Dave Schwantes - Vice President of Finance, Investor Relations & Decision Support Shelly R. Ibach - President and Chief Executive Officer David R. Callen - Chief Financial Officer & Senior Vice President.

Jon N. Berg - Piper Jaffray & Co. (Broker) Bobby K. Griffin - Raymond James & Associates, Inc. John Baugh - Stifel, Nicolaus & Co., Inc. Seth M. Basham - Wedbush Securities, Inc. Bradley B. Thomas - KeyBanc Capital Markets, Inc. Jessica Schoen Mace - Nomura Securities International, Inc. Curtis S.

Nagle - Bank of America Merrill Lynch Mark Rupe - Longbow Research LLC.

Welcome to Select Comfort's Q2 2016 Earnings Conference Call. All lines have been placed in a listen-only mode, until the question-and-answer session. Today's call is being recorded. If anyone has objections, you may disconnect at this time. I would like to introduce Dave Schwantes, Vice President of Finance and Investor Relations. Thank you.

You may begin..

Good afternoon, and welcome to the Select Comfort Corporation second quarter 2016 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..

investing in our growth, financial flexibility and share repurchases. In summary, our transformation is complete and we are well-positioned to meet the expectations of a dynamic, demanding consumer and accelerate shareholder returns. I appreciate our team's dedication and commitment to our customers' experience.

We are excited about the opportunity in front of us, especially as we prepare to introduce significant product advancements next year to deliver what we believe will be the future of sleep. Thank you. And now I'd like to turn the call over to David..

Thank you, Shelly. We are pleased to continue to meet our operational and financial milestones as we recover from our ERP implementation completed last quarter. Our business performed relatively well considering the strong 17% sales growth we were up against from the prior year quarter.

Sales were slightly below expectations which we offset by favorable operational improvements to deliver $0.03 of EPS.

The residual carryover from the ERP implementation impacted Q2 sales by an estimated $5 million to $10 million with an associated $0.03 to $0.05 impact on EPS for the quarter bringing the ERP impact isolated in the first half to an estimated $0.28 to $0.30 per share.

The second quarter top line growth reflects a 6 percentage point step up in performance sequentially when you exclude the $21 million backlog benefit included in Q1 net sales. This is an important milestone as we return to high single digit sales growth long term.

Specific sales metrics for the quarter include a comp sales decline of 6% with a positive 7% two-year stacked comp. ARU of $4,206 was up 3% and units declined 3%. Our trailing 12-month average comp store sales of $2.3 million declined 6% versus the prior year largely due to ERP impacts in Q4 of 2015 and the first half this year.

Gross margin of 61.9% represented a 270 basis point sequential improvement over the first quarter of this year and was equal to the prior year. This marks another major milestone toward the accelerated profitability we expect beginning in Q4.

Improved customer experience especially in delivery operations drove lower returns and scrap charges in the quarter. As we learn to use our new tools effectively, these gains were partially offset by inefficiencies in routing density, third party logistics, and order fulfillment.

We expect actions already underway to drive improvements, especially in Q4. Operating expenses of $169 million were up 10% versus the prior year and slightly favorable to our plans for the quarter. Sales and marketing costs including depreciation on new stores were up 6% for the quarter.

This also includes 11% increase in media spending to support the brand. As expected we incurred incremental depreciation of $3 million primarily through the G&A expense line and $4 million of incremental R&D costs for the SleepIQ LABS, an advancement of our innovation pipeline in the quarter.

Our business model enabled us to generate $47 million in cash from operations year-to-date, compared with $45 million the prior year-to-date. As planned, our lower capital spending meant our free cash flows in the first half were $23 million compared to $6 million the prior year first half.

We invested $24 million in capital projects year-to-date, primarily in new stores. We also repurchased $70 million of our common stock, year-to-date, up 40% from the $50 million repurchased in the first half of the prior year.

As expected, during our seasonally low sales quarter, we ended the period with $16 million drawn against our $150 million revolving credit facility. As discussed previously, we expect to use the line for temporary support of seasonal operating needs. Inventories were $74 million at the end of the quarter, as planned.

We are reiterating our 2016 guidance for full-year earnings per diluted share of $1.25 to $1.45. The guidance continues to assume low-teen net sales growth for the year. Specific to Q3, we expect mid-single-digit net sales growth, largely from new stores.

Please remember that in the third quarter last year, we pulled forward approximately $10 million of sales ahead of our ERP launch in Q4. Also note that Q3 of 2015 included acquisition gains in G&A and income taxes that were offset by ERP launch costs. Q3 this year will include approximately $0.08 of incremental R&D and ERP depreciation.

