Dave Schwantes - Shelly R. Ibach - Chief Executive Officer, President and Executive Director David R. Callen - Chief Financial Officer and Senior Vice President.

Joshua Borstein - Longbow Research LLC John A. Baugh - Stifel, Nicolaus & Company, Incorporated, Research Division Budd Bugatch - Raymond James & Associates, Inc., Research Division Jessica Schoen - Nomura Securities Co. Ltd., Research Division Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division Peter J.

Keith - Piper Jaffray Companies, Research Division Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division.

Welcome to Select Comfort's Q3 2014 Earnings Conference Call. [Operator Instructions] Today's call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to introduce Dave Schwantes, Senior Director of Investor Relations. Thank you. You may begin..

Thank you, Angie. Good afternoon, and welcome to the Select Comfort Corporation Third Quarter 2014 Earnings Conference Call. Thank you for joining us. I am Dave Schwantes, Senior Director of 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 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..

Our customer relationship leads to benefit-driven innovations that are additive to our core business; our national scale is resulting in advertising efficiency and increased traffic; our customer experience and selling process continue to result in high conversion; our highly productive stores continue to increase average sales and profit per store as we fill in new locations; our customer loyalty continues to be a strength and outcome of our vertical model.

With that, I will turn the call over to David to highlight additional financial details from the quarter and provide perspective on our fourth quarter outlook..

Thank you, Shelly. Good afternoon, everyone. As Shelly discussed, our record sales of $323 million in the third quarter represents 23% growth over the prior year. Earnings per diluted share grew 22% over the prior year to $0.44. Results were ahead of internal expectations and as anticipated, returned us to year-over-year bottom line growth.

We are strengthening our long-term relationships with our customers through connectivity like SleepIQ technology. Our customers now interact with our brand every day, which is a powerful advantage. This ongoing exchange with our customers through SleepIQ is creating a growing source of future income.

While generating cash immediately, SleepIQ revenues and certain direct costs are deferred to our balance sheet. As a result, our third quarter reported net sales exclude $4 million of SleepIQ technology sales and $0.02 of earnings per share. The deferrals will be recognized over the useful life of the product, currently estimated to be 5 years.

Our comments and metrics going forward reflect these deferrals. Comp store sales grew 16% over the prior year in Q3, and new stores added 8% of the growth in the quarter. Both metrics accelerated from the second quarter and demonstrate how the disciplined spending and investments in key growth initiatives are driving shareholder value.

Traffic to our stores also improved during the quarter, which drove a 10% increase in deliveries of our company-controlled mattress units. Our trailing 12-month sales per comp store grew to a record $2.2 million.

While a $2.2 million store delivers four-wall profit of approximately $800,000, a $3 million store contributes profits of approximately $1.2 million. We continue to target average sales per store of $3 million and more than 550 stores in the United States, while strengthening our online customer experience.

14% of our stores currently generate greater than $3 million in annual sales compared to 10% a year ago. In the third quarter, we entered 3 new markets, including one additional state, while developing 13 of our existing markets. Total store actions included 10 new stores, 3 remodels and expansions and 3 relocations.

We ended the quarter with 460 stores and plan to end 2014 with 463 stores. Our disciplined market-based development approach leads to market share gains and sustainable, profitable growth. Our site selection process combines art with science, utilizing our proprietary customer prospecting model to evaluate each market.

This process contributes to increasing productivity of existing stores while adding new stores, with cannibalization rates of less than 20%. Over the past 3 years, we have increased our average sales per comp store 38% while improving the real estate and store experience of over 250 stores.

We continue to achieve a payback on our new store actions of approximately 2 years. Gross profit of $199 million for the quarter grew 19% on record sales. A higher mix of our new FlexFit adjustable base series contributed meaningfully to the gross profit growth and to our 61.4% gross margin rate.

While up 70 basis points sequentially, gross margin was 50 basis points lower than expected. High demand in the quarter strained our legacy infrastructure and supply chain. Our team worked heroically, but inefficient manual processes are impacting the business as we scale.

