K-Swiss Inc. Q1 2008 Earnings Call Transcript

K-Swiss Inc. (NASDAQ:KSWS) Q1 2008 Earnings Call April 29, 2008 11:00 AM ET

Executives

Steven Nichols - Chairman of the Board and President

George Powlick - CFO

Analysts

Scott Krasik - CL King

John Shanley - SFG

Virginia Genereux - Merrill Lynch

Sam Poser - Sterne Agee

Jeff Van Sinderen - B. Riley

Jack Ripsteen - Potrero Capital Research

Steven Martin - Slater Capital Management

Stan Steinman - Cedar Creek

Jason Kaspar - Kaspar Investments LP

Operator

Good day and welcome to the K-Swiss conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Chairman of the Board and President, Mr. Steven Nichols. Please go ahead, sir.

Steven Nichols

Thank you and good morning everyone. With me today is George Powlick, our Chief Financial Officer. We appreciate you are being on the call this morning. Before I begin, I would like to have George cover the Safe Harbor language. George?

George Powlick

Certain matters discussed in this press release are subject to certain risks and uncertainties that could cause actual results to differ materially, including but not limited to non-achievement of the assumptions discussed herein, general and regional economic conditions, industry trends, merchandise trends, including market acceptance of the company's product offerings, customer demand, competition, the impact of terrorism and/or a potential global conflict on the worldwide economy, and order cancellations and reduced sales resulting from a slower worldwide economy.

A complete description of these factors as well as others, which could affect the company's business, is set forth in the company's periodic filings, including its Form 10-Q for the quarter ended March 31, 2008, which is currently on file with the SEC. Backlog as of any date represents orders gets to be shipped within the next six months. Backlog does not include orders scheduled to be shipped on or prior to the date of determination of backlog. The mix of futures and at-once orders can vary significantly from quarter-to-quarter and year-to-year and therefore. Futures are not necessarily indicative of revenues for subsequent periods.

Steven Nichols

Thank you, George. The first quarter results were inline with what we had expected and budgeted. Worldwide revenues and backlog were down overall with domestic business experiencing considerable softness and the international business up slightly in revenues and down slightly in backlog. Our concern, while working to reestablish momentum through the company and particularly here in the United States, was the international business, what we can considerately.

That has in fact happened. With international futures declining double-digits for the third quarter, based on this new trend, we have turned our outlook for the full year. The news is not all bad as investment in our premium sports branding initiatives were [front and center] in the quarter and a very highly profile lay around the globe. Royal Elastics was a breakeven for the quarter.

The breakdown of sales by product category for the first quarter 2008 continued to reflect the decline in business that demonstrated improvement in other areas. Effect of this is that for the quarter, we will report our sales by category consistent with our premium sports strategy. The product break down will be performance, sports style and other. So for the quarter, our revenues for our brands were as follows.

Performance was 19%, sports style 75% and other 6%. Our performance revenues were up 30%, when compared with the prior year period. This category includes all genders of tennis, running, free running and training. Sports style revenues were down 25%, when compared with the prior year period. This category includes all genders of nonperformance footwear. The biggest seller for the quarter in sports style was Classic was sold 264,000 pair was down 30% from the prior year period, Lozan II with 215,000 pair, and the Gowmet Low Canvas with 126,000 pair. Other revenues were up 12%, when compared with the prior year period. This category includes Apparel and Royal Elastics.

During the first quarter of 2008, our new global brand positioning for K-Swiss was launched. This new multimedia campaign utilizes television print, outdoor, online and in-store and has a tag line "Keep It Pure". The campaign features Anna Kournikova, Tommy Haas, Alona Bondarenko, Chris Lieto, and also Sebastien Foucan. It showcases our key sports of tennis and running as well as premium lifestyle. The tagline in campaign will continues to the balance of the year with slight modifications to showcase new footwear and apparel styles to back to school and full timelines.

In March we opened our first K-Swiss pop-up retail store in Santa Monica in the Promenade. This store was designed to provide consumers with a meaningful experience with K-Swiss showcasing the best of our apparel of footwear offerings. We also had many events throughout the three week time period. The stores opened with the grand opening party with Anna Kournikova and other celebrities. The purpose of the store opening was not only to gain sales, but to provide consumers with best of brand interaction.

We are learning from this pop-up retail experience and we will open again in New York City in the August, September time period in conjunction with the US Open. Given the importance of consumer experiences as part of our marketing plan during the month of March, we also embarked on a Free Running leisure tour. We have seven colleges around the country with sponsored Free Running teams. The purpose of this tour was to demonstrate Free Running and allow consumers to try the shoes into sport more exposure to this emerging discipline.

Tennis is what K-Swiss is most known for continues to be a key focus of the brand. We fortunate to have our tennis players; Tommy Hass, Elena Bondarenko and Mardy Fish have stellar performance at Indian Wells. Mardy unexpectedly beat Roger Federer and made it to the finals and at the Pac-Life Open, was a great win for him as well as K-Swiss, and we were showcased head to toe.

Finally, online is a key selling channel to our consumers. We have overhauled kswiss.com with new design and more user friendly consistent with our brand direction. Additionally, we have devoted more significant portion of our media budget than ever before to the support in consumer medium.

I will now turn it over to George for few minutes into the financials in more details.

George Powlick

Thanks, Steven. Revenues were towards the high end of our range at $103 million, which represented 16% decrease from the prior year quarter and a 19% decrease in the volume of footwear sold. At-once business was 7.6% for the quarter, which is inline with the 0% to 10% we have anticipated and compares with 10% a year ago. Earnings were up the lower end of our projected $0.18 to $0.28 this year principally due to lower gross margin and forecast.

