Welcome to the U.S. Auto Parts Second Quarter 2019 Conference Call. On the call from the Company are Lev Peker, Chief Executive Officer; and David Meniane, Chief Operating Officer and Chief Financial Officer. By now, everyone should have access to the second quarter 2019 earnings release, which went out today at approximately 4:05 PM Eastern Time.

If you have not viewed the release, it is available on the Investor Relations section of the U.S. Auto Parts website at usautoparts.com. This call is being webcast, and a replay will be available on the company's website through August 22, 2019.

Before we begin, we'd 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, customer and suppliers and competition.

The 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. The 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 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 can cause actual results to differ materially from those projected in any forward-looking statement. 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 to release 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, non-GAAP financial measures, such as adjusted EBITDA, will be discussed. An explanation of U.S.

Auto Parts use of non-GAAP financial measures in this call and the reconciliation between GAAP and non-GAAP measures required by SEC Regulation-G is included in the U.S. Auto Parts press release issued 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. With that, I'd like to turn the call over to our CEO, Lev Peker. Please go ahead, sir..

Thank you, operator, and good afternoon, everyone. It has been a little over seven months since I took over as CEO, and I'm very proud of the progress our team has made to begin repositioning U.S. Auto Parts for growth and profitability.

We have rebuilt and strengthened our team with key personnel, most of which joined in the last few months, and we have executed on various initiatives laid out at the start of the year, including a significant consolidation of our e-commerce websites.

We started the year with 18 and are now down to four websites with the goal of ending the year with three core sites.

As was discussed on previous calls, we want to focus our resources on fewer properties to do a better job on both growing and optimizing these sites, while ensuring each property has a unique and differentiated value proposition for the customer. These three core websites include carparts.com, jcwhitney.com and autopartswarehouse.com.

I'll have more to discuss on these later in the call. Since our last update, we have begun to roll out our new 3-year strategy that we're calling right parts, right time and right place.

To put simply, we want to make sure that the customer orders right parts for their vehicle, we want to deliver it to them quickly and we'll want to be agnostic to how they want to install their parts. I'll have more on our strategy later in the call as well.

As noted in our press release today, we have begun to emphasize our focus on our private label products. We have sourcing capabilities, a great supply chain and a catalog that has thousands of hours invested into it.

Our ability to effectively source and monetize these private label products is one of our strongest assets, and we plan to take full advantage of that. As a result of the shift in focus, we have begun to allocate fewer resources to our branded business, which will continue to impact revenue and traffic over the near term.

However, we expect the benefit of a higher proportion of private label sales to drive considerably better margins and profitability. Emphasizing our private label business will enable us to better manage our operating expenses, and we're in the process of implementing various initiatives to run a leaner and more efficient cost structure.

But before commenting further on our plans, I'd like to turn the call over to our COO and CFO, David, to speak in more detail about our second quarter financial results.

David?.

Thank you, Lev. Jumping right into results. Net sales in the second quarter was $73.7 million compared to $77 million in the year ago quarter. This was primarily driven by 13% decrease in e-commerce sales due to our proactive reduction of negative and low-margin transactions and de-emphasis of branded product sales.

Private label sales increased 1% in Q2 and accounted for 79% of net sales compared to 75% in the year ago period. As we accelerate our private label sales, we expect this trend to continue at a faster pace. Gross profit in the second quarter increased 6% to $21.8 million compared to $20.5 million last year.

Given our proactive reduction of branded product sales, which accounted for 24% of total revenue in 2018, we believe gross profit is now a more effective barometer to gauge our growth going forward. Gross margin in the second quarter increased 280 basis points to 29.5% compared to 26.7% in the year ago period.

Last year, our margins were impacted by the merge and detention charges and we have detention charges this quarter as well.

Excluding these charges from both periods would have led to a gross margin of 30.1% in Q2 2019 compared to 28.1% in Q2 2018, a 200 basis point improvement, which was primarily driven by an increase in selling our higher-margin private label products and improved pricing strategies.

Total OpEx in the second quarter was $23 million compared to $21 million last year. As a percentage of revenues, OpEx increased to 31.2% compared to 27.3%, primarily driven by increased marketing spend, investments in our marketing platforms and people as well as severance and other employee transition costs.

Our team has been laser-focused on improving gross margin since we joined the company this year, and we are now beginning to focus on our operating cost structure. As Lev mentioned, this business can be operated more efficiently, so we plan to take aggressive action to realign our cost structure to better match our new directive and strategy.

