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Executives

Mark Kimball – Senior Vice President, General Counsel

William McLaughlin – President, Chief Executive Officer

James Raabe – Senior Vice President, Chief Financial Officer

Analysts

Chad for Budd Bugatch – Raymond James

Mark Rupe – Longbow Research

Bradley Thomas Keybanc Capital Markets

John Baugh – Stifel Nicolaus

Select Comfort Corporation (SCSS) Q1 2010 Earnings Call April 21, 2010 5:00 PM ET

Operator

Welcome to Select Comfort’s first quarter 2010 earnings conference call. (Operator Instructions) I would like to introduce Mr. Mark Kimball, General Counsel.

Mark Kimball

Good afternoon and welcome to the Select Comfort Corporation first quarter 2010 earnings conference call. Thank you all for joining us. I’m Mark Kimble, Senior Vice President and 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 selectcomfort.com. Please refer to the details set forth in our news release to access the replay on our website.

Please also refer to our new release for a reconciliation of certain non-GAAP financial measures included in the 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 question 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 McLaughlin

Good afternoon and thank you for joining us for our review of Select Comfort’s first quarter performance and outlook for the remainder of the year.

Earlier today, we reported strong first quarter results with improved performance across all measures. Revenue was up 13% versus prior year led by an increase in same store sales of 29%. Net operating profit was $14.2 million versus $300,000 in prior year with a margin of 9%, a first quarter record. In our cash balance at the end of March was just under $45 million with no debt and a new credit agreement in place.

We are very pleased with the quality of our quarter’s results. Not only did we deliver against our stated priority of increasing profit in an uncertain environment, but also we achieved solid top line growth and momentum.

There are three points that I’d like to emphasize today that influenced the unique long-term potential of Select Comfort. The first relates to demand. Consumer demand for our unique product and total customer experience is strong and growing stronger. Second is discipline; we will continue to focus on cost control and margin expansion, selectively increasing spend on what’s proven to drive more immediate results.

And third is our long-term outlook. Because of our improved financial strength and performance, we now have some flexibility in our pursuit of investment and long term growth initiatives that build on our competitive advantages.

First, let’s start with demand. Consumer interest in our unique and life-changing product is increasing, as is our confidence in our ability to sustain this positive momentum. We’ve now experienced five consecutive quarters of improved sales trends with increased marketing and selling leverage, which reflects both the quality and sustainability of our improvements.

Given our results, and our strong believe in our product and our programs, we have raised our outlook for the year as indicated in our release. The first quarter was an important test of our ability to sustain growth against improving year ago trends.

During the first quarter of last year, while the economic outlook was quite uncertain, we had started to see improvement in same store sales trends as we enhanced our value proposition which included both repositioning the entire product line and reformulating our promotional strategy.

We also returned to the fundamentals of our advertising and media in the first quarter of 2009, which we believe also improving trends, and these strategies were refined throughout 2009 and into the first quarter of 2010, delivering consistent improvement in same store sales trends including this past quarter, which is when we began lapping prior year improvements.

We believe that during the quarter we benefited not only from strong execution and innovation, but also from an improved consumer environment. We will continue to control what we can control, improving our core programs to take advantage of market growth which our unique vertically business model allows us to do well.

Second, let’s focus on discipline. We remain cautious in our outlook for the economy and discipline yet flexible in our approach to investments. Though there are clear signs of stabilization in the past few quarters, we believe the concerns around employment, housing and interest rates suggest that we must continue our tight control on fixed costs and not invest too far ahead on variable or discretionary spending.

However, despite a conservative approach we are fundamentally a growth-oriented company looking to improve more people’s lives and to invest further in proved opportunities.

For example, during the first quarter we tested, proved and accelerated new marketing and sales approaches. This included incremental local market spending for accelerated development in key markets and it also included increasing national advertising support around specific consumer holiday periods. And given the positive test results, we invested an incremental $2.5 million versus prior year to both offset media inflation and to fuel incremental growth.

We did this successfully in the quarter, leveraging total marketing and sales expense for a 380 basis point improvement. We will continue to apply this learning going forward and increase marketing spend as sales increase.

And third and last is our focus on our long-term outlook. We have made important progress rebuilding our financial strength, which has allowed us to advance longer-term initiatives to bolster our core advantages and contribute to sustained growth.

Our long-term company objective is to become the new standard in sleep by elevating, and individualizing the total customer experience. We firmly believe we can deliver individualized solutions and experiences like no other manufacturer retailer in the mattress and sleep industry.

