Tandy Leather Factory, Inc. (TLF) Q1 2019 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the Q1 2019 Tandy Leather Earnings Conference Call. [Operator Instructions] And as a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Tina Castillo, CFO. Please go ahead.

Good morning and welcome to Tandy Leather's first quarter 2019 earnings conference call. Also joining me today is Janet Carr, our CEO. This morning, I will start with a discussion of our first quarter 2019 results. Then I'll turn the call over to Janet, who will provide an update on the progress we've made around strategic initiatives to drive longer term earnings growth. We will then provide some time to take your questions. Before we get started, our earnings release and related SEC filings are available on our Investor Relations section of our website, and a replay of this webcast will be available later today. Please keep in mind that there may be forward-looking statements on this call today. Statements would include words like expect, believe, anticipate, plan, intend, target or words with similar meaning and are based on our beliefs and expectations and are subject to certain risks and uncertainties that may cause actual results to differ materially from our forward-looking statements about those results. Many of these risks are detailed in our various filings with the SEC such as the most recent Form 10-K and 10-Q as well as in news releases and other communications. We do not undertake to update or revise any forward-looking statements, which speak only as of the time they are made. Looking at our first quarter results, there were a few positives. We delivered a 2.4% sales growth, our operating expenses excluding either onetime or noncash expenses declined nearly $300,000. We also made progress on rightsizing our store fleet in closing three underperforming stores. In addition, we reduced our inventory levels, which helped drive our cash from operations to $3 million for the quarter. Nevertheless we also saw our gross profits decline and combined with an overall net increase in operating expenses, our operating earnings declined nearly 34% as we're just beginning the investments in our new operating model, which may continue to negatively impact our results in 2019. Later in our call, Janet will share with you an update on our progress towards strategic initiatives that are intended to provide the foundation for future earnings growth. For our top line sales, the 2.4% improvement this quarter over last year's first quarter was primarily due to the launch of new sewing machine that contributed nearly $500,000 in new sales as well as higher clearance and promotional activities as we cleaned up some of our inventories including closing out our store in Australia. While these promotional activities favorably impacted sales, they had a negative impact to gross profit which declined $400,000. Approximately half of the gross profit decline was due to these promotional activities while the other half was due to customer and product mix and higher freight costs. Turning to operating expenses, we incurred $155,000 of onetime store closure cost related to the 3 underperforming stores we closed this quarter with the majority of this amount related to Australia. In addition, we incurred $100,000 of onetime severance cost related to eliminating certain positions mostly at our corporate office. We also had an increase of $156,000 in noncash share-based compensation. Excluding these items, our operating expenses declined $300,000, mostly due to cost savings from our U.K. store that closed in September 2018, lower advertising, print and postage cost, lower healthcare cost and savings on the pause in store relocations. As a result of the $400,000 gross profit decline and the $200,000 net increase in operating expenses, our income from operations declined $600,000 to $1,169,000 compared to 2018, $1,769,000. This 33.9% decrease in operating earnings, while not unexpected, was of course significant. As we've said in our prior calls, 2019 will be a year of significant investment and while painful in the short term, we believe these investments are required to deliver longer term earnings growth. During the first quarter, we fully repaid our outstanding debt, which helped reduce interest expense by $33,000 this quarter compared to the last quarter. Our effective income tax rate was 26% compared to 27% last year. This slight decrease was due to the mix of domestic and foreign taxable income. We continue to generate strong cash flow from operations which was $3 million for the quarter driven primarily from the $3.3 million reduction in inventory. This reduction in inventory was the result of 3 store closures this quarter as well as our efforts to clear out damaged in sale inventory and slowing our [indiscernible] as we deplete some of the excess on hand. While we made progress on some of the damaged in sale inventory, there are still more to go and we will be taking more aggressive discount on selected items in the second quarter to sell three. Looking at our cash levels, we started the year with $24.1 million on hand and during the quarter we added $3 million from operations. We do need cash to buy $5 million in U.S. Treasury with maturity less than one year. We fully paid off our $9 million outstanding debt and bought back $714,000 of outstanding shares of treasury stock. That leads us with $12.7 million of cash at the end of the first quarter. Consistent with our position on the last earnings call in March, we are not providing guidance for 2019 as we focus on growing longer term profitability. With that, I'll hand the call over to Janet.

