May 12, 2008
Executives
John Mills – IR, Integrated Corporate Relations Inc. Jirka Rysavy – Chairman and CEO Vilia Valentine – CFO and Treasurer Lynn Powers – President
Analysts
Mark Argentino [ph] Lloyd Walmsley – Thomas Weisel Partners
Operator
Welcome and thank you for standing by. At this time, all participants are in a listen-only mode.
(Operator instructions) Today's conference is being recorded. If you have any objects you may disconnect at this time.
And now, I would like to turn the meeting over to Mr. John Mills.
Thank you.
John Mills
Thank you. Good afternoon everyone and welcome to Gaiam's first quarter 2008 earnings conference call.
The following constitutes the Safe Harbor statement the Private Securities Litigation Reform Act of 1995. Except for historical information contained herein, the matters discussed in this call are forward-looking statements that involve risks and uncertainties including, but not limited to, general business conditions, integration of acquisitions, the timely development of new businesses, the impact of competition, and other risks detailed from time to time in the company's SEC reports.
The company does not undertake any obligation to update forward-looking statements. On the call today representing Gaiam is Jirka Rysavy, Chairman and CEO, Lynn Powers, President, and Vilia Valentine, CFO.
Now, I'd like to turn the call over to the company's Chairman and CEO, Mr. Jirka Rysavy.
Go ahead, Jirka.
Jirka Rysavy
Thank you, John, and welcome everyone to our first call. And I'm very pleased to say again, it was another good quarter.
Revenue for the first quarter ended March 31, this year, increased 11.5% to $65.2 million from $58.5 million in the same period of '07. Gross margin was 62.9% compared to 64.1% of revenue in the same period of last year.
The change in gross margin reflects the company investment in lower-margin solar business. Excluding solar, our gross margin actually improved to 66.8%.
Operating expenses as a percentage of revenue decreased 250 basis points to 58.8% from 61.3%. Selling and operating expenses decreased 120 basis points and G&A expenses decreased 30 basis points.
Operating income increased 64% or 130 basis points to 4.1% of revenue from 2.8% of revenue in the first Q of '07, which reflects the good leveragability of our infrastructure. EPS increased 29% to $0.09 per share from $0.07 in the first Q of last year.
The $0.09 EPS includes $0.03 loss from our community business during the quarter, which is $0.01 improvement from $0.04 loss than in the fourth quarter. Depreciation and amortization for the quarter was $2.5 million.
During the first quarter, we acquired SPRI, Carlson Solar and the remaining 49% ownership in Conscious Enlightenment, and also our non-LOHAS publication which were part of a previous acquisition. Also during the quarter, we sold our ownership in UK subsidiary, which completed our strategy to change how we operate in international markets.
We expect that the transition from sales of products to licensing arrangement will improve our profitability, reduce complexity of the operations, lower capital requirements and limit the impact to the weak U.S. currency.
Because of the impact of reporting change of international revenue, we will provide this time some additional revenue information and some guidance. So the change in international strategy to licensing is expected to reduce reported international revenue by approximately $25.7 million from $33.7 million recognized in 2007 to approximately $8 million in 2008.
Our international licenses fees average between 20% and 25% of the product sales. The companies we acquired during the first Q of 2008, net of the divestiture of the publication, represent approximately $12.5 million in 2007 revenues.
The companies we acquired through the last year, 2007, if we would acquire all of them as of January 1, 2007, would increase on pro forma basis Gaiam '07 revenues by $10.9 million. Including this conversion of international product sales to licensing, acquisitions and divestitures, Gaiam expects the revenue for 2007 to be approximately $300 million, which very, very strong internal growth.
With all the first Q activities, including acquisition and divestitures, integration of acquisition into the Gaiam existing sales infrastructure, and also a transition in international approach, it is virtually impossible to report the first Q comps, but Lynn will provide some gross data for the quarter as we can reliably calculate. As a guidance for second quarter, if deliver internal growth in the mid-teens, which was the recent rate and we do expect that, it would result in approximately $56 million in reported revenues in the first and second quarter.
And lastly, to capitalize on our solar strategy, we felt the best way for our solar subsidiary Real Goods solar to grow and enhance its strong 30-year-old brand would be as a standalone company. Last week, Real Goods Solar priced its IPO of Class A common stock and sold 5.5 million shares at $10 per share.
