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Select Comfort Corp. (NASDAQ:SCSS)

Q3 2009 Earnings Call

October 22, 2009; 5:00 pm ET

Executives

Mark Kimball - Senior Vice President and General Counsel

Bill McLaughlin - President and Chief Executive Officer

Jam Raabe - Chief Financial Officer and Senior Vice President

Analysts

Budd Bugatch - Raymond James & Associates

Brad Thomas - KeyBanc Capital Markets

Jeeva Ramaswamy - GJ Funds

Operator

Welcome to Select Comfort’s third quarter 2009 earnings conference call. All lines have been placed in a listen-only mode until the question-and-answer session. Today’s conference is being recorded. If anyone has any objections, you may disconnect at this time.

I would like to introduce Mr. Mark Kimball, General Counsel. Sir, you may begin.

Mark A. Kimball

Thank you, Sharon. Good afternoon and welcome to the Select Comfort Corporation third quarter 2009 earnings conference call. Thank you all 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 Senior Vice President and Chief Financial Officer.

In a moment I’ll turn the call over to Bill. Following our prepared remarks, we will open the call to 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 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 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.

Bill McLaughlin

Thank you all for joining us today to discuss our third quarter performance. We’re extremely pleased with the results of the third quarter and their implications for our company’s long term potential. We’ve made substantial progress since last year, and look forward to discussing the implications with you.

Our immediate priority through the recession has been to manage our business for improved profitability and cash. While at the same time, taking steps to reinforce and strengthen our fundamentals for eventual long-term growth.

This past quarter is as an early indication of the potential of our company in market share, profit leverage and cash generation. As many of you know, the third quarter is historically the strongest seasonal quarter for the mattress industry and for Select Comfort. We took full advantage of it to demonstrate our flexibility and leverage potential.

In the quarter earnings per share was $0.15 after a one-time expense of $0.05 per share related to terminated financing. This compares to earnings last year during the same period of $0.02 per share. Same store sales this third quarter increased 9% year-over-year with total company’s sales declining 6% as we consolidated distribution.

We generated positive free cash flow of $17 million in the quarter, and we have now reduced our debt balance from $79 million at the start of the year to $26 million at the end of the third quarter.

Since the beginning of the year, we’ve shared with you our three strategic priorities designed to turn around our business in the near term and to position us for growth in the long term. These three strategic priorities remain first to align our cost with expected sales trends, second to reignite the Sleep Number brand for growth, and third to preserve cash and improve our capital structure. For those of you who may be new to Select Comfort let me provide some historical context.

Prior to this recession, our strategy for the business centered on rapid expansion, more stores, more points of distribution, more marketing and more products. A positive outcome of the challenges faced by our company has been a renewed focus on fundamentals in core advantages.

Simply put, we’re concentrating on improving and getting more out of our core business, making it significantly stronger and more advantaged. We believe that the actions taken to refocus the company also position us very well to both manage through this period of uncertainty and to take advantage of a sustained economic recovery when it occurs.

Now, let met provide and update about our stated priorities. First the third quarter demonstrated the impact of our cost actions that they have had on the leverage potential of our unique business model. On revenues 6% below prior year we delivered an increase in gross margin of 120 basis points. We also improved sales and marketing expense as a percent of net sales by 740 basis points. We achieved these results because we have worked during the past two years to align our cost structure with anticipated lower sales.

Lowering our breakeven point by more than 30%and it’s important to note that Select Comfort has distinct advantages versus traditional retail business models for leverage as sales increased. Our fixed cost do not need to grow as much to accommodate increased demand. Our stores are essentially showrooms and can support substantial sales expansion without increasing store size, inventory level or making significant staffing changes.

For example, well our average sales per store is approximately a million dollars per year. We have similarly sized stores selling as much as $3 million per year with the addition of one or two sales professionals. We are also learning through our reduced marketing levels that we maybe able to leverage marketing further with growth.

