Somnigroup International - Earnings Call - Q1 2012

Transcript

Speaker 5

As a reminder, today's conference is being recorded. I would like to turn the program over to Mark Sarvary.

Speaker 8

Thanks, Matt. Thank you for participating in today's call. Joining me in our Lexington headquarters are Mark Sarvary, President and CEO, Dale Williams, EVP and CFO. After our prepared remarks, we will open the call for Q&A. Forward-looking statements that we make during this call are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that forward-looking statements, including the company's expectations regarding sales and earnings, involve uncertainties. Actual results may differ due to a variety of factors that could adversely affect the company's business. The factors that could cause actual results to differ materially from those identified include economic, competitive, operating, and other factors discussed in the press release issued today.

These factors are also discussed in the company's SEC filings, including the company's annual report on Form 10-K under the heading "Special Note Regarding Forward-Looking Statements and Risk Factors." Any forward-looking statement speaks only as of the date on which it is made. The company undertakes no obligations to update any forward-looking statements. The press release, which contains a reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures, is posted on the company's website at somnigroup.com and filed with the SEC. With that introduction, I will turn the call over to Mark Sarvary.

Speaker 5

Thanks, Mark. Good evening, everyone, and thanks for joining us. We're pleased with our first quarter. We're off to a good start to the year. Sales were up 18%, and earnings per share were up 26%. On a constant currency basis, North American sales increased 18%, and international sales increased 22%. In a few moments, Dale will provide details of the first quarter results, as well as discuss our outlook for 2012. First, I'd like to talk about the progress we've made on our key strategic initiatives during the quarter. The first of these initiatives is to make sure that everyone knows that they would sleep better on Somnigroup. As we discussed at our Investor Day in February, our investment in brand advertising is a key driver of our future growth.

We know that increasing rates of advertising results in higher Somnigroup brand awareness, which in turn drives increased sales, share, and profitability. We said we were going to significantly increase our investment in advertising in 2012, and during the first quarter, we did just that. Our advertising was a record $47 million, with considerable year-over-year growth, both in North America and in our key international market. In the U.S., we significantly expanded our Heavy-Up marketing program. Internationally, we increased our brand advertising investment in Germany, France, and the United Kingdom, and introduced TV campaigns into additional markets, including Italy and Australia. While it is still early, these marketing campaigns are showing positive results, with brand awareness, purchase consideration, and website traffic growing in line with plan. In particular, strong performance in our key international markets during the quarter proves that our advertising investment continues to be successful.

However, while our confidence is high that these investments will continue to be effective, we will also continue to monitor the results closely and adjust as necessary. The second of our initiatives is to make sure that there's a Somnigroup mattress and pillow that appeals to everyone by expanding and strengthening our product line. In the U.S., we introduced the Simplicity Collection at the Las Vegas Market in late January and just recently began shipping the product to customers. As we discussed in detail at the Investor Day, Simplicity is the most researched product we have ever launched and addresses a very large market segment that we had not previously targeted in a meaningful way.

At $1,499 for a queen set, the three-bed collection with soft, medium, and firm comfort options addresses the $1,000 to $2,000 price span, a segment which has the same dollar value as all the segments above $2,000 added together. While it remains very early, we're pleased with the performance we've seen so far. Retailer feedback continues to be very positive, and we've gained considerable incremental thrive. Internationally, we continued the successful rollout of the Cloud Collection, as well as just introduced the Sensation Deluxe model in certain markets. These launches are part of our collection selling strategy, which drives both slot growth and broadens our addressable market. Our third strategic initiative is to make sure that Somnigroup is available to everyone by gaining broad, high-quality distribution.

During the first quarter, we continued to add distribution and slots, both in North America and internationally, and expect additional gains throughout the balance of the year, Simplicity being a large contributor. The recent launch of our new Elite Retailer program is also expected to support and contribute to our distribution effort. Lastly, we want to make sure that we continue to deliver the best fleet by investing in R&D and consumer research. We did that too during the first quarter. We significantly increased our R&D spend, both on new product development as well as breakthrough new technologies. We've made solid progress on all these initiatives in the first quarter. Before I hand over to Dale, I'd just like to make a couple of contextual comments. As I said, I'm pleased with our results. We have continued to grow our top and bottom line substantially.

