Sleep Number Corporation (SNBR) Q1 2011 Earnings Report, Transcript and Summary

Good afternoon. Welcome to Select Comfort's First Quarter 2011 Earnings Conference Call. [Operator Instructions] This call is being recorded. If anyone has any objections, you may disconnect at this time. I would like to introduce Mr. Mark Kimball, General Counsel. Sir, you may begin.

Thank you, Angie. Good afternoon, and welcome to the Select Comfort Corporation First Quarter 2011 Earnings Conference Call. Thank you for joining us. I'm Mark Kimball, Senior Vice President and General Counsel. With me on the call today are Bill McLaughlin, our President and Chief Executive Officer; Jim Raabe, our Senior Vice President and Chief Financial Officer; and Hunter Saklad, Vice President of Finance. In a moment, I’ll turn the call over to Bill. Following our prepared remarks, we will open the call to your questions. Please be advised, this telephone conference is being recorded and will be available by telephone replay. It also will be archived on our website at selectcomfort.com. Please refer to the details set forth in our news release to access the replay on our website. Please also refer to our news release for a reconciliation of certain non-GAAP financial measures included in our release or that may be discussed on the call. The primary purpose of this call is to discuss the results of the fiscal period just ended. However, our commentary and responses to your questions may include certain forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties outlined in our earnings release and discussed in some detail in our Annual Report on Form 10-K and other periodic filings with the SEC. The company’s actual future results may vary materially. I will now turn the call over to Bill for his comments.

