Welcome to Sleep Number’s Q2 2019 Earnings Conference Call. All lines have been placed in a listen-only mode until the question-and-answer session. Today’s call is being recorded. If anyone has any objections, you may disconnect at this time. I would like to introduce Dave Schwantes, Vice President of Finance and Investor Relations. Thank you. You may begin.

Good afternoon and welcome to the Sleep Number Corporation second quarter 2019 earnings conference call. Thank you for joining us. I am Dave Schwantes, Vice President of Finance and Investor Relations. With me today are Shelly Ibach, our President and CEO and David Callen, our Senior Vice President and CFO. This telephone conference is being recorded and will be available on our website at sleepnumber.com. Please refer to the details in our news release to access the replay. Please also refer to our news release for a reconciliation of certain non-GAAP financial measures and supplemental financial information included in the news release or that maybe discussed on this call. The primary purpose of this call is to discuss the results of the fiscal period just ended. However, our commentary and responses to your questions may include certain forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties outlined in our earnings news release and discussed in some detail in our Annual Report on Form 10-K and other periodic filings with the SEC. The company’s actual future results may vary materially. I will now turn the call over to Shelly for her comments.

Good afternoon and thank you for joining our earnings call. My SleepIQ score was an 88 last night. We’ve transformed Sleep Number into a purpose driven company that is delivering proven quality sleep with our life changing 360 smart beds. The execution of our consumer innovation strategy is linking quality sleep to wellness through smart technology and is translate into superior financial results. Consumer response to our 360 smart beds has created double digit demand growth for four consecutive quarters including performance at the high end of our expectations for Q2. Our operational excellence is apparent in key metrics across our vertically integrated business. For the second quarter results included, record net sales of $356 million, up 13% over prior year with an 8% comp, operating income of $7 million versus $2 million the prior year. Earnings per share of $0.14, up 40% over the prior year and year-to-date operating cash flow of $70 million versus $29 million the prior year. This robust performance has been fueled by the investments we’ve made to strengthen our competitive advantages of proprietary sleep innovation, exclusive distribution and lifelong customer relationships. These advantages differentiate Sleep Number in the hyper commoditized marketplace and support our long term focus on sustainable profitable growth. They also work synergistically across our business to drive top quartile financial results. Here is an example of how these advantages are making the difference for our customers. Lee from Louisiana said, “we’re so happy with our Sleep Number bed, this is genuinely a comfortable mattress, we had no idea how much our previous mattresses were lacking in support and comfort. Not to mention it is a smart bed, the ability to track our sleep patterns, breathing and heart rates has really made a difference and made us aware of how important sleep…

Thank you, Shelly. We've emphasized how the changes we've made to this business would reveal the power of our EPS drivers through a combination of topline growth, accelerated leverage and capital deployment. In 2017 and 2018, we grew sales in average of 8% per year while delivering average EPS growth of 32%. Our initiatives and 360 smart beds have accelerated performance through the first half of 2019 resulting in 11% net sales growth, 38% net operating profit growth and 48% growth in diluted earnings per share. And our capital deployment decisions have delivered 16.8% ROIC on a trailing 12-month basis. This is a premium of more than 80% over our weighted average cost of capital. It is an exciting time to be a Sleep Number shareholder as the investments we've made create the value we envisioned. We expect to deliver compelling total shareholder returns in 2019 with earnings of $2.35 to $2.75 which reflects 33% growth at the $2.55 midpoint. Second quarter results include net sales of $356 million which grew 13% including 8 points of comp growth and 5 points from new stores. ARU for the quarter grew 10% while units grew 3% on top of the 7% unit growth the prior year. For the first half of the year, net sales of $782 million are up 11% including 7 points of comp growth. While sales growth comparisons get tougher in the back half, the continued advancements of our competitive advantages are geared to deliver mid to high single digit sales growth, the balance of 2019. Our operating efficiency actions drove 13% incremental operating profit flow through in the second quarter while absorbing 55 basis points of incremental incentive comp costs and 30 basis points of tariffs. We also leaned into our demand generators with a 15% increase in…

Our first question comes from John Baugh from Stifel. Your line is now open.

