Welcome to Sleep Number's Q4 and Full-Year 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 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 fourth 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 year-end earnings call. My SleepIQ score was 96 last night. In 2021, our 360 smart beds drove double-digit demand growth and record earnings for the third consecutive year even with pandemic induced global supply chain disruptions. The fourth quarter proved to be the most challenging as we ultimately did not receive a semiconductor component soon enough to fulfill our planned deliveries in the quarter. Electronic supplies remain constrained near-term as semiconductor demand is still overwhelming global supply capacity. The suppliers are adapting as they enter the third year of difficult operating conditions. As we navigate the disruptive constraints from this industry, we have been agile in retaining our customers and generating demand. Strong demand for our smart beds reflects the life-changing wellness attributes of our innovations. As evidenced by the events of the past two years, our purpose to improve the health and wellbeing of society through higher quality sleep has never been more urgent or important. Highlights of our 2021 performance as compared to 2020 results adjusted for the 53rd week include net sales growth of 20% to $2.2 billion, earnings per share rose 34% to $6.16, cash from operations increased to a record $300 million and our return on invested capital was nearly 28% more than 3x our cost of capital. Over the past five years, we have delivered an EPS CAGR of 41%, nearly 4x the 11% compounded average sales over that time frame. We also generated a five-year EBITDA CAGR of 14% further demonstrating the superior cash-generating ability of this business. Now let me elaborate on the capabilities that are enabling us to navigate supply chain challenges while driving demand growth. We are utilizing numerous levers of our vertically integrated business model to anticipate and respond to dynamic business…

Thanks, Shelly. Here are four things I will cover today. What happened in Q4? How our long-term bias drives performance? Risks we are addressing and Q1 implications and 2022 guidance assumptions and long-term expectations. Our teams and partners have applied all the tactics in Q4 that successfully closed supply gaps and led to very strong Q3 financial performance, including leveraging supplier relationships, component redesigns, finding alternate components and expediting shipments. Despite these efforts, a large well-known global electronic supplier delivered one component too late in December. This moved more than $125 million of net sales, about 2.5 weeks of deliveries out of the quarter. Q4 net sales were $492 million versus the $600 million to $610 million needed to reach full-year EPS of $7.25. While this demand is not lost, the shift caused temporary inefficiencies across the business and lower delivered volume to leverage infrastructure. Margin rate pressures in Q4 were significant, unusual and temporary. Importantly, 30% or more of these cost pressures are temporary while our pricing actions and efficiency initiatives are sustainable and will drive profit rate improvements over time. We took three 2021 pricing actions with $140 million of annualized benefit to offset $140 million of cost pressures. This strategy protects demand generation and gross profit dollars, but pressures gross margin rate by 440 basis points. This was the largest driver of the 580 basis point Q4 gross margin rate declined versus the prior year. This dynamic converts to 220 basis points of NOP rate pressure, explaining half of that Q4 rate decline versus the prior year. The remainder of the gross margin and NOP rate declines were driven by logistics inefficiencies and lower leverage due to the net sales shift. With continued strong demand and liquidity, we have positioned our infrastructure to drive accelerated financial performance…

[Operator Instructions] Your first question comes from the line of Peter Keith with Piper Sandler. Your line is open.

Thank you. Good afternoon. I guess I just want to follow-up on the guidance commentary. So David, just in the last remarks, it sounds like you're calling for demand growth of mid to high single-digit. I think can you confirm that would be in line with what you guys were talking about last quarter? And then your – correspondingly, you're not factoring in a reduction of this backlog. So you're basically carrying about an excess $125 million of demand on the balance sheet through the year, that's what's factored into the guidance at this point?

Hey, Peter, thanks for the question. You're right about the demand generation. We do expect the same demand growth in 2022 as we were thinking about last quarter for 2022. In terms of the access backlog that we're carrying into 2022, it's far more than that $125 million. As you know, our demand meaningfully exceeded our net sales for the year. However, with the supply constraints that we are managing our way through and the visibility that we currently have, we're basing our EPS guidance for 2022 and the color we provided on the shape of the year, largely on the commitments that we've got now from our electronic suppliers.