Thanks, Mark, and thank you for joining us to discuss Select Comfort's first quarter performance and to update our outlook for the balance of the year. Select Comfort is demonstrating that it is solidly positioned to continue to grow. Our first quarter not only confirms our formula for sustained revenue growth but also provides important insight into the leverage potential of our unique business model when you layer on incremental sales. During the quarter, the company demonstrated that potential, which resulted in the following accomplishments. First quarter, we achieved a 22% increase in revenue versus a strong prior year period, and company-owned comparable sales were up 26%. Second, we earned record-setting operating profit and margin performance on revenue that was below our historic first quarter high point. Operating income increased 86% versus prior year, and operating profit margin in the quarter was more than 13%, which is an important step towards our goal of full year margin performance of 12% or better within the next few years. And third, we significantly grew cash and increased the strength of our balance sheet. Our advantage business model leverages growth for significant cash generation, and we've now grown our cash balance to more than $100 million and remained debt-free. Our performance in the quarter clearly demonstrates the power and potential of our strategies. And it starts with top line growth, which means more traffic and a higher transaction size. Our first priority involves increasing consumer awareness and consideration of the Sleep Number brand. To achieve this awareness and consideration, we increased our media investment by 30% in the quarter. Also, our sales, marketing and product teams continue to refine their sales, promotion and merchandising formulas, balancing brand development with urgency around consumer shopping periods. The rate of growth in the quarter was exceptional as the teams responded to the challenge to make Presidents' Day as important to the first quarter as Labor Day is to the third quarter. This unique opportunity to capitalize on a previously underdeveloped event contributed as much as 4 points of our growth in the quarter. We also have been positioning our company to accelerate earnings faster than revenue growth through leverage in margin expansion, particularly in selling. We continue to adjust our store base, closing stores to reduce overlap in trade areas and repositioning for upgrading locations to support our long-term objectives. As of the end of the quarter, average sales per store topped $1.4 million annually, up 26% versus prior year. And we are well on our way to exceeding our historic average sales per store of $1.5 million, with the next goal of being sales per store of $2 million and beyond. And the result of our increased growth and leverage is the ability to allocate more resources against important expansion opportunities. In the quarter, we continued investing in the advancement of advertising, digital marketing, new store formats and local market development. In that vein, I promised during the last earnings call that we'd discuss in more detail 2 important initiatives: our evolving marketing efforts and retail strategy. Both programs are squarely focused on increasing consumer awareness and consideration of the Sleep Number brand, products and exclusive selling channels, particularly our stores. Let's start with marketing, specifically, our TV advertising. Awareness of the Sleep Number brand is about 75% lower than that of the leading inner springs. And more importantly, awareness of our stores is significantly lower still. Therefore, increasing the effectiveness of our advertising to raise awareness is a key driver of accelerating profitable growth. And in the quarter, we launched an important advancement of our TV campaign. We have a differentiated brand, product and store experience, and our sales professionals and customers are our greatest advocates. Our new TV execution brings all of this together in an impactful documentary-like style. We highlight our Sleep Number store and show real sleep experts interacting with real customers, spotlighting the unique benefits of our bed and our shopping experience, which you can only find in a Sleep Number store. Along with the advanced creative, we evolved our media strategy to broaden reach, targeting new higher-potential audiences. While it's too early in the launch to provide conclusive results, preliminary qualitative feedback from our store teams is positive, both on consumer interest, in our product and in our store. In the second quarter, we plan to introduce additional versions of this creative and further read and refine the effectiveness of both message and media strategy. All in all, we are confident in the direction and proud to feature our sleep experts and their unique passion for our product and its ability to improve lives. Second, we continue to advance testing of our non-mall retail strategy. For a full quarter, we've had 5 of our non-mall stores open in high visibility locations. Again, this initiative is designed to understand how to cost-effectively increase consumer awareness in consideration of our brand, product and stores. We believe the combination of high traffic locations and marketing that illustrates our unique product and customer experience will improve our awareness and consideration. We also believe that non-mall stores complement existing mall stores by building brand and store awareness as consumers will ultimately find the Sleep Number store location that is most convenient to them. Again, initial results are encouraging. We've seen sales equal to or greater than our in-mall locations. And anecdotally, our mall stores are reporting benefits from early increased store awareness. That said, it will require the remainder of 2011 to complete the rollout of our 20 store pilot and to fully understand the seasonality of this new format. Both of these initiatives have important long-term implications, and we will continue to update you on these programs as well as others that are targeted for the second quarter launch. And on that note, there are 2 additional initiatives in the second quarter that are important to highlight: the launch of our new website, sleepnumber.com; and the launch of the updated Sleep Number i10 bed. The majority of consumers do some form of research online prior to visiting a store, especially a high consideration purchase. And consumers expect a seamless, informative and individual experience regardless of the channel. Our new website meets and exceeds these consumer needs and is another initiative designed to increase awareness and consideration of both our brand and exclusive distribution. Website redesigns are significant projects, and we remain on track for a second quarter launch. The re-launch of our top-of-the-line Sleep Number i10 bed advances the individualized comfort and craftsmanship that makes the Sleep Number bed so different from other mattresses in the market. The i10 is designed to maintain our strong mix within the line, supporting our clear trade-up offering between good, better and best product offerings. And as of this past weekend, the Sleep Number i10 bed is available for consumers to purchase across our company-owned channels. First quarter performance and learning continued to build confidence in our strategies and investments. We are now into our third year of consecutive quarterly earnings improvement since the economic downturn. By focusing on our core business and strengthening execution, we are consistently delivering top line growth and expanding margin for accelerated earnings, and our balance sheet allows continued investment to sustain long-term growth and value creation. After a record quarter, our sights are set on delivering a record year. One note before I turn it over to Jim. Given the strength of Select Comfort's performance after years of rebuilding, it is likely that members of the senior leadership team will rebalance portions of their company stock holdings over the coming quarters. This is solely motivated by the need and anticipated opportunity to diversify. Let's now turn to Jim for further insights from the first quarter and implications for our outlook.

