter fiscal 2008 earnings conference call. At this time all participants are in a listen only mode. Following the presentation we will conduct a question-and-answer session. Instructions will be provided at that time for you to queue up for questions. (Operator Instructions) I would like to remind everyone that this conference call is being recorded.

Before we begin I would like to remind everyone of the company’s Safe Harbor language. Please note that this call will include forward-looking statements within the meaning of the Securities laws. All forward-looking statements included in this call are based on information available to the company on the date of this call, the company’s current expectations and various assumptions. The company believes that there is a reasonable basis for its expectations and beliefs but they are inherently uncertain. The company may not realize its expectations and its beliefs may not prove correct.

For a list of important factors that could cause the company’s actual results to differ materially from the forward-looking statements in this call please refer to the company’s public filings with the SEC including risk factors contained in the company’s annual report on Form 10-K. You are encouraged to read that section and all of the company’s other filings with the SEC. The company intends that all of its forward-looking statements in this call will be protected by the Safe Harbor provisions of the Safe Harbor provisions of the Securities Exchange Act of 1934. The company undertakes no obligation to publicly update or revise any forward-looking statement as a result of new information, future events or otherwise. All subsequent written and oral forward-looking statements attributed to the company or persons acting on the company’s behalf are expressly qualified in their entirety by the cautionary statements contained throughout this call and the company’s public filings with the SEC.

I would now like to turn the conference over to the Chief Executive Officer, Don Carroll.

Donald K. Carroll

Good afternoon everyone and thank you for joining us. I’m Don Carroll, the company’s new CEO. I joined the company at the end of January as Senior Vice President of Marketing and was named President and CEO in late May. I’ve been in the consumer products industry for over 20 years and my background includes management consulting, marketing strategic planning, product development at organizations such as Radio Shack, Ogilvy & Mather and a management consulting group I co-founded called Vector2Group.

I’m excited to be here and although there is still work to be done there is a tremendous opportunity to continue to build the Heelys brand and re-grow our business. We’ve taken the early steps to stabilize the core domestic business and we’re moving in the right direction. However, we are also working on putting the necessary people and systems in place to better manage the business. On the people side we’ve hired a new Chief Financial Officer, Lisa Peterson, and a new Vice President of Product, Ben Price. Both Lisa and Ben are veterans in their respective fields who bring a new level of talent and a fresh perspective to our business.

Lisa who is with me today on the call, and you’ll be hearing from her in a few minutes, brings 28 years of finance and accounting experience with startup and turnaround companies in both the public and private sectors. Most recently she was the Chief Financial Officer for Freedom’s a jewelry retailer with more than 450 locations. Ben has experience in footwear product development and merchandising with companies such as The Foot Locker, Champs Sports and Kaba Both Lisa and Ben are strong additions to our team and we’re certainly happy to have them join us.

Now just for a quick strategic overview. As many of you know our near term focus is on stabilizing the core domestic business. In order to do this we have focused on three key areas, the first one being inventory management, the second raising our margins and the third generating demand for our products. On inventory management we’ve seen a decline in our future orders over the past several months and as a result have been filling demand primarily with add once orders. We’ve also taken aggressive action to clear old inventory. This has reduced the level of inventory in the retail channel and eased the promotional pricing environment.

As a result most retailers have taken their prices back up to full suggested retail levels of approximately $50 and $60. In particular in the Northeast where we’ve seen the highest imbalance between supply and demand we have made significant progress with key accounts. We’re seeing healthier sell through levels and prices now approaching full suggested retail levels. As retailers begin generating more normalized margins on the sale of a pair of Heelys their confidence about the Heelys brand is being restored.

Now on raising margins as I just mentioned lower levels of inventory in the retail channel, a higher mix of new product and more focus on inventory management have translated into better margins for our retailers. As for our own margins we’ve experienced a similar positive trend on the newer products. However a lot of these positive developments have been offset by markdowns and aggressive actions we took on some of the older and excessive product that we have. So there are really two stories behind our gross margins in the quarter, one is the improving margins of our core business which consists primarily of a new in season wheeled product that is selling close to full retail prices and the other one is deep markdowns on older products across the apparel, non-wheeled and even some wheeled product categories. So it’s a little hard to tell from our results but we believe we are making progress on the margin front.

