Welcome to Sleep Number’s Q4 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. [Operator Instructions] 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’s fourth 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 maybe 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. Please also note that, we have posted an updated investor presentation on our website at sleepnumber.com. I will now turn the call over to Shelly for her comments.

Thank you, Dave. Thank you for joining our 2018 earnings call. My average SleepIQ score is 82. Consumers are highly engaged with our purpose-driven brand and responding strongly to our revolutionary 360 smart beds. The execution of our consumer innovation strategy has broadened our relevance as individuals increasingly understand the importance of quality sleep to their overall well-being. Results for the fourth quarter included. Net sales growing 13% to $412 million including 10% comps growth; net operating profit increasing to $38 million; and earnings per share increasing 108% to $0.81. For the full year, net sales increased 6% to over $1.5 billion including positive comp sales for the fifth consecutive year. Net operating profit increased to $92 million, while absorbing approximately $60 million of transition impacts and earnings per share increased 24% to $1.92 compared with $1.55 for 2017. Our record sales and EPS performance reflects the acceleration from our 360 smart beds. In the second half of 2018, our adjusted net sales grew by 12% and adjusted earnings per share grew by 48%. The momentum in our business continues and we expect to generate full year earnings per diluted share of between $2.25 and $2.75 in 2019. Our strategic consistency, investments and fortitude over the past six years have focused on strengthening our competitive advantages, proprietary sleep innovations, exclusive distribution, and lifelong customer relationships which work together to drive results. We are excited to be in the position of much broader relevance in a changed consumer and competitive landscape. Our initiatives deliver performance through three EPS drivers which are creating demand, driving leverage and deploying capital efficiently. We remain committed to using all three of these EPS drivers in 2019 and beyond. Here are the highlights, starting with demand. Number one, our proprietary sleep innovations remain at the heart…

Thank you, Shelly. Since 2012, we have completely transformed Sleep Number to enable long-term sustainable profitable growth. In addition to the significant investments of capital, this painstaking work required that we build vital new capabilities. We prioritized innovation, increasing our R&D spending from 0.7% of net sales in 2012 to about 2% today. This led, most recently, to the completed rollout of our revolutionary 360 smart beds which drove 8% reported or 12% adjusted net sales growth and 31% reported or 48% adjusted EPS growth for the back half of 2018. Consumer adoption of our innovations has led to a 47% increase in our ARU since 2012. We've built and implemented two game-changing technology platforms. One, our ERP system is the backbone of our integrated operations providing scale, security, and growth capacity. The second SleepIQ technology combines artificial intelligence with adjustable comfort and provides a daily interaction portal for our customers with the Sleep Number brand. We've overhauled our direct-to-consumer distribution strategy ending 2018 with a healthy portfolio of 579 stores 41% more than six years ago. We shifted from 19% non-mall locations to 63% at the end of 2018. With these investments, we created an exclusive best in retail in-store experience through award-winning designs, technology enhancements, and stores that are about 50% larger on average. Today, we operate more than 580 stores in 50 states delivering strong economics with meaningful capacity for growth. While advancing our physical retail we also streamlined our online experience to improve search, product comparisons, and shopping cart convenience. Our vertically integrated go-to-market strategy provides a true omnichannel experience for our customers. Our average annual sales per store including online is now $2.7 million with 25% of our stores exceeding $3 million in sales annually, up from 12% in 2012. The mattress industry has also…

Thank you. [Operator Instructions] Our first question will come from John Baugh from Stifel. Your line is now open.

John, are you there?

Yes, I’m here.

Okay.

Can you hear me?

Yes, thank you.

Okay. I was curious a little bit I guess on the tone…

Sorry, John. I think we lost you. Operator, is John still with us?

I do apologize. It looks like we've lost John. If you can give me one moment. Our next question will come from Bobby Griffin. Your line is now open.

Good afternoon, everyone. Thank you for taking my question and contracts on a great quarter and a great end to the year.

Thanks, Bobby.

