Party City Holdco, Inc. (PRTY) CEO James Harrison on Q3 2018 Results - Earnings Call Transcript

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About: Party City Holdco, Inc. (PRTY)
by: SA Transcripts

Party City Holdco, Inc. (NYSE:PRTY) Q3 2018 Earnings Conference Call November 8, 2018 8:00 AM ET

Executives

Ian Heller - Associate General Counsel

James Harrison - Director and Chief Executive Officer

Daniel Sullivan - Chief Financial Officer

Ryan Vero - President, Retail

Analysts

Seth Sigman - Credit Suisse

Matt McClintock - Barclays

Rick Nelson - Stephens

Simeon Gutman - Morgan Stanley

Mike Baker - Deutsche Bank

Joe Feldman - Telsey Advisory Group

Curtis Nagle - Bank of America

Tami Zakaria - JP Morgan

William Reuter - Bank of America

Operator

Good morning. My name is Matthew, and I'll be your conference operator today. I'd like to welcome everyone to the Party City Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the call over to Mr. Ian Heller, Associate General Counsel of Party City. Thank you. Mr. Heller, you may begin.

Ian Heller

Good morning, everyone, and thanks for joining us. This morning, we released our third quarter 2018 financial results. You can find a copy of our press release on our website at investor.partycity.com.

And now I'd like to introduce our executive team who are here on today's call. We have Jim Harrison, our Chief Executive Officer; and Dan Sullivan, our Chief Financial Officer. We'll start the call with some prepared remarks by Jim and Dan, before we open it up for Q&A.

Please note that in today's discussion, management may make forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995 regarding their beliefs and expectations about the company's future performance, future business prospects for future events or plans.

These statements are subject to risks and uncertainties that could cause actual results to differ materially from these statements. Although we believe that the expectations reflected in these forward-looking statements are reasonable, we can give no assurance that such expectations will be realized.

We expressly disclaim any duty to provide updates to our forward-looking statements whether as a result of new information, future events or otherwise. We encourage everybody to review the safe harbor statements provided in our earnings release as well as the risk factors contained in our SEC filings.

During today's call, we will refer to both GAAP and non-GAAP financial measures of the company's operating and financial results. For information on our non-GAAP financial measures and reconciliations to the most directly comparable GAAP measures, please refer to the earnings release.

And with that, I'll turn the call over to Jim Harrison.

James Harrison

Thank you, Ian. Good morning, everyone, and thank you for joining us today. I will begin by providing an overview of the company's performance for the third quarter, as well as the top line results for the month of October and share an update on the progress we are making against our strategic initiatives.

Dan will then discuss financial and operational results in further detail, and provide an updated view of the full-year guidance.

Third-quarter revenues were slightly softer than we expected with continued strong gross margin performance serving to partially offset the effect on net income. Revenue declined by 70 basis points on a constant currency basis. The shortfall came from both the retail and consumer products segments.

Retail posted a brand comp decline of approximately 100 basis points primarily caused by soft seasonal summer sales reflecting weather issues, and a number of one-off operational challenges in the quarter, which negatively impacted the results.

Specifically, as the new tariff policy began to take effect we experienced tremendous supply-chain disruptions moving products out of China at the start of the Halloween season. This affected inventory availability and overall in-stock positions in September.

We also experienced accelerating helium supply shortages in the quarter providing a headwind to the growth trajectory for both the latex and metallic balloon categories, which had been key sources of growth to date.

Dan will talk more about these items and quantify the impact they had on the business shortly. The e-commerce business performed well in Q3 especially in light of the challenges I just mentioned.

The consumer products segment results reflect the continuing softness in the independent channel and the negative timing effect associated with late in the quarter franchisee acquisitions, which shifted approximately $3 million of sales from third-quarter wholesale revenues to retail sales in fiscal October.

Outside of the United States, continued strength in the core international markets of Germany, Australia and the UK was more than offset by sluggish results in the FOB and direct from plant businesses.

On a positive note, we continue to reap the benefits of the vertical model, expanding gross margins by 60 basis points in the third quarter, while navigating some increasingly challenging inventory pressures, specifically as it relates to certain input costs, including commodities, labor and freight.

For the quarter, adjusted earnings per share totaled $0.08. In addition to the sales declines increased supply-chain costs and higher interest expense adversely affected earnings on a year-over-year basis. Operationally, we continue to make progress on our strategic growth initiatives. These efforts will continue to improve the business as we go forward.

Starting with the retail business, we continue to invest in improving the shopping experience for customers whether in-store or online as the line between brick-and-mortar and the web continue to blur. While early in this collective effort, I am pleased with the progress seen to date.

In-store, the productivity and labor initiatives that we rolled out to the entire fleet earlier this year continue to provide the catalyst for reinvestment in the party planner program. This program is now active in 145 stores, and we are very pleased with the results, which Dan will disclose some more detail.

In September, we launched Toy City pop-up with the opening of 50 temporary joint Halloween City Toy City stores. As previously stated, the goal here is to capitalize in a disciplined and controlled manner on the toy opportunity created by market dislocation.

We have been pleased with the offering, proposition and execution of what we have brought to market. We have created a strong in-store experience featuring a full range of on trend items. Thus far consumers are responding positively to the merchandize offering and breadth of assortment.

Online we continue to invest in critical omnichannel capabilities that complement the in-store shopping experience. In the quarter, we successfully executed the side re-platform with minimal business disruption.

The new site offers consumers advanced product creative and content, improved usability and check out flow, as well as a seamless mobile browsing experience.

During the quarter, we saw traffic to the site grow in part as we cycle issues SEO challenges. More significantly, mobile penetration increased over 12% reflecting the benefit of the site redesign.

