Earnings Call Transcript - CENT Q1 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to Central Garden & Pet's First Quarter Fiscal 2020 Financial Results Conference Call. My name is Diego, and I will be your conference operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. As a reminder, this conference call is being recorded. I would now like to turn the call over to Howard Machek. Please go ahead.

Howard Machek, Executive

Thank you, Diego. Good afternoon, everyone. Thank you for joining us. With me on the call today are Tim Cofer, Central's Chief Executive Officer; Niko Lahanas, Chief Financial Officer; J.D. Walker, President, Garden Branded Business; and John Hanson, President, Pet Consumer Products. Our press release providing results for our first quarter ended December 28, 2019 is available on our website at www.central.com and contains the GAAP to non-GAAP reconciliation for the non-GAAP measures discussed on this call. Before I turn the call over to Tim, I would like to remind you that statements made during this conference call, which are not historical facts, including adjusted EPS guidance for 2020, expectations for new product introductions, long-term organic growth goals, future acquisitions and future revenue, margin expansion, cost savings and 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 and others are described in Central's Securities and Exchange Commission filings, including our Annual Report on Form 10-K filed on November 27, 2019. Central undertakes no obligation to publicly update these forward-looking statements to reflect new information, subsequent events, or otherwise. Now, I will turn the call over to our CEO, Tim Cofer. Tim?

Tim Cofer, CEO

Thank you, Howard, and thanks to all of you on the phone for joining today. As you know, this was my first quarter here as Central's CEO. My time with colleagues, customers, and consumers over the last four months has only strengthened my conviction about the value-creation opportunities ahead. These include sustained and attractive organic top line growth, margin expansion, and continued smart M&A activity. We have the platform, the people, and the resources required to unlock our potential. And I look forward to providing as promised on the last call, a more robust view when we share our strategy later this year. As you have seen from our press release, first quarter performance was generally in line with the guidance we gave on our last earnings call. Total sales rose 4.5%, with the increase driven principally by the Arden and C&S acquisitions. Organic sales were flat. Our loss per share was $0.08, close to our November guidance of a loss of $0.10 to $0.15. This compares to income of $0.03 per share in the first quarter of 2019. You'll recall that the key factors that made for a tough comparison with last year's first quarter include our strategic exit of the fashion-oriented pottery product line in mid-2019, a major retailer’s decision in 2019 to exit the live fish business, a fire in one of our pet bedding facilities, and the inclusion of Arden in our Garden segment. Arden typically has a loss or little to no profit in its out-of-season quarters. Importantly, Q1 is typically our smallest in terms of revenues and earnings because of the seasonality of our Garden segment. Back in November, I spoke to you about my view that Central needed to invest more in growth initiatives and consumer-oriented capabilities to drive success in the years ahead. To that end, I challenged each of our businesses to identify areas where they believe significant opportunity exists to increase sales and profits if resources were made available to them to help spur growth. The response from the businesses was encouraging with numerous areas identified for smart investments. Examples include: incremental marketing and promotion activities, enhanced digital and e-commerce initiatives, increased capital expenditures, and select additional personnel in targeted functions. We plan to begin executing on these initiatives very soon with many of them being funded during 2020. The early top line benefits of these actions will likely begin to show up later this year, and we expect to see a nice overall return on these investments over the next 18 to 36 months. So, while there may be a negative income impact as we invest in the short term, including in our second quarter, this is the right path to enable sustainable growth and strong shareholder returns in the years ahead. Importantly, our planned investments are embedded in the fiscal 2020 EPS guidance we gave last quarter. We are not changing that guidance today. We continue to expect 2020 EPS to be at or modestly above fiscal 2019 EPS of $1.61. Last quarter, I also discussed Central's efforts in the months ahead to evaluate and fortify our long-term strategy. We've kicked off these efforts to identify and prioritize the initiatives we believe will be most important in driving our success in the years ahead. Internally, we're calling it Vision 2025. And we currently have leaders across our business units and functions engaged in this important effort. We expect to share further information of this plan with investors this summer, and we'll tell you more about the specific date and format as we get closer. Finally, I want to reinforce my confidence in the long-term potential of Central Garden & Pet. We've got work to do, but I'm confident that we can deliver. And with that, let me turn it over to our CFO, Niko, to share more of the Q1 details for the company and across our Garden and Pet segments.

