Aaron Coleman - CEO Neil Watanabe - CFO.

Eric Beder - Small Cap Consumer Research.

Welcome to the U.S. Auto Parts Second Quarter 2018 Conference Call. On the call from the company are Aaron Coleman, Chief Executive Officer; and Neil Watanabe, Chief Financial Officer. By now everyone should have access to the second quarter 2018 earnings release, which went out today at approximately 4 p.m. Eastern time.

If you have not received your release, it's available on the Investor Relations portion of the U.S. Auto Parts website at usautoparts.net by clicking on the U.S. Auto Parts Investor Relations tab. This call is being webcast, and a replay will be available on the company's website through August 22, 2018.

Before we begin, we would like to remind everyone that the prepared remarks contain certain forward-looking statements within the meaning of the federal securities laws, and management may make additional forward-looking statements in response to your questions.

The forward-looking statements include but are not limited to, statements regarding future events, our future operating and financial results, financial expectations, expected growth and strategies, key operating metrics, and current business indicators, capital needs and deployment, liquidity, product offerings, customers ,and suppliers and competition.

Forward-looking statements are based on current information, and expectations are subject to uncertainties and changes in circumstances and do not constitute guarantees of future performance. Forward-looking statements involve a number of factors that could cause actual results to differ materially from those statements.

We refer all of you to the Risk Factors contained in the U.S. Auto Parts Annual Report on Form 10-K and quarterly reports on Form 10-Q filed with the Securities and Exchange Commission for a detailed discussion on the factors that could cause actual results to differ materially from those projected in any forward-looking statements. U.S.

Auto Parts assumes no obligation to, nor does it intend to, update or revise any forward-looking projections that may be made in today's release or call or to update or revise the reasons actual results could differ materially from those anticipated in these forward-looking statements even if new information becomes available in the future.

Please note that on today's call, in addition to discussing GAAP financial results and the outlook for the company, the following non-GAAP financial measures will be discussed, EBITDA and adjusted EBITDA. An explanation of the U.S.

Auto Parts' use of these non-GAAP financial measures in this call and the reconciliation between GAAP and non-GAAP measures required by SEC Regulation G is included in U.S. Auto Parts' press release today, which again can be found on the Investor Relations section of the company's website.

The non-GAAP information is not a substitute for any performance measure derived in accordance with GAAP, and those with such non-GAAP measures have limitations which are detailed in the company's press release.

Please note that we are not including a reconciliation of adjusted EBITDA guidance to projected net income due to the high variability and difficulty in making accurate long-term forecasts and projections of our net operating loss carryforwards, which have a significant impact on future net income.

As a result, we are unable to quantify a projected net income without unreasonable efforts. In addition, please also note that percentage and basis points discussed are calculated using net sales with the exception of advertising, which we'll be discussing and comparing to net online sales.

Unless otherwise stated, all financial data reported, including but not limited to revenue, gross margin, operating expense and net income loss, excludes our discontinued AutoMD reporting segment. With that, I would now like to turn the call over to Aaron Coleman..

Thank you, Operator. Good afternoon everyone and thank you for joining us to discuss our second quarter 2018 results. Before we get into the second quarter, I wanted to provide an update on our pending litigation against the United States Department of Homeland Security in the U.S. Court of International Trade.

As we mentioned on our last earnings call, our lawsuit asserts that United States Customs and Border Protection, an agency of the Department of Homeland Security, has been wrongfully seizing automotive grilles being imported by U.S.

Auto Parts on the basis that the grilles are allegedly counterfeit and infringe trademarks held by the original automobile manufacturer. We commenced the lawsuit to remove the overly burdensome bonding requirements arising from the wrong procedures and to ensure that Customs expeditiously process the flow of our goods into the United States.

During the second quarter, the Court granted our motion for a preliminary injunction and ordered that Customs would be restrained from enforcing any type of bonding requirements on U.S. Auto Parts in order to obtain entry of it's shipments into the United States. And that Customs must use its best efforts to process all of U.S.

Auto Parts import products not implicated by Customs underlying trademark infringement allegation in a timely manner. Despite the favorable court order, we continue to experience issues with our product flow arising from Customs inability to process our shipping containers in an expeditious fashion.

At the time, the court order was granted; Customs was holding approximately 200 of our shipping containers that carried not only the grilles alleged to be counterfeit but many of our other products as well.

So although the seized automotive grilles initially accounted for less than 1% of our annual revenue, we began to experience out of stock rates across many other categories due to the backlog of containers which Customs were holding.