Buy online, pickup in-store continued to gain traction with penetration of e-commerce sales now reaching 16% up from 10% in the first quarter.

We are very pleased with the initial performance of the Party City store front on Amazon marketplace and the ability to expand the reach of our brand and unique product offering.

To date we have limited the merchandise assortment while we continue learning a tremendous amount about the consumer, their shopping preferences and the inherent price sensitivities associated with winning the buybacks.

These learnings are being leveraged across our business. The level of traffic to the site continues to grow and conversion rates are strong serving as a catalyst for us to build towards a broader assortment.

Regarding other digital assets, we are pleased with the progress we have seen from Kazzam, the party services marketplace, which is now live in over 40 markets as we progress towards our stated goal of reaching 50 markets by the end of the year.

Recognizing that to a large degree, we are still very much in a test to learn mode, more or less. We have successfully executed over 500 parties to date and are pleased with some of the key underlying metrics.

We believe that the Kazzam website will serve to support our expanding CRM efforts, capturing unique customer information for our consumer database of party throwers.

We are also growing and expanding our CRM capabilities beyond Kazzam collecting customer data, strengthening the relationship with our customers. A robust CRM will allow us to deliver targeted and personalized marketing messages to consumers for their specific party needs.

Currently the customer database contains over 25 million identifiable customers representing almost four years of purchase data. This data is organized by over 45 discernible attributes.

From this we have created customer segmentation and have appended buyer model all of which will help us inform our target and promotional campaign.

This has been deployed on a limited pilot basis, and today we have seen improved response rates and overall promotional effectiveness. Finally, we continue to invest in the consumer.

While total marketing spend in the quarter was flat year-over-year looking to optimize the spend we shifted dollars away from traditional media towards a variety of digital and social channels increasing our presence where consumers are engaging with brands.

On the acquisition front, during the quarter we completed the acquisition of 37 franchise stores across Pennsylvania, Minnesota, North Dakota and the Texas markets. These acquisitions further expand our [footprint] at an attractive market multiple and we believe remain an excellent use of capital.

Turning to our October performance, I'd like to begin by recognizing the Herculean efforts of our consumer product design and sourcing teams, who did a fabulous job of creating and sourcing products for the season in the face of a myriad of challenges.

The Party City Halloween City product assortment quality and value proposition is truly second to none. Also I like to thank our thousands of associates and managers at the retail whose tireless efforts and dedication is beyond exemplary. Today our retail organization in my view is stronger and better than it has ever been.

Total global retail sales for fiscal October of $432.7 million was an increase of 4% over the prior year. Retail comp sales for the Party City Halloween City brands on a combined basis was slightly negative at minus 90 bps, a portion of which was attributable to the issues related to helium.

While the Party City brand comps were below expectations, our total Halloween sales were generally [in level with our] expectations.

How we got there was substantially different than how we had planned. Our multichannel approach to the holiday and our retail teams efforts to improve the customer experience in all channels allowed us to achieve a very solid result even as the consumer for costumes broaden their search beyond more traditional brick-and-mortar channels.

We experienced very strong performance in both the e-commerce and Halloween temporary store segments, which had positive comp sales of 16.6% and 14.2% respectively. Dan will be providing more details in a moment.

I also want to take this opportunity to address a topic, which I believe is perhaps misunderstood regarding our business and that is the potential impact of tariffs. While many of our products today are sourced from China, it is important to highlight that just under $250 million of our annual purchases are sourced from China and less than $50 million in total are subject to the current tariffs.

So, the full effect of the tariff would be less than [$12 million]. We fully expect that between resourcing, product reengineering and price increases that on an annualized basis we will significantly reduce this exposure.

Additionally, more than 40% of our consumer product sales are comprised of items that we manufacture ourselves generally in North American factories. As such, since paper and plastic tableware will soon be significantly impacted by the tariffs we believe that there is an opportunity for us to grow our market position.

Obviously none of us know what the future state of international trade negotiations hold, but I felt it was important for me to share this information with you. And lastly, we announced today that the board of directors has authorized a new $100 million share repurchase program.

As I have stated previously, we view share buybacks as largely opportunistic and certainly not a core component of our capital allocation strategy. This authorization gives us the flexibility to make share repurchases and take advantage of what we believe is a severely depressed share price while having a de minimis impact on our ability to continue to delever the balance sheet.

So, in summary, while Halloween was generally in line with our expectations, a softer third quarter than we had expected and the recognition of the operational headwinds of supply-chain and helium mentioned earlier are now reflected in our updated guidance.

More significantly, however, we continue to make progress against our key initiatives and see encouraging results in many areas of the business. The execution of these initiatives will ensure that we become even better operators and achieve our long-term growth objectives.

The investments being made across the business have and will continue to strengthen the company's market position as the leading global wholesaler and retailer in the industry.

And now I would like to turn the call over to Dan to discuss the third quarter results and the 2018 outlook in greater detail. Dan?

Daniel Sullivan

Thanks, Jim, and good morning, everyone. I will review our financial and operating performance for the quarter and fiscal October top line results before discussing our outlook and guidance for the rest of 2018, and then we'll open up the call for questions.

Third quarter top line financial results were softer than expected, only partially offset by gross margin expansion with bottom-line results below our expectations. Despite the top line challenges, we continue to focus on leveraging our vertical, driving costs out of the business, effectively deploying capital and strengthening our business model through investment in and execution of our growth strategies.

In the quarter, consolidated revenues declined 1.3% to $553 million, or a 0.7% decline when adjusted for currency.

