Welcome to Sleep Number's Q2 2018 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 second quarter 2018 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 David Callen, our Senior Vice President and CFO. 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.

Thank you, Dave. Good afternoon and thank you for joining our second quarter earnings call. My SleepIQ score was 75 last night. Last week, we completed an important milestone for the company. Our transition to all 360 smart beds including the most recently introduced c2 model. This is the culmination of a lot of heavy lifting over the last few years to position our brand for accelerated top and bottom line growth including margin expansion. In an increasingly commoditized environment, we remain highly differentiated by offering quality sleep through technology. The Sleep Number 360 smart bed is improving our customers’ lives, through proven more restful sleep, and our lifelong relationships are an important source of ongoing growth for our business as they translate into new customer referrals and repeat sales to the brand. Our second quarter net sales of $316 million were up 11% versus last year. Our earnings per share were $0.10 versus the prior year’s $0.02 loss per share. Note, the prior year’s second quarter sales were impacted by an inventory shortage, which shifted $25 million to the third quarter. This year's earnings per share also included a one-time $0.08 tax benefit. Our results were slightly better than our expectations for the second quarter. David will review the financial details in greater detail. I will focus on the performance drivers for the back half of the year. We are on track to deliver our 2018 guidance of $1.70 to $2.00. We expect to build further sales momentum in the back half through 1) our Sleep Number 360 smart beds delivering proven quality sleep, 2) our new marketing campaign called “This is not a Bed,” 3) brand amplification through our NFL partnership; and 4) our differentiated direct-to-consumer retail experience. In a marketplace where consumers are inundated by a proliferation…

Thank you, Shelly. At our Investor Day in November 2016, we highlighted how the transition to 360 smart beds and evolution of our supply chain will unlock significant profitability well in excess of the one-time transition investments required to get there. Fast forward to today, we've realized the bulk of the transition spend in our advancing the growth and profit acceleration we planned. In the second quarter, we achieved the sequential sales growth step up from Q1 we forecasted. Net sales grew 11% over the prior year or 2% adjusted for the estimated $25 million of deliveries that shifted from Q2 to Q3 last year due to a temporary inventory shortage. In Q2 this year, value customers responded to our c series closeouts leading to 7% company controlled unit growth. We expect the value packed c2 smart bed to also contribute to full year unit growth in 2018. In addition, our ARU increased 5% as customers continue to embrace the benefits of our 360 smart beds, complete the SleepIQ technology and adjustable base. We continue to see ARU growth opportunity in the back half of 2018 and beyond as more customers opt for a complete package of sleep innovations. Comp sales grew 9% again reflecting a step up from Q1. We continue to forecast low to mid single-digit comp growth for the year as we benefit from the full price range of 360 smart beds. New stores contributed 3 points of Q2 sales growth as planned ending the quarter with 565 stores operating in all fifty states. Our trailing twelve month average sales per store including online is up 4% year-over-year to $2.6 million. Growing this metric towards $3 million is a compelling profit driving opportunity through the 30% to 40% incremental four wall profits in those stores. Transitioning to…

Thank you, sir. [Operator Instructions] The first question comes from Bobby Griffin with Raymond James. You may ask your question.

Good afternoon guys and I appreciate you taking my question and congrats on getting the whole smart series beds rolled out.

Thanks, Bobby.

Thanks, Bobby.

So I guess the first question I want to ask was may be just a little help on unpacking kind of what's changed since we last spoke at the end of 1Q on with – in reference to the full-year guidance, and this quarter offered some upside, but the full year was kind of left the same. So it implies a little bit of shift and -- downward shift on the EPS for 3Q and 4Q. I guess just help me connect the dots on what's driving that, is it inflation, change in consumer behavior, or a little different ramp of the new products from prior expectations, any help there would be appreciated.

Bobby, I think, just starting with our full year guidance, we're on track to achieve our full year guidance of $1.70 to $2, which represents a midpoint of full year 19% EPS growth. And you see that as appropriate especially in this environment.

Yeah just to add on to that, Bobby, too. Its 23% increase in the back half in our EPS at the midpoint, and that's a pretty healthy rate as well.

All right, I followed that. I was just kind of – I mean maybe I didn't understand, but did the $0.08 tax benefit was it always included in the full year numbers, because that's what I was kind of trying to understand. If the full year numbers weren’t adjusted for the $0.08 tax benefit, that does imply a change versus the last time we spoke. That's what I was trying to dig into.

