Welcome to Select Comfort's Q2 2017 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 objection, you may disconnect at this time. I’d like to introduce Dave Schwantes, Vice President of Finance and Investor Relations. Thank you. You may begin.

Good afternoon and welcome to the Select Comfort Corporation's second quarter 2017 earnings conference call. Thank you for joining us. I'm Dave Schwantes, Vice President of Finance and Investor Relations. With me today are Shelly Ibach, our President and CEO; and David Callen, our Senior Vice President and CFO. This telephone conference is being recorded and will be available on our Web site 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 and supplemental financial information 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'll now turn the call over to Shelly for her comments.

Good afternoon and thank you for joining our call today. My SleepIQ score last night was 86. We are very pleased with consumers continued demand for our brand and products. Our growth initiatives are producing steady traffic and sales performance. Demand in the second quarter was ahead of our internal expectation and traffic was again consistent throughout the quarter as it has been all year. We are reaffirming our full-year guidance. While demand has remained strong, our second quarter results reflect a delay in deliveries and shipments with a corresponding shifted sales into the third quarter. Net sales of $285 million were up 3% over the prior year with a $0.02 loss per share. These results include $25 million of delayed shipments that will be delivered in the third quarter. For context, this represents one week of customer delivery that moved from the second to the third quarter due to a shortage of inventory. The reason for this is that production at one of our new suppliers fell short of our demand needs as they scale and work through new specification. We now have the necessary inventory levels to fulfill the outstanding second quarter deliveries. Our suppliers weekly production is also now exceeding our forecasted sales needs for the third quarter and beyond. The issue is results and we don't expect a shortage in the future. Taking a wider view, this supplier change was an important one for us to make to achieve our innovation plans and financial goals. So although it resulted in some challenges in the quarter, it will have no impact on our ability to deliver our plans for the year. We have taken numerous actions to reduce the impact on our customers. Our gross margins in the quarter include these costs, yet are still slightly ahead…

Thank you, Shelly. We continue to advance important profit accelerators across the business to enable delivery of our 2019 EPS target of $2.75. As Shelly detailed, we’ve continue to improve the effectiveness of our data-driven marketing tools and are seen strong consumer demand for our revolutionary sleep innovations. We expect to complete the phased rollout of our 360 Smart Beds over the next three quarters. In the first phase, we introduced two of our upper end 360 Smart Bed models which make up about 10% of our unit volume. As planned, beginning in our seasonally slowest quarter gave us room to work through learnings without impacting our performance expectations for 2017. The inventory shortage we had from one of our new suppliers is now resolved. While early customers and team members have embraced our 360 innovations enthusiastically. In addition to our demand drivers, another important evolution underway is of our supply chain. Back in November, had our Investor Conference. We talked about several facets we’d be addressing to accelerate profits including design to value and design for manufacture -- manufacturability through our 360 Smart Bed. Evolution of our outbound logistics network and global sourcing for innovation and profitability. Our operating teams have delivered meaningful efficiencies while successfully piloting in hub mattress assembly at a new company operated location. They’ve also relocated two partner hubs and transition more than 20 suppliers. All but one of these vendors ramped production seamlessly. That supplier had productivity challenges that lead to temporary inventory shortages for us in Q2. This shifted a week's deliveries worth about $25 million in revenues and $0.12 of EPS from Q2 to Q3. Today those inventory shortages are resolved and the supplier is consistently producing at volumes that exceed our demand plans to balance of the year. We are confident…

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Peter Keith of Piper Jaffray. Your line is now open.

Hi. good afternoon. Thanks for taking my questions, and thanks for the detail on the various dynamics of the quarter. I was curious with the supplier issue. Two questions on that. Was that specific to the 360 products or is that more broadly across the product line? And then secondly, would there be any change in the launch timing that you’re expecting for the oncoming 360 products later this year?

Great. Hi, Peter. Well, first of all, the inventory issue is resolved and the suppliers meeting our inventory requirements and forecast and demand is strong. This was across our entire line for the inventory shortage. And then, specifically to the question of the 360, we are really excited about the demand that we're seeing from the i7 and the i10, both product mix and ARU are ahead of expectations. And being in this position, we're confident with the product line up as we are set today, as we execute Q3 and we will continue our phased launches over the next three quarters.

