Welcome to Sleep Number’s Quarter Three 2022 Earnings Conference Call. All lines have been placed in a listen-only mode until the question-and-answer session. Today's call is being recorded. If anyone has any objections, you may disconnect at this time. I would like to introduce Dave Schwantes, Vice President of Finance and Investor Relations. Thank you. You may begin.

Good afternoon, and welcome to the Sleep Number Corporation third quarter 2022 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 Chair, 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 thank you for joining our third quarter 2022 earnings call. My SleepIQ score was 77 last night. Our purpose combined with our culture of individuality and wellbeing are competitive strengths, they drive high team engagement, best-in-class commitment and effort to perform. These attributes are essential in this challenging macro environment. Today, we'll provide an update on how macro and supply challenges are pressuring our 2022 results and the factors causing a shortfall to prior expectations. We'll also describe actions we're taking to reduce costs in this inflationary environment, preserve our balance sheet flexibility, navigate supply constraints, and strengthen demand. And I'll highlight how we're sustaining strong brand health and judiciously prioritizing strategic initiatives that will enable us to outperform as the environment improves. External business conditions worsened in the third quarter, which had a direct implication for our results and outlook. Third quarter net sales were $541 million, a decline of 16% from 2021 because of constrained supply of semiconductor chips and consumer sentiment were near record lows. Q3 operating profit was $13 million reflecting significant gross margin pressure with operating expenses down $27 million. Third quarter earnings per diluted share were $0.22 better than we previously guided even with the additional pressures. We expect the consumer environment to remain challenging for the balance of the year and into 2023. In addition, several years into the pandemic, single threaded global supply chain built for specialization and cost optimization remain fragile and easily destabilized by events as simple as an equipment failure or as significant as a geo political shock, COVID lockdown or natural disaster. With global inventory of semiconductors depleted, uneven, interrupted chip flow continues to affect Sleep Number delivery timelines and volumes, operating efficiency and forecast. Based on these ongoing pressures, we have revised our 2022…

Thank you, Shelly. Macro pressures intensified in Q3 on all three fronts; demand, chip supply and COGS input costs. As a result, we further reduced our 2022 EPS expectations to range of $1.50 to $2. Specifically, demand worsened in Q3 to down 16% versus last year despite a solid Labor Day. Current performance reflects a more reluctant consumer with a strong preference for value offerings, which negatively affected mix and margin. We now expect Q4 demand to be down mid-teen year-over-year and have reflected this in our updated EPS guidance. Chip supply expectations for Q4 also worsened about 15,000 chips from one supplier are now expected to come too late to support Q4 deliveries, which will be constrained to about 90,000 to 95,000 smart beds. As a result of the assumed changes in demand and chip supply we now expect less backlog benefit in 2022 back half net sales. While our backlog is primarily dependent on the timing and volumes of demand and supply it is also subject to disruptions like weather and labor availability. A revise guidance assumes back half net sales approximately $80 million less than our previous call assumption with about half each from lower demand and less backlog service. COGS input costs were also higher than expected as we prioritized customer experience and value. This results in expedited freight to pull forward chip receipts to the earliest possible dates, brokerage part premiums, unfavorable mix and inefficient operations from uneven chip flow. As a result, gross margin in the back half of 2022 is expected to be about 56% or 200 basis points lower than the first half, and our previous expectations. As we wrap-up a challenging 2022, we are reducing operating expenses about $150 million versus plans across all areas of the business. About 40% of…

[Operator Instructions] Your first question comes from the line of Brad Thomas from KeyBanc Capital Markets. Your line is open.

Hi, good afternoon. Thanks for all the detail and thanks for taking my question. Wanted to first start off with just a question around the backlog and hoping you could provide a little more color around where that is today in dollars. I think if I'm, my notes are accurate you were at about $110 million last quarter, so just wondering where you are today? What the guidance range contemplates in terms of where you'll be at the end of the year? Thanks.

Sure, Brad. Glad to provide additional color. We ended this quarter with about $100 million of net sales equivalent excess backlog. Where we'll go from here is dependent as I've tried to communicate on a number of factors, primarily the timing and volume of sales and the timing and volume of deliveries and that can also be affected by things like weather as we saw with Hurricane Ian in Q3 had a little bit of an effect on deliveries in Florida. And then labor availability is always, it can be a constraint as well. But that's how we're thinking about it right now and we'll keep you updated as we go through the year.

And then David, could you just remind me, that's the – that's the net unusual elevation in level versus a normal backlog. So whatever you end this year add there's still the potential that you have more that could be a benefit to fail in 2023 by that magnitude. Is that right?

