Dave Schwantes - VP, Finance & IR Shelly Ibach - President & CEO David Callen - SVP & CFO.

John Baugh - Stifel Peter Keith - Piper Jaffray Bobby Griffin - Raymond James Brad Thomas - KeyBanc Keith Hughes - SunTrust Seth Basham - Wedbush Michael Lasser - UBS.

Welcome to Select Comfort's First Quarter 2017 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 you have any objection, 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 first quarter 2017 earnings conference call. Thank you for joining us. I'm 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. Please also note that we have posted an updated Investor Presentation on our website at sleepnumber.com. I will now turn the call over to Shelly for her comments..

investing in our growth, financial flexibility, and share repurchases. We repurchased $50 million of shares in the first quarter which was consistent with the prior year.

The investments we have made in digital capabilities, stores, products, technology, and infrastructure have made us a stronger competitor with superior products and customer experiences. We expect accelerated earnings growth, cash generation, and returns to shareholders in 2017.

With the strong results we posted in the first quarter, we have increased our full year 2017 earnings guidance to a range of $1.25 to $1.50 per share. We are confident in our ability to deliver on our plans and continue to make the necessary progress towards our 2019 EPS target of $2.75.

I want to thank our talented team for their dedication to our customers experience in their commitment to improving more lives. We are all excited about our revolutionary Sleep Number 360 smart beds and the opportunities we have in front of us to gain market share.

Now, David will provide more details about our first quarter performance and our outlook..

Thank you, Shelly. Steady execution of our plans delivered stronger than expected Q1 sales growth and profits demonstrating the power of our vertical business model. The combination of top-line growth, accelerated operating leverage, and efficient capital deployment contributed to strong Q1 results in an improved consumer environment.

Our initiatives continue to move the business forward on our path to $2.75 of EPS by 2019. We grew Q1 net sales 12% over the prior year to $394 million. Remember that our prior year Q1 net sales were impacted by an estimated $40 million of ERP implementation pressures, partially offset by a $21 million backlog benefit.

Adjusting for these prior year impacts, year-over-year net sales growth would be 6% an important lens as we think about the balance of the year sales assumptions. As expected most of our 12% Q1 GAAP net sales growth came through a 10% increase in company controlled units while also expanding our ARU by 2%.

Also as expected the bulk of our growth came from net new stores which contributed 10 points of our growth in the quarter. We ended the quarter with 546 stores in 49 states. Our comp store sales also added to our Q1 growth with a 3% lift overall including one point from our online and phone sales business which grew 18%.

Our trailing 12-month average comp store sales were $2.4 million. We expect to move this toward an average of $3 million per store longer-term with 30% to 40% incremental four wall profits as sales per store growth. With our powerful ERP capabilities we're delivering an improved customer experience and a lower return rate.

This and continued operational improvements have driven strong gross margins. As expected, our Q1 rate of 62.6% improved 340 basis points versus the prior year. The benefits of our ERP and operational improvements are apparent in the 90 basis point gross margin expansion on a two-year basis versus Q1 of 2015.

We also delivered 10 points of operating expense leverage in Q1 including 50 basis points of media leverage while increasing media spend 7% to $48 million in the quarter. Leverage in marketing G&A and R&D were partially offset by selling compensation deleverage.

The 39% incremental operating profit flow through rate we delivered in Q1 reflects the complete recovery from the ERP implementation challenges last year and meaningful productivity enhancements across the business. The result is a 350 basis point improvement in our net operating profit rate to 9.1% for the first quarter.

Our diluted earnings per share of $0.56 reflect a 107% increase over the prior year which included an estimated $0.15 of net ERP pressure. Our Q1 EPS this year include a $0.02 benefit from lower income taxes resulting from the new stock-based compensation accounting rules.

We generated 42% more free cash flows in the quarter than the prior year quarter. Cash from operations were $87 million. We invested $13 million in high value capital projects and used $50 million to buy back shares.

Our trailing 12-months ROIC at the end of Q1 was 13.9% up 480 basis points from this time last year and well in excess of our weighted average cost of capital.

Our 2017 updated EPS guidance range of $1.25 to $1.50 continues to include $0.15 to $0.22 of transition costs primarily to refloor our stores with the 360 smart bed product line and for the current year cost of our logistics evolution.

