Welcome to Select Comfort’s Q3 2017 Earnings Conference Call. All lines have been placed in a listen-only mode until the question-and-answer session of today’s conference. Today’s call is being recorded. If anyone has any objection, you may disconnect at this time. I would now like to introduce Mr. David Schwantes, Vice President of Finance and Investor Relations. Thank you. You may begin.

Good afternoon and welcome to the Select Comfort Corporation’s third quarter 2017 earnings conference call. Thank you for joining us. I am Dave Schwantes, Vice President of Finance and Investor Relations. With me today are Shelly Ibach, our President and CEO; and David Callen, our Senior Vice President and CFO. This telephone conference is being recorded and will be available on our website at sleepnumber.com. Please refer to the details in our news release to access the replay. Please also refer to our news release for a reconciliation of certain non-GAAP financial measures and supplemental financial information included in the news release or that may be discussed on this 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 news 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 Shelly for her comments.

Good afternoon everyone and thank you for joining our call today. My SleepIQ score last night was 74. Our consumer innovation strategy continues to gain traction in a dynamic retail environment. The investments we’ve made to strengthen our competitive advantages and expand our brand reach are resulting in profitable growth and strong cash flow generation. With the progress we’ve made this past few years towards our vision of becoming one of the world’s most beloved brands by delivering unparalleled sleep experiences. It is an appropriate time to change our corporate name to Sleep Number Corporation effective November 1st. At that time, we will also change our NASDAQ ticker symbol from SCSS to SNBR. Our reported third quarter net sales of $403 million reflects steady growth throughout the quarter including Labor Day weekend. The exception to our consistent performance with the week before and the week after Labor Day weekend, which were each impacted by hurricane Harvey and Irma. About 13% of our store portfolio was directly affected by the hurricane, including stores in Florida, Texas and the surrounding states. We also experienced consumer distraction across the country during this specific timeframe. We estimate that the hurricanes resulted in $12 million to $15 million in lost or delayed sales in the quarter. Traffic and sales before and after these two weeks were on plan and all affected stores are now open. We are thankful that our team members in Florida and Texas are safe and we’re very proud of how they have supported one another and their community. In addition to our team’s individual effort, Sleep Number has made $1 million donation of products to support the recovery in affected communities. We offset most of the sales impact from the hurricanes with stronger than expected gross margin and expense controls. Earnings…

Thank you, Shelly. As a sleep innovation leader, we are on the right path to deliver superior shareholder value. So far in 2017 our demand drivers, which include our latest innovations in the 360 smart bed, led to 8% net sales growth in a noisy retail and changing consumer environment. Our leverage drivers have delivered a higher than expected 120 basis point year-to-date gross margin rate improvements. These drivers combined with our capital initiatives have led to a 30% increase in year-to-date free cash flows a 36% increase in our diluted earnings per share and an ROIC of nearly 14% more than 70% stronger than our estimated 8% weighted average cost of capital. This is the beginning of the cash and profit acceleration we expected when building our differentiated business model. For the third quarter, net sales increased 9% to $403 million. Our results include the $25 million of delayed deliveries carried over from Q2. As noted in Shelly’s prepared remarks our business during this seasonally largest sales quarter were negatively affected by hurricanes Harvey and Irma the week before and the week following the Labor Day weekend. Our sales performance was steady prior to and after these storms, and we’re on plan for the Labor Day weekend. However, we operate in a low interest category and during those two weeks, consumers across the country were concerned by the extensive damage from the hurricanes. We estimate these temporary disruptions cost us $12 million to $15 million in net sales in the quarter, which equates to $0.05 to $0.08 of EPS. That said, we offset most of the earnings impact of these lost sales through stronger than expected gross margin and expense controls that I’ll discuss further in a moment. We continue to expect high single digit sales growth for 2017…

Thank you. We will now begin the question-and-answer session for today’s conference. [Operator Instructions] Our first question is coming from John Baugh with Stifel. Your line is open.

Good afternoon and thanks for taking my questions. I was just curious on the hurricane impacts that you broke out. Could you – you mentioned, you were on plan for and after and during Labor Day and I don’t know recall the exact timing of the two storms. But I was wondering if you could just parse it a little finer and so we can discern how you came up with the number. Appreciate it.