These constraints underscore the importance of building new capabilities and systems. We are midway through a multi-year plan to build key business processes, and to replace our nearly 20-year-old core operating system. This is a large undertaking that will support the key processes of our vertically integrated business for many years to come.

Approximately $30 million of our $80 million in capital spending this year is to support this project. Our 2015 guidance, which we will provide next quarter, will include estimates for CapEx, launch costs and depreciation associated with this implementation. We plan to go live with our new technology platforms 1 year from now.

This infrastructure is critical to enable scale for growth by streamlining our operations and therefore, improving our customers' experience. We expect our Q4 gross margin rate to be slightly better than Q4 last year. Improvements to processes will benefit the business in 2015 and accelerate in 2016 as our new systems and related processes mature.

Total operating expenses of $163 million leveraged 100 basis points as a percentage of net sales during the quarter to 50.5%. Sales and marketing expenses of $138 million or 42.6% of net sales were levered 230 basis points versus the prior year. This included a higher-than-expected 170 basis points of leverage from media spending.

We expect Q4 media leverage to be less than Q3. Remaining operating expenses for the quarter of $25 million or 7.8% of net sales deleveraged by 120 basis points as a percent of net sales compared to the prior year. This spending increase reflects our efforts to build the infrastructure to support our growing business.

We expect similar G&A and R&D spending in Q4 to Q3. Diluted earnings per share for the third quarter were $0.44, up 22% versus $0.36 the prior year. We raised our 2014 full year EPS outlook to $1.12 from $1.07 previously. Please keep in mind that the 53rd week this fiscal year adds an estimated $0.05 of EPS in the fourth quarter.

Excluding the 53rd week, the implied fourth quarter EPS would reflect a 42% growth over the prior year.

Our new outlook reflects strong customer response to our marketing, product innovation and store experience, balanced with continued gross margin impacts from source products and process inefficiencies, continued investment in spending on growth drivers, operating capabilities and infrastructure, including our new ERP platforms, to sustainably support our growth and appropriate caution in the fourth quarter, given the continued mixed signals regarding the overall macroeconomic environment and a less predictable consumer period.

Year-to-date, we have generated $136 million in cash and cash from operations compared to $90 million the prior year-to-date. We ended the seasonally high cash quarter with $177 million in cash and securities or $148 million, net of customer prepayments. Our $49 million in inventories ended lower than we expected.

To support our initiatives, we plan to increase our inventory to approximately $55 million by the end of 2014. Cash and securities, net of customer deposits, are expected to be approximately $15 million lower than the prior year end.

During the quarter, we thoroughly reviewed our capital structure, in conjunction with near-term and long-range strategic and financial plans. This includes consideration of capital spending plans and $250 million in operating lease commitments.

With the goal of superior value creation over time, we aligned on the cash deployment priorities Shelly outlined today. We concluded that our capital structure and plans are appropriate to provide strong returns to shareholders as we execute our organic growth strategy.

This structure and strategy have enabled us to invest in the business while returning $100 million or nearly 100% of our free cash flow to shareholders since our share repurchase program began in Q2 of 2012.

The confidence we have in our plans is illustrated by the increased $250 million share repurchase authorization and our commitment to repurchase up to $60 million of our outstanding shares per year. It is gratifying to see the strong results arising from the hard work of our Sleep Number team. That said, we have significant opportunities ahead.

We expect our disciplined investment and spending approach to deliver sustainable profitable growth. With that, I'll turn the call back to Shelly for closing comments..

I'd like to close by thanking our Sleep Number team for their unwavering dedication to our mission of improving lives by individualizing sleep experiences. The third quarter performance begins to reflect the impact of our growth initiatives.

We expect our consumer-focused innovation strategy and capital priorities to deliver sustainable value for shareholders. We appreciate your attention. David and I now welcome your questions.

Angie, would you please open the line for questions?.

[Operator Instructions] Our first question comes from Josh Borstein from Longbow..

Just to begin, I guess most impressively, you returned a positive unit growth on a same-store sales basis, I think, for the first time in 7 quarters.