Approximately $200 million of the proceeds will be paid to Gaiam for loans we provided to our solar business. Post-offering, Gaiam owns 10 million shares or approximately 65% of Real Goods.
We do not intend on this earnings call to answer question about Real Goods and ask that you defer those questions until the Real Goods call. Now, before Vilia will provide you some details on our numbers and Lynn a business review, I'd like to talk about our consideration of changing our segment reporting and instead of two direct-to-consumer and business segments we report currently, we are evaluating creating of three segments which would be the Solar, Community and Lifestyle.
We believe that such reporting might create more transparency, but I'd like to hear from you on that, if possible. And now, Vilia.
Vilia Valentine
Thank you, Jirka. We are pleased with our first quarter performance, the continued growth in revenue and increase in operating income.
In the first quarter of 2008, we achieved another quarter of double-digit revenue growth, with sales of $65.2 million, up 11.5% from $58.5 million in the first quarter of 2007. Revenue generated by our direct-to-consumer segment increased 13.8% to $38.8 million from $34.1 million in the first quarter of 2007, reflecting the strong performance from our direct marketing and community programs and businesses acquired since the first quarter of 2007.
Revenue from our business segment increased 8.2% to $26.4 million during the first quarter of 2008, from $24.4 million in the first quarter of 2007, driven by our successful roll out of category management in retail and the acquisition of SPRI, partially offset by the change to licensing arrangements in our international business. As we discussed in our last quarter conference call, we are transitioning our international businesses to licensing arrangements, which has and will continue to have an impact on our revenue line.
This change is expected to reduce reported international revenue by approximately $25.7 million from the $33.7 million recognized in 2007 to approximately $8 million in 2008, as international license arrangements average between 20% to 25% of product sales. Converting our international businesses to a licensing model will contribute a higher percentage of bottom line income and will allow us to better leverage the infrastructure of our international partners.
During the first quarter, we divested our UK direct operations and transitioned this relationship to a license agreement. This divestiture completes our transition to licensing agreements in all international markets.
During the first quarter, we also divested our non-LOHAS publications that were included as part of a previous acquisition. Giving effect to these divestitures, our recent acquisitions and our international shift from a distribution strategy to a licensing strategy, we reaffirm our revenue estimate for 2008 of approximately $300 million.
This equates to strong internal revenue growth for 2008. As expected, our gross margins were 62.9% for the first quarter of 2008 compared to 64.1% in the first quarter of 2007, primarily the result of a shift in our sales mix to lower-margin solar and an increase in transportation cost.
Excluding the margin impact of our solar business, our gross margin, even after absorbing the increased transportation cost, increased to 66.8%. Our selling and operating expenses declined 220 basis points to 53.6% of revenue from 55.8% in the same period last year, as we were able to leverage our infrastructure across higher sales and acquired businesses.
Our corporate, general and administration expenses improved 30 basis points to 5.2% of revenue for the first quarter of 2008 from 5.5% in the same period last year, reflecting our continued focus on leveraging corporate resources. Operating income for the first quarter of 2008 increased 64.1% to $2.7 million compared to $1.6 million in the same period last year, even after our community spend.
Operating margins as a percentage of revenue expanded 130 basis points to 4.1% compared to 2.8% last year. Our interest income for the first quarter of 2008 decreased to $0.5 million from $1.1 million in the same period last year, reflected our repurchase of 2.5 million shares of our Class A common stock and the decline in average interest rates received on our cash investments from 5.18% as of March 31, 2007 to 2.37% at March 31, 2008.
As our invested interest rate decreased over 50%, we are reducing our accounts payable to gain leverage with our vendors to help offset the devaluation of the dollar compared to international currencies. Our capital expenditures in the quarter were $2.5 million, reflecting investments in our infrastructure of $1.1 million and video production costs of $1.4 million.
We also paid a $4 million deposit on an option to acquire a new facility. In April, we exercised this option and purchased a property for total purchase price of approximately $13.2 million, representing purchase price of approximately $88 per square foot.
