Thank you. Welcome to Sleep Number’s Q3 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. You may begin.

Good afternoon, and welcome to the Sleep Number Corporation third 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 Francis Lee, 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, everyone. My Sleep IQ score was 91 last night. I’m pleased to be joined on this call by our new CFO, Francis Lee, who brings significant relevant experience to Sleep Number as we evolve our operating model and maximize our competitive advantages to drive long-term shareholder value. The third quarter was challenging. As the demand trajectory abruptly changed in August and September, we acted quickly, taking immediate actions to recalibrate our sales and marketing approach, further reduce costs and strengthen our balance sheet. As a result of these broad based actions, we are better positioned to navigate a range of economic environments next year and fulfill our purpose of improving the health and wellbeing of society through higher quality sleep. During today’s call, I’ll focus my comments on steps we have taken to build a more durable operating model for efficient growth, increased profitability and cash flow generation. Then Francis will provide further details on Sleep Number’s financial results and guidance. As context, macro volatility continues to pressure consumers. The bedding industry has now been operating at recessionary levels for two years. We estimate that industry demand was down double digits in the quarter and mattress units on a trailing 12-month basis are below 25 million units, down nearly 20% from 2019 and at their lowest level since 2015. With sequential improvements in Sleep Number demand trends through the first seven months of 2023, we expected to benefit from stronger year-over-year demand trends in the back half of the year. However, industry demand weakened significantly in the quarter as consumers’ purchasing power moved to the lowest on record. Consumer behavior shifted from spending selectively to scrutinizing their spending and price to value took on tightened importance in their purchasing decisions. Our marketing, digital and sales promotional strategies were…

Thank you, Shelly, and good afternoon, everyone. Before I begin, I wanted to share a bit about my background in joining Sleep Number. I spent the last 15 years of my career in a variety of finance and strategy roles at leading consumer product, retail and technology companies. Most recently, I served as CFO of Wyze Labs, an AI powered smart home technology company, where we transformed the company’s business model from hardware to software solutions. Before that, I spent 13 years at Nike, including as CFO of Nike Japan, where we reset the business to deliver double-digit growth and significant margin expansion and in global finance roles, leading profitable growth initiatives across the enterprise. Sleep Number is undergoing a period of intense change. I believe that my background is well suited to help us through the current restructuring and to generate long-term shareholder value. As we transform our operating model, we will pursue sustainable, profitable and capital efficient growth. We are taking a disciplined approach to strengthening our business through expense management and resource allocation that drives strong returns on invested capital. We are focused on paying down debt while assessing our optimal leverage to strengthen our balance sheet and enhance the durability of our operating model. Now, let’s move on to the results from the third quarter. Third quarter net sales of $473 million were down 13% versus last year and below our expectations of down low to mid single digits for the quarter. We leveraged our fulfillment network to deliver incremental smart beds from our existing backlog to help offset a portion of the demand decline. Our third quarter gross margin of 57.4% was up 130 basis points year-over-year and included the benefit from pricing actions taken over the past 12 months and improvement in commodity prices,…

[Operator Instructions] Your first question comes from the line of Bobby Griffin with Raymond James. Please go ahead.

I guess, first up for me, I just want to more understand kind of progression of the quarter and what exactly kind of changed from your -- the consumer perspective? I fully understand the industry is not great right now and things might have slowed sequentially, but looking back, this is probably the lowest unit number out of Sleep Number since 3Q of 2013 or 2014, depending on if my data is correct and the model. So, what exactly from speaking in July changed? Did the financing not resonate? Did the marketing message -- when you we are tooling with marketing dollars, did that not resonate? Like, what exactly changed? The store base was about 200 stores less back then, so it’s a very significant unit decline is, I guess, what I’m getting at here.