And Bobby, we had both headwinds and tailwinds, and this would be a good example of a tailwind and gross margin pressure was a headwind in the quarter, as we outlined.

Okay, okay, fair enough. And then I guess lastly for me when I think about the inventory balance that I'm seeing on the balance sheet today, what are kind of the expectation of where you expect that to kind of end up as you work through kind of this new product introduction now behind you and you start to – it starts to become more of a normalized cadence I guess.

Yeah, Bobby, I would say that the $90 million on our balance sheet of inventory is about $5 million higher than where we would otherwise expect it to be and it reflects where we are with the transition between the two product lines. We're still closing – delivering out some of the legacy products and look forward to operating one product line and gaining some efficiencies as we go through the back half.

I appreciate that. And then I guess, Shelly, just more of a kind of a high level thought, the attachment rate called out in some of your prepared comments, seeing that all the way down to the C series beds, it’s pretty impressive. Is that just kind of more emphasis on the selling process? I guess what do you think is driving some of that from a consumer preference?

I missed the very first part.

I was referring to kind of the comments you had in your prepared remarks about the higher attachment rate and really seeing that goes through the product offering. And I was just curious if what exactly in your opinion from a high level standpoint is driving that, is it change in the selling process a little bit just more of an emphasis on it et cetera?

Sure, well, it's a great question and it goes back to the core design of the smart bed. And the design concept was to provide a customer the ultimate smart bed which is inclusive of SleepIQ as well as our adjustable firmness technology and of course the benefits that come with our adjustable base. In doing so in a manner that is highly attractive to the consumer and all the benefits it provides. And I think the FlexTop mattress is a great example of one of those benefits that our customer really enjoys too, which works perfectly with the adjustable base. So we do expect growth from both units and ARU for the full year, and I do think that's a good way to look at the ARU and units. We're going to have quarterly fluctuations, but we certainly expect some great growth there and we're really excited to be in the marketplace with the c2 smart bed at 999 and how that is going to compare from strong value equation to similarly priced beds that do not give the proven quality sleep that this bed will, and at the same time continuing to drive ARU with some of the attachments that that you touched on. And this is part of the reason why as we head into the back half, we’re excited to invest into media behind our initiatives and to be able to support that 360 smart bed and we want to make sure that we use our full power here in the back half and that's part of why we're keeping our guidance where it is and being committed to it.

Very much – thank you very much for the color and best of look through the back half of the year.

Great, thanks.

Thanks, Bobby.

The next question comes from John Baugh with Stifel. You may ask your question.

Thank you for taking the time and my questions this evening. I guess the first one is on the revenue guide. Has that changed – I recall the year revenue guide was up mid-to-high single digits. I think the revenue guide I see now is for the back half is mid-single digits. And that I believe would equate to roughly mid-single digits for the year. Am I getting something confused?

No, John, you’ve got it exactly correct. When we talked about the back half, we're talking about mid-to-high single digits, but on an adjusted basis that's high-single digits and that's adjusting for that $25 million shift last year with Q3 at mid-to-high, single-digit growth and Q4 at high-single digit growth.

Okay. And then help me with the media spend. So maybe you could equate it, give us the percentage of revenue in the first half of versus where you think you might be in the second half? I guess I’m trying to get a sense for now that we've loaded the – or reset the product line and we're in front of the Labor Day and that's a big event. I’m just kind of curious how your media spend is going to change?

Right. As well as I indicated in my remarks we've held our media spend fairly flat so far this year, so similar rate as prior year. And then as we move into the back half, I indicated that we will be investing behind some of the initiatives we’ve tested and also now that we have our entire 360 smart bed lined out there. We’ve in the past talked about good percent of sales to look at on an annual basis maybe around 14%. And I'll probably just hold it there given how competitive this particular part of the marketplace is.

Understood. And then I was curious on the gross margin, is there a way to help us think about how we exit 2019? You mentioned that you'll be hopefully clear of all of the old legacy products by then, the transition cost I think will be more or less behind you. And yet, there's this mix shift going on which is understandable with adjustables and that's a good thing in terms of dollars. But just curious if there's any kind of feel when we are totally clean? Where that gross margin percentage is as we exited the year or enter 2019?

Yes, John, so we're talking about at least a 50 basis points sequential improvement from first half to second half that would take our back half to around 61% gross margin rate. And then, we – as we look forward, as we benefit from the tailwinds of not having transition cost as well as eliminating some of the inefficiencies that we've absorbed this year while having two supply chains, two product lines, those will both be tailwinds expected in next year. Over some period of time, we expect 100 basis points to 200 basis points of additional gross margin expansion is within reach.

