Select Comfort Management Discusses Q4 2012 Results - Earnings Call Transcript

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 |  About: Select Comfort Corporation (SCSS)
by: SA Transcripts

Edwin Boon

[Audio Gap]

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.

Shelly R. Ibach

Good afternoon, and thank you for joining our call. Today, I will share highlights from the fourth quarter full year 2012 and 2013 expectations, and I will also comment on a recent acquisition of Comfortaire and the additional strategic investment.

Despite a challenging fourth quarter, we made significant progress toward our long-term goals throughout 2012. We are focused on what we can uniquely deliver, an unparalleled sleep experience that recognizes the individuality of our customers. Specifically, our business model and customer-focused strategy, including proprietary benefit-driven products and exclusive distribution, allow us to control innovation, pricing and our customers' experience.

Let's start by reviewing the fourth quarter. Net sales increased 17% to a fourth quarter record of $221 million. Company-controlled comparable sales grew 11% on top of a 31% comp in the fourth quarter of 2011. EPS was $0.22 versus an adjusted EPS of $0.24 in fourth quarter 2011.

While we did not meet our expectations in the fourth quarter, the reasons were isolated to the quarter and we do not expect them to be a factor moving forward. First, I will speak to the top line. Compared to plan and trends, our sales unexpectedly and abruptly declined in the last 2 weeks of December. This shortfall in December meant the difference between exceeding our fourth quarter sales guidance and missing it. This weak December sales period was an anomaly, as January is performing as planned with comp trends similar to pre-December time frame.

Our voice of customers suggest these sales shortfall was related to the uncertainty around the fiscal cliff. This is a great example of our unique ability to hear directly from frontline employees and customers. This real-time insight allows us to remain steady in our execution and focus on the longer term.

And now I will speak to the bottom line. Beyond sales, 2 primary factors impacted our EPS. First, let me speak to the marketing deleverage.

We expanded the scope and size of media testing in October that did not deliver the results we expected, therefore, will not be repeated. In addition, we deployed a longer test period for our new advertising campaign.

Second, we proceeded with planned investment in the fourth quarter, as they were important to our business as we set up 2013 and beyond. Specifically, expense in the new production of our new advertising campaign that reaches our broader target customer and investing in transformational product and service concepts, specifically in R&D and consumer insights. We expect the return on these investments to build during the next 12 to 24 months, further strengthening our competitive advantages. While we were disappointed with our quarter, we do not expect these factors could negatively impact our performance as we move forward.

Moving on to our full year 2012 results. We made significant progress toward our goal of achieving at least $1.5 billion in sales and 15% operating margin by 2015. Net sales increased 26% year-over-year to a full year record of $935 million, up from $743 million in 2011. Company-controlled comparable sales grew 23%, a 49% increase in 2-years stack comp growth. Adjusted operating margin was a record 13.4%, up 120 basis points from prior year. Adjusted earnings per diluted share were $1.43, which represented a 34% increase over prior year. These results were at the top of the mattress in retail industry, reflecting the strength of our business model and customer-focused strategy.

As we move to 2013, our plan surpass the $1 billion revenue milestone. We will maintain our disciplined approach to driving sales, including advancing our growth formula, which involves building brand awareness, developing local markets and progressing product innovation while investing in our long-term strategy. We are excited about the advertising, media and marketing development advancements we have in place for 2013, especially given the sales effectiveness of our team as demonstrated by the ongoing growth in average sales per store and ASPs.

Our 2013 investment priorities include: expanding distribution in existing markets, advancing transformational product concepts focused on individualizing sleep experiences and building our infrastructure to enable the top-tier growth we are achieving.

The Comfortaire acquisition supports our long-term plan and strengthens our competitive advantages. We intend to operate Comfortaire as an independent company. However, we will immediately focus on the convergence of intellectual property, which we expect to be meaningful. We are excited about operating the 2 largest air bed companies with talented, experienced teams, who have a shared commitment to quality, innovation and individualization.

