Interline Brands, Inc. Q2 2008 Earnings Call Transcript

Executives

Tom Tossavainen – CFO

Michael Grebe – Chairman and CEO

Analysts

Jen Consoli – JP Morgan

David Manthey – Robert W. Baird

Sean Connor – BB&T Capital

Keith Hughes – SunTrust

Shannon O'Callaghan – Lehman Brothers

Matt McGeary – Sentinel Asset Management

Interline Brands, Inc. (IBI) Q2 2008 Earnings Call Transcript August 5, 2008 9:00 AM ET

Operator

Good morning. My name is Dennis and I will be your conference operator today. At this time, I would like to welcome everyone to the Interline Brands second quarter 2008 conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions) I will now turn the call over to Mr. Tom Tossavainen, Chief Financial Officer. Please go ahead, sir.

Tom Tossavainen

Thank you, Dennis. Good morning and welcome to the Interline Brands earnings call for the second quarter of 2008. Joining me on today’s call is Michael Grebe, our Chairman and Chief Executive Officer, who will provide an overview of the quarter and the current market environment, as well as discuss some recent and ongoing initiatives to improve our operational efficiency and effectiveness. I will then review our financial results in more detail and Mike will close with our outlook for the third quarter and full year 2008. We will then open the call to your questions.

Before beginning today's call, let me remind you that some of the statements made today will be forward-looking and are made under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected or implied due to a variety of factors. We will also discuss certain non-GAAP financial measures which are described in more detail in last night’s earnings release. We refer you to recent Interline Brands’ filings with the SEC for a more detailed discussion of the risks that could impact the company's future operating results and financial condition. These factors are also described in greater detail in the press release and the company's website.

Also please note that we have posted certain supplemental slides for your reference on the Investor Relations page of our website at www.interlinebrands.com. I would now turn the call over to our Chairman and Chief Executive Officer, Michael Grebe.

Michael Grebe

Thanks, Tom. Interline Brands reported sales of $311.4 million and diluted earnings per share of $0.34 during the second quarter of 2008. This result included a $0.03 per share one-time gain due to favorable tax settlements, offset by the $0.02 per share charge we announced on June 16 related to amending option and employment agreements with Bill Sanford. Relative to Q2 of last year, sales were essentially flat and diluted earnings per share were down approximately 8%.

Our performance continues to be affected by a challenging domestic economy. In spite of these headwinds, we were pleased to see sales volume stabilize on a consolidated basis compared to the first quarter of this year. While sales are still not where we want them to be, we continue to aggressively pursue our growth strategy and execute on a number of key operational improvement initiatives that have been underway for several quarters now.

Additionally, while market conditions remain challenged, we are going to take this opportunity to further address our cost structure to ensure we navigate the current environment. As always, our goal is to make permanent improvements to our operating platform for the long-term and not just cut cost to right-size our business to current sales levels.

We are continuing to build an operating platform capable of delivering sustainable improvements in our profitability over the long haul and one that will further position us to even more successfully integrate future acquisitions. I have more to share on these initiatives in just a minute. First, to give additional color around our performance and strategic initiatives during the quarter, I’d like to provide you an update on the key markets we serve, beginning with our largest market, facilities maintenance.

Sales to facilities maintenance customers increased approximately 3% for the quarter on top of 20% organic growth comparable to the prior year. The multi-family housing market demand for apartments continues to be relatively steady. Vacancy rates rose slightly by 10 basis points to 6% at the end of the second quarter. However, the number of occupied apartment units in the US, a key indicator of the demand for repair and maintenance products, increased during the quarter demonstrating the market’s overall resilience. The number of occupied units in the US has not materially declined in the last ten years. Bear in mind that stability is nothing new for the multi-family housing market. So, if demand for apartments remained steady, so will the demand for repair products within multi-family housing.

That said, due to the tough credit market, pressures continue to mount for apartment owners and operations managers to maintain tight budgets and contain costs. As a result, the pace of upgrades to apartments, for example, adding new appliances in order to achieve higher rent payments, appears to have slowed compared to the level we experienced during the first quarter and during 2007. This is also true with respect to major development projects with the multi-family operator fully remodels an apartment unit or the entire complex.

The net takeaway is twofold. First, the multi-family housing market has proven over the years to be a relatively stable market that has and should continue to provide steady growth. Second, we will continue to manage our very successful renovations business against the level of renovations demand we see in the multi-family segment.