Yes, thanks John. It’s exactly the way that I was describing it, it was about the week prior to the Labor Day weekend and then the week after that was hurricane Harvey. And then the week after Labor Day weekend hurricane Irma came ashore. Those are the two weeks in which we saw a meaningful difference in our performance versus our plan. That’s how we’ve triangulated the estimated impact of $12 million to $15 million on our net sales for Q3.

Okay, thanks. And I noticed payables were up significantly. Is there something driving that or it’s just timing?

John, we continue to work on all elements of our balance sheet including our working capital management largely though that’s just timing.

Okay. And then on the hubs-and-spokes and DCs it’s sounds like there’s a fair bit going on and it sounds like there’s some transition cost within benefits. And I guess I’m trying to discern what happens, what’s helping, what’s turning into sort of the timing of all that and I’m not looking for quarters, but maybe the 2017, 2018 and 2019 the annuals.

Yes, John. This goes back to our conversation at the November investor conference. We highlighted then that we’re going to have some transition costs associated with the launch of the 360 as well as the evolution of our supply chain. Both of which we’ve highlighted that they pale in comparison to the benefits that will ultimately gain. We’re starting to see some of those benefits already you’ve seen based on the two 360 models that we’ve had launched very strong ARU growth, very high demand with consumers they love the product. And on the supply chain evolution, we’ve encountered a couple of hiccups that we’ve highlighted, but resolving those rapidly and taking care of our customers is our focus. And we expect the transition costs we’ve highlighted that there are about $0.18 worth in 2017 and we haven’t yet talked about 2018, but I’m sure that there will be some level maybe half as much again in 2018, but we’ll highlight that more when we provide our 2018 guidance on a Q4 call.

Okay. And lastly, is there been any pricing changes I know you changed pricing in and around holiday events, but any year-over-year changes worth calling out. Thank you.

Our promotions John, were largely consistent with what we’ve run in the last year. We felt really good about the response and then Shelly highlighted demand in our performance was steady through the quarter other than those two weeks that we highlighted.

Thank you. Good luck.

Thanks very much.

Thank you. Our next question is coming from Peter Keith with Piper Jaffray. Your line is open.

Peter, are you there? Eljoe he may have his line muted. Maybe you can…

Yes, sir. Our next question is coming from Budd Bugatch with Raymond James.

Hi, thank you for taking my question. I missed a little bit of the call as the operator was coming back on the line for whatever reason. But David if you could just on the sales issue the way comps are calculated. If you take the $25 million out of the comp, I get short of a negative about 2% some comp is that the right way to think about that. And again the hurricane back in, the effect back in I get a 1% to 2% positive comp ceteris paribus everything else being equal?

Yes. That’s directionally okay, but I know that you don’t love it when I say that, but the bottom line is – the $25 million was both from new stores and comp stores so it sounds like you’re attributing it to all comp and the same thing goes on the impact from the hurricane but directionally you’re fine.

Okay. Just I’m trying to understand how to parse out the…

Yes. If I could highlight one thing is, when we think about it in total that adjusting for those two impacts we were in the 6% to 6.5% growth range.

I got that. And if I look at the advertising budget for the fourth quarter it looks to me like advertising over a flat year-over-year or very close to flat year-over-year in terms of total dollars to get to a 60 basis point improvement which would be like 14% versus 14.6% last year?

Yes. That’s about right, Budd.

Okay. And then as I look at, also look at then if I take that and do the math to get what are the – what I would call non-media sales and marketing expense, look like that grew about 14% quarter-over-quarter. And I know that, that’s not – I don’t think that includes the incentive comp. Can you talk about how much of that is spending and how much of that’s transition? Where – that’s part of what I think I missed in the conversation you were having during your script.

Yes, we’ve highlighted that we have – the store increase in terms of the count, the depreciation, the staffing, et cetera, that’s all included in the selling and marketing costs. We’ve also got financing costs embedded in there. With the stronger ARU that we’ve been seeing, some of that’s being – more of that is being financed, and that’s flowing through in the sales and marketing side. So we started the year with guidance of 44% to 45% of net sales, and we’re maintaining pretty consistent to that. We’re ending our guidance today, we’re talking about it as 45% of net sales for the year.

