Adam Hauser - Director, IR Chris Homeister - Chief Executive Officer Kirk Geadelmann - Chief Financial Officer

Daniel Moore - CJS Securities Peter Keith - Piper Jaffray Seth Sigman - Credit Suisse John Baugh - Stifel Nicolaus Peter Benedict - Robert W. Baird Joe Feldman - Telsey Advisory Group

Thank you, operator. Good morning to everyone and welcome to the Tile Shop's second quarter earnings call.

Following our prepared remarks, the call will be opened for analyst questions. Questions will be limited to analysts and we would appreciate if participants would limit themselves to one question, with one follow-up.

As a reminder, certain statements made during the call today may constitute forward-looking statements made pursuant to and within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 as amended. Words such as, but not limited to, plan, expect, anticipate, believe, estimate, target and any other similar words to identify forward-looking statements may be made.

Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from such statements. Those risks and uncertainties are described in the earnings press release issued today and in the Tile Shop's filings with the Securities and Exchange Commission.

The forward-looking statements made today are as of the date of this call and the company does not undertake any obligation to update these forward-looking statements. Today's presentations may also include certain non-GAAP measurements.

Please see the company's earnings release for a reconciliation of those non-GAAP financial measures, also available on the Investor Relations section of our website at investors.tileshop.com. With that, let me now turn the call over to our Chief Executive Officer, Mr.

Chris Homeister.

Thanks, Adam. Good morning, everyone and thank you for joining us today.

I'm here with Kirk Geadelmann, our CFO and we appreciate your joining us this morning as we report our results from the second quarter. We are very pleased with the results from the second quarter that have signaled additional progress on our key initiatives.

We continue to work on and refine a variety of initiatives with the intention of delivering improved financial results while serving all of our customers at a very high level. Taking a long view, our efforts are still in their early stages but we are very pleased with the progress made through the first half of the year and how that progress has led to strong results in each of our first two quarters of 2015.

We will seek to take another step forward as enter in the third quarter with the goal of delivering strong results in the second half of 2015 and beyond. Sales for the quarter were $75.7 million, exceeding our largest quarterly revenue previously achieved during Q1 by $2.7 million.

$75.7 million of revenue represented a growth of 13.6% versus last year including comparable store sales growth of 5.7%. This sales growth incurred throughout the entire quarter and our efforts to improve sales in our stores that opened in 2013 and 2014 led to strong results for these stores which Kirk will explain in greater detail shortly.

Our adjusted earnings per share in the quarter was $0.09. Adjusted EBITDA grew 15% and adjusted EBITDA margin was 20.5% during the quarter, an improvement from the prior year and the previous quarter of 40 basis points.

Now let me walk you through the highlights of Q2 in relation to our key initiatives for 2015. I will begin by discussing our retail talent identification and training initiatives.

We added three additional market managers during the second quarter and we now have approximately two-thirds of the store base being led by market managers. Stores under their leadership again exceeded sales expectations during the quarter and also played a role in continued turnover reductions.

As previously discussed, we are planning to have the entire chain covered by market managers by the end of 2015. We had meaningful declines in sales associates and assistant manager turnover from prior year levels and store management turnover continues to be low.

Additionally, sales associate turnover dropped during the second quarter as compared to Q1. Average store manager tenure had another meaningful increase in the second quarter with average tenure reaching levels not experienced since 2012.

As we have discussed in the past, manager tenure is important driver in successfully deploying our in-store strategies. Finally, our bench of manager candidates continues to strengthen as a result of our ongoing training and development efforts.

The next key initiative is expanding our focus on the professional customer. During the quarter we continued to execute numerous efforts to build our Pro business, including direct marketing, additional new product offerings and in store events.

In the second quarter, our Pro sales growth again outpaced the balance of the business by a meaningful factor while essentially leading to an increase in our total Pro sales mix of about 200 basis from Q2 of last year. This increase was driven by younger markets where our emphasis on building the Pro business has been most focused.

The opportunity for greater penetration with this customer segment is still very significant, especially in our less mature markets. In addition to our efforts to build our business with the professional customer, general improvements in our market effectiveness were also a key component in achieving our 2015 goals.

