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Select Comfort Corporation (NASDAQ:SCSS)

Q2 2009 Earnings Call

July 23, 2009 5:00 pm ET

Executives

Mark A. Kimball – Senior Vice President and General Counsel

William R. McLaughlin –President and Chief Executive Officer

James C. Raabe – Chief Financial Officer and Senior Vice President

Analysts

Analyst for Budd Bugatch - Raymond James

John Baugh - Stifel Nicolaus & Company, Inc.

Joel Havard - Hillard Lyons

Operator

Welcome to Select Comfort’s second quarter 2009 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 any objections, you may disconnect at this time.

I would like to introduce Mr. Mark Kimball, General Counsel.

Mark A. Kimball

Thank you, Holly. Good afternoon and welcome to the Select Comfort Corporation second quarter 2009 earnings conference call. Thank you for joining us. I’m Mark Kimball, Senior Vice President, General Counsel. With me on the call today are Bill McLaughlin, our President and Chief Executive Officer and Jim Raabe, our Chief Financial Officer and Senior Vice President.

In a moment I’ll turn the call over to Bill. Following our prepared remarks we will open the call up for your questions. Please be advised that this telephone conference is being recorded and will be available by telephone replay. It also will be archived on our website at www.selectcomfort.com. Please refer to the details set forth in our news release to access the replay on our website.

The primary purpose of this call is to discuss second quarter results. As you know, we previously announced that we have entered into an investment agreement with Sterling Partners which remains subject to shareholder approval. The Sterling transaction and its background and rationale will be fully detailed and definitive proxy materials that we expect to mail to our shareholders in the next 7 to 10 days. Therefore, we do not intend to discuss the Sterling transaction in any detail in our comments or in our answers to your questions. We urge our shareholders to review and carefully consider the definitive proxy materials when available.

Our commentary and our 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 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 Bill for his comments.

William R. McLaughlin

Thanks Mark, and thank you all for joining us today. We are looking forward to discussing with you our second quarter performance and our continued progress to improve operating results.

During our last earnings call we shared with you that the anticipated lower sales and earnings and negative cash flow given second quarter’s seasonal low selling period. However, I’m pleased to report that we outperformed our expectations in the quarter. While as expected sales were lower than prior year and the prior quarter, but we delivered improved operating income and cash flow, and importantly, same store sales trends improved both sequentially from the first quarter and during the quarter.

Our second quarter results reflect the impact of the strategies and priorities that we set in motion late last year. Let me share a few of the highlights from the second quarter and why they are important for the second half as well as our continued long term advancement.

Our first priority involves resizing our cost structure to reflect the realities of today’s macroeconomic environment and changes that are designed to allow us to be profitable at lower sales. The fact that we achieved positive operating profit during our seasonally low quarter demonstrates that we’re on the right track.

Several key metrics reflect the positive effects of our cost actions in the quarter. First, we achieved a 200 basis point improvement in gross margin despite volume deleverage and increased focus on value. Second, we experienced a 560 basis improvement in sales and marketing expenses as a percent of sales. Media investment in the quarter was down approximately 44% year-over-year as we left a high spend quarter a year ago.

We continued our 2009 strategy to invest at historic levels of media per unit and to test and prove efficiency before increasing support levels. Year-over-year sales trends in the quarter were in line with our closest competitor despite our media reductions and more than 50 fewer company stores in the quarter. This outcome demonstrates the effectiveness and the efficiency of our recent sales and marketing initiatives.

Finally, our actions to reduce overhead drove a $2.5 million reduction in G&A and R&D in the quarter. Despite this reduction we achieved increased employee engagement across the organization which we measure on a regular basis. Looking ahead ,we are committed to continue to identify and execute additional ways to reduce fixed costs across the company.

