Allison Malkin - ICR, Investor Relations Sharon John - CEO, President and Director Voin Todorovic - CFO.

Alex Fuhrman - Craig-Hallum Capital Jeremy Hamblin - Dougherty & Company Greetings, and welcome to the Build-A-Bear Workshop Second Quarter 2017 Results Conference Call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Allison Malkin of ICR. Thank you. You may begin..

Good morning. Thank you for joining us. With me today are Sharon Price John, CEO; and Voin Todorovic, CFO. For today's call, Sharon will begin with a discussion of our 2017 second quarter performance and review our strategies for the year. Voin will review the financials and guidance, and then we will take your questions.

(Operator Instructions) Members of the media who may be on our call today should contact us after this conference call with your questions. Please note the call is being recorded and broadcast live via the Internet. The earnings release is available on the Investor Relations portion of our corporate website.

A replay of both our call and webcast will be available later today on the IR site. Before I turn the call over to management, I will remind everyone that forward-looking statements are inherently subject to risks and uncertainties.

Actual results could differ materially from those currently anticipated due to a number of factors, including those set forth in the Risk Factors section in the Company's annual report on Form 10-K. We undertake no obligation to revise any forward-looking statements.

Finally, as previously announced, the Company continues its exploration of a range of strategic alternatives. As you are aware, this could take many directions, and there is no assurance that this exploration will result in any strategic alternatives being announced or executed.

We continue to be limited as to any additional comments on this topic, as the process unfolds, unless and until our Board of Directors determines that further disclosure is appropriate. And now I would like to turn the call over to Sharon..

Thanks, Allison. Good morning, everyone. In the second quarter, we continued to make progress with our strategy to evolve and accelerate the execution of our retail diversification initiative as well as the plans to leverage the power of the Build-A-Bear brand to deliver a profitable growth.

Specifically, in the quarter, total revenues increased by 2.8% as alternative revenue streams and volume from new retail locations not included in the comparable store base, more than offset the marginal decline in consolidated comparable sales. Retail gross margin improved by 150 basis points to 43.7% of total revenues.

And we narrowed pretax loss to $2.6 million, which is a $3.6 million improvement over the prior year.

We believe that the strategy that is in place to extend and monetize the inherent value of the Build-A-Bear brand into new avenue streams while evolving our retail channel to have multiple dimensions and increased flexibility, we'll continue to move the Company forward toward our goal to sustained, more profitable growth as demonstrated this quarter despite the comp headwind.

Specifically, consolidated comparable sales for the quarter showed a 0.9% decrease, which was primarily driven by an overall decline in store traffic.

While traffic at Build-A-Bear Workshop stores delivered against our historical norm of outpacing the national trend and we achieved increases in other controllable metrics, including conversion, units per transaction and dollars per transaction, it did not offset the macro traffic declines that continue to challenge traditional mall-based retail.

And while consolidated comparable sales were positive in the U.K. in the quarter at plus 2.2%, the trend took a negative double-digit turn when multiple unfortunate terrorism incidents occurred in the months of May and June.

It is important to reiterate that the ongoing changes in our real estate footprint are expected to continue to cause choppiness in comparable sales trends at some of the new stores, remodeled stores and new formats that are delivering positive results are not yet included in comparable sales calculations.

For example, some of the locations have not been in operation for a full year or were downsized when they were remodeled.

In fact, although traffic could continue to be a challenge for the foreseeable future, specifically in traditional malls which could adversely affect comps, we expect our retail diversification strategy as well as continued improvement in key metrics and store productivity to drive total retail revenue growth for the year.

We have confidence that we have the right plans in place to drive toward our long-term goals as we continue to make progress on our 4 key strategic platforms.

Specifically, as it relates to the channel evolution strategy, we are focused on leveraging the strength of Build-A-Bear's experiential retail concept, which has value in multiple locations where families go for entertainment, while also advancing our capabilities in e-commerce and enterprise selling to leverage macro trends in consumer shopping habits.

As it relates to our store fleets, we have approximately 130 leases coming due over the next 3 years, which gives us a high degree of flexibility to execute our retail diversification plans.