In addition to this acquisition, we have made a commitment to invest $4.5 million in a product development company that also is a key partner per Sleep Number. This investment complements our R&D capabilities associated with the transformational product concepts we previously mentioned. We expect to quickly realize the benefits of this partnership and are particularly excited about the next 12 to 24 months as we introduce our new product concepts.

These investments are great examples of our intense focus on one of our long-term goals, innovative Sleep Number products will move society forward with meaningful consumer benefits.

I will now turn the call over to Wendy to share greater financial detail about the fourth quarter full year and 2013 guidance.

Wendy L. Schoppert

Thanks, Shelly. Good afternoon, everyone. I will cover 3 key topics today. First, our fourth quarter and full year 2012 results; second, our guidance for 2013 within the context of our previously stated 2015 goals; and third, our 2013 capital allocation strategy, including a few quick notes on the Comfortaire acquisition.

Fourth quarter sales increased 17% to a fourth quarter record of $221 million. Sales were below the 20% guidance we provided in October due to the isolated impacts at the end of December that Shelly referenced. As stated, month-to-date comp performance in January quickly returns to plan, which is built into our 2013 guidance.

Fourth quarter sales on our company controlled channels also grew 17%, including an 11% comp and 6 points due to net new store growth. Total company-controlled growth also reflected a 16% increase in ASP and a 1% increase in mattress units. The ASP growth was driven by product innovation, including continued increases in our FlexFit adjustable base attach rates, bedding collection sales, mix and pricing.

Mattress unit growth reflects annualizing the Classic Series closeout that began in November of 2011 and continued into January of 2012. On a 2-year stack basis, total company-controlled mattress units in the quarter increased 17% and company-controlled, ASP increased 29%, both of which were similar to second and third quarter's 2-year stack performance.

Note that we have adjusted our definition of ASP in the supplemental financial information to reflect total net sales, while the prior measure included sales from only mattresses and bases. This new ASP disclosure represents our customers' total purchase, which is consistent with how we operate the business and how we speak about ASP on our quarterly earnings calls.

Operating margin in the fourth quarter was 8.8%, compared to 10.6% in the prior year. This 180 basis point year-over-year decrease was primarily driven by a 250 basis point increase in sales and marketing expense, most notably offset by a 60 basis point improvement in gross margin. These results also included the $4 million of investments we discussed during our October call. Media spending in the quarter was $32 million.

Earnings per share in the fourth quarter were $0.22, a 19% decrease versus prior year on a GAAP basis and an 8% decrease after adjusting fourth quarter of 2011 for the $0.03 nonrecurring net decrease to income tax expense related to the favorable resolution of prior year's tax matters.

Fourth quarter EPS was negatively impacted by $0.05 of sales-related factors that were highlighted previously and $0.03 of expense not built into our guidance, both of which were isolated to the quarter. The incremental expense was related to inefficient media testing and enhancements to our product and service concepts that we expect to benefit from in 2013.

Full year 2012 net sales grew 26% to a record $935 million, and full year comparable sales grew 23%. Average retail sales for comp store increased 26%, reaching a record $2.2 million, and we increased our store count by 8%, ending the year at 410 stores. We, once again, gained market share against the backdrop of a competitive industry and an unpredictable economy.

Adjusted operating margin increased by 120 basis points to a record 13.4%, and we increased our adjusted earnings per share in 2012 by 34% to a record $1.43. These results were driven by our consumer-centered growth strategy focused on building brand awareness, local market development and product innovation.

Our commitment to product innovation results in specific components of the P&L fluctuating from quarter-to-quarter as we close out and introduce products. Examples in 2012 included first quarter with its record high mattress unit growth and lower gross margin rates as we closed out and relaunched our entry-level Classic Series; impacts that we will again annualize this quarter; and third quarter with its double-digit ASP increase as we introduce our new memory foam series and new FlexFit adjustable basis.

