Welcome to Sleep Number’s Q1 2019 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 first quarter 2019 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 contain 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. Thank you for joining our first quarter earnings call. My SleepIQ score last night was an 88. I will provide an overview of our quarter and the initiatives that are driving our performance. We are proud of our progress, the life changing sleep we are providing our customers and the related total shareholder returns. Results for the first quarter included net sales growth of 10% to a record $426 million, operating income increased 22%, operating cash flows increased 38% and earnings per share increased 54% to a record $0.80. We continued to advance our three EPS drivers: demand creation, business leverage and efficient capital deployment to drive growth and profitability. On the demand side, our purpose-driven brand differentiated products engaging marketing and relationship based retail experience resulted in a 5% comp gain and 5 points of growth from new stores. Our revolutionary 360 smart bed resonates with consumers as they deepen their understanding that sleep is at the core of performance and well-being. It is the only bed that delivers proven quality sleep by automatically adjusting to your individual comfort and support. Our initiatives resulted in steady, high qualified digital traffic throughout the quarter with high store conversion. Strong sales execution is resulting in customers attaching adjustable bases, bedding and temperature solutions to their smart beds. As we previously communicated, we expect growth from both ARU and units for the full year. We will have quarterly fluctuations in these metrics as we lap closeouts and other actions. We expect the following initiatives to extend our brand reach, deepen consumer engagement, and deliver sustainable profitable growth. First, driving highly qualified traffic to our website and stores, media percent of sales was flat year-over-year in a heavy spending competitive marketplace. At a high level, there are four main components…

Thank you, Shelly. We continue to benefit from taking the long view with the execution of our consumer strategy. Our investments are delivering accelerated performance and reinforce the importance of prioritizing our growth drivers: innovation, marketing and retail. We are also realizing benefits from our operating efficiency programs. And the evolution of our capital structure has generated double-digit returns on the shares we have repurchased. Our trailing 12-month return on invested capital of 16.5% reflects an 80% plus premium to our weighted average cost of capital. Our capital priorities are clear and consistent. This integrated approach is delivering top tier total shareholder return and positions us well for the future. Net sales in Q1 of $426 million grew 10% over the prior year. Comp growth and new stores each contributed 5 points of growth in the quarter. ARU increased 9% and units grew 1%. We continue to expect quarter-to-quarter fluctuations in these metrics and growth from all four in 2019. Our operating efficiency initiatives are also delivering results, which combined with our growth drivers, delivered 15% incremental operating profit flow-through this quarter. As a result, our net operating profit margin improved 80 basis points over the prior year to 7.7% of net sales. As we highlighted on the last call, we are managing meaningful tailwinds and headwinds in 2019. I will take a minute to walk you through the puts and takes that netted to a 40 basis point gross margin rate improvement over the prior year. We realized 70 basis points of lift by eliminating transition costs and 90 basis points from efficiency gains and pricing. These improvements were partially offset by 70 basis points of rate pressure from higher attach of our adjustable bases, 30 basis points from higher tariff costs and 20 basis points of delivery cost…

Thank you. At this time, we would like to begin the question-and-answer session of the conference. [Operator Instructions] The first question comes from Bobby Griffin with Raymond James. You may ask your question.

Hey, Bobby.

Please check your mute button. We are unable to hear you.

Operator, maybe we go to the next caller and then come back to Bobby.

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

Hi, good afternoon, David. Good afternoon, Shelly. Congratulations on a strong start to the year here.

Thanks Brad.

I guess just in terms of momentum in the business, could you share some more color with us on the underlying trends that you saw month to month in 1Q and how you are thinking about comparable revenue as we model 2Q?

Sure, Brad. We – first of all starting with, this is our third sequential quarter of double-digit growth since we completed the transition to all 360 smart beds. So we are excited about our consumers’ response to our innovations and our other initiatives. We saw strong growth in traffic throughout the quarter with the strongest period being during the important President’s event.

And then as far as Q2, Brad, you had highlighted about that we also highlighted that we expect stronger growth in the first half of the year than the back half and 6% to 10% net sales growth for the full year.

Great. And then obviously you all are reiterating the full year guidance relative to our model given the share counts coming in at a lower rate than we would have expected and then the tax rates more favorable, but it does feel like perhaps there are some headwinds on the margin front that are maybe a little bit worse than what you thought 3 months ago. Is that the right way to think about kind of maybe the two changes versus how you initially guided the year or is there anything else we should be thinking about here?