As these leases come due, we do extensive market analysis to determine which locations to close, remodel, reformat or reposition, while identifying viable sites for store expansion. Our ultimate goal is to reposition Build-A-Bear Workshop from a primarily U.S.

mall-based experiential retailer of plush toys to a global company with diversified retail locations and multiple profitable revenue streams, and we continue to show progress on that front.

Specifically, as it relates to real estate, our objective is to maximize profitability by diversifying formats, increasing flexibility, reducing capital requirements, lowering occupancy cost and minimizing the number of long-term lease commitments.

With those objectives in mind, we designed a new innovative concourse shop model, which had successfully tested -- which we successfully tested in last year's fourth quarter.

As a reminder, concourse shops are self-contained retail units that can be positioned in a variety of venues with a smaller footprint, higher mobility and shorter leases with terms that tend to be more favorable.

With the backdrop of the successful test, we are rapidly leveraging the concourse model for a new location and as an alternative to traditional store remodel. In the second quarter, we opened 17 concourse shops in the U.S. in a variety of settings, giving us a current total of 20.

Concourse shops are projected to have an average annualized sales of $500,000 to $600,000 per location, which given their smaller size, translates to $2,500 to $3,000 per sales per square foot.

With a capital investment that is currently approximately $100,000 and a 4-wall contribution margin that is projected to be higher than our traditional store target of 20% to 22%, the average payback for this innovative new format should be less than 1 year.

In addition, research indicates that consumers are rating the experience at concourse shops on par with the scores given for our traditional stores. Clearly, we're excited about the potential of this new model as it could be a game changer for our real estate strategies, both domestically and internationally.

In summary, concourse shops are currently projected to achieve approximately 50% of our traditional store sales and 10% of the square footage, requiring 80% less capital than a new or remodeled Discovery store. They offer high flexibility in lease length and terms, and they can be easily relocated if needed.

Importantly, profit per square foot is expected to be multiple times higher than a traditional store. In fact, pretax profit per square foot for a concourse shop is expected to be higher than sales per square foot of a traditional store. This model hits on all the objectives that have been laid out for our real estate strategy.

While the concourse shop plays specific purpose in our portfolio, allowing us to continue to profitably operate in traditional mall locations across a variety of markets to primarily local guests, they also can play an important role in expanding into new venues, including lucrative tourist areas.

For example, we recently added a concourse shop at the second location in the Mall of America to capture a larger market share in this high-traffic setting.

As you may know, our stores in tourist locations over index on sale, transaction metrics and profitability as Build-A-Bear workshop is a popular destination for guests that want to make a furry friend as a souvenir, given the localized product lines that are featured in these special locations.

We have focused on upgrading or expanding our presence in these markets in select mall and non-mall settings, including seasonal sites to be where families go to have fun and make memories. Acknowledging the tourist opportunity, we're excited to announce our plans to open a new Discovery store in New York City early in the fourth quarter.

This marks the return of Build-A-Bear workshop to the number one market in the U.S. and the top tourist area in the country with a position next to one of the top tourist destinations in Manhattan, The Empire State Building.

As we have planned, the data that was gathered from the operations of last year's temporary store in The Empire State Building was critical to our successful negotiations for this site. We are also in the process of redefining our opportunity in the second largest U.S. market and large last tourist destination in Southern California.

As part of the market analysis, it became clear that the radius restrictions associated with the lease of our store in Downtown Disney in Anaheim, California, have been prohibiting us from optimizing this expansive market.

Although we are disappointed to exit this value location when the lease expires at the end of September, we believe we now have an opportunity to strategically expand the number and position of other locations, enabling guests to more easily and frequently enjoy Build-A-Bear across the vast Los Angeles trade and tourist area.

Other nontraditional retail locations also continue to perform well. For example, we expanded our relationship with Gaylord Resorts for the summer, and we took advantage of the busy second quarter movie slate, leveraging many related license products by expanding into 15 AMC Theaters.

The experiential wholesale business is also growing as Build-A-Bear is now on all 25 Carnival Cruise Line ships and has expanded to 3 Beaches Resorts in the Caribbean.

As it relates to progress with our successful Discovery format for traditional stores, we have continued to upgrade select locations with 16 remodels or reformats completed in the second quarter.

Discovery stores continued to outperform heritage stores by double-digit rates on a comparable sale basis in their first year, with higher traffic levels and dollars per transaction. As expected, there are many moving parts when it comes to executing our channel evolution strategy.

