Welcome to Sleep Number's Third Quarter 2020 Earnings Conference Call. [Operator Instructions] 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 third quarter 2020 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 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, and thank you for joining our 2020 third quarter earnings call. My SleepIQ score was 88 last night. Quality sleep has the power to improve lives. And because of our team's dedication to our mission and our relentless focus on innovation, Sleep Number is at the forefront of delivering this life-changing benefit. We have now improved nearly 13 million lives and counting. This is particularly important in this time of extreme stress and disruption in everyone's life. In the face of significant ambiguity caused by the pandemic, the Sleep Number team is helping our customers achieve an unparalleled sleep experience with our 360 smart beds. I am grateful every day for our team's tenacity, ingenuity, and the care they show to one another and our customers. Together, we have built a beloved brand and a purpose-driven company based on individuality and well-being. Our years of pacing and prioritizing strategic investments have contributed to our ability to deliver superior performance, despite simultaneous health and economic challenges. We are well-positioned for continued profitable growth and significant shareholder value creation. Our third quarter 2020 performance provides undeniable evidence of the strength, resilience, and sustainability of the differentiated consumer innovation strategy and efficient business model we have built since transitioning to all 360 smart beds in 2018. For the third consecutive year, our third quarter results reflect double-digit demand growth, including 16% growth this year. Record third quarter financial results include net sales of $531 million, up 12% versus prior year with an 11% comp gain; net earnings per share were $1.79, up 90%; net operating profit was $70 million or 13% of net sales, an increase of 78%; year-to-date cash flows were $287 million, up 51% versus the prior year to date; and net debt was $180 million lower than a…

Thank you, Shelly. Throughout this pandemic, our teams demonstrated urgency and agility while advancing our initiatives. The superior execution in Q3 delivered record performance, cash generation and tremendous shareholder value creation. These results are an outcome of the structure we have been building for several years. Both our capital structure and capital deployment are oriented for maximum flexibility. Securing liquidity early in the pandemic enabled us to focus quickly on cost controls and performance-driving initiatives. Those decisive actions led to exceptional performance in Q3 across the P&L and record operating cash generation of $287 million year to date, up 51% versus the prior year to date, despite the impacts of COVID. While macro uncertainties remain, including possible COVID resurgence, distracted consumers due to the presidential election and possible recessionary pressures, our performance reflects a dramatic improvement in our risk profile. In accordance with our capital deployment priorities, we retired six months early the $75 million one-year term loan taken out as insurance in the early days of the pandemic. Along with the loan repayment, we also removed the related share repurchase and LIBOR floor restrictions from our $450 million revolving credit facility. We are leaning into our initiatives and now expect our 2020 full-year CapEx to be approximately $45 million. Third quarter net sales of $531 million grew 12% versus the prior year. As expected, units drove all 12 points of growth in the quarter while generating a healthy $4,800 ARU, $14 greater than the prior year. Consumer shopping preferences largely normalized in Q3 with 98% of our stores open on average. Our brand reach expanded demand 16% in Q3, leading to sizable growth, both in stores and online. 14% of our Q3 net sales were transacted online, about twice our historic norm. Comp sales made up 11% of our…

[Operator Instructions] Our first question comes from Peter Keith with Piper Sandler. Your line is open.

I wanted to just get a little more insight on the demand shifts or revenue recognition shifts from Q3 to Q4. I know in the last call, you thought there might be $10 million of shift from the late Labor Day, but you were saying on the call that you didn't experience any meaningful consumer disruptions. So, we still add a $10 million shift or is that number bigger now that we're in Q4 you have better visibility?

Yes. Hi, Peter, thanks for the question. It is bigger. Our explosive growth in the quarter, 16% demand certainly led to a bit of a higher backlog at the end of the quarter, but it's about offsetting the benefit that we had coming into the quarter.

All right. The sort of the $30 million benefit coming in gets fully offset?

Right.

And then I want to ask a broader question on the new product launches. So you noted you're pleased with the new products that have the temperature-balancing technology, and those are at the high end of the price spectrum, although your ARU didn't really show much year-on-year growth. And so I'm wondering if there was maybe an offset from higher Internet sales or if potentially these higher-end product launches maybe weren't fully recognized in the third quarter, and some of that will now show up in the fourth quarter.

