Harte Hanks Inc (HHS) 2006 Q4 法說會逐字稿

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 objections, you may disconnect at this time.

Now, I would like to introduce Richard Hochhauser, President and CEO of Harte-Hanks. Thank you, sir. You may begin.

Thank you. Good morning, everyone. On the call with me today is our Chief Financial Officer, Dean Blythe, and Jessica Huff, our VP Finance and Controller.

The comments we make on this call will include forward-looking statements. These forward-looking statements are subject to known and unknown risks and uncertainties that may cause actual results to differ materially from those projected or implied in such forward-looking statements during this call. A description of some of the risks and uncertainties potentially impacting the Company's business and future performance can be found in the Company's Form 10-K and other documents filed with the Securities and Exchange Commission.

After I make some opening remarks, Dean will give financial details, and then we will take your questions.

Going into 2006, we knew that we were coming off two very strong growth years for each of our businesses, and that there were certain challenges that we would face in 2006. While there were many things in 2006 that were different than we expected when we started the year, our EPS performance was in line with our expectations. We delivered $1.39 of EPS in 2006, which, after adjusting 2005 results to add the amount of 2006 stock-based compensation expense of $0.06 per share to 2005, was growth of 8.6%, in line with our goal stated at the beginning of the year of high single-digit EPS growth.

That being said, 2006 was a more challenging year than we thought it would be. In quarter four, our EPS of $0.39 was up $0.01 over the prior year, and excluding the $1.9 million of stock-based compensation expense in the quarter, EPS would have been up $0.02 over the prior year. We indicated at the beginning of and throughout 2006 that we expected Direct Marketing revenue to be stronger in the second half of the year than in the first half. It was, and quarter four was the strongest, with revenue growth of 5.4%.

Margins were also strong, up 60 basis points over the prior year to 17.8%. Adjusting for stock-based compensation expense, margin improvement was 100 basis points.

Shoppers had revenue growth of 1.8%, and we saw our margins decline year over year. Dean will give you additional details of our Shoppers performance, but as we have seen all year, increases in paper and postage rates, circulation expansions, operational issues and stock-based compensation all hurt our margins this quarter.

In Shoppers over the past year, we have continued to invest in this business, adding circulation and enhancing and expanding our digital presence. Given the recent revenue performance and the cost issues we have seen in this business, we're cautious about the near-term outlook for this business. But it certainly comes as no surprise that we strongly believe in the strength and durability of this unique and unduplicatable franchise.

In Direct Marketing, we're optimistic that the momentum that we saw building throughout 2006 will continue during 2007. There are many opportunities for us going into 2007, as we are leaders in two very sound businesses.

The employees throughout our organization have responded well to the current realities of our businesses, and they make it happen for our clients and our stakeholders every day. Thanks to everyone, and a special congratulations to Dean Blythe, Kathy Calta and Gary Skidmore, who were promoted to EVPs of Harte-Hanks.

Over to you, Dean.

Thanks, Richard, and good morning. Here is a companywide overview of the fourth quarter and full year 2006. Revenue was up 4.1% for the quarter and 4.4% for the year, with revenue up in both Direct Marketing and Shoppers. Direct Marketing revenue was up 5.4% for the quarter and up 2.2% for the year, while Shopper revenue growth for the quarter was 1.8% and 7.8% for the year.

Operating income was down 1.8% for the quarter and 2.1% for the year. For the quarter, Direct Marketing had operating income growth of 9.4%, while Shoppers was down 15.3%. For the year, Direct Marketing operating income was up 1.3%, and Shoppers was down 5.7%.

These comparisons versus operating income levels in the fourth quarter of 2005 and for full year 2005 were impacted by the inclusion of stock-based compensation in 2006. Excluding that expense from the 2006 numbers, operating income comparisons would be, for the quarter, total company up 1.7%, Direct Marketing up 11.7% and Shoppers down 13.1%; and for the year, total company up 1.8%, Direct Marketing up 4.9% and Shoppers down 3.8%.