Yes. Thanks for the question, Bobby. Yes, this is clearly not the quarter we expected. And no doubt, it’s a very tough environment to predict consumer behavior. We had been making progressive improvement for the first seven months of the year and exited July at flat to prior year performance. So, the abrupt change in August to down double digits, which persisted through September was certainly not our horizon. So clearly, a number of things happened. And our performance was consistent with what we forecast the industry’s performance to be for the quarter. But as you know, I mean, we expect to not just hold share, but take share and perform better, especially with all of our big drivers in the marketplace and at work. So, a couple of things. We dug into the consumer in-depth. And the consumer’s purchasing power moved to its lowest level on record. That’s when we saw the behavior shift. And they shifted from spending selectively to really scrutinizing their spending, making very prudent decisions. And this led to the severity of the demand change. We assessed everything in our business, and especially with the consumer. And we did research on those customers who interacted with our brand, we call them leads, during this timeframe, those leads who did not buy yet. And they had a perceived affordability barrier for our smart bed. That is the number one factor across the board. Our execution was too focused on selling overall smart bed system, meaning both the smart bed and the smart adjustable base driving a very high ARU. So for example, our selling process, presented the entire solution upfront, and customers fell in love with it. But they weren’t willing to spend that much at this time when they’re scrutinizing their spending. So we pivoted and changed our execution in a coordinated manner across sales and marketing. We changed our messaging to focus on our differentiated value proposition, adjustable firmness, comfort and temperature starting at our competitive price of $1,000. We changed our online and in-store experience to focus on selling the smart bed first and making sure that we were, first and foremost, fitting the customer’s budget. Then, we introduced the smart adjustable bases. And we reworked our media strategies and plans for greater impressions against our target customers for lower cost. And these changes all went into place in the last couple of weeks of September, early October and performance improved to down mid-single-digits. So, concurrently, while we were making these changes, we also began our restructuring to strengthen our model to make sure that we’re more enduring through this volatility and certainly have a laser focus on driving incremental cash flows.

Okay. One follow-up on that, Shelley, and then additional non-related question to the top-line. But did the Synchrony partnership change during the quarter where they tightened rates and that was part of the reason you guys weren’t able to successfully sell the whole package? The financing aspect as a percentage of sales changed drastically during the quarter that we need to understand?

Thanks. I meant to touch on the financing. We dug deep into financing to try to understand, was that having any of the changes we’ve made? Was that having a negative impact on our demand and conversion? And we do not believe that our financing strategy had a disproportionate negative impact. It was very clear that our biggest opportunity is perceived price value of our smart beds. So the financing actions we have taken have helped mitigate significant financing cost pressures that we’ve faced all year. But during this time and during Labor Day in particular, we had consistent year-over-year financing offers. So, we did not see that as a factor here. And the relationship hasn’t changed. We’ve actually made adjustments to make sure that we’re neutralizing this and that it -- to rule it out as a factor.

And then, Francis, welcome to the team, and nice to meet you over the phone. I guess, my question is just on the OpEx reductions and the store closures. Are the 40 to 50 store closures that we’re targeting, are they negative four wall EBIT or EBITDA stores? And if not, can we talk about a little bit of, like, what’s implied in the recapture rate? Because then, they are generating EBIT and EBITDA in that scenario, so we’d have to have some type of recapture to make it net out and be a positive impact?

Hi, Bobby. Thanks for the question. It’s nice to meet you too. So, as we thought about which stores we’re looking to close, we’re definitely looking at stores that are lower profitability within the portfolio, and also ones that have naturally expiring leases, so that we’re minimizing additional, lease buyout purchase costs. The recapture rate for these stores we’re also looking at are ones that we can effectively transfer, and have performance within the DMA that could basically be absorbed within the market effectively. So, again, we’re looking to, in this abrupt change of this demand environment, reduce some of our fixed costs, adjust our store base to align with the demand environment out there. And when we do come out of this position, off of a lower fixed cost position, be able to accelerate in a more profitable way off of our store base?

