Interline Brands Inc. Q3 2008 Earnings Call Transcript

| About: Interline Brands, (IBI)
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Interline Brands Inc. (NYSE:IBI) Q3 2008 Earnings Call November 4, 2008 9:00 AM ET


Michael J. Grebe – Chairman and Chief Executive Officer

Thomas J. Tossavainen – Chief Financial Officer, Principal Accounting

Kenneth D. Sweder – Chief Operating Officer


Jen Consoli – JP Morgan

Kyle O'Meara – Robert W. Baird

Matt McCall – BB&T Capital

[Sarah] – SunTrust

Shannon O'Callaghan – Lehman Brothers

Ryan Merkle – William Blair

Bob Franklin – Prudential Financial


Thank you for joining us today for the Interline Brands third quarter 2008 earnings call. I will now turn the call over to the Interline Brands Chief Financial Officer, Tom Tossavainen, please begin sir.

Tom Tossavainen

Good morning and welcome to the Interline Brands earnings call for the third quarter of 2008. Joining me on today’s call is Michael Grebe our Chairman and Chief Executive Officer, and Ken Sweder our recently promoted Chief Operating Officer.

Mike will provide an overview of the quarter and the current market environment, Ken will share his thoughts on a few key operational items, and I will then review our financial results in more detail. Mike will close with our outlook for the fourth quarter and then we’ll open the call to your questions.

Before beginning on today’s call let me remind you that some of the statements made today will be forward-looking and are made under Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected or implied due to a variety of factors. We will also discuss certain non-GAAP financial measures which are described in more detail in last night’s earnings release.

We refer you to the recent Interline Brands filing with the SEC for a more detailed discussion of the risks that could impact the company’s future operating results and financial conditions. These factors are also described in greater detail in the press release and on the company’s website. I will now turn the call over to our Chairman and Chief Executive Officer, Michael Grebe.

Michael Grebe

In light of these unprecedented times, I want to begin the call today by highlighting a few critical factors that we believe positions Interline Brands well to weather the current storm and emerge a stronger more profitable company over the long-term. Challenging economic periods have a way of revealing the strength of a management team’s resolve.

As we face one of the most severe economic crises in recent history, I’m confident in two things. Our resolve will be tested, and we will meet all challenges to create an even healthier and more successful company. At Interline Brands we have the experience of managing our business through significant adversity and we know that will serve us well in this environment.

Let me spend some time to give you a recent example. Back in 2003 our management team successfully navigated one of the more challenging situations in our history. At the time we were backed by private equity, had significant leverage of over 4.5 times, and had virtually no cash on the books.

At the same time our country had recently invaded Iraq, consumer confidence was low, unemployment was rising, multifamily vacancy rates were at an all time high, and our industry had been severely impacted by a prolonged west coast port strike. In spite of these circumstances we managed our operating costs, we pulled back the reins on working capital and we generated significant free cash flow.

What we learned from this experience and others like it, is that end market diversification, profitability and cash are king. From a cash flow perspective we are ensuring that we will continue to generate and preserve it so we can maximize our flexibly and growth potential across any phase of the economic cycle.

We will also maintain healthy liquidity while managing the operating model to ensure costs are properly and proactively aligned with sales levels. These are steps we must and will take to navigate effectively through any difficult environment.

But what is equally important is to ensure that we don’t lose sight of our value proposition and long term strategy. This includes making prudent investments justified by healthy ROIs to protect and advance long-term competitive advantage.

In comparison to our situation in 2003, we are at a much stronger position today. We are larger in size, generating twice the revenue and earnings. We are more diversified with more than double the exposure to the institutional end market, which has proven to be more resilient during recessionary times.

We have a healthier balance sheet with significantly less leverage at three times. We also have far better interest coverage at over 4.5 times, more than double that of 2003. We have cash in investments of approximately $50 million as of today and have ample liquidity. We have no exposure to toxic derivatives and we do not utilize the commercial paper market to fund our ongoing operations.

Although we are in a much stronger position today, I want to make it clear that we are not done, we’re not resting, nor are we otherwise taking emphasis off of what we must do to effectively navigate the current environment. We will touch on many of the specifics here on this call, but the bottom line is we will generate more free cash flow.

Our expectation is that over the course of the fourth quarter of 2008 and first quarter of 2009 we will generate as much as $30 to $40 million in free cash flow. In addition, we are aggressively pursuing our cost and efficiency initiatives that we outlined last quarter.

While we had no way of predicting the depth of the economic crisis at the time we introduced our plan, we certainly felt we needed to be prepared for the worst while building a stronger more efficient platform from which to operate long-term.

Bear in mind our intention is to make permanent improvements to our operating platform that can deliver sustainable profitability over the long-term. Many of these initiatives are in full swing and we will update you on our recent achievements in just a moment, but first let me share with you our performance highlights for the quarter.

Interline Brands reported sales of $318 million and diluted earnings per share of $0.42 during the third quarter 2008. This includes the anticipated $0.03 per share in one-time costs associated with our reduction in force and closure of certain professional contractor showrooms, notwithstanding we delivered within our guidance range provided last quarter. These results compare to sales of $330 million and diluted earnings per share of $0.49 for the same period last year.

Our facilities maintenance end market, which accounts for approximately 70% of our sales, was down 3.7% on an average organic daily sales basis for the quarter. This compares to the record quarterly sales growth we posted in 2007 that we discussed it on our last call. Recall in the third quarter of 2007 the facilities maintenance end market grew 14% organically, which included 23% growth in our multifamily housing market.

