Welcome to Sleep Number's Q3 2024 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 2024 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 and thank you for joining us. My SleepIQ score was 76 last night. In addition to announcing our 2024 third quarter results today, we also announced that I will retire as Board Chair, President and Chief Executive Officer no later than the 2025 annual shareholders meeting. In keeping with Sleep Number’s established succession plan, the Board has engaged an independent executive search firm to help identify my successor. To further support an effective transition, I will serve as strategic advisor to this new CEO and Board through the end of 2025. I am filled with gratitude for our team's deep commitment to our mission and purpose which has inspired innovations like our revolutionary smart bed and digital wellness platform that have improved almost 16 million lives. These life-changing innovations combined with our company's remarkable culture, vertically integrated business model and operating model transformation give me tremendous confidence in Sleep Number’s enduring competitive advantages and stakeholder value creation. The company also announced additional Board and governance changes today, consistent with our deliberate long-standing practice of aligning the company's strategic evolution with progressive board composition and governance. Details of these changes are described in today's separate CEO retirement release and associated letter to shareholders. Now shifting to our third quarter results. Throughout the past year, we have taken ongoing actions to transform our operating model for greater financial resilience across a range of economic environments. During the third quarter, our initiatives drove broad based efficiencies and a gross margin rate improvement to 60.8% resulting in third quarter adjusted EBITDA of $28 million which was in line with our expectations even with persistent weakness in consumer demand. I am proud of our team for their agility and stellar execution in delivering these results. This increased financial resilience combined with our…

Thank you, Shelly. Let me say congratulations on your pending retirement and thank you for your leadership and partnership. Turning to the business, our third quarter results demonstrate our team's commitment to deliver against our controllables while continuing to navigate a historically weak demand environment for the betting industry. Our ongoing cost control rigor and gross margin improvement initiatives resulted in us achieving our third quarter adjusted EBITDA guidance, despite a softer than expected top line. We continue to focus on maximizing cash flow generation with year-to-date free cash flow up $50 million versus the same period last year. Now let's turn to a review of our third quarter results. Third quarter net sales of $427 million were down 10% versus last year and five points below our expectations. Net sales for the quarter included a high single-digit demand decline, a couple of percentage points of headwind from year-over-year, backlog changes and 1 point of pressure from fewer stores. We delivered a 60.8% gross margin rate for the quarter, up 340 basis points versus the prior year and we accomplished this even with deleverage from the year-over-year net sales decline. Our year-to-date gross margin rate of 59.5% was up 150 basis points versus the same period last year and ahead of expectations driven by broad based gross margin initiatives which as a reminder include material cost reductions including redesign actions, reducing number of parts for selected products, ongoing supplier negotiations for all material components, year-over-year cost efficiencies in our home delivery and logistics operations including a more flexible labor model, increased efficiency in home delivery truck utilization and savings from switching our primary parcel provider. Over the past several quarters, we have continued to streamline and align our cost structure with the ongoing weak demand environment. In the third quarter,…

Thank you. We will now begin the question-and-answer session. [Operator Instructions] We'll take our first question from Bobby Griffin at Raymond James.

Good afternoon, everybody. Thanks for taking my questions And Shelly, congrats on your pending retirement.

Thanks, Bobby.

So, I guess, first up for me is just maybe unpacking a little bit more of just kind of how the quarter played out. And maybe just in October, actually, we've heard of various reports heading into election, media spending is tough, businesses actually pulled back more. Just kind of curious if you're seeing that and if, obviously, that's being reflected as part of the 4Q updated guidance.

Yes, Bobby, regarding the shape of the quarter, I gave a few highlights in my prepared remarks. We had low single-digit growth on both holiday weekends, July 4th and the Labor Day weekend. And the rest of the quarter was challenging. And we particularly were somewhat – we had spent media going into the Labor Day event in that August period, and the consumer really wasn't there. And we did pull back in media quite significantly after the Labor Day weekend, again, not seeing the consumer in the marketplace. And same with July. Early July, around the July 4th weekend, we had a low single-digit growth, and then very minimal activity from the consumer outside of that period, and that has continued into October. And as we stated, we had about 5 points, 6 points of demand pressure greater than we had anticipated so far this year. It's been consistent all year. We expected a sequential improvement in the third quarter, and that didn't happen. And that's how we're seeing it play out for Q4 as well, given the ongoing uncertainties and challenges our category is facing and big ticket in general.

Okay. That's helpful. Shelly, I mean, just to put into context, the two holiday numbers seem very good. Is it fair to say those were at – the holidays were in line with expectations, and it was just weaker during the non-holiday period? Or was the original plan and the spending for the holidays to actually even be stronger themselves than the low single-digit growth you have?

No, you described it well. The consumer outside of the holiday weekends, we're just seeing a much more pronounced spending. It's consistent with the consumer behavior that we've been talking about. Not only are we dealing with a scrutinizing consumer, but she is also more delayed in her decision making than we've seen. And that's been particularly persistent here in the last – well, since July, since the latter part of July, just less decisive, so yes, very pressured with all of the macro challenges.

