Lovesac Co Q2 FY2020 Earnings Call

Greetings. Welcome to Lovesac's Second Quarter Fiscal 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to Rachel Schacter of ICR. Thank you. You may begin.

Thank you. Good morning, everyone. With me on the call is Shawn Nelson, Chief Executive Officer; Jack Krause, President and Chief Operating Officer; and Donna Dellomo, Chief Financial Officer. Before we get started, I would like to remind you that some of the information discussed will include forward-looking statements regarding future events and our future financial performance. These include statements about our future expectations, financial projections and our plans and prospects. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, you should review the Company’s filing with the SEC, which includes today’s press release. You should not rely on our forward-looking statements as predictions of future events. All forward-looking statements that we make on this call are based on assumptions and beliefs as of today and we undertake no obligation to update them except as required by applicable law. Our discussion today will include non-GAAP financial measures including EBITDA and adjusted EBITDA. These non-GAAP measures should be considered in addition to and not as a substitute for, or in isolation from our GAAP results. A reconciliation of the most directly comparable GAAP financial measures to such non-GAAP financial measures has been provided as supplemental financial information in our press release. Now, I’d like to turn the call over to Shawn Nelson, Chief Executive Officer of The Lovesac Company.

Thanks, Rachel. Good morning, everybody, and thanks for joining us today. I will begin today’s call by discussing the financial and operational highlights of our second quarter results, after which I’ll briefly review our high-level thoughts around our outlook and provide an update on our tariff mitigation efforts. Then, Jack Krause, our President and COO, will outline the progress we are making on our key growth initiatives, including details on an exciting new shop-in-shop program that is launching in Q3. Finally, Donna Dellomo, our CFO, will review our financial results and a few items related to our outlook in more detail. We feel great about our second quarter financial results. Net sales increased by almost 45% to $48.1 million. Total comparable sales, which include same showroom and internet sales, increased 40.7%, driven by a strong showroom comp increase of 31.8% and significant growth in our internet business of 71.5%. In Q2, we again saw our comp growth driven by both transactions and ticket growth as our digital marketing strategies and multi-channel model allow us to draw new customers to the brands while also driving repeat purchase behavior. Adjusted EBITDA was a loss of $3.3 million for the second quarter. Operationally, we made good progress against our strategic priorities in the second quarter. A few highlights are: One, we continue to lean into marketing, including a successful Memorial Day campaign to increase brand awareness and drive sales, which is reflected in our almost 45% topline growth for the quarter; two, we made strategic investments in our infrastructure to improve the overall customer shopping experience and position us for continued success as we scale the business including expanded capacity and increased accuracy of customer delivery; three, we opened two new and remodeled three showrooms during the quarter as we continue to increase our showroom presence; four, we enjoyed strong results from our pop-up shop business with Costco and given our continued success during the quarter, we were given the opportunity to run an 18-day event on costco.com, which emulates the in-store pop-up shop partnership online. We had very encouraging results from these initial online events and have plans for another two online roadshows with Costco for later this year. In addition to our pop-up shop business with Costco, we continue to foster new relationships with other retailers, and we are very excited to announce today our new partnership with Macy’s to pilot four permanent shop-in-shop test locations. Not only will it increase our brand awareness and drive customer acquisition, but it is also a testament to the existing strength and appeal of our small but rapidly growing brand and innovative product line. Jack will discuss our second quarter operational progress and expand on the details of this exciting new partnership in just a moment. As it relates to our outlook, given our strong Q2 financial performance, our marketing, and other plans for the remainder of the year, we are reiterating today our fiscal 2020 annual revenue guidance of 40% to 45% sales growth. We are also reiterating our expectations for positive adjusted EBITDA for fiscal 2020. We are very pleased to be in a position to reiterate our full-year adjusted EBITDA outlook, despite increased tariffs, which is a testament to the tremendous progress we have made with tariff mitigation actions. To start, I could not be more proud of our teams for their efforts and dedication to mitigating the impact of these special tariffs and optimizing our supply chain. Our focus on optimizing our supply chain is threefold. Number one, swiftly relocating manufacturing out of China; two, negotiating aggressive vendor discounts; and three, assortment, promotional shifts, and surgical price adjustments that have shown zero negative impact on sales to date. First, in terms of relocating manufacturing outside of China, we have already successfully moved the majority of our Sactionals manufacturing to Vietnam and also Malaysia for