I think I know what John was asking, so I'll go ahead and help him out and maybe ask that as my first quarter. Can you just give us any color on how the tone of the business carried through the quarter? I know October orders were up double digits from the last time we spoke, but how did November and December unfold?

Yeah, Bobby, we're very bullish about our business. Our guidance reflects the strong momentum that we've experienced since we moved to the new 360 smart beds. I indicated that we've been driving a double-digit increase since that time and that momentum continues into 2019.

Okay. And then David maybe two modeling questions for you. One, on the cash flow this year. It look like cash flow from operations was down about 24%. Can you maybe give some color on some of the drivers of that if there is any timing issues within the working capital accounts and then maybe the outlook for 2019?

Sure, Bobby. We had some changes in our balance sheet going both directions. We had benefits from inventory and we had year-over-year cash flow basis and we had some pressures that were associated with our incentive compensation programs we can grow through the complete list. There’s also an accounts payable pressure of about $32 million upswing from year-over-year, but we can go through that list with you off-line. As far as guidance for next year, we've provided a lot of collar around the growth we expect both top and bottom line. There is a slide in the updated IR deck on page eight on our website that you can look at. I would just model out EBITDA as a guidepost for cash flows and use that going forward for 2019.

Okay. That's helpful. I appreciate it. And then I guess lastly from me on G&A this is just to help tune up the model. Should we expect more kind of that $32 million type run rate per quarter next year or I guess a little bit higher? How should we think about that?

We're not going to provide a lot of color on the individual line items. What we've done on that slide is give you the overall rates of our total operating expenses of 54% to 55% of net sales. Variable comp in 2018 was a tailwind for 2018. We expect it to be a bit of a headwind in 2019 as well as we prioritize our innovations, marketing and retail spending to support our growth drivers.

Okay. That's helpful. So I can think of it as G&A maybe a tailwind from a percentage of sales and then maybe inside the other line items within operating expenses you could have a little -- I’m sorry, G&A is a headwind from percentage of sales standpoint and then tailwinds with inside the other line items from operating leverage, is that fair?

Not necessarily. If you just look at the modeling how we're calling it out Bobby, I called out that we expect 80 basis points to 120 basis points of gross margin rate improvement. And overall, our operating profit is expected to increase from 50 basis points to 100 basis points. So that implies that we're not expecting a ton of leverage out of our operating expenses in 2019 as a result of the things I just mentioned.

All right. I appreciate that and helpful to clean up the model. Best of luck going forward in 2019, and once again, congrats on the EBIT growth here in 4Q. Really nice to see that pickup.

Great. Thanks a lot, Bobby.

Our next question will come from John Baugh with Stifel. Your line is now open.

Can you hear me now?

Yes, John.

There you are.

Hi, John

Okay. Sorry, about that. I guess I was -- on the consumer, it sounds like Shelly, you're cutting through some of the macro noise. Obviously, a lot of concern around Christmas with the stock market, you have still some mall-based stores, but it sounds like things have held fairly steady because of all the various things you're doing with products and digital marketing, et cetera. Is that a fair characterization? Or did you see a big drop off and then a big recovery since the markets recovered?

No, your description in the beginning is a fair characterization. We've seen consistent growth since we introduced the new 360 smart beds and we're caring that double-digit momentum into the New Year.

Okay. And Shelly, how is the mix? Now, I guess, it's been about six months, seven months we've had the full smart bed 360 on the floor. Is the mix about where you thought it better or worse? I thank you for all the unit guide. But just curious is this tracking on a mix basis about where you thought?

Again, great question. This is an important topic. And when we look at our brand messaging, it is clearly breaking through on proven quality sleep at $9.99. Now that drives quality traffic to our brand. And then our selling process and our mission-driven team convert that traffic throughout the line finding the best product for our customers. So we're really happy with the results that we're seeing. We have a similar series mix as we had prior to the 360, but yet you can see the unit and ARU growth as a result of bringing more customers into the brand overall.

