Somnigroup International - Earnings Call - Q2 2011
July 26, 2011
Transcript
Speaker 6
As a reminder, this conference is being recorded. I will now turn the conference over to Barry Hytinen. Please begin.
Speaker 3
Thanks, Tyrone, and thank you, everyone, for participating in today's call. Joining me in our Lexington headquarters are Mark Sarvary, President and Chief Executive Officer, and Dale Williams, Executive Vice President and Chief Financial Officer. After 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 a press release issued today.
These factors were also discussed in the company's SEC filings, including the company's annual report on Form 10-K, under the headings "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, it is my pleasure to turn the call over to Mark.
Speaker 4
Thanks, Barry. Good evening, everyone, and thanks for joining us. Today, I'll provide an overview of our performance in the second quarter and an update on our strategic focus areas. Dale will then provide a detailed review of financial results, as well as our updated financial guidance. We're pleased with our second-quarter performance, both in the U.S. and internationally. Sales were up 30% from last year, and earnings per share were up 65%. In the U.S. and in all the countries where we have reliable data, Somnigroup outgrew the industry. Our market share is growing globally. Gross margin improved by over 400 basis points year over year, a result of a favorable mix, a continued focus on productivity programs, and fixed-cost leverage. The gross margin improvement allowed us to maintain our commitment to significant investment in marketing while still expanding operating margin to 24%.
As a result of our strong performance in the first half of 2011 and our expectations for the remainder of the year, we are increasing our financial guidance, and Dale will provide details later. Now, I'd like to provide updates on our strategic initiatives. First, the progress that we've made to ensure there's a Somnigroup mattress and pillow that appeals to everyone. In our international markets, the Cloud collection launch is progressing nicely throughout much of Europe and is beginning in Asia, and we're receiving very positive feedback, both from retailers and consumers. In the U.S., we're seeing positive trends in the early days of the Contour line rollout, which began distribution in June. Contour is a newly designed line that replaces our traditional Somnigroup collection for those consumers who prefer the traditional Somnigroup feel.
The Contour is planned to roll out quickly, likely complete in advance of the Labor Day shopping period. Also, late in the year, we will be increasing the prices of the Contour and the Contour Select. Also, in North America, the Cloud Lux completed its initial distribution and continues to perform very well. Beyond mattresses, we're excited about the potential for our pillow business. We've integrated the findings of new consumer research into our pillow development, and at the Las Vegas bedding show next week, we will introduce a range of new pillows and a redesign of the existing line. The redesigned products maintain what consumers have always loved about our pillows, but improved upon them.
Our new pillows provide a more traditional look and feel and will be available in varying degrees of softness. I would also like to comment on our mattress product development pipeline, the details of which are obviously confidential, so I won't provide a lot of detail. I would like to provide a brief update to our investors. Through our ongoing consumer research, we've identified several large market segments where our existing product line does not fully address certain consumer needs and wants, and we've focused our R&D team against these opportunities. Across a range of different initiatives, product development is in varying stages, with some efforts well-developed and in the final stages of consumer testing and commercialization, and some still in the laboratory phase. As we look into 2012 and beyond, we expect to introduce several new concepts to drive considerable growth and market share gains.
The next strategic imperative I want to provide a progress update on is making sure everyone knows that they would sleep better on Somnigroup. In the second quarter, we increased our marketing investment by more than 50%. This increase was both a continuation of our U.S. initiative, which we've been doing for some time now, and also our international initiative, which we kicked off a few months ago. Those of you who attended our investor conference last year will remember that we have good levels of distribution in our largest overseas markets, comparable with the U.S., but much lower levels of awareness than we have here in the U.S. This year, we have invested in advertising to raise awareness in these larger markets, and although it is still quite early, we're quite pleased with the response we're seeing.
In those markets where we've made significant increases in advertising, our brand awareness is growing, and also our web traffic is growing, which is an important indicator of awareness and interest. Most importantly, retailers are telling us that consumers are coming to their stores and asking for Somnigroup. Obviously, we're watching this very carefully, but early results are promising. The last initiative I'd like to update you on is making sure that Somnigroup is available to everyone. This quarter, we opened slightly more than 200 doors globally and are currently in the process of opening several new accounts. In the U.S. this year, we've continued to gain slots with the Cloud collection rollout. In our international markets, we have achieved considerable growth in slots.
The Cloud launch is gaining traction overseas, and as it rolls out, retailers are implementing what we call the collection assortment, meaning that they are carrying a portfolio of Somnigroup International products that includes representative items from each of our three international collections: Somnigroup Original, Somnigroup Sensation, and Somnigroup Cloud. Finally, also focused on our objective of ensuring that Somnigroup is available to everyone, we are pleased to announce that we've converted our third-party distributor in South Korea to a wholly owned subsidiary at the beginning of July. South Korea is a strategic market where we see potential for growth over many years. To summarize, we had a great quarter and a great first half of 2011, and we confidently expect that 2011 will be a record year. We continue to take the long view.
