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Ladies and gentlemen, thank you for standing by. Welcome to Central Garden & Pet's Third Quarter Fiscal Year 2018 Financial Results Conference Call. My name is Kevin, and I'll be your conference operator for today. [Operator Instructions] As a reminder, this conference is being recorded.
I would now like to turn the call over to Steven Zenker, Vice President of Investor Relations, FP&A and Communications. Please go ahead, sir.
Thank you, Kevin. Good afternoon, everyone. Thank you for joining us. With me on the call today are George Roeth, Central's President and Chief Executive Officer; Niko Lahanas, Chief Financial Officer; Howard Machek, SVP, Finance and Chief Accounting Officer; J.D. Walker, President, Garden Branded Business; and Rodolfo Spielmann, President, Pet Consumer Products.
Our press release providing results for our third quarter ended June 30, 2018, is available on our Web site at www.central.com and contains the GAAP to non-GAAP reconciliation for any non-GAAP measures discussed on this call.
Before I turn the call over to George, I would like to remind you that statements made during this conference call, which are not historical facts, including adjusted EPS guidance for 2018, expectations for new product introductions, long-term organic growth goals, future acquisitions and future revenue, cost saving and profitability as well as the expected impact of the recent tax reform act 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 29, 2017. 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, George Roeth. George?
Thank you, Steve. Good afternoon everybody. Central Garden & Pet continued its strong growth trajectory in Q3 by increasing overall sales 15%, and EPS by 27% to $0.79 per share versus $0.62 a year ago. The business remains on track to deliver our fiscal '18 EPS guidance of a $1.90 per share or higher on a non-GAAP basis.
Results for the quarter were driven by our recent acquisitions, particularly Bell Nursery, which helped us overcome flattish overall company organic sales due to particularly challenging weather patterns and significant impact caused by calendar year shift in weeks that negatively impacted Q3 Garden sales versus a year ago.
Importantly, we believe that we built overall market share in Garden, and fiscal year-to-date, Garden organic sales are down just 0.6% versus year ago and are trending ahead of our category estimates. Strong organic pet sales growth of plus 7% left organic sales for the total company virtually flat for the quarter.
Despite the weather challenges, fiscal year-to-date organic sales for Central overall were up 2.5% versus year ago, within our long-term goal range of 2% to 3%. And importantly, we continue to build market share in both the Garden and Pet segments, while making progress setting up our businesses for continued sustainable long-term growth.
Overall, our Garden net sales for Q3 were up 16% due to the acquisition of Bell Nursery business, which, of course, was not on last year's results, because Bell competes in a live garden goods has extreme seasonality and as expected, significantly contributed to our Q3 sales and profit results. Bell, along with very tight spending management and cost savings on the base business, while Garden delivered EBIT growth of $2.6 million or plus 7% over a year ago.
Our Pet business had a terrific Q3, up 13% in net sales and 9% in EBIT versus year ago. Organic sales grew a robust 7%, most notably in our legacy pet distribution business and dog & cat business, which were more than enough to offset softness in our animal health businesses.
We continue to build share overall impact with robust sales growth in both brick-and-mortar and e-commerce. Our overall Pet sales also benefited from the General Pet acquisition. General Pet filled a key missing piece in our Pet distribution geographic footprint, and we are excited about what that business can contribute to the company over time.
We are on track for overall operating income EPS goals. We continue to remain attentive to margin pressure on the business. The total company's gross margin declined 120 basis points with operating margin down 90 basis points for the quarter. Lower organic volumes in Garden were a key factor; however, we also face mixed issues in our Pet business. Raising input and logistics costs are also factors in both segments.
Importantly, our margins have benefited from low-cost producer initiatives, and we are on track to deliver our cost savings target for the year. For example, we continue our expansion of our grass seed enhancement activities, which has helped drive product performance and margins in that business for the last several years.
Additionally, we have taken pricing on key pieces of our portfolio, including in the Garden segment. However, increases will not be evidenced until next year season. In addition, we have near-term plans to take even broader pricing and cost of portfolio, including pets to offset higher costs, including tariffs in order to protect our margins.
