School Specialty, Inc. (SCHS) CEO Joe Yorio on Q3 2018 Results - Earnings Call Transcript

About: SmartChase Corp. (SCHS)
by: SA Transcripts

School Specialty, Inc. (NASDAQ:SCHS) Q3 2018 Results Earnings Conference Call November 9, 2018 8:00 AM ET


Glenn Wiener - IR

Joe Yorio - President and CEO

Ryan Bohr - EVP and COO

Kevin Baehler - EVP and CFO


Kevin Tracey - Oberon Asset Management

Patrick Retzer - Retzer Capital

Craig Carlozzi - Bulwark

Charles Neuhauser - Mainwall Investment


Good day, ladies and gentlemen, and welcome to the School Specialty’s Fiscal 2018 Third Quarter Results Conference Call. [Operator Instructions] And as a reminder, today’s conference call is being recorded.

I’d now like to turn the conference over to Glenn Wiener, Investor Relations. Please go ahead.

Glenn Wiener

Thank you, Candice, and good morning, everyone. Welcome to School Specialty’s Fiscal 2018 Third Quarter Results Conference Call. On our website, under the Investor Relations section, you’ll see our Form 10-Q, press release and updated investor presentation. All documents can be downloaded, but if you need a copy, please feel free to reach out to my office.

Joining us today are Joe Yorio, School Specialty’s President and Chief Executive Officer; Ryan Bohr, Executive Vice President and Chief Operating Officer; and Kevin Baehler, Executive Vice President and Chief Financial Officer. All will have prepared remarks and will be available during the Q&A portion of our call. Additionally, the call today is being webcast on our website under the Investor Relations section, and we also have a replay available for those who are unable to join today.

Before I turn the call over to Joe, I’d like to remind everyone that except for historical information contained herein, statements made on today’s call and webcast about School Specialty’s future financial condition, results of operations, expectations, plans or prospects, constitute forward-looking statements. Forward-looking statements also include those preceded or followed by the words anticipates, believes, could, estimates, expects, intends, may, plans, projects, should, targets and/or similar expressions. These forward-looking statements are based on School Specialty’s current estimates and assumptions and, as such, involve uncertainty and risk.

Forward-looking statements are not guarantees of future performance, and actual results may differ materially from those contemplated by the forward-looking statements because of a number of factors, including those described in the company’s Form 10-K. Any forward-looking statements on today’s call and webcast speaks only as of the date on which it’s made. We undertake no obligation to update any forward-looking statements to reflect subsequent events or circumstances. Except to the extent required under the Federal Securities Law, School Specialty does not intend to update or review the forward-looking statements.

At this time, I’d like to turn the call over to Joe.

Joe Yorio

Thanks, Glenn, and good morning, everyone. First, I’d like to apologize particularly to our West Coast colleagues for the movement of the call to 8:00 AM Unfortunately, due to some customer commitments, we have to bump it up early. So I apologize for that. As you saw from our results and the commentary in our release, we had a challenging third quarter and have lowered our outlook for the year. This is due to challenges on multiple fronts, which we fully understand and have been working diligently to address. Every challenge we face has been addressed and corrected. Our strategy remains intact and my view of the opportunity for our company and my commitment to make it happen is even greater and more resolute.

In our third quarter, staffing challenges and high turnover in our fulfillment centers at the height of our peak season resulted in shipping delays and large backlogs at quarter-end. The backlog has been abated and our fulfillment centers are operating according to plan, but this has impacted our results and our outlook. Given our operational success over the past 3 years, the challenges this peak season were very disappointing. Assuming the labor market remains extremely tight, we’ve developed a number of changes to our labor plan and contingencies for next year to ensure our challenges do not repeat. However, more importantly, myself and other leaders in the organization have been spending considerable time with our customers to ensure that we retain their confidence. While certain peak season orders may have been delayed or lost, we are not seeing customers stop doing business with us and the order trends have improved in the fourth quarter.

Fortunately, our Furniture supply chain operated quite effectively throughout peak season, which helped us maintain double-digit growth rates and continued to be a market leader in this area. As our year-to-date and outlook show, science curriculum and Instruction & Intervention have continued to trend below my expectations. Much of this, particularly in Science, is timing. And I’m very confident these areas will produce strong results in 2019. You may recall that prior to the Triumph acquisition, our sales coverage for Instruction & Intervention product area was limited. Post-acquisition building a combined strong I and I sales team took longer than we expected. But we have a new leadership team, a good coverage plan in place and the team is positioned to perform well in 2019.

For some time now, I’ve talked about the need to reset our margin expectations in certain categories within the Supply Systems line. This is based not only on my years of experience with Corporate Express, Staples and Unisource but also on competitive intelligence and our performance trends in these areas. We executed on this initiative and as a result, we’re moving more volume, increasing our touchpoints with customers and positioning ourselves to expand our business into other higher-margin areas. Yes, it did contribute to some margin erosion, but this was a necessary step as some of our commodity product prices were out of line with competition.

Please do not misinterpret this as an action, that we were absolutely not trying to lead with price. That was never our intention. There were simply certain areas where we unquestionably needed to be in line with the competition. Unlike many of our niche education suppliers and large office supply competitors, we have a greater depth and breadth of products and services to bring to the customer. And that advantage is key to our long-term success. I believe that the company’s historical efforts to maintain margin led to the gradual erosion we experienced in recent years. Ryan will cover this in more detail but the real impact to our margins have been the mix of products purchased. Where we clearly have underperformed is leveraging our relationship with customer to sell higher-margin items and more products under our brands. Deploying our team sale model effectively and better leveraging our inside sales associates is the key to customer penetration and improving this mix. The complete realignment of our sales organization the second half of the year is also key to accelerate our progress in this area.

