Sleep Number Corp Q1 FY2024 Earnings Call

Good afternoon, and welcome to the Sleep Number Corporation First Quarter 2024 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 Chair, President and CEO; and Francis Lee, 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. We also want to refer you to the latest version of our investor presentation, which is available on the Investor Relations section of our website. I will now turn the call over to Shelly for her comments.

Good afternoon, everyone, and thank you for joining us. My SleepIQ score last night was 90. Since our last earnings call in February, our team members throughout the company have consistently demonstrated resourcefulness while executing our three strategic imperatives: competing effectively, restoring margins, and increasing cash generation to pay down debt. As this work to transform our operating model continues, the industry-wide challenges that we have faced over the last two years also persist. Our actions are positioning Sleep Number for greater resilience across a range of macroeconomic and industry environments. First-quarter results are largely as we expected and we are reiterating our full-year adjusted EBITDA guidance. During today's call, I'll provide a brief context on the consumer environment, share our first-quarter performance highlights, and describe ongoing actions we are taking to deliver on our commitments. Following my remarks, Francis will provide further details on our performance. The mattress industry remains in a historic recession with demand for the category likely down mid-single digits for the first quarter after enduring two previous years of double-digit mattress unit declines. While consumer sentiment is showing signs of improvement, consumers' purchasing power is limited due to elevated interest rates and record-high credit card debt. As a result, consumers continue to scrutinize their spending and make near-term decisions based primarily on need, price, and perceived value, deferring higher-ticket durable purchases. These factors contributed to consumer purchasing volatility throughout the first quarter. We experienced our strongest demand in February driven by the President's Day selling period and the weakest demand in January impacted by weather. For the quarter overall, our demand was down mid-single digits. In the first quarter, we generated net sales of $470 million, down 11% from the prior year compared to the 10% decline we expected. Despite the pressured sales climate, our strong execution resulted in better-than-expected first-quarter adjusted EBITDA of $37 million. Against this backdrop, we prioritize actions that efficiently activate consumer interest and demand while lowering our customer acquisition costs compared to the prior year. These precise real-time adjustments to our marketing and selling strategies led to improved adjusted EBITDA margin performance. We have focused our efforts on three areas: First, Consumer Attitudinal segments to optimize our media strategy and lower our costs while maintaining impressions and increasing traffic. Next, marketing messaging to convey more clearly the differentiated benefits of our Smart Beds. Our new 'Why Choose Sleep Number' campaign highlights our leadership in adjustable firmness, active individualized temperature benefits, the value of our Smart Beds for every budget, and claims of high customer satisfaction with our Smart Beds, including our J.D. Power #1 ranking for mattresses purchased in-store. The campaign is resonating with consumers, and our brand health metrics are strong on consideration, value perception of the affordability of Sleep Number Smart Beds, and brand trust, particularly among premium tenders. Finally, we are taking actions that drive conversion by helping customers select the right Smart Bed for their budget before they consider the additional benefits of a Smart adjustable base. By continuing to test, learn, and adjust our online experience, promotional strategy, and selling process, we are generating a more profitable sales mix across all our digital and in-store touchpoints. These actions drove lower promotional spend and a higher mix in the first quarter, resulting in a gross margin rate that was better than we expected. The efficiency improvements we have implemented over the past two quarters are meeting the revenue and margin targets established in our different tests. With this validation, we are now beginning to scale these actions for accelerated impact. We will accomplish this goal by leveraging our current econometric model used to inform media channel mix and investment levels and the predictive capabilities of our new elasticity model used to guide our promotional strategies in a range of consumer environments. Our teams have also developed a new Smart Bed that we plan to launch by the third quarter. The C1 Smart Bed will be priced at $999 every day. We expect a strong value equation of smart adjustability starting under $1,000 to resonate with scrutinizing consumers. In addition, we will be taking $200 in pricing on our C2 Smart Bed. These actions strengthen our competitive position and support more efficient demand generation, particularly among value-conscious consumers. Our second strategic imperative is restoring margins. We are continuing to target operating cost improvements of $40 million to $45 million in 2024 on top of the $85 million we realized in 2023. As a result, we expect 2024 operating expenses to be $125 million to $130 million below 2022 levels. We also remain intently focused on returning our gross margin rate to our historical average in the low 60s and expect our actions to restore our adjusted EBITDA margins to mid-double digits as industry demand normalizes. To deliver on these operating expense and margin improvements, we are driving sustainable change across the organization in four principal areas: cost of customer acquisition, cost to serve customers, cost of goods sold, and G&A R&D leverage. During the first quarter, we made tangible progress in each of these categories, including reductions in customer acquisition costs through the advancement of our predictive analytics, reductions in our cost to serve customers through self-service offerings, outsourcing strategies, and component sustainability efforts, and reductions in our cost of goods through structured sourcing strategies with additional flexibility in product and logistics. These actions will drive improved 2024 results as well as processed capabilities that will enable performance improvements in future years. Increasing cash generation to pay down debt is our third strategic priority. In the first quarter, our adjusted EBITDA performance led to free cash flow generation of $24 million compared to $3 million for the same period last year. As we realize the benefits of our operating model transformation through 2024, we expect to generate $60 million to $80 million of free cash flow. Despite the persistent near-term headwinds, our long-term growth opportunity remains intact as illustrated in the Investor Relations deck we posted to our website last month. Sleep remains one of the top health and wellness priorities of consumers and also one of the areas in which they have the most unmet needs. Sleep Number is uniquely positioned in the industry to address consumer barriers to quality sleep, help solve critical sleep health challenges, and improve lives through proven quality sleep. Company culture is an important contributor to performance, and Sleep Number's exceptional culture is the result of our 4,000 team members' purpose-driven commitment. Thank you to our teams and partners for your passion, teamwork, and innovative mindset as we find new ways to compete effectively, restore margins, and generate robust free cash flow. We continue to focus on delivering value for our shareholders as we capitalize on the implementation of our durable operating model, the industry's gradual recovery, and our strategic progression as a sleep wellness technology company. With that, I'll turn the call over to Francis, who will provide more details on our first-quarter results and full-year guidance.

