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Systemax Inc. (NYSE:SYX)

Q2 2008 Earnings Call

August 7, 2008 5:00 pm ET

Executives

[Denise Roche]

Richard Leeds – Chairman, Chief Executive Officer

Gilbert Fiorentino – General Manger

Lawrence Reinhold – Chief Financial Officer

Analysts

[Andre Gardner]

John Curti – Principal Global Investors

Operator

Welcome to Systemax's 2008 second quarter earnings conference call. (Operator Instructions)

I would now like to turn the conference over to [Denise Roche].

[Denise Roche]

I'm here today with Richard Leeds, Chairman and Chief Executive Officer, Max Fiorentino, General Manager of Systemax Technology Business which includes Tiger Direct, Comp USA and Masco, and Larry Reinhold, Executive Vice President and Chief Financial Officer of Systemax.

This discussion may include certain forward-looking statements. It should be understood that actual results could differ materially from those projected due to a number of factors including those described under the caption forward-looking statements in the company's annual report on Form 10-K. This call is the property of and is copywrited by Systemax Inc. I will now turn the call over to Richard Leeds.

Richard Leeds

I'm pleased to report that during the second quarter, we delivered strong financial results despite continued softness in consumer spending, and more specifically in IT spending. Consolidated sales grew by more than 17%, $756 million driven by sales in our two key business segments. Technology product sales which include computers, computer supplies and consumer electronics grew 17.5%, $694 million.

Growth in this segment came from three sources; our websites, our TigerDirect.com, our brick and mortar Tiger Direct locations and the Comp USA assets that we reopened. In our investor products group which includes material handling equipment, storage equipment and consumable industrial items, sales increased 10.4% to approximately $62 million.

On a consolidated basis, our gross margin for the quarter was unchanged compared to the second quarter of 2007. Our operating income grew 5.2% versus the same period in 2007. This translated into 2.8% operating margin, a 30 basis point decline from the second quarter of 2007. Our operating margin, as well as additional expansion in our gross profit margin was tempered by the investment required to establish the 16 Comp USA and the web site, as well as opening two additional stores that were already in the works.

Some of the costs were one time expenses incurred related to grand reopening promotional events, branding and other related expenses. While the majority of the increased expense is attributable to employee costs, these costs are expected to stabilize now that we are fully staffed. Further, as store sales ramp up, we expect to improvement in operating margins.

Consolidated SG&A as a percentage of sales was 12.6% in the quarter, up 40 basis points from 2007. The six months ended June 30, 2008, SG&A costs were 12.3% as a percentage of sales, up 60 basis points from 2007. Going forward, we expect to leverage our SG&A as sales from Comp USA ramp up.

Net income for the quarter remained virtually flat in the second quarter at $13.5 million versus $13.7 in 2007. On a diluted EPS basis the company earned $0.36 versus $0.37 during the same period last year. Earnings per share was negatively impacted in 2008 by lower interest income as a result of lower cash balances, higher tax expense and a higher operating loss in our host software segment. I will provide further details on the financials later in the call.

We remain excited about the potential to create value with Comp USA. We remain confident that the investments we are making in the near term will increase our profitability over the long term. Further, we have positioned our business for growth when the economic environment and more specifically, consumer spending improves. Management remains committed to returning value to shareholders.

In May, we announced that our Board of Directors approved a stock buy back plan for up to two million shares of the company's common stock. Although we did not repurchase any shares during the second quarter, we believe repurchasing shares at recent market prices may be a prudent use of the company's cash and demonstrates the confidence we have in our operations and assets.

I will now turn the call over to Gilbert to discuss highlights from our technology products segment, including Tiger Direct, Disco and Comp USA.

Gilbert Fiorentino

The technology products group remained hard at work this quarter which translated into net sales of 17.5% versus the second quarter of 2007. Additionally, we grew our operating income within this division by 12.4% versus the same period one year ago. Our team made great strides in implementing our near term strategy to effectively integrate the Comp USA assets that we purchased last quarter into our overall business.

