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The Container Store Group (NYSE:TCS) Q3 2018 Earnings Conference CallFeb. 5, 2019 4:30 p.m. ET
Contents: Prepared Remarks Questions and Answers Call Participants Prepared Remarks:
Operator
Greetings, and welcome to The Container Store's third quarter fiscal-year 2018 earnings call. [Operator instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Farah Soi, investor relations. Thank you.
You may begin.
Farah Soi -- Investor Relations
Thank you, good afternoon, everyone, and thanks for joining us today for The Container Store's third-quarter fiscal-year 2018 earnings results conference call. Speaking today are Melissa Reiff, chief executive officer; and Jodi Taylor, chief financial and administrative officer. After Melissa and Jodi have made their formal remarks, we will open the call to questions. Before we begin, I need to remind you that certain comments made during this call regarding our plans, strategies and goals and our anticipated financial performance may constitute forward-looking statements and are made pursuant to and within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.
Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from such statements. Those important factors are referred to in The Container Store's press release issued today and in our annual report on Form 10-K filed with the SEC on May 31, 2018. The forward-looking statements made today are as of the date of this call, and The Container Store does not undertake any obligation to update their forward-looking statements. Finally, the speakers may refer to certain adjusted or non-GAAP financial measures on this call.
A reconciliation schedule of the non-GAAP financial measures to the most directly comparable GAAP measures is also available in The Container Store's press release issued today. A copy of today's press release may be obtained by visiting the Investor Relations page of the website at www.containerstore.com. I will now turn the call over to Melissa. Melissa?
Melissa Reiff -- Chief Executive Officer
Thank you, Farah, and thanks to all for joining our call. Let's begin by reviewing the drivers of our fiscal Q3 results, and then I'd like to update you on the progress we are continuing to make against our strategic initiatives. Jodi will then review our financial results in more detail and discuss our outlook for the year. For the third quarter, we reported net sales of $221.6 million and a comp store sales decline of 0.8%.
Our comp store sales shortfall was driven entirely by our three holiday departments, which represent a disproportionate amount of our sales in Q3, but only a small portion of our annual sales. These departments underperformed versus our expectations, declining by 15.8% as compared to Q3 last year and cost us three percentage points of comp store performance. Our Elfa third-party sales were down 12.6%, primarily due to foreign currency translation. Adjusted EPS came in at $0.07 compared to $0.11 in Q3 last year.
With the sales from our three holiday partners -- while the sales from our three holiday departments were disappointing, we were very pleased with our continued strong performance in Custom Closets. In fact, Custom Closets contributed 180 basis points to our overall comp sales results, increasing by 4.5% compared to Q3 last year. All other categories, excluding holiday departments and Custom Closets, also comped positive for the quarter, a direct result of our sales revitalization and optimization initiative that encompassed, among other things, merchandising and marketing improvements. We have great optimism as we move forward, continuing to execute our strategic initiative that I'll update you on more in just a moment.
Before I do that though, I wanted to share what we've learned from the performance of our holiday departments in Q3. As we discussed, based on the performance of our holiday categories last year, we implemented a number of changes this year. These included using a reduced holiday product presentation in many stores so that our everyday storage products were less displaced, also incurring lower investment at payroll and visual expense. We also had more stocking stuffer assortment devoted to kids and men as well as more price points at $10 or below.
And third, we had more focus on convenience and value by offering gift packaging, grab-and-go value packs. We believe these changes drove better performance than we would have seen absent them. However, it is clear to us that our customers' interest in our traditional holiday offerings continues to decline, and we will deemphasize our holiday categories going forward. With that said, it is a meaningful portion of sales for us in the third quarter, so we must be prudent and smart in how we tailor this offering and how we allocate our marketing spend going forward.
Our teams are already working on updated plans for holiday 2019 that include less emphasis on traditional holiday products and more focus on Custom Closets and our other product categories, which, again, did perform well throughout our third quarter. With the holidays behind us, I am very pleased with the overall momentum in our business. We started our Annual Elfa Sale on December 19 and are happy with the results so far, especially the sales we are experiencing around our other product categories during this campaign. For Q4, to date fiscal January, which is through January 26, our comp store sales were up 9.4%.
While we are encouraged by the strong start to Q4, we do have a number of high volume weeks ahead of us still. However, given our year-to-date performance, we are updating our outlook accordingly, and Jodi will review that shortly. Let me know just take a moment to review the progress we are making with our strategic initiatives. First, to own Custom Closets.
