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Duluth Holdings Inc. (NASDAQ:DLTH)
Q2 2019 Earnings Call
Sep 12, 2019, 9:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to the Duluth Holdings Second Quarter Fiscal Year 2019 Earnings Conference Call. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]

Please note this event is being recorded.

Now I'd like to turn the conference over to Donni Case, Investor Relations for Duluth Holdings. Please go ahead.

Donni Case -- Investor Relations

Thank you, Carrie, and welcome to today's call to discuss the Duluth Trading second quarter of fiscal year 2019 financial results. Our earnings release, which we issued this morning, is available on our Investor Relations website at ir.duluthtrading.com under Press Releases.

I'm here today with Steve Schlecht, Founder and Chief Executive Officer and Dave Loretta, Chief Financial Officer. On today's call, our management will provide prepared remarks and then we will open the call to your questions. Before we begin, I would like to remind you that the comments on today's call will include forward-looking statements, which can be identified by the use of the words such as estimate, anticipate, expect and similar phrases.

Forward-looking statements by their nature involve estimates, projections, goals, forecasts and assumptions, and are subject to risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements. Such risks and uncertainties include, but are not limited to those that are described in our most recent annual report and Form 10-K and other SEC filings as applicable. These forward-looking statements speak only as of the date of this conference call and should not be relied upon as predictions of future events.

And with that, I'd like to turn the call over to the Steve Schlecht, Chief Executive Officer of Duluth Trading. Steve, go ahead.

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

Good morning, and thank you for joining our second quarter 2019 conference call. We have a fair amount to cover on today's call, but before we begin, I want to acknowledge the contributions that Stephanie Pugliese has made to our Company. As CEO, she worked tirelessly and enthusiastically to execute our strategy to build an omni-channel approach to marketing, she led the growth of our successful women's category, and oversaw the addition of 50 retail stores. Her talents and achievements did not go unnoticed and opened the door to a new opportunity with Under Armour. Everyone who has worked with Stephanie will miss her and we will -- we wish her the best success in her new endeavor.

Following her unanticipated resignation, it was an easy decision for me to step back into the role of CEO. As Duluth's Founder, I'm very proud of what we've accomplished and I'm truly committed to ensuring the continuity of our vision, our culture and our forward momentum. While I haven't been the public face of Duluth Trading for some time, I have been actively involved in all aspects of the business.

With our talented and dedicated team, we have achieved a smooth transition without any disruption to our business and we remained totally focused on our all-important fourth quarter. That said, we have our work cut out for us. Our performance in the first half of the year was below our expectations, and it will definitely pressure the outcome for the full fiscal year. In response, we have taken down our guidance for 2019. Dave will address the details of our second quarter financial results, this revised guidance and the plans we have moving into 2020.

Also I want to recognize that we have had some growing pains over the last year-and-a-half. I want to see a slowdown in the pace of our retail expansion in 2020, and focus more on improving asset productivity and thus our operating margin rate. We have made a number of behind-the-scene improvements in our business that will bear fruit in 2020, which excite me. We have a strong team in place to execute our plans and to ensure the long-term success of the business.

In general, our top priorities remain the same. First, is to drive top-line growth through new product offerings and targeted marketing that expands our brand awareness. Second, is to leverage our cost structure to drive profitability, while ensuring that we exceed customer expectations. And third, to achieve greater return on our investments. Our team is well under way to implementing these top priorities, and we expect to see signs of improvement in the second half of this year.

And now, I will turn the call over to Dave.

Dave Loretta -- Senior Vice President and Chief Financial Officer

Thanks, Steve, and good morning, everyone. For the second quarter, we reported net sales of $122 million, up 10% compared to $111 million last year. Our Direct segment sales were essentially flat to last year at $60.3 million and our Retail segment sales grew 24% to $61.7 million. For the quarter, shipping revenues were $1.6 million compared to $1.9 million last year. The growth in Retail was primarily driven by new stores opened in 2018 and 2019. During the quarter, we added four new stores and over 60,000 gross square feet, with each of them being our first stores in the states of Arkansas, Connecticut, Alabama, and Georgia. We ended the quarter with a total of 55 stores compared to the prior year of 39 stores.

