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Zep Inc. (NYSE:ZEP)

F4Q08 Earnings Call

October 14, 2008 11:00 am ET

Executives

Jill Gilmer - Assistant Corporate Secretary

John K. Morgan - Chairman, Chief Executive Officer and President

Mark R. Bachmann - Chief Financial Officer and Executive Vice President

Analysts

Robert Felice - Gabelli & Company

Daniel Rizzo - Sidoti & Company

Matthew McCall - BB&T Capital Markets

Eric Swanson - KeyBanc Capital Markets

Andrew Cash - Point Clearview Management

Robert Zasowski - OFI international

Operator

Welcome to the Zep, Inc.’s conference call. (Operator Instruction) Now I would like to introduce Jill Gilmer, Assistant Corporate Secretary.

Jill Gilmer

Good morning and thank you for joining Zep today on our fourth quarter and fiscal 2008 conference call. Here with us today are: John Morgan, Chairman, President, and CEO; Mark Bachmann, Executive Vice President and CFO: and other selected Zep officers.

I would like to remind everyone that certain information included in this conference call may contain forward-looking statements that involve risk, uncertainties, and assumptions. If the risk or uncertainties ever materialize or the assumptions prove incorrect our results may differ materially from those expressed or implied by such forward-looking statements. All statements other than statements of historical facts could be deemed forward-looking, including but not limited to, any projections of financial information, any statements about historical results that may suggest trends for our business, any statements of the plans, strategies, and objectives of management for future operations, any statements of expectation or belief regarding future events, potential market, or market size, and any statements of assumptions underlying any of the items mentioned.

For a description of the risks and uncertainties, please refer to the company’s filings with the Securities and Exchange Commission, including its Form 10-K and its 10-Q. Now I will turn the call over to John Morgan.

John K. Morgan

Let me first comment on our fourth quarter and fiscal 2008 results and the highlights of our strategic initiatives, and then I will ask Mark to provide a detailed description of our financial results. Then we will open up the call for questions.

Our first fiscal year as operating as a stand-alone company proved to be very successful despite operating in a challenging market environment. Zep delivered strong financial performance and made real progress on our strategic initiatives, as well as our long-term financial and operational goals.

As a result, we established a solid foundation from which to grow long-term profitability. While growing economic challenges impacted the economy and our industry during the year, our strong financial performance highlights the recession-resistant nature of our business, especially related to our cash flows that we have spoken about in the past.

We now have an opportunity to improve operations, take further costs out of our business, organically and acquisitively grow and strategically position the company for long-term value creation. That belief is supported by the results we announced this morning, as well as our positive outlook for our long-term future.

Net income for the fourth quarter of 2008 increased 10.8% to $8.0 million, or $0.37 per diluted share versus $7.2 million, or $0.35 per diluted share, reported in the same period of the prior year. That was for the year ended August 31, 2008. The company reported net income of $16.3 million, or $0.77 per diluted share, compared with the $14.1 million, or $0.68 per diluted share reported in the prior year.

Excluding special charges, in both years, the company generated adjusted net income of $22.7 million during fiscal 2008, which represents an increase of 17% over the adjusted $19.4 million recorded in the prior year. Moreover, the company earned $1.07 per diluted share during fiscal 2008, which represents a 15.1% increase over the adjusted $0.93 per diluted share earned in fiscal 2007.

Mark will provide further commentary on our financials but I want to take just a moment and highlight the strength of our balance sheet, especially in these uncertain times. Specifically, the stability of our cash flows remains intact and we continue to focus on paying down debt.

During the year we were able to effectively and efficiently manage our business while operating in a market with significant raw material price increases and a difficult economic landscape. The team has done an excellent job on pricing in this volatile, inflationary environment.

Next I would like to provide a few highlights since our last conference call, starting with the progress of our key strategic initiatives. First, as you saw from a press release issued yesterday, we announced the launch of our Zep Professional Product Line, which will be marketed through our new industrial distribution partners.

To help our distributors effectively market our Zep professional products, we are offering the support of dedicated field training, customer service, and marketing, along with state-of-the-art electronic ordering tools to streamline the order-to-cash processing.