Hi, Bobby. Just to add to that, Bobby, this is Dave. So, if you look at collectively at the stores we’re closing, they do on average have positive four wall profit. Where we pick up incremental profit is as we transfer those sales to other stores and eliminate the fixed cost of the stores we’re closing that is absolutely going to be a net positive. So we’re not looking at a situation where we’re necessarily closing a significant number of stores that are four wall negative.

So when I look at the $50 million for next year, is the largest portion of that $50 million the corresponding lease and employee expense of those closed stores or are there other areas inside the operation that are getting cut as well?

The $50 million of operating expense reductions for next year, is that the $50 million that you’re referring to?

Yes. So the large portion of that the corresponding lease expense and store and employee cost that comes with those store closures or are there other areas in the operations that are getting cut as well or getting rationalized, I guess, is the better way to say it?

It’ll be a holistic view of our overall costs, but certainly the stores action is a piece of it.

Yes, it’s broad based, Bobby, from G&A, R&D, headquarters, stores, changes in manufacturing and also our logistics network.

Your next question comes from the line of Peter Keith with Piper Sandler. Please go ahead.

So, Shelly, I just want to come back to Bobby’s first question, because we’re really trying to understand this drop off of demand in August and September. And I’m not sure if it’s coincidental, but it does align with when you relaunched a large amount of your new product line. And I’m wondering if there was issues that you ran across with pricing of that line? Maybe some of the new features didn’t resonate. Did the marketing not resonate? And then, as you’ve pivoted the sales strategy here in October, I guess, are you now reducing prices or is it just as a lower ticket that’s going to maybe reduce the ARU sequentially?

Yes. Peter, thanks for the question and the opportunity to clarify. So, it really was around three different things, and all consistent with the perceived price perception, as the consumer moved into a place where she was very scrutinizing of how much to spend. I’ll use the example of the selling process in the store. When you came into our store during that timeframe, we were selling the full smart bed system first. So the selling process showed the consumer or the customer in the store, both the smart bed and the adjustable base. And she fell in love with that full system. And the quote ended up being very high, because it was inclusive of the smart adjustable base. So, one of the big changes we’ve made since that time is to sell the smart bed first, which is what we historically have done. When we introduced Climate360 a year ago, the Climate360 comes with the smart adjustable base. And we had great success with selling it that way. As we introduced the full line, we also included that full system for -- in that full solution for our customers. And we have found that since we went back to first and foremost understanding where the customer’s budget is and selling the smart bed and meeting her budget, that has made a significant difference in conversion. In a similar manner, our online experience now compares the smart beds first and then goes through a later step of adding a base, so that the price doesn’t get too high too fast, especially for the consumer in this environment. And then third would be messaging, our marketing messaging getting back to just our very simple value proposition around adjustable firmness and temperatures starting at $1,000, so that we’re very competitive, and helping reduce that perception of the smart bed is way more expensive than it really is.

I guess, I understand the effort to reduce the cost base, but it sounds like if you’ve adjusted the sales process, sales have gotten somewhat better. I guess, why the pivot to now closing a bunch of stores and then does this cap what would be a future store opportunity where maybe we won’t be growing stores anymore?

Yes. No, it absolutely doesn’t cap the future opportunity. The macro volatility continues to pressure consumers. We obviously were surprised by the shift in consumer behavior in August and September. It’s difficult to predict these changes, and we need to make sure that our operating model is more durable for a broader range of macroeconomic situations. I don’t -- sitting here today -- I mean, we went into back half expecting a recovery in the mattress industry, and that’s not what we’re experiencing. And we want to make sure that we have the business model in a place that is greater, has greater durability and that we’re completely focused on generating cash, paying down our debt, returning the business to a strong profitable position. And at the same time, being well prepared for the future rebound and getting back to double-digit EBITDA. So, these are the actions we’re taking now to get our fixed cost structure down. And they’re not at all going to keep us from realizing greater sales in stores in the future. We’re being opportunistic on the stores that we’re selecting and the lower performers. We also have developed some really great digital sales tools that over the last couple of years since the pandemic has started. And we expect to utilize those in our other stores and our online operations to be able to generate a greater transfer of sales than we historically have done, even though it was very high historically, it’s been over 30%. We expect these tools to help us make that even greater. And again opportunistic in our approach, we’re looking at all the DMAs and really making sure that we have other ways to serve our customers in these markets.

