Welcome to Sleep Number's Q2 2021 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. [Operator Instructions] I would now like to introduce David Schwantes, Vice President of Finance and Investor Relations. Thank you. You may begin.

Good afternoon and welcome to the Sleep Number Corporation second quarter 2021 earnings conference call. Thank you for joining us. I am Dave Schwanes, Vice President of Finance and Investor Relations. With me today are Shelly Ibach, our President and CEO; and David Callen, our Chief Financial Officer. 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 welcome to our 2021 second quarter earnings call. My SleepIQ score was 84 last night. As a company with purpose, Sleep Number is keenly focused on innovation and long-term investments that improve the health and well-being of society through higher-quality sleep. Every night our life-changing 360 smart beds with SleepIQ technology deliver an effortless individualized sleep solution that benefits millions of smart sleepers. As consumers continue to prioritize their health, we are driving exceptional demand for our Sleep Number 360 smart beds. And even as consumers increase their travel and entertainment activities we are deepening and broadening our brand relevance. Our unprecedented demand growth combined with global supply chain disruption limited our Q2 deliveries. Our mission-driven team's relentless focus on our customers' experience has led to the acceleration of key initiatives that scale our capabilities, increase our efficiency, and contribute to superior stakeholder value creation. As a result of exceeding our internal expectations we are again raising our full year 2021 EPS guidance. Our new outlook of at least $7.25 compared with EPS of $4.60 for full year 2020 excluding the 53rd week and is nearly three times our 2019 EPS of $2.70. Our first half performance represents another sales and profit record demonstrating the power of our competitive advantages and benefits of our vertically integrated business model. Specifically, consumer demand for our smart beds in the first half of 2021 was up more than 40% versus 2019, reflecting an acceleration in the second quarter. In fact since transitioning to all smart beds 12 quarters ago, our average quarterly demand growth accelerated to 18%, significantly outperforming the market and further increasing our market share. Net sales for the first half grew 39% to more than $1 billion and were up 35% over the first half of 2019.…

Thanks, Shelly. Our teams and suppliers have been working tirelessly to manage four consecutive quarters of accelerating unit demand including escalated velocity in Q2. They are expanding output and capacity while navigating temporary component and labor constraints inflation and expedited logistics pressures. Despite this, Q2 performance broke top and bottom line second quarter records. Our teams have driven three consecutive years of double-digit average demand growth by continually progressing our differentiated innovations, digital marketing and experiential retail operations. This momentum is carrying forward into the back half of 2021. We now expect to deliver at least $7.25 in 2021 EPS on at least 35% two year net sales growth. Demand has temporarily exceeded supply. Component shortages limited output from two third-tier suppliers affecting our deliveries in June and July. COVID-driven labor shortages at a Tier 1 supplier which have now been resolved, delayed their installation of additional production lines and will constrain our delivery upside through Q3. Our teams and suppliers are working rapidly to more than double production output and deliver capacity to support continued market share gains. Already in 2021, we expanded our home delivery workforce 50% and invested significantly in skill training, our delivery fleet and digital capabilities. We have also advanced resilient supply partnerships including increased support of second, third and even fourth tier suppliers. We source from geographically distributed plants and multiple suppliers wherever possible. This modular strategy offers flexibility for greater support capacity to get ahead of the extraordinary demand growth we are driving. In addition to flexible sourcing, our fulfillment approach prioritizes proximity to customers. Sustained double-digit demand growth has led us to accelerate the execution of our outbound logistics network. We have evolved plans to increase flexibility with a total of eight to 10 assembly distribution centers by next year, up from…

[Operator Instructions] Our first question comes from the line of Peter Keith of Piper Sandler.

Hi. Good afternoon, everyone. Thanks for taking my questions. I guess I'll just kick it off with some of the commentary you made around pricing and inflation pressure. So, Dave, I believe you said $100 million of pricing which is about, 4% to 5% by my math. And then, $50 million of inflation pressure in the back half of the year. So, is that effectively a wash, when we're thinking about a half year basis, or is that $50 million of inflation pressure, incremental to the price increases that you're taking?