We expanded our gross margin rate by 60 basis points despite increasing inflationary pressures, again demonstrating the strength of the vertical model, while total operating expenses delevered resulting in reported operating margin contraction of 100 basis points and adjusted net income of $7.4 million or $0.08 per adjusted diluted share. We generated free cash flow of approximately $38 million.

Looking more closely at our third quarter top line results, our retail segment net sales increased 3.2% on a reported basis or 3.5% in constant currency, driven by an 8% increase in retail store footage over the last twelve months.

At quarter's end, our store network totaled 959 stores, 862 of which were corporate stores, as we opened three net new stores and acquired 65 franchise and independent stores over the past 12 months.

We also strengthened our pop-up store offering, while operating 23 less stores than a year ago. For the season, we opened 249 pop-up stores of which about 50 were joint Halloween City Toy City formats and an additional four converted from Halloween City to Toy City immediately after Halloween.

Brand comparable sales, which include our US and Canadian permanent stores and our North American e-commerce business, including our Amazon pilot, declined 1% in the quarter on both a reported and run rate basis.

As Jim said, we were pleased with our overall web performance highlighted by comp sales growth of just over 19%, when including BOPIS sales. This growth is reflective of a combination of improved underlying performance metrics and our enhanced customer targeting efforts.

In the quarter, we saw a healthy increase in traffic and conversion partly a result of cycling the SEO issues of a year ago. While we are pleased with the initial results of the Amazon pilot, its contribution to total sales and comp sales in the quarter were small.

The strong customer response to our new site, traffic and conversion gains, deepened focus penetration and positive results from the Amazon pilot all reinforce the meaningful steps we have taken to strengthen our online offering.

Our everyday category grew about 1% in the quarter or about 2% when adjusting for the negative effects of the helium shortages. This growth rate for the everyday business is slightly above the year-to-date trend and reinforces the consistency of a core component of our business.

Within the everyday categories, we saw improved results from juvenile birthday and continued growth in our metallic balloon business although below recent trend as a result of the helium shortage.

We did see a weaker summer seasonal business in part due to weather and as Jim mentioned, the Halloween business was softer than expected in September.

The surge in demand ahead of the September tariff implementation caused significant disruption to both the manufacturing and distribution of Halloween products, most notably costumes and accessories.

As a result, we saw higher cost to bring the product to the stores and manage through an overall weakened inventory position at the start of the season. The comp results for the quarter are obviously noisy in that we are cycling the SEO issues, have hurricane impact in both years, and this year managed through both the helium shortages and the aforementioned operational challenges out of China.

Having said that we estimate that our run rate comps for the quarter were down about 1%, or in line with our reported comp result when normalizing for all of these factors.

Turning to the non-vertical consumer product businesses. Net revenue decreased 4.8% in Q3 after adjusting for the impact of franchise acquisitions and foreign exchange.

International consumer products declined approximately 5.9% in constant currency. Deepening key retail relationships and leveraging our unmatched strength in the foil balloon category helped fuel double-digit growth in Australia and high single-digit growth in Germany and in the UK.

However, softer results in Mexico and in our non-core markets, particularly our direct from plant FOB business were an offset in the quarter.

As we previously discussed, the domestic consumer products business remains challenged due to continued sluggish franchise and independent performance. However, we are encouraged by a few secured wins with key retailers more recently, which will help fuel improved trends in Q4.

Our consolidated gross profit margin was 36.5% or 60 basis points above the same quarter last year, partially a result of the shift in promotional spend to Q4.

Continued strong gross margin expansion in retail as a result of this less promotional activity increased manufactured Share of Shelf, and the benefit of our retail productivity efforts were partially offset by a decline in our wholesale division due mostly to increased inflationary pressures.

The operational challenges associated with moving products out of China resulted in the significant use of air-freight and the incurrence of additional labor in our DCs putting added pressure on gross margins although this impact will largely be felt in Q4.

Additionally, while pure wage pressure in our distribution centers mostly stabilized, we saw heightened commodity cost inflation largely a result of the helium shortage. Total Share of Shelf decreased 80 basis points to just over 77% with a portion of the decline a result of the product availability issues discussed earlier.

Manufactured Share of Shelf increased 90 basis points to approximately 25% driven by further leveraging of our manufacturing assets including SCIM, acceleration of the Granmark integration, and continued growth in the foil balloon category.

Operating expenses as a percent of net revenue delevered 150 basis points year-over-year, largely reflecting increased G&A expenses as a result of general inflation, wage increases and one-time severance costs.

Investments in Kazzam increased about $1 million year-over-year mostly due to the further expansion of the business into 43 markets as Jim discussed earlier.

Retail operating expenses increased only 3% versus Q3 of last year despite the addition of 68 new permanent stores, continued minimum wage cost pressures and higher temporary store costs, as we remain focused on our productivity initiatives and efficient labor management.

In the quarter, we saw a 30 basis point decrease in retail labor costs year-over-year and as these store productivity initiatives begin to mature, we have already begun identifying the next wave of initiatives for 2019.

We are also pleased with the performance of our party planner program, which scaled up to 145 stores with about 60 having been launched in the most recent quarter. We have strengthened the labor model, improved training and reduced associate turnover.

And customers have noticed as those customers assisted by a party planner reported a 20 point increase in service and satisfaction scores. Overall, we are seeing about a 1% to 2% comp lift versus rest of chain and stronger results in the more mature stores.

We will continue to execute the program and have begun developing broader expansion plans for 2019. Reported income from operations was $31.7 million or 5.7% of net revenue compared to $37.4 million or 6.7% of net revenue in the prior year period with the decrease partly a function of lower sales in the nonrecurring operating items mentioned earlier.

Excluding such items, underlying operating margin declined 60 basis points versus Q3 of last year.

