Schawk, Inc. Q2 2008 Earnings Call Transcript

Schawk, Inc. (SGK)

Q2 2008 Earnings Call

August 19, 2008 10:00 am ET

Executives

David A. Schawk - President, Chief Executive Officer, Director

Timothy J. Cunningham - Interim Chief Financial Officer, Chief Accounting Officer

A. Alex Sarkisian - Chief Operating Officer, Executive Vice President, Secretary, Director

[Christine Walvak] - Dresner Corporate Services

Analysts

James Clement - Sidoti & Company

Craig Kennison - Robert W. Baird & Co.

[Myron Kaplan]

Presentation

Operator

Welcome to the second quarter 2008 Schawk earnings conference call. (Operator Instructions) I would now like to turn the call over to Christine Walvak, Dresner Corporate Services.

[Christine Walvak]

I’d like to thank everyone for joining us this morning. Yesterday a press release was distributed outlining the results for the second quarter of 2008. If anyone has not received the release, please contact us at 312-726-3600 and we’ll provide you with another copy. Joining us today from the management of Schawk is David Schawk, President and Chief Executive Officer, Alex Sarkisian, Executive Vice President and Chief Operating Officer, and Tim Cunningham, Interim Chief Financial Officer. Management will begin with an overview of the results and then we’ll open the call to your questions.

Before we begin however, I’d like to remind participants that this conference call may contain certain forward-looking statements that are subject to the Safe Harbor disclaimer found in yesterday’s press release.

At this point I’ll turn the call over to David Schawk.

David A. Schawk

Good morning everyone and thanks for joining us. As you saw from our press release issued late last night the results of our second quarter were a continuation of the slowdown that we experienced during the first quarter. We believe that the slowdown in business reflects the general softness in the US economy. While we were optimistic near the latter half of the second quarter given the uptick in business that we had seen in April and May, results from the month of June were below our expectations and the positive momentum did not continue as planned. Furthermore, in June we experienced delayed client project activity as the month progressed. As a result we believe that clients are taking a cautious stance with respect to their promotional, innovative and marketing activities due to the uncertainty that exists within the economy.

For the second quarter of 2008 our sales were down approximately 6.5% over the second quarter of 2007 as consumer products packaging companies continue to deal with higher raw material and transportation costs and private label competition, along with the entertainment and advertising retail customers experience adverse sales performance versus last year. The 6.5% decrease in sales was driven by an 8.6% sales decline within our North American and Europe segments. This was partially offset by an 8.6% increase in sales in our other reportable segments which was a result of strong sales at Anthem, our creative design group.

Unlike in the first quarter we experienced a slight increase in consumer product packaging sales and a decrease in advertising retail entertainment accounts. The weakness in sales was broadly based. In the second quarter of 2008 versus the same period last year, consumer products packaging accounts decreased 2.7%, advertising retail decreased 7.7%, and entertainment accounts decreased 9.9%. As a reminder, consumer products packaging accounts represent approximately two-thirds of our total revenue so this part of our business has the largest impact on both our revenues and our profits.

As we highlighted on last quarter’s conference call consumer products companies know that when their branded products do not provide innovation in the form of new product introductions along with new packaging and design, they start to lose business to private label brands. Therefore despite the reduced activity on behalf of our consumer products packaging clients we are fairly optimistic that they will begin to resume marketing activities such as new product introductions, package redesigns, and promotional materials as the year progresses. Additionally, in difficult uncertain economic times like we’re experiencing now, private labels tend to gain market shares as consumers look for ways to cut back on spending. Therefore we continue to see robust activity in our private label market.

As to retail advertising and entertainment accounts we continue to see weaker overall market versus last year. In general companies in these areas have reduced their spending on advertising and marketing.

As a result of the adverse sales performance in the first half, growing price pressures, and the related profit impact we are focusing on enhancing our capacity utilization and anticipate that we will improve our operating margins.

During the first quarter conference call we had announced a plan to consolidate and right size our workforce and our operations to improve capacity utilization by reducing personnel, consolidating manufacturing locations, and realigning work sites to perform work in lower cost venues. During the second quarter of 2008 the company began to implement this cost reduction plan by closing and consolidating manufacturing locations and expanding our sales and service offering while reducing staffing levels. We are seeking to consolidate technology and work flows thus allowing the company to improve its capacity utilization rates.

