Purple Innovation, Inc. Q3 FY2022 Earnings Call

Good afternoon, everyone. Welcome to the Purple Innovation Third Quarter 2022 Earnings Conference Call. It is now my pleasure to introduce your host, Cody McAlester of ICR. Please proceed.

Thank you for joining Purple Innovation’s third quarter 2021 earnings call. A copy of our earnings press release is available on the Investor Relations section of Purple’s website at www.purple.com. I would like to remind you that certain statements we will make in this presentation are forward-looking statements. These forward-looking statements reflect Purple Innovation’s judgment and analysis only as of today and actual results may differ materially from current expectations based on a number of factors affecting the company’s business. Accordingly, you should not place undue reliance on these forward-looking statements. For a more thorough discussion of the risks and uncertainties associated with the forward-looking statements to be made in this conference call and webcast, we refer you to the disclaimer regarding forward-looking statements included in our third quarter 2022 earnings release which was furnished to the SEC today on Form 8-K, as well as our filings with the SEC referenced in that disclaimer. We do not undertake any obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. Today’s presentation will include reference to non-GAAP financial measures such as EBITDA, adjusted EBITDA, adjusted net income and adjusted earnings per share. A reconciliation of these non-GAAP financial measures to the most comparable GAAP financial measures is available within the earnings release which can be found on our website. With that, I’ll turn the call over to Rob DeMartini, Purple Innovation’s Chief Executive Officer.