We see enormous potential for our company in the years to come, and we will continue to invest in building consumer awareness of the Somnigroup brand and in technology and innovative new products as we strive to fulfill our ambition to become the world's favorite mattress and pillow brand. With that, I'll now hand over to Dale.
Speaker 5
Thanks, Mark. I'll focus my commentary on the second quarter financial results and our updated 2011 guidance. In total, second quarter net sales were $342 million, an increase of 30%. On a constant currency basis, sales were up 25%. North American sales increased 29%, and international sales were up 34%. On a constant currency basis, our international sales increased 18%, reflecting the positive trends Mark referenced relating to investments in marketing and new products. By channel, in North American retail, net sales were $227 million, an increase of 31%. Internationally, retail sales were up 35% to $72 million. On a product basis, mattresses were up 30%, driven by a 19% increase in units. North American mattress sales increased 28% on a 20% increase in units. The increased average unit selling price reflects favorable price and mix, partially offset by our closeout and increased floor model discounts.
In the international segment, mattress sales increased 37%. On a constant currency basis, international mattress sales were up 20%. International mattress units increased 16%. In total, pillows were up 25%, driven by a 16% increase in units. North American pillow sales increased 19% on a unit growth of 18%. International pillow sales were up 31% on a 14% volume increase. On a constant currency basis, pillow sales internationally increased by 15%. Sales of our other product category, which includes items that are normally sold along with a mattress, were up 32%. Gross margin for the quarter was 52.9%, up 420 basis points year on year and 60 basis points sequentially. On a year-over-year basis, the gross margin improvement related to a variety of factors, including favorable mix, our ongoing productivity programs generated improved efficiencies in manufacturing and distribution, and fixed-cost leverage related to higher production volumes.
Partially offsetting these benefits were higher commodity costs and new product launches. On a sequential basis, the improvement in gross margin is primarily driven by favorable mix and productivity, offset by higher commodity costs and new product launches. Looking at operating expenses, we increased our advertising investment by 150 basis points, reflecting our commitment to ensure everybody knows they would sleep better on Somnigroup International. Second quarter G&A expenses include two items I'd like to address. First, we benefited from the settlement of certain tax items. This benefit was largely offset by a second item. As we've mentioned before, the majority of our long-term equity incentive compensation is variable and aligned with our financial performance. As a result of our strong 2011 performance year to date and our outlook, we have increased the 2010 plan to the maximum target.
In the second quarter, we recorded a significant expense to catch up to this level and will be accruing at a higher rate going forward. Our operating margins expanded 370 basis points to 24.2%. Interest expense was $2.6 million. Net income was $53.1 million, up from $33.5 million last year. EPS was $0.76, up from $0.46 last year. Now I'll turn to the balance sheet for a brief review. Receivables were up, reflecting higher sales, while our DSOs were down approximately two days from the second quarter of last year and flat sequentially. Inventory was up $15 million, or seven days, sequentially as planned to support the rollouts of the Contour in the U.S. and the Cloud internationally. As Mark mentioned, we expect the Contour to be a fast launch with distribution complete by Labor Day. With that, we anticipate our inventory days to normalize in the second half.
Let me address the increase in other non-current assets. The change reflects deferred financing costs in conjunction with our newly amended credit facility, which I will discuss shortly. Turning to our buyback through open market purchases, we bought back 1.59 million shares during the quarter at an average price of $61.19 for a total cost of $97.5 million. During the first half of 2011, we bought back 2.91 million shares at an average price of $54.92 for a total cost of $160 million. Our funded debt, the EBITDA ratio, increased modestly to 1.38 times, reflecting debt deployed to purchase stock. As we've said before, our target level ratio is 1.5 to 2 times versus our debt covenant of 3 times.
We recently amended our credit facility with changes including an extension through June 2016, an increase in availability to $770 million, an accordion feature that would increase borrowing capacity by an additional $250 million, and increased interest margin, reflecting market conditions. With a favorable outlook for sustained sales growth, expanding margins, and strong cash flow generation combined with low capital needs, we continue to view share repurchases as the best way to return value to shareholders. We are pleased to announce that our board has authorized a new repurchase program of up to $200 million, which replaces the previous authorization. Now I'd like to address our updated guidance for the full year. With our new outlook, we are balancing our strong results through the first half while acknowledging the macroeconomic environment is still unclear. Industry conditions remain choppy, and our retail customers continue to report that traffic is variable.
We think it is prudent to project the remainder of the year in a manner reflecting a level of uncertainty. We currently expect net sales to range from $1,370 million to $1,400 million, and we currently expect EPS to range from $3.07 to $3.14 per diluted share. We expect our gross margin to be approximately 250 basis points higher for the full year, driven by a favorable mix, ongoing productivity programs, and fixed-cost leverage, partially offset by higher commodity costs. We expect interest expense for the full year to be approximately $12 million. This projection includes the changes to our interest margin cost in our amended facility. We anticipate the full-year tax rate to be 33.5%. We are lowering our share count projection to 70 million for the full year, which includes the net benefit of our repurchase activity through the second quarter.
