Welcome to Sleep Number's Q2 2022 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, Investor Relations. Thank you. You may begin.

Good afternoon, and welcome to the Sleep Number Corporation second quarter 2022 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 earnings call today. My SleepIQ score was 80 last night. As we operate in a global business climate that is unpredictable and economically challenged, our mission and purpose provide the clear path to deliver long-term superior value creation for all stakeholders. Overall, consumer sentiment in Sleep Number demand continue to be highly correlated. Economic conditions for consumers have deteriorated throughout the year. The annual inflation rate accelerated to more than 9% in June, the highest level since 1981. And nearly half of US consumers now say that inflation is eroding their standard of living. Consumer sentiment plummeted to record low levels in May and June, with declines across all demographic segments. Correspondingly our demand for the second quarter declined 12% versus the prior year. Our performance during the second quarter reflects our team's incredible agility in navigating the challenges of operating in this business climate. As we discussed on our Q1 earnings call, the composition of our excess backlog was heavily skewed to the high end of our line. As a result, during the second quarter, our delivered smart bed units represented a stronger-than-average profit profile. Net sales in the quarter grew 13% to $549 million as we benefited from servicing a portion of our profitable excess backlog, while being, again, constrained by new delays in electronic components and weaker demand. Q2 net operating profit was $50 million, up 68% from 2021. Net operating profit rate was 9.1%, up 300 basis points from a year ago, during what is historically our softest financial quarter. Second quarter earnings per diluted share were a $1.54, a 75% increase compared with $0.88 a year ago, and trailing 12 month ROIC was 21.8%. External business conditions worsened in the second quarter and the global environment remains…

Thank you, Shelly. As Shelly highlighted, we are navigating challenges on three fronts: record low consumer sentiment; disruptive timing of electronics supply; and cost pressures from inflation and supply constrained inefficiencies. We are taking prompt mitigating actions on all three fronts. As a result, we have revised our 2022 earnings guidance to $3 to $4 per share. Consumer sentiment dropped materially since our last call. The timing of electronic supply receipts continues to prevent level loading operations and optimal smart bed delivery volumes. And fulfillment costs, arising from the inefficient flow of electronics continue to pressure profits. Our teams are taking actions to mitigate these challenges. In addition to the demand driving initiatives Shelly highlighted, other actions include: cutting more than $100 million of planned costs with line of sight for more reductions if warranted; suspended share repurchases after acquiring just $12.6 million in Q2 with no repurchases planned for Q3; narrowed our 2022 capital spending projects by $10 million to approximately $70 million; negotiated and extended a more favorable contract with our partner Synchrony to serve our customers and contain financing costs through 2028. Taking another targeted price increase in early August, worth about $30 million annually resulting in total annualized pricing actions of approximately $180 million. Rapidly tested, qualified and implemented another electronic component to replace an at risk part and are diligently working to pull forward sleep innovations which will bolster demand and reduced supply risks with their 30% fewer components and more available technology. Before reviewing details of our Q2 financials, please recall that imbalanced electronics flow significantly constrained deliveries in Q4 last year and, again, in the first quarter this year. As a result, the excess backlog at the beginning of 2022 grew from about $150 million to approximately $200 million at the end of…

[Operator Instructions] Our first question comes from Bobby Griffin with Raymond James. Your line is open.

Good afternoon, everybody. I appreciate you taking my questions. Dave, I just -- I guess I wanted to circle back and just kind of walk through a little bit of the details you given us for the sake of the year. And I appreciate all that. If we -- so with breakeven 3Q, we've got any more than just profitable to kind of get to the year EPS guidance, if we're looking at, we've earned basically about $1.63 or so far this year and if it's $0 for 3Q, what is -- like what's the flow out or what's the pathway to help that happen? Like, I'm struggling a little bit just to kind of understand the progression here?