I am very proud of how the company has, shall we say, weathered the storm in Garden, while integrating two meaningful acquisitions, managing the continued transformation of the retail landscape in the Pet industry and in both segments building market share in the intense competitive environment we face.
I'll now turn it over to Niko to review some of the details of our financial results.
Thank you, George. Good afternoon everyone. We issued our third quarter press release with our financial results earlier today. I'll give you some more detail on the results and then turn it back to George for his closing remarks.
Central's earnings per share was $0.79 for our third quarter, up 27% from $0.62 over the same period a year ago. Third quarter sales rose 15% versus the prior year to $658 million, with our recent acquisitions of Bell and General Pet, the primary drivers, along with strength in the Pet segment. Organic growth was relatively flat, as weakness in April due to the late start of the season impacted Garden results significantly, essentially negating strong organic growth in Pet. Keep in mind that in last year's third quarter, we had a very strong organic growth of 8%. So the comparison was difficult even without the unfavorable weather.
Consolidated gross profit rose $19 million, and our gross margin decreased to 120 basis points to 30.7%, impacted by a number of factors, including low organic volumes in Garden, mix of revenue and higher raw material and freight costs across both businesses.
SG&A expense for the quarter increased 13% or $16 million versus a year ago, but as a percent of sales was down 30 basis points at 21.5%. Company operating income for the quarter increased 5% to $61 million. Operating margin declined 90 basis points to 9.2%, primarily due to the gross -- lower gross margins as well as the negative impact of the General Pet acquisition. As you may recall, the distribution business typically carries a lower operating margin in our manufacturing businesses.
Turning now to the Pet segment; Pet segment sales for the quarter increased 13% or $41 million to $355 million, with organic sales rising 7%. The increase was driven by continued strength in the mass market, e-commerce and club channels. Our dog & cat segment continue to exhibit good growth, and our legacy pet distribution business experienced strong sales from a national rollout for a large supermarket customer. Our animal health business saw a small decline in sales due in part to a lingering impact from unfavorable weather.
Pet segment operating income for the quarter increased by $3 million or 9% compared to the prior year to $39 million. Pet operating margin decreased 40 basis points to 11.1%, but on an organic basis was flat. While several businesses in the Pet segment saw higher margins, most notably wild bird, small animal, dog and cat and pet distribution, the improvement in those businesses was offset by an unfavorable mix of sales versus last year in higher raw material, transportation and labor costs.
Turning to Garden; for the quarter, Garden segment sales increased 16% or $42 million to $303 million, due to the acquisition of Bell Nursery. Organic growth declined 8% as disappointing April consumer takeaway for the company in the industry as a whole and followed a weak March led to lower-than-expected reorders from retailers. While May and June saw some solid POS gains, the higher-than-normal inventory levels at stores due to the lower demand in March and April absorbed much of this demand. There was also shift in weeks during the quarter, essentially adding a week at the end of June and losing a week during the peak selling season at the end of March.
Keep in mind, we have reported organic Garden growth of 6% last quarter, which benefited from the shift in weeks and in addition, we are comping against a very challenging 15% gain in the third quarter a year ago.
Garden's operating income rose to $41 million from $38 million in the third quarter of last year, but operating margin decreased to 120 basis points to 13.5%. Bell Nursery and its largest quarter of the year was responsible for the gain in operating income, more than offsetting a decline due to lower volumes in the Garden organic business. Much of the drop in Garden operating margin was due to the decline in volumes, which reduced production efficiencies. Also higher costs, including raw material and inbound freight charges, also negatively impacted the operating margin.
I should note that Bell's profit contributions this quarter were significant as it is its largest quarter of the year. However, in the other three quarters, Bell typically has loss. Since we acquired Bell in late March, our fiscal year 2018 will not include two full quarters of Bell losses. Had we add Bell for the entire year, we estimate our annual EPS would likely be $0.10 lower, albeit, still accretive for the full year.
