Build-A-Bear Workshop, Inc. (BBW) Q3 2019 Earnings Report, Transcript and Summary

Greetings, and welcome to the Build-A-Bear Third Quarter 2019 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Allison Malkin of ICR. Thank you. You may begin.

Good morning. Thank you for joining us. With me today are Sharon Price John, CEO; and Voin Todorovic, CFO. For today's call, Sharon will begin with a discussion of our 2019 third quarter performance and review the progress made on our strategy. After, Voin will review the financials and share our guidance. We will then open the call to take your questions. [Operator Instructions] Members of the media who may be on our call today should contact us after this conference call with your questions. Please note, the call is being recorded and broadcast live via the Internet. The earnings release is available on the Investor Relations portion of our corporate website. A replay of both our call and webcast will be available later today on the IR site. Before I turn the call over to management, I will remind everyone that forward-looking statements are inherently subject to risks and uncertainties. Actual results could differ materially from those currently anticipated due to a number of factors, including those set forth in the Risk Factors section in the company's annual report on Form 10-K. We undertake no obligation to revise any forward-looking statements. And now I would like to turn the call over to Sharon.

Thank you, and good morning, everyone. For the third quarter, we advanced towards our long-term goals with improved results compared to the prior year as we maintained our focus on executing our key strategic initiatives. In the quarter, which is the smallest of our fiscal year, we had sales growth in both our direct-to-consumer and commercial revenue streams as well as expansion in gross margin. We improved our operating loss compared to the prior year by $2.3 million. The period saw no borrowings on our line of credit, and we finished the quarter with no debt and $6 million in cash. Overall, we remain steadfast in our mission to monetize the power of the Build-A-Bear brand. Our brand's consumer metrics are in line with those of much larger companies, including aided awareness with moms in the U.S. of over 90%, over 8 million opted in e-mail addresses for direct marketing and communication and 4 million active loyalty club members that represent an estimated 20 million consumers. Additionally, on an annual basis, we brought nearly 45 million guests to physical store locations and have an additional 110 million combined digital impressions through our website, YouTube channel and other social media platforms. Our goal is to leverage the consumer affinity that these metrics represent and diversify revenue streams beyond the mall and traditional retail model and drive growth in areas that can add incremental revenue and accretive profitability. Looking in more detail at our revenue growth in the quarter. We saw improvement from this evolving business model, including a 2% increase in net retail sales, with improvement across geographies in both North America and Europe, and inclusive of the eighth consecutive quarter of double-digit e-commerce growth and an 18% increase in our commercial revenue segment, led by growth in wholesale primarily through relationships that we refer to as third-party retail. We expect to continue to see improvement in results as the strategies that we have implemented to diversify the business and monetize the power of our intellectual property come to fruition. We expect these efforts to allow us to continue to evolve the company beyond the traditional mall and retail model to create a more dynamic and resilient business model. Now let me turn to an update on the 4 of our key priorities that are intended to better leverage our brand assets and contribute to long-term success. These include more effectively taking advantage of growth in the digital economy; increasing acquisition, engagement and lifetime value of loyal program members; diversifying retail locations to broaden consumer accessibility to our brand; and monetizing the awareness and trust that consumers have for our brand through incremental profitable revenue streams, such as outbound licensing, wholesale and entertainment. As it relates to growing in the digital economy, as I mentioned, we delivered double-digit e-commerce growth for the eighth consecutive quarter, which represents every quarter since the update of our Web platform. The holiday season is important in this space with nearly 50% of our e-commerce occurring historically in our fiscal fourth quarter. With this in mind, we have been laying the groundwork and building capabilities to take advantage of the ongoing macro trend of online shopping. Because over 85% of our site traffic on average originates from a personal device, we recently upgraded our mobile capabilities, and we continue to see improvements with reduced card abandonment and higher conversion rates. For the holiday season, in addition to our traditional gifting options, we have expanded the product range appealing to our teen and adult gifting segment, which represents over 25% of our consumer base, with an assortment of characters from classic Christmas movies, including A Christmas Story and National Lampoon's Christmas Vacation. These Web-exclusive products draw affinity consumers who tend to prefer the convenience in mobile shopping. And we continue to improve search results with SEO enhanced product descriptions and expanded search terms supporting targeted campaign optimization programs with the goal of driving incremental