Rocky Brands, Inc. (NASDAQ:RCKY) Q3 2022 Earnings Conference Call November 2, 2022 4:30 PM ET
Company Participants
Brendon Frey – IR, ICR
Jason Brooks – Chairman & CEO
Thomas Robertson – EVP & CFO
Conference Call Participants
Jonathan Komp – Baird
Operator
Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the Rocky Brands Third Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time for you to queue up for your questions. [Operator Instructions] I would like to remind everyone that this conference call is being recorded.
I will now turn the conference over to Brendon Frey of ICR.
Brendon Frey
Thank you, and thanks to everyone joining us today. Before we begin, please note that today’s session, including the Q&A period may contain forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Such statements are based on information and assumptions available at this time and are subject to changes, risks and uncertainties, which may cause actual results to differ materially.
We assume no obligation to update such statements. For a complete discussion of the risks and uncertainties, please refer to today’s press release and our reports filed with the Securities and Exchange Commission, including our 10-K for the year ended December 31, 2021.
I’ll now turn the conference over to Jason Brooks, Chief Executive Officer of Rocky Brands. Jason?
Jason Brooks
Thank you, Brendon. With me on today’s call is Tom Robertson, I’d like to start by congratulating Tom on his promotion to Chief Operating Officer that was announced in this quarter. I’m glad to have him here with me today serving as Chief Financial Officer, while we search for his replacement. But I am very much looking forward to working with Tom in his new role for the company that should allow us to drive even further gains in profitability and operational efficiencies.
Turning now to our third quarter results. We were again encouraged by the durable consumer demand for our diversified portfolio of brands this quarter, even as the microeconomic headwinds continue to pressure the U.S. consumer, as a key provider of functional and affordable footwear that is core to the work and the way of life for millions of Americans. We have been afforded a degree of insulation from the demand softness that more discretionary footwear and apparel brands are currently experiencing.
This quarter, we were able to capitalize more efficiently on the demand as the actions we’ve taken to address cost pressures allowed us to translate our top line strength into enhanced profitability. The work we’ve done over the past year to improve operational efficiencies in our distribution facilities allowed us to flow more of our revenue performance to the bottom line this quarter. Additionally, we were much more efficient with our marketing spend, driving further leverage without impacting consumer demand.
Before Tom covers the financials in detail, I want to spend a few minutes discussing the performance of each of our brands this quarter. Starting with Durango. We saw another quarter of expansion as the brand continues to be one of the strongest names in Western footwear. Consumer appetite for the Durango brand has been resilient this year and we were pleased to see demand continue to drive positive results in the third quarter.
While there weren’t constraints on inventory like last year when many of our competitors struggled to source and ship product, which has led to a higher than normal level of inventory in the channel this year. Durango has still experienced solid gains with several key retailers, fueled by sales of our popular Rebel and the men’s Westward collections. Looking ahead, despite some general market uncertainty heading into the holidays, we feel good about Durango’s momentum at retail and are expecting a solid finish to the year for the brand.
Turning to Georgia. Sales were up slightly compared to last year. The brand exhibited pockets of strength during the quarter, but is feeling some pressure from a market that is over inventoried and a consumer that is having to spend more on essential items. After a slow start in July, when consumer confidence was at its low point for the year, our field account business accelerated nicely in August and September. Meanwhile, demand was strong in important Pacific Northwest region where farm and ranch retailers restocked key styles ahead of the upcoming holiday season.
Finally, Georgia continues to sell through well in many of our online retail partners. Overall, I’d categorize the current state of the work footwear is mixed, but with the trends improving as the third quarter progressed, we are cautiously optimistic heading into the final months of the year. The Rocky brand, which spans work, outdoor, western, commercial military and duty footwear were together overall flat in Q3 despite some very difficult comparisons in certain segments.
Outdoor was an area of strength this quarter with strong results across the outdoor farm and ranch and independent retailers ahead of start for fall and winter hunting season. New releases in our hunting boot collection fueled the growth as the trend to be outdoors post-pandemic continues to gain steam.
In work, Rocky was up against a difficult comparison last year with a large retail program in 2021 that did not reoccur this year. Despite this, the category was only down slightly as increases with our dealers and new products like the all-new Worksmart USA made up nearly the entire gap. This is a key new product for Rocky Work that we anticipate will become a leader in the category.