Now let's talk about guidance for 2013, which continues to progress us towards our goal of at least $1.5 billion in sales and 15% operating margin by 2015. We expect full year 2013 earnings per share to increase 15% to 26% from an adjusted $1.43 in 2012 to between $1.65 and $1.80. Because we operate our business for both short and long-term profitable results, we have planned for quarterly fluctuations in our business in 2013, including EPS. For example, we expect the first and fourth quarters to have the highest EPS growth rates. We also expect second quarter's EPS growth rate to be lower than other quarters, as we continue advancing product innovations and infrastructure improvements during our seasonally lowest quarter.

For 2013 sales, consistent with our long-term strategy, we expect growth from both increased productivity of existing stores with full year comp of at least 10%, as well as the addition of new stores with an expected 25 to 35 net new stores during the year. We will continue operating with discipline while moving forward with investments and product innovation, distribution and infrastructure consistent with our 2015 goals.

Operating margin rate in 2013 is expected to be slightly higher than 2012's rate even as we invest, as productivity enhancements to gross margin fund investments in SG&A. Included in this guidance is the planned incremental depreciation driven by increased growth-related CapEx, which is expected to negatively impact operating margin by 70 basis points.

Let's review the P&L components. First, we expect annual gross margin rate in 2013 to grow at a similar rate as we experienced in 2012, driven by manufacturing efficiencies and product innovation. We expect modest deleverage in 2013 selling and marketing expenses due to our significant investment in new and remodeled stores, resulting in higher depreciation. We plan to increase R&D and G&A in 2013 at approximately the rate of sales, as we invest in product innovation and infrastructure improvement, including depreciation. And finally, we expect the tax rate of 35% in 2013.

Moving to cash. Our year end cash and securities balance of $178 million was a $32 million year-over-year increase, which reflected operating cash flow of $101 million, self-funded CapEx of $52 million and stock repurchases of $30 million. For 2013, we expect free cash flow levels that are similar to 2012. Higher year-over-year operating cash flows as we profitably grow, offset by higher capital expenditures.

Our capital allocation strategy in 2013 will again prioritize growth investments, given the returns we've been achieving. Specifically, we expect 2013 CapEx of $70 million to $80 million, with approximately half dedicated to new stores, relocations and remodels; 1/3 dedicated to technology as we continue to update and enhance our customer information systems; and the remainder dedicated to product development, supply chain and other infrastructure needs associated with innovation. We also plan to continue our current pace of share repurchases, with the objective of maintaining share count at current levels, and we expect our balance sheet to remain debt-free in 2013, an important advantage in this uncertain macro environment.

The acquisition of Comfortaire is an all-cash $15.5 million asset purchase agreement. We expect the majority of return on this investment to come from the value created by the acquired intellectual property. As such, we do not expect the stand-alone Comfortaire business to be materially accretive or dilutive to shareholders in 2013.

In summary, achieving our 2015 goals will result in significant earnings per share growth over the next 3 years, and we are excited about the plans we have in 2013 to drive sales and invest in the business to increase shareholder value for both the short and long term.

Thank you for the interest you have in Sleep Number, and I'll now turn it back over to Shelly for final comments.

Shelly R. Ibach

Thank you, Wendy. Obviously, fourth quarter results fell short of our expectations for the reasons we shared with you. That said, we will realize the benefits of the fourth quarter investment in 2013 and beyond. As we look ahead, we could not be more excited and confident about where we are in our trajectory towards the goal of at least $1.5 billion in sales and 15% operating margin by 2015. In 2013, we will continue to advance our integrated growth formula with disciplined execution, while strategically investing for long-term profitable growth and targeting 20% annual EPS growth.

In closing, I'd like to thank our Sleep Number team for their dedication to providing unparalleled and life-changing experiences to our customers. This year, we will achieve 8.5 million customer lives improved.

Thank you for joining our call today. We now welcome your questions and comments. Sharon, you may now open the line.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Brad Thomas of KeyBanc Capital Markets.

[Technical Difficulty]

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

I wanted to, first, just touch on the recent trends a little bit. Obviously, you provided a great deal of color about that in the prepared remarks. But could you give us a better sense of how October and November and perhaps, early December were playing out? What that run rate had looked like before the last 2 weeks of December?

