The Wet Seal, Inc. F2Q08 (Qtr End 08/02/08) Earnings Call Transcript

Aug.25.08 | About: The Wet (WTSL)

The Wet Seal, Inc. (WTSLA) F2Q08 Earnings Call August 21, 2008 4:30 PM ET

Executives

Ed Thomas - President and Chief Executive Officer

Steve Benrubi – Chief Financial Officer

Jen McEntee- Vice President of Financial Planning and Analysis

Analysts

Anna Adreeva - JPMorgan

Eric Beder - Brean, Murray, Carret & Co.

Janet Kloppenburg - JJK Research

Daniel [Inaudible] - Tiburon Research Group

Operator

Welcome to Wet Seal Inc. second quarter 2008 earnings conference call. (Operator Instructions) At this time for opening remarks and opening introductions I would like to turn the call over to Ed Thomas, President and CEO.

Ed Thomas

Thank you for joining us today to discuss our second quarter fiscal 2008 results. With me today are Steve Benrubi our CFO and Jen McEntee, VP of Financial Planning and Analysis. Before we begin Jen will provide our Safe Harbor statement.

Jen McEntee

Certain statements during this call may contain forward-looking information. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about our company, economic conditions and market sectors and the industry in which we do business among other things. These statements are not guarantees of future performance and we undertake no obligation to publicly update any forward-looking statements rather as a result of new information, future events, or otherwise.

Actual events and results may differ from those expressed in any forward-looking statements due to a number of factors. Factors that could cause our actual performance, future results, and actions to differ materially from any forward-looking statements include, but are not limited to, those discussed in risk factors within our form 10K for the fiscal year ended February 2, 2008 and our form 10Q for the fiscal quarter ended May 3, 2008, as filed with the SEC.

On today’s call we will make references to net income and earnings per diluted share for the second part of the 2008 before certain charges. These non-GAAP financial measures are provided to facilitate new full year-over-year comparisons. An explanation of why these non- GAAP financial measures are useful and how they are used by management can be obtained from the company’s website at www.wetsealinc.com

Ed Thomas

I will provide today’s call by providing an overview of our second quarter results and priorities for the business. Then Steve will review our financial highlights and turn the call over to the Operator to conduct the question-and-answer portion of the call.

Since we began the implementation of our action plan late last year, we streamlined our organizational structure, improved inventory management, increased operating efficiencies and cut excess costs, while overhauling the merchandise assortment at R&B. All of these efforts were evident in our second quarter results. With that said we are not nearly done with our restructuring and re-positioning efforts and continue to work diligently to make enhancements across all functions of our business.

Illustrating the rapid progress toward achieving the company’s historical high single-digit operating margins, we were able to nearly double our operating margin on a 4.4 % comp decline by eliminating excess costs from all areas of the organization, and maintaining better inventory disciplines at both Wet Seal and R & B divisions.

Specifically, in the second quarter, we generated operating income of $11.8 million for an operating margin of 7.9% as compared to 4.0% for the same period last year, and through the first half of 2008 we generated an operating margin of 7.0%, a significant improvement over the prior year operating margin of 4.4%.

We ended the second quarter with nearly a 13% decrease in inventories per square foot as compared to the end of the second quarter last year, reflecting a continuation of inventory management discipline implemented late last year, and our cautious outlook on the macro environment. Declines in the year-over-year inventories per square foot at both divisions were greater than comparable store sales decline, reflecting an improvement in inventory turns during the quarter. We have made significant improvements in the Arden B divisional operating results reflect both our year-over-year and sequential progress.

Under the leadership of Sharon Hughes who joined us in early February, Arden B generated operating income before corporate allocations of $1 million in the second quarter, and has been nominally profitable through the first half of 2008. These results are representative of an improvement of more than $2 million over the first half of last year, and show far greater improvements sequentially over the significant losses incurred at Arden B in the second half of last year. We ended the second quarter with approximately 70% of Arden B’s merchandise mix based on our new strategy. During the quarter we were encouraged by favorable response to merchandise introduced at Arden B by Sharon, which generated stronger sell-through than merchandise associated with the previous Arden B strategy.