In addition to these tough comparisons, much of the weakness during the quarter was a result of a significant slowdown in apartment market renovation and upgrade activities, which account for approximately 10% of sales within our multifamily end market.

REITs and other property managers have been impacted by the turmoil in the credit market and as a result many renovation and upgrade projects are being put on hold. However, the remaining 90% or so of our multifamily housing business, which is focused on everyday repair and maintenance, has historically held up relatively well in down markets and multifamily housing market demand for apartments continues to be relatively steady.

Vacancy rates rose slightly again this quarter by 10 basis points to 6.1% at the end of the third quarter and are projected to increase in the fourth quarter. However, the number of occupied apartment units in the US, a key indicator in the demand for repair and maintenance products, continues to increase.

Importantly this key indicator has not materially declined in the last 10 years which demonstrates the market’s long-term stability. Also with respect to stability, our institutional market is the bedrock led by janitorial and sanitation products, which continue to demonstrate recession resistant qualities. Importantly this segment of our business represents 25% of our sales and continues to post steady growth of 3% to 4%.

During the quarter, AmSan completed its final integration onto the Interline platform and we are pleased to have this very important inflection point now behind us. As we move forward, we will focus more intently on cross selling opportunities as we see the potential to increase our wallet share with existing customers.

To that end, about two months ago we announced the acquisition of Eagle Maintenance Supply. The addition of Eagle strengthens our footprint in the northeastern United States and bolsters our AmSan product offering.

On an earnings basis we expect the transaction to be neutral for the remainder of 2008 and accretive in 2009. We believe the completion of the AmSan integration and the recent Eagle acquisition positions us as a more valuable partner to our customers. We remain confident that our scale, breath of product offering, and quality of services and products will position us well for additional market share gains, particularly as smaller competitors struggle in this environment.

We’re also actively engaged in evolving our specialty plumbing business into broader based national brands with full suites of institutional products. In September we launched one of the largest new product offerings in our history. We added over 7,000 SKUs to our offering including electrical, HBAC, janitorial and security products.

This new offering makes us more valuable to our customers, markedly expands our share of wallet potential and will support our strategic national accounts initiatives in combination with AmSan's complementary product line. Within four weeks of launching our new product offering the team was selling these products at an annual run rate of $2 million with over 1,300 customers purchasing these new products during the initial launch.

Sales in our professional contractor and specialty distribution business, which comprised 30% of our revenues, were down 10.1% and 3.6% percent respectively in the quarter. On a consolidated basis these percentages of clients are smaller than prior quarters, which is encouraging but not an indication of a recovery. We fully expect continued difficulties in the residential construction and remodeling markets for the foreseeable future.

Despite the current weakness these are very attractive end markets that will recover. Within these large fragmented markets we have strong and durable customer relationships and less fixed infrastructure than most competitors. We’re therefore confident Interline will benefit when customers resume more normal purchasing patterns.

Now I'd like to shift gears and provide you with an update on what we refer as project 20-20, our recently announced cost and efficiency plan. You may recall last quarter's conference call I outlined the initiatives that we have put in place to reduce operating costs by $20 million and drive $20 million in net working capital improvement.

We designed this plan with a balance between obtaining significant short-term reductions in our cost structure and generating sustainable operational efficiencies over the long-term. We have already started to see some return on our investment and we remain confident in the execution of our plan.

Our first effort undertaken was a headcount reduction announced last quarter that called for a net reduction of approximately 4% of our workforce. This effort is now largely behind us and we remain on track to reap the estimated $10 million run rate in savings by next April.

As projected we incurred a $0.02 per share of cost during the third quarter but regained roughly $0.01 in operating cost savings. We anticipate another $0.03 of savings in the fourth quarter of 2008 and closer to $0.05 per quarter after April of next year.

That said we are currently operating under the assumption that 2009 will remain a challenging environment. We will therefore continue to very closely evaluate our operating cost structure and act decisively to further right size our business based on market conditions.

Another near-term initiative announced last quarter was the rationalization of several of our Barnett pro centers. As you will recall we identified certain locations that had not met specific growth requirements. Closure of these Barnet pro centers would lead to approximately $3 million in operating cost efficiencies and another $2 million in working capital improvements.

We incurred one of the projected $0.02 per share in the third quarter. We remain on track to being realizing savings from this initiative in early 2009 and we’ll continue to closely evaluate the remaining pro centers.

We also made meaningful progress on our longer term initiative to consolidate certain smaller distribution centers into more efficient regional distribution centers or RDC’s. This initiative is expected to yield $3 million in annual cost savings and $8 million in working capital improvements once the new regional distribution centers have been up and running for roughly two full years and we’ll have more to say on this topic in just moment.

Next, our initiative to optimize and improve our customer service operations is proceeding according to plan. Our newly installed next generation telecommunications PBX network is yielding high returns and will continue to afford us the opportunity to streamline our call center operations. For example, we consolidated some call center operations during the quarter.

Our attention as you know is to reduce total cost to serve while improving over all service to our customers, and as I said last quarter we expect to generate annual cost savings of approximately $2 million and over this timeframe we will incur a one-time cost of approximately $0.01 per share.