Okay. That is about where I come out. All right, I let others have it in hopefully we can catchup afterwards, I got more questions.

That sounds good, Budd.

Thank you. Our next question is coming Brad Thomas with KeyBanc. Your line is open.

Yes, good afternoon everyone. Couple of questions if I could. First, just wanted to touch on ARU. The growth there obviously very strong. You referenced solid response to the i7 and i10 relaunches. I was hoping you could just talk a little bit more about that growth in ARU, strongest in a couple of years. And is that what you’d like to be driving in the business or perhaps is there an opportunity to drive more units if you weren’t driving the ARU up so much?

Brad thanks for the question. Well, of course, we always appreciate the benefits of this business model with having both ARU and unit growth. And as we’ve communicated for the last number of years, consistent with our consumer innovation strategy, we expect both out of the business and continue to deliver both on an annual basis. We, with this first phase, launched the high end of our 360 smart bed line, so it is driving more ARU growth than we had originally planned in the year. But we also expect unit growth, and we will expect growth from both in 2018 as well. So year-to-date, our ARU growth is 5% and 3% and – or units is 3% – 4%, sorry 4%, so growth for both.

Got it. Okay. And then just to follow up on gross margin, I think this is for 3Q and for 2Q before it, you’ve clocked in better than we and I think the Street more broadly was looking for. I guess I was hoping to just follow up about what it was that was driving that outperformance. And as you get further into some of the supply chain evolution, if you could just talk a little bit more about your confidence in continuing to drive margins higher over the next couple of years.

Well, the gross margin improvement was largely due to mix as you look at the 360 smart beds at the high end of our line and being able to drive up mix. So that’s contributing to both the ARU and gross margin and also manufacturing productivity. So it’s coming from two important aspects of our EPS drivers in demand and leverage. And of course, we like to see that in the business. And as we move forward, again, we have the additional models of 360 coming, which we expect to contribute to that unit growth as well as ARU and then also the advancements in our supply chain. Regarding confidence in the margin expansion potential as a result of the initiatives we’re working on right now, it’s very high. We’re excited with the amount of opportunity we have in front of us. As we become both more efficient with our phased launch of 360 but also the network redesign, the continuous improvement that we’re able to make progress in across our organization with all of our lean initiatives. And really, it’s been quite fun to see the culture grow in this area and the desire throughout the organization to find ways and drive it out of our business.

That’s helpful. Thank you so much, Shelly.

Thank you. Our next question is coming from Seth Basham with Wedbush. Your line is open.

Thanks a lot and good afternoon.

Hey Seth.

My first question is on comp units. I know you don’t provide the number, but if your comp sale is adjusted for the delayed sales as well as the hurricanes were up 1% to 2% and your ARU was up 11%, it means your comp store units on an applied basis were down high single digits. I know that’s not up to your plan, but what is going to drive significant improvement in that to get to positive levels again?

Seth, we see – we see the significant improvement coming from the 360 smart bed when we roll it out with all of our models. Right now, as I stated, we’re focused on the high end of the line first, the B unit growth will – we expect to be very strong with the C series and the P series.

Got it. Are you guys experiencing a high level of cancellation rates more so than normal because of some of the challenges that you faced operationally?

Yes, slightly. But that’s baked into how we’re thinking about our performance and our guidance for the year.

Understood. And then as it relates to commodity inflation, we’ve seen pretty significant increases in input costs for foam. How are you looking at commodities into your gross margin plans for the balance of the year and 2018?

Well, that’s a part of the business model, and we have contracts with our foam providers that help us limit the amount that they can increase their pricing quarter-by-quarter. However clearly, the hurricanes also impacted Houston, and there were some pressures in that region. We expect it to be short term in nature and – but again, with this model, Seth, we love that we have pricing power over the course of time. We’ve had a 3% price improvement, benefit-driven price improvements over time going back for five or seven years.

The other thing I would add, Seth, is we are working very closely with our suppliers in continuing to find more efficient and productive ways to do business and align with suppliers who have a similar lean mindset as we do. And that kind of partnership and long-term view is very helpful in us working together to find other ways for efficiency.