Interest expense for the third quarter was $27.7 million or $4.5 million above the same quarter last year. With the increased attributable to increase borrowing under our ABL facility, the impact of increasing LIBOR rates on both our term loan and ABL facility. And the recent high yield offering that was successfully executed in August.

In the quarter, our reported effective tax rate was impacted by a non-recurring adjustment related to tax reform. Our adjusted effective tax rate was 24%.

Adjusted net income was $7.4 million or $0.08 per share compared to $15.2 million and $0.13 per share last year. For the nine months ended September, consolidated revenue increased 2.5% or 2.1% in constant currency.

Gross margin expanded 50 basis points and operating margin increased 30 basis points versus the same period last year. Adjusted EPS increased to $0.55 per share from $0.45 per share inclusive of buybacks.

During the quarter, we delivered free cash flow defined as adjusted EBITDA less CapEx of $38.4 million which was approximately $10.7 million below the third quarter of last year.

As we increased capital investments in the quarter in support of our web re-platforming and retail productivity initiatives.

Cash flow from operations was a use of $84 million inclusive of $21 million in CapEx. And working capital was a use of $91 million in the quarter. We ended the quarter with net debt of about $2 million resulting in a debt leverage ratio of 4.9 times.

At the end of the quarter, we had approximately a $197 million available in our existing asset base revolver.

Turning to our fiscal October results. Net revenue for the month was $486.8 million which represented a 2.5 increase over last year. Retail revenue grew 4% in the quarter despite a slightly softer than expected 2.8% decrease in brand comps which included 60 basis points of headwind through the helium shortages.

Our temporary store business grew in absolute dollars year-over-year despite the fact that we operated 23 less stores. Sales for Halloween City excluding the sales of Toy City increased over 14% on a like-for-like store basis.

In addition to our strong temporary store performance, we're also pleased with our North American web business which grew 16.6% on a reported basis and 38% when including the impact of both the sales.

This strong web performance reflects the benefit of the site re-platforming and the full effect of both is which was also available on the mobile site this year.

The Amazon market place pilot performed in line with expectations represents a small piece of the Halloween business and we will continue to explore additional seasons and expanded assortment.

Turning to our full-year guidance. Given our softer than expected Q3 results and overall performance, we are revising our previously provided fiscal 2018 outlook.

As we look to the fourth quarter, despite the solid total Halloween performance, there are a few items that we anticipate will further impact our results.

We expect the helium shortages which accelerated in Q3 will continue in the near-term providing both the headwind to our metallic and latex balloon growth and increased gross margin pressure.

Also, as mentioned, we experienced meaningful disruption towards supply chain in September associated with the surging demand for moving product out of China. As a result, we incurred incremental freight and distribution costs much of which will be recognized in the fourth quarter.

In the fourth quarter, we will continue to experience heightened inflation with ocean shipping rates materially higher than the rates of a year ago. And we expect that these conditions will likely continue ahead of the next round of tariff implementation.

Taking this and our year-to-date results into account, we now expect revenue to be in the range of $2.43 billion to $2.46 billion and comp sales to be flat just slightly down for the year. We anticipate full-year adjusted net income to be in the range of a $157 million to a $162 million or a $1.60 to a $1.65 per share.

And adjusted EBITDA to be in the range of $400 million to $410 million. Embedded in this outlook is an assumption for full-year gross margins to be flat to slightly down versus 2017 given the headwinds discussed earlier.

Finally, we continue to expect interest expense to be approximately a $105 million for the year. In terms of capital allocation priorities, we expect to spend about 3% of net revenue on CapEx. As you saw on our press release, the board has authorized a $100 million share repurchase.

As is our practice, our guidance does not reflect share repurchases. We anticipate ending the year with a net debt leverage ratio of about 4.2 times and we anticipate that this ratio will be under 3.5 times by the end of 2020.

For all other detail around our outlook, please refer to our press release.

And with that, I'd like to turn the call back over to the operator and open it up for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Seth Sigman with Credit Suisse. Your line is open.

Seth Sigman

Thanks, good morning guys. Thanks for taking the question. My question is about Halloween to start. Can you just talk a little bit about Halloween actually played out, how it's different versus your expectations.

And I'm also trying to reconcile the different performance between your core Party City stores and then which obviously were a little bit weaker than you expected versus Halloween city and online which seem to trend a little bit better. Could you just help us better understand what new things going on there? Thanks.

James Harrison

Sure, Seth. Let me start with saying, Halloween was pretty much fighting the book value below our expectation, obviously with the move, to Wednesday we expected that to be a drag. There were several different aspects though to the season which constitute serious earnings for us which are really important.

Firstly, operational issues out of China. As importers across the board accelerated their purchases for Q4 holiday orders and shipments in advance of the first round of tariffs. And that really put pressure on the whole China supply chain from labor build to shipping capacity and rates as Dan mentioned.

And we had not projected our own demand planning. Secondly, more importantly, the way the season played out, really ratify the investments we made leading into the season as well as strategic initiatives that we laid out for the season.

The and increased consumer activity has I tell you for their product needs really cross all channels, not just brick and mortar but looking at all channels. Really aligned with the investments that we made to improve the customer experience both at partycity.com as well as in Halloween City temporary stores.

I think additionally a large component of our management strategies with broader product performance and dig that uncertainty really paid off. Additionally by broadening of e-commerce presence to Party City marker place that was clearly a solid move and completed our multi-channel strategy.

I think the last part is important is many of the store operation initiatives from staffing to music technology in stores that we planned in doing that we did execute really paid off in the holidays especially last 10 days we've got 65% of the business was stores occurs.