Thank you, Cody, and good afternoon, everyone. With me on the call today is Bennett Nussbaum, Purple's Chief Financial Officer. As you saw from our earnings release issued earlier today, our improvement in profitability on both a year-over-year and quarter-over-quarter basis further accelerated in the third quarter. Adjusted EBITDA of $12.1 million represents a significant improvement compared to $0.6 million in the year-ago period and a loss of $0.3 million in the second quarter of this year. In fact, when compared to pre-pandemic 2019 levels, we out-earned three of the four quarters from last year on an adjusted EBITDA basis this quarter, demonstrating the progress we've made in stabilizing and now improving margins and earnings. This performance is a direct result of the hard work we've done managing costs through manufacturing and supply chain efficiencies, along with rightsizing our organizational overhead and marketing spend to align with the current demand environment. I'm pleased that we're building momentum with our operating initiatives and continue to forge a stronger financial foundation for the company. While the improvement in profitability has been clear, sustained macroeconomic headwinds again muted revenue growth this quarter. Like the rest of the sleep industry, we continue to face a shift in demand away from home-related categories at a time when inflation is also pressuring consumer discretionary spending. We've seen estimates that domestic mattress volumes are down 20% to 25% year-to-date. Purple has experienced a similar pullback over the first nine months of the year in addition to a shift in consumer spending habits from online, a position of strength for Purple, to in-store where we're still in the earlier stages of developing our capabilities. Bennett will review the numbers in more detail in a moment but from a channel perspective, e-commerce revenue was nearly flat to the previous quarter on significantly lower ad spend which is encouraging and gives me confidence in the work we've done, both on our ad spend efficiency and our brand messaging. Showroom performance also improved sequentially, primarily driven by the addition of 11 new showrooms opened during the quarter plus the Intellibed showroom bringing our total showroom door count to 52 at the end of Q3. Wholesale revenue was flat to the third quarter last year, although down modestly quarter-over-quarter and inclusive of a very small contribution from our recent acquisition. Our wholesale business is certainly experiencing the category headwinds but we're encouraged by the performance improvements we're seeing with some of our partners. When we work together on presentation and full-line distribution, we're seeing encouraging results that are outpacing the impact of the category softness. We will discuss in more detail later but we are beginning to execute a strategy with our wholesale partners that we believe will be game-changing for the gel category and for the category as a whole. Despite current industry headwinds, we're optimistic that the actions we're taking to fuel demand through our product and marketing strategies will drive share gains in the premium category and position the company for accelerated growth when market conditions improve. We took an important step towards this objective with our acquisition of Intellibed on August 31. For those less familiar with Intellibed, it's a luxury sleep and health and wellness company offering a premium line of gel grid mattresses targeted to the luxury consumer. Having held licenses to certain gel technology from Purple for nearly 25 years, Intellibed employs a very similar gel material to Purple and found success integrating that technology into their luxury mattress line with price points reaching over $7,000. The shared technology, geographic proximity to their primary facility in Salt Lake City, and the natural extension of Purple's target market made Intellibed an excellent fit for our organization. We view this as an opportunity to accomplish two objectives that we feel will fuel growth in the years ahead. First, we're able to consolidate our intellectual property under one roof which will allow us to more fully capitalize on growing demand for the gel grid technology as that space matures. We believe that gel grid technology has the opportunity to be the next evolution of the mattress beyond memory foam. As the pioneers of this revolutionary technology, we are well positioned to continue to lead and grow the gel segment. Secondly, Intellibed's higher price points compared to Purple's existing offerings provide the brand with the entry to the luxury category. With mattresses ranging from $4,300 to $7,500, the acquisition accelerated our product development schedule by several years and allows us to immediately address the market's $5,000 and higher margin segment of the sleep and wellness industry. The business is small relative to Purple today but we see ample opportunity to expand Intellibed products into our existing wholesale door network in addition to adding the premium line to our showroom footprint. We don't expect to mature this set of our business overnight but we're excited about the longer-term opportunity this combination offers. Overall, we continue to be encouraged by the elements of our performance this quarter, especially the significant quarter-over-quarter improvement in profitability. The important progress we've made by building the framework for sustained growth and strong operational results has put us in a solid position to weather the current macroeconomic environment. While the second half of the year has started better than we expected from a profitability standpoint, the historically unpredictable nature of the fourth quarter performance, coupled with the current operating environment, leads us to remain cautious in our outlook for the remainder of the year. We anticipate Purple brand revenue coming in at the lower end of the revenue guidance we previously provided but with the modest contributions from Intellibed landing us in the middle, therefore, we're reaffirming our previous full-year revenue guidance of $570 million to $590 million. Based on our strong Q3 performance, we're raising our adjusted EBITDA and now expect to be profitable for the year with a projected adjusted EBITDA between $2 million and $7 million. While we're pleased with the improvement in profitability we experienced in Q3, we are guarded about Q4, primarily due to expensive advertising rates during the holiday period and the expectation of continued increased discounting for Black Friday and Cyber Monday promotions which is expected to negatively impact fourth-quarter gross margins. While the environment remains challenging, we are confident that our four strategic initiatives: operational excellence, elevating our brand positioning, channel development, and accelerating innovation, outlined earlier this year, form the foundation of the right plan to get the company back to sustained profitable growth. We still have a lot of work ahead of us but I'm encouraged by our continued progress this quarter. I'll further detail some of the progress we've made and expect to see in the coming quarters with our initiatives before our question-and-answer session. I'll now turn it over to Bennett, who will review the financials in more detail, after which I'll provide an update on our strategic initiatives ahead of your questions. Bennett?