traffic and higher conversion rates. Closely tied to our digital road map is our initiative to enhance the lifetime value of our Bonus Club loyalty program members. As I noted, there are currently 4 million active members as well as a robust database with over 8 million consumers opted in to receive marketing and promotional messages across geographies. Specifically relating to the U.K., following the implementation of GDPR regulations last year, we launched a new registration process. This has led to a significantly larger e-mail database of approximately 500,000 to which we have been actively marketing. We believe the enhanced marketing communications contributed in part to the positive sales results in our European sector in the quarter. On a global basis, we are focused on improving our segmentation models in order to optimize open and click-through rates as we refine messaging and frequency to be more personally relevant to our Bonus Club members. In addition, birthdays remain the top occasion for a visit to Build-A-Bear Workshop, and we are now in the second year of our successful Count Your Candles campaign, in which Bonus Club members can bring a child to our store during the month of their birthday and pay their age for a collectible teddy bear. We are pleased with the level of repeat visits that the program is driving as well as the ongoing levels of guest acquisition. We expect to create customer journey models through our CRM program and leverage the rich data that has been collected. This includes birthday information provided by members that now totals over 1.5 individuals associated with 0.5 million member accounts with the goal to add incremental lifetime visits and value in the future. Turning to our next priority of broadening consumer accessibility at retail and diversifying our real estate portfolio. Although Build-A-Bear has generally outpaced national traffic trends, we expect consumer activity in traditional malls to continue to be challenging. Accordingly, in line with our real estate strategy, through planning and persistence, we have maintained the high levels of optionality in our leases that I've reported in the past with nearly 70% of our store leases expiring in the next 3 years. In addition, we continue to pivot our business to venues that better align with where today's families visit for shopping and entertainment as we develop and grow revenue streams that more fully utilize the Build-A-Bear brand. As a retailer that has a high level of preplanned visits in an environment where experience is a competitive advantage, Build-A-Bear tends to be a desired tenant. We believe this puts us in a good position to continue to renegotiate rents or take other action as needed. It is worth noting that in addition to the traditional retail model on which our company was started, we have been developing a new business model, which I mentioned, that we call third-party retail. Revenue from third-party retail is captured in our commercial revenue segment. This model has several advantages for Build-A-Bear. These include little to no start-up capital expenditures to open a store; no direct operational overhead expenses, including both rent and labor; and the opportunity to leverage retail areas that tend to be in family-centric, tourist-oriented locations. The model is also beneficial for our partners who can take advantage of space and labor that they typically have readily available as well as being able to offer the power of the Build-A-Bear brand to their consumers. As noted in this morning's release, we ended the quarter with 54 locations in third-party retail relationships, which includes Carnival Cruise Line, Great Wolf Lodge Resorts, Landry's Inc. and Beaches Family Resorts, among others. Recently, we opened our first 2 locations within military bases using the third-party retail model. To summarize, revenue from our third-party retail model is reported in commercial revenue as a wholesale pricing base. As such, our financial statements do not reflect the retail revenue that the third party generates, just the portion that they pay us for the products and related fixtures and supplies. Importantly, third-party retail is a key part of our tourist diversification initiative that has been growing. When evaluating our business, we are focused on building our overall enterprise value, which includes a mix of corporately managed and third-party retail locations. Other diversification programs have been the addition of shops inside of select Walmart locations, which not only supports our real estate plans but also expands the accessibility and convenience of our brand to a wider consumer base, with approximately 60% of the shoppers newly registered to our Bonus Club. We now have 22 locations in operation within Walmart, with additional locations planned in the next fiscal year. On the tourist front, following the successful opening of a shop-in-shop within FAO Schwarz in New York City as well as the addition of a franchise location in FAO's flagship store in Beijing, we added a third location of the FAO-managed toy department in the iconic Selfridges store in London. We also will be operating on a seasonal basis with the return of our historically successful locations in Gaylord Resorts and other select venues through the holiday season. On a separate note, we had planned to open an additional flagship tourist location in the U.S. in a major new project, the American Dream, in the New York market. The developer has delayed the opening of the retail component until 2020, which caused a material top line headwind for us in the current fourth quarter. Moving into