Central Garden & Pet Company (CENT) Q1 2014 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to Central Garden & Pet's First Quarter 2014 Financial Results Conference Call. My name is George, and I will be your conference operator for today. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the call over to Steven Zenker, Vice President of Investor Relations and Communications. Please go ahead.

Thank you, George. Good afternoon, everyone. Thank you for joining us. With me on the call today are John Ranelli, Central's President and Chief Executive Officer; and Lori Varlas, Central's Chief Financial Officer. As a reminder, our press release providing results for our first quarter 2014 ending December 28, 2013, is available on our website at www.central.com. Before I turn the call over to John, I would like to remind you that statements made during this conference call, which are not historical facts, including expectations for inventory reduction, new product introductions, cost reductions and improved profitability, are forward-looking statements subject to risks and uncertainties that could cause actual results to differ materially from those implied by forward-looking statements. These risks are described in our SEC filings. We undertake no obligation to publicly update forward-looking statements to reflect new information, subsequent events or otherwise. Now I will turn the call over to John Ranelli. John?

Thank you, Steve. This year, my first as CEO, has been very eventful. We accomplished a great deal. We're refocused on the customer. We increased the profits in our Pet segment and are now beginning to focus on Garden. We established a balanced approach of servicing our customers with excellence while, at the same time, seeking to drive growth in sales, reduce expenses and increase profits. We made management and organizational changes. We fostered an environment of accountability to emphasize the performance throughout the organization. The foundation is now being laid to enable us to realize our ultimate objectives of substantially increased earnings and a higher stock price. However, we still have much work to do to get our operating and financial performance where it should be. We focused first and have made the most progress in our Pet segment. During the past year, we raised prices and reduced expenses while improving customer service and enhancing our product innovation process. Most importantly, we implemented new operating philosophies and principles throughout the Pet segment. These changes have led to improved performance, stronger relationships with our customers and more effective planning for the future. They have also facilitated more effective cross-functional communication, better coordination and greater accountability throughout the Pet organization. We are beginning to see some [ph] tangible results in the form of better execution in the Pet segment. For example, we increased profits in both the fourth quarter of last year and first quarter of this year. We increased gross margins and reduced our SG&A, resulting in higher operating margins in both periods. We improved customer fill rates significantly, and we took positive steps to improve our cash flow and reduce our inventory levels. We are confident that the steps we have taken to date are the right ones for our Pet business. However, we expect that it will take time for the full impact to show up in our financial statements. Notwithstanding our recent improvements, our pet sales remain below prior year levels as we wait for the changes we are making in customer service and innovation to translate into increased shelf space and consumer takeaway. With respect to our Garden segment, we are taking the operating philosophies and principles we instituted in our Pet segment and are beginning to deploy them in Garden. Our Garden strategy will be the same as Pet: a balanced approach focusing on sales growth and profitability improvement, with continuing emphasis on expense reductions and disciplined pricing. We will focus, as we are in Pet, on executing better and more consistently. We will develop a steady supply of meaningful new products that appeal to the consumer and provide superior customer service. We will scrutinize all of our spending to ensure we are getting a proper return on our investment. We recently made key management changes to better structure our Garden segment for success in the years ahead. J. D. Walker will lead our Garden branded products commercial organization. Dan Pennington will lead our wild bird and private label Garden businesses. These changes are part of our efforts to put our customer first and to place experienced and successful business leaders in positions to improve our results. Both J. D. and Dan have a wealth of experience in the garden industry, and by increasing their responsibilities, we will be able to leverage their knowledge and expertise. We have made changes to position us to work more closely with our customers by removing a layer of management just as we did in Pet. Mike Reed, our Executive Vice President, who previously ran Garden for 5 years and has held other senior leadership positions within the company, will have oversight responsibility for the Garden segment. We are engaged in putting in place a whole new forward way of thinking throughout the entire organization, defining the future and making it a reality through a disciplined approach that we did not previously have. This includes introducing new and innovative products, which is key to our organic growth. These efforts take time, and we believe it will be another year to 2 before we will be firing on all cylinders. This doesn't mean that we do not expect improvement sooner, just that the improvement will not be linear and will not be as dramatic or consistent as we expect it to be in the future. We are executing our balanced strategies in a consistent and methodical way. These efforts are starting to show results, confirming we are going in the right direction. I am confident that the solid progress which we are making will be more visible as time goes on. I am very optimistic about the future. And now let me turn it over to Lori.