Hi, Peter. Thanks for the question. The $50 million incremental cost pressures that I highlighted started in Q2 and progressed through the balance of the year, relative to previous expectations. And the $100 million is an annualized number including the price increases we just took, last week.

So if I could follow up on a couple of moving pieces. Are the prices going up a little bit more than the input cost or about equal?

There's a timing difference Peter. So the -- as we deliver out some of the backlog in Q3 we're going to be absorbing some of that incremental costs before some of the pricing benefit comes through the P&L. So, we expect some cost pressure in Q3. That's included in the assumption for 50%, 2-year EPS growth that I highlighted for Q3. But then those -- I think those pricing increases will then kick in more and then get delivered later in Q3 and the balance of the year.

Okay. That makes sense...

All in on an annualized basis the pricing would more than offset.

Okay. Got you. Very good. And another just a financial modeling question but you talked about the 500 basis points of EBIT margin improvement since 2019 in the first half of the year. You've guided now for 300 basis points for the full year going back to 2019. So that implies a pretty notable drop off in the 2-year improvement for the back half. Is it inflation pressures, or what's causing that sequential step down it seems to look bigger than I would have expected?

Right. And if you look at the sequential improvement in Q -- or in the first half of 2019 versus second half of 2019 Peter, there in lies your answer. There's just a higher hurdle in the back half that we're lapping as we continue to drive operational efficiencies this year and deliver a full year's worth of operating leverage. We're also expecting more sales in the back half than we do in the first half.

Very good. Okay, thanks very much.

You bet.

Your next question comes from the line of Bradley Tom with KeyBanc.

Hi, good afternoon, Shelly and Davis, this is Andrew on for Brad. Thanks for taking our questions. I wanted to start by talking about demand. I know that your average quarterly demand growth over the last 12 months grew about 18%. But I was hoping you could give us a little more color on the quarter specifically and perhaps on a month-by-month basis on how things have played out, and if there are any nuances around Memorial Day or more recently around the July fourth weekend? Thank you.

Sure. Hi Andrew. Well for clarification the 18% average demand growth is over 12 quarters, so three years ever since we transitioned to our 360 smart beds. So, we felt it was important to share that number because it's been accelerating for the last four quarters. And also, it shows the sustainability in our ability to lap strong performance from the prior year. And that's exactly what happened in the second quarter. So we had accelerated demand in the quarter overall. And then we also demonstrated our ability to lap double-digit growth as we got deeper into the second quarter. And we're therefore really, really pleased and excited about our opportunity here in the back half with very strong initiatives to be able to drive year-over-year performance. Again, this will be our fourth year of lapping the double-digit demand here in the back half. And we're very, very excited about doing so with the initiatives that I outlined.

Got it. Understood. And I wanted to shift back to the near-term supply chain issues that you've been facing. Could you give us a sense for the size of the backlog right now? And given the extended delivery times have you seen any evidence of higher-than-usual cancellations of orders from customers?

Well, the easy answer to that last part is absolutely not. All of our metrics, we're a very metric-driven organization, are very stable and steady. We've been very pleased with the demand creation. And consumers are demonstrating their willingness to wait for life changing benefits of our 360 smart beds. As far as the backlog, we're going to defer or avoid talking about specific amounts. We've been providing a lot of color as to the carryover of demand from one quarter to the next. What you need to know is that we are committed to delivering at least $7.25 of EPS this year in 2021 and that's based on the assumption that we'll deliver at least 35% two-year growth in net sales.

And strong deliveries for -- we talked about strong deliveries in August and the balance of the year.

Understood. That's great to hear. And my last question would be on, are these supply chain challenges, are they impacting a particular product line more than others? And how -- and if so, how is that impacting your product mix?