Thanks, Tina. And hello again, everyone. In the 2 short months since our last call, we continue to make significant progress against our strategic initiatives. Before I discuss these initiatives in more depth, let me just review our overarching strategy and the rationale for the actions we're taking. Our assessment of our situation is that we have strong brand equity with Habius and room for improvement with advanced and business customers. Our stores and service are our competitive advantage, in particular with Habius who value the expertise of the store staff, ability to demo tools and machines, and to touch and feel the leather. Habius advanced leather crafters and smaller business customers, collectively we're calling them retail customers, also value the convenience of retail stores and the Tandy store as the hub of the leather crafting community. Stores are a critically important part of our model and we need to fine-tune them for success. Our larger business customers or commercial customers as we're calling them now as a segment have declined over the years. It's been difficult to meet their needs for tailored products, consistent quality, competitive pricing and a professional service model out of our retail stores. These customers have for the most part been left a shop for their wholesale needs off of our retail shelves. As a result, their perceptions of Tandy are less positive than we would like. They think we're great for Habius, but not for professionals and we believe we have lost share to a number of small wholesale focused, but fragmented competitors. As we discussed in March, to address these two different segments of customers, we need two different business models tailored to their needs and economics. The relatively high margin retail customers need to be served with a relatively high touch, high class retail operating model. And a relatively low margin but higher volume commercial customer can be served with a lower cost but better targeted operating model. This is what we've begun to build along with the infrastructures, the processes, the talent, the data, the systems, the how-to as we're calling it, to make it all happen with an optimal economic return. This overarching strategy ties back to the three priorities that we described in November and March: one, re-establish our brand credentials, two, build an emotional and compelling leather crafting retail experience and three, create the right proposition to bring business customers back into the brand. Now let's talk about some of the initiatives that we've begun and how they support the strategy and reflect the priority. The most important is the pricing initiative, what we call Everyday Honest Prices, that we phased in globally over the last six weeks. It simplifies our previously very complex and confusing price tiers, makes our pricing transparent to customers and most importantly makes our prices more competitive for all customers. We heard loud and clear from our customers, especially the highest vendors that our regular retails were too high. And after in depth competitive benchmarking on virtually every skew in our assortment, we agreed. In addition to being trapped in the high-low promotion cycle with customers trained to wait for sales, these high prices and many complex levels of price contributed significantly to a perception that Tandy was ripping customers off. To address all of this, we took a number of integrated actions. We lowered price on virtually every skew in the line. We eliminated the wholesale clubs and the separate prices on every product that we maintain for gold members, elite members, business customers and what we called manufacturing customers. If you've been in our stores, you would have noticed that every price tag had three prices on it, and we have separate prices for business and manufacturing customers. Now we have one clear competitive price at retail with an additional 10% discount for military and first responders and an additional 15% off for business customers. We eliminated the ability of store managers to set price on product in-store, eliminating stores competing against each other and creating fairness and consistency for customers. We launched the commercial division to serve the largest customers with pricing targeted against our wholesale competitors. And we implemented a reseller license agreement to provide a leveled playing field for the resellers and maintain brand and price integrity for Tandy. We launched our new pricing program with a full-on marketing campaign with in-store, direct mail, digital, social and even direct personal outreach to our largest customers. We do expect to see longer term lift in sales and gross margin dollars from the price elasticity alone. And we expect the improvements in positive perceptions of the brand, which we are already seeing in social media, to drive share gains as well. However, it's going to take some time for the full impact of this change to be seen and there may be significant variability in the short run. The longer term goal is to both increase customer spend and to bring lapsed customers back into the brand, especially the higher spenders. We will continue frequent marketing messaging to drive traffic and conversion, but the call to action will evolve from sale: get something cheap right now; to inspiration: we've got just the product you want at great competitive prices. Big promotional events like Black Friday will continue to be a hugely important part of our business. And we will continue to fuel those events with special items bought in at low cost, so we can offer super values. It is still very early days with this initiative and we do expect to learn and evolve over time. We wouldn't do this if we didn't think it would drive real long-term sales and profit growth. But there will be an investment in the short run with a lot of puts and takes as both we and our customers learn from each other and adjust to the new value equation. Our second major initiative since we last spoke in March is the launch of our commercial division. This division is targeting our largest commercial customers, those running real full-time businesses and for whom shopping in retail stores is neither convenient nor economical. Many of these customers need products that we don't currently carry in our retail stores, but can easily and quickly source. They need consistency of supply and quality. They need tailored shipping options, including the ability to use their own shipper accounts or ship to multiple locations. Most importantly, they need competitive commercial pricing, including volume price rates. And while this competitive pricing drives a lower gross margin rate, the margin dollars can be incremental as we expand the business and it operates with a much lower SG&A base. We started with a small team of three with a few more to come in the near term. They're focused on transitioning the larger customers from the retail store relationship to the commercial account representatives. These reps are located in their territories, are deeply knowledgeable about product and the industry, and are taking orders directly from customers. We have a dedicated Operations Manager in Fort Worth who is handling leather selection, order management and sales support. This team has a direct conduit into our product management group, to quickly identify, source and price requested products. This team is also in a startup mode. They started with our current line, priceless, hardware samples and swatch books and our current customer base. But the plan is to use this only as a starting point and to be ready to evolve all aspects of the offering as we learn what customers need, what competitors are doing, and what it takes to bring new or last customers back into the brand and how the economics play out. So far, the feedback from these customers, both old and new, has been overwhelmingly positive. Now that we have the basics down, our highest priority for this team is to get more qualified commercial account representatives hired. So while the pricing and commercial are the two biggest initiatives that we've launched in the last two months, we have a lot of other things going on as well and I'll touch on a few that are likely of interest to you. As we discussed in March, we are rigorously evaluating the 4-wall cash flow performance of stores as a key factor in shaping our fleet. We finalized the closure of 3 stores in Q1: Australia, Fort Wayne, Indiana and Irving, Texas. While we have incurred some onetime operating expenses related to the closures, we have retained a better-than-expected portion of sales from those stores in our other stores, as we implemented a targeted marketing program designed specifically to drive retention. When we can retain at least 30% of the gross margin dollars while eliminating all of the unproductive operating costs, we can improve the long-term operating income run rate. We have also announced that our Manchester, U.K. store will close in mid-June. Its high rent and operating costs were a long-term limitation to its ability to get to positive cash flow. The U.K. will now be served like Australia, through the web and fulfilled from our warehouse in the U.S. The other area of focus is inside the four-walls of our stores, inventory. As Tina mentioned, our inventory declined by $3.3 million from December 31. We achieved this through a combination of factors: selling through some of the discontinued and obsolete inventory that we wrote down in Q4 and giving more control of replenishment to store managers, along with a bonus target based on inventory turns. But the longer term opportunity with inventory requires that we build some foundational merchandise planning capabilities. In March, I told you that we needed to understand and forecast demand in season selling, price and promotion responsiveness and sell-through to manage and plan buys, receipt flow and finally, optimal inventory levels. When we have these tools and capabilities in place, we will be able to more deliberately manage our inventory to the right levels. To do all of this, we need to evaluate our product development, merchandising, merchandise planning, sourcing and in-house manufacturing capabilities, and determine where to invest and where to divest. We've made progress on two fronts. First, we reduced our factory workforce by 75% with very significant inventory positions in most of the products produced in our factory. And as we are evaluating lower cost outsourced options, it became clear that we could not support the factory staff at those levels. We're making some tough decisions to put us back on the path to growth. And on the second front, we now have a senior leader overseeing the merchandising and commercial functions. In the time that she has been on the team, she has already brought a disciplined analytical approach to product category management, product lifecycle, open to buy, promotion and of course inventory. This role is critically important in helping us achieve our strategic and financial goals. With our senior team now close to complete and with a clear customer facing strategy, with significant progress on key initiatives, we are well on our way to rebuilding the foundation for longer term earnings growth. As we keep repeating, in case anyone missed it, 2019 is a year of investment in repositioning the brand in the market and building foundational business processes and infrastructure, and in our talent and capabilities. We have a lot of very strong assets to work with to put the brand on the path to sustainable growth and we are committed to having the patience to get there. Now, your questions.

