Welcome to the Sleep Number Q4 and Full Year 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's Fourth 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 CFO.

This telephone conference is being recorded and will be available on our website at sleepnumber.com. Please refer to the details in our news release to access the replay.

Please also refer to our news release for a reconciliation of certain non-GAAP financial measures and supplemental financial information included in the news release or that may be discussed on this call. The primary purpose of this call is to discuss the results of the fiscal period just ended.

However, our commentary and responses to your questions may include certain forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties outlined in our earnings news release and discussed in some detail in our Annual Report on Form 10-K and other periodic filings with the SEC.

The Company's actual future results may vary materially. I will now turn the call over to Shelly for her comments..

investing in high confidence, high return growth and profit drivers; maintaining appropriate liquidity; and investing in Sleep Number stock where we continue to see meaningful value. Our consumer innovation strategy has resulted in a strong foundation for growth and profitability.

We are excited to begin the next chapter of our journey as a purpose-driven company in the health and wellness space with a more broadly relevant brand, expanded competitive advantages and an integrated vertical business model with digital at our core.

Thank you to our talented and highly engaged Sleep Number team and partners for your dedication to improving lives by individualizing sleep experiences, which is having a meaningful impact on society. Your passion, integrity, innovation, courage and teamwork are resulting in record financial performance and superior shareholder value creation.

Now, David will share more details on our financials and outlook..

we've got millions more lives to improve. Running clean in 2019 did not change our long-term mindset. Leaning into our near and long-term growth drivers enabled our 2019 performance including 11% net sales growth, 130 basis point improvement in gross margin, 21% operating profit growth, and a 41% increase in earnings per diluted share.

Top and bottom-line growth at the higher end of our expectations allowed us to accelerate spending on innovations and marketing. As our results demonstrate, executing this way is good for shareholder value creation. When compared to adjusted 2018 results, our current year Q4 net sales grew 14% and EPS grew 41%.

Our reported fourth quarter net sales grew 7% and EPS grew 1%. Please refer to the 2018 fourth quarter press release non-GAAP reconciliation tables for details of the $24 million of deliveries that shifted from Q3 into Q4 last year. Our full year 2019 comps contributed 6 points of growth while new stores added 5 points.

We ended the year with 611 stores across all 50 states. During the year, we opened 59 new stores and grew average sales per comp store, plus online 6% to $2.9 million. Our revolutionary innovations and proprietary retail selling process drove a 9% lift in our ARU, while units were up 2% for the year.

Operational improvement initiatives drove a 130 basis point lift in our full year gross margin rate to 61.9%. This was at the high end of our internal expectations, while absorbing higher than expected tariffs and final mile delivery costs during the year.

Favorable product mix, elimination of prior year transition costs and improved operations and customer experience contributed to the strong gross margin rate in 2019. Outsized top-line growth and gross margin expansion enabled additional funding of our growth initiatives throughout 2019.

For example, we ratcheted our R&D spending 21% for the year, including accelerated growth of 25% in Q4. This funding to support longer term growth is leading to life-changing innovations like the new 360 smart beds we will begin introducing next quarter.

While delivering a 21% increase in our net operating profit to $112 million in 2019, we also absorbed more than 100 basis points of pressure across the P&L from higher incentive compensation, medical claims, and legal expenses. This NOP growth was nearly double our 11% top-line growth and reflects a 60 basis point improvement year-over-year.

We generated 44% more cash from operations in 2019 to a record $189 million and funded 30% more high-value capital projects this year to a total of $59 million. We also realized double-digit internal rate of return on the $146 million we invested to buy Sleep Number stock.

Our ending leverage ratio of 2.7 times EBITDAR is within our target operating range of 2.5 times to 3 times as planned. Performance momentum has continued into 2020.

Our EPS guidance of $3.10 represents a 15% increase over record 2019 earnings, while absorbing 5 points of EPS growth headwinds from higher expected income tax rate and $4 million of estimated transition costs. We continue to run the business for full year and long-term performance.

Here is some color on performance drivers and the expected shape of 2020. We expect consumer sentiment this year to be similar with 2019. However, we believe it's prudent to plan for some consumer distractions from the Olympics and Presidential election in the back half of the year. The Coronavirus has blanketed headlines recently.

While we don't have immediate supply exposures, we continue to work closely with our handful of China-based suppliers to build contingency plans. We expect this dynamic situation to become clear over the coming months. For the 2020 fiscal year, we expect high-single-digit top-line growth including 2 points from the extra week.

We expect our initiatives in 2020 to again drive growth from ARU and units as well as through comp and new stores. The strongest year-over-year sales and earnings growth are expected in the first and fourth quarters.

The first quarter is up against the easiest two-year compares and the fourth quarter will benefit from a Labor Day calendar shift of approximately $10 million plus the extra fiscal week of sales of approximately $30 million.

