Julie Davis - Senior Director of Investor Relations William P. Angrick - Co-Founder, Chairman, Chief Executive Officer, President and Chief Executive Officer of DOD Surplus LLC Kathryn Ann Domino - Chief Accounting Officer James M. Rallo - Chief Financial Officer, Treasurer and President of Retail Supply Chain Group.

Colin A. Sebastian - Robert W. Baird & Co. Incorporated, Research Division Jason S. Helfstein - Oppenheimer & Co. Inc., Research Division Alex Chavdaroff - Stifel, Nicolaus & Company, Incorporated, Research Division Rohit Kulkarni - RBC Capital Markets, LLC, Research Division Rohit Kulkarni - Robert W. Baird & Co.

Incorporated, Research Division Jason Mitchell - BofA Merrill Lynch, Research Division.

Good day, ladies and gentlemen, and welcome to the Q2 2014 Liquidity Services Inc. Earnings Conference Call. My name is Whitley, and I'll be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Ms.

Julie Davis, Senior Director of Investor Relations. Please proceed..

Thank you, Whitley. Hello, and welcome to our second quarter fiscal year 2014 financial results conference call. Joining us today are Bill Angrick, our Chairman and Chief Executive Officer; Jim Rallo, our Chief Financial Officer and Treasurer; and Kathryn Domino, our Chief Accounting Officer.

We will be available for questions after our prepared remarks. The following discussions or responses to your questions reflect management's views as of today, May 8, 2014, and will include forward-looking statements. Actual results may differ materially.

Additional information about factors that could potentially impact our financial results is included in today's press release and in our filings with the SEC, including our most recent Annual Report on Form 10-K.

As you listen to today's call, we encourage you to have our press release in front of you, which includes our financial results, as well as metrics and commentary on the quarter. During this call, we will discuss certain non-GAAP financial measures.

In our press release and our filings with the SEC, each of which is posted on our website, you will find additional disclosures regarding these non-GAAP measures, including reconciliations of these measures with comparable GAAP measures.

We also use certain supplemental operating data as a certain -- as a measure of certain components of operating performance, which we also believe is useful for management and investors. This supplemental operating data includes gross merchandise volume and should not be considered a substitute for or superior to GAAP results.

At this time, I'd like to turn the presentation over to our CEO, Bill Angrick..

from small dealers and depot repair firms, to plant managers at large corporations. This offering will enable third-party self-service clients to leverage the supply and demand we currently attract in key industry verticals such as transportation.

The development and growth of our GovDeals marketplace validates the attractiveness of the self-service offering, which currently enables over 6,500 municipal clients to benefit from our scale and investment in technology and buyer marketing.

The third new service area we are investing in is a data warehouse and data-as-a-service applications that enhance the experience of buyers and sellers in our ecosystem. Our marketplaces generate significant volumes of data on the value, condition and availability of high-value equipment and inventory in the global reverse supply chain.

We intend to package and provide access to this data and associated analytics to support our internal operations and the sale of additional services such as warranties and analytics related to asset management and valuations.

All of these new services will be modular and extensible to other players in the reverse supply chain, who will benefit from leveraging our marketplace, services and data analytics.

Providing other players access to these capabilities will strengthen our ecosystem of sellers, buyers and channel partners and the volume of activity and revenue on our platform.

Investments in these new services and capabilities during fiscal year '14 will enable Liquidity Services to serve and monetize previously untapped markets and unlock new opportunities for growth in fiscal year '15 and beyond.

Finally, we are continuing to invest in the development of an aligned global brand to increase awareness of our service offering.

To support this effort, we have centralized our brand marketing organization under a single leader and are in the process of developing a new brand message focused on our reliable performance, scalable solutions and the strategic impact we make with our clients.

In a recent survey of over 150 investment recovery professionals across a wide range of industry verticals, Liquidity Services was rated superior to the competition on key evaluation factors, including net recovery value, service quality, expertise, risk mitigation and coverage.