With the Arden B infrastructure now properly aligned with the scale of it’s business, and with the transition to more everyday, casual, and wear-to-work merchandise nearly complete, our focus at Arden B now turns toward the new merchandise strategy and cautiously pursuing opportunities to drive greater sales productivity in that business. That said, we are assuming that selling environment will remain difficult through the second half, and therefore we do not expect a significant change in near-term comparable store sales trends for the concept.

Now, turning to the Wet Seal division; during the second quarter the Wet Seal business felt the effects of a very competitive, highly promotional, fast fashion sector. While the Wet Seal division generated a slight increase in transactions per store, a decrease in average unit [inaudible] during the quarter more than offset this, resulting in a 1.8% comparable store sales decline. We expect business to remain challenging at Wet Seal and the market to remain very promotional through the second half of the year, and we have various marketing strategies planned for the major categories to optimize sales productivity in this environment.

Overall we were satisfied with our Wet Seal inventory position as we entered the important back to school selling season, with the exception of certain elements of our tops business which we believe are somewhat over-sorted.

Consistent with our plans outlined in the spring, we expanded the overall denim presence in our stores versus the prior back-to-school season, including expansion of certain denim brands we tested earlier this year into 100 stores, and in the case of one of those brands, in 200 stores. In early August we opened our first Power Center, or off-mall Wet Seal location in Fresno, CA. We built this store using certain designs and fixture elements of a new store prototype we developed earlier this year. We will cautiously monitor performance of this store to evaluate the potential of the Wet Seal brand in such venues.

After the favorable publicity from celebrity publications and other media outlets, as well as the positive customer reaction we received from the Ashley Simpson merchandise promotion we ran at Wet Seal earlier this spring, we are evaluation further opportunities to align with other performing artists and hope to announce another exciting new artist affiliation in the near future.

As a final comment regarding Wet Seal, I would like again to express our excitement about the appointment of Maria Comfort as President and Chief Merchandise Officer of our Wet Seal division. Maria joins our team later this month and brings tremendous leadership experience and proven merchandise success to Wet Seal. As I have gotten to know Maria this summer, she has already shared many thoughtful insights on the Wet Seal business, and I know she will be a great fit with our organization. Given the timing of her arrival, Maria should have the opportunity to influence merchandising during the very important holiday season.

Turning to other initiatives, one of the key priorities we identified last year was to upgrade certain of our antiquated information systems and gain mark-down and size optimization and capability. In this regard, during the second quarter we entered into an agreement with Oracle to upgrade our retail merchandising and point-of-sale operating systems and will also work with Oracle to implement their mark-down and size operation tools. We intend to begin implementation later this year and with [inaudible]continuing in various stages through early 2010 we look forward to numerous merchandising benefits and operational efficiencies as we complete the implementation of all of these systems over the next 18-24 months. Currently we plan to have a small increase in store count and footage in fiscal 2008 with the opening of 16 new Wet Seal stores, offset by approximately 5 Wet Seal closings, and 10 Arden B closings, primarily upon lease expiration. We will speak in greater detail as to our Q2 results and Q3 earnings expectations.

With much uncertainty in the outlook for the second half of this year and beyond we have not yet finalized our store-growth plans for fiscal 2009. We will continue to monitor the retail and leasing environment through the third quarter and revisit our fiscal 2009 growth plans accordingly. We are pleased with the progress we have made to date in many merchandising and operational facets of our business which have led to our improved financial results and have positioned us well to take further advantage as we see an improvement in the overall retail environment.

Steve Benrubi

Consolidated sales for the second quarter ended August 2, 2008, were $149.1 million, compared to net sales of $143.3 million for the second quarter ended August 4, 2007. Consolidated comparable store sales declined 4.4% in the second quarter. On a comparable store basis second quarter combined transaction count per store increased 1.1%. Average unit retail in the second quarter decreased 5.2% to $10.71 while our average number of units per transaction increased 0.4%.