We continue to specifically allocate advertising dollars in the second quarter towards a subset of our [2013] [ph] and 2014 new store markets in an effort to build awareness and traffic. Sales results in these markets continued to improve by a factor that indicated strong return on the local buys, advertising spend, our plan is to continue these marketing efforts in new store markets for the balance of the year.

Enhancements made to our search engine optimization and other vehicles to drive traffic to our Web site continued to payoff for another strong quarter of sales growth online and has significantly enhanced online experience. In addition, there were several other accomplishments from our second quarter that I would like to take a moment to highlight.

Free cash flow was $8 million, bringing our year-to-date free cash flow to over $30 million. We paid down approximately $5 million of debt during the quarter bringing our long-term debt reduction during the first half of 2015 to $23 million.

At quarter ending inventory increased only 1% versus the second quarter of 2014, [indiscernible] at 12% store unit growth and nearly 14% sales growth. As indicated in our press release this morning, we tightened or improved our guidance range for sales, comparable store sales growth, adjusted EBITDA and adjusted earnings per share.

Finally, the second quarter represented a meaningful milestone for us as we increased our adjusted EBITDA margin percentage from the prior year. We expect Q2 2015 to be an important inflection point for our company of many years of adjusted EBITDA and margin expansion.

One metric we expected performance on during the quarter was our gross margin rate. Kirk will explain the decline in greater detail in a moment but it's important to note that we don’t feel that the lower rate had a meaningful impact on our total sales during the quarter.

During the second quarter, we opened one new store in Charlotte, North Carolina market and now expect to open a total seven to eight stores this year. A slight reduction from our prior expectation of eight to ten as a result of certain previously identified markets for new stores for 2015 not having sites that met all of our selection criteria.

The remaining store openings for the year, we expect that all will incur in existing markets. Looking beyond 2015, we feel that 8% to 12% annual store unit growth is solid expectation for the foreseeable future with openings focused largely in existing markets, the major new market expansion expected in early 2016.

From a product category perspective, marble, subway tile and faux wood were again the key drivers of growth in the quarter. At first half in 2015 we have brought in over 300 news SKUs from across the world that bring more color, the latest design trends and large format tiles into the assortment.

In our second half, the key addition to this assortment will be several new SKUs that will be at opening price points across the chain as we seek to have all price points covered in all product categories. We are very energized by the results of our first half against the goals we set forth at the outset of the year.

We are focused on making additional progress in the quarters ahead on our journey to becoming the nation's leading specialty tile retailer. And with that let me now turn the call over to Kirk for further discussion on the quarter and our outlook for 2015.

Thanks, Chris. Today we reported net sales of $75.7 million for the second quarter of 2015 which represents an increase of $9 million or 13.6% over sales of $66.7 million in the same quarter of last year.

Comparable store sales growth was 5.7% in the quarter. Sales productivity increased again during the quarter at our stores opened during 2013 and 2014.

Our 2013 vintage stores opened in average two years at quarter end at high teens comparable store sales growth. These stores had a sequential increase in sales from Q1 to Q2 of approximately 6% compared to our more mature stores opened in 2012 or earlier that were approximately flat from Q1 to Q2, which is typical for mature stores.

Our 2014 vintage stores had a sequential increase in sales of 14% in Q2 what is Q1 and high double-digit comparable store sales growth, indicating very solid progress up the maturity curve. Many of the underperforming 2014 stores remained below the desired revenue levels for their current age.

But they again made significant progress during the quarter. Our more mature stores opened in 2012 or earlier had low single digit comparable store sales growth during the quarter.

Gross profit increased $4.8 million in the second quarter or 10.3% over last year. Gross margin of 67.8% represented a decline of approximately 200 basis points versus both last year and Q1.

There were three primary drivers of the decline in gross margin that occurred in the quarter. First, we tested many regular price changes during the quarter in competitive and young markets in order to improve close rate.

Unfortunately, minimal changes to discounting habits occurred in most stores leading to unexpected margin erosion. As a result, the number of stores and SKUs with these price changes has been reduced to locations where both the sales and bottom-line return was positive.