Our plans continue to contemplate mid-to-high-single-digit sales growth the balance of the year primarily through mattress units. We assume four to five points of our growth will come from new stores and low-single-digit comp store growth. We remain on track to execute a phased launch of our 360 smart beds over nine to 12 months beginning in Q2.

This product line includes seven new 360 smart bed models, a new integrated base and three new adjustable bases. We also made progress in Q1 with our supply chain evolution.

We opened a new company operated hub adjacent to our Irmo, South Carolina manufacturing plant and are testing final assembly of our new beds in the hub rather than in customer's homes. We are pleased with results so far. This initiative is expected to continue through 2018 and is an important enabler of efficiency and improved customer experience.

Here's a reminder of other 2017 guidance assumptions. I mentioned earlier that our EPS guidance includes $0.15 to $0.22 or $10 million to $15 million of one-time costs the balance of 2017. We expect these costs about evenly per quarter with about 25% each in COGS and G&A with the remainder in selling expenses.

We expect to improve our 2017 gross margin by 30 to 50 basis points on top of the 80 basis point increase in 2016. Our sourcing, lean, and continuous improvement initiatives are expected to more than offset 40 to 50 basis points of expected margin pressure from legacy product close-out sales this year.

This implies a gross margin rate just north of 62% the balance of the year. Over the two years, and in 2017, we're expecting to deliver 110 to 130 basis points of gross margin improvement and have line of sight to additional margin expansion opportunity in future years through our value engineering and supply chain evolution.

Our 2017 plans call for sales and marketing expenses of 44% to 45% of net sales including at least 50 basis points of media leverage. Our guidance also assumes about 50 basis points of deleverage in G&A and R&D combined due largely to incentive comp, transition costs, and about $5 million higher depreciation and amortization in 2017.

G&A costs are expected to be approximately $32 million per quarter the balance of 2017. All things considered, we're planning to improve our operating margin by at least 50 basis points in 2017 with an effective income tax rate the balance of the year of approximately 34.5%. We expect to generate record cash flows again in 2017.

We're planning to invest approximately $55 million in capital projects this year with about half year mark for 60 retail store actions and the remainder split between our technology advancements, facilities, and tooling and equipment for operations.

We expect to generate low teen ROIC for the year meaningfully higher than our weighted average cost of capital. And finally, we enter the second quarter of 2017 with $195 million remaining under our share repurchase authorization. We are pleased with the start to 2017 as our initiatives deliver accelerated profits in cash flows as we knew they could.

These value drivers offer a compelling investment opportunity as we execute our plans and improve people's lives through individualized fleet experiences. Sam, at this point we'd like to open the line for questions..

Thank you. We will now begin the question-and-answer session. [Operator Instructions]. Our first question is from John Baugh with Stifel. You may ask your question..

Thank you. Good afternoon, great quarter and really pleased with the several of the metrics improved. I was wondering on a couple of things jumped out I think one was the comment about lower returns.

I assume you're not going to give us your rates of return but any sense of magnitude and then can you perhaps comment on what you think is driving that?.

Hey, John thanks for the question. We've talked a bit about the in-store scheduling of the home delivery that we put in place in 2016 and we said we saw at that point an improvement in the customer experience and that has continued into Q1.

We're not going to break it down but probably I'd say 25% of the overall gross margin rate improvement that we've seen since 2015 pre-ERP is kind of coming from that line..

Okay.

And are you -- what are you or what's your average delivery time from a consumer order, how has that changed?.

Well lot of the scheduling is really customer choice, so they're in the store and they're actually able to choose from a variety of different dates, some closed in, some is closed in as within seven days, others two weeks or sometimes they choose, sometimes longer but overall we still average closer to the 14 days..

Okay. And you mentioned I believe a 10% unit increase. Can you give us some color on what beds drove that? And then always hard to tell with your average revenue per mattress unit, I think that was up 2% how much that might be driven by ancillary products versus mattress unit mix? Thank you..

Sure, John. The ARU growth of 2%, the strongest driver of that growth was the growth in FlexFit Bed attached for the quarter, and then I mentioned that we had new strong mix, so our mix has continued to be steady and performing well certainly one of the advantages of our selling process in our stores and how engaged our frontline is..

Thanks for answering my questions and good luck..

Thank you..

Thank you. Our next question is from Peter Keith with Piper Jaffray. You may ask your question..