Thank you, Rob, and good afternoon, everyone. For the three months ended September 30, 2022, net revenue was $143.3 million, down 16.1% compared to the $170.8 million in the prior year period and down less than 1% compared with the second quarter. The year-over-year decrease was due to a number of factors, including changing demand for home-related products, inflationary pressure on discretionary consumer spending and our intentional reduction in advertising spend which was down 56.8% compared with a year ago. By channel, versus prior year, direct-to-consumer net revenues declined 25%. Within DTC, e-commerce declined 36.6%, reflecting the aforementioned pullback in ad spend. This was partially offset by an increase in wholesale net revenue of 1.3%, driven in part by the Intellibed acquisition. Showroom net revenue increased 110.4%, driven largely by the opening of 32 net new showrooms over the past 12 months. Gross profit dollars were $59.4 million during the third quarter of 2022 compared to $61.1 million during the same period last year, with gross margin at 41.5% versus 35.8% in the third quarter of 2021 and 33.9% in the second quarter of this year. The increase in gross margin from the prior year and from the second quarter of this year can be attributed primarily to the cost reduction initiatives implemented in 2022, partially offset compared to the prior year by an increased proportion of wholesale channel revenue which carries a lower average selling price than sales from our DTC channel. Wholesale net revenues comprised approximately 41% of net revenue for the quarter, compared to 33.9% in the same quarter last year. Additionally, the gross profit percentage in the prior year period was adversely impacted by inefficiencies related to the resolution of prior year production issues. Operating expenses declined $9.6 million to $58.1 million compared to $67.7 million in the third quarter of 2021. This was largely driven by the intentional reduction in advertising spend that began in the second quarter of this year. Advertising spend for the third quarter was reduced by $16.7 million or 56.8% year-over-year. It is also important to note that the third quarter of 2022 includes $3.4 million of general and administrative expenses related to the acquisition of Intellibed that will not recur in subsequent quarters. Excluding transaction expenses, operating expenses were 38.2% of net revenue in the third quarter of 2022 versus 39.6% in the prior year period, even as sales were down 16.1% for the same period. Net income for the quarter was $2.3 million compared to net income of $2.2 million a year ago. As previously disclosed, based on the SEC statement dated April 12, 2021, regarding warrants issued by SPAC, we determined that our outstanding warrants should be accounted for as liabilities and recorded a fair value on the date of the transaction and subsequently remeasured to fair value at each reporting date. For the three months ended September 30, 2022, we recognized a non-cash loss of $0.1 million associated with the change in fair value of warrant liabilities. For the three months ended September 30, 2021, the company recognized a non-cash gain of $5.4 million associated with the change in fair value of warrant liabilities. On an adjusted basis, net income in the third quarter of 2022 was $2.8 million or $0.03 per diluted share based on an adjusted weighted average diluted share count of 86.1 million compared to an adjusted net loss of $4.9 million or $0.07 per diluted share based on an adjusted weighted average diluted share count of 67.3 million in the prior year period. Adjusted net income has been adjusted to reflect an estimated effective income tax rate of 23.7% for the current year period compared to 25.4% for 2021. EBITDA for the quarter was $5.9 million compared to $2.4 million in the third quarter of 2021. Adjusted EBITDA, which excludes certain non-cash and other items we do not consider in the evaluation of our ongoing performance and as detailed in today’s earnings release, was $12.1 million compared with $0.6 million a year ago and an adjusted EBITDA loss of $0.3 million in the second quarter of 2022. Moving to our balance sheet. As of September 30, 2022, the company had cash and cash equivalents, including restricted cash of $59.1 million compared with $91.6 million at December 31, 2021 and $41.2 million at June 30, 2022. The $17.9 million increase from the end of Q2 was driven primarily by cash from operations of $22.3 million, partially offset by capital expenditures of $8 million, primarily related to showroom expansion. We also acquired $3.6 million in cash and restricted cash from the acquisition of Intellibed. In addition to the $59.1 million in cash at the end of the third quarter, we also have the full $55 million amount available under our credit facility and we believe our cash is adequate for at least the next 12 months. Inventories at September 30, 2022, were $91.4 million, a decrease of 7.4% compared with the $98.7 million at December 31, 2021. The decrease in inventory since the end of 2021 was driven by a reduction in both manufactured as well as resale finished goods and raw materials, as we rightsize our production to the current demand environment. Turning now to our current outlook. As Rob said, given the current economic environment, we remain conservative in our view on revenue for the remainder of 2022. We now expect Purple brand net revenue to come in at the lower end of our previous revenue guidance of $570 million to $590 million which, along with the contribution from Intellibed, should put us around the middle of the range for overall net revenue. While we are pleased with the improvement in profitability we experienced in the third quarter, we are guarded about the fourth quarter, primarily due to expensive advertising rates during the holiday period and the expectation of increased discounting for Black Friday and Cyber Monday promotions which is expected to negatively impact fourth-quarter gross margins. With respect to adjusted EBITDA, based on the third quarter’s outperformance and with one quarter left in the year, we are increasing and narrowing our full-year range to $2 million to $7 million profit, up from our prior range of a loss of $5 million to $15 million. Now I’ll turn it back to Rob.