No. There were two specific challenges that we had in Q2 with two, third tier suppliers. Those issues have been resolved and they impacted our deliveries in June and July. And then I provided additional color about how we're thinking about the shape of the year and that our deliveries in Q3 overall will be somewhat limited by the delay of some additional production equipment that went in place to one of our tier one suppliers. So, we're excited about all of our suppliers and our teams. I have to give them a huge shout out, because they've been working tirelessly to work through what is extraordinary demand growth and having to deal with COVID issues, supply chain challenges, logistics problems. So, shout out congratulations. You guys are killing it. And I am thrilled at the progress that we're making that gives us confidence that supports our upsized guidance for the balance of the year.

Understood. Thank you. That’s all for me. Thank you both.

Great. Thank you, Andrew.

Our next question comes from the line of Alessandra Jimenez from Raymond James.

Good afternoon. This is Alessandra Jimenez on for Bobby Griffin. Thank you for taking our question. First I wanted to follow-up on the backlog. Could you give us any color on how much the supply chain impacted the quarter in terms of sales in 2Q?

Well, as Shelly highlighted, we were at one point at four to six weeks in terms of the first available date for our customer deliveries. And now that's down to three weeks, as we stand here today, those kinds of fluctuations are going to be normal as we go through the balance of the year. We're expecting to continue to drive very strong demand growth through the balance of the year and that's going to continue to inflate our backlogs. And we expect even with our guidance to have strong backlogs all the way through the end of the year.

Okay. That's helpful. And then a follow-up for me is in the second quarter e-commerce represented about 12% of sales versus 14% in 1Q. Did the step-down in e-commerce penetration had any impact on profitability?

That's a great thing about our touch points is it's really -- we're happy to support our customers however they want to shop and wherever they want to transact with us. There's the -- the percentage -- the proportion of our business through one touch point or another can change and it will fluctuate on a quarterly basis as you go through the year. But, we're very pleased it's substantially higher than what it's historically been. Shelly highlighted in her prepared remarks that it is now 13% year-to-date versus two years ago was 7%.

Yes, 13% on a trailing 12-month basis compared to 7% from two years ago. So that gives you a good sustainable number looking at the trailing 12 months. And as I also highlighted, we generated on average more than $3.5 million per store. We're so excited about the level of productivity that we're driving in our stores and online. And we look at that in total. It's one of the benefits of exclusive direct-to-consumer distribution. And we are on track with nearly 30 stores are now averaging over $6 million. So yeah, this is very profitable for us as we continue to put this level of revenue or volume through our assets.

Okay. Perfect. That is very helpful. Thank you and best of luck on the second half.

Thank you.

Your next question comes from the line of Atul Maheswari with UBS.

Good evening. Thanks a lot for taking my questions. Can you provide a little bit more color on the component shortfalls like when did the problems start or what components were impacted? And essentially, what's been done to get the lead times back from four to six weeks to three weeks? And then on the go forward, are you expecting things to progressively improve further from here, or is it going to be more volatile in the near term?

Thanks for the question Atul. We had two specific supplier challenges that happened late in the quarter. And that's why the shortages impacted our deliveries in June and July. Those have been resolved. And then I highlighted some challenges with some COVID-related labor availability for one of our suppliers that's going to constrain some of our deliveries in Q3. When you're driving the kinds of accelerated demand growth that we have been driving, it's bound to strain your supply chain and that's what we've been managing through. But as I said earlier, we're excited about the progress that we've been making to radically expand capacities in our delivery fulfillment capabilities. So as I said, we're going to be on track starting in August with very strong deliveries through the balance of the year.

Okay. And then as my follow-up question, Shelly, you quoted some very strong demand numbers in the release and some of your competitors are also reporting very strong growth over in the double-digit range. This is all against a backdrop of 1% or even less population growth. So do you worry that this level of unit expansion for the overall industry and for yourselves might be pulling forward some demand from future periods since the trends could drop off in a meaningful way once the environment normalizes? So is that a, a risk that you worry? And b, if that is a risk when do you think that plays out?

