Greetings, and welcome to The Container Store Third Quarter Fiscal Year 2019 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note, this conference is being recorded.

I will now turn the conference over to your host, Caitlin Churchill, Investor Relations. You may begin..

Good afternoon, everyone, and thanks for joining us today for The Container Store’s third quarter fiscal year 2019 earnings results conference call. Speaking today are Melissa Reiff, Chairwoman and Chief Executive Officer; and Jodi Taylor, Chief Financial and Administrative Officer.

After Melissa and Jodi have made their formal remarks, we will open the call to questions.

Before we begin, I need to remind you that certain comments made during this call regarding our plans, strategies and goals and our anticipated financial performance may constitute forward-looking statements and are made pursuant to and within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from such statements. Those important factors are referred to in The Container Store’s press release issued today, and in our Annual Report on Form 10-K, filed with the SEC on May 30, 2019.

The forward-looking statements made today are as of the date of this call, and The Container Store does not undertake any obligation to update their forward-looking statements. Finally, the speakers may refer to certain adjusted or non-GAAP financial measures on this call.

A reconciliation schedule of the non-GAAP financial measures to the most directly comparable GAAP measures is also available in The Container Store’s press release issued today. A copy of today’s press release may be obtained by visiting the Investor Relations page of the website at www.containerstore.com. I will not turn the call over to Melissa.

Melissa?.

Thank you, Caitlin, and thanks to those of you who are joining our call today. Let me begin by sharing the highlights of our fiscal Q3 performance and then I’d like to talk about our progress on key strategic initiatives. Jodi will then review our financial results in more detail and discuss our outlook.

For the third quarter, we reported net sales of $228.7 million and a comp store sales increase of 3%. Our Elfa third-party sales were flat to the prior year in U.S. dollars, but up 6.6% when excluding the impact of foreign currency translation. We also delivered adjusted EPS of $0.05 compared to $0.07 in Q3 last year.

Our results include approximately $3 million or $0.04 per share of net cost associated with the opening of our second distribution center and incremental Custom Closets marketing.

Prior to the ICR Conference that Jodi and I attended last month, we released Q3 preliminary results and share that our comp store sales performance was driven by continued strength in our Custom Closets business, which represents approximately half of our sales and remains a key strategic priority for us.

We delivered Custom Closet sales growth in Q3 of up 10.2%, which contributed 4.2% to our comp store sales. Sales of our other product categories decreased 2% contributing a negative 120 basis points to our Q3 comp.

This decline was more than entirely driven by our three holiday sales departments, which, as a reminder, represents less than 4% of our annual sales, but close to 13% of our third quarter sales.

As we commented at the ICR Conference, we had planned for these three holiday departments to be down and we scaled back our investment in inventory and store set up incorporating learnings from last year. These three holiday departments were down 12.2% which costs us two percentage points to our Q3 comp store sales performance.

We have already made and executed changes for holiday fiscal 2020 based on a fresh perspective from our buying team, and I’m really pleased with the assortment that we have already curated.

I am also pleased that our efforts to focus more on our everyday storage and organization solutions during Q3 prove to be successful and more than offset the holiday department’s selling weakness.

We are proud of our comp store sales growth performance this quarter and I’m also excited for the progress that we have made in growing our online business and the results we are seeing with our recently opened new and relocated stores. We delivered another quarter of strong online performance, with online-only sales up 22.6.

After several months of prior testing, we made the decision to move the $49 free shipping for a limited time during the quarter versus our prior threshold of $75. The results from this lower threshold are encouraging and we saw a strong online sales performance during the quarter.

We will continue to perform testing and currently anticipate that we will run 49 free shipping for certain periods of time during the year as long as we continue to see positive results from our test.

With regards to our stores, our brand-new Dallas Galleria store which we recently relocated and which is now branded the container store Custom Closets store, similar to our Farmer's Market store in LA, opened on December 18 to positive initial customer reaction.

The store is, in a word, beautiful, and we have – and we believe provides a fabulous customer experience.

As the name on the front of the building would suggest, this is a Custom Closets-focused store with over 60 closet displays and a strategically edited collection of the other product category offerings to ensure that we provide the complete solution for our customers.

This store brings together all the learnings that we have taken from our Farmer's Market Custom Closet store as well as the learnings from the changes we made at our Dallas store at Northpark a couple of years ago.

We believe that these two Custom Closet-branded stores will provide key learnings that we can productively apply to an even smaller footprint store in the future, and we will continue to monitor their performances closely.

Along with our improvements and focus on new stores and online growth, let me review our other key strategic priorities with regards to our distribution center and marketing investments. Our new distribution center at Aberdeen, Maryland, is up and running, and as I have said before, was on time and on budget.