Shelly R. Ibach

So Brad, as I stated, until mid-December, we were on track with our guidance, so we do not believe that this miss reflects a fundamental change in consumer behavior or our strategy. And as you know, uncertain conditions are not new to us. This was an isolated time frame that was sudden and significant and fell at the end of the quarter. We do expect uncertain macroeconomics as we've all been experiencing and have taken this into our guidance as we move forward.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Okay. Okay, great. And then, Wendy, to follow up on some of your comments about the guidance and how there will be variability from quarter-to-quarter. On the comp front, would you think that there could be quarters where you have less than a 10% comp?

Wendy L. Schoppert

Sure. Well, let me speak a bit more about guidance and then I will get to your question about comp. Our guidance is based on 3 things: one, where we are in our long-term growth trajectory; second, where we exited 2012; and then third, our current trends. It also considers the investments in our 3-year plan. We've widened the range as we've grown the business to $935 million in sales, and then the midpoint of the range is growth of 20%, which is consistent with our long-term goals. Specific to comp, I'll add that our road map to 2015 includes growth from both comp, as well as net new store growth, and 2013 will be the first full year to benefit materially from net new store growth. And with respect to comp, yes, we're targeting at least 20 -- excuse me, 10% comp consistent with our long-term guidance of 10% to 12%. Don't expect significant variability in that quarter-to-quarter.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Okay. And if I could just squeeze in one more kind of bigger picture question to the point you just made, Wendy, this is the first year that you will start to really see the benefit of new store openings. Over the last 3 or 4 years, the company has really gotten the nice boost in the selling and marketing line as you've closed underperforming stores, recaptured sales. What are you seeing as you open more stores in markets where you already have stores? And what have you been seeing, just in terms of the productivity levels, in these stores that you've been opening in general?

Shelly R. Ibach

Brad, this has been a real competitive advantage for us with our exclusive distribution and our local market development strategy, and we absolutely have a different distribution strategy than we had in the past, where our radius is now doubled what it was in the past as we target new store openings. We do look at the total market, and we have been experiencing substantial incremental profit and sales in our markets as we open up, and minimal cannibalization, less than 15% cannibalization, as we close in and fully develop the market.

Operator

Our next question comes from Peter Keith, Piper Jaffray.

Peter J. Keith - Piper Jaffray Companies, Research Division

I just wanted to follow up, Wendy, on a question, or better, I guess, the response you had with the comp quarter-to-quarter. You did not expect much variability. And I guess, I was surprised because I think myself and others have thought that Q1 would be a challenge going up against that 34%. So I guess, could you get us comfortable on how maybe you're kind of lapping that quarter from last year? And I guess, therefore, sort of imply a decel on a 2-year stack basis for the rest of the year?

Wendy L. Schoppert

Yes, Peter, I think one of the things that you're referencing is just the difference in the way that we achieve our growth quarter-to-quarter, and I think that's really the bigger message. And as you noted in Q1, most of that growth was from units. So one of the things I will point out is that we do expect to reflect that a bit as we look at how we will comp those quarters going forward. And so with Q1 similar to Q4 with respect to units, Q2 weighted a bit higher towards units and second half could be a bit more balanced.

Peter J. Keith - Piper Jaffray Companies, Research Division

Okay. All right. And then, I guess maybe you got a little bit acute on your guidance, but it sounds like January has bounced back quite nicely would imply that you're comping something above the 12% at this point because December was weak for you. Would you -- I guess, for the remaining months here, February and March, would you anticipate you slowing down a bit from the current level that you're at?

Wendy L. Schoppert

Well, Peter, I won't get into month-by-month, and we'll just reiterate that our guidance is based on our long-term growth trajectory, where we exited the year. And then to your point, it does reflect our current trend, but won't get into the month-by-month.

Peter J. Keith - Piper Jaffray Companies, Research Division

Okay. That's fair. One last question for you. It's understandable your depreciation's ticking up quite a bit. So I guess on -- maybe a run rate going forward as we think about your long-term guidance, what sort of comp-store sales growth do you need at this point in order to drive some leverage on the expense line?