However, as anticipated, there have been significant new competitive launches and aggressive price promotion in the industry, as it has moved increasingly toward non-spring mattresses. Our major initiatives this year: brand advertising, integrated retailer advertising, the new Simplicity line, and improved dealer margins will all strengthen our competitive position. The impact of these initiatives will largely be felt in the second quarter and beyond. We remain very confident in our long-term strategy for growth, based on our commitment to providing superior sleep. People who sleep on Somnigroup sleep better than those who don't, and our sustained significant investment in consumer advertising, making sure that everyone knows they would sleep better on Somnigroup. We will continue on our path toward our goal of $2 billion in sales by 2014 and to our recently introduced five-year goal of $3 billion by 2016, through a continued focus on execution of our strategic initiatives.

With that, I'll now hand the call over to Dale.

Speaker 8

Thanks, Mark. I'll focus my commentary on the financials and our 2012 guidance. Let's begin with an overview. In total, first quarter net sales were $384 million, an increase of 18% over the same period last year. On a constant currency basis, net sales increased 19%. North American net sales were up 17%, and international net sales increased 19%. On a constant currency basis, international net sales increased 22%. By channel, in North American retail, net sales were $242 million, an increase of 16%. Our North American direct channel increased by 35%, to $24 million. Internationally, retail sales were $96 million, up 26%, and up 29% on a constant currency basis. By product, mattress sales were up 18%, driven by a 17% increase in units. North American mattress sales increased 15% on a 12% increase in units.

In the international segment, mattress sales increased 26%, driven by a 26% unit increase. On a constant currency basis, international mattress sales were up 29%. Total pillow sales increased by 20% on an 18% increase in units. North American pillow sales increased 22% on a unit growth of 19%. International pillow sales were up 17% on a 17% increase in units. On a constant currency basis, international pillow sales increased 19%. Sales of our other products, which include items that are normally sold along with a mattress, were up 18% in total and up 23% in North America and 4% internationally. Gross margin for the quarter was 53.6%, up 130 basis points year on year, and up 150 basis points sequentially.

On a year-over-year basis, gross margin improved related to the following: improved efficiencies in manufacturing and distribution related to our productivity program and fixed cost leverage related to higher production volumes. These benefits were partially offset by a higher new product cost. On a sequential basis, gross margin increased 150 basis points as a result of the lack of costs associated with U.S. shipments to support our Danish manufacturing facility, improved efficiencies in manufacturing and distribution related to our productivity programs, and fixed cost leverage related to higher production volumes. Our European factory produced at record levels during the first quarter and did not experience any subsequent system-related issues. In line with our plan, gross margin improvement was more than offset by a significant investment in advertising during the first quarter.

We increased advertising by 37% to a record $47 million, or 12.3% of sales, compared to $34 million, or 10.6% of sales in the first quarter of 2011. We also invested heavily in R&D during the first quarter, which was up 47% year over year. These investments are the cornerstone of our key strategic initiatives and thus will remain an investment focus of the company. Our first quarter operating profit was $86.1 million, or 22.4%. Interest expense was $4.1 million. The tax rate was 31.1%, down reflecting a net benefit of $2 million from the resolution of foreign tax matters. Earnings per share was $0.86 as compared to $0.68 per diluted share in the first quarter of 2011. Next, I'll turn to the balance sheet and cash flow for a brief review. Our accounts receivable balance was up, reflecting sales levels.

However, our DSOs were down one day from last year. Inventories were up $26 million year on year, or 36%, largely due to the planned build for the planned rollout of Simplicity and increased volumes. Payables were down four days due to timing. During the quarter, we generated $45 million of operating cash flow, and capital expenditures were $7 million. We lowered debt by $20 million to $565 million. Share repurchases during the period were 0.2 million shares for a total cost of $12 million. Our remaining authorization under our existing share repurchase program is $238 million. Our cash balance increased by $23 million to $134 million. Funded debt to EBITDA ratio was 1.4 times, slightly below our targeted range of 1.5 to 2 times. Now, I'd like to address our guidance. We are confirming our 2012 financial guidance.

We expect net sales to range from $1.6 to $1.65 billion, and we expect earnings per share to range from $3.80 to $3.95 per diluted share. We project our gross margin for the full year to be up as much as 200 basis points at the high end of our guidance range and slightly less than this at the low end. Our gross margin projections assume continued productivity and volume leverage, partially offset by higher commodity costs. Also, as a reminder, our 2011 gross margin was negatively impacted by 50 basis points due to the system upgrade issues incurred in our Danish facility. However, in the second quarter, as compared to the first quarter, we're expecting gross margin to be slightly down sequentially as we've accelerated the Simplicity floor model rollout and face slightly higher commodity costs than previously expected.