Included in total purchase price is the $4 million purchase option that was paid in the first quarter. We will consolidate our three existing Colorado operations to this newly-acquired property during the second quarter of 2008 when our existing lease expires.
As a result of our strong operating financial performance, our earnings per share increased 28.6% to $0.09 per share from $0.07 per share for the first quarter of 2007. Our balance sheet remained strong at the end of first quarter, with cash of $48.2 million and no debt.
Our shareholders' equity at the end of the first quarter was $205 million. Subsequent to the first quarter, our subsidiary, Real Goods Solar, Inc., priced its $55 million initial public offering of shares of Class A common stock.
Real Goods Solar sold 5.5 million shares in the offering at $10 per share. Post-offering, Gaiam owns 10 million shares or approximately 64.5% of the outstanding stock of Real Goods Solar.
Gaiam will receive approximately $20 million of the proceeds from the IPO to repay Gaiam for loans previously advanced. We entered the second quarter with a strong financial position, solid opportunities to expand upon our product offerings and distribution channels, and our community.
At this time, I'd like to turn the call over to Lynn for the business overview.
Lynn Powers
Thanks, Vilia. Following another year in 2007 of strong internal growth and bottom line performance, we continued this trend into Q1 with double-digit revenue growth, a 64% increase in operating income and a 29% increase in earnings per share.
We began this year focused on executing our 2008 strategies outlined in our year-end earnings call. During Q1, we began the process of capitalizing on our solar division by filing an IPO, finalized our international market transition to a licensing-based model, including divesting our ownership in our UK subsidiary, launched our wellness media into retail and expanded our store-within-store presence, executed on our strategy to be the prominent category manager for fitness media, acquired SPRI products and initiated its integration into our trade business, continued to drive our catalog customers to utilize our e-commerce site and join as community members, and evaluated several acquisition opportunities in the media space.
I would now like to elaborate on some of our key initiatives and accomplishments by business unit. Early in the first quarter, our solar subsidiary, Real Goods Solar, completed the acquisition of a solar integrator in Southern California, increasing Real Goods' presence in the lucrative Southern California market.
On May 8, Real Goods Solar announced that it priced its $55 million initial public offering of Class A common stock. Approximately $20 million of the proceeds of the offering will be used to repay inter-company debt to Gaiam.
Post-offering, Gaiam owns 10 million shares or approximately 65% of Real Goods Solar. Our business unit segment's performance in Q1 remained strong despite an overall weakening of the retail sector as a result of a variety of unfavorable economic conditions.
While we have certainly felt the impact of increased fuel costs and the weakening U.S. dollar, we executed a number of innovative sales strategies that we began in 2007 designed to strengthen our market position and diversify our retail portfolio.
These strategies have helped to insulate us from the difficult economic conditions that have affected many other consumer products companies in recent months. For the quarter, the business segment, excluding international, achieved internal growth of 10%.
First quarter results were highlighted by the successful roll out of our category management strategy into retail, the first full quarter of our Amazon.com online store-within-store concept, and the acquisition of SPRI Products, adding new channel of distribution to our current sales portfolio. Placement of our media titles grew to approximately 71,000 doors in the U.S.
through the end of March. Our market share in fitness/wellness media remains a core strength for this segment.
At the end of March, according to Nielsen VideoScan, Gaiam ranks sixth in overall U.S. non-theatrical DVD sales, ahead of 20th Century Fox, Universal and Sony.
Based on Nielsen VideoScan statistics, the overall fitness/wellness media market grew approximately 16% in Q1 compared to the first quarter of 2007. This growth is largely the result of incremental sales from Gaiam's category management initiative in designated channels during the first quarter.
As I mentioned in the last call, one of our key strategies for 2008 is to utilize some of our market share in the fitness category in order to take on a category management role, which we feel will further solidify Gaiam as the leader in fitness/wellness media as well as increase revenues and profitability. Our Q1 implementation of this strategy successfully grew the overall fitness category, while preserving strength in the Gaiam market share, 41%, and controlling placement of almost 50% of this increased fitness/media market.
By continuing to focus on this strategy in the year ahead, we believe we can drive overall growth of the fitness category through controlled placement of media in Gaiam-managed sections. Our 2008 strategy to take on a category management role in fitness media market began with a 13-week test in Target during the first quarter.