Your next question comes from the line of Brad Thomas with KeyBanc Capital Markets. Please go ahead.

The first I just want to ask about, a follow-up on sort of pricing, and I know, Shelly, you’ve explained that you’ve changed how you’re selling. But can you talk a little bit about the need or the potential need to do more promotionally and how necessary that might be for you now and what your plans are from a promotional standpoint?

Yes. As I said, we’re very focused on the differentiation and the value. So, making sure that consumers understand that our c2 starts at $1,000. And that is highly competitive, especially when you consider the adjustable firmness and the temperature benefits that are now -- that now come with our c2 as of August when we introduced the new line. So, you’ll see us focus on, temperature claims, our adjustability at an affordable price, as well as great deals at the high-end.

Maybe just a couple of follow-ups on some of the earlier questions. I was wondering if you have the numbers on the financing side of things. I know that’s just an important part of your business. Is that higher or lower as a percentage of sales than a year ago? Again, we just get the question a lot and we’re hearing some tightening from the credit providers. And I’m just trying to understand, is that a smaller portion of sales here now for you?

Well, we share this number on an annual basis. What I will hone in on is that we don’t believe that our financing strategy adjustments have really had a negative impact in the demand results. We’ve looked at this 100 different ways. And we see the greatest opportunity as the perceived price value of our smart beds. And that’s where we’re honing in on our messaging. And we like the improvement that we’ve seen in the demand trajectory since we’ve made the changes. So, we continue to iterate and test different actions, as the consumer’s very constrained in this macro environment. We are focused on 0% for longer duration periods than we had been earlier this year, to drive units while using the APR offers for other periods. But we’re making sure that it’s not a barrier to entry for our brand.

Maybe asking a little bit of another way. And again, we know there are many other companies that have called out slower results here of late. But if you look at the financing side of things, you don’t think that’s material for the pressure we’ve been seeing on sales here, the ability to offer just the financing. You don’t think that’s material?

We don’t, Brad. I mean, we’ve done in-depth analysis, and, both internally and third-party to fully understand this. Matter of fact, we have used three different external resources on the consumer -- understanding the consumer behavior during this time period, as well as our internal. And everything ties back to the value and the perceived value and the changes we’ve made, we’ve seen that reverse. So, we went back out and researched it again with the changes, and then of course, we have the results of, by focusing more on our differentiation at a price. We’re seeing the digital traffic improvements. We’re seeing unit growth in October. So, it’s moving in the right direction with the changes we’ve made.

Maybe I could squeeze one here for Francis. And Francis, welcome. Just as we as we think about the covenants, anything in particular we should be focused on in terms of, any methods that might reduce the capacity that you have, and how should we think about kind of the run rate here on interest expense? Any help for us would be great. Thank you.

Hi, Brad. Thanks for the question. It’s nice to meet you. I think thinking about the covenants, it’s -- we’re really thinking about the abrupt shift in the demand environment and the ongoing uncertainty in the future. And we worked closely with our bank teams to create a lot of capacity and leverage for us over a longer period of time to create flexibility for us. So, when we think about the covenant and the bank agreement, that’s really been the goal is to create flexibility over a longer period of time for us to work through our restructuring, generate cash and pay down debt. And we’re pleased with the additional clearance that we have to operate with more flexibility through the end of next year.

[Operator Instructions] Your next question comes from the line of Atul Maheswari with UBS. Please go ahead.

Shelly, I know that industry is challenged, but really if we look at your performance versus your larger competitor, there has been a pretty material gap that has now existed for the last several quarters. So, earlier the thought was maybe this was because of the supply chain issues and the chip shortage that you had last year, maybe early this year, but that’s in the rearview mirror as well. So, even as of now, why do you think this underperformance exists, and what do you think you need to do to address this performance gap?