Yes, Brad. There are a lot of moving parts that we are managing through as we have highlighted with our guidance for the year. And I think you are on to the right things that we saw about $0.05 more benefit in the tax line and a little more pressure on the gross margin rate, but we have great confidence in the initiatives that we are driving and expect even more than 40 basis points of margin expansion the balance of the year.

Great. Very helpful. Thank you all so much.

You bet.

Thank you.

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

Good afternoon and thanks for taking my question. It was a tough quarter, it struck me for the consumer in general and you mentioned your traffic was good throughout. And you mentioned I think also your media spend was flat. So I guess the first question I have is just help us understand the media spend strategies for the rest of the year without giving away competitive information I guess and how you see the year unfolding and as the tone gotten any better in the last few weeks versus some of the coast, I don’t know, December market meltdown, government shutdown etcetera where traffic was very steady?

Yes. Well, thanks for your good questions here, John. Let me give a little color on the media as you requested. First of all, the media spend year-over-year was up. It was the media percent of sales was flat and the spend was actually up 10% in the quarter, which drove a 10% top line growth. As you look at the media spend for the balance of the year, we continue to have great confidence in our overall business. We are hitting on all cylinders. We have a revolutionary product that is delivering proven quality sleep for our customers, our marketing is effective, our brand metrics are high, our stores are highly productive and we have great innovative suppliers working with us and our manufacturing is improving and delivering some nice leverage and we have a highly engaged team. So we are definitely leaning in at a time when the overall industry is providing a fair amount of weakness. So we are taking share, we intend to continue to take share and coming from a place of strength we intend to lean in. And as you think about media as a percent of sales, we have continued to stay to model around with the 14% last year we came in at 13.7%, so somewhere in that range, but I definitely would indicate that, that we are leaning in.

Okay. And then two other quick ones, one, the G&A was higher and I think if I heard, David, you said that the stock comp piece, because the stock price going up was a big part of that. Could you quantify that? Was there anything else going on there?

John, the impact of the stock comp was in our tax rate that I highlighted and that’s just for that new accounting treatment for stock comp. As we indicated on our last call, we expect pressure from broad-based participation in our incentive comp programs in G&A and that was what with the primary driver of the higher G&A in Q1.

Okay. And will that persist through the whole year, David?

Yes, we certainly hope so, yes and we hope so for our team.

That’s the call.

And we think as I highlighted, I expect G&A in Q2 to be similar to what it was in Q1 for example.

Okay. And lastly quickly, I appreciate that the units are lumpy as we look at quarters, could you refresh for us quickly the lumpiness by quarter last year or in other words what the unit comparisons are like for the four quarters this year in terms of that lumpiness? Thank you.

Yes, John. Well, let me start with indicating that we continue to expect growth in both ARU and units for the full year and as you indicated and we highlighted we will have quarterly fluctuations. So if you look at last year 2018 by quarter, we were down 9%, up 7%, up 3%, up 8%, for full year up 2%.

Okay. Thank you. Good luck.

And part of that shifts, John, you might be talking about was in the week of deliveries that moved from Q3 to Q4 last year that we highlighted and that was within the year, but just keep that in mind as you are looking at the comparisons year-over-year.

Right. Yes, understood. Thanks.

The next question comes from Matthew McClintock with Barclays. You may ask your question.

Hi, this is Jordana Cooper on for Matt. So as there are lot of store openings planned for this year, can you talk a little bit about your real estate strategy for the year particularly given the high degree of macro store closures that have occurred over the last several months? Specifically, how did this strategy help drive a strong 5% sales growth from new stores during the quarter and how sustainable is this?

Yes. Well, we see it as very sustainable and it’s really the premise of our entire strategy to drive sustainable profitable growth and we have deployed a consumer innovation strategy starting in 2012 to be highly relevant with the consumer over time. And part of that strategy has been investing in the business and strengthening our three competitive advantages of proprietary innovations that deliver meaningful benefits to our customers in a commoditized industry. And secondly, exclusive distribution and we have very highly productive stores and we have moved our average revenue per store from prior around $1 million per store to targeting well now at the end of this quarter over $2.7 million per store and targeting $3 million and beyond and then our third competitive advantage being lifelong customer relationships with over 40% of our sales being driven from referral and repeat sales. The new stores are performing ahead of expectations for the year. We have a destination approach, we look at a total – we look at the entire country wherein all 50 states, but then we take a local market development approach and our radius is 20 minutes or 10 miles on average and we pay close attention very disciplined execution of rebuilding our store portfolio since 2010 and we have moved a good share of our stores from mall to non-mall and today have about 64% of our stores in non-mall locations. All-in-all, this is about having a very healthy retail footprint with mission-driven team members who are dedicated to improving customers’ lives and selling products that deliver life changing sleep.