Niko Lahanas, CFO

Thank you, Tim. Good afternoon everyone. First quarter total company sales increased 4.5% or $21 million to $483 million from $462 million in the first quarter of last year. Our recent acquisitions were the main drivers of the sales gain. Organic sales came in relatively flat, negatively impacted by the factors Tim mentioned earlier. Consolidated gross profit for the quarter increased $1 million and our gross margin decreased 100 basis points to 27.2%, negatively impacted by an unfavorable mix of sales and the impact of the lower volumes in décor and live fish businesses. SG&A expense for the quarter rose 8% or $9 million versus a year ago, due to the recent acquisition. Our corporate expense increased versus the first quarter of last year, due primarily to higher variable compensation expense and increased third-party expenses. As a percent of sales, SG&A increased 80 basis points to 26.8%. Central's operating income for the quarter decreased to $2 million and operating margin decreased 180 basis points to 0.4% due in part to the Ardent acquisition, the lower gross margin, and the higher SG&A expenses. EBITDA for the quarter decreased 33% to $15 million. Turning now to the Pet segment. Pet segment sales for the quarter increased 4% or $14 million to $354 million and grew 1% on an organic basis, despite the live fish and pet bedding declines mentioned earlier. Most of the other Pet categories had positive organic growth. Pet segment operating income for the quarter increased by approximately $0.5 million or 2% compared to the prior year to $30 million, aided by the C&S acquisition. Pet operating margin decreased 20 basis points and remains at 9%. Our aquatics business was the main factor in the decline as supply constraints that carried over from the prior quarter impacted the period. We would expect those challenges to now be behind us. Pet EBITDA for the quarter increased 2% to $39 million. Turning now to Garden. For the quarter, Garden segment sales increased 6% or $7 million to $129 million due to the Arden acquisition. Organic sales decreased 4% despite a 4% increase in POS for the quarter. Sales were negatively impacted by our exit from the fashion-oriented décor business, lower grass seed and control sales, due in part to timing factors and much higher than normal temperatures in the eastern part of the country in early fall were also factors in the decline, offsetting some of the weakness with stronger sales in our Bell Nursery business which benefited from new distribution. And just to remind you, the first quarter is typically the smallest for our Garden segment. Garden's operating loss increased to $8 million in the quarter compared to $5 million in the first quarter of last year. Garden's operating margin decreased 270 basis points to negative 6.5%. Almost two-thirds of the decline was due to the inclusion of Arden, which was not in last year's Garden results and the décor category which was impacted by lower volumes and the disposition of obsolete inventory of the exited businesses. Garden EBITDA was a loss of $5 million versus a loss of $2 million a year ago. Now getting back to our consolidated results. In the first quarter, we had other income of $300,000 compared to other expense of $200,000 a year ago. Net interest expense increased $0.5 million to $8.6 million, due primarily to lower interest earned on our cash balances this year versus a year ago. Our tax rate for the quarter was 27.6% as compared to 14.3% in the first quarter a year ago. Turning to our balance sheet and cash flow statements. Cash at the end of the first quarter was $446 million, down from $479 million at the end of the first quarter last year. For the quarter, cash used by operations was $18 million versus cash generated of $7 million in the first quarter a year ago, due primarily to the loss for the period and higher inventories. CapEx was $10 million, an increase of $2 million from $8 million in the first quarter of 2019. Total debt was $693 million, relatively unchanged from last year. Our gross leverage ratio at the end of the quarter decreased to 3.0 times, well within our target range. We had no borrowings under our $400 million in credit line at the end of the quarter. Depreciation and amortization for the quarter was $13 million, up from $12 million a year ago. During the quarter, we repurchased approximately 829,000 shares, or $22 million of our stock. There remains $100 million on the Board's previously authorized share repurchase program, an additional 600,000 shares under the Board equity dilution authorization. It is worth noting, the substantial change to our balance sheet this quarter; we adopted the new GAAP lease accounting standard and have now added leases to our balance sheet. The effect was to gross up our balance sheet by about $105 million. At quarter end, we had a right-of-use asset of $105 million and a related liability of $110 million. As Tim mentioned earlier, we are maintaining the 2020 earnings guidance we gave last quarter at or slightly above last year's diluted EPS of $1.61. It is still very early in the year and our first quarter is typically the smallest of the year in terms of sales and profitability. As we see how the Garden season plays out, we will be in a better position to update our guidance, if needed, on the next earnings call.