We are the proven market leader in the reverse supply chain with the world's largest marketplace for business surplus, and consolidation of our marketing spend behind a single global brand message will enhance our sales efforts. We expect to see the benefits of this as we move into fiscal year '15. Next, let me comment on our DoD Surplus contract.

As previously announced, we are pleased that we will continue to drive innovation for the DoD for up to 6 years under the terms of a new surplus contract for all usable surplus items other than rolling stock.

Under the terms of the new surplus contract, which have yet to be finalized, we expect to handle an estimated $9 billion of original acquisition value of property over the contract performance period. This continued relationship delivers a steady source of anchor supply in the key verticals we serve in our commercial business.

Moreover, as we continue to drive innovation with our merchandising and sales strategies, we are positioned to capture attractive incremental returns for Liquidity Services' shareholders.

In summary, investment in our Liquidity One [ph] transformation plan, which includes the enhancement of our marketplaces and operations, the development of new services and capabilities and the launch of an aligned global brand enables us to build a diversified multibillion-dollar GMV business serving buyers and sellers of all sizes in the $150 billion reverse supply chain with high returns on invested capital.

In addition, we will continue to leverage the long-term supply under our DoD Surplus contract to support our commercial growth strategy. Our current business has strong free cash flow, a proven track record of customer satisfaction and the talent and financial strength to deliver on our vision.

Now let me turn it over to Kathy for more details on Q2 results..

Thanks, Jeff. Although our profitability was below expectations for the quarter, we continue to make improvements in enhancing our marketplace experience for our global buyer base, while at the same time integrating our global capital asset marketplaces to increase long-term efficiencies for our sales and operations teams.

These costs are part of the $7 million to $9 million increased spending we discussed at the beginning of the year, and we are currently on plan to complete most of these projects this fiscal year, with final completion occurring in fiscal year 2015, as we previously outlined. Next, I will comment on our second quarter results.

Total GMV was $227.2 million. GMV in our GovDeals, or state and local government marketplace, increased to $38.8 million, or 7.1%, as we continued to add new clients, bringing total clients to over 6,500 out of a potential 88,000 in the highly fragmented state and local government market.

GMV in our commercial marketplace has decreased to $133.4 million or 20.4%, principally as a result of a decrease in our commercial capital assets marketplaces, as we have seen a slowdown in global energy asset sales affecting our Network International marketplace, and a reduction in global manufacturing assets available for sale in our GoIndustry marketplace.

GMV in our DoD Surplus marketplace decreased to $38.6 million, or 0.3%, as a result of the mix change in property flows on the DoD to lower-value, smaller niche items. GMV in our DoD scrap marketplace decreased to $16.4 million, or 7%, as a result of decreasing property flows from the DoD.

As sales of DoD scrap have become less material, fluctuations in commodity prices are not materially affecting our financial performance. Total revenue was $128.3 million. Technology and operations expenses increased 29.7% to $29.1 million. As a percentage of revenue, technology and operations expenses increased to 22.6% from 17.2%.

These increases are primarily due to staff and temporary wages, including stock-based compensation and consultant fees associated with technology-marketplace integration and enhancement projects we have previously discussed, to productize our services, technology and marketplace data to serve a broader set of enterprise and middle-market customers, including our returns management solution and self-service offering and additional warehouse space due to the growth in our inventory.

Sales and marketing expenses increased 4.9% to $10.5 million. As a percentage of revenue, sales and marketing expenses increased to 8.1% from 7.6%. These increases are primarily due to an increase in staff wages, including performance and stock-based compensation. General and administrative expenses increased 5% to $12.4 million.

As a percentage of revenue, general and administrative expenses increased to 9.7% from 9.1%. These increases are primarily due to staff wages, including stock-based compensation.

Adjusted EBITDA of $16.7 million decreased 42.7%, primarily due to the decrease in our commercial capital asset marketplaces and an increase in technology expenses, as previously discussed. Adjusted net income of $8.5 million decreased 45.5%.

Adjusted diluted earnings per share decreased 45.8% to $0.26 based on approximately 32.3 million diluted weighted average shares outstanding. We continue to have a strong debt-free balance sheet.