As I mentioned, we are seeing strong momentum in our Custom Closets business, which gives us confidence in our go-forward plans to drive market share and achieve our goal of closet domination. Our plan is to continue to grow the space allocation in our stores that is devoted to Custom Closets. A key part of this growth is expected to come through a new Custom Closets line and new product introductions where we have an exciting roadmap that we are executing against. In fact, we will be unveiling more about this next month.
Our remodeled Dallas flagship store has also generated valuable earnings, and we are eager to build upon them with a test in two existing stores that we plan to complete this summer. These stores will be far more heavily Custom Closets focused than our typical store, but will also include products dedicated to other space solutions to help our customers accomplish their projects. We have also introduced this as a new strategic initiative that we are executing against to ensure maximum success. We will use what we learned to guide our go-forward plans, both on new store formats as well as the optimal configuration and SKU offering at all existing stores.
All of our consumer insights work consistently points to the opportunity that we have with owning Custom Closets despite having sold the category for over 40 years. Our marketing plans for the coming year will be even more prioritized on this opportunity, especially as we launch our new line and new products and rebrand our Custom Closets offerings. I look very forward to sharing a whole lot more about this on our Q4 earnings call. Our second priority is to deliver on accomplishing projects across all customer touch points.
Starting with marketing, as you know, during the second quarter, we launched our brand-new marketing campaign with the tag line The Container Store, "Where Space Comes From." We continue to use this tag line in all our marketing in Q3 and will do so moving forward as well. Regarding our stores, as I mentioned, our Dallas flagship store redesign is providing us with many insights. We have received favorable customer feedback and continue to be pleased with the performance of this store. We will continue to utilize this store to test and learn as we work to refine our go-forward store strategy and to capitalize on the opportunities such as the opening this summer of the two test stores that will be, again, heavily Custom Closets focused.
Furthermore, we've selected our Dallas Galleria store to test and implement numerous visual merchandising changes to better help our customers accomplish their projects. Early reads of these changes are positive, so we plan to roll out shortly to an additional five stores with a goal of continuing to test and learn along the way to positively impact all stores in the future. Our third priority is to leverage digital and data insights to enable omnichannel growth. With over seven million POP stores now enrolled in our POP program, we are enthusiastic about the growth we continue to see and what we are learning about the shopping behavior and preferences of our pop stars.
We are using this information in our monthly targeted offer campaigns to our pop stars and they are responding favorably. As we test and learn, we will focus heavily on our POP program with differentiated and targeted campaigns to drive incremental sales and gross profit dollars. In addition, our media mix model is our guide on optimizing our paid media spend, and we remain pleased with the increased effectiveness of our campaigns. We've also launched additional tools, both in our stores and on our website, that will make it easier for our customers to accomplish projects and find solutions.
During Q3, we were excited to launch an updated Elfa design tool in our stores. This tool allows our stores to design custom spaces more efficiently and also provides our customers with an improved overall experience, including better visual representations of their custom spaces. This tool also sets the stage for us to add new Custom Closets lines and products with ease. Our plans for fiscal 2019 include developing this tool so that it becomes available online as well.
Fourth, we are focusing on closing the gap on value for the money. During the third quarter, we continued to make pricing and visual changes that were a result of the work we completed around our pricing initiative. As a reminder, our pricing initiative includes adding opening price points in certain product classes, like hangers or storage totes, reducing and increasing prices on products and solutions using deep data analysis, including competitive and consumer insight work, and we've also incorporated the results of these tests into our go-forward plans and our annual guidance. We've also added a few new strategic priorities as well.
These include capitalizing on the significant opportunity we see to further grow our private label product offerings. Our customer insights work showed us that customers believe our TCS branded products to be of the highest quality. We think this represents a sizable opportunity, so we have formalized this initiative with a cross-functional team for swift execution. Under John Gehre's leadership, our EVP of Merchandising and Planning, we have begun with adding some new private label solutions arriving in our stores in several categories, such as our closet department.
We believe we have one of the most trusted brands with significant opportunity to grow our private label program, which we think will yield gross margin improvement over the next few years. We've also added a new initiative under the accomplishing project strategy priority that is focused on refining our brand positioning around helping customers accomplish their projects. This includes a more curated and competitive product assortment with focus on our private label brand structure and clearly differentiated product selections within our assortments that will simplify the customers' shopping experience. And finally, we've added a formal foundational strategic initiative around our second distribution center that we plan to open later in calendar 2019 in Aberdeen, Maryland.
This includes a large cross-functional team dedicated to ensuring that this project is implemented as smoothly as possible. As a reminder, this second distribution center will significantly improve our customer service delivery time for web-generated orders as well as provide meaningful freight savings once fully operational. Before I close, I just want to touch on the tariff situation briefly that I know and we discussed on our last call. Since that time the impending 25% tariff has been deferred and trade talks are ongoing, however, we remain committed to our work to mitigate any potential financial impact of further tariffs to our business.