Great, thanks. And then can you talk a little bit about some of the changing dynamics and consumer behavior for smart health technology, have you seen really any changes in traction for the sleep health category overall in 2019? Thank you.

Well, this is such an important consumer trend. Consumers are understanding that sleep is a key component of their overall wellness and that is helping people with really thinking about their sleep and the connection is still not quite apparent to consumers broadly, this clean, the mattress and quality sleep. And this is where we over-index in delivering a smart bed that ensures and delivers proven quality sleep by reading individual’s biometrics and automatically adjusting the firmness to ensure that the consumer achieves their highest quality sleep. And yes, smart technology is becoming a given. Our research has shown that over 55% of broadband households have an interest in purchasing some type of smart technology related to their sleep.

Great. Thanks for the color.

The next question comes from Keith Hughes with SunTrust. You may ask your question.

Thank you. Really a couple of questions. Number one, the strong numbers from ARU in the quarter, it’s been a hallmark for you for several years. Could you just talk in more detail how much of that was driven by any increase in ticket from the 360 launch and how much of it would be from things such that attach rate adjustables and other accessories?

Hi, Keith, about 3% was driven through pricing and that’s been consistent over a number of years now. So, it’s a fairly good number to think about. As we move forward and what we’re seeing with the 360 smart bed, it’s consumer and our selling process is resulting in attaching the adjustable base across all models at a higher rate along with our other innovative bedding products such as temperature balancing products and some of the advancements we’ve made in pillows. And also I think importantly, this is an average revenue per unit. It’s not average price per mattress. So, average revenue per unit with the mattress as the – the mattress unit as the denominator. So, it does include repeat purchases by existing customers coming back and purchasing additional products.

Okay. But the 3% number you quoted, would that be pure price or would that include any mix changes among the mattresses of somewhat up, the mix moving up to a higher price unit?

Yes, we took $100 on our mattresses that were above the – in the I&P [ph] series in October last year. That’s what it is.

Okay.

That’s the gross price increase. And of course, then we have promotional cadence as well that you have to take into account.

Okay. Now second question on units, they’re up 1% I believe you said, which would mean they go negative on a same-store sale basis. So, I was little surprised by that given some of the optimism on units coming out of the fourth quarter with the final push of the 360 in the stores, if you talk more about what’s going on there?

Well, just to start at, we continue to expect growth in both ARU and units for the full-year and we repeat – we consistently repeat that quarter-by-quarter we will have fluctuations. We continue to see great strength in our selling process in the stores and converting at a higher level up the line and with additional products, which has been driving more ARU growth. We believe we took market share in both sales and units again this quarter according to the various reports that we’ve seen from sell-side analysts and other indicators. And we continue to feel strongly about being able to drive growth in both metrics for the full-year.

So, have you – is the 360 launch, has it lost some unit momentum as we moved into the first – initial excitement about it is, this is the normal move down into a normal path?

No, we’re still seeing overall momentum with the 360 smart bed.

Okay. Final kind of easy question on tax. With a 25% tax rate for the year you’re obviously going to have higher the rest of year, you discussed the second quarter. What I put that kind of ratably in second, third, and fourth quarter to get to the 25% or am I going to see peaks and valleys in the second half of the year?

For modeling purposes, putting 25% each of the 3 quarters is fine.

Okay. Well, that would give me below 25% for the year though?

It will, yes.

Would that be above that? Yes. So, I guess my question is that your comment in the press release is you’re saying that is 25% for the year or the 25% for the remaining quarters of the year?

It’s for the remaining quarters of the year.

25%, so that means your tax rate is going to be below 25% for the year, right?

That’s correct.

Okay. Can you give us an estimate of what the tax rate will be for the year?

I think that depends on what you model for earnings and that’s up to you guys. I can – we can handle any modeling questions on that after calls.

What it have to do with what we assume for the year, I mean, barring big losses or something like that the tax rate should remain the same, should it now?

But the proportional tax rate has an impact relative to the first quarter. So, if you just model 25% the balance of the year, you’re good to go.

Okay. Alright, thank you.

You bet.

Thank you.

The next question comes from Bobby Griffin with Raymond James. You may ask your question.

Hi, good afternoon, everybody. Hope you can hear me now?

Yes, we can.

Yes, hey, thanks, Bobby.