Taken altogether, we expect Q3 EPS in 2016 to be a nickel or so lower than the prior year. Here are a few other 2016 guidance callouts. We expect to deliver approximately 50 basis points of gross margin improvement in 2016.

Targeted actions with our third-party logistics providers, as well as using new ERP-enabled home delivery capabilities and streamlined processes, will drive results, especially in the fourth quarter and beyond. Sales and marketing costs are expected to be 44% to 45% of net sales for the full year.

We continue to forecast approximately $60 million of depreciation and amortization in 2016. The bulk of the $12 million, year-over-year increase is ERP deprecation flowing through our G&A expense line. We also expect approximately $12 million higher R&D costs for the year, largely SleepIQ LABS. Our forecasted income tax rate is 34.5%.

We continue to expect more than 100 basis points improvement in our EBITDA margin, and to generate record cash from operations in 2016. We have lowered our capital expending forecast slightly to approximately $65 million, while prioritizing our target of 535 retail stores by year-end and advancing the productivity of our website.

We expect ROIC to exceed 13% for the year and expect share repurchases for the full year to somewhat exceed 2016 free cash flows. And lastly, our outlook does not contemplate a worsening of consumer spending the balance of the year.

We are well-positioned to improve margins, leverage our business model, and deliver on our $2.75 EPS commitment for 2019. This will require high-teen EPS growth from the midpoint of our 2016 guidance, adjusted for the estimated ERP impacts.

This is in line with our expectations for accelerated profitability beginning in Q4 and the 17% EPS CAGR assumed with our long-range guidance. I will close by adding my sincere gratitude to our highly dedicated and motivated Sleep Number teams. With that, Sean, please open up the line for questions..

Thank you, sir. We will now begin the question-and-answer session. For our first question on queue, we have our first question coming from the line of Mr. Peter Keith of Piper Jaffray. Your line's open; you may begin..

Great. Thanks a lot. This is actually Jon Berg on for Peter tonight. Thanks for all the color on the call. First off, David, just circling back to your comments for Q3, I know, as you mentioned, I think you had a $10 million sales pull forward last year into the quarter as you prepared for that ERP launch which will now be a headwind.

Do you think, I guess, under that scenario, do you think a positive comp is still possible for the third quarter?.

Yeah. Hey, Jon. Thanks for the question. We are expecting most of the growth to come from the new stores, but do expect flat to positive comp in Q3..

Okay. Great.

And then, I guess, as you look at all the new store growth you've had here kind of over the last few years and where you're planning to go, what has kind of the cannibalization level been running and how do you expect that to play out as we go forward here? I mean, do you think it's going to step up or it could – is there any way you could quantify that for us?.

Yeah. We're seeing about the same cannibalization that we've seen historically, which is less than 20%, from our new stores. We think that's directionally going to be the same going forward..

Okay.

And then just one last quick one on the addition of SleepIQ, I guess, to the m-Series, and the i – the i-Series and the m-Series beds now, will those beds then be increasing the base price, the $300 step up that you've – as the option you've had thus far or is there a bigger step up than that?.

No. That's the step up, the $299 or $300, yes..

Great. All right. Thanks a lot, everyone. Good luck for the rest of the year..

Thank you..

Thanks, Jon..

Thank you, sir. Next question on queue; this one is coming from the line of Mr. Budd Bugatch of Raymond James. Your line is open; you may begin..

Good afternoon, everybody. This is Bobby filling in for Budd. I appreciate you guys taking my questions..

Hey, Bobby..

I just want to first touch on the gross margin guidance for the year.

Is it now 50 basis points instead of the 50 basis points to 100 basis points that we talked about last quarter? And if so, can you maybe give a little color on what changed within that guidance?.

Yeah, Bobby. Glad to. We – given where we are with our evolution and post recovery from the ERP implementation, we feel confident that our initiative to improve our gross margin are really going to drive a benefit in the fourth quarter and 50 basis points for the full year is the right target to have..

Okay.

Is the 50 basis points to 100 basis points sight for 2017, still something that you feel comfortable with?.

Absolutely. We, you know, the margin improvements that we're delivering for this full year, and that's on a full year basis, 50 basis points, largely coming from benefits in Q4 and beyond. We still have line of sight for that 50 basis point to 100 basis point improvement in 2017..

Okay. I appreciate that.

And I also wanted to touch on units, can you maybe give a little more color on what you are seeing for overall units, it looks like overall units were down 3% from the quarter, while the store count was up roughly 9%, maybe with some of the initiative are there through the back, to flip the unit cadence?.