For the year, free cash flow was $116.8 million, slightly down from the $117.7 million last year. We ended the year with $33.7 million in capital spending, $5.5 million more than the capital spending of $28.2 million in 2005. For 2007, we expect our capital spending to be in the area of $35 million to $40 million. For 2006, we adjusted our free cash flow definition by adding back tax-affected stock-based compensation expense to make the periods and the comparisons comparable.

Turning to each of our two businesses, we anticipated and communicated that Direct Marketing performance in 2006 would improve as the year progressed. While the improvement started somewhat slower than we thought, performance did improve over the course of the year, and we are optimistic about what this portends for 2007.

For the fourth quarter of 2006, our Direct Marketing revenue was up 5.4% and operating income up 9.4%, with this positive leverage yielding operating income margins up 60 basis points year over year to 17.8%. For the year, operating income margins finished at 15.4%, a slight drop from 2005 margins of 15.6%. These results were impacted by the inclusion of stock-based compensation in the 2006 periods. Excluding stock-based compensation from the 2006 quarter and year, Direct Marketing operating income margins would have been 18.2%, up 100 basis points for the quarter, and 16%, up 40 basis points for the year, respectively.

For our vertical markets in 2006, retail, our largest vertical, represented 27% of Direct Marketing revenue, high-tech/telecom 22%, financial 19%, select 18% and health-care/pharma 14%. International business represented 8.4% and 8.9% of our Direct Marketing revenue for the fourth quarter and year, respectively. Our top 25 Direct Marketing customers represented 41.6% of Direct Marketing revenue for Q4 and 40.1% for the year. Our largest customer in Q4 2006 represented less than 8.5% of our total Direct Marketing revenue and approximately 7.5% for the year.

Turning to Shoppers, our performance for the quarter and the year was disappointing. Shoppers grew revenue by 1.8% in the quarter and 7.8% for the year. Operating income, however, declined 15.3% compared to the prior-year quarter, which is down 13.1% excluding stock option expense, and for the year was down 5.7%, again down 3.8% excluding stock option expense.

Operating income performance in the quarter and year was negatively impacted by several factors -- first, the impact of the inclusion of stock-based compensation in 2006 periods, which had a 40 basis point impact on margins in each of the quarter and the year. The amount of expansion activity and the performance in these expansion areas also negatively impacted profitability, both absolute and in terms of margin performance. Continuing double-digit paper price increases and the January 2006 postage rate increase combined to further erode profitability. These items were exacerbated in the fourth quarter by a slowdown in the revenue growth rate.

For 2006, our effective tax rate was 37.6%, 100 basis points down from our 2005 effective tax rate. For full year 2007, we expect our tax rate to be higher than what it was for the full year 2006, at above 39%.

On the balance sheet at 12/31, we were showing a net debt balance of $166.7 million, which was $205 million of outstanding debt minus $38 million of cash. Book equity at December 31, 2006, was $493.5 million. Net accounts receivable were $189.4 million versus $184.5 million at December 31, 2005. DSO at the end of December 2006 was 56 days, the same as at December 2005.

Looking at our statement of cash flows, net cash provided by operating activities for the quarter was $26.1 million and $146.4 million for the year. We repurchased 2 million shares during the quarter and 7.1 million shares for the year, bringing since January of 1997 50.6 million shares repurchased by spending over $940 million under the repurchase program.

We also announced yesterday that the Board of Directors declared a regular quarterly dividend for the first quarter of 2007 of $0.07 per share, an increase of 17% over the prior dividend level. This is the 12th time the dividend has been up in the past 12 years.

For 2006, we stated that our goal for the year, looking at 2005 and 2006 on a comparable stock-based compensation basis, was to deliver good EPS growth for the full year in the high single-digit or better range. While we did not perform as well in 2006 as we originally expected or as we aspire to, we did achieve our high single-digit targeted EPS growth goal, with 8.6% EPS growth. We are optimistic that the momentum we have seen building in Direct Marketing will continue in 2007. Given the recent Shopper revenue performance, however, we are cautious about the near-term outlook for this business, but strongly believe in the strength and durability of the long-term franchise value of our Shoppers.