Hi thanks everyone and congrats on the quarter. Shelly, I was surprised your SleepIQ score was higher this quarter versus last quarter. But to jump into the question, so with the sales strong success of Q1 it looks like you basically kind of maintained the sales outlook for the rest of the year that you had been at the beginning of the year.

But I guess how do you feel right now, now that you're three months in sounds like you had better backdrop, better return on media and there may be any insights you could give us on the early test of 360 technology?.

Sure, Peter. Well first of all regarding my SleepIQ score, I want you to know my average continues to be in the 80s so still where I live most days.

Regarding our guidance you're absolutely right the balance of the year is very similar to how we were thinking about it last quarter when we were on the call, our updated outlook now includes the first quarter results that we just discussed and we're also -- it's early in the year and we are going to get ahead of ourselves, we see the balance of the year as planned, we have significant transitions ahead of us with the rollout of 360.

But we are excited about how our initiatives are progressing and we did still see environment with higher competitive spend and the initiatives that we put in place in the back half of last year have continued to advance and we're really pleased with the performance and we'll continue to advance them in this environment.

Oh, and you asked about the 360 test? So very small pilot right now, it's a great advantage of our model to be able to put it in a few stores and just work through all the different aspects of it from the overall setup to delivery and we're happy with the results, no big surprises by any means, really excited about the consumer's response to it in the store and how our sleep professionals have been able to quickly adapt to the change in selling process with this new innovation..

Okay, great.

May be on sticking on the 360 dynamics, I think you are referring to some pricing, you referenced that pricing on ancillary products might come up a little bit; is that the adjustable basis?.

No, it's a very small like this would be small SKU or a mattress size; it may be an outlier size..

Okay.

But broadly speaking those the rollout across the line will be sort of flat with previous models?.

Yes. And keep in mind that now with the 360 smart bed, it includes SleepIQ. So the price will automatically reflect that additional pricing of the SleepIQ and then many of the features work so closely with the FlexFit adjustable base we see opportunity there too.

We've added a lot of features -- we've added features and benefits to the adjustable basis that we know the consumer response very strongly to, things like Partner Snore under bed lighting, the enclosed base design, and then and as we go up the line, the foot warming feature..

Okay, great. One last one for me.

So you were in this hard dynamic right now where you have this through massive floor model clearance from Mattress Firm that's going on right now are you guys seeing any weird activity or any disruption from that and that's taking place right now?.

No, I mentioned that, it continues to be, that we continue to experience an elevated spend from competitors but I would say we expect that at this point and I'm just not sure that customer understands what's going on as much as the industry or everybody else talking about it, here who understands the various players.

So, no, we have not experienced much with the changeover..

Thank you. Our next question is from Budd Bugatch with Raymond James. You may ask your question..

Good afternoon guys. This is Bobby filling in for Budd, I appreciate you taking my questions and congrats on all around good quarter..

Thanks, Bobby..

Thanks..

So I just want to jump back and look at the first quarter and from a trend standpoint, if things improved throughout the quarter versus your expectations little bit better than you expected or was there anything there to kind of help us understand how the progression went and why sales came in above expectations for you guys?.

Yes, Bobby, we have experienced steady and consistent performance since January week one both in and outside of market share events. So it's a little bit about the shape.

As far as what has been driving our performance for us we benefited from the advancement of our marketing initiatives that we put in place in the back half of 2016 and that's in combination with the innovative products and the value added retail experience and specifically our internal digital capabilities for more effective search and higher quality traffic.

And then, second the more efficient television buying and the advancement of our creative. And third would be the insider activation which has increased through our data mining with machine learning and personalized messages..

Okay, appreciate that.

And then Shelly may be can you just help me understand better with how the rollout of the 360 smart bed work it sounds like two beds out of the seven would be introduced in the second quarter and then the remaining five would be in 3Q and 4Q; is that correct?.

It's a good way to think about it..

Okay..

Phased approach..

Has that always been the phased approach has that always been the plan and then I guess it or you how do you decide I guess which is it just timing or are you guys looking at which beds introduced a different time based on a different type of metric or something that you're seeing?.

Sure. First of all yes this is how I spend our timeframe we've stated, nine to 12 months in a phased approach and we're right on track with our plan.

Regarding the specific models that we have selected it's one of the benefits of our vertical model and there are quite a few metrics that drove the decision of our selection process everything from our selling process to the mix and representation of that specific model really positioning ourselves to learn as we go and balance the opportunity and any risk..