Peter, thanks for the question. This is such an important area of our strategy that is unique to our business model and competitive advantages, our ability to drive both units and ARU. And as you know, we look at these metrics. On an annual basis, we always have quarterly shifts. So, in the quarter, it represents both some closeout from our older models as well as the introduction of new. We introduced the m7 and i10, the new Sleep Number smart beds here in the quarter and then just recently in October introduced the i8. So when we look at driving our ARU growth in this case for the quarter, we were up about $14. So we're really happy with delivering a very big average revenue per unit while also driving units that represented 15% of the 16% growth in the quarter. But the ARU is driven by a combination of our innovations, our selling process and the promotions that we put forth, all designed to deliver the utmost in customer benefit. So we have lots of different ways to go at this. And of course, repeat sales contribute to that, too. So we have many levers to work with, and we have high confidence in our ongoing ability to drive both ARU and unit growth as we have these last number of years and certainly expect to continue to into the future.

And Peter, I'd add. One other aspect of this is, generally, there is a pretty strong correlation between our ARU growth and gross margin rate, and that wasn't the case. We were able to drive both, a solid $4,800 ARU while generating 70-basis-point year-over-year improvement in our gross margin rate in the quarter. That 12% unit volume velocity is certainly part of that as well.

Peter, one part of your question I did not answer was on the - was regarding online sales, and you're absolutely right. 14% penetration, which is about two times prior year, results in a lower ARU growth. So there's some impact there. And at the same time, you can see our stores certainly performed very well and grew along with a triple-digit growth in our online and phone sales.

And if - I want to ask one last question. Sticking on new products, very intrigued with the Climate360, products you guys had announced in January this past year. As we're getting closer to 2021, do you have any sense on timing and when that might actually be available in the market?

Yes. Peter, as you know, with the onset of the pandemic, we pushed the launch of our new 360 smart beds. And instead of beginning the introduction in Q2, we just started it here in the third quarter. So, we plan to do that over the next few quarters, and then Climate360 will most likely launch early in 2022.

Our next question comes from Brad Thomas with KeyBanc. Your line is open.

Congratulations on the quarter and the momentum here. I wanted to ask about - thinking about the margins and costs in the fourth quarter. As I do some rough math on the strong revenue that you're set up to generate here on 4Q, it looks like the margin expansion or the contribution margin that you're implying in your guidance may only be about half what you saw in the third quarter. Can you just talk about what's changing from an expense standpoint or margin standpoint that limits you from getting as strong a flow through going forward as what we just saw here?

Yes. Brad, thanks for the question on that. It's really important as you've seen how we operated this year. At the onset of COVID late in Q1, we made big changes to our business model, and we took about $80 million sequentially out of our operating - out of our sales and marketing expenses, in particular, from Q1 to Q2. And then here in Q3, we've - we built some of that and added about $80 million back into the business. And - but yet aren't where we need to be to support the business that we expect to have going forward. So we are continuing to rebuild our structure in Q4, and that's some of the costs that you're seeing in Q4 relative to Q3. However, we're very excited about the opportunity to deliver $4 or more in EPS while absorbing $0.45 loss in Q2 and know that we have momentum beyond that.

That's helpful. And I know that you're not here to give formal 2021 guidance yet, but I was curious if you could give us any initial takes on how to think about modeling next year. Obviously, you wouldn't have an extra week so that we know you would take out. You got easy comparisons in 2Q, but how are you thinking about what growth for the company might look like next year as we lap an unusual 2020?

Right. It is going to be an interesting comparison on a quarter-over-quarter basis all year next year. That's not new for us. We've done that kind of thing in the past, and we will certainly provide you lots of color on the February call. Your callout, Brad, about the $0.25 we expect from the extra week and the 2 points of growth is correct, though it should be considered adjustments to take down our 2020 numbers on which to build from. But you can count on us using all of our EPS drivers, meaning growth on the top line, leveraging the business model and deploying capital efficiently to continue to drive EPS growth and value for shareholders.

Our next question comes from Bobby Griffin with Raymond James. Your line is open.

Thank you for taking my questions. I hope everyone is staying safe and healthy. I guess to follow up on Brad's question, really, Dave, really interesting year with all the moving parts and the pandemic. You had costs coming out, costs coming back into the business. You guys have been working on the supply chain from some interesting things, too, throughout the last couple of years. So if we take maybe a high-level look versus - at the business model versus pre-COVID, has the fixed variable cost nature of the model changed drastically?

There are some elements of our changes that are certainly changing, Bobby. I - but we're also in terms of getting some efficiencies out of several areas. At the same time, we know that our innovation pipeline is tremendous, and we need to lean into that lever to make sure that we are protecting the future. Our bias is to support the long-term profitable growth of the business, and that's what we'll continue to do. One other element that I meant to comment on in the prior question about the gross margin or the overall profitability in Q4 versus Q3, the gross margin rate we expect in Q4 is likely to be directionally about flat to prior year, which is about 50 basis points or so less than it was here in Q3. That's a reflection of some of the inflation factors that we're starting to see in logistics, operations, as well as phone costs and home delivery tech, labor. Just thought I'd share all of that for your modeling purposes.