Okay. And my final question is you mentioned a record conversion rate. Your conversion rate has always been high.

Yes.

Maybe on a call like this you don't want to give out the secret sauce. But is there any color you can give us as to what you think drove that improvement?

Yes, a number of factors. First of all, we talk about driving quality traffic. So, not all traffic is equal, and this is such an important area right now with so much media spend in the marketplace to be able to cut through and have high-quality traffic and the higher quality traffic also leads to stronger conversion. So, it's certainly a factor. Another important factor is the 360 smart bed. It's a much simpler sale for our sleep professionals. And especially, when you consider that for the past year, they were selling both of our old line as well as some models in the smart bed. Now, it's streamlined. We've learned a lot about how to sell that bed and their mission driven and having a band that has proven quality sleep and our customers' testimonials and advocacy is so strong and we have the 4.8 rating on the balance. When you can get that kind of value equation as a consumer it converts high-quality traffic, strong conversion based on their incredible product that we are offering in a very commoditized marketplace.

Great. Thanks. Based on what we're seeing, it took significant share in the fourth quarter so good luck.

Absolutely. We think so too. Thank you.

Our next question will come from Brad Thomas with KeyBanc.

Hi, good afternoon and let me add my congratulations as well on solid year here.

Thanks Brad.

I want to ask about advertising first and get a sense of how you're thinking about advertising as a percentage of sales this year and maybe your appetite to crank up the level of marketing you're doing given that stores have been reset with a new product and you have all these new partnerships out there like the NFL.

Yes, as we think about our media as a percent of sales in 2019, we expected to be similar to 2018. We've set for a few years around that 14%. We are at 13.7% in 2018. We did drive an increase in media in the back half and we will continue to hear in 2019.

Great. And then Shelly with respect to the outlook for stores, I guess, could you give us a sense for what your latest thoughts on what the long-term number of stores should be for Sleep Number in The United States and how many today are still candidates for a relocation or repositioning of the model?

Yes great. Our distribution strategy is such a key element of our sustainable profitable growth and we continue in evolutionary manner with great discipline of execution here. And we're excited about where we are and our growth opportunity in front of us. We're clearly opening a significant number of stores this year in retail backdrop that is not where that's not necessarily the case. For us we sell at markets that were further developing, but importantly, there are great relocations too. We had a number of -- just in the last few weeks that have just been phenomenal right out of the gates, particularly in some of our more mature markets continuing to have a healthy real estate portfolio and making sure that you're not just opening a new store and leaving it to sit there over time and focused only on store count. This is about sustainable profitable growth and it's about driving top and bottom line and we really liked some of our great performances right now in relocations and seeing how much more we can take out of the marketplace, when we're constantly evolving and improving that location based on where the consumer shopping in each local market. So, we haven't put in a number out there on, how many stores. We had stated that a target for 2019 would be between 600 and 650 and that's where we are coming. We still see growth potential and we are also signaling that online sales are important to us to and we expect our online sales to continue to outpace our store growth and just percentage of growth overall, but it is obviously a very small base.

Great. Thank you very much,

Our next question will come from Peter Keith with Piper. Your line is now open.

Hi. Thanks a lot. Good afternoon, everyone. I just want to look at the full year guidance of $2.25 to $2.75 and I'll just call the midpoint at $2.50. So it is down about $0.25 from what you were telling us about three months ago and targeting $2.75. The bottom end of the sales range came down a couple of percent too. It sounds like you have some good momentum into the New Year. And you sound good I guess, could you help us frame-up what the changes for a couple months ago?

Yeah, Peter, as I stated, our business is performing really well. Our guidance reflects those strong momentum that we've experienced with our new 360 smart beds and that has continued into 2019. Our EPS guidance range of $2.25 to $2.75 represents a 17% to 43% growth versus our $1.92 EPS for 2019. And we believe that will represent the top quartile to top decile performance. And finally, I would just add that the execution of our consumer innovation strategy has strengthened our competitive advantages. We are driving accelerated performance and confidence in how our business is performing.

