Purple Innovation, Inc. (PRPL) Q2 2018 Earnings Report, Transcript and Summary

Greetings, ladies and gentlemen, welcome to Purple Innovation’s Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] It is now my pleasure to introduce your host, Brendon Frey of ICR. Please go ahead.

Thank you for joining us today to discuss Purple Innovation's second quarter 2018 earnings results. On today's call are Terry Pearce, Co-Founder, Chairman and CEO; and Mark Watkins, Chief Financial Officer. A copy of today's press release is available on the Investor Relations section of Purple's website at www.purple.com. I would like to remind you that certain statements we will make in this presentation are forward-looking statements. These forward-looking statements reflect Purple Innovation's judgment and analysis only as of today and actual results may differ materially from current expectations based on a number of factors affecting the company's business. Accordingly, you should not place undue reliance on these forward-looking statements. For a more thorough discussion of the risks and uncertainties associated with the forward-looking statements to be made in this conference call and webcast, we refer you to the disclaimer regarding forward-looking statements that is included in our second quarter 2018 earnings release, which was furnished to the SEC today on Form 8-K, as well as our filings with the SEC reference in that disclaimer. We do not undertake any obligation to update or alter any forward-looking statements whether as a result of new information, future events or otherwise. Today's presentation will include references to non-GAAP financial measures such as adjusted operating income, EBITDA and adjusted EBITDA. A reconciliation of these non-GAAP financial measures to the most comparable GAAP financial measures can be found within the earnings release, as well as our quarterly report on Form 10-Q, each of which can be found on our website. With that, I'll turn the call over to Terry Pearce. Terry?

Thank you all for joining us. With me on today's call is Purple’s CFO, Mark Watkins. The second quarter represented another period of robust growth for Purple as revenue increased 58% to $75 million, which was above the high end of our guidance range. Our top line performance was driven by successful execution of product, marketing, manufacturing and channel strategies that we outlined at the start of the year. Beginning with product, we continued to experience strong demand for our original mattress, the Purple Bed, in our direct-to-consumer channel. At the same time, consumers continue to respond positively to our new mattress models that feature a choice of 2 inch, 3 inch or 4 inch deep Purple Hyper-Elastic Polymer for incrementally personalized comfort along with a completely different mattress core design. With a broader product offering and higher price points we have been able to target a wider audience and reach new consumers, which is benefiting our top line and market share. As we discussed on our Q1 call in May, following the launch of the new models on our website earlier this year, we have seen the expected decline in conversion rate. This was anticipated given the new models are a higher priced considered purchase. Shifting to marketing, the investments we have made over the past year have significantly increased brand awareness and helped focus customer interest on our differentiated technology. In Q2, we continued to direct the majority of our ad spend towards digital programs, mainly videos and social media to drive increased demand for our product portfolio. Considering the recent trends in the cost of digital advertising, especially in the highly competitive bed-in-a-box category, we're also testing other marketing platforms in an attempt to acquire new consumers more cost effectively. Turning to our channel strategies, we continue to work towards capturing a larger piece of the overall $20 billion sleep market, and diversifying our revenue stream through the growth of our wholesale operations. Since launching our test with Mattress Firm late last year we have expanded beyond the initial 51 doors and ended the second quarter in 142 locations. We are very pleased with the results to date from both a sell-through perspective as well as the Purple brand in-store experience. We recently added another 46 locations for a total of 188 and continue to have productive discussions with Mattress Firm regarding plans for further expansion. At the same time, we are exploring other potential wholesale partnerships with leading retailers in different channels. On the manufacturing side, we have significantly expanded our manufacturing capacity to support our growth initiatives by increasing the number of proprietary molding systems, which make our Hyper-Elastic Polymer layer for our mattresses. With our fourth machine coming online in first quarter 2018, we are well-positioned to meet current demand and fulfil orders in a timely manner. Manufacturing is an important part of Purple's DNA. This core competency including our proprietary manufacturing processes provides Purple’s clear differentiation and helps to create an IP model around our business. More recently our focus has been on refining our processes and procedures and enhancing our supply chain capabilities through investments in automation and a new warehouse management system. To that end I am pleased to report that we solved the issue with rolling our new mattress models, which initially required us to ship them flat packed resulting in higher freight costs. With this headwind now fully behind us, we should see even further benefits to gross margin from our higher priced models going forward. We continue to search for a highly capable CEO replacement, and will publicly announce when that hire has taken place. Despite some internal challenges typical of a new high-growth company, I'm confident that the business is well-positioned to succeed in the current competitive environment and generate profitable growth and increase shareholder value over the long term. Mark will now take the floor.