Our second priority focuses on reigniting the Sleep Number brand to drive consumer awareness and move us toward our goal of restoring sustainable growth. Our product and our brand clearly remained the key foundations of our future. In today’s environment we understand the importance of delivering value to our consumers and in the second quarter we benefited from the continued refinement and execution of our value strategy. Highlights include first the re-launch of our product line in the first quarter which involved repositioning nine mattress models into three series aligned to good, better, and best with three models below $1500 for a queen bed set continues to simplify consumer understanding of our price range and our competitive value.

Second, we continue to emphasize our value utilizing enhanced promotional offers at the entry level and trade up offers within our product line, carefully managing our mix and gross profit contribution. Mix within our mattress line has remained stable with good, better, and best still approximately 30%, 50%, and 20% respectively.

As part of the value strategy, we also continue to make progress with our accessories offering which we use to attract consumers at a lower price point. Our bedding collection mix of sales increased 130 basis points sequentially from the first quarter to 10.9% of mix, a record high for the second quarter. Importantly, even with the value emphasis, we’ve held our average selling price fairly steady with mattress ASPs down only 2% versus prior year and at the same time we improved gross margins.

Also in the quarter, we conducted significant testing and development of our marketing strategies which we believe will benefit the second half and beyond. This includes both enhancements to our traditional direct marketing programs and continuation of the local market development via radio and print.

Given the sales environment is unlike any we’ve faced before and appears to reflect a long term change in consumer sentiment, we continue to test and learn in order to refine our marketing and selling approach for this new economy and consumer. We are committed to enhancing our brand and broadening our target market by communicating the compelling range of price points and value as well as the unique benefits that only a Sleep Number bed can provide.

Our third priority revolves around preserving cash and improving our capital structure. We made significant progress in the second quarter generating positive operating cash flow during our seasonally low period of sales and reducing our outstanding borrowings under our revolving credit facility to $43.8 million.

Additionally, during the quarter we successfully attracted an investor which would further strengthen our capital structure. As we announced in late May, we entered into an agreement with Sterling Partners under which the company would sell 50 million shares of common stock at $0.70, representing a total transaction of $35 million or 52.5% ownership interest in the company. This transaction would represent a key step in our efforts to improve the company’s short term and long term liquidity and to provide resiliency in the face of this uncertain economy.

If the transaction is approved by shareholder vote in late August or early September, then Sterling Partners has announced its intent to change CEO leadership. Let me assure you that during this process both the team and I remain fully engaged and focused and committed to continuing to improve our business and to enhance our long term prospects.

With respect to the remainder of the year, we are looking forward to carrying our first half momentum into our seasonally stronger second half. Our financial position is stronger and our proven and evolving strategies will allow us to take advantage of this traditionally stronger traffic and demand period.

That said, our plans and outlook are tempered by the potential for continued and even greater macroeconomic challenges. Nevertheless, we expect in the second half to break even or be slightly profitable and importantly anticipate continued positive cash generation. We are committed to holding the line on costs and cash and look forward to continued advances in our marketing and sales programs to continue sales trend improvements.

Our employees are excited by their accomplishments during the first half of the year as they should be. It’s been a real team effort with improvement ideas contributed from across the company and for many of our partners. The progress we have seen thus far gives the company confidence about the prospects for continued improvements in the second half of the year and beyond.

Jim will now expand on our second quarter performance and outlook for the remainder of the year.

Thanks, Bill. As noted in our release, we reported a net loss of $4 million in the quarter or $0.09 per diluted share. This loss includes a $3.6 million non-cash charge for deferred tax assets. We have now removed all deferred tax assets from our balance sheet and anticipate no similar charges in future periods.

On a pretax basis, we recorded a net loss of approximately $500,000, an improvement of $10.4 million compared to the second quarter of 2008 and $1 million improvement when compared to the first quarter despite lower seasonal sales.

Year-to-date our pre-tax results have improved by $20 million as compared to 2008 and we have generated $35.6 million in operating cash flow including $25.8 million in income tax refunds associated with prior year losses.