We feel good about our progress that includes reducing our reliance on third-party sourcing, negotiating with our vendors as well as the benefit of the pricing work we had already begun prior to any trade issues. With all this in mind, we do not see a notable tariff impact to fiscal 2018, and we are working hard to mitigate any future potential financial impact. So in summary, we continue to see so much opportunity ahead for us and look forward to continued and focused execution of our strategic priorities. As I've said, we were obviously disappointed with our third-quarter results and know that the underperformance is isolated to our three holiday departments, while our Custom Closets business and all other product categories performed well in Q3 and are performing well so far in fiscal Q4.
As said before, we are already working on plans to improve over positioning for the holiday quarter next year, but we believe that our -- overall, our biggest opportunities lie with our Custom Closets business as we help our customers accomplish their projects, maximize their space and make the most of their home. So this is where we will focus our marketing dollars as well as our merchandising innovation and space allocation in our stores. We are working hard to ending this year with a strong finish and building on our progress into next fiscal year. And finally, before I turn over to Jodi, you may have heard that Kip Tindell, our Chairman; and Sharon Tindell, our President and Chief Merchandising Officer, will be retiring after our annual meeting in August.
They have both put their heart and soul into building this company into what it is today, and we will be forever grateful for their many contributions, including the time and thought they put into succession planning. And I am delighted to announce that John Gehre, who joined the company last year as EVP of Merchandising and Planning, will become our Chief Merchandising Officer upon Sharon's retirement. In a short time with us, just about eight months, John has already added tremendous value. So thank you, and I'll now turn the call over to Jodi to discuss our financial results and our outlook in more detail.
Jodi Taylor -- Chief Financial and Administrative Officer
Thank you, Melissa, and good afternoon, everyone. For the third quarter ending December 29, 2018, our consolidated net sales were $221.6 million, down 0.6% compared to the prior-year period. Sales for The Container Store retail business were up 0.5% to $204.9 million. An increase in new store sales was partly offset by a 0.8% comp store sales decline.
As Melissa shared, our Custom Closets continued to deliver very strong performance but did not fully offset the shortfall in our three holiday departments. Custom Closets contributed 1.8% of comp store sales growth in the third quarter and our non-holiday other product categories contributed positively as well. We ended the third quarter with 92 stores and approximately 2.2 million of gross square footage as compared to 90 stores and the same gross square footage at the end of the third quarter of fiscal 2017. Now turning to Elfa International AB.
Elfa's third-party net sales decreased 12.6% to $16.7 million, primarily due to the negative impact of foreign currency translation during the quarter, which decreased third-party net sales by 7.4%, as well as lower sales in the Nordic and Russian markets. From a profitability perspective, in the third quarter, consolidated gross profit dollars declined 0.4% to $130.1 million, and consolidated gross margin increased 10 basis points compared to the prior-year period. Gross margin at The Container Store retail business was up 30 basis points, driven primarily by lower cost of goods associated with our Optimization Plan, partially offset by higher promotional activities and a negative impact from FX. Elfa's gross margin decreased 390 basis points from the prior-year period, primarily due to higher direct material costs attributable to a shift in product mix and a weaker Swedish krona.
Moving on to SG&A. As a percentage of net sales, SG&A increased 240 basis points during the quarter, primarily due to the leverage of occupancy and payroll costs associated with negative comparable store sales, as well as increased marketing expense in the third-quarter fiscal 2018. The increased marketing expense is associated with a shift in the timing of recognition of campaign-related marketing costs from the fourth fiscal quarter to the third fiscal quarter due to accounting changes as we discussed on our second quarter call. New store pre-opening expenses decreased this quarter to approximately $700,000 from $1.9 million in the third quarter last year.
The decrease year-over-year is primarily driven by fewer store openings this year, as our real estate activity in the current period focused on two relocations compared to three store openings, which included one relocation in the prior-year period. Our net interest expense in the third quarter of fiscal 2018 decreased 17.7% to $6 million from $7.3 million in the prior-year period, due to the September 2018 amendment of our senior secured term loan facility. The effective tax rate for the quarter was negative 72.8% compared to negative 330.1% in the third quarter of last year. The change in the effective tax rate is primarily due to the impact of the Tax Cuts and Jobs Act enacted in fiscal 2017 in both periods.