Market penetration of our Zep professional brand will be aided by the recently announced strategic alliances with five well-known distributor partners, including W. W. Grainger, Lab Safety Supply, Graybar Electric, R3 Reliable Redistribution Resource, which is a division of Bunzi N.A., and VWR International.

These agreements will serve to expand Zep’s market presence by leveraging those distributors’ reach and leading market positions in market segments not served previously by our business model.

In late August we began the process of building inventory to support those agreements and I am pleased to report that an initial order of Zep professional products was shipped to one of our new partners just last week.

We also anticipate Zep Professional will be marketed through some of these distributors’ catalogue operations in calendar year 2009. While we do not expect an immediate significant impact on sales volume, we are very optimistic about the long-term goal of 10% to 15% of our sales going through distributors and the benefit these agreements will have for our business and our customers.

In our retail business, I would like to say how very pleased I am with the progress we made year. We are continuing to invest in the Zep commercial image and brand name and expand our relationship with the Home Depot, our biggest partner in this space.

Additionally, Zep commercial products are now available at Ace Hardware and True Value, through which we will continue to increase our customer reach and our name recognition. We selected these two retailers because we believe they complement our relationship with the Home Depot as they serve a fundamentally different customer with respect to our products.

Turning the focus to our other initiatives, we continue to make significant progress with our demand shaping efforts. As a reminder, these efforts are designed to reduce the number of products we carry without sacrificing the depth of our product offering. By doing so, we expect to reduce overall inventories and drive long-term margin improvement. During the third quarter we began rationalizing our product offering in an effort to simplify our portfolio of products. In the fourth quarter we completed the first stage of this initiative and successfully eliminated more than 50% of our overall product offering in the North American I&I business.

Demand shaping contributed to productivity gains during the quarter as sales per associate increased by 10% and transactional volume has decreased by more than 20%. While we have completed a majority of the product rationalization, we will continue to evaluate and further streamline our product offering as we move forward.

Additionally, our decision to increase the minimum order size continued to pay dividends during the quarter. Average order size increased more than 20% in the U.S. I&I market compared to the year ago period. I would like to point out that the savings from the demand shaping initiative and the efficiencies we gained by simplifying our business have allowed us to continue to reinvest in our new regional business model.

We have also reduced the selling capacity in our I&I business as a result of modified hiring practices and adherence to stricter performance standards. As a result, we may see some pressure on our top line in the near term, in addition to the economic factors that have an impact on all companies in our space today. While we don’t believe this will have a long-term impact on sales, it may influence revenues in the coming months.

One of our other important initiatives is our North American manufacturing and distribution strategy. For those of you who are new to the company, name ads is designed to consolidate existing distribution centers and deploy regional manufacturing plants to bring service capabilities in closer proximity to our customers, while also reducing costs and delivery times.

During fiscal 2008 we focused on site selection for regional distribution and blending facilities and began the process or narrowing our focus to the exact states and communities for our new sites. During the last three months we continued our consolidation of distribution centers by closing two branches and are in the late stages of negotiating a site that will house our Northeastern United States operations.

Lastly, we are making good progress with respect to our lean initiatives, which in our business are directed at increasing flexibility of our capacity, streamlining the manufacturing footprint, and dramatically improving service to our customers. Our fill rates, for example, reached an all-time record during our peak summer season as a result of this focus.

Another key development during the quarter was the completion of the first phase of SAP with the finance and general ledger conversions. I am pleased to say that our team completed the transition with minimal disruption and did it on time and within budget and I think that this successful implementation once again highlights our associates’ great ability to manage projects and initiatives. Going forward, the SAP system is expected to improve efficiencies, time limits, and productivity.

Switching gears, I would like to spend a few minutes discussing our international operations. Our European operation had another strong quarter and year, which makes five consecutive years of sales growth and continued market penetration. Our European management team has continued to perform well. We are very proud of their accomplishments and are optimistic about the near- and long-term prospects of this business.

During the last twelve months we made significant progress towards our strategic initiatives and at taking costs our of our business. We are encouraged by the progress achieved in our transformation and to this end I want to take this opportunity to thank our dedicated associates, and our customers, that have supported us for so many years.