Rocky Western had a down quarter, but was also impacted by a few one-time factors. The early release of fall orders last quarter moved a portion of the sales from this quarter into Q2. Additionally in Q3 of 2021, we experienced a number of one-time order from retailers desperate for product due to supply chain disruption that limited availability of competitor products.
With respect to Rocky Commercial Military and Booty division, the category was mixed with notable strength in the public service and — our public service business had a terrific quarter due to well-planned forecasting, new fire product and proper inventory planning, many of our public service retail partners had exceptional retail sales and our inventory position put us in a position to take advantage of the increased demand.
While inventory management drove strong results in the public service, it was the lack of inventory in key sizes in July that was the primary driver of commercial military shortfall. While we made up some of the portion of those lost sales in inventory rebounded in August and September, the poor start to the quarter, coupled with a difficult comparison to non-repeated government orders in 2021 resulted in a year-over-year decline in the business.
Our Muck, XTRATUF and Servus brands all posted solid gains in the third quarter. The Muck brand performed very strongly with a great level of fall bookings from our key farm, outdoor and sporting good retail partners. XTRATUF also continues to see positive momentum, especially in the outdoor channel. For the quarter, we more than doubled last year’s shipments, a testament to the work we’ve done to drive demand, enhancing the efficiency of our Reno distribution center.
Additionally, the new XTRATUF product launched this year continued to drive demand. The Auna sandal and the kids ADBs or Ankle Deck Boots are keeping customers engaged, leading to low digit — leading to low digit sales increases for the year. With respect to Servus, we continue to make improvements with product distribution and are seeing better inventories levels of key sizes to lead corresponding increases in sales.
Turning now to our retail segments and starting with our direct-to-consumer channel. The team continues to focus on optimizing shopper journeys, compelling products, brand storytelling and efficient marketing tactics. These efforts have allowed us to maintain conversion rates despite the challenging operating environment.
We continue to make progress driving organic traffic with our SEO, content and first-party data marketing tactics, which typically convert more efficiently compared to our performance marketing tactics such as paid search or social. And when we do selectively spend on paid advertising, we are seeing improved returns, thanks to the success we are having with the new automated ad programs on the large social media platforms.
Lastly, our Lehigh B2B retail business had a very good third quarter, driven again by meaningful growth with both new and existing accounts. With price increasing across the footwear industry, many of our customers have increased subsidies amounts for their employees, which has helped fuel our top line performance. Additionally, many accounts are beginning to view providing safety PPE such as footwear, orthotics and compression socks as a tool to drive employee retention.
With its wide offering of safety products, Lehigh has been able to organically drive additional revenue with existing accounts. And as COVID concerns have continued to abate the number of on-site iFit events is gaining pace, which combined with our e-mail and SMS strategy is driving higher account participation rates, increasing our account revenue and penetration rates.
Overall, I’m very pleased with the durable demand we’ve seen for our portfolio of brands. Even as inflation and other factors have weighed on the U.S. consumer. This resilience, coupled with the work we’ve done to enhance profitability positions us well to continue gaining share and generating increased value for our shareholders.
I’ll now turn the call over to Tom. Tom?
Thomas Robertson
Thanks, Jason. As Jason outlined, resilient demand and improved profitability drove another solid quarter for Rocky. Reported net sales for the third quarter increased 17.5% year-over-year to $147.5 million. By segment, on a reported basis, wholesale sales increased 25.8% to $120.7 million, retail sales increased 7.3% to $23.4 million, and contract manufacturing sales were $3.3 million.
As we announced on October 3, we divested the NEOS brand. As part of the sale process, we sold our remaining NEOS inventory to the new owners. For the accounting rules, we must recognize the inventory portion of the asset sale as a large one-time sale on our P&L. Excluding this transaction, adjusted net sales for the third quarter of 2022 were $143.9 million.
Turning to gross profit. For the third quarter, gross profit increased 10.6% to $51.9 million or 35.2% of sales compared to $47 million, or 37.4% of sales in the same period last year. Excluding the cost of the goods sold related to the NEOS brand divestiture during the quarter, adjusted gross profit for the third quarter of 2022 was $50.8 million, or 35.3% of adjusted net sales.