Our Furniture business continues to excel. Q3 revenue was up over 12% and year-to-date revenue was up over 14% with a continued strong demand. We’re seeing strong growth in basic furniture sales, up 9.4% and exceptionally strong growth and furniture sales within the learning environment projects, which were up 23.9%. We are aggressively building out our capabilities as a comprehensive 21st century learning environment partner. This is an anchor element in our 21st Century Safe School value proposition as it’s more than furniture and equipment. We’re creating the environments needed to advance student outcomes and address the social, emotional, mental and physical well-being of students. We believe sales in this area will continue to build next year and beyond. Success in learning environment projects is also a key gateway to expanding our business in the basic supplies, Early Childhood, Special Needs, Safety & Security, art, science supplies and Ed Tech. And we’re now beginning to better leverage these synergies through better sales collaboration.

Throughout the year, we’ve been looking at product lines, acquisitions and potential partnerships up and strengthen our position in the Ed Tech product area, which is a key component of a comprehensive learning environment offering. We’re not rushing into this, and we want to make sure that the new products resonate well with our customers. But we do expect to see some momentum on this front in 2019.

We’re now 11 months into the year, and we have a pretty good handle on how 2018 will finish. Yes, we are going to be materially below our expectations and I’m not happy about that. As CEO, this rests squarely on my shoulders and I accept full responsibility. However, they should not take away from the bigger picture and the opportunities ahead of us. I strongly believe in our strategy, as does our team. It’s solid and it’s disruptive. And the initiatives we’ve executed this year will have a positive impact and will further our position in the future.

In 2018, we changed sales leadership, completed the restructuring of our sales force and aligned the company on our go-to-market strategy behind the 21st Century Safe School value proposition. For 2019, our field-based team will focus on larger districts and our rapidly expanding inside sales team will not only collaborate with the field organization but will also more effectively and directly cover small to medium-sized accounts. We hired a new Senior Vice President of Marketing and are expanding their team. This team is focused on the revitalization of our overall image, building our brand awareness and better positioning our highly recognizable products and services to ensure we communicate the 21st Century Safe School value proposition effectively in the marketplace. We’ve expanded and realigned our team of subject matter experts and sales specialists in the area of Early Childhood, STEAM and learning environments, especially important as we drive growth in the specialty areas and support the overall learning environment initiative.

Finally, we’ve just recently created regional development roles to engage and build relationships at the most senior levels within education, including administrators, board members and trade organizations. All of these steps enable us to move away from being viewed solely as a transactional catalog company. We are much more engaged with our customers of all sizes on a more direct and efficient basis at both a higher and more impactful level with more collaboration and more value. We’re deploying a two-pronged approach. In that, we are reaching key decision makers, those responsible for overall budgets and visions for the schools and school districts, while ensuring that we can still engage and serve the customers at a more transactional level with our inside sales team through more effective e-commerce and marketing strategies as well. This will enable us to improve the mix by selling the breadth and depth of our comprehensive products and services, utilize our knowledge and insight of industry best practices and bringing to the forefront the experienced professionalism of our sales team, which is a key strength. The bottom line is I expect to rebound in 2019 and have a strong year. So let me recap why.

Curriculum and Instruction & Intervention should have solid growth years and improve our margin profile. Furniture will continue to grow. And as we further integrate our offering and expand our services, it puts us in a position to sell additional products and services across the Distribution segment.

Safety & Security has been growing significantly. And while it’s still a small part of our overall mix, we are pushing several significant opportunities in this area. Our strong position as a recognized national subject matter expert continues to pave the way for success in this area through engagement with legislators and decision-makers across the country and the amount of state and federal funding that has been earmarked for fiscal 2019 is significant. While the general supplies category is very competitive, our position continues to improve, and we have an opportunity to better leverage our standing on state contracts within purchasing cooperatives. Changes to our sales structure, new pricing methodologies and a heightened focus on our proprietary brands and more effective marketing campaign should help drive this category and 2019 and beyond.

Finally, our revenue, margin and transportation cost challenges this year have masked a positive impact of our Process Excellence initiative. And this will enable us to continue cost reduction and process improvement in 2019. We have a great opportunity to drive meaningful growth and profitability in 2019 and beyond. And while I’m not pleased with the pace that we’ve moved at and the results relative to our plan, I’m very pleased with the way we continue to position ourselves for sustained and future success.

Now, before I turn the call over to Ryan, just one more comment with respect to our potential NASDAQ up-listing. All the paperwork is in, and we’ve addressed all of NASDAQ’s inquiries. The only thing that remains is that -- the addition of one independent director to our board. We’ve engaged an external recruiter, and we’re evaluating options while we’re working to have this completed shortly. But, of course, we want to make sure it’s the right fit for our companies and our shareholders. With that, I’ll now turn the call over to Ryan. Thank you.

Ryan Bohr

Thanks, Joe. While there are some important positives embedded in our 2018 year-to-date performance and outlook, it is clear that we have experienced certain challenges and underperformed our expectations in key areas. Joe has provided some insights into that, and I will provide some additional detail and information. From a revenue perspective, Science and Instruction & Intervention are trending considerably below expectations. And in the case of Science, below prior year overall. This has had a pronounced impact in both our top line gross margin and bottom line performance versus our expectations given the relatively high margins in these product areas. Science curriculum was expected to be down in 2018 with limited adoption in large open territory opportunities slated for the year. However, performance will be lower than expectations, as the result of certain large opportunities planned for the second half of 2018 moving into 2019.

Our current outlook is that Science curriculum will be down in excess of $12 million year-over-year, which has a particularly significant impact on our gross profit and bottom line. However, between pilot programs in process and existing customers in the midst of multiyear implementations, we have visibility into nearly $10 million of large opportunities, excluding California, which present a significant opportunity for us in 2019 and 2020. These opportunities, plus the impact of the California adoption drive optimism for a strong rebound in 2019 and 2020 for our Science curriculum business. While the I&I product -- within the product -- the Instruction & Intervention product line. While we expect to report considerable year-over-year growth, it is driven by the full year impact of the Triumph Learning acquisition. On an organic growth basis, the product category will be down modestly year-over-year.

