Welcome to the Sleep Number Q3 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 you have 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's Third 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 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 may be 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 third quarter earnings call. My SleepIQ score was 86 last night. As the leader in sleep innovations our unique and differentiated 360 smart bed experience is clearly resonating with consumers. We have delivered double-digit demand growth since completing our transition to all 360 smart beds in mid 2018. As expected this momentum continued in the third quarter as we advanced our initiatives and lapped the double-digit sales order growth from the prior year. Third quarter results against prior year included; record net sales of $475 million, up 14% with a 10% comp. Operating income of $39 million up 55% and earnings per share of $0.94, up 81%. Year-to-date results included net sales growth of 12% with an 8% comp. Operating income up 46%, EPS up 63% and return on invested capital for the past 12 months of 18.4%, up 470 basis points versus a year ago. This record performance is the outcome of our transformation. We are where we expected to be and are doing what we said we would do. Our multi-year initiatives have resulted in double-digit earnings per share growth since 2015. We are excited to have nearly completed the first part of our strategic journey, which enables our future growth as we become the hub for consumers health and wellness. With the performance strength across our business, we have increased our full-year EPS guidance to a range of $2.45 to $2.75. My comments will focus on sales orders, which were not affected by the shift in deliveries from Q3 to Q4 last year. The five initiatives we outlined on our second quarter earnings call contributed to third quarter sales order growth of 11% on top of double-digit sales order and unit growth from the third quarter of 2018. We…

Thank you. Shelly. I believe two words to describe our Q3 and year-to-date performance, execution and excellence. Consumers continue to embrace proven quality sleep driving significant demand growth for Sleep Number and our engaged Sleep Number teams are performing at high levels, delivering superior financial results. Third quarter net sales grew 14% year-over-year and are up 12% year-to-date. Remember that double-digit demand in the back half last year, shifted approximately $24 million of deliveries from Q3 to Q4. Please refer to the 2018 Q4 non-GAAP reconciliation tables on the Investor Relations page of our website. Compared to the adjusted net sales last year, net sales grew 8% this year in Q3 and 10% year-to-date. Our demand drivers are delivering as expected and support our continued assumption for up to 10% revenue growth for the year. Comp sales as reported, grew 10% in Q3 and 8% year-to-date. New stores added 5 points of growth to both the quarter and year-to-date. During the last 12 months, we've added 42 new stores, plus relocated 25 stores. Combined, this is 72% more actions, then the prior trailing 12 months when we prioritized rolling out our game changing 360 smart beds. We ended Q3 with 602 stores and expect to end 2019 with approximately 610 stores across all 50 states. Our market development pace has been planful yet opportunistic. By year-end, we will have grown our store portfolio an average of 6% per year since early 2015 in-line with our previous long-range growth assumption of 5% to 7%. Today, our portfolio is 30% larger, healthy and productive. Consumer shopping preferences including online sales also continue to change and we will evolve with them. Through 2025, we expect average annual store growth of approximately 4% to 5% while continuing to advance all our retail shopping experiences.…

Thank you. Our first question is from John Baugh with Stifel. Your line is open.

Thank you and good evening and great results. Could you perhaps provide just a little more color on the various drivers on gross margin, which clearly came in better was -- and I'd love it, if you could talk about either pricing or mix as well as inputs and the efficiencies, you talked about all that kind of color? Thank you.

Yeah. Thanks, John. We had eliminated the transition impacts from the prior year, that was about 100 basis points of improvement. The remaining 100 basis points was a combination of the elements that you described pricing, mix benefits and operating efficiencies, which more than offset the -- about 50 basis points of pressures that we're also absorbing from additional tariffs, labor costs that we highlighted, and things of that nature.

Okay, and last year, if I'm not mistaken, on October 1, you took a 3% price increase. We haven't seen on like-for-like items an increase this year. First of all, is that correct or if I missed something there? And then what -- you've introduced some new products as well. I'm just curious as to sort of maybe the SKU lineup in terms of mix and what you're seeing in terms of your sales and it looks to me like you're less promotional than you were at least for the third quarter last year?