Over the past few months I have visited many of our customers, partners, and the communities we serve and I believe our vision aligns well with their long-term needs. Not only did we make significant progress on our strategic initiatives but we did so while delivering very strong financial performance in the face of very difficult economic conditions.

Despite our recent successes, however, we continue to anticipate inconsistent quarterly financial results as we move forward with our restructuring initiatives, particularly as we identify ways to improve the business that may require us to incur costs in the short term.

More specifically, while we anticipate that our strategic initiatives will positively impact our business in the future, as we continue to formalize our regional operating structure and implement our name ad strategy, some initiatives have the potential to adversely impact our operating results in the coming quarters, both at the top line as well as profitability stand point. Further, we would expect an even larger than historical contribution of earnings in the second half of our fiscal 2009 as compared to our first half of 2009.

I remain confident that these decisions will position the company for long-term growth and profitability.

Now let me turn the call over to Mark for a review of our fourth quarter and our fiscal 2008 financial results.

Mark R. Bachmann

Our fourth quarter revenues were essentially flat at $152.8 million compared to the $152.6 million reported in the year-earlier period. Sales were positively impacted by a currency translation of $2.2 million on international sales and a $5.4 million gain from higher selling prices following the price increases implemented earlier in the year.

These gains, however, were offset by a $7.4 million decline in volumes resulting from reduced sales representatives as we continue to enforce sales performance standards and we had one less selling day in the comparative year-ago period.

While we recognized some volume declines as a result of the continued softness in our transportation segment, with both auto servicing and vehicle wash being down, we were pleased to see retail volume partially offset those declines during the quarter.

As John mentioned previously, our fourth quarter net income increased 10.8% to $8.0 million, or $0.37 per diluted share, versus $7.2 million, or $0.35 per diluted share reported in the same period of the prior year.

Operating profit was $13.5 million, up compared to $13.2 million in the fourth quarter of fiscal 2007. The improvement in operating profit was driven by increased selling prices, favorability in our insurance programs, reduced salaries and compensation-related costs, which were partially offset by rising raw material and manufacturing costs.

I would now like to spend a few minutes and provide an update on raw material costs. First is a brief background on our pricing strategy, which is critical to better understand the net impact of rising raw material prices.

At the beginning of the calendar year the company instituted priced increases to offset the rapid price increases of raw materials, specifically energy-related commodities. However, during our fiscal third quarter the unparalleled increase in raw material prices outpaced the pricing actions taken earlier in the year. As a result, in an effort to offset this continued spike, during the month of June we announced a 7.5% price increase on our North American industrial and institutional products.

While we were able to fully cover the rising price of our raw material inputs during the quarter, the unprecedented volatility in the commodity markets is something we continue to monitor closely. Given this volatility, it is our intent to continue to raise prices consistent with the cost increases we are incurring in our raw materials.

To this end, we have completed our negotiations for price increases in our retail channel and those went into effect last week. As a point of reference, we have been facing difficult year-over-year increases in raw material prices as commodity prices were very stable during the first quarter of 2008. Despite our price increases, raw materials volatility have adversely impacted those profit margins over the past few quarters.

As we move forward, we expect raw material costs in the first quarter to be unfavorable compared with those seen in the year-ago period.

Now let me turn to the results for fiscal 2008. Net sales were $574.7 million, up 1.6% compared to the $565.9 million generated in fiscal 2007. For fiscal 2008 net income grew 15.9% to $16.3 million, up from the $14.1 million recorded in fiscal 2007.

Earnings per share for the twelve months were $0.77 per diluted share versus the $0.68 we recorded last year. Adjusting both periods for special items, EPS on an adjusted basis for the twelve months of fiscal 2008 have increased 15.1% to $1.07 compared to the $0.93 for the same period last year.

The effective tax year for the total year was 37.2% compared with 43.3% in the same period last year. The prior year’s tax rate was adversely affected by the non-deductible fine paid during fiscal 2007.

Capital expenditures for the year totaled $9.2 million, an increase of $3.4 million from last year. These expenditures were used to consolidate office space, enhance information technology, and improve manufacturing capabilities. We anticipate fiscal 2009 capital expenditures will range between $12.0 million and $14.0 million.