And Peter, I'll add that we largely expect to have the same level of backlog at the end of this year as we did at the end of 2021.

Okay. And then just a clarifying point, it sounds like the shortages are specifically with the FlexFit adjustable basis. So you're not making any deliveries whatsoever if a base is part of the purchase or couldn't you just deliver the bed initially and then follow on with a base at a later date?

Yes. Peter, in the fourth quarter, the semiconductor component that came late impacted all. Here in the first quarter, the delay is related to a chip that is associated with our high-end FlexFit 3 smart adjustable base. So it's that one that has either a delivery right now of six weeks or 11 weeks. So we are delivering. And right now, if you purchase that bed, it would be six weeks or 11 weeks depending on the specifics of the combination, whether it's a queen or a king. Over 60% of our smart beds, including our opening price point FlexFit adjustable base, is available within one to two weeks.

Okay. And I want to slip in one last question, just kind of outside the quarter, more big picture. So you've talked in the past about having all of this sleep science data with the Sleep360 technology. You're leaning into that further. Could you tease out any plans to monetize this information or maybe provide some type of subscription service to your customers? It seems like you have something fairly proprietary. There is a number of other competing devices on the market that are doing this type of subscription dynamic. How are you guys thinking about this on a go-forward basis?

Well, thanks for that question, Peter. Absolutely, that's a future new revenue stream for the company. We're really excited to introduce the Climate360 smart bed late this year. And then our new, all new 360 smart beds are full line the following year. This will be a new platform, our most dynamic platform that has expanded monitoring of additional factors such as temperature, which temperature and weight and other factors. And that enables even a much broader deliverable to our customers, all of our customers. And that then puts us in a position not only for monitoring, but also the potential to do health assessment. And as we expand that monitoring and things like health assessments, those are all important components for a subscription series.

Okay. Thank you very much.

Thanks, Pete.

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

Thanks a lot and good afternoon. I just want to better understand the backlog situation again. I think you said it was over $100 million exiting the third quarter expected to be same range exiting the fourth quarter with $150 million shifting from the fourth to the first quarter and beyond. Is the backlog exiting the fourth quarter now $250 million? Do you expect to carry that through the entire year 2022?

Hey. Seth, we haven't quantified the exact dollar amount in the backlog. But it's safe to assume that it's the excess backlog is north of $150 million of net sales equivalent.

North of $150 million. So it expanded only some $50 million or so from the third to the fourth quarter?

That's right.

Got it. Okay. And then as it relates to improving that backlog through 2022, it's just a matter of the supply of the chips more than anything else. And would you expect to make more certain progress later in the first quarter or is it really going to be related to online?

Yes. Seth, absolutely. Our guidance includes the allocation we have today from those big global technology manufacturers. And this remains a challenged industry for semiconductor components, and we fight for additional allocation every single day. I would characterize it as a bit more stable than the back half because of the weekly allocations and less disruption around them as we head into the balance of the year. And our guidance includes what we expect to receive at this time. We do see this industry being a little more stable, there's certainly a lot more capacity coming on board through additional factories in the back half, but by the time that flows through, it's probably 2023. So we really don't expect to have any meaningful reduction in our backlog until 2023. It will increase here in Q1 with the delays. But then we'll be getting after that in Q2. By the end of first half, we expect it to be about where it was at year-end and then exiting this year. So the cut in will be in 2023 as we sit here today. Now obviously, if we're able to procure more we'll update – and we'll update you on that on our next call.

All right. Thank you. And just to follow up, making sure I understand the dynamics in the fourth quarter. If your backlog expanded by $50 million more than you expected and you missed sales expectations by over $100 million, what's the missing piece there?

Well, some of the excess backlog that went into the fourth quarter was going to be contributing to our delivered sales in the quarter. So we're talking about the cumulative ending backlog at the end of 2021, the excess portion of that based on the larger size of the company and the larger volumes of demand that we're generating is now in that neighborhood of north of $150 million of net sales equivalent.