Lastly, this past quarter we completed the first implementation of our technological solution to improve our collection efficiencies. Timing is certainly right given the current economic environment. Collections have become more challenging. One of the benefits of the new collection software is the ability to maximize our existing employee resources by leveraging the functionality of the software to increase customer contact without having to increase headcount.

This was one of the features that initially attracted us to this type of solution and we are already seeing market improvement in our collections productivity. We remain confident this new process will yield significant financial benefits over the long-term. However, the uncertainty of the global economy now makes it more difficult to predict when these benefits will be fully realized with respect to credit and collections.

While we have made very good progress on our cost and efficiency initiatives this past quarter we are by no means done. Additional opportunities above and beyond the initial scope of our plan across all facets of our business are under close review. Again, we are committed to gaining both short and long-term efficiencies during this challenging period.

While this may appear to be a tall order, we are accustomed to running a tight ship and am confident our leadership team that is tasked with this important responsibility. To this end I was very pleased announce last month that Ken Sweder was promoted to Executive Vice President and Chief Operating Officer.

Ken has been with Interline since May of 2007and knows our industry and our customers very well. I have great confidence in his ability to lead our efforts in improving the growth profitability and scalability of the Interline Brands platform. With that I would like to turn the presentation over to Ken Sweder our Chief Operating officer.

Kenneth D. Sweder

As Interline's new COO, I’d like to take a moment to discuss both our inventory and distribution focus and priorities. First, let's start with distribution. To dovetail on Mike’s comments surrounding our 20-20 initiative, we remain focused on two key elements of our distribution strategy both a larger strategic distribution center projects that we discussed on prior calls and the tactical management of the shear number of distribution points.

From a strategic perspective the larger regional distribution centers on which we are focused are more efficient and are expected to yield solid returns on investments in the coming years. Given the length of time that it takes to secure and outfit large facilities, the costs for these future projects are not expected to materialize until the middle of 2009 at which point we anticipate about $0.02 to $0.03 per share per consolidation so no change from previous conversations.

In addition, from a tactical perspective Jim Spahn our Vice President of Operations and I have also commenced a review of all of our points of distribution further simplifying our structure to improve our scale all while ensuring we in no way reduce our customer or geographic intimacy.

Let me move on and discuss some of the planned inventory investments we made during the quarter. Our inventory at the end of the third quarter was approximately $29 million higher than the prior year period and I want to address this for moment since it pertains to our net cash flow. Let me start by saying and also being very clear that these increases were planned well in advance and were anticipated as part of our customer and distribution strategy.

The majority of the inventory increases related to the $12 million, the initial stocking order for our western national distribution center. Just over $3 million related to our broad and new products offering to support our institutional platform that Mike has already discussed and $3 million in support of our final two very large AmSan conversions of all of which we have talked about extensively over the last few quarters.

I am extremely proud of our team as we transition to sizable portions of our total sales to NBC west for example, which was by the way our most significant distribution center move in years. We had no operational issues and a seamless customer experience truly outstanding and a testament to the team's ability to execute efficiently.

The remaining inventory increase relates in combination of things. First, inventory brought in to support higher fill rates during our traditionally busier summer season, some opportunistic product purchases made in advance of substantial price increases, and additional safety stock to combat the potential west coast port strike, which is as you know fortunately was avoided.

These investments are indicative of Interline's commitment to protect and provide the best customer experience as we further improve our platform and very importantly add customer capabilities. I should also note that given our strong liquidity position we were able to make these strategic and opportunistic investments.

That said we expect a significant reduction in inventory levels over the next three to six months as we further normalize our stocking levels across our network and of course we have our seasonal inventory reduction.

Finally, I would like to reinforce that all AmSan system conversions and our 2008 distribution center projects are now behind us. With that I'll turn the call over to Tom Tossavainen our Chief Financial Officer.

Thomas J. Tossavainen

In the third quarter of 2008 we generated net sales of $318 million, a 4% decline compared to the prior year quarter. As a percentage of total sales our end markets represented the following concentration, 70% from facilities maintenance, 19% from professional contractors and 11% from specialty distributors.

Gross margin for the third quarter 2008 was 38.1%, a 10 basis point improvement compared to our gross margins in the third quarter of 2007. While we expect margin pressures to continue and possibly increase, our sales team remains focused on continuing to make prudent decisions around the profitability of our sales.

Selling general and administrative expenses in the quarter were $87.8 million. Our operating costs in the quarter include $2.1 million in previously announced costs including a $0.02 per share severance charge associated with our reduction in force, a $0.01 per share associated with the cost of closing five professional contractor showrooms, $400,000 in costs related to the completion of our Richmond, Virginia and our Auburn, Massachusetts distribution center consolidation and costs associated with the opening of our west coast NDC, our national distribution center.

Excluding these costs, SG&A expenses were $85.7 million or 27% of sales. On a percentage basis this is 30 basis points higher than the prior year period on the lower revenue base. As Mike said, we continue to operate under the assumption that 2009 will prove to be a challenging operating environment, so we are keeping a sharp eye on our operating costs and we are prepared to continue right sizing our business.

Interest expense of $7.1 million in the quarter was down nearly 18% reflecting a lower interest rate environment compared to the third quarter of last year. In taking all of this into consideration, our operating margins for the third quarter of 2008 was 9.1% compared to 10.2% in the prior year period.

Net income for the third quarter of 2008 was $13.7 million or $0.42 per diluted share compared to net income of $16 million or $0.49 per diluted share for the same period of 2007.

