The Lovesac Company (LOVE) Q2 2020 Earnings Report, Transcript and Summary

Greetings. Welcome to Lovesac Second Quarter Fiscal 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note, this conference is being recorded. I will now turn the conference over to Rachel Schacter of ICR. Thank you. You may begin.

Thank you. Good morning, everyone. With me on the call is Shawn Nelson, Chief Executive Officer; Jack Krause, President and Chief Operating Officer; and Donna Dellomo, Chief Financial Officer. Before we get started, I would like to remind you that some of the information discussed will include forward-looking statements regarding future events and our future financial performance. These include statements about our future expectations, financial projections and our plans and prospects. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, you should review the Company’s filing with the SEC, which includes today’s press release. You should not rely on our forward-looking statements as predictions of future events. All forward-looking statements that we make on this call are based on assumptions and beliefs as of today and we undertake no obligation to update them except as required by applicable law. Our discussion today will include non-GAAP financial measures including EBITDA and adjusted EBITDA. These non-GAAP measures should be considered in addition to and not as a substitute for, or in isolation from our GAAP results. A reconciliation of the most directly comparable GAAP financial measures to such non-GAAP financial measures has been provided as supplemental financial information in our press release. Now, I’d like to turn the call over to Shawn Nelson, Chief Executive Officer of The Lovesac Company.