Wendy L. Schoppert

Well, let me talk a little bit about depreciation for a moment. And as I mentioned, it will add 70 basis points to expense. And some of that's in selling, some in G&A. And this is definitely how things are shipping as we move from, as you noted here is, the store decline to store growth. And one thing I'll highlight -- just to highlight this point, nearly 40% of our comp store had less than $10,000 of depreciation last year, so it is a significant components of our expenses going forward. So -- but specific to comp, again, our comp guidance is for at least 10%, and that's consistent with our 2015 goals that we've set out.

Operator

Our next question comes from Josh Borstein of Longbow Research.

Joshua Borstein - Longbow Research LLC

With respect to the 6 markets that you have left to target through -- in the 2013 to 2015 time frame, are those markets structurally different from the first ones that you went after?

Shelly R. Ibach

There's a wide variation within the 13 markets, Josh. We did -- in the very first 4, we did had the variation built in for our pilots so that we could learn in a variety of situations. We do have some large underdeveloped markets yet in front of us and we spend dealing with some complexity here this last year, with some of the new markets, then it will be very similar to what we've experienced so far.

Joshua Borstein - Longbow Research LLC

Okay. And could you say the percentages of total sales that are now coming from the markets that you, so far, targeted?

Shelly R. Ibach

The percent of sales from the markets...

Joshua Borstein - Longbow Research LLC

Of those 13 markets where you plan to double market share.

Shelly R. Ibach

Couple of things that I will share there for you, Josh, is that those markets represent about 1/3 of U.S. setting sales. And when we started the program years ago, they were about 24% of sales. So we have, clearly, through the progress that we've made over the last 2 years, made some progress in closing that gap.

Joshua Borstein - Longbow Research LLC

Okay, great. And then just one last one for me. On the cost side, what are the commodity costs look like so far in 2013, and what are some of your expectations?

Wendy L. Schoppert

Sure. Well, for Q4, commodities were relatively steady. With respect to our 2013 outlook, we expect low to mid- single-digit commodity inflation. But as we have successfully accomplished in the past, we expect to mitigate this with supplier and also our own operational efficiencies.

Operator

Our next question comes from Todd Schwartzman of Sidoti.

Todd A. Schwartzman - Sidoti & Company, LLC

On the sales hiccup that the 2-week period, would you say that cost you roughly in the neighborhood of $10 million?

Wendy L. Schoppert

So Todd, let me break this down a bit more for you. The $0.05 of sales-related impact that I spoke to included primarily the late December factors that Shelly highlighted, but it also did include new store timing. And while we ended on track with 410 stores, our store weeks in the quarter were lower than planned. The $0.03 of expense-related impacts included the inefficient media testing that Shelly referenced and also the incremental investment and products and service program, including some legal-related costs to protect our brand assets.

Todd A. Schwartzman - Sidoti & Company, LLC

Okay. And on that 14-day -- essentially 14-day anomaly, could you reveal a little bit more about your insight, what gives you the confidence that you've got the fiscal cliff isolated as the sole driver or perhaps the primary driver culprit, if you will? Where is this insight coming from? What are your folks telling you?

Shelly R. Ibach

Well, 2 things. As I stated, our sales did abruptly slow in this isolated period of time. The voice of customer via our strong and immediate feedback loop indicated this hesitancy as a result of the fiscal cliff discussion. And that's what we heard. We also saw the immediate build back of sales commensurate with the resolution around the fiscal cliff. It was further amplified by the negative impact of the calendar shift, which moved Christmas a little later in the month as well because we did lose post-holiday market share event days during that time.

Todd A. Schwartzman - Sidoti & Company, LLC

Okay. Can you expound a little on the inefficient media testing? What was going on there?

Shelly R. Ibach

Yes, we expanded the scope and size of a media test in October, and there was the backdrop of the election period at that time. But that media test did not deliver the results that we had expected, so it really led to some inefficiency. And it was magnified by the fact that we also, in the quarter, tested our new advertising campaign and did not launch that campaign until January here with the post-holiday event.

