Good day everyone. Welcome to Sleep Number's Q4 and Full Year 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. Please go ahead, sir.

Good afternoon, and welcome to the Sleep Number Corporation fourth 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 President and CEO; and Chris Krusmark our interim CFO and Chief Human Resources 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 2022 year-end earnings call. My sleep IQ score was 83 last night. Before providing details about our 2022 results, I'd like to express my appreciation to David Callon for his many contributions to Sleep Number and wish him well in his future endeavors. Chris Krusmark, fleet member Executive Vice President and Chief Human Resource Officer has assumed the role of Interim, Chief Financial Officer as we conduct a search for a permanent replacement. Chris has been a fleet number team member since 2005. And it's held a variety of financial and operational leadership roles during the past 18 years. Prior to joining fleet number, Chris served as a CPA in the Assurance and Advisory Practices of EY and Arthur Andersen. During today's call, we'll review our 2022 financial performance, share early observations about the 2023 business climate and our outlook for the year and highlight 2022 strategic milestones that underscore our long-term orientation and position fleet number to capitalize on profitable growth opportunities when the economic environment improves. First quarter net sales increased 1% to $498 million, with an 18% decline in demand for the quarter, which was offset by the servicing of our excess backlog. Our Q4 loss per share was $0.24. For the full year, results included net sales of $2.1 billion down 3% year-over-year, and earnings per share of $1.60. Our 2022 performance reflects the sustained impact of external business and economic disruptions that began early in the year. Constrained microchip supply the spread of Omicron the war in Ukraine, and skyrocketing costs drove record low consumer sentiment, which significantly reduced demand and pressured profits. Yet as we navigated a steady stream of macro challenges, commitment to our purpose galvanized our passionate team to find creative solutions to enhance…

Thank you, Sally, and good afternoon, everybody. I am pleased to join you today as Interim CFO of Sleep Number. As we lead through this transition, we are fortunate to have an incredibly talented finance team including Dave Schwantes, Vice President of Investor Relations and FP&A, who will join Shelly and me for Q&A. It is a privilege to lead this experienced team, during the active search for our next Chief Financial Officer. In 2022, external factors had a significant impact on both our fourth quarter and full year results. Reported net sales for the fourth quarter were $498 million of 1% versus the prior year. Our Q4 loss per diluted share of $0.24 was at the lower end of our guidance range. We delivered 93,000 smart bed units in the fourth quarter consistent with expectations shared in our third quarter earnings call are delivered ARU increased 1% primarily due to net pricing actions. Gross margin rate for the quarter was 54.7%, down 220 basis points from the prior year. We came in short of our gross margin rate expectations for the quarter as we faced modest downward pressure on delivered product mix and inefficiencies due to the uneven supply of chips. We offset most of this gross profit pressure with spending controls. Our 2022 full year results included net sales of $2.1 billion. Full year EPS of $1.60 reflects a 3% net sales decline, a 350 basis point reduction in our gross profit rate and operating expense deleverage from the sales decline. We reduced planned operating expenses more than $150 million during the year and ended the year with operating expenses up to 1% year-over-year. In 2022, we prioritized investments in long term initiatives, including our product innovation pipeline, while reducing spending across the organization. Interest expense impacted 2022…

Prioritizing innovation leadership in maintaining thoughtful strategic progress while prudently managing costs position fleet number to capitalize more quickly on profitable growth opportunities in the future. It is inspiring to engage with Sleep Number team members throughout our company. I have been touched by their selfless courage and commitment, and so truly grateful for their hard work and their passion for our life changing sleep innovations, which are creating a more sustainable future for all of us. Now Chris, Dave, and I will be happy to take your questions. Kellyanne, please open the line for questions.

Thank you. [Operator Instructions]. We'll hear first today from Bobby Griffin with Raymond James.

Good afternoon, everybody. Thank you for taking my questions. I guess first, I want to touch, it seems like a good bit of the outlook here to get a little bit better in profitability, does center around the recovery in gross margin. And with this business, it really does take around having gross margins as close to above 60% as you can get. So, can we just unpack a little further for everybody here the visibility into the 150 basis points plus? I understand there has been a lot going on in the supply chain, but is it more on things now that you actually have visibility into, you have the tips, you have the costs, under control, you kind of have the delivery aspect or is there still some variability in there for us to keep in mind?

Hey, Bobby. This is Dave. Thanks for the question. Certainly, improving our gross margin rate, it's a big priority for us for 2023. And as Shelley mentioned, we are looking to improve that by over 150 basis points during the year. As we have talked about over the last couple of years, we have observed significant commodity pressures in our cost of goods sold, along with really inefficiencies that we have also taken on because of the uneven flow of chips. So, the good news is, as we enter '23, it's the first time since really September of last year that we have had the full product assortment in place. And the even flow of chips that we really need to get efficiency. So maybe turning to some of the specific drivers that we look for '23. Starting with, we expect about $15 million to $20 million of benefit from the easing of commodities. So, we have seen some modest easing of commodities here late in the year, specifically in foam. And we also are excited to no longer be procuring parts in the broker markets, which we paid premiums in those markets during last year to procure some of our components, and also, we are paying expedited delivery costs. So, if you combine the commodity easing with some avoidance of some of those costs, we see that worth about $15 million to $20 million of year-over-year benefit, which is about 80 basis points. The second area that we look for is really pricing. So, we did take pricing in August of '22. We also took about $30 million worth in December of '22. And as you look at those pricing actions benefiting our '23 results, we expect that to be worth about 80 basis points of benefit as well. The third area would really be around mix. So, we are excited to have our Climate 360 now in our lineup. It was introduced in October. It had really strong demand for it during the fourth quarter and several of those units are sitting in our backlog, as we enter '23 and we look for those units along with a full year of Climate 360 sales benefiting our gross margin rate for the year. And we do expect maybe to throw one item going the other direction, some modest deleverage from expected lower unit volume for the year. So that's going to create some fixed cost deleverage across our business. So really kind of three main buckets with really one headwind being deleverage from unit volumes.

Thank you, Dave. That was very clear. I appreciate all the details. I guess secondly for me, you guys talked a little bit about the shape of the year with back half revenue a little stronger than the front half revenue given the comparisons. Is there any issues on the shape of profitability, as it relates to the covenant? I know you guys did some work to I think take it up to 5 time as the ceiling for the covenant. Anything we have to think about for the first or second quarter covenant related.

As we look at the shape of the year, we certainly expect the net sales performance to be a little bit stronger in the first half of the year. Part of that is just the comparison we have are going to be much tougher, particularly in Q1. So, we do see, if you think about the proportionality of sales, a little more sales falling in the first half of the year and a little less than first half a little more in the back half, sorry. And if you look at the EPS splits, I'll say at the midpoint of the guidance, I probably think about our EPS kind of being 40% to 45% in the first half of the year. And the rest of it being in the back half of the year. Relative to the to the covenants, we did have an amendment that we did back in October that did amend our covenants to be up to five times leverage through the second quarter. And our forecast had is well within those leverage covenants through the second quarter and through the balance of the year.

We'll here next today from Peter Keith with Piper Sandler.

Hi, thanks. Good afternoon everyone. Looking at the sales guide, there's a lot of puts and takes, and I was hoping you could kind of break it down for us in terms of how you're thinking about demand versus pricing, versus backlog recognition and any other factors that I might not be thinking of?

I'll start, and Dave can provide some additional color here. First of all, just start with we're really pleased with the sequential demand improvement that we've experienced since restoring our full line of smart adjustable basis with normal delivery time lines as a result of having the semiconductor chip inventory. So, we're well-positioned with our chip inventory for the balance of the year. And February represented another step up from January. So, we're happy to see that against several difficult compares. And at the same time, we know that as we progress through the year, that compares get easier. So that's a little bit on the shape.

Yes. I think, Peter, maybe to add a little bit of color on both ARU and units, which I think is embedded in your question. So, we are looking at ARU being up at least mid-single digits for the year. There's a few areas that we think are going to be benefiting us in the year number one, pricing. So, the pricing I mentioned in the gross profit question, that's going to be a plus up as well as really the benefit of mix. So, the Climate360 smart bed, it starts at about $10,000 for that product. And as that gets in our mix, it really helps with ARU as well. So that's how we see the ARU side of the business implied in our guidance of being flat to down mid-single digits for net sales would imply we expect units to be down year-over-year. I think as we progress through the year, we do expect the greatest challenges in the first quarter and then expect those to moderate, particularly as we're up against the easier compares to balance of the year. So maybe just to touch on quickly on the industry. The industry data isn't out yet for the year, but we actually believe that like others that I think the bottom has probably been reached on units in '22, but we're just not frankly expecting any significant improvement in units in '23. And we really think it's prudent just based on how we see the metrics in our business to be cautious about the top line and not get ahead of ourselves in terms of that unit expectations for the year.

Okay. And within that, I think maybe Chris said it, but I didn't get it down, but how much backlog revenue would be recognized in 2023?

Yes. So, Peter, we ended the year with about $40 million of excess backlog, and largely, we expect that to benefit the first half of the year. So, we talked about year-over-year, we still expect a drag because of year-over-year backlog changes. So, we did get more benefit from backlog in '22 than '23. But specifically, that backlog that we have at the end of the year, we do expect it to largely benefit the first half of the year.

And another topic that's getting more attention is just financing costs with the rise in interest rates. So, we know you guys through a third-party finance about 50% of your beds. What are you guys seeing with financing costs? And maybe are you -- is that going to show up in the P&L at all or do you have to cut back on the months of interest refinancing provided?

We utilized both discounts and financing as conversion tools in our business, and we think about them as a total bucket and have pretty creative approaches depending on the current environment to be able to execute in different ways. Financing is definitely more costly and in fact, added about 100 basis points of pressure in 2022. So, as we are here in 2023, we're actively managing the financing cost along with our discount bucket. So, we're thinking about it in totality. I think a good example would be during the President's event. We had 24 months financing on the low end of our line that carries a lower gross margin and then 36 months on the balance of our line. So just being creative in our approach to be able to mitigate that cost while still driving the performance.

Okay. Thank you, very much.

We'll hear now from Brad Thomas with KeyBanc Capital Markets.

The first just around the assortment, and I know that you had limited or no availability of some of your popular selling adjustable basis. I was wondering, if it's possible just to frame up for us, and I know you have to estimate in that puts and takes. But how you maybe think of what kind of headwind you had from an assortment standpoint from not having products available and when we think we can get to the point where they're all available with the assortment that you want to have here for this year.

Thank you, for the question Brad. We had the constrained Microchip challenge for the past 18 months. And that resulted in us not having the FlexFit 1 in the FlexFit 2 adjustable base in our assortment up until December 26 of 2022. So, at first, it didn't appear to be hurting our demand. But once the consumer sentiment fell last May, it really had an impact on our performance from what we could see, and we could see that on the digital behavior from customers. And so, we are so excited to be in this position of having the Microchip inventory not only for our full assortment, which means we have good, better and best, smart adjustable basis to support our full line, but also having the normal delivery time periods. I guess the best way I can describe how big of an impact it had would be the sequential improvement that we've had from December in fourth quarter, having demand down 18%. And then right now, quarter-to-date, down high single digits. That's a pretty significant improvement that we saw right away with the change. And then the media effectiveness has been really strong as well. And then here in February, another step-up in performance during our most difficult compare. So, we're super excited to be operating on all cylinders again and having the effectiveness of our selling process with good, better, best. And then the Climate360 on top of that and then heading into the balance of the year with introducing our next generation of smart beds with new creative and lots of initiatives to be able to drive performance, especially as the consumer environment or when the consumer environment improves.

And to dovetail off of that, can you talk a little bit about the approach you'll be taking with advertising and with operations kind of tightening up here, given that the world is hopefully getting better than it was during the height of the pandemic. Is this -- how are you feeling about perhaps putting more into advertising here to see if you can drive some greater traffic?

Well, we started doing that when we return to our full assortment and normalized delivery time periods, at least against our plans and -- but we are at the same time, we're driving media effectiveness. And I think that's important to highlight. So, we're going to be prudent in our approach and continue to drive performance and cautiously take steps forward that we're definitely making some good progress, and we have new creative to support our next-gen smart beds.

We'll hear now from Seth Basham with Wedbush Securities.

My first question is, if you could add some more color on the improving demand trends quarter-to-date. What was the decline in demand in each of January and February? And if you look at it on a two-year stack basis, was there much improvement from January to February?

Hey, Seth. As I highlighted, we're down high single digits quarter-to-date with a step up in February. If you look at last February for the President's event, we were up high single digits against a record year the year before. And so definitely a step up in our performance here this year and against tougher compares.

But you're still anticipating material improvement for the remainder of the quarter despite the fact that compares [indiscernible]

As we look at it, this -- the backdrop is still a very cautious consumer with inflation and drawn down savings and higher interest rate variability. So, we're just entering a very -- in a very prudent manner. Consumer sentiment is the highest correlation -- has the highest correlation to our trends overall. So, we'll see. We're going to continue to take steps forward and at the same time, be very prudent.

And then my second question is on SG&A. Just thinking about some of the moving pieces in 2023. I know you talked about advertising before. Should we think about advertising being a point of deleverage? And then on incentive compensation, that seems like a pretty big deleverage point. Are there any other big moving pieces to think about? Thank you.

Hi, Seth. This is Dave. I think if you look at SG&A kind of broadly, we would expect modest deleverage from SG&A in total. And really, that's primarily due to the fact that we are guiding to sales being flat to down mid-single digits. So, at the midpoint of our guidance, I think in total, you're looking at total operating expenses pretty flat year-over-year, but with some modest deleverage because of where we have the sales page. As you kind of move through the different elements of SG&A and you look at sales and marketing, we would expect some leverage in marketing overall and some deleverage in selling. Again, we have more fixed cost in the selling side, so they do tend to delever a little bit more. And we do expect to see improved marketing efficiency as we benefit from having our full product assortment, normalized delivery times. And then we're excited about the next-gen products that we're introducing here in the second quarter. So, we think that all is going to lead to some improved marketing efficiency year-over-year. We are expecting some modest deleverage. And if you think about G&A and R&D combined, I think if you look at base spending, base spending would actually be down slightly. But then when you do bring in the funding of very important variable comp programs for the broad-based employee set, that rig does bring in some pressure relative to just the overall leverage in G&A and R&D.

And the pressure from higher financing interest costs, that flows through the selling component of SG&A?

Yes. So, the financing expense itself that we utilized at the time of purchase, that runs through our sales and marketing line. The interest to cost, obviously, related to our revolver runs through the interest expense line, which is below NOP.

Got it. And you expect that line to deleverage in 2023, the financing costs associated with professional financing programs?

Actually, we expect financing to be relatively flat. I think Shelly mentioned that we had about 100 basis points of deleverage in '22, but we aren't expecting that to be a big source of deleverage in '23 in part because of how we're going to manage the programs.

Understood. Thank you, very much.

We'll hear next from Atul Maheswari with UBS.

Thank you. Good evening and thanks for taking my question. Shelly, you mentioned a couple of times about normalized delivery times, even supply of chips and some of the excess costs have incurred last year that should potentially not recur this year. So, would it be fair to say that Sleep Number supply chain has largely normalized at this point?

Has largely -- I'm sorry, you cut out.

Back to normal.

Yes. That is absolutely fair too. Thank you.

So, in the backdrop, Shelly, you're still guiding to gross margin, which is 200 basis points below -- more than 200 basis points below your peak level. I guess what is holding back the gross margin even with normal supply chain? I mean what are some of the drags on the gross margin that still exists today that you should be able to potentially recover in later periods.

Yes. I'll start and Dave can add some additional detail. But first of all, let me just start with, hey, we expect improvement this year of at least 150 basis points and both the easiness of commodity costs as well as having the even flow of chip inventory so that we don't have the stops and starts in our delivery time frame and also not using the air freight and the expensive broker markets that we've had to these past couple of years. And then we still have significant inflation cost on board that we took on this last year and pricing has offset some of that, and we are seeing some easing in the commodity costs, but we have -- we have more work to do to get back to the rates that we were at before, and that will take us this year and into next year.

Yes. I would just add. Atul, I would just add to that. This is Dave. Sorry, that -- if you think about our business, I mean, we certainly have been investing and developing the business to support our long-term trajectory. So, we just completed at the end of last year a whole new delivery network, which is supporting a much-improved customer experience. And we're excited to, as we rebuild our unit volumes to really leverage that new network that we've established. And so, as I mentioned earlier, we think we're probably at somewhat trough-ish levels for units for the industry and probably for ourselves. And as we rebuild our units over time, that presents huge efficiency and leverage opportunities that we can scale across the business.

Got it. Just a couple of follow-ups here. Are there costs that are part of your COGS currently that you believe are structurally higher than where they were pre-COVID. Could you share some examples that you have? And is it realistic for us to expect again? I'm not asking for a time line, but is it realistic that Sleep Number can get back to 2019 gross margin level of around 62%?

Yes. It's definitely realistic for us to get back to our prior margin levels. And as Dave mentioned, the unit leverage is an important aspect of that as well as the commodity costs and the labor costs are all elevated and those are pressures, right now. So, we have headwinds that we're managing. We have key initiatives to drive our margin over the next couple of years, and we have a lot of confidence in our ability to do so.

Yes. And keep in mind Atul, as we think about the gross margin improvement for the year of over 150 million, we're doing that against the backdrop of sales expectations that are kind of flat to slightly down. So, I think we are going to be working, have some unit deleverage working against us, but we do expect to continue to get leverage over time and also really claw back some of the commodity pressures that we've been facing.

Okay, awesome. That’s super helpful. Thank you for that, and good luck with the rest of the year.

And with no other questions at this time. I would like to turn things back to the company for closing remarks.

Thank you for joining us today. We look forward to discussing our first quarter 2023 performance with you in April. Sleep well and dream big.

And that does conclude today's conference. Thank you all for joining us, and you may now disconnect.