What's changed for you? To what do you attribute the turnaround to? And can we expect positive unit growth in 4Q as well?.

Hello, Josh. As we have communicated, we see units tied to generating traffic, which comes from marketing effectiveness. And we have progressed our growth initiative, marketing effectiveness each and every quarter this year. And the third quarter represents the advancements of our effectiveness.

It's a combination of our creative, along with our media buy. And we see the marketing effectiveness result in traffic, which generates units. Therefore, we had the 10% unit growth and the comp positive unit growth.

As we think about the fourth quarter, we -- at the -- on the top line, as we look at fourth quarter, we are looking at a 20% or greater sales increase. And of course, that's inclusive of the 53rd week, which we estimate to be about 8% of growth.

At the same time, we are being prudent because we have -- we had a more challenging time in the fourth quarter. It's a less predictable consumer time period for our business. And we've yet to prove out our initiative in being able to drive unit growth in this time period.

We remain very confident in the ARU growth with the innovations that we put forth this year. And we're anxious to learn how our marketing initiatives will apply to traffic during the fourth quarter, and therefore unit growth..

Okay. I appreciate the color there. And then, just a question on gross margin. You talked about the gross margin being driven lower by mix and also the higher logistics cost to meet the increased demand.

Could you break out how much was due to logistics and if you expect that to repeat here in 4Q?.

Sure. We see the impact from the logistics costs as being about 50 basis points in the quarter. We are expecting our Q4 gross margin to be slightly better than Q4 last year, as we expect some of that pressure to continue into the fourth quarter this year and expect some improvements in our processes to help us in 2015 and beyond..

Okay. And the negative mix issue from the increase in bases. Obviously, it's a good problem to have, may bring the rate down but brings your dollars up.

Is there something structurally different, do you think, with gross margin going forward now that people seem to be buying more bases?.

So you're right. The 19% increase in our gross profit dollars was directly tied to the growth that we're having, which is driven largely by our FlexFit adjustable bases, as we commented on. So we're expecting that we'll be able to continue that trend going forward..

John Baugh from Stifel..

Questions, let's see. First of all, I notice customer deposits were up almost twice last year at the end of the quarter. Does that indicate some additional strength later in the quarter, or? Help me to understand that number..

Hey John, thanks for the question. We -- as we talked about, some of the high demand we saw in the third quarter impacted some of our lead times, our delivery times. But the customer deposits reflect a very short window of our business. And it's not correlated to sales growth in the next quarter..

Okay. What were the new markets you entered? You mentioned, I think, 3, and help us think about store openings by market going forward..

We're going to have to get back to you on the specific locations, John. We'll take that off-line..

Okay. Any update, Shelly, on brand and store awareness? I know how key that is to driving traffic. It sounds like those numbers maybe got better.

Anything you can give us?.

Yes, John. We're in market with that study right now. The last read we had on our brand unaided awareness, which is probably the number you're asking about was, in January of this year, and it was 20. We certainly have strong metrics around brand regard with the business and, but they're smaller metrics..

Understood. And then back on the gross margin question. You gave us help on some of the inefficiencies. But, and those will, I guess, will mitigate through time.

But is there any kind of guide relative to the 62% to 64% range have been the last couple of years prior to this year, in terms of all of these SleepIQ things, adjustables, all of these things that are impacting that number in terms of a goal to think about longer range where you'd like to get back to, once the inefficiencies are behind you?.

John, we've been talking about the importance of the gross profit dollars and the gross margin rate is also important to us. We expect some improvement in that area, but we're not providing longer-term guidance in that regard.

What we are providing is some perspective that we're expecting our returns on invested capital over time to increase to the mid-teens, from the 13% we saw last year..

John, one other thing to think if you think about regarding gross margin, you're right. Our business is evolving and it's an important evolution. The innovations that we're bringing forth all attach back to our core bed line, so they are additive in the area of ARU and you're seeing that in our ARU growth.