By the end of November, the new DC began shipping to all planned stores, and our direct-to-customer shipments will continue to ramp up through next month. At that time, we expect 50% of direct shipments will come from Aberdeen and 50% from our distribution center here in Dallas.

Overall, we expect to ship about 60% of total unit volume for stores and direct-to-customers out of our Dallas DC and about 40% out of our Aberdeen DC. As Jodi will share, we incurred approximately $2.2 million of net expenses during Q3 from this new second distribution center.

And as a reminder, we expect to see considerable savings and improvements in customer delivery, faster service for our customers during fiscal 2020.

With regards to marketing, as we've been sharing, with the launch of our new Avera Custom Closets line in April, an incredible opportunity to gain share in the estimated $6 billion Custom Closets addressable market, we have been investing in brand marketing to build awareness of our Custom Closets offerings and capabilities.

Our POP! program enrollments continue to grow, and we finished Q3 with over 8.3 million POP! Stars. Our POP! Stars generate the majority of our sales, and those loyal customers shop with us most frequently.

The extensive customer data this program provides us is a critical part of our strategic and targeted marketing strategy and a key driver of our increased marketing effectiveness. We also continue to see great success with our brand ambassadors and influencers program.

For example, we had great fun, attracted new customers and generated meaningful sales of our shoe storage through our many sneakerhead influencers. Additionally, the A-List celebrity organizing team, The Home Edit, is an important exclusive product and social media partnership that continues to generate lots of social buzz, new customers and sales.

During fiscal 2020, we plan to expand our collection of exclusive products at The Home Edit, and also look forward to their Netflix show that will be launching this year. We believe this show is sure to build even more awareness around the category of storage and organization and solutions.

We are pleased to maintain our fiscal 2019 outlook that we shared last quarter, and we will be sharing our detailed fiscal 2020 outlook on our Q4 earnings call in May.

We're looking very forward to fiscal 2020 as we anticipate harvesting the freight savings from our second distribution center and continuing to capitalize on the large and attractive $6 billion addressable market for Custom Closets, with continued focus on this as our number one strategic priority.

And lastly, our fiscal 2019 fourth quarter and annual Elfa sale are well underway. As we've shared last quarter in Q4 and January, in particular, is a period of time when we experienced strong sales in our other product categories when Marie Kondo's Tidying Up Netflix show launched last January on January 1.

While we've seen some pressure in these categories early in the quarter, so far, we are well within our expectations and encouraged about Q4 and our full fiscal year. Jodi will now go over financial results and outlook in more detail..

Thank you, Melissa, and good afternoon, everyone. I'll now cover our third quarter financial results in more detail. Consolidated net sales increased 3.2% year-over-year to $228.7 million.

By segment, sales for The Container Store retail business increased 3.5% to $212 million, reflecting a comp store sales increase of 3% as well as sales contribution from new stores.

We saw strength across our Custom Closets business, which was up 10.2%, while our other products categories, as Melissa discussed, were down 2%, more than entirely driven by a 12.2% decline in our holiday department sales.

Elfa's third-party net sales were flat at $16.7 million due to the negative impact of foreign currency translation during the quarter. Excluding the impact of foreign currency translation, Elfa third-party sales were up 6.6% year-over-year. From a profitability perspective, consolidated gross profit dollars increased 3.3% to $134.4 million.

Consolidated gross margin increased by 10 basis points to 58.8%. Gross margin at The Container Store retail business was down 80 basis points, primarily due to successful merchandise and marketing campaigns that drove a higher mix of service sales year-over-year. This was partially offset by foreign currency tailwinds.

Elfa's gross margin increased 530 basis points from the prior year period, primarily due to lower direct material costs and production efficiencies. SG&A as a percentage of net sales was flat to last year as the leverage we drove with our occupancy and payroll costs offset the incremental Custom Closets marketing expenses.

Our net interest expense in the third quarter of fiscal 2019 decreased 14.6% to $5.1 million from $6 million in the prior year period, primarily due to lower to lower interest rates combined with the lower principal balance on our senior secured term loan facility.

Preopening costs increased to $2.5 million during Q3 of fiscal 2019 as compared to approximately $700,000 in Q3 last year. The increase is primarily due to $2.2 million of net costs associated with the opening of the second distribution center as well as costs incurred related to the opening of our relocated Dallas Galleria store.

The effective tax rate for the quarter was 43.9% compared to negative 72.8% in the third quarter of last year. In the third quarter of fiscal 2018, we recorded a $5.9 million tax benefit as a result of the finalization of the onetime transition tax on foreign earnings. On an adjusted basis, our effective tax rate for Q3 last year was 29.3%.

The increase in our effective tax rate year-over-year was due to the jurisdictional mix of income and additional tax deductions related to stock-based compensation.