Thanks, Bill. Bill shared the highlights of our Q1 performance and the path we're taking to sustain revenue growth and operating profit leverage. I'd like to provide a little more color on some of the numbers, starting with sales. First in the quarter, total sales grew by 22% on 12% unit growth. The mix was stronger than a year ago; in part, because of the shift of our promotional calendar, but more significantly, because of up-sell execution of our sales team and improved penetration of our bedding collection and adjustable foundation. As a result, total ASP was 8% above year ago. Looking forward, we expect continued sequential ASP growth but at a more modest rate than the gains achieved in Q1. Second, a reminder that last quarter, we announced a shift to reporting to a multichannel comp versus retail same-store sales. We made the change because we believe this is the best representation of same-store distribution growth. Our comp numbers were stronger than expected at 26% for the quarter, led by unit growth and supplemented by ASP growth. And finally, we experienced sales growth throughout the quarter. Sales performance was particularly strong in January and February for the record Presidents' Day period. And while sales growth in March continued to be strong, it was not quite as robust as early in the quarter. Current trends have been factored into our comp guidance of mid-teens for the balance of the year. Probably most gratifying for us has been our overall profit leverage in the quarter. We have been talking with investors for some time now about the profit flow-through potential on sales growth. It's very satisfying to see these gains realized even while investing incrementally in the quarter. A few key callouts. First, operating margin increased to 13.7% was led by improving gross margins, which totaled 63.8% or 170 basis points higher than last year. The gross margin improvement is partly due to improved sales mix and pricing adjustments at the beginning of the quarter as well as leverage from increased volume and other manufacturing productivity gains. We experienced only minor inflationary impacts, primarily in diesel costs and home delivery. Sales and marketing, as a percentage of sales, improved to 41.6% compared to 44.4% last year or 280 basis points better than last year. The leverage gains were entirely in our sales channels where we've been targeting them. Selling expenses, as a percentage of sales, improved by 440 basis points on increased store productivity. Total selling expenses increased only 2% compared to last year. The increased leverage in selling was partially offset by increases in media and marketing. Media investments increased by 30% to $23.7 million as compared to last year. $2 million of the increase was incremental to our original plan as we adjusted spending to incorporate national advertising support for Presidents' Day and to increase advertising tests as sales trends improved. Year-over-year increases in spending also included $1.8 million in tests and other new approaches, including local market development advertising, new digital campaigns and the launch of our new advertising creative. As expected, media, as a percentage of sales, increased year-over-year to 12.3%. We are learning a lot, and it will take some time to build to full efficiency with these new programs. Finally, G&A improved as a percentage of sales by 20 basis points. This improvement was achieved despite the significant increase in incentive compensation resulting from our overall performance. It was another very strong cash flow quarter. We have now achieved our target cash level of $100 million. Q1 cash balances do not yet reflect store and systems investments that were started in Q1, and we are now entering the seasonal low point for sales and high point for cash needs. So we expect somewhat lower cash balances at the end of the second quarter. Looking forward, we are increasing our 2011 guidance for earnings to between $0.85 and $0.93 per share. This outlook incorporates our exceptional first quarter performance, including Presidents' Day. The execution over this holiday, which was a unique opportunity in the first quarter, added 4% to sales and approximately $0.02 to earnings per share. The outlook also incorporates continued solid sales growth, albeit at a someone more modest pace versus Q1. Sales trends assume no deterioration in consumer sentiment, although we remain cautious that world events and broader inflationary pressures, such as rising gas and food prices, could eventually have an impact on consumer spending. We are less concerned with the impact of inflationary pressures on gross margin rates. We are seeing increases, but believe we have productivity opportunities and pricing flexibility to sustain gross margins at or above 63% for the balance of the year. One final note on our outlook. As I'm sure most of you know, we are entering the seasonal low point of the year. While we expect to continue to demonstrate operating margin gains throughout the year, the leverage inherent in our business model is most pronounced in the first and second quarters. We see the greatest leverage benefits in the first quarter and our most constrained margins in the second quarter. To summarize, we've experienced a great start to 2011, and we are on track for a record year at Select Comfort. We are also aware of the uncertainty of the macro environment, and we'll remain disciplined in our approach to driving long-term sales and profit growth. I'd now like to turn it back to Bill for final comments.

Thanks, Jim. Our first quarter performance is the result of great work company-wide. Specifically, sales teams across the country and in all channels capitalized on the opportunities created by marketing. Our manufacturing and logistics teams stepped up to meet the strong demand, ensuring a quality product and elevated service at every individual touch point. And the entire organization stayed focused on leveraging our core business, and our team is lean and high performing and we stretched to execute as well as to innovate and further develop our advantages. To close, Select Comfort remains a unique growth opportunity, both in share and revenue. The company is demonstrating that it also has further margin expansion potential. We have the cash and discipline to self-fund our growth, and this is an opportune time to consider the long-term potential of this unique business. So we sincerely thank you for your time and your consideration. And Angie, we'll now open the call to questions.