Additionally, stores that remain with these price changes have received additional training on how to best leverage this part of their assortment without significantly reducing their gross margins. These actions should significantly reduce the gross margin pressure related to this factor as we move forward.

Second, we had a higher mix of customer delivery sales in the quarter. And we generally run this portion of our business at flat to negative margins.

Much of this increase is attributable to customers wanting orders as quickly as possible at newer stores that have a lower frequency of standard deliveries from our distribution centers to their store. Finally, we had some national margin erosion due to significant inventory transition activity during the quarter.

This pressure should ease given much less inventory entering the assortment in the back half. Our selling, general and administrative costs for the quarter were $42.9 million as compared to $39.4 million in the second quarter of last year.

Second quarter of 2015 SG&A included approximately $0.3 million of nonrecurring costs related to litigation expenses. We concluded the second quarter with 110 stores, a 12% increase versus the conclusion of last year's second quarter when our store count was 98.

Therefore, when looking at the $3.5 million year-over-year increase to SG&A, most of it is attributable to new store growth. Depreciation and amortization, rent, property taxes, utilities and other occupancy costs represented $1.9 million of SG&A growth versus the prior year during the quarter.

The remainder of SG&A growth during the quarter was mostly attributable to variable compensation growth from sales and store growth and to a lesser extent advertising which increased very modestly as a percentage of sales. Preopening expenses were approximately $94,000 in the quarter.

Adjusted EBITDA was $15.5 million in the second quarter representing growth of 16% versus the prior year period. Adjusted EBITDA margin was 20.5%, increasing versus both last year and our first quarter by 40 basis points.

We expect to increase our full-year adjusted EBITDA margin by 100 to 200 basis points in 2015. The non-GAAP net income presentation in the earnings release and just our GAAP quarterly results by eliminating unusual are nonrecurring costs and then applies the tax rate to the result.

This presentation results in non-GAAP net income for the quarter of approximately $4.8 million, growth of 20% versus the prior year period. The current year non-GAAP net income translates into a basic and fully diluted Q2 earnings per share of $0.09.

Turning to our balance sheet. As of June 30 we ended the quarter with $12.8 million of cash and $63.8 million of long-term debt.

Our free cash flow of over $8 million during the quarter allowed us to pay down $4.8 million of debt in Q2. We are pleased with our $64.6 million quarter ending inventory which represented 1% increase from last year during the quarter was nearly 14% sales growth and 12% growth in store count.

Capital expenditures were approximately $2.9 million in the quarter, primarily related to new store investments, store remodel activity and distribution center projects. Half one capital expenditures were approximately $7 million.

As detailed in our earnings release this morning, we are providing updated expectations for the full year based on where we are through the first half of 2015 and our current outlook for the remainder of the year. I will highlight the handful of items that changed from our original expectations set forth in February and reaffirmed in April.

First, from a topline perspective, our full-year sales expectation has changed from $275 million to $290 million to $280 million to $290 million. Additionally, we now expect comparable store sales growth of mid-single digits, a change from our previous guidance of low single digits.

Next, we expect full-year gross margin of approximately 69%, a change from our previous range of 69% to 70%. From a bottom line perspective, the starting point of our expected range for both full-year adjusted earnings per share and adjusted EBITDA were increased.

We now expect adjusted earnings per share of $0.28 to $0.33 versus previous guidance of $0.27 to $0.33. And we now expect adjusted EBITDA of $55 million-$60 million versus previous guidance of $54 million-$60 million.

Finally, as Chris explained earlier, our new store opening expectation is now seven to eight stores rather than eight to 10. Capital spending expectations remain at $17 million to $20 million as we are shifting additional dollars towards store remodel activity and merchandising projects offset by fewer store openings.

From a modeling perspective, we expect strong year-over-year growth in sales, operating income, adjusted EBITDA and adjusted earnings per share for the entire second half. The growth rates are expected to be stronger in Q4 than Q3.

As expected, our SG&A growth moderated in the second quarter to high single-digits and SG&A growth is expected to remain in the mid-to high single digits during the second half of the year. With that, operator, we can now turn the call over for questions.