[Operator Instruction] And the first question comes from the line of Kelly Cardwell from Central Square Management.

So I appreciate all the commentary and just wanted to dig into the 2019 as a year of investment, which I think you guys have made abundantly clear. But actually if you look at the quarter, I guess if you strip out the onetime store closure costs, operating profit was only down, what, $200,000 year-over-year. So number 1, just want to make sure my math is right. And then number 2, I guess, wanted to better understand, do you think the first quarter reflects some of the investments that you're making or is what you're telling us that you were just getting things started and we should expect even more non-onetime cost types of investments going forward?

So, Kelly, I'll take the first question which is operating income and you're exactly right. Excluding those onetime noncash operating expenses and looking at gross profit, yes, our operating income would have just declined by $100,000. And I'll let Tina answer the second question.

I think as we have said, Kelly, it's a lot of uncertainty. We do have a plan, we do have a target that we're working toward. We are -- because of the high level of uncertainty, because of all of the initiatives and actions that we're taking, we are very reluctant to give you a direction about where that's going to land frankly. We're not exactly sure, we don't have the crystal ball either. What we do know is that we're taking a lot of actions, that we are making investments. And so I'm very reluctant to draw any connection between Q1 results and what we may see for the rest of the year.

No, I appreciate that and I'm certainly not looking for any specific numbers. I guess, what I'm just trying to better understand is if these actions were already underway in Q1 or if this is something -- because it's evolving, it's kind of a -- maybe it builds throughout the year and so what we should expect is you're layering [indiscernible].