I think we process the customer through stores better than average. So, I think in summary the season played out pretty much to where we thought it would be. How, and as I said in my comments, how we got there was a little bit different than how we've planned.

Daniel Sullivan

And Seth, maybe to respond to your question on the matric. So, I think we looked at the total Halloween business through the lens of both our permanent and temporary stores. Remember, improving the shopping experience in our Halloween City pop-up stores was core to our Halloween strategy not just obviously adding the Toy City.

So, the matric that we introduced which Jim discussed as a minus 90 basis points, that is looking at our total brand comparable sales which is the matric you all recognized and the Halloween City temporary store performance on a same store basis. Because we think again that's an important metric when you think about our total Halloween performance.

The sum of those two is the minus 90 basis points that we refer to.

Seth Sigman

Understood. Okay, thank you for that. And then I guess a question, as you think about moving past 2018, obviously this year you faced a number of headwinds and it sounds like some of that's continuing, continue to September and it's a Q4 at least.

Do you think it's fair to assume that this is the trough that some of the operational issues, the one of issues you're talking about will start to improve here. And as you look to '19, you got a better calendar yet there are content.

Do you think that allows for stronger growth in 2019?

James Harrison

Sure. Let me start and I'll list at the end of the comments as well. Obviously we're not providing at this point in time guidance on 2019. There is a lot of puts and takes. As Dan mentioned, we've got a lot of good momentum starting to build in the mass market channels, the drug channel, the grocery channel and the craft channels with the alternative market strategies.

Obviously Dan mentioned the guide if you would for a leverage of the NB a 3.5 coming down from 4.2 then this year. Obviously, we anticipate a solid year to journey that sort of cash flow to pay that debt down, so it'll be closer.

Anecdotally, I would say that we expect a solid year but with all the puts and takes on the headwinds you mentioned and whether they resolve themselves, simply the yielding situation should resolve itself in the second half of the fourth quarter. We'll see, we'll find that out pretty soon.

The operational issues out of China, really went more of a one off for lack of better term, I think getting the pressure we got with the availability of labor as well as the headwinds on the cost of ocean freight, and the simple availability of ocean freight clearly is something that’s one off.

I mentioned, I think one of the things is important, I really that I did mention is obviously tariffs. It's important that we realize the tariffs as currently issues by the Trump administration is not a serious headwind for our business and in fact may prove to be a slight tailwind.

So, I think in terms of providing guidance specifically we're not doing that but anecdotally you can look at the component parts, stronger IP in the market place next year. Thursday Halloween. Our ability to deal with the that we do operational issues that occur.

There were more in our list, I think well positioned as them to have a solid year next year.

Seth Sigman

Okay. Thanks, and good luck.

Operator

Our next question comes from the line of Matt McClintock with Barclays. Your line is open.

Matt McClintock

Hi yes, good morning everyone. I was wondering if kind of related to two part question. One is just inventory, with inventory where it's at, could you maybe just give us a little bit of an overview of how you think about the quality of that inventory and your strategies for dealing with that.

And then, kind of related is with the tariffs being in place and those tariffs being somewhat related to more of your costume business. How do you think about pack a way as you think through your strategies for dealing with potential EDM pack from the next round of tariffs if those two go in place? Thank you.

James Harrison

Sure. So, first thing with respect to the quality of inventory. I think the decline of inventory today is probably as good as it's ever been.

This year and last year for the first time we actually were in clearance events after the season for three or four days to really give us the opportunity to set our sales up for the room to really breathe next year, the hard IP and be totally on trend with what we offer for the season, Halloween.

You mentioned the tariffs. The tariffs issue really for us, today the items infected, yes, it includes some costume accessories particularly ear pads and head boppers and things like that. But the other tariff there is which are really substantial, things like make up and glow and those sorts of products.

We actually have already begun the process of resourcing things like table rolls, we've already done resourcing. Candles, we're working hard at resourcing. And when we, and when I say resourcing, it's either from domestic or non-China resources or in many cases particularly that are ink and paper in our own factory particularly in Monterrey.

So, I think our ability to deal with the tariffs really is based upon today's legislation is a very re-fenced event that like I mentioned earlier that deal of the day on the invoice basis we believe will be the minimums as it stands today.

Obviously, who knows with the national trade guys but hopefully that answers your question.

Matt McClintock

Yes Jim, that's very helpful. And then, just on Toy City, it's relatively new, we're starting to expand into that. Can you just give us some early lessons learnt from this because this is a new pop-up strategy for you? And just anything else anymore color just on how that progressed, how that type of performance your expectations. Thank you.

James Harrison

Right. I'll turn it over to Ryan to give us some more color. But just to make this from a headline standpoint. Obviously we offer toys during the Halloween City but the Halloween was the focus of those stores at that point in time. Ryan?

Ryan Vero

Yes so, I think as Jim mentioned earlier in his comments, we've been pleased with the start of Toy City program in about 50 of our stores. If you recall, the majority of those Toy City stores were in combination with Halloween City's and during the Halloween season.

So, I think what was really encouraging is the interaction of the customers between the Halloween and the toy business, getting the visibility and awareness of the category to those customers. And frankly, them actually buying quite a bit of product in the Toy City side of the store as well.

So, we're encouraged with the early results. Obviously, the bulk of this business comes during the holiday season and our teams are getting the stores ready to go for that, that period of time.

Matt McClintock

Thank you very much for that color.

Operator

Our next question comes from the line of Rick Nelson with Stephens. You're line is open.

Rick Nelson

Hi, thanks, good morning. So, you mentioned ecom was 16% of sales and Amazon was a small portion of that. Did you did that surprise you the Amazon being such a small piece of the business?