During fiscal 2008 the company generated $26.4 million in cash flow from operations, once again demonstrating the recession-resistant nature of the business. This is a very important achievement considering that number of strategic initiatives undertaken during the year, along with the challenging economic environment.

Just as important, our net debt position decreased by $21.2 million during the year. We believe our focus on free cash flow and paying down debt is important, especially in today’s current economic landscape where credit has become more scarce.

Given the market’s current focus on debt positions, I thought it would be helpful if I provided some additional details regarding our debt structure. As of August 31, 2008, we had approximately $45.0 million of availability under our revolving credit facility. During the quarter we entered into four interest rate swaps totaling $20.0 million at interest rates ranging from 3.2% to 3.5% that will mature in June of 2010. We do not rely on commercial paper issuances to finance our business. We remain in a strong position to both pay down debt and continue to make further investments in the business. As an aside, our debt-to-capital ratio, net of cash, is just over 31% and we have flexibility with all of our debt covenants that support our current business.

Lastly, we are pleased to report that returns on invested capital, adjusting for special items, increased to 17.4%.

At this time we would like to open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Robert Felice – Gabelli & Company.

Robert Felice - Gabelli & Company

I guess first, as we look to next year, how should we think about balancing the annualized impact of demand shaping initiatives, the higher performance trend standards that will likely result in decreased volumes with other organic growth initiatives, like the expansion in distribution.

John K. Morgan

Let me give you just a general overview of my thoughts about that and I will ask Mark to provide any specifics that you might need.

We don’t see any reason at this point in time to change our thinking about our long-term objectives for the business. You know we describe those in terms of annual improvement objectives over the long term for the business, specifically in the area of growing at rates exceeding the market and maintaining return on invested capital at 15% or greater and earnings per share increases in the 11% to 13% range.

And we are pleased that we were able to outstrip some of that this year but we think that with all the various different moving parts, including our reinvestment back into the business that we are affording ourselves from some of those improvements, that those are still viable long-term objectives described on an annual basis.

Mark, do you have anything more specific than that?

Mark R. Bachmann

Not really, John. As you said, we would expect that the distribution business would build throughout the year, as we’re just entering into those agreements this year.

Robert Felice - Gabelli & Company

As we roll up all the pieces, should we expect organic growth over and above what you showed this year, as some of these initiatives get underway, or do you think as we balance the annualized impact of the demand shaping that it will come a little below this past year?

John K. Morgan

I really think for the immediate future you wouldn’t expect organic growth to accelerate as a result of these initiatives. What we’re obviously betting on is that organic growth over time will accelerate as we invest in these other initiatives, especially the distributor model as well as now releasing our businesses, if you will, in our I&I model to get back into the business of adding rep head count, where they can bring reps in that are more experienced than was our previous model.

But I wouldn’t expect in the next handful of months for that to have a dramatic impact on the business just because of where we are in the stage of getting that accomplished.

Robert Felice - Gabelli & Company

And then I guess SG&A as a percent of sales really kicked down quite a bit during the fourth quarter, about 200 basis points to 250 basis points. What drove the decline and is this a new run rate we should expect over the next couple of quarters?

John K. Morgan

That’s some specific things that we ought to highlight. Mark why don’t you touch on those specific things and then I will be happy to comment on our general thoughts about SG&A.

Mark R. Bachmann

One, we had noted that we had some favorability in our insurance for the company, both in property and casualty and in group medical. And the property and casualty, I think some of it is both a run rate but some of it is an adjustment on the forecast of future payments relative to benefits achieved from lower salaries, you know, that would be an ongoing run rate.

John K. Morgan

And I guess just more generally, we still think we have a business structure that has SG&A costs in total that’s somewhat higher than we want it to be and that’s one of the reasons we’re focused so much on sales productivity as measured by sales per associate. So we’ve still got some work to do in that area, quite frankly, but I am pleased with some of the progress that we made in that area.

Operator

Your next question comes from Daniel Rizzo - Sidoti & Company.

Daniel Rizzo - Sidoti & Company

In terms of Europe, are you using demand shaping there as well?

John K. Morgan

Not in the same way that we have here. And frankly, the reason is our European business is at a little bit different place than we are in the U.S. I&I business. I frankly think that we’ve done a better job in Europe than we have in the U.S. in managing the product line and focusing on the higher value customers. And we don’t have the exact same situation there that we have here. They’ve just done a really good job there.