Moving on to institutional facilities, sales to customers including healthcare, government, and educational facilities were up in the second quarter, consistent with our historical performance in this market. AmSan continues to perform well and our integration process is proceeding according to plan. We have just one AmSan region remaining to be converted on to the Interline platform. We expect that last conversion to be complete by the third quarter of this year.

As we have mentioned, with any integration process, our efforts partially impacted our sales team and thus temporarily affected our sales. However, you may recall that we took this into consideration as we developed our initial integration plans and we specifically chose to space out our conversions to mitigate this risk. Our carefully planned conversion also allowed us to better manage AmSan’s profitability, which is steadily improved since we acquired the business.

For example, operating margins for AmSan were in the low-to-mid single digits when we made the acquisition. Today the profitability for that business is much higher and we still have room to improve as we finalize our integration efforts. Overall, we achieved our initial goal of $6 million in synergies. In addition, we have been able to make the necessary distribution and product changes to ensure we get a broader product offering to more institutional customers. This includes a recently launched targeted MRO product offering under the AmSan brand and the addition of cleaning and janitorial products to our national accounts offering.

While we are still early in the process, the MRO catalog was launched to 15% of the AmSan sales force in April. The average field sales representative in this first group is now securing two MRO orders per week with an average of $47 per order. We began to roll the program out to the rest of the sales team in June and expect to be fully rolled out by the end of October. We believe that less than 1% of our existing customers are shared customers between AmSan and the rest of Interline Brands. Therefore cross-selling products to already captive customers present a great opportunity.

As of today, the offering has 300 items. As we complete our conversion process and momentum builds in this initiative, we will be able to add additional items as well as additional categories to expand our offering. The strategies allow us to continue to gain wallet share from existing customer base.

We also actively engage in expanding the capabilities for our Sexauer business. Sexauer is currently a great brand focused on selling specialty plumbing to institutional facilities. We are evolving Sexauer into a broad-based national brand with a full suite of institutional products. Within the institutional facilities market, customers annually purchase more than $30 billion in maintenance, repair and operations products.

To more fully participate in the sizable market, our strategy is to broaden our reach within the industry by adding over 7,000 SKUs. These new SKUs, which include electrical, HVAC, and security products will be formerly launched under the Sexauer brand in mid September of this year. The new offering will also support our strategic national account initiatives in combination with AmSan’s complementary product line.

Sales to professional contractors and specialty distributors, which comprise roughly 30% of total revenues, declined approximately 9% and 5% respectively in the second quarter. While we are pleased to see the percentage decline moderate, sales in both of these markets are still at the lowest levels in three years driven by continued weakness in residential, construction, and remodeling activity.

Despite the short-term weakness, these are very attractive end markets that will eventually recover. Within these large fragmented markets, we have strong and durable customer relationships, and we are confident Interline will benefit when customers resume more normal purchasing patterns.

Before I shift gears and discuss our costs and operational initiatives, I want to provide you with a brief update on the acquisition front. Given the over-valued market last year, we have remained selective in evaluating potential acquisition opportunities and that has slowed our recent deal activity. However, we are by no means sitting on the sidelines. Valuations in our industry are becoming more attractive and our pipeline of acquisition candidates is still very active.

We will remain focused on attractively valued companies that integrate well into our existing platform, create tangible operational synergies, and present significant incremental cross-selling opportunities. We also look for opportunities to diversify our geographic footprint, penetrate new markets, or improve the speed in service to our customers. As always, we are willing to pay good prices for great brands.

Now let me provide you with an overview of several key operational initiatives we have been working on for several quarters and are committing to over the next few years. First, let me say that our continuous focus over the years on operational improvement has yield historical operating margins within the top tier of our publicly traded peer group. And if you were to adjust for our acquisitions, which have brought our operating margins down until we were able fully integrate them onto our platform, our margin performance would be even better. But while we are proud to have one of the stronger operating margins in the industry already, we think we can make it even stronger and more profitable. We also believe these actions will continue to strengthen our ability to integrate future acquisitions.

Many of the initiatives that we will discuss today are ones that we have shared with you before. They do not reflect the shift in the strategy or focus. We have built a track record of successfully executing similar initiatives and have a high degree of confidence on our ability to executive on our current plans. What is new in this quarter is that we are stepping out with a road map that provides our shareholders with increased visibility into our specific actions and expected results.

We will execute these initiatives with both the near-term and the long-term in mind. The short-term of these programs and actions will take cost out of the business and further rationalize our operating structure. Over the intermediate and long-term, they will provide us with an operating platform capable of improved efficiency and productivity and ultimately higher profitability. These initiatives are good for our business and our shareholders, and but more importantly they are good for our customers.