We are focused on differentiating our selves not only with our product, but also in how we engage our customers; for example, through marketing, the selling experience, product service and post purchase customer engagement.

We are pleased with early consumer response to our efforts and are confident that this unique total experience will distinguish the Sleep Number brand from others, leading to increased customer satisfaction, referral and repeat and ultimately profitable growth.

To that end, we have identified four areas of focus that will allow us to elevate our customer experience and become the new standard in sleep. The four areas include products and service, brand, distribution and culture.

In the area of product and service, we already have the most innovative bed that uniquely meets customer’s needs for individualized comfort. That said, we are committed to making our fundamental product design even better and with stabilized financial conditions, we are also able to look at more innovative product development opportunities.

We also are developing our young yet powerful brand. Next year the Sleep Number brand turns 10 years old and we continue to refine our messages around what we stand for and what makes us different; personalized comfort, pain relief and best bed for couples. We are also driving consistency of our message across all our marketing and sales materials.

On the distribution front our emphasis over the past year has been on doing more with less, consolidating around our core company owned channels and exiting stores that did not fit our long-term market development plans.

We are now investing to improve execution and performance across our current store base, advancing our unique in-store experience for our customers with an outcome of continued same store growth and leverage.

For example, consider Ray Roberts, a store manager in our Philadelphia DMA. One of his customers recently took their time to write the following to me. “At first I wasn’t sure what to expect when I walked into your store. After meeting Ray, wow, that all changed in seconds. The time spent at your store was a very different experience. Both my wife and I saw Ray as the down to earth people person, liking his job and truly caring about our sleep comfort needs. We see him as one of a kind.” This is what we mean by setting the new standard in customer experience.

Finally, and perhaps obvious from this letter, I can’t say enough about the importance of our team. Our employees and culture are driven by our passion and commitment to improve people’s lives and to make our company better. Our employees have truly fueled the innovation and execution resulting in our improved performance and they will continue to be even more important going forward as we further develop our unique customer experience.

So this was another solid quarter of progress for our company. We are continuing to deliver on all metrics to accelerate profitable growth in the near term and raising the bar on our customer experience in order to drive sustained profitable growth for years to come.

And now I’ll turn the call over to Jim.

James Raabe

Thanks, Bill. As Bill noted, we’re very pleased with our results as we continue to improve sales, profits and balance sheet strength and flexibility. Earnings per share growth was very strong, increasing to $0.14 per share compared to a $0.06 per share loss in the prior year.

More significant is our operating earnings growth from essentially break even a year ago to $14.2 million this year. The $14 million profit improvement was delivered on an increase in sales of $18 million and reflects the flow through margin on those incremental sales as well as improvements to our gross profit rate.

On a sequential basis, profit gains were also in line with our expectation relative to the $21 million increase in sales from Q4 to Q1. While the first quarter is one of our more productive from a profitability standpoint, the 9% operating margin in the quarter, demonstrates that we can achieve our full year target rate of 10% or more in the coming years as we are beginning to approach or achieve our leveraged targets in each financial statement line item.

Our gross margin of 62.1% is in line with our long-term target and 350 basis points above year ago numbers. The improvement compared to a year ago, comes from manufacturing and logistics productivity gains realized during our turn around as well as refinement of our promotional programs which have resulted in ASP growth related to product mix.

Selling and marketing expenses were 44.4% of sales, 380 basis points better than a year ago. Marketing costs which included 16% increase in media spend was 17.4% of sales, or 40 basis points better than a year ago, and selling expenses were 27% of sales, 340 basis points better than a year ago as we begin to leverage a leaner fixed cost structure.

Sales compensation levels were higher than normalized run rates reflecting our strong sales performance. Selling expense leverage will benefit the most from future sales growth.

G&A expenses were 8.3% of sales, 130 basis points better than a year ago and in line with our longer-term targets. These gains were particularly impressive since the incentive compensation was $2 million higher than normalized run rates due to our first quarter performance.

Finally, interest expense of $1.7 million relates to the charge off of deferred cost associated with our previous credit agreement. Interest expense in future quarters should be nominal.

We are also very pleased with our cash flow performance. EBITDA in the quarter totaled $18.3 million compared to $6.3 million in the first quarter last year. On a 12-month trailing basis, our EBITDA totaled $54.3 million increasing cash balances to nearly $45 million.

