Sleep Number Corporation (SNBR) Q4 2013 Earnings Report, Transcript and Summary

Welcome to Select Comfort's Fourth Quarter and Full Year 2013 Earnings Conference Call. [Operator Instructions] Today's call is being recorded. If you have any objections, you may disconnect at this time. I would like to introduce Dave Schwantes, Senior Director of Investor Relations. Thank you, you may begin.

Thank you. Good afternoon, and welcome to the Select Comfort Corporation Fourth Quarter 2013 Earnings Conference Call. Thank you for joining us. I am Dave Schwantes, Senior Director of Investor Relations. With me today are Shelly Ibach, our President and CEO; and Wendy Schoppert, our Executive Vice President and CFO. Since Wendy is in the process of transitioning out of the company, Shelly will be handling the comments today. This telephone conference is being recorded and will be available on our website at sleepnumber.com. Please refer to the details in our news release to access the replay. Please also refer to our news release for a reconciliation of certain non-GAAP financial measures included in the news release or that may be discussed on this call. The primary purpose of this call is to discuss the results of the fiscal period just ended. However, our commentary and responses to your questions may include certain forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties outlined in our earnings news release and discussed in some detail in our Annual Report on Form 10-K and other periodic filings with the SEC. The company's actual future results may vary materially. I will now turn the call over to Shelly for her comments.

Thanks, Dave. Good afternoon, everyone, and thank you for joining our call. Today, I'll discuss fourth quarter results including what we are doing to deliver short-term performance while we position the company for sustained long-term growth. I'll also speak to our outlook for 2014. We remain confident in our strategy in competitive differentiators, which include proprietary products, exclusive distribution and an unparalleled customer experience. In 2013, we made progress in strengthening these advantages for the long term, while generating operating cash flow of $88 million. However, our short-term sales growth was slower than planned, creating pressure on our bottom line. While the current retail environment invites aggressive discounting and commoditization, we remain focused on game-changing improvements in our customer sleep experience and on delivering growth over the long term. In the fourth quarter, total net sales increased 5% to $231 million, with EPS of $0.12. Our comparable store sales were flat versus prior year. The 6% sales growth, within company-controlled channels, included a 4% increase in ASP, driven by product innovation and pricing actions taken over the past 12 months and 2 points from mattress unit growth. We added 17 net new stores in the quarter. New store growth from the past 12 months contributed 6 points of sales growth in the fourth quarter, which was consistent with our plan. Here's what happened in the quarter and why. Sales were on track with our expectations through Cyber Monday, with comps exceeding our mid-single-digit guidance. Traffic declined through the remainder of fiscal December. Our traffic trends were consistent with ShopperTrak's report of an approximate 18% decrease in mall traffic in December. We believe this decline was due to multiple factors including the compressed consumer calendar in December, reduced marketing effectiveness and, possibly, weather, which impacted 2 of our 4 regions. In…

[Operator Instructions] Our first question is going to come from John Baugh with Stifel. John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division: I guess, I wanted to just clarify -- so the $7 million of incremental expense you referenced for the first half of '14, that's due to exactly what, again?

Yes, the $7 million incremental expense is due to the product introductions across the first half of the year. So it's the additional expenses associated with a changing out, a very significant floor change in all of our stores, as well as some marketing expense and other -- and of course, R&D and testing, and a number of other expense items. So it's across the business, associated with the products. John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division: And as we think about modeling comps for the first half versus the second half, your comparison is much easier in the first half, that everything being equal, should argue that should be higher, but you expect acceleration in earnings in the second half, I'm just curious how the comp might play out first half versus second half.

Sure, John. We're coming off our 13-week trend. We're coming off the 2013 sales performance and our sales growth guidance of mid- to high-single digits includes 5% to 6% from net new stores and a low-single-digit comp, including the 53rd week, so the 53rd week certainly comes to play in the back half along with our initiatives. John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And then, Shelly, could you -- is the big problem here mall traffic? Is it much deeper than that? Could you give us where you are off-mall versus mall currently? Where you would be with the 20 to 30 net new stores at the end of this year? And any color on the new store or -- excuse me, the off-mall, new store experience, any metrics?