We project our operating margins for the full year to expand nearly 100 basis points at the high end of our guidance range, despite our continued investment in strategic initiatives to drive long-term growth. However, in the second quarter, as compared to the first quarter, we are expecting operating margins to contract modestly as we further accelerate investments in advertising and R&D. We continue to anticipate interest expense for the full year to be approximately $19 million. We anticipate capital expenditures will be approximately $50 million, which includes the cost of our new office in Lexington. We continue to anticipate the full year tax rate to be approximately 33.3%. Given the slight reduction in our share count during the first quarter, we are now expecting 65.7 million shares for the full year.

This share count does not assume any benefit from a potential further reduction in shares outstanding related to the company's purchase program. In conclusion, our guidance continues to reflect that it is a long year with many strategic initiatives and products that are just underway. Therefore, we believe it is prudent to plan the remainder of the year as I have outlined. As noted in our press release, our guidance and these expectations are based on information available at the time of the release and are subject to changing conditions, many of which are outside the company's control. With that, operator, please open the line for questions.

Speaker 5

Thank you. Ladies and gentlemen, if you would like to queue up to ask a question, please press star, then one on your touch-tone keypad. If your question is asked by another party or you wish to leave the queue for any reason, you may do so by pressing the pound button. In the interest of fielding questions from as many people as possible, we ask that you limit yourself to one question and one follow-up question at a time. Our first question in queue comes from John Baugh with Stifel Nicolaus. Your line is open.

Speaker 1

Thank you. Good afternoon. I wanted to just touch on the product launch, drag on gross margins in the quarter. Is that due to factory issues in terms of making the new product, or is there also selling of samples at a lower cost in there?

Speaker 8

Yeah, primarily, John, it's related to starting up in the factory. As I mentioned in the inventory, we built a lot of inventory on Simplicity, so we had to go through the startup process. We had to get the product out into our distribution system, because we wanted to have a very quick launch here in April. We did have a few products go out a little bit early, but not a lot. Primarily, it's related to just getting started up and getting the warehouses ready and in place to hold the Simplicity inventory for a very quick launch here in the second quarter.

Speaker 1

Does the gross margin pressure related to the Simplicity shift in Q2 tie to the sample sales, or do we still have lingering impact for manufacturing, or do we offset all of that with sales unit gains from the product because it'll be fully placed in selling?

Speaker 8

Yeah, the manufacturing startup, you know, that's just kind of a one-time first batch kind of issues that you run into with new formulas and brand new products. We feel very good about the production of Simplicity. Essentially, as I mentioned in my remarks, we're accelerating this rollout. You know, we said it would be six to nine months. We now think it's going to be six months or less in terms of getting Simplicity out, and it's going to be actually even more heavily weighted into the second quarter than what we had anticipated at the beginning of the year, as customers wanted.

Speaker 1

Thank you.

Speaker 5

Thank you. Our next question in queue comes from Jessica Schoen with Barclays. Your line is now open.

Speaker 2

Good afternoon, everybody. I had a question. You mentioned the current environment right now and the competitive changes that you've seen happening, and you talked a little bit about some initiatives and starting to see the impact in 2Q. I was wondering if you could give a little bit more detail on what those initiatives are and what the themes in the environment that you're seeing that has led to that.

Speaker 7

What we're hearing from customers across the country, and I mean, we've been hearing this for some time now, is that there's an increasingly fast movement in the premium mattresses away from spring mattresses toward what are called specialty mattresses, which obviously we're the leader in, in our channel. As this has happened, our competitors have noticed and have started to participate. The initiatives that we're focused on, though, are obviously the launch of the Simplicity, which is a very important product for us because it greatly broadens the range of consumers who we target. It targets this group of people who are willing to pay between $1,000 and $2,000. That's one very big initiative. The second one is our integrated advertising, working with our retailers there to make sure that theirs and our advertising is coordinated and effectively working together.

Of course, our brand advertising itself is a very important part of the initiatives that are driving growth. Finally, we've made some changes to our promotional structure so that it makes Somnigroup International more profitable for our retailers to sell. Those are the key initiatives that we're working on.

Speaker 2

Okay, great. When you look at the market and you see a lot of that outsized growth coming from the popularity of specialty mattresses, what kind of expectations do you have for the rest of the year, how the market will continue to trend?

Speaker 7

Projecting the market is always a tricky thing to do, which we try to avoid. What I think we, you know, honestly, I think the big thing, which is quite significant, and I, you know, I mean, I know this from our own experience here at Somnigroup International, but from speaking to a lot of retailers, what is happening is that this move to specialty is something that is going to continue. It's more than simply a move one for the other, because what it means is that consumers are trading up. Consumers are prepared to spend more on a good night's sleep, which is a pretty fundamental, a pretty fundamental change. We see this as being, you know, something that's going to continue to happen. It's going to continue to be good for consumers, for retailers, and for us.