Sure, Bobby. On units, we've stated before that for the full year, we expect flattish ARU and the growth to come primarily from units; and of course, much of that will come in the fourth quarter when we're up against that easier compare.

However, I want to take you back to something I highlighted in the prepared remarks about the step up that we experienced between the first half of second quarter and the second half of second quarter.

Along with the recovery of our customer metrics, we also experienced a similar recovery and step up in our online traffic and then our sales and units follow that. So, you know, we are seeing the progression that we expected with units as we head into the back half.

Again, units are primarily driven by bringing new customers to the brand and that's where most of our initiatives are focused this year is on bringing new customers into Sleep Number either through referrals or reaching new customers with our other actions..

Okay..

Bobby, I just want to add a little – Bobby, I would like to add a little....

Sure..

...color on the quarter-to quarter sequential improvements. Keep in mind, that Q1 of this year benefited from the $21 million backlog carryover, and so the unit growth in Q1 was down probably on an adjusted basis around 6 percentage points. So that's marking a sequential improvement going from there to what we saw in Q2..

Okay. Perfect. I appreciate that. And just to follow-up on Shelly's comments. Just two follow-ups from me, and then I'll jump off.

Is one, Shelly, when you looked at the kind of the separation between the first half as you detailed, and the second half, was that just the general consumer environment you're kind of pegging that as? Or was there – did you guys change your marketing message? Or how should we think about that? And then, Dave, on the backlog do you feel kind of you've gotten the backlog down now to where it's kind of at more of a normalized level?.

Yeah. So regarding the change that we experienced in the second quarter, let me start with that the consumer environment has been very consistent for us since February. So, we have experienced a more sluggish resistant consumer through that period.

Now we've had our own internal challenges around the ERP implementation in Q1 followed by the recovery in Q2. And what we – the pressure we had in Q2 in the first half of the quarter was related to where our online customer sentiment was, our referral metrics, all the customer metrics based on the customers we impacted with ERP.

So as we move those metrics and improve them to equal to or higher than prior years, that was midpoint in the quarter. And then that's when we saw our other metrics improve as well..

And regarding the backlog, Bobby, just want to highlight that, yes, the backlog currently is normalized level very similar to last year. But just want to highlight again that we expect over the next year to cut our delivery times in half to seven days..

Okay.

And that will – yeah, and then you'll clear out some more of the backlog accordingly, probably, right?.

Yeah, exactly..

All right. I appreciate the detail and you guys answering all my questions. Best of luck moving forward..

Thanks so much, Bobby..

Thank you, sir. The next question on queue. This one is coming from the line of John Baugh of Stifel. Your line is open, you may begin..

Thank you, and good evening. Just a couple things quick.

One, Shelly, could you comment on how you're thinking about, I don't know, the second half as it relates to the election, your ad spend – does it get crowded out? Do we see the election spend really cranking post-Labor Day so it won't impact Labor Day? Any color there?.

Yeah. When we take a look at the back half, you know, an election year is always a bit dicey as we all know. We're excited about the advancement in our digital communications.

And that's a place – I mentioned the digital media platform that we now have, that we can react to real time, and that's a capability that we did not have four years ago or even a year ago, so when we're faced with changes like the election, and that will change from week to week through the back half, knowing that digital communications are second most effective media, and we're watching that real time and we can move it, real time, each and every day to be able to respond to how customers are engaging.

So that's an agility point that we have now that we're excited about as we head into it..

So you would expect you'll see some pressure on TV and you hope to be able to offset to some degree that impact with more digital; would that be fair?.

Yes. Digital initiatives, and the second initiative that I would highlight is just what we're doing with our loyal customer base and focused on referrals and using social to advance our referral behavior..

Okay. And my second question was related to R&D, BAM, the acquisition. You've referenced in the past how it should help with future product launches. I guess, I don't expect you to tell us what those launches will be and when on this call, but I'm just curious whether there's any update. I know the it bed will drive some units post-Labor Day.

Are there planned new beds as we move into '17 or anything you can give us that you expect to see return on that investment as we move into '17? Thank you..

Great. Well, I'll highlight three things around SleepIQ technology. First, I'll start with the advancement we have next week with SleepIQ API.

John, what we've experienced on referrals is a higher referring rate from SleepIQ customers, so we know how important it is and continuing to advance our software in meaningful ways re-engages the customer and results in additional referrals. Secondly, with the it bed, we are very excited about this.

It's to market within a year from the acquisition, and it is simple, convenient and has strong value for the consumer on being able to adjust and have the benefits of SleepIQ technology. And then I mentioned, at the end of my remarks, about next year.