[Operator Instructions] Okay, our first question comes from Brad Thomas.

Thank you, yes. Brad Thomas with KeyBanc Capital Markets. I want to just kick off talking a little bit more about this very strong sales during the quarter. Jim, I think you mentioned that about 4% of that benefit had to do with some of the way you promoted around Presidents' Day. It's clear you all have a lot of good things going in terms of sales drivers. But as you rank those, do you have any other ability to quantify the impact of the incremental marketing versus some of the merchandising enhancements that you're making?

I'd say, Brad, it's always difficult to quantify the various pieces. We certainly can see some of the direct benefits that we've had around execution, Presidents' Day and really throughout the quarter. We've certainly made some advancements on the media side, both in actual spend but also in the creative with new creative, new digital. There's also certainly pretty good consumer trend out there as well. It's just difficult to break those individual pieces up, I think, but they all contribute something to this performance.

Great. Then, Bill, I think you referenced a goal of getting stores to that $1.5 million in revenue level, and then shooting towards a $2 million goal. As you look at the portfolio of stores and where they're tracking right now, what is the breakdown between some of those different revenue tiers?

Well, as you'd expect, we do have a range, though we've been shortening the range under $1 million. I believe we're at about 75% of our stores are over $1 million in sales now. And the tale of $2 million and $3 million stores is growing. The one key thing to think about is that for us to add another $100,000 to that average, it's about 1 bed per store per week on average. So it's a pretty attainable goal. The other thing I'd point out is that this quarter kind of marks the end of the decline in the store base. And from this point forward, we'll be adding stores back, albeit slowly, this year as we still have some restructuring within the portfolio. But from this point forward, the store count should start to increase again.

Great. And then just one last follow-up on the guidance, if I could. Last quarter, if I recall correctly, you had not baked in an impact from some of the advertising investments and some of the incremental spend on R&D, if I'm not mistaken. As we think about the current guidance, are there still some areas of investment that you're not factoring in? Or at this point, are we on pace to be more in line with what your initiatives are for the year?

What I would say that what our approach tends to be to factor things in as we see the -- as we prove them and we see the benefits of them. So I think the statement with regard to R&D remains true in that while we're making R&D efforts, there's not a lot of new product or new changes that we've made to date. Although, as Bill mentioned, we just introduced the i10, but we haven't seen actual results from that. And we're certainly, as we're making changes on the media side and on the sales execution side, we're building in those gains that we're seeing. But there's still a lot of things in test. There's still new things that we're developing. And I would say that those items that we're testing, we're only building them in after we prove the results of them. So it's a little bit of both. As we see the performance, we build them in, but we still have things out there that we haven't fully built in.

Got you. Thanks, Jim. Thanks, Bill.

Budd Bugatch. Budd Bugatch - Raymond James & Associates, Inc.: Raymond James. Bill and Jim and Hunter, I guess, I'd like to talk a little bit about the media spend. 12.3% is what I calculate this quarter. Can you give us an idea of what the media spend will be for the year or either in percentage or in dollar terms or both?

Budd, at the beginning of the year, I believe we gave the guidance of about 12.5%, which is about a full point higher than we had -- than actual was in 2010. And that's still a pretty good target that we're working towards. Budd Bugatch - Raymond James & Associates, Inc.: That fits with what my thoughts are. When you look at gross margin and the improvement of 170 basis points, can you quantify -- you gave us sales mix, pricing, leverage, productivity and modest inflation. Is there any quantification to that? Or is it in that order?