Daniel Rizzo - Sidoti & Company

And with the announcement with the distribution partners yesterday, are those like long-term deals? Are they in years or how does it work?

John K. Morgan

Generally speaking, I’ll call it those documented agreements, if you will, just describe our terms and their terms under which we really want to work. The practical commercial reality is that while it might be a year or two or three, there are escape clauses, if you will, for both them and us if commercially the relationship doesn’t work. I think that’s pretty typical in distribution industries so it’s really incumbent on us to have a good working relationship, help them pull product through.

As you know, they’re buying product for speculative resale and it’s incumbent upon on to help pull products and help develop sales there. We certainly anticipate and would hope that these relationships are on into perpetuity.

Operator

Your next question comes from Matthew McCall - BB&T Capital Markets.

Matthew McCall - BB&T Capital Markets

Just to be clear, on the first question when you were talking about organic growth, were you excluding any benefits of the recent price increases?

John K. Morgan

Yes.

Matthew McCall - BB&T Capital Markets

So no accelerated organic growth and then you’ve got to add in the benefits of price?

John K. Morgan

That’s correct. Now, again, it’s one of our core long-term goals we described we want to grow at a pace outstripping the market growth rate. But I just think that we’re not at that sort of inflection point yet in that we’re still going to feel the effects of our own, I will call it sort of self-inflicted demand shaping, if you will, and we are not expecting our distributor agreements to start off, if you will, with a major influx of business.

We think that that’s going to be the start up of a relationship that then grows over time at an accelerated rate as time goes one, as they come to know our products and we get people trained and so forth. So for the next few months that’s what I would expect.

Now, quite frankly, as we get another quarter or two out we will have a lot better clarity and be able to provide to you a lot better clarity about what our expectations are from the distributor agreements as well as from some opening up of additional hiring of reps now in our I&I model.

Matthew McCall - BB&T Capital Markets

And sticking with the price increase, Mark, you talked about the June 7.5% price increase. Are you going to raise prices again? Can you give us an idea of you add up all the benefits you should be receiving from each of the three price increases that you talked about, starting with the one at the beginning of the calendar year, and then compare that with what the raw material pressure you were seeing is like. Either talk about it in dollar terms or in percent terms, however we can get an idea of where you’re going to stand. I know you said there’s going to be maybe some pressure in Q1, but help us understand the magnitude.

Mark R. Bachmann

From a pricing standpoint, it’s important to note that in our fiscal fourth quarter that ended in August we still had experienced increasing pricing pressures on raw materials. Then we had disruption resulting from hurricane Ike in the Gulf. And the supply of our raw materials that come and producers who rely on supplies that come through the Gulf. There was disruption because of electrical outages and the like. Some of our suppliers were on force de jour.

So we’ve managed through that but we certainly haven’t seen the benefits yet of any of the decline in some of the commodities that are associated with oil. We will manage that very carefully. There will also be other commodities that we will be monitoring as well, based on what the global supply and demand are for such things as steel.

As we get that input and monitor that, then we will evaluate what our pricing actions will be in the coming months and quarters. And as I had stated, we intend to recover our price to offset our dollar cost.

Matthew McCall - BB&T Capital Markets

So just expect an offset and some kind of gross margin neutral versus the prior year periods?

Mark R. Bachmann

Well, I think you can look at our gross margin percentages and what I have stated is they have declined through this year as a result of being able to recover our dollars but not the percentage with our pricing increases. We obviously want to be sensitive to the market and the competitive conditions as well as we evaluate our pricing.

John K. Morgan

And generally speaking, you know for the long haul, our policy, our philosophy, our view, is that we need to be able to price in a way that allows us to maintain gross margin percentages but this last year was just such a dramatic increase in commodity costs, especially as Mark said, the energy-related costs, we don’t think that that would have been the responsible thing to do. We think that it would have had a lot greater impact, frankly, on our unit volume had we tried to do that. So we focused aggressively on offsetting those dollar increases.

We believe if we’re in a more, I’ll call it, normal inflationary time as opposed to what the whole world has experienced over the last year, our internal focus is to maintain gross margins.