As a result of the initiation of this plan during the second quarter, Schawk incurred expenses totaling $3 million. The total costs of this plan to reduce personnel and realign sites to perform work in lower cost venues while continuing to provide high level of services and quality to our clients are still expected to be approximately between $7.5 million and $8.5 million for 2008 fiscal year. However, cost savings are estimated to range between $4 million and $5 million in 2008 with a full-year 2009 savings estimated to be between $12 million and $13 million.

Again I would like to point out that none of these actions we are taking will impact our clients or the level of service they receive from Schawk.

Additionally, Schawk remains focused on its goal to expand its service offerings to better serve its clients. On the acquisition front, effective May 31, 2008 Schawk acquired Marquis Brand Consultants an Australia-based strategy and creative design firm that provides services primarily for the private label market. We began to recognize Marquis’ results in our financial statements beginning June 1. This is an exciting acquisition as it expands Schawk’s creative design capabilities in Australia and will allow us to provide services for our multi-national clients with Australian operations. By focusing on private label, Marquis will be complementary to our Anthem, Australia group that provides visual branding services to consumer products markets throughout Australia and New Zealand.

Finally, I will address the remediation of material weaknesses in our internal controls. While we have made progress in this area as evidenced by a more timely earnings release and the 10Q filing, we continue to work diligently to improve our processes to design effective controls and to add accounting resources as necessary. It is our goal and expectations to significantly improve our internal control system and our material weaknesses by year end.

While demand within the markets we serve continues to be soft, we are aggressively pursuing new revenue by bringing innovative products and work flows to markets globally. Furthermore we believe we are in a good position to deliver traditional and expanded products and services more efficiently than ever before as our clients’ demands accelerate.

Now I’d like to turn the call over to Tim and he’ll review the numbers in more detail.

Timothy J. Cunningham

Good morning everyone. As David mentioned comparing the second quarter of 2008 with the second quarter of 2007, our sales were down 6.5% representing decreased sales across most of our business areas including consumer product packaging sales, our largest area, which represents nearly 64% of sales. On a geographic basis the softness continued to be particularly evident in our domestic business in the US which represents more than two-thirds of our total consolidated revenues. Somewhat offsetting the decline in sales for the quarter were strong sales in Schawk’s other reportable segment which is drive by the company’s creative design group, Anthem.

Now I’d like to highlight two charges on our financial statements for the second quarter of 2008. The first charge for discussion is for $3.2 million and is connected to the acquisition, integration and restructuring expenses related to the cost reduction plan that David spoke about earlier, and we also discussed this cost reduction activity during our July 2 conference call.

The second charge that I want to highlight is an impairment charge of $2.2 million related to long-lived assets. During the second quarter of 2008 software that had been capitalized by the company in accordance with AICP Statement SOP 98.1 Accounting for the Cost of Computer Software Developed or Obtained for Internal Use, was reviewed for impairment due to changes in circumstances which indicated that the carrying amount of the asset might not be recoverable. These changes in circumstances included the expectation that the software would not provide substantive service potential as well as a change in the extent to which the software was to be used. In addition it was determined that the cost to modify the software for the company’s needs would significantly exceed the originally-expected development costs. As a result of these circumstances, the company has written down the capitalized cost to a fair value. This non-cash expense was recorded in the North America and European segment.

Also for comparative purposes the company had a pre-tax gain of $1.1 million for the sale of a building in the second quarter of 2007. To assist investors in comparing this second quarter of 2008 and 2007, we have included a non-GAAP financial metrics and a reconciliation to GAAP in last night’s press release. We did this both for the quarter and year-to-date numbers. So excluding the acquisition, integration and restructuring expenses of $3.2 million and the impairment of internal use software expense of $2.2 million in the 2008 quarter and excluding the $1.1 million gain for the sale of the building in the 2007 quarter, operating income was $10.7 million for the second quarter of 2008 versus $17.4 million in the same period last year.

Excluding these unusual items in both periods, second quarter 2008 operating income decreased 39% versus last year’s second quarter. And again you can reference the tables presented in yesterday’s press release. While most of that 39% increase was attributable to lower sales, operating income in the 2008 second quarter was also impacted by an increase in professional fees of $1.5 million attributable to audit fees and other costs related to Schawk’s restatement, internal control remediation and related matters, and consulting fees related to the company’s rebranding initiative.

