Roots Corp

TSX:ROOT

Earnings Call Transcript 2023-Q2

[Operator]

Good morning. My name is Michelle, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Roots' Second Quarter Earnings Conference Call for fiscal 2022. [Operator Instructions]

On the call today, we have Meghan Roach, President and Chief Executive Officer; and Mona Kennedy, Chief Financial Officer of Roots. Before the conference call begins, the company would like to remind listeners that the call, including the Q&A portion, may include forward-looking statements of our current and future plans, expectations and intentions, results, level of activities, performance, goals or achievements or any other future events or developments. This information is based on management's reasonable assumption and beliefs in light of information currently able to Roots, and listeners are cautioned not to place undue reliance on such information.

Each forward-looking statement is subject to risks and uncertainties that could cause actual results to differ materially from those projected. The company refers listeners to its second quarter management's discussion and analysis and/or its annual information form dated April 6, 2022, for a summary of the significant assumptions underlying forward-looking statements and certain risk factors that could affect the company's future performance and ability to deliver on these statements. Roots undertakes no obligation to update or revise any forward-looking statements made on this call.

The second quarter earnings release, the related financial statements and the management's discussion analysis are available on SEDAR as well as on the Roots Investor Relations website at www.investors.roots.com. A supplementary presentation for the Q2 2022 conference call is also available on the Roots Investor Relations site. Finally, please note that all figures discussed on this conference call are in Canadian dollars, unless otherwise stated.

Thank you. You may now begin your conference.

[Meghan Roach, executive]

Good morning, and welcome to our earnings call. Before I go for my prepared comments, I want to thank the team for another great quarter. Although the macroeconomic environment has been more challenging in recent months, the team's hard work and dedication has enabled the brand to continue tracking well against its long-term growth strategy. Roots maintained its top line momentum in Q2 2021, with sales increasing 22.9% year-over-year to $47.8 million. Notably, the first and second quarters are generally equally weighted and taken together, typically account for less than 30% of our total annual sales.

Our strong performance in the second quarter was driven by higher in-store traffic, demonstrating the strength of our brand and the loyalty of our customer base during the ongoing market recovery from COVID-19. We also benefited from the absence of pandemic-related restrictions in Q2 2021 compared to the same period last year. Specifically, Roots stores were fully opened this quarter, compared to last year when they were opened for approximately 2/3 of the quarter due to partial lockdowns in many regions across Canada.

Excluding COVID-19-related government subsidies and rent abatements, we also generated improvements in net loss, which improved by $2.5 million year-over-year and adjusted EBITDA which increased by $2.5 million compared to Q2 2021. Mona will provide more details about these improvements and her financial overview. These solid financial results reflect our enduring brand affinity and our differentiated product offering as well as a focus on operational excellence across the entire organization. I am particularly pleased with our team's efforts to meet the industry-wide supply chain challenges. As mentioned in last quarter's conference call, we took a proactive approach to addressing these disruptions by balancing airfreight with premium and regular ocean freight.

Since the last quarter, we have witnessed incremental improvements in shipping times and freight costs. And the team's efforts have also ensured our inventory levels are more closely aligned with expected sales in the second half of the year as well as enabled us to secure earlier deliveries of our important fall/winter collection. Accordingly, inventory rose 15% year-over-year to $54.8 million end of the second quarter. We are comfortable with this inventory increase as our core collections represent the majority of our product offerings, and we have the flexibility to manage inventory as we advance through the quarter using our pack-and-hold strategy if necessary.

Turning to our operating pilots in the second quarter. The Beaver Canoe launch and celebration of its 40th anniversary proved to be highly successful. Made with 100% organic cotton, the collections featured a diamond shape logo with the Beaver entries and included t-shirts, hoodies, sweats and accessories branded with Beaver Canoe design. The relaunch celebrates the retro trend we increasingly see in the marketplace, particularly the demand for vintage Roots logos and products. We plan to build on the success of Beaver Canoe 2023 by expanding the depth of the product offering. As we look to the second half of the year, we have several exciting collaborations in the pipeline. And we are continuing to make changes in our product offering that reflect our ongoing commitment to becoming a more sustainable brand.