Thank you and good evening. Congratulations on a good quarter.

Thanks John.

Could we maybe talk a little bit about how Memorial Day went, how July 4th went, talk a little bit about the advertising environment, the competitive environment, a competitor this morning said, they felt there was a little less digital marketing going on. I find that a little hard to believe. But, I'm just curious about how you're navigating obviously a good comp is still very competitive environment?

Thanks John. Well, let me start with and perhaps the most important trend for us which are four quarters of double-digit growth since we've transitioned to our 360 smart beds. Secondly, the quarter itself we again had strong consistent performance and I think the fact that at this point that we've raised the low end of our guidance by $0.10 is a great illustration of our confidence as we head into the back half. You asked also about the media and some of our tactics there. We have been refining and testing the advancement of our proprietary media strategy each quarter and if you recall on the April conference call, I spoke specifically about our confidence with some of our initiatives and that we would be leaning into our spend as we head into Q2. And we are really pleased with the results delivering at the high end of our internal expectations. And finally, you asked about the competitive environment in the competitive spend and we saw a very consistent competitive spend level in Q2 as we did in Q1, actually slightly up, 38% increase in competitive spend in the second quarter and I think we had quoted about a 30% in Q1. So that is not coming down overall. And I think that just speaks to the effectiveness of our strategies and specifically our innovation.

[Operator Instructions] Our next question comes from Bobby Griffin from Raymond James. Your line is now open.

Good afternoon Shelley, David and Dave. I appreciate you taking my questions and congrats on a good quarter.

Thanks Bobby.

So, my first question is more of a high level type question, but when you look at the ARU growth it's been nothing but impressive here for multiple quarters. How do you think about the feeling of ARU going forward when you look at your current attachment rates and maybe some of the products you have in R&D pipeline?

Well Bobby, great question and both ARU and units are important to our strategy and I think really speak to the investments that we've made in our three big competitive advantages. The ARU has been coming up nicely and we expect to continue to get growth from ARU. This is an outcome of the innovations that we're delivering, how the different pieces of the smart bed system work together and our selling process. Our stores and sleep professionals, their ability to continue to drive up the line and then I would also highlight our ongoing investment and increase in R&D speaks to how bullish we feel about our innovation pipeline.

Thank you, Shelly.

Our next question comes from a follow-up from John Baugh from Stifel. Your line is now open.

Thank you. Shelly, you were emphasizing retention rate and referral and it sounds like that's ticked up a little bit. Do I understand that correctly number one? And can you speak to, are these customers who maybe bought a Sleep Number bed, a number of years ago and they're intrigued by the new offering? Are these people who bought pillows maybe at first and are trading up and just kind of curious as to what you're seeing with your existing customer base?

Yes John and appreciate this important question. This is important area of growth for us and area of focus. Retaining your customers especially in this world of having a direct relationship between your brand and your customers and the kind of value that customers place on brands today we want this relationship to be lifelong. So yes, you're seeing growth here and that's what we have expected with our consumer innovation strategy and it's really a key part of SleepIQ technology. With our technology, our customers are now interacting with our brand every single day and when our customers see their SleepIQ score they're reminded of the incredible night sleep that our customers are getting from their bed and therefore that keeps them highly engaged and referring. So this is a key metric for us. There's growth there, the growth is coming from all of the above. Older customers who are opting in for the new technology as well as customers who may be entered the brand with a pillow and are now adding the bed and then of course referral, the key part of the SleepIQ technology is the referral.

And then maybe as a follow-up. Is there any way you can parse out the ARU, I mean how much was roughly like-for-like pricing and how much maybe adjustable helped, how much mix helped, any color? Thank you.

Yes John. We have consistently said that we get about 3% from pricing, benefit driven pricing on an ongoing basis. You recall in last call we highlighted that we had taken some pricing at the end of 2018 that we're benefiting from. That said, the biggest driver is the attach rate of our adjustable bases and bedding products as the customer chooses to take a more complete package as Shelly highlighted and how those elements work together is a big deal. There's also been in this current year since we rolled out 360, fewer cases where customers are taking the mattress only and that's helping our ARU and we see some further opportunity there.