Thank you, Bennett. Before we open the call to questions, I want to provide an update on our progress with our four strategic initiatives this quarter, starting with operational excellence. Our efforts are leading to more effective capacity utilization, improved product quality, and better returns on our capacity investments. In the past, many of our raw material purchase contracts were vulnerable to inflationary pressures. Although this wasn't a significant concern for most of the company's history, the current inflationary environment has begun to affect our raw material costs. We have managed to mitigate these impacts through negotiations on larger expenditures and value engineering to lower component purchase costs. Looking ahead, we have a series of procurement and innovation projects lined up that will help continue reducing input costs. Operationally, we are focused on enhancing our productivity while managing supply and demand, which has helped us maintain a sustainable cost structure aligned with current demand expectations. We are also working to consolidate operations from our Alpine, Utah facility into our primary facilities in Grantsville, Utah, and McDonough, Georgia, expecting to complete this transition in the fourth quarter. This will streamline our overheads and allow us to allocate production of pillows and seat cushions closer to our customers, similar to what we've done with mattresses, improving logistics efficiencies. Our second strategic initiative is elevating our brand and enhancing marketing effectiveness. Last quarter, we mentioned our progress on brand positioning aimed at creating a distinct and consumer-relevant identity for Purple, which will form the foundation for future advertising and brand communication. This positioning was further defined through the Intellibed acquisition, allowing us to penetrate the luxury market and further differentiate the Purple brand as a premium alternative in the high-end segment. By mid-next year, we will phase out the Intellibed brands and segment the Purple product line into two tiers: Purple Lux, Purple Premier, and Purple Essentials. Purple Lux will feature our highest-end products priced between $5,300 and over $7,000, available through both DTC and wholesale channels. Purple Premier will include our mid-range offerings priced from $2,000 to $4,500. Purple Essentials will cover our most accessible products, starting at $1,000 and going up to $2,000, primarily marketed through e-commerce but available across all channels. This brand unification and segmentation will significantly enhance Purple's position and the gel grid as a genuine alternative to traditional mattresses across various price points. To spearhead these initiatives, I'm thrilled to welcome Keira Krausz as our Chief Marketing Officer, who joined our team on November 1. Keira brings extensive experience in direct-to-consumer marketing and brand management. We are confident in her ability to advance our marketing strategies, grow revenue, and improve profitability. Her immediate focus will be to elevate our brand positioning in line with our premium strategy and refine our advertising investment for better returns. More details will be shared at our next quarterly earnings call after she has had time to assess the situation. Regarding our third initiative, the development and expansion of our channels, we concluded the third quarter with 52 showrooms after opening 11 new locations and an Intellibed store. We intend to finish 2022 with a total of 55 locations. The newly opened stores are facing similar challenges as our wholesale business, but with more control over sales, we are navigating through the current landscape towards our target economics of at least $2 million in annual sales per store. Our own showrooms will remain essential as we move forward with our premium strategy. For our wholesale channel, as I mentioned last quarter, while we plan to open additional locations selectively, our priority is enhancing the productivity of existing ones to grow market share and profitability for us and our partners. Our strategy includes premiumizing the wholesale Purple offering through the re-segmentation I mentioned earlier, which will strengthen our appeal to wholesale partners by transitioning to more premium products and price points that benefit all parties, raise average ticket prices, enhance our selling narrative, and grow the gel category. We are initiating the expansion of the Intellibed product line within our wholesale network, which we view as a long-term opportunity for both our brand and partners. Lastly, as a premium omnichannel brand, we are also focused on enhancing our e-commerce channel. E-commerce has historically been a strength for Purple, and we've made progress this quarter in aligning our digital marketing messages and product assortments with our target customers. Although it will take time to reposition our e-commerce channel, I am encouraged by our progress so far this year. Our fourth strategic initiative is innovation in product development. Purple was founded on providing innovative solutions that enhance comfort and sleep. I am pleased to report that our new Chief Innovation Officer, Jeff Hutchings, has made significant strides since joining us last quarter. His immediate focus has been to revitalize our innovation team and pipeline, which he has managed in a short time. Additionally, we are adopting a continuous innovation process to ensure we consistently launch truly innovative products. After seeing some of the new developments from his team, I am optimistic about Purple’s future and confident in our leading position in the market. From a product perspective, while the Intellibed acquisition hastened our entry into the luxury market, we have also been diligently working on addressing the lower-end segment. This quarter, we introduced the Purple NewDay mattress, an entry point for our Purple Essentials collection, targeting the digitally native market and competing directly with bed-in-a-box brands. It is performing well and strengthening our product collection. NewDay provides us with a competitive online price point and allows our showrooms and retail partners to concentrate on the premium Purple experience. In conclusion, I would like to make two points. First, many of you are aware that on September 17, Coliseum Capital proposed to acquire all of the Purple stock it doesn't already own. This proposal is public and was not solicited by the company. The Board of Directors has established a special committee to evaluate Coliseum's offer and has hired independent financial and legal advisors. I currently do not have any update on this matter and will not be able to discuss it further during the Q&A session. Secondly, I want to express my gratitude to our employees for their hard work this quarter. I am encouraged by the progress we are making and our ability to improve quarter-over-quarter in many of our key metrics this year. Our strategic initiatives are providing a strong foundation for profitable growth as we continue to navigate the current business environment. Operator, I'm ready to hand it over to you for questions.