We know that on average, our material choices are one of the biggest ways we affect the environment. As we begin to measure our impact moving to more sustainable materials, such as organic cotton is an important step forward for us as the brand. In early Q3, we relaunched our popular and iconic Cooper Beaver sweats in a combination of organic cotton and recycled polyester. In addition to this change in materials, in line with our goals of becoming an increasingly inclusive brand, we are also offering more fit and sizes as well as gender free style. With the launch of our updated Cooper Beaver collection, which is one of our highest volume product lines, we remain well on track to most of our apparel made with sustainable materials by the end of the year, and achieving this sustainability objective is integral to our CSR commitments for 2022.

Turning to the second half of the year, which typically accounts for approximately 70% of our annual revenues. We believe Roots has a strong foundation, which enables us to address many potential scenarios. Consistent with prior quarters, we will not be providing guidance. However, depending on how the quarter unfolds, we have many strategic tools at our disposal to maintain our competitive position. We are entering our peak period with healthy inventory levels, comprised mainly of timeless items with [indiscernible] fashion risks that are seasonally relevant.

In addition, we have a robust balance sheet, supported by nearly [ $60 ] million in unused boring capacity. We also plan to continue deploying capital prudently to ensure our financial position remains solid. As I close my prepared remarks, I want to highlight that the growth strategy we have communicated in previous quarters remains unchanged. We are staying the course on our 4 growth pillars, which include offering an elevated omnichannel experience, reinforcing the brand position globally with our exceptional products, strengthening our focus on CSR initiatives and operational excellence. However, we are monitoring the changing market environment and proactively preparing for multiple possible scenarios.

On that note, I will turn the call over to Mona Kennedy, our CFO.

[Mona Kennedy, executive]

Thanks, Meghan, and good morning, everyone. Roots delivered strong sales growth and margin improvement in Q2 2022, despite the external macroeconomic uncertainties. As previously mentioned, we're cautiously entering the second half of 2022 from a position of strength. Our team remains fully committed to executing our long-term strategy and raising the Roots brand to the next level on a global scale. Our solid balance sheet will support our growth plan, while our focus on operational excellence ensures we address challenges with agility and proactiveness. Total sales increased 22.9% to $47.8 million in the second quarter of 2022 from $38.9 million last year. DTC Sales were $38.5 million, up 26.6% year-over-year.

This significant improvement was driven by higher store traffic following the recovery from COVID-19 and the absence of pandemic-related closures and restrictions versus last year. It was encouraging to see this traffic increase was more pronounced in urban centers and tourist areas, which have been hit the hardest as a result of the pandemic. P&O sales amounted to $9.3 million in the second quarter of 2022 compared to $8.5 million last year. This 9.6% improvement is driven by increases across the entire P&O portfolio. The Taiwan business, B2B, licensing, China TMall and a favorable foreign exchange effect. Gross margin improved year-over-year, rising 120 basis points to 59.3%.

In DTC, gross margin increased 60 basis points to 64%, driven by continued promotional discipline through reduced markdowns and the favorable impact of foreign exchange rates on U.S. dollar purchases. As you may recall, last year, DTC gross margins benefited from pandemic-related government subsidies amounting to 320 basis points. Another onetime impact on margins is 50 basis points of additional air freight costs incurred to bring in some inventory earlier than last year. Without the impact of these onetime items, gross margin would have shown an improvement of 430 basis points.

I'm pleased to see the strength in our DTC gross margins continuously. We also gained leverage in SG&A expenses. We continue to be prudent in managing our SG&A, while also ensuring we invest in the right areas for long-term growth. Excluding the year-over-year impact of government subsidies and temporary rent abatements, expenses rose 12.9% from last year. This percentage increase is approximately half of the growth we saw in DTC sales, which reflects our discipline in managing expenses and our focus on operational efficiency. Higher SG&A essentially reflects higher store labor costs as stores were fully opened this year. Additionally, we made some investments in talent and marketing at our head office.

Adjusted EBITDA was negative $0.6 million in the second quarter of 2022 compared to positive $2.9 million in 2021. It is important to keep in mind that last year's adjusted EBITDA included $6.5 million of pandemic-related government subsidies and rent abatements from landlords. Excluding these items, our adjusted EBITDA improved by $2.7 million year-over-year. The net loss in the second quarter of 2022 amounted to $3.2 million or $0.08 per share versus a loss of $1.2 million or $0.03 per share in last year's second quarter. As well as adjusted EBITDA, government subsidies and rent abatements had a material impact in this year-over-year variation. Excluding these items, the net loss improved by $2.5 million compared to a year ago.

Turning to our balance sheet highlights. Our inventory position is healthy, standing at $54.8 million at quarter end. This compares to $47.5 million in Q2 of last year. This 15% inventory increase is essentially related to our decision to bring in certain fall and winter collections sooner to mitigate supply chain risks.