And it is important to note that all of this activity is designed to result in more stores in diversed formats, delivering high levels of profitability. Turning to enterprise selling, we remain on track to launch an updated website in the third quarter prior to the critical holiday season.

We are excited about the capabilities that we expect to gain from the new site.

We believe we offer a better overall guest experience with more intuitive navigation, enhanced search features and a shopping configurator app we called the Bear Builder that prompts add-on items through a guided process that should also make the online experience more customized and more fun.

We expect to see increased traffic to the site and improvements in conversion and basket size, enabling us to grow revenue from the e-commerce and enterprise selling channels and better benchmark against industry standards.

As part of the e-commerce initiative, we will be rebranding and reformatting our loyalty program, with a goal of growing membership and increasing the lifetime value of the member base.

Although there could be some of the typical transition challenges that can accompany a project of this scale, we expect to be fully operative when traffic ramps up for the holiday season. Turning to the product expansion strategy. We are focused on offering a balanced assortment of owned and licensed properties.

As I discussed last quarter, we plan to leverage a number of entertainment properties this year. Importantly, this creates ongoing excitement in our stores as we are able to offer new products for many of our core consumer segments.

Looking ahead, in the third quarter, we'll be launching a new My Little Pony collection in advance of the movies released later this fall. My Little Pony has consistently been a popular seller with our Young Girl segment, and we expect the movie to heighten interest for this property.

Turning to boys, we will be celebrating Star Wars Force Friday on September 1 with the launch of a new Star Wars character in advance of the fourth quarter release of the next film. And for our Universal segment, Pokémon continues to be very popular.

We will be hosting a Pokémon party for 2 weeks in September, during which we will offer our complete collection in stores for the first time, while also launching a new limited edition character. On the proprietary side, we will be updating our Promise Pets collection in August with a vet clinic theme.

We also have developments under the brand and experience amplification strategy. We believe that our store location can serve as a valuable marketing tool to enhance consumer engagement, and as such, plan to continue to leverage them by offering in-store events.

We've also expanded our use of traditional media to reach both moms and kids, while enhancing social and direct mail programs by leveraging our valuable internal database. For example, one of the most anticipated in-store events will occur in third quarter, as we once again celebrate National Teddy Bear Day in September.

We plan to replicate the successful and robust and efficient communication plan that we had last year, which included social media and PR. Last year's event was one of the highest sales days in our history, with guests forming lines before the store opened.

We were excited to further capitalize on this opportunity with the release of a new exclusive teddy bear. Finally, as a sneak peek, Build-A-Bear's 20th birthday falls in late October. We have had integrated events throughout this year and will cap off the celebration during the month highlighted by the grand opening of the new New York City store.

Finally, as it relates to our profitability improvement strategy, in the second quarter, we once again demonstrated a disciplined approach to expense management and enhancement in merchandise margin, which continued to improve year-over-year profit performance.

With the disciplined execution of our strategic priorities, we believe we are on the path to deliver higher total revenue and profitability in 2017 versus last year. Overall, I'm pleased with the progress that we have made to leverage the Build-A-Bear brand to evolve into a global multidimensional business.

The changes that we have made in our owned and operated business model are driving international growth as well. As an example, we expect our franchisees to end the year with the most international locations in our history, but truly the sun now never sets on Build-A-Bear Workshop.

As we continue to evolve our overall business model, we believe it's also necessary to evolve the way we think about key business metrics to assure that we are driving against the correct goal.

Although it can vary by location, current data clearly implies that traditional mall-based retail was experiencing traffic pressures, likely due to the increasingly rapid evolution of consumer shopping habits. However, in many cases, retail rent levels and deals have not yet aligned with those trends.

With that in mind, we believe that the retail diversification strategies that I have discussed, including the concourse shop model, are providing critical flexibility and leverage to maintain access to consumer demand for Build-A-Bear's retail experience, while managing rent and reducing the number of long-term leases.

We remain focused on driving profitable revenue. However, it may come in a variety of forms, not just comp sales as we have demonstrated this quarter.

With that in mind, we have taken a disciplined approach to managing the business with a goal to avoid aggressive promotional actions designed to prop up comp sales in what could be a futile effort to offset macro traffic trends.