In the third quarter of fiscal 2018, we recorded a $5.9 million tax benefit as a result of the finalization of the one-time transition tax on foreign earnings. In the third quarter of fiscal 2017, we recorded an estimate of the impact of the lower federal income tax rate on our deferred tax balances, which resulted in an approximately $24.3 million tax benefit during the third quarter of fiscal 2017. On an adjusted basis, our effective tax rate for Q4 -- Q3 was 29.3% compared to 30.9% in the third quarter last year. Our net income for the quarter was $9.3 million or $0.19 per share as compared to $28.4 million or $0.59 per share in the third quarter of last year.
On an adjusted basis, excluding a gain on disposal of real estate at Elfa this year, cost related to an Elfa manufacturing facility closure and the Optimization Plan last year, and certain one-time tax-related items in both periods, our adjusted net income was $3.5 million or $0.07 per share as compared to $5.1 million or $0.11 per share in the third quarter of last year. Adjusted EBITDA was $21.8 million in the third quarter this year compared to $25.6 million in Q3 last year. Turning to our balance sheet. We ended the quarter with $21 million in cash, $304.9 million in outstanding borrowings and combined availability on revolving credit facilities and cash on hand of approximately $90.1 million.
Our total debt position was down approximately $9.2 million from last year. We ended the quarter with consolidated inventory up 5.1%, primarily due to new stores and new product introductions. On a per-store basis, inventory levels at The Container Store were up 0.6%. Regarding our fiscal 2018 outlook, as Melissa mentioned, given our year-to-date performance, we now expect adjusted earnings per share at the low end or slightly below our prior guidance range, the comparable store sales at the higher end of our guidance.
We have revised our GAAP earnings per share to incorporate the finalization of the one-time transition tax on foreign earnings during third quarter. Also, given foreign currency moves, we now expect our consolidated sales to be toward the lower end of our prior guidance. Please refer to our press release for further details on our fiscal 2018 annual outlook. Specific to our fourth quarter, there are a few call-outs.
One, our fourth quarter comp sales through January 26 are up 9.4%, as Melissa said. While it is not our practice to discuss intraquarter comp sales performance, given the dramatic improvement in the underlying trend of the business since exiting holiday, we felt it important to share this information. Two, we still expect meaningful operating margin expansion in Q4, largely due to pricing initiative-driven gross margin improvement, that are expected to be partially offset by higher penetration of targeted offers that are resonated more with our customers. And three, we still expect some SG&A leverage in Q4, largely driven by accounting changes that shifted a large portion of our Annual Elfa Sale marketing expense out of Q4 and into Q3.
In summary, while our holiday performance is not what we expected, this performance was isolated to the seasonal categories, while the rest of our assortments drove positive comps store sales results led by Custom Closets. We've had a strong start to the fourth quarter and have large selling weeks ahead of us. We are focused on delivering against our goals and ending the year on a strong note. Thank you.
And now I'd like to turn the call back over to the operator so that we can open the lines for questions. Sherry?
Questions and Answers:
Operator
Thank you. [Operator instructions] Our first question is from Steve Forbes with Guggenheim Securities. Please proceed with your question.
Steve Forbes -- Guggenheim Securities -- Analyst
Good afternoon. So maybe regarding the fourth quarter comp to date, right. So can you help us understand the significance of Custom Closets in the fourth quarter, maybe not just for the January, February, or the fourth quarter as a whole? And then how is Custom Closets performing quarter to date, so you take that 9.4%? What is Custom Closets doing? And how is the nonholiday category doing quarter to date?
Jodi Taylor -- Chief Financial and Administrative Officer
Hi, Steve, as it relates to Q4 and Custom Closets, we do over index Custom Closets to the quarter just because of the Annual Elfa Sale. So Custom Closets represent a greater portion of our total sales in Q4 than they do in other quarters. As it relates to the interim comp that we reported for fiscal January, that comp is relatively between Custom Closets and other product categories. So we have seen acceleration throughout the store, affecting both of those areas of the business.
Steve Forbes -- Guggenheim Securities -- Analyst
Perfect. And just a quick follow-up. You mentioned the new DC in Maryland. So maybe can you talk about the model implications, right, as we think about next year and the potential margin drag after it goes live and the timing right for it, maybe, the savings capture?
Jodi Taylor -- Chief Financial and Administrative Officer
Sure. I'll start and Melissa, if you want to chime in with anything else. First, from a CAPEX perspective. The CAPEX is split relatively evenly between fiscal '18 and fiscal '19 with about $11 million to $12 million hitting in each of those fiscal years.