Hi. Thanks for letting me get back in the queue and taking my questions. Sorry about the technical difficulties earlier. My first question though I just really want to try to understand the trends better. We exit January when we spoke last with kind of double-digit, above double-digit sales growth, President’s day in February was the strongest period. Does that imply March slowed down pretty drastically or am I missing something there?

Yes, we saw strong performance throughout the fourth quarter with the greatest strength during the President’s event.

Okay. Did that carry over into April? I think there is some fear out there just with everything that happened 1Q tax refunds, weather, what’s going on at the high-end spending, so that strength carry into April, Shelly?

Yes. We normally do not go into intra-quarter trends.

Okay. I thought I’d at least give it a shot.

Yes.

But alright. So –

I think – here’s what I would say, Bobby, we’re reiterating our guidance and we delivered the quarter that we needed to and expected to achieve our full-year guidance and we’re on pace, we’re excited with our initiatives, we’re leaning into them. So those are good indicators of how we feel about the overall marketplace and our opportunities in it.

Okay. Is it fair – is it safe to say that you feel no different about the consumer, the health of your underlying consumer today versus you did versus how you felt kind of during the first quarter as well?

That is safe to say. Yes.

Okay. Okay, that’s helpful. I appreciate that. And then lastly for me Dave, we talked about the pressure of adjustable, the higher mix of adjustables at the end of the fourth quarter call. Is some of your commentary pointing that the attachment rate has been even higher now than your expectations going into the year and that’s why the percentage headwind is getting called out again?

That’s exactly right.

Okay. And when did that really, is it – did take a step-up here in 1Q or did start to step-up in 4Q and 3Q of last year? I’m just trying to get a better sense of how to model in when we will lap the big step-up in attachments?

We’ve seen a higher attach rate ever since we launched 360 and that has continued to grow. Our professionals in our stores and the selling process, selling by number process is exceptional. And we do a very good job in store of getting people into the product that best meets their needs and we’ve seen a lot more of our customers really interested in taking more complete package.

Okay, perfect. I appreciate that detail. And then lastly for me and I apologize if it was asked already, I had to get back on the line. But if the 10% tariffs go away, can you give us some color on maybe what the tailwind would be or if it’s just going to be neutral because you’ve already made changes in your supply chain just to help us model out the back half of the year?

Right. We have some of our components that are in the 25% bucket on List 2 already and then there are others that are on the List 3 that are 10% that could go to 25%. In any event we’ve taken actions already because we felt that it was prudent to lock in our supply and lock in pricing. So, some of that action has already been taken to mitigate some of the exposures. But if all of the tariffs were completely rolled back to zero kind of immediately, we would see about a $2 million tailwind in the back half of the year.

Okay. I appreciate that detail. Best of luck in the second quarter and thanks for taking my questions.

You bet. Thanks, Bobby.

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

Good evening, Shelly and Dave, thanks a lot for taking my questions.

Hi, Michael.

So, given that – hi, Shelly, given that units were up 1%, you grew units 5 – you grew number of stores around 5%, should we think about units that same-store down in the kind of mid-to-high single-digit range?

Yes, that’s right.

Okay. And –

It’s important Michael, we should talk about this a little bit because we are not your traditional retailer and with our strategy and the expansion of our local market development, we have a lot of stores that come into existing markets that cannibalize the existing stores. We also have when we relocate a store, it comes out of our comp base and so that looks different. So, looking at total unit growth is really more important for our business model than focusing in on same-store comp growth.

What do you think the –

Cannibalization?

The – I think market growth – yes, cannibalization was in the period?

I think our estimates of about 20% still hold true.

Okay. And Shelly, you said you expect units to be up for the year, they were up 1%.

Right.

If the unit comparisons get a lot tougher and presumably they get tougher on a same-store basis, you’ve been thinking on it, may be that is not necessarily the way you look at it. So, are you going to have to sharply increase your advertising as a percentage of sales to drive some of that unit growth you’re expecting over the next several quarters and that $2 million benefit from President’s Day [ph], Dave, could you reinvest that back in the business or would you let that fall to bottom line?