Also in 2006, we experienced a relatively low tax rate, and received a large contract termination fee that we discussed in connection with our second-quarter earnings release. While these events helped our 2006 reported numbers, they will also impact the 2006 versus 2007 year-over-year comparisons. Given all of this and how we see our businesses performing in 2007, our 2007 EPS growth rate goal is similar to the high single-digit growth rate we saw in 2006.

With that, operator, we will be happy to answer questions.

(OPERATOR INSTRUCTIONS). Paul Ginocchio, Deutsche Bank.

Good morning. This is David Clark for Paul. First, I guess, if we could get a bit more color on the categories that were the source of the weakness in the Shopper business in the first quarter, I guess in particular I'm wondering the degree to which a decline in real estate advertising hurt you.

Then, second, we have heard some positive things in the past quarter about the L.A. Times/ADVO partnership. I was wondering if there was any impact from that on your business in Southern California.

Let me answer the second question first, and Dean will answer the first one. The competitive environment that we are seeing in Southern California has always been and is a significant one. There has never been a time that there weren't a lot of competition out there fighting for the advertising dollars. We have not seen any material change as a result of the L.A. Times thing that you are referring to, nor other initiatives that are constantly taking place in that market.

But it is a competitive market, and we're having to deal with those realities every day.

In terms of categories, I think real estate is not as -- it was actually still positive in the quarter, not as strong as we have seen it over the past several quarters. Automotive continues to be soft, but that has really been a softness that has been around with us the entire year. Our employment/educational services was not as strong in the quarter as we had seen it prior in the year.

Year over year, was the help wanted/employment what brought you down to just positive 1.8% growth? Or was there some other category? Was it display? What was the source of the weakness in the quarter?

I think I have just described it. I think real estate not being as strong growth -- I mean, we're still up 2%.

Right, got it.

But everything was lower growth.

Deceleration, okay.

Real estate and education, than prior.

Mark Bacurin, Robert W. Baird.

Maybe, Dean, to touch on that a little further, was there any noticeable softness in specific geographies, absent the vertical breakdown, might be looking at different geographies, or was it pretty widespread?

I think there was some variation among the geographies, as there always is. But it was not a single geography, particularly, that created the revenue performance in the quarter.

That is a pretty significant slowdown from where you guys have historically been tracking, in the mid to even upper [low-digit] growth rate. Is there a way for us to look at what the growth would have been on a same-book type basis, stripping out what the expansion revenue impact might have been, and then also maybe looking at it from what the contribution was, if any, so far from your PennySaverUSA.com initiative?

Well, first of all, the revenue growth was reasonably small. So you can certainly assume that when you count the expansion revenue in there, we didn't have much, if any, revenue growth in our base business.

As far as the Web initiative is concerned, there are a lot of good things that are going on. It's still really early. We are beginning to see some revenue, but we're talking about very small numbers.

So we are cautiously optimistic, and we think that we're on the right track. There's nothing that has happened in the past quarter in any of our metrics or in any of our initiatives that point, to us, to a specific problem. It is going according to our plan. I would like to see it all go faster. I think our people would like to see it all go faster. But there is certainly -- the good news is that the opposite side of that is, it's not going slower than we thought.

Richard, as you look at that softness, specifically in the Shoppers business this quarter, would you characterize it more as a function of the economic environment, where it stands today and specific to some of those individual categories? Or is there a competitive issue involved here as well, where maybe more things going online and out of the book? I guess what I'm trying to boil it down to is, how much of this is kind of within your control to help return it to a more normal growth rate, versus things that might be much more macroeconomic driven?

Well, there are some things -- it's very hard to tell whether digital is having any impact on our business. We know it's out there, and we know we're going to be playing in that game.

There are issues related to the economies that we are in. California and Florida both had this disproportionately fast growth during good times, and hit a little bit of a break. So there are some of those environmental things.

There are some performance things. There are some things about our execution that we have talked about that are not going as well as we would like.

So there are a lot of different factors that contribute to it, but it surprised us as well. It was a big change from what we had experienced in the past.

As both Richard and I said in our comments, and we probably said in the press release, this is a great business. It is still a great business, and it has been great for many, many years. We have had some pretty spectacular revenue growth through good times and bad, and we are seeing a little bit of softness now.