Additionally, as you may remember, last year, we had significant delays in arrival of inventory. The inventory we also brought in by airfreight, which adds to the reported value as these costs are capitalized. Of the $7 million year-over-year inventory increase, approximately $2 million is attributable to airfreight. Our objective remains to have products in store on time at the most efficient cost possible. We believe our inventory position is well balanced as we entered a seasonally strong back half of the year. It reflects the practice that's taken to tackle supply chain volatility. We're aware of market concerns about certain retailers' high inventory levels, which could lead to markdowns. At Roots, we believe our inventory is less subject to potential markdowns.

First, it mostly consists of timeless, limited fashion risk products with core collections representing approximately 2/3 of our inventory. Second, we also have the option to strategically manage our pack-and-hold inventory. For these reasons, we're comfortable with our current inventory level. We ended the second quarter in a solid financial position with a net debt of $50.2 million, supported by unused borrowing capacity of $59.6 million under our revolving credit facility. Our net leverage ratio was also very sound at 1.1x at the end of Q2.

We view our financial position as a key strategic advantage given the uncertain global economy. It provides us with the flexibility to make appropriate adjustments as conditions change like we did this quarter with the additional airfreight to bring inventory yet. Over the short-term, we intend to remain prudent with our cash usage, which includes limiting activity on our NCIB program. In summary, looking back at the first half of fiscal 2022, we're pleased with our performance in what is a seasonally soft period for Roots. Store traffic rose significantly, reflecting our brand's appeal and promotional discipline contributed to improved profitability. As for the third quarter, I draw your attention that we will not take advantage of subsidies and rent abatements, whereas such benefits totaled $3 million last year for the same period.

Looking ahead, we have no control over the economy, but we believe we have a clear understanding of who our core customers are, which is not a [ fast ] fashion brand. We offer comfort and quality to long-standing customers who see value in our product's actual price. Roots' sustained efforts over nearly 50 years have built a strong appealing brand, while fostering passion, pride and resilience throughout the organization.

With these words, I sincerely thank our entire team for another solid quarter. This concludes our prepared remarks. With that, operator, please open the line for questions.

[Operator]

[Operator Instructions] Your first question comes from Brian Morrison of TD Securities.

[Brian Morrison, analyst]

With respect to -- I actually got dropped on the call. But just with respect to your outlook going forward, it sounds like you're preparing for many different scenarios. Can you maybe give us a little color on how Q3 to date has unfolded and how the back-to-school season trended for you?

[Meghan Roach, executive]

Brian, yes, absolutely. So I think as we've mentioned in previous quarters, we don't give guidance on an annual basis or really in the quarter. We have a lot of the quarter sales to go, so we're not providing guidance on back-to-school. I know I'm sure you know being [ on par ] that many people came back to school on a staggered basis at the end of last week. And so as we look at the Q3 overall, we're still kind of looking at a lot of the year as the quarter left to go. I'd say as we look forward to refocusing again on monitoring the changing market environment, preparing really proactively for multiple scenarios. But I think we feel good about the fact that we have a really healthy inventory position.

We've got strong brand equity, and we've got a really solid balance sheet going into the second half of the year. So those are the things we're considering as we're looking to how do we develop long-term growth in the business.

[Brian Morrison, analyst]

So when you talk about the strength of your balance sheet, and Mona had commented that you're going to limit your NCIB activity, you're still going to have tremendous free cash flow in the back half of the year. I'm wondering why you're not taking advantage of maybe the valuation discrepancy in the marketplace at this time.

[Mona Kennedy, executive]

I think, Brian, at this point, we're just being prudent with our cash. It's an uncertain environment out there, as you know. And while we have a solid financial position, there's a little bit of uncertainty in the back half of the year. So we're being prudent and we're just not providing guidance on what we're going to be doing with our cash. We continue to monitor it. We continue to work on different scenarios, and we'll be maximizing the value of the cash that [ sits ] on our balance sheet.

[Brian Morrison, analyst]

What are some of those options, Mona?

[Mona Kennedy, executive]

From an optionality perspective, obviously, we've talked about it, and most companies have the same options, right? So the priorities changed, and it changed and then you can kind of change that, but it could be dividends, it could be acquisitions, but it's a lot of different things. That's how we're constantly monitoring. And -- but at this point, we're not really providing any guidance.