Our goal is to reduce our annual operating cost by $20 million and reduce working capital by $20 million over the next several years. We fully expect to leverage incremental cash flow to support our growth initiatives, including strategic acquisitions. To accomplish these goals, we are focused on several key initiatives, ranging from immediate short-term action steps to longer term ongoing improvement programs.

We expect to hit a significant run rate in the first 18 months and get the 40% of our target benefit by the end of 2009 and realize the full bulk of savings in 2010 and beyond. Now let me review each of these initiatives for you now. A most immediate action is a $10 million reduction in payroll expenses. This will be accomplished through a combination of eliminating positions that were recently vacated due to attrition, a reduction in force, and through ongoing near-term integration efforts.

Overall, we expect a net reduction of 4% of our total work force of roughly 3,640. These reductions impact many functional areas of business with more emphasis on administrative and operational departments. While our decision is motivated in part to right size our cost structure with current sales levels, we are taking this opportunity to build a leaner, more efficient structure that will improve operating expense leverage over the long-term. We will incur one-time cost over the next six months totaling $0.02 per share for severance and related costs.

Second initiative involves accelerating the consolidation of our smaller distribution centers to larger, more efficient, regional distribution centers or RDCs. We intend to consolidate three sets of local distribution centers into RDCs between 2009 and 2010. As a result of this initiative, we expect to gain approximately $3 million in annual cost savings.

We also expect to improve working capital by at least $8 million by the third year after the consolidation process is complete and the new RDCs are up and running at full capacity. This initiative closely follows recent facility consolidation and RDC launch in Atlanta, Boston, and Richmond.

As we said before, our larger distribution centers generate better economics, including reduced cost per shipment, improved working capital management, and ultimately higher profit margins. Our previous RDC projects are expected to yield on average a 40% return on investment. As with the case for these recent RDC projects, we will incur approximately $0.02 to $0.03 per share in cost associated with each regional consolidation.

Third initiative centers on optimizing and improving our customer service operations. As you know, we recently upgraded our systems, including the installation of a next-generation telecommunications PBX network that provides look-ahead routing capabilities for our national call center operations. Our investment has already yielded high returns. The increased capabilities of the system afford us the opportunity to streamline our call center operations thereby reducing total cost to serve while improving overall service to our customers. We expect to generate annual cost savings of approximately $2 million. Over this time frame, we will incur a one-time cost of approximately $0.01 per share.

The fourth initiative is rationalizing our Barnett Pro Center footprint. We continue to view the Barnett Pro Center concept favorably, given its ability to increase our share of wallet with certain customer segments. As you know, in addition to customer pickup locations within all of our distribution centers, we currently have 25 standalone Barnett Pro Centers. However, recall the last quarter we mentioned that we had identified certain locations that either failed to achieve sufficient scale or in markets that, given the change the economic environment, were not projected to generate adequate growth. We therefore elected to close certain underperforming centers within the coming months. Potential closings could save us approximately $3 million of operating costs and improve our working capital by $2 million. We expect to begin realizing these benefits in 2008 and will incur approximately $0.02 per share for cost related to these closures.

The fifth and final initiative is improving our credit and collections systems and processes. Last quarter Tom briefly discussed a technology solution that we recently began implementing to improve our overall collection efficiencies. While we are still in the process of rolling out this solution, we anticipate realizing significant working capital savings of approximately $10 million. In addition, once fully implemented, we expect lower interest and bad debt expenses will provide annual cost savings of approximately $2 million. We expect to begin reaping benefits from this initiative in 2009 and we will fully realize cost savings and cash flow improvements in 2010 and beyond.

So in summary, our goal just from these initiatives is to reduce our annual operating cost by $20 million and reduce working capital by $20 million over the next several years. We have assumed very conservative sales growth in our expectations. Should sales growth accelerate, the impact to our profitability will be even more pronounced. Our intent today is to provide our shareholders a comprehensive roadmap to our key operating initiatives over the next several years. This includes short-term actions to take cost out of the business and rationalize our operating structure and longer term initiatives that are geared towards developing a leaner, more efficient platform from which to grow.

We’ve told you what we want to achieve in terms of goals, we’ve given you details on the key action steps and we’ve justified the contribution of each initiative from a cost and return perspective. However, bear in mind, the specific timing of certain initiatives is highly sensitive to our other constituencies, namely our associates, customers and local communities in which we operate, which is why we are choosing to provide general guidelines around the timing of these initiative which we think appropriately balances the interests of all of our key constituencies. Combination with our customary quarterly annual guidance, we will provide you with the means to appropriately evaluate our progress. As we move forward with our plans, we look forward to updating you in key developments and milestones.