Okay. And then, lastly, quickly, you don't necessarily guide I don't think the stock buybacks or is there any help on you're done a lot year-to-date, on what our expectations should be for the back half of the year?

Yes, John, we had some unusual kind of fluctuations in our cash flows year-to-date in the first half. We expect our cash flows in the second half to be much stronger. We're looking at accelerated sales growth and accelerated profitability along with more normalized working capital elements to support our cash from operations generation in the back half. You can use those as a guide along with our liquidity cushion guidance of $100 million as kind of framework to work within in terms of how you're thinking about share repurchases.

Great. Thank you and good luck.

Okay. Thanks a lot.

The next question comes from Peter Keith with Piper Jaffray. You may ask your question.

Hey, good afternoon everyone. Thanks for taking the questions. I wanted to just maybe reflect back on the first half of the year. I know you said that Q2 came in a little bit better than your expectations. I guess, if I'm trying to adjust out the $25 million of sales shift, I will say your first half of the year same-store sales growth is relatively flat. And I guess, I wanted to just bounce it off of you that you had 75% of the product line within new format. It just feels like it should be a little bit better than slide same-store sales growth. So I'm wondering if there is – anything if you got back in the first half of the year that with a headwind or will things change to give us a little bit more confidence about the back half outlook?

Well, we're largely in the position where we expected to be first half, back half and on track with our full year guidance. As you recall, in the first half, we were expecting flat sales and we were down 1% and now you indicated that we're slightly ahead here in second quarter. Obviously, second quarter is the seasonally lowest quarter. But we achieved the step-up that we were looking for and in the second quarter. And we are now as of last week, we have our full line of 60 smart beds in the marketplace and it is supported with our new advertising campaign, talking about this is not a bed, it is proven Smart sleep at $999. And illustrating what the benefits are for the consumer. And that's also supported with our NFL amplification of the brand, along with our retail initiatives, both market development and also, advancements in our selling process being much simpler with all 360 smart beds. And same with online experience, we do expect our conversion to be stronger year-over-year in the back half. If you think about where we were last year with just two models at the high-end, on the floor in the third quarter, and then, adding the p6 in the fourth quarter. It’s a very different situation. We're really pleased with our conversion here in the second quarter, as I indicated on the last call, we did see that immediate step-up with the p5 and i8. So yes, we're on track with what we expected to see to be able to achieve the sales momentum we've talked about and planned for all year.

Okay, good. And Shelly, one thing I noticed within the script that you were talking a lot about the commoditized products at the low-end. My perspective just felt like you were mentioning it more than normal. Do have may be an evolving perspective on how that low-end is impacted in the industry and perhaps, even your business at the high-end? Is it taking some traffic out of stores or making that conversion even more difficult?

Alright, our conversion and traffic were as expected in the second quarter. I'm stating what I'm seeing and what we're all dealing with. I mean you write about it all the time too. It is a very intense commoditized marketplace in not only in our industry, but you see it in other industries as well. And when you have that amount of money coming into the marketplace with lots and lots of different brands, it does confuse the consumer and it does drive up search cost and search cost continue to be pressured at a greater degree each quarter and more and more businesses are getting into mattresses as well as more and more brands entering, and that has continued. And it is focused on commoditized products and it's focused at the low-end.

Okay.

So bringing it forward and I think all the Chinese imports that have entered the space on top of that that will be around $5 million this year, and that is all at the low end. So how that impacts – translated to how that impacts our business? First of all, we're excited. We’re excited with the opportunity and the interest overall in sleep and for consumers to be able to do the research and understand where the value is at. And so for us to be out in the marketplace now with our c2 at $999, when majority of these products that I'm talking about it, are at that $600 or $1,200. And to put our value equation up against it, Peter, we're really excited about this opportunity and where we are right now. And we think it's a good thing and we're well-positioned.

Okay. Thanks a lot for all the feedback and good luck.

You bet.

The next question comes from Brad Thomas with KeyBanc Capital Markets. You may ask your question.

Hi, good afternoon everyone.

Hi.

Wanted to ask about the store openings later this year and the growth in New York. If my math is right, you're in the year with about 8% growth in your store base this year, which looks like in the fourth quarter that alone could single-handedly get you to that high single-digit growth rate in 4Q. I guess, for one, is that a fair conclusion? And then, for two, more broadly, could you talk a little bit more about your strategy in New York and how if at all that market might be different and other store growth you've done?

