Welcome to Sleep Number's Q3 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 Dave Schwantes, Vice President of Finance and Investor Relations. Thank you. You may begin.

Good afternoon, and welcome to the Sleep Number Corporation third quarter 2021 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 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 third quarter earnings call. My SleepIQ score was 87 last night. The value of our Sleep Number purpose to improve the health and wellbeing of society through higher quality sleep is evident in our record third quarter top and bottom line performance. We improved more than 225,000 lives during the quarter. Before sharing greater performance in detail, I'll highlight three key takeaways for today's call. First, we continue to drive sustained demand and market share gains for our life-changing smart beds, including delivering our fourth consecutive third quarter of double-digit demand growth. Second, global supply chain shortages continue to challenge our business. I'll discuss how we navigated this disruptive environment in Q3 and the implications going forward. And third, robust demand in operating leverage are producing record financial results as we continue to advance key initiatives within our proven strategy to deliver sustainable profitable growth. Third quarter results exceeded our expectations. Net sales were up 21% versus prior year and were 35% higher than 2019, and earnings per share were $2.22, 24% higher than our record 2020 third quarter and up 136% from 2019. Our third quarter performance was particularly gratifying given the significant global supply chain disruption. Our teams' dedication, tenacity and agility once again made a meaningful difference enabling Sleep Number to service the growing demand for our life-changing 360 smart beds. The year-to-date financial performance results demonstrate the power of our advantaged business model and our teams' stellar execution. Earnings per share of $5.63 for the first nine months of 2021 is greater than our record 2020 total year results and more than double our 2019 annual EPS. We are driving strong leverage across our business with the year-to-date net operating profit rate at 10.6%, up 200 basis points from…

Thanks, Shelly. The fundamentals of our business remain strong. Managing business risks amid global COVID disruptions is bringing out the best in great companies like Sleep Number. Our teams' resilience and ingenuity are driving exceptional financial performance because we embrace our common goal to improve lives through proven quality sleep. The technology embedded in our 360 smart beds is driving strong and steady double-digit demand growth now into our four straight year. In fact, our demand creation has exceeded our net sales year-to-date by more than $50 million. Our Q3 ending backlog was comparable to the balance at the end of Q2. These booked orders provide confidence in future net sales. Unfortunately, the electronics that enables our smart technology and steady double-digit demand growth are also creating uncertainty in fulfillment, timing and costs. While we believe these electronics supply constraints are temporary, we know the highly differentiated life improving benefits of our smart beds are enduring. Customers recognize this and are choosing Sleep Number. Our record referral and repeat business engagement scores and low cancellation rates are all indicators of our customers' passion for Sleep Number innovations. So what has changed? The three supply challenges noted on the Q2 earnings call were resolved as expected. Since August, our teams have been working directly with two very large electronics vendors three layers deep in our supply chain after they abruptly decommitted against our open purchase orders. We recaptured some of that supply from them directly and some electronics through higher cost open market purchases. These rapid actions enabled record weekly deliveries in Q3 and released pressure on deliveries previously expected in Q4. To achieve our full-year EPS target, we need to deliver Q4 net sales of approximately $600 million to $610 million versus the $640 million in Q3. The timing of…

Thank you, sir. We will now begin the question-and-answer session. [Operator Instructions] Your first question comes from the line of Peter Keith with Piper Sandler. Your line is open.

Thank you. Good afternoon everyone and nice results here for the quarter. We've got a couple of questions on the guidance for $7.25. So it's kind of a subtle change, but you took out the words, at least with regards to $7.25. It seems like the demand trends are pretty strong. So, it's kind of a two-part question, has there been any change in your demand expectations and is the removal of at least more a function of just some of the backlog and some of the potential carryover into 2022?

