Greetings, welcome to The Container Store’s Second Quarter 2021 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. Thank you.
You may begin..
Good afternoon, everyone. And thanks for joining us today for The Container Store’s second quarter fiscal year 2021 earnings results conference call. Speaking today are Satish Malhotra, Chief Executive Officer; and Jeff Miller, Chief Financial Officer. After Satish and Jeff 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, expectations regarding liquidity and goals, our anticipated financial performance and our plans in response to COVID-19 and the potential impact of COVID-19 on our business 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 June 3, 2021.
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, 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 and investor deck may be obtained by visiting the Investor Relations page of the website at www.containerstore.com.
I will now turn the call over to Satish.
Satish?.
Thank you, Caitlin, and thank you all for joining our call today. I'll first discuss the highlights of our outstanding fiscal Q2 performance, followed by an update on our growth initiatives. Jeff will then review our financial results in more depth and discuss our outlook.
Our outstanding financial performance continued into Q2 as we delivered our highest second quarter sales results and our most profitable second quarter on record.
As a reminder, this is our fourth consecutive quarter of record growth and profitability, demonstrating our ability to drive the business forward while maintaining strong cost discipline and a complex economic environment.
For the quarter, we drove consolidated net sales of $276 million, an increase of 11% compared to last year and an increase of over 16% compared to the second quarter of fiscal 2019.
Our robust sales performance combined with our better than expected gross margin results delivered exceptional earnings per share of $0.54 compared to adjusted EPS of $0.43 last year and $0.08 in the second quarter of fiscal 2019.
Our excellent financial performance was fueled by strong consumer demand and by continued progress against our strategic pillars, including driving more profitable sales as we purposely reduced the depth, breadth and duration of our promotional cadence.
As mentioned in our prior earnings call, we have focused our efforts this fiscal year on maximizing the productivity of our existing store base and our Q2 results reflect that hard work by curating and resetting our merchandising assortment and betting more storytelling into store visuals, implementing more engaging promotional campaigns.
And by adding more specialists to the selling floor, we believe we can deliver a better customer experience with much greater profitability. Improving the fundamentals of our existing store base provides a solid foundation for our future growth plan.
Now while we are still in the early innings of these improvements, we are extremely proud of our results to-date. In Q2, we saw continued strength across our assortment led by the impressive growth of our Custom Closets business at 22%, compared to last year and to fiscal 2019.
Our Custom Closets business offers our customers superior quality, affordability and customization, and is a competitive advantage when paired with our general merchandise completion products and in-home services.
As previously mentioned, we see a significant opportunity to drive market share for spaces over $2,000 and demonstrated by the continued success of our premium Avera closet line with sales almost doubling compared to Q2 of last year.
Even more impressive with how our most affordable closet line Elfa performed during the September Fall In Love With Elfa campaign, which ended mid-October.
By incentivizing customers to purchase more Elfa products to receive a higher discount, we were able to drive a much higher basket with two-thirds of campaign sales, delivering a basket size of approximately $3,000, whether it's more premium closet offerings or through strategically orchestrated promotional events.
We are delighted that our ability to deliver higher basket and improve sales productivity in our Custom Closets business. When it comes to our general merchandise business, we delivered 3% growth compared to last year, which has a reminder greatly benefited from the successful launch of the Home Edit Netflix series.
Compared to fiscal 2019, our general merchandise business grew a healthy 13%.
As part of our effort to drive more profitable sales growth in our general merchandise business, we made some bold changes to our promotional cadence during Q2, such as eliminating our traditional mini office sale and significantly narrowing and shortening our Customer Favorites campaign.
As a result of these changes, we not only saw higher average basket, but we also saw a better overall margin for the campaign as compared to last year. In addition, we surprise our customers with significant newness across our general merchandise categories. I presented newly remerchandised discovery areas, which began with garage at the end of Q1.
During the second quarter, we created a captivating kitchen gadget wall, reduced our travel and gift wrap departments while bolstering our closet department. We also introduce an effortless way to experience our Elfa pre-pack and grab-and-go assortment.
The new Elfa made easy discovery area, not only centralized all of our pre-packs, but also allowed us to add new kit and graphics to demonstrate the versatility of our pre-packs. These new discovery areas look fantastic. And the customer response has been extremely positive.
As mentioned on our last earnings call, Marie Kondo’s free show Netflix series, Sparking Joy launched at the end of August with much anticipation. However, we did not see a robust lift in correlated sales despite dedicating our front of store presentation to our exclusive and sustainable KonMari product line.