Net loss in the second quarter was $1.5 million or $0.04 a share compared to a net loss of $0.8 million or $0.02 per share in the year-ago quarter. Adjusted EBITDA was $1.4 million in Q2 compared to $2.8 million in the prior year quarter.

The decrease was driven by lower sales due to the aforementioned decline in our e-commerce channel and proactive reduction of lower-margin sales. Although we anticipate these factors to continue impacting adjusted EBITDA through the end of the year, we remain committed to positive adjusted EBITDA in 2019.

Now let me provide some details on our key operating metrics for the second quarter. Traffic in Q2 was $14.2 million compared to $16.3 million in the year-ago quarter, with the decrease primarily driven by our focus on private label sales, which led us to proactively reduce marketing spend for branded product sales.

And as Lev mentioned, the lower traffic is also a result of the consolidation of our sites as we had 18 last year and now are down to 4 sites. Conversion in the second quarter was up 30 basis points to 3% compared to 2.7% for the same period last year, which mostly benefited from channel mix and a decline in traffic.

Revenue capture, defined as total sales after returns, credit card declines and product fulfillment was 87.8% compared to 87.7% last year. Online average order value, which includes orders from both e-commerce sites and marketplaces was $80 compared to $88 in Q2 2018.

Decline in AOV was primarily driven by our shift in product mix from branded to private label, which comes with a lower price point but significantly higher margin. Turning to the balance sheet. At June 29, 2019, we had no revolver debt and a cash balance of $0.9 million compared to $2 million of cash at fiscal year-end 2018.

The decrease in cash as a result of employee transition costs, technology CapEx, marketing expenses as well as set-up costs for a new distribution center in Las Vegas, which will begin shipping next week about a month ahead of schedule.

This new 125,000 square-foot DC will enable us to provide two day delivery or less than 94% of the country, while realizing savings in freight costs. The expansion of our footprint will also position us to compete more effectively as a two day shipping or less has evolved into a requirement for many consumers.

We ended the quarter with inventory of $52.6 million compared to $49.6 million at the end of 2018. We still have work to do to improve our inventory productivity, and this will remain a key focus for us in 2019 as our current position is not optimized. Our objective is threefold. We do stock outs, improve inventory turns and minimize carrying costs.

In order to accomplish this, we have completely overhauled our demand planning and forecasting team and have also started to use more advanced forecasting formulas and software solutions. Out-of-stock items have had significant negative impact on our revenues in the past. So we expect to continue improving our inventory position moving forward.

With that, I'll turn the call back over to Lev..

Thank you, David. Across the organization, our management and associate teams have embraced our new strategy of right part, right time and right place. In order to execute on these three pillars, we needed to focus our attention on fewer assets.

At this time, we have consolidated our sites down to 4, and we'll continue down this path until each of our sites offers the consumer a unique value proposition. Without going into too much detail, our goal is to make carparts.com our flagship site.

We have focused our efforts over the last few months on that site and have replatformed the site entirely. We're in the process of rolling out the new site to select users right now, and it should be available to 100% of our traffic by the end of August.

he site is significantly faster with speed below three seconds, and we have also redesigned the user experience to make it easier to find the right parts for your vehicle and to checkout. We have other improvements that we'll be rolling out over the next few months, and I plan to share those on our next call.

Overall, the technology and user experience teams have done a great job getting this new and improved experience to our users ahead of schedule. We also expect replatform, both the JC Whitney and Auto Parts Warehouse sites over the next 6 to 9 months.

It's also worth noting that we still have the usautoparts.com domain that now serves as our General Corporate and Investor Relations website. Moving on, as part of our right time initiative, which is to be able to deliver the parts quicker, we opened the third distribution center in Las Vegas, and have received several containers in facility.

We expect it to be fully operational by the end of this month. I'll have more details to share with you on our next call. Another key initiative for us over the last few months has been to continue building out our team with highly talented personnel.

Since our last update call, we have brought on a new senior VP of Engineering, VP of Operations and a new planning and replenishment team. There is still work to be done to round out these organizations, but we have made great progress, and the early results from these new individuals and teams have been very promising.

I'm also happy to announce that we recently reached settlement terms with the U.S. Customs and Border Protection Agency regarding last year's issues with our automotive growth.

And while the terms of the agreement are confidential, we can say that neither party admitted any wrong doing, all of our outstanding enforcement issues are resolved and we now have no outstanding damage or duty claims.