Okay, good. And maybe, I guess, the change from Q1 is you probably optimistic around 360, but you didn’t really have any idea, how it perform against now that is out in the marketplace, do you feel more confident in that 275 in earnings or do you feel relatively consistent where you were earlier this year?

Yes. This first phase with the i7 and i10, we did expect some ARU growth, and it's better than we expected. So, we’re very pleased with the demand that we're seeing and -- its early, but we see the additional efficiencies throughout our supply chain and will take this time before the next phase 2 build on that and also capitalize on the increased mix and ARU's that we’re getting and we'll see a little more growth in ARU in the back half than we had originally thought. So it will be both from units and ARU, and all of this gives us great confidence as we head towards our $2.75.

Okay. Sounds good. Good luck with the rest of the year.

Thank you.

Our next question is from Brad Thomas of KeyBanc. Your line is now open.

Yes. Hi, good afternoon. Thank you for taking my questions. Why don’t you just follow-up on making sure I’m doing the math right, bridging the comparable brand revenue growth, if we went to add back the delay in revenue it does imply your comparable brand revenue would have been up about 5%. Is that an accurate way of looking at things and can you talk a little bit about what the trends look like in the quarter and as we moved into 3Q? Thank you.

Yes, Brad your math is spot on. And I will have Shelly talk about the trends during the quarter.

Yes, Brad, we’ve seen steady performance all years since January week one, regarding traffic and sales. So we're very pleased with that in Q2 as well.

Great. And then a question in terms of modeling the back half year. Will there be any specific costs that you all will incur with respect to the delays that will hit sales here in 3Q? And then, David, if I heard you right, did you say G&A is going to be $34 million in each 3Q and 4Q. And if that's right why is that the case? Thank you.

Yes, Brad. The -- in terms of the transition costs I highlighted those in my prepared remarks has been $3 million to $4 million in each of the quarters at the back half. Those would capture any supplier related transition costs as one-time items. We are very cautious and careful about including only those types of items that are one-time in nature in those buckets when we call those out. In terms of the G&A color, we saw favorability in Q2 and overall for the year. I provided that guidance just to help you with your modeling, but overall I think it's directionally consistent with what we provided before.

Got you. Thank you so much.

Our next question is from John Baugh of Stifel. Your line is now open.

Thank you for taking my questions. Assuming the first one is, if I did the math right, the incremental flow through in the $25 million you missed is about 30%. That seems a little higher than what you’ve done in the past or could you just comment on that please?

Yes, John. Its -- you’re right. The math is about 30% on that business and you know that incremental sales has that impact. We talked about incremental sales on the four wall profits. That would be in 30% to 40% same thing goes with our model on the incremental sales that we’re talking about in this regard. And that we've already spent media dollars, marketing dollars to deliver those or get those orders on the books.

So, John, on the media, we did leverage 30 basis points in the quarter that you with the shift of the $25 million, if you put that back into the quarter our leverage would have been over 100 basis points in media.

And then you're telling us "would have been with the $25 million" too and I realized that the Labor Day's the intensive period, but is it fair to say that because it works out weekly, roughly that you does $30 million a week in shipments. But I understand that maybe weighted more to Labor Day. But -- so we look and alike the first two weeks of July were your sales were $25 million a week and then another $25 million spread over those two weeks or are we catching up later or is there some impact to the July business to date from what transpired the John quarter?

John, we expect to be fully caught up and back to normalized lead times by before Labor Day.

Okay. And then my last question is, I don’t think you’ve given us these timing of the 360 launch and don’t expect you to, but is there a change from your internal plan as it relates to Labor Day or you might have to for something back a talk a little bit or you’re trying to say, no, everything is on the exact same schedule. We had and I guess my concern would just be whether you have to change any of the marketing or promotional stuff around the key Labor Day event? Thank you.