As Bill noted, we have raised our earnings outlook for the year increasing our guidance to between $0.45 and $0.50 per diluted share. This increase reflects better than planned performance in the first quarter as well as an improved sales outlook for the balance of the year, and while we remain cautious about the macro economic factors, our sales outlook is based on recent sales trends and assumes no improvement or degradation in the coming months.

We continue to expect same store sales growth in each quarter of 2010 although it will be a slowing trend as we lap higher comparisons from a year ago.

Our revised guidance includes the impact of more that $10 million or 20% incremental shares, yet reflects a year over year improvement in as adjusted earnings per share of between 80% and 100%.

While this performance demonstrates continued improvement in our business trends, more importantly, it represents solid progress to our longer term goals of a strong balance sheet along with consistent sales growth and operating margins of 10% or more.

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

William McLaughlin

Thanks, Jim. To summarize, we are pleased with our strong performance in the first quarter, which is based on solid execution bolstered somewhat by an improved macroeconomic environment. Our immediate priority is to deliver consistent profit improvement in this uncertain environment.

We are demonstrating that we can generate strong profit and cash flow on moderate increases in sales. In going forward, our focus is on leveraging what is unique to our company. We believe that our product, business model and culture are one of a kind and advantaged. We are excited to have the opportunity to further enhance our strong platform for longer-term growth and expansion.

We continue to believe that this is an opportune time to learn about Select Comfort, and it’s also a time to begin looking ahead at our company’s unique advantages and long-term growth potential. Thank you for your time and consideration. I’d now like to turn the call over to Kelly for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Chad for Budd Bugatch – Raymond James.

Chad for Budd Bugatch – Raymond James

Let me first start by congratulating you on another very good quarter. When you talk about the outlook for this year in terms of revenue, you talked about continuation of the current sales trends adjusted for normal seasonality. Could you remind us, how do we think about normal seasonality for this business? I know looking back in past years, in some years Q1 was the peak and some Q3. How do we think about that hierarchy?

William McLaughlin

The soft point in the seasonality continues to be the second quarter when we don’t get the benefit of mall traffic or the normal mattress seasonality so there’s a normal step down in the second quarter. It’s a good question about what’s normal seasonality, but I think if you go back a few years, what you see is that first quarter is a strong quarter. Third quarter and fourth quarter are both strong quarters although probably a little bit lower from a sales standpoint in the first quarter and I think the other consideration when you go back and look historically is that you go back three or four years and we were having some pretty significant store growth which would bolster the third and fourth quarter sales at lease compared to the first quarter.

And obviously this year we won’t have any store growth, but I think going forward we will again, so hopefully that provides a little color.

Chad for Budd Bugatch – Raymond James

Looking at the gross margin line the year over year improvement was terrific, but it did dip a little bit sequentially despite higher volumes. Could you help me understand the mechanics of what drove that? I know it looked like ASP was maybe down a bit sequentially but just walk me through that movement.

James Raabe

On a sequential basis I think we were down about 60 basis points from the fourth quarter, and it’s really the – we had some cost increases late in the fourth quarter on a couple of our components and as much as anything, it’s the flow through of that. That was the major factor.

Chad for Budd Bugatch – Raymond James

Along those lines, how are you thinking about those input commodity cost as we go through the balance of the year.

James Raabe

We are seeing some increases in oil prices and some pressure. I think for right now we’re just keeping an eye on it and continue to execute as we can to try to mitigate any increases that we might see over the balance of the year.

Chad for Budd Bugatch – Raymond James

Do you still anticipate a slight improvement in full year gross margin or are we thinking flattish?

James Raabe

I think first quarter is pretty representative of how we think about the year.

Chad for Budd Bugatch – Raymond James

If I calculate it right, I’ve got media spending at about 11.5% of sales. I know you’ve talked before about managing that up towards 12%. How do we look at that for the balance of the year? Is it going to increase as a percentage of sales or do you have a specific dollar target in mind?

James Raabe

You’re right about the 11.5% in the quarter and in that 11.5% to 12% is how we’re thinking about media for the full year, so as a percentage of sales, it might be a little bit higher over the balance of the year, but I think it is something that we’ll continue to increase spend as we continue to see sales growth.

Operator

You're next question comes from Mark Rupe – Longbow Research.

Mark Rupe – Longbow Research

As far as the operating margin performance, obviously, it was a record for the first quarter and you button up on that 10%. I would assume if the industry holds and you continue to perform you’d be up on that really fast. Is there some point in time where you maybe update your longer-term thoughts on that line or as it relates to gross or is it going to be more leverage on the selling and G&A line as you look out?