Okay.

And then two last ones from me one the comment about FlexFit gives an increasing penetration you may provide a little bit of color what I guess your guidance may be assumes in terms of the penetration you expect there's still room there in terms of growth and the attachment rate? And then lastly just a quick modeling one what is the updated guidance assume for share count at end of the year its $43 million when you last spoke..

Great, well regarding FlexFit, yes, we do you still see opportunity. We've been experiencing, continuing to experience growth in this area as I mentioned from the 2% ARU growth. We overall have spoken about the primary driver of growth will be units for us. We continue to see ARU for the balance of the year fairly flat.

So we haven't built a lot in but we do see opportunities..

And Bobby regarding the share count for your modeling, yes, $43 million works..

Still the same. Okay, I appreciate all the detail, best of luck going forward..

Thank you, sir..

Thank you. Our next question is from Brad Thomas with KeyBanc. You may ask your question..

Yes, hi let me add my congratulations as well and thank you for taking my question.

I was wondering as we think about the investments you have this year the $0.15 to $0.22 any more color that you all could provide about how much of that might fall in 2Q versus 3Q and 4Q?.

Sure, Brad. I think you can plan for it about evenly by quarter. I highlighted that we expect about a quarter of it each in COGS and G&A and the balance in selling expenses..

Great. And then just with respect to the guidance for the full year, I think versus consensus you were $0.11 above the midpoint of your guidance goes up by about $0.075.

I mean from your perspective was there anything may be timing related that sell into 1Q rather than the other quarters or is this just you all being conservative in your outlook?.

With all the pieces that we're thinking about this is the best way to plan for the year; we've got a lot of, of year left ahead of us. So in the first quarter and there's nothing that has changed significantly since when we gave guidance last quarter..

Great. Very helpful and congratulations again..

Thanks Brad..

Thank you. Our next question is from Keith Hughes with SunTrust. Your line is now open..

Thank you. My question is on the G&A spending you said $32 million per quarter for the rest of the year, $1 million higher in the third and the fourth excuse me the second and the third and then good bit more in the fourth.

I know there are some costs from the launch coming in there but are there other numbers involved around that number disrupting more higher than expected?.

Yes, hi Keith yes Q4 you recall Q4 last year we highlighted that we benefited from reversal of our incentive compensation programs and that was weighted heavily in the back half of the year probably about $0.15 overall in the back half last year..

Okay, it's going to be a more normal compensation is that the expectation?.

That's right..

Okay.

And could you repeat again on sales and marketing expense percentage number, I just missed?.

Yes, sure it's consistent with what we've been saying 44% to 45% of net sales for the year..

Okay. And final question if I look at sales expense in this quarter 43% of sales kind of excluded last year to so many things going on.

I look it at versus two years ago your sales were up over two years ago, your gross margins are up, that number though is also up to the negative side, what your selling expense look like now versus two years ago those increase?.

The big factor in there is additional stores and occupancy costs over that two-year period and the compensation associated with staffing of those stores, those are the primary driver over that two-year period.

Depreciation related to the stores that's what I'm in terms of the occupancy as well as percent grantor and any of those types of items utilities that kind of things..

Thank you. Our next question is from Seth Basham with Wedbush. You may ask your question..

Thanks a lot and good afternoon. Just a follow-up on the last question regarding selling expense as a percentage of sales for the first quarter as media leveraged 80 basis points -- 50 basis points, I mean selling expenses deleveraged 80 basis points.

Why was that and can you provide a little bit more color there?.

Sure, Seth. Glad to you recall that last year Q1 we had a bit of a benefit from that backlog benefit, the $21 million of backlog that came into the quarter and that caused more leverage in Q1 last year than you would have otherwise seen. And so on a year-over-year basis when you get to Q1 this year, it puts some pressure on our selling expense.

Now the other piece of it that I highlighted we had over performance versus our plans on the selling compensation side for our store personnel and so that that caused some deleverage in the quarter..

Got it, okay. Thank you.

And as we look at the composition of ASPs for balance of the year looking for flattish as we think about the next couple of quarters the close-out sales would you expect ASPs to decline?.

Yes, again we don't we don't talk ASPs, we talk ARU but we do we're talking that we expect the growth to come from units not from ARU.

And that's a couple of different things going the -- Shelly highlighted that we expect some benefit from some of the items that are by choice now to be embedded in the product core that helping ARU and we have also highlighted that we expect some pressure from discounts on the close-out sales.