At March 31, 2014, we had a cash balance of $101.8 million after spending $3.1 million in stock repurchases during the quarter, current assets of $225.6 million and total assets of $478.3 million, with $102.6 million in working capital. Capital expenditures during the quarter were $2.3 million.

We expect capital expenditures to be $7 million to $8 million for fiscal year 2014. I will now turn it over to Jim for the outlook on the next quarter and full year..

one, acquisition costs, including transaction cost and changes in earnout estimates; two, amortization of contract intangible assets of $33.3 million from our acquisition of Jacobs Trading; and three, for stock-based compensation costs, which we estimate to be approximately $3.5 million to $4 million per quarter for fiscal year 2014.

These stock-based compensation costs are consistent with fiscal year 2013. We will now answer questions..

[Operator Instructions] Your first question comes from the line of Colin Sebastian with Robert Baird..

Bill, given the change in circumstances that you face next year with the DoD, I think we need to understand better what the impact will be on the profit profile. You guys have made a point to talk about the improving margins of the commercial segment in the past. So I wonder if you can help us with that math as we adjust our models for the year ahead.

That's the first question..

Sure. We can answer the question in the context of where we are with the discussions and the award process under the new contract.

First point to make is that we have a current need to receive, process and sell inventory under the current contract, and the current contract has a base performance period that goes through at least December of 2014 with renewal option through February 2015.

And as we've commented over the last quarter, the nature of the property received and the volume of property received under the current program has changed. We are processing a much higher volume of lower-value items.

We are taking on significant expansion of space and staffing to maintain pace with the DoD's need to move these items out of their supply chain. And we will be required to process and sell this inventory beyond the base performance period of our current contract due to that volume.

And so that activity will exist well into the future, and we will continue to maintain the cost structure to process and manage that overhang of inventory under the current contract well into the future.

And since we are still receiving a significant volume between now and the end of the current contract performance period, it's very difficult for us to give a projection on the actual timing and mix of the property we're selling and the impact to profitability.

Under the new contract, we are in a pre-award phase and the final specifications, cost structure and rollout date of that new contract have not been determined. And therefore, it's premature for us to give any sound guidance on what the future of this multiyear transition of the DoD program will look like..

Okay.

I mean, but just to be clear, if we're looking at just the commercial side of the business, retailing and capital assets, what sort of margin profile can we assume for that segment, irrespective of what the cost and -- that you're managing with the DoD?.

Let me have Jim answer that, as he's expanding his role in that area..

So Colin, I think a couple of things. One, it's going to depend on the mix of business. Obviously, from the remarks we made earlier on the call, we were able to achieve the GMV for this quarter and yet had a profitability mix, and a lot of that had to do with -- I'm sorry, profitability miss, which a lot -- which had to do with the mix of business.

So it's difficult right now to say specifically what that margin will be. I think it's clear that the aggregate margins in the business will be coming down from what I would say is the low double-digits to low teens.

What -- exactly what that mix looks like is going to be difficult to gauge right now, as we have to figure out what is going to happen with the DoD business, as Bill said. So the DoD business, obviously, is still going to be part of our business going forward.

We are in the process of reengineering our operations around that business to make sure we drive the highest possible margins we can under the new contract arrangements. That's going to take some time to do that, given that we're still going to be dealing with property under the old contractual terms and commitment.

So again, at this point, I think that we should certainly expect margins to come down in the business into the -- in -- somewhere into the single digits..

And just so you know, we have had a good uptick of additional value-added services that drive our take rates into the high teens, low 20s as a percentage of GMV in the commercial business, particularly in the capital assets business. And so this is a high gross profit business.

Of the fee revenue we collect, we're able to generate gross profits in the 70-plus percent range. And so then the question becomes, what scale do you need to be to absorb the investments -- substantial investments we've made this year in areas like product development, IT, leadership development, compliance, HR, sales and marketing.

And our view is that our clients want us to be able to provide scalable solution, global coverage, a full range of services to track and manage these items, provide reporting on these items. So that fixed cost is not being absorbed in the current period.