However, it does not assume benefit from the potential for a further reduction in shares outstanding. As a reminder, repurchases made in the second half would have less benefit on the full year, given their weighted average impact. 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. This concludes our prepared remarks. At this point, operator, we'd like to open the call to questions.
Speaker 6
Thank you, ladies and gentlemen. If you have a question or comment, please press star then one on your touch-tone phone. If your question has been answered and you wish to remove yourself from the queue, you can do so by pressing the pound key. Again, if you have a question, please press star then one on your touch-tone phone. Our first question is from Brad Thomas of KeyBank Capital Markets. Your line is open.
Speaker 0
Thanks. Good afternoon and congratulations on a nice quarter.
Speaker 4
Brad.
Speaker 0
I wanted to just first ask about the Cloud launch internationally. Mark, you mentioned that it was progressing nicely. I was wondering if you could provide a little bit more color in terms of what you were seeing in terms of slot growth in the markets that you've rolled out the product and what level of sales lift you've seen in those markets.
Speaker 4
Yeah. I mean, we're generally getting not quite, yeah, two slots extra from the rollout of the Cloud. With the three products, we're getting generally two new slots. It's still early, so it's hard to tell exactly what is the level of incremental. Frankly, it looks pretty good. It looks very similar to what we saw in the U.S. The relative proportion of business that's coming from the Cloud and from the old products is comparable to what we saw with the Cloud here, and that's something of the order of 50% incremental, 50% to 60% incremental. It's too early to say if that's absolutely going to be the case, but that's what we're seeing so far.
Speaker 0
In addition to the slot growth, are you seeing a similar lift in terms of your sales in the stores that have had Cloud added to them?
Speaker 4
As I said, we're getting the additional slots, and the sales that we're getting from that are driving incremental sales. You know, the answer is yes. Yes, we are getting incremental sales.
Speaker 0
Great. Just to follow up on the outlook for your input costs, last quarter when you gave guidance, oil was at $115 a barrel and had been trending in an upward direction. We're now lower than that, and it hopefully seems to be a little bit more of a benign outlook, and you're closer to the point where you would have an idea of what your chemical costs would be through the end of the year. What's your expectation at this point for raw materials?
Speaker 4
Yeah, actually, our outlook for raw materials hasn't changed much. Our third-quarter raw materials are basically locked in at this point, and there's always a slight delay on the upside on the pricing. The price increases that we got kind of late in the quarter were what we were expecting to get. As we sit here today, if oil continues to stay at a more moderate level, we would hope to possibly see some benefit later in the year. We haven't seen any downward pressure yet or downward opportunity yet on chemical pricing, so our outlook for that has not changed. We were able to delay it a little bit, so we had a little less impact in the second quarter on chemicals than we were expecting. Those chemical prices are in place now.
Certainly, we'll work every day to try to knock them back down if oil stays at a more moderate level. It's not always, as we've often said, our chemical prices are not always moving directly with oil.
Speaker 0
Great. Thanks so much, guys, and congrats again on a great quarter.
Speaker 4
Thanks.
Speaker 6
Thank you. Our next question is from Bud Bugash of Raymond James. Your line is open.
Speaker 5
Hi. Good evening, Mark, Dale, and Barry. That's actually Chad pinch hitting for Bud, and let me add my congratulations as well on another great quarter.
Speaker 4
Thank you. Thanks, Chad.
Speaker 5
First question, Mark, I think in your commentary, you alluded to obviously market share gains in the U.S. as well as internationally. I mean, we have a pretty good feel for what the overall market is doing here in the U.S., but could you give us a sense for how your UP18 in local currency compares to the overall market or at least some of the key overall markets that you're rolling out Cloud in?
Speaker 4
We look across the markets of our major markets. Quite frankly, most of them are flat or down. If you look at Germany, the UK, certainly France, it is a very tough environment out there. Spain, it really is tough. We're doing, touch wood, we're doing quite well compared to an industry that is really not doing very well. Obviously, the whole economy in Europe is suffering. Our other businesses in Japan and Australia, they're too, while not as terrible as it is in Europe, there's a weak environment, and we're doing better. In fact, in Japan, it's really quite bad.
Speaker 5
Yeah.
Speaker 4
I would say that the compare, if you look at how we're doing relative to the U.S., here at least there is some growth in the industry. In the rest of the world where we're competing, there's little or none or negative.
Speaker 5
Okay. I guess turning back to the U.S., you alluded to a kind of a choppy macro environment, and commentary from retailers that traffic has gotten more variable. Have you seen any signs of slowing? Can you give us a sense of how things progress through the quarter, what business trends look like in early July?
Speaker 4
Let me start, and then I think Dale's got a bit more detail, but let me just give you a top line on this. The second half of the quarter, we saw a little bit of strengthening relative to the first half of the quarter, so it kind of got better. I think the point that you picked up on was quite right, which is there has been a choppiness. Retailers are saying that literally from day to day, they'll have a good day, then a bad day. They'll have a good weekend and then a bad weekend. We've heard this from retailers across the country, and we see it from our results. It's sort of choppy is the right word. While so far this quarter, trends are consistent with what we've been seeing, we continue to see the choppiness.