Now let me move on to the balance sheet. As of the end of the third quarter we had $36 million in cash and $2 million in short-term investments on our balance sheet. Since the end of the third quarter we have sold off our small remaining exposure to auction rate securities at par and generated additional cash bringing our total cash balance to $50 million as of today.

Our core networking capital at the end of September was $331 million, which was made up of $231 million of inventory plus $170 million in accounts receivable less $70 million in accounts payable. This core working capital is roughly $40 million higher than last year and as Ken just described approximately three-quarters of that increase or $29 million is associated with planned inventory initiatives.

As we stated earlier on the call, we expect to see significant improvements in our cash flow in the range of $30 to $40 million over the course of the fourth quarter of 2008 and first quarter of 2009. The reduction of our overall inventory levels will play an important role in our free cash flow generation.

As an illustration, a reduction in existing inventory over the last three weeks accounted for $5 million of the $12 million in additional cash flow generated during the month of October alone. Thus, we have already made significant progress toward achieving our targeted increase in cash flow over the next two quarters.

On the accounts receivable side of our business, receivables are 5% lower than the prior year on a 4% sales decline. That said our days sales were one day higher than the comparable prior year period at 49 days and in line with the second quarter of 2008.

As we have mentioned in the past, we expect and are seeing some of our customer's ability to pay impacted by the challenges in our economy today. Accordingly we incurred $300,000 in higher bad debt expense in the third quarter compared to the prior year.

As part of project 20-20 we are finalizing the implementation of our new technology solution in the next three moths. This solution is designed to significantly improve our credit collection processes and productivity. Once we begin to fully realize the benefit of the new technology, we expect our overall collection efficiency to improve significantly over time.

With respect to accounts payable, our balances have decreased from $91 million at the end of the third quarter of 2007 to $70 million at the end of the third quarter of 2008. Our 2008 balance excludes incremental $10 million of payables that has been classified as accrued expenses and other current liabilities pursuant to a successful electronic payable supplier program.

This program has allowed us to convert a large number of transactions from paper to electronic and therefore reduce our overall transaction costs significantly. In addition from a timing prospective we brought in more imported product late in the second quarter and early in the third quarter to support our west coast national distribution center that was substantially paid for prior to the end of this quarter, but on average we have not changed our payment policies or terms.

With respect to cash flow, year-to-date net cash provided by operating activities of $14 million was lower than the $45.5 million in the same period of 2007 for the reasons I just mentioned. The first and fourth quarters of our fiscal year have traditionally been our strongest cash flow quarters and we fully expect that to be the case again now.

Capital expenditures in the quarter were $5.2 million which is roughly 25% lower than the average of the first two quarters of the year as we have several major distribution center consolidation efforts behind us. This third quarter amount represents 1.6% of sales for the quarter compared to 1.1% of sales in the same period last year. As we progress through the remainder of the year we will continue to prudently manage our capital expenditures.

Our liquidity position continues to be strong and will support us well in today's environment. We have $38 million in cash on the balance sheet at the end of the quarter and $50 million as of today, and two of our strongest free cash flow quarters are ahead of us.

From a borrowing capacity prospective, you may recall that in July 2006 we financed our senior credit facility with a syndicate of banks. This revolving credit facility provided us with capacity to borrow up to about $100 million subject to traditional financial covenant. We have not drawn upon our revolving credit facility over the past two years and we do not have any plans to do so.

However, one of our seven banks was Lehman Brothers which was responsible for a $17 million commitment under that revolving credit facility. I therefore wanted to call out that our revolver commitments now stand at $83 million.

As Mike mentioned earlier, we remain highly confident in our cash and liquidity position as well as our ability to continue to fund our operations through internally generated operating cash flow. At this time I would like to turn our call back to Mike to discuss our business outlook.

Michael J. Grebe

As we enter the final quarter of 2008 we continue to believe in the strength and viability of our facilities maintenance end market. In particular, the institutional market led by our AmSan brand continues to generate steady growth in the face of a challenging economic environment.

The multi-family housing market, which had been performing well for most of the year, faced new headwinds resulting from the escalating financial crisis and the resulting lockdown in the credit markets. These factors are having an adverse impact on large renovation and upgrade projects which we will expect to continue into the fourth quarter.

Professional contractor and specialty distributor markets continue to demonstrate some near-term weakness. The decline in sales has moderated which is encouraging but not an indication of a recovery yet. For the remainder of 2008 we are expecting results to be on par with performance exhibited in the first quarters of the year with respect to the professional contractor and specialty distributor markets.

While much of the one-time cost associated with our cost and efficiency plan are now behind us and we are positioned to reap the associated benefits we will not realize the bulk of the cost savings until 2009.

Finally, the impact of a widening spread between our interest earned and interest paid is expected to cost us an additional $0.01 per share during the fourth quarter compared to the past few quarters. Taking these factors into considerations, we are providing the following updated guidance for the fourth quarter.

Earnings per share are expected to be between $0.30 and $0.35 which implies earnings per share of between $1.33 and $1.38 per diluted share for the full year of 2008. During challenging times like these we are fortunate to have a deep and seasoned management team with years of experience in managing our business through significant adversity.

We have ample liquidity, approximately $50 million in cash, a strong balance sheet with no exposure to the derivatives or commercial paper market and a long track record of generating significant operating cash flow.