As we talked about this multiyear transformation plan, we expect, as it will, we'll have very high contribution margin on additional volume, a very high EBITDA margin as a percentage of GAAP revenues to service fee revenues we'd collect, which is very apparent if you look at auction business models, e-commerce models that are out there..

Okay. I'll get back in the queue, but just very quickly, lastly. The increase in the inventory days, presumably, that's the shift to more of a purchase from a consignment model. If you could just clarify why -- what went in -- what's behind that shift from -- to purchase..

Sure. That's a great question, Colin. And frankly, a very positive for the business right now. So what's happened is, as we've discussed earlier, we are taking an enormous flow of property from the DoD right now. And at this point, that's why it's difficult for us to gauge exactly how long this runoff's going to be because that property flow continues.

And that is a significant amount of the increase in inventory. The other area of the business that saw some increase in inventory this quarter, although not as dramatic as the DoD, is the retail part of our business.

And part of the reason for that is, I'm going to be frank, we did not move through that inventory as well as we wanted to this quarter because it came mostly towards the end of the quarter. We had significant delays in shipping this quarter due to weather.

So our facilities around the country, for example, our Minneapolis facility was closed a number of days because of weather. Our Indianapolis facility, actually Indy had record snowfall this year, was closed a number of days.

And so it wasn't just our facilities that had problem receiving, but the shipping lanes, if you would, the trucking lanes were really tied down this quarter. So the good news is that we have received all that product and are in the process of processing and reselling these products over the next quarter or 2.

But that did drive up the inventory balance at the end of the quarter..

Your next question comes from the line of Jason Helfstein with Oppenheimer..

I just want to go back to the beginning comments. And you guys kind of have been the leader in this kind of size-wise, right? And so I just want to understand, Bill, kind of what you're basically saying.

I mean, if I think back over the past 18, 24 months, kind of there was a movement to go to more enterprise selling, which required -- it was a longer selling process, and it was selling to a less fragmented or a smaller buyer base.

It sounds like now you want to try to get the business to have a self-service element, if I heard you correctly, to effectively get more sellers on it, and then to try ultimately go back to a bigger buyer base, kind of leveraging the platform.

I mean, am I understanding that correctly? Just help us understand how you're thinking about kind of this -- kind of the -- I mean, these are a number of transformations, all in a relatively short amount of time.

And then secondly, can you just give us your opinion on what you think happened at the DoD bidding? I mean, I guess, help us understand how you think the bidding by your competitors was justified in the context of what you understand is the cost infrastructure to run these programs..

one, as a standalone business opportunity to continue an important relationship and leverage competencies; I think we also look at it as an opportunity to complement the growth of our commercial business and the supply that comes through the program -- that comes through the supply chain populates the asset categories that our Fortune 1000 sellers are transacting in everyday.

And so from that perspective, the DoD program is an important complement to growing our buyer base, growing the scale of the industry events and online sales activities in those verticals. So we see it as a very important supplement to the commercial growth strategy.

In terms of the return on effort and return on investment, as I've said, going into the process, we will always invest in profitable growth. We'll always invest in those areas where we believe that we get compensated for making that incremental investment and innovation.

And our view is that over the course of a 6-year performance period, as we continue to find ways to enhance the value of the merchandising process, the way we segregate and sell property, the non-rolling stock business provides an opportunity to be compensated for that. As we improve recovery rates, we will be rewarded.

Our shareholders will be rewarded for that investment. And so that's why that was a very important program to go after, and we will make it successful. On the not -- on the rolling stock piece, we think there was a little bit of irrationality in the way that, that bidding went.

And I think there was this notion that maybe someone was willing to bid at any cost just to say that they were a successful bidder.

We don't see the value in exchange of working for a loss or for no profitable return on effort or investment, and we stood down when we felt that the pricing had gotten to a level where we would not be able to adequately fund an operation and provide the high level of service that the agency has been accustomed to over time, or where we felt we weren't getting compensated for the risk assumption of having to take title to inventory and then process the transportation of the inventory, the storage inventory, the inventory screening and all the administrative support and requirements of the DLA, which are substantial.