We also began to incur significant port and carrier fees resulting from the increased period of time for containers remained at the port.

These fees associated with the unreleased product as well as the increased legal costs associated with the product seizers and the bonding litigation also negatively impacted our quarter and together with the increased out of stock rate, we experienced lower sales, lower gross margins, and higher operating expenses for the second quarter.

We do finally believe the supply chain disruption to our non-grille related parts is largely behind us as all of our containers which had been hold up at Customs have been released as of the end of July.

However in an effort to avoid future supply chain disruption, we have seized importing all automotive grilles from outside the United States and begun to procure alternative sources despite the fact that we firmly believe these grilles do not infringe on any trademarks.

This was a much less expensive alternative and continuing to incur port and carrier fees and the ongoing disruption to the rest of our supply chain. This will reduce revenues and gross margin over the near-term as our entire growth category accounts for approximately 3% of our total annual revenue.

The amortization treatment of the port and carrier fees associated with unreleased products will also continue to impact gross margin and operating expenses for the next three quarters. We will continue to evaluate our options to help expedite our ability to import grilles as we do not believe the trademark infringement allegation has any merit.

Nor do we believe the allegation should prevent us from importing grilles which are not alleged to violate trademark law or which we would otherwise be authorized to sell. With that, I'll turn the call over to Neil for our second quarter results..

Thank you, Aaron, and good afternoon everyone.

I'd like provide a summary of the financials reported in our press release today as well as an overview of key business metrics, unless specifically noted I would also like to remind listeners that all metrics exclude the AutoMD operating segment which is being reported as discontinued operations following the dissolution of the AutoMD subsidiary in the second quarter of 2017.

Moving on to our second quarter results, net sales in the second quarter were $77 million compared to $80.2 million in the year ago quarter with the decrease primarily driven by 9% decrease in e-commerce sales attributable to a decrease in e-commerce traffic and lower in-stock rates resulting from our previously disclosed Customs issue.

We also experienced a slight reduction in marketplace sales resulting partially from the same lower in-stock rates. Private label sales were flat in Q2 and accounted for 75% of net sales compared to 72% in the year ago period. Also note that offline sale which is comprised of our wholesale revenues were up 13% in Q2 to $8.5 million.

Gross margins in Q2 was 27.9% compared to 29% in the year ago period. The decrease was given by higher freight costs as well as factors associated with the Customs issue including lower in-stock rates on higher margin products and port and carrier fees associated with the unreleased product at the port of Norfolk.

As a result of the amortization treatment of these fees, the company expects gross margin to range between 27% to 28% over the next three quarters compared to our typical 29% to 30% range. For fiscal 2018, we currently expect the amortization of these port and carrier fees to approximate $1.8 million.

Total OpEx in the second quarter was $21 million compared to $21.7 million last year. As a percentage of revenue, OpEx was 27.3% compared to 27.1% with the increase driven by higher legal costs resulting from the aforementioned Customs issue.

Net loss in the second quarter was $0.5 million or negative $0.02 per share compared to net income of $26.9 million or $0.67 per share in the year-ago quarter. Note that the 2017 period included a $25.9 million tax credit resulting from the release of a valuation allowance on our cumulative net operating losses.

Adjusted EBITDA which adds back stock-based compensation expense and cost associated with our Customs issue was $2.8 million compared to $3.8 million in the prior-year quarter. As a percentage of revenue, adjusted EBITDA was 3.6% compared to 4.8%.

The decrease was primarily driven by the aforementioned lower net sales and gross margin resulting from the Customs issue and a decline in organic and pay traffic. Now let me provide some details on our key operating metrics for the second quarter. Total orders in Q2 were 857,000 versus 954,000 in the prior year.

E-commerce orders at Q2 decreased 10% to 443,000 with an average order value of $102 compared to $103 in the year-ago period. Despite the lower orders we improved efficiency during the quarter with a 70 basis point increase in the e-commerce conversion to 2.7%.

This is our fifth quarter in a row of improved year-over-year conversion rates which tells us that the investments we made to enhance the customer experience on our core sites are working.

Revenue capture, defined as the amount of actual dollars retained after taking returns, payment capture and product fulfillment into consideration, also improved to 88% of gross sales, compared to 85% in the year-ago period. This was a result of the improvements made to our return process, order fill rates, and payment capture.

In the second quarter, our customer acquisition cost increased to $7.29 compared to $6.99 last year. The increase was driven by an increased mix of paid versus organic traffic. Turning to the balance sheet, at June 30, 2018, we had no revolver debt for the 10th consecutive quarter.