Yes, importantly, we have significant initiatives to drive our overall performance. And every quarter we have various fluctuations by design in our promotional plans and how we go to market. I’ll use the example of the first quarter during the President’s event, our primary focus was on a limited edition innovation series that – which drove incremental traffic towards that high-end of our series overall. At other times we may focus more on the $999 price point. We didn’t do that as much in Q1. And this is why we talk about – we’ll have fluctuations by quarter, keep your focus on the full-year metric of driving ARU and unit growth. And that – this is a key advantage of our business model that we can drive both ARU and unit growth, ideally both, which we did in this quarter and expect to for the full-year, but the benefits of being able to achieve top-line growth whether it’s through ARU or units or both is a key advantage of our business model. And in the end, it’s about total revenue and total profit dollars and total shareholder return. And units is a component of that along with ARU and they’re both important and we expect to grow both annually and over time as we have been in the past.

My last question is on attach adjustable bases over the last few years within the industry there’s been a sizable move to adjustable bases. It seems like some of the growth from that is probably going to cap out as the penetration of that attachment will reach levels that you just can’t go any further. So, where are you in the penetration of your sales that include an adjustable base?

I love this question because I think it was 5 years ago someone said that very same thing to us and we’re still growing. We’re still growing our attach and this is why with an innovation strategy, when we’re delivering meaningful benefits to consumers and continuing to evolve this product to be able to drive benefits, it’s exciting to us. And this is where that ARU measurement is so important for our business, it’s not an ASP measurement, it’s ARU. And we still see great opportunity and we’ll continue to lead the marketplace with our attach of adjustable bases.

So, you think you still have significant growth. Can you give us like a measure, is it closer to 50% of transaction, closer to 75%?

Yes, we haven’t shared this metric. I’m confident we’re the leader in the marketplace and this is a combination of the innovation. Our adjustable bases are unique to us, have benefits that are unique by price point. And also, our selling process and how we’ve innovated and developed the smart bed to be complementary and integrated with our adjustable bases. Those are unique attributes and differentiation that we provide at Sleep Number and we expect to continue to lead the industry with this.

Alright, thank you so much.

Yes. Thank you, Michael.

[Operator Instructions] The final question comes from Curtis Nagle with Bank of America Merrill Lynch. You may ask your question.

Good evening. Thank you very much for taking my questions. So, I apologize if I missed this, but would you guys be able to give the specifics on the margin rate guide for the full-year like you did last quarter? I think Dave you said we saw gross margin up – up to 100 basis points, I think the prior top was up to 120 basis points and you mentioned some of the drivers, but if you could just give by line what the guidance is, it would definitely be appreciated?

Sure. And I guess you probably have a copy of the investor deck that had all of the assumptions in it from last quarter. And in that deck, it did say 80 basis points to 120 basis points as the range of potential gross margin expansion this year. We – after the quarter we just had, I did highlight in our comments that we did see a little bit more margin rate pressure here in Q1 than we expected that we offset with about a nickel of benefit on the tax line. So, we have – but we have great initiatives in play to deliver gross margin expansion of up to 100 basis points for the full-year, including the 40 basis points in Q1. We’re managing a significant number of tailwinds and headwinds. They include – there was $16 million worth of transition impacts last year, which is $8 million of hard costs and another $8 million combined of inefficiencies and close-out sales. Those are major tailwinds for us and include – and our initiatives and pricing initiatives as well gives us some tailwinds. Headwinds include the – this item we’ve been talking about quite a bit, which caused some pressure in Q1 which is the attach rate of our FlextFit Adjustable Bases and other source products. It caused us 70 basis points of pressure in Q1 and we expect that there to be some pressure going forward. But I think we will get more benefit from our other operating improving initiatives the balance of the year to drive much stronger gross margin rate improvement on a year-over-year basis the balance of the year.

Okay. Would you be able to give the EBIT rate guidance or you are not providing that anymore?

I’m sorry. Can you – could you say, if actually, I’m sorry.

Yes, yes. Would you be able to give the EBIT rate guidance? So prior range was approximately 6.5% to 7%, is it maybe 20 bps below that now or how should we be thinking of that?

Yes. We don’t – we’ve – not – well I’ve been here, we haven’t given any guidance about EBIT or that – we provide top – we provide EPS guidance and then we provide a lot of color about how we’re thinking about delivering that EPS, but we’re committed to using all of our EPS drivers, growth, business leverage and then capital deployment.

Okay. And then just a quick follow-up, can you confirm that EBITDA will be up on a year-over-year basis in 2Q, I think I heard that?

For the year we are expecting...

For 2Q, not the year.

In Q2, I said that we expect operating profit to be up, but EPS to be down.

Got it. Okay. Thanks very much. I appreciate it.

Okay. No doubt.

At this time, there are no further questions. I would like to turn the call back to your host for closing remarks.

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

Thank you. This concludes today’s conference. Thank you for your participation. You may disconnect at this time.