The net of that all is expected to be about flat on the ARU side..

Got it. Okay and then a housekeeping question on your guidance you're looking for 4 to 5 percentage points of sales growth from net new store openings, which is up a point I think from your last guidance.

Is that driven by more new stores or higher productivity of new stores that you are now expecting?.

It's intended to be directionally the same as what we had said before, we had some improved performance contribution in Q1 but overall we're expecting it to be directionally the same as we had guided before..

Got it.

Okay and my last question is just on the 360 pricing structure, I know you're not planning on raising prices but with all the value-added features that you're putting into this bed, why not take price on it if you're delivering more value to the consumer?.

Yes, Seth, this is a balance, we are looking for the optimization and breaking through with our brand and incredible value to the consumer with real sleep benefits that will make a difference and we intend to take market share. We know we have pricing opportunity as well for the future.

Right now we're focused on a very strong healthy transition and taking market share and overtime, we continue to see pricing benefiting our ARU growth at around 3% similar to what we've experienced in the past..

Okay, helpful.

If I could squeeze one last one in, just SleepIQ an update their how sales tests have trended there and if you complete your test of in-store sales?.

With 360 was that Seth or you said SleepIQ?.

SleepIQ I'm sorry, I meant the IT Bed..

Oh, the IT Bed, okay and the question is I'm sorry now I have to go back to the question..

I'm sorry the question is how have sales of IT Bed trended and have you completed testing of IT Bed sales in-stores and how have they performed?.

Yes, our store sales we did increase our store rollout a few more stores in the last quarter more specifically targeting three to four markets right now with the IT Bed and continuing to keep that incubated with a dedicated team running that brand, well we prioritize the rollout of 360 in our overall core brands.

But advancing our learnings and it's becoming clear every week about where we need to put our effort..

Thank you. [Operator Instructions]. And our next question is from Michael Lasser with UBS. You may ask your question..

Thanks a lot for taking my question; it's on the gross margin.

You saw very good expansion in the first quarter what pieces are you expecting to fade as your guidance implies that your gross margin is not going to be off as much as it was in the first quarter?.

Hey, Michael thanks for the question. I just want to remind you first let's start out with Q4 of last year, we'd highlighted that there was about 50 basis points of the margin from last year Q4 that was due to our incentive compensation reversal.

And then I highlighted in terms of this year, we continue to expect our improve -- our advancements in the manufacturing operations, logistics operations and the better return rates to continue to benefit us the balance of the year.

However we're planning for some margin rate pressure from the close-out sales that we've highlighted as we transition to our entire product line to this 360 bed..

And is your expectation that once you get to close-out pressure done and you anniversary this one-time issue that you could see a similar rate of gross margin expansion?.

Yes, definitely..

Okay.

And Shelly you mentioned that it continues to be a very competitive environment, customer acquisition costs are on the rise, how long do you expect that to continue and what do you expect to lead to less competitive pressure?.

Well, I think exactly what we're doing leads to and I can, you can see that in our first quarter results, with increased customer or competitive spending as we experienced in the third and fourth quarters and we talked about for the fourth quarter that we were advancing our actions to be more efficient in that increased competitive environment and the first quarter demonstrates the advancement of those initiatives and some very strong success with our media leverage and the overall sales that we were able to drive in the quarter..

Okay, good luck..

And then, one other question about the competitive environment, I mean this is good for the industry.

We have, there are two big things going on, one many new brands have, have surfaced online which I think is helpful in helping in consumers transact online and just become more engaged with the category overall that's beneficial to us with our direct-to-consumer model.

And secondly, just having the increased trends overall around sleep and wellness is helpful and that's a big driver that we're most excited and our innovative products deliver on increased sleep benefits that tie back to wellness..

Shelly it seems signs that all the new competitors that have sold online as starting to consolidate or even go away?.

You can see some of them facing off with, with their spending presence, yes..

And is it more the smaller ones or is it less activity from some of the bigger ones?.

It's more the smaller ones in our observation..

Thank you. And we show no further questions at this time. I'd like to turn the call back to our speakers for closing remarks..

Thank you for joining us today. We look forward to discussing our second quarter 2017 performance with you in July. Sleep well and dream big..

Thank you for participating on today's call. The conference has now ended. You may disconnect at this time..