Okay. Thanks.

And Seth, I'll just add about the demand in the fourth quarter, because I think that's a really important part. Our demand is strong and does not seem to – does not appear to be impacted by the supply constraints that we've experienced. We had a high single-digit demand in the fourth quarter. It was the demand that we needed to be able to hit the 725. And it was only the last two weeks of deliveries that ended up, moving that $125 million equivalent at the end. And then importantly demand continues to be strong here in this quarter.

Thank you.

Thanks, Seth.

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

Good afternoon, everybody. Thanks for taking my question. I guess, David, first, I just want to clarify and make sure we got the details, but you said within 5% for 1Q. Are you talking plus or minus 5% or you just want us minus 5% in revenue? Can you just clean that up real quick while we're on the line?

Yes. Sure. Yes, within 5% means we're – the constraints are keeping us from getting to that point. So it's on the downside as opposed to plus or minus.

Okay. Yes. That's helpful. I agree with that, but I figured, it's better to ask now than have questions later.

Absolutely.

Yes, it's a pretty big range, if it were plus or minus. I would have called it out that way.

Yes. Thank you.

Yes. And I guess, Shelly, I wanted to circle back on how you're kind of managing the customer relationship, given that this is a longer lead time to get bed and typically for Sleep Number? I guess, are you guys pulling back on media because you're kind of stripped out on capacity right now? Or are you still kind of running the meeting strategy as normal? And are you giving some discounts to customers have to wait for 11 weeks? Like what is – what's going on to protect the brand value and protect the backlog. Because the one thing, I think that is unique to your business is your backlogs more real than maybe some other backlogs because they have customer deposits and they – the closed control distribution network?

Yes. Thanks for the question, Bobby. Absolutely the backlog is real, this demand is not lost. And while we talk about a backlog level similar at the end of the year, as you know, we ended this year with, it's a different backlog. We are servicing our customers. And in fact, over 60% of our smart beds are available within seven to 14 days right now. So the advantages of our vertical model, Bobby really allow us to stay very tight with our customers, whether it is online or in person in the stores, and the relationship our team members develop with their customers, as well as the selling process and being able to meet the customer's needs based on the right match for them. And also that right match includes when they need the smart bed buy. We are full steam ahead driving our demand. This is, such an important strength of our business for us to be in this situation where we're constrained by supply that yet we're not losing demand because of the supply. Our demand is strong and we talked about on the third quarter call that we expected mid to high single digits here in the 2022. And as we sit here today with February, we just completed our all important President's weekend. We had an outstanding weekend with record performance. And we're here at high single digits in February month-to-date with that performance. And it's really exciting, and it speaks to the strength of all these attributes of our business model. We have steady returns, cancels. We don't see an increase there, in fact, a slight favorability. We have strong conversion and a record level of traffic, and that speaks to the advantages of this business model and the importance of our smart beds and the value of health and wellness that they provide our customers.

Yes. Bobby, I'd add on. Shelly highlighted one of the great benefits of this vertical model and that is in this digital capability and the visibility that we're creating now to be able to manage our way through this that we can see where that inventory is deep into the supply chain. That's different. That's new. And that's helping us make better decisions on behalf of our customers while they're standing at the cash register. And that makes a big difference when they just want us to do what we promise and that's – we can commit to it, if it's several weeks, and these are life-changing improvements. They've proven that they want to – that they're willing to wait.

Okay, that's helpful. And I guess lastly, when we think about the supply chain and the new products and you have some compelling new products with the climate control bed coming out and stuff. Are the new products and new systems going to be a simpler global supply chain? Or is this kind of risk and understand the, hopefully, the world gets back close to normal, its just going to be embedded in how these beds are assembled and where you go to source from going forward?

Yes. We're working with the top global electronic suppliers in the world. And our team is working closely with their software developers on the necessary semiconductor chips for our new platform as well. So this top to top and close relationship in the developers for our future is really important to both our company and their company. And then we also have a fairly robust, significant around 30% reduction in actual component SKUs as we transition to our all-new line and that will obviously be helpful as well.