Thank you, John. You've likely seen the press release we put out earlier today, but I'll give you some more color in a few areas. On a consolidated basis, sales for the quarter were relatively flat to last year while our growth and operating margins improved. A decline in Pet revenues was largely offset by revenue gain in our Garden segment, resulting in a sales decrease of 1%. Our consolidated gross margin improved 110 basis points in Q1 from 26.3% last year to 27.4% this year. We delivered improvements on our gross margin in both our Garden and our Pet segment, with the lion's share of the improvement coming from Pet. Our first quarter operating loss was $8.4 million, improved from a loss of $13.1 million in the first quarter of 2013. Our consolidated operating margin was negative 2.9%, a 160-basis-point improvement from last year, reflecting the higher gross margin improvement in SG&A as a percentage of sales. Let's move on to segment results starting with Garden. As a reminder, the majority of the garden season spans our second and third fiscal quarters, which have historically been the highest for revenues and profit for our company. Our first quarter is typically the lowest revenue quarter due to the seasonality of the Garden business. In the first quarter, the Garden segment revenues increased 9%, predominantly due to higher seasonal décor, wild bird feed and professional fertilizer sales. All 3 benefited from increased distribution this year. Grass seed sales declined, due in large part to lower export sales and the timing of orders from certain customers. The Garden segment's gross margin improved. Operating margins showed an even larger gain of 290 basis points. The operating margin improvement was due in large part to better results in the seasonal décor and wild bird feed businesses. To expand on that, the seasonal décor business was negatively impacted last year by sales returns and expenses that did not reoccur this year. Wild bird feed margins reflect the benefit of the lower raw material cost versus a year ago. Going forward, bird feed revenues and input costs may be impacted by market changes, as commodity costs have recently come down. Partially offsetting the improvement in the seasonal décor and wild bird seed margins were lower grass seed margins, which were negatively impacted by higher raw material cost and the mix shift to lower-margin products in the first quarter. In the Pet segment, sales declined 5% on lower revenues in our aquatic, wild bird feed and small animal businesses. Sales in the aquatics industry as a whole have softened, and we lost distribution of certain aquatic SKUs for one of our customers in the summer of last year. Wild bird feed sales were down, due in part to customers shifting their buying until after scheduled price decreases were implemented. Our operating margin in our Pet segment increased 260 basis points, primarily due to improved gross margins, as well as reduced headcount from a year ago. The area of greatest margin improvement was in our Dog & Cat businesses. Pet margins, in general, benefited from pricing, favorable mix, the discontinuance of marginally profitable SKUs and manufacturing and distribution efficiencies. Moving back to our consolidated results. In addition to improved gross margins in both Pet and Garden, consolidated SG&A expenses as a percentage of sales continued their positive trends for the fourth quarter in a row, excluding the goodwill charge in the fourth quarter of 2013. SG&A expense as a percentage of sales improved 50 basis points to 30.3%, due principally to improved selling and delivery expense. Net interest expense increased $2 million to $12.2 million in the first quarter. Interest expense included a noncash charge of $1.7 million for unamortized deferred financing cost associated with our former revolving credit facility. As you may recall, we replaced the previous line with our new ABL in December of 2013. Our first quarter net loss was $12.7 million, or a loss of $0.26 a share, including the $1.7 million noncash charge I just mentioned. Our first quarter loss last year was $15.3 million, or a loss of $0.32 a share. Turning to cash flow and the balance sheet, our cash flow from operations improved $58 million from a year ago. The improvement in cash flow from operations was largely driven by reduced spending on inventory during the quarter. Inventories of $427 million were $29 million higher than a year ago. We increased our inventory in fiscal 2013 in response to supply chain disruptions in the prior year and began to reduce the inventory balance in the back half of last year to more normalized levels. While we are currently building for the upcoming garden season, we are focused on bringing our investment in inventory down over time when compared to comparable quarters. We've made progress in our inventory reduction while balancing these actions with maintaining our fill rates. CapEx for the quarter was $5.4 million versus $8 million in the first quarter of 2013. Depreciation and amortization for the quarter was $8.3 million, relatively flat to last year. Our cash and short-term investment balance was $31 million, and net debt was $419 million, both relatively unchanged from the first quarter of 2013. During the quarter, we paid off our previous revolver. We had no borrowings outstanding on our current facility at the end of the first quarter. During the quarter, we did not buy back any of our outstanding shares. Approximately $50 million remains available for repurchases under our board-authorized share repurchase program. In summary, while consolidated sales were relatively unchanged, we reduced our first quarter loss as a result of higher gross margins and lower SG&A expense as a percentage of sales while also improving our operating cash flow. Thank you for joining us this afternoon. We'd be happy to take your questions. George, would you please open the line?