This included launching new marketing and branding initiatives, our co-branding Comp USA with our established Tiger Direct business. Newspaper circulars are already being duly branded across our entire retail footprint as are employee work shirts, name badges, in store signage and other items. Our long term goal is to create a single Comp USA brand retail strategy in the United States and have both Comp USA and Tiger Direct.com brands in the United States on the internet.

Getting 18 new brick and mortar stores open successfully and running in a short period of time was a tall order, but by the end of April, we had already re-staffed, re-stocked and held grand openings for all of our new stores. This is an accomplishment we are very proud of and one that would not have been possible if not for the hard work and dedication of our employees.

As a result of this hard work, we are able to recognize revenue of over $76 million from Comp USA in the second quarter. Despite a challenging economic environment for retail business, we are seeing improving sales and close rates at many of our new stores as we continue to have high expectations for Comp USA.

While we are very pleased with the streamlined roll out of the physical locations, we still intend to re-configure each store's layout over the coming months to more closely reflect the proved layout of our Tiger Direct stores. This means more emphasis on PC component categories, improved merchandise of televisions and consumer electronics and a spot light focus on our stores in-store technical services.

Our total store count, both Tiger Direct and Comp USA has now reached 29, with 24 in the United States and five in Canada. We currently have plans to open one more store in 2008. Further, we successfully converted the Comp USA URL into an entirely new e-commerce site with improved content, a more attractive layout and new functionalities and as expected, we have seen promising growth and steady increase in sales and traction. In the second quarter Comp USA.com had over 10 million visits to its site. Our average weekly unique visitors improved by 24% over the first quarter of 2008, and it continues to grow.

We remain very excited about the Tiger Direct and Comp USA online businesses. During the second quarter 2008, hit wise, a leading industry ranking service for websites again ranked Tigerdirect.com in the top ten both heavily traffic sites in computer sales category. In its June 2008 issue, Internet Retailer Magazine ranked Systemax number 22 in its annual review of the top 500 internet retailers up two spots from the prior year.

Traffic to our web site continued to grow as we saw a 31% increase in total traffic over the second quarter of 2007. When users arrive at one of our sites, their experience continues to improve with more enhanced web content and over 100,000 users generated reviews and almost 30,000 user questions and answers posted on our site. Our video content has been viewed over six million times now.

During the second quarter, our development team was also very busy improving our site to provide a better online experience for our customers. We added PayPal as a method of payment to the CompUSA.com web site in addition to an aggressive cash back promotion to help stimulate incremental demand. We implemented a state-of-the-art web analytics package from Core metrics to give us improved insights into our customers behaviors, and this will help us serve to market to them more effectively in the future.

During the quarter we also completed some major infrastructure improvements, adding a new state-of-the-art data center to house our critical servers, improve our network capacity, handle traffic more quickly and with more fail safes than ever before.

In the second quarter, we added Panasonic consumer electronics to our list of tier one direct consumer electronics manufacturers in our efforts to further solidify Tiger Direct and Comp USA as a major player in the higher margin world of home entertainment consumer electronics. In the consumer electronics world, we now have direct purchasing relationships with Sony retail products, Toshiba, Mitsubishi, Hitachi, Visio, Bowes, Yamaha, On Kio, [Arm and Cardin], Garmin, Magellan and Nokia. We will continue to cultivate more direct relationships in our effort to improve service and product availability to our customers as well as increase our sales margins.

Turning to product sales, revenue from TV's in the second quarter increased by 13% versus the same period one year ago. In the computer category, Tiger Direct is leading the industry growth. Notebook revenues climbed 45% in Q2 compared to a nationwide retail average of only 16.5% according to MPD group. Accordingly, desktop sales grew by 17% versus the nationwide retail average of only 8.4%.

The North America business to business group has also been quite busy. While our core B to B business has continued to grow faster than the industry average, we've been quietly expanding into new areas. In partnership with out brick and mortar retail group, we are creating small business sales departments in many of our stores to provide more customized service to small business markets in the local areas that we serve.

In response to an opportunity that we have served in the marketplace, we formed a specialized sales group focused on software licensing. This is a very exciting market for a number of reasons; less intense competition, increased complexity of the products creates a higher barrier to entry for others and high margins and a captive audience of potential customers.