Based on the success of that test, Gaiam was awarded an additional four feet of permanent media space in the Sporting Goods Department to accommodate this media offering, expanding our presence in Target to 12 feet. We believe that this expansion will create a more complete overall fitness offering for the consumer, drive incremental sales for both Target and Gaiam in the coming months, and is a strategic use of our leading market share position.
We believe our successful implementation of the category management role partially contributed to double-digit quarter-over-quarter revenue growth of Target. Target remains a strong partner in furthering our reach to the mass-market LOHAS and the fitness/ wellness oriented consumer.
For the third time in five years, Gaiam was named A Vendor Of The Year for outstanding partnership in Target Sporting Goods Department for the year 2007. Another key strategy for 2008 includes growing the number of our branded stores and store concepts at retail, including custom fixtures designed and produced by Gaiam.
As of the end of March, our store-within-store concept can be found in approximately 7,100 doors, up from approximately 6,000 in first quarter of last year. After our launch of the first online store-within-store concept with Amazon in the fourth quarter, we saw for the first time the impact that the branded lifestyle concept can make, when migrating from a traditional retail merchandising strategy to an online environment.
Results were very positive, including a jump in sales of more than 60%. This concept was designed by Gaiam to emphasize our proprietary media-centric branded merchandising strategy and includes both fitness and wellness offerings made available through an interactive shopping experience for customers.
We believe there is a growth opportunity in offering our retail partners the same store-within-store experience for their online customers as more and more consumers are choosing to shop online. We believe we're uniquely positioned to offer this customized online experience to our retail partners based on our in-house studio and post-production facility.
During the first quarter, we executed a soft launch of the wellness program into retail. The wellness programs includes a full assortment of media, co-branded with our partners at the Mayo Clinic, to address specific medical conditions.
Early results from the soft launch of wellness are positive and we recently moved to the branded store-within-store presentation of the wellness line within the book store channel to be shipped in Q2. Several of our media distributors picked up the line as we see this new brands gaining momentum.
The firm, wellness and our green living initiative will each play an important role in our strategy to expand store-within-store concepts in retails for the remainder of the year. Our green living store-within-store concept initiative will include new media and kits featuring well-known green movement advocate, Ed Begley, Jr.
We will launch a full line of green living media and products during third and fourth quarter and we are working with retail partners in our racking program to begin tests for green living line in Q2 and Q3. Whole Foods, Safeway and Pharmaca have each committed to tests of this line in the months ahead.
In first quarter, we acquired SPRI Products, the leading manufacturer and distributor of resistance exercise products for the professional health and fitness industry. SPRI is one of the original companies in the professional market with over 20 years' of experience and is well established among health clubs and professional trainers.
We began the integration of SPRI into our business segment. We expect to realize cost savings beginning in Q3, as we move all distribution to our facility in Cincinnati and centralized back-office administration.
This is the model we've been so successful with in the past, as we realized synergies from our targeted acquisitions. During Q1, we completed our strategy to move to a licensing model for our international business.
While this strategy has reduced top line revenue, it will contribute a greater bottom line percentage as we leverage the infrastructure of our international partners versus establishing an infrastructure ourselves. International market volumes declined in the first quarter as compared to prior years as we implemented this model in Canada, Japan and Mexico.
We also completed the sale of our UK subsidiary during the quarter. The UK represented approximately $2 million a quarter in revenue.
We expect to realize only approximately $100,000 quarterly licensing revenue from that base in the future, as that subsidiary revenues included a majority of third-party products. We remain focused on building sustainable relationships in key global markets for 2008 and are now working with a core group of international partners that we feel are well aligned with the branded lifestyle strategy that Gaiam employs domestically.
Sales from our direct-to-consumer business, which includes results from direct mail, Internet sales, community subscriptions and our direct response campaign, increased 14%. As we announced recently, our community and subscriber networks have over 200,000 members.
While top line revenue in the direct business remains healthy, we continue to invest in our community efforts, which contributed a negative impact of $0.03 a share during the quarter which is an improvement from a negative $0.04 a share in Q4 2007. Efforts to migrate our core catalog customer base to an online point of sale are succeeding.