Right. Thanks, Bobby. Yeah, it's a little unusual, just like it was in the first half of this year where Q1 deliveries of our most profitable smart beds were constrained in Q1 and we didn't make a lot of money in Q1, which is normally seasonally one of our strongest and most profitable quarters. And then followed by Q2, where we delivered those very profitable smart beds and delivered a 9.1% operating profit rate and a 75% increase in our EPS over the prior year. So, we're facing the same kind of constraints in Q3 from the electronics supply that are going to limit our deliveries in Q3. At the same time, we need to spend to generate demand against a little bit of a resistant consumer in our largest consumer selling period of the year. So, those things combined pressure our earnings in Q3 to make us think that it's going to be about breakeven. Then we deliver a lot more in Q4. I said about 15% to 20% more units and we don't have to spend against all of our demand that we just created. It's already been created in Q3, we had spent against it. And so, when you drop through more backlog benefit in Q4, it comes through at a much more profitable rate.

Okay. So, is the right way to look at the 90,000 to 100,000 units that you're targeting here for 3Q, should we look at that as a similar ARU as 1Q at 49,000 and then have 4Q step up materially in ARU?

No. That's a little harsh, because Q1 ARU didn't have a normal mix of our overall smart beds. And Q2 also didn’t have the normal mix, because we are catching up on the carry-forward of all those smart beds. I'd say, in the back half in general, Bobby, I would assume ARU growth over the prior year, but a couple of hundred dollars less than what we did in the first half of this year.

Okay. That's helpful. I'll jump -- for now, I'll jump back in the queue. But I appreciate the further details.

Thank you very much.

Your next question comes from Peter Keith with Piper Sandler. Your line is open.

Hi, thanks. Good afternoon, everyone. I guess the pricing changes you're planning on making was a little bit surprising to me. Are you seeing higher input costs coming through? Or is this just something you think you can take a little extra price to drive some excess profit?

Hi, Peter. Thanks for the question. Yes, we believe in this environment -- in this inflationary environment that it's prudent for us to take the additional pricing. It is around $100 per smart bed with the exception of the C2 and it's appropriate when we look at all the puts and takes. I would say more than the cost input the higher -- the lower efficiency and effectiveness with the uneven flow of supply this year.

Peter, I’d add. A little bit of our pricing has been -- our pricing actions to date have been on the conservative side. We've been doing our best to make sure we're simply passing along the cost increases that we've been absorbing and with an eye on not dampening demand. The additional price increase I said is, is an incremental $30 million. So it's about another point. We're still significantly below where others in the industry have gone with their pricing.

Yeah. Okay. That makes sense. So you've got the Climate360 launching in October, of course, that's been kind of on hold for or quite a while, I guess, over a year. And you have really ramped up your R&D budget in the last 18 months or so. So maybe just looking forward without revealing any of the products, I mean, should we see in 2023 and 2024 some excess or elevated innovation launches coming to market?

Absolutely, Peter. It starts with Climate360 here in the fourth quarter and we've been progressing towards this date for the last year and we're really excited to add this halo to our smart bed assortment. And with the Climate360 at the high end of our line, we also moved to our new platform. And this platform has a reduction, about a 30% reduction in components overall and benefits from more consistent components and also has a lower number of electronic parts and what we expect will be a more available chip. This platform is the beginning of our launches this next year, in 2023 we will transition our full line of smart beds to this new platform. And we're really excited about making that change for both the demand and supply reasons. And with the new 360 that we introduce next year, it's an important milestone to support the diagnostic and connected health benefits that we'll be able to add in the future. And then keep in mind, we're building off millions of connected smart sleepers today, so continuing to broaden the capabilities to be able to reach our existing smart sleepers, as well as new smart sleepers.

Okay. That's great detail. Thank you very much.

Thank you.

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

Thanks a lot, and good afternoon. If you guys could please give us a bit more color on the shape of demand through the quarter? And when you think about the comparisons, demand wise for the back half of the year, how do you expect year-over-year demand to trends?

Sure. Seth, first of all, we saw a correlation in demand with the change in consumer sentiment, which dropped to record lows in May. So May demand was the most impacted in the quarter with some recovery in June and so far in July as we made adjustments to respond to this different consumer environment.

And as you think about the back half of the year?

So as I said, the -- our guidance assumes a decline of high single digits to low double digits. As we believe, given the current environment, where the consumer is, it's prudent for us to not assume that demand is going to -- or that consumer sentiment is going to increase the balance of the year. So that's how we pegged our expectations for demand.