One word about our acquisitions, in general; in the case of both Bell and General Pets, on an annual basis, we expect they will have a negative impact on our operating margin, partly due to the amortization of results from purchase accounting. Consequently, when we look at making an acquisition, we are really looking at EBITDA and how the financials will be impacted on an EBITDA basis as well as the return on invested capital relative to risk-adjusted cost of capital. Going forward, you'll see us talking more about EBITDA, which will give investors a better sense of the contribution from our acquisitions.
Now getting back to our consolidated results; in the second quarter, we had other income of $2 million, up 500,000 from a year ago. Net interest expense increased $3 million to $10 million, primarily due to incremental interest expense on our new notes that we issued in December 2017.
Our tax rate for the quarter was 21.5% as compared to 37.2% in the second quarter a year ago. The decrease includes the reduction in the federal tax rate and the favorable impact from the changes in our recent accounting standard around non-cash equity compensation expense. The impact of the latter is likely to vary quarter-to-quarter, depending on among other things, the market price of our stock and employee option exercise activity.
Turning to our balance sheet and cash flow statement; cash at the end of the third quarter was $204 million, up from $14 million at the end of the third quarter last year. The increase reflects the inclusion of the proceeds of the debt offering we closed in December last year, partially offset by our Bell Nursery and General Pet acquisitions, which together totaled $86 million.
Total debt was $692 million versus $435 million last year, up due to the December 2017 debt offering. Our leverage ratio at the end of the quarter was 3.2x compared to 2.1 a year ago, well within our target range.
We also had $400 million of availability on our credit line at the end of the quarter. For the quarter, cash flow provided by operations was $112 million, down from $139 million in the third quarter a year ago, due primarily to an increase in working capital due to the acquisitions we had made. Additionally, we also had lower accruals for federal taxes due to the reduction in the tax rate.
CapEx was $9 million versus $10 million in the third quarter of 2017. Depreciation and amortization for the quarter was $13 million, up from $11 million a year ago, primarily due to recent acquisitions.
Now I'll turn it back over to George.
Thanks, Niko. As I mentioned earlier, we remain on track to achieve our EPS guidance for the year of $1.90 or higher on a non-GAAP basis. Please note that the guidance does include the benefit from the most profitable time period on Bell's business in this fiscal year, while excluding almost two full quarters that typically exhibit losses.
Despite the timing and purchase accounting challenges are sometimes associated with M&A transactions, we remain very bullish about the shareholder value creation of our M&A program. Both Bell and General Pet meet key strategic needs, and were acquired at EBITDA multiples that we are very comfortable with.
The company is in an excellent operating rhythm and acquisitions over the last several years have contributed to our growth with collective revenues up 4% annually since becoming part of our portfolio. You can expect us getting more aggressive in the quantity and size in our acquisition activity in the coming years. Having said that, I should note that you can never control deal signings and Central will continue to be prudent in the valuation stage for companies.
In summary, we are pleased with the results of the quarter. Year-to-date, we are financially where we were expected to be with market share gains in both business segments and well positioned for future organic and inorganic growth.
Now we can turn it over for your questions.
Thank you [Operator Instructions] Our first question today is coming from Bill Chappell from SunTrust. Your line is now live.
Thanks. Good afternoon.
Hey, Bill.
Hey, Bill.
George, just trying to understand, and then, sorry if we are a little bit confused, just how the quarter came in versus your expectations? Just when you last talk to us in May, we'd known, kind of, April would look like. You obviously always knew about the weak shift in the season. So is it safe to say this was all kind of in line with what you're expecting, including kind of the gross margin degradation or what have you, or were there some surprises that we did not see?
I would say, there's a lot of moving pieces in our company, and we have signaled at the beginning of the year, that's a year would probably be bumpy because of all the moving pieces. You have tax changes, you have the Garden season weather you can never predict, you have investments that we can gauge the timing on depending how things are tracking and we have the two acquisitions, frankly, which we've never felt before. So there are a lot of moving pieces. I would tell you, in aggregate, we came in, as I said, pretty much where we expected to be. Every piece probably vary to some degree, but overall in line with expectations.