I'll add on Peter that we also given a little bit of color about the front half versus back half growth and we're expecting stronger growth in the first half. And then mid single-digit kind of growth in the back half as we lap the 12% adjusted growth from 2018.

Okay. That is helpful. And then certainly on the tariff front the headwinds there are very understandable. What are the logistics and transportation headwinds right now? And I guess thinking that most companies saw that in 2018, but are now potentially looking that as a slight tailwind for 2019.

We saw it last year too, we highlighted it. It certainly still exists and there is a slide in the IR deck that outlines the headwinds and tailwinds and there is also labor pressure. We have home delivery in our business model as well and there is labor pressure in that arena too.

Yeah. Peter, the continued challenges for the trucking industry to hire enough drivers that continues to be a pressure point that we anticipate for to be a headwind in 2019. We are also -- while gas has been favorable recently the labor rates have been high. You see a lot of people issuing bonuses or hiring bonuses just to attract people into these jobs. So we expect that to be a headwind for us in 2019.

Okay, that's all fair enough. And actually David, one last quick question for you. So thanks for framing up the targeted debt-to-EBITDAR range. Where do you guys stand at the end of 2018?

I think it's 2.7. I just want to look it up 2.7.

Okay. Thank you very much. Good luck.

2.8. Thanks. Okay.

Our next question will come from Seth Basham with Wedbush. Your line is now open.

Thanks a lot and good afternoon.

Hi, Seth.

Hi, there. So you've talked about some growth expectations in terms of both units as well as ARU in 2019. If we look at the fourth quarter results and we back out the $24 million from the backlog shift looking at implied comparable store unit growth, we actually saw declines. So I'm trying to understand why that is? And what gives you confidence for 2019? Are you expecting declines in comparable store unit growth or are you just thinking things will reverse?

Well, first of all I'll speak to ARU and unit growth overall and we do expect growth from both metrics in 2019.

Yeah. Seth I think you're reaching pretty hard to try and find a blemish in these results. Frankly we had really impressive growth. We provided you a slide on page 10 that highlights the impacts from all the shifts both in 2017 and 2018 delivering on an adjusted basis 12% top line growth in the back half, 11% in the fourth quarter that included both ARU and units and comp.

Understood. I'm not trying to take anything away from your results and certainly it seems like you have some momentum in the business. But to that effect, you talked about strong double digit order growth for the first few weeks of the quarter. Shelly last time we spoke your results ex-the backlog shifts suggest there is a slowdown for the balance of the quarter. First of all is that correct? And have we seen an improvement into 2019?

Since we introduced the 360 smart bed, Seth we have had double-digit growth in our business and that has continued in 2019 and we have had growth from both units and ARU. We expect that in 2019. We will have quarterly fluctuations on the units and ARU. So when we're up against closing out the C series, we drove a lot of units last year at lower margin on that closeout. We'll have some fluctuation there. But we often talk about that because we always will on a quarterly basis but again we'll see growth from both in the full year.

Again just to highlight again over a longer period of time, back half of the year and going into 2019 we're saying, we've had strong double-digit growth. So I mean there has -- that's a very long stretch of period of time for us to be talking about. If you want to look at day-to-day or month-to-month there are always going to be fluctuations but that's a really strong performance over a long period of time.

And it's been consistent.

Very good. Thank you guys.

Thanks.

Yes. Thank you.

Our next question will come from Matthew McClintock from Barclays. Your line is now open.

Hi, yes. Good afternoon everyone. Earlier you referenced to the chaotic industry environment and clearly your performance today appears pretty solid. I was wondering if you could give us just an overview of what you see across the industry so far this year, especially as we enter the all important Presidents' Day weekend maybe from a promotional standpoint or just from a competitive standpoint. Thanks.