Todd A. Schwartzman - Sidoti & Company, LLC

Okay. On the -- again, on the demand side, it sounds as though the elections per se did not -- were not problematic. Is that a fair assessment?

Shelly R. Ibach

We saw the normal fluctuation related to external factors throughout the quarter that we generally experienced, and obviously, there were a lot of them in the fourth quarter. It was a complicated quarter from that perspective. But really, this period that we've discussed around the last 2 weeks of December meant the difference for us, meeting our guidance and not.

Todd A. Schwartzman - Sidoti & Company, LLC

So built into that, your expectations that first 11 weeks, things are in line with your expectations. It seems that built into that was a weaker November vis-à-vis October due to the uncertainty over the election. Is that fair?

Shelly R. Ibach

No, I did not say that about November, no.

Todd A. Schwartzman - Sidoti & Company, LLC

Okay. On the investment spend for 2013, is there any additional color that you could give as to how things ramp by quarter? Are they -- is it even? Is it lumpy?

Wendy L. Schoppert

No. Nothing that I would point out on a quarterly basis, Todd.

Operator

[Operator Instructions] Our next question comes from Keith Hughes of SunTrust.

Judy Merrick

This is actually Judy in for Keith. And just on -- question on the average selling price. Was the -- the ramp-up of the adjustable base, is that kind of similar to what you saw in the third quarter, the contribution between that and the mix in the new products?

Wendy L. Schoppert

Sure. I'll speak a bit about ASP. First, I'll just start with growing our ASP is a cornerstone of our strategy, and our experience is all about the total sleep experience. We don't compete on price. We build relationships with our customers, which enables us to provide this wide range of solution, and this results in a higher ASP. So for 2012 and going forward, our ASP growth is driven by our product innovation program. So yes, the FlexFit adjustable base attach rate is an example of that. And so in Q4 the higher FlexFit adjustable base attached was a key driver, as well as strengthen our bedding collections. And secondly, mix and pricing, again, associated with our innovation program was another significant driver.

Judy Merrick

Okay, great. And for your target of 25 to 35 net new stores next year, would that be primarily the non-mall-based stores as you expand in the existing markets?

Wendy L. Schoppert

Yes. So with respect to our growth in stores, yes, we do expect the majority of our new stores to be in the non-mall format given the success that we've seen. And I will add that our mall stores continue to serve a very important role in our portfolio.

Operator

Our next question comes from Joan Storms at Wedbush.

Joan L. Bogucki-Storms - Wedbush Securities Inc., Research Division

Shelly and Wendy, I just -- you're talking about the product innovation and investments. Can you share what some of -- we're -- there's a lot going on in Vegas next week and some people have already announced new products. Can you share with us what you're thinking in terms of new products this year?

Shelly R. Ibach

Joan, we are excited about where we're at with our robust product innovation pipeline. And we mentioned last quarter on the call that we had some breakthrough in our R&D, and we're investing against that. That's part of this $4.5 million investment, strategic investment we made, and we do intend to bring this new product concept to market in the next 12-plus months. In addition to that, we will have other change that's going on here in the year, and we're not prepared yet at this time to speak to them specifically. The one thing I will say is that we are focused on our platform of individualized sleep experiences.

Joan L. Bogucki-Storms - Wedbush Securities Inc., Research Division

Okay. I guess I was just referring to, in particular, when you had the closeout and the rollout in the first quarter of the Classic Series last year, is there anything particularly planned for the first quarter to help you meet that barrier?

Shelly R. Ibach

We do not have a closeout going on. We do have an introduction of a promotional item that we'll be featuring during our Presidents' event, and that will really help us during that time period. It's very consistent with our proven strategy during our market share events.

Operator

Our next question comes from Keith Hughes of SunTrust.

Judy Merrick

Our questions have been answered.

Operator

At this time, I'll turn the call back over to our host for closing remarks.

Edwin Boon

Well, if there are no further questions at this time, we will conclude the call. Thank you very much for your participation, and we look forward to reporting further to you following the first quarter of 2013. Thank you.

Operator

This concludes today's conference. Thank you for your participation. You may now disconnect.

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