[Operator Instructions] Our first question is from the line of Joe Altobello with Oppenheimer. Joseph Altobello - Oppenheimer & Co. Inc., Research Division: I guess first question for you, John. It seems like, in terms of the tone, it's pretty noticeable that this evening compared to last quarter, it's very much improved. And I'm just curious, obviously, the number is a little bit better than we saw in the last quarter, but did it just take some time for those cost savings initiatives and the pricing initiatives you just talked about in Pet to really kind of take hold? Or did something else happen in the last 3 months that has sort of changed the organization?

Well, I believe it's a whole series of things, including the 2 items that you mentioned. I think our operating philosophies and our operating disciplines that we're putting into place is starting to work. I believe our relationships with our customers are improving. I believe our fill rates are improving. I believe our innovation is improving. So we have a lot of good things going in our favor. Unfortunately, it's just going to take time for them to take hold, and for us to be able to see the potential of our company on the financial statements. Joseph Altobello - Oppenheimer & Co. Inc., Research Division: Okay. You did mention that -- obviously, you've taken some steps on the Pet side, and you're seeing it in the margins, and you want to kind of do the same thing to Garden. How much of what you did in Pet is transferable to Garden? Or is Garden a little bit different? And what's the opportunity, if you could sort of size it for us, in terms of potential cost saves you see across the organization in the next 12 to 18 months?

With regard to the transferability of the operating principles that we're putting in, obviously, no 2 businesses are exactly the same. But they, from a business perspective and an operations perspective, are very similar. So the concepts that we're putting in to Pet definitely apply. And having started the process, I'm more convinced just about every day. With regard to future potential, we are, right now, so focused on improving our earnings, and improving our relationships with our customers, improving our fill rates, et cetera, developing our new innovative products that we -- while we're doing this, it's taking up most of our time, most of our energy. We are looking at what the potential is. But we are learning what that potential is every day. So as soon as we have a better feel for our potential, we would then be happy to communicate how we feel of what the potential is about the business. Right now, we're just focused on increasing earnings. Joseph Altobello - Oppenheimer & Co. Inc., Research Division: Okay. Just one last one if I could. The last time, you guys really took a -- an ax to cost savings. It caught a -- it sort of kind of caught up to you with regard to customer service, and we're now heading into the heart of the garden season. Are you concerned at all or worried at all that you're not prepared for the garden season? Or do you feel like you're in a good spot at this point?

No. I think we're in a very good spot for this season. I think there's really 2 aspects to your question. First is the operations side and the cost reductions. The cost reductions have been done very surgically on more of a continuous improvement basis. So I don't see any major change in the cost reductions that would result in any impairment of service. In fact, we made sure that, as we put the changes in, that they would not impact service. The second aspect, I believe, of what you were asking about was inventory. And as we're reducing our inventories, we are monitoring and then have set a priority for our fill rates not to be impacted, and that's why we're taking a much more measured approach to reducing inventories, so that we do not impact our fill rates or our service levels in any way, shape or form as part of our inventory reduction.

And our next question is from the line of Kevin Ziets [ph] with Citi.