Now moving on to interest expense, we continue to lower our interest expense as we have for the past two years. Second quarter 2008 interest expense was down 29% compared to 2007 as we continued to use our strong cash flows to reduce our debt. In fact, outstanding debt fell by $9.2 million at quarter end compared to outstanding debt at March 31, 2008 as a result of the company’s generation of $15.4 million in operating cash flow in the current quarter. Compared to June 2007 outstanding debt has decreased by over $22 million at June 2008 which further confirms the strong financial position of Schawk.

Income tax expense for the second quarter of 2008 was at an effective tax rate of 79% compared to an effective tax rate of 38.3% in the second quarter of 2007. The increase in the effective tax rate is primarily driven by the recording of a UK income tax valuation allowance of $1.5 million. And again you can see this on the reconciliation shown on the back of the press release issued yesterday.

Moving on to the balance sheet, while our accounts receivables increased by approximately $1.1 million compared to March 31, receivables declined by approximately $8.7 million as compared to December 2007 due to our continued strong cash collection efforts in 2008. Our debt-to-equity ratio is 35.3% in June 2008 which is improved from the 38.5% in March 2008. Our debt-to-total capital ratio is 26.1% at the end of the second quarter which again is favorable to the 27.8% at the end of March 2008.

The company is well positioned to finance its growth in 2008 between operating cash flow and over $78 million of availability on our revolving credit facility. The company with the assistance of a major accounting and advisory firm recently completed the plans to remediate our material weaknesses and improve our SOX program. We are in the process of implementing these plans in the third quarter and anticipating this implementation continuing into the fourth quarter of 2008. We anticipate that we will make substantial progress with our internal controls by the end of this year. The company expects to continue receiving assistance from a major accounting and advisory firm as we progress through the remediation activities.

This will be a key driver of the planned increased G&A expense in the remaining two quarters of 2008 as well as higher external audit and related costs until such time as we complete and test the revised internal controls. We expect that such costs could range between $3 million to $3.5 million in the last half of fiscal 2008. The executive management team and other business leaders of Schawk are committed to taking the steps necessary to ensure that our accounting and finance functions reflect the level required of a $550 million global enterprise.

With that we’d now like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from James Clement - Sidoti & Company.

James Clement - Sidoti & Company

David, with respect to the cost savings plan and that sort of thing, are we to assume based on the timing of the announcements and that sort of thing that you didn’t get much of a benefit from that in the second quarter?

David A. Schawk

Yes. We really got zero effect of the benefit in the second quarter. As we stated in the release we’ll see savings in the back half of this year and then substantial savings next year.

James Clement - Sidoti & Company

What’s in SG&A in the June quarter, about $1.5 million increase in professional fees, as you improve the internal controls and get SOCKS compliance and that sort of thing would you expect that some of those dollars would actually flow out of SG&A eventually or are these costs that are going to be with you for the foreseeable future, even beyond the $3 million to $3.5 million that you mentioned in the second half of this year?

Timothy J. Cunningham

I would say a lot of those costs are one-time costs. There likely will be some continued increase in the cost structure of the company just to maintain the appropriate levels of controls, but there is a significant business and financial commitment to accomplishing remediation this year.

James Clement - Sidoti & Company

And Tim I think you said about $3 million to $3.5 million in the second half of this year. On an apples-to-apples basis you’re basically talking about roughly what’s in line with the second quarter, right, on a quarterly basis or are these other costs? In the press release it says that professional fees were up about $1.5 million in the June quarter and I’m assuming you’re talking about the same kind of functions in the back half of the year where you mentioned $3 million to $3.5 million in the back half. So what it basically sounds like is the spending on these kinds of things is going to continue at the current level. It wasn’t like some incremental jump up beyond what you’re already spending. Am I interpreting that right?

Timothy J. Cunningham

That is correct.

James Clement - Sidoti & Company

David a question for you. With consumer related weakness out there, with a lot of companies pulling back on marketing spending, why were your Anthem results actually up?

David A. Schawk

First of all it’s due to some acquisitions. We acquired a couple businesses year-over-year and we’re starting to see that’s the first sign of the start of a pickup. Since we are in the beginning stages of new development in design and promotion, it should flow down to us in the third and fourth quarters. That’s what we’re looking for.