I don't know, Dale, is there anything you want to add?
Speaker 5
No, I think that covers it. Okay. Last one from me, I guess within the U.S., could you tell us what the U.S. furniture and bedding sales were during the quarter? Is there any variance between what you're seeing from full-line furniture stores versus bedding specialists?
Speaker 4
Furniture and bedding sales in the quarter were $212.6 million. In terms of bedding specialists versus furniture, we've seen strength on both sides.
Speaker 5
Okay. Thank you, guys, for taking my questions. Congratulations again, and good luck for the rest of the year.
Speaker 4
Thank you very much.
Speaker 6
Thank you. If you have a question, please press star then one on your touch-tone phone. If you have a question, please press star then one on your touch-tone phone. Our next question is from Mark Roop of Longbow Research. Your line is open.
Speaker 5
Hey, guys, congrats as well. Just on the rollout of the Cloud International, I know you commented kind of maybe from a macro level or from a higher level, but is there any kind of learnings that you found on a market-by-market basis as you've rolled this out? I know that each of the markets are very different, but is there anything that's surprised you one way or another on the Cloud rollout?
Speaker 4
You're quite right to say that each of the markets are different. That is true. I think that they're different for a variety of reasons. One of the fundamental reasons that they're different is because almost without exception, every country has a unique retail environment. The German retail environment is not at all the same as the French and not at all the same as the UK or Italian and so on. The method that it rolls out and the challenges are different by every country, and we've had to customize how we've launched it in each country. What is interesting is that obviously the Cloud bed is a Somnigroup bed that has a softer initial feel. We had expected a greater degree of variability in how appealing that would be in different countries.
A lot of countries, people perceive that some countries prefer to sleep on firmer beds than others, for example. We found a lot less variability in that than we had thought. What people profess to like the best and what they actually like the best is interestingly, what they actually like is more consistent across the countries. There are some outliers. China is different. Fundamentally, across the main European countries, there's more consistency in consumers' preference than I would have guessed.
Speaker 5
Okay. Perfect. On the media spend, I know you cited a fairly significant increase. Was it weighted a lot more towards internationally? Is there a number you can point to?
Speaker 4
Yeah, you know, our overall media spend in the U.S., we saw a media spend increase about 43% on a year-over-year basis. Internationally, we increased it 84%.
Speaker 5
Okay.
Speaker 4
As we said, we're investing internationally.
Speaker 5
How much? It's worth adding how much we invested in the U.S.
Speaker 4
Yeah. I mean, the total media spend for the quarter was right about $36 million, and that was, you know, about $10 million in the international and the balance in the U.S. It's a we've stepped up investment here as well as internationally, and we're seeing very positive results from that, actually, in both segments.
Speaker 5
Okay. Perfect. You called out a price increase on the Contour and the Contour Select. Correct me if I'm wrong, but is that incremental to what you had previously thought on rolling it out when you rolled it out?
Speaker 4
We hadn't communicated it before, but we'd always anticipated doing it. We introduced the prices that we introduced that were set essentially to be consistent with the products that they were replacing. Now that that replacement is essentially all but through, we're going to make sure that the products are priced comparably with the other lines, most notably the Cloud.
Speaker 5
Okay. Perfect. Lastly, you called out some new concepts you're looking at for 2012. Without going into detail, did you mention that it was across all product offerings in all regions, or is there one particular area that you see might have the most meaningful, I guess, hold to fill, if you will?
Speaker 4
I don't want to go into great details. First of all, I don't want to go into great details for obvious reasons. Secondly, it is a broad brush. It is broad, and it is not a single thing.
Speaker 5
Okay. Perfect. Thank you, guys. Good luck.
Speaker 4
Thanks.
Speaker 6
Thank you. Our next question is from John Barr of Somnigroup International. Your line is open.
Speaker 1
Thank you, and congratulations as well. I was just curious on the Contour rollout and the impact it had on Q2, whether you could quantify that, and will the impact be lower in Q3 than Q2?
Speaker 5
We've got about 40% to 45% of the rollout of the Contour done in Q2. We'll get higher rollout in Q3. However, the overall impact to the program will be moderated a little bit because obviously in Q2, on top of the rollout, you also had the discontinuance of the old Tempur line, so you had the closeout going on. Now it's spilled over a little bit into July, and you can still find the while supplies last, but we're basically out of those now. From an overall standpoint, Q3 will see a little bit more impact of Contour rollout, but a little less impact from the closeout. However, as I stated before, chemicals are going to be up. I wouldn't be looking for a big growth in gross margin here in Q3.
Speaker 1
Okay. On the compensation, you mentioned that in Q2 spiking. Does that catch you up for the whole year, or how do we think about modeling Q3 and Q4 year-over-year on that line item?