Speaker 2

All right. Thank you so much. Congrats on the quarter.

Speaker 7

Thanks.

Speaker 5

Thank you. I would like to remind everyone, if you wish to queue up to ask a question, please press star, then one on your touch-tone keypad. If you wish to leave the queue for any reason, you may do so by pressing the pound button. Our next question is from Keith Hughes with Somnigroup International. Your line is open.

Speaker 3

Thank you. I just wanted to ask on the growth in U.S. mattresses. We saw one of your competitors out the other night. Where do you think you stack? Are you just in the middle of a product cycle, or where do you think this looks versus your long-term growth rate?

Speaker 7

I'm not quite sure what you mean by a long-term growth rate. As we look at the market, we're up 18% this quarter on top of very significant growth last year, and consistent with our growth projections for the full year. We feel pretty good about it. As we look at the industry as a whole, we think that the industry is certainly back from the doldrums that it's been in. As we look forward for our full year, we're pretty confident that we're going to continue to gain share as we have been for the last year.

Speaker 3

Exactly. In the first quarter, did you gain share in specialty?

Speaker 7

In specialty, probably not. Remember that that's a challenge when you think that in it for a long time, we were a very dominant player. As new people come in, the dominant player is always going to be impacted disproportionately. We look at it as a share of total category, and in that, we believe we will have continued to grow.

Speaker 8

Yeah. Keith, this is Dale. Let me add a couple of points. On your first question in terms of you were asking about the long-term growth rate, in February at our Investor Day, we talked about, reiterated and talked about the $2 billion growth plan. Obviously, to hit $2 billion in 2014, we have to compound the growth at 12%. We talked about a $3 billion growth plan for 2016 to be $3 billion in 2016. That requires a 16% compound growth rate. We have certainly a lot of plans around products and a lot of plans around how we go to market to drive the growth of this business. This is a global growth goal. It's not just a North America goal. We feel very good about where we're at and our position on that.

As to your second question, on share within specialty, we've said for as long as I've been with this business, the long-term goal here, the long-term gain is not to necessarily maintain our share of specialty. We want specialty to become gain share in the market, and we expect to lose some share of specialty along that way. If specialty is 20% of the market and we're 70% of specialty, that's nice, but we would much rather be 50% or 45% of specialty and specialty be 50% of the market. That's a much better equation for us.

Speaker 3

Okay. I hear what you're saying. Just one more quick one on international, like outstanding numbers there. Is that the influence of the cloud?

Speaker 8

Yeah, the cloud and the advertising are really working over there, building the brand awareness.

Speaker 3

All right. Thank you.

Speaker 5

Thank you. Our next question comes from Joe Altabello with Oppenheimer. Your line is open.

Speaker 0

Thanks. Good afternoon, guys. Just a couple of quick ones. I guess first, just going back to your comments earlier on competition. You know, you've had competition in the space for a while. I think you've had some branded competition in the space for almost a year now. You know, is there something that's changed in the landscape in the last three months or so? Is the competition getting more price competitive? Have there been new entrants in the last three months, or has something changed recently that's caused you to sort of tone down your comments today?

Speaker 7

Obviously, there's been competition forever, and the competition we've always said is very strong. I think that what's happened, not over the last three months, but over the last 12, 18 months, is that as the recognition has come that specialty, as Dale says, is trending toward being probably 50% of the market in dollars, everybody is going to participate in that. That is going to, that has happened and will continue to happen as we, you know, as, and this is in fact, you know, in some ways, something that's being driven to a large extent as the new people come in by being very promotional and very focused on price.

We intend to maintain our focus on making sure that we're focused on the consumer, making sure that our products are right for the consumer, and that our communication is, or our investment in marketing is largely on direct consumer communication. This is what we have long anticipated as the market shift. I think it's, as I said, it's a 12 to 18 month phenomenon, not a three-month phenomenon.

Speaker 0

Okay. Fair enough. Secondly, in terms of accelerating the rollout of Simplicity, just to be clear, it sounds like the rationale or driving reason for that is simply the fact that retailers want it faster. Is there anything else that's causing that?

Speaker 7

The buildup was quicker than we always put a certain amount of conservatism as we plan building of a new product. Just to get, you know, just to get it, as Dale was saying, it's a new manufacturing process, getting everything right, and so on. We put a little bit of conservatism in it. Our supply chain guys were ahead of schedule, and the demand was very high, and we were able to move it. We've essentially moved the rollout schedule earlier, largely driven by demand, but also by our ability to meet that demand.