Sure. Okay, so first of all, regarding the mall versus non-mall traffic. Our traffic performance in the fourth quarter -- and I actually, I'll speak to just December, because that's where we saw the significant traffic fluctuation. So in December, post-Cyber Monday, we saw significant traffic decline. That decline was consistent with what we read from ShopperTrak. We attribute it, primarily, to the consumer calendar and, of course, our marketing effectiveness. And we hear about weather and that possibly contributed, but we, quite frankly, had more significant weather issues in January and in February and have trends that have returned to pre-Cyber Monday performance. The traffic decline we saw in December, we experienced at both our mall and non-mall stores. We're seeing a little bit of seasonality this year in our non-mall stores. This year we had about 130 non-mall, so close to double where we were prior year, for full year, and we did not see any seasonality change in fourth quarter in 2012. But in '13, we did in the non-mall, and the traffic was more challenged there. Now, we also see a slight pattern of that seasonality in our favor here in Q1. And saw a little bit of that last year. So it looks like the non-malls will perform just a little behind in the fourth quarter and probably a little ahead in the first quarter, but it's still early and we want to read that through the first quarter of this year, and then, we'll, of course, read it again in fourth quarter next year. But the issue for us is definitely brand awareness and traffic. And you can see that play out in our units, and our ASP growth has continued to be quite steady with a 4% ASP growth in the fourth quarter.

Our next question will come from Peter Keith with Piper Jaffray.

Shelly, I just want to get some clarification on the answer you just gave and some comments in the prepared remarks. So if I understand this correctly, your comp recently has returned to pre-Cyber Monday levels, which, I think, in the prepared remarks you said was solidly mid-single digit. And then, I guess a follow-on to that, the way you're guiding your comp for the year is based on a 13-week run rate, if that's correct and that sounds like that's low single-digit. Could you clarify those 2 comments?

Exactly right, Peter. You clarified them exactly right.

All right. Kind of big picture, just looking back on your year in 2013, you had the marketing mishap in Q1 and then you wanted to right size that marketing strategy. But really, when we look back in the year that -- it was really -- starting in Q2, your EBIT year-on-year performance is when it really deteriorated Q2 to Q4 pretty consistently. That would sort of line up with when you launched DualTemp and, I guess, is there anything, looking back in 2013, related to DualTemp that has all of a sudden caused that-- these year-over-year EBIT declines?

Yes, other than -- there is obviously a slight margin difference with DualTemp than the products that we manufacture, but certainly not. We see a positive impact from DualTemp and this is a product that's meeting an unmet consumer need and we see it as an important product in the future as we continue to evolve our product innovation. It has generated increased traffic to the brand. We have seen the transactions, about half coming from new customers that came to Sleep Number because of DualTemp, and over 1/3 of those customers are also purchasing a Sleep Number bed the same day. And it also has been a great product for our existing customers. So no, no correlation there.

Okay, as you begin to lap the DualTemp then, in early Q2, or -- excuse me, late Q2, does that then create a bit of a sales headwind? Do you have a tough compare there? Or do you lose a sales tailwind? Anything that we need to be mindful there on your overall ASP trends?

Yes, as we're thinking about it right now, we see ASP having a stronger performance in the front half, partially due to the DualTemp coming in at that time. But units, we expect will have a stronger back half. So it really ties to our initiatives overall, while DualTemp was introduced late April, early May and started being advertised in June. We have so many product innovations, as I stated in my prepared remarks. This is the greatest time of product change in our company's history, over the front half of this year, and we have a lot to work with to be able to stimulate the business.

Our next question will come from Brad Thomas with KeyBanc Capital Markets.

I wanted to just follow up on the advertising, if I heard you right, Shelly, you were talking about the potential for some leverage in the back half of this coming year. As we think about the year as a whole, how are you thinking about advertising dollars or percentage of sales?

Yes. Well, for the advertising, we do expect over 100 basis points of leverage in the back half of the year, as I stated in the prepared remarks. We have numerous initiatives progressing us in that direction. As far as how to think about the media spend, year-over-year, right now, we're forecasting media, with our current plan, to be around flat to slightly up compared to what we spent in 2013. And that really speaks to our expectation of driving improved efficiency in our marketing strategies. And as we see that efficiency, we may revisit that, but right now, that's how we're looking at it.

That's dollars for how you're thinking about it?