Adjusted gross profit for the third quarter 2021, which excluded a $900,000 inventory purchase accounting adjustment was $47.8 million, or 38.1% of net sales. The decrease in gross profit, considering these adjustments was mainly attributable to increases in product costs, inbound freight costs and other shipping and logistics costs compared to a year ago period.
On a reported basis, wholesale gross margins were 33.1%, down 300 basis points from a year ago, but up 220 basis points from Q2 this year. Retail gross margins were down 120 basis points year-over-year to 48.7% and down just 20 basis points from Q2 and Contract Manufacturing gross margins were 15.4% compared to 18.8% a year ago.
Operating expenses were $40.3 million, or 27.3% of net sales in the third quarter of 2022 compared to $44.2 million, or 35.2% of net sales last year. Excluding the $0.8 million in acquisition related amortization and expenses related to the disposition of assets this quarter and the $2.9 million in acquisition related expenses in the third quarter of 2021. Adjusted operating expenses were $39.5 million in the current year and $41.3 million in the year ago period.
The decrease in operating expenses was driven primarily by a decrease in discretionary expenses, coupled with improved distribution center efficiencies compared with the year ago period. As a percentage of net sales, adjusted operating expenses improved 550 basis points to 27.4% in the third quarter of 2022 compared to 32.9% in the third quarter of 2021. Income from operations was $11.6 million, or 7.9% of net sales compared to $2.8 million, or 2.2% of net sales in the year ago period.
Adjusted operating income, which excludes the expenses related to the acquisition and restructuring charges in both periods was $11.3 million, or 7.9% of net sales compared to adjusted operating income of $6.5 million, or 5.2% of net sales a year ago. For the third quarter, interest expense was $4.2 million compared to $3.1 million in the year ago period.
On a GAAP basis we reported net income of $5.7 million or $0.77 per diluted share compared to a net loss of $0.4 million or a loss of $0.05 per diluted share in the third quarter of 2021. Adjusted net income in the third quarter of 2022 was $5.5 million or $0.74 per diluted share compared to adjusted net income of $2.5 million, or $0.34 per diluted share in the year-ago period.
Turning to our balance sheet. At the end of the third quarter, cash and cash equivalents stood at $7.3 million, and our debt totaled $284.8 million, consisting of our $122 million senior secured term loan facility and $165 million of borrowings under our senior secured asset backed credit facility. As of September 30, 2022, we had $34.3 million of borrowing availability on our credit facility.
Inventory at the end of the third quarter was $265.1 million compared to $200.2 million in the year ago period and $287.8 million at June 30, 2022. The increase in inventory for prior year was driven by distribution and fulfillment challenges we experienced in the second half of 2021 along with overall cost increases and strong sales growth in the current year. Compared with June 30, 2022, inventories are down $22.7 million. Looking ahead, we plan to further align inventory levels and sales growth and inventory purchasing strategies over the coming quarters.
With respect to our outlook, based on a more challenging macroeconomic backdrop, combined with a difficult fourth quarter comparison, we are adopting a slightly more cautious view for 2022. We are now — we now expect a full year net sales increase of approximately 18% over 2021 and our view on gross margins hasn’t changed. We are still expecting overall gross margins of approximately 34% for the fourth quarter or just under 35% for the year.
In terms of SG&A, we are now targeting achieving approximately 50 basis points of expense leverage over 2021, adjusted levels versus our prior target of approximately 100 basis points, reflecting our modest reduction in projected revenue.
That concludes our prepared remarks. Operator, we are now ready for questions.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] We can take our first question now from Jonathan Komp of Baird. Please go ahead.
Jonathan Komp
Yeah. Hi. Thanks. Good afternoon. Maybe first, I’ll start with the guidance update. You just shared, Tom, could you maybe just confirm more specifically what you’re thinking for the fourth quarter? And were there any shifts between third and fourth quarter, maybe as a starting point, just to understand what you’re expecting for revenue in some of the top line pieces?