And so we stood down on that. I would say we still retain a very strong competency, buyer base and know-how in that field, and we are free to deploy that competency in the open market..

Your next question comes from the line of Michael Purcell with Stifel..

This is Alex for Michael Purcell. I wanted to follow up on the surplus segment.

Can you just talk a little bit about what percentage of the operating costs are fixed versus variable? And also, can you break out sort of the approximate operating costs in the surplus business between the rolling and non-rolling, particularly when things are a little more steady-state?.

That detail is not available. We don't do segment accounting. What we have said is that historically, rolling stock has been 30% to 35% of the GMV.

I think the other issue in this multiyear transition for the DoD program is we will continue to retain the operating footprint and structure and personnel to manage the significant volume coming in under the current program.

And we'll continue to have processing, sales and activity beyond the base term expiration of calendar year December 2014 or Spring of 2015. So that business continues, and that's really all I can offer..

I think last we heard, there were 300 people working in the segment, is that still the case?.

That data is not a company-provided metric..

All right. And then just one last one, then.

Is Jacobs still a low- to mid-20s percent margin business?.

From my earlier comment, we don't do segment reporting. The business is established, it's been integral to the growth of our Retail Supply Chain Group, the buyer base is very complementary.

We talk a lot about the services -- the new services we're developing to serve manufacturers, and we credit, not only the Jacobs expertise, but the expertise of our team to put us in a position to provide not only access to our sales solutions and marketplaces, but increasingly, a fee-for-service add-on business to manage, process, refurbish and sell vendor inventory.

And we believe there's an opportunity to bundle returns and management solutions with our asset sales solutions..

So Alex, it's Jim. Look, these are detailed modeling questions, and I understand how you like to look at the business. But at the end of the day, we've fully integrated all of these acquisitions over the years. So we don't look at individual acquisitions like you're trying to do.

The other thing is, on the DoD business, as Bill said, so I gave some margin guidance in a prior question. I believe, either Colin or Jason had that question -- I think it was Colin, actually. And that's, again, a blended-margin basis. There has been no change in the margins of the Jacobs business since we bought it.

So that business continues to be a solid channel for us. Again, fully integrated and we expect that to be successful in the future as it has been in the past..

Your next question comes from the line of Rohit Kulkarni with RBC Capital Markets..

Great. First, 2-part question on the DoD. Again, regarding the surplus rolling stock that was given to IronPlanet, just as you are waiting for the pre-award phase for non-rolling out, I assume they are also waiting, too. And probably, they have an even bigger hurdle as they do not have the history that you had with DoD.

So from what you understand, are -- is that almost a done deal? Or is there something that IronPlanet may not be able to do that DoD, may have to go back to the drawing board? And second, DoD Scrap Contract, you are in the 12-month extension. I think it's the last one.

So what have you learned from the recent rebidding of surplus contract? Do you feel that confident that when it comes up for renewal, the Scrap Contract, next year in June, you would be able to have that renewed as well?.

Sure. Let me give you a couple of thoughts on the rolling stock segment of the DoD supply chain. The first thing to note is that this is not a commercial rolling stock. It is specialized vehicles and equipment that are used in the military for logistics purposes, and the supply chain and use -- the life cycle of an asset in the military is very unique.

So military units are using the equipment and then as items become end-of-life, the items are typically salvaged for parts. And then the items are made available to other Federal agencies or a donation to state agencies. And then anything that's not claimed for reutilization or donation, then it's referred over to the sales channel.

So what comes in to the sales channel, in the vast majority of cases, is nonoperational rolling stock that is very specialized for the military marketplace. And so this is not Class A tractor trailers that drive freight over the road.

This is very specialized green equipment that misses major components, a steering, an engine part, axles in some cases. And so it's expensive to ship, it appeals to a very niche buyer base. In many cases, buyers that are using it to refurbish items, existing items. And therefore, it's sort of a very unique buyer base and sales process.