And we'll take our first question from Brad Thomas with KeyBanc Capital Markets.

I wanted to first ask about margin. First one I ask about margins. And just, I think, some really encouraging results here that you’re sharing with us this afternoon, EBITDA margin 8.5%. I know that we can’t take one quarter and extrapolate it out. But I was wondering if you could just talk a little bit more about your learnings and your optimism about what normal margins look like for Purple in the years ahead?

I think in the years ahead, we've got a lot of hard work still to do but I do see significant and continued margin improvement opportunities. We said, I think, last quarter and to some degree, the quarter prior, that we would exit the year north of 40%. Our performance in Q3 is certainly encouraging that. I think the other big question that we've been able to answer, we took the hard decision to rightsize the company pretty aggressively in the end of the first quarter. And there were a lot of questions from both us and from you guys on the analyst side, the two plants at relatively low utilization, could we make that system work. And under Eric Hainer's leadership, it is absolutely clear that when we look at total delivered cost, even at relatively low capacity utilization, we can make the company more profitable. So to me, the good side of that is those moves are sustainable and we've got capacity upside that will not require us to make significant CapEx investments in the future. So long-winded way to say, Brad, we're optimistic about the margin progress so far and we believe there is more to be had.

Could you provide more details about the timing of the product changes and some initial feedback you've received from your wholesale partners regarding the new lineup?

The products will be introduced to the market soon, with a more widespread availability expected a few months later. I am still understanding how quickly new products are available in the wholesale sector, which is more complex than the recent launch of the NewDay mattress just two weeks ago. We have a significant range of new products coming, and with a major trade show happening in January, it will provide an excellent opportunity for this introduction. We are not planning 12 months out; we are moving as quickly as possible to present a refreshed lineup. Additionally, we will address the discontinuation of the Intellibed line and the emergence of the Purple Lux line. We have communicated with most of our customers regarding this change. About a month and a half ago, we conducted roadshows, and the response has been positive. They appreciate our ability to attract customers to their stores, and with the new product lineup better tailored to the wholesale market, it should enhance their margin offerings, leading to strong support from them.

And we'll go ahead and move on to our next question from Seth Basham with Wedbush Securities.

My first question is just a follow-up on Brad’s question. Just thinking about the comments you made around outpacing the industry at certain retail partners when you’re working together. And what exactly have you done in those instances to drive that outperformance? And how would you pursue that across the rest of your retail partner accounts?