redundancy. Sactionals without covers currently represent approximately 57% of our overall sales based on costs. The remaining portion of our Sactional production will have moved entirely out of China by the end of Q2 next year. A long-term Chinese manufacturing partner of ours is currently in construction on a new purpose-built, highly automated Sactionals factory located in Vietnam to support our continued rapid growth along with co-located cut and sew facilities for both Sac and Sactionals covers. Based on our success thus far, we are confident that we will make progress this year toward resourcing the balance of our Sac and Sactionals covers at a similarly rapid pace and expect to have only a small percentage of our covers manufactured in China by the end of Q2 next year. These expeditious production moves will eliminate our exposure to special tariffs and also result in lower first costs for these goods, even versus their pre-tariff levels, which you will see starting to flow through our P&L with the turnover of the associated inventories throughout next year. Second, regarding vendor discounts, the minority piece of our Sactionals manufacturing that remains in China today has been discounted by our manufacturer to a cost that offsets most of the effect of the recently announced tariffs increase from 25% to 30%. Our cut-and-sewn covers for Sac and Sactionals and various accessories like throw pillows and blankets still manufactured in China are all subject to List 1 through 4 tariffs, and we have recently achieved aggressive vendor discounts on all of these items as well to carry us through the near term as we transition nearly everything out of China. We are particularly grateful to our vendors for their support in this area. They have been collaborative partners, and most of them are moving their operations with us out of China to various other countries in the region to retain our business, save on costs, and diversify our overall supply chain risk. As a result of this work, we are pleased to share that as of this month, only 44% of our total goods are now manufactured in China, down from approximately 75% at the end of last year. And we expect this number to continue to fall by year-end by a few more points, heading toward zero before the end of next fiscal year if tariffs are not lifted. It is because of all this swift execution and sourcing coupled with surgical assortment and pricing adjustments and disciplined expense management that we expect to deliver positive adjusted EBITDA, even with all of the recent tariff elevations and additions and our growth. Essentially, by the second half of next year, we project that the majority of our products will be coming in at lower costs than they were a year ago, and our supply chain will be far more robust and diverse. This year, we expect gross margins to decline temporarily by 320 to 350 basis points for the full year versus last year. However, with our newly well-diversified supply chain and the lower corresponding ongoing product costs, we expect to return our run rate gross margins to the mid-50% range by the second half of next year. Because of our exhibited pricing power, strong value proposition, collaborative manufacturing partners, and relentless innovation machine, we are confident that we can maintain these best-in-class gross margins over the long term. Finally, speaking of innovation, we are excited by the launch of the new Sactionals Power Hub this month. It is our first foray into electronics and it opens the door into numerous new technology innovation opportunities ahead for this brand. The concept is patented, and we believe it will not only drive repeat business, increased basket size, and our average order value, but more importantly, because it’s reverse compatible with all the Sactionals pieces we’ve ever sold, it reinforces our unique commitment to our Designed for Life ethos in the eyes of our loyal customers. Sactionals are a platform that is designed to grow and evolve allowing customers to add to it or upgrade it throughout their own lifetime, even in ways they could not have imagined when they originally bought the product. Every Sactionals piece that we have ever sold over these many years already has the receiver hole embedded in it just waiting for this Power Hub, and maybe other inventions as well that are yet to come. We believe that over the long term, this will result in customer satisfaction and brand loyalty levels that will be unprecedented in the competitive landscape. So, in summary, I’m very pleased with our financial and operational progress throughout the quarter. As we look to the second half of this year, we will continue to focus on executing against our strategic initiatives and leveraging our distinct competitive advantages to realize the significant growth potential that exists for Lovesac. Before I turn the call over to Jack, I want to again thank all of our team members for the great job that they do day-in and day-out. Their hard work is driving rapid growth, and we look forward to building on this performance as we move into the second half of the year. From our standpoint, it’s simple. As I hope we’ve demonstrated across the four quarters we reported since becoming a public company, we’re going to keep delivering high sales growth while maintaining positive adjusted EBITDA on an annual basis. External challenges notwithstanding, we are very confident in our ability to deliver on our near and long-term goals and look forward to updating you on our progress. I will now turn the call over to Jack, our President and COO, to go over our key priorities for the remainder of this year.