Our net income for the quarter, on a GAAP basis, was $2.4 million or $0.05 per share as compared to our GAAP net income of $9.3 million or $0.19 per share in the third quarter of last year, which included certain onetime tax-related items and a gain on the disposal of real estate at Elfa.

Excluding those items, adjusted net income for third quarter fiscal 2018 was $3.5 million or $0.07 per share.

As we outlined in our press release, we incurred approximately $2.2 million in net pretax costs related to our new distribution center as well as $800,000 in pretax marketing investments in Q3 which together represented a drag of approximately $0.04 to EPS in the quarter.

Adjusted EBITDA was $22 million in the third quarter this year compared to $21.8 million in Q3 last year. Turning to our balance sheet, we ended the quarter with $14 million in cash, $305.7 million outstanding borrowings and combined availability on revolving credit facilities and cash on hand of $64.1 million.

As a reminder, we adopted the new lease accounting standard at the beginning of this fiscal year, which resulted in a growth up of our balance sheet by approximately $350 million. As expected, we ended the quarter with consolidated inventory of $23.6 million or 20.3%.

The increase is almost entirely related to inventory held in our new second distribution center as well as inventory due to new product introductions including the new Avera Custom Closets line and new grade core from alpha.

On a per store basis, excluding the inventory associated with our distribution centers, inventory levels that our stores were up 2.7%.

We still expect our inventory position to be more normalized by the end of the fiscal year after taking into consideration the – when our new distribution center is fully operational and taking into consideration inventory ownership of new products not yet owned last year.

Regarding our fiscal 2019 outlook, we are maintaining our established outlook for the year as Melissa shared. We continue to expect fiscal 2019 consolidated sales and comp store sales to be at to slightly above our previously provided ranges of $915 million to $925 million and up 2% to 3% respectively.

We also continue to expect GAAP and adjusted EPS to be towards the low end of our prior outlook of $0.41 to $0.51 on a weighted average of $49 million diluted shares outstanding. We now expect our tax rate for the full fiscal 2019 to be approximately 30% and our annual interest expense using forward LIBOR rates to be approximately $22 million.

In addition, we now expect the estimated impact of our incremental Custom Closets focused marketing in fiscal 2019 to be approximately $5 million or $0.07 per share, compared to our original expectations of $6 million or $0.08 per share due to the overall efficiency of our marketing spend.

We are also updating our expectations for the timing of realized benefits from direct-to-customer shipping savings for the fourth quarter as employee hiring at our second distribution center over the holiday period did not ramp as much as we originally forecasted.

We now estimate a headwind for fiscal 2019 associated with the net expenses to get the second distribution center up and running to be approximately $6 million or $0.09 per share compared to our original outlook of $4 million or $0.06 per share.

We still expect to be shipping fully out of our second distribution center as planned by the end of fiscal 2019. As a result, the combined headwinds in fiscal 2019 related to incremental marketing and the second distribution center is now approximately $11 million or $0.16 per share.

In addition, given the updated expectations for the timing of realized benefits from direct-to-customer shipping savings, we now expect higher freight savings in fiscal 2020 from the second distribution center of approximately $8 million or $0.10 per share benefit to EPS compared to fiscal 2019.

Our fiscal 2019 outlook continues to include the impact of all currently announced tariffs from China. And specific to our fourth quarter there are a few call outs.

One, we continue to expect our Q4 comp store sales to be down low single digits as we cycle the launch of tidying up on Netflix last January, which helped to drive an 8.5% comp in Q4 last year.

Two, during Q2, we expect to spend approximately $1 million incremental marketing dollars over last year in order to support the launch of the Container Store Custom Closets brands marketing efforts, including supporting the Avera product line.

Three, in Q4, we also expect to see approximately $1 million of net expenses related to the second distribution center. As a result, we currently anticipate EPS to be up slightly in Q4. In summary, we continue to be pleased with our operating performance this year.

Fiscal 2019 has been a year of important strategic investments that set us up well for the future, and we are already beginning to see the benefits of these initiatives take hold. We are positioned well to deliver on our goals for the year and look forward to updating you on our Q4 and full fiscal year progress on our next earnings call. Thank you.

Now I’d like to turn the call back over to the operator so that we can open the lines for questions.

Darryl?.

Thank you. [Operator Instructions] Our first set of questions come from the line of Steve Forbes of Guggenheim Securities. Please proceed with your questions..

Good afternoon. .

Hi, Steve..

Hi, Steve..

I wanted to maybe start with the free shipping threshold change, right, just given the change in the likely strength in that channel, the e-commerce channel, can you just help us better understand the potential implications to gross margin, right, especially within the TCS segment? And maybe just comment on how that impacted the third quarter performance, right, the down 80 basis points?.