Well, it's generally in that order. I would -- well, it isn't really exactly in that order. The product that, I would say, the product efficiencies and the pricing is about 2/3 of it, and the promotional and mix side of it is about the other third. So roughly, it's in that direction. Budd Bugatch - Raymond James & Associates, Inc.: Okay. As I look at the ASP -- and I think now you've included the adjustable foundations in that versus what you showed last year, if I remember right, and I think you changed the definition of that. I calculate kind of an attachment rate of maybe about 14% or 15% of adjustables. Is that about right? Or is it better than that? Or...

That's pretty much in the ballpark. That's a pretty good number. Budd Bugatch - Raymond James & Associates, Inc.: And your goal, where would you like to see it at?

The answer would always be higher. But I think we're feeling like we're making good progress in that direction right now. Budd Bugatch - Raymond James & Associates, Inc.: What was it last year? Maybe that's a better way to ask the question.

It was in the very low double digits, a little over 10%. Budd Bugatch - Raymond James & Associates, Inc.: Okay, so it's improving.

It's absolutely improving, yes. And it has to do with both what we're doing up from a promotional standpoint, but we made -- we added a product at a little bit lower price point, really, to attract more customers to it, and that's been successful. And we've been working on how best to get the right mix of our various models from adjustable foundation to get the most out of that product. Budd Bugatch - Raymond James & Associates, Inc.: Okay. And I may not have heard this correctly. Did you say that you think you'll be at 63% gross margin in every quarter or just for the year?

That number was directed more towards where we would expect to be going forward, 63% or better in each one of the quarters. Budd Bugatch - Raymond James & Associates, Inc.: In each one of the quarters, I got you, okay. And do you see any inflation that's bothersome to you?

I think we feel good about where we're at with our contracts and our ability to manage that cost side, but we are seeing some pressure. And we always have our eye on oil prices and energy prices, but I think we feel pretty well positioned for where we're at right now.

I'd say the other thing on that, Budd, is that I think we -- well, we are very confident in our product and the value that we're offering, particularly on a competitive basis. And so if at some point we need to raise prices, we feel like we'll be doing so similar to the industry. And again, our price-value relationship will still hold. Budd Bugatch - Raymond James & Associates, Inc.: Okay. And finally, the G&A reflected the variable comp for this quarter. Is that something -- obviously, it should continue, but is it going to continue? What do you think G&A looks like now for the year?

Well, the G&A for the year will, as we've got it currently projected, would run certainly higher than where we originally thought. But I would say, our variable -- our incentive compensation is tied directly to net operating profit targets. So to the extent we perform against those targets, the incentive compensation moves with it. So you're looking at a G&A number that is 10% to 20% probably higher than a year ago with where we're running with the incentive compensation. Budd Bugatch - Raymond James & Associates, Inc.: That would put it at about $58 million to $63 million. Is that right?

Yes. I mean, we were -- we expected to be in the ballpark of more flat in the first quarter to where we were a year ago, and the incentive compensation is certainly bumping that number up a bit. Budd Bugatch - Raymond James & Associates, Inc.: Got you. Okay, thank you very much.

John Baugh.

Yes, John Baugh, Stifel, Nicolaus. Jumping right into it, Bill, did I hear you right in saying that some of the non-mall stores are helping mall stores? In other words, they're not cannibalizing mall stores; they're actually helping. Or did I read too much into that?

No, I think -- what I said was that we believe as non-mall stores help build the awareness of the Sleep Number brand and the fact that we have stores, consumers then do their research online. They find the store nearest them. And so we are getting anecdotal feedback from some of our mall stores that they've had customers coming in saying, "Boy, I didn't even know you guys were here. I didn't know there was a Sleep Number bed store in this market." And they're getting that because they have either seen the advertising or driven by a store in their market or in another one, so. And the placement of these stores, John, is such that we're trying to minimize the overlap or -- I think we've learned a lot about our trade areas and are positioning ourselves in these markets for good incremental growth as we go forward.

And I realize that it's only 5 stores. Not to harp on it, but is there some kind of average distance from a mall? And again, just trying to get clarity, it's not cannibalizing even if it's 10 or 20 miles away or something, it's not cannibalizing the mall store locations revenues.