Okay. That's helpful. And then…

And Bobby, I'll maybe just jump in to - just from an overall perspective of driving performance. As I highlighted, this is the third year, the third consecutive year that we've put up a double-digit demand - growth demand. And we're so bullish on the initiatives that we have in place and our ability to continue to drive growth quarter after quarter and year after year. And yes, we'll continue to invest in our innovation to ensure we have the sustainability for the long term, but I think this is a quarter where it's really evident that a lot went right. We took hard-and-fast actions in Q2, and we cut expenses deeply to ensure our continuity. And through this, we have found new, more efficient ways to reach customers. We've enabled digital solutions across the business in marketing, sales, home delivery and fulfillment. Those efficiencies and that agility will all stay with us as we move forward. And while we'll bring back some expenses to be able to support the business and the long-term nature of it, there are going to be investments in some different and new capabilities while also hanging on to the efficiencies. And I would just say that we're still learning on the efficiencies. I mean, this is - you can see it in the tremendous flow-through here in the third quarter. There's a lot to learn and take forward, so it's a little too soon for us to say exactly how this is going to model out for the next year, but we'll be doing - we'll certainly do that in the coming months. So we're really excited with what we've uncovered, how we're reaching consumers and delivering life-changing value to them. And we see greater opportunity than we had probably otherwise in the past on a number of fronts. And I think the consumer trends around health and wellness is a big part of that as well. It's giving us the foresight to really lean into some future areas faster than we otherwise would have.

And that's kind of exactly where I was trying to dive in there. Because you take 2Q out of it and you look at 1Q and 3Q of this year, the flow-through has really stepped up versus some historical standards. So it makes me wonder if some of these efficiencies gains change the fixed variable structure. I mean, Dave, I guess just to follow up lastly on, I mean, you look at the sales and marketing line this quarter, the 80 points of deleverage from media Shelly called out, but it also implies over 400 points of leverage from the non-media portion, which is really the first time that we've seen that type of performance on that line item in a long time.

Yes. For sure. We were operating significantly differently in this environment. And as Shelly said, we've got some learnings that we're applying, and we expect to hang on to some of those efficiencies as we go forward. But stay tuned. We're going to have a lot to talk about on the Q4 call in February.

All right. That's very good. Well, I appreciate the details and going through kind of the line items. Best of luck in fourth quarter.

Thanks a lot, Bobby.

Our next question comes from Seth Basham with Wedbush Securities. Your line is open.

My question is also around the expense line. It seemed like you had some unprecedented sales and marketing leverage this quarter, primarily, it seems, because you had pulled back on expenses during the pandemic. If you think about the fourth quarter going forward, your expected leverage there is much more limited, especially when you back out the extra week. Are you thinking that Q4 is going to be more normalized from an expense standpoint going forward?

No. I don't. I expect that we're going to have more leverage than we would normally have, even excluding the extra week.

And then secondly and thinking about the backlog here. Based on your forecast for the fourth quarter, would you expect to have caught up on the backlog? Or could it extend into the first quarter of 2021?

We've had quarterly shifts in demand in prior years, and we see this to be much the same. We - by adding the 53rd week this year, that actually gives us another week to get caught up on everything. And - but we're delivering explosive demand growth at the same time, so this is kind of the next new level. And so yes, this is going to be normal as we go forward as we see it.

And my last question is just around media leverage. Good performance this quarter. How much of that would you attribute to lower advertising rates?

So just to be clear, we spent more in our media year over year in the quarter, just like we spent more in our R&D year over year. We continue to support our near- and long-term growth drivers. We did, indeed, get some favorable cost benefits in the marketplace, but our teams are leaning into the digital side of our media as well and are winning in the marketplace.

Could you just provide some color on what you're seeing from advertising digital rates through the year?

Well, I first just need to highlight the majority of the leverage in media. And again, this was another step-up in our media ROI. So it was our most efficient quarter, and that has been continuous since 2014. But we also had tremendous efficiency with how we're managing our overall digital platforms and utilizing our algorithm and proprietary data. And that was the source of the greatest efficiency for us because of our ability to reach potential high-converting consumers and also drive increased digital traffic. So I'm not going to split out what part came from rate, and it will certainly vary by business, but we continue to secure our media as we move forward here in the fourth quarter and feel confident about our placements and our ability to drive growth and advance our initiatives even further. And we also - and maybe it's helpful to hear that we would expect leverage whether we have favorable rates or not in the fourth quarter.

Our next question comes from Atul Maheswari with UBS. Your line is open.