Thank you, Shawn, and good morning, everyone. As Shawn said, we’re pleased with our second quarter results. We delivered strong financial performance and continued to execute against our key growth initiatives. I’ll now review some of the operational highlights and discuss our plans for the remainder of the year. Starting with expanding our marketing efforts to increase brand awareness and drive sales. Our second quarter top line results are a testament to the continued effectiveness of our marketing strategies. For the quarter, we achieved overall comparable sales growth of 40.7%, driven by web comps of 71.5% and showrooms at 31.8%. Overall, Memorial Day marketing ROI finished very strong, as indicated by our sales performance. The Memorial Day pre-tentpole TV campaign test market saw a strong lift in weekly sales averages versus their pre-twelve-week sales average, increasing both sales and program ROIs. Given these encouraging results, we scaled the test to 11 markets for Labor Day, and subject to continued positive results, we will look to scale this nationally in the fourth quarter of this year. In terms of digital media advertising, the six-week Pinterest test campaign during Memorial Day proved to be an efficient driver of brand awareness and site traffic with over 360,000 clicks to the site at a very favorable CPC or cost per click. We also saw great engagement within the platform with almost a 30-time increase in monthly viewers and an over 30x increase in monthly engagers. Overall, we’ll continue to test increased digital marketing in the second half, as we continue to see increased ROIs as a result of the synergy with TV advertising. We will look at new efficient marketing strategies to drive the business as we look towards the fourth quarter. Importantly, many of the marketing initiatives we have successfully tested so far this year to drive sales will be leveraged the most heavily in the fourth quarter. Next, we’re expanding and improving our showroom presence. We opened two new showrooms and remodeled three in the quarter, ending the quarter with a total of 80 showrooms and approximately 70 of our locations having been remodeled to the current rebranded showroom design. We remain on track to open 17 new showrooms in fiscal 2020 including showrooms in 12 new markets and improving our penetration in 5 markets. Turning to our pop-up shops. In the second quarter of fiscal 2020, we operated 209 pop-up shops with Costco, up from 137 in the second quarter last year, which drove a 40.9% increase in our other channel sales to $7.4 million. Pop-up productivity increased 5.1% in the quarter. As discussed on previous calls, pop-up shops have been a contributor to our growth over the past 24 months. Last year, our 10-day road shows with Costco delivered $1 per square foot productivity, multiples higher than even our own showrooms, driving over $19 million in net sales, which was over a 300% year-over-year growth. In addition, we believe these pop-up shops drive additional revenue on our website, both during and post show. We continue to believe that the pop-up shop format allows us to capitalize on customer acquisition opportunities in high-traffic locations by showcasing a limited offering of our products in the areas where we don’t necessarily have a showroom presence, introducing our brand and unique product attributes to a wider market. Due to the success of our road shows, we worked with Costco to bring an 18-day event to costco.com, providing Lovesac with nationwide coverage. This event ran in July, and the results were very encouraging. The dotcom event generated nearly $750,000 in sales in 18 days. Due to the success, we’ve scheduled another two events for the balance of the year. We’ve also been exploring more permanent shop-in-shop opportunities to deploy a similar concept with other retailers and are very pleased to announce that we have officially entered into a partnership with Macy’s to pilot a test of shop-in-shop in four highly attractive Macy’s locations in Q3 of this year. The locations include their Herald Square flagship store in New York City, as well as Carle Place Furniture Gallery in Long Island, Del Amo Fashion Center in LA County, and Lenox Square in the Buckhead District of Atlanta. Macy’s is a logical choice for us as they have demonstrated the ability to be a leader in bringing innovation to the retail furniture space. We have had tremendous success with pop-up shops outside of our own channels and look forward to establishing additional reach for the Lovesac brand with Macy’s as we expand the Lovesac shop-in-shop presence in an agile and efficient manner. Unlike the Costco road shows, which are 10-day shows in pop-up locations, the Macy’s test will be launching permanent asset-light shop-in-shops in key Macy’s locations. We know that experiencing the Sactionals demo is extremely important to many customers’ shopping journeys, and through this partnership, we will be able to deliver more demos to a broader audience and accelerate the adoption of the Sactionals platform. We believe the Macy’s brand and customer profile is a great fit with the Lovesac brand and look forward to kicking this pilot off in Q3, with the majority of the sales impact expected in Q4. These shop-in-shops will be designed to be permanent locations carrying the same digital technology of our showrooms and will be staffed by Lovesac employees under the direct supervision of our sales operation team. Because these will be run like our own showrooms, we expect margin rates and contribution to be similar to our freestanding showrooms, but with significantly less CapEx investment, less than a third of our current CapEx per showroom. The current plan is to test these four initial locations for at least the full year prior to expansion. And we will continue to update you on test details, performance, and potential expansion plans as that information becomes available. Finally, as part of our continued investment in our team in support of our substantial future growth, we’re very excited to announce the appointment of Tom Lee as our Chief Supply Chain Officer, effective September 9th. Tom is a seasoned supply chain and merchandising executive, and most recently served as SVP, Chief Supply Chain Officer at SpartanNash. Before that, he spent years at Walmart and Office Depot in both senior supply chain and merchandising roles. We’re very excited to have him on board and look forward to benefiting from his expertise as we continue to develop a world-class supply chain that delivers an unparalleled customer experience. This important addition positions the business well for continued success. So, in summary, we’re pleased with our second quarter results and the operational progress made on our strategic priorities, including all of the tariff mitigation work that Shawn went over. As we look to the remainder of the year, we’ll continue to focus on growing the business and strategically investing in our infrastructure and technology to position the business for long-term growth. Donna will discuss our guidance in further detail. But, as we look ahead, we continue to be confident in the drivers of our business, which we will see the greatest impact in Q4, including the new business opportunities I just discussed with Costco and Macy’s, the marketing plans with the proven highest effectiveness and year-over-year spend increases in Q4, as well as increased showroom openings along with the launch of the Power Hub that Shawn discussed. And with that, for a more detailed review of our second quarter results, as well as a few items related to our outlook, I will now turn the call over to Donna Dellomo, our Chief Financial Officer.