Now regarding generating demand, we have focused more effort on the prior development side of the business and driving demand to a better flow of new trend right product. Newness drives demand particularly in this environment. We’ve consistently seen this over the past few quarters where our newest styles have had the highest sell through rates. Young customers are increasingly aware of the latest colors, looks and designs in footwear and they’re certainly making their first decisions based on the looks and functionality of the shoe. We brought in Ben Price from The Foot Locker to head up our product area and have begun working with a new trend service group to identify these trends. In addition we are working more closely with our biggest retail customers in developing styles and colors. This more collaborative process has given us a better feedback loop and visibility with our customers. We saw this first hand at the WSA Trade Show last week.

Lastly, we’ve been working with new agencies in the areas of advertising, public relations and digital media which we hope should have a positive impact on demand generation over time.

Now for a second quarter overview, that’s a bit of a strategic overview but now let’s take a few comments on the quarter and then I’ll turn it over to Lisa to go through the numbers in more detail. Given the state of the overall environment and the impact on our business over the past year the new management team tends to look more at the business on a sequential quarterly basis rather than just a year-over-year basis. We think this is a bit more meaningful towards evaluating our incremental progress during the transition period. On that front both our revenues and margins improved from the first quarter in a manner that is consistent with our plan and our transition efforts.

In general our sell through rates across the country remain relatively healthy particularly in the new styles in the less penetrated areas such as the Midwest. As indicated earlier our gross margin in the quarter was impacted by aggressive markdowns on older inventory and non-core categories. That older inventory is being cleared primarily through the off price channel and with retailers that will not advertise the product. We expect to clear through most of the older product over the next few months. The Northeast has been our toughest region and as I mentioned earlier we’re starting to see some improvement in this region. We brought down inventory in this region to more manageable levels and restructured our sales team going from three independent reps to 12 independent reps in the Northeast and really working with an organization that is much better on planning and allocation. The average unit price at retail continues to move higher and the majority of our current business is now being done at traditional full prices of $39.99 and $59.99. It’s a very positive metric and probably the most telling at this point.

The overall economic environment obviously remains very challenging. Retailers are being very cautious with their orders and continue to plan inventories down. They’re also relying on more in season at once re-orders and are placing fewer future orders. In addition they are holding off placing futures until later than normal. This trend of course limits our visibility of the business so we’re having to manage our inventory carefully and strike the right balance.

Now I’d like to introduce Lisa Peterson, our new CFO and have her run through the quarter in more detail.

Lisa K. Peterson

Hello everyone. It’s nice to be on my first conference call and part of the Heelys organization. As Don mentioned in his opening remarks I’ve been in finance and accounting for 28 years and have worked for a variety of consumer related companies in both the public and private sectors. I’m excited about our opportunities to grow the business and increase the value for our shareholders. My initial focus will be on improving our forecasting capabilities in order to better manage our working capital and improve our earnings visibility. We are also diligently working on establishing systems and controls in our new Belgium office so that we have the necessary infrastructure to grow and manage the international business as well as be SOCs compliant for 2008.

In going through the second quarter numbers I will include the year-over-year comparison as well as sequential quarterly comparisons. We think the sequential quarterly comparisons might be a better tool in gauging progress during our transitional period. Net sales for the second quarter were $18.2 million comprised of $8.2 million domestically and $10 million internationally. The $18.2 million second quarter net sales compares to $74.3 million in the second quarter 2007 and $13.1 million in the first quarter 2008.

Gross profit was $4.2 million compared to $26.3 million last year and $2.8 million in the first quarter this year. Gross margin was 23% compared to 35.4% last year and 21.5% in the first quarter. As Don indicated improving trends in our gross margin from our core business were offset by markdowns on older and non-core merchandise to improve the quality of our inventory. Domestically our gross margin for the second quarter of 2008 was 13.2% which was negatively impacted by the inventory markdowns. Internationally our gross margin for the second quarter 2008 was 31.1%. In line with previous commentary we expect second half margins to improve over the first half as we clean up and better manage inventory.