Thank you, Terry. I'll begin by discussing our quarterly results, and we'll then review our guidance for the third quarter and full year. For the three months ended June 30, 2018, net revenue was $75.4 million, up 58% compared to $47.7 million in the prior year period. The revenue increase was primarily due to higher direct consumer demand for mattresses driven by increased marketing investments. We also benefited in the quarter from contributions of mattresses sales in our wholesale channel, which comprised approximately 11% of total revenue. Gross profit dollars were up 56% to $33 million during the second quarter of 2018, compared to $21.2 million during the same period in 2017 with gross margin of 43.8% in the second quarter of 2018 compared to 44.4% in the second quarter of 2017. The year-over-year decrease in gross margin was partially due to higher freight costs as we continue to flat pack the new mattress models through the month of April. As a reminder, we initially had flat packed the new mattress models post the February launch, but as of May began rolling those models and shipping it at more economical freight rates. In addition to higher freight costs reducing gross margin we experienced lower net revenues relative to gross margins as a result of high dollar returns. The resulting impact of the high dollar returns is lower gross margin as a percent of net revenue. These headwinds were partially offset by the higher product margins from the new mattress models. Operating expenses were $36.5 million in the second quarter of 2018 versus $17.5 million in the prior year period. This increase is primarily due to higher marketing investments to expand brand awareness and drive consumer demand for the company's product portfolio. During the second quarter, we reported an operating loss of $3.5 million compared to operating income of $3.6 million in the second quarter of 2017. After adjusting second quarter 2018 results for stock-based compensation expense and CEO search costs, adjusted operating loss was $2.9 million compared to an adjusted operating income of $4 million in the second quarter of 2017. Net loss for the quarter was $4.3 million compared to net income of $3.6 million in the second quarter of 2017. EBITDA for the quarter was negative $2.9 million compared to positive EBITDA of $3.8 million in the second quarter of 2017. Adjusted EBITDA, which excludes the same non-recurring items I just mentioned, was negative $2.3 million, which was in line with our guidance range versus adjusted EBITDA of $4.1 million in the second quarter of 2017. Turning to our results for the first six months of the year, net revenues for the first six months ended June 30, 2018 were $136.4 million, up 75% compared to $77.8 million in the comparable prior year period. Gross profit dollars were up 67.6% to $59.4 million during the first six months of 2018 compared to $35.5 million during the same period in 2017 with gross margin at 43.6% compared to 45.6% in the second quarter of 2017. The decrease in gross margin was driven primarily by inventory adjustments related to inefficiencies we experienced in quality control and manufacturing process as we scaled the production of new mattresses to meet higher than expanded demand in Q1 2018. In addition, higher freight costs and higher dollar returns also pressured gross margin during the first half of 2018. These headwinds were partially offset by higher product margins of our new models. Operating expenses were $65.8 million in the first six months in 2018 versus $33.8 million in the prior year period. This increase is primarily due to higher marketing investments to expand brand awareness and drive consumer demand for the company’s products. In addition, operating expenses included $3 million of one-time nonrecurring costs related to the business combination transaction with Global Partner Acquisition Corp, as well as CEO search and severance costs. During the six-month period ended June 30, 2018 we reported an operating loss of $6.4 million compared to an operating income of $1.7 million in the same period in 2017. Adjusted operating loss was $3.4 million compared to an adjusted operating income of $2 million in the second quarter of 2017. Net loss for the six-month period was $7.9 million compared to net income of $1.7 million in the comparable period of 2017. EBITDA was negative for the first six months of 2018 at $5.4 million compared to positive $1.9 million in the comparable period of 2017. Adjusted EBITDA was negative $2.4 million versus adjusted EBITDA of positive $2.3 million in the comparable prior year period. Moving to our balance sheet. As of June 30, 2018, the company had cash and cash equivalents of $10.4 million as compared to $3.6 million at the end of 2017, reflecting the funding of the business combination with GPAC and our term debt that finalized on February 2, 2018, which was partially then offset by working capital investments primarily inventories, as well as capital expenditures. Net inventories totaled $33.2 million at June 30, 2018 compared with $13.3 million at the end of 2017. The increase to inventory at the end of the second quarter was due to an expanded product line, the growing demand for our products and the stocking of new models at third-party regional distribution centers. In addition, purchases of raw materials and production were ramped up in late Q1 and early Q2 related to revenue forecasts that were subsequently reduced. Turning to our guidance, for the third quarter of 2018 we anticipate net revenue to be in the range of $71 million to $75 million, and adjusted EBITDA to be between negative $1 million and positive $1 million. For the full-year, we continue to expect net revenue to be between $290 million and $310 million, an increase of between 47% and 57% over 2017. We are still forecasting 2018 adjusted EBITDA to be approximately breakeven. With that we are now ready to take questions. Operator?