the monetization of our brand assets. We made solid progress to leverage the awareness and trust that consumers have for our brand through incremental profitable revenue streams. As I mentioned in the quarter, our commercial revenue segment increased by nearly 20%, and we continue to execute against our recent agreements tied to entertainment and content development. These agreements cover multiple areas in entertainment, from music with Warner Music Group's Arts Music division to films with Sony Pictures Worldwide acquisitions as well as the Hallmark Channel. We also are pleased to have solidified our agreement to move Build-A-Bear Radio to iHeartMedia, the leading audio company in America. We expect to begin to realize financial benefits from these new entertainment initiatives starting later in 2020. We believe that our business model will benefit on a number of fronts, including the synergy of leveraging the branded entertainment content, which effectively acts as a marketing tool to drive our own retail as well as outbound license product sales. We expect the interaction with our iconic retail experience to in turn drive additional interest across multiple entertainment platforms in an ongoing circle of engagement and value creation, reflective of a model that has been proven successful in other branded companies. Looking forward, we currently expect total revenue in the fourth quarter to be in the range of slightly positive to a low single-digit decrease, resulting in total revenue for the fiscal year to be in the flat to down low single-digit range. However, we still expect to deliver pretax income that is slightly positive for the year given our disciplined approach throughout the year to manage margin, promotional activity and expenses. The change in our revenue expectation is due to lower-than-expected quarter-to-date traditional mall traffic and sales associated with Disney's Frozen 2 movie as well as the previously mentioned loss of revenue due to the delay in the opening of a new flagship store. Although we had planned for some continued mall traffic headwinds, we expected the successful release of the Frozen 2 movie in late November to generate incremental shopping traffic to malls, similar to the prior top license movies especially given that the original Frozen film was the best-selling license in our history. The property has gained momentum since the movie premiere and is generating nearly double our average dollars per transaction. However, the lower traffic and transaction levels, the -- for the property, which is expected to be our #1 story, is now actually tracking at #2. We are actively addressing the situation with strategic promotional offers especially given the reported higher-than-expected discounting of the property across multiple categories and retailers. Currently, our popular Merry Mission holiday collection is our #1 story with a fresh assortment of updated characters, outfits and accessories. Separately, in addition to the expanded Web-exclusive gift-giving options I mentioned, we have offerings beyond our traditional Make-Your-Own plush assortment. This includes slippers and blankets for kids as well as grab-and-go stocking stuffers available both in-store and online. The holiday season is peak time for gift cards, and we are pleased to have our cards added to the sale in all U.S. Walmart stores this holiday season, in addition to our traditional channels of stores, online and third-party retail locations. Thus far, gift card sales on a year-to-date basis are tracking above the prior year, boding well for the post-holiday redemption period. As a reminder, with the change in our fiscal calendar year to the end of January, we expect to benefit from the redemption of gift cards sold as well in these -- in the initial launch of Valentine's Day merchandise, which is generally our second-biggest holiday of the year. On the digital front, we believe that we will continue to more effectively leverage the trends to online shopping, with our enhanced site features and improved marketing activities fueling traffic and transaction conversion to build on our e-commerce momentum, with the goal to deliver our ninth consecutive quarter of double-digit growth in e-commerce. And we also expect another quarter of strong commercial revenue. We have additional locations in the third-party retail segment, which, as noted, we believe, is a strong business model for us, and intend to look for ways to accelerate the growth in this area in the future. The holiday season tends to be a peak time for our branded license products as well. In fact, one of the Build-A-Bear branded products developed through an outbound license agreement is the Build-A-Bear Stuffing Station, which was recently named to Walmart's Top Rated by Kids toy list. In summary, Build-A-Bear continues to evolve in an evolving environment. Our goal is to understand and leverage the changing consumer habits to position the company for the future with a diversified business model that expands our retail options and broadens our consumer base and accessibility built from brand strength. We believe our brand and the strong relationships that we create with consumers can be activated in multiple categories, ranging from our traditional Make-Your-Own furry friend retail experience to heartfelt personalized gifts to licensed products to entertainment formats, all while continuing to actively manage our expenses. We continue to be energized by this strategy designed to advance the company for long-term success and enhance shareholder value. I'll now turn the call over to Voin to review additional financial details.