I previously mentioned that we were fortunate to grow our wholesale business over the past couple of years, but we haven't kept up with what’s necessary for success in that distribution. In the stores where we excel, we have strong training resources in place that help the retail sales associates sell our products effectively. We've also developed appealing marketing and presentation materials for our beds to ensure they are competitive with other leading brands. While these strategies may seem straightforward, without them, our brand struggles to reach its full potential. It's essential to understand what it takes to be a strong wholesale partner and to deliver on those needs. In locations where we showcase three, four, or five beds, we see significantly improved performance for both our brand and the retailer. We plan to aggressively expand this approach as we move forward into next year.

My next question is just around your performance in the fourth quarter to date in light of your guidance for the fourth quarter. For the quarter-to-date, are you seeing a material slowdown in sales trends or some of those margin pressures that you’re referencing? Can you give us a little bit more color, please?

Yes. I don't want to go too far beyond Q3 but I will say that I think you've probably read as we have that it was a pretty decent Labor Day holiday and then volume was relatively soft coming out of it. We know that each Tier 1 major holiday promotion period this year has gotten more and more competitive. So we just think it's appropriate to be cautious, given the demand in the market is pretty negative. Mostly everybody is reporting down 20%, 25% in category, both in units and dollars, and we're experiencing some of that same headwind.

And we'll go ahead and move on to our next question from Bobby Griffin with Raymond James.

Congrats to the team on the progress shown in gross margin there. I guess – I want to switch over to just the DTC segment and it’s more of a high-level question, maybe even going – kind of when you guys going into 2023 but what are some of the opportunities to maybe jump start that segment back again? It kind of seems for this business and model to work really well and profitability to drive having both wholesale and DTC grow with that margin mix is very powerful. So just any high-level thoughts there on kind of what’s the plans to get that going again, is it just a function of the overall environment? Or is there some new marketing plans or a different way to attack it with some of the advertising changes? Anything there for us to think about.

I would categorize it into two main areas, Bobby. First, prior to launching NewDay, we tested its price point with our current products. We realized that there is a crucial business segment we had unintentionally moved away from due to price increases. Therefore, we designed NewDay to fit that price point, making it significantly less challenging for our gross margin. The initial product range will be priced between $1,000 and $1,900 and will be offered across all three channels, though the lowest price point will only be available online. The second point I want to mention is our recent major leadership change aimed at strengthening our direct-to-consumer marketing. Keira will be enhancing our efforts in this area. We need to improve our execution, and we now have a more competitive product lineup to participate effectively in the lower end of our price range.

Okay. That’s helpful. And then maybe just switching over to the inventory side and the cash flow generation, great to see the positive cash flow from operations this quarter. Inventory still went up sequentially. So we think about the $91 million or so, is that the level of required inventory at this sales balance that you want to run with? Or are there opportunities for that to decline and turn into a source of cash going forward?

Yes. I'd point out two things for you. First of all, that sequential inventory number now includes Intellibed, which as you can see in the 10-Q was about $4 million. So on a Purple-only basis, we actually did a little better than what you see. And second of all, I think there is more opportunity there as Eric takes more command of the operations group. I think we're going to be able to run a little tighter on raw materials and on imported finished goods. So the answer to your question is, it's a little better than it looks and that we will do better going forward.

We'll take our next question from Brian Nagel with Oppenheimer.

I would like to add my congratulations on some nice progress here. So the question I have is, on Intellibed and the acquisition, this year you’re making clear that you’re really going to integrate this product into the Purple products. So the question I have is with Intellibed, is it – is your unique manufacturing for that product or would you be able to produce this product within the Purple facilities? And then from a wholesale partner…

Yes.

Okay, go ahead. I’ll ask my next question next go ahead.

We want to take things one step at a time to ensure thorough understanding. We were familiar with the licensed technology and its capabilities. However, some agreements in the licensing structure restricted both parties from overlapping in our experiments. Now that everything is consolidated under one roof, we are excited to pursue innovative formulas with the material that we couldn't explore before. To answer your question, the material and manufacturing process are quite similar, with a few key differences. Their machines operate a bit differently than ours, producing it continuously rather than on a shop basis. We will continue production at the Salt Lake facility, which is relatively small, around 6,000 to 10,000 square feet.