Fortunately though, the strength of our new discovery areas within kitchen and closet helped offset the unmet expectation of KonMari product sales. With respect to our e-commerce channel, we continue to make progress and enhancing our online capabilities and reach.
Our site speed and customer time to interact improved with every major technology update. And we are pleased with the initial reaction to the rollout of Instacart and Afterpay. Our Afterpay customers are about eight years younger than our average customer. And we are committed to building a longstanding relationship with this new younger demographic.
Additionally, we launched a new rating and review tool, enhanced badging on our product pages to identify sustainable and exclusive products.
And then now after we’re working on simplifying the checkout process and streamlining our product pages to help combat rising shipping costs and cart abandonment rates, we showed customers how much they can save by choosing a store pickup option when their online basket was below the free shipping threshold.
The shift in messaging result in an increase in pickup orders, outside the enhancements have already created a cleaner customer experience, increased site performance and lowered cart abandonment rate.
We will continue to enhance our e-commerce experience by investing in modern technology stacks, to reduce site friction and deliver a seamless customer experience.
Shifting gears, I’d now like to speak about our incredible team, whether or not our stores, distribution centers or support center, our teams are invaluable to the success of our business, and it is their dedication, passion, and resolve that has enabled us to deliver such outstanding results to-date.
In fact, in our most recent 2021 employee poll survey, our team members overwhelmingly shared proud they are to work for The Container Store and that they are extremely excited about our future.
Given the strength of our financial performance, we are pleased to be in a position to restore pre-COVID benefit, including merit increases and 401(k) matching. In addition to implementing variable based incentive plans and increasing our minimum wage to $15 per hour for all employees.
We remain diligent and steadfast and taking prudent steps to improve our employer value proposition and in being an employer of choice. I'm immensely proud of our execution during the second quarter, especially given the fluid environment we continue to operate in.
While we're not immune to the increases in raw materials and freight costs, we were able to mitigate this risk through price increases, less promotional activity and by encouraging in-store pickup in Q2. Jeff will discuss our financial outlook and how these pressures are expected to impact us in the second half.
But I believe our performance to-date is a great testament to the caliber of our people and in the way that they are executing against our strategic pillars. A quick update now on our three strategic pillars. First, deepening our relationship with our customers, we know our customers value our product offering and the services we deliver.
We believe we have an opportunity to enhance these relationships, to help drive increased spend and expand our market share. We enter the holiday season well position, despite the many headwinds in labor and supply chain.
We are also armed with the valuable learnings from prior years, where we have once again narrow down holiday packaging and assortment. I will be using visual merchandising strategies in store for managing to our strength and our brand promise.
Our front of store presentation would spotlight our new ways to holiday campaign with our incredible kitchen assortment, inspiring customers to think of new ways to prepare their kitchen, pantries and fridges for the holiday season.
Our holiday kitchen product will feature baking sets and aprons from Food52, cold brew coffee makers, and cereal dispensers from OXO and an explicit product bundle from the crafting brand Cricut, which will enable our customers to create some amazing label.
Additionally, our buyers have done an amazing job curating new gift packaging and stocking stuffers, the tally compelling story from reusable and sustainably soft gift boxes and bags to richly diverse center wraps and automates, our product offerings will highlight the many different and inclusive ways our customers celebrate the holidays.
Lastly, new ways to holiday campaign will also be supported by the rollout of known specialists in key areas of the store to help assist and engage our customers.
When it comes to branding that evokes emotion, we are pleased to share we're in the final development stages of our new brand campaign, in addition to the introduction of a new brand icon that will be recognizable for years to come, we anticipate launching both the new brand campaign and icon in late Q4. Finally POP! Program continues to grow.
At the end of Q2, we had 10.5 million pop styles and roles as a reminder of our 75% of sales are linked to our POP! Program, we believe we can enhance our loyalty program by rewarding a deeper level of engagement with a new tier-based loyalty program, which we also aim to launch in late Q4. Moving to our second strategic pillar, expanding our reach.
We are thrilled to share, we have entered into an exclusive multi-year marketing partnership with Cassandra Aarssen, Founder of the Clutterbug organizing method, author of four best-selling books and host of HGTV’s Hot Mess House.
Cassandra has an approachable style we know will resonate with customers interested in transforming their lives to the power of organization. She will create content for our brand to showcase a simple and approachable way to organize it that our customers can implement themselves with the help of our extensive product assortment.
Additionally, plans are being finalized to expand our store network. We see the potential to add at least 100 additional doors in the coming years and anticipate the majority of these doors to mirror the smaller store format we plan to open next year in Colorado Springs, Colorado.