Obviously, you touched on the balance sheet. Really significant deleveraging over the last couple of quarters, lowered debt by about $25 million year-to-date.

I think you are now down below one times 2015 expected EBITDA. What are your expectations for additional deleveraging in the back half of the year given the CapEx expectations?

Do you expect inventories to start to work back a little bit higher as new stores open? And a quick related follow-up.

Yes. Hi, Dan, this is Kirk.

We do expect inventories to tick up just a little bit, it's mostly seasonal. But I think we still feel good about being able to generate some additional free cash flow in the back half and pay down some additional debt.

So we think we made some very good progress over the last six months or so. And hopefully that will continue over the next six months.

But probably it will moderate just a little bit in the back half of course.

Okay. That’s helpful.

And then as we think about new store growth going forward, maybe '16 or even beyond, are you looking towards the balance sheet in terms of leverage? Are you looking toward specific EBITDA margin targets that you'd like to get back up to before perhaps accelerating growth?

Just maybe talk about how you are balancing those thoughts as we move maybe even beyond fiscal '16.

Sure. Yes.

This is Kirk again. We feel unit growth in the range of 8% to 12% is about right.

We are very committed to that, that figure. I think we are gaining confidence.

We noted again that our goal is to get 100 bps to 200 bps of leverage in adjusted EBITDA NOI this year versus prior year. And I think we are feeling better and better about that trend continuing on for the next several years.

We would like to get back in to the mid-20s adjusted EBITDA range over the next several years.

Hey, Dan, this is Chris. Just one item to add.

I just want to reiterate to all of our listeners is that on the 8% to 12% guidance that we are having for store unit growth for next year and beyond, we feel that’s a very manageable number for the company. We feel that from a opportunity within the regions that we serve right now, that we are well positioned.

And then as we go into 2016, as we mentioned in the release, we will primarily be focusing in on our existing markets where we have had a tremendous amount of success. And stores historically within those markets come out of the gate much quicker than a new market.

As we mentioned in the script that we will be going into a new market within 2016 which we are very excited on. I feel that will have a tremendous amount of success and also leveraging assets that we currently, from a distribution standard standpoint right now, that we will be able to continue to utilize and be more efficient with the assets that we deploy right now.

And then just lastly. You mentioned the slight reduction in guidance for this year in terms of new stores having difficulty finding a location that was suitable.

Is that anything that is concerning to you or is it a particular market that you still feel very good about, just couldn't quite find that ideal location short term?

No. I wouldn’t classify it as difficulty.

I would look at it more from the selection criteria that we have in place is more robust. We have a broader team looking at sites across the company.

And from our vantage point I really would expect that the seven to eight number from our standpoint, we thought it was a good number. We feel confident about it.

We also feel good about the selection of those sites. So I won't look at it as difficulty of finding sites.

There is plenty of sites to choose from, certainly with any retailers closing stores and not opening them. But I think we are also looking at what do we have from a utilization of our capital and what will have the largest return of the capital for stores that we feel that we can go into and go out really very aggressively within those markets and not seeking a marginal site in order to get to a number that we have arbitrarily set.

I want to just dig in a little bit on the gross margin dynamic around pricing. I wasn't quite clear coming out of the prepared remarks.

So, maybe you could provide a little more detail. It sounded like you tested some price discounting.

It worked in some stores and then it didn't work in others. And net-net you are going to keep it going in a handful of stores.

Is that the right interpretation?

That would be correct, Peter. So we have done a multi-month test on different price points.

And really what we are looking at is testing out price elasticity amongst SKUs within families of products as well as families across the board. We have started that test in March.

It continues going through June. Where much of the origin happened was in the middle part of the quarter and as Kirk mentioned in our prepared remarks, the training that we passed to our sales team was not as clear as it could have been or should have been.

And we certainly have an opportunity there about looking at the level of discounting that would happen at a reduced price point within the store. So that’s an opportunity for sure that we have from that standpoint.

But I want to be clear that the stores that remain in this pricing task continue to have, it's accretive across the board from their store standpoint as well what we are looking at from a company standpoint as well where we ran into some difficulty as Kirk mentioned, was when we ran into a broader, a large degree of SKUs, as well as a higher number of stores. And the level of discounting was higher or perfectly unchanged when we have the price point that we actually reduce in order to generate traffic and also the increase the close rate.