In Europe, revenues grew by 13% in the quarter, 5% after taking into account favorable exchange rates. Revenue growth was driven by strong internet and business to business sales. We continue to see substantial returns from the strategies that we've implemented over the past several years there.

We are pleased with our results in the technology products group and the progress we've made integrating the Comp USA brand and stores into our business, and the prospects for our continued success through this and future years. With that, I'll pass the call back to Richard.

Richard Leeds

Our industrial products business, Global, Industrial and Nextel Industries, continued to grow at a double digit pace during the second quarter. We continue to utilize our proprietary profit center software solution which I'll speak about further in a moment to increase levels of efficiency, further scale this business and increase profitability. Our growing customer base continues to put high levels of satisfaction, a low price, top quality product selection as well as the ease of use associated with our leading web site technology.

By maintaining the growth in our product offerings and better managing those products that have not performed well in the recent past, we've increased net sales in this division by 10.4% versus the same period one year prior. Further, because of the operating efficiencies we've been implementing, our operating income grew 18.4% in the quarter. Our efforts have helped us increase our product selection on the web by 40% versus 2007.

New web visitors to our Global Industrial web site were up 41% versus the six month period last year. What's more, the total number of new web customers grew 29%. The growth generated from our web sites parlays nicely with our outbound telemarketing sales force and additional catalogue mailings.

As I mentioned earlier, our hosted software business profit center software has played a big role in helping us grow our business. It was developed as a 100% web based on-demand application designed specifically for sales of multi-channel direct marketing companies challenged with the need to automate and manage products for the entire customer life cycle across multiple sales channels.

Last quarter we announced the roll out of version 3.0 which improves continuity, world wide shipping, web search and navigation, personalization and enhanced accounting functionality. We currently have two customers live with this new version. One went live during the quarter and one went live more recently in July. We have a great deal of confidence that this solution is best in breed and will play a big part in our growth going forward.

Finally, I'd like to note that we settled a portion of the rebate litigation. PC USA, a third party vendor who engaged us as a subsidiary on rebate to process its rebates had sued onrebates.com and Tiger Direct claiming initially that we had not paid all of the customers that purchased PC USA products covered by a PC USA rebate program, then revising it to claim that we had in fact overpaid these customers by accepting incomplete rebate applications and/or extending the deadlines to file rebate applications.

While we continue to believe that our business dealings were appropriate and in good faith, we came to a settlement with PC USA in July for a total payment of $5,000 U.S. dollars an amount that is less than nuisance value. The status of the rebate law suit, the Florida Attorney General investigation remains substantially unchanged since our last call. The law suit, the court has yet to certify the case as a class action, therefore has not been able to rule on our motion to dismiss and we continue to cooperate with Florida's AG office.

I'll now turn the call over to Larry Reinhold who will provide a more detailed review of our financial results.

Lawrence Reinhold

As Richard mentioned earlier, the company reported solid second quarter results. Consolidated sales for the quarter were $756 million, up 17% from $647.1 million in the second quarter 2007. Net income for the quarter was $13.5 million, or $0.36 per diluted share compared with $0.37 per share in the same period last year.

Earnings per share in the quarter was impacted by about $500,000 of lower interest income and by about $700,000 in higher income tax expense. Interest income was down due to lower cash balances as a result of the cash used to purchase Comp USA, its stock for new retail stores and to pay the special dividend.

Income tax expense was higher principally due to our United Kingdom being taxed this year. You may recall that through Q3 of 2007, we had a large valuation allowance on our United Kingdom deferred tax assets. This valuation allowance was released in Q4 of 2007 due to the success of our turnaround in that business.

Technology product sales were $694 million, an increase of 17.5% over the second quarter of 2007 representing 92% of the company's overall revenue. Operating income from this division was $23.3 million, an increase of 12.4% over the second quarter of 2007. Our technology products operating income for the quarter was impacted by an operating loss of about $1 million at the Comp USA retail stores.

During the second quarter of 2008, net sales for our industrial products division was $61.6 million, an increase of 10.4% over the second quarter of 2007. Operating income in Q2 of '08 was $6.7 million, an increase of 28% over the second quarter of last year.