William McLaughlin

I think as Jim said in his comments we expect the most leverage coming forward to come out of that sales line. As you are thinking about it though and as we think about long term a 9% margin in the first quarter and from selling and marketing standpoint we do still think we have opportunity. So when we think out a couple of years, certainly an operating margin above 10% is certainly very achievable.

Mark Rupe – Longbow Research

As far as the propensity to grow, how disciplined are you going to be as far as, obviously there was a five year period years ago where you grew a lot of the store base. I’m assuming there’s still some low hanging fruit on some holes in distribution or store locations. Are you going to attack those this year? Is that part of some of the CapEx?

William McLaughlin

To a certain extent, yes. There certainly are opportunities for us to fill out markets. I think there are also opportunities that we talked about in the past that the combination of closing an under performing store and opening another store in a similar geographic area that we think can perform better are ways for us to continue to generate that sales increase.

The balance of the year, we’ll see a little bit of a net store decline, but as we get into 2011 and forward, we will start building the store base back.

Operator

You're next question comes from Bradley Thomas - Keybanc Capital Markets.

Bradley Thomas - Keybanc Capital Markets

It looked like CapEx moved up a little bit from $10 million I think to $15 million, and I apologize if I missed it, anything specifically that incremental spend is going to be associated with?

James Raabe

There’s some things that we are evaluating. You are right. We did kind of bump the target up a little bit with the increased improved performance. There are a few things that we’re evaluating around improving the overall store experience as well as I think we mentioned before; we’ve got some brand inconsistency in the stores that we would like to get updated.

So a lot of it is really focused on improving the brand image and the customer experience and in really improving our performance that way.

Bradley Thomas - Keybanc Capital Markets

When we think about that spend and some of your CapEx over the next year or two, should we think about that as sort of a maintenance spend that may be a little bit deferred from last year’s low level of CapEx or is there more of an opportunity associated with that investment.

William McLaughlin

To answer that, a little bit of both. I mean there is certainly some catch up on some things that we’ve been wanting to do for some time and there’s things that we think will improve the overall performance of the business, but they are a little bit longer term return which is why we deferred them to this point.

But I think we do see them as offensive in really consistency of brand and also we are looking at a little bit of some tests and some new stores as well, so it’s a bit of working back to a more aggressive stance on the Cap Ex.

Bradley Thomas - Keybanc Capital Markets

I believe average selling price was up year over year more than any time in the last five or six quarters or so. Could you talk a little bit more about what’s going on with different price points and how much of that is consumer spending trends in general versus some of the promotional initiatives you have in place right now?

William McLaughlin

The year over year is more a function of what happened last year than current. Last year we had a – we were really still learning how to do the promotional strategy and emphasizing our value, and what we learned over time is how to help people trade up to higher price points, and that’s what we’ve really seen gone with this Q1 versus a year ago Q1.

What we’re seeing in the ongoing sequential basis, is not a very significant change in the mix. It’s been pretty steady over time.

Bradley Thomas - Keybanc Capital Markets

With one more quarter under our belt here, any new thoughts in terms of the recapture rate that you’re seeing from store closures and from the exit of the wholesale business?

William McLaughlin

Those numbers have continued to remain pretty consistent. We are seeing from the store closures, we continue to get a 30% to 40% transfer into existing stores, and I would say that the markets where we exited those wholesale relationships have been some of our better performing markets. So we’re very pleased with the results of both of those actions.

Operator

You're next question comes from John Baugh – Stifel Nicolaus.

John Baugh – Stifel Nicolaus

I was curious, did you change, when you look at the quarter year over year was there a difference in the discounting or did you promote a higher end bed than what you did last year? A little color around that please.

William McLaughlin

As I was saying, what we did I would say is we balanced our – through 2009 we learned a lot about having a strong entry level price promotion and then an offering in the middle family of our products as well as up at the I series.

Last year in the first quarter, we really had more of the focus on the entry-level price point. So that’s the change that I would say that happened year over year. We kind of learned through 2009.

John Baugh – Stifel Nicolaus

You mentioned two items; one was comp and I can’t remember the other as being above normal. How do I think about that in terms of the year and either a number or percentage of revenue. In other words, did you accrue something in bonus unusually high in the first quarter that’s not going to repeat in the latter quarters? Help me with that.