Thank you, Shelly, and good afternoon, everyone. I will focus my remarks today on three primary areas: one, a review of our first-quarter results; two, ongoing progress we are making in our cost restructuring efforts; and three, our 2024 outlook. Our results for the first quarter came in largely as expected, with adjusted EBITDA slightly higher than planned and net sales a couple of million dollars below expectations. Now let me unpack more details regarding our first-quarter results. First-quarter net sales of $470 million were down 11% versus last year. Our net sales growth for the quarter included four points of headwind from year-over-year backlog changes. Our delivered units were down 9% for the quarter with our average revenue per unit down 1% versus the prior year. Restoring our gross margin rate to higher levels is a key priority for the company, and we were pleased with the progress we made in the first quarter. Our first-quarter gross margin of 58.7% was above our expectations and a meaningful improvement from the back half of last year. We continue to identify and execute cost efficiency initiatives across the organization, including in our cost of goods sold. We also continue to make meaningful progress in driving efficiencies in our business, and we are ahead of plan in the first quarter. Operating expenses, pre-restructuring costs, were down $24 million versus prior year. Cost reductions were broad-based, including reductions in selling and marketing expenses and R&D. We continue to target $40 million to $45 million of operating expense reductions for the year. We recorded $10.6 million of restructuring costs in the quarter and expect approximately $3 million of additional restructuring costs for the balance of the year. As a reminder, restructuring costs are reported as a separate line item in our financial statements, and we have also provided an as-adjusted EPS figure in our financial statements for comparative purposes. We generated $37 million of adjusted EBITDA in the quarter versus $49 million last year, primarily due to the year-over-year net sales decline. Our first-quarter adjusted EBITDA was slightly ahead of expectations as we benefited from the acceleration of our cost efficiency initiatives. A key focus for us in 2024 is to generate free cash flow to reduce our outstanding credit line balance, even with the expectation of a modest sales decline for the year. For the first quarter, we generated $24 million of free cash flow compared with $3 million last year. The $21 million increase in free cash flow year-over-year included a $15 million improvement in operating cash flow combined with a $6 million reduction in CapEx spending. For the full year, we expect to generate free cash flow of $60 million to $80 million, which we intend to use to pay down our credit line. Now let me provide an update on the ongoing work we are doing in support of a more durable operating model. The mechanisms we put in place to promote and build sustainable change are enabling us to meet our operational transformational goals. Our initiatives and efforts are resulting in greater operating efficiency and financial resilience. We have progressed strategic sourcing initiatives across materials and logistics that have lowered our total cost of goods and services. Simplification programs with increased digital assets for customer self-service options are lowering our cost to serve. We have also implemented new stringent practices around indirect costs in support of sustained G&A leverage. Our store actions are on track with our expectations and there are no material changes to the plan for the year that we communicated last quarter. As a reminder, we expect the net impact of store actions to be about a one-point drag to 2024 net sales growth, and we expect to end 2024 with approximately 30 fewer stores compared to 2023. Our gross margin improvement actions are progressing. We are focusing on durable operating activities that drive value engineering for our products, material cost reductions, and additional efficiencies through our manufacturing and home delivery network. Let me turn to an update on our 2024 outlook and a reminder of key assumptions included in our projected performance for the year. The demand environment remains challenging, and we continue to focus on the things we can control. We have built our operating expense plans for the year on the basis of the industry not experiencing any material recovery in 2024, despite undergoing over two years of recessionary demand levels. We are reiterating our 2024 full-year adjusted EBITDA outlook range of $125 million to $145 million. Here are a few items to highlight regarding the full-year guidance and second-quarter expectations. We continue to expect net sales to be down mid-single digits for the year with a low single-digit demand decline. We are still assuming three percentage points of headwind from year-over-year backlog changes and one percentage point from net store actions. We expect sales growth to improve throughout the year with low single-digit net sales growth expected in the back half of the year against easier comparisons. We continue to expect a majority of the approximately 100 basis points of gross margin rate expansion in 2024 to be in the back half of the year. We are estimating restructuring costs of approximately $14 million for the year, slightly higher than our prior estimate of $12 million. Our debt-to-EBITDAR ratio was 4.2x at the end of the first quarter compared to our covenant maximum of 5.0x for the quarter. We continue to expect our debt-to-EBITDAR leverage to peak in Q2 and end the year below 3.75x. We also wanted to provide some clarity regarding our second quarter 2024 performance expectations. We are expecting net sales to be down high single digits versus the prior year second quarter, including 5 to 6 points of headwind from year-over-year backlog changes. We expect second quarter adjusted EBITDA to be $20 million to $25 million. I want to thank the entire team for the rigor and tenacity they have exhibited as we make important changes to our business for a more durable operating model while positioning ourselves to rebound with pace when the demand environment improves. We look forward to sharing our ongoing progress with you as we proceed throughout the year.