For the K-Swiss brands, the overall, the average wholesale price per pair increased to $28.65 for the first quarter compared with $27.63 in the prior year period. The volume of footwear was sold 3.3 million pairs in the first quarter compared with 4.2 million pairs in the first quarter of 2007.

Overall gross profit margin as a percentage of revenues was 46.6% in the first quarter compared with 47.0% in the prior year period. Our SG&A measured as a percentage of revenues was 41.4% compared with 30.1% a year ago, which was slightly lower than we had projected for the quarter.

Our operating margin for the first quarter was 5.2% compared with 16.9% from the prior-year period. Our income tax rate was 2.4% due to our geographic mix of sales and earnings.

Our balance sheet at March 31, 2008, remained strong with working capital reaching $356.3 million compared with $336.8 million a year ago. Accounts receivable were $53.5 million or 47 days outstanding compared with 44 days the previous year.

Our inventories were up 2% compared with March 31, 2007, and we ended the quarter with approximately $274 million or $7.90 per share in cash on the balance sheet.

I'll now turn the call back to Stevens to wrap up the operational highlights.

Steven Nichols

The slowdown in our international business materialized in the first quarter. Revenues were up 2% in the quarter, yet backlog was down 3% at March 31st, '08.

Europe sales were down 1% for the quarter with a 2% decrease in backlog. Europe accounted for 40% of our worldwide revenues, up from 34% a year ago.

Sales in the Asian region were up 31% for the quarter, and we posted 5% increase in backlog. Asia is our third largest region, accounting for 15% of worldwide revenues in the quarter compared with 9% a year ago.

Our largest customer continues to be Foot Locker. Our sales for the Foot Locker group were 9% of Q1 worldwide sales compared with 14% a year ago. In Q1, sales for Foot Locker were down 46%, and sales for all others were down 11%.

Foot Locker represented approximately 8% of our backlog at March 31st, '08, compared with 15% a year ago, a 58% decrease in the total backlog, while the worldwide backlog with all other customers is down 20%.

Royal Elastics operated at essentially breakeven on a per share basis for the quarter compared with a loss of $0.02 per share a year ago. We expect that the investment in Royal Elastics will continue in 2008 with a net loss per share now expected to be approximately $0.06 per share.

We repurchased 149,456 shares of Class A common stock during the first quarter of 2008, leaving us with approximately 3.911 million shares in our current authorization. We continue to explore our options for allocating capital to ensure the best long-term returns for our shareholders. Stock repurchase represents one of these options.

I'll now turn the call over to George to wrap up the financials.

George Powlick

Thanks again, Steven.

As noted in our press release, the total worldwide futures order backlog decreased 26% to $128.3 million at March 31, 2008. The domestic backlog decreased 47%, while the international backlog was down 3%.

The total backlog is comprised of a 20% decrease in the second quarter 2008 futures orders to $67.8 million and a 31% decrease in third quarter 2008 futures orders to $60.5 million. Domestic backlog is down 43% for the second quarter of 2008 and down 51% for Q3. International backlog is up 7% for Q2 and down 11% for Q3.

As stated in the press release, we expect revenues for the second quarter of 2008 to be approximately $70 million to $80 million and earnings per diluted share to be in the range of a loss of $0.05 to earnings of $0.05 per share. For 2008, we expect revenues to be in the range of $305 million to $330 million and earnings per diluted share to be in a range of $0.05 to $0.25.

Our estimates for the second quarter of 2008 and full year 2008 continue to reflect the significant decline in domestic revenues, substantial investments in product development and marketing for the K-Swiss brand, slowdown of international operations and continued investments in Royal Elastics brand.

The estimates are based upon the following assumptions. Gross margins will be approximately 46.5%. SG&A will not rise above $37 million for the quarter and $150 million for the year. Customer order cancellations will be moderate. The company's growth initiatives with respect to Royal Elastics will not exceed a net loss of $0.06 per share for the full year. And the annual income tax rate will be roughly zero due to approximate breakeven results from operations and tax-free interest income.

I would also add that these estimates do not include the impact from any disruption to the worldwide economy from the global conflict or a terrorist act here in the States.

That covers our prepared remarks. We will now be happy to answer any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions)

And our first question comes from the line of Scott Krasik from CL King. Please go ahead.

Scott Krasik - CL King

I was looking at the backlog. Obviously the business has deteriorated, at least the forward order outlook from the fourth quarter. I guess my question is that as you've been so judicious in terms of not buying shares back while your visibility has been cloudy and no turnaround in sight, what has caused you to buy stock back considering the business keeps getting worse?

Steven Nichols

We felt the stock moved to an attractive price and the quantities we bought back were not huge and significant. So we got our pinky toes wet. That was it.

George Powlick

If you look at the price, the average price we paid was done early in the quarter, and it was…

Steven Nichols

14 and a nickel

George Powlick

$14.19 a share

Scott Krasik - CL King

Let's look at this year being a breakeven year on an operating basis. Would we expect to see you continue to use cash at those levels to buy stock back?

Steven Nichols

If we bought stock back as we did, it indicates that we believe at some point in the future the stock will be selling at a higher price. That was a pinkies' worth, the teaspoons' worth is our belief.

Scott Krasik - CL King

Sure.

Steven Nichols

We will get more aggressive in some areas, and still stand on the sideline. It really depends on how our product is received and how our marketing is perceived? We think we are making good progress there, but that is only inside the building. We are not making good progress in the marketplace as yet.

We have shoes that we will be showing to our sales management this afternoon. Then our sales force at the end of the month of May and that will be shoes that will be deliverable for Q1 '09. We think they are better at this point. But it will be more important what the retailers and eventually the consumers think. And that will nine months away.

Scott Krasik - CL King

Yeah. So then, naturally, your third quarter international backlog seems down. What category of product is really driving that decrease year-over-year internationally?