During the second quarter internet sales increased by 22.9% as compared to the same period last year. Net sales in the Wet Seal division increased 8.3% to $121.7 million in the second quarter compared to net sales of $112.4 million in the prior year second quarter. Comparable store sales decreased 1.8% in the second quarter. Comparable store sales in last years second quarter decreased 0.2%. Net sales in the Arden B division decreased 11.4% to $27.4 million in the second quarter, compared to net sales of $30.9 million for the prior year second quarter. Arden B comparable store sales decreased 13.8% in the second quarter. Comparable stores sales in last years second quarter decreased 6.5%.

Consolidated gross profit was $52 million, a rate of 34.9% of net sales as compared to $49.8 million, or a rate of 31.7% of net sales in last years second quarter. The 20 basis point increase was attributable to improvement in merchandise margins and reductions in buying, planning, and allocation and distribution costs, partially offset by approximately 90 basis points in leveraging in occupancy costs.

Selling, general, and administrative expense for the second quarter was $39.9 million, or 26.8% of net sales, as compared to $43.8 million or 30.6% of net sales in the same period last year. Selling expenses, one of two components of that SG&A were $32 million in the second quarter, or 21.5% of net sales, as compared to $34.9 million or 24.4% of net sales compared to last years second quarter.

The 290 basis point improvement in selling expenses was primarily attributable to: reduced store compensation as a result of improved productivity and bonus incentives targeting more in mind with overall company objectives; a decrease in advertising expenses; decrease in field supervision costs; and a reduction in store supplies and other operating expenses. General and administrative costs for the second quarter totaled $7.9 million, or 5.3% of net sales, as compared to $8.9 million or 6.2% of net sales in last years second quarter.

The decrease in G&A as a percentage of sales was due primarily to a decrease in corporate wages as a result of our January 2008 organization restructuring, a reduction in recruiting fees as the prior year quarter including fees associated with the search for our new CEO, and reduced costs for various consulting services. We recorded an asset impairment charge of $303,000 in the current year as compared to a charge of $144,000 in the second quarter last year.

Operating income for the quarter was $11.8 million, or 7.9% of net sales, compared to operating income of $5.8 million, or 4% of net sales in the second quarter last year. Operating income in the Wet Seal division was $18.1 million in the quarter compared to operating income of $15.3 million for the same period last year.

Operating margin at Wet Seal was 14.9% in the second quarter as compared to 13.6% in the same quarter last year. The higher operating margin was attributable to our reduction in selling expenses, partially offset by the de-leveraging of occupancy costs and the decrease in merchandise margin due to a somewhat greater promotional environment.

Operating income in the Arden B division was $1 million in the second quarter, compared to an operating loss of $1.2 million for the same period last year. Negative comparable store sales in the Arden B division were more than offset by a significant improvement in the merchandise margin rate due to much stronger inventory management as well as major cost reductions across almost all areas of the business.

Net interest expense in the quarter was $1.5 million as compared to net interest income of $1.2 million in the same period last year. Current year second quarter included $1.9 million in non-cash interest charges associated with the June 2008 conversion of $3.4 million of the company’s secured convertible notes into Class A Common Stock.

Excluding the impact of this non-cash charge interest income was still below the same period last year due to lower yields on invested cash this year versus yields that were achieved on option rate securities in the prior year.

The effective tax rate was 1.7% for the second quarter. We began fiscal 2008 with approximately $138 million of federal net operating loss carry-forward available to offset taxable income in fiscal 2008 and thereafter, subject to certain annual limitations. We believe net operating loss carry-forwards available will be sufficient to offset all federal regular taxable income in the current year. Accordingly, we have forecast an effective income tax rate of 1.8% in fiscal 2008 related to a limited portion of federal alternative minimum taxes that cannot be offset by net operating loss carry-forwards, as well as certain state income taxes.

Currently we maintain a 100% valuation allowance against our net deferred income tax assets which are comprised primarily of net operating loss carry-forwards. As of August 2, 2008 evidence does not support realization of these net deferred income tax assets. However, going forward, as we continue to evaluate available evidence it is possible that some or all of our deferred tax assets may begin to be realizable and accordingly the valuation allowance recorded against them which we currently estimate will be in excess of $70 million by the end of the year, may be reversed at or before the end of this year.