Well, Atul, I'm going to start with pointing to the demand creation we at Sleep Number have created by moving to all smart beds. So we've delivered an average demand – quarterly demand growth of 18% over the last 12 quarters three years of that growth. So that was before you saw these industry trends. And absolutely, the last four quarters we've accelerated our performance. We sell a very differentiated product that is improving people's lives with proven quality sleep. And this is why we are and have been focused on being the innovation leader and creating a product that truly improves one's sleep in their overall health and wellness. And so we see the consumer trends that we anticipated years ago. And those trends include the consumer caring more about their health and well-being and understanding how sleep is impacting their health, and also adapting products and services that are digital like ours. And third gravitating to brands that have a purpose and our purpose of improving the health and well-being of society through higher quality sleep is a really important one at this time in making a difference and contributing in a meaningful way to society. So those trends are sustainable. We see them continuing to work in Sleep Numbers' favor as we move forward. And then all the initiatives that I talked about in this digital flywheel that we created, this ecosystem that we've created, continuously perpetuates higher levels of engagement of our existing customers and that drives referrals and repeat sales. That's for Sleep Number. We have now nearly 50% of our sales in referrals and repeat and leads to sustainability overall.

Got it. Thank you and good luck with the rest of the year.

Thank you, Atul

Next question comes from the line of Seth Basham with Wedbush.

Thanks a lot and good afternoon. My question is around your quarterly production and delivery capacity, assuming you have some pull and shortages, what is that number these days?

Seth, we're not going to get into providing a specific number surrounding our production or delivery. What we will say is that we were impacted somewhat here in Q2 in the month of June, just by a couple of weeks. And we expect to catch that up in the back half primarily in Q4.

And I think the other add that we highlighted is the work that we've been doing the acceleration of our initiatives to expand our capacity and output and we're on track. We're ahead of pace in that regard and feel really well positioned to be able to support our accelerating demand in the months and quarters and years to come.

Just I guess to add to the question Seth though, if you're worried about our ability to keep up with extraordinary demand that we've got, that's not really the challenge. These are temporary constraints that we have overcome. And we're doing things, all the right things that you would expect us to be doing. We have multiple suppliers on key components and we've been doubling capacity at both sides, so that we have plenty of capacity to support extraordinary demand creation as we go forward.

As it relates to that demand creation for the second half of 2021, are you expecting more or less year-over-year demand growth than 18% trend that you've commented on the last three years?

Well, we expect to continue to drive strong performance. There are a lot of elements that Shelly highlighted in her prepared remarks talking about the incremental activities here in the back half, we're just up against now the fourth year of double-digit growth. And so whether the rate grows at the same pace as what we've been talking about to the first quarter – or excuse me, Q4, that trend had been up 12% then it went to 14% in Q1. You can see the acceleration, when we talk about all the way back to the back half of 2018, it's now up 18%. That was pretty significant acceleration on a rate basis. But Q2 is one of the smaller dollar quarters and so on a percentage basis it's different. So now Q3 is going to be one of our largest quarters in terms of dollars. So of course on a rate basis, it's going to be less.

Got it. And my last question regarding the price increases of $100 million. First of all have they been fully implemented at this point in time?

Yes, we did – you remember that we did some last quarter about $20 million worth. And then the incremental to get to the $100 million annualized we put in last week.

Got it. And do you expect any elasticity of demand to weigh on your demand growth because of the price increases?

Yes, we don't. This is one of those unique advantages of our model between our selling process and discounts and financing and price increases. We can navigate between all of those points and this is where our innovation and marketing and sales teams work so closely together to be able to optimize performance. So we do expect our price increases to contribute a good three points of growth in ARU in the back half.

If that's the case you're not expecting any demand destruction from price increases and you've been facing inflation in certain areas of the business for a number of months now. Why did you wait so long to take these price increases?