The second quarter, our hosted software business incurred an operating loss of about $4.5 million which was $1.5 million greater than the same period of last year, as we invested in infrastructure to support development and implementation needs.

Turning to our geographical breakdown, total North American sales were $512 million, an increase of 18.8% from the second quarter, and representing 68% of our total sales in the quarter. Our total European sales were $244 million U.S. dollars, an increase of 13% from the second quarter of last year, representing 32% of our total sales. We benefited from movements in foreign exchange rates as the weak dollar positively impacted European sales comparison by about $18 million in the quarter.

During the second quarter, our SG&A expense increased 40 basis points to 12.6% of revenue versus the second quarter of 2007. This increase is mostly attributable to additional employee costs associated with the re-opening of the Comp USA stores and related expenses and growth in our other businesses.

In total, we hired more than 700 employees to staff the stores. Fortunately, most of these employees were Legacy employees from the original Comp USA operation, saving us a considerable amount of time and capital associated with employee training. What's more, this allowed us to re-open the stores faster and therefore begin to generate revenue sooner. Total SG&A costs in the quarter from Comp USA were about $8.3 million.

Our effective tax rate in the second quarter was 37.1% up from 34.5% last year, and as previously discussed, was primarily due to our United Kingdom profits being fully taxed this year.

Moving to the balance sheet, the company continues to maintain a strong financial position. At June 30, 2008 our balance sheet reflected $240.8 million in working capital and $66.8 million in cash. As previously mentioned, cash balances for the quarter decreased as we paid the dollar per share special dividend on April 2, invested in inventory to stock the stores. Our current ratio at the end of the quarter was 1.7 to 1.

During the quarter, we generated $9.4 million in operating cash flow, added $297 million of inventory, a 16% increase over $250 million we had on hand at December 31, primarily as a result of the additional 16 Comp USA stores as well as the other two that we opened.

At the end of the second quarter we had about $2.1 million of debt outstanding, principally in Europe. Currently we have $107 million available under our credit facility and together with the cash on our balance sheet we have access to a total of $174 million, providing us with additional financial flexibility.

With that, we'd like to open the call up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Andre Gardner – Iris

[Andre Gardner]

Could you talk a little bit more about the PCS business and specifically about the customers? You said there's two live customers with the 3.0 version. Can you tell us anything about what markets they're in or what size companies these are?

Richard Leeds

I'm not going to give you the names on a conference call but they're basically business that are financial web businesses. I would categorize them as on the smaller side where the web site is in my opinion better than they've had in the past, and I think it's worked out well for those customers.

[Andre Gardner]

Are you going to at some point, when do you plan on breaking out the PCS numbers on the income statement?

Lawrence Reinhold

The PCS is already reported as a reporting segment, so the revenues and its operating loss or future income are in note eight. If you look in note eight of the 10-Q, it will be on file today. You'll see that broken out, also it's in the K's for the prior years. I'd like to warn you that as a hosted software product, that it's a deferred revenue so as those customers get live, we start recognizing the revenue.

[Andre Gardner]

So that's subscription based then? It's recurring?

Lawrence Reinhold

Yes. And there's in excess of $5 million of deferred revenue on the balance sheet.

[Andre Gardner]

And the $76 million attributed to Comp USA, can you tell us, is that retail?

Lawrence Reinhold

It's both. We haven't broken out specifically the revenue between the web site and retail.

[Andre Gardner]

You said you would be willing to look at some conferences. Any plans to attend conference this fall?

Lawrence Reinhold

We haven't announced any yet, but yes we are planning on attending. We're lining them up for the next Q. They'll be announced in advance when we've finalized what our space and plans.

Operator

Your next question comes from John Curti – Principal Global Investors

John Curti – Principal Global Investors

I had a question on the hosted software business. You just mentioned $5 million of deferred revenue; over what time frame will that be recognized?