As Bill mentioned, we’ve reduced outstanding borrowings under our line of credit to $43.8 million. Our progress is the result of a combination of cost reductions and stabilization in sales. With the actions we have taken to date we have reduced our pre-tax break even point to just over $500 million in sales.

Now I’d like to cover some of the more notable drivers to our 2009 performance to date. Second quarter sales were 21% lower than the prior year. While this was slightly greater than the 17% decline we reported in the first quarter, most indicators point to improving trends. The timing of QVC shows and 51 store closures this year affect the year-over-year comparisons of sales trends. Excluding these factors, the rate of decline in sales improved by 7 percentage points between the first and second quarters.

Another indicator of improving trends involves same store sales which were down 11% in the second quarter compared to a 14% decline in the first quarter. On the operating margin side, we achieved a 200 basis point improvement in gross profit margins in the quarter over the prior year and 300 basis points better than last quarter. The improvements reflect significant cost reduction initiatives which began in the fourth quarter of last year and include product redesign, productivity gains, staffing reductions, facility closings, and supply chain renegotiations. Lower commodity costs also contributed to the year-over-year improvement while channel mix and lower discount rates contributed to the sequential improvement

Other significant cost reductions occurred in sales and marketing. Our first half marketing expenditures were down by $34 million including $20 million in lower advertising costs. Selling costs were reduced by $13 million while the most significant reduction driven by this closure of 51 stores. In additional to natural lease terminations we bought out approximately 10 store leases and now expect to close a total of 65 or more stores in fiscal 2009 leaving us with slightly more than 400 stores by the end of the year.

The net cost impact of these lease buyouts did not have a material impact on our second quarter results. Total sales and marketing costs in the second quarter were $61.1 million down $24 million or 28% versus the prior year. Likewise, we reduced general administrative costs including research and development expenses by nearly $6 million in the first half of the year. We continue to evaluate our infrastructure costs and opportunities to improve our operating structure.

During the quarter we generated positive EBITDA of $6.6 million and operating cash flow of $11.5 million. EBITDA year-to-date totaled $12.8 million while Cap Ex totaled only $1.9 million. Looking ahead, we are not planning on improvements in the economic environment and understand the risks and potential for further deterioration. The significant improvements in our cost structure and negotiated transaction to infuse additional capital position us for renewed growth once the economy improves.

Even with our expectation for continuing challenging economic environment, we expect to continue to see improvements in our operating results during the second half. Excluding charges associated with the closing of the Sterling transaction and subsequent actions, our expectations for our second half 2009 benchmark indicators are as follows: gross margins are expected to be in line with the second quarter rate. Median investments will be approximately $30 million in line with the first half.

We project selling and marketing dollars in total to be slightly lower than the first half expenses, the result of first half store closures and additional closures in the second half. Second half G&A and R&D expenses will be in line with the first half and interest expense should be slightly lower than the first half. While we are planning for a second half income tax rate of approximately 40%, the rate is difficult to predict and could vary significantly over the balance of the year.

Finally, we will continue to limit our capital expenditures to only mission critical projects with full year expenditures projected at less than $5 million. By maintaining costs and cash discipline, we expect break even or better profitability in the second half while generating positive EBITDA and cash flow.

I would now like to turn it back to Bill for some final comments.

William R. McLaughlin

Thanks, Jim. In summary, we experienced an improved second quarter ahead of our expectations and we maintain a positive though cautious outlook on the second half of the year. Our priorities are clear and our progress encouraging. Every Select Comfort employee understands our three areas of focus. Resizing costs to ensure increasing profit and at anticipated sales levels, reigniting the Sleep Number brand and customer experience for growth, and preserving cash and improving our capital structure.

Now in the second half we are building on our accomplishments and learning from the first half and we are preparing to take full advantage of the seasonal strength in the back half of the year. Again, I’d like to thank all of the individuals on the Select Comfort team, our employees, agencies, and suppliers. I greatly appreciate their dedication, involvement, creativity, commitment, hard work, and accomplishments.