We expect continued advancement of our integrated initiatives to deliver 25 to 50 basis points of incremental gross margin in 2020 on top of the 130 basis point gain in 2019. We intend, again, to accelerate our R&D spending as we progress through the year causing 30 to 40 basis points of deleverage for the year.

With our clear data-driven insights, it's the right time to invest a good portion of the estimated $0.15 extra week benefit to support our future innovations. Funding our initiatives and growth drivers is expected to result in modest operating profit leverage for the year.

We expect about 5 points of EPS growth headwinds from a 22% estimated full year income tax rate. This estimate includes about $3 million of full year excess tax benefits from equity accounting, primarily in the first quarter.

We expect to generate approximately $190 million in cash from operations and to deploy approximately $60 million on capital projects, primarily to expand our store portfolio, 4% to 5% in 2020. The balance of our free cash flow is expected to be invested in Sleep Number stock, as we continue to see meaningful value there.

We expect to deliver high-teen ROIC, while operating within our targeted leverage range of 2.5 times to 3 times EBITDAR. The enthusiastic consumer response to our life-changing innovations shows consumers understand there is no compromise needed when choosing the 360 smart beds. Each sleeper gets what they want.

They each feel the benefit of the bed actually using data to effortly adjust on their behalf to deliver deeper, higher quality sleep. Who wouldn't want 100 more hours of proven quality sleep each year? We look forward to raising the bar on behalf of our customers again in 2020 and to delivering strong value creation for Sleep Number investors.

Sheila, at this point, please open the line for clarifying questions..

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

Good afternoon everybody. Congrats on a good quarter and a good year. And I appreciate you taking my questions..

Hey, Bobby..

Great. Thanks, Bobby..

So, I first wanted to just take maybe a high-level question, and when you guys look at the business today, do you think the actual natural contribution margin of the business has changed, because the dynamics of the industry, whether higher investments are required, more R&D spending? Or is the mid-teens type contribution that we've talked about in the past, something that the underlying business is achieving it is just getting offset by maybe one-time transition costs?.

Hey, Bobby, it's really about where we are in our journey and the opportunities that we see. We've highlighted that investing in our growth drivers and having a long-term bias is the way we operate this business.

And with the clarity that we have from having 10 billion biometric measures every night from our sleepers is informing our future innovations and give us great visibility as to what we should be spending behind. So, the flow-through rate that we're talking about I think in 2019 was 12% operating profit flow-through.

We see that it will be slightly less in 2020 as we lean into these growth drivers for the long-term benefit..

Okay. I appreciate. That's helpful. And then, from the cadence of the new product introductions, is there anything that we should keep in mind in our models as you guys roll these out? And help us think about the size of them.

Are the new products gone on the floor, is it updates just to the app, in SleepIQ system, what exactly should we be thinking as we roll through the year from a cadence standpoint for those?.

Yes, Bobby, we are really excited about the advancement of our 360 smart beds. As you recall, it was 6.5 quarters ago that we transitioned to all 360 smart beds and this will be our first advancement since we've made that big transformative move for the company. These are absolutely new 360 smart beds.

These are the beds that we revealed and won so many awards with at CES and they have numerous advanced features from both a comfort and a cooling. And then, also the SleepIQ technology has advanced too and every time we make advancements in the technology, that will go to all the customers who have SleepIQ technology back to 2014..

And then, just to tack on, Bobby, I think you asked about the timing, we're planning the roll out to start next quarter in Q2 and be completed here in 2020..

Thank you. I appreciate the detail. I'll jump back in the queue. Good luck in the first quarter..

Great..

Thank you..

Thank you. Next we will hear from John Baugh with Stifel. Your line is open..

Thank you. Good evening and likewise, congrats on a great Q4 and start to 2020. Jump right in, the transition cost, I think you called out $4 million.

Is that new product launch? Or what specifically are you referencing there?.

That's exactly right. That's related to the roll out of our new products..

Primarily in Q2 and Q3..

Okay. And then, Shelly, you've had a lot of experience with this. How do you think about the election specifically, and there was commentary around Labor Day shifting and I believe that's when we'll see some election impacts.

So could you walk us through a little bit how sort of Q3 looks and what you're maybe anticipating is a possible headwind from the election spend on advertising?.

Yes. Well, I'll just start with where we are and move through the year. We love our brand momentum right now and how well received our smart beds are from both the potential new customers, as well as our existing customers and how life-changing this sleep is.

So we are really excited on the demand side and to be in our seventh quarter of double-digit growth and as we look at the full-year, we expect our guidance of $3.10 contemplates a high single-digit growth as David said, primarily our strongest quarters we expect to be Q1 with the easiest two-year compare and then Q4 with the extra week.