Early in our learning, we believe the margin potential of our business as sales increase is greater than what we achieved at higher sales levels in the past. Our second priority involves reigniting the Sleep Number brand. Raising consumer awareness and interest in our products’ unique benefits and value to stabilize sales and to prepare for a recovery in consumer spending.

We have updated all of our marketing and sales materials focusing on the very real consumer need for personalized comfort and separate dual adjustability, which no other mattress or sleep system can match. We also now emphasize the exclusive availability of these unique beds and accessories only at Sleep Number centers or other company owned channels.

Earlier in the year we redesigned our product line to more clearly present value. Our mattress product line was simplified into three categories and this streamline structure features attractive entry price points for our mattress as well as clear and compelling trade up opportunities.

We also took actions to strengthen our sales leadership in selling process. Resulting in improved customer presentations and conversion rates. To ensure a consistent and unique consumer experience with the Sleep Number bed, we also came to a mutual agreement with our retail partners to discontinue distribution through their stores, and we continue to close and consolidate company owned stores, which concentrates customer interaction on our best stores and company sales teams.

This combination of refocused marketing enhanced product value and improved sales and distribution focus resulted in important progress towards stabilizing sales trends as demonstrated by same store growth during the quarter.

Finally, with regard to preserving cash and improving our capital structure we made significant progress in the quarter. Capital spending was restricted to what was essential. In our vertical integration and just-in-time supply processes, we’re refined for even lower inventories and increased operating free cash flow, and going forward we’ll continue to invest behind proven growth with the ability to self fund from operating cash flow.

This year, a corporate priority also included improving our capital structure for long-term security and flexibility. We have reduced our debt exposure by 67% in the year. We continue to work with our lenders to secure a long term financing agreement, and we continue to evaluate incremental financing alternatives beyond the recently announced revised Sterling Partners investment in order to meet this objective.

So in summary, clearly we have made great strides in the past few months. We are confident in our future and the leverage potential that this past quarter as demonstrated. Yet we are prudently cautious in our planning and commitment of resources as we anticipate continued volatility in the economy the remainder of this year and next.

We are well prepared to take advantage of opportunities and to increase our share of mattress sales improving more peoples life as we do.

Jim will now expand on the third-quarter performance and outlook for the remainder of the year.

Jim Raabe

As Bill noted, we reported net income of $6.9 million in the quarter or $0.15 per diluted share. These results reflect continued progress against our stated priorities, most notably, improvements in our cost structure and stabilization of sales trends.

Year-to-date we have improved our pre tax profits by nearly $30 million. We generated $30 million in EBITDA and reduced outstanding borrowings under our line of credit by nearly $53 million to $26.3 million. I would like to start by covering a few items of note before turning to our outlook.

We are extremely pleased with the 9% same-store growth reported in our retail stores. Sales remained volatile from month-to-month but have progressed in each quarter year-to-date. On the unit basis, the growth was even more impressive, with 21% same-store growth. The unit growth reflects our focus on value, making entry-level pricing points more visible in our marketing and advertising materials along with more aggressive promotional activities, both continuations of efforts we began at the end of last year.

Total company sales declined by 6% in the quarter, a significant improvement versus the 21% decline reported in the second quarter and better than recently reported industry sales trends. The overall decline in sales on a year-over-year basis reflects a reduction in our overall distribution days including 57 fewer stores as compared to a year ago and more than 600 retail partner doors.

Our direct and e-commerce sales declined in the quarter as these channels are impacted to a greater extent by reduced advertising levels and the tightening of consumer credit. In the third quarter, we reported significantly higher profits. The improvements reflect a significant cost reduction actions we have taken over the last nine months, across all functional areas.

Operating margins in the quarter were 8.1%, 10.4% if you exclude the 3.3 million of one-time cost associated with our terminated financing efforts. Gross profit margins continue to improve with third-quarter margins at 63.4%. Our company on channels continued to see higher margins reflecting manufacturing and logistics productivity that more than offsets the higher discounting of our product line. The improvement also reflect a higher percentage of sales coming from higher margin company owned channels as we deemphasize retail partner distribution.