And then -- and I appreciate that. If I look at the Garden -- I mean, into the Pet business, you talked about the distribution business growing. I mean, where are we on the Kroger rollout? Will that have a bigger impact going forward? Or are we seeing kind of the full impacts in terms of expanded distribution this quarter?
Bill, this is Rodolfo. We are pretty much done in the rollout for Kroger. Yes, so right now, the only thing you would see is a wrap-around effect during next fiscal year, which would affect mainly Q1 and Q2.
The only thing I'll add to that is in the rollout of Kroger, there were some startup costs, I'll call it, in terms of -- you're putting people in place, you're spending to make sure your customer service levels is high as they possibly can be during a challenging time, and it's -- you'll see a more efficient operation going forward.
Yes, among the big ones is we need to add facilities to take care of Kroger.
Got you. And then, last one from me. Just trying to understand maybe input costs and pricing as you go into next year. Certainly, we've heard Scotts talk about meaning to take some price for some inputs that you compete on private label. But also didn't know if there was a way to quantify kind of how tariffs are or expected to impact you?
Yes, so, Bill, this is Niko. I'll start with the tariffs. As we look at our business, we have about 10% of our costs coming in from China. So we don't have a ton of exposure on that front. That said, we are very intent to work with the vendors over there to see what kind of costs we can take out. We look at our own business every year, as you know, taking costs out. And then, the third move is obviously pricing and working with our retail partners around making sure that everyone is making their reasonable margin to get the product to the consumer.
As far as inputs go, we're going to probably echo a lot of what you are hearing from our competitors, delivery, trucking expenses are up, we're seeing labor going up and then we're seeing some raw materials go up, particularly, in the fertilizer area with respect to urea and potash. We have yet to see how the harvest plays out and see how the grains in our grass seed do. But that's -- yes, we'll be taking some price along with our competitors.
Got it. Thank you so much.
Thank you. Our next question is coming from David Westenberg from CL King. Your line is now live.
Hi. Thanks for taking the question. So just a quick one on tax rate, do you have any clarity on what you would expect? I think, before you gave around the 25%, is that still correct?
Are you talking about for the fiscal year? Or you talking -- what time period you're talking?
Fiscal year; just generally speaking, where we should be -- where you think your company is going to fall?
If you look at where we struggle, maybe this will be helpful. Our statutory rate is closer to 27%, 27.5%. You saw year-to-date, we're at about 7%. That differential is about two-thirds of it is due to the revaluation of our deferreds and about one-third of that is the stock compensation that we had to, the ASC we adopted. So that gets you there.
Yes, thank you very much. And then, can you talk about a little bit about where you are -- where your products are in terms of product segmentation? And maybe some of the advantages and disadvantages you have for price increases relative to competitors? Now I know your cost inputs are going to be industry wise. So everybody's prices are going to go up, but just some way to think about how you differentiated versus competitors when these prices go up?
Okay. So, David, let me start; this is Rodolfo again. Before I go into, which product can we take or which one we cannot take, what I can take -- let me start a different -- slightly different question is, hey, why should I believe you can take the price, and the first piece is, we have done it before. We have done it this year already instead of our categories. And we have not done that in many years before. So it's clear for our customer partners. But this is not us, just putting out the P&L.
The second one as we mentioned that very clearly, the inflationary cost is obvious, yes. So it's clear what's going on with trade, it's clear what's going on with labor. So the pressure is there. And related to that, we have seen movement in many of the categories where we compete. Now you are right. Our brands are very meaningful in the categories where we compete. And because of that, we are very comfortable with the fact that we will have clear conversation with our customers in where the cost is and what needs to be to do what Niko mentioned, and make sure that everyone can make good margins in these categories.
Okay, thank you. And then maybe just one more on acquisitions here, any change to what you're thinking about either Pet versus Garden and which one will be the focus? I know, Garden, there's been more opportunities just given the fact that your competitors aren't necessarily there. Is that still where you see the most opportunity? Or is that shifting at all?
Well, just so from a numbers standpoint, there's going to be more opportunities over Pet. You've got 1,400 suppliers of pet products out there in the world to choose from. And over on the Garden side, it's a much more consolidated market from both the supplier-customer standpoint. So Pet being a little more target rich, you're going to see more opportunities, seeing more things around like pet tech kind of opportunities.