In summary, these initiatives, in combination with our ongoing efforts to protect and increase sales, like the expansion of our capabilities within the institutional space should help us gain efficiency and scale in the current economic environment and will foster more profitable growth when conditions improve.

With that, I’d like to turn the presentation over to Tom Tossavainen, our Chief Financial Officer.

Tom Tossavainen

Thanks Mike. In the second quarter of 2008, we generated net sales of $311.4 million, essentially flat compared to the prior year period. As a percentage of total sales, our end markets represent the following concentration; 70% from facilities maintenance, 19% from professional contractor; and 11% from specialty distributor. Our gross margin for the second quarter of 2008 came in at 37.2%, a 50 basis point decline over gross margin in Q2 ’07. The decline in gross margin was primarily due to a shift in sales mix. In particular, sales in the HVAC category were up disproportionately during the quarter, which lowered our consolidated gross margin due to the lower margin associated with this product category.

On the plus side, our merchandising team has done a good job of managing rising product cost on the buy side while maintaining price and discipline on the sell side in spite of the current environment. Selling, general and administrative expenses for the quarter were $88.6 million, up from $86.9 million for the same period of 2007. As a percentage of net sales, second quarter 2008 SG&A expense was 28.4%, up 60 basis points from the prior year period. The 60 basis points increase in SG&A is attributed to our previously announced one-time charge that Mike mentioned with respect to Bill Sanford and an incremental cost for our distribution center consolidation efforts during the quarter. This includes the cost of moving our operations then our product into our new regional distribution centers in Boston and Richmond, as well as the startup costs associated with our new West Coast national distribution center in Salt Lake City, all of which we discussed last quarter.

Operating margin for the second quarter of 2008 was 7.4%, a decline of 130 basis points over the prior year period. 60 basis points of this change is related to the one-time charge that I just mentioned and 50 basis points is due to lower gross margin. While we are not satisfied with the current margin level, we continue to actively manage our operating cost and we look forward to the ongoing contribution from the initiative that Mike mentioned earlier.

Moving down the P&L, interest expense of $7 million in the quarter was down approximately 17% over the second quarter of last year, reflecting the favorable impact of lower interest rate environment compared to last year. Taking all of this into consideration, net income for the second quarter of 2008 was $11.2 million or $0.34 per diluted share compared to net income of approximately $12 million or $0.37 per diluted share for the same period of 2007. Again, fully diluted EPS for the second quarter of 2008 included a $0.03 per share gain due to a favorable tax settlement, offset by our previously discussed $0.02 per share charge related to Bill Sanford's transition. Excluding the impact of these two very specific items, fully diluted earnings per share would have been $0.33 for the quarter.

Let’s move on to the balance sheet. During the second quarter of 2008, we continued to efficiently manage our working capital. However, our net working capital days sale increased to 83 days as of the end of June. This is a one day increase from last quarter and a three-day increase from our all-time record performance in the second quarter of 2007.

As we discussed on last quarter’s earnings call, we’ve temporarily increased inventory levels to stock $7 million of inventory in our new West Coast national distribution center in Salt Lake City, and we increased general inventory level by another $13 million to prepare for the busier summer season and hedge against the possibility of a potential West Coast port strike, which as you know has recently been averted.

Our inventory days sales were inline with the prior year at 59 and one day higher than the end of the first quarter of 2008. As Mike mentioned, our professional contractor customers in particular continue to begin affected by a challenging environment. And we have therefore seen a slowing of our accounts receivable days sale. As of the end of the second quarter, our days sales at 49 were one day higher than last quarter and four days higher than our record performance of 45 at the end of the second quarter last year.

We incurred $200,000 in higher bad debt provisions in the second quarter compared to the prior year quarter. Also as Mike discussed, we are finalizing the implementation of a new technology solution design to improve our credit and collections processes. Once we begin to fully realize the benefit of the new technology solution, we expect our overall collection efficiencies to improve significantly over time. Accounts payable days increased one day compared to the first quarter of the year and remained consistent with the prior quarter at 25 days.

Moving on to cash flow, cash provided by operations was $27.2 million as of the end of the second quarter, which is slightly below an exceptionally strong first quarter of 2007 when we generated $31.1 million of cash from operations. Consistent with our investment plans for 2008, capital expenditures in the quarter were $7 million, up $2.7 million from the prior year as we brought our West Coast NDC online as well as the Boston and Richmond regional distribution centers. This spending represents 2.3% of sales for the quarter compared to 1.4% of sales in the same period last year.