So your third quarter demand comp was quite a bit below one of your larger competitors. Why do you think that was the case? And then versus the broader market, do you think you gained share? And if so, who do you think you gained share from?

Well, I'm so glad you asked this question because we operate our business for the long term, and this is the third consecutive year for us of delivering double-digit growth. That's very different than any of our competitors. We've taken share for over four years and absolutely continue to believe we're taking share, and we'll take share this year.

Our next question comes from Curtis Nagle with Bank of America. Your line is open.

Thanks very much for taking my question. I just wanted to follow up quickly on Seth's questions in terms of some of the component sourcing and where you're seeing, I guess, perhaps, some of the biggest points of pressure. And are the shortages or kind of issues you're seeing better or worse than they were at the beginning of 3Q relative to now?

Well, I'll start, and David can add some additional color. Certainly better than they were in Q2. There were - in Q2, we were dealing with a lot more issues where different supplier factories were shut down or they were at partial productivity. And for the most part, that has been resolved. And this has really been a matter of responding to a hyper-shaped V recovery when we were at fairly low inventory levels for obvious reasons as - shortly after the pandemic hit. And what I'm really excited about is how, I would say, masterful our teams have coordinated across all aspects of our integrated vertical model and how closely they worked with their suppliers and business partners and how creative everyone has been together to solve and find ways to get the right inventory in the right places at the right time. I'm not sure how you would do that without this advantaged integrated business model, and so I really put some highlight on that because it is pretty extraordinary to deliver this level of revenue while not having disruption in our delivery times for our customers in any meaningful way. And as far as the specifics of where there's some shortage, it moves around because it's very highly responsive to our demand. And keep in mind, we also layered in the complexity of introducing a new product line during the third quarter. And so our teams have collectively managed all of that and delivered on the performance that we drove on the top end. So I'm really - a big shout-out to our team all across the board, just really impressed. None of this would happen without everyone's dedication and passion.

I want to also take a second to revisit the last prior question about our demand versus competitors, and there's some misunderstanding. We are fully direct to consumer, and our - the three years that Shelly highlighted of double-digit demand growth is all based on real demand to end consumers. And some of our competitors have - are delivering some of their demand growth through sales to independent retailers. And that - they have different models. I don't know that there's another competitor out there today that is a pure DTC player anymore. So just keep that in mind as you do your comparisons.

One other just quick follow-up, if I may, in terms of the sourcing. I guess any issues with some of the single-sourcing components, like the air - sorry, air pumps? Or is that in good shape?

We're in good shape. Everything is tight, but we're in good shape.

Our next question comes from Brad Thomas with KeyBanc. Your line is open.

Thanks so much for letting me get in for a follow-up. I was hoping to just talk a little bit about the demand trends. I think you told us last quarter, you were running up high single digits toward the end of last quarter of May and June. You reported 16% demand growth for 3Q. I was hoping you could give us a little more color month by month how things had played out and if there were any nuances around Labor Day, for example.

We've had robust demand growth throughout the quarter, both before, during Labor Day event and after and continue with strong momentum as we head into the fourth quarter.

And so if I try to triangulate your guidance for GAAP revenues versus thinking about the demand trends, it seems to me that your guidance implies about 20% to 24% revenue growth for 4Q. You've got an extra week that has about 8%. If you had a $30 million backlog that you worked through, that could be 7%. So that might imply demand revenue traction in maybe the 13% to 17% range through 4Q? Am I breaking it apart the right way, if I think about it that way?

Sure, Brad. I think that that's fair. And what you should just keep in mind that we're delivering 7% to 8% top-line growth for the full year despite having 20% decline in sales in Q2. And the performance and the rebound overall has been nothing short of stellar, and we're excited about the opportunities for $4 or more in EPS in Q4, and the momentum won't stop there. This is - we've got - our initiatives are working on all cylinders, as Shelly highlighted, and we're excited about where we're going.

If I could squeeze in one last one, just on stores. I think you're down a few stores for the second quarter in a row. How are you thinking about openings and repositions in 4Q and maybe an initial thought on 2021 and longer term as it relates to the store base?

Right. Yes. We're expecting - as we highlighted, we paused some of our initiatives because of COVID, and stores were - store openings was part of that. And our CapEx change at $45 million reflects that as well. We expect now to end this year with about 600 stores. And then long term, we still continue to see great opportunities for local market development and store expansion. The overall portfolio is expected to grow 4% to 5%, on average, per year between now and 2025.

And that's while driving online and phone sales increases as well, Brad.

There are no further questions at this time. I will turn the call back over to Sleep Number for closing remarks.

Thank you for joining us today. We look forward to discussing our fourth quarter 2020 performance with you in February. Sleep well and dream big.

This concludes today’s conference call. You may now disconnect.