Sure. I'm primarily speaking to the amount of media dollars in the marketplace and the number of brands with a variety of different messages. There is a lot of what I would say clutter for the consumer to sort through. In the end, this is the type of environment that we've been operating in and it continues and we are breaking through with a strong message of proven quality sleep starting at $9.99 with our Sleep Number 360 smart beds. And yes, this heavy spending environment particularly around search terms continues in the first quarter of this year and at the same time we're speaking to the momentum that we've been driving here in the first year continuing as well.

Thanks for that. And then if I could get one follow-up. Just you talked about the relos and I was wondering if you could give us -- and you were pretty optimistic about how those perform. I was wondering if you could give us any metrics toward how a relo typically performs in terms of maybe four-wall uplift or sales uplift or anything just so we can get our head around that.

There are couple of pages in the deck that go into a fair amount of detail on slides 16 and 17 that provide a fair amount of detail on our distribution strategy and how we execute against that and it does illustrate some four-wall profit based on average revenue per store too.

Okay. Thanks.

Our next question will come from Keith Hughes with SunTrust. Your line is now open.

Thank you. Based on what you said earlier, it looks like this is going to be a heavy store opening year just in terms of units one of the biggest we've seen. And I think you have said on the guidance for 2019 revenue it only will be a low single-digit contributor. It seems like it would be more than that based on the numbers. What kind of I'm missing and how this is going to work?

Yes it's a heavier year than last year. The first half of last year we are so focused on the introduction of the full line of smart beds. We've had some other years in the recent past that have been this large as well and it always includes a combination of net new stores along with closures and relocations.

It also depends on when the store gets opened in the course of the year the number of store weeks that is actually open during the course of the year that contributes to your results and it's on the largest store base overall.

No, it looks like from the net you're going to increase your stores about 7% this year. So I would normally assume about half of that would contribute. You're saying it's less than that, is that right?

If you're splitting the difference at 6% to 8% growth it's in the range that we provided 6%, yes.

That would be half or…?

Yes. We said, we've got 3% growth in 2018 from new stores and that's a little higher than that and we're saying a low single-digit growth in 2019 from new stores.

Okay.

And we opened -- we were a little heavier in opening our stores in the back half post 360 implementation.

And the remainder of the organic growth I think it should certainly be split between ticket and units correct?

Yes. It's fair to look at it that way on an annual basis. Again, yes, quarterly fluctuations, yes.

And so when you worked those numbers down, its positive number, but based on consumer side, I expected it to be higher on the unit given you've refranched the whole line. Is there anything else within the numbers there that's mix thing I'm missing, or something like that that would impact just the raw calculation?

Well, in the back half, units were up 8% or, excuse me, 6% and in the fourth quarter they were up 8%. That's on an as-reported basis, not adjusted for the shifts that we talked about. But that's when we saw the acceleration that we've been highlighting from the 360 smart beds.

Okay. Thank you.

Thanks a lot.

[Operator Instructions] Our next question will come from Michael Lasser with UBS. Your line is now open.

Good evening. Thanks a lot for taking my question.

Yes. Hi, Michael.

Hi, Shelly. So you seem to be really confident and excited about the tenor of the business. And 90 days ago you knew you're going to have a tough comparison in the back half. So what's changed in the last 90 days that has resulted in the midpoint of your 2019 top line guidance to be ratcheted down by 100 basis points and the low end to be ratcheted down by 200 basis points?

Yes. Michael, we're providing guidance today for our 2019 performance and it reflects the momentum we've experienced since we've introduced the 360 beds. It also reflects a 17% to 43% growth in EPS with a 30% growth at the midpoint.

Michael, I'll just add on that, we haven't provided detailed guidance for 2019 before this call. So we provided a walk that helps you understand how we were thinking about going from 2018 performance, which had a guidance midpoint of $1.85 and bridging that to the 2019 $2.75 target. Today is the first time that we're actually providing you our detailed guidance for 2019 and this is how we're thinking about the business.