Yes, that's exactly right. Brad, and on the previous call, on the last call we had indicated that we have – we were expecting an improvement in our flow and total chips available for Q4 that would help us with about 15% to 20% more deliveries in Q4 than in Q3. That didn't happen and so as a result, we're expecting less backlog benefiting in the fourth quarter, in the back half in total.

Great. Real estate sitting here with the demand trends, tracking whether tracking can you talk a little bit about what you're doing in terms of lease signings and how you're thinking about 2023 at this point?

Well we are as always very happy with our market expansion initiatives and the payback on our store investments continue to be very, very fast and we still are finding great opportunities in the marketplace. We haven't put together a full plan for 2023 at this point, Brad we'll provide you some additional insights in – on the Q4 call. We are of course being appropriately conservative in the sense that we want to drive as much business through existing stores as we can and because comp sales are always more profitable than new store sales, but at the same time that's a lever that we'll continue to invest in as one of our growth drivers over the long-term. Again, I'll provide you more specific insights for next year on the Q4 call.

Great, thanks David. I'll turn over to others.

Thanks Brad.

Your next question comes from the line of Peter Keith from Piper Sandler. Your line is open.

Hi, this is Matt Egger on for Peter. Thanks for taking our question. Two quick ones for me. We're just curious if there's been any change or increase in either cancellations or conversion rates? And then secondly I think you've talked about the plan to transition from the free to the kind of the subscription model with your SleepIQ. Just curious what that will look like from – maybe from the consumer perspective? Thanks.

So I can do my best to tackle some of this. But I think you were breaking up a little bit on the last question, but I think I got it. But the first one about cancels and conversion we have not seen any meaningful change in our cancel rates despite having longer than normal lead times and weight periods for our customers to get their life changing smart beds. But that's something that we watch really carefully on an ongoing basis. Conversion rates continue to be very high. Consumers are doing a lot of research before they ever come into our stores, and our teams are great at getting them into some amazing products. And then on your comment about the subscription model, that's not something that we have rolled out yet at all. That's something that we have hinted that, that our future technologies give us insights that might enable something like that, but that's not something we're providing any guidance for at this point.

Yes. Appreciate it. I guess I was just curious. So what that might look like if you decide go down that route?

Well, you may be referring to us moving to our new platform, which enables broader capabilities including diagnostics and monitoring and that opens the door for a subscription in different ways and so that's a future opportunity for us for sure.

Understood. I pass on to the next question. Thanks.

Okay.

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

Good afternoon. Thanks for taking my questions.

Thanks Bobby.

Hey everyone. I guess the first question is just, you guys over delivered on units versus the internal guide by 5,000, 6,000 or so but then we're hearing that the chip constraint got worse, so just help me connect that aspect. Over delivering versus the guide on units to us probably implied that things got a little better, but just going forward it looks like it didn't and so can you help connect that?

Absolutely, Bobby. So there are two different things we're talking about. It's relative to what we were expecting in terms of smart bed deliveries in the third quarter. We got about 5,000 more beds delivered in the quarter than what we had thought we were going to be able to get out. That's the slight improvement in the third quarter. And I just take a second to just emphasize and that drove $0.22 of earnings, which is a pretty remarkable reminder that the leverage of this business model when we get just small incremental benefit of more units through the model, just how much more profitable it gets. Because I have guided provide color that we were expecting to be about break even for the quarter. So just keeping that in mind. Now, let's turn to Q4 expectations. As I said on my Q2 call comments, we were expecting enough chips and the flow of those chips, the timing of that flow of chips to be early enough in the quarter to get 15% to 20% more deliveries out the door in Q4. The reality has turned that that's not going to happen. That the chips that we're getting are coming too late in the quarter about 15,000 of them in fact are coming too late in December for us to be able to get all the deliveries out the door that we were expecting previously. So that's what we were talking about. We got slight improvement in Q3 and worse outlook for Q4.

And Bobby for being in the situation of having no inventory of chips, the flow of chips is everything. And where we have worked all 24/7 on trying to get incremental improvements, even the smallest improvements, and we made some headway, but not the headway we needed to. Now sitting where we are it's back loaded in the fourth quarter. It does set us up and we will actually have enough chips to be able to bring back the Flexfit 1 and the Flexfit 2. And those two skews, good and better in this environment are really important for our smart bed system that focuses on snore and temperature benefits, et cetera. And also support our flex top which is a really important skew as well. So we'll have them heading into Q1 and the commitments we have for flow in Q1 opens up the pathway for us to level load and not have the kind of inefficiencies that we – that we have right now in the fourth quarter, which is driving this change in guidance. I mean, chips are impacting the supply, the cost and the demand right now. And we really look forward to getting beyond having this be such a barrier for us and have it be the important aspect of innovation that, that it was designed to be. It's still in the long run having smart beds and having the capabilities that we do for our future. It's where we're going to deliver the superior shareholder returns and we're very confident in that path, and we're also confident in our ability to work through the current situation. We're experienced as a management team, we know how to do this, we'll handle it and to look forward to being in a different environment and being able to benefit from all the innovative work that we've done.