Matthew McCall - BB&T Capital Markets

On the industrial distribution agreements, I think in the past you have talked about some level of expected operating margin improvement from transitioning some of that lower volume business over to those distributors. Is that still the expectation, as we move into 2009?

John K. Morgan

It is. I think what Mark has said in the past is the expectation is about 1 point to 3 points, 100 basis points to 300 points, improved is our current estimate. And that, of course, comes from a lower gross margin, but a significantly lower cost to surge.

Operator

Your next question comes from Eric Swanson - KeyBanc Capital Markets.

Eric Swanson - KeyBanc Capital Markets

You guys had a strong quarter in Europe and I was just wondering if you see any softness towards the end of the fourth quarter or in the first quarter so far in Europe and if so, what regions of Europe have you been seeing softness?

John K. Morgan

In their local currency and in their local market, we did not see any significant softening, if you will, moving into the end of our fourth quarter. Of course, we can be somewhat negatively impacted by the foreign exchange rate, depending on what happens to that Euro and dollar. But in terms of their local markets, we really have not. Now they’ve also done a good job of managing their sales force, and not having to go through some of the same changes we’ve made here in terms of demand shaping here in the U.S. they’ve continued to focus on managing their selling capacity.

So frankly, I’m not exactly sure how much of their continued resiliency, especially in Italy, is the general economy versus simply the effectiveness of our team there that’s continued to focus on expansion of their sales model.

So we’re watching and of course they’re watching the general economic conditions of Europe, which have gone the wrong way pretty quickly. But we don’t seem to be impacted by that just yet.

Operator

Your next question comes from Andrew Cash - Point Clearview Management.

Andrew Cash - Point Clearview Management

With the new distributor agreements wouldn’t there be a benefit from some pipeline filling over the course of the next fiscal year?

John K. Morgan

Yes. We do expect that there would be and I think you are clearly hitting on one of our expectations as you get some benefit from pipeline filling, probably then some you’ll decline until they start selling through, and then some increase as they start replenishing. My sort of cautious words with respect to that really mostly have to do with the fact that we literally have just penned these agreements.

There’s work to be done on really identifying what inventory goes into what branch locations and into their VCs and how that is ramped up. And they have people to train and so forth. So we do expect that, at some point. We are certainly not recommending to them that they overload their pipeline, if you will.

Andrew Cash - Point Clearview Management

I guess that’s what you were referring to earlier. Maybe it’s the second half of fiscal 2009 impact.

John K. Morgan

That’s kind of what we’re thinking.

Andrew Cash - Point Clearview Management

Just for clarification, with your long-term earnings per share growth of over 10%, are you saying that for this coming fiscal year that adjusting for non-recurring type of items, some of the growth objectives, would you still expect to achieve at least 10% of this growth?

John K. Morgan

Well, what we’ve tried to really consistently do is project that 11% to 13% earnings growth on an annualized basis, but over the long term. The thing I’m always very cautious of and very careful to do is to avoid a situation where we’re managing the business quarter-to-quarter or year-to-year with that kind of precision.

What I want is a trajectory where we would expect our earnings growth to continue at that sort of annualized improvement rate. I’m not inclined to issue what we would call guidance and talk about a specific quarter or a specific year, but certainly over that long term I would expect that double-digit earnings growth rate on an annualized basis as you’ve described.

And there might be some years where we’re far and away above that and sometimes when we might be below that, due to some kind of investment, but we want that to sort of continue as a run rate.

Andrew Cash - Point Clearview Management

You mentioned earlier in your prepared comments about acquisitions. Is that something that is more further down the road, are you planning to continue to pay down some debt? What are your thoughts there?

John K. Morgan

Unless the right acquisition comes along, we would intend to just simply continue to pay down debt. We are interested, significant more interest at this time than a year ago, in looking for some properties that might exist there in the market. We think there are some things that could make a lot of sense for us. I am interested in deals that are accretive. I am interested in deals, obviously, that fit with the strategies we previously described for the business.

So we do have our ear to the ground. We have made it clear to a number of folks in this space that we believe that we are in a position now to become acquisitive but it’s just early in those stages. You know, it’s awfully hard to control the timing of those opportunities. But it is now on our radar screen and it was not a year ago.