Thank you, Jack. Good morning, everyone. I will begin my remarks with the review of our second quarter results and then provide some commentary around our thoughts for fiscal 2020. Total net sales increased 44.8% to $48.1 million from $33.2 million in the prior year quarter. This sales growth was driven by strong showroom, internet, and pop-up shop performance with both transaction and ticket growth resulting from successful advertising and marketing strategies, which drew new customers to the brand while also driving repeat purchase behavior. An increase in the number of showrooms also helped fuel our Q2 sales performance. Comparable sales, which include showroom and internet sales, increased 40.7%. Comparable showroom sales increased 31.8% and represent our 11th consecutive quarter of positive comp showroom sales increases. We opened two new showrooms and ended the quarter with 80 showrooms. Looking at our results by channel for the second quarter, showroom sales increased 35.8% to $31.3 million, internet sales increased 71.5% to $9.5 million, and our other channel, which includes our pop-up shops in Costco locations, increased 57.7% to $7.4 million. By product category, our Sactionals sales increased 51.5%, our Sac sales increased 35%, and our other category sales, which include decorative pillows, blankets, and other accessories, decreased to $200,000 from $800,000 in the second quarter as compared to the prior year quarter. Gross profit dollars increased 36.1% to $24.3 million in the second quarter. As expected, gross margin percentage decreased by 320 basis points to 50.4% from 53.6% reported in the same period last year. This year-over-year decline was primarily driven by the 10% tariff impact, partially offset by reduced costs of our Sactionals and Sac products, primarily related to cost savings from a change in the sourcing of our Lovesoft and down blend fills and an ongoing shift of our manufacturing to Vietnam and other countries outside of China. For the second quarter, total SG&A, excluding advertising and marketing expense, increased 7.3% to $22 million from $20.5 million in the second quarter of last year. Excluding approximately $300,000 of other non-recurring expenses, total SG&A increased to $21.7 million. The increase in SG&A was driven largely by variable expenses related to the increase in sales, as well as higher employment costs and rent, which were partially offset by a decrease in overhead expenses and equity compensation, as detailed in our press release. As a percentage of sales, total SG&A expense decreased by 15.9%, driven largely by decreases in stock compensation and IPO-related expenses as described above. Our investments in advertising and marketing which benefit extended periods increased $2.5 million or 68.8% over Q2 last year. As a percentage of sales, advertising and marketing expenses increased 180 basis points to 12.6% this quarter, largely due to an increase in advertising related to Memorial Day, which had a very positive ROI. Depreciation and amortization increased $447,000 from the prior year period to $1.2 million, principally related to capital investments for new and remodeled showrooms. In the second quarter of fiscal 2020, operating loss was $4.9 million compared to an operating loss of $7 million in the second quarter of last year. In the second quarter of fiscal 2020, the adjusted operating loss was $4.6 million, excluding approximately $300,000 of non-recurring expenses. In the second quarter of fiscal 2019, the adjusted operating loss was $5.7 million, excluding approximately $1.3 million of non-recurring expenses. Net interest income was $169,000, which relates to the impact of our IPO and other primary share financing. Tax expense in the second quarter of fiscal 2020 and 2019 was less than $10,000 and is related to minimum state income tax liabilities. Before we turn our attention to net income, net income per share, and EBITDA, I would like to point out that my discussion of these metrics will focus on net income and net income per share adjusted for the IPO and other financing costs, as well as adjusted EBITDA. Please refer to the terminology and reconciliation between each of our adjusted metrics and their most directly comparable GAAP measurements in our earnings release issued earlier today. Adjusted net loss was $4.5 million in the second quarter of fiscal 2020, compared to an adjusted net loss of $5.7 million in the second quarter of fiscal 2019. Net loss per share adjusted for the IPO and financing costs was $0.31 in the second quarter of fiscal 2020 and $0.63 in the second quarter of fiscal 2019. Adjusted EBITDA was a loss of $3.3 million, as compared to a loss of $2 million in the second quarter of last year. Turning to our balance sheet, we ended the quarter with $44.2 million in cash and cash equivalents. Ending inventory increased 101% year-over-year, driven by higher sales, as well as an increased investment in the weeks of supply of inventory on hand to support sales growth across all channels to be agile enough to support the success of our advertising and marketing investments, and includes an increase in capitalized