Okay. And then, secondly for me, you guys have made some store portfolio changes this year, closing some underperforming stores. And not – I understand you're not going to give 2025 guidance. But as we sit here today and kind of look at the store portfolio, what are your thoughts on the size of it today, given the current demand environment? Does there need to be another round of closing? Is there negative four-wall EBITDA stores today? Just help me think about how we've made progress on that with some of these closings we've had this year.

Yes. Thanks for that question. As we went into the year, we – overall, everyone was expecting the industry to be flattish. We expected it to be down low single-digits with about 1.5 points of pressure from store closures. And that's about what we still see, about 1.5 points from store closures. We were opportunistic when we decided on these store closures last year and took action around this time period. And we focused on underperforming stores, stores that were part of a test on density. We're really happy with the transfer rates, which are exceeding our expectations, over 50%. But also, like I said, we are quite selective in making those choices. We have a really healthy retail portfolio. Our store portfolio across the country has been healthy, and we're happy with it. We think it's largely where it should be. And we can generate a lot of comp sales in our current retail portfolio. We'll be able to grow strongly with strong flow-through as the industry recovers. So I wouldn't characterize it as a store problem.

Okay. And then, lastly for me, Francis – go ahead, I'm sorry.

Yes, Bobby, I was just going to add that we have an ongoing process where we look at our store profitability by DMA, and that's going to continue to be an ongoing process for us. So, as we plan into next year, we're confident we're going to continue to adapt and adjust our business with the active contingencies like we've done all year this year, and store closures or stores will be part of that. But there's – as Shelly mentioned, we generally have a really healthy fleet right now.

Okay. Thank you, Francis. And then, last one for me was just on gross margin. I mean, one of the bright spots this year has been some of the self-help that you guys have shown in the gross margin side of things. Can you – Francis, can you sort of unpack where we are in that journey? I guess, we got World Series going on. So maybe use a baseball analogy. Is there more self-help into 2025? Or is 2025 and kind of the future gross margin really just going to be dependent on industry volumes and Sleep Number's volume?

Yes. I'd say we're – using the analogy, we're along in the journey, but we're not – we're nowhere near done. We've put in robust processes as part of our planning and inspection of all the planning that we do. And the actions that we put in place, we've given you some strong examples of those across product redesign, material cost-out, looking at how we deliver products. These are things that our team is doing on an ongoing basis through active planning. And so, we'll have benefits next year, one, from anniversarying some of the initiatives and actions that came online partially through this year. And then, honestly, the ongoing activity and programs we have in place to not stop but look at this as just part of how we run our business is to have constant improvement and agility. That's going to be ongoing.

And then, it will be really fun as we get the growth in units.

Yes. At some point, it will turn. I'm waiting on it as well, Shelly. Thank you for answering my questions.

Thanks Bobby. I keep saying when, when it turns.

Exactly.

We'll move next to Brad Thomas at KeyBanc Capital Markets.

Thanks for taking my question. And Shelly, wish you all the best as you move on to other things here.

Thank you.

I wanted to maybe first just start as maybe a follow-up on the sort of consumer weakness that we're seeing out there. Could you just talk a little bit more about what you're seeing when you run promotions and maybe how you're thinking about weaving in promotional activity or what kind of new products might be needed in the assortment if this kind of tough environment continues?

Yes. Great. Well, I'll start with the end of your question. The kind of new products that need to be introduced are exactly what we're doing. Super proud of the team, both executing the operating model transformation, but also advancing our innovation, go-to-market with our new Climate series. This is – the Climate series gives a range of price points and addresses one of the most significant issues of temperature fluctuation that consumers deal with. And it's really exciting to be able to offer solutions of active temperature management at a range of price points. And we're – our teams are really excited, and customers are highly responsive. So addressing these segments of consumers that are responsive, that's an area of focus for us in this environment. We absolutely need to find ways to be more and more efficient with our media spend when there are far less customers in queue for purchasing a mattress right now. And that's where our focus is – in marketing is deeper marketing segmentation, more tailored messages, working to get greater efficiency. As you know, we've been more conservative than others on our media spend as we've prioritized our EBITDA dollars this year, which we're not going to overspend in this area. And we experienced a little bit of that in August, where we spent more media looking at historically how consumers have behaved. But they're more concentrated around the holiday periods, and we have to pay attention to that and make sure we're honing into those periods more selectively. I would say the other change in the consumer is this delayed decision making. Being direct-to-consumer with all of our stores, we see and hear pretty immediately how the consumer is behaving. And she just wants to wait until we see what happens with the election and other factors. So there's some real hesitancy out there to part with money, and then, a little pressure on the financing in the quarter as well from approval and usage.

That makes sense. And just to follow up on that approval usage comment, Synchrony is such an important partner for you. And I know you're one of their better partners is how you've always described your importance to them and what you see out of them. But if I heard you right, you're saying that the approval rates and perhaps the usage and maybe the dollar values being approved, are those lower year-over-year for you with Synchrony?

Slightly.

Okay. Maybe just one last housekeeping if I could. I don't think you have big China exposure, but could you characterize for us, as we think about your inputs, how much of them and how much of maybe cost of goods sold might be subject to incremental tariffs if those come to fruition next year in China?