As it relates to SG&A, we do expect headwinds in fiscal '19 as we will incur the cost to get the facility set up with it not becoming operational till later in calendar 2019, and with the related freight savings being incurred, only for a limited period of time really in Q4 of next year. So we expect that to be a headwind to our expenses as it relates to fiscal '19. We're not talking hundreds of basis points, but could be talking somewhere in the 50-ish basis-point range, Steve. But as it relates then to fiscal 2020, we would expect to see a very significant tailwind as it relates to freight savings that we will capture or expect to capture associated with both direct shipments to customers as well as the freight, inbound and outbound from the facility.
Melissa Reiff -- Chief Executive Officer
So, so much better service to our customers once we get the DC -- second DC opened.
Steve Forbes -- Guggenheim Securities -- Analyst
And a real quick last one. Just any color on free cash flow guidance for the full year?
Jodi Taylor -- Chief Financial and Administrative Officer
We do still expect to see positive free cash flow for the business and also to see our debt come down year-over-year. So nothing different than what -- how we thought about the year at the beginning in terms of positive free cash flow as well as debt payment.
Steve Forbes -- Guggenheim Securities -- Analyst
Thank you, both.
Melissa Reiff -- Chief Executive Officer
Thanks, Steve.
Jodi Taylor -- Chief Financial and Administrative Officer
Thank you.
Operator
[Operator instructions] Our next question is from Matt McClintock with Barclays. Please proceed with your question.
Cait Howard -- Barclays -- Analyst
Good afternoon. This is Cait Howard on for Matt. I have two questions related to the fourth quarter. First, with relation to the portion of other categories seeing significant comp growth throughout January.
Can you parse out how much of this, you think, could be related to the recent success of Tidying Up? And if so, what things, if any, have you done to take advantage of the recent heightened interest in decluttering an organization to maybe sustain that growth. By our tracker, it seems like you've been very active in the social channel, whether it would be through digital advertising or through social engagement with customers. So any color on that would be really helpful.
Melissa Reiff -- Chief Executive Officer
Yes, Cait, and you're absolutely correct. We have been very active on all social medias and leveraging this. It's just been wonderful to hear our customers talk about it when they're in-store or whether they call or whether they're online. And we certainly know that this Netflix show that Marie Kondo has done has certainly inspired, we hope all consumers to get organized, which is great.
And we're going to leverage that all we can. We're certainly not going to count on it, but we're going to leverage it and we're very, very, very excited about it. Because we have seen an increase in mentions associated with The Container Store, the volume has increased, which is fantastic, but we also know that we can't contribute all of Q4's success to that, because we have revitalized a number of actions across really all functions of the business that we've been working on for many, many, many months. And one of the things, there are several things, but one, we had some wonderful new product introductions in January.
We also were in a much better inventory level this year as compared to last year. We've made many visual and marketing changes, which I talked about in my remarks. I think our pricing initiative is having an impact. We've had online enhancements, which we think have an impact.
Some tech innovation with our updated design tool and then, again, the company is just moving -- our momentum is strong and we're doing so many tests and learns and reacting quickly to what we're learning. So I told Jodi, it's kind of like the perfect storm. I mean, we just love Marie Kondo and we love the KonMari method because it just fits with -- right with our organization and what we're all about. And so when our customers come in our stores or online or call us, we can help them again accomplish all of their projects throughout their entire home and really maximize their space.
Cait Howard -- Barclays -- Analyst
Great. Thank you. That's super helpful. And then just second one in terms of the fourth quarter, on promotional events, are you still planning on running the kitchen sale campaign in March as you have in the past? And more specifically, I think you changed your strategy last year, and just wondering if you're going to move forward this year on the same strategy of doing the more targeted percent off select products versus the blanket percent off the entire kitchen?
Melissa Reiff -- Chief Executive Officer
Yes, the answer is yes, Cait.
Jodi Taylor -- Chief Financial and Administrative Officer
Timing and discount.
Cait Howard -- Barclays -- Analyst
Great. Thank you so much.
Melissa Reiff -- Chief Executive Officer
Great.
Jodi Taylor -- Chief Financial and Administrative Officer
Thank you.
Operator
We have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing remarks.
Melissa Reiff -- Chief Executive Officer
Thank you, Sherry, and thank you all very much for joining us. Thanks, Farah, we appreciate it, and we will look forward to definitely talking with you at the end of our full fiscal year. Thanks so much.
Operator
[Operator signoff]
Duration: 31 minutes
Call Participants:
Farah Soi -- Investor Relations
Melissa Reiff -- Chief Executive Officer
Jodi Taylor -- Chief Financial and Administrative Officer
Steve Forbes -- Guggenheim Securities -- Analyst
Cait Howard -- Barclays -- Analyst
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