Orchard Supply Hardware Exec Insights: CapEx Guidance, Home Depot & Gross Margins

On Wednesday, Orchard Supply Hardware (NASDAQ:OSH) reported its first quarter earnings and discussed the following topics in its earnings conference call. Here’s what the C-suite revealed.

CapEx Guidance

Jeffrey Kalicka – Mangrove Partners: Just a couple of questions. First is, I was curious if you could give maybe a full year CapEx guidance and how much that – how that breaks down between maintenance, remodels and new stores?

Chris D. Newman – EVP, CFO and Treasurer: Sure. I can give you some level of indication on CapEx. As I think we’ve talked to you little bit before, Jeff, we have debt covenants in our loan arrangements and those are set in line with our capital spending requirements for the year and for 2012. It’s a pretty good indication of where we will be. As we look at the spending in terms of the components, roughly half is going to be store related spending of that CapEx for 2012.

Jeffrey Kalicka – Mangrove Partners: I’m sorry. I don’t have the covenants in front of me, what’s the number just curiously enough?

Chris D. Newman – EVP, CFO and Treasurer: It’s around $20 million.

Jeffrey Kalicka – Mangrove Partners: $20 million, okay. So, half is related to stores spending, I’m curious how that breaks out between remodels and new stores, that half?

Chris D. Newman – EVP, CFO and Treasurer: That’s the extent of the guidance we’re going to give you on the CapEx, Jeff.

Jeffrey Kalicka – Mangrove Partners: You know the balance sheet has changed quite a lot in the last six months, can you offer up any guidance for fiscal year interest expense?

Chris D. Newman – EVP, CFO and Treasurer: I think as we discussed in the 8-K that we filed last year, we are looking at interest expense that’s up $3 million to $4 million over last year, I believe is the figure, $3 million to $5 million.

Jeffrey Kalicka – Mangrove Partners: Finally, I guess if I’m just looking at this press release, I just want to make sure I’m interpreting this correctly. When you say increasing our focus on marketing, will you be spending more on advertising is that implying spending more on advertising, and if so, how much or is it just more of a focus on that particular area?

Mark R. Baker – President, CEO: I think, Jeff, what we see is ourselves doing is spending roughly the same amount and looking always for leverage on marketing, but trying different things that excite different customers particularly as these new formants rollout, ways to talk through social media, other types of promotions that get the traffic into the store. So, it’s a little bit of experimenting but the costs are manageable and kind of consistent with where we’ve been.

Chris D. Newman – EVP, CFO and Treasurer: Correct, it’s more of a focus.

Home Depot & Gross Margins

Nick Farwell – Arbor Group: I just wanted to follow up on the comments that you made earlier about trends in May. Can you comment a little bit about the impact of the promotional levels at Home Depot and the higher service levels that Home Depot has implemented over the last year or so, and what kind of impact has that had on your expectations of volume?

Mark R. Baker – President, CEO: Certainly Home Depot (NYSE:HD) is a good performer and doing well in this current market than we’ll ever expect them. But it think if you really understand the Orchard offer and kind of the way we go to market, and the best example I can give is our newest store which is less than a mile from our own depot. We kind of run, and we think we offer more convenience to get credit from our consumers from survey we do from having a higher service component than Home Depot. We are competitive on those key items like grills or (indiscernible) and things like that we think they have broader assortments that affect customers. So we’ve had a solid May and June’s been okay and we look forward to, this is Q2 is our most important quarter of the year and we are feeling pretty good about it.

Nick Farwell – Arbor Group: Your comments Mark about gross profit margins, which were in essence flat despite a $9 million decline in volume. And at the same time it seems to your higher margin SKUs like outdoor and nursery et cetera were also under pressure for the reasons you mentioned earlier, inclement weather. Could you help me understand a little bit about what accounted for your ability to hold gross margins?

Mark R. Baker – President, CEO: Since we’ve been working through the merchandising group we started our line review process last summer. We’ve been working really hard in working with our key suppliers and doing a better job of putting assortments together that the customers want, we think we can better pricing which we kind of have been seeing a nice track record, and buying at a better rate by consolidating some suppliers, good example would be, year ago the company had 11 suppliers in the glove business and today we have 2 primary suppliers in glove business which gave us better cost. We think we have got better assortment and the consumers our business is up in those kind of categories that we’ve reviewed and kind of rationalized the assortment. So we’ve got some tailwinds going on in that area. As well as, and if you look at some of the seasonal areas, like when you sell less grills or power equipment, those margins are not as robust if you will kind of small repair and so you get a mix lift in that margin rate.