If this valuation allowance is reversed we would record an immediate benefit to income taxes in the amount of the reversal and respectively we would report an effective income tax rate much closer to statutory rates which we estimate would be in the range of 38-40%. However, this would not change our expectation that we will not incur significant cash income tax payments in fiscal 2008 or fiscal 2009 as we continue to utilize available net operating loss carry-forwards.

Net income in the second quarter was $10.1 million, or $0.10 per diluted share based on 100.6 million weighted average shares. This compares to net income of $6.8 million or $0.07 per diluted share in the second quarter of 2007 which was based on 103.5 million weighted average shares outstanding.

Excluding the effects of the $1.9 million in non-cash interest charges noted above, net income in the current year second quarter was $12 million, or $0.12 per diluted share. We entered the quarter with a strong balance sheet; at quarter end we had cash and cash equivalents of $123.6 million. We generated $13.1 million of cash from operations in the second quarter and incurred $6.1 million in capital expenditures which includes $5 million on new store construction or remodels of existing stores.

At the end of the second quarter inventory totaled $44.6 million representing a decrease of 4.7% as compared to end of the second quarter last year despite the store count growth during the year due to improved inventory management and our plan to maintain conservative inventory positions for 2008. Average inventory per square foot decreased 12.5% at the end of the second quarter as compared to the prior year.

During the second quarter investors exercised warrants that resulted in issuance of just over 1.5 million shares of the companies Class A common stock, generating approximately $5.6 million in proceeds. As of August 2nd, 2008, warrants exercisable into approximately 11.1 shares of common stock remain outstanding. Exercise of all remaining warrants via cash payments by the warrant holders would result in proceeds of $40.3 million.

The six months ended August 2nd, 2008 net sales were $281.5 million compared to net sales of $281.3 million for the six months ended August 4th, 2007. Comparable store sales in the sixth months of this year declined 5.9% comprised of a 2.5% decline at Wet Seal and a 17.8% decline at Arden B. Comparable store sales increased 1.5% for the twenty six weeks ended August 4th, 2007, comprised of a 1.7% increase at Wet Seal and 3.5% decline at Arden B.

Net income for the first six months of current year totaled $19.1 million, or $0.19 per diluted share. This compares to net income of $14.3 million or $0.14 per diluted share for the same period last year. Excluding the fact of the current year $1.9 million non-cash interest charge we previously discussed, net income for the first six months of fiscal 2008 was $21 million, or $0.21 per diluted share.

Turning to our third quarter 2008 guidance we estimate earnings-per-diluted share in the range of $0.05 to $0.07. This guidance is based on the following major assumptions: total net sales between $144.5 million and $149.1 million versus $150.3 million in the prior year third quarter. We expect a comparable store sales decline of between 6% and 9% versus a 3.4% decrease in the prior year. We are planning 3 net new store openings with 5 net new openings at Wet Seal and 2 net closings at Arden B. In the prior year third quarter we opened 32 net new stores. We expect the gross margin rate to be between 30.6% and 31.9% of net sales versus 28.6% in the prior year third quarter with the increase driven mainly by improvement in merchandise margins as last years third quarter had unusually high mark-down levels.

SG&A expense is expected to be between 27.2% and 27.4 % of net sales versus 30.6% from the prior year third quarter. We forecast operating income to be between $4.6 million and $7 million versus an operating loss of $4.4 million in the prior year third quarter. We forecast interest income of $500,000 versus $1 million in the prior year, and income tax expense of $100,000 versus an income tax benefit of $100,000 in the prior year. And finally we forecast weighted average shares outstanding of $101 million; however, a change in the company’s stock price could cause the weighted average share count to change significantly.

For all of 2008 we now expect a small increase in net new stores with approximately 16 planned openings at Wet Seal offset by approximately 5 closings at Wet Seal and 10 closings at Arden B, primarily as leases expire. The actual number of net new store openings can fluctuate depending on the outcome of several store lease negotiations still in process. We estimate gross capital expenditures for all of fiscal 2008 of $24 to $25 million with offsetting landlord improvement allowances of approximately $3 million for a net cash impact of $21 to $22 million. This includes approximately $17 million for net new store openings and the remodeling of existing stores upon lease renewals and/or store relocations.