We also had a cash balance of $6.8 million compared to no revolver debt and $2.9 million of cash at fiscal year-end 2017. This increase was attributable to the timing of payments with one of our shipping vendors. We ended the quarter with inventory of $54.2 million which is flat compared to the end of 2017.

I'd also like to mention that we have completed a detailed review of the recently announced tariffs for products imported from China. There are three different groups of tariffs that have been contemplated by the administration.

The first group which was implemented on July 6 included approximately 450 of our SKUs which represents approximately 1.5% of our net sales. The second group which has not been implemented yet includes approximately 30 of our SKUs and will not have a material revenue impact.

The third group has also not been implemented yet and is $500 billion in scope. We believe that the third group would cover the majority of our industry. It is important to note that our goal with any tariffs would be to pass the cost along to consumers and maintain gross profits. With that, I will turn the call back over to Aaron..

Thank you, Neil. Let me begin by thanking all of the U.S. Auto Parts team members for their continued focus on improving the customer experience and building long-term value.

Despite the challenges, we encountered on the Customs issue, we have continued to focus on executing our core initiatives of revitalizing our e-commerce site and expanding our marketplace channel partnerships. On our e-commerce sites, we believe the investments we've made to improve the customer experience are bearing fruit.

We've improved our product landing pages, product discovery process, checkouts, mobile insight fees, and post purchase experience all with a goal of accelerating growth in our e-commerce business and improving conversion.

Difficult to accurately assess how our e-com sales would have performed during the quarter without the Customs disruption and lower in-stock rates, however the consistent improvement to conversion tell us that our customers are valuing the improved experience.

We're in a process of deploying additional initiatives from our product roadmap to our flagship sites and early results continue to show promise.

Despite the improvements to conversion, we have continued to experience decline in our e-commerce traffic which is attributed to lower organic traffic and a decline in paid traffic due to customer acquisition economic.

We're in the process of enhancing our marketing capabilities through consulting and leadership changes with the goal of reversing these trends. Our marketplace sales were down 0.1% compared to the year-ago quarter which ends our more than two-year consecutive streak of generating double-digit marketplace sales growth.

Again this was partially a result of the Customs issue. Nevertheless we continue to work on expanding our marketplace partner network during the quarter as we were made committing to being present wherever customers are purchasing automotive parts online.

I'm pleased to report that in June we signed an agreement with a major global retailer to begin selling our branded and private label products through their online marketplace. This expansive marketplace presents a tremendous opportunity for us to sell automotive products to a large new customer base.

We're very excited about this marketplace channel development as well as our ongoing improvements to our e-commerce sites which we believe will significantly enhance our business for years to come. I would also like to announce that we recently sold our AutoMD assets to Power Stop for $1.4 million.

As you may recall, we shutdown our AutoMD operations last year to focus solely on our core operation and we're utilizing AutoMD solely as a media business. We'll use the cash proceeds from this transaction to focus on our core operation.

Turning to guidance for the quarter, we now expect net sales for 2018 to decrease low-single-digits on a percentage basis compared to 2017 primarily as a result of the Custom issues and the current limitations on our ability to import grille and lower than expected marketplace sales which compares to our previously issued target of low-single-digit growth compared to 2017.

Given the materiality of the cost incurred from the Customs issues and its extraordinary nature as well as the non-recurring nature of the sale of our AutoMD assets, we're excluding these items for adjusted EBITDA to provide a more accurate representation of our core business results.

However as a result of the lost sales attributable to the Customs issue and lower than expected marketplace sales, we are revising our adjusted EBITDA guidance and now expect it to range between $12 million and $14 million compared to our previously issued target of $13 million to $14.5 million. With that, we'll now open up the call for question..

Great, thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions]. Our first question is from Eric Beder from Small Cap Consumer Research. Please go ahead..

Hey.

Just one quick accounting question, so Neil on the Customs cost are those going to be expense dramatized going forward, how should we think about those grille modeling?.

You know, Eric, there's really two buckets of costs that have been incurred based on the Customs issue. The first one is direct costs which are related to the port and carrier fees which we have incurred through the end of July which we indicated was approximately $1.8 million.

Those costs are going to be amortized over the next three quarters as part of the cost of goods calculation. The other direct cost is legal and these costs will be expensed as incurred.

The indirect costs are productivity loss in our distribution center processing based on the abnormal flow of product and the other indirect costs are lost sales due to our out of stock due to the 200 containers which receives and delayed.