Our e-commerce business grew nearly 29% over first quarter 2007. As this trend continues, we expect that the benefits will be twofold: First, our ability to customize the buying experience to each customer and to enhance the overall buying experience will increase, and overhead cost to the company will decline as compared to current marketing efforts made through the catalog business.
Revenue from affiliate programs, search engine optimization and e-mail campaigns continued to drive the overall growth in the Web business for Q1. Also during Q1, we launched a test program for our fair trade initiative on the Web.
A full launch of the fair trade initiative in direct is slated for later this year and a test in trade for early 2009. We're focused in the coming year on continued growth in these areas as well as cost saving initiatives to lower overall direct marketing costs in future quarters.
In summary, we made some great strides during first quarter, executing on our strategy to improve our operating results and focus on our core business. We continue to review and revise strategy across our different business units to better position Gaiam for future earnings growth.
Gaiam continues to be recognized as the authentic leader of choice in the LOHAS industry. We're focused on the execution of our key corporate initiatives to further this message in the year ahead.
Our strategies for the remainder of 2008 include: Increasing revenues from our community memberships, expanding our wellness store-within-store, launching green living into retail stores, expanding our category management role in fitness, expanding our brand and improving profitability through international licensing, creating the premier LOHAS Internet presence for our retail partners as well as our direct business, and pursuing strategic acquisitions that can be tucked into Gaiam infrastructure. We continue to be excited about the opportunities we see for 2008 and future periods.
Thank you. And, Mary, I would now like to open the call up for questions.
Operator
Thank you. (Operator instructions) And our first question comes from Mark Argentino [ph].
Your line is open.
Mark Argentino
Good afternoon, good quarter. Just got a couple of quick questions for you.
Lynn, you were talking about how you guys got another four feet at Target after the original test, the 13-week test. Is that going to be in line with other Gaiam feet or is that an encap, or could you talk a little more specifically on exactly what that's going to look like?
Lynn Powers
Sure, Mark. Obviously, we're still working with Target, but it is anticipated that the four feet will be in line as a lead-in to the department.
Mark Argentino
Got you. Can you use it for both hard good products and media or just media?
Lynn Powers
This will be a 100% media and it will be our official category management role for fitness media within Target.
Mark Argentino
How many different brands are you guys carrying right now in terms of the different media products, or how many different brands are you managing roughly?
Lynn Powers
I think we're probably working with about five or six.
Mark Argentino
Got you. Have you seen any mix shift at all?
I know one of the things you guys had talked about when introducing the category management role would be, there's an opportunity to increase revenue, you might see a down-tick in share. Has that played out at all?
Lynn Powers
Absolutely. We saw certainly an increase in revenue and an increase for the entire category according to Nielsen VideoScan, which is a nice increase of 16%.
So, yes, we saw the Gaiam share go down, but overall what we manage maintained around 50%.
Mark Argentino
Great.
Jirka Rysavy
It's category expanding, so we actually get increased revenue.
Mark Argentino
Is the category definition expanding to include wellness, or is that a different channel altogether?
Lynn Powers
That's up to Nielsen VideoScan but, right now, I believe that they'll be putting wellness under the fitness category.
Mark Argentino
And just quickly following up on the Mayo Clinic launch as well, do you know roughly how many stores you guys were able to get distribution for that product in, in Q1?
Lynn Powers
Well over 1,000 doors.
Mark Argentino
Okay. And then you said also you're going to just see a store-in-a-store there in the book channel?
Lynn Powers
We are, and we are launching the wellness kits or products in Q2, so we'll see some full store-within-store rollout in Q2.
Mark Argentino
All right. And then Jirka, in terms of the community, I know you didn't provide an updated subscriber number.
I know you don't do that every quarter. But, overall trends on the subscriber community and subscription side, still seeing the adds where you'd like, customer acquisition costs, is there anything there that you could touch on?
Jirka Rysavy
We provided the update as March 1, so I kind of remember (inaudible) March 30. We won't [ph] do it monthly, but we will do it quarterly on pretty much every quarter, we intend to do update.
Yes, I think that it continues pretty nicely and we mentioned the losses dropped for $0.01 which is 25% from the $0.04 to the $0.03 and I think as we go and start to market it, as we always said, end of the year, so that's when you're going to see a dramatic impact in expansion of our marketing efforts.