Accordingly, we have greatly reduced our charges related to temporary storage season over time, as well as managed to clear the majority of our containers on a lot and will be completely out by next month.

The remaining charges that should flow through our financials are the retention-related charges that are being amortized to cost of goods sold for the remainder of 2019. As for automotive growth, we're now importing all grilles not previously seized.

One, our manufacturer, in particular, has taken an aggressive stance against aftermarket parts manufacturers and is now litigating this issue with one of our competitors. We're taking a wait and see approach with respect to these grilles. But otherwise, we expect to be substantially back to normal in terms of our ability to sell grilles.

And although we're finally moving past the issues with customs and the ports, we still have work to do to improve our in-stock rates and inventory levels. As David mentioned, our inventory productivity is not meeting the standards that this new management team has set. So we'll be keenly focused on inventory optimization in the back half of the year.

Overall, we have made progress on multiple fronts to reposition the company for growth and profitability. There is still many initiatives that we need to execute on, but the company is moving in the right direction. We now have a better handle on our marketing and technology, personnel and infrastructure and most importantly, margins.

Our next steps are to realign our cost structure, which were expected to result in meaningful cost reduction by year-end, replatform and optimize our sites, improve inventory productivity and begin to leverage our new DC in Las Vegas to reduce freight costs and speed up shipping times for our customers. The journey for the new U.S.

Auto Parts is just beginning, but we're taking the necessary steps to deliver positive adjusted EBITDA in 2019 and look forward to maximizing value for all shareholders as we execute on our operating plan. With that, we will now open up the call for questions.

Operator?.

Our first question today is coming from Gary Prestopino for Barrington Research. Your line now alive..

Good afternoon, gentlemen..

Hi, Gary.

Well, Daniel, when you kind of flow through some of those numbers you went through, could we just possibly just revisit some of your narrative, first of all, on the price label? You said they were up how much? 1.2% private label sales?.

That's correct, yes, that is the main focus of the company moving forward. This is what we're built for. It's a much higher-margin product line, and this is what we're focusing on..

Okay.

And they comprise 79% of your sales in the quarter?.

Yes, this quarter, 79.2% compared to 74.9% last year..

Okay.

And then in terms of the branded, could you give me those stats too in terms of the growth and then the percentage of sales?.

Yes. Branded was down about 20% year-over-year..

And yes, I think you had said it was a percentage of sales, about?.

So yes, last year, for the second quarter was 24.1%, this year, 20.4%..

Okay.

Can you also, just to help us, because you had some great gross margin expansion, what is the growth – the gross margin differential to your company from a private label versus a branded basis? How many bps of gross margin betterment do you get from selling a private label product?.

Private label is significantly higher. That's what I can say. And moving forward, that's going to be the main focus. Again, even if you see branded sales down about 20% quarter-over-quarter or year-over-year, the gross profit is higher company-wide..

Right.

So at least in the next couple of quarters as you go through this exercise, this – the fact that the private label is going to take more of the sales, that would kind of mute your sales growth overall, but really improve your gross margin, am I correct in that assumption?.

Yes, that's correct. And I think as we stated on the call, I think in David's remarks, I think a better barometers is maybe gross profit dollars, and we'll also report on growth in our private label. So our goal is to accelerate that growth.

Obviously, we still have a lot of issues in Q2 as far as detention bills and inventory sitting in the parking lot and not being able to sell it. So the growth was kind of muted, but our goal is to accelerate the growth of our private label business..

Our next question today is coming from [indiscernible] from Small Cap Consumer Research. Your line is now alive..

Good afternoon. Just a couple of questions. Lev, you and the team have now been at U.S. Auto Parts for a little over two quarters.

What has been the biggest or what have been the biggest surprises? And what do you think is the greatest potential longer-term upside driver?.

Yes. I think the biggest surprise was the detention issue. So I've been here for 6 months, David has been here for call it, 1 quarter, one, maybe 3 months. So I think right when he started, that's when we caught the detention issue. So that was about a, call it, a $2 million hit to our gross margin and to our operating expenses.

So that has definitely been the biggest surprise. I think as far as the upside, I think our strategy kind of addresses that. Our focus is on private label, which we sell at a higher margin. And the company was actually built to sell private label. We have very good sourcing capabilities, quality control, we warehouse product.

So there are some barriers to entry into this business as far as private label goes. And so I think for us, that's the biggest upside, and that's where we're taking the company..

Okay. Going back to the detention charges for the first half of the year.