But we believe that this is going to (technical difficulty) a short pause. We're going to be able to turn this around. How long this will continue we don't exactly know, and we said we're somewhat cautious about the near-term outlook. But we're still believers in this business.

We don't talk about quarters, but certainly the beginning of the year will be harder than the end of the year, given the relative performance in Shoppers at the beginning of the year, which was quite good, and in fact, even in Direct Marketing, which was surprisingly good in the first quarter, given the difficulties, those difficult comparisons we had. So there's an early-in-the-year issue again, in 2007, not terribly dissimilar that we thought we would have in 2006.

Dean, I thought I heard you say in your 2007 growth expectation for earnings that you were talking about a tax rate that would be north of 39%? Is that correct?

Right.

Then are you also factoring into that EPS growth number some continuing share repurchase activity that would probably bring the share count down further?

Yes. I think we are planning, in looking at that number, some level of share repurchase activity, probably not the level that we saw in 2006. But that could change, depending upon market conditions.

Of that Direct Marketing growth number, can you tell us what it was ex-Aberdeen?

Yes. We also had the divestiture of a business, really within a couple of weeks of when we bought Aberdeen. I think it was in the first quarter, first week or two of October. Really, kind of the revenue that we sold and the revenue that we acquired pretty much offset each other.

So that was a pretty pure organic growth number, then?

Yes.

Alexia Quadrani, Bear Stearns.

I'm sorry to harp on the Shopper business, but I have another [thought] question on the same topic. I guess you said some very optimistic things about the longer-term view of the Shopper business. Is there anything more you can tell us about what you see in that business that clearly isn't evident in the fourth quarter? Is there any sort of ballpark number you can give us, even a wide range, of what we probably should be thinking at for a revenue growth number in 2007 for the Shopper business?

I think your question was, what kind of revenue growth do we expect from that business in 2007?

Yes.

While we haven't given guidance and typically haven't given guidance on revenue growth rates, we talked about this business being a 6% to 8% top-line growth business over time. We obviously did not see that in the fourth quarter, so probably our expectations would be that we may not be within that range, and we certainly wouldn't be in the high end of that range, but we might be below our long-term, which we always said was a long-term growth rate, and hard to measure by any given quarter or any particular year, as a matter of fact.

Has the pricing environment changed pretty significantly, and have you seen any -- is it too early to see any indication at all of whether or not the fourth-quarter trends continued into January?

Well, the pricing environment -- we tend to have price increases in our business, and those didn't take hold as well as they had in prior years. Let me give you the flip side of that, the good news of that. The postage rate increase in 2007 doesn't happen until probably May or June, and the expected postage rate increase for Shoppers will be about half of what we observed in 2006.

So we get a little bit of free time and then we get a lower increase. So we're cautiously optimistic about that benefiting us. We got hit by postage, we got hit by double-digit paper increases, we got hit by a softer environment than we had in the prior years, we got hit by some of our own performance issues. There were a lot of things going on at the same time which contributed to the kind of performance that you saw in the fourth quarter. It is not satisfactory to us, and we are going to change it.

So it sounds like what you're saying is things will be better than in Q4, but maybe not as good as your long-term growth range, if I'm understanding correctly.

Yes, and it will take a little bit of time to get back there, because you don't just turn something that quickly.

On the Direct Marketing business, if you could just let us know what your outlook is by major vertical in 2007, if it changes, if there are any significant changes from what you saw in Q4 by vertical?

Well, I think the verticals were all up in the fourth quarter. We have some pretty decent expectations for our select market business, for our pharmaceutical and health-care business. Clearly, the retail business is as we have said it was over the past, I don't know, I can't remember how many years now we have been talking about it the same way. We are optimistic about the high-tech/telecom business.

The financial business is a little bit more of a struggle for us because, as you know, while we were up a little bit, we haven't cracked that code quite yet. Obviously, being up a little bit is better than not being up, but we can't declare victory there yet.

In your guidance, I just wanted to clarify -- is it your guidance is EPS up in the high single-digit -- is that including the tough comparisons with the change in tax rate and the one-time benefit from the contract termination fee in 2006, or is that excluding them?