[Brian Morrison, analyst]

Okay. Maybe one change of gears here. The market of Taiwan, obviously, there's some political activity there. How do you prepare for -- or is the business being impacted by any of this? Or maybe what are the -- how do you prepare for any sort of scenarios that unfold there?

[Meghan Roach, executive]

Yes. First, yes, the business is not being impacted. And I think it's difficult for us to really speculate on the political side of the situation. But from our operational and structural basis of the business, we have some good protections in place in the contract, things like minimum purchase agreements. And we also have all of our sales in U.S. dollars. So from an FX perspective, we have limited exposure there. So we feel good about the business as it currently stands, and we're obviously closely monitoring the situation as it evolves.

[Operator]

Your next question comes from Stephen MacLeod of BMO Capital Markets.

[Stephen MacLeod, analyst]

Just wanted to follow up on a couple of things. In the last call, you had talked about just some of the H2 margin impacts that you expected to see from increased air freight. And I'm just wondering if any of those impacts or expectations have changed now that you've made your way through the second quarter?

[Mona Kennedy, executive]

Stephen, from a margin perspective, we remain disciplined with our promotional activities. We are continuing to focus on full price selling. And as you know, we have taken a minor price increase in kind of towards the end of Q2 and in Q3 as well. Some of the organic product that is coming in is coming in at higher prices. So from a margin perspective, we continue to ensure that we maintain the high margins that we have. On the air freight side of things, last quarter, we had communicated a range of 150 to 250 basis points in the back half of the year. We're now expecting to be on the lower end of that. As you know, the supply chain markets are improving, their rates have come down. The time -- the transit times have shortened. So that has actually helped us to try to land on the lower end of that.

[Stephen MacLeod, analyst]

Okay. That's great. And is that -- would you expect that to be sort of evenly split between Q3 and Q4? Or is there still maybe a bit of a higher weight to Q3 on that?

[Mona Kennedy, executive]

You know what, I can't really provide that level of detail because it's dependent on how that product sells through. But from a back half perspective, I think you can weigh slightly towards Q3, but I wouldn't feel comfortable providing that guidance at this point.

[Stephen MacLeod, analyst]

Yes. Okay. No, that's fair. And then just curious with -- just with the increased traffic that you saw in Q2 and on a year-over-year basis with stores being closed last year, did you see any moderation in your e-commerce channel in Q2?

[Mona Kennedy, executive]

Yes, I think the reason...

[Meghan Roach, executive]

Sorry, I'll go ahead on that Mona. I think on e-commerce, we've kind of been commenting for quite a long time that we expected some moderation. When the pandemic started to ease and people decided to go back to physical stores. I think that we've talked about a little bit in the past, the fact that our customers -- we have a good set of customers that do online and in-store shopping. We have a set of customers only shopping stores. And we have a lot of customers who want to come to our physical store environments to touch and feel the product before they purchase. And so we do see e-commerce moderating versus pandemic levels, which is expected in line with our focus in the business. But our business focus has really been around omnichannel.

And so we're really looking at how does traffic overall across both channels trends and how we see sales across both channels trends, as we think they really are [ symbiotic ] between online and in stores. So that's really been our focus as a company as we think about online and retail and how they play together.

[Stephen MacLeod, analyst]

Right. Okay. That's great. And then maybe just finally, you talked about the fact that you're approaching your 50th year. Any big merchandising plans that you have in place to celebrate that milestone?

[Meghan Roach, executive]

Yes. We have some exciting collaborations coming in the pipeline. So we won't tell them yet. So we'll save that exciting for our 50th year, but we've got some exciting collaborations. We've got -- we definitely see some unique product for the 50th in celebration of some of our key icons. And I think also, as I mentioned on the call, one of the big things we've been focused on is the shift towards more sustainable materials in our products. And so we're going to continue toward that push. With the Cooper collection being organic this fall, most of our products are now made with sustainable materials, but that's going to continue to be a push as we go towards the 50th also. But we've got about a year left to go until we turn 50, so we'll save some of the surprises for when that actually happens.

[Operator]

[Operator Instructions] There are no further questions. I would like to turn the conference back to Meghan Roach for closing remarks.

[Meghan Roach, executive]

Thank you. That concludes our second quarter conference call. We look forward to seeing you in December a new quarter and third quarter. Have a great day, everyone.

[Operator]

Ladies and gentlemen, this does conclude your conference call for this morning. We would like to thank everyone for participating and ask that you please disconnect your lines.