Thanks, Sharon, and good morning, everyone. The third quarter saw growth across key financial metrics and traction against our strategy highlighted by increased revenue, expansion in gross margin and an improvement in pretax loss versus last year's third quarter. Specifically, for the period. Total revenues were $70.4 million, an increase of 2.5% compared to the third quarter of fiscal 2018. Retail gross margin expanded 400 basis points to 39.5% compared to the prior year. This expansion was driven by stronger merchandise margin from less promotional activity. In addition, we leveraged fixed occupancy expenses due to rent reductions through aggressive real estate portfolio management. The balance of the improvement in retail gross margin was primarily related to noncash impairment charges incurred in fiscal 2018 third quarter. SG&A was $35.4 million, an 80 basis point improvement in the SG&A rate as a percent of total revenue. This improvement was driven by disciplined expense management, including lower marketing spend, partially offset by an increase in accrued incentive compensation. Separately, we also had a favorable noncash currency impact as the British pound strengthened at the end of the period, offsetting losses from earlier in the year. Combined, this drove a $2.3 million improvement in pretax loss compared to the fiscal 2018 third quarter or $1 million improvement from the prior year after adjusting for costs primarily related to noncash asset impairment charges. Turning to the balance sheet. At quarter end, cash and cash equivalents were $6.2 million with no borrowings against our revolving credit line. This compares to $8.6 million at the end of the third quarter last year, which had $7.3 million in borrowings. We ended the quarter with approximately $66.2 million of consolidated inventories, representing an $8.9 million increase compared to the prior year. The inventory increase was driven by receipt of merchandise supporting key product stories and acceleration of China-sourced goods due to potential implementation of tariffs. We expect to finish the year at a similar level of inventory compared to fiscal 2018 and are comfortable with the composition and level of inventory that we have on hand. Capital expenditures totaled $5.2 million for the third quarter of fiscal 2019 compared to $1.7 million in the third quarter last year. The increase in capital expenditures is driven by the opening of additional shop-in-shops within select Walmart stores. In total, we operated 371 corporately managed locations at quarter end, which is flat with last year as the opening of 16 Walmart locations offset 16 other store closures from throughout the year. As a result, we had an overall reduction of our corporately managed retail square footage for the period. Separately, we had an increase of 20 locations in third-party retail, ending the period with 54 in total. Before commenting on our updated full year guidance, I would like to reiterate the comments we have made on tariffs. Should the previously announced tariffs go into effect, we expect minimal impact this fiscal year. This is due to the aforementioned pull forward of select inventory receipts and the work we have done to mitigate any tariff impact, including select retail price increases and diversifying our sourcing structure. As we go into the last couple of months of the fiscal year, we now expect total revenue in the year to be in the flat to down low single-digit range. As Sharon noted, this is primarily due to challenges in traditional mall traffic and sales associated with a key license movie property as well as the loss of revenue from the developer's delay in opening of a planned flagship location. Even with this revenue pressure, we continue to expect pretax income to be slightly positive reflecting reduced promotional activity throughout the year and disciplined expense management leading to expansion in gross profit margin and a reduction in SG&A. We expect a significant improvement in fourth quarter pretax income versus the challenging performance from a year ago that included an $8.4 million in noncash operating costs associated with impairment, bad debt and store closing expenses, among other things -- among other items. Due to the tax valuation allowance in foreign jurisdictions on our deferred tax assets and mix of earnings by jurisdiction, it is currently difficult to provide an accurate full year effective tax range. That said, we do not expect to pay any material cash taxes on a full year basis. And finally, we expect to finish the fiscal year with a healthy balance sheet, including $20 million to $25 million in cash, no borrowings on our credit facility and positive operating cash flow less capital expenditures. We continue to believe in our long-term plans to leverage the strength of the Build-A-Bear brand and to diversify our business model. We expect our multifaceted approach to allow us to improve profitability. We expect to see benefits as we evolve our retail footprint, including an intentional reduction in reliance on mall-based retail locations as alternative models, such as the growing third-party retail option, continue to expand. We are actively diversifying our consumer base and expanding other revenue channels in order to enhance the content and monetization of our intellectual properties. This concludes our prepared remarks, and we will now turn the call back over to the operator for questions. Operator?