[Operator Instructions] The first question comes from Seth Basham with Wedbush Securities. Please go ahead.

Thanks a lot and good afternoon.

Hi, Seth.

My first question is around your marketing expense, as a percent of sales it was higher than we had modeled. I'm wondering if it came in line with your expectations and if not, how you are thinking about managing your marketing expense going forward?

Thank you for the question. So it did come in slightly higher than our expectation as well. However, the primary driver of it coming in above our expectation was not the actual spend to get to revenue. It was primarily because we had higher than anticipated returns for the quarter, which then separated our gross to net revenue ratio, such that the net revenue came in lower relative to the demand that we are able to create and the gross sales that we are able to create. And so as a percent of that net revenue that is why it came in higher than anticipated. It was not significantly higher than anticipated, less than 100 basis points but that made a difference for us.

Got it, and as a follow-up can you give us some more color on your return rates, where are they now and why are they increasing and what are your mitigation plans?

So, returns have been higher than we expected. You will recall in Q1 we launched the new mattress models in February. At that time we saw returns increase. That was anticipated as we expected our consumers to possibly trade out some of those recently purchased models. They would return those. We also expected that as the price increased there would be some correlation to returns; just kind of the value proposition. So we saw a spike in returns in late February and early March. We expected that those returns rates would come down to normal levels. They have not. They are at a couple of hundred points higher than our historical run rate for returns. They are coming down slowly, but not as rapidly as we thought they would. And so it is really that correlation that we see between the higher priced models and those return rates that are impacting our overall return rates. So as we look forward we are watching it closely. We are deepening our analysis in the return so that we can try and impact that. But going forward into the next quarter meaning Q3 that we are currently in, we expect that those return rates will be roughly the same as what we saw in Q2.

Okay, and then last question here then I will turn it over, it is just on working capital – your working capital was not [indiscernible] this quarter, I am wondering how you are thinking about that balance of the year in terms of working capital and cash flow?

The biggest impact to working capital during the quarter was inventory. And as I mentioned in my prepared remarks the increase in the inventory was due to several factors; our expanded product line, the growing demand for our products obviously raised our inventory levels, talking to third-party fulfilment centers as part of our [indiscernible] delivery increased our inventories as well, as well as in Q1 and early Q2 we had higher forecasts that were then subsequently reduced and so some of those purchases that were already in the works when we decided to reduce our forecast did affect our profitability. Those have played through and obviously the purchases of those raw materials came in. Production has been phenomenal and higher than it was in previous quarters and so we do have a decent amount of finished goods and work in process on our books at the end of Q2. But we have a burn down plan because it is higher than what we need. So over the course of Q3 we expect that inventory balance to come down to some normalized levels. The other working capital item that I point out is accounts receivable. Our wholesale channel has expanded. It was 6% of our sales in Q1 and 11% of our sales in Q2. And so subsequently we do have a higher balance of accounts receivable that is welcomed, and our receivables are healthy right now. So those are the two items. The burn down plan for inventory is really going to be a cash benefit in the third quarter, but hopefully that gives you enough color.

That does. Let me just sneak in one last question thinking about your channel strategy, and one in wholesale, your relationship with Mattress Firm, you are expanding doors, you said your receivables are healthy, you don't see any receivables given the state of the company. That is one, two, any update on the progress with Bed Bath & Beyond, and three, how you are thinking about the competitive environment from the standpoint of other direct to consumer brands going to retail bricks and mortar, are you considering doing anything along those lines as well? Thank you.