James Clement - Sidoti & Company

That was really what I was asking. I know it’s not a huge driver of the financial results of your business, but can the Anthem results sometimes be a little bit of a leading indicator for the rest of your business?

David A. Schawk

Yes, it certainly can.

Operator

Our next question comes from Craig Kennison - Robert W. Baird & Co.

Craig Kennison - Robert W. Baird & Co.

Just on the topic of visibility, I’m trying to get a feel for the visibility you have into your business. I appreciate that in some cases you have as little as 24 hours into some of these projects, but what’s the normal time lag between when you capture revenue and when you become aware of that at the corporate level?

David A. Schawk

I’m not sure I understand the question. Is it the activity that we see at the operating level; is your question when we receive it at the corporate level?

Craig Kennison - Robert W. Baird & Co.

I guess the question is getting back to the July conference call you seemed rather optimistic about the tone of the quarter and of course June was over at that time and yet June didn’t materialize like you thought it would. So how long does it take between internally when [inaudible] turned down let’s say in June and you become aware of it? Is there a mechanism there that takes some time?

David A. Schawk

Even though June’s over we don’t have our revenue numbers calculated until the middle of July, so we really wouldn’t see the downturn until then. Most of our billing activity is really at the last couple weeks of the month and the first week in July obviously billing work that’s produced in June and billable. So that’s the type of timeframe we have.

Craig Kennison - Robert W. Baird & Co.

Is that something that as you address some of your other remediation issues that you can quicken?

David A. Schawk

Yes. What’s happened especially with the remediation and revenue recognition and the controls and the processes we have in place that we’re improving on today will probably give us a little better visibility especially around revenue recognition because that’s not a big part of our total sales but it’s still a part of the process that we’re working on to remediate and there is some continued confusion out there. So we’re getting those processes in place to help improve that, absolutely.

Craig Kennison - Robert W. Baird & Co.

And shifting to the comment that projects are being delayed, what gives you the confidence that they’re delayed and not canceled and what historically has been your ability to recuperate most of those delayed projects?

A. Alex Sarkisian

What happens on a lot of these projects and we saw a lot of that in the June period in fact is projects that we’re briefed on in terms of campaigns and so on, the design work has been completed, the preparation has been completed for it, and then a decision is made by senior members of the management of a lot of these clients just to stop it. And the good news and bad news about these things is we’re able to turn it on and generate revenue pretty quickly because the turnarounds are so quick, but on the other hand as a result of that they can be stopped equally as quick. And that’s what we experienced at the end of the second quarter. We’re very confident in our ability to be able to react and go forward with projects and our clients are aware of that. One of the benefits of our size as opposed to a lot of our competition is the scalability that we enjoy and as a result our ability to step up and go quickly is a benefit for our clients.

David A. Schawk

And one of the other issues if you remember last year we had a very soft third quarter. Most of our clients told us the projects were delayed and not canceled and we had a very strong fourth quarter last year while it was masked by all of the other issues that we worked on. That was evidence that our clients are telling us that things are delayed and not canceled.

Craig Kennison - Robert W. Baird & Co.

Are you seeing any indication yet that projects delayed in the first or second quarter have been renewed or is it still too early to tell?

A. Alex Sarkisian

It’s choppy. Some have been and others have not been.

Craig Kennison - Robert W. Baird & Co.

One of your longer-term initiatives has been to migrate some of your cost structure to low-cost regions. You’ve already begun to make some progress on that initiative. Where would you say or what inning would you say you’re in, in terms of achieving your ultimate goal of moving much of your cost structure there?

David A. Schawk

I’d say we’re in the third inning.

Craig Kennison - Robert W. Baird & Co.

You spent some money recently on a branding initiative and you’ve changed your business description to focus on brand point management. Could you just help investors understand what your message is and how your business has changed?

David A. Schawk

Yes. It’s a message of really changing to be able to help our consumer products companies sell more products and we built this company to really touch every major brand point that there is out there relative to consumers. If you really think about wanting to get a consistent and compelling message across to the consumer, you need to make sure that you have that message consistent across all different mediums such as billboards outside, at home when you’re flipping through a publication or a magazine and you see an ad in the magazine, if you go in the store you see the end aisle displays and point of sale material, and then on the shelf with the package. And what we’re really doing is delivering a product and a service that will give that consistent and compelling message across all the different mediums including the Internet. And that’s really the message that we’ve been working on for the last couple or three years of developing that service offering and now going out and selling it.