Yes, John, we approach this as a phased launch, so that we could benefit from flexibility. And as we went into a -- our first launch was executed as scheduled. We had anticipated looking potentially add a second phase here in the third quarter. And instead based on two things, one, the demand that we're seeing from i7 and the i10 has been so strong and it's been driving the incremental mix in ARU, that we went to continue to benefit from that. And we have a great confidence in where we are with our product lineup as we execute Q3. And we also have efficiency opportunities throughout the vertical business model that we see in this first phase that we want to capitalize on before we launch the next day. So we intent to do that and we have confidence on where we are from both a demand and efficiency as we move into the balance of the year.

Thank you. Good luck.

Thanks.

Our next question is from Keith Hughes of SunTrust. Your line is now open.

So the -- that the sale have been pushed forward is that of the i7 360 and the i10 360? Is that why the volumes were up?

We saw inventory delays across our entire product offering.

Across to including the historic ones that were going to be going away income. Is that correct?

That’s correct.

So they’re not confused. I thought this was, given the new construction of the new beds or supplier associated with that. Is that not the case.

We’ve -- when we identified this supplier, we went to them because of their partnership on the innovation side and their willingness to work with us on the profitability goals that we have. In conjunction with that whole process, we gave them the opportunity to take more of the product line, the entire product line.

Okay. So there we’re going to supplying for the new construction. And that's where the shortfalls came or just on their entire offering.

On the entire offering.

Entire offering, okay. So when -- how -- in terms of the first two 360s that are going to roll out, I believe you said that earlier. Is that already started and reach our stores on -- its not coming on the Web site.

Yes. It absolutely should be on the Web site to be 360 smart bed is there and we were set in off source by the end of May. And we launched our marketing campaign to support that, the second week in June.

And is it called -- I was on the impression that you were going to be having all the models with another name plus 360 at the end. Does that change?

It has not changed. We’ve intended to in our calling as to the 360 smart bed Sleep Number 360 smart bed and we will through a phased execution changeover our entire product line to the 360 smart bed.

However the model name for example the i10, is still the i10. The -- what was M7, now the i7.

M7 is the i7. That is kind of say like i7 360. I thought that was the whole marketing picture.

Yes. The Sleep Number 360 smart bed, yes.

So it will be the i7 360 smart bed is that correct?

360 smart bed i7 model.

i7 model. Okay. All right. I was confused. Sorry about that. I guess, also at you’re running discounts now on the old beds. How long will that last and is that been factored into the $3 million to $4 million per quarter. Transaction costs that you refer to early in the call.

In regards to the transition costs, it doesn’t have any discounting included in that number. Those are purely one -- one-off types of costs that we would be incurring in conjunction with 360, our supply chain evolution and our network -- logistics network evolution.

Okay. So with as the shape of gross margin in the second half of the year on a year-over-year basis. What we see more the gain or a better number in the fourth as that transition runs right through?

You know we’re expecting 30 to 50 basis points of gross margin improvement for the full-year, that’s how we’re guiding. That’s based on all the puts and takes that we’re seeing across the business.

Okay. A follow question just on the phase of business. I know you’ve had some demand get push forward into the third quarter, but if you would have think about that, has there been any change over the last several months either up or down in terms of your weekly -- weekly pay services.

Yes. Keith, this is where we’ve seen a steady performance on an ongoing basis since January week one consistent with our plans.

Okay. Thank you very much.

You bet. Thank you.

Our next question is from Seth Basham of Wedbush. Your line is now open.

Thanks a lot and good afternoon. My first question is on store traffic. If you could comment on trends in comp store traffic relative to your expectations, it seems that there was a much improvement in comp store traffic even when you add back in the sales that shifted forward?

Yes, we’re happy with our demand here in the second quarter as we were in the first quarter, the steadiness, the consistency of traffic and sales. You know we intentionally went into the second quarter holding our marketing or our media spend flat to prior year based on it being a seasonally low quarter and also knowing that we had been experiencing efficiency gains on our initiatives, and we again advance those initiatives in the second quarter and pleased especially with the quality traffic that we've been able to generate.

Got it. As you look forward given the strengthened new products that you see, would you expect comp store traffic growth to accelerate for the back half of the year?

You know, Seth, we’re planning for low single-digit comp growth for the year.