Steven Nichols

We in the United States experienced a lack of an exciting product a little over two years ago and we started to correct it. We have changed management and product design and development and Europe had tremendous momentum and kept going longer than the United States. Eventually, however, the uninspiring product caught up with them as soon as we could get better product back into the marketplace, by better product I mean more relevant and product that our core consumer believes is desirable and really wants. Then we think their business will turn around even faster than the United States.

Scott Krasik - CL King

So, it’s really Classic in Europe now, that's starting to flow?

Steven Nichols

Well, Classic was never as important as in Europe, as it was in the United States. They have a similar shoe, but without our three-piece toe [court] Lozan, and that particular shoe was a significantly better shoe in Europe. We think that shoe has to be freshened up and made thinner and lighter. Other things are necessary to happen in shoes that are similar to that and we're in the process of doing it.

Scott Krasik - CL King

Okay, thank you.

Steven Nichols

You're welcome.

Operator

Thank you. And our next question comes from the line of John Shanley from SFG. Please go ahead.

John Shanley - SFG

Thank you, and good morning.

Steven Nichols

Good morning.

John Shanley - SFG

George, can you give us the domestic backlog orders between second quarter delivery and third quarter. I think you gave it for international, but it'll be helpful to have it domestically as well.

George Powlick

Second quarter is for domestic is down 43% and down 51% in Q3.

John Shanley - SFG

Okay. It doesn't getter better against a little tougher?

George Powlick

Slightly worst.

John Shanley - SFG

Which markets in Europe underperformed because the fall off in revenue? Has the company made any progress and moving beyond the UK, Germany and Benelux markets in terms of penetrating the European sector?

Steven Nichols

Yeah. I think our business was still positive in Germany and it was down in the UK. The UK is where we made huge progress. We have to get more interesting at innovative product in there and we are in the process of doing it. We have not made significant progress as yet in Italy, France and Spain that's the southern part of Europe, and we're still virgins in that territory.

John Shanley - SFG

Is there a sales effort underway to try to correct that situation, Steven?

Steven Nichols

Yes, there is. We have about 1.5 or 2 in France and still in the year one in Italy and Spain just approaching through a select retailers. We're still young in those markets and not had any success worthwhile reporting.

John Shanley - SFG

Okay. Is the FREE RUNNING working in Europe has a product interests the retailers?

Steven Nichols

I would say, if I had to give it A, B, C, D. I give it a C minus. So, it has not really been successful, that hasn't failed. It's got a passing mark, but just belly and what we are doing with FREE RUNNING is we are kind of investing. We are creating something new and it's not easy and the question is whether ever be done. If we pull this off it could be very important to us, but it will not be easy and it's not guaranteed.

John Shanley - SFG

Okay. Fair enough. The FootLocker numbers that you gave is I think 8% of backlog currently versus 15% a year ago was that FootLocker global or is that just the domestic FootLocker that you are talking about?

Steven Nichols

We report global. So, that's FootLocker global.

John Shanley - SFG

Is their business in Europe about the same, as it is domestically?

Steven Nichols

Yes, with us it is about the same it's a mirror.

John Shanley - SFG

Okay. I guess good and bad it falls off in one market it looks like it falls off in the other market as well.

Steven Nichols

Yes.

John Shanley - SFG

Last question I have is this is the first time that Royal Elastics is broken even?

Steven Nichols

It might be. It might be the first quarter that ever broken even. That's a starting point, but we are not runaway express train.

John Shanley - SFG

Are you still indicating your loss for the years or assume that?

Steven Nichols

Yes, we are still indicating $0.06 as the maximum loss for the year.

John Shanley - SFG

Okay. All right, good enough. Thank you very much. I appreciate it.

Steven Nichols

Thank you, John.

Operator

Thank you. And our next question comes from the line of Virginia Genereux with Merrill Lynch. Please go ahead.

Virginia Genereux - Merrill Lynch

Thank you. George and Steven what about the gross margin, the gross margin outlook is down a little in the quarter and George down I think you were at 47 previously for the year, so you're a little lower than that. Is that clearance or is it some of the manufacturing cost pressures you cited on the last call and Steven, can you give us any update on?

Steven Nichols

I’d say, it's all of the above. As our business declined, you saw our inventory was up 2% and a business is down. So we have to some degree more shoes that we cleared up. Yes, there are all kinds of currency and raw material cost and labor cost going up in Asia, so we're affected by that. But if you take half a step back, I mean, the difference in 47 and 46 is rounding error. It hasn't changed dramatically. The average price of our shoes have gone up. We're not just running by a sale, in fact, our strategy is quite. I think we've told everyone in the office about a year and half ago that we withdrew our Classic from about 40% of our distribution.

If anything, the vast majority of the decline in our sales because its less demand for our brand. Added on to that is us contracting our distribution and our getting rid lower end shoes. We're looking for premium sports position for our brand, those are the words we use, but the actions are what really back it up. It has got to be very unusual for a business to decline as much as we have and the average price prepared to go up. And we're so fortunate that we could say some very nice high up scale words and actually do it and we're doing it.

In the short run there is a tremendous disadvantage. Most companies going on hard times will quickly come out with promotional shoes and lower price shoes and then find business at the lower end of the market that they never did business with. We're running in the opposite direction. And this is the third time we've had a significant downturn in my 20-plus years here. And that's essentially what we did the other two times. It's all counter-intuitive. In the short run, it hurts your business. In the long run, however, it greatly resuscitated the brand, and we ended up hitting totally new heights the first two times.

I guess any time you get an indication from a stockbroker of a stock, they always say past performance is no indication of what will happen in the future. It's the same story here. Past performance is no indication. We've been here twice. We've done it and it worked and we're hoping that would work again. But we can't guarantee it.