Thanks, Rachel. Good morning, everybody, and thanks for joining us today. I will begin today’s call by discussing the financial and operational highlights of our second quarter results, after which I’ll briefly review our high level thoughts around our outlook and provide an update on our tariff mitigation efforts. Then, Jack Krause, our President and COO, will outline the progress we are making on our key growth initiatives, including details on an exciting new shop in shop program that is launching in Q3. Finally, Donna Dellomo, our CFO, will review our financial results and a few items related to our outlook in more detail. We feel great about our second quarter financial results. Net sales increased by almost 45% to $48.1 million. Total comparable sales, which include same showroom and internet sales, increased 40.7%, driven by strong showroom comp increase of 31.8% and significant growth in our internet business of 71.5%. In Q2, we again saw our comp growth driven by both transactions as well as ticket growth as our digital marketing strategies and multi-channel model allow us to draw new customers to the brands, while also driving repeat purchase behavior. Adjusted EBITDA was a loss of $3.3 million for the second quarter. Operationally, we made good progress against our strategic priorities in the second quarter. A few highlights are: One, we continue to lean into marketing, including a successful Memorial Day campaign to increase brand awareness and drive sales, which is reflected in our almost 45% topline growth for the quarter; two, we made strategic investments in our infrastructure to improve the overall customer shopping experience and position us for continued success as we scale the business including expanded capacity and increased accuracy of customer delivery; three, we opened two new and remodeled three showrooms during the quarter as we continue to increase our showroom presence; four, we enjoyed strong results from our pop-up shop business with Costco and given our continued success during the quarter, we were given the opportunity to run an 18-day event on costco.com, which emulates the in-store pop up shop partnership online. We had very encouraging results from this initial online events and have plans for another two online roadshows with Costco for later this year. In addition to our pop up shop business with Costco, we continue to foster new relationships with other retailers, and we are very excited to announce today our new partnership with Macy’s to pilot four permanent shop in shop test locations. Not only will it increase our brand awareness and drive customer acquisition, but it is also a testament to the existing strength and appeal of our small but rapidly growing brand and innovative product line. Jack will discuss our second quarter operational progress and expand on the details of this exciting new partnership in just a moment. As it relates to our outlook, given our strong Q2 financial performance, our marketing, and other plans for the remainder of the year, we are reiterating today our fiscal 2020 annual revenue guidance of 40% to 45% sales growth. We are also reiterating our expectations for positive adjusted EBITDA for fiscal 2020. We are very pleased to be in a position to reiterate our full-year adjusted EBITDA outlook, despite increased tariffs, which is a testament to the tremendous progress we have made with tariff mitigation actions, which I will now discuss. To start, I could not be more proud of our teams for their efforts and dedication to mitigating the impact of these special tariffs and optimizing our supply chain. Our focus on optimizing our supply chain is threefold. Number one, swiftly relocating manufacturing out of China; two, negotiating aggressive vendor discounts; and three, assortment, promotional shifts, and surgical price adjustments that have shown zero negative impact on sales to date. First, in terms of relocating manufacturing outside of China, we have already successfully moved the majority of our Sactionals manufacturing to Vietnam and also Malaysia for redundancy. Sactionals without covers currently represents approximately 57% of our overall sales based on costs. The remaining portion of our Sactional production will have moved entirely out of China by the end of Q2 next year. A long-term Chinese manufacturing partner of ours is currently in construction on a new purpose-built, highly automated Sactionals factory located in Vietnam to support our continued rapid growth along with co-located cut and sew facilities for both Sac and Sactionals covers. Based on our success thus far, we are confident that we will make progress this year toward resourcing the balance of our Sac and Sactionals covers at a similarly rapid pace and expect to have only a small percentage of our covers manufacturing in China by the end of Q2 next year. These expeditious production moves will eliminate our exposure to special tariffs and also result in lower first costs for these goods, even versus their pre-tariff levels, which you will see starting to flow through our P&L with the turnover of the associated inventories throughout next year. Second, regarding vendor discounts, the minority piece of our Sactionals manufacturing that remains in China today has been discounted by our manufacturer, to a cost that offsets most of the effect of the recently announced tariffs increase from 25% to 30%. Our cut-and-sewn covers for Sac and Sactionals and various accessories like throw pillows and blankets still manufactured in China are all subject to List 1 through 4 tariffs. And we have recently achieved aggressive vendor discounts on all of these items as well to carry us through the near term as we transition nearly everything out of China. We are particularly grateful to our vendors for their support in this area. They have been collaborative partners, and most of them are moving their operations with us out of China to various other countries in the region to retain our business, save on costs, and diversify our overall supply chain risk. As a result of this work, we are pleased to share that as of this month, only 44% of our total goods are now manufactured in China, down from approximately 75% at the end of last year. And we expect this number to continue to fall by year-end by a few more points, heading toward zero before the end of next fiscal year if tariffs are not listed. It is because of all this swift execution and sourcing coupled with surgical assortment and pricing adjustments and disciplined expense management that we expect to deliver positive adjusted EBITDA, even with all of the recent tariff elevations and additions and our growth. Essentially, by the second half of next year, we project that the majority of our products will be coming in at lower costs than they were a year ago, and our supply chain will be far more robust and diverse. This year, we expect gross margins to decline temporarily by 320 to 350 basis points for the full year versus last year. But, with our newly well-diversified supply chain and the lower corresponding ongoing product costs, we expect to return our run rate gross margins percent to the mid-50% range by the second half of next year. Because of our exhibited pricing power, strong value proposition, collaborative manufacturing partners and relentless innovation machine, we are confident that we can maintain these best-in-class gross margins over the long term. Finally, speaking of innovation, we are excited by the launch of the new Sactionals Power Hub this month. It is our first foray into electronics and it opens the door into numerous new technology innovation opportunities ahead for this brand. The concept is patented, and we believe it will not only drive repeat business, increased basket size and our average order value, but more importantly, because it’s reverse compatible with all the Sactionals pieces we’ve ever sold, it reinforces our unique commitment to our Designed for Life ethos in the eyes of our loyal customers. Sactionals are a platform that is designed to grow and evolve and allow customers to add to it or upgrade it throughout their own lifetime, even in ways they could not have imagined when they originally bought the product. Every Sactionals piece that we have ever sold over these many years already has the receiver hole already embedded in it just waiting for this Power Hub, and maybe other inventions as well, yet to come. We believe that over the long term, this will result in customer satisfaction and brand loyalty levels that will be unprecedented in the competitive landscape. Not to mention, the platform’s unique implications in terms of sustainability and reduced waste and landfills. So, in summary, I’m very pleased with our financial and operational progress throughout the quarter. As we look to the second half of this year, we will continue to focus on executing against our strategic initiatives and leveraging our distinct competitive advantages to realize the significant growth potential that exists for Lovesac. Before I turn the call over to Jack, I want to again thank all of our team members for the great job that they do day-in and day-out. Their hard work is driving a rapid growth, and we look forward to building on this performance as we move into the second half of the year. From our standpoint, it’s simple. As I hope we’ve demonstrated across the four quarters we reported since becoming a public Company. We’re going to keep delivering high sales growth while maintaining positive adjusted EBITDA on an annual basis. External challenges notwithstanding, we are very confident in our ability to deliver on our near and long-term goals and look forward to updating you on our progress. I will now turn the call over to Jack, our President and COO, to go over our key priorities for the remainder of this year.