Speaker 0

Okay, great. Thank you.

Speaker 5

Thank you. Our next question comes from Bradley Thomas of William Blair. Your line is open.

Speaker 0

Thank you. Good afternoon. Just to follow up on the sales in the domestic segment, you know, Mark, I was hoping you could just talk a little bit about performance by different price points. Was there anything that you saw differently among your lower price models or by any channels that you sell in, or anything that maybe points more to the competitive or promotional landscape in terms of how your sales played out?

Speaker 7

We don't split our sales by price point, but as we've said before, and I can reiterate it again this quarter, not really. I mean, there's no systematic differences in the distribution of sales by price point this quarter versus prior quarters.

Speaker 0

Okay. In terms of Simplicity at this stage, I know it started shipping. We've seen it in retailers. You know, you've talked in the past about the ability to gain, you know, hopefully two or more incremental slots. Is that still something that you could see? You know, how are you feeling about the order process at this point?

Speaker 7

It's extremely early, so everything I say about Simplicity has to be caveated by that. The initial plans, the initial rollout plans, what retailers have agreed to does seem to be consistent with that plan to get two or so incremental slots. We'll see it when we see it, and that is what people are agreeing to. That's what we're rolling out to. That's what we're seeing.

Speaker 0

Okay. If I could just maybe squeeze one more in here. In terms of the investment in advertising, I mean, if we were to really nitpick here, this is one of the lower sales quarters that we've seen in a while, one of the lower contribution margins in a while. Admittedly, you have an exciting new product coming out. Are you seeing the returns that you want to see still on that incremental advertising dollar investment?

Speaker 7

We are, but we have, and as I said in my prepared comments, we are, but we monitor it very, very closely. One of the things you have to realize is that advertising doesn't pay for itself in the day you do it. It has to be over a period of time. This obviously is the lowest proportion of promotional times, which is when advertising is most effective and when our heavy-ups are coordinated. There's a limited amount in the first quarter. It is consistent with it, but we monitor it very carefully. One of the things that is kind of a leading indicator is web hits. It's true in America and it's true in the rest of the world. Web hits are a good indicator of whether advertising is breaking through.

I think I saw data that we're well above 50% higher on web hits this quarter than we were last quarter, and we believe that's very driven by advertising. Sorry, by this quarter than we were first quarter last year.

Speaker 0

Great. Thank you, Mark.

Speaker 5

Thank you. Once again, ladies and gentlemen, if you would like to queue up to ask a question, please press star, then one on your touch-tone keypad. You may leave the queue if you wish by pressing the pound button. Our next question is from John Anderson with William Blair. Your line is open.

Speaker 0

Good afternoon. I just had a question on the guidance. By my math, the top line guidance of $1.6 to $1.65 billion kind of implies growth through the balance of the year somewhat below what you experienced in the first quarter. I guess with the launch of Simplicity, the benefit of the incremental advertising spending, it's not immediately intuitive to me why that might be the case. Is this more to have to do with conservatism because we're early in the year, or is there something else you're seeing there? Thanks.

Speaker 8

I would say, as in regards to Simplicity, we have a plan for Simplicity. While we're accelerating the rollout of Simplicity, we haven't changed the plan that we had for the year in terms of what Simplicity would do at this stage. It's only been in the market for a couple of weeks. It's really only been on floors for a week and a half or so. It's way too early to have a gauge of what Simplicity is going to do. It's way too early to know what the real benefit of the heavy-up is going to be. We're just embarking here, as Mark said, a lot of the programs are just kicking in here in the second quarter. We have had ideas in our planning for the year of what the benefit of those programs like the integrated advertising, etc., would do for us. They're just starting.

There's no basis to change what our original plans were. One other thing that I would comment on from a total year standpoint, at the start of the year, we thought FX would be fairly neutral this year. It proved to be a headwind in the first quarter, based on how the Euro specifically is trading. It doesn't look, and the continued uncertainty around the, particularly the European, markets, we're performing very well there, but you read the headlines in the news as much as we do, and there's still significant uncertainty as to what the economies over there are really doing. We're trying to be a little bit cautious. We built in FX is now going to be a headwind for the year. We'll see pressure from FX as the year goes on. We'll also continue to be concerned about the overall macro environment in Europe.

I think it's a function of not enough has changed to change our plans for the year. We don't have the evidence and proof points yet, because most of the major initiatives for the program for the year are just starting.