Nick Farwell – Arbor Group: Does nursery offset that Mark.

Mark R. Baker – President, CEO: Nursery’s got good margins in it. We like our nursery margins as well. And it’s been a growth category for us, because we think we sell a better assortment if you will and bigger products than some of our competitors. So therefore, the commensurate margin is more likely what you find in a specialty store.

Chris D. Newman – EVP, CFO and Treasurer: The other think that I would add, part of the Mark and my comments, we did refer to a higher level of clearance activity that occurred last year that did aid the margin comparison year-over-year in the first quarter as well.

Nick Farwell – Arbor Group: So, to make sure, you had less clearance this year than you did last year?

Chris D. Newman – EVP, CFO and Treasurer: Correct.

Nick Farwell – Arbor Group: And you’re able to bring your inventories down year-to-year?

Mark R. Baker – President, CEO: Yes.

Chris D. Newman – EVP, CFO and Treasurer: Yes.

Nick Farwell – Arbor Group: One last question is, I’m curious to go back to Chris’ comments about higher interest expense, if I impute, which is a risky process, but if I impute an interest rate on your current debt, I get something like 11% versus 7% last year’s first quarter. Again, I am annualizing, I realize this is fought with risk, but is that roughly what you’re paying, and if so, in what ways do you see your ability to reduce that rate?

Chris D. Newman – EVP, CFO and Treasurer: So, we have – if you go to the documents, we’ve got three different facilities. They have very different rates. We’ve got an ABL revolver that’s in the 3.5% kind of range. We’ve got a cash term loan, or a senior secured loan, I think we call it, which has about a 7% in a pick rate on top of that. There is a real estate loan that’s in the five. So, our cost of borrowing is going to be 6%, 7%. There’s capitalized leases payments that are also included in the interest line. So, it does – it is challenging to try and look at this simple sort of math, but year-on-year our interest rate would be up in the 150 to 200 basis points.

Nick Farwell – Arbor Group: Are there any ways short of paying down debt for you to reduce any three of the – it doesn’t look like it, actually just on the surface, but are there any ways that that debt can be reduced for your offering of paying down the debt or some capital transaction?

Chris D. Newman – EVP, CFO and Treasurer: If it was a focus on reducing interest expense, it would have to be kind of an equity pay down of the debt. It would be the only way to reduce that interest level rate, but we feel comfortable with our financing arrangements that we have today. It is something that we do look at with a high degree of regularity, because it’s something that we need to stay abreast of.

Nick Farwell – Arbor Group: If you had conjecturally the opportunity to generate cash beyond what your internal plans are, would that incremental capital be in your opinion or management’s opinion utilized in plant and equipment, in essence in the business versus debt repayment, what would be your priorities?

Chris D. Newman – EVP, CFO and Treasurer: That’s a really good question. I think it would depend on the facts and circumstances if we had stores that we could open along the lines of the Princeton location that is our prototype that we are quite pleased with. Those were in the pipeline and ready to go. We could work against that. Generally, I think the business does have a desire to reduce to leverage. So, I’m not can give a single answer. I think it’s one that could be of both answers. We do generally want to reduce our debt, but we do see pretty significant opportunities to generate cash with this new store format, as well.

Mark R. Baker – President, CEO: I’m just going to support what Chris says, we are here because we believe we’ll got a growth opportunity but we’re not going to grow so fast. So, to cause ourselves to not be prudent about what our balance sheet looks like and striking the right balance between growth and debt and giving some headroom in the way we operate. But we believe, we do have a growth story it’s just going to take us some while, to kind of push that paddle down slowly and manage that growth.

Nick Farwell – Arbor Group: (One to last), Mark, and you’re probably more aware of this than I but before Sears bought the company Orchard also was managed in a highly leverage financially, with a highly leveraged balance sheet, as it currently has. Is your expectation that you’re, as a growth generalization comfortable with the current balance sheet or you prefer to have the debt pay down to some degree?

Mark R. Baker – President, CEO: Well, I think like Chris said, it depends on the circumstances and the timing. We feel we’ve got momentum starting in our business. So, you looked at the trends over the last five or six years at Orchard and where we’re at today, we’re starting to see a nice positive turn for retailer, we got a long way to go, very long way to go. But we have a manageable debt load, manageable expenses at this point in time that we’re comfortable with. I want to have enough growth to kind of build out the story, but we’re not going to go crazy, if you’re kind of read about that we’re going to make sure, we’ve got the right structure, as we go forward. And I’d like to have it pay down some, but I don’t think there is any urgency in that near-term.