Thank you, Shawn, and good morning, everyone. As Shawn said, we’re pleased with our second quarter results. We delivered strong financial performance and continued to execute against our key growth initiatives. I’ll now review some of the operational highlights and discuss our plans for the remainder of the year. Starting with expanding our marketing efforts to increase brand awareness and drive sales. Our second quarter top line results are a testament to the continued effectiveness of our marketing strategies. For the quarter, we achieved overall comparable sales growth of 40.7%, driven by web comps of 71.5% and showrooms at 31.8%. Overall, Memorial Day marketing ROI finished very strong, as indicated by our sales performance. The Memorial Day pre-tentpole TV campaign test market saw a strong lift in weekly sales averages versus their pre-twelve-week sales average, increasing both sales and program ROIs. Given these encouraging results, we scaled the test to 11 markets for Labor Day, and subject to continued positive results, we will look to scale this nationally in the fourth quarter of this year. In terms of digital media advertising, the six-week Pinterest test Campaign during Memorial Day proved to be an efficient driver of brand awareness and site traffic with over 360,000 clicks to the site at a very favorable CPC or cost per click. We also saw great engagement within the platform with almost 30-time increase in monthly viewers and an over 30x increase in monthly engagers. Overall, we’ll continue to test increased digital marketing in the second half, as we continue to see increased ROIs as a result of the synergy with TV advertising. We will look at new efficient marketing strategies to drive the business as we look towards the fourth quarter. Importantly, many of the in marketing initiatives we have successfully tested so far this year to drive sales will be leveraged the most heavily in the fourth quarter. Next, expanding and improving our showroom presence. We opened two new showrooms and remodeled three in the quarter ending the quarter with a total of 80 showrooms and approximately 70 of our locations having been remodeled to the current rebranded showroom design. We remain on track to open 17 new showrooms in fiscal 2020 including showrooms in 12 new markets, and improving our penetration in 5 markets. Turning to our pop up shops. In the second quarter of fiscal 2020, we operated 209 pop up shops with Costco, up from 137 in the second quarter last year, which drove a 40.9% increase in our other channel sales to $7.4 million. Pop up productivity increased 5.1% in the quarter. As discussed on previous calls, pop up shops have been a contributor to our growth over the past 24 months. Last year, our 10-day road shows with Costco delivered $1 per square foot productivity, multiples higher than even our own showrooms, driving over $19 million in net sales, which was over a 300% year-over-year growth. In addition, we believe these pop up shops drive additional revenue on our website, both during and post show. We continue to believe that the pop up shop format allows us to capitalize on customer acquisition opportunities in high traffic locations by showcasing a limited offering of our products in the areas where we don’t necessarily have a showroom presence, introducing our brand and unique product attributes to a wider market. Due to the success of our road shows, we worked with Costco to bring an 18-day event to costco.com, providing Lovesac with nationwide coverage. This event ran in July, and the results were very encouraging. The dotcom event generated nearly $750,000 in sales in 18 days. And due to the success, we’ve scheduled additional two events for the balance of the year. We’ve also been exploring more permanent shop in shop opportunities to deploy a similar concept with other retailers and are very pleased to announce that we have officially entered into a partnership with Macy’s to pilot a test of shop in shop in four highly attractive Macy’s locations in Q3 of this year. The locations include their Herald Square flagship store in New York City, as well Carle Place Furniture Gallery in Long Island, Del Amo fashion center in LA County, and Lenox Square in the Buckhead District of Atlanta. Macy’s is a logical choice for us as they have demonstrated the ability to be a leader in bringing innovation to the retail furniture space. We have had tremendous success with pop up shops outside of our own channels and look forward to establishing additional reach for the Lovesac brand with Macy’s as we expand the Lovesac shop in shop presence in an agile and efficient manner. Unlike the Costco road shows, which are 10-day shows and pop up locations, the Macy’s test will be launching permanent asset light shop in shops in key Macy’s locations. We know that experiencing the Sactionals demo is extremely important to many customers’ shopping journeys, and through this partnership, we will be able to deliver more demos to a broader audience and accelerate adoption of the Sactionals platform. We believe the Macy’s brand and customer profile is a great fit with the Lovesac brand and look forward to kicking this pilot off in Q3, with the majority of the sales impact expected in Q4. These shop in shops will be designed to be permanent locations carrying the same digital technology of our showrooms and will be staffed by Lovesac employees under the direct supervision of our sales operation team. Because these will be run like our own showrooms, we expect margin rates and contribution to be similar to our freestanding showrooms, but with significantly less CapEx investment, less than a third of our current CapEx per show room. The current plan is to test these four initial locations for at least the full year prior to expansion. And we will continue to update you on test details, performance and potential expansion plans as that information becomes available. Finally, as part of our continued investment in our team in support of our substantial future growth, we’re very excited to announce the appointment of Tom Lee as our Chief Supply Chain Officer, effective September 9th. Tom is a seasoned supply chain and merchandising executive, and most recently served as SVP, Chief Supply Chain Officer SpartanNash. And prior to that, he spent years at Walmart and Office Depot in both senior supply chain and merchandising roles. We’re very excited to have him on board and look forward to benefiting from his expertise as we continue to develop a world-class supply chain that delivers an unparalleled customer experience. This important addition positions the business well for continued success. So, in summary, we’re pleased with our second quarter results and the operational progress made on our strategic priorities, including all of the tariff mitigation work that Shawn went over. As we look to the remainder of the year, we’ll continue to focus on growing the business and strategically investing in our infrastructure and technology to position the business for long-term growth. Donna will discuss our guidance in further detail. But, as we look ahead, we continue to be confident in the drivers of our business, of which, we will see the greatest impact in Q4, including the new business opportunities I just discussed with Costco and Macy’s, the marketing plans with the proven highest effectiveness, and year-over-year spend increases in Q4 as well as increased showroom opening along with the launch of the Power Hub that Sean discussed. And with that, for a more detailed review of our second quarter results, as well as a few items related to our outlook, I will now turn the call over to Donna Dellomo, our Chief Financial Officer.