Thank you. Holly, we would now like to open the floor to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Budd Bugatch - Raymond James.

Analyst for Budd Bugatch - Raymond James

This is actually Chad filling in for Bud who’s traveling tonight. Congratulations on a very notable improvement on the financial results. I guess as I look at you in comparison with my model and perhaps against the expectations that you’ve put out there last quarter, gross margin was obviously quite a bit stronger and I know Jim you walked us through some of those puts and take. Could you maybe elaborate a little bit or quantify a few of those points or flesh out what really stood out as the big variance and also the increase in the outlook for the rest of the year in regard to gross margin.

Mark A. Kimball

I would really point to a couple of things. I mean, we have been working hard on the discount structure as you know in the fourth quarter and in the first quarter we were much more promotional and we continue to be so but we are trying to find ways to be effective in promoting the product while reducing that a little bit. I think we were fairly effective in doing that in the second quarter.

I think the second thing is just our operations group has done an outstanding job in really continuing to look for productivity enhancements and find different ways to reduce the costs and they continue to look for those things so without quantification, I would say those are really the biggest factors and I think as we look at the balance of the year, I would say we’re expecting just really a continuation of that. We have built in a little bit of anticipation of some commodity price increases thinking they’re not going to stay as low as they are and then we just continue to work down the path of finding productivity enhancements and in other ways to improve the cost structure on the manufacturing and home delivery side.

Analyst for Budd Bugatch - Raymond James

I think Bill said in his comments that the comps actually improved month to month through the quarter. Is that the case, do I hear you correctly, and if so, could you quantify that for us, let us know how things progress?

William R. McLaughlin

What we said was that the comps improved sequentially and during the quarter. We are still in a period where there’s volatility that I think you’d understand with the economy and actually some of our programming. So we don’t really comment on month to month trends. We have seen a pretty steady improvement over time but not sequentially I would say, month to month.

Analyst for Budd Bugatch - Raymond James

Just a couple of quick housekeeping questions and I’ll defer to others. What was the media spend in dollars in the quarter? I know you gave I think it may be down 44% year-over-year?

Mark A. Kimball

The media dollar number in the quarter was just short of $14 million.

Analyst for Budd Bugatch - Raymond James

Don’t want to go over the line in regards to questions regarding the Sterling transaction, but just theoretically kind of for modeling purposes, assuming everything goes in as expected in late August or early September, will we just see about a month or so of that additional 50 million shares in the third quarter and then have the full 50 hit the run rate for Q4? Is it that simple or is there something there that I’m not aware of or don’t understand?

Mark A. Kimball

I think it’s pretty much that straightforward so you’d be assuming kind of an August, September vote and close. You’d get about a third of those 50 million shares in the third quarter, then you’d get them all in the fourth quarter.

Operator

Your next question comes from John Baugh - Stifel Nicolaus & Company, Inc.

John Baugh - Stifel Nicolaus & Company, Inc.

I think I heard you right. You said your average unit selling price was only down 2%. I just wanted to confirm that and then so your comps, your units, were down single digits, is that right? Refresh me, how does the product lineup look in terms of price points today versus say a year ago? You gave some reference to good, better, best and if the mix hasn’t shifted appreciably. If you could just sort of refresh my memory on your opening price points and I guess you’re not really seeing a big trade down but commentary around that would be great.

Mark A. Kimball

Let me do the second part and give Jim some time on the first part. The product line is in a good, better, best range. It opens for a queen set just under $1,000 and then in that first category of good, goes up to about $1,500. I’m talking list prices off of this, there are promotional discounts. Then it goes up to close to $4,000 for a queen set and as I said, it is about a 30% - 50% - 20% mix within the good, better, best categories.