Based on past learnings and a number of recent promotional test scenarios, we believe taking aggressive promotional actions would likely have minimal positive impact on sales while potentially reducing profits. Additionally, due to the high degree of transition in our real estate portfolio, we executed an evolved real estate strategy.

At least 15% of our stores, including many of those that have been updated or added, are excluded from our second quarter's standard comp calculation, making comp a less indicative measurement of our retail health versus normalized circumstances.

With this in mind, although we will continue to assess comp as an important business metric, we intend to operate with a more balanced approach placing a greater weight on delivering against broader business metrics, including revenue and profitability.

Now I would like to turn the call over to Voin, who will give more details on the second quarter financials and provide an update on our expectations for the balance of the year, including some color on the third quarter..

conversion, units per transaction and average units retail. This was more than offset by a decrease in transactions, primarily due to a decline in store traffic. We remain pleased with the performance of Discovery format stores.

The locations in their first year of operation continued to achieve a double-digit increase over heritage locations, and stores in their second year are performing in line with the company average. We are also encouraged by the opportunities that the concourse shops bring.

In approximately 200 square feet, these locations are projected to average $2,500 to $3,000 in sales per square foot on an annual basis and achieve higher four wall contribution margin versus traditional stores.

In addition, during the second quarter, commercial revenue rose 166% and franchise revenue grew 64%, demonstrating the results from strategies to drive growth beyond the traditional retail base.

Retail gross margin expanded 150 basis points to 43.7%, reflecting a 190 basis point expansion in merchandise margin, partially offset by the leverage of occupancy cost.

Merchandise margins benefited from a focus on lowering discount and improving initial markup, driven by higher retail pricing and ongoing efforts in value engineering and increased sourcing efficiencies. SG&A decreased by $1.2 million to $35.8 million or 46.4% of total revenues compared to 49.3% of total revenues last year.

The improvement was the result of unrealized currency gains compared to losses last year from the significant weakening of the British pound sterling. In addition, we saw reduction in overhead and marketing costs, offset by higher store expenses, driven by growth in store count.

Preopening expenses were $900,000 compared to $1.2 million in the second quarter last year, in part reflecting the lower cost associated with the opening concourse shops as expected. Second quarter pretax loss totaled $2.6 million compared to pretax loss of $6.2 million last year.

Income tax benefit was $1.1 million with an effective tax rate of 41.4%, reflecting a $124,000 benefit from discrete items. Net loss was $1.5 million or $0.10 per share compared to net loss of $4.3 million or $0.28 per share last year.

For the first 6 months of the year, pretax income was $2 million, a $3 million improvement from the $1 million pretax loss reported in the first 6 months of fiscal 2016. Turning to the balance sheet. At quarter end, cash and cash equivalents were $12.6 million and there were no borrowings under our revolving credit facility in the quarter.

We ended the second quarter with $58.4 million of consolidated inventories, representing a 5.3% increase over the prior year. The increase in inventory is driven by the timing of receipts to support planned events in the third quarter such as National Teddy Bear Day.

On-hand inventory in stores in down compared to the prior year and we are comfortable with the composition of our inventory as we entered the second half of the year, which is historically our largest and most profitable period.

For fiscal 2017, we now expect capital expenditures in the range of $20 million to $24 million, approximately 2/3 of which are expected to be for store activity and the remainder for IT infrastructure and financial system improvements as well as the upgrade of our web platform.

Depreciation and amortization is expected to be between $16 million and $17 million. Our objective for fiscal 2017 is to continue to lay the groundwork to position the Company to deliver sustained profitable growth through the execution of our stated strategy.

With this in mind, for the year, we now expect total revenue growth in the low single-digit range. Comparable sales to be flat to down in the back half of the year, as we expect to see improvement in conversion and dollars per transaction and anticipate the traffic patterns in traditional malls will continue to be a challenge.

And pretax income to be between $12 million and $14 million. Separately, we are forecasting merchandise margin expansion on a full year basis through continued cost improvement initiatives and lower promotional activity. Higher SG&A dollars compared to the prior year.

As a reminder, in the second half of fiscal 2017 to support the critical fall and holiday selling periods, there is a planned shift in marketing expenses. In addition, last year's second half reflected a reversal in performance-based compensation that lowered reported SG&A.