And then any update on the assembly sites and the rollout of that nationally?

Sure. We ended the quarter with about 37% or 38% of our deliveries going preassembled mattresses and as we highlighted, we opened our third distribution, assembly distribution center in Baltimore in Q1. We're very pleased with how that location is performing and we continue to learn and advance the strategy. We've also opened a few other DDCs and those are providing an opportunity for us to limit the number of deliveries that go through the less than truckload LTL carrier network which reduces the amount of damage and ultimately reschedule that we ultimately have with our customer. So we're very pleased we think that we'll probably have close to half of our beds being delivered preassembled by the end of the year and continue to see this as an opportunity for margin rate improvement and most importantly a better customer experience as we go forward.

Thanks. Good luck.

Thanks a lot John.

Our next question comes from Brad Thomas from KeyBanc. Your line is now open.

Good afternoon. Great quarter here.

Thanks Brad.

I was hoping maybe just as it relates to the guidance with the strong first half here, you've raised the low end of the range. I guess as we think about the second half of the year maybe what's different than how you were thinking about it 90 days ago?

Not much. We really are seeing some -- we've always said that we expected stronger growth in the first half of the year than in the back half. We really like the progression in the business. You can see going from the sequential changes in sales, gross margin, operating profit and EPS that we're getting the kind of acceleration across all lines that we were looking for as we head into the back half of the year. So we're bullish on the business and feel like we're hitting on all cylinders. We had said that 2019 was the year for us to run clean and that's what we're doing.

That's great. And so, on that theme of running clean I guess, could you talk a little bit about your confidence in the 360 line and how long you think maybe this current lineup can last before your next refresh? What's the likelihood that we end up doing a refresh of some kind in 2020 or something that you could stretch out for a few more years?

Yes Brad, we stay very focused on making sure that we are broadly relevant to consumers and delivering meaningful value that move society forward and feel so strongly about the quality, our proven quality sleep that we're delivering with the 360 smart beds in that it's effortless. And our R&D investments in pipeline will continue to build on that and we today have innovation being pushed every quarter to all of our SleepIQ customers through our software. So that absolutely improves the overall experience on an ongoing basis and then we will continue to have new advancements in our product, thinking about the smart bed, the 360 smart bed as the base and the evolution will come off that bed in the future.

Great and if I could squeeze one last one and Synchrony has been very important partner for you all, can you talk a little bit about how that's working and where you still think there's opportunity there going forward?

Yes. This is such a great illustration of our deep and long in innovative partnerships that yield steady outcomes and also progressive partnership in relationship which is important to us and they've been key partners for us as we evolve and we see continued upside here just like we do with ARU growth. It's up to all of us to ensure that we're advancing all aspects of our business to engage consumers and deliver what matters to them and if you're doing so, you'll continue to see growth and responsiveness and we see that with Synchrony as well as with our innovations.

Great, thank you, Shelley.

Our next question comes from Peter Keith from Piper. Your line is now open.

Hi thanks. Good afternoon everyone. I want to ask a longer-term question around store growth. So now that you're at 600 stores and moving higher, have you contemplated any type of international expansion? It seems the brand and the product certainly could translate well to other parts of North America and wondering if you're beginning to contemplate any further expansion in that regard?

Yes. Hi Peter. That's an important question. Absolutely our vision is a great indicator of that. Our vision is to become one of the world's most beloved brands by delivering an unparalleled sleep experience and that's certainly much broader than the U.S. and an important part of our growth strategy over the next few years.

Okay, very good. And maybe for David just on the balance sheet. Looking at the revolver, can you remind us is that at a fixed rate or variable rate, I was just looking at 10-K, I know it said an up landed rate of 4.2%.

Yes, that's a variable rate.

So, on that notes, sort of you sort of using the revolver to fund your share repurchases with that variable rate. Would you at some point look to maybe towards longer term debt was some type of term loan, maybe it's some type of comparable rate that which you have right now?