Yes.

And then, just a follow-up on one of the comments you made in the prepared remarks, I think that you said the current environment sort of invites discounting, some of the traditional mattress companies out there are getting a little bit more aggressive with their promotions. How are you thinking about the company's level of promotional activity in this coming year, that balancing of margins versus sales?

We're really excited about what we're doing with our product innovations, and as I stated in prepared remarks, we're just about to introduce an all-new Classic Series. This is the first time that we've ever made material changes to our opening price point series. And we're excited about the edge-to-edge technology that we've incorporated into this bed, with increased comfort and support. And we haven't had that at the low end in the past and we're holding that opening price point at $999 and we expect the Classic Series to play an important role in our unit activity as we move forward.

It sounds exciting. I look forward to seeing it.

Yes, and it's very tested as well, so...

Our next question will come from Budd Bugatch with Raymond James. Budd Bugatch - Raymond James & Associates, Inc., Research Division: Just a couple things I want to make sure I've got right. Advertising this year, was it total about $145 million, about $35 million or $36 million, $37 million in the fourth quarter? Is that about right?

Yes, it's about right. Budd Bugatch - Raymond James & Associates, Inc., Research Division: So aren't you going to spend $145 million, then, next year? That's what you told Brad a few minutes ago?

Exactly. Budd Bugatch - Raymond James & Associates, Inc., Research Division: Okay, the extra $7 million that John asked you about, can you tell us where -- geography on the income statement, or the P&L, where that will show up? Is that in cost of goods? Is it in marketing -- I mean, in sales and marketing? Where is that going to show up?

Budd, you're going to see it across the P&L. All of the above, you're going to see some in selling, some in cost of goods, some in the marketing. Budd Bugatch - Raymond James & Associates, Inc., Research Division: But you said -- I think you said -- told us that the $27 million of fixed expenses, which I take it is the balance of sales and marketing above media spend, that's the $27 million delta that you had in '12, '13, and you expect to have in '14 as well, is that right? Is that the way to think about it?

The $27 million was related to the store actions, inclusive of fixed occupancy, depreciation and selling, compensation related to the incremental store actions. Budd Bugatch - Raymond James & Associates, Inc., Research Division: And that's actually up in sales and marketing, I believe, right?

That's right. Budd Bugatch - Raymond James & Associates, Inc., Research Division: Okay, so that's where that would show up, in the 2 of that, combined. Okay. I'm also confused to how'd it go from $63 million in G&A to $80 million. What's -- that's a $17 million delta, what's in that number?

Yes, in the G&A number, there is an increase for IT-related expenses and depreciation. And also a depressed variable compensation from last year, when we had such a significant fall-off to achieving our goals, particularly in the first quarter, but that extended through the second quarter. Budd Bugatch - Raymond James & Associates, Inc., Research Division: That's right. It was $67 million last year. So it was a $4 million delta down, I take it. So even that way, that's a $13 million increase, which seems sizable in a fixed expense bucket.

Yes. It's sizable in IT, with both IT expenses with where we're at right now in our technology road map, the infrastructure initiatives, in order to support the growth of the business and the depreciation related to that, along with the variable compensation incentive compensation impact that -- those are the big drivers in this increase. Budd Bugatch - Raymond James & Associates, Inc., Research Division: But that $4 million is the variable, is that about where it would size out?

It's $7 million. Budd Bugatch - Raymond James & Associates, Inc., Research Division: It's $7 million, for the variable. And so, then, therefore, what we're looking at is $10 million for IT?

Directionally. Budd Bugatch - Raymond James & Associates, Inc., Research Division: Oh, I know it's directionally up. I'm just trying to figure how far directionally. Okay.

Most of it, I guess. Budd Bugatch - Raymond James & Associates, Inc., Research Division: And lastly, I guess, on R&D. It was $9.5 million last year, what kind of number are we looking at, as a budget kind of number for this year?

Yes, about flat, Budd.

Our next question comes from Joan Storms with Wedbush Securities.

I had a question just related to, and this was in the prepared remarks, about the necessity to continue to open stores, particularly in some of your more under-stored or under-branded markets, and how that brings -- so you can get to, I guess, a tipping point of some sort in order to increase the brand awareness and profitability of the business. Could you discuss that a little bit?