Okay. That's a good summary.

I appreciate it, Chris. So just to follow on that real quick.

Since you've now narrowed it down to a much smaller set of stores, you've seen the gross margin stabilize back in that 69% to 70% range?

Yes. We feel comfortable for the guidance that we are at, 68.8 for the first half of the year.

We narrowed the guidance from 69 to 70 to approximately 69. We feel very comfortable Peter to achieve that guidance range for the duration of the year.

Okay, great. And then I wanted just to shift gears then on the 2013 and 2014 stores.

So, the class of 2013, I think you said it comped high-teens. Was that a slight acceleration from Q1?

And then when you say 2014 comped high double-digit, is that the same as high-teens or what kind of general range should we think about for that class?

Good morning, Peter, it's Kirk. Yes, you are correct.

We had a slight uptick in the comp for the 2013 vintage stores compared to Q1. So again we are very pleased with both those stores and also the 2014 vintage stores.

They continue to exceed our expectations for this year. In terms of the 2014 stores comp, there was about -- nine of the stores were comp during all or part of the quarter.

So still a little bit under half of that portfolio of stores from 2014 are comp. But it's a high double-digit comp, significantly higher than teens at this point.

Obviously, it's early at. As we get closer to having all those stores in the comp base at the end of this year, we will have a better read on how much they had caught up to where we would like them to be based on historical expectations.

But again, very good progress with both groups of stores. We are pretty pleased there.

Nice progress on the quarter, guys. I want to follow-up on the pricing test you talked about.

I'm wondering if you could elaborate on the rationale for the pricing test in the quarter? I think it's a productive exercise but just wondering if it's a response to anything competitive as it does seem to be a little bit of a shift in the philosophy, historically.

And perhaps --?

Just one -- this is Chris. So from a competitive standpoint as we have noted on previous calls, I mean the competitive environment for our business I review as very dynamic ranging from obviously the big box home improvement centers to local tile distributors that have been in business in the local market for decades.

Really we wanted to do a couple of different things from our standpoint. One is we really wanted to look at, see if -- what level of price elasticity really exists within some of these families of products that we have been selling for years and do we have an opportunity to increase as well as decrease prices and see what actually happens with demand coming from our customer base.

So I wanted to let you know that on both side, that we are actually looking at -- from a pricing standpoint. I wouldn’t necessary look at it from a change on philosophy.

I think it's necessary for us to, as a management team, to really look at what levers are at our disposal. What are the things that are really going to drive a higher close rate but also generating gross margin levels that we all expect to achieve and we are certainly disappointed that we didn’t achieve in the quarter.

So that’s certainly one. And then I think we also want to look at what are the ramifications or impacts on online as well.

It's a channel that we don’t talk about as much from a competitive standpoint. It's certainly very dynamic.

We are very pleased with our performance in online and online channel -- an omnichannel retailer. And I feel that we are getting closer to that definition of an omnichannel retailer closer every day.

And so that was a necessary thing, element, for us as well. We are working on having that dynamic pricing capability within our online channel and we felt that it was appropriate to begin that testing in our store channel, really beginning back in March and really continuing up to today.

Okay. That's very helpful.

And just any additional color on how much of the assortment was impacted by the pricing test and what percent of the store base?

It was a relatively small number of SKUs. I would certainly say less than 15% at its height.

From a store count standpoint it was about half of the chain and as we exit into Q3, it's certainly around -- it's around 20% of the chain that has a pricing test ongoing at the moment.

Okay, got you. And then just one final one.

On the Pro, it seems like the focus there is progressing. Can you discuss what's working as you try to target the Pro and give us a sense of how big that business is today.

What percent of your business is driven by the Pro and any additional commentary on the economics of those transactions? Thanks.

Yes. So this is Chris still.

So the Pro business continues to be approximately a third of total revenue for the company. As I mentioned in our prepared remarks, that accelerated during the quarter on a year-over-year basis.