Thank you, Jack. Good morning, everyone. I will begin my remarks with the review of our second quarter results and then provide some commentary around our thoughts for fiscal 2020. Total net sales increased 44.8% to $48.1 million from $33.2 million in the prior year quarter. This sales growth was driven by strong showroom, internet and pop up shop performance with both transaction as well as ticket growth resulting from successful advertising and marketing strategies, which drew new customers to the brand while also driving repeat purchase behavior. An increase in the number of showrooms also helped fuel our Q2 sales performance. Comparable sales, which include showroom and internet sales, increased 40.7%. Comparable showroom sales increased 31.8% and represent our 11th consecutive quarter of positive comp showroom sales increases. We opened two new showrooms and ended the quarter with 80 showrooms. Looking at our results by channel for the second quarter. Showroom sales increased 35.8% to $31.3 million, internet sales increased 71.5% to $9.5 million, and our other channel, which includes our pop up shops in Costco locations, increased 57.7% to $7.4 million. By product category, our Sactionals sales increased 51.5%, our Sac sales increased 35%, and our other category sales, which include decorative pillows, blankets and other accessories, decreased to $200,000 from $800,000 in the second quarter as compared to the prior year quarter. Gross profit dollars increased 36.1% to $24.3 million in the second quarter. As expected, gross margin percentage decreased by 320 basis points to 50.4% from 53.6% reported in the same period last year. This year-over-year decline was primarily driven by the 10% tariff impact, partially offset by reduced costs of our Sactionals and Sac products, primarily related to cost savings from a change in the sourcing of our Lovesoft and down blend fills and an ongoing shift of our manufacturing to Vietnam and other countries outside of China. For the second quarter, total SG&A, excluding advertising and marketing expense, increased 7.3% to $22 million from $20.5 million in the second quarter of last year. Excluding approximately $300,000 of other nonrecurring expenses, total SG&A increased to $21.7 million. The increase in SG&A was driven largely by variable expenses related to the increase in sales, as well as higher employment costs and rent, which were partially offset by a decrease in overhead expenses and equity compensation, as detailed in our press release. As a percentage of sales, total SG&A expense decreased by 15.9%, driven largely by decreases in stock compensation and IPO-related expenses as described above. Our investments in advertising and marketing which benefit extended periods, increased $2.5 million or 68.8% over Q2 prior year. As a percentage of sales, advertising and marketing expenses increased 180 basis points to 12.6% this quarter, largely due to an increase in advertising related to Memorial Day, which had a very positive ROI. Depreciation and amortization increased $447,000 from the prior year period to $1.2 million, principally related to capital investments for new and remodeled showrooms. In the second quarter of fiscal 2020, operating loss was $4.9 million compared to an operating loss of $7 million in the second quarter of last year. In the second quarter of fiscal 2020, adjusted operating loss was $4.6 million, excluding approximately $300,000 of nonrecurring expenses. In the second quarter of fiscal 2019, adjusted operating loss was $5.7 million, excluding approximately $1.3 million of non-recurring expenses. Net interest income was 169,000, which relates to the impact of our IPO and other primary share financing. Tax expense in the second quarter of fiscal 2020 and 2019 was less than $10,000 and is related to minimum state income tax liabilities. Before we turn our attention to net income, net income per share and EBITDA, I would like to point out that my discussion of these metrics will focus on net income and net income per share adjusted for the IPO and other financing costs, as well as adjusted EBITDA. Please refer to the terminology and reconciliation between each of our adjusted metrics and their most directly comparable GAAP measurements in our earnings release issued earlier today. Adjusted net loss was $4.5 million in the second quarter of fiscal 2020, compared to an adjusted net loss of $5.7 million in the second quarter of fiscal 2019. Net loss per share adjusted for the IPO and financing costs was $0.31 in the second quarter of fiscal 2020 and $0.63 in the second quarter of fiscal 2019. Adjusted EBITDA was a loss of $3.3 million, as compared to a loss of $2 million in the second quarter of last year. Turning to our balance sheet. We ended the quarter with $44.2 million in cash and cash equivalents. Ending inventory increased 101% year-over-year, driven by higher sales, as well as an increased investment in the weeks of supply of inventory on hand to support sales growth across all channels to be agile enough to support the success of our advertising and marketing investments, and includes an increase in capitalized