Operator, Operator

Thank you. Ladies and gentlemen, at this time we will conduct our question-and-answer session. Our first question comes from Chris Carey with Bank of America. Please state your question.

Chris Carey, Analyst

Hi. Good evening.

Niko Lahanas, CFO

Hi, Chris.

Tim Cofer, CEO

Hey, Chris.

Chris Carey, Analyst

How are you? Hi. Niko, I just wanted to ask quickly on your last comment there around, you'll see how the Lawn & Garden season shapes up before thinking about adjusting the guidance. And I ask this in the context of clearly more of a weighted year to the next three quarters than what was typical given the Q1 earnings, which you had expected. So were you referring to the fact that weather is always a bit of a wildcard or were there other comments embedded into that view on the potential to change earnings guidance only after seeing how the Lawn & Garden season shaped out?

Niko Lahanas, CFO

No. The exit there is just that, the largest part of the year still remains out in front of us. And like every year, after Q1, it's really too early for us to call, and it would be unwise for us to change or adjust guidance at this stage because really the season hasn't played out.

Chris Carey, Analyst

Okay. That makes sense.

Tim Cofer, CEO

And Chris, it's Tim. And the other thing to build on what Niko said is just what you said, which is the good news is that the quarter result was within our expectations. I'm talking Q1. And so far, we're on track with our plan and that puts us in a position of confirming that full year guidance.

Chris Carey, Analyst

Yes. Okay. Makes sense. And then just given that the Pet segment has been one that has required a bit more attention recently, are you able to kind of frame the impact of the live fish retailer exit and the fire in the pet bedding business to get a sense of what the underlying trend of the business might be? And how you might see that playing out over the remainder of the year with some of these headwinds behind you?

John Hanson, President, Pet Consumer Products

Yes, this is John. As we mentioned, live fish as well as the fire did have an impact on our Q1. We would say that it was less than 3% of total Pet sales combined. The fire impact is something that's fully covered by insurance. I mean, there may be quarterly based on when we see the insurance payments come in, there may be some quarterly ups and downs on it, but we feel very good that it's fully covered. And in addition, we are currently filling all orders, dealing with all customers, and in a very good position going forward.

Chris Carey, Analyst

Okay. So the impact was relatively small, and it seems reasonable to assume that the trend we've observed this quarter in that business reflects the underlying trend of the business more or less.

John Hanson, President, Pet Consumer Products

Yes.

Chris Carey, Analyst

Okay. And then, I suppose, just last one, right? In the context of the outlook for this year and the investment spending that you're going to be putting into the business, hence the earnings outlook. And you had mentioned expecting some of these investments to come to fruition over the next 18 to 36 months and starting to feel the impact of the P&L. I wonder if you're expecting any of the investments that you'll be getting in this fiscal year to have any upside in the back half of the year? Said another way, whether you're embedding some positive impact from these investments over the course of this year in order to hit your numbers?

Tim Cofer, CEO

Yes, Chris. As I mentioned in the prepared remarks, the investment strategy was a key part of our overall plan and has been included in the guidance we provided regarding EPS. There isn't any new information on that front, positive or negative. However, as we begin to approve those investments now, there’s the potential for a slight increase in organic growth as we move into the latter half of the year compared to Q1. But since we are currently in investment mode, we shouldn't expect much impact on the bottom line. Over the next couple of years, we're making these investments based on strong ROI expectations, and we are confident about the returns over a longer period. I would emphasize two important points: first, the investment is already factored into the guidance we've shared; and second, we are making the right decisions for the long-term health of the business. This has been a focus for us over the past couple of years, but I believe we need to increase investment in certain areas I've mentioned. There are specific brand positions where we can strategically increase our investments to expand our market share. Additionally, particularly in digital marketing and e-commerce, we're at a point where there's significant return potential if we invest more. We need to strengthen some capabilities and areas to ensure the company is set up for long-term sustainable returns.