Yes, John, thanks for the additional questions around ARU, our average revenue per mattress unit. We have -- you characterize the pricing accurate. That was about a year ago and when we look at our ARU growth over time, generally about 3% is attributed to pricing, along with the benefits of the innovations. We have not had price -- pricing increases on like-for-like in this calendar year and we continue to drive ARU growth year-over-year in combination between our selling process and our innovations and it really speaks to our mission-driven team and their ability to connect with the consumer, but it also speaks to the broad range of innovative products we have. Again, this is average revenue per mattress unit. It's not average price, and this is reflective of us selling more items to customers and also of our repeat sales.

Got it. And my last question, simply is around your planned introduction next year it sounds interesting. I guess I'm trying to get a sense for how big a deal this is I guess, Shelly, number one? And number two, does it happen in stages through '20 and '21 or are there sort of increments or tweaks to existing products and it all gets changed whenever you make the transition?

Well, we are very excited and it is really interesting and speaks to the 360 smart bed foundation that we put in place mid 2018. If you think about our new line, the line we have today of our smart beds as the baseline and our innovations as we have talked about in the past will continue to evolve off this 360 smart bed, so different than when we transitioned our full line to the smart beds a couple of years ago, which required a large change in suppliers and the transformation of our company and we're in a different place. Today that's our baseline and the innovation will continue to build off it. Importantly, it is meaningful to consumers, making a difference in their quality sleep and that's where we stay focused and will continue to evolve in a way that is broadly relevant for consumers.

Okay. So just in terms of summarizing that, not major re-launches and drops but additional innovations that will be added to beds so I presume there would be last cost or disruption involved?

It does involve, our entire portfolio will evolve.

Okay.

John just in terms of our 2020 guidance, on the Q4 call, we will provide some additional color of how we're thinking about it, but we've incorporated all of that into the color that I gave you earlier about how we're thinking about 2020.

Got it. Thank you.

Our next question is from Bobby Griffin with Raymond James. Your line is open.

Good afternoon, everybody. I appreciate you taking my questions.

Hey, Bobby.

My first question is just around the guidance for 2019 and I was hoping maybe just to get a little bit more color on what's driving maybe the low-end of the range versus the high-end of the range and what leaves the $0.30 range out there for -- in our numbers for the full-year?

Well, first of all, let me just start with -- this is the second quarter in a row of raising our guidance, we're up against double-digit growth again in the fourth quarter. We have great confidence in the performance of the business and the consumers respond to our 360 smart beds and how our initiatives that I described in my remarks are working to continue to evolve and drive that performance going forward. Looking at a midpoint with the 35% increase of EPS at the midpoint, we see as top-quartile top-tier performance overall. And the guidance appropriately reflects the headwinds, tailwinds overall in the business and we're excited to put up a another great quarter.

Okay. Maybe just to help us connect a little bit better off of that. Can we maybe to talk about or expand upon what some of the headwinds and the tailwinds are? Those typically have a tendency to change from quarter-to-quarter, it seems like the momentum of the business is pretty strong heading into the fourth quarter, but is there other uncertainties that we might not be anticipating when we think about what's driving the range out there that you have seen arise that give you a little -- that make you want to keep a little bit of a wider range with just one quarter left in the year?

Yeah, I'll start, nothing new that we're seeing, fourth quarter is always different than every other quarter that's probably one factor. But the other headwinds and tailwinds are consistent with what we've been talking about.

Yes, hey Bobby I -- I've called out that we have been managing some of the tariff headwinds, as well as labor rate headwinds, as well as our investments in our growth drivers, both media and R&D, those will all continue into the fourth quarter. Of course, through Q3, now we have fully lapped the elimination of all the transition impacts that we had incurred the prior year, and so we are -- while we are expecting gross margin rate expansion in Q4, it will be less than what we've been seeing year-to-date. And hence, we're thinking about it in terms of about 100 basis point gross margin rate improvement for the full-year.

Okay, that's helpful, I appreciate that. And Dave, thank you again for the color on future store growth. When we think about that 4% to 5% number. Should the total number of actions decline versus what they've been going over the last couple of years and there's less remodels to be done now? Or should the level of remodels continue at the same pace?