There are two key drivers of the underperformance. In conjunction with the acquisition of Triumph, we worked to build a single, strong team of supplemental and intervention curriculum sales specialists to drive sales across this now $60-plus million I&I category. While we expected this to be completed early in 2018, the I&I sales team and coverage model was not fully in place until midyear. This created some coverage gaps during the core selling season for this important, high-margin product line. The opportunity for sale synergies remains, and we expect organic growth in the I&I product line in 2019. Further, despite the transition in the I&I selling organization, our proprietary Worldly Wise and Spire family of products, are showing year-over-year organic growth. Another factor negatively impacting our performance is the limited number of new products brought to market, specifically relating to the Coach product line. We have a new leadership within our supplemental and intervention curriculum publishing team and have several new products in development that will enable growth in 2019 and beyond.

Now I’d like to turn to the Supplies product line. While year-to-date, the Supplies product line is reporting a decline of $6.4 million or 2.5%. Booked sales at quarter-end were actually up $7.7 million or approximately 3%. We exited Q3 with $16 million of open orders in the Supplies product line, which was $10.7 million higher than last year. The high open order position wound down completely in October, and our current open order position is consistent with prior year.

Although we expect the Supplies category to report considerable growth in Q4 and finish the year up approximately $6 million or 2.1% year-over-year, we have lowered our full year growth outlook based on the fact that our year-over-year booking trends weakened in late-August through mid-October through primarily to shipping delays experienced in our fulfillment centers.

Specifically, from the last week in August through the third week in October, we experienced a 7% year-over-year decline in Supplies bookings. Order trends have improved considerably and the fourth quarter is currently flat to prior year. While our outlook assumes that we have lost some late-season peak orders or fill-in orders, we are also aware of other industry participants, who have experienced similar shipping delays this season. Recent trends may indicate that follow-on orders have simply been delayed.

Importantly, we did not experience an increase in order cancellations and our analysis does not indicate that we have lost customers. While a temporary setback in the fulfillment centers dampened what was trending to be the strongest year of growth in the Supplies product line in several years, our gross margins in the supplies product line are trending to be down approximately 380 basis points. While partially offset by volume increases, Supplies gross profit is expected to decline by approximately $9.5 million in the current year. This is a key contributor to our underperformance in the current year. The anticipated full year variance in the Supplies gross profit and gross margin can be broken down as follows. Volume increases associated with strong customer penetration is estimated to have approximately a $3.5 million positive impact on gross profit; mix of products purchased within the Supplies product line is expected to have nearly a $5.5 million negative impact on gross profit and drive approximately 195 basis points of the gross margin decline.

Our Supplies product line is very broad and consist of more than 60,000 items across 12 departments. The standard margins within this -- within these departments can vary significantly from a low of 28% to nearly 42%. Cost increases are expected to have a negative impact of approximately $2.5 million. Cost increases have reduced Supplies gross margin by approximately 80 basis points. We have experienced overall cost inflation in the Supplies product line of approximately 1.6%. Lower effective selling prices at the item level is expected to have approximately a $5 million year-over-year negative impact on gross profit and reduce gross margins by approximately 105 basis points. This indicates overall price compression of approximately 1.8% for items offered in both years.

Importantly, approximately third of the price compression relates to the full year impact of the multi-year New York City contract which became effective in May 2017. This is a reset after experiencing more than five years of relatively fixed prices. The balance is attributable to efforts to ensure pricing is competitive on key commodity items and continued increases in the use of purchasing cooperatives by our school districts. While we just walked through the expected Supplies product line performance in detail, I’d like to provide some higher-level perspectives.

First, price competitiveness in the market was not materially different in 2018 than in prior years. Limited demand for -- limited demand growth for basic supplies, pricing transparency and usage of cooperative purchasing agreements will continue to ensure that commodity products are competitively priced. For certain products and groups of products, we needed to better utilize competitive market intelligence to reset our expectations in those areas. Our long-term growth strategy is not to maintain above-market margins in basic supplies, office supplies, paper and other more commoditized items. It is to leverage competitive pricing in those areas and bring to our customers what our competitors cannot. And that is comprehensive 21st Century Safe School value proposition that not only encompasses specialty areas within Supplies, such as our Early Childhood, Special Needs and Safety & Security, but outside of supplies: in Furniture; Science, Instruction & Intervention.

To put our focus in perspective, consider the following. Within the 12 departments in the Supplies product line, three had negative compound average growth rates from 2014 to 2017. And the overall compound average growth rate was a negative 1%. This excludes our business through Amazon, which continues to show strong growth. All but two of these departments had lower gross margins in 2017 than in 2014. Overall, the gross margin rate had declined between 70 and 90 basis points annually. It’s based on these trends that we’ve taken smart action. Through September, we have seen growth in bookings in 11 out of 12 departments and overall bookings growth of the 3%, which we mentioned. We have been successful, reversing trends in a number of these categories and improving our penetration. However, we have not been as effective as we had planned in driving sales in higher margin departments and shifting mix towards our higher-margin proprietary brands. Specifically, our top proprietary brands within the supplies product line represent approximately 27% of sales in 2018. This is compared to 29% in 2017. Margins associated with these brands are considerably higher than the Supplies product line overall.

Further, products within the PE, Special Needs and Early Childhood areas of supplies are relatively higher margin categories within the product line. These specialty areas represent approximately 13% of the Supplies product line and bookings in these areas are collectively down 2% overall. Strong performance in Early Childhood has been offset by flat performance in Special Needs and declines in PE. The bottom line is that we need to more effectively deploy strategies to improve mix, increase our penetration of our brands and better leverage our strong position within purchasing cooperatives, which is a competitive advantage.

In 2018, we have made considerable organizational changes in sales and marketing, aligned with addressing our performance against these objectives and expect those changes will have a positive impact on 2019. The revenue and margin challenges I’ve discussed in detail have clearly overshadowed continued strong performance in the furniture area, which is up 14.1% year-to-date. Our ability to provide comprehensive learning environment solutions continue to resonate with customers and the architectural design firms that support the education market. We are investing in learning environment sales and support organization, enhancing our product line and expanding the range of services we can offer our customers. We expect investment in learning environments to remain strong. And we are well-positioned to continue to benefit from this. However, we have an opportunity to better leverage learning environment opportunities to drive sales in the Supplies, Safety & Security and Ed Tech product lines.