James Harrison

Let me, I'll make a couple of comments and Dan may want to chime in as well. Firstly, we our ecommerce business was up 16.6%. It was a 60% business, so it was 16.6% on the year-over-year basis.

And Amazon really pretty much played out in line with our expectations. This was a pilot for us, it was our first venture into the space. And we have a lot of learnings to make sure were set up to do it. We offered a very limited assortment on Amazon versus what would on price here at ecom.

To make sure that we won more in stock and secondly to make sure that we executed and the fact we had at our Naperville facility. So, I think we're pleased with the results and really not surprised that where it ends up because just like I say it's pretty much in line with our expectations.

And if Dan has anything there?

Daniel Sullivan

No, that's it. I think you cleared up all.

James Harrison

Thank you, Dan.

Rick Nelson

Dan or Jim, can you provide more color around with the roll out plans for the party planners, you seeing a nice comp lift pursues the rest of the store.

Daniel Sullivan

Yes. We continue to be really encouraged by the results that we're seeing. We actually as I said in my prepared remarks, we actually launched 16 new stores in the third quarter. So, this is still very much in pilot and then pilot expansion mode.

The key learnings, Rick, that we're seeing so far is obviously the importance of continuity. So, we put a lot of effort into the further training and development of the associates. We've significantly reduced turnover of those associates and not surprisingly the more mature stores are actually performing at an even better rate than what I discussed in my prepared remarks.

As far as the expansion of it goes, that's obviously what we'll we are preparing now for 2019 but we've seen certainly enough in proof-of-concept that we know we have the right model here. And so, Ryan and the team will ultimately determine how fast this model gets deployed across the fleet and that'll be part of our 2019 plan.

Rick Nelson

Okay. How many stores that will touch?

James Harrison

We're not there yet. Again, we have to remember, we're almost new in 60 of the 150 stores we're in today. So, this is still very much early pilot for us. But we'll certainly bring that forward in our Q4 call.

Rick Nelson

Okay, great, thanks and good luck.

James Harrison

Thank you, Rick.

Daniel Sullivan

Thanks, Rick.

Operator

Our next question comes from the line of Simeon Gutman with Morgan Stanley. Your line is open.

Simeon Gutman

Good morning, guys. I want to piggy back off Seth's question to start with the call. So, the EBITDA history has been pretty steady overtime. This was pretty uncharacteristic this quarter. And I think the key question is separating out the temporariness of both the top-line short fall and the higher cost.

And it sounds like you made pretty good reasons why that they should sort of roll off, why this isn’t some unusual period of cost that will persist. But can you again explain why a little more detail and then talk about the timing of when we should start to sort of see relief from both the top-line and in the cost side?

James Harrison

I'll turn that over to Dan. Good.

Daniel Sullivan

Yes, nice to meet. So, look as we said in the prepared remarks, we expect gross margin rates to be flat to slightly down for the year. And this outlook reflects about a 150 basis point gross margin pressure in Q4. And that is a combination of the one off items that we've discussed so far as well as some of the structural inflationary challenges.

On the one off side, we feel very comfortable that about 2/3rds of the pressure in Q4 is of the one off nature. It's coming from the significant disruption and challenge that we had in China, whether that'd be in manufacturing pressures, whether that'd be in the capacity constraints on the ocean that drove up rates. Whether that be in an unusually amount of air freighting enough product.

We incurred higher wages in our DC's due to overtime. So, the pressures that came out of the operational issues in China were significant and that is as I said a large portion of the headwind will face in Q4.

In terms of more of the structural and inflationary headwinds, I assume to about 25 basis points to 30 basis points, this has nothing to do with tariffs, this is very much logistics and distribution and freight pressures which we've been talking about.

And so, as we think about that, we're in a very unique position as a vertically integrated operator that we have opportunity to address this. We'll continue to expand the vertical and you'll continue to see manufactured share of shelf increase for us, you're considered to see Granmark increase that look to do significantly more volume than they do this year.

And will also continue to focus on making the vertical more efficient and investing in CapEx that can help drive automation in our manufacturing production. So, that's how we think about sort of the margin pictures and how the pressure that we will see this year ultimately, we think we'll ease and will be addressed by the vertical.

James Harrison

Yes. And just to add to that, the other pressure we've mentioned in our comments several times is helium. And as I said, we -- all indications from the experts on the subject are that by the middle of this month we should see the headwinds on helium substantially start to subside.

And we fully expect to be totally in stock with helium for December selling season which obviously includes New Year's which is a very big holiday for balloons. So, we're got to be very optimistic of the helium situation as well will resolve itself later this year and not be a true headwind next year as well.

Simeon Gutman

Okay. And then, my follow-up just digging a little deeper into Halloween. In October or leading up to what Jim discussed whether in store or online. If you're seeing the consumers lead time extend as they purchase ahead of the holiday or is it still last minute very close up until the date?

James Harrison

I would say it was complete servitude that the consumer is buying later and later every year. If you look at our sales and on a daily basis, you would see a tremendous surge of activities actually in the last five days particularly at the store level.

In terms of online, that consumer obviously tends the buying in advance of season but once again between both is as well as 24 to 48 hour delivery, we continue to see a pretty steady flow of consumer activity right up to the last couple of days before the holiday itself.

So, I think the consumer continues to buy late particularly at store level but even the consumer online has certain expectations for being in stock and being able to deliver products even at the last minute.

Simeon Gutman

Thank you.

Operator

Our next question comes from the line of Mike Baker with Deutsche Bank. Your line is open.

Mike Baker

Hi. Two questions. One, in the past you've been able to share some data on your market share for the Halloween business because of your relationship with some of your competitors as they're suppliers. So, if you could comment on Halloween market share and how your results compared to others.