Chris Carey, Analyst

Okay. Makes sense. Thanks very much.

Operator, Operator

Thank you. Our next question comes from Bill Chappell with SunTrust Robinson Humphrey. Please state your question.

Bill Chappell, Analyst

Thanks, good afternoon.

Tim Cofer, CEO

Hi, Bill.

Bill Chappell, Analyst

From the last release to this one, I guess we've moved the financial update from the spring to the summer. And then I think the guidance was slightly better than last year to now slightly better inclusive of some of the changes that you're making. So can you give us I guess why it's been pushed out a little bit further? And then also maybe quantify if there is some difference or maybe some color there, are you not going to spend that much this year anyway so it's not that big of a difference or is there a $0.05 to $0.10 cushion to your guidance?

Tim Cofer, CEO

Sure. I'll start Bill. This is Tim. Look I mean spring and summer are adjacent seasons. So I think we're still as I said in my comments Bill, we're looking for a date. A date that's going to work for us and where we're going to get an appropriate participation rate from folks like you. So we'll be back shortly on that. It will be somewhere in that late spring early summer season. And so I don't think a big change there. On your second point, Bill no, I guess I don't see it that way. We guided at the end of last year to be at or modestly above 2019 EPS. That included our investment plans and we're reconfirming that today. So I don't see a change Bill.

Bill Chappell, Analyst

I guess asked another way, is there a way to quantify what the investment changes are doing to this year's EPS?

Niko Lahanas, CFO

We don't know that yet because we have to still see how the ROI plays out on a lot of those investments. So it's a little bit hard for us to predict. And some of them obviously are going to dribble over into next year and the year after, which is why we're a little reluctant to give an exact number.

Tim Cofer, CEO

Yes. For competitive reasons, we are not willing to disclose the specific amount of our incremental investment at this stage. However, as we progress through the quarters, you will likely see that reflected in our numbers regarding additional commercial investment. This is all included in the guidance provided last quarter and reaffirmed this quarter.

Niko Lahanas, CFO

And keep in mind too Bill that on the Garden side those investments, we still have to see how the weather plays out. If it's a horrific weather year we're not going to lean into that and send incrementally. So we're going to be pretty disciplined in the approach and we still have to see how things play out.

Bill Chappell, Analyst

Okay. Switching gears just actually into the Garden segment. Scott's implied on their call and in their numbers that they're kind of I guess reaccelerating some growth at Walmart, which has been both your core customer and your core kind of place, where you've gained some share over the past four or five years. Didn't know if that impacts your outlook, if you're seeing that. How we should read that for your upcoming Garden season?

J.D. Walker, President, Garden Branded Business

Bill, it's J.D. I'll address that question. It's challenging to provide specifics, and we won't comment on how it affects any particular retailer. Their portfolio differs from ours, so they might see gains in areas where we do not compete. They have a strong presence in mulch, rodent traps, and soils, while we excel in areas like wild bird food and are active in live goods as well as the pottery and terra cotta segments. However, we are optimistic about the upcoming year and confident in our plans with that retailer and others. Even if they highlighted certain aspects, I don't think it will hinder our ability to meet our goals for the year.

Bill Chappell, Analyst

Okay, guys. Thanks so much.

Operator, Operator

Our next question comes from William Reuter with Bank of America Merrill Lynch. Please state your question.

William Reuter, Analyst

Good afternoon. My first is a channel question in the Pet segment. I guess, if you could provide any color on how the growth of brick-and-mortar is trending versus the growth that you're seeing in your e-commerce customers?

John Hanson, President, Pet Consumer Products

Yes, this is John. Firstly, we are witnessing e-commerce grow significantly faster than brick-and-mortar in both our categories and our business. We are pleased with our growth but believe there is much potential ahead. We are continuing to enhance our capabilities and invest in this growth, particularly in marketing and other areas, and we are very optimistic about the future of e-commerce. In terms of brick-and-mortar, we are still collaborating with our major customers and have made progress. While we do not discuss specific customers, we feel confident about our relationships and the outlook moving forward.