Mark Argentino
All right. And that's still planned second half of this year, is that the goal, Q3, Q4?
Jirka Rysavy
Yes, it's going to be definitely after people get back from school, so probably from like mid to end September. But, really the push is for Christmas.
Mark Argentino
All right. And then Vilia, I don't know if you have handy any of the cash flow metrics in the quarter.
I know it looks like you guys prepaid some of your payables a little bit, so do you have free cash or operating cash for the quarter?
Vilia Valentine
Yes. Just as an FYI, we just filed the Form 10-Q, so that information is out there.
Our cash flow from operations was a use of cash of about $1.4 million, which is showing our planned reduction into accounts payable during the quarter.
Jirka Rysavy
That's $11 million between payables and accrued liabilities when we pay down, so that's really causing that.
Mark Argentino
Great. Thanks, guys, appreciate it.
Vilia Valentine
Thanks, Mark.
Operator
And our next question comes from Lloyd Walmsley with Thomas Weisel Partners. Sir, your line is open.
Lloyd Walmsley – Thomas Weisel Partners
Great, thank you. I was wondering if you could provide us with what your plans are for the $20 million in proceeds to Gaiam from the Real Goods IPO?
Jirka Rysavy
No immediate plans. It is up to the Board.
We're going to the Board on June 3.
Lloyd Walmsley – Thomas Weisel Partners
If you had to just guess now where that would be focused, do you think more buybacks versus M&A opportunities?
Jirka Rysavy
I'm not going to guess; we wait for the Board meeting.
Lloyd Walmsley – Thomas Weisel Partners
Yes, okay. In terms of the M&A opportunity, do you see a lot of interesting targets out there for tucking in?
Jirka Rysavy
Yes, as Lynn mentioned, we recently reviewed one and we expect to probably have a couple deals announced in second quarter.
Lloyd Walmsley – Thomas Weisel Partners
Which segments would those be focused in, do you think?
Jirka Rysavy
Media.
Lynn Powers
Media.
Lloyd Walmsley – Thomas Weisel Partners
Media.
Lynn Powers
And the business segment.
Lloyd Walmsley – Thomas Weisel Partners
Yes. Is it possible to provide a quarterly breakdown from last year of the international revenue that's converting from direct to licensing?
Jirka Rysavy
We can look at that. We probably look at what was actually reported, but as we introduce these changes by countries and by product line, it's going to be quite a project for accounting to do something what our auditor's going to bless to release.
But, I don't want to commit to it because I'm sure – really that's kind of putting – not like to because there will be a lot of work for her to do, so I don't want to commit to it, but when we follow up let's talk about it.
Lloyd Walmsley – Thomas Weisel Partners
Yes, okay. And did I hear you right, you said for the second quarter you think revenue, existing internal growth rates equates to $56 million?
Jirka Rysavy
Yes, I said if you were to deliver existing climate mid-teens number what we historically last two years we did probably between $15 million and $19 million, so if you stay within a range for the second Q which we fully expect to do, that would equate to about $56 million. I'm just saying it because the impact of international from last year, it's hard to adjust it differently.
And I understand fully your question the international for quarterly so that's why we try to assess, and so I try to provide a guidance, which we usually don't do. So assuming we deliver the mid teens, it will be about $56 million and we do expect to deliver in mid-teens in internal growth for second Q.
Lloyd Walmsley – Thomas Weisel Partners
Okay. Is it possible to quantify the e-commerce portion of your business?
It sounds like growth there is really strong.
Jirka Rysavy
Yes, that business is growing pretty strong. Maybe I would like to also hear back from Mark, what do you guys think about changing our reporting for reporting community and solar separate?
Mark Argentino
I think that would be helpful. The more transparency, the better.
Jirka Rysavy
Thank you. Sir, I might have stopped you from the questions.
Lloyd Walmsley – Thomas Weisel Partners
That's it for now, but thank you.
Jirka Rysavy
Hey, Mark, can you put your opinion in from changing to reporting to back? Operator, if you have another question in the meantime?
Operator
I'm not showing any further questions at this time.
Jirka Rysavy
Okay. Thank you very much and we'll be talking to you next quarter.
Operator
Thank you.