Our view is that it requires very specialized attention, significant investment in the removal and transportation. The way the contract was written requires the contractor to remove the items and process the transportation and storage of the items and get it out of the way of base commanders.

And I can tell you today, if you go to any of our transportation storage locations, and we have 5 of them, there is a lot of military rolling stock sitting on those locations. Why? Because if it's not removed, base commanders can't execute their business. They can't train, uniform and equip men and women in the military. So that's a big investment.

The way the contract was written is, it is a minimum referral requirement. It is not an exclusive contract. And so like in any contract in the commercial market, in the agency market and public sector, it's a best-efforts performance. You have to maintain service levels, you have to maintain screening of the items.

If an item appears for sale and is contained on a do-not-sell list maintained by the State Department, the contractors assess the penalty equal to 50% of the original acquisition cost. And so you could have individual items with penalty of several hundred thousand dollars if you're not able to profit.

So it's not a business that you would normally have to undertake for commercial. It's very specialized. And so the DoD would always have the option to investigate other solutions based on the actual performance of the program.

And as I said, in a scenario where you're not retaining enough revenue to cover the transportation and shipping cost or maintain one-on-one customer relations in almost 300-plus locations where items could be referred, it erodes the quality of service.

And so in that regard, like any client, the DLA will assess the quality of service being provided, and will have the degrees of freedom to make adjustments along the way. From our perspective, we want to focus on the current operation. And as we see opportunity in the market, we'll certainly be available to provide solutions.

And the scrap venture contract, let me just answer the scrap venture contract. I think the scrap venture has many of the same characteristics. It's a very unique business, operationally intensive. It's a business where the vast majority of the upside goes back to the government. It's been a program where service and reliability have been important.

And my sense is that the program and the current model has worked quite well for the DoD. And therefore, it would be the model going forward..

Okay. And another one on the commercial strategy. And how does GoIndustry fit in there? In the past you've mentioned it's in $130 million, $140 million run rate.

To what extent do you expect that to grow from those levels? Any additional color on GoIndustry?.

Look, during this initial on-boarding process, we've taken a look at our marketplace platform, our sales structure, the sales methodology, the way we manage information, and all of that is being enhanced. What we have learned is that clients really value the service, rate the service highly. The offer we have is very unique.

We've gone to different parts of the world and competed and won mandates from large global companies. There's really no one else providing the level of service and the type of technology-enabled marketplace that we offer. So it's a great service. We expect that business to grow organically as we move through fiscal '15.

We are very excited about the investments we're making to support the sales organization, the branding efforts, and that will, we believe, reignite growth in that part of our business..

[Operator Instructions] Your next question comes from the line of Nate Schindler with Bank of America..

This is Jason Mitchell here for Nate Schindler. I have a couple of questions. The first one is you kind of mentioned electronics, the mix shift in your commercial business. You've mentioned that in the past.

Do you see this as kind of something that you expect to continue in the future with just the way consumers are buying electronics? And then, second, do you have any kind of update on how your Wal-Mart business is doing?.

Sure. I'll take that. So on the -- as far as the mix of electronics, that has not changed in the last couple of quarters. There obviously is a significant amount of opportunity in the electronics vertical for the retail side of the business, primarily because there is a lot of manufacturers that need help with the product.

Obviously, it's an area of concern for retailers. These are high ASP products. And so when you look at returns and the dollar-amounts return, there is a lot in that category. So I don't really see a big shift there.

I do think that we are, today, when I look at what's in our warehouses, we actually have a tremendous amount of apparel, houseful of techs [ph] and other general merchandise. So I think it would be, going forward, again a similar mix to what we've seen in the past, when I look at the opportunities ahead.

As far as our Wal-Mart relationship goes, I mean, Wal-Mart continues to be our largest client on the retail side of the business. We continue to build that relationship, and there has been really no significant changes with that client..

There are no further questions in queue at this time..

Yes, thank you for joining our call today. We will be taking follow-up questions concluding this call. Thank you..

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day..