Total SG&A for the quarter was $5.4 million compared to $7.2 million last year and $6.1 million in the first quarter. The first quarter included approximately $900,000 of one time costs associated with the transition of the former CEO. Our operating loss for the quarter was $1.2 million this compares to operating income of $19.1 million last year and an operating of $3.3 million in the first quarter. Interest and other income was $830,000 versus $734,000 last year and $1.6 million in the first quarter. The first quarter included other income of $750,000 resulting from a patent and trademark lawsuit settlement. Net loss for the quarter was $394,000 or $0.01 per diluted share compared to net income of $12.8 million or $0.45 per diluted share last year and a net loss of $1 million or $0.04 per diluted share in the first quarter.

Turning to the balance sheet at June 30th we had cash and cash equivalents of $96.8 million. This compared to $53.1 million at June 30th last year, $100.8 million at March 31st this year and $98.8 million at year end. We ended the quarter with inventories of $19.2 million compared to $22.7 million at the same time a year ago, $12.2 million at the end of the first quarter and $15 million at the end of the year. The increase in inventory from year end as well as Q1 is due to the build in inventory prior to the back-to-school season and approximately $30 million of inventory in Belgium. Of the $19.2 million of inventory at June 30th, 2008 we had $6.4 million in transit and of that $3.6 million was being shipped directly to domestic retail customers.

On the liabilities side we continue to have no long term debt so our overall balance sheet remains very strong. As stated a few times the business continues to shift to more of an at once model and along with the challenging retail environment our visibility over the business remains limited. With that said we still expect total sales to increase sequentially as the year progresses but to be down in total in 2008 versus 2007. International sales should increase in 2008 versus 2007 but the increase will not be enough to offset the decline in the domestic business. Gross margins should improve in the second half versus the first half as we work through the older excess and non-core inventory and sell primarily current in season product.

I will now turn the call back to Don for some closing comments.

Donald K. Carroll

We know what we need to over the short term and we’re making progress in the core three areas of inventory management, margins and demand generation. Beyond stabilizing and growing the core domestic business we need to diversify and expand into other products and categories. We’re in the process of putting together a mid-range strategic expansion plan and will look to talk more about this on future calls. We think the strong brand awareness of Heelys combined with diverse base of retailers and nearly $100 million in cash puts us in a strong position to expand the business into new directions. However we also recognize our limitations and want to be very careful in how expand and potentially use our cash.

We just came back from WSA Trade Show in Las Vegas where we met with mostly medium and smaller sized accounts. Traffic in our booth was better than expected and we were pleased with he positive feedback and the number of orders we received at the Show. So we feel like we’re moving in the right direction and consciously optimistic about the future.

With that Lisa and I would be happy to take any questions. Operator.

Question-And-Answer Session

Operator

(Operator Instructions) We’ll pause for just one moment. We’ll take our first question from Mitch Kummetz – Robert W. Baird & Co., Inc.

Kevin Kim – Robert W. Baird & Co., Inc.

Just a couple quick questions, first as far as just a housekeeping question, tax rate and shares outstanding for the year, what are you guys expecting?

Lisa K. Peterson

As far as June 30th?

Kevin Kim – Robert W. Baird & Co., Inc.

Yes.

Lisa K. Peterson

As far as our tax rate for the year what you will see in our quarter is that we have done our effective rate through June 30th so we have not gone through an effective rate calculation for the year. As far as our shares outstanding, we had at the end of the quarter our shares were 27,193,000.

Kevin Kim – Robert W. Baird & Co., Inc.

But for the year?

Lisa K. Peterson

I’m sorry, that’s as of June 30th in our EPS calculation.

Kevin Kim – Robert W. Baird & Co., Inc.