Speaker 0

Thanks. I don't want to beat it to death, but on competition, I know we've kind of talked in the past about, you know, that competitors have had specialty offerings in the marketplace with varying degrees of success. It kind of sounds like, and looks like, based on some of the industry growth rates, that might be getting more traction. Do you think there is a different approach that's being taken by some of your competitors, better in-store presence, better marketing, or, you know, I'm just trying to kind of get a better handle on why there may be more traction in the premium area?

Speaker 7

I think that the really kind of astonishing change in the world is that specialty is being accepted as being the bulk of what business above $1,000 is going to be. As you look at it like that, what it means is it's the retailers themselves who say, in that case, that opens their ears to that. It also provides us an opportunity. I think the fundamental change is in that. I think that there is a recognition and a trend that has started to accelerate, which is causing, obviously, the competitors to participate, for the retailers to be more, to have the justification for the space on their floors. It's something that we've talked about for a long time, and it's happening something like we expected.

Speaker 0

Okay. Thanks for the caller.

Speaker 5

Thank you. The next question in queue comes from Joan Storms with Wedbush Securities. Your line is open.

Speaker 2

Hi. Good afternoon. Can you guys hear me?

Speaker 1

Yep.

Speaker 2

Okay, great. Mark, you had mentioned earlier, and I want to make sure I got the comment right about, obviously because of the product rollout, in particular in the U.S., that, you know, business is likely to accelerate. Obviously, you have some of these headwinds on the raw material costs and the, and the FX, but, you know, just due to the rollout of the Simplicity and the extra slots that we should see, you know, some acceleration of business into Q2 through to Q4.

Speaker 7

What I said was that we have a lot of initiatives which are essentially kicking in in Q2 through Q4. As Dale said, you know, we made our guidance for the year three months ago, and we're not modifying it, even though we're slightly ahead of, in terms of top line growth, where we thought we'd be. The fact is that these initiatives are still extremely early in their rollout. It's too early for us to change our expectations of these things. As we stand here today, we think that the best way to look forward is to stick with what we had originally thought. That's what we're doing. We're excited to see them. We're watching them with great anticipation. At the moment, it seems appropriate, and our projections say that the best projection we can make is this, is our guidance.

Speaker 2

I mean, most of the early channel checks we've done on the rollout of the Simplicity event, most of the stores are taking the entire three beds so far. Are those part of the Elite Retailer program companies that you're servicing first during the rollout?

Speaker 7

Forgive me, I didn't quite hear what you said. Say that again.

Speaker 2

The Elite Retailer program.

Speaker 7

You're.

Speaker 2

Sure. On the, most of the early channel checks we've done on the rollout of Simplicity, a lot of the stores are taking all three slots.

Speaker 7

Nice.

Speaker 2

For that line, I don't know if you can. Are those customers or retailers part of the Elite Retailer program that get the product first, or how does that work?

Speaker 7

As I said, in order for us to get an average of two in total, a majority of people are going to have to take three. It is not a big surprise. The majority of people are saying that they want to take two or more. I'm sorry, we just heard a buzzing sound. I don't know what that was.

Speaker 2

Yeah.

Speaker 7

It's not a surprise to me that you're seeing three in the stores you're visiting.

Speaker 2

Okay, thank you very much.

Speaker 7

Thank you.

Speaker 5

Thank you. Our next question in queue is from Bud Bugatch with Raymond James. Your line is open.

Speaker 6

Good morning. Good afternoon, Mark. Good afternoon, Dale.

Speaker 7

Bud.

Speaker 6

Dale, one specific question. I think in the last quarter guidance, you said that gross margin would be up modestly, and it was up pretty nicely. I know you talked about the efficiencies, and yet some new product drag. Maybe you could give us a little bit of additional color on that.

Speaker 7

You know, we had, obviously on a sequential basis, felt like we were through, and we said that we were through the Danish facility issue, but you never know absolutely until you go a few months, make sure that everything is going as it appears to be. As I mentioned in my comments, we did not have any lingering Danish support needs from the U.S. That was a positive. We had very good productivity, build and response. While we had a little bit of startup cost around Simplicity, actually, the startup costs were a little bit less than what we thought they would be. Basically, from a gross margin standpoint, we saw very good performance in terms of what our plans are and what our outlook was.

We are projecting and seeing some chemical pressure in the balance of the year from what we expected at the start of the year. Bud, you've mentioned a couple of times that you've heard of more price increases and stuff. Yeah, we've built in some more chemical pressure into our outlook. We think that will give us a little bit of headwind in the second quarter. Because of the performance that we're getting on our cost improvement programs, we think that we can offset that in the second half and actually get back whole for the year, which is why even with higher chemical costs, we're not changing our outlook for gross margin for the year.