Craig Kennison - Robert W. Baird & Co.

Any examples yet of how that message has helped you win new business?

David A. Schawk

Yes. Alex?

A. Alex Sarkisian

We have one client that we’ve historically done a little bit of packaging for. We don’t get into the naming of these companies but this is a very large athletic company that we’ve done some packaging for in our facility out in the Pacific Northwest who has been struggling with a lot of their Internet activity and because of our brand point approach to things, they’ve become aware of the Schawk retail group and some of the work that we’ve been able to do on the Internet. They’ve awarded us global work now for both North America and Europe, work that we otherwise would not have had. One of the issues that goes on with most of our clients is they are very [silo’d] and because there hasn’t been an innovative offering of the nature that Schawk is able to bring, so this is one that because of some of the information that we’ve gotten out there we had a client who was aware of some of the things that we had done on the packaging side. They’d seen some of our work and they inquired about it and we were able to bring that to realization of some new revenue and we expect that to grow for us.

Operator

Our next question comes from [Myron Kaplan].

[Myron Kaplan]

Something that puzzled me is in the paragraph about consumer products packaging sales, it says “Additionally consumer products sales reflect this group’s struggles with higher raw material and transportation (we can understand that) but also in private label competition.”

David A. Schawk

Yes, the private label market is expanding and affecting the major consumer brands that are out there. What we’ve seen is that there’s an uptick in new designs, new creativity because private labels have to compete with the corporate brands and the corporate brands have slowed down a little bit but we anticipate that because of the pressure of private label on their business, they’re going to now go back to the redesigning and promotion activities in the balance of this second half.

[Myron Kaplan]

Right. But don’t some of the producers of private label products employ your services as well?

David A. Schawk

Yes, absolutely. And we state in there that we’ve seen an uptick in that business but it’s certainly a lot smaller than our CPG business.

[Myron Kaplan]

So in other words, it’s having more of a deleterious affect on the brand portion of the consumer products packaging even though there’s a somewhat -

David A. Schawk

Uptick in the others. Yes.

[Myron Kaplan]

Uptick in the private labels sector which is much, much smaller?

David A. Schawk

Right. And that’s why we believe that a lot of these projects have been delayed and not canceled because they know when they get pressure from private labels they’ve got to be innovative; they know they have to come out with new products; and we see that again in the second half.

[Myron Kaplan]

Can you discuss at all now that you’re filing, I assume you’re going to file the 10Q shortly?

Timothy J. Cunningham

That was filed yesterday as well so it’s available.

[Myron Kaplan]

So then you may consider implementation of your stock buy-back?

David A. Schawk

It’s certainly in place so we’re certainly looking at it. We have the restrictions of buying shares as insiders so it’s 48 hours after our release of the Q and we have I think 10 days after that.

[Myron Kaplan]

Now that you’re filings are now timely, you’re not longer delinquent.

David A. Schawk

Yes.

Operator

Our next question comes from James Clement - Sidoti & Company.

James Clement - Sidoti & Company

This is a follow up to Mr. Kaplan’s question. I’m curious also what the acquisition pipeline or the picture might look like. You guys have done a great job of paying down your debt over the last couple years and certainly you’ve got availability. Are these the times when businesses because times are tough might actually be shaken loose? Can you talk about what you see out there? Have sellers valuation expectations come down at all? Are there potential deals out there for you?

David A. Schawk

I wouldn’t say we have a robust pipeline but we do have a few going and there are some valuations that are coming down but not significantly. As you know we’re always looking and again I would say that it is not robust but there is activity.

James Clement - Sidoti & Company

Is it fair to say over the next couple of months you might be a little more inclined to repurchase stock versus doing a deal of any significant size?

David A. Schawk

Well we certainly see this as a better investment than anything else today, so yes.

James Clement - Sidoti & Company

That was what I was looking for.

Operator

We have no further questions in the queue at this time.

David A. Schawk

Thanks for joining us today. We’ll talk on our next quarterly call.

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