Finally, SG&A was favorably impacted by currency in the second half of 2016, which is not expected this year, assuming current exchange rate. We also expect to have increased expense related to the IT upgrades that are currently underway, including the new web platform and financial system.

As a reminder, these costs will be reported as expense rather than depreciation given our decision to move to a flexible cloud-based software solution. In addition, for fiscal 2017, we expect the annual tax rate to approximate 36% outside of discrete items, assuming consistency with the current tax code.

We expect to see volatility in the future effective tax rate from the adoption of the recent changes in the equity-based compensation guidelines. And we anticipate ending the year with 360 to 365 stores, 105 to 110 of which are expected to be in the new Discovery format, including approximately 25 to 30 stores in the concourse shop model.

As it relates to the third quarter, we expect total revenue to grow in the low single-digit range compared to the prior year. Selling, general and administrative dollars to be in line with 2015 levels, as the impacts to 2016 that I just noted made this period less comparable for modeling purposes.

And third quarter GAAP pretax income to be between $2 million and $4 million. Thanks for your time this morning. We'll now turn the call back over to the operator to take some questions.

Operator?.

[Operator Instructions] Our first question is coming from the line of Jeremy Hamblin with Dougherty & Company..

I wanted to just follow up first actually on your operating expenses on your SG&A costs and get some clarity. So it looks like year-to-date, you're down about $3 million.

And in terms of thinking about the back half of the year, the uptick, is that primarily just incentive compensation? Or there are other items that are going to push it? I think what you guided to is just that it's going to be up on an absolute basis above the $157 million from last year.

Should we be thinking it could be up above like the $160 million that you saw in 2015?.

First of all, as I explained in our prepared remarks, we talked about -- there is some timing shift between first half and second half of the year in SG&A. Primarily, we focused a lot of our marketing activities in the second half of the year to take advantage of some missteps that we took last year, in particularly, December in Q4 of last year.

So that's probably one of the bigger shifts. In addition, as I mentioned, last year, we had a reversal of our performance-based comp in the second half of the year, so this year this is expected to be at a more normalized level. That's why we are guiding back to 2015 levels.

As well as I mentioned that some of the investments that we are making in business from the IT infrastructure perspective and some of these costs are continued to be headwinds for us.

Also, FX is one of those things with the fluctuation and strengthening of British pound versus second half of the last year, assuming current levels, our expenses will be higher. So that's what we are guided to and that's all contemplated within our guidance on a full year basis between $12 million and $14 million on a GAAP basis..

And then it's pretty exciting the numbers that you guys are showing with the concourse shops and as we look at your, particularly your North American footprint, I think you've mentioned, you've got a 130 locations coming up for at least over the next three years.

Is this something where maybe a significantly higher portion of your store base could be in that format of stores simply, because the economics dictated along with the flexibility it provides? What's the average kind of lease term structure look like on a concourse location? Is it just a year or 2? How does that work?.

There are a couple of questions in there. First, what will our portfolio look like? So yes, we do have 130 leases coming up over the next three years.

And we've created a very robust decision tree to help us through the complications of the leases that are coming up to include the type of mall that it is in and the lease structure that we're getting, the terms that we're getting.

But also included in that is the concept of keeping the store that's fully depreciated and kind of just kicking it down the road another two or three years. So there may be ways to just optimize that location without moving it to a concourse shop.

So that's got -- you have to get that into your consideration set while you're also considering potential remodels in some of the mall locations that are actually not incurring some of these really, really difficult double-digit traffic trends, which you see in some places. That it's valuable for us to remodel those stores.

So it's a case-by-case basis. Net-net, though, yes, I think you can expect to see if concourse shops continue to perform the way they are performing right now, little caveat, still early stages.

They got first one opened in September, October of last year, but we're getting enough data under our belt here to feel like that this -- in a number of different locations, these are like -- these are not -- there's not an anomaly, there really is a game changer here.

So with that in mind, certainly, you can expect to see a greater percentage of our stores to become concourse shops in the future. It's a great tool for us. It creates flexibility and leverage. And so to your second question, yes, the average lease terms are shorter. They are clearly just more flexible.