Speaker 5
Basically, on the 2010 LTEP program, by stepping up to the max payout, the charge we took in Q2, which you'll find in the queue when it's published tomorrow, was about $1.8 million. However, that gets us current through the second quarter. From catch up for 2010 and the first half of 2011, we would see an ongoing increase in the accrual rate on that particular program of about $300,000 a quarter.
Speaker 1
Great. Thank you. Good luck.
Speaker 5
Thanks.
Speaker 6
Thank you. Our next question is from Bob Darbow of Barclays. Your line is open.
Speaker 1
Hi. Good morning. Good afternoon. Sorry. Long day. A couple of questions I have for you. First, on the international side, can you talk a little bit about the, you know, Cloud collection, how you're doing internationally, some of the sort of historical products?
Speaker 4
The growth is coming from the Cloud, or part of the growth is coming from the Cloud, but by no means all of it. A lot of the growth that we're coming, we are attributing a great deal of the growth that we're getting, which all by nature comes from the base, from what you're calling, you know, historic business, is driven by the advertising. We're actually seeing quite good growth in our older products as well as the Cloud.
Speaker 5
Yeah. I think it's really important to remember, Bob, that, you know, the Cloud rollout is still progressing. We got it into the Germanic regions right at the end of the first quarter. In the second quarter, those were the primary countries: Germany, Austria, Switzerland, Benelux. Those were the primary countries selling the Cloud. As the quarter progressed, we got it into kind of Southern Europe, Spain, France, Italy, but not a lot of impact from those countries in the second quarter.
Speaker 1
Okay. Dale, you talked a little bit in terms of the gross margin in the third quarter. From a mix perspective, when you look at what you guys just delivered in terms of gross margin and the mix benefit, should there be much of a change for the rest of the year on mix?
Speaker 5
I mean, there's a slight change because, you know, as we get past the rollout of the Contour, the margin on the Contour is a little better than what it's replacing. You know, the Cloud Lux continues to perform very well. That's the two primary mix drivers that we'll see in the back half. Beyond that, not a huge change in mix.
Speaker 1
Are you seeing any price resistance throughout any portion of the portfolio over the year?
Speaker 5
On the price increases?
Speaker 1
Yeah.
Speaker 4
No, we haven't yet.
Speaker 1
Okay, thanks very much.
Speaker 5
Yep.
Speaker 6
Thank you. Our next question is from Joe Altobello of Oppenheimer. Your line is open.
Speaker 0
Thanks. Good afternoon, guys. First question is just a quick one. We've now fully anniversaried the Cloud launch in the U.S., correct?
Speaker 5
The CloudStream was launched in the fourth quarter of 2009. The Base Cloud was launched in the first quarter of 2010, so it's been fully anniversaried. The Lux, though, was launched late third quarter, early fourth quarter of 2010, so we haven't anniversaried the Lux yet.
Speaker 0
Okay. Perfect. In terms of the pockets of opportunity that I think Mark referred to earlier, I understand he doesn't want to go into too much detail there, but it's sort of a longer-term question. Is that all in bedding, or are there other opportunities for the Somnigroup material, you know, beyond just mattresses and pillows, for example?
Speaker 4
There are opportunities for Somnigroup International material beyond bedding, but frankly, there's enormous opportunities in bedding, and that's where we're focused first. We still have a very small unit share, and we see enormous potential for growth within the bedding industry, and that is where our focus is.
Speaker 0
Okay. Got it. Just one last one. In terms of the new product launch scheduled for 2012, would those be incremental to your existing SKUs, or would they be replacing older lines?
Speaker 4
I'm not going to go into details at this stage.
Speaker 0
Okay. Actually, just one more if I could. You know, most of the growth recently has come from slots or new slots as well as higher-priced products. Your door growth obviously has slowed in recent years. Is there a thought to re-accelerating door growth, or are we going to continue to see additional slots as really the key driver of that?
Speaker 4
If I may, while what you say is true that the slots are growing, we think of it another way. We think of what % of the consumers will be moving over. The reason that the slots grow is because the retailer is justified to carry additional products, additional Somnigroup International products, because an appropriate proportion of their sales come from that range. What that means is we're getting more consumers to buy our products. The question really, the way we think about it, is what proportion or what targets of consumers are we not yet meeting the needs of? I would say that, yes, there's likely to be more slot growth, but I would say that the productivity per slot is still something we're very focused on.
Speaker 0
That's helpful. Thank you.
Speaker 6
Thank you. If you have a question, please press star then one on your touch-tone phone. If you have a question, please press star then one on your touch-tone phone. Our next question is from John Anderson of William Blair. Your line is open.
Speaker 0
Good afternoon. Thanks for taking my questions. I was just wondering if you could refresh my memory on the geographic mix. Are your margins higher outside North America than inside North America? As the international business, presumably, the growth rate accelerates, or we saw it begin to accelerate in the second quarter, does that become a favorable driver of gross margin as well?