Virginia Genereux - Merrill Lynch

But I guess, Steven, this isn't the beginning of more gross margin pressure, more substantive gross margin pressure?

Steven Nichols

Yes, it is. Everything comes from demand for the brand. And if we can't create demand for the brand, then the normal market forces will work against us. If we can, they won't.

The only thing is obviously, we're not knuckling under and chasing quick volume at any cost. When you look beyond that and you say, a total time on backlog moved up three days in a horrible retail climate, so the retailers are not paying us.

The statistics behind our business, even though the top and bottom line is not good in the middle, we have the type of business that we manage the way we think it should be managed and we're sticking to it.

Virginia Genereux - Merrill Lynch

So, following on that, Steven, let me ask you this, because one of our sales guys wants to know why they are trying to reposition the brand as a performance brand whereas these prior turns have been more sport style oriented. Have they not, Steven?

Steven Nichols

All right. Great question, and the answer is we're not really looking to do anything very different than we've always done before. For the 20 years that I've been here we have spent a hugely disproportionate amount of our advertising budget on performance tennis.

In fact if you would allocate out advertising and marketing spending, we never a made a dime on tennis in 20 years. Our feeling is that we want to be a performance-based company. The largest casual athletic shoe company in the world is a company called Nike. Maybe the number two casual athletic company in the world is Adidas.

The beauty of athletics is the feeling and the association of the consumer surrounding sports. We're saying that number one tennis can just take us so far, it's 6% of the total market worldwide and running is about 30%.

And we think based on what we've accomplished obviously is in tennis. Tennis is upscale. It's premium and through running is also like that. We think that it's probably ultimate sport. If you can get a reputation in running, it rubs off to your everyday footwear that we are very good at selling.

So, the danger point would be for us to be a company like old L.A. Gear or Heelys. These are non-performing gear-maker companies and we don't want to go there. We want to stress that we have long-term athletic qualities about us and we do and that our Heritage shoes were once athletic shoes as the Classic was and a bunch of our other shoes are.

I think this is just really a personification and a honing in and what we've done for 20 years and I think with a wholesale announcing at this level, announcing it better. At the consumer level, the ads will look more performance orientated and with real athletes that are very good looking was opposed to models. This is not a strategy that we invented. This has been around in athletics for many, many years.

Virginia Genereux - Merrill Lynch

Okay. That's a helpful perspective. And Steven, let me ask you this, If international is slowing, and it was 63% of the backlog, can your '09 results be much better? Can you be much more profitable in '09? If international slows going into '09, even if the U.S gets better, can you either throttle back on spending? Does that slow the turn of the whole company?

Steven Nichols

Great. Here is the big picture. In bad times, we don't do the short-term things like get the retailers and the consumers upset with us. We have got a very big customer in the UK and our business is down with them. We've got a wonderful relationship and they made a lot of money on our shoes and they are desperately helping us to figure out what can we do to get the fire and the magic back.

We have a wonderful relationship with Foot Locker, and our business is down. It was actually engineered down as much by us as by them. We don't want to send them shoes that they have to put on sale. So, we are very cautious what goes into their stores.

The FREE RUNNING launch happened two months ago worldwide with Foot Locker. They took a chance just as we did with something new and different and unusual. We know that this wasn't what's known as a slam dunk. We were out on a limb. And out on a limb, I would say I don't know.

I know it wasn't the runaway success, but the question is did we plant the seeds of something that will be a success in '09. I think an answer to the big question, we do the long-term things, hopefully well thought out and hopefully it will be correct. And we don't play the short-term game.

We turned down low margin business everyday. We turned down business with the people. You will always hear about our select distribution. All the people that we set are below the line that we want to sell in bad times. We still don't sell them. Retailers, once we can get our product and brand, both backed favorably in the mind at consumer, the retailers will come onboard very, very rapidly or at least that's what happened in the past.

Virginia Genereux -Merrill Lynch

Yeah, I think you're doing all the right things, Steven. You respectfully, you're really not answering my questions.

George Powlick

I think another way to put it, Virginia, if it doesn't happen in '09, but '010 is stronger because we've kept the pressure on the reins and how the reins back we're okay with that.

Virginia Genereux - Merrill Lynch

Right, adhere to the strategy. That's fair. George, How should we think about the tax rate? You're paying zero in taxes this year. Is that because you've got a lot of cash or is that tax rate?

George Powlick

Yeah. We don't pay a great deal of tax. Our bottom line is almost all interest income. We are almost a bank.

Virginia Genereux -Merrill Lynch

Right.

George Powlick

And it's tax free.

Virginia Genereux -Merrill Lynch

Okay. That's the big driver. If the core business starts generating higher profits next year, you will pay some taxes again? The tax rate will go up to 20%.

George Powlick

We look forward to paying taxes.

Virginia Genereux - Merrill Lynch

Yeah, okay.

Steven Nichols

Taxes, is a good thing.

Virginia Genereux -Merrill Lynch

Yeah. I'll let somebody else get in. Thank you all.

Steven Nichols

Thank you, Virginia.

Operator

Thank you. And our next question comes from the line of Sam Poser from Sterne Agee. Please go ahead.

Sam Poser - Sterne Agee

Good morning.

Steven Nichols

Hey Sam.

Sam Poser - Sterne Agee

Could you give us some feel for the currency effect both on international revenue and on the futures?

Steven Nichols

I think we know everything in the world there is to know about currency, but so does everybody else. If we make a Euro profit, in Europe, when we bring it to the United States, it's more than the dollar. When we buy things in China, that we used to be able to buy for a dollar, they want a little more than a dollar. American currency is down. The euro is up. Chinese currency looks like it's rising. Canadian currency is up and you could figure out how this affects. Ask and every other company that does business globally, there are no secrets here it all.