James Raabe

It’s a good question. The two points were both related to incentive compensation. The first one being on the sales side and selling expenses that our performance was very good in the stores so we had more incentive compensation that the normal run rate would, so even with that we had really good strong leverage in selling expenses. But that’s an item that hopefully we continue to see that good strong performance, and if so, we’ll continue to have a little bit higher compensation.

A similar answer on the incentive compensation on the G&A side. We refer to a number that is higher than normal and what that really means is that we’re accruing our bonuses, our incentive compensation at above 100% payout because we are running above where our targets are.

So the balance of the year will be dependent on how we run in those sequential quarters, but it is something that when you start looking on a year over year basis in 2011, it could get back to 100%, there’s some opportunity on the cost side.

John Baugh – Stifel Nicolaus

So if you actually shrink back to 100% you could see some leverage because you’re above 100% in terms of payout.

James Raabe

That’s correct.

John Baugh – Stifel Nicolaus

And then you said interest expense would be nominal. What’s nominal mean?

James Raabe

Well we have some fees but we don’t expect to be borrowed so we’ve got some feels on some LC’s and we’ve got some normal facility fees, so you’re talking maybe in the $100,000 on a quarterly basis.

John Baugh – Stifel Nicolaus

Are you still committed to the end of calendar 2010 to close these stores and have the net shrink or does the results you’re seeing, the economy sort of move up the time frame of opening stores and if you’re not going to do it in ’10 what’s the preliminary thinking about ’11 in terms of how many stores with a ball park range to open?

James Raabe

Two questions, the first one relative to are we committed to closing the stores we’ve talked about. I think that’s only a little bit of a moving target. We don’t make a final decision on stores until we need to make a decision, so it is somewhat open.

Having said that, there’s really two drivers to store closings that we’re looking at. One is just strictly overall sales performance, and there are still certainly a number of stores that we would see closing on that basis.

The second factor though is also more strategic and more geographic on a market-to-market basis where we feel as if we’re over stored and have an opportunity to reshape the market from a store distribution standpoint.

So those are the two considerations. We’ll continue to make those considerations up until the point that we actually have a time to make that decision, but at this point, we still look at ending the year in the 380 to 390 store range.

We haven’t talked about – we haven’t given a specific number with regard to 2011 but I guess two comments I would make. First of all, we would expect store count to increase next year and second, I would say that it will also be certainly on a more conservative pace. That’s probably the wrong term because we’re looking for aggressive growth, but we see the – we do see trade areas as being important consideration and we want to be more selective on our real estate choices.

So in years when we’ve opened 50 or 60 stores a year, we will not be at that pace. It will be on a more considered pace.

William McLaughlin

Just one quick point to add to what Jim said. Our focus is much more on same store growth at this point. We believe we’ve got a lot of opportunity there. We ended this quarter at about $1.1 million as an average. We’ve got a ways to go to hit our historic peak. That was $1.5 million and it’s driving that same store growth that’s going to be the real fundamental driver. The store additions is important. It’s gravy, but the same store growth is our primary focus.

John Baugh – Stifel Nicolaus

Will the share count go up? Will there be more options coming with the price of stock up or is that at 55 or slightly higher.

James Raabe

I think relative to the first quarter hopefully there will some more that come into the money. The full year number that we gave at the end of the year at 56 million I think is still a good number to think about for the full year.

John Baugh – Stifel Nicolaus

In light of the increased profitability and strong cash flow, update us number one on what you think free cash flow will be for the year and the year with a considerable cash balance. I’m curious to what if any Board discussions have been had about the capital structure.

William McLaughlin

With regard to the second question on the capital structure, that is something that we’re beginning to talk about but I think we’re still a ways away and we still feel as if funding internal growth to the company and continue to build the strength of the balance sheet are priorities for the near term.

From a free cash flow standpoint for the full year, I think it’s really more a matter of just backing off of that earning guidance of $0.45 to $0.50 and then just knowing that we’ve got in the range of $20 million in non cash and while we’ve talked about $15 million of CapEx.

From a working capital standpoint, we did a pretty good job last year of really leveraging the balance sheet. We continue to be focused there, but on a full year basis, would continue to expect to see some improvement but not dramatic changes over the course of the year.

John Baugh – Stifel Nicolaus

What was the CapEx number again?

James Raabe

Up to about $15 million this year.

Operator

There are no further questions at this time.

William McLaughlin

If there are no further questions at this time, we’ll conclude the call. We wish to thank you all for joining us and we look forward to reporting further in our second quarter results. Thank you.

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