And then, secondly, I believe I thought you said that your share of shelf was down, like say about 90 basis points, I can't remember it ever being down which has been a while it's been down year-over-year in any given quarter. So, can you flush that out a little bit for us? Thanks.

James Harrison

Sure. So, I'll do with your first question in terms of market share. As we mentioned in our remarks, our total how October business at retail was globally was up 4%. I believe that we've actually gained share with that 4% number compared to where we were in the prior year.

As it elevates to the business we do with third party customers, most of our business for Halloween with the returning customers is not costume related. For one very large reason which is our license portfolio properties is only available for us to sell at Party City and Party City sites as well as on Halloween City.

So, I think the independence clearly look to other resources for those license products. So, we from a costume standpoint, it really is not relevant for us to look at the independence. In terms of the party side of the business, it was pretty consistent on a year-over-year basis.

I'll let Dan to address your early question regarding the shelf.

Daniel Sullivan

Share of Shelf. Yes. So, we were down about 80 basis points in absolute Share of Shelf, about half of that Mike, is related to the operational issues that we had getting product out of China. But remember, in Q2 actually total share of shelf was flat.

I think the more important matric is manufactured Share of Shelf, it becomes less important to our gross margin accretion that we grow share of shelf as it does that we grow manufactured Share of Shelf. And in the quarter we grew that 90 basis points year-over-year.

Mike Baker

Okay, thanks. I appreciate the color.

James Harrison

Thank you, Mike.

Operator

Our next question comes from the line of Joe Feldman with Telsey Advisory Group. Your line is open.

Joe Feldman

Hi, good morning guys. Thanks for taking the question. I wanted to go back, you guys mentioned a comment about marketing spend was flat but you shifted towards more digital and social. And I was just wondering if you guys in hind side looking at that, was that the right decision and with more traditional as advertising will help better for this quarter period.

James Harrison

I'll throw the question to Ryan.

Ryan Vero

Yes, sure. I think a couple of things. First of all, a lot of our digital spend is evolving to a real consumer direct CRM focused stand, so that we're targeting customers where they are whether they're it could also be video by the way. It's just consuming it in the channels where they are currently consuming video including a lot of online.

We did do quite a bit of traditional media during the Halloween season. That maybe is typically more focused closer to Halloween itself which takes it out of Q3 and puts it into Q4. And so, while overall our spending in Q3 was relatively flat, it is not as material as the spend that we do in the October period where we do quite a bit of national broadcast.

And in fact, this year focus more of our broadcast stand on major media networks and real high quality broadcast programs including Thursday night football and some of the other top popular shows on the major broadcast networks.

Joe Feldman

Thanks. And then, a follow-up on the gross margin. You guys mentioned that you're shifting some of the promotional spend in the fourth quarter. Can you explain that again, I guess I didn’t follow that?

Ryan Vero

Yes. It's just a year-over-year shift, Joe, from -- we spent a bit more ahead of the holiday last year in Q3 and some of that spend was shifted into Q4 for us. That was the only point I was making. So, some of the margin favorability that we saw in Q3 is a timing headwind in Q4.

Joe Feldman

Okay. That's helpful, thank you. Good luck, guys, thanks.

Ryan Vero

Thank you.

James Harrison

Thanks, Joe.

Operator

Our next question comes from the line of Curtis Nagle with Bank of America. Your line is open.

Curtis Nagle

Good, thanks very much. So, I appreciate the comments in terms of trying to quantify the exposure at I guess the extent that tariffs, disruptions of I heard running so far, I think you quantified about 12 million at this point. Is that under the current 10% and I guess what would 25%. Thank you.

Daniel Sullivan

Okay. Let me try and -- try this again. If we look at what we bring in from Asia, from China, and on a full-year basis, approximately 15 million of purchases would theoretically be subject to the full 25% tariff which would go in effect on January 1st. that would be a full-year exposure of $12 million.

We have not incurred $12 million of exposure nor do we anticipate incurring anywhere near $12 million of exposure because we have the ability through our own manufacturing through our organizations throughout the world, particularly in Indonesia, Vietnam, India, Cambodia and other geographies to resource from other places.

We also have the ability to resource a number of major categories actually domestically because the domestic pricing now becomes much more competitive with the China ultimate China course and actually substantially below the China course. And we also have the ability to manufacture product there sales on our Mexican factory as well as potentially some of our other factories.

So, the theoretical potential exposure is roughly $12 million based upon the current legislation at the full 25%. The real exposure we expect to be substantially less than that. And I have even mentioned the opportunity for us to raise prices because remember we are the leader in the category, we're the industry leader.

And if we can't resource it and if we can't make it ourselves and we still have to buy it with the tariff on it, so too with all of our competition. I hope that clarifies that.

Curtis Nagle

Greatly. Yes, much appreciate on that. And then, just a quick one I guess on capital allocation. Look, obviously shares are trading at quite a low valuation and hopefully this should be tough year. But I guess just looking at the current levered position, looking at rising rates, looking at the fact that at least it doesn't seem like the market's giving you credit for buybacks.

Why not just at least at the moment focus more on debt reduction and get interest cost down?

James Harrison

Right. That's a very good question. So, when we look at where our stock prices today, as I mentioned, we believe it is then following-up your comment, we believe it is depressed. If we look at our stock at the current price, the cash-on-cash return, looking at free cash flow to find it, it'd be a minus interest, minus tax.

If the cash-on-cash return north of 15%, we think that is from a purely economic standpoint a good use of capital and in the best interest of our shareholders. We also believe that we should do this in a very prudent and measured way that the reason for borrowing money should not be to reduce equity.