Yes, the new store growth net of closings or repositions would be 5% for this period. And we expect to end about 585 for the number of stores.

Got you.

And then if you look at as we open each new store so we do have 40 stores we're opening here in the back of compared to the 24 that are not on that new. And if you look at the new store weeks, the majority of that will impact 2019. Overall, for the full year, we expect about 3% new store growth, just what we experienced here in Q2.

Got you, that's helpful. And then, how if at all, Shelly, is the market different from some of the other ones, in terms of the returns you’re looking for?

As far as New York it goes – Manhattan – opening in Manhattan is a complete different strategy than our other stores or DMAs. I mean, just looking at Manhattan in itself and it’s far more localized and we are so excited. It’s the right time for us to open in Manhattan now that we have all 360 smart beds, it makes perfect sense. We're really excited about our location and being able to activate there and have that overall brand awareness in that particular marketplace. And then supported by many other great quality locations, we've been doing numerous relocations to improve real estate that has been there in the DMA and then adding some net new opportunities. So you know getting much better positioned and we're happy with the performance of some of our other stores in the [indiscernible] as well.

Overall, Brad, I'd add that we expect similar kind of economics from the new stores that we're opening this year as we've seen in the past.

New York included.

Yeah.

Got you. And then just to ask a question that every company getting asked right now. As you look at your business, do you see any impact from tariffs coming down the pipeline here?

Yeah, very little for us. I mean I think there will be some impact in the industry as we’re – as I was just surfacing some comments with Peter about the commodity and the imports that are coming into the industry at the low end. There will be some impact between that and antidumping will start to help normalize some of those issues at the low end, but for us it really won't impact us.

Got you, thank you so much.

Thanks, Brad.

The next question comes from Seth Basham with Wedbush Securities. You may ask your question.

Thanks a lot and good afternoon.

Hi, Seth.

My first question is around gross margin. You guys help to spell out some of the headwinds you experienced this quarter, but maybe you could give us a little bit more color at which of those headwinds were bigger than your expectations?

Sure, Seth, I would say that we had about 100 basis points additional pressure than where we really thought about it coming into the quarter, largely from the inefficiencies from operating the two product lines and closeout sales, which are we expect those to wind down towards the end of the year.

Got it, okay. And when you think about the mix effects that you’re experiencing and part of this quarter was due to closeouts, but you’re also very excited about the new lower end c2 products. Would you expect continued mix driven pressure going forward from a mattress standpoint?

Yeah a couple of things there. We've considered that and how we’ve talked about the 50 basis points of improvement in gross margin in the back half that we did consider the mix that we expect from both attach as well as c series. And then importantly, we’ve got market share to go guess at. We have good, better, best pricing within premium and for us to compete strongly in this c series area. We're really excited. In the end, the key is to bring more customers to our brand and that's what we intend to do with this value equation. So, we see market share opportunity there. We also see it at the better price points in our line and we see it at the high-end. So we do expect to grow both units and ARU. And then on a separate note, one of the exciting things about this business model is that we have exclusive distribution direct to consumer with proprietary products and that means that we have a selling process and a promotional process that can drive mix change based on the dollars of we use for conversion. So if you look at the second quarter, for example, we did not drive year-over-year promotional dollars while achieving what we expected for the quarter. And you can drive mix shift based on different activities. So keep that in mind too and you can make some of those adjustments pretty quickly. So we like where we're at and really excited to have the full line in place at good, better, best pricing in premium.

That makes perfect sense in terms of your goals to grow both units and ARU. If you look at on a comparable store basis, Shelly, what's your expectation for unit growth? Are you concerned that there is a cannibalization effect as you introduced the c2 as you might trade customers down from some of the higher end products as well?

This goes back to, the key is bringing more customers to the brand and we think about new customers similar to unit growth. So the more customers we’re bringing into the brand and converting that c series means the more customers that won't be purchasing something else. In addition to the many customers, who continue to – who are able to afford and want to benefit from all the value at the higher end of our line. I mean there is – there are great reasons to trade up and there is also for the c2 smart bed against any commodity product. And there is a really great reason, pretty compelling to buy it. And at the same time, when you move up our line, there's exciting features and benefits along the way and we're confident in our frontline in our selling process to be able to convert sales across our line. So, what we do well? This is our core competency.