And then from an overall growth in the back half mid to a high single-digit growth.

Yes, excluding the shift of the $25 million.

Got it. As you see more of your sales migrate to the online channel, do you think that will potentially lead to more limited ability to sell attachments or are you encouraged by that trend?

Yes, we were very encouraged, excited about being a direct-to-consumer brand at this particular time. We’ve been executing against the strategy for a few years now, strengthening our competitive advantages of proprietary product, exclusive distribution and lifelong relationship with our customers. And this is where we will really see it play out especially in the overall retail environment and we have an extraordinary experience in our stores. We know that absolutely generates a higher ARU overall when our customers get the full experience. But the Web site actions that we're building and taking work in an integrated way with our store experience. The two go hand-in-hand and we've always looked at them as a complete customer experience because the customer interacts at different times with the site as well as the store. And they’re seamless and they’re meant to fuel and support one another, and that's what we're seeing in our ability to track the digital actions from the customer and being able to see that pull through to store purchase. And in specifically, yes the site does have a lower ARU than our stores and we've taken that into consideration for our longer-term guidance as well.

Got it. Understood. My last question is just around upcoming changes in terms of suppliers. Do you have any other significant changes such as the one that you called out that causes transition issue recently?

No, we don’t. that1 we made significant changes in the second quarter with the first phase and we're set in executing against this plan as we head into the back half.

Got it. Okay. If you have that degree of confidence and I guess also a question I have is with your guidance for the year. You still are relatively wide range of EPS guided for the year. What are the considerations that keep the guidance range wide at this point in time?

You know, Seth, we raised our guidance on the last call and we feel confident with the elements that we've got in front of us and the things that we put in place, the initiatives that we have made progress against. We feel like the $1.25 to $1.50 is a good solid range across to deliver against.

Got it. All right. Thank you very much.

You bet.

Thank you, Seth.

Our next question is from Budd Bugatch of Raymond James Financial. Your line is now open.

Thank you very much. Good evening, everyone and thank you for taking my questions.

Hey, Budd.

Yes, hi, Shelly. If I did my math right, it looks like 5,800 or so beds were delayed, is that correct? And is the ARU of what the $25 million the same as the ARU of the average 4,300 or so?

That’s directionally fine, Budd.

I’m hoping it’s not more directionally, David. Is it -- I mean is it -- I think the direction we will get there. I’m just trying to understand, it's about 11 beds per store that you kind of disappointed customers and have you lost any of those sales or what you have to do to keep those sales?

Budd, there is a little bit higher ARU, as Shelly highlighted, and we’ve had active outreach working with customers that have been affected by the inventory delays that included some appeasements etcetera, but those have already been baked into both our Q2 results and our thinking for the balance of the year.

Okay. And can you talk -- can you give us a little bit more detail on what happened with supplier? How can that -- how did it become a surprise? And during the quarter did they get to be a surprise?

You know, Budd we transitioned more than 20 suppliers and we had one that had some productivity challenges. And we continue to work with them during the quarter to get productivity where needed to be and since done that. We are really glad to see how much this vendor has been a strong business partner and has been leaning in with the business, and they are producing now at a level that’s more than we need for demand for the balance of the year.

So I’m curious as to why the big change in supplier base? I guess, I must've missed that, because I don’t think you were dissatisfied with 20 suppliers?

You know that’s -- it's part of our overall plan that we talked about at the November Investor Day that we would be looking for suppliers that are working with us both on the innovation side and those in support of our profitability objectives.

And Budd, it was a combination, the 360 bed is a very different product than our current one and it did require additional suppliers. So it -- and we cast the broader net on supplier changes to keep pace with the margin expansion goals that we have over the next number of years as well as the innovation.

So maybe I don't have any problem with that. It's when you told us it was a wider array of issues affecting a wider number of beds that was the legacy beds as well, that’s kind of what you just said doesn’t kind of make intuitive sense to me. Maybe I'm just too dense to get it, but -- maybe it affects other beds, those are things that we’re operating well and you had already had enough, I mean, we had enough issues with ERP that we didn’t need to replete any of those. What am I missing in that equation?