My question is on the Pet side of the business. If you take away the aquatics business that you lost last summer, would the business be up? Or I think could you talk about sort of what's going on at POS versus in your sales?

The decrease in sales came really from a myriad of impacts from -- on our various businesses. We had weaknesses in certain of our categories. We've lost distribution in certain of our categories, and we had some reduction in sales as a result of some anticipation of rate -- price reductions in certain of our businesses. So as you can see from that group, there is no one factor. But we also had some positive aspects. First, we eliminated some unprofitable SKUs, which impacted our financial statements, primarily our revenues. And also, we eliminated some promotions that we weren't as profitable on. And time -- reduced the timing of those promotions. And on top of that, we introduced pricing which improved our margins. So all in all, there was a myriad of impacts on our -- several different businesses. It's very hard to just say it was one thing.

Okay. And as -- I guess as pricing comes down on the bird feed business, do you think you can hold the same level of profitability that you've had over the last several quarters?

That's what we're trying to do. That's our objective.

Okay. And then as you look at the Garden business and making changes on that side of the business, are you -- should we expect that you're looking to -- that you may look to get out of businesses or get out of products in the same way that you did on the Pet side that weren't meeting your profitability thresholds? Or is there a different focus on that business?

One of the principles that we have, if we have any unprofitable business, we will always be looking at it. So as time goes on and we further develop our analysis and review and put in the operational changes in the Garden businesses, obviously, if there's unprofitable products, we would look at it and make adjustments appropriately.

Okay. And then the higher inventory levels that you have right now, is that an indication of better shelf space or distribution going into this garden season? Or is it all sort of an abundance of caution to make sure your fill rates stay very high?

Right. So back in 2013, we deliberately raised our inventory rates because we had some fill rate issues the prior year. And so the back half of 2013, we started to bring those down. It's taking time. And obviously, on the garden side, we have to get to the garden season to take advantage of moving some of the seasonal products. So while we raised it last year for fill rates, we think we're in good shape there and have been very disciplined, very focused on bringing those inventory levels down over time. But it will take some time.

Right. I guess I was just saying that they're higher year-over-year at the same time of year. So is it continuing to be -- for fill rate perfection? Or is it -- is there something we should -- that should tell us about how your placement stands for this garden season?

I think inventories are still high as kind of a carryover from last year because we went through the seasonally -- exited the season in June with our inventories very high. And so it's part of the carryover for that.

Okay, I appreciate that. And then just -- you mentioned you didn't buy back any stock. Can you see where the -- I know you haven't filed the credit agreement yet. Can you say where the RP basket stands on the credit agreement and the indenture?

With respect to all our debt covenants, we are fully in compliance. When we changed facilities from our previous revolver to our current revolver as it relates to the various covenants, there's one primary covenant, which is a -- only kicks in when we borrow up to 85% of the amounts outstanding. And we had no borrowings from the -- on the line at the end of the quarter.

Okay. And there's no restricted payments beyond that restriction?

We only have one really fixed charge covenant ratio with the new ABL.

And our next question is from the line of Carla Casella with JPMorgan. Carla Casella - JP Morgan Chase & Co, Research Division: One question, just a clarification. You talked a bit about inventory. Would [ph] you just say inventory in the channel as you go into the current quarter, is it -- how is it shaping up on -- by channel, meaning both in the mass versus other channels? And -- because it varied dramatically by Pet versus Garden.

From the channel perspective, I think -- obviously, as we approach the garden season, there's a seasonality to both our inventories and the retailers' inventories building for that garden season. I don't think we're seeing anything that's abnormal in the channel. Carla Casella - JP Morgan Chase & Co, Research Division: Well, it sounds like you said there are still some holdover from last year?

Oh. As far as our inventory, the inventory we hold on our balance sheet, again, our inventory levels are still too high. We're working on bringing them down. So as we work through the garden season, we'll be working our inventory levels down. Carla Casella - JP Morgan Chase & Co, Research Division: Okay. And then any thoughts on refinancing your -- the notes that are now [indiscernible] total [ph]?