Thomas Robertson
Yes. Hey, John. So we’re guiding to an overall growth of 18% for the year, which would imply a decline — a decrease in sales for the fourth quarter. But again, we’re going up against incredibly tough comparisons. Third quarter of 2021 is when we ran into our distribution challenges post acquisition. And so there was a lot of sales that should have originally shipped in the third quarter of 2021 that ultimately got shipped in the fourth quarter of 2021 creating this very difficult comparison. Does that help clarify the top line portion?
Jonathan Komp
Yeah. And just — so on a year-over-year basis, I just want to clarify, it looks like year-over-year will be down more than 20% is what you’re guiding. And then even on a sequential basis, fourth quarter will be quite a bit below third quarter this year?
Thomas Robertson
Yeah. I would say that’s pretty accurate. I would say there’s some — just slightly less than our fourth quarter sales though — or the third quarter sales, I’m sorry, this year.
Jason Brooks
But yes, you’re going to be down from LY in the fourth quarter.
Jonathan Komp
Okay. And then any broader context on what you’re seeing in terms of that — I’m sure it’s different across brands, but your general sense of the consumer environment, your ability to engage with wholesale accounts and start to book orders for next year and just any color on the broader consumer demand environment?
Jason Brooks
Yeah. Sure, John. I’ll take this one on. It’s Jason. So I think we are definitely feeling and seeing and hearing some of the stuff that’s going on in the marketplace. I talked a little bit about the fact that our products are still more of a need than a want. And so I don’t believe that we’re hearing and feeling it quite as aggressive as maybe some other types of footwear in the marketplace. And so I think we still feel really good about our brands.
They’re still checking well at retail where we’re able to get that information. I talked a little bit about the different levels of that. Durango is doing really well. The Georgia brand is doing good, slow down a little bit. Our Muck brand is still very strong and XTRATUF. So we still feel good, but look at the Feds just raised the interest rates again today. So we’ll see what that does for the rest of this quarter.
We feel our bookings in the next year look reasonable. It’s a really hard thing to navigate as we went through the acquisition last year and where those orders fell as bookings or transfers over. But we still believe the brands are strong and that we’ll finish this year in a good place and be able to continue that drive in 2023.
Thomas Robertson
Yeah, John. Just to add on to — I mean you called it out a little bit. There’s some noise between the brands. But I think what we’re kind of seeing is kind of a tale of two different behaviors. And I think accounts where we saw them take much more aggressive booking positions or much more aggressive positions coming into 2022.
We’re seeing them slow down a little bit more so than maybe the accounts that rely more on that one business. And so it’s really kind of a tale of two different behaviors. But the good news is we’re still seeing things check at retail and turnover. It’s just a matter of these retailers that took larger inventory positions kind of working through that inventory.
Jonathan Komp
Understood. I’ve got a couple of more, if you don’t mind. But just going back then to inventory, you highlighted the sequential decline. How should we think about modeling inventory going forward and any color on how you’re managing your production orders as you continue to work down the balance?
Jason Brooks
We got to get the inventory down, John.
Thomas Robertson
Yeah. So we’re — we had guided in the last call to a decrease of about $40 million in inventory by year-end. And our plan is to use that as a source of cash to pay down debt. We took a very big step in that direction with the $22 million decrease from the second quarter. I would tell you $40 million is still very obtainable and we’re going to even aim for more if we can. We’ll see how things work at retail.
But from a managing our inventory standpoint, the beauty of our inventory is that it’s a product that carries over from year to year. It’s not fashionable. It doesn’t go in or out of style. And so we’ve just been moderating our purchases with our sourcing partners and managing our production in our manufacturing facilities. And we think we’ve gotten through the hard part of managing the inventory and now it is time for it to come down or continue to come down for that matter.
Jason Brooks
Yes. I would just add, John, it’s been a really interesting time over the last year — year and a half, as we have relationships with our sourcing partners and how we were able to maintain our ordering and sourcing with them through the COVID and through the challenging times of the transportation and logistics. And then things got really hard there when everybody came back and started placing more orders and people are looking at, hey, I don’t know if I can get your stuff made and now all of a sudden, we’re back into, well, do you have any more orders like we could use more.