I wanted to discuss the demand trends and clarify a few points. The quarter ended with a decline in demand in the mid-single digits, similar to what was reported during the Q4 call. Is it accurate to say that this negative mid-single-digit trend continued in March? Additionally, do you have any insights on what we are experiencing so far in Q2?

Peter, thank you for the question. You're right in your summary of the demand trends. The shape of the first quarter was certainly choppy. We did end the month of February down low single digits, and March and Q2 to date, so March and April to date, are also down mid-single digits. We expect the strength of Q2 to be in May, again, around the market share period. And that, of course, is the largest month. And for the second quarter, we're expecting demand to be down low to mid-single digits in the quarter. And from everything that we've read and understand, it appears the industry probably also was down mid-single digits for the first quarter.

Very helpful. I agree with you on that. You mentioned that the c1 product will launch in Q3, and the pricing for the C2 is being reduced a bit. Will that affect the gross margin as we consider the second half of the year with these pricing changes and new products being introduced?

Yes, it's positive. We are increasing the price of the C2 by $200. The C1 will be priced at $999, reflecting the value-engineered innovation our teams developed in a short time. We believe the initial price point for the Smart Bed with Adjustable Firmness is appealing, and we see these pricing changes contributing positively to our expectations for gross margin improvement in the latter half of the year. We still anticipate an improvement of about 100 basis points in the gross margin rate for the year, mainly in the second half.