But they also stimulate the core business and you can see that in our repeat and refer sales. And you know the strength of the margin with the core business. So when we can build the business in an additive way, that's a good healthy opportunity and challenge for us. And we're pretty pleased with what that looks like, going forward.

And then ultimately, as we improve our infrastructure, where we're experiencing some margin pressure right now, like the 50 basis points that we didn't expect here in the quarter, that will come back to us as we install our ERP and begin to benefit in 2016 from that install and the agility that we have with the new systems..

Budd Bugatch from Raymond James..

Most of them have been asked. Let me ask just a couple of detailed questions. David, any accrual for incentive comp above what you would have originally expected for the year? And I guess, it would be in G&A, if I'm not mistaken, or maybe it's all through a couple of other expense buckets, too..

Sure, Budd. With the higher-than-expected performance, there has been some incremental, company-wide incentive compensation accrual. It amounted to about $0.01 in the quarter..

About $0.01, okay. And is there a way to walk through the gross margin change. I know you gave us the 50 basis points. I think gross margin was down, I think -- well, about 170 basis points or 100 [ph] -- from year-over-year.

Can we get a walk from that, and are there other items in terms what the mix ratio was in some of the other factors?.

Sure, Budd. That's largely driven by the higher mix of our FlexFit adjustable bases..

So has that got a -- that's the -- pretty much the entire balance?.

Yes, exactly, beyond the 50 basis points that we talked about already..

Okay, terrific. That's good. And the attachment rate has got to be got to be some impressive number on that FlexFit, I would -- I'd hazard a guess but I would -- I'm singeing my own eyebrows out.

What can you say about the attachment rate? Is it the highest ever, Shelly?.

Budd, I think this is a great example of the power of innovative products in our exclusive shopping environment. So yes, that's high..

Okay, fine. And I guess, fine for me is -- you said 550 stores.

Any timeframe on that? And what's the percentage now of stores on-mall, off-mall?.

Regarding the on-mall, we ended -- nonmall stores, at the end of the third quarter were 38%. We're expecting that to be above 40% by the time we get to the end of the year. And we haven't given time line guidance for the 550..

Okay.

And if I heard Shelly right, the, kind of the revenue guess for the fourth quarter is in the $275 million to $280 million range, up 20% versus year-over-year, somewhat -- is that kind of the way we heard that?.

Yes, Budd. We're calling that at least a 20%..

Jessica Mace from Nomura Securities..

My first question is about a comment you made regarding kind of the mixed signals from the overall consumer environment. And I was wondering if you could talk about your strong results in the context of that environment, and maybe any factors that might point to some market share gains.

And then as a follow-up to that, I know you were up against some promotions or some significant discounts from last quarter, in this quarter.

And any kind of moving pieces we should be aware of going into next quarter?.

Yes, sure. Thanks, Jessica. Regarding the macro, I mean, we all hear the news every day, and there are a fair amount of different macroeconomic indicators out there that lead to both confidence and caution. And we view the fourth quarter having been less -- a little less predictable these last 2 years regarding specific consumer behavior.

But at the same time, we're confident in our growth initiatives. And we look forward to applying them to the fourth quarter and specifically being able to read them in this different environment that does not possess a major market share event.

Having said that, our trends in the third quarter, and we had strong performance throughout the quarter, and certainly very much so in the 21-day Labor Day event period. So we've had strong growth throughout, and our traffic has resulted from our marketing effectiveness and the advancements we've made there.

So we, on the flip side, have strong confidence going into the quarter, but it's yet to be proven in this different type of environment. The last part of your question was around did we take market share. We certainly anticipate that we did. We've yet to hear from some of our other peers. We'll know more here in the next couple of weeks.

But we would expect that our 16% comp at retail would be one of the top retail performances..

Great. My second question is just on the comment you made about the logistics in the quarter and the 50 basis points that you should get back over time.

When you say that the ERP platform will go live a year from now, is there any way for us to think about, from now until then? How we can think about those kind of logistical issues?.

I think one way to think about it would be our guidance on margin here for the fourth quarter, that we expect it to be slightly up from prior year..