And so I think we’re in a pretty good place. Like Tom said, we have brown and black boots. And so we’re not too worried. We are — we talk about the inventory being too high, and we’ve got to get it down, and we’re going to take the time to do it. But I think we’re in a really good place with our partners and then our own manufacturing. We’re able to navigate that a little bit different in Rock Island, in Illinois, Rock Island, Puerto Rico and the Dominican. So I think we got to continue to monitor it and do the right things, but we’re in a good place and made some good moves in Q3.
Jonathan Komp
Got it. And then one more balance sheet question, Tom. Could you just share where your credit defined leverage ratio is at the end of the quarter? And how should we think about that going forward in terms of bringing the leverage down and is there any risk to your financial flexibility or paying a dividend where you’re at currently?
Thomas Robertson
Yeah. Good question, John. And so we are in close discussions with our lenders all the time. We are not in the fall of the neighbor our loans, obviously. I do anticipate us amending the term loan agreements here in the fourth quarter to make sure that we’ve got ample cushion, so we don’t trigger anything. As it relates to the dividend, we have no plans or discussions at all to eliminate or reduce the dividends. We anticipate we will keep paying that.
I think the important takeaway here is that we’ve seen the tipping point with inventory with it coming down. The inventory is out the door and the cash will be coming in here, and we’re starting to pay down the debt. So I imagine, from a balance sheet perspective, you guys will see the debt decreasing here by the fourth quarter and headed in the right direction.
Ultimately, the goal is to get the inventory down, call it to 30% of sales, $200 million-ish in inventory. And so that $90 million decrease in inventory from the second quarter will be a good source of cash to take all the debt concerns away.
Jonathan Komp
It sounds like the new CFO will have an easy time whenever you bring that person in [Multiple Speakers] all the heavy lifting will be done. Maybe just last one then. The operating margin for this year, looks like you’re pointing somewhere in the low 7% range, maybe just to confirm that?
And then do you think — or what are your thoughts on that being sort of the new baseline and then gradually building from there or do you expect to get some significant savings back? Just trying to get your thoughts on the direction of operating margin going forward?
Thomas Robertson
Yeah. So as it relates to 2022, I think you’re pretty spot on, right. I would say that is not our goal moving forward and certainly, the reality of 2022. Jason and I have had a lot of conversations team here at Rockies had a lot of conversations about 2023, and we’ll give more guidance at the next earnings call about our expectations.
But if we think back to the last nine months, we’ve had a lot of costs associated with setting up a new distribution center in Reno, a lot of these port logistics costs, which were very meaningful when the inventory swell to its highest levels.
And so there’s a lot of things that have improved over the last nine months, and we’ll continue to improve. And so we anticipate showing operating income growth in 2023. I’m trying not to tie myself up here, operating growth in 2023, just given that a lot of the pain points are behind us at this point.
And we’re going to continue to kind of make incremental steps each quarter as we move forward. And I think Q3 was representative of that, right. We showed inventory going the right way. We showed margins improving from Q2 and operating expense leverage. So we’ll continue to take steps in that direction over the next 12 months to 18 months.
Jason Brooks
Yeah. And John, I would just add that you’ve been around — you’ve been following Rocky for a while, and you’ve been with Tom and I now ever since Tom and I took over in 2017. And so I would just tell you, think of that cadence that we want to get back on, call it, a building block, but we’re going to take our time.
We’re going to get back into a good cadence, stay focused on our core business, continue to improve on the operational excellence and find ways to grow the operational income as well. And so I think you know that and have seen us do that in the past, and we believe we can do it again.
Jonathan Komp
Yeah. Great. Thanks for answering all my questions. Best of luck.
Jason Brooks
Thanks, Jon. Appreciate it.
Operator
We have no further questions at this time. I’d now like to hand the call back to Jason Brooks for closing comments.
Jason Brooks
Thank you very much. I want to thank everybody on the call today. I thank our investors and I really would like to thank all the Rocky Brands employees and the efforts that they are making to help Rocky Brands become the best company we can become. Without our great employees, we would not be where we’re at. And I want to thank you personally for everything that you’ve been able to do this year and this quarter, and let’s keep doing it and finish out 2022 and onward upwards. So thank you very much and that’s it for today.
Operator
This concludes today’s call. Thank you for your participation. You may now disconnect.
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