Sure. We have pulled back on this in 2014 in a couple of ways. First of all, the number of store actions we've moved down from 6% to 9%, to 5% to 7%. And real estate, of course, you work quite a few months and, to some degree, years out. And so, we do have a number of these already well in play for 2014. But importantly, the actions that we are taking are the most important ones that we see in the development of our local markets. As you know, we're in over 46 -- we're in 46 states right now, and there are some markets where we're still very under-stored for the overall national level of media spend that we have. So it is about optimizing the product innovation as well as the marketing and stores.

Okay, so that being said, so there'll be like that many more stores, what are you still thinking about the total organic growth potential, domestically, for the company?

Well, couple of things. First of all, for the new stores, we're continuing to see a very similar payback as we have experienced. So it's less than 2 years, averaging 1 to 2 years. And we're also seeing an average revenue of over $2 million in our stores. So that new store increment is still there and our cannibalization is less than 15%, and we're seeing a positive comp performance in year 2 of the new stores as well. So our indications are all in the right place for that store buildout. When we look at longer term, we continue to see an average revenue of over $3 million, very possible for our store portfolio, along with somewhere in the 500 to 550 range of total stores. We're committed to our targets and ambitions still remain at double-digit top and bottom line growth, but certainly we are not able to call the timing.

Okay, and then just one sort of follow-up from, just maybe related to the consumer, so -- and your marketing strategy. So when you were coming out from the doldrums and you guys were doing like pretty good even before the end of the Great Recession and seems to be pretty consistent with units and ASPs. And then it sort of seems like there was a change in, whether it was promotional and/or marketing strategy that really created a lot of volatility among those 2 metrics, is there a way to have better visibility on that with the new products coming out this year? Or will that continue to be a little volatile?

No, we see fluctuations in the ASP primarily associated with product innovation. So when we're introducing new products, it will generally drive that ASP up and when we close out, it will drive the units. That would be the dynamic that created some fluctuation -- it started creating that fluctuation with ASP. From a unit perspective, it's more around our opportunity, or challenge, whichever one you want to call it, that we have in front of us, around marketing effectiveness. That's the one that we need to be able to break through, continue to raise our brand awareness and be able to drive increased traffic to our store portfolio. And having the exclusive distribution, we're well positioned when we have that traffic in our stores and we continue to deliver a very strong conversion. So our operational metrics in that regard are quite strong, but we do have a traffic issue. And we're excited about the new creative. Our prior creative is from 2009. And so this is the first significant campaign that we have had, really, in the history of the company. This is the biggest campaign we have ever launched. And I say biggest, not from size of spend, because, obviously, we plan to spend very similar to prior year, but biggest in regard -- regarding to the actual work that we have, the commercials, the variations and how they relate to the product innovation. So it's really the first time in history we've brought the product in introductions and the marketing together at one time. And we expect that to have a great impact on the consumer, especially in light of how meaningful the benefits are, of the introductions, and how they are fulfilling unmet consumer needs.

Our next question will come from Josh Borstein with Longbow Research.

Could you talk a little bit about the gross margin and what guidance implies for gross margin for the year, and how that may play out on a quarterly basis?

Yes. We expect the gross margin to be approximately flat to slightly up for the year. And your other question was, how it plays out of...

Will one half, for example, the first half gross margin continue to be down, until you lap the DualTemp, for example?

Yes. We do see pressure and this goes back to that pressure on the EPS in the front half of down, similar to the back half of 2013, and gross margin rate will play a role in that where we do see some pressure on the first half.

And Josh, this is Wendy, and part of the reason for that is that, in the first half, we expect to still have the pressure from the change in the returns policy, which will then lap mid-year.

Okay, that's helpful. And then, all the new products that you have coming out, it sounds very exciting. Are those new products going to be gross margin dilutive, do you think?

Considering the change of the FlexFit introduction, the FlexFit continues to be an important product for our customer. And so, there may be a little bit of pressure on margin from mix regarding that, but we'll also be annualizing the DualTemp midpoint of the year. So as I stated, we expect the rate, overall, to be flat to slightly -- to a slight increase. And so, as we would see any pressure there, we would mitigate it in other ways.