We aim to concentrate our openings in a dozen key markets where we have the opportunity to gain significant market share. We believe these smaller format stores can actually be more productive than our larger format stores on a square foot basis. And we look forward to sharing more details in the coming month.
Turning to our final strategic pillar, strengthening our capabilities. In Q2, we kicked off the materiality assessment project to help refine our ESG strategy. However, we’re not waiting for the completion of that assessment to address our ESG footprint. During the quarter, we joined the U.S.
EPA Green Power Partnership, and we’ll continue to take steps to lead the transition to a cleaner energy future. Additionally, I’m proud to share customers will now see a green leaf badge on product signs in-store so they can easily identify the more than 1,100 sustainable products we carry.
Finally, I recently signed the CEO Action Pledge, which aims to rally the business community to advance diversity and inclusion within the workplace. Again, we are still in the early stages of our ESG journey, but we continue to make great progress.
When it comes to technology, we are currently piloting a store inventory management system that shifts picking and packing work historically done in our stores to our distribution centers, creating added capacity for our stores to spend more time with customers on the selling floor.
Additionally, we’re upgrading our store phones from traditional landlines to voice over IP. This change will not only reduce operating costs for each store, but will also allow us to efficiently route poles to our call center. So that store specialists can again, spend more time serving our customers in-store.
In closing, we are proud of our results today and we could not be in a better position to go by brand. Expand our profile and drive value for all of our stakeholders. Simply put, we are well in our way to becoming the best version of ourselves. I will now turn the call over to Jeff.
Jeff?.
Thank you, Satish and good afternoon everyone. As Satish reviewed our Q2 performance well exceeded our expectations and we are very proud of the strong execution by our teams across the board.
For the second quarter, consolidated net sales were $276 million reflecting a year-over-year increase of 11.2% and an increase of 16.7% compared to the second quarter of fiscal 2019.
By segment, net sales for the Container Store retail business were $259.4 million an 11.3% increase compared to $233 million last year and a 17.2% increase compared to $221.2 million in the second quarter of fiscal 2019. Custom closets sales were up 22.1% compared to fiscal 2020 and contributed 9.6% of the 11.3% year-over-year increase in net sales.
Other product categories were up 3.1% in Q2 and contributed the remaining 1.7% of our net sales increase year-over-year. Compared to Q2 fiscal 2019 custom closets were up 21.7% and other product categories were up 13.5%. The disruption from COVID-19 spurred a strong acceleration in our online channel in the first half of fiscal 2020.
In Q2 of fiscal 2021, we continued to see a shift back to brick-and-mortar stores and our online channel decreased 23.9% year-over-year. However, when compared to the second quarter of fiscal 2019 our online channel increased by 41.8%.
Including curbside pickup, our website generated sales in Q2 were down 24.4% from last year, but up 44.8% when compared to the second quarter of fiscal 2019. Website generated sales represented a total of 19.9% at TCS net sales in Q2 of fiscal 2021 compared to 29.3% in Q2 last year and 16.1% in Q2 of fiscal 2019.
We ended the quarter with online orders taken, but not shipped totalling approximately $2.3 million compared to $6.5 million in the prior year period. We also had unearned revenue of $22.4 million this year versus $16.4 million last year, driven by a large increase in custom closet orders taken, but not yet installed.
Elfa third-party net sales of $16.6 million increased 8.8% compared to the second quarter of fiscal 2020. Excluding the impact of foreign currency translation, Elfa third-party net sales increased 5.7% year-over-year.
From a profitability standpoint, our consolidated gross margin for Q2 was 59.3% compared to 58.8% last year and 57.9% in the second quarter of fiscal 2019.
By segment, gross margin at the Container Store improved 60 basis points compared to last year, primarily due to decrease shipping costs as a result of the previously mentioned channel shift away from online and into brick-and-mortar combined with less promotional activity and a favorable mix of products and services, partially offset by increased freight and commodity costs in Q2 of fiscal 2021.
TCS gross margin improved to 110 basis points compared to the second quarter of fiscal 2019, primarily due to less promotional activity. Elfa gross margin decreased 800 basis points compared to last year, primarily due to higher direct material costs associated with commodity price increases combined with an unfavorable customer mix.
Elfa gross margin decreased 420 basis points compared to the second quarter of fiscal 2019, primarily due to higher direct material costs. Consolidated SG&A dollars increased 12.7% to $114.1 million compared to $101.2 million in Q2 last year.
As a percent of sales, SG&A increased approximately 50 basis points year-over-year, primarily reflecting our planned restoration of expenses that were temporarily pulled back during the pandemic, including merit increases and 401(k) contributions.