Its reported numbers.

Troy Mastin, William Blair & Company.

Can you first just give us a quick perspective on the Direct Marketing growth in the quarter? If you normalize for the lost business that involved the contract termination fees, what would the growth have been in the quarter?

It would have been another 0.5 points to 1 point higher.

Has there been anything that has happened in the recent past, say the last quarter, among your top 25 clients, in the form of a major merger/acquisition on either side -- they were acquired or made an acquisition or gone private?

Those things are always going on, as you know. I can tell you that whatever has happened is reflected in the forecasting that we are doing, whatever we know. Clearly, there are things that could happen tomorrow that we're unaware of. But whatever we know is already reflected.

Then, to go back to the Shoppers business, can you give us some perspective on what specific actions you're taking to try to turn the growth around here? You said some of the issues are internal and self-inflicted. So can you give us some perspective on what you will do or what you have done? I think you said your long-term growth outlook for this business is no different, the 6% to 8%. I just wanted to confirm that I heard that correctly.

What would the longest -- I guess I don't want to pin you down here. But what would you be disappointed by, in terms of how long it would take you to get back to that 6% to 8% range?

Well, first of all, you're correct. Your assumption is correct about our long-term view. We will be disappointed if, by the end of 2007, we don't have our eye back on that kind of growth rate. As far as the actions we are taking, we don't invite analysts to our management meetings, and it's hard to describe some of the things that are going on.

But suffice it to say, many of the people on this phone have a long history with us, and they know that we are a proactive company, and that we're going to deal with the issues head-on that we're facing. We are facing some. Some take longer than others to resolve, but every one of then is getting addressed.

Michael Kupinski, A.G. Edwards.

I was wondering if you can update us on any circulation expansion plans for 2007. Are you going to continue with any expansion in the Shoppers business, particularly in Florida, at this time? Or are you going to pare that back a little bit, given the challenging advertising environment?

Then I was just wondering if you can talk a little bit about what abilities you have to cut costs, and if you can just talk a little bit about the margins in 2007 in the Shoppers business.

Well, first of all, to expansions, we started out with the goal a couple years ago to expand -- I think it was 2 million in circulation. We are probably 80% of the way to achieving our goal, even a little bit more than that. So even without the hurt that we're having with some of our current expansion, we would probably have slowed that down a little bit in 2007.

The hurt that we have -- that is, the expansion revenue not being as strong as we anticipated, not being as strong as the prior expansions that we achieved -- that is also contributing to our desire to go a little bit slower there. We're going to need some more time to reach breakeven in those markets than we originally planned for. These are the ups and downs and the (indiscernible) of this kind of stuff. You know, it got worse, it got better, then it's now getting a little bit worse. We will figure some new things out in some new markets. Having said that, there maybe one or two opportunities for some selected expansion, and there may be one or two opportunities to cut back a little bit to deal with the short-term realities and the longer-term highly strategic value of the expansions that we have made.

What about the margin potential, given the weakness that we're seeing? Do you think that you have the ability to cut costs to maintain margins where they were at 2006, or do you think that we should look for some margin decline? Do you have any thoughts on that?

We're going to be [facing that] in 2007 in the Shopper business. The big expansions that occurred in 2006 occurred kind of Q2 and Q3. So we have still got year-over-year negative expansion impact for the first half of the year, certainly, in the Shopper business. The paper price increases are continuing, and while we are going to get a little reprieve from postage, we are looking at another postage rate increase in [2003].

So some of the same factors that negatively impacted margins for us in 2006 will continue into 2007. But certainly, our goal is to, at the very least, stabilize margins and then hopefully move from there and improve them.

There is always an opportunity to reduce costs.

In terms of Direct Marketing, you indicated that the momentum is pretty strong. Can you talk a little bit about the pricing power? Are you seeing any pricing power, then, develop? Or is this just mostly coming from just additional contracts and things like that?

It's still volume-driven. It's still demand-driven. It's not pricing.

Then can you talk a little bit about your plans on your debt levels, $205 million? You have, obviously, a lot of free cash flow. Are you going to be paring down debt, maintaining debt levels? Or should we just assume that the free cash is going to go to share repurchase activity?