Got it. Just to be clear, you expect to be able to take price to offset any commodity price inflation?

No, I’m just saying that we have that capability, but we’re also driving a lot of initiatives, including the lean manufacturing operational efficiencies. And we want to deliver strong value propositions to our customers as well. So we’ll take it on a case-by-case basis as we encounter it.

All right. And lastly, as it relates to the launch of the other units in November as well as in 2018, would you expect those to be priced at the same level as the prior models? Or do you expect them to be priced higher?

Similar. We’ll talk about the p6 because that’s launching in November, and we are planning on a similar price to the p6. Again, we are benefiting from the ARU growth by attaching our FlexFit adjustable base at a higher level along with SleepIQ technology.

Got it. Thank you very much.

Thank you.

Our next question is coming from Keith Hughes with SunTrust. Your line is open.

Thank you. First question, back to some of the product challenges you were talking about earlier, could you talk again on the adjustable bases? I was just a little confused of what happened in the quarter around those and where you are fixing that.

Yes. So what’s important, Keith, is that these are not material items that we’re talking about. What they are, are material innovations that our consumers love. And we’re trying to make sure that you understand both sides of that, that it’s important for our strategy and for the consumer that, in this case, we have a new surround that encapsulates the entire FlexFit base, and it’s very attractive. And during the initial part of the launch, we saw more damage than we expected to that surround. We’ve quickly responded and fixed the packaging associated with that, and we feel good about where we’re headed going forward.

Okay. And the other question, the expenses you’re looking at another $0.08 potentially next year around launch costs, is that correct? Is that where all the $0.08 come from?

We haven’t provided specific guidance for 2018. I just threw out that directionally, half of what we’re expecting for this year, you can use that as a benchmark as you put together your model for next year. I’ll provide more detailed guidance when we have our Q4 call.

Okay. And will the launches for the remaining of the 360, will they be done midyear? Or are you willing to say when at this point?

We expect to be completely launched by middle of next year. And the other side of the transition costs though is associated with the supply chain evolution, which is a multiyear effort.

Okay. That’s all I have. Thanks very much.

Thank you, Keith.

Next question is coming from Peter Keith with Piper Jaffray. Your line is open.

All right, Peter take two.

All right, here we go. That’s for last right? So the $12 million to $15 million of sales impact from the hurricanes, how should we think about that now going forward? Are you guys – does that maybe create pent-up demand? Or do you view it as sort of lost sales that you’ll just lap next year?

Well, our guidance for mid to high single-digit growth in Q4 doesn’t assume that we get a big rebound of those sales coming back into Q4. However, it would take us to the higher end of our guidance range should some of those sales come back, and we’d certainly – we’re here to take care of those customers.

Okay, very good. And just looking at Q4, using the midpoint of your guidance would imply Q4 EPS of $0.22. Consensus right now is at about $0.15, so pretty big delta. Do you have any visibility on where the Street might be underestimating your Q4 performance?

We can take a look at the modeling questions on the after calls, Peter. This is basically in line with how we had been thinking about the year, at the midpoint, even going back to the Q2 call when we’re guiding to the midpoint, our EPS was different than where the consensus was landing, and I think the biggest delta there was in the cost structure. So let’s take this off-line.

Okay, got it. Maybe one or two more. So you had mentioned earlier, I think in response to Seth’s question, that you were experiencing a higher level of cancellations. And it did appear with some of the social media trends in the quarter that there were some delivery issues. I guess, a, are you through the delivery issues? B, why are you experiencing them? And then C, when can we expect maybe getting back to a normal level of cancellation?

I talked about the cancellation rates being just modestly higher. We talked, coming into the quarter, that we’d had some inventory challenges that we got resolved pretty quickly and taking care of those customers in the quarter, that created some noise for us. We highlighted a couple of things related to the 360 launch that we’ve worked through, and those created a little bit of noise for us. We are really excited about the p6 launch next month in November and feel good about where we are and our ability to deliver a very strong customer experience with that. I guess the other element I highlighted as well during the call that the hurricane also impacted our supply. And we had FlexFit bases coming out of Tampa that were delayed, and that impacted some of our deliveries as well in the quarter.