Speaker 5
Yeah, John. Just a quick recap. Internationally, our gross margins are higher than they are in the U.S., and operationally, they're, you know, it varies a little bit quarter to quarter, but they're 600 to 800 basis points higher internationally from an operational standpoint. That's driven by two things. Like most consumer product companies, our price is a little bit higher internationally. The other thing that drives that is the products themselves. As we've often said, people in the U.S. like big, thick, fat mattresses. People internationally don't. For even a comparably priced mattress, it might be, it's likely to be thinner in the international markets, therefore less material in it. We have the kind of nice combination there internationally where we've got a little bit higher pricing as well as a little bit lower cost because there's less material in the product.
Yes, as the international business growth rate picks up, obviously, we're still in a position where the U.S. growth rate on a constant currency basis is growing faster. Right now, we're really experiencing negative mix. Should the day come, when the day comes, that the international growth rate starts exceeding the U.S. growth rate, that will be an additional benefit to overall company margin.
Speaker 0
Thanks. That's helpful. Where are you currently in terms of capacity utilization? I think last time I'd heard it in the low 40%. Any update on the progress against the multi-year cost savings or productivity program would be helpful.
Speaker 5
From a capacity standpoint, you know, we're still, I would say, in the mid-40s. I don't have an exact number in front of me, but that seems, feels right based on where we were tracking and the volume growth we've seen. On the overall productivity program, as I said, that's been a key driver of our gross margin growth. The productivity initiatives cover a gamut of areas. It's not just, you know, we're not talking here just labor productivity. We're talking machine productivity. We're talking through productivity. A key driver is yields. You start with a certain poundage of chemicals and how much good product you get out the back. We've made tremendous progress over the last several years in terms of improving yields. It also invokes the whole supply chain in terms of getting more efficient distribution network, in terms of getting more efficient purchasing.
The productivity program has been a tremendous boost to the business from a cost management standpoint and gross margin improvement standpoint, and it's got a long way to go. Originally, it was set up as a four-year program. The program's not ending anytime soon. It's now part of the fabric and framework of the business.
Speaker 0
Okay. On the ergo adjustable base, I think you began some advertising for the first time earlier this year. I think you've garnered some incremental distribution and done some training in store. Are you continuing to see positive progression in terms of the attach rates there? How would you kind of characterize the opportunity there going forward?
Speaker 4
We are, and it is a focus. We did do advertising, and we are focusing on training, particularly for the retail sales, the people who are the sales teams and the retailers. It is paying dividends. Consumers are increasingly buying adjustable bases, our ergo bases with their Somnigroup International beds. It is one of these things where consumers are, as we have very, very high satisfaction rates with consumer satisfaction rates of people who buy our beds. People who buy our beds with an adjustable base have, in fact, even higher satisfaction rates, and they are very satisfied with the bases. These adjustable bases are a very powerful thing for the consumer, but they are also obviously a good thing for the retailers and for us in terms of increasing the value of the customer.
We are focused on it, and it continues to grow, and it is something that has been important in the first half and will continue to be.
Speaker 0
Perfect. One last one, if I could. Mark, I think you mentioned Cloud beginning to roll out in Asia. I just wanted to make sure I heard that right. If there's any color you can provide us there in terms of your update to your China plans, that would be helpful. Thanks.
Speaker 4
Yeah. No, it is. It's rolling out in Asia. It's in Japan, and it's in Australia, and it's in China too. It is rolling out there, and it is doing well. It is as early of a stage as it is in the rest of Europe, but it's so far so good.
Speaker 0
Thank you very much.
Speaker 6
Thank you. Our next question is from Joshua Pollock of Goldman Sachs. Your line is open.
Speaker 0
Hi. My first question is, how much higher are the anticipated margins on your new and redesigned pillows versus the current company average?
Speaker 5
Compared to our current pillows, the new pillows are in the same ballpark as what we currently have on pillows. Pillows are our highest margin product category. It's hard to get much better than that, but they're in the same ballpark as what we currently get on pillows.
Speaker 0
As you guys look at your overall product suite, is there any anticipation that with this new pillow product, pillows as a % of total sales could actually tick up, or is there enough product and pricing changes that from a sales perspective, you guys wouldn't expect much of a change?
Speaker 4
I think pillows are an important thing to us for several reasons. One, because people love our pillows, and two, as Dale said, they're a good, they're a high-margin product. One of the things that's particularly good about pillows is that people who own a Somnigroup International pillow are much more likely to buy a Somnigroup International mattress. We see them as a very good seeding tool from our marketing point of view. We're keen to get the number of people who have Somnigroup International pillows to grow. That is part of what the initiative that we'll be launching in Vegas next week is, to broaden the range, maintain the margins, but broaden the range to appeal to a wider range of people so that we can get, obviously, we can sell more, but also so we can continue to seed people's affiliation with Somnigroup International. It will grow.
It is our expectation that it will grow as a percentage, but I wouldn't see that it's going to change the dynamics of the business on its own. It's not something that's going to change the models in the near term.
Speaker 0
That's very clear. Two more very quick ones. One, on commodity costs in the first half, could you just quantify how much your total commodity cost spend was up first half 2011 versus first half 2010?