Yes, minimal. But as we've talked before, with the semiconductor chip challenge that we experienced a few years ago, even a few things can create some pressure. That was a shortage issue. But the overall – it's a small percentage to the total, but it's all important.

Great, thank you so much.

We'll move next to Peter Keith at Piper Sandler.

Good evening, Shelly, congratulations on retirement. We'll probably have you for a couple more quarters here, but wish you all the best, of course.

Great. Thank you.

Just trying to frame up the industry backdrop. I think we're all pretty aware that it's been a challenging period. And what I'm really trying to ascertain is if Q3 was actually more challenging than first half of the year. Shelly, I think you said the demand comp is similar to first half. Then Francis, I thought, later in the script, you said it was down 9% versus first half, which was down mid-single. So maybe just a straight-up question, do you think it was a worse quarter for the industry than perhaps the first half of the year?

Yes. I believe we – yes, we see it as in line with – the third quarter was in line with the first half of the year, and that's how we're thinking about the fourth quarter demand as well. And we're going to be prudent about and cautious about calling a demand improvement until we see it. I would characterize it as we didn't get the step-up we expected. We were down double-digits, the industry was and we were for two years in third quarter. So we all expected a sequential improvement, and that did not happen. So it remained very similar to the first half, and that's what we're seeing and expect to see in the fourth quarter. And that's why we adjusted our guidance. And at the same time, we continue to advance our initiatives in gross margin and EBITDA to deliver on the range that we shared.

Okay. Very good. And then, just pivoting over to the gross margin, which was obviously quite strong for Q3. So, Francis, in the guidance now for gross margin to be up 150 basis points, it implies Q4 in turn, I guess, would be up about 150 basis points, so a step-down from Q3. Are there any initiatives that are starting to, I guess, get lapped? Or is it more challenging or just want to be prudent on how you're thinking about the gross margin expansion?

Yes. I think for Q4, you can anticipate a gross margin rate of around 59% to 60%. Seasonally, our Q4 tends to be lower than Q3 sequentially. But on a year-over-year basis, we're going to have a significant step-up versus last year's Q4.

Okay, very helpful. Thanks so much.

Yes, thank you, Peter.

We'll take our next question from Michael Lasser at UBS.

Hi, everyone. This is Dan Silverstein on for Michael. Thanks for taking our question.

Hello.

Congratulations, Shelly, as well from our team. Just two quick questions. Maybe to start on 4Q, the sales guide is for trends to get a little bit better. Is that just a function of less of a backlog impact? Or is there any other texture there that you can provide, just given all the distractions the consumer will be facing?

Yes. You're speaking to net sales?

Yes.

Yes. Thanks, Dan. This is Dave. So if you think about our guide for Q4, we've talked about sales at the midpoint of the guide being down high-single digits. Year-to-date for the first nine months of the year, we're down 10%. So high-single versus 10%, I'd say, they're quite similar. So we're not expecting any dramatic difference. There will be probably a little less backlog pressure in Q4 than what we saw in Q3, maybe call it 1 point or 2 points. So there'll be a little less backlog pressure. But overall, we aren't expecting a material difference in demand trends from where we were first 9 months of the year versus the fourth quarter.

Okay. Thank you. And then, our second question, appreciate the commentary about the revenue base needed next year to avoid triggering the debt covenants. I understand you'll be giving 2025 guidance next quarter, but I think the covenants start to kick in at 4.0x in 1Q. So the question is, A, is that correct? And B, is there anything else you're preparing in terms of mitigating actions if demand remains significantly challenged or gets even a little bit worse?

Yes. Your read on the covenants is correct. At the end of Q1, the covenants go to 4.0x. So, a couple of things. One is, with the changes to our cost structure and our gross margin rate advancements, we expect to remain within our leverage covenants through 2025. And based on our current cost structure, that is what would keep us require that minimum net sales of approximately $1.7 billion. We continue to evaluate all of our alternatives as part of our ongoing processes to supplement and/or work within our existing credit line. But importantly, we've got a lot of the elements of our transformation in place. We have made significant progress against our cost structure, our gross margin rate. And these are going to be ongoing tailwinds for us as we plan into the year next year.

Dan, maybe just to add a comment on Q1 – this is Dave again. So, if you think about Q1, as we go into Q1, we're going to be up against a sub-59% gross margin rate in Q1. We're also – Q1 of this year, we didn't have the benefits of all the cost actions that we continue to execute all year long. So we would expect exiting the year, call it, an EBITDA ratio of around 4.1x. We would expect that to improve in Q1 based on just the ongoing execution of our expense initiatives and certainly exceeding last year's – or I should say, this year's Q1 gross margin rate. So just a couple of items to think about as we move into Q1, specifically, when the covenant does drop down to 4.0x.

Very helpful. Thank you.

And that concludes our Q&A session. I will now turn the conference back over to the company for closing remarks.

Thank you for joining us today. I also want to congratulate Shelly on her retirement announcement and wish her all the best as she embarks on her next chapter in her life. Well deserved, Shelly. Sleep well and dream big.

And this concludes today's conference call. You may now disconnect.