In 2018, we have some nice examples of combining furniture opportunities with supply bundles, particularly as it relates to Early Childhood learning environments. We have a competitive advantage in this regard, and we are focused on better capitalizing on it.

Partially offsetting our strong furniture growth has been a year-over-year decline in gross margins associated with this product line. We currently expect full year gross margins to decline approximately 180 basis points overall in the furniture area. The net impact of price and cost changes at the item level has had a positive impact on gross margin. The negative impact is entirely driven by the mix of items being purchased by our customers and the completion of certain large projects, which tend to carry an overall lower margin.

Transportation cost increases have had a meaningful impact on our bottom line year-over-year. Based on how we report our transportation cost, the majority of the impact is recognized in SG&A with a lesser amount impacting gross profit. We recognize transportation costs for products shipped from our fulfillment centers in SG&A. Through September, we have experienced approximately a 15.8% increase in our outbound transportation cost. This has had a year-to-date impact of approximately $4 million, and we are estimating the full year impact to be nearly $5 million. Transportation costs have also had a negative impact on gross margins. Increases in transportation costs relating to vendor-direct shipments have had nearly a $2 million year-to-date impact on gross profit and are expected to have approximately a 46 basis point impact on full year gross margin within the Distribution segment. While the transportation cost increases we are experiencing appear to be consistent with what is being reported in the market, they are higher-than-expected. We have identified a number of changes we can implement working with our customers, vendors and carriers to lower cost in 2019. But the transportation market remains very tight.

After three exceptional years of performance in our fulfillment centers, we experienced challenges during the peak season, which Joe alluded to. The challenges stemmed from our ability to attract and retain quality seasonal employees in a period of historically low unemployment. In the early part of the season, we had challenges ramping up our seasonal workforce in accordance with our staffing plan. Through a combination of wage increases, incentives and enhanced recruiting efforts, we were able to ramp up hiring. However, we experienced materially higher turnover and relied more heavily than normal on staffing agencies. Specifically, during the months of May through September, we hired approximately 50% more seasonal workers, 600 versus 400. But higher turnover left us with only a comparable level of labor hours. High turnover in an unpredictable workforce resulted in a 7% to 10% decline in productivity in the peak season. This caused a backlog in our fulfillment centers and ultimately the shipping delays referred to. In the month of September, our backlog reached a peak of approximately 18 days.

By late October, the backlog is reduced and our fulfillment centers were operating current. Q4 productivity through early November has been better than prior year. As we prepare for 2019, we are changing key aspects of our staffing plan to account for a continued tight labor market. The key to that will be the implementation of more flexible part-time shifts. In the face of the many challenges noted above, we have aggressively managed all other aspects of SG&A and expect full year SG&A to be relatively flat year-over-year as detailed in our investor presentation. In preparation for the coming year, we have been keenly focused on understanding inflationary and/or tariff-related cost increases. The Section 301 tariffs identified impact approximately 6% of our purchases. Total cost increases on these items amounts to less than $1.5 million. Beyond tariffs, looking ahead to 2019, we are seeing modestly higher cost inflation as compared to 2018. This will be factored into our pricing for 2019. And note that the majority of our multiyear pricing agreements generally allow for pricing adjustments based on market-driven cost increases. As Joe mentioned, despite some of our setbacks in 2018, we firmly believe our strategy to deepen customer relationships, better drive penetration of our unique set of products and services and leverage our capabilities as a 21st century learning environment provider remains intact.

Looking ahead to 2019, we are expecting significant improvement in our financial performance from a top line, bottom line and cash flow perspective. A rebound in Science and I&I, 2 high-margin categories, are expected to lead the way from a revenue perspective. Preliminarily, we see $15 million to $20 million plus of growth in these areas. This will help our overall gross margins from a mix perspective and contribute strongly to the bottom line.

We expect our supplies growth rate to pick up in 2019. And we would expect supply margins to modestly improve through improved mix, refinements to our pricing and better penetration of our proprietary brands. In addition, our business with Amazon continues to be very strong, up 34% year-to-date. This presents considerable upside and many significant Safety & Security opportunities are beginning to emerge. Safety & Security is up 71% year-to-date.

The opportunity pipeline driving our Furniture business remain strong and will support continued growth. We expect our growth to be enhanced by improvements and expansion of learning environments sales and support organization, which will help us to identify and pursue a larger number of opportunities.

Finally, we are confident our fulfillment challenges will not recur, and we will continue to manage cost effectively. We’ve had some setbacks, but our leadership team and associates throughout the organization are energized and confident we can deliver a strong 2019.

With that, I will turn the call over to our CFO, Kevin Baehler, who will provide further insights into our balance sheet, cash flow, taxes and other matters. Kevin?

Kevin Baehler

Thank you, Ryan, and good morning. I will start with our income tax. As you’ll notice, our income tax expense for the first 9 months of fiscal 2018, which was $9.4 million, resulted in an effective tax rate of 101.1%. Considerably above the combined federal and state statutory tax rate of approximately 26%. The most significant factor contributing to the high effective tax rate is the relatively minor amount of forecasted full year pretax income that we have for 2018. As pretax income approaches zero, even minor permanent tax adjustments between pretax income or loss for financial statement purposes and taxable income, can have a significant impact on the reported effective income tax rate.

As a result, it’s important to note that the year-to-date income tax provision through our third quarter and the effective income tax rate for 2018 do not reflect either our expected cash tax expense for the year or our anticipated effective income tax rate in future years. Expected fourth quarter pretax losses, as is typical for us due to our seasonality, will generate tax benefits to offset a substantial amount of the year-to-date Q3 tax provision of $9.4 million. Year-to-date net cash taxes paid are $1.5 million through September, and we’d anticipate cash taxes in the fourth quarter to be less than $0.5 million, resulting in full year cash taxes for fiscal ‘18 of between $1.5 million and $2 million. Our cash taxes consist primarily of foreign taxes related to our Canadian operations, state income and franchise taxes and a portion of the federal onetime transition tax from the 2017 tax bill related to repatriated earnings. We expect to generate a federal net operating loss in 2018 based in our current outlook, which we will utilize in 2019 to offset a majority of our estimated taxable income in 2019.