As we progress through the remaining half of the year, we expect capital expenditures to end within the 1.5% to 2.0% range for the full year. Our liquidity position continues to be strong with $150 million in availability comprised of $90 million of capacity available under our revolving credit facility and $60 million in cash.

Our return on intangible capital was 39% this quarter compared to 42.1% in the second quarter of last year. As we discussed on our last call, the slowdown in the pro contractor and specialty distributor end markets have negatively impacted returns compared to prior years.

At this time, I’d like to turn our call back over to Mike to discuss our business outlook.

Michael Grebe

Thanks, Tom. From a market standpoint, we expect similar headwinds and tailwinds in the second half of the year relative to the first. We continue to feel positive about our facilities maintenance end market. Multi-family housing market has proven over the years to be a relatively stable market that has and should continue to provide steady growth. And the institutional facilities market is expected to continue its space of performance led by AmSan, which is performing well, which will be offset by continued weakness in the professional contractor and specialty distributor markets for the remainder of 2008 similar to the levels we saw in 2007 and in the first two quarters of 2008.

In addition, we expect our profitability to improve in the second half of the year relative to the first, reflecting a seasonally stronger third and fourth quarter. For the third quarter of 2008, we expect earnings per share to be between $0.41 and $0.46, which includes approximately $0.03 per share in one-time costs associated with a reduction in work force and closing certain Barnett Pro Center showrooms.

For the full year 2008, we expect earnings per share to be between $0.40 and $0.50. Our guidance for the year also reflects the one-time cost associated with the reduction in work force and closing certain Barnett Pro Center showrooms. We expect to take a $0.02 charge for each; $0.03 in the third quarter and $0.01 in the fourth quarter. In addition, although we have already announced and recorded $0.02 per share charge related to Bill Sanford’s amendments, this is our first time accounting for that in our full year guidance.

Moderator, you may now open the lines for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question will come from the line of Michael Rehaut with JP Morgan.

Jen Consoli – JP Morgan

Hi, good morning. This is Jen Consoli on the line for Mike.

Michael Grebe

Good morning, Jen.

Jen Consoli – JP Morgan

Good morning. So, I just want to make sure that I understand this correctly. The $0.04 in the second half of the year, that’s completely incremental to the $0.03 that you already – that was already included in your previous guidance and you absorbed that in the second quarter. Is that correct?

Michael Grebe

That’s correct, Jennifer.

Jen Consoli – JP Morgan

Okay. My second question is, within the facilities maintenance business, you talked about the renovations business and how that business is obviously slowing due to the credit tightening. How much of the business do you characterize of that whole segment is the renovations business?

Michael Grebe

It is not the most significant portion of that business, Jennifer. The key element of that business is every day repair parts that we sell to the operator and the maintenance man to keep that apartment complex moving. So our renovations business, which happens to primarily be under a brand called Renovations Plus, has been rapidly growing through – or had been rapidly growing through 2006 and 2007. It is still growing but at a much lower rate due to those trends that I just mentioned. But it is not – for example, less than 20% of our total multi-family housing business.

Jen Consoli – JP Morgan

Okay, great. Thank you.

Operator

Your next question will come from the line of David Manthey with Robert W. Baird.

David Manthey – Robert W. Baird

Hi guys, good morning.

Michael Grebe

Good morning.

David Manthey – Robert W. Baird

I was wondering if you could talk about the facilities business. Are you still seeing REIT customers deferring spending or what else are you seeing out there that’s leading to this slowdown in facilities maintenance? And then the second part of this question is, in terms of the linearity that we saw during the second quarter, in early May you were expecting mid-single digits and we came in at 2.5 that implies a very low single-digit growth rate in May and June. And I’m just wondering if you could talk about the linearity there and your expectations for the third quarter?

Michael Grebe

Sure. Let me answer that second part of the question first, David. Yes, we did see some softening throughout the quarter in the facilities maintenance business and somewhat in the multi-family housing space in particular. The trends that we are seeing in July are fairly similar to what we’ve seen in the first and second quarter. I mean, there have been some ups and downs and so forth, but nothing dramatic to point to there. I would say that, going back to your first question, in terms of what’s happening with spending and so forth, there is some reining in of spend on the routine maintenance that I just spoke about. I mean, that clearly is the dominant portion of the spend in the space. The part of reining-in that we are seeing the most of right now is in those upgrades and complete renovations. And again an upgrade is where maybe in 2006 and 2007, the apartment REIT operator was investing more in new appliances or new fixtures in the hopes of getting another $100 per unit in rent or $200 per unit in rent. We call those upgrades or a light renovation. We are rein in spend that’s primarily in that area and in the large renovations where essentially they are either gutting an apartment or gutting an entire apartment complex. So that’s the biggest area that we are seeing caution. Certainly just in routine spend we see people trying to cut cost and so forth, because obviously everybody is concerned about economic conditions out there. Those tend to be a little shorter term in nature. As long as the occupancy rates are staying reasonably good, we will be in a position where those products have to be replaced due to damage to the apartment and so forth. So I’d say that the biggest area of control that we are seeing is in that second half of the spend.