Speaker 1

Okay. Could you give us a little bit more color? You talked about the revenue guidance. I was struck, and I think John got a little bit to this. The revenue guidance is unchanged. I recognize it still is early in the year. You are accelerating Simplicity, which would have said you should have gotten a little bit more revenue, as that gets placed earlier and has longer to get seasoned on retailers' floors. You did talk about a little bit of FX headwind. Maybe if you could quantify the FX headwind, and is that what is offset by the accelerated revenues from Simplicity? Is that the right way to look at it? Those are the two major moving parts.

Speaker 8

Yeah, I mean, those are the two major moving parts. Even though we're accelerating the floor model rollout of Simplicity, we're not changing the sell-through assumptions of Simplicity per se, just because we really haven't sold much yet. We don't have broad response or input back in terms of how it's performing in the market. We've heard some good anecdotal things. Until we get some time with it, we're not going to change our plans around Simplicity. We are anticipating ongoing FX pressure. In the first quarter, it cost us, I guess, globally about a point. I think for the full year, we're expecting it to cost us a couple of points.

Speaker 1

Two points or more?

Speaker 8

Yeah, probably two.

Speaker 1

Okay.

Speaker 8

On the international side, outstanding first quarter, 22% constant currency growth in the first quarter. Very pleased with the performance overseas, still concerned about the economies, particularly in Europe. The comps do get tougher as the year goes on, as we're comping the cloud. We started rolling out the cloud internationally just late in the first quarter last year, and then it built and built throughout the year. The comps do get tougher as the year goes on. We're not necessarily expecting an acceleration of growth. We said at the beginning of the year, we thought for the year, the growth rate between U.S. and international would be more balanced. Those are all the factors that we're looking at.

Speaker 1

You did, I'll sneak one final one in there. You did, I think, last quarter say that the Simplicity inclusion into 2012 guidance was modest. Could you give us maybe a little bit more color on what's included in the $160 to $165 million for Simplicity this year?

Speaker 8

Yeah, we're not going to get into the exact specifics of how much Simplicity we expect to sell. It is still a relatively modest expectation. It's not going to become, you know, our expectation for this year is that it's not going to become the whole driver of the business.

Speaker 1

In terms of growth rate, can you get any way to characterize it in terms of the delta to growth rate?

Speaker 8

No, we don't want to get into that.

Speaker 1

Okay. Thank you. Good luck on the second quarter and the year.

Speaker 8

Thanks, Bud.

Speaker 5

Thank you. Our next question is from Leah Villalobos with Longbow Research. Your line is open.

Speaker 4

Hi, thanks. This is Josh Borstein in for Leah. Thanks for taking my calls. You implemented some pricing in early April. Did you see any pull forward in demand ahead of that increase?

Speaker 8

Really, no. One of the key things about this price increase, you always see a little bit, but this one was very different than how we have typically done price increases. This price increase was relatively small. It was actually fairly heavily weighted to non-high volume sizes, twins, kings, where queen is by far the highest volume. The price increases were in areas where retailers are less likely to try to take advantage of it. Also, the flip side of that is some of the new programs that we introduced that start off in the second quarter that are geared around volume actually kind of counterbalance any potential impact of trying to get a benefit from the price increase. Last year, we had a sizable price increase in March on the Cloud Supreme, which is our highest volume unit. On a year-over-year basis, the price increase impact was significantly different.

Speaker 4

How should we think about ASP, you know, going forward for the year in the U.S.? You have a little bit of pricing, you said, from the April price increase that presumably is going to be offset by some lower price points from the Simplicity. Just in thinking about ASP for the year, how should we think about that?

Speaker 8

For the year, I believe we said that we thought ASP on the North America side of the business, we thought that ASPs would be flat.

Speaker 4

Okay.

Speaker 8

Because of the impact of Simplicity.

Speaker 4

Okay. If I can just sneak one in, house cleaning question, could you update us on the door count for the U.S. and internationally?

Speaker 8

Let's see. Domestic door count, 7,700 I've got. International looks like 5,300.

Speaker 4

Okay. That 7,700, does that include Canada?

Speaker 8

No, that's just U.S.

Speaker 4

Okay.

Speaker 8

Canada, the door count doesn't change much. There's about 400 doors in Canada.

Speaker 4

Great. Thanks very much.

Speaker 5

Thank you. The next question is from Eric Holloway with Stevens Incorporated. Your line is open.