You guys obviously provided a lot of guidance as far as second half and that’s helpful but I guess I was curious, if you guys don’t see the pricing hold up with some of these newer core products that have been seeing some improvement in the second quarter, what are your internal plans of possibly providing margin assistance again into Q4?

Donald K. Carroll

The key for us is certainly the inventory management piece. Where you saw us provide markdown assistance in the first quarter was drive by the product environment where you saw retailers going to $29.99 and so forth. We believe through better inventory management we’re not going to see necessarily those retail prices return and so from a perspective of managing the retail price be it with the suggested retail we’re planning on limiting the inventory to maintain more premium pricing at both $49 and $59.

Kevin Kim – Robert W. Baird & Co., Inc.

I know it’s a bit early but coming out of the WSA Show, any reads on early spring orders?

Donald K. Carroll

The spring line was well received. I say that with a little caution though because the retailers were cautious toward the fourth quarter and certainly their fourth quarter will certainly affect how they look at spring orders.

Operator

We’ll hear next from Dimitri Cornasofskia – First Wilshire Securities.

Dimitri Cornasofskia – First Wilshire Securities

I just have one general question about what trends are you seeing in action sports market specifically wheel sports? How are other wheel sports products doing like skateboards, the wave skateboards and so on and so forth?

Donald K. Carroll

I think the entire category is challenged a little bit and it’s more probably from the macro economic environment more so than necessarily just any particular product. I think the fourth quarter really tells but as you’ve seen probably from additional reports retail has been relatively flat this year and that’s not different in this category.

Dimitri Cornasofskia – First Wilshire Securities

Are you seeing any difference between how your products are doing compared to some of those other products? Anything that stands out?

Donald K. Carroll

It’s tough to draw a comparison given that our product is so unique. We’ve seen quarter-to-quarter growth from where we’ve been but it’s hard to make a comparison to some other category.

Dimitri Cornasofskia – First Wilshire Securities

Are there any new cutting edge products that have come out recently in the wheel sports base?

Donald K. Carroll

None that I can speak of probably in the past couple of quarters.

Dimitri Cornasofskia – First Wilshire Securities

On the balance sheet I know that your payables have increased significantly. Could you talk about that?

Lisa K. Peterson

Both our AP and our accrued expenses increased, a lot of the accrued expenses is due to inventory where we’ve not been invoiced so we have the inventory and have not been invoiced for the merchandise yet.

Dimitri Cornasofskia – First Wilshire Securities

On the retail channel how much of old product would you say there is still left in there versus how much new product is going in there right now?

Donald K. Carroll

It’s rough to say because you’re looking at it by region. For us in the Midwest we’re the most new so to speak with the highest sell throughs of new product, compare that to the Northeast where we had the longest lag time as far as clearing old product so it’s very much a regional type of an approach by retailer. You’d have to look specifically by individual retailers to really get to the heart of that question.

Dimitri Cornasofskia – First Wilshire Securities

Could you give us an overview by the major regions how it looks?

Donald K. Carroll

The Midwest certainly is one of our better regions, it was probably the least penetrated early on, we see good sell through rates there as well as in the South. The West certainly would probably be third for us and the fourth would the Northeast.

Dimitri Cornasofskia – First Wilshire Securities

On Europe, how much of the revenue was international this quarter?

Lisa K. Peterson

On the revenue it was the $10 million. Of our $18.2 million net sales, $8.2 million was domestic and $10 million was international.

Dimitri Cornasofskia – First Wilshire Securities

How does that compare with the first quarter for international revenue?

Lisa K. Peterson

In the first quarter international is about $7.6 million.

Dimitri Cornasofskia – First Wilshire Securities

So it’s showing very strong growth.

Lisa K. Peterson

Yes.

Dimitri Cornasofskia – First Wilshire Securities

On the domestic $8.2 million how much of that was new versus clearing out old products?

Donald K. Carroll

It’s certainly going to be a blended number based on that. You can see with our margin rate from a perspective of being in the low teens, certainly the majority of that was older product because the new product just started blending in over the summer months.