Sales and marketing expenses have demonstrated the greatest leverage gain with 740 basis points improvement for 44.8% of sales in the third quarter. The two most significant contributors were media and store cost, media which at 15.6 million in the quarter was 32% lower than a year ago. While fixed and discretionary store cost were 5.1 million or 14% lower in the same quarter a year ago.

In the third quarter, our retail sales per store were $297,000, 15% higher than in the same period a year ago. Same-store growth as well as the close of under-performing stores contributed to this increase and the profit leverage that comes with it.

General and Administrative costs including the research and development expenses were essentially flat to a year ago. Reductions in infrastructure costs were offset by an increase in corporate bonuses up $2.9 million linked to performance and profit targets.

Our net debt also improved significantly with positive EBITDA of $17.6 million and operating cash flow $17.4 million in the quarter. Capital expenditures totaled only $2 million year-to-date. We have accomplished much during these past twelve months with significant progress in our sales trends and profitability, yet much remains to be done in an uncertain environment.

In the fourth quarter, we will lap the most severe part of the economic downturn from a year ago, which should lead to further improvement in same-store growth. The expected same-store sales growth will likely to be offset by the year-to-date reductions in stores and retail partners. I would also note that fiscal fourth quarter last year included an additional week which we will lap this year.

We’re managing our cost and infrastructure to the uncertainty of the consumer environment. While we have not recently provided estimates about profit performance, we feel it is appropriate given our turn around and the uncertainty in the economy to provide greater clarity around our 2009 earnings expectations and as such have provided estimated earnings for the full year of $0.02 to $0.08 of diluted earnings per share.

As you would expect consumer spending patterns will have a significant impact on our ability to deliver and improve on these expectations. Our fourth quarter 2009 benchmark indicators are as follows. Gross margins are expected to be lower than the 63.4% we experienced in the third quarter, reflecting lower seasonal sales volumes and some pricing pressure.

We expect selling and marketing dollars in total, to be slightly less than the $66 million in the third quarter expenses inclusive of approximately $16 million in media investments. Fourth quarter G&A and R&D expenses will be slightly below the $12.3 million incurred in third quarter and interest expense should be lower than the $1.7 million in expense we incurred during the third quarter, reflecting lower debt levels.

We are planning for a fourth quarter income tax rate of approximately 40%, although the rate remains difficult to predict. Full year earnings per share is based on approximately 47 million shares outstanding, including shares to be issued under the Sterling Partner’s transaction as required by accounting rules, but not any additional shares that could be issued in future financing transactions.

And finally from a CapEx standpoint, we continue to limit our expenditures to only mission critical projects with full year expenditures projected at less than $4 million.

Now, a few comments on the financing front. We continue to operate under short term waivers to our credit agreement, and are in negotiations with our existing bank group to put into place a more permanent credit facility. If we are successful in completing this agreement, the $10 million investment commitment from Sterling Partners should be closed at approximately the same time of the closing of this new credit facility.

In addition, we continue to believe it is advisable for the company to seek and complete additional equity financing in order to further strengthen our balance sheet and provide additional financial flexibility. We are sensitive to the current shareholder interest and will balance the consideration of dilutive effect of newer equity with the benefits that would come from a stronger balance sheet.

At this point, there is no further information regarding our financing efforts that I can provide, but we will give update as soon as practicable.

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

Bill McLaughlin

Thanks Jim. Our confidence earning commitment to becoming a leader in the mattress industry has never been stronger. We’ve a unique product that needs real consumer needs as no other product can. We have a unique and young brand with significant growth potentials. We’ve a unique selling process focused on our customers’ personal sleep needs and we have a unique business model in the bedding industry, selling directly to consumers with significant profit and cash flow leverage.