As Satish mentioned, investing to reward talent is a priority and the outperformance we are delivering from a sales perspective is enabling us to lean in on this front by increasing our starting minimum wage to our stores and all employees to $15 an hour and implementing variable based incentive plans throughout the organization.
As compared to the second quarter of 2019 SG&A decreased 690 basis points as a percent of sales, driven primarily by fixed cost leverage on higher sales combined with less marketing spent.
Our net interest expense for the second quarter of fiscal 2021 decreased 29.1% to $3.2 million from $4.5 million in the prior year due to a lower principal balance on our senior secured term loan facility combined with lower interest rates. The effective tax rate for the quarter was 25.7% compared to 31% in the second quarter last year.
The decrease in effective tax rate is primarily due to the impact of permanent discrete items on higher pre-tax income in the second quarter of fiscal 2021.
Net income for the quarter on a GAAP and adjusted basis was $27.2 million or $0.54 per diluted share as compared to GAAP net income of $20.2 million or $0.41 per diluted share in the second quarter of last year. Adjusted net income for the prior year period was $20.9 million or $0.43 per diluted share.
Our adjusted EBITDA increased 8.2% to $47.7 million in the second quarter this year, compared to $44.1 million in Q2 last year and increased 112.9% compared to the $22.4 million in Q2 of 2019. Turning to our balance sheet.
We ended the quarter with $23.1 million in cash, $166.4 million in net debt and total liquidity, including availability on our revolving credit facilities of approximately $132.5 million. Our current leverage ratio is less than 1x. Consolidated inventory ended Q2 up 47.1%.
Keep in mind that last year we had taken actions to cut inventory levels in order to preserve cash. This year, we continue to increase unit levels to support strong sales trends and to account for longer lead times resulting from supply chain disruption.
And like other retailers, we continue to experience freight and shipping costs headwinds along with higher commodity prices, which are reflected in this increase in our inventory.
We have and plan to continue employing multiple methods to help mitigate the impacts of higher costs, which include vendor negotiations, actively managing our supply chain along with adjusting our retail pricing and promotional cadence. We generated $10.4 million in free cash flow compared to last year when we generated $84.3 million.
As a reminder, last year we focused on preserving cash in the first half of fiscal 2020 due to the uncertainty related to the pandemic. Including the just mentioned inventory management actions, as well as deferring almost $12 million of cash lease payments to future periods.
On that note, we paid down approximately $1.1 million of the deferred cash lease payments in the second quarter of fiscal 2021. The outstanding balance as of October 2, 2021 was $1.1 million, which will be paid over the remainder of the fiscal 2021. Now for our outlook.
We expect Q3 consolidated sales to decline as compared to last year by approximately 5%. Adjusted EPS in the third quarter is expected to be approximately $0.20.
The expected sales decline in Q3 amounts to a 15% increase as compared to the third quarter of fiscal 2019, and an expected adjusted EPS improvement of over $0.12 or 150% over that same time period. Consistent with our approach on our last call, we are not providing full year guidance.
However, given our continued outperformance in Q2, we are sharing an updated scenario for sales growth and resulting associated margin outcomes.
In a scenario where fiscal 2021 sales increases are slightly above the mid single digit range compared to last year, we would expect operating margin to decline slightly and to deliver growth in adjusted EPS year-over-year.
With regards to gross margin, in this scenario we would expect at least 200 basis points of year-over-year gross margin pressure in the second half of fiscal 2021, given the significant freight and commodity cost headwinds with less than 200 basis points of pressure in Q3 and more than 200 basis points of pressure in Q4.
Despite these headwinds, we would still expect slight gross margin improvement on a full year basis in the sales growth scenarios.
On the SG&A side, as previously mentioned, we have restored certain expenses that were temporarily pulled back in fiscal 2020 as part of our pandemic management strategy such as reinstated 401(k) match and merit increases, while also implementing variable-based incentive plans and increasing our minimum wage to $15 an hour for all employees.
Therefore, in this slightly above mid single digit sales growth scenario, we expect overall second half fiscal 2021 SG&A dollars to be slightly higher than the second half of fiscal 2020 with increases in Q3 SG&A dollars year-over-year and relatively flat SG&A dollars in Q4.
Please note, the fourth quarter last year included a 53rd week that contributed $17.7 million in sales, $5.3 million in adjusted EBITDA and $0.07 of EPS. My comments on sales, margins and expenses versus fiscal 2020 do not adjust for the impact at the 53rd week last year.
We are proud to be on track to deliver EPS growth for the full year overall in the sales scenario I outlined. Even with the margin pressures that build through the fiscal second half and despite being up against the 53rd week year.