Beginning in 2019, we expect our effective income tax rate will approximate the statutory tax rate of 26%. However, cash taxes in 2019 are expected to represent approximately 5% to 10% of our pretax income due primarily to the utilization of the expected 2018 net operating loss and the use of other deferred liabilities. Beginning in 2020, again, we expect the effective income tax rate to remain at approximately 26% while our cash tax rate will begin to approach -- or be very similar to the effective tax rate that will report for financial statement purposes, again, beginning in 2020. As for balance sheet, cash flow and net debt, each of these areas was affected by the shipping delays, which Ryan covered during his remarks, as the delays and later shipment resulted in a shift to our cash conversion cycle, as cash collections are occurring later in the fiscal year and will lag into the early part of 2019 as it relates to the collection of receivables.

Focusing first on networking capital. Our net investment in working capital increased by $18.8 million or 10% in Q3 2018 as compared to Q3 2017. The net working capital increases are primarily related to accounts receivable, which is up $12.8 million year-over-year and days sales outstanding are up 3.7 days and inventory, which is up $11.7 million year-over-year with an increase of 3.1 days in days inventory on hand. A portion of the inventory increase is offset with a higher accounts payable balance of $4.8 million, which represents inventory increases that relate simply to the timing of purchases. The remaining inventory increase of $6.9 million and the entire $12.8 million increase in accounts receivable are directly attributable to the shipping delays mentioned by Ryan. The incremental inventory is tied to the fulfillment of the incremental open order position of approximately $14 million, which we carried into the fourth quarter. As our year-over-year open order position stabilizes in the fourth quarter, we expect our inventory balances and days inventory on hand will return to levels more consistent with prior year and more consistent with our expectations by year-end.

The year-over-year accounts receivable increase, as of the end of the third quarter, is related both to the timing of Q3 shipments, which skewed to later in the quarter as compared to past years, and the increase in the days sales outstanding of 3.7 days. The DSO increase is directly tied to the fulfillment center challenges, as our order complete rate and line fill rate, which are two key fulfillment center metrics, decreased in Q3 2018 as compared to Q3 2017. As many districts issue payments only when their purchase orders have been 100% fulfilled, decreases in order complete and line fill rates can have a negative impact on days sales outstanding.

We expect our accounts receivable balances to continue to be up year-over-year throughout the fourth quarter, as the incremental open orders from the end of Q3 ship in Q4. However, the year-over-year gap will there roll throughout the quarter as Q4 cash collections will be higher in 2018 versus 2017. And we expect accounts receivable balances and the days sales outstanding metrics to return to historic levels by the end of January 2019 as we work through the shift in the cash conversion cycle. We do not expect that these increases in the receivable balances will result in any material increases in uncollectible amounts.

Free cash flow for the first nine months of fiscal 2018 has been negative $98.5 million or down $39.8 million from the first nine months of fiscal 2017. The combination of lower operating performance and fulfillment center challenges, which led to the working capital increases and a shift in the cash conversion cycle are the main drivers of the year-over-year decline. The working capital increases and the shift in the cash conversion cycle, though, are both timing and we expect Q4 2018 net cash generated in the fourth quarter to exceed Q4 2017 net cash generated by approximately $20 million. In Q1 2019 cash flow will benefit from the shift as well by an estimated $10 million. The resulting full year free cash flow for 2018, which will be approximately zero or down $20 million from 2017. Full year estimated decline is comprised of a $10 million of lower EBITDA year-over-year as indicated in our current guidance and $2 million of the $10 million timing shift related to the cash conversion cycle shift, which pushes the cash collections from approximately $10 million of cash collections from 2018 into the early part of 2019. Full year capital expenditures and product development spend are expected to be approximately $19 million, relatively consistent with fiscal 2018 amounts.

As for debt levels, our net debt is up $23.9 million at the end of Q3 2018 versus 2017. The main drivers of the incremental debt are: number one, $19.8 million of negative free cash flow over the trailing 12 months; number two, noncash interest accretion of $2.1 million in our deferred payment obligations; and number three, $1.6 million of post-closing working capital adjustment and contingent purchase price paid for the Triumph Learning acquisition. Based on our free cash flow guidance, end of year net debt will be up approximately $4.5 million year-over-year.

Finally, as discussed in our Q3 Form 10-Q, we have amended both our term loan and ABL debt facilities. Following the end of our third quarter, we determined that the adoption of ASC 606, which is the new revenue recognition standard, for purposes of calculating our financial covenant ratios was required in order that the fixed cost coverage ratio meet our term loan’s minimum required ratio for the quarter. While ASC 606 was adopted for financial reporting purposes as of the beginning of 2018, our debt agreements require that the coverage ratios were to be determined under prior GAAP unless the company notified it -- the lender -- our lenders of its intent to utilize the new accounting standard in the calculation of the financial ratios and be the agreements were amended accordingly. At the end of the third quarter, we did notify the lenders of such change and thus, have amended the agreements accordingly. The year-to-date benefit from the adoption of ASC 606 was $0.5 million, which as of Q3, is reflected in our financial coverage ratios. Since we approached our lenders to amend the debt agreements for purposes of reflecting the accounting method change, we took the opportunity to address prospective periods based on our 2018 performance.