freight and warehousing costs relative to the build of inventory and tariff charges. Now, I would like to discuss a few items as it relates to our fiscal 2020 outlook. From a showroom perspective, for the full fiscal year 2020, we are on track to open 17 new showrooms this year with 11 showroom openings in the second half of fiscal 2020 and continue to expect to remodel 8. We are now referring to our Costco road shows as pop-up shops and our Macy’s pilot as shop-in-shops, given the nature of the shop setup. As mentioned for fiscal 2020, we will operate three Costco online road shows in addition to our in-store pop-up shops with Costco, as well as four pilot shop-in-shops with Macy’s. We continue to expect to deliver strong levels of sales growth between 40% to 45% in full fiscal 2020. However, we do expect Q3 revenue to be below the low end of our annual growth target with growth of approximately 30%, while Q4 is expected to be significantly above the high end of this annual range. This expected cadence is due to the following items. We expect to see a deceleration in total comp sales in Q3 with Q3 comps expected to be slightly ahead of Q3 total sales growth with a significant increase in total comp sales in Q4. However, it is important to point out that Q3 total comps on a two-year basis are projected to be in line with Q2 of fiscal 2020. Normal seasonality of the business with Q4 being our largest volume quarter, the cadence of planned investments in marketing and advertising with investments in working media strategically being made late in Q3, which have greater ROIs and greater impact on Q4 sales growth. In addition, total showroom revenue will be impacted by the timing and the number of new showroom openings during Q3 and Q4, which this fiscal is weighted more heavily in Q4 than Q3. The number of Costco pop-up shops continued to increase over the prior year with the most significant increase in the number of pop-up shops happening in the first half of fiscal 2020 as compared to the prior year. Second half 2020 Costco pop-up shops are projected to be as revenue productive as those in the first half of fiscal 2020. The new initiatives that Jack mentioned to include Costco.com roadshows and the four new Macy's pilot shop-in-shops will have the greatest amount of fiscal 2020 impact on Q4 revenues. Consistent with the just discussed expected sales growth cadence, we expect a larger Q3 adjusted EBITDA loss than we reported in Q2, followed by a substantial improvement in Q4. Given the significant tariff mitigation process we've made, as Shawn discussed, we continue to expect to generate positive adjusted EBITDA for fiscal 2020. We expect full-year gross margins for fiscal 2020 to be approximately 320 to 350 basis points lower than fiscal 2019, principally related to the following: Expected tariff pressure, which is being offset by mitigation actions and SG&A initiatives; investments into our distribution infrastructure to support future growth; a slight headwind due to the continued shift in product mix towards Sactionals, as well as slight impacts from prior pop-up shop channel mix sales. These decreases are partially offset by product margin gains relating to changes in discounting and promotional strategies, reduced product costs related to vendor sourcing strategy, and vendor rebates, as well as an accelerated shift of sourcing outside China. In terms of SG&A, excluding advertising and marketing expense, as previously mentioned, we expect the most significant SG&A leverage to be generated in Q4, given the seasonality of our business. As a reminder, embedded in our SG&A outlook are all of the investments we are making in the business across people, processes, and infrastructure, and our Q4 net sales volumes enable us to produce the greatest amount of leverage on these investments over the prior year. So, in summary, while we continue to expect quarterly fluctuations due to the timing of our tariff mitigation efforts, our advertising and marketing investments, and investments across all areas of the business to support the significant growth opportunity we have, we anticipate that we will again deliver a high sales growth rate and will generate a positive adjusted EBITDA in fiscal 2020. Finally, as it relates to capital expenditures, we now expect to incur approximately $11.5 million of CapEx in fiscal 2020 versus our prior guidance of approximately $13 million, due to a timing shift of investments of the Sac manufacturing CapEx to fiscal 2021. The vast majority of our CapEx will be spent on the opening of 17 showrooms, the remodel of approximately 8 legacy stores, the opening of 4 Macy's shop-in-shop pilot locations, and approximately $1.3 million being invested into the Sac manufacturing facility this fiscal. The remaining spend is being allocated to technology in our showrooms, inventory management and logistics systems, e-commerce platform enhancements, and for headquarters data and support systems. For all other details related to our results, please refer to our earnings press release. With that, we would like to turn the call back to the operator who can open it up for questions.