Yes. Hi, Peter. Thanks for the question. Absolutely, what you just described. We certainly have sufficient demand and backlog to deliver a number higher than $7.25. We're clearly constrained by the electronic supply. So it is a timing issue. We entered Q4 here with strong demand and that's after delivering four consecutive third quarters of double-digit demand and lapping the 16% growth here in the third quarter from 2020 with another double-digit growth. So we're bullish on our demand.

Okay. And so I guess, we've had some questions too just sort of on like the implied backlog maybe going into the New Year. So you said Q4 revenue implied at $600 million to $610 million, I guess, you have an estimate on like how much backlog would then carryover into 2022 and you wouldn't be recognizing in the fourth quarter?

Peter, that's a hard one to gauge, I would say, because our demand is very strong and we don't yet know what that's going to actually tally up to be for the full year, but I would say – I highlighted that this year we've added about $50 million net sales equivalents that haven't yet been delivered, where our demand exceeded our net sales. That's in addition to what we talked about as we came into the year. I'd say probably in the order of magnitude of about $100 million excess net sales equivalents that at some point are going to come through.

Okay, all right. That's helpful. I'd like to sneak in one more question. You did throw in a comment Shelly that caught my attention just on 2022 that you expect demand growth of mid-to-high single-digit. So that would exceed the current sales estimates out there today and I'm guessing you'd probably have some pricing on top of that for sales growth may be more high-single digit, low double-digit. Could you give us maybe your some – maybe just say maybe unpack that a little bit to help us understand why you are so enthusiastic about that level of demand growth as we look out to next year?

Well, we've had continued strength of demand. The demand first part that remained strong. We've just had the fourth consecutive quarter. We lapped a 16% growth here in Q3. And Peter, we've been advancing key initiative every quarter since we transitioned to all smart beds and this dry consistency each quarter and it's around the engagement, the digital ecosystem, the innovations and we're really pleased with how formulate this is in the ongoing strong demand. And the in-house capabilities in the AI gives us such real time progression. It helps us within the quarter and then we have clarity of the advancement of the initiative each quarter. Going back to what I said about 2022, I was speaking about the demand and mid-to-high single-digit growth for our 360 smart beds that includes innovation, pricing, the digital ecosystem initiatives, the retail expansion and online evolution.

Okay. So to make sure that would include pricing within the mid-to-high single?

Right.

Okay. Very good. Thanks for the clarification and the insights. I appreciate it.

Absolutely. Thank you.

Your next question comes from the line of Bobby Griffin with Raymond James. Your line is open.

Good afternoon, everybody. Thanks for taking my questions and congrats on a strong quarter in a very difficult supply chain environment.

Thank you, Bobby.

So I guess, first, I just wanted to touch on the electronics side of things that you are talking about, your beds are – include a lot of technology in it and it's very common out there that electronics shortages are happening, but what parts of the beds is it impacting. Is it just the adjustable bases or is it the motors and some of the other controls for the adjustable [indiscernible]. I mean, what parts to help us visualize where on your products you're getting hung up at?

Well, the main challenge has been semiconductor chips and other electronic components associated with our smart beds and smart bases.

Okay. So both, so inside the bases as well as some of the other smart bed components for adjusting mattress itself?

Yes.

Okay. That's helpful. And then Dave, I just want to clarify, you mentioned the backlog comparable to 2Q, but when we look on the balance sheet, you had customer deposits down quarter-over-quarter and I know those don't include the financing side of the business. So it can get a little funky from different quarters, but just to ask you directly, did deliveries this quarter outpaced demand, so we actually worked down a little of the backlog?

No. And that's why I was compelled to say that our backlog at the end of Q3 was comparable to Q2 because that's one of the dangers of making the assumption based on the customer prepayments. That number is – fluctuates with the kinds of offers that we're providing, the timing of when things happen, both in terms of the orders and the delivery. So it's not a perfect proxy for backlog.