Yes. Seth with our business model we're focused on -- obviously focused on growing operating profit and have been doing so with about 500 basis point of operating profit growth here in the first half over the last two years. And so we had some pricing here in the first half and this was the right time for us to take it as we head into the back half $100 per model. And we still have pricing elasticity in power and beyond and we also like to attach that to the value adds that we introduce to our lines overall for the customer.

Understood. Thank you.

And just to add let me -- hey, Seth I will just add on to that one is we are focused on EPS growth and operating profit expansion and market share gains. And so trying to drive take pricing just to cover our gross margin rate is not the game that we're trying to execute. We're trying to create superior shareholder value for our shareholders and our stakeholders. And we think the best path to do that is continue to take share and drive operating profits and EPS growth.

Understood.

It's a combination of everything Seth. We're going after all of it.

And your next question is…

Thanks.

Your next question -- I’ll just apologies. Your next question comes from the line of Curtis Nagle with Bank of America.

Good evening. Thanks very much. Just wanted to be focused on the 2Q margins. Totally get supply chain issues dampening sales considering from 1Q. But I don't know margins looked a little light around 6%. You had supply chain issues. In 1Q, they were much higher. I realize there's a differential between the two quarters in terms of overall volumes. But you still had sales levels well above sort of historic levels. So I guess what are the real puts and takes here? Is it just the added cost and not having all the pricing? And how should we think about S&M for the whole year in terms of rate of sales?

Yes. I think you highlighted it, Curtis. The sales are lighter in Q2 and that's seasonally normal. However, these were exceptionally high. You remember, keep in mind, we usually don't make much money at all in Q2 and we had very strong performance in the quarter. Part of what you're not seeing is we continue to drive demand. And it's somewhat tied up in our backlog at the end of the quarter. As we service that, we've paid for some of that here in Q2 and it gets delivered later in the year. So that's an element of our model. So looking at it on a quarterly basis, looking at the rate on one quarter, it's a little bit of a -- that can be very misleading. Looking at a longer period of time, it makes a lot more sense. It's 10.1% operating profit margin in the first half. That's a 500 basis point improvement over two years ago in the first half. And it gets us well on our way toward at least 300 basis points of operating profit expansion versus 2019 for the full year. So we are continuing to carry forward the digitally led operating efficiencies that we've been carrying ever since the back half of last year.

And then on the sales and marketing lines for the year just percentage of sales if I think about that?

I'm sorry Curtis. Could you?

Yes. The sales and marketing lines for the full year in terms of percentage of sales, how should we think about that?

Yes. We're going to use all of our levers. We're going to continue to lean into our growth drivers, our near end growth drivers. As I highlighted, our media actually delivered, while delivering significant leverage in our sales and marketing. But for the back half, as we layer in more stores, there's going to be some additional costs that come through in the retail line, as we have depreciation and staffing associated with them. But, yes, we're going to -- it's going to be delivering higher contribution to our sales growth overall by having those stores. So at the end of the day, the focus really needs to be on a longer-term basis, at least 300 basis points of operating profit margin, while absorbing a ton of incremental headwinds and costs here in 2021. So we're really pleased with the teams and how they're performing and excited that we're on pace to deliver at least $7.25 in EPS this year.

Okay. And just as a quick follow-up, I may have misheard things, but did you say that the price increases that you're just kind of putting through are not going to flow through to 4Q, or is that just due to the slow orders, or did I just mishear things?

Yes. Thanks for clarifying, Curtis. That's not what I meant. I was just saying that, as those price increases that we just took last week, if it takes two or three weeks or four weeks, five weeks sometimes to get those products delivered, that's when that revenue will be recognized at the higher price.

Okay. That makes a lot more sense. All right. I appreciate your insight, of course. Thank you.

Okay. You got it.

Thanks. And there are no more questions at this time. Are there any closing remarks?

Yes. Thank you for joining us today. We look forward to discussing our third quarter 2021 performance with you in October. Sleep well and dream big.

This concludes today's conference call. Thank you for participating. You may now disconnect.