For the year, we still expect total capital expenditures to be approximately $47 million, interest expense to be approximately $13 million and our effective tax rate to be approximately 30%. I will now pass it back to Satish for closing remarks..
Thank you, Jeff. In closing, we are thrilled with our performance for the first half of fiscal 2021. We outperformed in executing against our three strategic pillars and the bold changes made to our promotional campaign paid off.
While we will face intensifying external headwinds in the second half, as Jeff outlined, I believe the Container Store has never been in a stronger position to combat those headwind and to fulfill our brand promise, transforming lives through the power of organization. This concludes our prepared remarks.
I’ll now turn the call over to the operator to open the lines for questions..
Thank you. [Operator Instructions] Our first question is from Steven Forbes of Guggenheim Securities. Please proceed with your question..
Good evening. So Satish I realized maybe early, but you mentioned the finalization of your growth plans here. So I think it’s an important question to put out here.
Just curious if you can give us any color on how you’re thinking about the cadence or potential pace of unit growth going forward, given the leverage ratio of the business today and remind us what the initial cash investment of a small format store is?.
Yes.
Steve, how are you?.
Good.
How are you?.
Good. Good, good, good. Yes, I’ll take the first part of that question and let Jeff answer the cash question. Look, we – as you noted, we’ve absolutely now have determined what we believe the right footprint is going to look like for our store growth. And we’re now very much in the process of looking at our site selections.
As you know, these things take time, but they’re selecting the slide during the lease negotiations and then the build out. But we do feel that we’ll be in a position to be able to talk about the number of doors that were opening primarily starting off in 2023.
In the meantime though, we continue to stay focused on maximizing the productivity of our existing store base, which as you know, is a critical prerequisite for our store growth plans. And we’ve done a lot of great work when it comes to improving our productivity. You’ve seen in the results.
When we think about a custom closet business, whether that’s selling more premium spaces or incentivizing customers to purchase more affordable spaces, and that’s really paid off. We saw a 22% increase in both Q1 and Q2 versus the same time period in 2019. And that’s really impressive.
And we’re also working extremely hard, improving the profitability growth of our general merchandise business, which grew 13% in both Q1 and Q2 versus the same time period in 2019.
That focus in terms of our custom closet business, general merchandise plus adding more specialist on the selling, engaged with our customers has helped drive our average basket and will be the precursor as we look to open up more doors in the coming years..
Yes. Steve, this is Jeff. And answering your question about the total cost, I mean, we haven’t actually priced it all out.
We’re in the process of doing Colorado Springs right now, but suffice to say it will be much less than what we were investing in the larger, full size footprint stores which was around anywhere from 4 million to 5 million for those stores..
And the only thing I would add, Steve, sorry, one thing to add on that is, again, as we look at this smaller box format stores, the productivity we believe is going to be much higher than even some of our existing stores because of the size of the store and what we think we can get out of it, hence all the work that we're right now in maximizing productivity with existing stores.
So I think the performance is going to be very positive..
Thank you. And then just a quick follow-up, I was wondering if you could expand on your comp expectation for the third quarter, the down 5% as I look online, right, you have the spend now get later promotion. I think that probably should feed right into the other category performance and hopefully the holiday departments.
But maybe just talk about your optimism around holiday in particular, given the performance over the past three years.
And if you could parse out what's sort of the underlying expectation for TCS Custom Closets in the third quarter?.
Yes. We kind of look at when we look at the comp comparison really over 2019, that seems to be a really good indicator, it’s less kind of noise when you look at it from that perspective. And as I mentioned, Q1, Q2, we are performing quite well. And we expect to see a similar performance as we enter into Q3.
Our holiday season right now is extremely well positioned. I just came back from our [indiscernible] store. And if you get a chance to go into our stores, you see that front of store presentation looks phenomenal with our incredible kitchen assortment backed by while narrated very compelling holiday packaging and stocking stuffer assortment as well.
I mean, our stores are busy. And in fact, I heard as we have a customer who purchased over $1,100 worth of packaging, holiday packaging. And she was that excited to see what we have to offer so that I think speaks up to the pent-up demand. And we're in a very great position to be able to satisfy that. And we have an Avera event going on right now.
Again, it's the second one that we're having now for the year and the initial indication show that to be a very successful, strong event for us as well. So I feel good about as we enter into the back half, as you know, it's still a lot of work to do, but we're in a great position to be able to deliver on our expectations..
Thank you. And best of luck..
Thank you..
We have reached the end of the question-and-answer session. I will now turn the call back over to Satish Malhotra for closing remarks..
Great. Well, thank you for joining us today and for your belief in The Container Store. And have a great evening..
This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation, and have a great day..