George Powlick

There is a currency positive of impact on our numbers. We've all have the penalty has never calculate again disclosing it. We didn't hide behind when it was going the other way, we are not going to triumph it when it is going this way.

Sam Poser - Sterne Agee

Was it more of an affect this time relative to the numbers? Did it have significantly more impact this quarter and other than in recent quarters?

George Powlick

No, I really don't have the numbers in front of me because we don't really disclose this very often, so, in fact, never so.

Steven Nichols

You could figure that out in a nanosecond. We're doing business and what is the currency we do business in?

Sam Poser - Sterne Agee

Okay, well as soon as I get off the call, so nanosecond to do it.

Steven Nichols

Okay.

Sam Poser - Sterne Agee

On the queue you talked about purchases of $6 million in trademarks. Can you tell us what that was?

George Powlick

Yeah, we are in the process of acquiring trademark rights to a footwear brand and when that process is complete, we're making announcement, but it's not complete yet.

Sam Poser - Sterne Agee

When do you expect that's a weak employee?

George Powlick

Certainly within Q2, well, I shouldn't' say certainly, we expected to be complete in Q2.

Sam Poser - Sterne Agee

Okay. And then what was your percent at-once in Q1 –

George Powlick

In Q1?

Sam Poser - Sterne Agee

Your at-once business?

George Powlick

Yeah, there was 7%.

Sam Poser - Sterne Agee

And what is your outlook for that looking into Q2 and onward?

George Powlick

3% to 18% and the prior year was 21%.

Sam Poser - Sterne Agee

Okay. And then so you are not going to give us the Classic's class training kids, tennis breakout any more?

Steven Nichols

No. Our strategy is premium sport, where we have two basic categories of footwear and that is sports. Our performance in sports style as well as other in the other includes Apparel and Royal Elastics. That's how we are looking at the company now.

Sam Poser - Sterne Agee

Okay. One last question your inventory, your sales were down significantly your inventories up, there is a lot of variance and unusual on your stock sales ratio going into Q2 and as I guess, who asked the question I think it was Virginia asked about the margin impact. I mean how current is the inventory considering the backlog and then inventories were up, backlogs down and sales have been down. It’s a sticks bought in time so it seems like it will have on paper.

George Powlick

The inventory is higher than we like it, Sam. We evaluate every quarter as I'm sure all companies do the adequacy of their reserves in relation to that inventory. We think we've provided adequate reserves, but the inventory is higher than we would like no question about it.

Sam Poser - Sterne Agee

And where do you I mean would you look ahead to the end of Q2, where would you like to see the inventories end up on a year-over-year basis, so I mean is there a number you’re looking going to based on the revenue guidance that you've given us and the outlook towards the back half at the moment?

George Powlick

Not really we just work, it's so hard to predict. We work I think we've always said, we just work on day to day trying to hit singles and it turns out we win the game at the end that's great and that's kind of what we are doing here. We are putting pressure on our people to get our inventories more inline with direction of our backlog and sales and believe me they are working very hard, but it's a moving target all the time.

Sam Poser - Sterne Agee

And then just I'm sorry one last thing. Do you have an interest income? I mean, should we use the $1.94 million for interest income for the year as you see it or a little bit less.

George Powlick

Yeah, obviously, it depends on what the interest outlook is and it depends if we ever get the opportunity to repurchase some shares, we'll have less cash but those are the two variables.

Sam Poser - Sterne Agee

All right, well. Thank you very much. Good luck.

George Powlick

Thank you, Sam.

Operator

Thank you. And our next question comes from the line of Jeff Van Sinderen from B. Riley. Please go ahead.

Jeff Van Sinderen - B. Riley

Hi, good morning. Recently saw some of your new performance product grouped with your other Classic product, (Inaudible) and FootLocker. I'm just wondering should we look for them to continue grouping your product by brand rather than by sport category.

Steven Nichols

It's hard to tell what they're going to do. We have enough trouble running our own business as opposed to running theirs, but I think that they had such a small amount of our performance product that it wasn't enough to be all four by itself. That's why they have put up with our everyday shoes.

Jeff Van Sinderen - B. Riley

You might have mentioned this previously, but you don't know any auction rates securities. Is that correct?

George Powlick

No, we don't.

Jeff Van Sinderen - B. Riley

Okay good. And then as far since we were talking about inventory. What is the bulk of the inventory consist of at this point, any color you can give us on that? Also, what do you think the excess inventory would go to reserve that channel occupies or what happens?

Steven Nichols

If you fully understand our brand policy and that is to take care of our brand on a very long-term basis. The bulk of our inventory is white shoes that are uniquely K-Swiss. We mean the timeless and the classic. We have the financial capability to sit on inventory for quite a period of time. This is not the type of inventory that spoils very rapidly. We might just dole it out, very small doses over a long period of time.

We don't have to run a big fire sale and get it out before it spoils. Our inventories will get in line but it could take a year or two years. I think the biggest factor will be our patience in dealing it out. It goes to people that we've traditionally sent our inventory to. We don't advertise and can move very, very large quantities of inventory at Marshalls and TJ Maxx and Ross and all of these people who have businesses that the amount of shoes K-Swiss supplies them is minor.

Jeff Van Sinderen - B. Riley

Right. Okay, good. And then also, can you give us any more color on the apparel business developments?

Steven Nichols

Yes, we are making some progress against our plan, and our plan is very upscale in apparel. The apparel will be going into Barneys. It'll be going into Saks. We currently have two windows at Harrods in London. So, this is pretty upscale.

One step down from those will be going into the largest athletic retailer in the U.K., somebody called JD. They will have our apparel in back-to-school period of this year. And our plan is for the apparel to be upscale and premium and be one of the things that pull the brand up. And we are sticking with that premise.