As we look at our capital structure, we constantly evaluate that. We have 2 pieces. One, we have our bonds and we have our revolver. As we look at the bonds, those carry obviously a higher interest rate. The ABL has -- gives us additional flexibility, and our first and primary use for that is in operations. As we build through the garden season, what we do is we borrow against that line and then we build inventories appropriately and then pay it down as we collect on the receivables resulting from the garden season. We'll continue to look at our capital structure and make appropriate adjustments as we deem appropriate. We're always balancing the potential P&L benefits versus our flexibility to achieve that appropriate balance. Carla Casella - JP Morgan Chase & Co, Research Division: Okay. And are you permitted to draw from your revolver to pay down notes?

The answer is very similar there. Again, we look at our capital structure constantly and try and balance between the potential P&L benefits of one scenario versus another. But we also want to make sure we've got the right flexibility for our operations, for potential changes we want to make in the business.

[Operator Instructions] Our next question is from the line of Alan Weber with Robotti & Company. Alan W. Weber - Robotti & Company, Incorporated: You talked about new and innovative products and like that. I guess, 2 questions. One is can you talk -- is there any specific areas or segments that you're focused on? And then also, is there any kind of data that you can share with us regarding the percent of current -- next year of new products relative to what it was 1 year or 2 ago, just so that we can see or quantify improvements there?

Very good questions. First, I think from a confidentiality standpoint, it's a little difficult for us to talk about the types of products that we'll be going into. But the -- our approach to product innovation or as we call it, "product, product and product," which are our 3 strategies to improve our shelf space and our self -- and our sell-through and including our market share, is really across the board. We want to be innovative in each and every line of business. Historically, we've been known for being the most innovative competitor in our industry, and that is our objective again. So there is no weight or balance to any one individual business. On the size of the improvement, I would like to say that we'll be delivering in the future. And you probably, as we've said, won't be able to see much of the difference. It really won't be in percentages, but I think it will be in multiples of what we've been delivering over the last year or 2. Alan W. Weber - Robotti & Company, Incorporated: I guess looking at it in a different way, there is obviously expenses for product development, and there were revenues from new products. Can you -- realizing you're not going to give those kind of numbers in detail, but is that kind of equation turned now -- at least heading in the right direction? Or is it just that relationship has stopped declining?

No. In fact, I would -- I believe that what we're doing is we are putting more resources behind our product development process than we have in the past. That may or may not be reflected in costs directly on the balance sheet or income statement. But we are also looking at what each and every project that we have and we're identifying the lowest hanging fruit that we possibly can and putting our resources more efficiently towards the highest revenue and profit-producing products. Alan W. Weber - Robotti & Company, Incorporated: Okay. And I guess my last question regards to when you talked about shelf space. Are you seeing -- again, if you take away products that you're discontinuing, excluding those kinds of products, are you seeing actual signs of improved shelf space at this point or heading into the season? Or how do you stand?

I think it's too early for us to tell, and we'll be taking reads as we go.

[Operator Instructions] Our next question is from the line of Ravi Devisetty with Nidhi Capital.

John, the question I have is, I know you guys have -- making a lot of progress on Pet segment and you are trying to make the same on Garden segment. But historically, Garden segment is a much tougher business than Pet segment. Do you think you have the scale necessary to turn around the Garden segment? And approximately, you said it will take probably up to 2 years to turn around. And if things don't turn around, would you be -- would you make any strategic decisions to remove that particular segment?

First, we truly believe that the Garden segment is an attractive opportunity there. We have strong brands in that marketplace, and we have a significant expertise. The brands -- our retailers believe that our brands have a significant place on the shelf and in the consumer's mind. So we feel very comfortable with the Garden business and its growth trends and our position in the marketplace. With regard to potentially selling it, right now, we have absolutely no plans to do that and truly believe in the potential of the Garden business.

And I'm showing no further questions. I'll turn the call back to John Ranelli for closing comments.

Well, thank you for your questions and for joining us on the call today. We look forward to talking to you again in the very near future.

Ladies and gentlemen, this concludes our conference. Thank you for your participation. You may now disconnect.