As I said earlier in the call, a lot is going to depend upon market conditions and acquisition activity and this, that and the other. But I would say that between share repurchases, dividends and capital expenditures, we have our free cash flow spoken for in 2007. So I would expect the debt levels to remain. But obviously, that's subject to change.

Brandon Dobell, Credit Suisse.

A couple of questions in the Direct Marketing segment. First, anything in the quarter that was kind of one-time or kind of more project-based, that kind of came out of nowhere? Just trying to get some color on the whole idea of a budget flush for people trying to get some things done.

Then, second, as you look at the Trillium applications or your more technology or software-focused applications, maybe some color around what the customer behavior looks like, sales cycles, what they're looking for, how long the projects are taking. I'm just trying to get a feel for what the activity looks like there.

The one-time stuff -- there are always one-time things, but there was nothing unusual about the fourth quarter, as far as one-time events were concerned.

Actually, we probably saw less rush from the retail sector than we historically have seen.

As far as Trillium Software System is concerned, we had a really good year last year. We have a good pipeline for 2007. We're excited about the prospects, and we're excited about a number of the new products.

The selling cycle is not materially different than it has been, although the bigger deals that we're involved with seemed to be taking forever. But I think that's the nature of bigger deals. But on balance, we're really excited about that business going into 2007.

Lauren Fine, Merrill Lynch.

This is actually Hester for Lauren. Just one question on the Shoppers side, again. You mentioned some operational issues as well. I was wondering if you could talk a little bit more about that, and what might have affected you in the quarter.

I'm taking a step back. I apologize for the silence here. I'm taking a step back to see how I want to position the answer, because it's so hard to talk about specific operational issues. We have a great business, and it has been great for many, many years, and it's going to be great for many years to come.

We didn't have good performance in the fourth quarter. We faced a lot of challenges. We're going through a set of circumstances with a lot of variables that are affecting us now. I talked about the postage increases. I have inferred our inability to pass some of those on as successfully as we have in the past. Talked about the double-digit paper cost increases. Talked about the softness in the marketplace or the environment, and talked also about our execution and not being as crisp as it has been in the past, in a few areas.

But other than making that general comment, I don't really want to get more specific about what we're doing to fine-tune performance. I assure you that it is present in every conversation, that it is topical and action is being taken as we speak. So I really don't think it's appropriate to go into more detail about that.

Do you want to hear that the inserting costs in one of our markets was a little bit higher than it should have been, and we are fixing that? I have 15 of those examples that we're working on. But each one of them is being addressed.

Kevane Wong, JMP Securities.

Looking forward, I'm sort of curious if you can give a little bit of sense on a little bit more of a quarterly flow of business in Shoppers. What I'm trying to look at is you obviously have, if you change the in-line labeling for your addresses -- trying to get a sense on how does that affect some of the revenue flow. You're going to pull out some of the dollar revenues. But you should get some, hopefully, benefit later as you get through some of those near-term issues. I was just trying to get a little bit of a sense on growth expectations through the quarters and also margin expectations, if margins upfront in the first half really get hit but later get improved.

We really don't talk about revenue performance or margin performance on a quarterly basis. It's just very difficult, given that the flow of business, as he talked about, to predict those. I think we have given some general guidance about where we see revenue in 2007 and how we see it progressing, as well as the things that were impacted from a margin perspective.

Maybe a different tack, then, is, can you give us a little bit of sense on the transition to the in-line addressing, how that is going to go, how that process should flow, essentially, in the year?

We're still working on the design that will allow us to deal with the loss of the detached card advertising, and we're confident that a portion of that advertising is transferable into the book. The revenue associated with detached card is under 2% of our total revenue, and we have a range of products that we offer our customers. As one goes away, we move them towards others. That has been our history for a long, long time now. I think maybe a more important thing is that we have tested the manufacturing of the in-line work, and we are satisfied that when we need to push the button, everything is going to go well.

At this time, we're showing no questions. (OPERATOR INSTRUCTIONS).

If there are no more questions, I just want to tell everybody that we appreciate their questions and their time this morning. Thank you.

Thank you.