Speaker 0

Dale, could you just reiterate what your guidance was on gross margin for the second quarter? You guys cut out, I think, when you were giving that.

Speaker 8

Oh, okay. Yeah, I said for the second quarter, I expect sequentially from 1Q to 2Q, gross margin to be down a little bit because of the impact of this, you know, heavy floor model rollout of Simplicity. Chemical prices are up.

Speaker 0

Right. Okay. The international, excuse me, the advertising expense increase in the quarter, could you give us a perspective on whether that was fairly evenly weighted, U.S. versus international in percentage terms, or how did that sort of play out?

Speaker 8

Yeah, in terms of percentage of revenue, the international spend was higher in the first quarter as a % of our revenue there. That's been the case for a while. In terms of growth rate of advertising, it was a slightly higher growth rate in the U.S., but not dramatically different in terms of growth rate in advertising between the two sides, because the U.S. is catching up a little bit. Last year, the U.S. was spending a 10% and picked it up this year to 11% and change. International, which was spending at a high over 12% last year, is now over 13%.

Speaker 0

Great. Okay, thanks.

Speaker 5

Thank you. Our next question is from Joshua Pollard with Goldman Sachs. Your line is open.

Speaker 0

Thank you for taking my question. Can you talk about what percentage of your existing clients actually took on the Simplicity, and then with the speed-up of the rollout in the U.S., can you talk about when you guys are looking to put that out for your international segment?

Speaker 7

The vast majority, I'm not going to give an exact percentage, of our customers will be taking the Simplicity. As Dale said, the rollout is going to be over essentially six months, so starting from now, six months. There'll still be stragglers, obviously, but that's roughly what we expect, and we're trying to get quite a bit of that into the second quarter. In terms of when we'll launch it in international, we will launch it. We haven't announced the date when we'll do that, but we do anticipate doing so. It's just not appropriate to announce when.

Speaker 0

Is it fair to ask whether or not that would be this year or next?

Speaker 7

It won't be this year, but I don't want to talk if I won't be more specific than that.

Speaker 0

Okay. That's fair. The other question I had was around your R&D spend. You didn't give the numbers, but you did say that it was up almost 50%. I'm trying to compare that with some comments you guys made in the second half of last year, where you said that the Simplicity ended up being your biggest product from an addressable market standpoint, but that you had a number of products that were ready to go. I'm trying to understand when I think about the increases in spending that are sort of needed in the more competitive environment, the new products that you have coming out, potentially in next year rollout with the Simplicity, worldwide. I'm trying to understand why such a big increase in R&D for you guys at this particular point.

Speaker 7

R&D is crucial to us. This is a very big, important component of our overall business strategy. We're committed to making sure that we have beds that people sleep better on, and we do that from research to product development. It is the backbone of our business. Secondly, if you look at it as an amount of spend, in big terms, it's a relatively small amount. It's less than 1% of our total sales. It's an important thing. It's a large number, but in the big scheme of things, not a thing that greatly moves our P&L. Having said all that, the concept of making, as I said, and I have said, and it is true that we have several things ready to roll, that doesn't mean we're not working on more things. There are two parts of R&D.

There is the product development side of it, which is using existing technologies to create new product, and there is the development of new technology, which enables new product. We genuinely do both. We cannot, we're never going to say we've got enough R&D. We're always going to think we're going to need more. That's going to be a continuing plan for us going forward.

Speaker 8

Yeah, Josh, from a specific number standpoint, the first quarter of 2011, we spent $2.3 million in R&D, and the first quarter of 2012, we spent $3.4 million.

Speaker 0

Okay. If I could just sneak one more in, are there any stores where you guys are net only, that you're actually losing a slot to put the Simplicity in? I know it's not something that's really been talked about much, but I'm wondering if there's a portion of your customers who are taking on two or three Simplicities, but taking one other off of the floor.

Speaker 7

is inevitably going to be some of those. The fact is, what we're looking for, as I've said, is a net gain of two. There is going to be averages. Some will take three. It will average out, but by the laws and specifics, there is going to be some people like that.

Speaker 0

Okay. All right. Thanks a lot. I really appreciate it. Great quarter, guys.

Speaker 7

Thanks, Josh. Thanks.

Speaker 5

Thank you. I do show that we are out of time for questions. I would like to turn the call back to Mark for any concluding remarks.

Speaker 7

Thanks very much. Thanks, everybody. We look forward to talking to you again in July when we'll host our second quarter earnings conference call. Thanks for joining us this evening.

Speaker 5

Ladies and gentlemen, thank you for joining today's conference. This does conclude the program, and you may now discuss.