It makes sense. Just lastly to reframe thinking about the back half guidance here, now what is your expectation for a comparable store unit growth, do you expect to grow units or not?

Yeah, we always talk about our total unit growth and we do expect full year unit and ARU growth.

Fair enough. Thank you.

Thank you.

Thanks, Seth.

The next question comes from Michael Lasser with UBS. You may ask your question.

Good evening. Thanks a lot for taking my question. So if we adjust for the $25 million shift from the second quarter, third quarter last year, it implies that comps were flattish or so this quarter. And that's with growth from closeout models and the c2 bed. So implicitly some of the higher end beds adjusted for this sale shifts were down. Why was that the case? Are you seeing folks trade down? Or are you just bringing folks in and having a harder time trading up to them?

No, Michael. The sales performance in the second quarter was as planned and we used the advantages of our complete model as we rolled out the remaining models of our 360 smart bed. We took advantage of some of those closeout opportunities as well and those were as planned in the quarter and we're expecting now with the full 360 smart bed line up in the stores as well as the support from media that highlights the advantages of that line. We're pretty excited about the step up going into back half.

So your sales were about as planned, but you're moderating your sales guidance from mid to high – from previously mid to high single digits to mid single digits. So what has changed?

Yep, the step up in Q2 was as we expected. I have mentioned that we had slightly better expectations in the second quarter and for the back half we expect mid single digit growth. And we are on track with our full year guidance of $1.70 to $2.

Okay.

Yeah, you know, it’s mid to high single digit growth in the back half. On an adjusted basis, it’s high single digits in the back half, adjusting out that $25 million. And we expect in Q3 to have mid to high single digit growth and a step up in Q4 of high single digit growth, but our guidance of $1.70 to $2 and EPS has been consistent and we are committed to delivering pretty significant acceleration in our profitability in the back half.

And so you spoke about rising customer acquisition costs and it seems like it was more intense this quarter. Could you give quantification for example was it rising single digits and now the cost to acquire customers rising double digits? Is that the right order of magnitude?

Well, let me clarify and correct the point here. I did not talk about rising acquisition cost. I did speak to increasing search costs, which is different than rising acquisition costs. So, yes, we are increasing search costs and we're so happy that we've brought our digital buying in home, so that – or in-house so that we can be very responsive to that. We leveraged our media effectiveness in the second quarter. We’ve held our media dollars fairly flat so far this year until we’ve rolled out our full 360 smart bed line and now we will be investing in media here as we move into the back half. Also you know we continuously highlight the importance and the competitive advantage we have with our lifelong relationship with our customers, which results in numerous advantages. But one important one is referral and repeat sales. And our referral and repeat sales have continued to be strong and it is a very efficient source of customer acquisition for us.

Okay, okay. Thank you so much and good luck for the year.

Great, thank you, Michael.

The next question comes from Curtis Nagle with Bank of America Merrill Lynch. You may ask your question.

Great, thanks for taking the question and good evening.

Hi, Curtis.

Hi, Shelly. How are you?

Good.

Good, good. Just a quick question on the liquidity cushion. It looks like if I'm not mistaken you're moving I guess the range from I think what was 100 to 150 to 100. I'm just curious why? Is it based on being a little more aggressive on the buybacks? Or do you just think that this is perhaps a more appropriate level going forward?

Curtis, you know we've said 100 million to 150 million, we think the 100 million is more reflective of how we think about the business going forward. It still gives us a very significant liquidity cushion. And we've talked about this on an ongoing basis that we review our capital structure with our board on a regular basis and in those conversations keep an eye on the upside and downside scenarios to evaluate what makes sense in terms of liquidity cushion and that $100 million is the appropriate level.

I think the other add to Curtis where we are right now. We have our full line of 360 smart beds now deployed and it’s if that progression and strategy that is also helpful.

Okay, understood. And then just a quick question to Shelly. I think you alluded to potential antidumping action. Is this you know something that you think is really probable? Or it might be in the works or just a reference to chatter that's been in the industry?

Yeah, I think, we've all read similar reports and it continuously comes up as potential action that will be taken.

Got it, okay, thanks very much.

Thanks, Curtis.

Thank you. At this time, I would like to turn the call back over to your host for closing remarks.

Thank you for joining us today. We look forward to discussing our third quarter 2018 performance with you in October. Sleep well and dream big.

This concludes the Sleep Number’s Q2 earnings conference call. Thank you for your participation. You may disconnect at this time.