As such, other provisions amended in our term loan included: number one, reductions in the required minimum fixed coverage leverage ratios for the next five quarters. The reductions range from a 0.5 turn reduction to a 0.20 turn reduction, again, in the fixed charge coverage ratio. We did not change the required maximum senior leverage ratios with the amendment; number two, a reduction in the number of days for fiscal 2018 for which our outstanding ABL borrowings are required to be zero. The original agreement required 60 consecutive days, including the last day of the fiscal year, for which ABL borrowings would be zero. The amendment reduces the number of days for which the outstanding borrowings are required to be zero to 14 consecutive days in the period covering December 15, 2018, through January 31, 2019. This provision in the amendment is related directly to the shift in our cash conversion cycle, which I’ve discussed earlier; number three, we also elected to terminate the remaining delayed draw term loan commitment of $16 million. The commitment would’ve expired in April of 2019, and it was unlikely that we would draw the $16 million over the course of the next five months. Terminating the delayed draw term loan commitment results in approximately of $100,000 of savings, primarily in reduced commitment fees; and fourth, that the fixed applicable margin at LIBOR -- the amendment fixed the applicable margin at LIBOR plus 700 basis points or prime plus 600 basis points from the end of Q3 2018 until we report our year-end results. At that time, the pricing will be determined based on the applicable margin in the original agreement, which is scale to our senior leverage ratio.

The ABL was also amended to reflect the accounting method change but there is no need to adjust either the financial covenants or the required minimum availability levels within the ABL agreement. These amended terms provide us with additional financial flexibility over the next five quarters. And based on our outlook, we are comfortable that we will remain compliant with these required financial coverage ratios. From a ABL perspective, our excess availability was approximately $38 million at the end of Q3 2018. And we also remain comfortable with availability levels over the next 12 months.

And with that, we’ll open up the call for questions.

Question-and-Answer Session


[Operator Instructions] And our first question comes from Kevin Tracey of Oberon Asset Management.

Kevin Tracey

So I think last year, you said that your branded products grew 5%. So that was a lot faster than the overall business grew last year. So now this year, we’re talking about mix being the biggest driver of the decline in gross margins. So I guess the question is, what change, is it sales force driven or some changes in the competitive environment? And I guess looking ahead to next year, do you think Next will continue to be a headwind?

Ryan Bohr

From the status of what’s changed when it gets down to actions at that an item level, nothing specifically has changed. However, what we are changing is our focus on it, our sales organization and all the things that we think are required to ensure that our customers are not just purchasing, kind of, more attractive products from a pricing or the everyday items that they need. It’s making sure that they’re also understanding and seeing the other elements of our offering. The other big thing is that we had -- we’ve been working on a better management of a good substitution program one of our biggest areas of opportunities within our School Smart brand. And that is -- that’s our largest brand within the Supplies category. And that is our, for all intents and purposes, core private label offering. And we have significant opportunity to do a better job of positioning that product line as an alternative to certain national brands. And it’s very advantageous for us to do that. So after experiencing some good traction in 2017, certainly, that shift from 29% of our offering roughly to about 27% was largely unanticipated.

Joe Yorio

Kevin, this is Joe. What I’ll throw onto that though is that the restructuring of the sales force, utilizing a much larger inside sales team with a much higher frequency of touch to those kind of smaller and more transactional customers will give us the ability to actually sell -- up-sell to more of the proprietary items that potentially those customers previously purchased just because they always bought from us. They knew our products. They had a consistent offering of products. Now someone’s actually reaching out to those customers and selling them, talking to them in a much, much more frequent manner. So we see a lot of encouragement in the upside to sell -- up-sell to our proprietary brands there, as well as the outside sales forces will be focused more on the larger accounts with a much more comprehensive business plan to penetrate those customers a longer breadth and depth. And in penetrating the breadth and depth, they’re going to focus on the proprietary items. So that two-pronged approach I talked about, I hate to say it but before it was just we always got in this customers. This is kind of what we did from a sales force perspective. Now it’s much more strategic and much more strategized based on the customer’s size and what they’re trying to doing and the initiative and the sales structure whether it be inside or outside and how we’re calling on them.

Kevin Tracey

Okay. And on this $15 million to $20 million worth of opportunities you see next year to grow the Science and construction and Intervention business. I’m surprised that number you have there is that low. My understanding was that California alone could be a significantly larger opportunity than that. When you mentioned that outside of California, you see $10 million of opportunities you’ve already identified. So is there something I misunderstood about the opportunity in California or how that adoption is going to take place? Or what that competitive environment around that looks like?

Ryan Bohr

No. So first of all, we have been adopted there, which is good. And that’s -- that is -- we’re officially recognized at this point, which is all that’s recently happened where they’ve completed that process in California. Part of it is that we’re simply -- when you look at the opportunity in California, it’s similar to what we’ve expected. And as we indicated, it’s -- this is our preliminary outlook. We’re still building our plans for 2019. And we said $15 million to $20 million plus. So we’re trying to be conservative until we see some of these other opportunities come to fruition. As we mentioned, there’s nearly $10 million of opportunity that is moving to 2019 that are currently in pilot within FOSS or our existing customers in the midst of a multiyear, kind of, rollout plan. And so we’re not -- in my comments, I’m not trying to be overly aggressive and say that 100% of that happens according to plan and there’s certainly going to be other things that fall off. So at this point, we’re trying to be relatively conservative but nothing has fundamentally changed in our outlook.

Joe Yorio

Well, I think though the one thing is and we’ve said this for over the last year, the $60 million or so that happened several years ago, that’s not the size of the opportunity this year, I mean, the size of the opportunity is much less than that. And also, there’s many more competitors than there were six, seven, eight years ago. So from my standpoint, we feel comfortable with what we’re seeing right now. Of course, we’re going to go after every nickel we can go after. But the opportunity is less and the competition’s more.

Kevin Baehler

Also I was going to add that California has been known for stretching its adoptions over a two year, and now lately, a three year cycle. So some of the adoption spend we fully expect to occur in the year following in 2020 and potentially even in 2021.

Ryan Bohr

And also a factor in that we have experienced some success even this year with California in anticipation of this. I just want to add one final comment to your core question. Part of the shift in Next or lower percentage of our proprietary brands is because since we mentioned the breadth of our supplies category. Since we believe we’ve been much -- gone much deeper in assessing the competitive pricing dynamics, we’ve seen real exceptionally strong growth in areas that you would not think of with us. We’ve seen 20% growth in Jan/San and areas like that; business machines, which is generally some components and cartridges; and various miscellaneous products. These are areas where you might not think about us about our customers do buy these products from us. But they have been very ancillary in the past. And as we’ve gotten more strategic about our position in some of those areas, it’s actually driven some growth in those areas. So some of it is due to higher growth and some of those areas as opposed to declines in our School Smart business or otherwise. It’s been kind of growth in those areas.