freight and warehousing costs relative to the build of inventory and tariff charges. Now, I would like to discuss a few items as it relates to our fiscal 2020 outlook. From a showroom perspective, for the full fiscal year 2020, we are on track to open 17 new showrooms this year with 11 showroom openings in the second half of fiscal 2020 and continue to expect to remodel 8. We are now referring to our Costco road shows as pop up shops and our Macy’s pilot as shop in shops, given the nature of the shop setup. As mentioned for fiscal 2020, we will operate three Costco online road shows in addition to our in-store pop up shops with Costco, as well as four pilot shop in shop up with Macy’s. We continue to expect to deliver strong levels of sales growth between 40% to 45% in full fiscal 2020. However, we do expect Q3 revenue to be below the low end of our annual growth target with growth of approximately 30%, whilst Q4 is expected to be significantly above the high end of this annual range. This expected cadence is due to the following items. We expect to see a deceleration in total comp sales in Q3 with Q3 comps expected to be slightly ahead of Q3 total sales growth with a significant increase in total comp sales in Q4. However, important to point out that Q3 total comps on a two-year basis are projected to be in line with Q2 of fiscal 2020. Normal seasonality of the business with Q4 being our largest volume quarter, the cadence of planned investments in marketing and advertising with investments in working media strategically being made late in Q3, which have greater ROIs and greater impact on Q4 sales growth. In addition, total showroom revenue will be impacted by the timing and the number of new showroom openings during Q3 and Q4, which this fiscal is weighted more heavily in Q4 than Q3. The number of Costco pop up shops continued to increase over prior year with the most significant increase in the number of pop up shops happening in the first half of fiscal 2020 as compared to prior year. Second half 2020 Costco pop of shops are projected to be as revenue productive as those in the first half of fiscal 2020. The new initiatives that Jack mentioned to include costco.com road shows and the four new Macy's pilot shop in shops will have the greatest amount of fiscal 2020 impact on Q4 revenues. Consistent with the just discussed expected sales growth cadence, we expect a larger Q3 adjusted EBITDA loss than we reported in Q2, followed by a substantial improvement in Q4. Given the significant tariff mitigation process we've made, as Shawn discussed, we continue to expect to generate positive adjusted EBITDA for fiscal 2020. We expect full-year gross margins for fiscal 2020 to be approximately 320 to 350 basis points lower than fiscal 2019, principally related to the following: Expected tariff pressure, which is being offset by mitigation actions and SG&A initiatives; investments into our distribution infrastructure to support future growth; a slight headwind due to the continued shift in product mix towards Sactionals, as well as a slight impacts from prior pop up shop channel mix sales. These decreases are partially offset by product margin gains relating to changes in discounting and promotional strategies, reduced product costs related to vendor sourcing strategy, and vendor rebates, as well as an accelerated shift of sourcing outside China. In terms of SG&A, excluding advertising and marketing expense, as previously mentioned, we expect the most significant SG&A leverage to be generated in Q4, given the seasonality of our business. As a reminder, embedded in our SG&A outlook is all of the investments we are making in the business across people, process and infrastructure, and our Q4 net sales volumes enable us to produce the greatest amount of leverage on these investments over the prior year. So, in summary, while we continue to expect quarterly fluctuations due to the timing of our tariff mitigation efforts, our advertising and marketing investments and investments across all areas of the business to support the significant growth opportunity we have, we anticipate that we will again deliver a high sales growth rate and will generate a positive adjusted EBITDA in fiscal 2020. Finally, as it relates to capital expenditures, we now expect to incur approximately $11.5 million of CapEx in fiscal 2020 versus our prior guidance of approximately $13 million, due to a timing shift of investments of the Sac manufacturing CapEx to fiscal 2021. The vast majority of our CapEx will be spent on the opening of 17 showrooms, the remodel of approximately 8 legacy stores, the opening of 4 Macy's shop in shop pilot locations, and approximately $1.3 million being vested into the Sac manufacturing facility this fiscal. The remaining spend is being allocated to technology in our showrooms, inventory management and logistics systems, e-commerce platform enhancements, and for headquarters data and support systems. For all other details related to our results, please refer to our earnings press release. With that, we would like to turn the call back to the operator who can open it up for questions. Operator?