That part of the facility is about 20,000 square feet.

The new facility is 20,000 square feet, which is smaller than our other two plants and is located 25 miles away. It can essentially operate as an extension of P West. Currently, there are no plans to merge production between the two locations, but we have substantial plans to explore both methods and determine how to maximize their advantages. We don't perceive establishing production in the third location as a costly option at all, and we will work on utilizing different gel technologies to enhance our products for consumers.

Got it. That’s really helpful. Then my second question, Rob, we talked a lot about just the focus on improving the wholesale relationship. So as you bring this new product then to wholesale partners, I got to assume that A, it’s going to enhance the relationships you have but does it also get you into, to the extent you want, into new relationships, new doors that were previously maybe not have taken Purple?

We don't have many new doors planned in the near term. Over the last 12 months, we've added 1,100 doors. My main focus is on increasing door productivity, as I believe that will help us open more doors. If a partnership hasn't materialized, it could be due to issues with the margin structure or a lack of confidence in the brand. However, I think it's worth noting that I don't believe any other brand in our category has added as many doors in the past year. So, in the near term, my priority will be to enhance door productivity. Most of the Intellibed technology and the expansion of our premium Lux line will be implemented in locations where Purple is already established.

And we'll move on to our next question from Jeremy Hamblin with Craig-Hallum Capital Group.

I’ll add my congratulations on some impressive execution. I wanted to come back to your marketing, your advertising spend, which you’ve really flashed down. And in terms of thinking about where the normalized level would be, is that – I’m trying to understand how much was maybe overspending or not the right type of spending and mediums previously versus just simply rightsizing the spend versus the current run rate on sales. Is there kind of a targeted level for that sales and marketing line item that you’re looking to hit on a longer-term basis? Is that bogey 30% of sales, or is it something more like 20%, 25%? And now you’re almost there for a year, you probably have a better sense of where you think that might be.

I am approaching my first year, but it hasn't been typical for the category, so I haven't drawn any firm conclusions yet. I do know that in the fourth quarter, just before my arrival, there was a significant divergence between advertising costs and efficiency. This was partly complicated by the demand for online advertising units, both in purchasing and deploying them in the market. We aim to invest in the brand, and our strategy for achieving a premium position will necessitate substantial investment. So far this year, we've allocated about 13% of total sales to advertising. I believe it should be closer to 20%, but it must be effective. While we haven't drastically cut advertising, we've managed to find a more efficient approach. Although our ad spend has decreased significantly by approximately 56%, our traffic has only declined by a much smaller percentage, indicating improved efficiency. However, there is a point where we are underinvesting. We plan to increase our advertising investment, but we will do so with confidence in the returns and ensure we are generating the necessary traffic and conversions to grow the business.

And as a follow-up to that, is there anything that you are finding kind of on the SEO side of how you’re marketing online that you think is not being optimized now that you see low-hanging fruit. But given that this is a digitally native brand, I just wanted to get a sense for where there is additional efficiency to wring out there as well.

Certainly in this market right now, there are no easy opportunities. I am sure of that. However, the leadership change and the strengthening of that team reflect our belief that we can improve. We brought in someone with significant experience in that area, and we need to support all three channels. This requires strong brand positioning, messaging, and communication. Additionally, we must be very effective in our e-commerce advertising spending. We want it to be direct, and our wholesale customers desire it because it generates interest in our brands. So, yes, we need to improve. There are no easy opportunities. Ultimately, we're dedicated to achieving that level of performance in this area just as we have in others.

Last one, real quick. In terms of – I understand the focus on making wholesale doors more productive, what you have now, in terms of thinking about opening up Purple showrooms next year and potentially beyond 2023. How are you thinking about that investment as a priority versus the wholesale business improving?