Thank you, Shelly. That was exactly what I was looking for. That's very helpful. Best of luck here in this environment.

Thank you.

Thanks Bobby.

[Operator Instructions] And your next question comes from the line of Atul Maheshwari with UBS. Your line is open.

Good evening. Thanks a lot for taking my question. Shelly and Dave, based on what you know today, what is the risk that the supply chain is worse than what you've incorporated into your 2022 guidance that could cause you to miss? I'm basically just trying to understand how conservative you were with respect to your expectations around supply chain when you’re setting this guidance?

Yes. Atul, thank you for the question. Our guidance contemplates what we know today on our supply chain. We have weekly allocations of the semiconductor chips that we've talked about here in the first half. I would – and then we have quarterly for the back half. And there's widespread belief that this industry starts to strengthen in the back half. We didn't build that in. We built in steadiness and delivery on the commitments, and we've built in delivering the demand we're able to create this year. But we did not build in any expectation to be able to reduce the backlog on top of the demand.

Yes. Atul, I'd add. Look, 2021 had some fits and starts in terms of COVID, and we saw with Omicron late in the year that had – that variant had a pretty big impact globally on people's performance. And that was new information. Something like that could happen again. We don't have that built into our guidance for 2022, but those are real risks that still remain.

Got it. And see, if I have to frame the upside potentially to your guidance, demand be stronger and that can cause upside, or you really need supply to get better for there to be upside to the guidance?

The answer is supply. We're going to continue to drive strong demand, and we're not – we're leaning into the demand. It's important. Strong demand, strong cash flow these are strengths of our business model and our strategy. But the upside, short-term, near-term comes from supply. Now obviously, any demand we create, it will be delivered. So there's still future upside by greater demand than our expectations as well.

Yes. And whether that happens in 2022, that would be great. That's not built into our assumed EPS guidance, but we'd love – we're trying to make that happen for sure.

Got it. And then a final question for me is on inventory was up 20% plus, even as you call out inability to fulfill demand. So it seems a bit of a disconnect. So could you clarify what this inventory increase was related to?

For sure. About 60% of that was in components other than the electronic chips that we're talking about be constraining our performance. And the remainder of the 40% is really tied to the cost inflation that we had pretty significant PPV, which is part of why Q1 gross margin rate is so low.

Understood. It's very helpful and good luck with rest of the year. Thank you.

Thank you very much.

Your next question comes from the line of Curtis Nagle with Bank of America. Your line is open.

Thanks. Thanks very much. So I just wanted to, I just confirm the commentary. It sounds like over the past couple of quarters, you guys have not seen any cancellation. Is that correct? And then just – I don't know, maybe forgive me for being a little obtuse here. I'm still not sure I fully understand why the backlog would, I think, fully carry to the end of the year, maybe that's not right. Is that just due to the semi issue? How do I reconcile it? It's such a big number?

Right. So on the cancellation rate, we have not seen any appreciable increase in the cancellation rates despite the lengthening of time that people are sitting in the backlog. Part of that, as Shelly highlighted, is the new communications that we have with our customers on a regular basis, keeping them warm, while they're and excited about their purchase. And that's another benefit of this vertical model that we've been talking about. So cancels are not higher, and we've been actually seeing some indications that, that could go in our favor because of these new capabilities. So in terms of backlog, how do I describe this? We're planning to drive demand growth. We talked about that we want to drive through the short-term supply challenges. And what I mean by that is we're continuing to invest to drive demand. We're still spending against driving greater demand, which will increase our backlog in Q1 and to the benefit of our performance the balance of the year. And how we're thinking about our guidance is we have not baked into our 10% to 15% EPS growth for the year any benefit of taking our backlog that we're carrying into the year, reducing that in any way in 2022. If we can get more supply, we will certainly do that. But that's not what we've assumed for our guidance.

Okay. Thank you.

Okay.

There are no further questions at this time. I'll turn the call back to the management team for any closing remarks.

Thank you for joining us today. We look forward to discussing our first quarter 2022 performance with you in April. Sleep well and dream big.

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