Hi, Steve. Yes, we are continuing to test this more competitive, lower shipping threshold of $49 versus the everyday one we've been using at $75. And what we've seen in the test so far, including the one over the holiday, is that our average ticket and all in profitability have remained steady even with the lower threshold.

So we're pleased with the early insights that we've gathered from our testing, but we will continue to test and learn and determine how much and to what level we'll utilize this as we go forward into 2020..

And then maybe just a follow-up on the fourth quarter comp guidance of down low single digits, right? Given the disparity of performance, Custom Closets versus others, the other categories.

Can you just help us understand the potential split, right, between those two? I mean, what is sort of the expectation for Custom Closets? Is it sort of steady as she goes? Similar level of growth right in the fourth quarter with the Elfa sale and so forth? Or just – what are you guys sort of expecting between the two subcategories?.

Yes. Steve, I think last year, it's important to remember that where we saw the most pressure in our comp store sales during Q4 was in other product categories. Also recall that Custom Closets for us, also, does include the Closet department, which is part of what I think you could argue was part of the Marie Kondo effect.

So we would expect to see more pressure in those categories than in the core selling of our four Custom Closet lines, particularly without being the period where we have our annual Elfa sales, which ends later this month..

And Steve, also, as I said in my remarks, just to reiterate it again, we are seeing some pressure in those categories that they are within our expectations. So we're quite encouraged about Q4 and the full year..

Thank you..

Thank you..

Our next questions come from the line of Tami Zakaria of JPMorgan. Please proceed with your questions..

Hi, thank you so much for taking my questions.

So can you talk about the Netflix show by Home Edit this year? The timing of it and your involvement in the project? The product categories you expect to highlight in that show? And any other details that you can share?.

Sure. Tami, yes, this is – we're very excited about our exclusive partnership with The Home Edit. We currently have 34 exclusive SKUs, and we will be adding to the collection this year. We're also very excited about their Netflix show. We don't know exactly when it's going to air yet, but it will air sometime this year.

So these are the type of partnerships, Tami, that we talked about last time that we love, and we will be pursuing other opportunities similar..

Got it. That's helpful. And then separately, it does seem like you're modeling $0.09 of drag from the distribution center expenses this year versus $0.06 previously.

So what's really driving that? And can you also remind the savings you expect from this next – in 2020 and then the cadence of that?.

Sure Tami, hi. Well, first of all, let me just say that we are very, very proud of our teams that executed this huge initiative for us to open the second distribution center in Aberdeen, Maryland because it's up and running and the cost side of this came in on-time and on-budget.

So we're very proud of them and very thankful for the hard work we've done because we certainly know others have stubbed their toes on these types of big projects. As you know, it's expected that it will give us considerable freight savings as we move forward with this project.

So just to be more specific as to the cost side that you're talking about for fiscal 2019, what happened is, during the holiday period, we experienced slower hiring than we had expected, which means simply that the benefits associated with the freight savings for the direct-to-customer shipping portion will be a bit transferred from fiscal 2019 into fiscal 2020.

So we'll receive less of those benefits in Q4 than we had initially expected, but then more in fiscal 2020. So it's purely timing of benefits. The benefits are still expected to be fully realized. And like I said, the cost side came in well within our expectations.

At that distribution center, in third quarter, by the end of November, we were fully shipping out all of our store replenishment trucks exactly on schedule as planned.

And we started to ship and had planned always to ship gradually the direct-to-consumer portion of shipments that we intend to do out of this facility, but they've just ramped at a slower rate than we had anticipated due to some hiring challenges that we're now feeling like we're in a position to be caught up with.

And we still fully expect that we will hit our targets in terms of being 100% operational, where we expect to be in the facility at the end of the fiscal year, with ultimately, about half of our direct-to-customer orders coming out of the Aberdeen facility and half out of Dallas, which has some tremendous customer service improvements because we expect to literally cut the time it takes for an order to ship and be received by a customer in about half.

From a cost perspective, you're right. We do anticipate that the cost this year will go from the – from the range we've been saying of $4 million up to $6 million. However, next year, we are saying that the benefits we expect to see – we see will go from $6 million to $8 million.

So again, it's really just kind of a $2 million transfer between the two fiscal years. .

Timing. And Tami, just one other thing I wanted to share that I meant to about The Home Edit when you were asking about that, if you don't mind. I think it's important to note that this partnership is a super great example of customer engagement, and it really is allowing us to engage with new and younger customers.

So that was part of the strategy as well, and we've just been really pleased.

Got it. Thank you so much..

Thank you..

We have reached the end of the question-and-answer session, I will turn the call back over to management for any closing remarks..

Thank you all very much for joining our call today. And Jodi and I will look very forward to our next call in May, where we will report on Q4 and our full fiscal 2019 year. Thanks very much. .

Bye-bye..

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation..