Welcome to Sleep Number's Q2 2023 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 objections, you may disconnect at this time. I would like to introduce Dave Schwantes, Vice President of Finance and Investor Relations. Thank you, Dave. You may begin.

Good afternoon, and welcome to the Sleep Number Corporation's Second Quarter 2023 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 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. We also want to refer you to our second quarter earnings presentation, which can be accessed on the Investor Relations page of our website. I will now turn the call over to Shelly for her comments.

Good afternoon, and thank you for joining our second quarter 2023 earnings call. My Sleep IQ score was 85 last night. I'm pleased to share that today, Sleep Number announced the appointment of Francis Lee as our company's Executive Vice President and Chief Financial Officer effective August 14. Francis brings significant leadership experience in finance and strategy at Fortune 500 consumer-focused brands, including Nike and Gap and most recently as CFO of Wise Labs, an AI-powered Smart Home innovator. At Wise, Francis increased cash flow and profitability through a business model evolution from hardware to software with reoccurring revenue streams that emphasize customer lifetime value. He has a proven track record in business planning, operational transformation and capital structure. We look forward to benefiting from Francis' leadership in advancing our differentiated strategy and creating superior shareholder value. During today's call, I'll provide highlights of our second quarter performance in the context of current market conditions, describe actions we are prioritizing in 2023 to compete effectively, drive operational efficiencies and generate cash and share how we have positioned our business for strong earnings growth and significant value creation as demand improves. Sleep Number and the mattress industry overall have been operating in a disrupted and challenging macro environment, which has resulted in a historic contraction in demand for mattresses with six consecutive quarters at recessionary spend levels. In this environment, our demand driving and efficiency actions delivered second quarter results that included net sales of $459 million with demand down mid-single digits. Over -- our year-over-year demand improved seven percentage points sequentially compared with the first quarter, but was a few percentage points below our Q2 expectations of flat to down slightly. As the quarter progressed, year-over-year demand trends improved with combined May and June demand down low single digits. Gross…

Thank you, Shelly. For the second quarter, net sales of $459 million were 16% below last year, with demand slightly below our expectations for the quarter, we leveraged our fulfillment network to deliver incremental Smart Beds from our existing backlog. As a result, we delivered nearly 77,000 Smart Bed units with an ARU of just under $6,000. Our second quarter gross profit rate of 57.6% was consistent with our expectations. Focused spending controls resulted in operating expenses of $253 million in the quarter down $22 million versus the prior year. We delivered second quarter EPS of $0.03. As a reminder, a shortage of semiconductor chips in last year's first quarter resulted in more than $100 million of margin-rich deliveries shifting into the second quarter of 2022. This shift included our higher-priced FlexFit 3 adjustable bases and related Smart Beds. Last year's second quarter net sales, ARU gross margin and net operating profit all benefited from this higher margin backlog reduction. This resulted in prior year second quarter EPS of $1.54 in what is traditionally our lowest sales and EPS quarter of the year. Now I'll spend a few minutes covering our year-to-date financial results before turning to our full year outlook. Year-to-date net sales declined 8% to $985 million with demand down high single digits year-over-year. The first half of 2023 included approximately $50 million of net sales benefit from the servicing of excess backlog, which was similar to the benefit in the first half of the prior year. Our year-to-date gross margin rate of 58.3% was consistent with the prior year. We offset deleverage from the net sales decline with pricing actions easing of commodities and ongoing operating efficiencies. Importantly, our year-to-date gross profit rate is up nearly 300 basis points from the back half of last year as…

I'm extremely grateful to our highly engaged team whose commitment to our purpose is apparent every day in their innovative mindset, dedication to our stakeholders and consistent execution of our strategy. Our investments and achievement of strategic milestones along with major operational improvements, a digitally connected customer and world-class partnerships have transformed our company, revolutionized the industry and positioned us for significant value creation in the future. Now Chris, Dave and I will respond to your questions. Lisa, please open the line.

[Operator Instructions] We'll take the first question from Bobby Griffin, Raymond James.

Good afternoon, everybody. Thanks for taking my questions. I guess first, and Chris, maybe I missed a few of the details there, but -- can we just spend a little time unpacking the acceleration in demand that's implied to kind of get to the guidance because it seems things are still running negative at least as at the end of the second quarter. And I know the comparisons get a little easier starting here in 3Q, I believe they ease by 4% or so. Is that the main function of what gives you guys the confidence in demand going back positive? Or is there some other embedded assumptions in there from the new product launches or whatnot or pricing or whatnot that helps you kind of get to that positive demand clip?

Great. Thanks for the question, Bobby. I will comment on this. First, our expectations for demand in the third quarter are up mid- to high single-digits as you noted. We're coming from a place of progression in demand. We've had positive improving demand trends since the start of the year, although a bit slower than we had originally planned, which put us a couple of points behind in demand here coming out of second quarter. But through second quarter, we believe we took market share. We outperformed each of the periods, demand steadily improved and we were down low single-digits here in May and June. And that steady improvement has continued here into the third quarter, July month-to-date were flat to prior year, which is where we expected to be as we head into the third -- the balance of the third quarter with expectations of mid- to high single digits. Yes, compare is a factor. Importantly, our initiatives innovation, all next-gen Smart Bed implementation, along with our next level, the next fleet next level campaign are the big drivers of demand in our business. And we like what we're seeing here early on. We see green shoots. There's consumer sentiment moving the right direction. We have positive search numbers for our brand. We have positive traffic as we're heading into the time period in the biggest event of the year. So we like what we're seeing, and we had a big progress, big demand trend progress here in the first half, and we expect that to continue in the back half.

Okay. I appreciate that, helpful. For the improvement that we saw quarter-to-date, was just to help us kind of connect the dots, was the promotional aspects in 2Q of this year, relatively similar to 2Q of last year, so we can read into this improvement that we saw as real and fundamental? Or was there something different in terms of closeouts or promotional calendar that might have been impacting what we saw throughout the second quarter and into July?

Well, it's a great question. And absolutely, we continue to drive promotional activity. And I think one of the benefits of our vertical model is we can adjust and make changes pretty real time and certainly within the quarter. Closeout is a great example of that. We plan for our closeouts in the second quarter and we delivered accelerated units at the low end of our line through our closeout activity. We did not drive the top line as big as we had hoped we would here in that closeout period in the June time frame. So we saw the unit impact, very positive we did not get incremental demand lift from that. So when you look at that and you look at where our performance and the step-up of performance, it's been progressive all year. We see it as real. I think July is another good example of that. And now we'll move into some higher ARU with our next-gen Smart Beds and continue to drive our performance going forward.

I appreciate the details. I'll turn it over to somebody else. Best of luck in the back half of year.

Thanks.

Next, we'll take a question from Brad Thomas, KeyBanc Capital Markets.

Hi, good afternoon. Thanks for taking my questions. I want to ask a little bit about the Synchrony relationship and what you're seeing out of them. I believe they've been public recently about saying that they kind of selectively done some tightening where they perhaps lowered the approval rate and lower the amount that they're approving. Just curious how important they've been to you here of late and what you're seeing out of them, just given their importance to your business? Thanks.

Yes. Thanks for the question, Brad. Synchrony is certainly an important partner, and our customers at Sleep Number are important to the Synchrony portfolio as well. So we've made adjustments in our financing strategy which have been very favorable for us, especially from an efficiency or margin and productivity standpoint. And we took on these actions in Q2, we tested into them, and we like what we're seeing. We've been able to mitigate a lot of cost increase related to interest. The programs have been effective. Our approval rates and sales conversion and financing are all in line with where we expect. So a specific answer to your question, no, we have not seen an impact based on the actions that you highlighted.

Got you. Okay. And then just a follow-up on Bobby's earlier comment as we think about demand in the back half -- can you just give us some updated thoughts on how you're thinking about the benefits from the average transaction size and how you're thinking about promotions and if at all, that might be different than what your plans were three or six months ago?

Yes. I think the promotion difference, I'll maybe start there. In Q2, we pulled forward our closeout activity closer to the start of June to drive increased units and demand, and we did drive increased units not so much on the overall top line. So that would be a good example of an adjustment. Right now as we head into the back half, we've made some adjustments to our financing plans based on what we've learned along the way. And we utilize financing programs and discounts as a conversion tool. So that's probably the area where we've made the adjustments. We are excited about our next-gen Smart Bed line here with the whole new portfolio and Climate360 and having those important drivers of our top line, along with the advancement of the advertising. And we also look at a number of leading indicators we look at traffic, sentiment, we have our econometric model and our year-over-year, importantly, the 13-week trend. Again, we've continued to see progression, positive progression on that 13-week trend. And then we also look at our performance compared to 2019. And we had a very robust almost about a 20% increase to 2019 in the first half. We're not expecting as high of an increase to 2019 in the back half, which gives us some room to outperform.

The next question is Peter Keith, Piper Sandler.

Thank you. Good afternoon. Shelly, just I want to dig into some more of those green shoots to get us comfortable with the demand outlook for the back half. I guess with the new product line, you have had the M7, the i10 in the marketplace now for a couple of weeks. Has the consumer reaction been positive on those newer models such that those specific models have moved up within your sales mix?

Thanks for the question, Peter. Our frontline has been really excited about our new model. So they have performed very well since the launch, and we're just completing the set in all stores for all next-gen Smart Beds. We're almost done. We have a few left here over the coming days. And we're on track with our expectations and feel very confident about our ability and to some degree, the ease of fully transitioning to all one line in the marketplace as we head into the Labor Day event. So we're excited about our promotional plans and feel they're right on track with where they need to be, considering price sensitivity with some consumers yet the high value that our Climate360 gives at the top of our line. So yes, we feel bullish about where we are.

Okay. So I guess, has there been a standout demand for those initial products in the market?

They have performed slightly ahead of our expectations while we've been in close out. It's small at this time because we haven't had a lot against it. So the real demonstration is now.

Okay. And then I wanted to just touch on the commodity costs, which have been a headwind for you and now a future opportunity. I think at the beginning of the year, you were expecting about $15 million to $20 million of relief or recovery. What's going on now that we're at midyear. Has anything changed? Maybe is there a little bit more relief, less relief give us an update on how that's looking?

Yes. Hey Peter, this is Dave. I would say largely the commodity benefits that we expected for the year are coming in as planned. We talked about that in the first quarter. And I think as we look at the full-year and getting to that 150 basis points of expansion, it's still really the three drivers that we talked about at the beginning of the year, which is pricing is one of them that we've taken. It's the commodity relief that we talked about, and it's the mix benefits that we're getting from having Climate360 at the high end of our line, be a growing and important part of our mix. So I think if we look at those three drivers, there's always puts and takes each year, but those three drivers are coming in as planned. And I think we continue to see additional opportunities on the commodity side for the back half of the year and beyond as we just kind of work through unraveling some of the pressures that we've taken on over the last couple of years.

Your next question comes from Atul Maheswari, UBS.

Thanks a lot for taking my questions. Shelly, I had a question about your media strategy. It sounds like media costs are down meaningfully given you're leveraging on lower sales. So do you run the risk of lowering the efficacy of the launch given historically Sleep Number and others in the industry have typically raised media spending ahead of important launches.

Atul, thank you for your question. Media is such an important part of our demand-driving formula. And we do expect efficiency on our media compared to last year's environment. Last year, we were -- we're in a much stronger position than we were a year ago. A year ago, we did not have the supply we needed of chips. And it impacted not only our delivery timeframe, it also impacted our ability to offer our full assortment. And so we had tremendous limitations and media, media wasn't as efficient as being in the situation we are today with strong, including a full new line of Smart Beds and Climate360. So we are driving greater efficiencies, while also driving traffic and much stronger search interest to our brand versus other brands in the industry. So we had 50 basis points of leverage in the first half. We do expect leverage in the back half, and we also expect to fully support our next generation Smart Beds and lean into it. Part of what we utilize as an econometric model, which helps us understand based on consumer sentiment and many other factors where to place that next dollar and how many dollars to lean into it, what that return is going to be. So we're approaching it prudently given the environment we're in and given our focus on taking share as well as expanding margin.

Got it. That's super helpful. Shelly, just my follow-up, it sounds like the 2023 guidance is fourth quarter heavy. So as things stand today, if we were to understand the risk to this guidance, is the greater risk of a miss on the top-line? Or is there a greater risk of a miss on the gross margin?

Well, as you think about the shape of Q3 and Q4, I'll start with both sales and margin. So we expect a net sales decline for third quarter, in part due to the year-over-year backlog changes. And gross margin impact of the one-time product portfolio transition cost, they're all hitting in the third quarter. So while we expect continued demand improvements, including the mid to high single-digit growth in Q3, we were a few points behind demand expectations in the second quarter, which resulted in a lower backlog heading into the third quarter. We're very focused on fulfillment efficiency, and we're expecting to build a little backlog in Q3. So we'll be benefit or building backlog from the low levels that we're entering the quarter with. So when you look at the fourth quarter, we expect progressive demand improvement. So Q3, up mid to high single-digit, and then Q4 up mid-single-digits to low double-digits. And this is a continuation of what we've been seeing in demand. And it also contemplates our initiatives as they continue to progress and how we layer on to those initiatives throughout the months of the back half and also the compare is getting increasingly easier as we approach the fourth quarter.

And Atul, just to add a little color on gross margin as a part of your question. So first half of the year, we did 58.3% gross margin rate, which was right on top of what we had expected. And importantly, it was almost 300 basis points improvement from the back half of last year. So as we head into the back half of this year, we're going up against, I'll call it, relative -- a much challenged compare from the prior year. And the initiatives that really help us achieve that 58.3% in the first half of the year are intact for the back half of the year. So we're looking at a gross margin rate of 58% to 59%. We certainly recommend if people have a chance to go out and look at the supporting deck we put on our website that covers how we're thinking about the back half versus the first half and as compared to the back half of last year. And that kind of shows you the progression we expect in the back half of the year. And frankly, the fact that we aren't expecting our gross margin rate in the back half of the year to be materially higher than the first half of the year with the initiatives intact and what we think is going to be a stronger top-line year-over-year as well.