Yes. As I mentioned in the script, showrooms remain a significant and fast-growing component of our distribution strategy, both for the value of the store from a financial standpoint and the value of marketing and getting the name out there. Some folks put these in kind of destination locations. We've been putting them in high-end lifestyle and high-performing malls and there is a benefit of the traffic that comes with that but there is also a benefit of just getting that name in front of consumers. So we have an aggressive showroom growth plan, we haven't nailed down the final numbers for next year. But I think what you saw this year will be between 1/3 smaller to that to 1/3 bigger than that in the next few years for sure.

We'll move on to our next question from Matt Koranda with Roth Capital.

I just wanted to see if you could unpack the gross margin change either year-over-year or quarter-over-quarter for us in a more detailed way. I mean you’re exiting – or sorry, you put up gross margins just far higher than where you said you’d exit the year. So I just wanted to kind of get a more detailed walk on where the improvements specifically came from.

Yes. Six or nine months ago, we began collaborating with McKinsey to analyze our plant operations, and since then, we have brought in Eric, who has taken over and expanded their efforts. The increase in gross margin is primarily focused on activities within the plant. Eric has enhanced our purchasing strategies to effectively counteract inflation. Additionally, due to the workforce reduction and improved machine operating efficiencies, we have successfully reduced costs related to labor and overhead in the plants. We believe that the margin improvements we have achieved are sustainable and can be replicated, and we expect to see continued progress in this area moving forward.

Okay. I guess what I’m also curious about is like is there any way to break down, I mean, if I look at the improvement year-over-year, it’s like almost 600 bps. Is there a way to bucket out the 600 basis points of improvement between sort of plant operating efficiency, labor cost reduction? Just any way you want to bucket it, it would be super helpful.

There are many factors that contribute to gross margin, including the product mix and discounting. However, the entire 6 points can primarily be attributed to labor, along with improvements in plant efficiencies and reductions in plant overhead. Therefore, I would say that all 6 points can essentially be traced back to the plants.

Okay, fair enough. And then just if I could do one follow-up on that. I mean, where are you seeing the most incremental discounting? I guess if you kind of break down your products in the higher or lower end? Is there more pressure in one segment or another? Maybe just help us understand kind of what's driving that promotional?

It has been more aggressive on the lower end of our price tiers which is kind of tough on both sides because there’s less margin to give and that’s where it’s been the most competitive.

And we'll go ahead and take our last question from Atul Maheswari with UBS.

Rob, first one on the gross margin, a pretty dramatic shift in trajectory there, so kudos to you and your team. But as it stands today, based on what you know, having been with the firm for almost a year. What is the realistic goal over the long haul as far as gross margin line is concerned as of the end of third quarter, about 300 basis points to 400 basis points below 2019 levels. So is that a realistic medium-term goal? Or do you believe you can go over and beyond that on gross margin? And if so, what do you need to do to get there?

We believe that in a more normalized demand environment, our target is more aligned with the 45s rather than the 40s. However, predicting when the market will change is difficult, and I wish I had that insight. Nonetheless, managing our business effectively with mainly two major facilities makes these targets achievable. We aim to update you on our timeline, but for now, we are focused on reaching those goals.

Okay. Got it. That’s helpful. And as my follow-up, Rob, it sounds like you do plan to be more promotional during this upcoming holiday period. What is the risk that you are conditioning your customers to rely on promotions going forward which would be in contrast to your plans to build a premium brand over the long term? So if I ask this in another way, what is the risk that these promotions could add brand value over the long-term.

I believe this is an area we need to pay attention to over time. This is a highly promotional category, and there isn’t much new promotional activity; instead, we are seeing deeper promotional offers. We are trying to follow the market rather than lead. However, we must remain competitive with Tier 1 promotions as defined by the category. Major three-day weekends see significant promotions across all brands. Recently, these promotions have become deeper and have lasted longer, so we need to approach this carefully to ensure we stay competitive.

And with that, that does conclude our question-and-answer session for today. And that does conclude our call as well. We appreciate your participation and you may now disconnect.

Thank you.