We believe that these costs, these indirect costs have been absorbed in Q2 and the negative impact of these items is behind us..

Okay.

Aaron so can you talk about some of the changes you're doing to the website, other pieces to drive more customer traffic and kind of how do you expect that to impact results now or what you would be thinking about going forward in the future?.

Yes, so similar to the comments -- similar to the prepared comments I should say that we've made significant promise -- progress on the customer experience across the entire journey the past couple of quarters. We've released enhancements across our flagship websites that include site speed, product discovery, making checkout easier.

In addition we've improved the mobile experience with accelerated mobile pages and progressive website -- progressive web app releases and these initiatives are translating into significant improvements in conversion.

In addition we've made improvements in the post purchase experience that translates into the improved metrics that you see on the revenue capture.

Where we need to deploy additional resources is trying to reverse the trends on traffic and so we'll be investing in new internal marketing leadership as well as engaging third parties to review all of our customer acquisition strategies and I look forward to updating you on the next couple quarters on those investments..

And then I want to add question additionally on the tariffs so obviously there is uncertainty whether the final round of that would affect you but I guess the flipside of this is that, this is probably these tariffs if go through little, these are higher cost and higher I mean ceiling costs on new cars.

Historically when you've seen increases in that level of pricing does it bring more customers to your website and what do you believe also in terms of the price flexibility if you have to raise prices of new customers to continue to come there..

Sure, a couple different things. I'll try to unpack that there's -- that the tariffs are certainly something that we're dealing with a lot as well as many others and we were relatively pleased that the first two rounds had a much smaller impact than anticipated obviously the third round seems to cover the majority of imports.

When you look at layering on the cost to our product cost because of our supply chain, because of the one or two steps there we will certainly have higher inputs but there's many things that go into it right now we’re see in fluctuations in currency and everything else, so everybody that's participating in our value-oriented product we think that will incur similar inputs and maybe even higher and people that are multi-step process.

So we're going to do our best to pass that along to the consumer and translate that into inflation and we'll have to be very focused to see what others are doing out there and see how it affects demand.

But we think that even with the increase in input cost there we still will have a value-oriented option compared to the alternatives that are in the marketplace..

Okay.

And finally I know you usually talk about adding more SKUs obviously this quarter had a lot of uncertainties to it is that still a big part of this business adding more SKUs this business you've always focused on?.

Yes, absolutely we've got a lot of different growth initiatives and one of those is focused around product assortment. We continue to invest similar to where we were in the past on identifying these SKUs we will pay similarly to last year in terms of volume and candidate. So we are continuing to invest in that area..

Our next question is from Beth Louis from [indiscernible] Partners. Please go ahead..

Hello? Hello?.

Hi, Beth..

Hi, hi guys. Good afternoon.

So Aaron and Neil, I want to understand I guess the cut and guidance right I mean it's the grille issue and then the traffic to the online is down but as you look out to 2019, do you expect to get back to mid-single-digit top-line growth and then my guess is with this major retailers or this major online retailers I should say, that actually really be additive as we look out into 2019, I mean the leverage in the model seems to be tremendous..

Yes, thank you for the question.

So obviously we haven't provided guidance for 2019 but we believe that whether it's a product assortment or conversion initiatives we're investing in this area around traffic or even new third-party partnerships where we're trying to position the company for growth next year and obviously we've had some headwinds in the first six months of the year with the Customs and obviously the grilles will be a headwind that we're going to try to mitigate as much as possible for the foreseeable future but we believe in the underlying growth initiatives will translate into growth over time..

Yes, I mean I'm looking at the valuations of the stock today and if you look at the enterprise value of the business that's, if you take away the cash it’s $41 million and you should be generous if you take the midpoint of your guidance that's $30 million in EBITDA so the valuation is three times enterprise value to EBITDA for your business today?.

Yes,sure..

So my next question is -- my next question is why aren’t you guys buying back stock?.

No, our board reviews any type of repurchase program with the last repurchase program we had out there expired few months ago and there were a few items capital projects and other things that they have deemed to be very use of cash versus stock repurchase not to say that we won’t renew our stock repurchase program but we currently had made decisions that the cash can be better utilized to build some of our business initiatives, private label, product inventory et cetera and some of our other areas that we’re building the customer experience that we feel is while return more value and benefit and the stock repurchase at this moment..

And I’ll say similar comments, maybe just phrase it differently.