So the question about Mattress Firm, right now Mattress Firm continues to pay on their schedule, and we don't see any changes there. So we see consistency and are pleased with that. There have been rumours out in the public about the health of Mattress Firm, but we have a good working relationship with their senior management. We continue our discussions about expansion as we come to the end of our test period. And so, right now all systems are good from our standpoint and we are not speculating on anything from that standpoint as far as Mattress Firm’s health. And so we continue see that relationship continued to expand. As it relates to Bed Bath & Beyond, they are currently selling our mattress online. We do not have any intention of expanding that at this point in time. We are looking at other wholesale relationships, and those will come to fruitition most likely early 2019 as opposed to anything impacting 2018. From a competitive standpoint, the competitive landscape is tough. It is very promotional in nature right now. And so from – I guess there is two perspectives that I will speak to. One is just the cost of advertising. We have seen the cost of advertising continue to rise at similar trends to what we saw in Q1 and Q2. On a year-over-year basis, we have seen similar increases. We have been managing through that. We are confident that we will continue to be able to manage through that so that we can provide roughly breakeven business for the year. We are expanding our advertising into other channels to ensure that we can achieve appropriate CPMs and cost to acquire the customer. And we are confident in our ability to continue to do that over the remainder of this year. We have seen competitors branching out into brick and mortar, Casper being one of those. They recently announced some expansion into their own stores. Our strategy right now is to focus on retail partnerships. There is some potential obviously in the future and we wouldn't take our own stores off the table, but that is not in the works for 2018, and we really will focus on our current retail partnerships and expanding that channel.

Thank you very much.

[Operator Instructions] The next question comes from Bobby Griffin with Raymond James. Please go ahead.

Good afternoon Mark and Terry, and thank you for taking my questions.

Hi, Bobby.

So Mark I was just hoping, can you maybe walk us through the gross margin expectations on you are kind of seeing it for 3Q and 4Q embedded in the full-year guidance?

So, we do anticipate slightly more favorable gross margin in the second half of the year versus what we have seen in the first half. We had some hiccups. Obviously in Q1 we had some inefficiencies there. Those continue to improve. We had a flat packing issue. That is now behind us. And so we expect that we will see some improvements from those two standpoints, the direct materials and the efficiencies in our manufacturing will continue to improve. With the higher return rates that we are seeing though, we do feel some pressure above and beyond what we had originally forecasted for the full year such that we really are expecting for the second half of the year gross margin to be in the range of 45% to 46%. That will bring the full year somewhere into the high 44% range to low 45% range. So just to restate, 44% – high 44% range to low 45% range. That will largely depend on how strong Q4 is as that is anticipated to be our largest quarter exactly where that lands. But these impacts will also be influenced by our wholesale mix as we do have a lower gross margin when we are selling at wholesale prices. So depending on the expansion of our wholesale channel would also influence that. But that is our current forecast.

Okay, and then on the returns are you able to parse into some of the data to see if there has been any meaningful change on the original model from consumer’s preferences or is it just the function like you said they would want to just upgrade to a higher end model and return the bed?

So, we do have some decent data. We are still digesting it and our ability to react to that is still in the early stages. But the original mattress has not substantially changed in terms of return rates.

Okay that is helpful and I guess last from me and maybe this is for both of you and Terry, but can you maybe just comment a little on how you see the management structure kind of taking place once the new CEO is announced? Do you see – are you guys plan on replacing the COO role or is that going to be – is that going to kind of be wound down into the new CEO role?

Well, our CEO search is five months old. We have interviewed a lot of great candidates. We have narrowed it down some, but we are still interviewing. We just – we will have to let you know when we conclude. We are being very selective because Purple deserves a great leader, and we are getting through right now with me in charge. On the COO, I am restructuring below that level in the operations department, but the new CEO – my philosophy is the new CEO should pick his own COO. If it gets out of hand I will put one in before he gets here, but they should be a great team. And so we are hunting for a CEO and we will let him bring his own COO.

Okay. I appreciate – go, ahead Mark. I am sorry.

I was just going to mention, we have built a very strong team right below the COO. And they are filling in very nicely right now. In addition we have brought in a consultant to provide some leadership and advice Terry and I on it, I think that we do have the right steps taking place in our operations group just to make sure we are protected from that standpoint. We are doing very well in that area right now.

Thank you. I appreciate the color and you guys answered all my questions. Best of luck to the back of half the year.

Thanks, Bobby.

[Operator Instructions] This concludes the question-and-answer session. I would like to turn the conference back over to Terry Pearce, CEO, for any closing remarks.

Thank you. I just want to thank everyone for participating. Purple is healthy. We are growing fast and that involves pain, but we are addressing those problems and we are staying ahead of the fight. So, I appreciate everyone's interest and attending today. Thank you for calling in.

This concludes today's conference call. You may disconnect your lines. Thank you for participating and have a pleasant day.