I wanted to let John Baugh know that the 3 locations that we opened in the quarter, new markets that we opened were in El Paso, Texas, Columbus, Mississippi and Cheyenne, Wyoming, which is the first one in that state, which made our 47th state that we're in..

Brad Thomas from KeyBanc..

I wanted to just follow up on the question about the investments in the systems, and I think you answered it in a previous question but just to follow up more directly.

What are the points here that we'll start to see some return on these investments, and some capabilities that you can start to leverage, rather than perhaps them offsetting quarters like this, where you have trouble fulfilling all of the orders, for example?.

Yes, thanks, Brad. It's an important question, and it's something that was important to me when I first joined Select Comfort. It's a large project, and one that I really wanted to get my hands around.

And the primary objectives for the project, the reasons for doing it aren't so much about the returns on the investment, though they will help deliver those over time, along with the improved ROICs that I talked about earlier. But they are really to help us establish the kind of agility that we need as we scale this business.

They're enablers, they are processing improvers, but we definitely see the opportunity for us to gain efficiencies. But those are really going to come primarily in 2016 and beyond as we mature those systems and the processes that go along with it..

Great. And then regarding the investments, I know you're not ready to give formal guidance yet for 2015.

But just if we try to think about it directionally, could you maybe characterize 2015, and if it's a year where maybe there is some moderation year-over-year in the rate of investment growth? Or do you think there's another step up and another incremental drag that we could get on earnings.

If you're in a position, we'd love any comments you can make on 2015..

Sure. We're expecting similar CapEx investments in 2015 as we have in 2014, which is the $80 million that we've highlighted..

And again, they'll be supporting primarily both doors as well as the infrastructure we spoke to..

Great. And then just one more housekeeping item, if I could. Could you comment a little bit more about SleepIQ? And again, any color that you give on the attachment rate or how much of that's adding to sales would be wonderful..

Well, first of all, we -- our customer's excited about SleepIQ. It's a wonderful thing to be able to understand exactly how you slept the night before, and to have a bed that you can adjust in correlation with that knowledge and to be able to make other adjustments in your life, to be able to improve your quality of sleep.

SleepIQ provides that specific information to consumers so that they know what they can do. So very strong consumer feedback. While we don't speak specifically to the attach of any one of our innovations, we're quite pleased with the role that SleepIQ is playing for both the business and in the consumer's life and their response..

Peter Keith from Piper..

Shelly, I wanted to ask about your comment regarding the marketing effectiveness. Clearly, something changed here in the quarter, where -- we love that the positive unit comp, traffic's gotten better. You attribute it to marketing effectiveness.

Can you give us an idea of maybe how it became more effective? Did something change within the marketing? A little more detail there would be helpful..

Sure, Peter. This really goes back to what we've been -- everything we've been talking about all year. So starting in January, at the very beginning of January, we put in tests around our media buying as well as launched our new creative, and we -- each quarter, we've been advancing both the creative and our media buying with our learnings.

And as we moved into the third quarter, we had 6 months of learnings under our belt and progressed the media buy as well as increased the media buy by 9% in the quarter. And as you know, we've also increased our leverage each quarter too, speaking to that effectiveness. So third quarter was the result of the continued advancements.

A couple of other specifics around the media that I can add, Peter. If you recall over a year ago, we added some strong analytics that helped us with the predictability of our media buy and how -- the weight that we're placing on each media type. It's such -- been an underlying source of the testing and learning and advancing.

And we've become quite proficient at what that mix looks like in combination with more effective creative. Regarding the specific creative, the creative is effective in reaching a broad target. So all segments of our target are responding to the creative, which features our innovations..

Okay, that's helpful detail. And then I wanted to ask about the ARU increase up 13%, it's impressive. It was up a lot in Q2.

Could you give us an understanding about what are the key drivers behind that so we can understand that, the maybe the go forward trend better?.

Sure. When you dimensionalize the sales, looking at ARU and the units, you can see that our growth is coming from both our innovations as well as our traffic. 13% from innovations, including 4 points of pricing and then 10% from the increased traffic. Again, last quarter, we also had strong ARU growth.