We’re pleased with the progress that we’ve made and equally enthusiastic about the opportunity in front of us. We’ve learnt a great deal and have clear plans to continue improving our core fundamentals for growth. I want to acknowledge and thank our employees and partners for their continued hard work and dedication, and I also want to thank our Board of Directors for their strong leadership and support during a challenging period.

In conclusion, we continue to navigate through uncertain times and remain steadfastly focused on our key priorities to improve people’s lives through personalized comfort and better sleep and to deliver consistent improved performance and value to our shareholders. Thank you.

Sharon, we would now like to take the first question.

Question-and-Answer Session

Operator

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

Budd Bugatch - Raymond James & Associates

Forgive me, I’m in an airport so never fail that the announcement always happens when I start talking. The first question would be the store base as you go forward. I know you’re planning to close six stores in the quarter. Can you give us an indication of where you think the stores, what looks forward after in 2010.

Jim Raabe

Sure, as you said about six stores, we’ll end the year with just over 400 stores. We would expect some reduction in the store base [Audio Gap] so I would expect 2010 will be in that 390, 380 range from the total store count.

Budd Bugatch - Raymond James & Associates

They will close kind of prorate during the year. Will you kind of ratchet down quarter by quarter.

Jim Raabe

That is probably half of the store closures will happen very close to the end of the fiscal year as we have looked at the stores that we see as opportunities to kind of improve the overall store base and the rest of more prorate over the course of the year.

Budd Bugatch - Raymond James & Associates

At the end of this fiscal year or next fiscal year?

Jim Raabe

Next fiscal year, about half we will be closing towards the end of next year.

Budd Bugatch - Raymond James & Associates

I know that the retail partner program is now I think been terminated, I think you have gotten like a 140 partners or something like that if I remember I read it right. Can you give us an indication of what the fourth quarter last year those retail partners might have accounted for in terms of retail sales versus 10 times of sales and maybe gross margin?

Jim Raabe

From a sales standpoint, it would have been in the range of three to 4% of our total sales, and the margins on those sales are roughly two thirds of what the retail stores are from a gross margin standpoint.

Budd Bugatch - Raymond James & Associates

So that’s what’s confusing me why the fourth quarter margin would be down there year over year because you are going to have less retail partners sales, so it would seem to me that the mix would be stronger towards the retail where sales have higher margin.

Jim Raabe

I thing the gross margins would be higher than the fourth quarter last year, they will just be down versus the third quarter this year. That decrease in the fourth quarter versus the quarter we just completed is a combination of a little bit fewer units from a seasonal standpoint which deleverages the manufacturing margins a little bit.

We have had a few small price increases that take effect in the fourth quarter, and then the other factors is our TVC activity is a little bit heavier in the fourth quarter than it is in the third quarter also. So there is still an increase in the overall wholesale business in the fourth quarter relative to the third quarter, at least what we expect this year.

Budd Bugatch - Raymond James & Associates

I understand that, one other question on kind of the sales front. Can you stratify kind of the success you’ve had in getting that in terms of the new merchandising and tell us if there needs to be any tweaking in and merchandising as you see it now.

Bill McLaughlin

If you are referring to the store layout, the bed line..

Budd Bugatch - Raymond James & Associates

The three different types of [testing] the merchandise. Where the successes coming?

Bill McLaughlin

Well as Jim, said we have been focusing on more on the value message, so as you saw our unit same sore growth was like 21% in the quarter. So clearly we are driving more in that classic series, but we are also getting the setup that we need to manage our gross margin dollars along the way. So we are feeling pretty good about the three categories and the products we have within them right now.

Budd Bugatch - Raymond James & Associates

Thank you, and good luck. Congratulations on weathering the storm.

Operator

Your next question comes from Brad Thomas - KeyBanc Capital Markets.