Okay, thank you. And then my follow-up is on the financing option with Synchrony. Can you give some more color there, how you revamped that agreement and what you're seeing for a finance rate penetration and the impact on your SG&A rate as a result of it?

Yeah. As you know the Fed has, again, today increased the rate and -- federal funds rate and financing is an important element of our offering for our consumer -- for our customers and Synchrony has been a fantastic partner for a number of years, number of decades. And again, we worked together with them over the last number of weeks to extend the contract to 2028. And along with that I wanted to make sure that we had -- we were sharing the load of how we are going to support our consumer as we go through a challenging environment now and then benefit both sides of the equation for a very long time. So we're excited about that continuing partnership and we certainly appreciate the strong partnership that Synchrony has brought to us over the years.

And the penetration?

Yeah. Our -- I think Seth, we've shared with you that we use financing and promotion kind of in one total bucket and we change promotions and offers on a regular basis to overall balance those costs. We have not seen any decline in our overall penetration rate of our financing. And in total, I think it was about 50% of our sales last year. And that's about normal.

Got it. And just lastly, following up on that point, when you look at that basket of financing in dollar off promotions, how did they trend in the second quarter year-over-year? And how are you thinking about them for the back half of the year?

Seth, I'll speak to the overall in the quarter. We learned a lot, we iterated and this is really one of the benefits of the vertically integrated business model as consumer sentiment dramatically changed. We started at a rating, is financing attractive, is dollars off, is it a combination of bundles offers at the low end, high-end and we have quite a few conclusions from everything we've been rapidly testing over the last six weeks, and look forward to applying those learnings here in the third quarter. I won't be real specific with our findings, but they were pretty clear. And I would also say they change with the consumer sentiment environment. So this isn't something you learn and then you stay steady on. We need to continue to learn in advance that and it's clearly a benefit of ours to be able to pivot quickly. But I would say, we saw periods since the onset of the war where financing was an important and we also saw periods where it was important, all within just the last couple of months. That's a lot of rapid change and way more than we normally would have in the business. Clearly a value, whether it's at the low or high end breaks through to the consumer. As I talked about in my remarks, there are a lot of intenders in the marketplace. It's not that it's --are they really ready to buy now, that's what has narrowed so much. So when you have an extraordinary value, it works.

Okay. Thank you so much.

Your next question comes from Bradley Thomas with KeyBanc Capital Markets. Your line is open.

Hi, good afternoon. I have couple of follow up questions here I could. Just as I'm modeling the shape of the back half. If I go through the implications from, I think, your unit commentary, it looks like your 3Q sales may be down somewhere in the 15% to 20% range? Does that math seem right to you all?

I’m just checking myself on -- yeah, I think that's directionally fine.

Okay. Thanks. And David, as you think about the backlog and working it down, it sounds like the -- within the guidance is an expectation of the supply getting a bit better of some of these products that have been in short supply and so perhaps you're at a more normal backlog for the company at year-end. Do you have a rough estimate for us for how to think about what the impact for sales for this year and profits is for this year from servicing the backlog, just as we try to model out to next year and come off that?

Yeah. It's a great question and one that we are wrestling with ourselves. You know, Brad, that in any given year there are headwinds and there are tailwinds and we navigate through the course of the year. We have a lot of year left to do that with. In total, I've already highlighted that we started the year with about $150 million worth of net sales equivalent excess backlog. That would be a place I would start in terms of thinking about that particular line. However, that is dependent on the timing and the amount of both demand and supply. And so, we may or may not benefit that much. Let's say, we have excess demand during the back half more than we think. It's possible that we don't get the full benefit of all of that carry forward excess backlog and we carry more into next year. So from a modeling perspective, I'd say, maybe you start with that number, but then you also have to strip out a lot of the one-off costs that we've been burdened with this year in terms of this inefficient electronics supply flow that has put a significant burden on us, while our Q2 gross margin rate was up 190 basis points sequentially from Q1, our year-to-date gross margin rate at 58.3% is still down 330 basis points versus the prior year. That $160 million worth of annualized cost increases that we're absorbing, some of that's going to come out next year as supply chains stabilize. We think that's going to happen starting in 2023. But there are number of factors we're going to have to work our way through. And we will keep you updated on our progress as we get through this year and we'll certainly give you a lot of color on the Q4 earnings call about how we're thinking about 2023.