Got it. Okay. That is helpful. If I could sneak in one last one. Shelly or Dave who wants to answer it. Like what has been the percentage of your sales in the -- historically that have happened on financing? And is that percentage lower or higher today?

Yes. It's about 50%, and it's steady.

Got it. Thank you. Good luck with the rest of the year.

Thank you.

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

Thanks a lot and good afternoon. My first question is just around pricing on the new line. Can you remind us, is there a price increase that you're taking on any models that's substantial relative to the previous models?

Yes, Seth. So we did -- when we introduced the new M&I models this year, we have taken $100 of pricing on those new models. And that went into effect, I think, in April of this year. And if you think about pricing more broadly for the year, we are expecting around three to four points of benefit from pricing. That would include the actions we took with the new line as well as the wrap around pricing from what we took last year. We did take some actions in both particularly August and December of last year, which are providing additional benefit as we get the full-year benefit this year. So yes, $100 on the top of the line, and then the wraparound benefit from the rest of the actions we took last year.

Got it. Okay. And the margin richness of the new products with limited price increases. Is it a much higher margin rate that you should earn on those new products?

I would consider it to be relatively similar, Seth, relative to the margin profile. I would just say similar.

Got it. Can you just remind us then the drivers behind the new line? What are the big changes in the features and functionality. I think that there are some changes in selling internal components like that was supposed to be cost efficient, what else is different?

Yes. You're right. And I would start with that we now, with the next generation Smart Beds have temperature features across the entire line. Starting at the C2, which is just below $1,100. So we're really excited about having these features, and so it's our front-line, especially based on how well Climate360 has performed and the traffic that Climate360 drives to our stores. And then also, there is increased comfort and support, which has also been well received by our front-line and it's noticeable change and very exciting. And then the technology platform with much broader sensors that sets up our future additional revenue streams through digital products and services. And then you also -- you highlighted the -- a large percentage of common parts, which will help us with especially with our new assembly distribution center to be able to add more flexibility and scale in the future as we ramp up units.

Great. And my last question for now is just on the promotional environment as you had in the Labor Day with this new product line. Do you think you'll have to be as promotional as you've been around other major holiday selling periods recently?

Well, we'll certainly compete aggressively as we have in the past. It won't be our closeout. Our closeout pricing was more aggressive that you saw in Q2, but we have a lot of confidence in our promotional strategy and how we're applying that throughout the Labor Day period, especially based on like what we've learned in this environment and even this year in the past few months, we apply it quickly to how we're approaching the time periods, the duration how we're utilizing the promotional dollars and financing for optimized results from both the top and bottom line.

We'll take a follow-up from Bobby Griffin, Raymond James.

Hey, thanks for let me get back in. On the progression, do we expect ARU to step up sequentially meaningfully in 2H and that's part of how we get the improvement as well in demand. So I'm just trying to connect the dots between what units demand can improve versus what dollar demand going to improve? Because it still just looks like a pretty strong step-up even when you factor in the positive comparisons moving in your favor?

Yes, hi, Bobby, this is Dave again. So if you look at the first half of the year, we had an ARU of around $5,900, a little over $5,900. And that was approaching $6,000 in Q2, which is the number I used on the last call. As you look at the back half of the year, we're actually looking at an ARU that's likely going to be quite similar to the first half, so around $5,900. We do expect the ARU to be stronger in Q4 than Q3. Q3 is going to have the impact of the closeout activity that we had late in Q2 at the low end of the line, in particular, which will put a little bit of pressure on ARU, I'd call Q3 may be closer to $5,800. And then I'd call Q4 around that $6,000 mark for an ARU.

Okay. And that's a function of the pricing, the new line and then offset by the closeouts or whatnot. Is there any mix going on there? Are you attaching more items, more beds or anything else like that or no?

Yes. So if you look at year-over-year, particularly in Q3, Q3 last year didn't have any Climate360. Q3 this year will have a full quarter of Climate360. Last year, we introduced Climate360 in October, and we did have a fair amount of deliveries in the fourth quarter. But we do expect even more deliveries in the fourth quarter this year with Climate than we did last year, which will help the ARU year-over-year. And the other thing you're going to get in both Q3 and Q4 is the benefit of the pricing actions we took. Some of the pricing we took last year was in August, some was in December. So really Q3 didn't get the full benefit of those August promotions or December from a pricing action. So we expect both pricing and some mix to help us in both Q3 and Q4 to get those numbers up. So if you do the math, Bob, I just gave it to you, but the back half of last year was $5,200 per unit, which means we're looking at a number north of double-digit ARU growth for the back half of the year.

Yes. I appreciate the details. Thanks for let me get the follow-up in.

Great. Thank you.

At this time, there are no further questions. I'll hand the call back to management for any additional or closing remarks.

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

And once again, that does conclude today's conference. Thank you all for your participation.