Thank you. Our first question is from Dave King with ROTH Capital Partners. Please proceed.

Thanks. Good morning, everyone. I guess, maybe first off, what's driving the confidence in the Q4 growth versus the Q3 guidance you laid out? It sounds like some of that's Macy’s, but what are you anticipating from a two-year comp perspective versus what you had in Q2 and what you’re expecting for Q3, and what's driving that?

Yes, we believe that the two-year comparisons will remain fairly consistent throughout the year. We are certainly facing tougher comparisons, but we are confident in this outlook. It can be challenging to assess total marketing spend quarter-over-quarter. However, the influence of our working marketing, which begins in Q3 and extends into Q4, will have the most significant impact in Q4 with year-over-year working media spending increasing by over 60%. In contrast, the effect of Q3 media spending was roughly flat compared to a year ago, which will lead to a notable acceleration in comparable sales.

Okay. That helps. And so, I know it's a little bit early on that front, but can you talk about the initial performance of the expanded regional media runs you had prior to Labor Day? Are the ROIs increasing, any early learnings so far?

Yes. The expansion of the pre-tentpole events is demonstrating increases in ROI and run rate. We believe it will be part of the Q4 program. I need to finalize our analysis of the Labor Day media in the next couple of weeks and incorporate it into the finalized Q4 program.

Our next question is from Brian Nagel with Oppenheimer and Company. Please proceed.

Nice quarter. The first question I want to ask, and I apologize, Donna, when you were laying out the guidance for sales, Q3 and Q4, I maybe just missed it. Could you remind or reiterate what the sales guidance for the third and fourth quarter is and the components of that?

Yes. We expect total sales to increase about 30% year-over-year, with a substantial rise in the fourth quarter. We are still aiming for our annual guidance of 40% to 45%. While we haven't provided specific guidance for Q4, we anticipate it will be significantly above the upper end of our annual guidance range.

Understood. We can explain that considering a missing element. The main reason for the fluctuations is primarily due to one, a more challenging comparison, and two, the timing of our marketing investment.

Yes. There are two things. So, you're right. So, I'll confirm that comment. And it's really broken into two things. So, you have on a comp basis, I just explained that we’re dramatically increasing our marketing, relatively speaking our working marketing in the fourth quarter relative to the third, and we believe we'll get significantly higher lift. The other component of that is just initiatives. So, for example, in the fourth quarter, we’ll have a dramatic increase in new showroom openings versus the third. The third quarter was really our lowest rate of new showroom openings we had in the last several quarters. And in the fourth quarter, we’ll also get the results of the Macy's shop-in-shop rollout as well as the two additional Costco shows we mentioned. So, those will have an incremental effect. So, we have some comp effects as well as just new business initiatives kicking in, in the fourth quarter.

Got it. I have another question regarding gross margins. You've clearly made significant efforts to address the tariffs, and congratulations on that. As we examine the decline in gross margins in the second quarter, could you break down the 330 basis points year-over-year drop? I'm interested in how much of this is due to investment or one-time factors related to dealing with tariffs compared to what might be considered a new baseline rate going forward.