Andrew Cash - Point Clearview Management

I guess that just goes to show how comfortable you are with your cash management in this so-called credit crisis we’re in right now.

John K. Morgan

Yes, we’re relatively conservative and we’re cautious but we do have a high enough level of confidence that we’ve now begun some conversations.

Operator

Your next question comes from Robert Zasowski - OFI international.

Robert Zasowski - OFI international

I just had a quick question about the distribution agreements. First off, each of the five, do they have access to the whole Zep Professional catalogue?

John K. Morgan

Yes, to the Zep Professional catalogue. We have introduced a Zep Professional line of products and there’s a pretty good description of that business on our website, www.zep.com, and the fact that we’ve got Zep Professional focusing on industrial distributors and Zep Commercial focusing on the retail and then our traditional Zep product in our I&I sales model. And yes, these distributors we mentioned yesterday and today, they do have access to that Zep Professional catalogue.

Robert Zasowski - OFI international

Would you expect to sign up more distributors in the next few quarters or so or are you pretty happy with just the five right now?

John K. Morgan

We are extremely happy with the five that we have and we would very much like to sign some additional distributors. And let me be specific about that.

As you can imagine when you look at this list of distributors, these are some, in my words, world-class distributors in the specific verticals that they serve. I was elated to see what our team was able to do in getting lined up with one of the top distributors in each of those verticals. But it does not exhaust the vertical market segments where we have interest.

So there is additional work to be done by us to try to attract distributors in other verticals where we think we have particularly suitable products for. So we would hope to expand upon that but certainly in a complementary fashion.

Operator

Your next question comes from Robert Felice - Gabelli & Company.

Robert Felice - Gabelli & Company

In the past we’ve talked about perhaps a step change in margins at some point during fiscal 2009. Maybe the second or third quarter as you get benefit of some of the lean or operational efficiency initiatives and you get a full year of the demand shaping. Do you still expect that and maybe you could provide us with some insight and to the magnitude of the improvement that we could expect.

John K. Morgan

And actually Robert, you can’t see me but I’m laughing. I think when you say when we’ve talked about that, I think you’ve talked about that actually.

I have been pretty consistent in sticking with my annualized rate of improvement on a long-term basis and as you can expect I really need to continue to do so. Certainly I would hope that we see very significant inflection points and the improvements don’t come in a linear fashion, they come in step levels.

But the thing that I’ve continued to reserve, if you will, is the right and the need and the opportunity to invest back into the business in ways that can solidify and grow the business for the long term, in ways that I think create greater shareholder values. So we haven’t tried to pinpoint the specific inflection points and the magnitude of those inflection points. We do certainly expect, on a gross basis, that improvements come with a whole variety of inflection points but I also would expect to time some of the investments we’re making back into the business such that we’re funding those investments ourselves.

As an example, this whole distributor outreach, we made some pretty significant investments in our fourth quarter of 2008. And that’s not acquisition accounting, we’re expensing those things as we go. And so as we reach those various different benefits, inflection points as you call them, of improvement, it allows us investments back into these areas that I think broaden and position the business for further growth.

I’m just going to continue to avoid trying to pinpoint specific inflection points and magnitude really for that reason.

Robert Felice - Gabelli & Company

I’m just trying to get my hands around whether or not fiscal 2009 is one of those years that shows earnings growth above the 11% to 13% range or below. So I guess maybe I should ask it a little differently. If we were having this conversation a year from now and discussing 2009 results as opposed to 2008 results, what magnitude of margin improvement or earnings improvement would make you say that the company effectively navigated the difficult economic environment and continued to execute on the internal plan. So what would make you say that things were going as you had hoped 24 months ago?

John K. Morgan

That’s a fair question. We still are focused on earnings per share growth of the 11% to 13% per year and we still think this business, this business model and the industry that we’re in is such that this business ought to be double-digit earnings in the 10% to 13% range, which we’ve talked about in the past.

So, what I’m not going to get in the business of doing is trying to predict when and if an inflection point is such that you get a step level improvement and continue that march toward that 10% to 13% kind of level that I believe this industry should afford us and still have reasonable revenue growth. But when we build our own internal thinking or internal models that’s the way we think of it.