Speaker 5
In the first half, commodity costs were up in the mid to upper single digits. On our last call, I said for the year we were expecting it to be up in the low double digits for the full year. Obviously, that's expecting an increase, much higher commodity costs in the back half. As I said earlier, we've seen those commodity costs come in, but we're also hopeful, not expecting, but we will be working diligently to try to improve that since oil has moderated a little bit and seems to have stabilized a little bit.
Speaker 0
Last question. Is there any way you could actually quantify the impact of the product model closeout in the quarter?
Speaker 5
You know, not a lot. There was a minor discount that was shared between us and the retailers, but it wasn't a big impact on the quarter.
Speaker 0
Thank you all.
Speaker 6
Thank you. Our next question is from Keith Hughes of Raymond James. Your line is open.
Speaker 1
Hi. Thank you. Just one question. You were speaking earlier about other product or other areas to address with product. Given your focus internationally, are we going to, in the next several years, see more international-only products, or is it going to be kind of a global approach with what you introduce?
Speaker 4
In general, we are becoming, you know, it is going to be more of a global approach for the simple reason that we want to make sure that our R&D people are focused against things which have the biggest bang for the buck. There are a lot of things that we can and are looking at and pursuing. We're going to put our primary emphasis on those things that have the widest application. That's the first truth. Now, there are, as I said in my comments, the collection in Europe is slightly different than the collection in the U.S. Over time, I anticipate these will become more similar. It is not something we're going to rush to do. Right now, we have good business models, a good range of products in both areas. For the future, in the longer run, I see it becoming more, coming together more.
Speaker 1
One other one. Historically, you've really got down to the low end of the industry in the United States in terms of the price of products. Has that view changed at all?
Speaker 4
Obviously, this is ours from time to time, and we've always said that the premium part of the mattress industry is where we've always focused, and it is still a very big part, and we still have a relatively small share. We see an enormous opportunity in the premium mattress in the U.S., and the same is true in the rest of the world. That hasn't changed.
Speaker 1
Okay. Thank you.
Speaker 6
Thank you. Our next question is from Rob Strauss of Guilford Securities. Your line is open.
Speaker 0
Hi, guys. Congratulations on the quarter. Just a couple of questions here. A lot has been asked already. First, I just want a quick number. On the R&D spend in the quarter, what was that?
Speaker 5
Yeah, I don't have that right in front of me. Hang on. Once I ask your second question, I'll come back to it.
Speaker 0
Okay. That's fine. There was a question earlier asked about the Cloud rollout into Asia. I recall, if correct, your expectations for your Cloud rollout in Europe were a little bit different than that in the U.S. I would ask, what is your Cloud expectation rollout for Asia as compared to your experiences in both now Europe and the U.S.?
Speaker 4
Asia is obviously a very broad thing. Australia, I would say, is essentially similar to the U.S. I mean, it's not exactly, and any Australians on the phone, I apologize. My point is, in broad terms, as a market, our sales in Australia are very comparable in terms of their mix to what they are in America. Japan is obviously a different market. Obviously, a lot of people in Japan sleep on futons to this day. I mean, a very large proportion. Our sales are quite different in Japan, you know, a much greater proportion of pillows and so on. However, the Cloud collection is being well accepted. It's very early, but I see it's doing quite well. In China, it's a bit different. The people there sleep on very different things. The Cloud collection is there and doing okay.
I anticipate at this very early stage that it's not going to be as big of a business there as our base business, but it's too early to say. If you ask me right this minute, that's the perception at this moment.
Speaker 5
On R&D for the quarter, R&D was $2.6 million.
Speaker 0
Thank you. Mark, I guess that leads me to the next question, just to understand Europe a little bit more. When you consider what you're doing behind the scenes in your R&D program, what are you thinking about when it comes to Asia and all of those different consumer preferences that you just described? I guess I'm still thinking primarily product segment-wise, mattresses and pillows, not beyond that.
Speaker 4
As I said to an earlier question, we are obviously focused on those things, given that we have limited resources and we want to focus on the things that have the biggest bang for the buck. We are going to be biased toward things that can be applied broadly across the globe. There are examples of things that we do have on our docket. I don't want to get into detail, which have a particular focus in some areas of the world. From time to time, that may make sense. I think the biggest learning that we've all had over the last few years is that there's more similarity than there is difference. There is more value here in focusing on those things that we can do generally, especially when it comes to developing new technologies, than there is for doing things country-specific.
Speaker 0
I guess one of the previous comments I think that you had stated was regarding some survey work or maybe it was focus groups. Maybe it was in relation to the Cloud rollout in Europe where you said something like what people thought that they liked didn't necessarily come true when they actually purchased a mattress. I think the Cloud has outperformed even your expectations in Europe. When you think about that experience, if I have that right, and you continue to do your focus work and your focus group work and your surveys, how do you then consider how consumers are responding to these surveys if you know there's a little bit of movement in opinion versus what they actually would like?