Brad Thomas - KeyBanc Capital Markets

Thanks good afternoon and you add my congratulations on a nice quarter and some nice efforts to turn around the business. Wanted to follow-up on the gross margin, Jim could you maybe give us little more color on the magnitude of some of the productivity improvements that you put into place versus the magnitude of the promotional activity that you’re doing right now.

Jim Raabe

Yes, I would say that some of the productivity gain that we are seeing is related to the fact that the unit closure that we’re getting. The activities that we’ve had from a promotional or a marketing standpoint is certainly helping the volume and unit volume and that helps the leverage of the manufacturing facilities a little bit, but the manufacturing team has been doing a great job all year along and overall managing that operation efficiently, and we also got a good amount of leverage in our home delivery service with that volume flow through as well.

So, those are all important factors in the margin improvement that we’ve gotten. From a promotional standpoint, we’ve been pretty much inline in the third quarter with what we had been doing in the second quarter. So we’ve been pretty consistent there.

I think when you’re looking sequentially at the margin improvements, most of it’s coming from manufacturing, some of it’s just pure productivity and then there is piece of it as well that’s just leverage from the increase in the volume.

Brad Thomas - KeyBanc Capital Markets

Then if you think about your average selling price, in this third quarter you’re up against the very difficult comparison and I think an 11% increase last year that starts moderate in the fourth quarter. How should we think about that as a benefit to your comps in the fourth quarter?

Bill McLaughlin

I think that I would think about the average selling price in the fourth quarter as being consistent as it was in the third quarter with a slight improvement related to accessory sales. We always get a little bit more accessory sale activity in the fourth quarter, and so that will help the average selling price at least overall from a comp standpoint.

What we see in accessory growth from third quarter to fourth quarter can be anywhere from $30 to $50 on a per unit basis improvement between third quarter and fourth quarter.

Brad Thomas - KeyBanc Capital Markets

Then a just a quick follow up on advertising, I mean it seems like you are getting a great deal more effectiveness out of your advertising dollars. Can you just talk about, how you’re thinking about that process, are there more opportunities to drive incremental efficiencies and perhaps even how you are thinking about advertising spend in 2010, would you think about it on a dollar basis or is it percentage of revenue, any color would be helpful?

William McLaughlin

Well as you say, we are pleased with both the effectiveness and the efficiency of our advertising spending. Media is down about just over 30% and revenue down 6% in the quarter. I think I would guide that we are basically going to continue doing what we’ve been doing, which is both in terms of dollars and percent of sales.

So we believe as I said that there maybe opportunities as growth is reestablished, but that’s into the future to work on taking that percent down a bit, but right now it would be more or less consistent dollars spent about the same way that we are and in terms of national emphasis and DR emphasis, but all are getting back to the basics of how our product is uniquely different with personalized comfort and the benefits of back pain relief and for couples.

Operator

Your next question comes from Jeeva Ramaswamy - GJ Funds.

Jeeva Ramaswamy - GJ Funds

Congrats on the great quarter. My question is unemployment is still rising, it’s reaching around 10%, so how do you guys feel about next year, in 2010 sales trends are, whatever you guys are seeing now?

Jim Raabe

I would say that, and we haven’t provided guidance with regard to 2010. I would say that I mean, certainly we like everyone else is hopeful for a recovery at sometime in 2010, but the way we are entering 2010 from an overall planning standpoint is to assume that it looks a lot like 2009. So from a sales standpoint, we think there is opportunity for growth, but from an execution standpoint we are going to manage it more conservatively.

Operator

(Operator Instructions). I show no further questions at this time, I will turn the call back to Mr. Kimball, go ahead.

Mark Kimball

Thank you. If there are no further questions at this time then we will conclude the call. Thank you all for joining us. Thank you for your continued support. We look forward to speaking with you again after the next quarter. Thank you.

Operator

This concludes today’s conference. Thank you for you participation. You may disconnect at this time.

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Source: Select Comfort Corporation Q3 2009 Earnings Call Transcript
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