Okay, got it. And then the 53rd week of the year, is it possible to quantify the sales and EPS impact of that?

Yes, the sales impact would be 2 points of comp.

Two points of comp, okay. And then, just a last one for me. Just going back to what you said about trends kind of coming back on pace, post -- or pre-Cyber Monday, I'm just -- I guess, I'm a little surprised only because retail traffic seems to have been so weak in January that you guys seem to be bucking the trend, as it were. Is there anything that you can point to why your performance seems to be maybe outpacing the retail sales out there right now?

Well, yes. I read a lot about January, too. And when I mentioned that, post-Cyber Monday, we were moved to down low-double digits and then, January, we're back to pre-Cyber Monday levels that we associate more of that December pressure to the calendar. Both where Christmas fell, because that doesn't work well for us for the post-Christmas sales, and also due to the compressed calendar. But for us, in January, we, of course, executed our post-holiday event and then, we introduced our new ad campaign the last week of the month. But as you've seen from us, here, these last few quarters, our quarters have been a little volatile within the quarter. So a month doesn't make a trend and we're staying focused on our 13-week trend as we forecast the business.

Our next question will come from Keith Hughes with SunTrust.

Just a question on the products. You had discussed, I guess, several new products. Can you give us any kind of metric on how many new you're going to be introducing, when they're going to be introduced, how much of the line you're turning?

Yes. From a competitive perspective, I'm going to be pretty tight on what we're sharing. What we did share is that we have the x12 being introduced and that will pilot in 9 markets in February. So actually, I haven't shared that yet, so you'll know that, that's only a pilot in 9 markets starting in February. And then, at the end of February -- right now, we're in closeout on our Classic Series. And at the end of February, we will introduce the new Classic Series, the all-new Classic Series. And at that time, we will also introduce a complete new FlexFit Series. So one of the changes with our FlexFit Series, historically, we've had 2 FlexFits. And now, we're introducing an opening price point of FlexFit as well.

Our next question will come from Todd Schwartzman with Sidoti & Company. Todd A. Schwartzman - Sidoti & Company, LLC: Looking at the issue of brand awareness and improving traffic, as you talked quite a bit, Shelly, it sounds you're adamant that, that's really the job that you have in front of you. The brand awareness surveys that you guys previously cited over the years, generally showed your media strategy was working, and you seem pleased with the growing awareness. Just wondering if you could talk a little bit about what, if anything, has changed and -- notwithstanding a decline in traffic, and were the awareness survey findings, quantitatively speaking, what were they in the past 2 to 3 quarters where maybe you didn't really have it as front and center as you had previously?

Well, you're right. Brand awareness is an important -- has an important correlation for us to gaining market share and also to driving traffic and units. So we see that correlation carry through and you're also right that we've made significant progress in our brand awareness over the last few years. In fact, moving it from 13% to 20%, 21%. And we generally report this number out maybe once a year and we did have a decline last year, early in the year, associated with our media -- our media missteps. So we were at 20%, actually 21%, in September of 2012 and then, we did go down significantly associated with the media missteps and then built that back. And by September of 2013, we were back to our previous brand awareness of 20%. Todd A. Schwartzman - Sidoti & Company, LLC: Okay. And it's still around that 20% level?

That's the last reading we have. So this is something we measure 3 or 4 times a year. We have other lower level metrics that we measure in between, but as far as the more significant study, the one that we would report out on, it's 3 or 4 times a year. Todd A. Schwartzman - Sidoti & Company, LLC: And the ones that you trust the most, have you made any changes over the years in terms of how much of that is in-house versus a third-party study?

Are you speaking to the actual measurement of the brand awareness? Todd A. Schwartzman - Sidoti & Company, LLC: Yes, yes, in other words, has there been any shift in how much Select Comfort does versus third-party entities?

No, we've utilized the same source over that time period. And any change to source, we will dual path and recreate that history in a dual pathway. Todd A. Schwartzman - Sidoti & Company, LLC: That sounds fair enough. Last question is, you briefly touched on the pricing strategies of the traditional mattress manufacturers. What else can you tell us, what are you seeing with respect to the competitive landscape?