Yes. The guidance we provided remains consistent, indicating that approximately 75% of the decline in margin year-over-year is due to tariff pressures. The remaining 25% is attributed to initiatives such as opening multiple warehouses, investing in infrastructure, rising FedEx costs, and increases in inventory levels. However, at least 75% of the decline is linked to the impact of tariffs.

My final question is about Macy's. Given that it's very early in the process, how should we view the Macy's initiative in relation to one of your own showrooms? What are the economics like for a Macy's location within a showroom? Additionally, are you in discussions with Costco and Macy's about potential retail partnerships in the near future?

Yes, that's a good question. I think you're right in noting that Macy's is more similar to our own showrooms since it operates with a lighter asset model. We anticipate that the capital expenditure for Macy's will be less than a third of what it typically costs for a normal showroom. We expect to aim for returns similar to those we seek in our showrooms. If you analyze the capital expenditure this way, you could estimate that the ongoing costs for a Macy's shop-in-shop will be approximately 30% to 50% of a standard showroom. Of course, there are notable exceptions, such as Herald Square, which presents a significant opportunity, and we will evaluate that separately. However, it's still early in the process. The best approach is to examine the financials and investments we are making, and model your expectations accordingly, as we are primarily in the testing phase right now.

Thank you.

Our next question is from Thomas Forte with D.A. Davidson. Please proceed.

Great. Thanks for taking my question. I had a couple follow-ups on Macy's. So, the first question I had is, and I know Jack touched on this a little. But, why Macy’s? Do you feel like they have a similar core customer base, just in general? And then, how should we think about the economics of the Macy's versus Costco? And then, refining that last question. So, if this pilot results in more shop-in-shops in Macy's, would you then limit adjacent showroom locations near those shop-in-shops?

Good questions. So, regarding why Macy's, we see this as a collaboration with their top stores. Looking at the top 100 and 50 Macy's, we notice many shared attributes with our customers. Macy's is a major player in the furniture market, selling hundreds of millions of dollars worth of products. This presents a great opportunity for furniture shoppers with similar characteristics to experience our products, especially in top-performing Macy's stores where they are doing innovative things. We believe this will be a valuable partnership. In terms of operations, these locations will function more like showrooms, staffed by our employees and managed through our systems. We are essentially paying a rent to be located in these stores, and we anticipate that the contributions from these locations will be significantly higher than what we've experienced with the Costco pop-up shops due to the different management approach.

And then, adjacencies for other showrooms, would you not fill the showrooms within a close proximity to Macy’s shop-in-shop?

Yes, a little bit of insight into that. So, the way we're running the Macy's test, the reason we ran those four is for some interesting test parameters. So, for example, Herald Square is very close to our Flatiron District showroom. So, we'll look at what happens between showrooms that are left within a mile apart. We'll also have a test which has a showroom in the same mall as the Macy's, and we'll have that opportunity to see what happens there. So, really at this point, the primary purpose of this test is to understand the dynamics and then to start laying out a plan in terms of how we maximize our penetration at the most efficient way and also do it in a win-win way with our Macy's partners.

Our next question is from Alex Fuhrman with Craig-Hallum. Please proceed.

Thank you for taking my question, and congratulations on another strong quarter. I wanted to touch on a couple of things. It seems you have made significant progress in relocating your production out of China, and you have a clear path to being completely out. Compared to the last conference call, it appears this has moved much faster and better than anticipated. Could you share what is driving this progress? It seems your vendors have been very supportive. Has there been more buy-in and capital commitment from your vendors than you expected? I'm curious about how you've been able to accelerate this process so effectively.

Yes, great question. We have been moving very rapidly and we intend to continue moving rapidly. I don't believe that we ever intended to go slow. I just don't think we gave specific guidance on how fast we thought we could do it. I think, everything's moving according to our plan, and it's exactly that. Our current suppliers have been very supportive, and in most cases, as I described, are investing themselves in other countries outside of China, Malaysia, Vietnam, and even some others that are coming up. Meanwhile, for the goods that are left behind still, they're offering us heavy discounts to keep that business and kind of get through the tunnel with their lights on so that they can support us on the other side outside of China. And I think it's just a confluence of things going well, things going according to plan, and our ability to execute, which obviously in the public markets, we're only a year out. I think it's a matter of those watching Lovesac getting familiar with how we operate.