Kevin Tracey

And you made some comments about the impact of tariffs. And the question is, we see tariffs on all Chinese imports. You mentioned that the majority of your contracts [indiscernible] to adjust pricing. But of those contracts that are down, I’m wondering what percentage of the business was on the fixed price basis? And how disruptive would a 10% tariff be on all Chinese imports?

Ryan Bohr

Not disruptive from this standpoint. I said generally all, I mean, that that’s because I’m accounting for the fact that there could be some small agreements that I’m not aware of. But generally, all of our contracts allow for price adjustments based on cost. And we don’t have many that are multiyear as well. So as we’ve been evaluating pricing for 2019 throughout 2018, we’ve been taken this into consideration. And the items within our Supplies category that are applicable are about 11,000 items, and it reflects about $18 million of purchases. So those are the items that are applicable at this point. Our direct imports from China under our brand is about a $30 million annual purchase. And as we have embed in the midst of finalizing 2019 costs going forward, we’re actually seeing little-to-no cost inflation relating to those items because we’re actually seeing efforts to reduce cost, offsetting any impact. So that’s where we stand right now.

Kevin Tracey

So I understand you’re not going to give 2019 guidance today. I guess what I’m trying to get at, what I’m trying to understand is how big of a step back did the business take this year. So perhaps a way to ask the question is excluding Science, another core Distribution business that looking ahead to next year, you mentioned you expect a strong 2019, I guess, how would you define that? Would you see a good outcome in getting to Distribution businesses profit back at 2017 levels or do you think that the improvements you’ve made over the past two years mean that next year can be better than 2017? Or how should we think about that?

Ryan Bohr

Well, I’ll start, and Joe, just please add. As we stated pretty clearly, you can see our growth rates in the Supplies category. We think we can do -- we plan to do better than that in 2019. Okay, number one. So that’s a big driver of our business. And we would expect to see some level of margin improvement. We expect continued strong growth in our learning environment area, which is broadly represented under Furniture. We’ve lowered our growth expectation for the full year from about 15% to 12%, which is considerably strong. So if you think of continued strong growth in that area and continued strong management of SG&A, I mean, we’re ending the year on a little bit lower overall run rate from an SG&A standpoint. We’ve made some pretty aggressive changes in the back half of this year that are going to positively impact the SG&A. We’ll have some things that will reverse. Like for example, some of the elements of incentive comp and incentive comp with our sales organization would also be expected to change in 2019. So from an SG&A standpoint, we think we’re going to get some leverage there. So I mean, I think, you can put that together and you can get kind of a pretty good view that we think that the business is certainly going to recover to levels that we’ve seen in the past.

Joe Yorio

So Kevin, so if you go back to a couple of comments and the changes that I made back in July of this year with the sales force, everything we’ve done, the restructuring of the sales force, the change of the go-to-market strategy to one of Team Sell, the value proposition of 21st Century Safe School, that’s all putting us in line to absolutely overachieve 2017 and move forward to take market share. That’s what it’s completely focused on; the ability to have the inside sales people have a more transactional and touchpoint with more transactional and smaller customers. A comprehensive Team Sell to the largest school districts as we’re making these relationships and building partnerships with superintendents and board members and trade agencies. Quite frankly, that is the goal, I mean, my goal is that we will achieve or exceed 2017. Otherwise, everything we’ve done in this little step back in the year would have been a failure. So everything we’ve done to this point structurally. Everything we’ve done from the standpoint from the mentality of the sales force we have moving forward and the assets of resources we provide them to become better business people is to exceed that 2017 number and continue to grow and take market share.


And our next question comes from Patrick Retzer of Retzer Capital.

Patrick Retzer

Joe, you touched on the listing and where that stood. Do you have any idea whether the up listing will occur by year-end or not?

Joe Yorio

I would say probably not, Pat. The deal is we were ordered like I said, the board has engaged a recruiting firm to look at candidates. We’re looking at those candidates. And as we find the right candidate, I’m sure that person would be nominated and put on the board. But I would say -- I’m not going to say no, exactly. But I would say probably not by year-end.

Patrick Retzer

And then you touched on some Safety & Security opportunities. Can you flesh that out a little bit for us?

Joe Yorio

Well, I think that everybody’s probably seen the amount of dollars were being earmarked toward locks, particularly locks. Lock Boxes are a big issue with the industry right now. And with our Quick Action Lockdown lock, that proprietary named, it’s one of the key locks out there that fulfill most of the needs of the school districts are you looking for. Again, we’re still trying to work with legislators to come up with best practices and guidelines because you’re now allowed to safe standards. And this lock is one that fulfills that. So we see ourselves at a pretty good position with that as well as working specifically with legislators on how to write bills and what not to position these locks. And we’ve done that with a rather large school district and state that I’m not going to talk about yet, but we’re in the process and have completed that, that the bills been approved. So that’s an effective key point. I’m sure you guys have maybe have seen Michael’s been even on the news more frequently. We’re getting a lot more attention on the training and how we can potentially work to train even SROs, the school resource officers. So I think the confidence comes from is that we’re being recognized nationally as the -- a thought leader and subject matter expert of best practices and the dollars that we hear that are being earmarked for Safety & Security as a whole in 2017. Not recognizing that when you talk about these dollars, there’s only a portion of that space that we play in because a lot of those dollars are actually going to higher school resource officers and we don’t play in that. But the portion that we play in is still substantial, and we feel very comfortable as we go into ‘19 that we’re well positioned. And then to Ryan’s comments earlier, we’ve tied it all into learning environments. And so not only in talking about Safety & Security because it’s focused on Guardian but it brings the whole comprehensive approach of the learning environment and the mental, physical, social, emotional, Safety & Security, which opens the gate for the rest of our products to partner with and go in there as one and not just be a one-off.

Patrick Retzer

Okay. And how are the margins in Safety & Security business? And it sounds like, could you confirm it, it sounds like we should expect to see some of that business hit in 2019.