Yes, we will have a very exciting product launch next year that will be a result of our advancements, and that includes the acquisition of SleepIQ..

Great. And then just one final housekeeping – your G&A came in certainly lower than where I pegged and I can't remember, David, if you gave us some kind of dollar figure. You've certainly broken out the depreciation piece, but any sense of how to model that, quarterly, going forward? Thank you..

Sure, John. I would – the run rate in the back half is going to be about $32 million a quarter..

Great. Thank you..

You bet, John..

Thank you, sir. The next question on queue is coming from the line of Seth Basham of Wedbush. Your line is open; you may begin..

Thanks a lot and good afternoon..

Hey, Seth..

First question is just on repeat and referral mix.

Could you give us a sense of where you are relative to historical trends and where you – when you expect to return to that trend?.

Yeah, we're – we have returned to our historical trend. In fact, we exited slightly higher as we entered Q3..

That's great.

And that's driven by some of your social initiatives and whatnot, so you'd expect that to improve from here to new highs?.

It is absolutely an initiative of ours. We're excited about what we're seeing with customers who own SleepIQ technology and they are referring, as well as some of the social referral initiatives that we have initiated..

Got you. Okay. Considering that and the fact that your traffic really turned around nicely in the back half of the quarter, it was – there was -point to some great momentum in the business in terms of interest in the brand, and I would think that should carry through to sales.

Is there a conversion issue that you're seeing that's not leading to higher sales as a result of increased traffic in repeat and referral?.

Our conversion was strong, very strong, and, matter of fact, we just had our national sales conference here last week, and it's the energy and it's great to hear the learnings from the stores on how they're using our new CRM capabilities, so no conversion – conversions where it needs to be as we look at the overall business, slightly higher as we went through the second quarter, and now we're well-positioned for the back-half goals that we've laid out..

Okay. Great. And then the last question from me for now is just on the it bed – or the it bed.

When you think about the contribution to your full year outlook, is it material? Are you just not building in much of any sales and profit from that into the full year outlook?.

Yeah, hey, Seth. We're not building significant amount of sales into our forecast for the it bed at this point..

Very good. Thank you..

Thanks a lot..

Thank you, sir. Next question on queue coming from the line of Brad Thomas of KeyBanc Capital Markets. Your line is open. You may begin..

Yeah, hi. Good afternoon, everyone..

Hey, Brad..

Just to follow-up on the last it bed question. I think, the 50 store initial rollout is a little smaller than what we tend to see. We tend to see the new products in the entire chain, if I'm not mistaken.

Maybe a little bit more color on the thought process of why you're testing it out and perhaps why the timing is post-Labor Day would be great to hear..

Sure. Well a couple of things, Brad. First of all from a timing perspective, we knew it would be late summer as we began to develop the bed with SleepIQ LABS at the time of acquisition last September, and we did have a small window before Labor Day.

But it was tight and we're focused on flawless execution as we head into the Labor Day with our overall core business, and it's where we decided to keep our energy right now. So post-Labor Day we will launch. We are primarily focused on online purchases. One of our key objectives with the it bed is to learn.

And we're learning from delivering a product that is very convenient and delivers on quality sleep. It ships in five days. It sets up in moments, and yet still has adjustability and SleepIQ technology. And we also have a simple online experience to compliment the bed. And it's attracting a new customer to our overall brand.

So we're staying focused there to be able to learn and make sure that we deliver a different brand experience than our overall master brand.

At the same time we want to benefit from having the stores, and we want to understand selling this brand along with our full line, what that means, and what it means from a cannibalization or an additive customer. And we'll learn that with 50 stores..

Great. Housekeeping question on sales. You call out, obviously, in a press release the $5 million to $10 million residual affect from the ERP implementation. I think last quarter you had talked about a $4 million pull forward from 2Q sales into 1Q sales, associated with being faster in deliveries than you had initially expected.

I guess, can you just help us think about maybe what the $5 million to $10 million was and where there's been pull forward and where there hasn't been as we're all trying to reconcile all these numbers? Thank you..

Yeah. We'll try to keep you straight on all the moving parts, Brad. The estimated impact of the ERP – residual impact on customers' experience.

With our estimate, we've triangulated it based on the same measures that we used in the first quarter, focused in on cancelation rates or returns that were above what we would normally see, and with those elements in mind, identified that the range of $5 million to $10 million is the right range of impact for the residual ERP impacts.

That's in line, generally, with what I had indicated last quarter, being about $10 million for the second quarter..

Great.

And then with respect to BAM Labs, 2017 is still a ways out here, but could you give us your latest thinking in terms of perhaps how accretive that business could end up being for you next year?.