James C. Raabe

With respect to your other question, John, just first on the comp, directionally you’re right on the unit. The unit comp was a little bit better than the overall comp. There was a little bit of an increase and the number we quoted is the mattress only number and it’s company owned so it’s not just retail, it’s direct in comp, but it’s directionally the same for retail. But it is a small double digit increase in ASP on the mattress only, then Bill mentioned in his comments, we did get growth in accessories as well. That contributes to the comp as well. So that is a contributor. I think I misstated it. A small decrease in the ASP, not an increase. But there was an accessory per unit increase which offset some of that.

John Baugh - Stifel Nicolaus & Company, Inc.

So is it fair to say, I think you said that discounting actually abated a little bit in the current quarter or the quarter you reported versus the prior quarter. Did I hear that right? So you’re seeing improving comps with no real change in mix and having to do less discounting to do that, is that correct?

Mark A. Kimball

A little bit of a qualifier on the discount. I think we’re doing the same things which is a heavier discount for a step up within the line and then we are still doing some heavy promotion on the entry level price points and kind of advertising and that might just be in store signage that just gets traffic into the store. But we’re working through what really is the right discount point. Can we knock $100 off and still get the same effect? So we’re just testing and trying to find the right discount, but the strategies remain the same.

Operator

Your next question comes from Joel Havard - Hillard Lyons.

Joel Havard - Hillard Lyons

Where do we stand sort of post cost containment efforts with regard to staffing levels at the plants? Any changes planned for the production/logistics system at this point?

Mark A. Kimball

We’ve got a structured goal about where we think it needs to be given the current sales run rates and mix. Again, second quarter is generally our lowest seasonality quarter so we feel like we’re in the right place now. We have reduced shifts. We have across the company taken pretty dramatic cost restructuring actions earlier in the year and last year. We do though have flexibility if we ever needed to continue to move with our business but right now we feel like we’re in pretty good shape.

Joel Havard - Hillard Lyons

I guess I’m being a little oblique and I apologize. To be more specific, is there a risk, and I know this may not be comfortable in a conference call, but is there a concern that things deteriorated from here? How close are you to the cusp of maybe reducing and absorbing greater freight. Does that not make sense in the realm of 10% or 20% business shift from here?

Mark A. Kimball

If it went that far we’d be looking at it but we’ve looked at this pretty carefully as we were studying the resizing for this year and feel comfortable that… I can’t remember right now how many shifts were running at the two plants but there is multiple shifts in there and there’s room to go if we had to but that is not the direction that we’re looking at this point because that’s not the trajectory of our sales.

Joel Havard - Hillard Lyons

Sure, clearly, and congratulations on that. So some head count reduction, running some short shifts or some flexible shifts, want to keep the two plants maintain the foot print. Shifting gears if I may for one follow up, would we anticipate, and I know we don’t want to talk about Sterling per se, but should the deal go through, would those funds be essentially entirely assigned to debt reduction? Is that the expectation?

Mark A. Kimball

No, the expectation is that along with the transaction there would be a revised credit agreement and that credit agreement would be funded and then there would be additional cash on the balance sheet is at least the initial expectation.

Joel Havard - Hillard Lyons

As I read it sounded like you’re going to want to restructure the credit facility but would it be as much, would you anticipate taking it down significantly ala 50% or kind of run it flat and keep the cash on hand for working capital?

Mark A. Kimball

It would be more keep it at the $70 million --

Joel Havard - Hillard Lyons

All right, thanks.

Operator

Thank you. I’ll turn the call back over to Mark Kimball for closing remarks.

Mark A. Kimball

Thank you. If there are no other questions at this time then this will conclude the call. We wish to thank you all for joining us and for your continued support. We look forward to talking to you again at the conclusion of the third quarter. Thank you all.

Operator

Thank you. This does conclude today’s conference. You may disconnect at this time.

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Source: Select Comfort Corporation Q2 2009 Earnings Call Transcript

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