William Reuter, Analyst

That's helpful. You continue to have a large cash balance you did some share repurchases during the quarter. Does the pace of share repurchases in the quarter reflect maybe what we should expect going forward? Or do you expect to put the pipeline for M&A may pick up and that that will be where you allocate more of the cash?

Niko Lahanas, CFO

Yes. We look at that obviously every day and we're going to buy back shares where it makes sense. We have different levels at which we purchase where we think there's tremendous value. And I think again we play that off of what's going on in M&A. My preference right now would be to do more M&A and then also invest in the business organically with CapEx or low-cost producer type of initiatives and then have the stock repurchase program be in third place.

William Reuter, Analyst

All right. And then lastly for me, I think last call you mentioned that CapEx is going to be up this year. I don't remember hearing a number. Do you have a target now that we're one quarter in? And I guess maybe one or two of the larger increases are items that are contributing to the increase are this year?

Niko Lahanas, CFO

Yes. We provided an estimate of $40 million to $45 million for this year. Some of that is due to carryover from last year, which had relatively low capital expenditures. That's why you are seeing an increase in capital expenditures this year, along with our renewed commitment to invest in the business with Tim joining us. There are no specific projects that stand out, as we have a solid array of initiatives in both the Pet and Garden segments. We are pleased with these projects. Additionally, we assess every project based on its potential return on investment before proceeding, and we have a comprehensive process and committee in place for capital expenditures.

William Reuter, Analyst

Great. That's all for me. I will pass to others. Thank you.

Operator, Operator

Thank you. Our next question comes from Brad Thomas with KeyBanc Capital Markets. Please state your question.

Brad Thomas, Analyst

Good afternoon. Thank you for taking my questions. J.D., I wanted to follow up on the trends you're observing. Could you clarify if there has been any timing shift between the fourth quarter and the first quarter? Additionally, could you provide more details on that? I would also like to hear your thoughts on how sell-in has been, as well as how your door count and shelf space are developing for this year.

J.D. Walker, President, Garden Branded Business

Sure. Thanks Brad. First of all and with regard to timing there were some minor timing differences between some volume that had shifted into Q4 versus Q1. That had a minor impact on Q1. I wouldn't call it significant. The two big drivers there were called out in the script. One was the addition of Arden and the other was our intentional exit of the fashion pottery business. So those were the big drivers there. In terms of timing that would be about it. In terms of how retailers are staffing up for the year or stocking up for the year, we're seeing opening orders that are a little bit smaller than they were a year ago and I think that's intentional on their part. Think they're being a little bit more surgical in the way they're flowing the goods to the stores. And by the way I think that that's probably smart. We had one major retailer last year, they put an awful lot of inventory in the stores early on. I think they did that to prove a point. And we're seeing their opening orders this year be a little bit smaller and it will be closer to consumption. Having said that, it will continue to build throughout Q2 and they'll be ready for the season. We feel good about the engagement level of the retailers going into the season and we feel good about our listings. So I'd say from the controllable standpoint things like inventory levels, inventory levels at retail were in great shape coming into this year. We weren't heavy on inventory. The retailers weren't heavy on inventory. The customers are engaged and we have the level of support we need. And in terms of our distribution for this year, if you factor out the – our intentional exit of some of the pottery SKUs, if you factor that out our points of distribution were up mid-single digits year-over-year. So we feel very good about that.

Brad Thomas, Analyst

Very helpful. Thank you J.D. And Tim, I was hoping to just ask you a question about the opportunity for acquisitions and how you're thinking about, if there's any brands that are maybe worth pruning? Just could you give us a sense of your state of mind on the portfolio today and your aptitude to take on maybe a medium or bigger acquisition if it presented itself?