Jeff Van Sinderen - B. Riley

Okay. Thanks very much and good luck.

Steven Nichols

Thank you.

Operator

(Operator Instructions)

Your next question comes from the line of Jack Ripsteen from Potrero Capital Research. Go ahead.

Jack Ripsteen - Potrero Capital Research

Hi, good morning. Thanks for taking my call. I just had a question on the investment in Royal Elastics as well as the Free Running. Can you give us idea of the kind of investment dollars or proportion of the spending in terms of your high P&L for both of those initiatives and what are kind of hurdle rates and at what points you would as clearly crawling down on Royal Elastics could be on Free Running, scale it back and decide, you know, what there was a C student, and we are not going to play more money behind a C student?

George Powlick

The Royal Elastics, the investment that we have in the brand as far as inventory and structural things is not major. We haven't been successful with it as yet in the United State. We have done better Asia and in Canada for a period of time, and we still think there is a possibility that this brand could break through.

As far as Free Running, we had a significant part of our marketing budget invested in it for Q1 of this year, and we have decided that we are going to do more grass roots work with the brand.

I think I announced that we had events and we have our running team, a free running team. I think we're going to work harder on that area of Free Running to establish it with the purists and the uses of the sport. And along with that decision, those things are generally less expensive. So, we will put maybe less money into it, but more energy and effort.

Jack Ripsteen - Potrero Capital Research

When you set up a budget, do you do it in the terms of sort of downside risk to upside whole rate of 'X'? I mean what would that hurdle rate be in terms of lifetime return or internal rates of return?

George Powlick

I don't know that we do it exactly the way you said. We might very subjectively come real close in our mind, but there is no hurdle rate of return. All those are internal rate of return. Is that when do you a plan [all] require you to rely on projections. I'm not sure that's worth a whole lot. In terms of our spending on Royal Elastics in terms of our operating expenses, it's about 5% of what we spend on Royal Elastics.

Jack Ripsteen - Potrero Capital Research

Okay. And it was profitable, AND that's great. It sounds like you are still going to spend some more, so it might take it back to loss. But as we kind of build year-on-year, is that something that could build back to consistent profitability since you've seen one quarter profitability? Was there something unique or is there kind of a (inaudible) hope that you are getting to where you need to be in on this investment?

Steven Nichols

I think the brand is becoming a real profitable brand and has consistently been profitable in Asia, and we have not been able to interpret that in the United States as yet. We opened Royal Elastic store in Santa Monica, California, and that's one of the reasons we did that was to showcase the brand on whatever you want to see the various products we have. The store is a few months old and is probably running at almost breakeven at this point. So, we are pleased with that, but we are not sure where Royal Elastics will end up. As long as it's 5% of our asset, we think we could keep experimenting with it.

Jack Ripsteen - Potrero Capital Research

Great. Thank you very much.

Steven Nichols

You are welcome.

Operator

Thank you. And our next question comes from the line of Steven Martin with Slater Capital Management. Please go ahead.

Steven Martin - Slater Capital Management

Hi, guys. You had some comments in there about some extra or some data processing costs?

George Powlick

Yes.

Steven Martin - Slater Capital Management

Can you get into a little more detail about what they were and how you expect that to diminish over time?

George Powlick

We are implementing SAP as you may know, Steve.

Steven Martin - Slater Capital Management

Right.

George Powlick

We started this two years ago. '07 was a big expenditure for us. '08 will be continuing a big expenditure because the second half of the implementation will be done in October and that is the European side.

We have done the American side and now we are doing the European side. It will not be as extensive in '08 as it was in '07, but it's still very extensive. And we would expect in '09 and thereafter the figures to come down relatively dramatically. We haven't done any detailed planning. That would be the theory.

Steven Martin - Slater Capital Management

Okay. And compensation, et cetera, how should we plan that in our model going forward? Given the sales declines should we look at it in a dollar sense or should we look at it in a percentage sense?

George Powlick

I am not sure what you mean. We have our bonus program. When you our proxy, you rely on a share of profitability has to do with how well we return profits. And you'll will se that there have been no bonuses at all in 2007 to any of executive management. Based on our current system, our [VA] system, that probably will be the same in '08. We have added some people and in particularly in product development and probably we will continue to do so. I don’t think that our compensation expense is going to go dramatically down.

Steven Martin - Slater Capital Management

Okay. So, in the queue, it says that compensation etcetera was up about 9.5% and so there is a dollar amount associated with that and going forward your guidance is for more decreases in revenue. So should we assume that the compensation will stay at the higher level despite the revenue decreases?

George Powlick

The reasons for the large increase in compensation in Q1, ‘08, was that there in Q1, ‘07, when we were declining, there was a credit from our EVA plan. We had bank balances that were taken back from the balances to the company and reduced compensation expense. So, the compensation expense in ‘08 didn’t go up a whole lot more than the real compensation expense in ‘07, except it appeared so because we had the credit from the bonuses in ‘07. Going forward, compensation and those credits and sometime during ‘07, so percentage increase in compensation should be less than it was in Q1.

Steven Martin - Slater Capital Management

Okay. And one last question, going back to the tax expense. I understand that the cashes invested in tax-free municipals. On an operating profit basis you had $5.4 million of operating profit, okay. But you only booked a $175,000 in taxes. Now regardless of where the earnings were and the operating profit were earned, how did you end up with that lower tax rate?

George Powlick

Well, couple of reasons. One, it doesn't make a difference where the operating profits are earned. If we earn it in places that have low tax rates, that contributes. On the other hand we've also have losses in the United States, which will allow us to do some carry bag, so the two offset.