Lawrence Reinhold

It varies. We talked about this in the past, John. The model that UCS business uses that we get paid to implement the software on a customers' site and then once they get installed and implemented, and they go live and we're paid on a subscription receipt basis over a contractual period. So with the customers that are in the implementation phase, we collect for performed services, we collect cash. We defer all that cash. The accounting model has us at the point of go live; we amortize that deferred revenue to income over the contractual hosting period. Typically that hosting period can range from one to many years, but it's probably safest to think about it as a three year on average.

John Curti – Principal Global Investors

What is your anticipated path towards breakeven for this unit, or profitability? The first half of the year you ran at about $8.6 million loss, it was up $1.5 million in terms of operating loss for the quarter.

Lawrence Reinhold

We're obviously not happy losing money there and we want to really focus on getting the business to be making money. That will come from a number of things. One is getting more customers live, scaling up as we scale up the business you have to have a certain infrastructure in place to run the business. It's a business that can scale and will scale, and once it's scaled, we'll be profitable.

John Curti – Principal Global Investors

Are we looking at maybe like a three year ramp towards that breakeven point?

Lawrence Reinhold

We're working very hard on getting a number of large customers live where not only do we recognize the revenue that I already talked about in deferred but also at that point we start boosting revenue and that all starts figuring in the model. But we're really not happy at this point.

John Curti – Principal Global Investors

Question on the Comp USA business, you mentioned about $1 loss for Comp USA. Were the 18 stores that you opened, were they open for the entire quarter?

Gilbert Fiorentino

No, they weren't. We started opening them in late March and finished in April, and then there were two additional stores that were already on our road map that were also opened during the period. And keep in mind we opened these stores basically not with a running start but almost from zero, so we spent the entire quarter trying to build the revenue during May and June.

Richard Leeds

I'm actually quite pleased with the progress that Gilbert and his team has made with these stores. A typical new store environment is when you open a store, you expect to lose money until the traffic and sales are there to support it. That we've lost so little here, we're quite pleased.

John Curti – Principal Global Investors

Are you anticipating that the stores will be profitable by year end?

Gilbert Fiorentino

We don't really forecast that type of stuff on our calls, but fourth quarter typically for a retailer is the best quarter and so in a whole, I think our retail operations will be very successful in the fourth quarter.

Lawrence Reinhold

We disclosed that we had a loss in the retail stores of about $1 million for the quarter. That's really in the first quarter.

John Curti – Principal Global Investors

That's from the stores?

Lawrence Reinhold

That's from the stores. So you can do you own model on that but it's kind of a heroic outcome for what started out at the beginning of the quarter were 16 empty stores. That's the Comp USA signage. It's a herculean effort, and that was the end result in a quite challenging retail environment.

John Curti – Principal Global Investors

What are your plans for store openings next year and maybe on a longer term basis, say over a five year period, what's your retail footprint going to look like?

Gilbert Fiorentino

We're very excited about the retail business because when you get a model that works, rolling that model out to additional stores has been proven by many competitors to be very successful, and so we are hoping to spend the rest of this year perfecting the model, getting the system in place, and the people and the training to be able to come back and say we are ready to open more stores at that point. It's a very exciting business for us because you can grow as rapidly as the real estate market allows and your own internal systems and people would allow. So there's a lot of short term investment being made there and people, time and money, but we really are excited about the possible future into the coming years.

John Curti – Principal Global Investors

Do you have some leases lined up for next year?

Gilbert Fiorentino

There's an amazing retail environment out there for space with some of the problems that competitors and others in the retail world are having, and so it seems like the longer we wait the better the deals are going to be.

John Curti – Principal Global Investors

On a segment basis, the unallocated corporate and other expenses were up about $1.2 million for the quarter to about $4.6 million. I was wondering what was behind that increase and should we look for something in that $4.5 million to $5 million range for the back two quarters of the year.

Lawrence Reinhold

Certainly we had increased costs. Many of them were associated with external reporting and internal auto organization that was just really being created starting in the second quarter of 2007. So from a corporate infrastructure run rate, looking to be more efficient, that amount is probably not going to come down significantly.

Operator

There are no further calls.

Richard Leeds

Thank you everybody for listening to our conference call and we look forward to talking to you next quarter.

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