So I'd just say, from a numbers game is, it's going to be more on the pet side that said, we just did one over on the Garden side, and we love the Garden business. We think there are some areas where we cannot really bolster that Garden business. It's got great momentum. It's got the great management team. So it is our pet size, but we just -- we love both segments. So we're going to be somewhat opportunistic and see which deals makes the most sense, run the numbers, and see where the best fit is.
Thank you, guys.
Thank you. Our next question is coming from Jim Chartier from Monness, Crespi, Hardt. Your line is now live. Jim, your line is live; perhaps your phone is on mute. Please return to the queue for question.
Our next question is coming from Bradley Thomas from KeyBanc Capital Markets. Your line is now live. Hello, Bradley, your line is now live. Perhaps your phone is on mute. Please proceed with your question.
Our next question is coming from William Reuter [ph]. Please proceed with your question.
Hey, guys. This is Mike on for Bill. Just a couple of questions here, first, recently, you guys introduced the new private label products for the specialty pet channel. We are just wondering how these introductions have gone, did they affect the mix in the quarter?
Okay. So this is Rodolfo again. We have been participating in private label for a long, long time, not only in the pet specialty channel, but actually in every major channel in which we complete. We believe private label makes sense when we have additional capacities, with certain capabilities, with certain customer partnerships that makes sense. In terms of margins, you are right. In terms of private label, obviously, having a lower margin in our branded business at gross profit level, but on operating margin, things are not that decent because investment is so lower. What I can tell you is that, as of today and we started shipping in Q4, we have private label businesses in every one of the major channels we compete, not only pet specialty, but everyone.
Yes, the only thing I would add is, it's a little over 10% of our business in Pets and Garden have been growing. And in the Pet channel, I would say, there was no unique material moving launch, just the base business largely growing.
Great. And then, just my last one, as you guys continue to grow revenue, is there a need to build any more distortion centers to increase capacity?
I wouldn't say there were any major inflection points on that front. Our distribution centers of both Garden and Pet have plenty of capacity to grow the businesses. We did have to add capacity on the pet side to accommodate the major growth to roll out where we're providing basically right job or services to them. But that's behind us and going forward, we don't see any major unique changes.
Great, thanks.
Thank you. Our next question is coming from Jim Chartier from Monness, Crespi, Hardt. Your line is now live.
Hi. Sorry about that earlier.
Hey, Jim.
Hi. So I just -- on the raw material freight, just I was wondering if you could quantify how much of an impact has higher raw materials and freight cost in terms of gross margin this year versus your expectations initially back in September?
Well, we don't give out the exact figures, but what I can tell you freight had -- so let me back up. When you look at the two segments, I'll start with Garden, which had the bigger drop in margin this quarter that was primarily driven by volume. And I would say, that's the overwhelming majority of it; second, on the Garden side would be mix; and then third, would be input costs.
On the Pet side, it's little bit of a different story where freight had a pretty big impact there. And then, the second would be input costs and then third would be labor.
And then, Niko, if I could add to that on an organic basis, if you're looking at year-to-date, the Garden margins are flat year-over-year.
Yes.
Okay. And then as you talk about price increases for the balance of this year and into next year, is that just a kind of recoup or kind of offset additional pressure you're seeing into next year, or will you be able to kind of recapture some of what you lost this year?
Yes. So we price to protect our margins and part of it's to catch up on what's happened on costs to-date, obviously. And then, we look at how costs are projecting out in the year based on what we're seeing in the marketplace and, yes, we will price ahead to protect our margins. We will not price to build margins. So we'll work hard to lower our costs. We will work hard to push back on suppliers. But all that can't necessarily be passed through covered with your current activities in an inflationary environment. And we will price to protect our margins going forward as well.
And then, Niko, you mentioned earlier, you've purchased accounting on the acquisitions. How much of an impact did that have in the third quarter? And how much do you expect for all of FY '18? And does any of that continue into next year for the acquisition to done this year?