Steven Martin - Slater Capital Management

Okay. So it's really the losses in the United States that are allowing you to offset whatever foreign taxes there are. I can imagine there is jurisdiction in the United States, where your tax rate would be 175, like three basis points.

George Powlick

No, you're right, that's the big component of it.

Steven Martin - Slater Capital Management

Okay. Thank you very much.

Operator

Thank you. (Operator Instruction). Your next question comes from the line of Stan Steinman with Cedar Creek. Please go ahead.

Stan Steinman - Cedar Creek

Hi. I was hoping maybe you just talk about getting into the running business. In speaking just the sport stores out there, if they all say how royal your tennis customers are that when someone goes for K-Swiss tennis there are lifetime customer pretty much. And in speaking with some of the higher end performance running stores their big concern has been how Royal runners are to specific brands. And they are concerned about taking up shelf space with new brand and displacing something that some of their core Royal customers might like. Can you just talk about how you are thinking about establishing that brand recognition within performance running maybe drawing on your experience in tennis in garnering that really Royal customers base?

Steven Nichols

Sure. Now we see a lot of similarity between tennis on the user bases and that means our biggest strength in tennis is a pro shops, country clubs with teaching pros and there is the closest thing to that is running and this not running at the mass retailers, but this running at what they call geek running shops and there maybe four or five times as many of these as there are pro shops and the feeling is the same.

It takes a while to be accepted and the acceptance if you know how to handle that business right and it runs very parallel to the tennis business. You have to protect the pro shops and the teaching pros and make sure that it have inventory for them to fill in only elements of the tennis business really is very, very similar to the running business and we think it will be difficult to break in. What we will need is some compelling must have product and we are working on that and hopefully by this summer time we'll be introducing at wholesale, some breakthrough running product and if we advertise it correctly and it must have then the retailers when consumers come in and ask for it, we'll have to have the shoe.

And then for it to continue as we have in tennis we have to do everything right in a industry that relies on high quality products and service. And we do it in tennis and we think we can do it running, we don't think it will be easy. This is not a two inch part or a slam dunk. This will be difficult, but we think we could draw on the experience we have for many years in tennis.

Stan Steinman - Cedar Creek

Thank you. As far as the product timeline goes, some of the stores have spoken with said they are getting their first batch of high performance running shoes maybe June, July timeframe. So, the shoes that you’re showing your sales force I think you said today and counting on for maybe first half next year that's really the next generation, where there is some more innovation.

Steven Nichols

Yes and hopefully we will have a breakthrough and we have had some more time to really critic what we've done. We've been amazed on the scale of starting at zero how the acceptance has been and it has been really nice, but those numbers again zero. The line that our sale force will get about the first week in June for selling in '09 will be the first real test. We called on the stores; we showed them what we have. Now, we're going to call on them for the second time, I think, with superior product in the first time.

Stan Steinman - Cedar Creek

Great and then could you just quickly talk about the pop-up store, how big was that. Did you have show the four apparel line, shoe line, what was in there, and maybe any plans, going forward as to how many or how often those will pop-up?

Steven Nichols

The pop-up store was in Santa Monica and something called Third Street Promenade. It was about 1200, 1300 square feet. We had very significant apparel offering there; about half of the store was apparel. Another half was footwear and it wasn't our entire line, but it was maybe 40% of our line, but we felt 40% more fashionable and desirable shoes for that point of the year and it was kind of spring summer almost in Santa Monica.

Stan Steinman - Cedar Creek

And then just last question, for your annual meeting coming up, is that's something where you guys take a number of questions or is it generally more of just business and then adjourning.

Steven Nichols

Last person that asked us a tough question at that meeting was shock and we cut his body out. Yes, we have the question.

Stan Steinman - Cedar Creek

Fantastic, thank you.

Steven Nichols

Okay.

Operator

Thank you. And our next question comes from the line of Jason Kaspar from Kaspar Investments LP. Please go ahead.

Jason Kaspar - Kaspar Investments LP

Yes, Steven. First of all, I'm listening to calls for years and I've told many people that every business, undergraduate and MBA student should be required to listen to the calls. I love the way you’re running your business. A couple of questions: One, I was just wondering how Royal Elastics in the long term, 5, 10 years from now, kind of fits into the way you are moving your K-Swiss brand.

You mentioned, Barney, Saks, Harrods, for some of the apparel. And when I look at a Royal Elastics shoe, I don't get the same image necessarily of where you are moving that K-Swiss brand. So, I was just wondering how from 5 or 10 years from now how that kind of fits into your big picture.

Steven Nichols

Great. We look at Royal Elastic as a totally separate project. The average consumer has no idea that there is any correlation with K-Swiss, and that allows Royal Elastics to do different things. So, whatever we're doing to K-Swiss almost has no rollover on Royal Elastic with certain exceptions.

We don't know how to sell shoes that we make pennies on the dollar and sell them at Target and Wal-Mart and places like that. We don't understand that business. So, we're in factories that make high-quality shoes. So, that means the price points for Royal Elastics either has to be K-Swiss or above, and the distribution has to be in places that we're comfortable with.

So, aside from that, Royal Elastics has some interesting sub-licenses, Andy Warhol. It has something called Harajuku. It has L.A.M.B. They can do a lot of innovative things in addition to the Royal Elastic brand. The brand is less classic, more irreverent. And basically just as a 5% of our total asset with the chance of us getting it right and something big time happening, we're still playing that game. Where it will be in 5 to 10 years or if it will be, I couldn't even begin to guess.

Jason Kaspar - Kaspar Investments LP

Right. So, in Asia, how are you positioning it? Is it more urban type of positioning or you're still going after that higher price point or --?