Hi, Atul. I think the backdrop starts with the industry. Well, it starts with the consumer and the macro environment, and then how that has impacted the bedding industry. The bedding industry has been at recessionary levels now for two years. And it’s forecasted to have been down double digits in the third quarter and that’s where our performance was as well. We completely expect to compete more effectively than we did in the third quarter. I highlighted the area that we see ourselves where we missed. And that was on the price value, the price value for the consumer. The consumer changed in August and our messaging was not on point with where the consumer changed, nor was our selling process or online experience. Those are the adjustments we made in the third quarter and we’ve seen progressive improvement since we implemented those adjustments. In October, we delivered mid-single-digit decline, which is where we expect our fourth quarter performance with our revised guidance. We’re going to continue to drive our media strategies and build on them. We’ve renegotiated and have greater impressions as we move into the fourth quarter. And those impressions are complemented with drive to store actions, and we expect to add media as we see greater traction. But for now, we’re holding our media below prior year.

That’s helpful, Shelly. I have a couple of follow-ups unrelated. First, on the revised covenants, does that add incremental interest expense? If so, are you able to quantify how much incremental interest it would add for next year?

It will move us up on our rates -- rate ladder slightly. I can get you the specifics.

Yes. I think, Atul, just to add to that. So, we did provide -- Francis did provide in his commentary specifics around this year’s number, which is $42 million for interest expense, which includes, if you do the math from where we are year-to-date, it would signal $12 million for Q4. That $12 million number does include the updated rate structure where our leverage is at the end of Q3, which is the peg point for interest rates in Q4. And there was some write-off of historical credit line fees that we had on the balance that have been written off as we amended the agreement. So, that all rolls into the $12 million number. We’re not providing guidance relative to next year on this call. What I would say is that higher interest rate environment is going to carry into next year. I would expect interest expense next year to be north of this year’s number, which is the $42 million. And I think I would just say we’ll give you more clarity on the February call, but for now if you’re doing your model, it’s definitely going to be north of $42 million. And that’s a big number. It’s a big weight on the P&L. And our goal is obviously to quickly pay down that debt as quickly as possible to start lowering the interest expense number and start getting our leverage to a level where we’d like it to be.

As my last question, if I may, and somewhat related is, there was, I think Francis and Shelly, both of you mentioned, the expectation to generate positive free cash flow next year. The question is, if the macro does remain challenged and you have the incremental drag from the store closures, the 1 to 2 points. So, at what level of sales decline would it become very hard to generate positive free cash flow, just so that we get confidence on the downside case scenario on free cash flow? Thank you.

Yes. This is Dave again. Just to give a little more color on how we’re thinking about that. I think we talked in the remarks about a demand environment that may not improve next year. We’re not signaling exactly where we think it’s going to be, but what I would say is we certainly could generate positive free cash flow next year with a lower sales number than this year. I’m not going to peg exactly where that number is, but a couple of things to think about next year. Number one, we are expecting a pretty significant reduction in CapEx. Now, this year we’re going to do $60 million, I’d expect a materially lower number next year. And that CapEx number will be also meaningfully below our depreciation number. So, we do have a lot of non-cash items in our P&L, including depreciation, and that will help with just cash flow generation next year. Again, we gave you largely how we think about next year at a real high level. We’re looking at a gross margin rate approaching 60%. We’re looking at OpEx, which is $50 million lower than this year. And I think -- and like I said, we’ll give more clarity to how we probably think about the exact top-line in February, but I think we’ve given you some good guideposts to do modeling. And, I think when you do the math on that, you’ll recognize that we certainly can generate positive free cash flow with those variables next year in a lower demand, lower net sales environment.

Ladies and gentlemen, there are no further questions at this time. I will now turn the call back over to the Company for closing remarks. Please go ahead.

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

Ladies and gentlemen, that concludes today’s call. Thank you all for joining and you may now disconnect your lines.