Thank you, Shelly. I appreciate that. And I guess lastly for me, and it’s kind of a two-part question, but it relates together. David, like if we look at this year and we want to try to level set the model for next year ourselves on a unit basis, the backlog while it's still at excess did go down this year. So like should we strip out some units and say like, hey, this year benefited from x-plus backlog delivery, then kind of go from there to predict our demand next year, or how should we think about this year's unit number? And then what does the guide imply excess backlog in depth this year? Is that a 100, does it end at 75 or if you hit your guide it stays at 100?

Well, predicting backlog is always a challenge and if you go back in time in the way back machine, Bobby, we never even talked about backlog. We've been doing it since Q3 last year because of the supply challenges that we've been living with. But nonetheless I would to answer your question directly, I'm not prepared to give you guidance for next year. I would say that there we still do expect in the current guidance to get some benefit from excess backlog in this year; it's meaningfully less than what it was before. As I highlighted I'm expecting in the back half about $80 million less net sales and half of that is coming from it, and then I'm talking about in the back half, half of that is coming from less backlog service. So as you recall on the Q2 call, I think I highlighted that we had gone from $150 million of excess backlog and net sales equivalent access backlog down to $110 million. So we got about $40 million in the first half and something less than what we had thought for the back half. So we're carrying some of that excess backlog into 2023. And we'll provide some additional color on 2023 on the Q4 call.

Okay. Thank you, David. Thank you, Shelly. I'll jump back in. Best of luck.

All right, thanks Bobby.

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

Thanks a lot. And good afternoon. My questions are really around the demand trends and the outlook. If you could give us some more color on what you think drove better demand over Labor Day and why it has since deteriorated and then how you're thinking about demand growth in 2023, that would be great.

Yes, Seth, one of the behaviors that we have seen from the consumer in this difficult, low sentiment environment is the purchase is closer to need. So, I think that really played out for the Labor Day event because we saw weakness before and then an on plan of long weekend, which those are the biggest days and then weakness afterwards. So, the customers certainly purchased close to need. And then we also have had the various interest rate hikes on both ends of the Labor Day. And we see pressure on the consumer sentiment with that inflationary behavior and worry. And the traffic to the brand is within 2% of prior year but she is not coming through the purchase funnel. She is not getting all the way to store traffic and purchase. There's just a much smaller base of customers doing so. And when we do have that deeper funnel interaction, we're driving the conversion that this has been a really difficult environment. And then we have some additional pressures with having smart beds, and having the longer lead time as well as not having our good and better FlexFit assortment, with that kind of consumer environment has been difficult. And again, looking forward to bringing them back into the line in January and being able to benefit from our smart system as designed.

Then you stated at the end of your question was about demand for 2023. We're not providing official guidance. I did provide you a couple of points that we’re excited about our innovations that we're bringing to bear. We're also talking about eliminating some of these headaches from the chip supply hopefully in 2023 with some improved chip flow and total supply. But at the same time, we believe that the consumer sentiment will be pressured at least to the first half of next year. So we're taking all of those things into account and we'll give you some specific color on the Q4 call.

Got it. And just to follow-up on the demand in third quarter, with consumers shifting their focus more to value, are you sure that your demand was meaningfully pressured by long lead times on the high end adjustable basis?

Well, I think it's a factor. I'm not attributing all of it to that. And the long lead times have been across the line. Right now we're at two to three weeks. So, it's more balanced for sure. And the FlexFit 1 and the FlexFit 2 bases are important absolutely to our assortment. And we've seen a change since the consumer sentiment dropped by not having them in our assortment. And we had to take them out of the assortment almost a year ago, and we were – the demand wasn't as impacted as it has been since the sentiment dropped so low.

Got it. Okay. One last follow-up question for David. Just in terms of the balance sheet, looking at the changes you made to the credit line agreement, the covenant, everything up to 5% for leverage, what else changed in that agreement? Did you guys have to accrue a higher interest rate for that line or anything else?