Steven Nichols

In Asia, our price points are very, very high in every thing we do. There are two Royal Elastics stores, actually three Royal Elastics stores that we own in Taiwan, and they drive the business and do very, very well. We have an excellent distributor in Japan. It does very, very well.

I always felt that because the shoes are fully elasticized and don't have shoe laces, you just slip them on, slip them off. That traditionally people in Asia, when they come in their house, they take their shoes off. And I always felt that there was a great advantage to have a brand without shoe laces in Asia, and maybe I've been correct and that's been one of the reasons that has worked.

There is a definite shift in what's been going on in the athletic business. In women shoes, athletics doesn't have the power and punch that it used to have. Something is happening at athletics. And a few years ago, we felt that what might happen is more fashionable athletics might be a place to go, and Royal Elastics has a possibility of capturing that niche.

So, we still haven't proven it with Royal Elastics, but up until this year, it's been immaterial until the entire scheme in the K-Swiss with some upside potential and that's the way we looked at it.

Jason Kaspar - Kaspar Investments LP

Awesome, awesome. Last question is listening to the calls of many other companies, various CEOs have repeatedly pointed to March and it continued into April of just economic activity kind of falling of the cliff from trucking companies to other retail companies. Did you at all see a slowdown in phone rings and calls and stuff in March, both in the US and international or can you even comment on that?

Steven Nichols

Yes, I could comment. We firmly believe that our problems are self manufactured that we didn't move our product and marketing ahead at a point where our brand was in demand, and we had to move ahead and we stayed where we were. And we are paying the price for it. And I think once we get our act together, then we will move ahead. In the worst of times, there is successes. In the best of the times, there are failures, and it's us.

Jason Kaspar - Kaspar Investments LP

Got you. Thanks, Steven, I appreciate it. Best of luck to both of you.

Steven Nichols

Thank you.

Operator

Thank you. And our next question comes from the line of Scott Krasik from CL King. Please go ahead.

Scott Krasik - CL King

Yes, hi. Thanks. Just one follow-up. In the first part of the decade or the middle part of the decade when you did add some pretty good earnings, it seems like your gross profit dollar is growing and holding G&A pretty flat. Since the business is now trending towards the bunch of little things that may not be working and may not be that profitable, would any real flow through the earnings be sort of push back and almost like a multiplier effect it would take a few years until classics or some other category really came back to give you that boost in actual gross profit dollars?

Steven Nichols

We have relatively small fixed costs compared to other industries, in our own factories, a number of things we've got to keep going. So, the only major variable we have that is big dollars and very variable is marketing. And this year, we elected not to drastically cut marketing. When you have a position of 1% of the marketplace, if our marketing and our products are right for us to go from 1% to 3% I mean that could happen in two quarters at which point we could return to the profitability we have had in the past. We don't if things start to look like we don't have to go out and break ground and open factories and open retail stores and the infrastructure is there to get our shoes made and get him sold. And it's just us creating demand.

Scott Krasik - CL King

Right, so but just from a unit perspective or a dollar perspective it seems like you really need to get some momentum that really it's going to take at least now 12 more months of that.

Steven Nichols

Very well it be.

Scott Krasik - CL King

Yeah, okay. Thank guys.

Steven Nichols

Thank you.

Operator

Thank you. And our next question comes from the line of Sam Poser from Sterne Agee. Please go ahead.

Sam Poser - Sterne Agee

Just one last question, thank you. You mentioned in your commentary you had marketed – in the past you would market in the performance product to drive the other sales be at the Classics or in this case, the sport style. With the sports style down significantly in the quarter and the futures as I assume on that product also down. What's in that sport style product that would what you see coming in that sport style products or what's out there now that's performing well or do you have anything that on the year-over-year basis or anything really standing out there. I mean your big items are all down on a year-over-year basis it sounds like.

Steven Nichols

We do not have anything that is performing very well at retail. We do have products that we will introduce for Q1 within the next 30 days to 60 days and big question is the significantly better products than what's our retail. And the marketing that's surround those products maybe better. If the answer to both of those yes, then our business will go up, if the answer is no, then our business will either go down or stay where it is. I mean you've been around long time, Sam, and in the very end it's the products and the marketing that the company does and it’s a very elusive thing, but when you get it right your business prospers and when you get it wrong, you pay the penalty.

Sam Poser - Sterne Agee

Of the new product that's coming out, is that more -- how is that going to be different because it doesn't sound like it's going to be Classic style driven. It's going to be more -- I don’t know how to describe what it is. I haven't seen it, but how would you describe it?

Steven Nichols

Well, you are an X-buyer and you have maybe a bit more feeling for product than most analysts, but the difference is that the brand that we have been for 40 years, we can't abandon that. So, when you see the shows and I guess you'd see it at the WSA Show or something like that. You will have to walk in and look at the shoes and say, alright K-Swiss is still number one. You haven't metamorphosised and come in a caterpillar and flown out a butterfly. You look at each individual offering and you will say that the lasts look thinner and crisper and the designs look fresher and newer.

If every shoe is 10% better, then that's terrific and that's what a real success could be. This is the category that we've been the strongest in. This is not reinventing everything from soup to nuts. This is refining and refining and along with that, has to be marketing campaigns that the core consumer. These are relatively young people and get excited about the brand. And it's hard to get excited about the brand, when the product is dodgy and hasn't moved and hasn't moved ahead. So, when you get on both lined up, great things happen.

Sam Poser - Sterne Agee

Well, thank you very much.

Steven Nichols

You're welcome, Sam.

Operator

Thank you. And Mr. Nichols at this I am showing that we have no further questions. Please continue, sir.

Steven Nichols

Great, thank you for your participation today and your continued interest in K-Swiss. Bye.

Operator

Ladies and gentlemen that does conclude our conference for today. Thank you for your participation and you may now disconnect.