Great. Thanks for all the details.

[Operator Instructions] Our next question comes from a tool Maheswari with UBS. Your line is open.

Thanks for taking my question. Hello, can you hear me?

Yes.

Okay. Thanks a lot for taking my questions. So it sounds like for the fourth quarter, you're banking on -- assuming demand plays out the way we expect it to be, you're banking on fulfilling the backlog or at least a portion of the backlog. What is the risk that there could be elevated order cancellations, especially given this challenged macro backdrop?

Well, we monitor that really carefully, especially given the challenges with the electronics flow. And we haven't seen a, what I would call, a material change to how consumers are acting. We did see in conjunction with the consumer sentiment drop in Q2, during the middle of Q2 a correlation with a bit of an increase in cancellations during that time period, but it's also not material to the overall business. And so, we are watch it carefully, we're seeing fairly steady performance in both our returns rate and our cancel rates, but we'll continue to monitor that and keep you updated.

And our delivery window, Atul, is four weeks to six weeks for a smart bed.

Okay. Got it. As my follow-up, and granted the environment is very uncertain, but there have been a couple of quarters of lowered guidance. The question is, how conservative is this guidance? And how much confidence do you have that you will not miss this new range.

And how much confidence in what?

In the new range.

In the new range. Okay. Sorry, I didn't hear the very end of it. As you know, as we look at the back half, we've taken on board the significant change in consumer sentiment, and that's reflected in our back half. Assuming that that sentiment stays approximately where it is. And we've also assumed that we will benefit from the allocation and flow the electronic parts that we have in our sight line today, which will support -- to support the planned deliveries. So those are two probably important significant assumptions as we think about it. So a change in consumer sentiment, we would put -- if consumer sentiment improves, we would expect to benefit from that change in the environment, but we're -- we think it's prudent to not assume that as we head into the back half.

Got it. That's super helpful. If I can, please ask one more. I think you mentioned a couple of times about supply normalizing next year. Is that more of a hope that it improves or do you have visibility to supply normalizing next year? And then importantly supply chain were to fully normalize, how much of a lost margin that you're seeing this year? How much of that would you get back, if you can provide some quantification?

Sure. Thanks for the question, Atul. As we look at the flow of supply, our challenge has been in electronic parts, specifically mostly the semiconductor chips. And as I stated when we move to the new platform, Climate360 and then transition our full line of next year to the new platform, we have line site and we expect increased availability of the new semiconductor chip. And it's a newer and more available chip and we also are utilizing less electronic parts and more common parts as we move forward. So that's part of the design overall and what we've been working towards. And we're doing everything we can to move up that implementation to our new platform.

I'd add. We had originally expected to have some gross margin rate improvement yet this year, but we've continued to see electronics disruption. Now those disruptions have been fewer and more scattered, but they are still impactful. We -- our line of sight – our partnership with the electronic suppliers who are three layers deep in our supply chain has been stronger than it was a year ago. And I think that's going to continue to improve, as Shelly highlighted, especially as we move to the newer technology. And so I would say, I don't know, originally I think we were talking about by Q4 this year we'd be approaching maybe 59 to 60 basis -- percentage points of gross margin rate. I think that is directionally feasible in the first half of ’23. But look, I'm providing you my thoughts without being closer to the year than what we would normally be. So we're certainly expecting to have gross margin rate improvements next year, we're finding ways to be more efficient, we will certainly benefit from the new innovations, all those things will be part of how we drive both gross margin rate and profit growth next year.

Got it. That's all super helpful. Thank you for that. And good luck with the rest of the year.

Thank you.

We have reached the end of the question-and answer-session. I will turn the call back over to the company for closing remarks.

Thank you for joining us today. We look forward to discussing our third quarter 2022 performance with you in October. Sleep well and dream big.

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