Yes, Budd, all of the products were new to the center. And taking on the Sleep Number bed line as well as the 360 smart bed line, they had some productivity challenges and you know glad to say that was contained to one week's with the deliveries at the end of the quarter and that its fully -- the inventory challenges that we had are fully resolved and we're moving forward.

So are you saying it occurred toward the end of the quarter or did it -- I thought it was -- I thought just the $25 million it equates to one week. I didn’t -- I thought it happened [multiple speakers]?

Yes, all I’m saying to you that at the end of the quarter we had an additional week's worth of deliveries that didn't get shipped out compared to what we expected.

Okay. And forgive my memory, I’m an aging guy and my memory is a little faulty. When I thought all of the 360s were supposed to be done this year, I thought it was towards a phased launch, but it was all this year. Am I not mistaken on that? It's now that -- its going to looks like the first quarter of 2018?

Last quarter we talked about it would be in a 9 to 12 months effort, which would have taken as to early part of '18.

So is it still the early part of '18 announced through the full -- first full quarter of '18?

Well, that’s -- I’m implying the same. Yes, three quarters, the next -- over the next three quarters.

Over the next three quarters, okay. And you -- David happened with tax? I know the lost was small, but the tax rate therefore becomes a big item you probably had some discrete items in there that affected tax. What’s the tax guidance for the full-year?

So for the balance of the year, I think it’s the part that matters. Its 34.5% is what you should be using in your modeling. What happened in Q2 is we had some tax credits related to the acquisition of the BAM Labs that we were able to realize. That was about $0.02 and then we had a penny related to the new accounting rules for equity compensation.

And that was a positive or a negative?

Those are both favorable.

Favorable. And so, if we were at a 34.5% for the balance of the year, that gets to about a 31 in change for the full-year, is that in the right ballpark as you would say directionally correct?

Yes, that’s directionally correct.

Okay. All right. Thank you. Thank you very much for [indiscernible] with all this old guy.

Okay. Thank you, Budd.

Anytime Budd.

[Operator Instructions] Our next question on queue is from Michael Lasser of UBS. Your line is now open.

Good evening. Thanks all for taking my question. On the delayed $25 million, did that only impact the retail same-store sales, because your retail comp went from up two last quarter to down six this quarter, where as your online and phone comp went from -- both went from 18% to up 26%.

Hey, Michael. Yes, the reported comp for the quarter was down 4 and adjusting for that $25 million, yes it would have largely all been comp growth. On an adjusted basis it would have been a plus 5.

But, I guess, my question was that only affected the retail comp and not the online channel?

Yes, for the most. Our comp store growth number includes both.

Okay. And as you look towards the third quarter the $0.12 that were impacted by the inventory shortage, are you going to get all of that back in the third quarter?

Yes.

In that, still how you’re going to be able to offset that you referred to earlier?

How are we going to offset the appeasements?

Yes.

We did in the second quarter and we will in the third quarter and back half due to our margin expansion initiative and the pace that they’re on.

Got it. And then my last question is, it looks like the i7 is currently $300 off on the Web site, the i10 is $500 off on the Web site. Was it part of your plan to discount those products still early in their 10-year?

Yes. We utilize dollars off in the close of the sale. So it's not in a track for us. We utilized benefits for the attract, but the dollars off or financing helps us with close.

Okay. Even though the iLE bed is not in discounting?

Right. Well, the ILE is in -- generally in market during a large market share event.

Okay. And Shelly, I think you didn’t necessarily comment on traffic earlier in response to a question. You said it was steady …

Yes.

… but you also mentioned that conversion rate was up. So it would suggest that traffic is down, is that right?

Yes, when we look at traffic and one of our key measurements is the qualified unique visitors. Yes, again it exceeded our expectations and we've been focused on quality traffic with our digital actions and yes that is driving a higher conversion, but it was not down.

It was not down. Okay. Thank you very much.

Thank you.

We show no further questions on queue at this time. Now let me turn the call over back to the Select Comfort.

Thank you for joining us today. We look forward to discussing our third quarter performance with you in October. Sleep well and dream big.

That concludes today’s conference. Thank you for your participation. You may now disconnect.