The total capital will probably decline like we've talked about, we're expecting $60 million of CapEx this year. Going forward, while I'm not providing 2020 guidance specifically right now, over that period through 2025, it will likely be $10 million or $5 million to $10 million less than that on average through that period. As that pertains to stores, we would see less new stores and -- but would see in all likelihood a continuation or an increase in the relocations and the remodels that we would continue to take on. We continue to see nice lifts when we move stores from even high performing stores to locations where consumers have shifted their preferences, and we'll continue to do that as we go forward.

Okay, I appreciate that. And then last thing for me, just a quick modeling one, can you tell us what the media percentage was during the quarter, or what the leverage or deleverage was for us to tune up our models?

Yes, we provided the color of thinking about sales and marketing 45% for the year and you should expect media to be up double-digits for the year. Based on competitive reasons we're not going to go into any more detail.

Okay. Thank you, Shelly. I appreciate it and congrats on the quarter and best of luck in the fourth quarter.

Thank you.

Our next question is from Brad Thomas with KeyBanc Capital Markets. Your line is open.

Hey, good afternoon everyone and congratulations on a great quarter and nice momentum here this year.

Thank you, Brad.

So just on the -- to clarify on the timing shift that you all had had last year, did you think you had all of that shift back into 3Q from 4Q this year.

Well that shift was all last year and it all related to about a week's worth of deliveries that we didn't get delivered in the third quarter that got delivered early in the fourth quarter last year. So that had nothing to do with our performance this year. Our performance this year was far more efficient and effective as we've highlighted and that drove strong top-line growth and profitability across the line.

Got you. But it's worth thinking about adjusting and then comparing it. From your best understanding you're more normalized everything was pretty normal here this year?

100%.

Great. And so just to ask about units, if you got the shipments and that helped you potentially by about 6% on the unit, then the total units may have clocked in slightly negative, if not for this shift. Now, I understand that now is a priority for you. Your ARU is fantastic this quarter, but I guess does that math seem right? And as you look forward, how should we think about you guys pulling that lever to push units more going forward versus the ARU?

Yes. Brad to be real clear and this is why I stated that my comments would reflect our sales order growth, so that you have a clear sense of the underlying health of the business, setting aside that shift. So our sales order growth in the quarter was up 11% and that included a 3% growth in mattress units. And keep in mind that is on top of a double-digit sales and unit growth from the prior year. So last year we were closing out of the C-series in the third quarter and that drove a lot of unit growth. So that was double digits and we drove another 3% on top of that this year.

Got it. I appreciate that clarification. And just a last one for me. Some of the online competitors I think have dialed back some of their advertising spend. I guess could you speak to the competitive landscape and some of the customer acquisition costs. Again, clearly you're driving some very strong results here?

Sure. Okay, so two things. First of all, some may have dialed back and some dialed up. So overall, the competitive spend environment was very similar to what we've seen all year in the third quarter and we -- as we said we would leaned into our media investment behind very strong creative and that helps us get after the acquisition part of this in addition to the retention of our customers that drives referral and repeat. So we're excited about the opportunity in front of us and as I've said, we're playing to win and have a lot of confidence in the initiatives that we're putting forth and the consumers response to our differentiated and unique products.

That's great. Thank you so much, Shelly.

Our next question is from Peter Keith with Piper Jaffray. Your line is open.

Hi, thanks. Good afternoon everyone and thanks for all the additional color and the prepared remarks today. I wanted to just dig into a little bit longer-term store growth. You guys had cited 4% to 5% growth overall, is that net growth or would that be, I guess like 4% to 5% of would be store projects including relos and remodels?

Hey, Peter. It's David, I highlighted that the last 6 years, the growth has been around 6%. The next 6 years we're thinking about it in terms of 4% to 5% that includes the assumption that consumer shopping behaviors and preferences will continue to evolve and that's not going to be a straight line. It was in a straight line over the last six years and it won't be going forward. That is the total portfolio. So the net number of incremental stores of the total portfolio that I'm talking about.

Okay, helpful. So looks like just doing simple math, you'd be implying around 800 stores looking out to 2025, are we thinking about that as a potential store target and would that just be stores in the US at this point?

We didn't quantify it as -- we didn't do that kind of math, I think, I mean I have, but it's in the 700 to 700 plus range by 2025 and that is focused on the US market.