With a combination of smart execution and aggressively pursuing our cost and efficiency initiatives, we will emerge from this challenging time a stronger more profitable business. Ashley, you may now open the line for questions.

Question-and-Answer Session


(Operator Instructions) Our first question comes from David Manthey – Robert W. Baird

Kyle O'Meara – Robert W. Baird

This is Kyle O'Meara on for David Manthey. The linearity of the quarter, I think in the last call you had said through July things range in the low single digits. How did things trend through the quarter? Was there a dramatic slowdown in September, and then also, how were things were trending through October?

Michael J. Grebe

Well as you know, we don’t normally talk much about monthly or interim results. We’ve learned from experience not to draw too broad a conclusion based on a few weeks of data. However, given the extraordinary economic events we are seeing now, it probably is helpful to provide some additional color there.

During Q3 I think it is fair to say that we saw what most other companies and distributors saw, which was a further slowdown in late August and September, compared to the beginning of the quarter. For example, on an organic daily sales basis we were down 4% in July compared to down 5.4% in September and in general we have seen the September trends continue into October. October was down overall on an organic basis by 5% aided a bit by sales at Copperfield, which sells alternative fuel products which are in high demands.

So, in general we’re certainly not happy to be down 5%, but we’ve not seen a dramatic deterioration in October from September and then September compared to July was off about 150 basis points. So, those are the trends that we’re seeing right now and that we’ve baked into our forecast for the fourth quarter.

Kyle O'Meara – Robert W. Baird

Was there any contribution from pricing in the quarter and do you expect to have any pricing going forward?

Michael J. Grebe

The whole area of gross margins is certainly one that it’s always a big focus for us and certainly an even more interesting focus for the moment. We are pleased that gross margin for the third quarter was a 10 basis point improvement, and as we have discussed in the past, there are always several puts and calls, and then fluctuation of our gross margin.

I think our merchandising team has done a great job in a period where prices can be changing rapidly of making sure that we’re competitive. We were able to pass along some higher freight cost and we’ve managed our fuel cost very effectively, some of our transportation expenses wind up in gross margins. So, I’d say that in general in the third quarter we haven’t seen dramatic pricing fluctuations.

Now that said, with respect to gross margins we are prepared for some compression in Q4, compared to Q4 of last year due to heightened competition, or the potential for some product cost deflation. Now as you know our business model suits us well during periods of changing prices because we have purchasing scale and we have multiple grams with multiple price catalogs hitting at different times. So with our purchasing power of how we work closely with our manufacturing partners both here and overseas, we tend to navigate these waters very well.

However, product cost deflation often stems from a slowing economy which in turn puts some level of pressure on customers who in turn often look to us to help them stay competitive and help them sharpen their pencils. So we are prepared for some margin compression in Q4.

We’ve done a great job over the years keeping our gross margins steady and have rarely seen our gross margins move by more then 50 basis points either way. We expect to stay within those bandwidths, but we did feel it was prudent to plan for some compression in the fourth quarter.


Our next question comes from Michael Reinhart – JP Morgan.

Jen Consoli – JP Morgan

It’s Jen Consoli on the line for Mike. I appreciate the color that you gave on cash flow for the fourth quarter and the first quarter of 2009. I was wondering if you could give us a sense of what that could potentially be for the full year of 2009 and what leverage you have to pull, whether it be CapEx or other things that could drive that number higher, and secondly, what your planned uses of the cash flow would be as we head into 2009?

Michael J. Grebe

Jen, first of all obviously we are not as prepared on this call to talk about 2009 compared to 2008. Our focus here has been on our Q4 projections and so forth and making sure we give you that data. So, I’ll let Tom comment in a minute on maybe giving some color there on what we would expect in a full year range, but let me just talk for a second about how we think about that process and levers that get pulled and so forth.

2008 was a pretty heavy CapEx year for us approaching 2% of sales. We’ve had a lot of investments in IT and a lot of investments in our large distribution center projects. We expect less investments in 2009, so you’re going to see that CapEx number moderate a bit, number one.

Number two, in the history of this company, and certainly I think it’s true with other distributors, we are in a position where in a period of slower growth Interline Brands has historically always created more cash because there is a general reduction in working capital needs. Inventory levels just fall if your maintaining the same turns, your accounts receivable balances fall a little bit and that’s typically working capital is the biggest user of cash, or can be the biggest user of cash in a growth environment.

So in general, we have historically thrown up more cash when growth has slowed or on the rare occasion like this year when it’s gone negative. Directionally, those are sort of the trends that we see, and I’ll let Tom comment in a minute about numbers.

With respect to the second part of your question about what our intentions with that cash, I guess really I’d want to separate my answer there as to short-term and long-term. As I said earlier from a short-term perspective, cash is king. We obviously are watching liquidity crisis as well as anybody and we are going to make sure that we generate the cash, hold onto it prudently. If we got in a situation where we wanted to pay down debt or felt that was the prudent thing to do, we would consider that.

For the long-term, obviously or as we’ve looked back over the past few years, we’ve always been an inquisitive company and so that’s an option for us. Today, that is not something we quite frankly looking at very actively. We did the eagle transaction a few months ago because we thought that was a great marriage. We thought it fit very well into our asset portfolio, and so if there are incredible opportunities like that we’ll obviously be opportunistic.

But in general we are looking at this moment in time with a very short-term lens and we are looking that we want to generate that cash, hold onto it, and maximize our liquidity. So, that’s sort of how we look at the use of those funds. Tom, I’ll turn it over to you for sort of how you think of 2009 with respect to cash flow.