Thank you. [Operator Instructions] Our first question is from Dave King with ROTH Capital Partners. Please proceed.

Thanks. Good morning, everyone. I guess, maybe first off, what's driving the confidence in the Q4 growth versus the Q3 guidance you laid out? It sounds like some of that's Macy's, but what are you anticipating from a two-year comp perspective versus what you had in Q2 and what you’re expecting for Q3, and what's driving that?

Yes. Consistently -- hey, Dave, it’s Jack. We believe, roughly speaking, the two-year comps will maintain pretty consistent throughout the year. Obviously, we're going against tougher and tougher comparables. And the reason we feel confident in that is it's harder to see in terms of total marketing spend on a quarter-to-quarter basis. But, the working market -- the effect of our working marketing, which starts in Q3 and goes into Q4 will be by far the greatest impact in Q4 with roughly year-over-year working media spends plus -- over plus 60%, whereas if you look at the effect of the Q3 media, it was roughly flat to a year ago, so that'll give us a dramatic increase in comparable sales acceleration.

Okay. That helps.

And to give just a background on that, the reason that we're doing that delay is, as we’ve talked about earlier, we've had several tests going on. And as we do our analysis, the opportunities to implement have come really in Q4 versus Q3.

Okay. And so, I know it's a little bit early on that front, but can you talk about the initial performance of the expanded regional media runs you had prior to Labor Day? Are the ROIs increasing, any early learnings so far?

Yes. The pretty pre-tentpole events, so the expansion of the events is showing increases in ROI and run rate. So, at this point, we believe it will be part of the Q4 program. What I'll do -- I'll need to do is, we still haven't done sort of the final analysis of our Labor Day media. So, we'll be finalizing that in the next couple of weeks and then putting it into Q4 finalized program.

Our next question is from Brian Nagel with Oppenheimer and Company. Please proceed.

Nice quarter. The first question I want to ask, and I apologize, Donna, when you were laying out the guidance for sales, Q3 and Q4, I maybe just missed it. Could you remind or reiterate what the sales guidance for the third and fourth quarter is and the components of that?

Yes. What we're saying is that year-over-year total sales will -- we're expecting to increase about 30% with a significant increase in fourth quarter. So, we're still lining into the annual guidance of 40% to 45%. So, we didn't give guidance for Q4. But, it will be significantly higher than the high range of the 40% to 45% annual guidance that we've provided.

Got it. We can back into that just given basically a missing piece. And the primary reason for that -- and again, I'm sorry, because I know, I think, you have reiterated. I just want to make sure I get this right. The primary reason for that, so to say, choppiness is one, more difficult comparison; and then, two, just the cadence of the marketing investment?

Yes. There are two things. So, you're right. So, I'll confirm that comment. And it's really broken into two things. So, you have on a comp basis, I just explained that that we’re dramatically increasing our marketing, relatively speaking our working marketing in the fourth quarter relative to the third, and we believe we'll get significantly higher lift. The other component of that is just initiatives. So, for example, in fourth quarter, we’ll have a dramatic increase in new showroom openings versus the third. The third quarter was really our lowest rate of new showroom openings we had in the last several quarters. And in the fourth quarter, we’ll also get the results of the Macy's shop in shop rollout as well as the two additional Costco shows we mentioned. So, those will have an incremental effect. So, we have some comp effects as well as just new business initiatives kicking in, in the fourth quarter.

Got it. Then, the other question I had, just with regard to gross margins. Now, clearly, you've been – as you articulated in the press release and in your prepared comments, there’ve been a lot of efforts done to deal with so to say, the tariffs, so congrats on that. As we look at the gross margin degradation here in the second quarter, is there a way to parse that out of how much of that -- we're down 330 basis points year-on-year, how much of that is investment or one time in nature, as you deal with these tariffs versus a newer run rate type number?

Yes. The guidance that we had given, and it's still pretty consistent, that about 75% of that decrease in margin year-over-year is related to the tariff pressure. The other 25% relates to initiatives we have with opening up multiple warehouses, investing into some infrastructure, some cost increases on FedEx, some cost increases relative to the increase in inventory levels. But, the majority -- or at a minimum of 75% relates to the impact to tariffs.

And then, my final question, with regard to Macy's, recognizing it's very, very early, how should we think about -- it sounds to me like the Macy's initiative will be closer to or more analogous, so to say, to one of your own showrooms. How should we think about the economics of a Macy's location in a showroom? And then, the second question on that is -- now this is, so Costco, Macy's, are you in discussions whether should we expect other type of retail partnerships in the not too distant future?