[Operator Instructions] Our first question comes from the line of Eric Beder with SCC Research.

In terms of the quarter and looking forward, how should we be thinking about longer term, where the mix should be between online and stores and where the store count should be kind of excluding the Walmart initiative?

On the mix between common stores, we -- it's only been a couple of years now since we launched the robust Web platform. And as we noted, we've seen the 8 consecutive years of double-digit growth. So without a doubt, that's outpacing our core store business model right now. But it's still a smaller percentage of -- a small percentage of sales, we believe, compared to other brick-and-mortar e-commerce comparative rates. That said, that provides us with the concept that we believe we have a good runway here. And we also haven't actually activated all the levers that we have available yet to continue to drive and enhance and improve our e-commerce sales and traffic as well as conversion rates. And so we're feeling good about the continued growth of e-commerce and continuing to outpace our store base. Right now, we're in the -- between -- depending on the quarter, we'll be between 5% and 10% of our total sales. There are many retailers where it's 15% to 20% of total retail. We're certainly shooting for somewhere in that, probably the lower end of that range in the foreseeable future. And we believe that also, as a note, our e-commerce sales are profitable for us. So I know there are some retailers where it's not as profitable, but it's a profitable endeavor for us.

And Eric, your question regarding the store count, we continue to cherish the optionality that we have with our leases as we have 70% of our leases coming up for renewal over next 3 years, which gives us tremendous leverage in discussions with our landlords. What we said that over next couple of years, we may close up to 30 locations. A lot of those locations may be outside of our North American market. We continue to work with our landlords in U.K. as well to possibly exit some of the unprofitable stores at their natural lease events. So this really helps us push through some of those things as we continue to work finding that optimal store count in addition to what we are doing internally to reduce our reliances on traditional mall-based retail. As we talked in our prepared remarks, there is a continuous effort to accelerate expansion in the third-party retail channel so that Build-A-Bear brand can be present in more locations and that we can find a more economic model for us to really capture and monetize the value of the brand. But again, at the end of the day, it's a discussion with each landlord one store at a time. We are in the business of operating profitable stores. We tend to do a good job of managing those expenses reflected in the margins that we are showing. So we continue to do that work, and we believe that we are positioned well in the upcoming negotiations. And depending on the willingness from landlords to work with us, it's going to depend on how many of those stores we may close up over next 2 years.

Right. I think strategically, it's important to understand that we need to maintain a balance between the brick-and-mortar retail and the e-commerce retail. Our experience is a big part of why we believe we have an opportunity to continue to diversify the company. It's why we build this brand strength with consumers is largely based on having that experience at retail. So although we have been able to leverage and build that e-commerce space, particularly related to expanding our consumer appeal to the teens and the adult consumers, which I mentioned in -- is over 20% of our business, it is just important to understand that we're not trying to transition away from brick-and-mortar retail and become an exclusive e-commerce site -- e-commerce company like a lot of other companies are. We don't believe that that's the best for our ongoing strategy. I did just want to correct something. I think I said 8 consecutive years. I meant 8 consecutive quarters, apologies for that, of continuous double-digit growth on e-commerce.

And just a quick follow-up. I know -- actually kind of pertains online, you have been much more aggressive in offering online-only exclusives, obviously advertising into the store. What has been the response to that? And is that, I would assume, something we're going to see even more of going forward?

Yes. That's been a very strong strategy for us. And it's reflective of what I just mentioned, Eric, in that we are actively pursuing a diversification of our consumer base as well. Many of those online exclusives are specifically targeted toward an adult affinity group. A lot of them are licensed. Some of them are kitschy. A lot of them are gifting. We started some of this really more pushing the envelope kind of approach last Valentine's. You're going to see a little bit of that this Valentine's as well, on being the ideal gift for an adult to an adult. So that's been successful for us. And it also generally achieves a premium price.

[Operator Instructions] Our next question comes from the line of Stephanie Wissink with Jefferies.

This is Ashley Helgans on for Steph Wissink. Fiscal year guidance for pretax income remains consistent despite reduced Q4 sales expectations. Is this a function of cost saves or other levers that were not anticipated before?

Thanks for the question. Yes, we continue to really stay focused on our controllables as we have done throughout the whole year. We continue to really drive our retail gross margin expansion as we have shown with a 400 basis point expansion in the current quarter and throughout the year. We continue to leverage our occupancy and push in those negotiations as we have this big lease optionality that we talked about. We did look at our SG&A structure, and we do continue to make daily choices to reduce our structure, to eliminate some of the redundancies. So we continue to push on that front, and that's definitely reflected in our results throughout the year. And we expect to continue with those initiatives, giving us a high level of confidence that we can develop the results that we are guiding to.

Ms. John, we have no further questions at this time. I would now like to turn the floor back over to you for closing comments.

Yes. Thank you, and thanks for everyone for joining us today. And we certainly hope you have a happy holiday. Look forward to updating you on our final results on our next call.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.