And yes, Labor Day is like five days later in September. So it rolls very late. So that will have a little bit of impact on when deliveries are made between the two quarters. So you'll see a little movement there between quarters. We stay focused on the full year, operate the business for the full year and the long-term.

Regarding the election, this is always a consumer distraction. I think that's the biggest thing, John. From a media perspective, we're pretty – we have a lot of agility and there are lots of moves to make. Yes, you could get into some specific local pressure in certain areas. But you can navigate around things.

It's really how distracted the consumer becomes, how resistant they are to behaving normally. Is that going to impact the Labor Day results? I don't know. But it's more probably a little later in the third quarter and early fourth quarter where we're going to see that distraction from the consumer..

And so, not to put words in your mouth, but you've embedded in your guidance some, some level of impact potentially..

Absolutely..

And then, my last question was just around your comments and maybe it was David about the year starting out, I think about it in 10% pace and we are on the back-end of President's Day, which I believe is a huge event in Q1.

So, my presumption would be, that event went well and you're kind of tracking for a quarter towards that 10% plus or did I misread something?.

No, you did not. We consider this our seventh quarter of double-digit growth. And you're right, we're deep in the quarter through the President's Day..

Thank you and good luck..

Thank you..

Thanks, John..

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

Hi. Thanks everyone. Congrats from me and good afternoon. .

Hi, Peter. .

Maybe just a follow-on John's question. So, the sales growth outlook, it did increased modestly to high single-digit and last time you spoke in Q3, it was mid-to-high single-digit was the outlook for 2020. So it's a small change, but an interesting one.

So is there anything behind that beyond the strong start to the year that's maybe reshaped how you think about 2020?.

Yes, I would say, Peter, as we have continued to progress our initiatives each quarter, these are initiatives that are integrated and we constantly are advancing them. And in December, we had acceleration in the fourth quarter and in December, we began to realize, at least half of our growth from units. And that has carried through here in 2020.

But I would say, most importantly, we had a terrific Q4 and year and what really matters is our long-term track record and the sustainability of our performance. And we have high confidence in being able to continue to advance our initiatives as we have been..

Okay. And you had mentioned around some of the strengthening unit growth trends. And so, just to go back to the prepared remarks, you had commented that unit growth in 2020 would be stronger than ARU growth, which would be a change from the last couple of years.

Could you just kind of help shape that for us, is there something behind this unit growth pick up or conversely, maybe is there – is the mix shift slowing with ARU to cause that shift with stronger units?.

Well, I think illustrating from the double-digit growth here again in the fourth quarter and in the first quarter, it's safe to say that both metrics are strong for us and the unit growth is absolutely a result of what we've been talking about since July with all of our fundamentals so strong and the great response from consumers on our innovation that we would begin accelerating our brand communication and media spend to be able to get after more customer acquisition in addition to the strong customer retention that we have.

And our business model and strategy is designed to benefit from both ARU unit growth over time. We continue to put up growth in these metrics on an annual basis and we've obviously had stronger growth from ARU with our innovations and selling process.

But as we said in Q2 and Q3, we are putting this additional spend against our media and we expected that to materialize to unit growth and now it is..

Okay. That's very interesting, helpful. I'll leave it there. Thank you very much..

Thanks..

Operator, do you have another question for us?.

Yes, I do. I apologize for the delay. Our next question comes from Seth Basham with Wedbush. You may proceed..

Thanks a lot and good afternoon..

Hey, Seth..

Hi Seth..

I missed part of the call, but if you could help us understand what's implied in your high-single-digit sales growth for 2020 from a comp standpoint. That would be helpful..

Yes. You should expect about an even split between comp and new store contribution in the year..

Got it. Okay. So and embedded in that high-single-digit, you are expecting units to increase more than ARU.

So, therefore, thinking the entire comp is going to be driven by units?.

We expect somewhat higher unit growth than ARU, but we do expect contribution from both in 2020..

Okay. I think I am following you.

And then, lastly, if you think about the ARU opportunities going forward, can you dimensionalize whether or not we are going to see any benefits from pricing or mix or attachments relative to 2019?.

Yes, Seth, this is a really great question. When you look at ARU overall, first of all, our strategy and business model certainly warrants – we have pricing power with our exclusive distribution and proprietary innovation. And at the same time, you can see that we are clearly able to drive unit growth without pricing, as well.

And I think the fourth quarter is a great example of that where we had fully lapped any pricing from 2018 and in the fourth quarter, we drove another 7% ARU growth.

And this is an outcome of how we integrate our initiatives, specifically, our innovations, our selling process, and other factors in our store process that leads to ARU growth, specifically both attach and mix. And yes, we do expect continued attach and mix. We see opportunity. We are excited about our new line and how that will contribute..

Got it.

And the new line will come at higher prices than the existing line?.