With that, I will now turn the call over to begin our question and answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Anna Adreeva - JPMorgan.

Anna Andreeva - JPMorgan

On Arden B, in your expectations for the year, are you embedding that this division makes income this year, versus a loss?

Steve Benrubi

For the first half of the year we are slightly profitable before corporate allocations and we still have the holiday in front of us, but it is a tough environment, but beyond that we aren’t commenting on individual segment performance or expectations. But we are certainly satisfied with the progress we have made through the first half.

Anna Andreeva - JPMorgan

Could you perhaps give us some granularity, I don’t know if you can do that by category or some of the positive reads that you are getting from Arden B? That would be helpful.

Steve Benrubi

We have had some pretty good sell-through on some of the categories that we went after, particularly in the casual sector, which was an element that has been missing in those stores for quite awhile. We had some pretty good sell-through on that. We saw some good sell-through on some of the related separate business. One of our challenges has been to get the mix balance between the everyday casual side, the wear-to-work, and occasion wear. I think we have accomplished that, it is no perfectly balanced right now but certainly we are a lot further along.

Our inventory levels were planned down significantly from last year. Some of the categories that have had good sales we have sold down probably a little bit faster than what we would have liked. However with that being said, I think that our challenge in the back half related to this division is probably going to be more related to the overall tough environment out there than it is to the merchandise mix. As you know we had a pretty significant promotional activity and mark-down activity in this division in the back half of last year and we are expecting to see some significant improvement to the bottom line.

Anna Andreeva - JPMorgan

I am not sure if you commented on inventories exiting the third quarter, but specifically to Arden B are you still expecting a decline in inventories per square foot as you go through the year?

Steve Benrubi

We definitely expect to be down again at the end of the third quarter at Arden B. It is really once we get to year end at that point last year we had pretty much reached the level we thought was appropriate where you will see inventory levels that are comparable year-over-year, but Q3 is still down.

Anna Andreeva - JPMorgan

And what should we expect overall inventories as you exit the third quarter?

Steve Benrubi

Overall we anticipate being down on a square foot basis Q3 this year to last year.

Anna Andreeva - JPMorgan

Could you quantify that?

Steven Benrubi

Perhaps similar to the neighborhood that Q2 has ended at.

Anna Andreeva - JPMorgan

Any color on the business month to date?

Steven Benrubi

I think that we, like many other retailers, have seen since the middle of July that business has been challenging and traffic has been off. We have seen it improve slightly as we get closer to the majority of the back to schools. Then again our transaction business in the Wet Seal division was pretty much even with last year and the average retails are running down slightly but there is no question that it is a challenging environment out there.

Operator

Your next question comes from Eric Beder - Brean Murray.

Eric Beder - Brean Murray, Carret & Co.

You talk about Arden B and less discounted and you are happy with the product, what is the swing factor I guess you tell me it is traffic that is going to have comps being as negative as they were last year. They were very negative for Arden B in the second half of ‘08.

Ed Thomas

We have been expecting all along that we would have a gradual improvement in the back half of this year in terms of our sales performance. It is one thing to change the merchandise; it is another challenge to get the customer to recognize it. I think the performance improvement has been a little bit slower than what we expected originally when we put our plan together. I think it is hard to predict right now, Eric, in terms of when we can see significant top line improvement in this division.

Eric Beder - Brean Murray, Carret & Co.

What are you working on for back to school at Wet Seal?

Ed Thomas

The strongest part of our business right now is the fashion denim category. It has been very strong despite the fact that everybody has been pretty promotional in that category. We have also seen pretty good sell-through in some of the accessory business, and some of our outerwear business. Where our challenge has been is in the tops business which has been off and really the tops business, with the exception of screen t’s, has been off for a number of months now and we have yet to see any significant emerging trend in tops that we have been able to capitalize on overall. So I would say the soft part of the business is more related to the tops.

Eric Beder - Brean Murray, Carret & Co.