Speaker 4
It's interesting, you're right, and you did remember right that the fundamental breakdown is if you ask people to use words to describe what they would like. Some people, particularly in the U.S., will say they love a bed that is soft and embracing, that they really feel wrapped around by, almost hugged by. In Europe, people would say, "I don't want a bed like that at all. I want a firm bed." If they're using words, they describe a bed in a way that is what they think they like. If you put a sheet over a bed and ask people to lie on it and say, "Rank that on points out of 10," their scores are very different from what they've said in words. What we increasingly do now with our testing is to not ask people in words.
We conduct extensive research now where we have beds all covered with white sheets, and we have large groups of people testing them and then ranking them on a rating. Then we ask them what they think they like, and try to correlate what people say they think and what they actually like. We're enhancing that by actually getting sensory work done by people who are trained in this, who can systematically describe the difference in how beds feel. It's actually a more complicated problem than you'd have guessed. In any case, it is something we're very dedicated to, and what we are not doing is taking at first blush what people say they prefer.
Speaker 0
Thank you. Just the last question. Regarding the new pillow rollouts that you're going to have at the Las Vegas show, is that rollout going to be kind of stepped through countries, or is that going to sort of go globally and blanket the world?
Speaker 4
Initially, that's going to be a U.S.-focused launch. The thing that we're going to show at Vegas, remember, there are trade shows around the world. The Vegas one is an American one, and this product line is initially focused on the U.S.
Speaker 0
Okay. Perfect. Thank you so much for answering all the questions. Good luck in the future quarters.
Speaker 4
Thank you.
Speaker 5
Thanks.
Speaker 0
Bye.
Speaker 6
Thank you. Our next question is from Joan Storms of Wedbush Securities. Your line is open.
Speaker 2
Hi. Good afternoon. Just a couple of quick questions. On the marketing, obviously, your campaigns in the U.S., you've built upon the Ask Me and then did some work with more specific products, including the Cloud and then the Ergo. I was wondering if you could give us any hints on where the evolution of that marketing campaign may be going or where you may be looking at going forward.
Speaker 4
First of all, we do at this stage intend to evolve that campaign. We like that campaign. It's doing very well for us, and it really captures the core message that we want to communicate, which is that we're encouraging people to ask other people to ask on the web about Somnigroup International because obviously, the recommendations that they'll receive is one of our core assets. We are, in fact, creating new spots, and frankly, I don't want to share them. Forgive me, but I just don't want to share them with you right now. They're going to be tied to some of our focus areas for promotions and so on in the fourth quarter. Forgive me, but I don't want to share them right now.
Speaker 2
Okay. Just a housekeeping question. If you don't have it now, we can talk offline, but on the 200 doors, with most of those being international, can you break down how many you opened in the first half, and then I can figure out the second half?
Speaker 0
Hey, Joan, you heard that slightly differently. I think we opened about 50 in the quarter internationally, and the rest were in the North American segment.
Speaker 2
Oh, so it's 200 in the quarter?
Speaker 0
Yes.
Speaker 2
Okay. Okay. For the year projection?
Speaker 0
Oh, projection. We generally don't give projections on doors, Joan, from a standpoint of because it's so facts and circumstances determined. As Mark mentioned, we're in the process of opening some additional accounts, and we kind of update that on a quarterly basis.
Speaker 2
Okay. Great. Thank you very much, and congratulations.
Speaker 0
Thank you.
Speaker 4
Thanks, Joan.
Speaker 6
Thank you. Our next question is from Eric Alawati of Stephens Inc. Your line is open.
Speaker 0
Dale, can you help us think about growth rates in North America versus international going forward? Is it likely that we could see international segment sales growth in % terms outpace North America by perhaps the end of this year, or how should we think about that?
Speaker 5
At the start of the year, and really, we haven't changed that outlook, we expected in the first for the year, the U.S. would grow faster than international would for the year. We expected the international growth rate to improve and ramp throughout the year because of payback on the marketing investments that we're making and with the launch and rollout of the Cloud as it gets to more and more markets and has more impact. Our expectation was that we would see an increase in growth rate in the international business, but for the year this year, we're looking for the U.S. business to still outgrow the international business. In the future, beyond this year, yeah, we would love to see the international business continue to see a ramp in its growth rate.
We think long-term, the potential is that we could start to see a gradual shift back in terms of balance of revenue. Right now, we're running about 70% U.S. or North America and 30% international. Not too many years ago, it was more two-thirds, one-third. When I came to the company eight years ago, it was almost 50/50. Over the long, long term, we would expect international with some of the market opportunities that are out there in some of the emerging markets to outpace the U.S. business in latter years.
Speaker 0
Great. Thanks very much. Good luck.
Speaker 5
Thanks.
Speaker 6
Thank you. This ends the Q&A portion of today's call. I would like to turn the conference over to the company for any closing remarks.
Speaker 4
Thanks. Thanks, everybody. We look forward to talking with you again in October when we'll review the third quarter. Thanks for joining us this evening.
Speaker 6
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect and have a wonderful day.