Okay. I guess the slides are -- when you look back at that third quarter slide of the past and the path you provided for your guidance, they're very similar. So I guess that's where the change is being interpreted but it sounds like you guys don't see that necessarily as a change, is that fair?

Yes. It's a guide map to help you understand how we're thinking about the business and how we can deliver against the guidance we've just provided.

Yes. And we mentioned on the slide the last quarter that was illustrative, and then for this year now, closer in, we have some headwinds and tailwinds that we detailed out as well. And providing guidance today on 2019 that includes the $2.75 target.

Okay. Understood. And as my follow-up your range of outcomes for this year in terms of earnings is a $0.50 range. It's much wider than you've provided in the past that's been typically of $0.15 $0.20 range maybe $0.30 last year. Why is it wider? And what could drive the upside case and what could drive the downside case? Is it all dependent on sales?

Yes well first of all the sales spread that we've associated with our EPS guidance is about four points. We said 6% to 10% growth. And as far as the different variables I think looking at the headwinds and tailwinds can give you a good illustration; there is varying degrees of where they will come in and that's a good way to think about it.

Okay.

It's also * let me just weigh in a little bit too. This is as a percentage of the dollars that we're talking about of our actual guidance it's not that much difference. And we've got benefits from both share count reduction and tax rate that make incremental impacts on an EPS basis much more. So, those have also be taken into account on how we're thinking about the guidance range.

Understood. If I can sneak one last one in. In light of the fact that you are committing to higher leverage ratio Dave, should we assume that the heavy drain from working capital that occurred in the fourth quarter is reversible or at the very least not going to continue again into 2019?

Yes, I mean a lot of that was the impact from our accrued compensation and incentive compensation programs and those things certainly do fluctuate from year-to-year. We did -- I called out earlier 32% -- or $32 million swing in our AP impact on the cash flows year-over-year but those things are going to change based on the amount of inventory, the amount of media that happens -- the timing of media et cetera. So, those will always fluctuate.

Okay. These are helpful answers. Thank you very much.

Thank you.

Our last question will come from Curtis Nagle with Bank of America. Your line is now open.

Good evening and thanks very much for taking my questions. So, I guess, the first one is let's talk about pricing a little bit. Just kind of looking back at the past maybe six three months or so it looks like you guys have taken price on a number of models some perhaps fairly materially and it does seem to be a bit of a change in stance relative to at least a year ago. I know you guys have made some commentary about your pricing power but just wondering if that is the case. How much you've taken? And then just how should we think about pricing for this year?

Yes, Curtis, we over time have talked about our ARU growth and that it represents approximately 3% pricing that is almost always associated with additional benefits for the consumer and that number still stands true. So, it's a good way to think about it. Overall, we did take $100 of price increase on the p and i series in October, but still that falls into that 3% overall ARU growth.

Okay. Fair enough. And then I'm just kind of curious to a little bit more of your thoughts when you made reference to, I guess an assumption for a confident consumer. I guess, just looking at the most recent indices we're still at high levels but it is declining. We're going to start lapping tax rates, housing softening who knows what happens with trade. I guess, what gives you confidence or what is behind that assumption of a strong consumer through the year?

When we look at our overall guidance and the environment that we've been operating in since we introduced the full line of 360 smart beds, we would characterize the consumer as confident. And generally, our business is most correlated with consumer confidence and that's what we've experienced and we've been able to perform with double-digit growth throughout this environment with our 360 smart beds. Clearly, the industry hasn't performed at that same level and that's I'm sure what's on people's minds, but we are – and with a confident consumer and a strong value equation like the 360 smart bed starting at $9.99. We are confident in our ability to take share and convert those customers and give them a quality night sleep with our smart beds.

Got it. Thanks very much. Appreciate it.

Thanks, Curtis.

I would now like to turn the call over for closing remarks. Thank you.

Thank you for joining us today. We look forward to discussing our first quarter 2019 performance with you in April. Sleep well and dream big.

This concludes today's conference. Thank you again for joining today's conference call.