Yeah.

We'll provide a lot more guidance, Brad, at the end of 2016 with what we're thinking about for 2017, but at this point, we're committed to that that acquisition will be accretive in 2017, and it'll be part of the driver for the 50 basis points to 100 basis points improvement in margin that we're expecting, as well as leading to product innovation, sales and cost reductions in our products..

Great. Thank you so much..

You bet..

Thank you, sir. Our next question on queue is coming from the line of Ms. Jessica Mace of Nomura Securities. Your line is open; you may begin..

Hi. Good afternoon, everyone..

Hey, Jessica..

Hi, Jessica..

My first question is I was wondering if you could give a little more color on the increase in ARU. You said it was above your expectations and mentioned some attach rates. I think, the FlexFit was contributing to that.

Was – were there any other trends in mix as far as premiumization or higher price points on like-for-like items?.

Yeah. It was slightly ahead of expectations with the 3% growth, and we did see year-over-year increases with our Partner Snore feature and also SleepIQ technology. From a mix perspective, a little bit up and a little bit down. But all in all pretty balanced..

All right. Great. And then my second question, you mentioned to get to your target of $2.75 of EPS, it would require 17% CAGR in earnings growth. Are there any buckets, certain expenses you can call out that would contribute to the margin expansion needed to reach that goal? Thanks very much..

Yeah. Jessica, just let me reiterate that it's based on our midpoint of our guidance, adjusted for the ERP impacts; it's high-teen growth rate. What I was referring to is when we initially provided our long-term guidance, it was 17% CAGR off of the 2014 earnings. As far as bucketing the improvements, we expect, again, high single-digit top-line growth.

We expect to leverage the business model to deliver mid-teens operating profit drop-through rates over time, and we expect to repurchase shares that would be accretive to EPS over time. Those are the primary drivers of getting us from where we are to the $2.75..

Great. Thanks very much..

Sure..

Thank you, ma'am. Next question on queue. This one is coming from the line of Curtis Nagle of Bank of America. Your line is open; you may begin..

Thanks very much. Just a quick question on store growth for second half of the year. So it looks like a little bit of a pickup in terms of units.

I guess, how would that be spread between the two remaining quarters, and what are you expecting for store closures? And then just a follow-up, any commentary in terms of consumer credit trends you guys are seeing over the past couple quarters?.

Hi, Curtis. As we highlighted, I think, the expectations for Q3 are for mid-single-digit sales growth, and that will largely come from new stores. We've said that we expect most of the growth to come from units and a little bit less from ARU in Q4. And that's really true for the back half of the year.

As far as – can you remind me your other questions? I'm sorry..

Store closures and....

Yeah. Store closures, how many you have remaining for the year, and then consumer credit trends..

We expect to end the year with 535 stores in total. We don't generally break out total additions or closures. But in terms of our consumer spending trends we're seeing the use of financing to be very similar to what we saw in the prior year..

And you could weight the number of stores opened similar to last year in the two quarters..

Okay. Thank you very much..

Thank you, sir. The next question on queue is coming from the line of Mark Rupe of Longbow Research. Your line is open. You may begin..

Hi. Just a couple quick questions. Did the pricing on the it bed change from your initial assumptions? I'm not sure if was 1,000 before, or approximately 1,000..

Yeah, we've always, since our launch at CES, we've talked about around a 1,000..

Okay. And then I know that there's a lot of details here on the call so it probably speaks for itself. But beginning the year, I think, you kind of framed up the guidance for the first half of the year to be 25% of the year and the back half 75%. And based on the first half it's a little bit lower than maybe what the profile would assume.

Is there anything else that put in the back half a little bit stronger than maybe what you would have thought at the beginning of the year?.

Yeah, as we called out on the last call, Curtis (sic) [Mark] (45:17) – we said that, or Mark, I'm sorry, we're – we were spending on the ERP at the high end of the range and that impacted us a bit heavier in the first half than what we had expected. But that's about the only thing and that's a shift of a few cents..

Okay. And then lastly there's been a lot of commentary on the first half versus second half in the second quarter. And thanks for that.

Is it fair to assume, I think it's pretty clear, that units then in the back half were positive?.

Yep. Unit were positive..

Perfect. Thank you..

Okay. Thank you, sir. As of this time we have no question on queue. I'll turn it back to you host. You may begin..

Thanks again for joining us today. We look forward to discussing our third quarter 2016 performance with you in October. Sleep well and dream big..

Thank you, sir. That will conclude today's conference call. Thank you for participating. You may now disconnect..