In the second quarter, we continued to experience the challenges we faced in the beginning of the year. Sluggish sales trends in the direct channel and existing store markets deepened in the second quarter, especially in May, with traffic and overall sales volumes falling short of our expectations. In an effort to drive more store and web traffic, we extended our global promotions and took deeper markdowns on spring and summer products, particularly on core men's items. As a result, our gross margin for the quarter declined 310 basis points for a gross profit of $64.8 million.

Our women's business continues to outpace men's, with an overall growth rate of over 20% for the quarter and mid-teens growth rate online. We expect this positive trend will continue in the back half of the year with a greater assortment of new women's items, the launch of our Workday Warriors collection and an increased number of plus-sized skews. To address the more challenging men's business, we also have new product launches and an increased number of new items that we expect will reverse the current trend.

Looking out to the second half of the fiscal year, we expect to see gross margins improve, but will fall short of making up for the first half declines. Two areas of pressure are heavier clearance activity in August and early September, and the unavoidable impacts of China tariffs, which we estimate will negatively impact gross margin by 20 basis points for the full year.

As of now, our total sourced product with exposure to China is less than 15%. And by 2020, we expect to transition all our apparel goods out of the country, but we'll have a small remaining amount of accessories with minimal margin impact.

Selling, general and administrative expenses increased 16.7% to $61.1 million compared to $52.3 million last year. This included an increase of $400,000 in advertising and marketing expenses, $1.3 million in selling expenses and $7.1 million in general and administrative expenses. As a percentage of net sales, SG&A expense increased 280 basis points to 50.1% compared to 47.3% last year. As a percentage of net sales, advertising and marketing costs decreased 90 basis points to 13.4% compared to 14.3% in the second quarter last year, primarily due to advertising leverage gained from a higher mix of retail sales.

Selling expenses as a percentage in net sales decreased 30 basis points to 14.4% compared to 14.7% last year. The decrease is attributed to improved shipping and fulfillment costs, partially offset by an increase in store labor due to additional stores.

General and administrative expenses as a percentage of net sales increased 400 basis points to 22.3% compared to 18.3% last year, primarily due to an increase in occupancy costs from the growth in the number of retail stores, an increase in depreciation expense due to investments in technology and corporate facilities, and an increase in personnel cost due to added headcount to support the growth of the business.

Despite the incremental store cost and associated lease expenses, we have now mostly cycled past the larger fixed investments in the business from last year. In the second half of the year, we expect SG&A as a percentage of sales to decrease by over 150 basis points compared with last year, and we'll support the expected growth in earnings going forward.

For the second quarter, we reported net income of $1.9 million or $0.06 per diluted share compared to net income of $6.4 million or $0.20 per diluted share last year. Our adjusted EBITDA was $9.6 million compared to $13.1 million last year.

Turning to the balance sheet and liquidity, we ended the second quarter with a cash balance of $3.5 million, net working capital of $66 million and $45 million outstanding on our revolving line of credit. As a side note, I'd like to clarify the presentation of debt on our balance sheet. In the notes of our filings, you'll see roughly $28 million, of long-term debt related to a third-party entity called TRI. In accordance with ASC Topic 810, which covers the accounting for variable interest entities, we are required to consolidate this entity as it relates to the development of our corporate offices here where we are a tenant.

Duluth Holdings is not a guarantor, nor are we obligated to repay this loan. The loan covenants under our bank line of credit exclude this debt.

Moving on, inventories increased 12% to $114.8 million compared to $102.4 million for the comparable period last year. The increase in inventories due to the additional stores, plus slightly higher levels of clearance goods.

As we mentioned on our last call, our inventory plans for the back half of the year will result in a higher third quarter ending balance. This reflects our goal of receiving goods several weeks earlier to mitigate issues we had last year with a dislocated inventory in our DCs and store channels. Our expectation is to have inventory back in line with expected sales growth by year-end.

Capital expenditures for the second quarter were $7 million compared to $12.8 million last year, and were primarily for the new store openings. While we will complete 2019 with 15 new stores, we expect the pace of capital outlays will moderate going into 2020, as we rebalance our business model to focus on driving greater returns on the capital invested and driving positive free cash flow.