So – and I think Dave touched on this, certainly, how are they going to affect the company for the second half of the year?.

Right. So just a good question. A quick reminder on the detention charges, just to make sure that we're on the same page. These are the late fees for not returning the containers to the carriers, which is different from the customs costs that we were incurring in prior years.

This is – Lev just mentioned it, this is the issue that we discovered as soon as I joined the company. So we set up a temporary storage to kind of increase that capacity and reduce those detention charges, but from a financial standpoint, these charges are being amortized into cost of goods sold. But they also hit OpEx.

So for the second quarter, the impact to gross profit was about $400,000 and the impact to OpEx was about $300,000. So overall, for Q2, the financial impact was $700,000. Now for the back half of the year, the total impact on the company is about $2 million. So we're left with about $1 million combination of gross margin impact and OpEx impact.

Now from a cash standpoint, we've already spent most of that money. But from a financial reporting standpoint, it's going to trickle down until the end of the year..

Okay. So you have a couple of – you have some things in place now. And I think you're looking towards the back half of the year.

But when do you think the inventory flows are going to be normalized?.

Yes, I mean, inventory is something that's going to take a little bit longer due to our long lead times. Obviously, we have a very good plan in place, but it takes time. But really, the goal for us is to address the underlying issues that we've been facing, which is out-of-stock issues and stuff sitting in the warehouse for a little bit too long.

So we want to optimize for terms and minimizing carrying costs, but it does – it 's going to take 6 to 12 months..

And just to add to what David is saying, I think a lot of this – we didn't really have teams in place. We didn't give the people that were here the right tools to kind of execute proper planning on inventory.

So I think as we have now started building a team for planning and for replenishment as well as started getting the right tools for them to use and utilize the right formulas, I think, you'll see it improving, but because the lead times are 3 to 6 months, it's going to take a little bit of time for us to get it correctly.

Hopefully, by the – by Q1, Q2 of next year, we'll have it right..

Okay thank you. That is it..

Next question is a follow-up from Gary Prestopino from Barrington Research. Your line is now alive..

Just a couple of more questions, guys.

In terms of e-commerce or online marketplaces, with your focus on private label, are you fairly agnostic as to which marketplace any of those sales go through?.

Correct. And I think the way to think about it is, while our e-commerce channel was doing the majority of the branded transactions that we're pulling out of. That's why you may be seeing a little bit of a decline in our revenue on the e-commerce channel.

However, we're going to be reporting the growth in the private label, and we're pretty agnostic to where we sell it. Now some marketplaces cost us more, but we'll have pricing mechanisms in place to compensate for that..

Right. And then at one time, you had about 50,000 SKUs on branded, I believe.

Where does that eventually shake out to? And what – I'm sorry Lev, and what categories would you want to stock for branded when all is said and done?.

Yes. So I think we've had at one point, where we're reporting the private label SKUs, and that number was 50,000. I think we're up to 60,000 now. On the branded side, we have roughly, call it, 500,000 to 600,000 SKUs, not including the variance, like color and material.

I think the way that we're approaching it is we're not going to be able to private label every SKU that's out there. This business is extremely long tail.

And so anywhere where we don't have a private label SKU, we will be complementing that with a branded SKU and then we may also choose to pursue a good-better-best strategy where we may show the user one or 2 other brands where we don't have inventory, for example, because it's almost impossible to stay in stock on everything.

So there's still going to be branded business, we're not exiting it completely. It just has – it plays a different role now..

Okay. And then as you work through more of what you're doing to rightsize the company, what is your target for stock out rates? What is your target for getting it down? I don't really want to know exactly what it is right now, unless you want to make it public. But in your mind, where do you think – obviously, zero stock-outs would be optimal.

But what is an optimal change from where you are now?.

Yes. I think there's really no optimal number for us. What we're trying to optimize for is that what time to optimize for the most sales was the least amount of carrying costs. And so it's hard to say what that stock out number is, because if it's hoods, it may be a little bit higher because they just take up so much space.

But if it's smaller parts, like door handles or lights, we may have a different tolerance. So I think it's really varies by part theme, which is why it's kind of hard to communicate on total..

Okay, thanks guys..

Thank you. We've reached the end of our question-and-answer session. I'd like to turn the floor back to management for any further or closing comments..

Thank you all for getting on the call today with us, and we will update you on our third quarter in November. Thank you so much..

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time, and have a wonderful day. We thank you for your participation today..