You can see the actual dollar amount of average revenue per unit increased again this quarter. We're now over $3,700. And last year -- last quarter's growth included 6 points of pricing while this quarter included 4. So the accelerated dollar growth is really coming from the innovation.

So keep in mind, we introduced the majority of our innovations in Q2. SleepIQ came in at the end of -- at the end of Q2, but of course that's not in this number..

Yes. Make sure I got the numbers right.

So it was 6% pricing benefit in Q3?.

No, in Q2. [indiscernible] Q2, 4% in Q3..

4% in Q3.

And so with a 13% ARU gain, the balance was innovations like SleepIQ?.

Correct. That's right..

Well, yes. SleepIQ is actually not in the number so it would be the remaining innovations..

SleepIQ is not. Right. As we talked about this, the SleepIQ is deferred. The revenue from SleepIQ is deferred to our balance sheet..

It's primarily related to FlexFit, FlexTop, the other innovations that we've been introducing this year. And of course, as I stated, SleepIQ plays a role in stimulating the overall core mattress line as well. And we're really pleased with our overall mix in the Classic Series, the Performance Series and the Innovation Series, including the x12..

Okay. That's great detail, appreciate it. And I wanted to get one question in to David. So you're clearly not talking about our year guidance, which is understandable. But as you talk about maybe that there are some changes in the mix in the business.

Can we think about how this -- the business is ramping to a contribution margin, going forward? It seems like you're starting to get better on that metric.

How can we think about that settling out, looking out 12 months?.

Well, we've talked to the expectations for Q4 at this point. And we're expecting a meaningfully larger contribution margin in Q4. But we -- as you pointed out, aren't talking about guidance for 2015 or beyond at this point, but we'll certainly provide that next quarter..

[Operator Instructions] Keith Hughes from SunTrust..

A couple of questions.

The deferral of income and expenses of SleepIQ, is that just for this quarter or does that continue in future periods?.

The long-term relationship that we have with our customer and the ongoing exchange of information with them is resulting in the accounting treatment of -- we have multiple deliverable accounting. And so the ongoing revenue will be deferred.

We are expecting the useful life of the deferral at the moment to be 5 years, but that will evolve and be trued up as we learn..

Okay, and so it will just come out ratably during that period, is that correct?.

That's correct, yes. And it's creating a long-term source of income for the company..

So when will -- when will you think it start to come back on as revenue? Will that start as early as the fourth quarter?.

It's already started, but because it's a 5-year deferral, the amount isn't that meaningful at this point..

Okay. Looks like you're going to grow the store base about 5% or so this year. And I know you have a 550 number, longer term.

Is 5% comp a rough, rough growth rate we would see for the next year or 2?.

We're not commenting about the pace of adding our stores, but we do have that 550 target that we've commented on..

Okay. And looking [indiscernible] many people have asked about the unit, mattress unit growth.

Is there any sort of metric you can give us around this pickup in units for you? How much of these various innovations are -- how much of the increased units are coming with those sort of sales attached to it? I don't want a percentage, but is it a large number, a small number, something -- anything would be helpful..

I think that the best way to think about it would be, that our units were up 10% in the quarter, while our average revenue per unit was up 13% in the quarter. So the attachment is growing while the unit growth is growing.

And so there's a strong relationship there, which all ties back to the strength of our in-store experience and proprietary products..

I think the driver in the questions that I know I'm getting is, you've had that -- sale per unit number's been good, really, for the entire year. But we've now just started seeing the units move in the direction you want them to move.

What sort of happened in the third quarter?.

Yes, again, we view the unit performance closely related to our marketing effectiveness. And we've been very diligent, starting well over a year ago about progressing our marketing, both media buying and our creative. So we launched SleepIQ with the new creative at the end of June, just as we entered the third quarter.

So this has been progressive each and every quarter..

At this time, I'd like to hand the call back to the company for closing remarks..

Thank you, again, for joining us today. We look forward to discussing our fourth quarter performance with you early next year. Sleep well and dream big..

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