We plan to continue opening stores in new markets, but we'll likely plan for expanding square footage by 30% to 40% less than we have over the last few years. We expect the capital deployed for systems and infrastructure will also moderate, as much of the foundational investments needed to scale and support our growing omni-channel business are now in place.

Two key initiatives that remain on our technology roadmap include an upgrade to our store POS systems and a replatform of our customer data warehouse. Both are expected to be implemented next year, and will have [Phonetic] tangible revenue driving benefits. We will provide further direction on our updated capital expenditure plans when we provide guidance for 2020.

As Steve mentioned, we are adjusting our outlook for the second half of the year based on the first half softness. We expect to deliver second half year-over-year sales growth of roughly 10%, supported by four main drivers. First, new market expansion with stores. We are on track to open 15 new stores in 2019 in 13 new markets. Second, we anticipate growth rates in online sales in the mid low-single digit range, supported by continued strong online growth in our established markets. Third, newness. We'll see growth from new products in both men's and women's categories supported by tighter whole house marketing messages and advertising that drives traffic to stores and our website. And lastly, improved inventory flow and positioning to satisfy our customers' expectation for completing the sale wherever and whenever they want.

In addition to growing top line, we've also been keenly focused on expense management, including getting the most out of our advertising spend. The steps we've taken to leverage fixed cost and gain variable expense efficiencies are already yielding results.

Now that I've given you some color around the second half of the year, here's an updated guidance for the full fiscal year 2019.

We expect to deliver sales growth of roughly 10% on a 52-week basis or net sales of between $610 million and $620 million in 2019. We expect gross margins to be down 50 basis points to 100 basis points, and selling, general and administrative expenses as a percentage of net sales to be in the range of 48% to 49%.

We expect 2019 earnings per diluted share to be between $0.60 and $0.66, which compares to $0.68 last year on a 52-week basis. This assumes a full-year weighted average diluted share count of 32.4 million shares and a tax rate of 26.5%. We expect adjusted EBITDA to be between $51 million and $55 million and capital expenditures of roughly $40 million.

But most importantly, we expect the second half of 2019 to be our turning point on growing operating margins and delivering the growth in bottom line results we've been planning for and investing in.

With that, we'll open the line for questions. Operator?

Questions and Answers:

Operator

[Operator Instructions] The first question will come from Jonathan Komp from Robert W. Baird.

Jonathan Komp -- Robert W. Baird -- Analyst

Yeah, hi. Thank you. Steve, I just wanted to maybe start and just ask a broad question. Given that transitioned in place and your positioned back in the leadership role, can you just give an update on kind of what you see over time? Do you expect to initiate any type of search for a permanent replacement, or how long might you be committed to overseeing operations in the current role you are?

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

Good morning, Jon. Well, as I told our Board, I'm all in this and very willing to spend the time that it takes to complete the search, but also to make sure that we have a very successful fourth quarter this year and we build the roadmap for 2020. I really see us starting the search in early 2020. And our focus will be on someone who really has strong brand credentials, merchandising, marketing, retail and direct marketing. Those will be a lot of things we'll be looking for. So hopefully, we'll have the search completed by mid-to-late 2020, Jon.

Jonathan Komp -- Robert W. Baird -- Analyst

Okay, great. That's helpful. And maybe a question about the comments into 2020 and the decision that this moderate the retail growth, maybe just bigger picture conceptually, how you're thinking about that moderation. Is that more of a pause temporarily till the business gets back on more of a solid footing from an operating margin and earnings perspective? Do you think that's a longer-term shift? And maybe if you could just talk about some of the benefits you expect to accrue from just being able to focus more on the core business and maybe less on the rapid retail expansion?

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

Well, yes, it is somewhat of a pause. But we're still committed to a national footprint with our stores in the future. My objective here is to see us improve our operating ratio. And to do that, part of it is to slow down the growth of the business. We've digested a lot over the last two years, took on a lot of changes and whatnot, and I think it's time that we really focus on executing well and continue to build the brand.

Dave, do you have anything else that you might add to his question at this point?

Dave Loretta -- Senior Vice President and Chief Financial Officer

Yeah, Jon. We don't have the longer range plans detailed out yet. Moderating capital growth into next year is a combination of focusing on what we've already invested, but also some cautiousness on where the economy, where the industry might be going and just not getting too far ahead of ourselves in terms of deploying more capital. But it doesn't mean that we don't think the brand still has the same long-term growth opportunity that we've always articulated. So, nothing is really set in stone on that longer range growth. We're still targeting the range of -- our long range objectives as we always have.