Perfect. That's helpful. That's why I was afraid about doing that math. That's helpful to clarify. And I guess just lastly from me on when you kind of back into the implied EPS for 4Q and compared to last year. Obviously, last year you had an extra week, $0.30 benefit. There's clearly some pressure coming on gross margin, but when you look inside the sales and marketing side, what's happening there? Is that still leveraging and be flowing through as expected or is there another round, are you stepping up investments in media or anything there in the fourth quarter to get the EPS to kind of shake out to where the guidance is implying?

Well, last year we did benefit from additional operating profits from the extra week and that was reflected in how we adjusted out our $0.30 from our total results from last year, Bobby. We do expect some pressure on our gross margin rates in Q4, that's temporary, I think, as we balance out the cost pressures with the pricing actions that we've taken and the efficiency gains that we're getting. What we're relying on is we're leaning into our efficiency gains through the sales and marketing – the rest of the P&L effectively to deliver strong overall performance. We expect for the full-year is still consistent with how we started the year, Bobby, to deliver more than 300 basis points of net operating profit margin expansion versus 2019.

Okay. I appreciate the details. And let me sneak in an extra one and best of luck here in the fourth quarter.

Great. Thanks a lot, Bobby.

And your next question comes from the line of Brad Thomas with KeyBanc. Your line is open.

Hey, good afternoon, Shelly, David and Dave. Thanks for taking my question. Nice results and demand. I want to ask at the guidance and gross margin. Maybe first on the guidance, just to clarify, so is the $7.25 that you're targeting, does that align with the prior sales guidance, which if I remember correctly, was 35% growth versus 2019. Is that how to back into that $7.25 number?

Yes. It is and on top of that I gave you the $610 million – the $600 million to $610 million in net sales for Q4 that supports us getting to the $7.25.

Great. And David what – do you have line of sight to the components to hit that number today or is that in question or is it possible you may get more of that – I know it's still early in the quarter, but any more color on your line of sight to hitting or beating that number would be of interest?

Well, just like we saw in Q3, if you'd asked me the same question at that point in time, we had no idea what happened in August – was going to happen and yet our teams were resilient and found ways to overcome those challenges and got the supply we needed to deliver record results in Q3, including record deliveries for the last eight weeks of the quarter. As we see here today, there is some misalignment between our demand and the supply and we're solving that every single day, Brad. But as Shelly highlighted in her call, in her comments, it's possible that some of those components could come too late in the quarter and then cause a shift in deliveries into Q1. We feel great about the expectations for components next year relative to the back half year, but we are working every lever to get there.

That's really helpful color. And then just at a high level, could you share a little bit more insight into just how you think about sort of your product margins today. I know your gross margin can have an element of leverage to it and the strong productivity of your stores can help you have a higher gross margin, but how are you thinking about product margins given that we're seeing inflation in so many areas of the world right now?

Great question, Brad, I love that because there are trade-offs that we make all the time between, for example, financing and discounts and that affects different parts of our P&L and so we give greater discounts than it affects our gross margin rate if we give greater financing. It's also a closing mechanism and – but that affects us in our operating expenses. So in total, we love what we're seeing with the business. The fundamentals are very strong. The selling process, the marketing efforts, the innovations are all working together to drive people into the store into the – on to the website or on to the e-com platforms and then converting at very high level. So all the way around really excited about the performance and fundamentals of the business.

Great. Very helpful. Thank you so much.

Yes. Thanks, Brad.

And your next question is from Atul Maheshwari with UBS. Your line is open.

Good evening. Thanks a lot for taking my questions. So just to clarify on the $600 million to $610 million revenue guidance for the fourth quarter. So for you to achieve that range or rather will you be able to achieve that range even if the supply remains constrained as it is today or will the supply has to improve for you to hit that range?

Yes, Atul, as I was highlighting with my previous answer, we have great line of sight to every single day, week in terms of deliveries and are working the levers to pull in some of that supply earlier into the quarter to support our deliveries. This is very similar to what we did in Q3 and had to do in Q3 and our teams are – I have to give a shout out, I mean working magic, finding different solutions and keeping our customers are getting life improving benefits of our Sleep Number smart beds into our customers' homes.