I guess one of the key learnings that we had over the last couple of years as we had to downsize the number of stores was we learned that our trade radius could be 10, 15 miles as opposed to what we have been operating under, which was more of a 5-mile radius. And so by unpacking these markets or designing them more to the 10-mile, 15-mile trade area, we feel like we've got a way to continue to grow all of the -- well, to grow the average sales per store.

And sorry, did you say something? Okay. On the i10 bed, could you just give us some color on how that's positioned, where that's positioned and the price points quickly?

Yes. It is the top-of-the-line of our product. So it is the ultimate in personalized comfort. It is priced -- for queen set, it is about $4,500. That's about $200 more than the previous i10 was.

And it's offered in a good, better, best selection.

No, it is the best.

It is just -- it's that one product at that one price point, okay.

Correct. It's the best within our line. It's the best within our innovation series.

Could you prioritize, now that you've hit your cash target, what order dividends, buyback, I don't know, buying a box at the new Twins ballpark? Where the cash would go?

I don't think there's any boxes at the Twins ballpark anytime soon. But certainly, the focus is still on growth, and investing in growth would be the priority. We do want to maintain that balance of $100 million or better. And we are coming up to the seasonal low point, so we're likely to dip below that in the second quarter. But with regard to where we go from there, that's an item that we can begin to now start to think about, but it probably would be no earlier than the second half of the year before we'd be ready to talk about that.

Okay. And then just lastly, as we think longer range about store openings, is it too early to opine on where your thoughts go until you see non-mall results? Or how do you think about square footage growth rate going out in time? Thanks.

Well, the direction we've provided is that, on an ongoing kind of go-forward basis, about 5% would be a good planning target. We have a lot to learn, obviously, but that's what our initial thinking is.

Thank you.

Mark Rupe.

This is actually Andy in for Mark Rupe from Longbow Research. I guess, first off, if you could just maybe -- I know you gave us a little bit of detail surrounding, I guess, maybe sales pacing throughout the quarter with January and February being a little bit stronger than March. Could you maybe quantify that at all? Or give us kind of a sense of maybe how much softer March was kind of relative to the first 2 months?

Really can't provide much more color than that, other than to say we were still very happy with March. I would just say it was certainly more robust in January and February, but that isn't to say that we didn't see really good growth in March because we did. And I really wouldn't add much to that. And I think you can -- certainly from the guidance that we provided around comparable store sales going forward, that certainly factors in the trend throughout the quarter as well as what we're seeing in April as well.

Okay, that's helpful. I guess, surrounding your new media campaign and, particularly, with the TV, the new TV advertising, maybe could you give us an idea of how many test markets you're in right now for the new TV advertising?

Yes. I'm not sure I would call it test markets, Andy. We've actually run the campaign nationally for a period of time during Presidents' Day. And then we've also -- we had about 11 markets that were TV before, and we've now converted the creative in those markets to the new execution.

Okay, great. Got you. And then just finally for me, on -- with the re-launch of your website, could you give us maybe a little bit of an idea of kind of what sort of changes we should expect to see? And also, I think you kind of hinted at it, but it sounds like maybe the site will kind of be used for more of a sort of vehicle to drive people to the stores versus kind of growing e-commerce sales. Is that the right way to think about it? Or would you expect to see some benefit on the e-commerce business as well?

Well, the changes to expect are really just more a lot more alignment with the brand and a lot easier functionality, both for a consumer doing research as well as purchasing. Though we would agree, I think, with your point there that the primary benefit of this is going to be to increase the awareness of our brand differentiation, increase the awareness of our store uniqueness and their locations. It should lead to some increased e-commerce sales, too, but we're not counting on that. The primary purpose of this is to support the #1 priority of increasing awareness and consideration of our brand and our stores.

Okay, great. Thanks a lot, guys. Good luck.

[Operator Instructions] At this time, I'm showing no other questions. I'd like to hand it back to our speaker.

Thank you, Angie. If there are no further questions at this time, then we'll conclude the call. Thank you all for joining us, and we look forward to reporting to you further following our second quarter. Thank you

Thank you. That does conclude today's conference. Thank you for your participation. You may now disconnect from the audio portion.