Ryan Bohr

Yes, Pat. Well, first of all, absolutely. I mentioned that the business, the product line itself is up 71% and is already approaching $4 million for the year in just kind of core products primarily. The margins can vary. We have certain large opportunities that are more, kind of, equipment-based type opportunities that can carry margins in the 20s. And we have other proprietary products in that area that can carry margins in the 40% to 50% range. And certainly, when we provide training services, those margins are very high. So it can vary. And at this point, in our development of that product line, those margins can fluctuate because one large order of a proprietary lock or another locking system or a stuff to bleed kit or some of those other types of products can make our margin fluctuate and I’ll give you just even another example. We’ve seen opportunities. We were providing unique backpacks to schools. And so that you might not think of that necessarily as a Safety & Security item. But these are custom-designed backpacks that meet the safety and security protocols of specific districts. And so we’ve done a few large orders of those types of items as well. That’s kind of all, kind of, relate to the comprehensive Safety & Security plans that schools are addressing.

Joe Yorio

And the opening to the additional products, that Ryan mentioned, with the backpacks, we’re literally having conversations probably weekly with vendors to make sure number one, that these products we bring them in; they resonate with our customers. But as schools, particularly, administrators and board members are taking a deeper look into Safety & Security, I think that just opens more opportunity for us as well to look at additional vendors that we should be working with to flesh out our offering.


And our next question comes from Craig Carlozzi of Bulwark. Your line is now open.

Craig Carlozzi

I just have two and the first is a clarification. Given all the moving pieces that are going on in your business. Did I hear correctly that you tentatively believe that you can exceed the 2017 EBITDA, which was, I believe, is like $56 million. Is that a statement that you made? Or is that just a hope or a goal of yours. I’m just looking for a clarification.

Ryan Bohr

I think, the exact statement we made is that, certainly, the things that we identified would indicate that we should be returning to those numbers. We’re still finalizing our budget and that $53 million that we reported in that year would certainly seem attainable at this point. But we’re still finalizing things.

Craig Carlozzi

Okay. And I guess my second would be given the stock at its 52-week performance and combined with your, looks like, pretty optimistic outlook and the fact that management doesn’t really own very many shares, should we be expecting some insider purchases?

Ryan Bohr

I mean, I don’t think we are going to -- we want to specifically comment on that. But we -- it’s certainly something that we will discuss.


And our next question comes from Charles Neuhauser of Mainwall Investment. Your line is now open.

Charles Neuhauser

I just wanted to get a better handle on the debt situation. You can save me a couple of minutes of looking at last year’s number. You said that net debt was going to be up $4 million, $4.5 million at the end of the year from last year. What is that number actually supposed to look like?

Kevin Baehler

This is Kevin. I have to pull that number out. I don’t have it right at my fingertips right now. But roughly, we ended last year with -- I know our term loan balance was approximately about $118 million, and we were not on the ABL at all at the end of the year last year. And our net cash balance was approximately $31 million with a vendor note amount of about in the low $20 million range.

Charles Neuhauser

So that looks like net debt of $100 million. So you’re looking at some increase toward the end of this year. But did not you say that you’re going to be collecting another $10 million in receivable in January? So forgetting the delay in shipments that have caused the -- whatever, the cash conversion cycle to extend into January, you should be looking at a net debt number as of the end of January, more like under $100 million. Is that a fair statement?

Kevin Baehler

Well, actually -- I apologize. I just was refreshing myself and pulling out the materials for last year. Our total debt, gross debt at the end of 2017 was approximately $145 million, which consisted of the term loan and the deferred cash payment obligations related to the vendor note. And again, the cash balance was about $31 million. So we were in the low or roughly in the neighborhood of about $114 million of net debt at the end of fiscal 2017. As I indicated, we expect that number at the end of fiscal 2018 to be up about $4.5 million, but there is a carryover effect of about $10 million of a positive cash flow that will hit in January. However, keep in mind that by the end of January or during January, we are beginning to build for the next season. So the net debt through the first quarter of next year will begin to grow again as we begin the cash cycle for the upcoming season where we are beginning to build inventory balances ahead of the season.

Charles Neuhauser

Now my point is simply if you look at your presentation or if you look at the numbers as of the end of the third quarter, the receivables number and the debt number, it looks rather alarming. So I think it’s important that we can quantify the amount of cash coming in from collecting receivables over in November, December and January to get you back to a more normal level of debt. That was my point.


[Operator Instructions] And I’m showing no further questions at this time. I’d like to turn the conference back over to Joe Yorio for closing remarks.

Joe Yorio

Thank you. Well, I just want to say we appreciate your continued support. And as I said earlier in the call, I know that none of us in the company are pleased with the results. But as I said, this rests severely on my shoulders as the CEO. But if you know anything about myself or the team, hopefully, you recognize that failure is not in our DNA, and we absolutely hate losing. And so if I can flash back a little bit to my military days, I just feel this that we got wounded and normally when you get wounded, all it does is make you fight a little bit harder.

But I’d also say that the best laid plans, that’s all I want to say, the best laid plans normally don’t survive first contact and that’s why you always have a primary, a secondary and a tertiary. And so you might be moving onto the larger bigger objective and you walk into an ambush. And all of a sudden you’re taking fire from two sides and everybody hits the ground. And then normal thought process that we just hunker down and you’re far back and you hope somebody comes to your rescue. That’s not really the best option. The best option is when you walk into an ambush is to jump up, charge to center of the ambush and break the apex and you’ll follow me while you’re doing it. And that’s what the team plans on doing. We ran into some ambush. It sideswiped us into the Distribution centers. But we’re not going to hunker down and hope someone is coming to get us. We’ve jumped up. We’re taking some fire. We’re running right into the apex of the enemy’s guns and we’re going to break it and win back more competition and take more shares.

So appreciate your continued support. Know that the team still has confidence and the strategy is solid. And we’re going to break this ambush and win as we move into 2019. So thank you and have a great day.


Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program. And you may all disconnect. Everyone, have a great day.