Okay, great. Last one for me on the same theme. Thanks for the quantification around the cannibalization rate. I think you said it impacts same-store sales by about 100 basis points. Has there been any change in that trend in recent years and maybe even looking forward now that you're in all the major DMAs. Would you think you would hold that rate of cannibalization steady or could that pick up a little bit with increased store density?

That number is an average across the entire portfolio as we execute the strategy and we do see different markets react differently and some have cannibalization, that's less than that and some have more, but the overall average hasn't really changed meaningfully in a number of years. We expect that same level of cannibalization will likely hold as we continue to execute the strategy in a local market development approach.

Okay. I thank you very much, guys and good luck.

Thank you.

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

Good evening. Thanks a lot for taking my question. Your sales and marketing grew about 13% in the quarter, if we take out some marketing for the new store growth, maybe it was up 6%, 7%, 8% and I think you mentioned your same-store units were up about 3%. So should we think that like a sustainable algorithm your overall marketing is going to grow maybe at twice the rate of your units over the long run?

We've highlighted that we expect this year sales and marketing to be 45% of our net sales. That's not wildly different than our historical trends. We have not yet provided that level of detail of our guidance for 2020 or any other time frame going forward. What I would say is that, Shelly has highlighted, that we're playing to win where the business is performing very well and we're hitting on all cylinders we're going to continue to lean into our initiatives and drive growth and leaning into those growth drivers benefits the total P&L and financial performance of the company, we'll continue to do that.

And Michael, you asked about how to think about units. For our business model and our strategy, it's important to think about both ARU and units. We can drive and have been driving growth from both and it's also important to look at these metrics on an annual basis. We will have quarterly fluctuations due to promotions or how we're lapping something from the prior year and I think this quarter is a good example where we had a 3% unit growth over a double-digit unit growth from prior year when we closed out of the C-series.

That's helpful. Thank you. Shelly. And one more for you, Shelly. As we know, next year is going to be an election year. There's probably going to be a lot of ad spending associated with the elections. In the past, how have you seen both marketing expenses and just overall demand for Sleep Number beds shape up during what essentially distracting election year?

Well, I think this is an unprecedented time from a number of factors. So for us this is the first time that we've had all 360 smart beds in the marketplace during an election. And we know that the consumer is resonating with the proven quality sleep that these beds are delivering and we'll continue to lean into the messaging around that and also our tactics and how consumers consume media today is very different than even the last time we had an election. So I think reflecting on the past for the election probably is not going to give us the right answers for moving forward. And really understanding the dynamic marketplace that we're in from a media consumption and how consumers get distracted with various messages and we've learned a lot and this is part of why we have digital buying in-house and search in-house, so that we can be nimble, agile and make adjustments in real-time.

And Michael, we've incorporated that the election and the Olympics and we have distractions any given year for different reasons and we just need to out-market through those things and we will plan to continue to do that, but we thought about that in terms of the color we provided on the top-line for next year as well.

Great. Thank you. Shelly and Dave.

Our next question is from Seth Basham with Wedbush. Your line is open.

Thanks a lot, and good afternoon. My question is just around ARU as we think about the go-forward ARU if you could help us dimensionalize on the drivers that would be helpful. You're lapping the price increase, you have seen a nice step-up in attachment rates over the last year. Do you think you'll be able to drive any close to the level ARU that you've reported year-to-date?

Seth, we do expect growth on an ongoing basis from both ARU and units. And this is an outcome of our proprietary sleep innovations, the advancements that we will have next year and beyond. It's also a result of our exclusive distribution, our mission-driven team, our selling process and how we go-to-market overall. Again, it's not average revenue per -- it's not average sale, it's average revenue per mattress unit.

Understood. And with these new innovations do you expect to be able to drive price on a like-for-like basis?

If needed -- I mean if we needed to Seth, that's one lever that we've been able to employ for years and historically that's driven about 3% benefit to our ARU growth. We haven't highlighted any indications on pricing to-date, but that we certainly have that lever in our quiver.

Understood. Thank you.

I'm showing no further questions. I would now like to turn the call back over to Sleep Number for closing remarks. Thank you for joining us today. We look forward to discussing our fourth quarter 2019 performance with you early next year. Sleep well and dream big.

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