And Peter, just as an example, those FlexFits coming out of Florida, they were being delivered in customers’ homes who were not at all affected by the hurricane. So that created some confusion for those customers not understanding that, that would be a delay that would impact them.

Okay, very good. One last one here. So on the Sleep 360 rollout, I believe you had two models, two of seven in the marketplace today. You have the p6 coming out in November, so that I guess would imply sort of by year-end, you’ll have less than half of the line converted, yet the transition costs are expected to step down meaningfully. I guess can you – in 2018 can you tie it together when it seems like there’s more models rolling out next year versus this year?

Yes, glad to do it. And I think what you’re seeing is that ramping up suppliers is a bigger component of the transition costs than maybe you were thinking about before. And that’s kind of front-loaded.

And also as we’ve talked about this phased approach and we gave you a couple of examples of learnings in the quarter and efficiencies that we’re able to improve on prior to the next phase. And so you can expect that too as we move forward with our transition costs, we’ll be more efficient.

All right. Very good thank you very much and good luck for Q4.

Thank you.

Thanks, Peter.

Our next question is coming from Michael Lasser with UBS. Your line is open.

[indiscernible] calling in for Michael Lasser. Thanks a lot for taking my questions. So I missed a little bit of the call early on, so I’m sorry if you already answered these questions. But on the hurricane, the $12 million to $15 million that you mentioned that you lost during the couple of weeks that we had hurricanes, is it a total amount for the quarter? Or is it a net amount, assuming that you recaptured a bit in the final couple of quarters – the final couple of weeks of the quarter, sorry?

Yes, we’re highlighting that the $12 million to $15 million is attributed to the two weeks where the hurricanes were coming ashore and impacting the country and impacting broadly in this low interest category consumers across the whole country as they were focused on seeing the devastation that those hurricanes were causing.

And also the specific 13% of our stores that were directly impacted.

Yes, both impact on the 70-plus stores, almost – about a 340 lost days of sales, and then the indirect impact for the consumers that were distracted.

Okay. So just to clarify, you were not seeing much of a recapture in the last two weeks when the weather stabilized in those markets?

As we highlighted, we were steady. Our performance was steady across the entire quarter outside of those two weeks.

Okay, that’s fair. And as my follow-up, can you just remind us as to how much of the $0.18 of launch costs have you already incurred in the first three quarters of the year?

$0.12

Okay, great. Thank you very much.

Thank you. Our next question is coming from Curtis Nagle from Bank of America.

Great. Thank for taking the questions. So I guess the first one is what is your level of confidence that you guys think your I guess – through I guess potential new issues with the 20 new vendors after the foam issue in 1Q and then another albeit smaller issue this quarter? I mean, are you guys going back and perhaps doing audits? I guess, how comfortable are you feeling with the new suppliers?

We’ve done our homework with our suppliers, and we’re working with suppliers that are working with us both on the innovation side as well as the profit objective side. And we’ve implemented some stronger controls and inspection over our suppliers and moving from a reactive place where we identify problems once they’re already in their customers’ homes to more of a preventive strategy where we’re focused on solid quality coming out of our suppliers factories before they ever get to us.

It’s a great question. This is one of the reasons why we’ve taken additional time in this particular phase as we uncover learnings and doing the – taking this time to do the deep dive in all aspects and striving to gain as much efficiency as we can and great customer experience before we roll out the next phase. And we’re about to do that with the p6, and that speaks to our confidence.

Got it. And then just a quick follow-up. On the new $500 million buyback authorization, could you give us some sense on perhaps what the timing would be? Is this perhaps, I don’t know, maybe a three-year window? Or are you thinking something a little shorter or longer?

Yes, Curtis, this is really important relevant to our strategy, and we’ve been highlighting that we expect from the model that we will accelerate profits and accelerate our cash generation. We are seeing that already, and we’re at the beginning phases of that. We expect that the $500 million will give us capacity to execute against our plans, our commitments to all three EPS drivers, that’s demand, leverage of our operations and the accretion through share repurchases. And this gives us the capacity to do that through 2019.

Got it. Okay, thanks very much.

Thank you. Our next question is coming from Jim Larkins with Wasatch. Your line is open.

Thank you. Hey, a couple of numbers, I may have missed, if you could review these. Did you give the number of shares you bought back in the quarter?