The things that are really working from our standpoint is really having that localized presence. Having the store management involved, working with our local trade associations.

Having our Pro network leader be a big part of that outreach. And then also looking at -- we have also had a fair amount of success with localized advertising elements of attending trade shows.

Getting involved in community and also the direct mail has been quite effective as well.

Great progress on the balance sheet in particular. I was wondering on two fronts.

One, could you update us on what the capital per new store is running at, is it down? What are sort of the opportunities there both between inventory and store layout to get that number down?

And then, secondly, I believe you made a comment that you didn't think the pricing initiatives improved or helped sales at all or much. I forget the comment.

And I was just wondering, how you are confident in that statement or some color around that. Thank you.

I think John I will start with the pricing elements, I will take that. So from our vantage point as it was mentioned in the previous question, the number of SKUs involved was fairly small.

And we also look at the total amount of revenue that was happening during the pricing tests as well. It was relatively what I will call, more [indiscernible] for sure.

So I think from our vantage point we view it as less than a point of comp of the total comp that we delivered within the quarter. That’s the way we would look at it internally and I wanted to share that with you as well.

Good morning, John, this is Kirk. I will answer your capital question.

I think we are feeling more and more confident about our ability to reduce the historical average of $1.4 million in capital for every new store to something lower than that. We have some of the smaller stores that we have built out here over the last 12 months or so, are performing quite nicely.

We also have been pretty actively engaged in identifying different ways that we think we can reduce both the capital investment and the store size on a go forward basis. There is different ways to reduce CapEx.

One of it is store size but there is some other things that we are working on as well. So I think the question is just in terms of real estate availability.

If we can find boxes that are smaller and we will certainly look to work with those smaller box sizes. But even if we are in slightly larger boxes, I think you will see us over the next year or two probably be able to reduce that initial CapEx investment by a decent amount.

More to follow on that. We will try to quantify that as we get deeper in to the next group of stores that we open.

A couple of questions. First, the delivery sales.

I don't recall hearing you guys speak to that before. What percentage of sales are delivery historically and then why do you think it up ticked in this quarter?

I think you said it was new markets. Was that it, is there also something that's used by the Pro's more?

Just trying to understand that better.

Yes, good morning, Peter. This is Kirk.

I don’t think we have really talked about the percentage of sales at our delivery. But it's historically been fairly substantial.

We do typically collect a significant chunk of revenue on those sales but really what's happening here is our new stores and the growth that we have experienced, particularly from the stores we opened in 2013 and 2014, this sort of added inflexion point. And they are right between that place where we can justify sending another truck per week or increasing the frequency of shipping between the DC and the store.

But they are not quite there yet. And so they had customers they are trying to serve, the customers are willing to pay for the delivery and so they are going ahead and they are doing that transaction.

So really we are mixing into more delivery sales because we are mixing into more revenue from new stores. As those stores grow further, I think that you will see that moderate and we will be able to justify some additional shipping frequency between the DC and the store and you will see the margin erosion related to that piece of it go down.

Okay. That's helpful.

And then kind of related to that a little bit, Kirk, is this related all to online as well? I mean I know online is not a big percentage of sales for you guys.

I know the home center guys kind of speak to this as being a pretty good category actually online. So maybe talk about that.

How you guys are progressing online. I think Chris touched a little bit on the promotional stuff.

Is there a difference between what you guys are promoting in store versus online?

Hi, Peter, this is Chris. I am not seeing anything really significantly different online versus in store.

Certainly any promotion that we run in an online channel would be honored in a store anywhere in the country. But as I mentioned, we are very pleased with the performance that we have had in the online channel.

As you mentioned, it's not a significant driver for the company as a whole yet. But certainly we like the progress that we have done we believe in the online channel as a growth field for the organization and certainly having a robust, dynamic site that has and provides the inspiration that we want to have, that we think that we are very good about show casing in a store.

Showcasing that type of experience in an online avenue when we feel that we are getting closer each day about the investment that we have made in online channel. It's certainly leading to revenue increases on a year-over-year basis that are pretty substantial.

So I wouldn’t look at the freight category as a meaningful driver to what Kirk called about earlier. It was primarily focused around the mixing into higher degrees of new stores.