Yes, that's a fair question and I would say, obviously we could not have launched something like our Everyday Honest Prices or our commercial division like boom out of full cloth. So to the extent that the question is, were you working on these things in advance, yes, we were and we have a number of other initiatives that we are continuing to work on through the year. This is not it, there was much, much more to come and we will talk about those things as they happen in each quarter. And much of what we did do in Q1 was just the beginning of what we will do through the rest of the year.

And Kelly, just to be clear, the pricing initiatives didn't start until April in Canada and then late April in the U.S. And our commercial group, they really didn't get started until mid-April. So our first quarter result do not reflect the pricing or the launch of our commercial.

[Operator Instructions] We have a question from the line of Josh Bailey, a retail investor.

So the decision to keep the Spain store open is interesting. Can you talk about that decision? Is that based on lease expiration or are the economics more favorable than your other international stores?

Yes, economics very favorable and I can't recall if we talked about this in our last call. But my reluctance to close a store that's delivering significant positive cash flow regardless of whether that store is strategic is a big driver of this decision. It's a good store, it's producing, it serving all of Europe, it does suck up disproportionate management time, but I think we all think that's probably worth it for now and it's hard to justify closing a very profitable store. So that's where we are with Spain.

Okay. There've been a lot of announcements recently about wage increases at the retail level. Are you seeing wage pressure in your markets?

We have seen some wage pressure in some of the markets. I have to say California I think is not a surprise, it's a tough market for us. We've taken a lot of other steps to be honest that are sort of about creating sort of more of a total package. So we increased the number of paid holidays that our full-time employees and our part-time employees receive. We changed and improved our time off, our PTO policy, we've just implemented a new health insurance benefits package. So the answer is that I think we're mitigating some of the wage pressure by creating a better overall package, to use HR speak of total rewards for our employees, a better work environment, better work rules, et cetera. Those things I think are really helping to mitigate. Most of our employees, if you think about store employees for Tandy, these are people who are tech, for the most part very passionate about leather crafting. And so they consider this to be a little bit more of a calling in some cases and I think you can create the right work environment and a little bit of a career path for these folks. You're not necessarily competing with like GameStop, right, or McDonald's for their -- for that kind of labor, if that makes sense.

It does, it does.

One of the other things that we did as you know, last year if you've been following Tandy, is we tested extending our store hours, we opened later on a couple of evenings and then we tested opening on Sundays. We've since done analysis and determined that these extra hours weren't really driving a return on that investment. And so some of what we saw in the first quarter is a saving from not having extended 2 hours, help mitigate some of the wage pressures that we're seeing as well.

Okay. And then as a perfect segue, what have you considered -- what has Tandy considered as far as moving equity participation down through the different levels of employees, is that a consideration?

It's something that the board will be taking up in the near future.

We have a follow up question from the line of Kelly Cardwell from Central Square Management.

Just one more, the inventory was very encouraging to see, bringing that down $3.2 million. Would you care to guess if or just elaborate if we're more confident perhaps that we can get back to those 3-plus times turn that Tandy had historically before they made some misguided moves?

I think I said in March that I don't see any reason why we can't get back to that at some point. But we've got a lot of work to do to put the right sort of foundation in there. We're very conscious with the 115 retail stores that you can't starve them of inventory or you're going to lose sales and that's also desks. So what -- we're taking it down where we can, where we can make sort of easy decisions, but we really need to have those analytics in place to be able to make real progress and chip away at it. So I believe we can get to 3 turns, we ought to be able to, but there is a lot of work to do to get there.

Is it fair to assume that the stores that are being closed are not only the least profitable stores, but also likely on the bottom end of on the inventory turn side?

We haven't necessarily seen that correlation.

Okay. So this is more of a problem than that.

We've been evaluating store mostly, yes, on a 4-wall cash flow basis. But as I said in the prepared remarks, we're really -- we've taken a position that some of these stores, especially in markets like Fort Worth where they're very -- we have a lot of stores, they've been very sort of densely populated stores. When we've taken various focused marketing efforts to retain those customers, we've been very pleased with being able to retain their sales and now you can do that on taking out all of the inventory, all of the SG&A of a store. So this is going to be part of our model going forward as we think about which store stay open, which move, which close, will have huge aspect of can we retain those customers in other stores or online.

[Operator Instructions] I'm showing no further questions at this time. I would now like to turn the conference back to Ms. Janet Carr.

Well, I'm very proud of the accomplishments of the Tandy team over the last 7 months and I'm really honored to be a part of it. We have a strategy, we have a plan to execute and we have the team to get it done. Thanks for your continued support of Tandy and we're looking forward to updating you on our progress in a few months.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.