Jonathan Komp -- Robert W. Baird -- Analyst

Okay. And maybe just one follow up, Dave. Following up on that and asking a little bit different, but when you look at the SG&A ratio this year, 48% to 49% would be a high mark for the Company. Is there any sort of longer-term vision on where that could be and maybe just any broad stroke comments on the individual pieces where you could get some leverage over time, especially with less of a focus on the capital investment growth in the short term?

Dave Loretta -- Senior Vice President and Chief Financial Officer

Jon, I guess, specifically on the SG&A rate, I mean, we know we've got the opportunity to leverage that and that's going to start to be realized this second half of the 2019. Getting our operating margins back to where they historically were in, high-single digit, low-double digit is still our objective. So, we think that's not coming at the expense of more capital. It's -- they go hand-in-hand.

Jonathan Komp -- Robert W. Baird -- Analyst

Okay. Appreciate the perspective. Thank you.

Dave Loretta -- Senior Vice President and Chief Financial Officer

Thanks.

Operator

[Operator Instructions] The next question will come from Dylan Carden with William Blair.

Dylan Carden -- William Blair -- Analyst

Yeah. Hi. Thank you very much. I was wondering either Dave or Steve, if you could talk about some of the behind-the-scenes investments that you alluded to in your prepared remarks and just sort of how those flow throughout sort of the balance of the year and into 2020, and when benefits from those at least from an operating margin standpoint are expected to really take hold?

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

Yeah, Dylan, I guess what we've talked about from the investments in our infrastructure and logistics, I mean, those have been in place starting last year and the benefits that we're getting from those are materializing in our ability to leverage SG&A. So I think that's been clear as to how we've articulated where some of the capital spend has been. If there's a specific area within that, that you were curious about, I'm happy to go deeper with you.

Dylan Carden -- William Blair -- Analyst

Yeah, I guess maybe then sort of store functionality. I know POS rolling out next year, but some of the inventory management tools that you've implemented, any kind of early signs as to how those are helping sort of drive efficiencies?

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

Sure. Well, we definitely have the opportunity within the inventory planning and flow of goods to improve that, where we're going to see in this back half of the year is a better inventory positioning from the planning standpoint and from an open to buy. So we expect that's going to be -- that's already materializing in a better handling, better throughput of the inventory, better logistics coming down from having inventory in the right locations and having the goods in the right place and having them in the stores more timely. And that comes from both, use of the tools, but also our planning approaches to that. So that's what's going to realize in the benefits.

Dylan Carden -- William Blair -- Analyst

Great. And then, sort of I guess, coined [Phonetic] from that, any sort of guidance you can give around on the flow, or particular around men's new product into the back half? Is mostly a holiday event?

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

The flow is starting right now. I mean, we now have a new pants category that we're really excited about that expands sizing. And then we have some goods coming in our Alaskan Hardgear category that's going to be new, that will come out in the next month. But we're -- we are resetting our store sets right now. And so, you'll see those on the floor starting this week and then more coming out in October.

Dylan Carden -- William Blair -- Analyst

Great. And then I just -- last one for me, sorry. Thanks for taking all the questions. Women's now, as a percent of the business, is there any update to that, sort of where that's landed or will end the year?

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

It's still going to be trending a little bit under 30%, close to 27%, but it's got a lot of momentum, and that comes from both, the product set that we put together for it, but also the strong marketing behind it, some of the TV advertising and in -- coordinated marketing behind women's campaign and upcoming our Workday Warriors collection is new for us. And so there is potential to see that 27% where we sit today, start to creep higher because of that opportunity.

Dylan Carden -- William Blair -- Analyst

Great. Thank you very much.

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

Thanks Dylan.

Operator

[Operator Closing Remarks]

Duration: 25 minutes

Call participants:

Donni Case -- Investor Relations

Stephen L. Schlecht -- Executive Chairman and Chief Executive Officer

Dave Loretta -- Senior Vice President and Chief Financial Officer

Jonathan Komp -- Robert W. Baird -- Analyst

Dylan Carden -- William Blair -- Analyst

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