Okay, that's helpful. And then the last question.

Just on the mature stores, the comp, the low-single-digits. You may have mentioned this and I apologize if I missed it, but how are they comping kind of in the first quarter?

Was there any sequential change there and any plans for advertising changes in those markets over the second half of the year? Thank you.

So Peter, this is Kirk again. Yes, the comp for the mature stores is similar in Q2 versus Q1.

I think year-to-date we are pretty happy with mature stores overall. There is some places we certainly think we can probably do better but overall I think it's pretty solid performance.

Good quarter on the comps and overall. I wanted to ask about, if you go back to the gross margin impact -- and I'm sure it's just maybe the math of it and obviously we don't have the full [indiscernible] or I didn't pencil it around a little bit.

You said around 15% of the SKUs were impacted by the price adjustments and it was only in half the stores. And I guess, I was wondering, it seems like a pretty big impact on the gross margin for the quarter and I was just wondering, am I misunderstanding something there or were the discounts pretty significant?

Or is it just simply, if I had the math in front of me, I would see how it pencils out?

Hey, Joe, good morning. This is Kirk.

If you think about the 200 basis points of margin erosion versus last year or versus Q1, about half of that was the pricing test that we talked about and the other half was the customer delivery and some impact from our inventory transition. So we feel pretty good about the pricing tests being something that’s not recurring in the back half because we reduced the number of SKUs and the number of stores where we are continuing some of that activity.

And we also expect that the customer delivery trend in the back half will moderate somewhat as well, again, as those newer stores get up the revenue curve and we can justify a little bit more shipping activity between the DC and the store.

Got it. That's helpful.

Thank you for that. And then just one other follow-up, I think, sort of maybe Peter touched on it, with the advertising a little bit.

But I wanted to ask about advertising effectiveness. I know it's something that you guys have been working on for a while.

Just anything new on that front? I know you mentioned that there is a modest impact from ad expenses being up a little bit in the quarter but anything on the effectiveness side of what you're doing there that you can share?

Sure, Joe. I will take a shot and then if Chris wants to chime in, I will let him do that.

But I think first of all just in terms of the overall investment, as you recall it was a little higher in Q1 year-over-year. We did some tests that were unique to Q1.

We feel like we gleaned a lot of learnings from the various tests that we did. The items that work, we certainly have deployed on into Q2 and we will continue to do that in the back half of the year.

And we did do some pretty good analysis in terms of what things were driving incremental profitability and we continue to do that. That really hasn’t stopped.

There is various things that we continue to try but the things that have worked and are definitely generating an incremental return, we will continue. But overall for the year, we still expect to be in that 2.5% to 3% of sales range.

So pretty consistent with historical expectations. We are just continuing to do a better job with the overall dollars that we have.

Got it. That's helpful.

Thanks. And then if I could follow up with one more.

I know you guys had said that the impact of some of the investments in price weren't as obviously as great as you had hoped. But it does seem like you saw an acceleration in sales.

And I apologize if I missed it, but maybe you could just clarify for me one more time like what was driving that lift, I guess. That overall sales were as strong as they were, but it wasn't really the price investment that drove it?

Joe, this is Kirk again. So when we started some of the tests in the early part of the quarter, we had a smaller group of stores where it appears we definitely generated margin less.

And it appears that generally within that group of stores, our team in the store was well equipped to deal with the lower priced SKUs and moderate their discounting activity. So I think they did a good job of leading in the store and making sure we had the right behavior from sales associates and not getting too aggressive on discounts for the lower priced product.

As we roll that out to a larger group of stores, we weren’t as successful. We didn’t get the right behavior.

I believe we needed to maybe do a better job of training and communicating to those sales associates in the larger group of stores and the discounting was frankly just unchanged and too aggressive given the fact that we had lower price point SKUs. And so we have rolled that back to the stores that have demonstrated that they can do it well.

And also I think in Chris' comments in the intro, we talked about bringing in the certain amount of opening price points SKUs here in the next several months. And that should be helpful in terms of both protecting our overall margin and profitability but also giving potentially a broader group of stores the ability to have those lower price points.