Yes. Good question. So, I think, you're right. I think, Macy's is more analogous to our own showrooms, really with it being an asset light execution. So, we expect the CapEx spend on the Macy’s to be less than a third of a normal showroom. And we expect those to -- obviously, it's pretty easy to assume our hurdle rate would be the same types of returns we want to get as we would in showrooms. So, if you look at the CapEx that way, you could easily say that roughly between a 30% to 50% of -- the run rate of a Macy’s shop in shop will be roughly 30% to 50% of a normal showroom. Obviously, there are huge exceptions. For example, Herald Square is a substantial opportunity. So, that we'd look at that separately. But, it's very early. So obviously -- I think, the best way to look at it is look at the math and the CapEx investment and the way we're running them and model and what you think makes sense, because that's going to be as close as it is right now, because what we're really doing is testing it out.

Thank you.

Our next question is from Thomas Forte with D.A. Davidson. Please proceed.

Great. Thanks for taking my question. I had a couple follow-ups on Macy's. So, the first question I had is, and I know Jack touched on this a little. But, why Macy's? Do you feel like they have a similar core customer base, just in general? And then, how should we think about the economics of the Macy's versus Costco? And then, refining that last question. So, if this pilot results in more shop in shops in Macy's, would you then limit adjacent showroom locations near those shop in shops?

Good questions. So, one is, why Macy's? I think, we're really looking at it -- I think, the one thing to do is think of this as a collaboration with Macy's and their top stores. So, if you look at the top 100 Macy's to the top 50 Macy's, we see a lot of shared attributes with our customers. Macy's is also a significant retailer in the furniture segment with hundreds of millions of dollars sold there. So, we think it’s a huge opportunity for furniture shoppers with like characteristics to be able to experience our product. And especially in those top Macy's, they're really doing a lot of interesting things. And I think that -- I think it will be a great partnership. In terms of the way it works is they are working much more like a showroom in terms of the way we will staff them with our own employees, we manage them through our own system. And we are essentially paying a rent rate to be inside of them that we expect the contribution of these to be significantly higher than what we’ve seen in the Costco pop up shops because of the way those are run.

And then, adjacencies for other showrooms, would you not fill the showrooms within a close proximity to Macy’s shop in shop?

Yes, a little bit of insight into that. So, the way we're running the Macy's test, the reason we ran those four is for some interesting test parameters. So, for example, Herald Square is very close to our Flatiron District showroom. So, we'll look at what happens between showrooms that are left with a mile apart. We'll also have a test which has a showroom in the same mall as the Macy's, and we'll have that opportunity to see what happens. And then, we have a showroom in the Carle Place, Macy's, as this is one of their furniture locations. And we'll see what happens there. So, really at this point that -- the primary purpose of this test is to understand the dynamics and then to start laying out a plan in terms of how we maximize our penetration at the most efficient way and also do it in a win-win way with our Macy's partners.

Our next question is from Alex Fuhrman with Craig-Hallum. Please proceed.

Great. Thanks very much for taking my question, and congratulations on another very strong quarter. A couple of things that I wanted to touch on here. One is, it certainly sounds like you guys have made a lot of progress in moving your production out of China and have a good line of sight to being completely out of there. It sounds like you're -- relative to the prior conference call, it sounds like that that has moved a lot faster and better than expected. Can you give us a sense of what's driving that? I mean, it sounds like your vendors have been incredibly supportive. Has there just been more buy in and capital commitment on the part of your vendors than you expected? Just kind of curious why you've been able to accelerate that so nicely.

Yes, great question. We have been moving very rapidly and we intend to continue moving rapidly. I don't believe that we ever intended to go slow. I just don't think we gave specific guidance on how fast we thought we could do it. I think, everything's moving according to our plan and it's exactly that. Our current suppliers have been very supportive, and in most cases, as I described are investing themselves in other countries outside of China, Malaysia, Vietnam, and even some others that are coming up. And meanwhile, for the goods that are left behind still, they're offering us heavy discounts in order to keep that business and kind of get through the tunnel, as it were with their lights on, so that they can support us on the other side, outside of China. And so, I think, it's just a confluence of things going well, things going according to plan, and our ability to execute, which obviously in the public markets, we're only a year out. And I think, it's a matter of those watching Lovesac, getting familiar with how we operate.

And then, a couple of questions just on the Macy's partnership. Obviously, this sounds like a huge opportunity, big difference relative to Costco. I imagine, is that -- Macy's is a large furniture retailer on their own, and I'm curious, if you have a sense of or if it's been a big part of your negotiations with Macy's, where in the stores your shop in shops are going to be located? Are they going to be in the furniture sections or are you maybe going to do some that are near other furniture brands and some that aren't? Just curious how we should think about the placement of those shop in shops? And then, if it's going to be your own employees, is it fair to assume that you will be able to capture all of the customer data and own that customer relationship?