I have a few questions regarding the Macy's partnership. This seems like a significant opportunity, especially compared to Costco. Given that Macy's is a major furniture retailer on its own, I'm interested to know if you have any insights from your negotiations with Macy's about where your shop-in-shops will be placed in their stores. Will they be located in the furniture sections, or will some be near other furniture brands and others in different areas? I'm also curious about the staffing; if it's going to be your own employees, can we assume that you will have access to all customer data and maintain control over the customer relationship?

Great questions. Yes, our team works closely with the Macy's organization, which operates with independent store management, so negotiations are done on a store-by-store basis. We conduct walkthroughs with their teams in every store. Macy's believes that this type of relationship is essential, and they're placing us in strategic locations. We've visited the stores with them and are pleased with the situations we've identified, which are primarily strong locations. Interestingly, many of the stores we're testing are not even located in the furniture section. This is part of our learning process to determine what works best. I anticipate that we will have answers to some of your questions regarding effective adjacencies, the successful parts of our model, and any specific attributes of certain Macy's stores that could help us accelerate our progress. Our goal is to gather this information so that in our next discussion, we can present answers and outline an execution plan. Thank you for your questions, and we will keep you updated.

Great. Thanks very much for that. And then, lastly, your marketing has, of course, been very successful over the last couple of years and TV seems to have played a nice role in that. It looks like up until the last couple of months, it’s basically been different versions of the same TV commercial, and then you came out with a different creative a few months ago. Can you talk a little bit about how you’ve seen a lift from that new TV creative, or was there maybe something kind of a magic formula in the last commercial? Just kind of curious, now that you've got your second commercial out there in the market, what type of response you've seen from that?

Yes. Good question. I would say that we were very careful obviously because we had such a successful creative execution as we started with this new execution. We tested these quantitatively and the new ones tested equal to or better than the old one across the board. We also can tell you that initial results on the new television are showing that it's driving traffic at levels that we expect it to drive at historically. Now, other than that, I think you start to get into a whole media mix discussion, which I can't get into because we still don't have the total results for the Labor Day media run, which is still being analyzed. So, we'll probably have a lot more information for you in the next quarter about that. But, we're feeling very good about the creative overall.

Next, we have a follow-up question from Thomas Forte with D.A. Davidson. Please proceed.

Great, thanks. So, an investor asked me to ask the following question. They are really impressed with your comments on your gross margin outlook for next year returning to the mid-50s. Can you once again discuss what are the inputs that will drive that strong gross margin performance next year?

Yes. I mean, the pressure on the business has been largely tariffs, as Donna has spoken to. We have a few other outside pieces, be it freight or pressures in the supply chain, logistics, et cetera, that are small, and Donna can touch on that. But, the vast majority has been tariffs. So, as we mitigate those tariffs, primarily through exiting China, not only are we then tariffs-free, at least special tariff-free, but we also, as I mentioned, are getting lower first costs in these outside countries. We were operating in the mid-50s range on gross margins and we expect to get right back to that as that product flows through our supply chain. So, it’ll be the second half of next year before on a run rate basis we begin to see that return to those levels. Because it's a run rate basis, it may take even longer to flow to the P&L. But we feel very good about our ability to get back there and our ability to maintain that on the go forward. And I don't know, Donna, if you have anything else to add?

Yes. I mean, really, the major component is the tariff, some investments into infrastructure, which we will still continue to see through next year. I think we'll start to see less of an impact on the shift to the pop-up shops and Sactionals. I think we're seeing the greatest amount of that shift happening now. So, when that all starts to level itself out, as Shawn has mentioned, we'll start to see on a run rate, right, start to see those margins elevate. We don't expect the full year to come in at that, but we'll start to see the quarters in the second half start to elevate to the higher mid-50% range.

Yes. And just to add a note beyond that, I think it's important to state that we've just hired Tom Lee as our Chief Supply Chain Officer. I think in the next 18 to 24 months, we'll really be working on combining that supply chain and the logistics aspects into a value chain that allows us to start leveraging other areas. So, I think we've only just begun to really get efficient as a company. We'll be catching up with that growth in the next 18 to 24 months, outside of the whole tariffs issue.

We have reached the end of our question-and-answer session. I would like to turn the call back to management for closing remarks.

Thanks very much for your support as investors. We appreciate all the questions and encourage you to continue to keep an eye on us as we grow.

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.