David Manthey – Robert W. Baird

Okay, thanks. And in terms of – as we are looking at slide five here and trying to understand the investments versus the benefits, in the fourth quarter of ’07 you said you increased your investment -- expense from $0.05 to $0.10 up to $0.10 to $0.16, and then in the first quarter you got $0.03 that was related to an acceleration of investments, and then now you have this slide five. Does slide five capture all of those expenditures or are those separate from this program?

Tom Tossavainen

Yes, Dave, this is Tom. The way we look at that is based in the first quarter when we first started talking about our expected investments than we were talking about the higher growth rates in investments. And we had peeled that back as part of our expectations and when we rolled into that at the end of the first quarter. What you are seeing on page five is our expectations going forward from the second half of ’08 forward. And so that – and then the last piece the three stance we saw in the second quarter of investment spend, which was the lion’s share of our 2008 investment spend related to a consolidating our distribution center networks, both in Boston, Richmond, and our Salt Lake City NDC.

David Manthey – Robert W. Baird

Okay. So the new $0.11 to $0.15 replaces the old $0.10 to $0.16?

Tom Tossavainen

Correct. The way we look at that $0.11 to $0.15 is over the long-term with some projects having a more immediate impact and some having a longer two to three-year or longer period for DC consolidation. What we try to do is lay out the cost for those projects as they are current and that is the longer term range of that $0.11 to $0.15.

David Manthey – Robert W. Baird

Okay, thanks guys.

Tom Tossavainen

You’re welcome.

Operator

Your next question will come from the line of Matthew Mccall with BB&T Capital.

Sean Connor – BB&T Capital

Hi, good morning. This is actually Sean Connor for Matt. I was hoping to maybe get a better understanding of the gross margin line. I know you guys talked about the mix shift and the impact from HVAC. But just looking sequentially on a plus $20 million sales increase and 90 basis points of gross margin pressure, I don’t know what else might be either in the Q2 results for additional pressure or maybe Q1 was a little bit better, something – I just kind of wanted to get a feel for the trajectory there so we can get a better idea of what to look for in the back half?

Michael Grebe

Sure. As usual, Sean, there are numerous puts and calls that make up the trends in our gross margins, but let me give you a feel for some of the underlying currents that we see as we look into the detail. The decline in gross margin that we saw in the second quarter was primarily due to a shift in sales mix and primarily related to HVAC products. The best example I can give you there is that sales of Freon [ph] as a particular product in the quarter were up over 100% on a year-over-year basis. We purchased quite a bit of Freon last year at very attractive prices and sold it for significantly higher prices this year and obviously that proves to be a very profitable exercise. And as a distributor, that’s what you do, right, is buy low and sell high. The growth in Freon actually brought consolidated gross margin down by itself by about 26 basis points because while it was sold at higher margins this year than normal margin, the product margin itself is lower than our consolidated numbers. HVAC equipment sales were up 5.3% for the quarter, but had about 10 basis point impact on our gross margin as those items have a gross margin less than the company average. So, most of that impact is due to HVAC and that type of product mix.

Sean Connor – BB&T Capital

Okay. And looking at the top line, you guys gave some details on the facility maintenance side. But if you look at the others, the professional markets, it looked like this quarter maybe the seasonal patterns improved a bit, I believe Q1 to Q2 over the last couple of years you had seen a sequential decline just from seasonality. But it seemed to show a modest increase this quarter. Anything specific there that drove that or are you seeing a stabilization and if there is any detail you might be able to provide there?

Michael Grebe

I guess it’s been hard for us to focus in on that market as one that’s moving in the right direct necessarily. But in the pro and specialty markets, we've seen quite a few quarters where we’ve been down in the 10% or larger range. Now again we think that’s very much driven by the downturn in residential construction and remodeling. We feel like our market position is strong. We feel like our – the moves that we’ve made in that space continue to be the right moves. But we were somewhat gratified to see that number no longer down 10. I mean, when you are down 9 and down 5, it’s still a negative number, but we were somewhat pleased that that number is starting to pick back up a little bit. Hard for us to declare an end to the struggles in that space obviously and we are not trying to do that when we say that we like to see those numbers improve a bit. But certainly a little bit of a pickup and we are pleased with that. Beyond that, there is probably no particular geographic area or no particular brand or even product category other than maybe the HVAC and Freon that I’ve cited that we would say would be a big driver within those categories.