But given this opportunistic purchase opportunity today, we believe that in the context of our ability to deliver, we have more than enough capacity to deliver our balance sheet and make this nominal amount of purchases.

Curtis Nagle

Okay, fair enough, I appreciate it.

Operator

Our next question comes from the line of Tami Zakaria with JP Morgan. Your line is open.

Tami Zakaria

Thank you, and good morning. I have two questions for you. The first is, could you comment on the past Halloween season in terms of promotion. Meaning, was it more promotion now and did you have to react accordingly?

James Harrison

I would say that on balance and I'll ask Ryan to chime in. obviously, on balance we were probably higher pursued from commercial standpoint. Now we did the promotions probably different from historical based upon the changing ship the consumers buying. But I'll throw it to Ryan.

Ryan Vero

Yes. I would say it's not materially different than the past year. I think that we have the benefit of having a very unique assortment of products, so that much of the product as Jim mentioned we have from a license perspective, it's only carried by Party City which gives us the ability to price those items against ourselves and nobody else because they don’t carry them.

Certainly the channel behavior between the web, obviously a bit more promotional of a medium in the stores and so there's some impact of that but as a broad statement I would say the promotional activity at the season was relatively consistent with the past.

Tami Zakaria

Thank you, that's helpful. And my follow-up question would be, could you remind us what percent of your business are balloons and regarding the helium shortage what are some of the wage you're planning to mitigate that?

James Harrison

So, first off we do not disclose our sales on a product category basis. But it's obviously one of the key products offered on stores out of 28,000 products and stores as a category as when the larger categories. In terms of mitigating the helium shortage, really is a matter of just finding resources and paying a premium price.

We're paying significant premium rate now of 15% to 25% on helium as we look to source it from intermediaries. As I mentioned earlier, we expect this to ease in the second half of this month into the fourth quarter and into the next year.

I do want to point out that we had helium shortages in 2012 and 2013. The shortages there are not as severe they were back then. It for whatever reason it seems to be a cyclical issue, that's exacerbated by geopolitical events like in guitar, where guitar is probably getting the helium, if it's 1/3rd of the world's helium and because of their political issues with Saudi Arabia, they had to find new routes to market not through Saudi Arabian ports.

And then unfortunately when the ports that were built to support this was hit by tycoons, I mean it was a cacophony of events that clearly created this disruption. But I think at the end of the day, we expect that to just stabilize. In balloons, we are the worldwide leader in metallic balloons both from the standpoint of selling them as a retailer as well as from the standpoint of being the primary manufacturer of approximately 60% of the worldwide sales of metallic balloons.

And we also obviously saw a tremendous amount of latex balloons more so which are manufactured on own facility in Madagascar.

Ryan Vero

If I could, this is Ryan, just add a couple of other mitigation things that we're focused on as Jim mentioned our relationship with Anagram is obviously very helpful. And they have developed a number of products that allow us to sell high impact balloons that actually require less helium in them. So, that's one of the things that we're focused on right now.

And then secondly, as I think we've talked about in previous calls, we've invested in improving our in-store distribution system for helium to reduce waste in the system.

So, the way that we connect the tanks from the back of the store, the front of the store, are filling techniques within the stores really allowing us even with some significant allocation issues in helium that started earlier in the year actually to mitigate a lot of that through reduction of waste within our distribution systems.

Tami Zakaria

Got it, that's helpful. Thank you.

Ryan Vero

You're welcome.

Operator

Our next question comes from the line of William Reuter with Bank of America. Your line is open.

William Reuter

Good morning. My question is on the wholesale segment. I guess I'm wondering whether there was any change or whether you've seen a change in the number of doors that you're currently servicing I guess domestically. Or whether you're seeing any changes in terms if wholesale customers in terms of an allocation of space through categories.

And I guess I'm speaking more in relation to the Halloween season.

Daniel Sullivan

Sure. So, with respect to the -- we need to break the market down into really channels, right. So, with respect to the independent side of the business, the independent side of the business is in terms of number of doors is the actual thing. Party City's presence and the this year way in of the Party City presence puts a pressure on the independence and it makes it difficult category to compete against Party City and as well as the mass market.

We're seeing tremendous opportunities and gaining some nice traction as I said earlier and some tail winds in the mass and in gross rate in drug and in craft. And that is will fuel the growth of the consumer products business outside of our own stores.

Internationally, we've done a good job of building store concept and that is gaining traction. So, as we look out to the geographies outside of the United States, stores is gaining a lot of traction and will continue to be a source of growth. But in terms of these the Halloween side of the business, our observations as I mentioned earlier because we don’t really sell costumes into the mass or into many other retailers is more anecdotal than it is based upon any data we have.

But we've seen some shifts in the market in terms of people's presence in Halloween, some expanding some reducing but as I mentioned earlier I believe we gained share this past Halloween.

William Reuter

Okay. And then just one follow-up from me. The deleveraging path has been a little bit different than we had expected based upon share repurchases or alternatively a little bit of software results. Can you remind us where you hope net leverage to go maybe over the next year or two?

James Harrison

So, as Dan said in his remarks, we expect next year to be about three five.

Daniel Sullivan

No, 2,200.

James Harrison

2,000 right. It is three five. I mean, would expect it to continue to de-lever. Our goal is to get down between around three.

William Reuter

Great. That's all from me, thank you.

James Harrison

Thank you.

Operator

There are no further questions at this time. I'll turn it back over to you.

James Harrison

Thank you, operator. Once again everybody, thanks for joining us in the call. As always, myself and Dan remain certainly available for any follow-up questions you all may have. We appreciate your continued interest to support the business. And we look forward to speaking to you soon.

Take care.

Operator

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