Peter, we review our capital structure with our board on a regular basis and even when we were expanding our revolver this last time, we looked at all different types of debt structure and we think that maintaining maximum flexibility is a priority for this business. We generate a lot of cash and yet have time periods where there's slower demand. So, we want to make sure that we have flexibility and that park ourselves into a capital structure that looks like that.

Okay.

That so far but someday that may change but right now that's how we think about it.

Okay, very helpful. Thanks so much, guys.

Thanks, Peter.

Our next question comes from Michael Lasser from UBS. Your line is now open.

Good evening. This is Atul Maheswari on for Michael Lasser. Thanks a lot for taking my questions. What have you baked in for overall consumer spending in your back half guidance and is this guidance a mid-to-high single digit sales growth contingent on consumer behavior remaining at say around the same place as in the first half. Thanks.

We think the consumer is really healthy and we expect that continue in the back half of the year.

Thanks.

[Operator Instructions] Our next question comes from Seth Basham from Wedbush. Your line is now open.

Thanks a lot and good afternoon.

Hi, Seth.

Hi, Seth.

My questions around gross margins. I may have missed it but if you call out mix in terms of adjustable attachments being a hindrance to your gross margins this quarter like it has been in the past?

Yes Seth, that's a good highlight. No, we didn’t call it out because we had other things within our mix that help offset that pressure that we have been seeing earlier especially on a year-over-year basis. So no, that wasn’t something we called out as a gross margin rate pressure this quarter.

Dave, could you add a little bit more color around that, is it within the adjustable do you see more trade up or within the mattress line did you see more of a trade up?

We actually saw both, we saw an improvement. Remember, Seth, last year in the second quarter we are closing out our C4 and so that a bit of our mix moved down into the C-series last year at this time. Our promotional cadence was a lot different this quarter and as a result we move people up the line and in terms of the mattress choices that they made. But we also the attachment of our flexible adjustable basis was higher much higher but they also attached at the higher end of the three models that we have at a greater rate. So, that helps to offset some of their margin rate pressure.

Got it, that's helpful color. And then secondly, maintenance this is well but I think you may had mentioned that conversion now you have record levels here, implied mattress unit and comp stores is down slightly, conversion is strong, that must imply that traffic is down within your comparable stores. What's happening with the consumer and how they're shopping in your stores? Are you seeing less traffic and is there something you can do to improve that trend?

Yes. Importantly, our traffic has been very strong and steady for four quarters and our key measurement there is qualified traffic. So, there's a difference in to quality traffic and we've been honing in over these last couple of years on quality and qualified traffic. And so, we've been really pleased with the results of that media strategy. And obviously, we've been growing our number of new stores and I highlighted in the remarks that we added 61 stores over the last 12 months that impacts comp and why we stay focused on total growth and total unit growth. And if you look at unit growth in the second quarter, we're up 3% in last year in the second quarter we were up 7%. But as we've said, we expect growth from both units and ARU on an annual basis. And looking at this on a quarterly basis, there is going to be fluctuations because of how we drive our promotion. And I think this quarter is a great example of that. Last year was 7% growth in units was heavily driven by the C-series closeout which also pressured margin in other aspects where this year this is all about the 360 smart bed and we're still expecting growth from units in ARU for the full-year in the back half.

Thank you, very much.

Our next question comes from Curtis Nagle from Bank of America. Your line is now open.

Good evening. Thanks for taking my question. Just quickly one I guess going back on the debt. So, kind of looking how did your free cash flow for the rest of the year, 3Q is a really strong quarter. Looking at what I think is left in terms of how much you guys want to buy back, you should have plenty of capacity to do that. Would you guys consider taking some of the debt down in terms of whatever excess cash you have exit buy backs or would you continue to take leverage up a bit?

Curtis, this is an important area that we manage carefully and we've highlighted that we operate within a range of 2.5 to 3.0 times EBITDAR and we are at the high end of that range at the end of our seasonally low cash generation period here in the second quarter. We expect that as we progress through the balance of the year that that might come down actually in the range but we are committed to operating the business relatively conservatively on the debt front or the leverage front. But you can count on us using that target range as a guideline.