We do, if the leverage goes above 4.5, I think, there is an additional gradation in the interest rate table, I think, it's 50 basis points higher interest rate if you go above 4.5 times leverage. The others were additional considerations for things like administrative elements. We changed to SOFR from LIBOR and we made an allowance for share repurchases to cover tax withholdings for employees that are acting on option exercises, stuff like that. So it's a de minimis amount of shares that are covered for the sake of our employees – our team members, sorry. Those are about those big primary things. There was also a placeholder bucket that we put in place for the potential if we were to go after an acquisition, want to make sure that we had a placeholder in there for that.

Thank you.

Sure.

Seth, one other add on the demand that may be helpful in Q3 is the category, the mattress category was quite pressured on organic search down 16%. So the category was certainly pressured. We had stronger digital traffic to our brand but you can see the entire category did.

Understood. Thanks again.

Thanks, Seth.

[Operator Instructions] Your next question comes from the line of Atul Maheswari from UBS. Your line is open.

Good evening. This is actually Michael Lasser on behalf of Atul Maheswari. My first question is on the supply chain piece. There has been many indications that the global supply chain has been improving as of late, especially for those that have been negatively impacted by it. Why do you think your impact from the supply chain is getting worse when others are getting better?

Well, Michael, I think what we are talking about is limited to one specific thing that is semiconductor chips. The supply of virtually everything else – the components that we need for our product, we have ample supply for. Supply of semiconductor chips continues to be a problem for most everybody that I'm reading about anyway. And our supplier isn’t our direct supplier, they are a third tier supplier, and so we've established relationships with them, we are exchanging data on a regular basis, having regular multiple calls per week with a third tier supplier because this has been so important. And frankly, they have been a good partner. They are trying to help us. But they are managing their way through some challenging things as well. We are starting to see some slight improvements. We got 5,000 more beds delivered in Q3, for example. And as Shelly highlighted, we are going to get some solid chip deliveries in late in Q4 that's going to enable us to bring back a couple of important elements of our product offering starting next year. And we're saying that we see 2023 chip supply being better than what we've been dealing with here in 2022. So I hope that frames it up for you. Michael, I think broadly our supply chain is in pretty great shape. It's really focused on this chip supply problem that we've been dealing with.

Yes, I'll maybe add a couple of points, Michael. The allocation that we expected of semiconductor chips is largely on for this year, but the flow, the disruptive flow, where we have inefficiency and we have gaps between receipt of chips is very costly, and that has extended lead times and has all kinds of implications and shifts delivery of units from one quarter to another. So, it's all about the flow. And the semiconductor industry remains very fragile because it doesn't have inventory in the entire system. So when a very small event happens like a production, an equipment failure, it could be a 10-day delay, which can result in a three-month delay throughout the entire global supply chain. So, it's certainly much bigger than us. We're a part of it because we have smart beds and Autos are in a similar position.

My follow-up question is how does the experience of this quarter, the next quarter, the last quarter, how does that influence the long term margin outlook for sleep number between 2015 and 2019? The company revs really had a 5% to 6% operating margin. Could it be lower than that? Because you are probably experiencing some customer disappointment and you may have to spend a little bit more in order to win these customers back. And so while you eventually experienced the flow through on incremental sales, it's going to take a while to get there.

Well Michael, your premise is mistaken. Let's just start there. Our customer loyalty and brand love has been very strong according to the metrics, and what we're hearing and seeing. Aside from that just to get to your answer or to your question we're not satisfied with where our margins are either gross margins or NOP. Frankly, it started when we started to have these massive influx of input cost inflation. We've called it 160 to 170 basis points or basis points of pressure – excuse me, $160 million, $170 million worth of pressure annualized. And we've said that we think about 30% of those we will be able to claw back at some point in the future. We've taken steps to offset the dollar impact of that with about, call it $180 million worth of pricing increases on a gross basis. But even when you do that, Michael, and you look at the math, that puts pressure of nearly 400 basis points at the gross margin line and call it 200 basis points at the operating profit line on a rate basis, if protect dollars but hurts your rate. Eventually, when we have full regular flow of our chip supply and consumer sentiment isn't at or near record lows we will continue to drive innovations and performance that delivers superior shareholder value. We are excited about where the future is. As Shelly highlighted, the innovations we're launching right now with the Climate 360, the new platform that supports our new 360 beds next year, those set the stage for some pretty incredible health and wellness opportunities as we go into the future as well, which will help us drive even better operating profit rates going forward.

Thank you very much. And good luck.

Thank you very much.

Thanks.

There are no further questions at this time. I would like to turn the call back over to the company for closing remarks.

Thank you for joining us today. We'll be releasing our fourth quarter results in February. Sleep well and dream big.

This concludes today's conference call. You may now disconnect.