Thomas J. Tossavainen

Jen, as we had talked about on our call going into the next two quarters, we feel extremely strong about our cash flow generation, so that's going to be a strong lead with our $30 to $40 million in cash flow going into 2009. As Mike had said, we’re not happy about slowing sales but we historically generate more cash [inaudible] and that’s typically true for most investors. So as a result with more inventory reduction and those types of cash flow expectations, you can expect us to see $30 to $40 million in annual free cash flow in 2009 under that type of environment.

Jen Consoli –JP Morgan

Just going back to the liquidity position, if you could remind us what are some of your more restrictive covenants and maybe where you are today versus those covenants?

Michael J. Grebe

Sure, and again I’ll let Tom comment on the technical data here. At the moment our net debt to leverage ratio is a four times debt to adjusted EBITDA requirement and there’s typically some add backs that have added about $5 to $10 million to that adjusted EBITDA from our financial metrics. That leverage rate at the end of the year steps down from 4 to 3.5 and then it stays at that level and does not reset further.

So, that’s something that obviously we were always very comfortable operating within a leverage environment. We’ve operated during challenging economic times like this before with leverage. We know how to run the business during periods like this and know how to generate cash flow. So, while these are certainly challenging economic times and we’re prepared for those to continue in 2009, we do not foresee any issues with meeting our financial commitments and those covenants.


Our next question comes from Shannon O'Callaghan – Barclays Capital.

Shannon O'Callaghan – Barclays Capital

Can you just give a little more color around the comments around multifamily? How much was that down overall and can you split it between the 10% renovation upgrade that you really highlighted and the other daily repair that you said was still pretty good?

Michael J. Grebe

In General, Shannon, multifamily is about a third of our sales, and just to give a little extra color there, our renovations plus business is a division that’s within that multifamily grouping for us, if you will. It focuses exclusive on large apartment renovations and upgrades and that business was down almost 40% in October after being down around 30% in Q3.

Conversely, the cornerstone of our multifamily business, primarily the Wilmore brand has also historically included some level of smaller renovation and upgrade work. What I mean by that is that what renovations plus typically does is deal with an apartment read operator who is trying to totally renovate 40 apartment units at a time when an operator is perhaps upgrading three or four appliances at a time.

That’s typically buried within our standard business for our Wilmore brand and it’s often really hard for us to figure out if that’s an appliance upgrade or that’s a repair. We don’t always know where that’s winding up. So when I say our core business still has some level of upgrade in it that’s what I mean by that.

That business, or again, our non-renovations plus business within multifamily was down roughly 6% in October. Again, similar to levels we saw in September and August and we believe that that decline is a combination of factors especially including a reduction in demand for larger ticket items such as appliances and we’ve been able to triangulate that with some of our suppliers and some publicly available information.

We’re also seeing some general belt tightening by the multifamily operators due to concerns about employment, credit, and then some slowing in the rate of effective rent increases. As we said earlier the vacancy rate was up about 50 basis points on a year-over-year basis. The effective rents or the growth of effective rent has slowed a little bit.

So, we’ve seen some pull back there but we also continue to believe that our market position is strong underlying demand for every day repair items will continue to be at reasonable levels, and if history is true that type of reign-in that occurs on every day repairs is usually pretty short lived. It’s not prolonged there’s some amount of contraction that occur but it typically doesn’t occur for very long.

So that’s sort of how we look at the renovation upgrade business as opposed to the every day repair business.

Shannon O'Callaghan

For facilities made more broadly, when was the last time that business actually saw an organic decline and how did it play out then?

Michael J. Grebe

Shannon, when you say facilities are you talking about the institutional business separate from multifamily?

Shannon O'Callaghan – Barclays Capital

I'm talking about them together overall combined in the quarter was down, so if you just want to talk multifamily that’s fine since that’s the piece that drove it.

Michael J. Grebe

Sure. I guess keeping in mind that, well, let me separate the two. Within all of our facilities maintenance businesses a significant portion is AmSan, which of course is new to us. We’ve only owned that business since 2006. It’s janitorial and sanitation products and, again, what we’re seeing today is those are a much more recession resistant because it’s involved in cleaning and not a lot of capital expenditure that line up on the books of the costumer. So there’s probably not a recession period to look at there or our history is pretty short.

So if you look at the rest of the business for us it’s really driven primarily from multifamily and the last real period that we saw a pullback was primarily in 2003 when, as I mentioned earlier, we saw vacancy rates hit an all time high in that marketplace again driven by some macro uncertainty employment rates or unemployment rates had risen and we saw a couple of percentage decline in that state, but it happens that that year also saw our gross margins go up, so we feel like we navigated that period fairly effectively. That’s pretty much the best most recent period we can point back to.

Shannon O'Callaghan – Barclays Capital

There's a lot of different initiatives you’re putting in place here and you mentioned most of the savings not until 2009, but on that thought about what happened in the last cycle, do you view this if conditions stay tough here these actions you’re taking are enough to sort of stem the margin decline. They’ve been down for a few quarters in a row here. Is that going to be enough to flatten out the margins next year? Is that the goal?

Michael J. Grebe

Certainly our goal is to get to that point, but let me be clear. We are not assuming that the initiatives that were already in place are enough or sufficient or all we want to do. We are looking at a lot of different aspects of our business. We’re going to continue to be very aggressive.