And the construct is for some reason after those three years, there is really no leasehold improvements. We just pick them up and move them to another location.

And the occupancy is lower because there's no charges associated with things that you generally don't think about when you're running a real estate entity, like HVAC and cleaning, you're not cleaning windows every night. And all that stuff adds up. And we're also out in the middle of the traffic.

And so even when the traffic is decreasing, we're placed in a position where it's harder to avoid. What we know is the consumer demand for Build-A-Bear, particularly from kids. So hard to walk around the Build-A-Bear when it's right in the middle of them -- of the causeway..

Well, we applaud you on the creativity and thoughtfulness and looking at different ways and nontraditional ways to drive profitability. Good luck in the second half of the year..

[Operator Instructions] Our next question is coming from the line of Alex Fuhrman with Craig-Hallum Capital Group..

I wanted to ask a little bit about gross margin. It sounds like you're looking for gross -- merchandise margins to be up in the back half of the year, looks like they were strong in the second quarter as well. Can you give us a sense, just in terms of your buying and occupancy costs.

I mean, how much should we expect to see that potentially delever if you were to have a low single-digit comp-store sales decline in the back half of the year? And do you think that when you put everything together, you would still expect merchandise margins to be up enough to offset the total gross margin improvement in the back half of the year as well?.

Yes. Thanks, Alex. Merchandise margin continues to be like one of the strong points. It's still a focal point for us. We are laser-like focused on the expansion of merchandise margin through variety of different initiatives.

This is a continuing effort as we talked about all the way from sourcing to pricing and even more recently very scaffolded approach to managing our promotional cadence. That's primarily resulted in a really strong merchandise margin performance in the second quarter of this year, but it's not new to us.

We expect to continue to see expansion in merchandise margin for the rest of the year as we guided at the beginning of the year.

As we talk about the occupancy, the leverage when we talk about retail gross margin, I still think we expect to have positive growth in retail gross margin, but again, within the constraints of that guidance that we provided on the top line flat to basically slightly down comp. So that's one of those things.

Things, as we said, that we believe that are within our control are really helping both retail gross margin and merchandise gross margins. As you know, some of the offsets of traffic and its impact on sales, it's a little bit harder to predict..

And, Alex, I am just going of take this opportunity to repeat something that I said in my prepared remarks. It relates to this and this will vary as the year rolls on. But when we're talking about comp sales, right now, what's calculated in our comp sales is 84%, 85% of our total retail base.

So there is 15-or-so percent of our stores that tend to be our stronger stores, almost by definition because they are new, their concourse shops that aren't calculated in the comp. That will vary as the year rolls out, but it's still going to -- there will be some subset of what is our total retail base.

So as we have (inaudible) and we talked about this all the way back couple of years now when we started this process of what we knew needed to be a complete total evolution of our retail footprint that it would be really choppy and hard to track, unfortunately.

And -- but it does put a little less of a focus and less reliance on just being overly focused on comp specifically and only comp, but trying to take a little more balanced approach to the way we think about the metrics that we should be delivering against..

Now I'll just add one more point. Also what we are working diligently on is to further continue to reduce our occupancy costs that are going to help offset the impact of that deleverage. And like a concourse shop, that Sharon talked about, is one of those tools that really helps us in that process..

Great, that's very helpful. And then thinking about the strategic review of alternatives, obviously, that's been going on for quite a while. I'm wondering if you can share with us how much of an impact that had on the Q2 numbers in terms of any costs that might have been involved in that.

And then thinking about your guidance in terms of pretax income for the full year, can you give us a sense of the cost in dollars of the strategic review in the back half of last year? And you expect that to go up or down? And does that factor into the calculation for the back half of this year?.

We really can't speak about that, Alex. I mean, you know that I can't really speak about that. So it is ongoing as you noted. And we -- when the board -- unless and until the board believes there is something that we need to share, we will maintain our position that we are just in the strategic alternative process. But I appreciate the thought..

Thank you. It appears there are no further questions at this time. So I would like to pass the floor back over to Sharon John for any additional concluding comments..

Yes, thank you, and we appreciate everybody joining us today. We look forward to speaking with you when we report third quarter..

Ladies and gentlemen, this does conclude today's teleconference. Again, we thank you for your participation and you may disconnect your lines at this time..