Just a second, Jim. Did you have that handy? We bought $40 million worth, Jim, at about $31 a share.

Okay, great. And then could you give me the dollars you spent on media this quarter and last quarter?

This quarter, it was up about 5%. Let me just take through my notes here. Media spending in Q3 was about $56 million and last quarter was $42 million.

Great. Can you give some more color on what’s working with the 360? It sounds like you’re above plan. Just maybe give us some more color on that?

Yes, a couple of things. First of all, I highlighted the consumer trends around the smart connect, smart products as well as the interest and the understanding that sleep contributes to improved wellness. And what’s great about the 360 product and consumers are responding so strongly to is the effortless nature of this bed, the effortless adjustability as well as connecting to your other devices. So the bed is there, and the customers really does not need to do anything because the bed will do it for her, and it delivers a higher-quality sleep, and again, that leads to improved wellness. I would also highlight the way the bed works with the adjustable base. So our FlexFit adjustable base and Sleep Number 360 mattress were designed together, and the customer is experiencing that in our stores with our selling process in a way that they’re choosing both, that integrated design driving the ARU.

Okay, great. And then could you talk about kind of when do you expect to kind of have optimal delivery and set-up times kind of hitting your targets? And what would those targets be?

As far as our delivery time period, we’re on…

I guess, how long would it take to get a bed after it’s been ordered and then set-up times. When do you think you’ll be to the optimal level and what’s your target for those levels?

Well, the optimal level may continue to move based on the consumer. What we love about our new system as a result of our ERP system is the ability to schedule customers in store. And this will vary depending on where a customer lives. So if you go into a store today and depending on what bed you select and where you live, there could be a delivery window as soon as three days from now and you could have your bed. Or if it’s in a more rural area, it may be two weeks before that first available delivery. So there is variation and there will be as we move forward who won’t optimize to every last delivery zone. This will continue to move and advance as we go through our network evolution.

And what kind of a sales opportunity is there as you improve on those metrics?

Jim, I’m not sure if it’s as much about the number of days as it is being on time and being there when you say you’re going to. And our focus for our business is first time complete, being on track with what we promised our customer. That’s our priority and where we’re staying focused and what’s most important to our customer.

Okay, very good. And then any color on kind of mall versus off-mall? Any important trends that we’d be surprised by there?

I would say no. No important trends that you would be surprised by other than the fact that we continue to have strong success in both mall and nonmall. Our portfolio is heavier now in nonmall than mall, so that significant change when you consider our first nonmall store was built in December of, I think it was 2010, and here we are at the end of Q3, about 56% of the portfolio in nonmall. I will say that we still have very strong significant stores in malls and the right malls. And we’re happy with both, and we’re really thrilled that we’re driving a portfolio that allows the customer – allows us to be where the customer is shopping.

Okay. And then any update you can give us on – I think you call it your focused markets or I’m not sure of the exact name you use on that, but I think you rolled out a new one this year. And just I know you’re pretty quiet on kind of what those look like, but any color you’d give us to that strategy?

On our aggressive growth strategy, continuing and continuing to make the progress that we expect and the necessary progress to achieve our goals.

Hey, Jim, I’m going to have to go to the next caller. We’ve got a couple more we got to get through yet.

Okay. Thank you.

All right. Thank you.

Our next question is coming from Seth Basham with Wedbush. Your line is open.

Just two quick follow-up questions. In the past, you gave us some color on your ARU components in terms of mix as well as contribution from attachments. Can you break down that 11% for us any further?

I don’t think we – I don’t recall providing a breakdown of our ARU, but the bulk of it was from stronger attach.

Okay, that’s helpful. And then lastly, some of the data that we’ve seen recently suggested an increase in the negative reviews of your SleepIQ app. I’m wondering if there have been any integration issues with the 360 beds or anything else that might be driving that.

Yes, we saw a little bit of some challenges in the early deliveries, Seth, and we’ve since remedied that with a software push. And we’re seeing very strong participation and enrollment with our 360 customers on SleepIQ.

Since we have no questions in queue, I turn the call over to the company for closing remarks.

We look forward to discussing our fourth quarter 2017 performance with you next year. Sleep well and dream big.