Tim Cofer, CEO

Sure. Look, I think as you well know, M&A has been just a real critical part of the playbook of building this company at Central Garden & Pet. And it was one of the many points of attraction for me in joining this company, and I expect that to continue. So, when I look at our positions across Garden and Pet, we've got a number of strong businesses, good brands in a number of niches and segments, but there's so much more to play. And there are both in terms of the categories and segments in which we compete today to strengthen leadership positions and fortify ourselves. And then in other places, I think there's some what I call more adjacencies that are very attractive. So, it's fair to say that in the last number of months, there's no proof in that putting yet. But as Niko has shared in the past, I mean, don't mistake that for lack of appetite and lack of activity. And you got to swing the bat a few times. And we are swinging the bat, but have nothing yet to report on. But I can assure you that, as Niko said from a capital allocation strategy standpoint for me, it's about reinvesting in the business and smart growth opportunities. Then, it's about M&A and adding to our platform. And then, if we feel it makes sense based on price some buybacks.

Brad Thomas, Analyst

Very helpful, Tim. If I could squeeze one more in here for Niko perhaps on modeling for the second quarter. I don't think there's real explicit commentary on how to think about 2Q, but I think there was a reference to there being investments as a little bit of a headwind. It looks like maybe the Street's modeling earnings up a little bit year-over-year. Does that seem reasonable to you? Or are there any other considerations we should take as we think about 2Q?

Tim Cofer, CEO

No. I think where the Street is reasonable assuming we have a relatively normal weather. It does not have to be a great weather quarter, but a fairly normalized one. And I think the numbers right now are fairly reasonable.

Brad Thomas, Analyst

Very helpful. Thank you all so much.

Operator, Operator

Thank you. Our next question comes from Hale Holden with Barclays. Please state your question.

Hale Holden, Analyst

Hi. Good morning. Thanks for taking the question. I had one or two quick ones here. The increased investment that's baked into your guidance for this year, it sounded like it was more on marketing muscle and SG&A. So I was wondering if – do you feel like you also have the right product set? Or is there – would there also be increased investment in product innovation for new SKUs?

Tim Cofer, CEO

Very much innovation is part of the consideration set. We do have some pretty exciting initiatives in a couple of different business units that are either hitting the shelves today or will in the balance of the year. And part of that growth investment is against supporting that innovation. I think on top of that in general, there's a recognition right now with me and the leadership team at Central Garden & Pet that we can still build further capability in innovation and increase our consumer orientation to improve the success rate of our innovation. So part of the investment envelope is also building some of those capabilities. And that is, including things like some – as I said earlier some select additional personnel in key areas. But innovation back to the core of your question is definitely part of the book set of investments.

Hale Holden, Analyst

And then when you get the flywheel moving, do you have a sense of what the capture rate would be in terms of how much more growth versus the category you could achieve for maybe what you're currently missing out on in either one of your two core categories?

Tim Cofer, CEO

Sure. I expect to be able to share more later this year regarding our evolved strategy. I believe that will be part of what we present. However, if you examine the organic growth of Central Garden & Pet over the last couple of years, you'll see it's been relatively flat, with most of the growth coming from mergers and acquisitions. We collectively aim to achieve better results, but there are certain actions we need to take to ensure this growth is sustainable and profitable. To give you a preview, we aspire to establish those improvements, but there will be more information available later.

Hale Holden, Analyst

Thank you. Are you experiencing any supply issues from China due to potential extended shutdowns related to the virus?

Tim Cofer, CEO

Well, we're monitoring that situation as is everybody. And interestingly, this virus broke out right around Chinese New Year. So we typically order quite a bit in advance of Chinese New Year. So I think in the short-term we feel really good about our position from an inventory standpoint. But again, more to come we don't really have a sense of how long this is going to go on. And so more to come we're going to continue to monitor that obviously, the longer this goes on the tougher it'll get. But I think that's going to affect a lot of people not just our company.

Hale Holden, Analyst

Great. Thank you so much.

Operator, Operator

Thank you. Ladies and gentlemen, there are no further questions at this time. I'll turn it back to Tim Cofer for closing remarks. Thank you.

Tim Cofer, CEO

Thanks everyone for joining the call today and look forward to talking to you again soon. Have a good day.

Operator, Operator

Thank you. This concludes today's call. All parties may disconnect. Have a great day.