Oka fair enough, thanks very much.

Okay.

Our last question comes from Brad Thomas from KeyBanc. Your line is now open.

Yes hi, thanks for letting me get back in. a couple of follow-up questions if I could. I think this press release might have been the first time you've broken out the percentage of your stores with sales over $3 million or maybe did a quarter ago and I just missed it. But I was hoping you'd talk a little bit about -- what's that?

Yes. No, this is the first time.

Yes. I was hoping, Shelly, maybe you could talk a little bit more about the qualities of those stores and as you think about maybe not necessarily growing the store base a whole lot more but store actions. How do you think about your portfolio of the stores and where there might be relocation or renovation opportunities?

Well, in such a key part of our strategy and the ongoing sustainable profitable growth for our business and we believe strongly in having a very healthy real-estate portfolio. And I think I gave an example on during the annual shareholder meeting video of a store where we did a relocation after being in that marketplace for some time. And that we had experienced a 20%lift in the first six months. And it was simply a move within a few mile but it speaks to the moving consumer and the marketplace and the value of having a local market development strategy in combination with a national strategy. And staying close to how the consumer's behaving in each marketplace and looking at that total market or total dollars in profit and what moves need to be made in a short and long term. We feel strongly about having a healthy real-estate portfolio nationwide that is on brand and what we mean by that is that the brand experience is consistent across the nation. And that, we're driving a high productivity driving comp as well as being able to fill-in with new stores and markets that were still developing or markets that are growing and staying close to that in our markets. And that is the key to us being in this position today where we average $2.8 million over the trailing 12 months for our stores. And we still are growing at all levels. So, our largest store is still growing. So, we have not peaked out and I think that speaks to this is we're still early in our trajectory both in developing existing stores, adding stores, expanding our markets outside of the U.S.

That's great. And if can squeeze in one more for David on guidance and modeling. Over the last few years and there's been a lot of puts and takes in shifts in 3Q and 4Q. as we think about these next two quarters, do you have any color for us and how we should think about the balance of your remaining earnings and how that might fall between those two quarters?

Yes. We highlighted that there was a shift last year of $24 million approximately of deliveries that move from Q3 into Q4 and we've provided in the Q4 earnings release there's a table that reconciles all of our GAAP reported numbers. So, the non-GAAP performance that we highlighted last year. That has a lot of details in it, that should help you with your modeling and we can help put together some other thoughts in our after calls. But generally speaking the way a consensus is looking in the back half looks about into actually in the right place.

And -- oh, sorry?

And no. I was just going to say I think this is a good illustration of David mentioned earlier running clean in 2019 and just the underlying trends at the business are the underlying trends. We don’t have big moving parts where we're driving the performance, overall it's pretty straightforward.

Yes. I think that seasonably, usually your third quarter is the biggest for sales. And so, I think historically you often had had the strongest earnings in your third quarter as well. If you have a somewhat normal second half, is that how things might play out here?

Yes, that's how I would think about it.

Okay, great. Thanks for getting me back in and congratulations again on a great quarter here.

Yes, thanks Brad.

Thanks, Brad.

We have one more follow-up question from Bobby Griffin from Raymond James. Your line is now open.

Yes, thanks for letting me jump back in the queue. David, have you noticed any change in composition of mattress units when you open up a new store in the market. And is there a rough estimate that you can maybe give us to help us think about how store growth is actually working against in cannibalizing units and why total units is probably the better metric to look at?

Yes Bobby that is an ongoing dynamic with this business. And with the acceleration of store growth Shelly mentioned that we opened 61 new stores in the last 12 months; that's 69% more than we had the prior 12 months. So, the amount of cannibalization is meaningful. And we generally see about 20% cannibalization overall and that you can assume that's dollars and units.

Okay, I appreciate that detail. And thanks again for letting me jump back in here real quickly.

Absolutely, thanks.

I would now like to turn the call back over to the company for closing comments.

Thank you, for joining us today. We look forward to discussing our third quarter 2019 performance with you in October; sleep well and dream big!