Okay. And then on the EPS guidance of $7.25, it does seem like even next – even backing out the extra week, it seems like a little bit more pressure in the fourth quarter related to the third quarter. So are you baking in more cost inflation in the fourth quarter? And if so, what are the sources of those pressures?

Yes. Atul. This is Shelly. Just highlighting the constraints that we – the constraint we have in the fourth quarter on our deliveries due to the electronic supply shortages. Those constraints are constraining our ability to deliver to our demand and our backlog certainly is sufficient for a much higher number in the fourth quarter, but the actual inventory is not. So that's the constraint that you're seeing and in the fourth quarter, we're continuing to drive our demand of course being very focused on the long-term and ensuring that our customers benefit from the life improving benefits from the smart beds and we're leaning into our demand drivers as you would expect us to for overall value and constrained on the supply and that's what – we've taken some of the risk and moved out of the fourth quarter because of that over performance in Q3. And this is what we have to do yet in the fourth quarter to hit our $7.25 target.

Atul, let me just add one more thing, I don't know whether you're making comparisons only to 2020, but as I highlighted and as it pertains to the Q3 comparison, last year was a year when we had taken significant cost cuts post-COVID and we hadn't yet rebuilt our infrastructure through Q3 and into Q4. We expect operating profit margin expansion in Q4 versus 2019 just like we've done all year long and as we've said we expect top and bottom line performance increases over 2019 for each quarter of 2021. So hopefully that helps you calibrate properly.

Yes. That definitely helps. Thanks a lot Shelly and Dave, and good luck with the rest of the year.

Yes. Thank you.

Thank you.

Your last question comes from the line of Seth Basham with Wedbush Securities. Your line is open.

Thanks a lot and good afternoon. I was just hoping to get a little bit more color on two items that you guys mentioned, one the efficiency gains that you are leaning into, what are those specifically and what can be the ability to drive them earlier than anticipated? I presume, they're not just volume-based?

Well, Seth it starts with volume and creating more demand for your business is the best way to generate leverage and we've been doing that. We've been, as I highlighted the synergy between our selling and marketing efforts are tremendous and being vertically integrated the way we are, we can share those insights across those platforms digitally and engage with customers in a way because of that lifelong relationship. We're driving a lot more volume with a given set of resources. I highlighted two specific examples pertaining to our store productivity, the $3.7 million average sales per store per comp store including e-com, that's up 29% since 2019 and then having more than half of our comp stores with more than $3 million in sales that they're processing trailing 12 month that's incredible volume that's going to those resources and so that's generating a significant amount of efficiency gains.

Okay. And then secondly in terms of the price actions that you mentioned to offset some of the cost pressures. What's the timing of those and how broad base were they?

They were across the product offerings and they've been – there are three different pricing actions that we've taken during the year. One was in the spring, one was in July and one we just took last week.

Got it, okay. And just to recap, relative to your prior guidance of 35% plus, sales growth versus 2019 and $7.25 in earnings at least, you're now just going for those specific points rather than seeing the upside, the upside is less likely because of some of the dynamics in the environment that you're talking to now. Correct?

Well, yes, I mean, not because the demand, there's plenty of demand and there's plenty of efficiencies in our business. It's just really dependent on the electronic supply and yet again, I'm just going to make that comparison back to what we did in Q3. We had similar kinds of challenges and delivered record performance. So the opportunity for us to deliver upside is still there. We just feel like it's pragmatic and appropriate for us to call it as targeting $7.25.

Understood. Thank you, guys.

Okay. Thanks a lot.

And that concludes today's question-and-answer session. I will now hand the conference back to the company for closing remarks.

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

Ladies and gentlemen, this concludes today's conference call. Thank you for joining. You may now disconnect. Have a great day.