The board is always looking to create shareholder value and they’re looking at one of the ways that they do that is the allocation of capital and so there will be active discussions this quarter and next quarter and in future quarters of how that that value can be most easily created and there has been two stock purchase plans in the past and I'm sure it will be considered on a regular basis.

Just one other note in terms of the cash at the end of the quarter if you remember in Neil’s prepared remarks, that is a bit higher than normal as there is a whole bag from where there is a vendor payment terms that are still getting reviewed. So that’s a component of that excess cash..

Yes, I understand that, all right, even if you put another couple million dollars on the balance sheet, you’ve got -- you've had a perfect storm for year in terms of this automotive grilles and the cost associated with that, but now you’ve signed on an agreement with major global retailer which arguably I mean your top-line should start to grow again you're going to get some leverage still, I'm just -- I’m a little bit scratching my head saying your company -- the valuation of your company in the market say is three times enterprise valued to EBITDA.

I’m just -- I'm confused why you wouldn’t initiate some kind of small share repurchase program?.

Yes, I understand your feedback and will certainly communicate that with the board and as I said they’re continually evaluating the best uses of capital..

Okay.

So along those lines, what will your expenditures be for 2000 for the rest of the year and then what do you think they’re going to be for 2019?.

Well, we haven’t provided the guidance on 2019 and specific for the CapEx side, we provided a range of with $5 million to $5.5 --.

Correct..

Million for the year and we invest -- and we expect to hit that guidance that we provided before and we're about halfway committed as we’re halfway through the year now..

Great.

And do you think next year it will be along those same levels?.

Well, we haven’t provided exact guidance for next year in terms of the CapEx spend, what I can tell you is that for the past three years we’ve been at just around between $5 million and $6 million and I don’t see anything that would significantly change that in the next couple of years..

[Operator Instructions]. And our next question is from Steven Branstetter [ph] from ABL Investments. Please go ahead..

Good afternoon gentlemen.

You stated that you signed an agreement with a major global retailer; we do assume that was not Amazon that was from the last call?.

That was from the last call, so it is a new one..

So it is a new one? Do you have a date when this retailer starts?.

The contract is in June and we will ramp up with new product assortment over this next quarter. So we always start with new marketplace partnerships with a subset of our assortment and we make sure that all the operations are executing as expected and then we’ll ramp up more and more of our catalogue..

Is there a reason not to disclose who the retailer is?.

Really just making sure that we’ve got a permission to use names on both sides. So we’ll be working on that in short..

So if permission is granted, then we possibly look at your press release when the permission is granted upon completion of the agreement?.

Yes, that's what we hope..

Okay, press release mentions leadership changes, what part of a leadership, are we talking about a sale to company?.

No, if I know what we’re referencing here I believe that that was in my mention on the marketing side, so clearly I think that we’ve made great progress on the supply chain and even improvement in customer experience through conversion improvements where we’re going to make changes to try to address -- to try to reverse some of the traffic changes we’re seeing.

So we’re going to bring in board marketing talent internally and we’ll also be working and engaging other third-parties to evaluate all of our marketing strategies. So it’s specifically on the marketing side..

So is the issue the basically by Google AdWords has gone up in price, is that what you're facing?.

The marketing is across multiple channels.

So we’ve certainly seen some headwinds on organic presence, we’ve seen some headwinds in terms of making the unit economics work on some of the paid which includes SCM or shopping and as we -- over the last couple of years as we’ve been disciplined around making sure that we get incremental margin from each transaction, we pulled away from some of the campaigns that were low to negative margin.

So we’ve got to figure out how we change the unit economics on that acquisition strategy, part of it was trying to make sure that the website experience is good, so we're converting more people as they arrive but we've also got to focus in terms of all the things that we're doing from customer messaging, segmentation things of that nature to improve that traffic..

Okay.

And on the container issue was there a reason it took two months with them to all be released or they going through piece-by-piece?.

We didn't have a whole lot of visibility into why it was delayed as much as it did some were weeks; some were actually closer to four months. Their processing throughput was very low and we were but we didn't have a lot of visibility on what's going on in -- on their side..

Is there an opportunity for your lawyers to seek payment from the government for these delays?.

Yes, we don't really comment on any sort of pending litigation..

Thank you. This concludes the question-and-answer session. I would like to turn the floor back over to management for any closing comments..

Thank you all for joining the call today. We look forward to meeting with some of you at the Canaccord Conference in August or the Liolios Gateway Conference in September, that we will be attending or during our periodic non-deal Road Shows over the next couple of months.

If we don't chat then, we look forward to speaking with you next when we report our third quarter results in November..

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you again for your participation..