As Ken mentioned, we are looking very, very closely at all of our distribution operations to see if they are further consolidations that we want to take on and accelerate, and there is a lot of other cost initiatives that we’re not as prepared to talk about on this call but that we are going to be very aggressive with and be jumpstarting over the next month or two.

So, the mindset of the team here is we're going to execute as best we can from a sales standpoint and make sure that we protect our costumer value proposition, but we’re going to assume the worst from an economic stand point and take actions to account from that.


Our next question comes from the line of Ryan Merkle - William Blair.

Ryan Merkle – William Blair

Mike was the slowdown in the multifamily business isolated to a few big costumers or is it more of a broader trend in terms of the lower renovation activity?

Michael J. Grebe

Well that’s a good question Ryan. In terms of renovations and upgrades, I guess there’s a couple of ways we look at that. First of all there are a small handful of operators that are still forging ahead with projects that were either underway or were in a position to be almost finished or that they feel are properties that clearly need to be renovated.

We understand that there’s at least one read out there that we’re pretty familiar with. For example, had done some deed study over the years and determined that it was equally dangerous to under invest in an asset as it was to over invest and therefore capital and maintenance deferrals are possible in the short-term, but they’re not sustainable over a longer period of time and can necessitate an even larger repair in maintenance expense to catch-up. It’s like maintaining your house and so forth.

So there are some like that but I would say that most of the large operators that we’re dealing with are either in the process of cutting back or have cut back or have sent us signals to be prepared for that. So, that’s on kind of the larger projects that, again, often tend to go to our renovations plus division.

With respect to the smaller projects which again tend to be an appliance upgrade here or there, again, our sales of those products are clearly recently down on a year-over-year basis and down double digits. We can't always tell exactly if it's an upgrade or a repair but we would say to your question, I would say that's fairly broad. It wasn't one or two customers that we felt that from it was fairly broad.

Ryan Merkle – William Blair

Is the slowdown in the multifamily business the main reason for lower 2008 guidance or is there anything else there?

Michael J. Grebe

Well, as always there's a lot of puts and calls in our earnings guidance. That is certainly a factor for us. That is probably the market that has seeped into the consciousness of the operators a lot more than others.

Within our institutional business, again we think AmSan is doing well, but some of our other brands are focused in on plumbing products in those institutional markets. There are a level of upgrades that occur in those spaces, hands free faucets and toilets for example. We are seeing a little bit more of a mentality to repair versus replace in some of those other spaces.

As I mentioned, we did feel it was prudent to prepare for some compression in our Q4 gross margins. We've also thought that based on current market conditions it was prudent to prepare for a little bit higher bad debt expense based on how people are paying us or might be paying us.

So, there's a couple of factors in there but certainly the top line that we saw of slower in September and October was the biggest factor.


Our next question comes from Matt McCall - BB&T Capital Markets

Matt McCall – BB&T Capital Markets

If I look at the results for Q3, it looks like you had a bout a $6 million sequential increase on the top line and you were able to convert that into a $6 million sequential increase from Q2 on operating income line. It didn't sound like you were able to recognize much of the plan cost savings. Help me understand how there were no incremental costs or you were able to offset any incremental expenses in your model and generate that type of improvement.

Thomas J. Tossavainen

Sure Matt. This is Tom. When we're looking at our initiatives and looking at project 20-20 specifically, we had expected that it was going to cost us some one-time costs, $0.02 on the severance side $0.01 on closing some of the pro centers, and while we did get $0.01 improvement in the third quarter expect $0.03 in the fourth from lower headcounts and salary costs. That was generally in line with our expectations there. Most of the initiatives that we're taking are really going to impact 2009, as we roll into the first quarter and hit full run rates on that, for example $10 million in savings by April of '09.

Matt McCall – BB&T Capital Markets

That was my next question, so the timing of the expected savings you're going to hit the full run rate in April and move it forward?

Thomas J. Tossavainen

Correct. By April of '09 we'll hit a full run rate of approximately $0.05 a share per quarter, which is $10 million run rate for the year.

Matt McCall – BB&T Capital Markets

Talk about the expectations for the west coast NDC, what kind of incremental growth opportunities do you have there next year? I'm assuming some, but can you quantify your expectations of what that's going to do for you?

Michael J. Grebe

I'm sorry Matt, you had asked specifically about the west coast NDC?

Matt McCall – BB&T Capital Markets


Michael J. Grebe

Well obviously, one of the things that's very critical to us is making sure we have very fast distribution to our customers, very high fill rate, and typically what that national distribution strategy enables us to do, just as a reminder, is to keep more safety stock in one location as opposed to in multiple locations. So we think that the victory over the long haul is having less space at our regional distribution centers, higher fill rates for our customers, and overall lower inventory levels because we can pull that safety stock back in.

Now, you have to put that investment in Salt Lake City to get it up and running before you can start to reap those benefits over the long haul. So quite frankly in the third quarter, really all we saw were the costs of that and no benefits of that on a going forward basis.

In terms of a sales growth opportunity there, Matt, that's really hard with today's visibility to calibrate. I can tell you as an example though, that the transit time of getting product from Nashville to Seattle, for example, used to run on the order of about 10 to 14 days, from Salt Lake City it takes two or three days. So we're able to re-fill for our customers better, we're going to see higher fill rates, we're going to see higher customer satisfaction levels, and we know that is going to make us a much more valuable supplier to our customers on the west coast, and you may recall that our market share and our penetration in the west is far lower than it is in the east and Southeast, and Midwest.