We haven't specifically shared the pricing of the new line yet. But it's absolutely our favor to focus on attaching and mix. So that we're able to sell more to each customer and also repeat and drive our overall performance at a higher level..

Got it. And lastly relating to this topic, a question that we frequently get from investors is, what is your attachment rate of adjustable basis right now on your mattress sales, because there is a concern that it can't go much higher from these levels after some really, really strong improvements over the last couple of years.

Would you care to share any comments on that topic?.

Yes, yes. I will share with you that we continue to see growth in this area. This is a strength of ours. It has been a strength of ours for many years now and we have great sight line to being able to continue to drive attach of our FlexFit basis.

Obviously, it's an important contributor in the fourth quarter with our 7% ARU growth and we expect it will continue to be in the future..

Thanks a lot and good luck..

Thank you..

Thanks a lot..

Operator, next question..

Hello, Sheila, are you there? I apologize. It seems we are having some technical difficulties with our operator. Just please hold on the line for one minute as we get this resolved and we'll continue with the Q&A..

This is the operator. Once again, I do apologize for the delay. We are ready for our next question. Our next question will come from Bradley Thomas with KeyBanc Capital Markets. You may go ahead..

Hey, good afternoon, this is Andrew on for Brad. A question we've been getting a lot recently is basically on competition and how you are viewing Mattress Firm's repartnership with the Tempur-Pedic? Clearly, it doesn't look like this is a significant issue in 4Q given your strong performance.

But we were wondering how you're thinking about the partnership over the next few quarters and how that could impact your business..

Yes, Andrew, this is Shelly. We have – we're in our seventh quarter of double-digit growth that is associated with our Sleep Number 360 smart bed.

And all the other initiatives that we've been driving over multiple quarters, we see great strength and have confidence in our own ability to continue to bring consumers into our brand and drive our performance..

Great, great. Understood.

And I guess my last question here is, wondered what your outlook was for input costs for 2020 and how you expect these trends to impact the margin outlook for the year?.

Andrew, it's kind of a push. We've got some things that are going against us, like some of our labor and so forth. But we do have some favorability in some of our commodity costs. So, we expect it to be basically flat impact overall..

All right. Great, thanks. That's helpful. That's all for me..

Okay. Thanks, Andrew. Okay, I am almost afraid to ask, but Sheila, are you with us? It sounds like we're having trouble. .

This is the operator.

Are you ready for the next question?.

Yes, thanks..

Thank you. It comes from Atul Maheswari with UBS. You may go ahead..

Good evening. Thanks a lot for taking my question. So my question is also on units and given the strong ARU growth in the fourth quarter, it would appear that units probably decline on a same-store basis. But then it looks like unit growth has improved thus far in 2020 and that should ramp further.

So I am just trying to better understand what has changed with respect to your strategy thus far in 2020 that's driving this improved unit growth?.

Yes. Hey Atul. I'll handle that one, because it's a fairly easy one. You need to remember that we had $24 million of deliveries in 2018 that shifted from Q3 into Q4 and that's kind of messing up your – I think your analysis. Our adjusted growth against the adjusted 2018 numbers in Q4 is 14% and half of that was from units..

Okay, that's very helpful. Thank you so much. And then, as a quick follow-up, how are trends in your mall versus non-mall stores? And is there any meaningful performance cabinets worth calling out? And is that gap any wider than it's been in the past? Thank you..

Yes, nothing meaningful to call out. We've continued to progress our strategy with stores outside of malls with now over 60% of our portfolio in non-malls..

Yes, generally speaking, the malls that we are in, we like and we see strong performance both in our mall and non-mall locations..

Thanks..

Thank you. [Operator Instructions] Our next question is from Curtis Nagle with Bank of America. You may go ahead..

Yes. Thanks very much. Just wanted to go back to Seth's question on the breakout of the sales growth. If I heard you correctly and maybe I didn't, I think you said that the contribution from comp and stores would be even. And if that's the case and store growth is about 4.5%, the extra week is 2%.

Wouldn't that imply comps of 4.5% and total sales growth of 11%, not high single-digits? Or do I have my math wrong?.

So, look, we are guiding to high-single-digit top-line growth with about two points from the extra week. We highlighted that that was about a $30 million impact. The math that we are providing is about directionally equal contribution from comp and new stores. I am not going to split the contribution by 0.5 a point..

Okay.

And if you could just clarify how much EPS benefit you get from the extra week?.

As I highlighted on the call, my comments I expected about $0.15 benefit from that extra week. However, we are intending to invest that back into the business with the accelerated spending in our R&D..

Okay. Thanks very much..

All right. You bet..

Thank you. I will now turn the conference back over to the company for closing remarks..

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

Thank you. That does conclude today’s conference. Thank you for participating. You may disconnect at this time..