In terms of the Power Center location; are you going to play with that in 2009 and see what it is doing? And what is the difference in terms of the prototype of the Power Center versus what we see in a normal Wet Seal?

Ed Thomas

We had a number of deals under negotiation for other Power Center type locations. We decided to not do them because two were in the state of Florida and two were in Las Vegas and because those markets are soft I elected not to do them. We are continuing to look for an additional 2-3 more locations to test. We operate some off-mall locations now but this is really more of a true Power Center. As far as the prototype goes we have developed a complete new prototype for Wet Seal. There is really not a difference in what you would see in Fresno versus what you will see in an in-mall store other than the façade of the store is different. The big change we made is our fixture package for the store is a lot more shop-able and enables us to bring a lot more merchandise down off the walls and make the customer experience more rewarding.

Operator

Your next question comes from Janet Kloppenburg - JJK Research.

Janet Kloppenburg - JJK Research

Didn’t you see gross margins go down in the second quarter? Am I wrong on that?

Steven Benrubi

We anticipated that they would be down on a year-over-year basis.

Janet Kloppenburg - JJK Research

So is this your mark downs? Your full price selling was better than expected?

Steven Benrubi

I think that and the inventory management to mitigate mark-down risk, especially in the Arden B business. Arden B had a significant turn in it’s profitability from the same quarter last year and a big part of that was merchandise margin improvement due to better management of what was in the stores.

Janet Kloppenburg - JJK Research

They earned a $1 million versus the loss of a $1.2 million last, right?

Steven Benrubi

That is right.

Janet Kloppenburg - JJK Research

And what were the primary drivers of the operating income at the Wet Seal division?

Was that margin, or was that more expense oriented?

Steven Benrubi

Merch margin was actually slightly down which was really more inline with expectations overall coming into the quarter from last years second quarter. But many of the things for expense management we put into place at the beginning of the year or late last year, continuing to anniversary periods where we weren’t nearly as efficient with store labor, and some of the non-merchandise related costs in the margin areas such as the buying and the planning and allocation.

Janet Kloppenburg - JJK Research

Did you make any comments about the marketing expense for the third quarter? As Ed knows I just received this mailer from Arden B. I don’t know if you did that last year. It looks terrific. I wonder if you are reaching our or marketing in a more aggressive way this fall season versus last?

Steven Benrubi

The marketing expense actually was down in the second quarter from last year. We have really stayed away from any significant marketing in the Arden B division in particular until we felt that the merchandise mix was starting to get more in line with where we want it to be. In terms of comparison to the next quarter I would say we are pretty much going to be equivalent or a little down to last year on marketing expense.

Janet Kloppenburg - JJK Research

I know he tops business is very difficult. Are you shifting inventory investments out of that category into other categories, or how will you manage through this cycle?

Ed Thomas

We are shifting a few dollars out of it but I think that Maria starts next week and she is taking a closer look at what we are doing, I feel that we can do a little better at editing our assortment and capitalize on it. There are things that are working that we have not invested enough in, and that is a pretty quick source business that we can correct quickly.

Operator

Your next question comes from Daniel [Inaudible] - Tiburon Research Group.

Daniel [Inaudible] - Tiburon Research Group

I have a question on your large and extra-large size merchandise. Can you provide any color on how that is being received by the customers?

Ed Thomas

We finally got into a decent inventory position going into back-to-school and the sales with that merchandise has been very good. We are fine-tuning it as we learn more. We probably went into a lot more styles with the introduction of that than what we normally would do going forward, but generally the results have been pretty good.

Daniel [Inaudible] - Tiburon Research Group

Regarding your merchandise shift at Arden B to more casual and fashion basic; how are you determining the new shift? Is it through focus groups or what is it?

Ed Thomas

We identified quite a while ago through customer feedback and focus groups and really the way the division operated prior to two years ago and really in bringing the division back to it’s roots. We have known enough about what was missing from the merchandise mix and we have worked the last several months to move more towards what the Arden B customer was and we believe still is.

Operator

There are no more questions at this time.

Ed Thomas

This concludes our conference call and thank you all for joining us today.

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