So we think there's a great opportunity there with the economy we're in right now and the visibility we have, it's hard for us to calibrate that, but we are convinced that is a great long-term investment. Unfortunately, a lot of cost in a tough quarter in a tough period, we could acknowledge that but we are unshaken from our knowledge that that's going to be a great investment for us.

Matt McCall – BB&T Capital Markets

I guess the thought there was the reduced transportation costs and the potential to maybe share in some of the savings with some of your customers or maybe generate some incremental revenue and gain some shares. That's kind of what I was getting at.

Mike J. Grebe

Yes, and we still expect that to happen. We think that our transportation costs will come down, our ability to get higher penetration with our customers will go up, hard for us to calibrate that right at the moment for 2009.

Matt McCall – BB&T Capital Markets

Tom can you remind us what you've talked about on the operating expense line and the breakdown there between fixed expenses and variable expenses and really what are the different components?

Thomas J. Tossavainen

Yes, I don't know that we necessarily broke it out in that level of detail, Matt, but generally after the cost of the products some of our largest costs are distribution center labor and delivery and freight costs, and those each running at 4 to 5% range of sale. So, when you look at the variability of the business overall that's how we look at that component.

Michael J. Grebe

I guess I would also add to the Matt, that our sales expenses are there's a portion of that obviously that sticks, but almost everybody on the team is on some sort of condition a percentage of sales or gross profit, those expenses all in typically run 5 or 6% of sales. So between distribution center labor, selling expenses, marketing expenses, and freight expenses which can again, depending on whether we add in freight in and freight out and so forth, on a gross expense base all in, those [inaudible] I just raised there probably approach 15% or more of sales. So we consider those either highly variable or pretty variable expenses.


Our next question comes from Keith Hughes - SunTrust.

[Sarah] – SunTrust

It's [Sarah] for Keith Hughes. You covered a lot of detail on the facilities maintenance segment, but outside of multifamily and institutional the steady growth there that you saw, was that pretty consistent across the different end customers there and throughout the timing of the quarter?

Michael J. Grebe

I'm sorry your question was with respect to the pro contractor and the specialty distribution markets, or other markets, was that your question?

[Sarah] – SunTrust

No, just within facilities maintenance and institutional side where you saw just between education, healthcare and hospitality, was it steady growth consistently across those other segments, or - -

Michael J. Grebe

I'm sorry; your question is throughout the quarter? Is that correct?

[Sarah] – SunTrust

Right, throughout the quarter.

Michael J. Grebe

We saw similar trends there in all of our markets that September was either slower or down more or however you want to put it, compared to July and so the trends that I mentioned earlier where late August and September were worse than July, that's true virtually across all of our institutional markets, and then I would also say that those trends also tend to be true in October as well. So they're not dramatic, I mean we didn't see down 5% in July and down 12, but they all tend to be off another 1 or 2%, so there's similar types of trends that we've seen in the rest of the business.


(Operator instructions) Our next question comes from Bob Franklin – Prudential Financial.

Bob Franklin – Prudential Financial

On the revolver, I think you said the commitment was 83 million?

Michael J. Grebe

Yes, the affective commitment is $83 million today.

Bob Franklin – Prudential Financial

Is that the same as the availability?

Michael J. Grebe

The availability today for example, we use that facility for capacity and then let me remind you that we haven't borrowed on that in the last couple years, but also covers LCs. So about $10 million is the normal level of LCs we use to transact business, so generally of that 83, 73 is available today.

Bob Franklin – Prudential Financial

If things play out as you expect it to, where you're generating $30 to $40 million over the next couple of quarters and rates stay where they are so they get paying a lot more than you're earning on your cash balance, if you've got this availability is there any reason not to pay down the term debt or buyback some bonds with where prices are these days?

Michael J. Grebe

One of the topics that we always look at very carefully here is our capital allocation policy and that's something that we as a management team are constantly reviewing. We're quite frankly reviewing that with our Board of Directors at all available times and we will take whatever action is prudent that it maximizes and balances our liquidity needs with our desire to drive profitability and position the company for the long haul.

So, we always evaluate any of those options and if those metrics make sense and that's what's prudent for us to do then that's the direction the company will go in, but we'll make those decisions as we proceed over the next couple of months.

Bob Franklin – Prudential Financial

You gave us your leverage ratio requirements. Where is your calculation of it right now?

Michael J. Grebe

It's at 3.06 and that excludes the extra cash that we have on our balance sheet.

Bob Franklin – Prudential Financial

So that's a gross number?

Michael J. Grebe

That number reflects the use of $25 million of cash per our agreement that allows us to reduce that debt. However, we have more cash if we can pay that down. So effectively, we're well under the 2.8 range if we use our cash.

Bob Franklin – Prudential Financial

So the calculation only gives you credit for you said $20 million?

Michael J. Grebe

$25 million, that's correct.

Bob Franklin – Prudential Financial

It only gives you credit for $25 million cash.

Michael J. Grebe

That's correct.


And there are no further questions at this time. I will now turn the call back over to Tom Tossavainen.

Thomas J. Tossavainen

It's Mike Grebe. I would like to thank everyone for joining us on the call today particularly on Election Day, and thank you very much.


This concludes today's conference call. You may now disconnect.

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