Great questions. Yes, our team -- I can tell you, it varies by -- the Macy's organization from the way they operate, obviously, because of the -- the stores are such a big volume and they have independent store management, the negotiations are store by store. We literally have to do walk-throughs with their teams in every store. What I can tell you is that they really believe in terms of the Macy's -- I'd say that the Macy's evolution, they believe this type of relationship is critical, and they're putting us in key places. And we’ve walked the stores with them and are very happy with the locations. And they're primarily very strong locations. Not necessarily obviously next to furniture, because in a lot of the locations we're testing, they're not even in furniture section. So, that's part of our learning agenda as to figure out what works most. And I would expect coming out of this, along with the answer to some of Tom's questions, would be some answers to your questions, in terms of what adjacencies are working most effectively, what parts of the model are working, are there attributes of a Macy's store over another store that allow us to accelerate the fastest? That's all that we're trying to do now, so that hopefully the next time we talk about this, we have some answers and we start laying out an execution plan. So, good questions, and we'll keep you posted on it.

Great. Thanks very much for that. And then, lastly, your marketing has of course been very successful over the last couple of years and TV seems to have played a nice role in that. It looks like up until the last couple of months that it’s basically been different versions of the same TV commercial, and then you came out with a different creative, a few months ago. Can you talk a little bit about have you seen a lift from that new TV creative, or was there maybe something kind of a magic formula in the last commercial? Just kind of curious, now that you've got your second commercial out there in the market, what type of response you've seen from that?

Yes. Good question. I would say that we were very careful obviously because we had such a successful creative execution as we started with this new execution. We tested these quantitatively and the new and a quantitative research mode in terms of persuasion and brand, attributes, et cetera. The new commercial actually tested equal to or better than the old one across the board. We also can tell you that initial results on the new television are showing that it's driving traffic at levels that we expect it to drive at, historically. Now, other than that, I think, you start to get into a whole media mix discussion, which I can't get into because we still don't have the total results for the Labor Day media run, which is still being analyzed and actually still -- the post Labor Day work is still going on. So, we'll probably have a lot more information for you in the next quarter about that. But, we're feeling very good about the creative overall.

Next, we have a follow-up question from Thomas Forte with D.A. Davidson. Please proceed.

Great, thanks. So, an investor asked me to ask the following question. They are really impressed with your comments on your gross margin outlook for next year returning to the mid-50s. Can you once again discuss what are the inputs that will drive that strong gross margin performance next year?

Yes. I mean, the pressure on the business has been largely tariffs, as Donna has spoken to. We have a few other outside pieces, be it freights or pressures in the supply chain, logistics, et cetera, that are small, and Donna can touch on that. But, the vast majority has been tariffs. So, as we mitigate those tariffs, primarily through exiting China, not only are we then tariffs free as it were, at least special tariff free, but we also, as I mentioned, are getting lower first costs in these outside countries. And so, we were operating in the mid-50s range on gross margins and we expect to get right back to that as that product flows through our supply chain. So, it’ll be the second half of next year before on a run rate basis we begin to see that return to those levels. And because it's a run rate basis, it may take even longer to flow to the P&L as it were. But we feel very good about our ability to get back there and our ability to maintain that on the go forward. And I don't know, Donna, if you have anything else to add?

Yes. I mean, really, the major component is the tariff, some investments into infrastructure, which we will still continue to see through next year. And then, I think we'll start to see less of an impact on the shift to the pop up shops and Sactionals. I think, we're seeing the greatest amount of that shift happening now. So, when that all starts to level itself out, as Shawn has mentioned, we'll start to see on a run rate, right, start to see those margins elevate. We don't expect the full year to come in at that, but we'll start to see the quarters in the second half start to elevate to the higher mid-50% range.

Great. Thank you, Shawn. Thank you, Donna.

Yes. And just to add a note and beyond that, I think, it's important to state that, we've just hired Tom Lee as our Chief Supply Chain Officer. And I think, in the next 18 months to 24 months, we'll really be working on combining that supply chain and the logistics aspects into a value chain that allows us to start leveraging other areas. So, I think, we've only just begun to really get efficient as a company. And we'll be catching up with that growth in the next 18 to 24 months, outside of the whole tariffs issue.

We have reached the end of our question-and-answer session. I would like to turn the call back over to management for closing remarks.

Thanks very much for your support as investors. And we appreciate all the questions and encourage you to continue to keep an eye on us as we grow.

Thank you. This concludes today's conference. You may disconnect your lines at this time. And, thank you for your participation.