Robert Felice - Gabelli & Company

If you think about your initiatives and the way they’ll hit in 2009, what would prevent the step change from occurring at some point in the back half of this year as opposed to 2010 or 2011?

John K. Morgan

Well, the risks to accelerate an improvement really fall into two or three categories. First and foremost, it’s execution. It really comes down to our ability and our execution and that’s probably the risk that we manage the closest, the thing we watch the most.

And the second thing is decisions that we might make from time to time about rates of investments back into the business if we think that they’re really investments that create a greater long-term value for the shareholders.

And those are probably the two things that are the greatest magnitude.

Robert Felice - Gabelli & Company

It does sound like that you do expect to show that hopefully, earnings growth within that 11% to 13% range.

John K. Morgan

I hope. And I think hope is different than an expectation. We are continuing to focus on our long-term goals, you know, that three to five year goal of those annualized improvement levels like we’ve described and like you keep properly referring back to.

Operator

Your next question comes from Matthew McCall - BB&T Capital Markets.

Matthew McCall - BB&T Capital Markets

In the prepared remarks you talked about two things. You closed two branches and you said you’re in the late stages for selecting a site for your Northeast operations. Can you help us understand what the cost savings is associated with each branch closure and secondly, as you’re getting a little closer to finalizing the deal of the first regional operations site or the next regional operations site, what’s the incremental cost that’s involved there that will be a part of this cause of some of these inconsistent earnings?

John K. Morgan

First of all, I’m sorry to do this to you, but we’re not prepared to articulate savings by branch, so to speak. And we are really in the late stages of negotiations with real estate developers as well as economic development authorities and governments and so that’s why we’re being still quite confidential about exactly where and when.

The cap-ex budget that Mark described earlier anticipates those investments in those regional sites. And just in terms of process, what our current view is that it will be a phased approach into those operations. I would not intend to go in, find a building and spend a year and a half setting up an operation. Instead it would be a phased approach where we would establish local offices with inside sales, call centers, customer service, so forth and so on, first and foremost, followed by the distribution center co-located, followed later then by actual manufacturing in that site.

So it’s a phased approach over a 12 to 18 month period on an individual facility. And we believe we probably need two to three of those that we do not have today. And I would not intend to run those perfectly [concompently], therefore you would expect a two or three year process of getting that accomplished. I don’t know if that’s helpful or not.

Matthew McCall - BB&T Capital Markets

Yes. I guess. You talked again about the inconsistent, expected inconsistent earnings. You talked about incurring some costs in the short term. Then you also said that you made some investments in Q4 in that distribution strategy and still did a nice job on your operating margin line. I’m trying to get an idea of, I know it’s tough to get an idea of the timing, but the order of magnitude is the one that I can’t get my arms around and what the net effect is on your margin line.

Mark R. Bachmann

I would go back to our long-term objectives of improving our EBIT margins 50 basis points and because a lot of these initiatives overlap and are supportive of one another, that’s why we’re not being specific about what one delivers versus another. But these are intended to help us to deliver that 50 basis points on average improvement in our EBIT margins.

Operator

That concludes our question and answer session. I would like to turn the call back over to Mr. John Morgan for closing comments.

John K. Morgan

As we wrap up a year of transformation for Zep I’m pleased with the progress made in our efforts to move the company toward sustained profitable growth and positioning the company for long-term profitability. During 2008 we made tremendous advances that will provide the building blocks for continued success in 2009 and beyond. There is still considerable work to be done but I am confident in the capability of all of our associates. While we are keenly aware of the economic challenges that face our industry, we are confident in our strategy, our leadership, and our product offering.

As we institute our transformation initiatives we continue to hold a leading industry position, maintain strong customer relationships, have a product offering that is unmatched in the industry, and are aggressively diversifying our end market exposure. Our strategy is supported by a strong balance sheet and business fundamentals that provides for the opportunity for continued shareholder value creation.

As we enter 2009 we are confident that we will continue to make meaningful progress on our initiatives and look forward to updating you on that progress as we move forward into our second year as a public company.

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Source: Zep Inc. F4Q08 (Qtr End 08/31/08) Earnings Call Transcript

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