Sean Connor – BB&T Capital

And I guess is the pace -- if you look into the back half, that 9 – down 9, down 5, something that might be sustainable for the rest of the year, is that’s kind of what’s built into the full year guidance or is it more the double-digit that we had seen the previous--?

Michael Grebe

There is – built into our guidance is a range and I’d say that we, on the low end, probably are anticipating something like the ranges that we saw in Q2 were little better for pro and specialty. And on the – that would be the high end, if you will, or the beneficial end. On the low end of our earnings guidance for profitability, we obviously would anticipate some higher sales deterioration. But that market again is very hard for us to predict at this time.

Sean Connor – BB&T Capital

And then just one more question on the guidance. If we take the midpoint of the full year and the midpoint of Q3, if my math is right, I believe the fourth quarter will be the strongest period from an earnings perspective. And I just wanted to make sure that I understand all the adds that are going to impact the second half and specifically in Q3 and Q4 to make sure you got the timing right. We got the slide that you guys provided on the website and that’s helpful. But what about the other items, the completion of I guess IT, the Boston, Richmond, DC, AmSan integration complete I think you said in the third quarter? And then if you might just be able to break those out one more time to make sure that we understand the timing in the benefit of those items also?

Michael Grebe

Sure. That may be beneficial. As I said earlier, the specific timing of certain initiatives is highly sensitive to associates and customers and various different constituencies. But I think it probably would be helpful for Tom to provide some additional color, particularly since you touched upon three or four of those. Let us do that. We’ll try to lay out that timing as best we can.

Sean Connor – BB&T Capital

Thank you.

Tom Tossavainen

You bet. As we look at the operational initiatives we highlighted, some of them have an impact in the shorter term instead of a longer term. So it’s probably best to go through each one. Two of the initiatives, that’s the reduction in force and the closing of certain professional contractor showrooms, those are geared towards a reduction of operating cost over the next 6 to 18 months. So our reduction in force has the largest short-term impact and that improves earnings by as much as $0.02 in 2008. That’s made up of two pieces; a $0.04 cost – excuse me, a $0.04 benefit associated with lower salary and benefit costs. And that $0.04 is offset by a $0.02 severance charge that we expect in the third quarter. So if we look at that combined on a net basis, we expect to improve earnings by about $1 million or $0.02 in the second half of 2008.

We also would expect to hit that full run rate of $10 million by April 2009 on an annual basis. Now the second is the closing of the more unprofitable professional contractor showrooms. That will end up costing about $0.02 in 2008 and that’s due to the closing of the facilities. However, the impact in 2009 and forward would be to take out about $2 million to $3 million in operating cost a year, improve the operating margins on that business, reduce our working capital needs by up to about $2 million, and improve earnings in the first full year and then being closed by $0.02.

The next three initiatives that we discussed are more geared toward continuing to invest in the longer term enhancements of our operating platform and our business model. And that timing again varies by each initiative. The more significant long-term impact will come from the continued consolidation of our distribution center network. These investments are going to provide improved profitability, better cash flow over the long-term, and more efficient use of our working capital over a three to four-year period. Our 2009 DC consolidations are scheduled to occur in the second half of 2009 or early 2010. At that time, we’ll incur anywhere from $0.01 to $0.03 per share in move related costs for each consolidation and that depends on the size of each region.

In addition, we expect to spend that normal $2 million to $3 million of sale and capital costs and that’s to buy racking and relating equipment to really get those new regional distribution centers up and running. On a combined basis, we would expect to achieve $3 million in improved operating costs and $8 million in improved net working capital by the end of the third or fourth year of operation. So the benefits are really twofold. First, we expect to achieve operating expense leverage in both occupancy costs, freight cost, and distribution center labor associated with having a larger facility. And this will result in the $3 million in lower annual operating expenses by the end of the third year of operation after coming online.

In addition, we expect improvement in customer service and fill rates and inventory turns similar to what we’ve had in locations like Atlanta. A portion of this cash flow improvement includes the reduction of $8 million of inventory over that three-year period by continually improving upon our inventory turns, as you can operate on large and more efficient building. The last couple initiatives is the customer optimization and credit and collection efficiencies. The majority of the capital costs associated with these two initiatives has already been expended. And that’s been reflected in our higher CapEx or capital expenditure trends in the first half of 2008.