Dimitri Cornasofskia – First Wilshire Securities

Could you talk a little bit more about how things are going in Europe with integration, the distributors and what trends are you seeing in the market over there?

Donald K. Carroll

We continue to see growth within the distributor that we repurchased earlier this year, both France and Germany. The key there is distributor, sales continue to look good but you see consumer confidence particularly in Germany has declined at this point so we’re cautious about that for the fourth quarter.

Dimitri Cornasofskia – First Wilshire Securities

Any developments in other international markets besides Europe worth mentioning?

Donald K. Carroll

No, I think the majority of that would be in Europe.

Operator

We’ll hear again from Kevin Kim – Robert W. Baird & Co., Inc.

Kevin Kim – Robert W. Baird & Co., Inc.

Just a couple quick questions, as far as your cash, what are your plans with it for the rest of the year? You guys obviously have a lot of it.

Donald K. Carroll

We’re working on a mid-range strategic plan. We mentioned that in the prior comments. Once we have that plan developed then we’ll have a better idea of what we’re going to do with the cash from this perspective.

Kevin Kim – Robert W. Baird & Co., Inc.

As far as domestic retail partners, any big change? I know Dicks is obviously out but if you can provide any kind of clarification.

Donald K. Carroll

There’s not been any significant change. I think the only thing on the horizon there was Mervyns. Since you’re familiar with them they’ve actually filed. We don’t really have any exposure to Mervyns at this point but we probably will not move forward with them.

Operator

We’ll hear again from Dimitri Cornasofskia – First Wilshire Securities.

Dimitri Cornasofskia – First Wilshire Securities

What kind of gross margin do you expect on new product if they’re sold at suggested retail prices?

Donald K. Carroll

Based on retailers and their discounting because there’s the price and there’s the wholesale then there’s dealer discounts by retailer, we target anywhere between 31 and 35 points of gross margin.

Dimitri Cornasofskia – First Wilshire Securities

So that means Europe is pretty much right on target for that?

Donald K. Carroll

Yes, Europe is doing well.

Dimitri Cornasofskia – First Wilshire Securities

On your inventory how much of that would you say is new product versus products that you’re still trying to clear out?

Donald K. Carroll

If you’re looking at the $19 million inventory number?

Dimitri Cornasofskia – First Wilshire Securities

Right.

Donald K. Carroll

Approximately 75% would be considered new.

Scott – First Wilshire Securities

This is Scott at First Wilshire. You’re talking about the old inventory and clearing it out which is at a lower margin versus new inventory aiming for the higher margin, what is substantially different between those products that would account for being able to charge the higher price?

Donald K. Carroll

If you recall in the first quarter we took product back from retailers to pull product out of the market. As you might imagine some of that was not in the best selling condition and so when you look at the condition of the product that’s one element certainly. Then there’s the new fashion and trend components to the product. When you’re looking at a seasoned shift, that’s also a component of the pricing.

Dimitri Cornasofskia – First Wilshire Securities

Then I think you mentioned briefly that you’re also getting into some non-wheeled products and do you have anything to report on that?

Donald K. Carroll

It’s a small test at this point. We’re actually seeing some decent sell through numbers but we’re not ready to talk about that quite yet.

Dimitri Cornasofskia – First Wilshire Securities

How much of the sales are accessories like additional wheels and so on and so forth versus shoes?

Donald K. Carroll

It’s minimal. When you think about the accessories business for us both the wheels, the protective gear, a very small percentage of the total.

Operator

We have no further questions from the phone audience at this time. I’d like to turn the conference back over to our speakers for any additional or closing remarks.

Donald K. Carroll

Thank you. As I hope you can tell we’re making changes and working hard to get the business back on track. We want to thank everyone for their continued interest and support of Heelys. We’re also interested in hearing from you so should you have any follow up questions please feel free to contact Lisa or myself and thanks again for taking the time to attend our call. Thanks and good afternoon.

Operator

That does conclude today’s conference call. We’d like to thank you all for your participation. Have a great day.

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