Yes, I think, we don't quantify exactly how much of an impact it had in the quarter. As I mentioned earlier, we're going to speak more in terms of EBITDA just to clean that up a little bit so that you can see how to clean or view the numbers as opposed to EBIT. I'd look, as a general rule, we're going to continue to be acquisitive. So the die is going to go up, which is why we want to start really talking more around EBITDA. So I would look for that to increase over time, particularly, next year.
Okay. And then, on the calendar shift, can you just quantify how much of an impact the calendar had as the benefit to second quarter and a detriment to third quarter for us?
We don't break that out specifically. It was a significant contributor to the year-over-year change, particularly, for Garden as we said in the script, the shift, that which shift year-over-year was losing the last week of margin picking up the last week in June due to seasonality that have pretty profound impact on the Garden business, hope, in Q2 where we reported very strong results and in Q3.
Yes. The only thing I'll add to that, there is a lot of assumptions when you go into that analysis. So I would say, both the weather and the week shifts were material.
Yes, right. And then my last question. In your last quarter, you mentioned that you're still selling some higher cost inventory in the Pet business. Have you started to sell the lower-cost product from the new consolidate in New Jersey facilities here?
Yes, so those facilities are up and running. I have not specifically looked at that item issue, but I know the margins apples-to-apples on this business is where we would expect them to be and pleased with the change.
Okay, thanks, and best of luck.
Thank you.
Thank you [Operator Instructions] Our next question is coming from Hale Holden from Barclays. Your line is now live.
Hi. Thank you for taking the call. I just had two. We've talked about the costs inputs quite a bit, but I was wondering are there any specific tariffs you guys are looking at in terms of inputs from China or elsewhere?
Well, I would say, the tariffs right now are concentrated in Pet and not significant yet. There are three ways to tariffs. The first one is rather small in one of our Pet businesses. The other two are to be decided. And as Niko pointed, only 10% of our costs have just come in from China. So we think, however, this plays out given what we'll do managing the costs with our suppliers, signing new suppliers, we'll be able to manage our way through effectively.
Okay. And then, the second one is, as mentioned in the scripts, you managed through some of the disruptions and changes in channel and Pet retailing. I was wondering if you could just give us a sense of where you think we are in that level of disruption. Do you see continuing in the back half of the year just in terms of channel mixes and consumer changes, or if it's starting to stabilize out?
Yes, so this -- we're also taking that one. So during the transition channel, it's been exclusively [ph] rapid in the last two years and talk about e-commerce side this year last couple of quarters, the growth has continued, but not at the same pace. So do I expect e-commerce to continue gaining share? Yes. Do I expect specialty and specifically one or two customers there to be a bit more challenged? The answer is yes.
Now the important piece for us is, we have proven, we can compete in every channel, we saw this coming a couple of years ago and we've changed our practices, yes, for doing two things: one is to make sure that we're there for our partners and pet specialty and other channels that were being challenged. And because of that, we have been able to grow share in every customer by one. And on the other side, we changed our capabilities to be able to take advantage of the growth in e-commerce, which we have then also did well and that's how we got to the 7% organic growth.
Got it. And I just had one follow-up. On the private label side, we've talked on this call little bit about your potential to take pricing later this year puts a focus on cost savings. Do you guys feel like you have the ability to take pricing on private label kind of organically without the brands equivalent moving, or do you have to wait for the brand to move?
Well, the whole industry is facing the same cost pressure. So I'm fairly confident that brand and private label products will have to go up. On the private label side, we get into private label where we are the low cost producer and where we have excess capacity. We believe that we can take pricing in private label or when input costs are going up because it would be safe for our competitors who are bidding with us. And the reality of it all, if you don't take price into covered cost filling up in the industry, that's a long way to disaster. So our view is, we have the competitive position to take pricing and we'll take pricing.
Great, thank you very much for the time. I appreciate it.
Thank you. [Operator Instructions] We've reached the end of our question-and-answer session. I'd like to turn the floor back over to George for any further or closing comments.
I just want to thank everybody for joining us today, and have a good one.
Thank you. That does conclude today's teleconference. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today.