The costs and the benefits associated with those initiatives beyond that initial capital expense are expected to occur in 2009 and 2010. So for example, if you look at optimizing our customer service capability, that’s expected to really improve our operating cost structure or cost to serve over a longer term, and that we would expect about $2 million run rate to be hit by the end of, say, 2010. And we get the – we obtain the cost efficiencies associated with improving processes and our system capabilities. The credit and collections project, that we have to kick that off of one-third of our business yesterday.

It’s live and up and running, and it’s expected to improve our overall day-to-day operational efficiencies anywhere from 50% to 70%. And that’s going to allow us to improve our collections capability. So the impact that we see there will be to reduce our net working capital by, say, $5 million by the end of ’09 and an additional $5 million at the end of ’10 for a total of $10 million in improved net working capital. Now when you do that, the earnings impact on that is, one, you improve your credit characteristics, which should result in about a $2 million savings associated with two things; lower interest rates and lower provisions on requirements on improved credit quality. So if you add it all up, we expect to achieve about 70% to 75% of our $20 million in annual operating efficiency and net working capital improving, say, by the end of 2010.

Operator

(Operator instructions) Your next question will come from the line of Keith Hughes with SunTrust.

Keith Hughes – SunTrust

Thank you. You’ve laid out pretty well when you expect to get the efficiencies gains, you said 40% by the end of ’09, it is 75% or so by the end of ’10. But could you just bottom line the $0.11 to $0.15? How much of that will we incur by the end of this year and how much will we incur by the end of 2009?

Tom Tossavainen

Sure, Keith, this is Tom. Let me start with 2008. And 2008, we expect to have a net zero impact. And let me explain that. First, we would expect to have a $0.04 improvement from our headcount reduction in 2008. Now that’s $0.04 offset by the $0.02 severance charge, Keith, that we’d have for a net $0.02 positive. That would be offset by $0.02 in cost associated with closing professional contractor showrooms. So if you add up that, that we would expect to cover the cost of our one-time cost, if you will, in ’08. And then actually if you look at that 40% run rate going into ’09, that’s what we would expect in that first full year. And then one of the largest pieces there, Keith, is that we expect by April 2009 to be running at a full $10 million clip on our reductions in headcount.

Keith Hughes – SunTrust

Okay. All right. I guess moving to another item, in terms of acquisitions, as you look at the acquisition market, if the right deal was to come along, what would it look like just from the kind of 10,000-foot level, would it be in the facilities maintenance type business or -- what do you think there?

Michael Grebe

Well, Keith, certainly our most attractive end market at this point in time is in the facilities maintenance space. And so that certainly is just as the general category going to be more interesting, then maybe business that was exclusively in pro contractor arena although obviously there is lots of interesting businesses out there. I guess our sweet spot has always been a business that has operating margins in the 5% to 6% range, and we’ve been able to get about to 10% or so through our integration efforts. It’s again, as you said, at 10,000 feet. It’s going to be a business that has good sales synergies with our business, meaning, we can add geographic reach to the business or we can add our product lines to that business. Typically the best acquisitions we’ve done have been high gross margin businesses because that usually implies very strong relationships with customers. So those are some of maybe the financial characteristics of the business, but certainly the ones that we find the most interesting at the moment are in the facilities maintenance space. And within that, we think there are a lot of opportunities for us to acquire in the AmSan space. So that’s probably the best high level feel I could give you there.

Keith Hughes – SunTrust

Okay. In terms of cross-selling, you’re saying right now you’ve got an MRO catalog out to 15% of the AmSan sales force. Now you’ve had AmSan for a while. Do you think on the next deal you would see a cross-selling effort come a little faster than this?

Michael Grebe

One of the reasons why it took us a while to get here, Keith, is the way that we’ve integrated this business. I mean, you may recall from deep history that AmSan was operating on many different IT platforms. And so it hasn’t been one big quick conversion. And we’ve always felt that the best way to generate a deep sales relationship with customers to cross-sell, but to do it from one distribution center, on one invoice, and have a very seamless ability to make that happen. And so, the way AmSan was restructured sort of took us a while to get to that point. Now that we are there, we have 90% of their divisions on our systems that comes more quickly. So, to dovetail that with your question, assuming the next business that we bought didn’t have that IT constraint, we would expect to be able to get at that type of cross-sell a lot quicker.

Keith Hughes – SunTrust

Okay, thank you.

Operator

Your next question comes from the line of Shannon O'Callaghan with Lehman Brothers.