I spoke to heavy discounting and commoditization, in retail, in general. It goes beyond the -- it certainly goes beyond the mattress industry when I speak to that, but there's also a lot of low-end -- I'm probably seeing -- we're seeing, certainly, in our studies, in a quantified way, lower prices than we experienced in 2008, in 2009. So there's a lot of pressure on pricing and, in general, a lot of noise that the consumer needs to work through. And that's, that pressured consumer who becomes a bit mystified and more resistant, overall. And as we build our marketing strategy, it's really to be able to break through that in a meaningful way.

And we have an additional question from Peter Keith, again, with Piper Jaffray.

We should mention that, Wendy, we are sorry to see you go, and we wish you nothing but the best. Shelly, I was wondering if you could provide us an update on how the CFO search is coming along, if you have a timeframe on when you expect it might be completed? And also, if you're looking both internally and externally, at candidates?

Great. Thank you, Peter. And first of all, I would like to take this opportunity to thank Wendy for her many contributions, as well. And we've been so appreciative of her staying on, in light of her decision, and continuing to help us transition. So we'll miss Wendy a great deal. We are in search for Wendy's successor, and we are amidst the interview process right now. The search firm has identified a number of strong candidates who are included in that process, and we're making good progress.

Okay, I know it's hard to put a timeframe on there, but do you have an idea of when that might be wrapped up?

You're right, it's hard to put a timeframe on something like this, and, obviously, it's an important search, and we do feel strongly about our candidates right now.

And we have an additional question from Budd Bugatch. Budd Bugatch - Raymond James & Associates, Inc., Research Division: If you answered this before and I missed it, just attribute it to my age. The gross margin for this quarter was down, I think, 260 basis points versus last year, and 220 basis sequentially. I just don't know -- remember that I heard you talk about what caused that delta.

Yes. No, you did not miss that, Budd, and you're right, we deleveraged 260 basis points. Approximately 100 basis points was due to the return policy changes and that will continue to put pressure on the first half of this year, although we do have numerous initiatives in place to that end as well, still haven't proven them out. So we also experienced about 100 basis points due to year-over-year promotional mix changes. It isn't incremental promotional dollars, but it is mix changes. So for instance, things like the P series closeout would impact gross margin in that way and the Memory Foam Limited Edition, which had a little bit of margin pressure to it, products like that, in that year-over-year variation that we do. Budd Bugatch - Raymond James & Associates, Inc., Research Division: And do we have the closeout of the C series, when's the C series going to get in, the new C series?

The new C series, February 24. So we're closing out the current C series through the Ultimate Sleep Number event which is going on now, it just started on Monday. Budd Bugatch - Raymond James & Associates, Inc., Research Division: So that will put some pressure on first quarter, or first and second quarter?

Yes, first. Budd Bugatch - Raymond James & Associates, Inc., Research Division: Any other closeouts, so P series, do we have any -- we just refreshed that, didn't we? Yes.

No. No. This was the -- I'm speaking to the deleverage from Q4. We closed out of the P series in October. Budd Bugatch - Raymond James & Associates, Inc., Research Division: Right. That's right. So we're not going to have that ahead of us.

No. Budd Bugatch - Raymond James & Associates, Inc., Research Division: And I'm thinking about next year. I'm thinking about 2014.

Yes, no. Okay, so as you look forward, the 2 pressures we have here in the first half from a closeout would be on our FlexFit Series, which we're currently closing out of and our C series. So both lower-margin products in our overall mix. We're closing out of both of them. Budd Bugatch - Raymond James & Associates, Inc., Research Division: But overall, in response, I think, to Josh's question, you think gross margins will come in around 62.7%, which is where you ended this year?

Yes, just slightly up. Budd Bugatch - Raymond James & Associates, Inc., Research Division: Slightly up. So slightly -- a bit ahead of 62.7%?

Yes. And, Budd, part of that is that, this is Wendy, we do have some manufacturing efficiencies and some programs in place and that's also built into the outlook. Budd Bugatch - Raymond James & Associates, Inc., Research Division: Okay. And Wendy, also, from me, good luck and thank you for all your considerations of the past.

Thanks, Budd.

We have no further questions. I will turn the conference back over for closing remarks.

Thank you, again, for joining us today. We look forward to discussing our first quarter 2014 performance with you in mid-April.

And with that, we will conclude today's conference. Thank you for your participation. You may disconnect at this time.