Very helpful. One last one for me, and Shelly, this is kind of an off-wall question, but it's something I've been thinking about. I'm wondering if you have ever contemplated taking the brand back to wholesale. I know that was done pre-GFC in quite a wide manner. And just thinking about it maybe if you were to go to more of a specialized manner, 1 to 2 key retailers, a nice way to expand the brand, take some share, and you'd certainly be taking advantage of an environment where retailers are looking for new and innovative products.

Well, thanks so much for the thought, and we continue to explore a wide range of opportunities as we look forward and are very focused on increasing our shareholder value. So we'll continue to compete aggressively. You'll see us lean in. And thanks for your thoughts.

This is Bobby. Shelly, I wanted to refer back to your prepared remarks where you mentioned changes in some of the promotional aspects. Could you elaborate on what has changed and share some of the data that supports your confidence that these different promotional strategies are not affecting sales? I believe many investors are currently focused on turning sales around in the business considering the flow-through.

Thank you for your questions, Bobby. I'll begin with our media planning and spending in the first quarter. We are maintaining a plan of about 14% of sales, aiming for efficiency in this challenging environment. In Q1, our media spending decreased in mid-single digits, corresponding to demand. We are focusing on testing, learning, and making adjustments based on initiatives we began in Q4, including our target segments, media allocation, messaging, and promotional strategy. Alongside our established econometric model for media allocation since 2013, we have developed a new predictive analytics model for our promotional strategy, which is guiding us to spend our promotional and financing dollars more effectively. This approach helps us operate more efficiently and allocate more funds to media. We have gained valuable insights from our testing and are prepared to implement them at a larger scale in Q2. Although Q1 results were limited by demand, our effective strategies led to a higher mix and improved gross margin overall. It's crucial for our operating model to maximize the efficiency of our media spending during this time of significant industry pressure. Typically, our industry benefits from natural traffic contributing around 20% of sales in a strong consumer sentiment environment, but currently, that base is approximately 12%. Therefore, the effectiveness of our spending is vital. We are enthusiastic about utilizing our advanced machine learning models and reviewing them comprehensively for both media and promotional dollars as we move forward to achieve our margin and revenue objectives for the year.

And I guess my second question before I turn it back over to others is just on the store portfolio changes. We've started some of the closing process, and I know it's still early but Francis, anything you can share on what you're seeing from a recapture basis as you've gone market-by-market and started closing some of these stores?

Bobby, thanks for asking. Our store actions are progressing on track. As we communicated, we will be ending the year with about 30 net store actions relative to 2023. The majority of those closures are happening in the first half of the year. Our early indications on the sales transfers are that they are tracking to or above our expectations. And we'll continue to monitor that as we get more solid data as time continues here.

My first question is on average revenue per mattress unit, which dipped year-over-year in the quarter. Could you give us some color as to why that is? And how should we think about that going forward?

Yes, I can share our outlook for the year. We expect average revenue units and units to remain stable in terms of demand, in line with our expectations. When we compare the first half of the year to the second half, we anticipate average revenue units to decrease slightly in the first half and increase by low single digits in the second half. These projections align with our planned expectations.

Got it. And that change is being driven by comparisons. Is it being driven by a mix? Or attachments or promotions? What's driving it?

Seth, I think you were asking specifically about Q1 ARU and the ARU from Q4 to Q1 came up about $200, and that was driven by mix. Mix within the Smart Bed line, driving a stronger innovation mix, and we continue to have strength with our Climate360. The year-over-year compare, you're right, was down slightly. And we do, as Francis said, continue to see these two metrics being about flat for the year, flattish. And there will be some fluctuations. When you look at last year's ARU, it was the first quarter that we had the FlexFit 3s and the FlexFit 2s back into our assortment after not having them for about 18 months. So there was some pent-up attach on the FlexFit 3 at that time. So thus, this composition with a higher ARU than fourth quarter, but yet a little lower than prior year, the relationship driving up the Smart Bed line drove higher mix and ARU and margin overall. So we spent less promotional dollars in financing in the quarter from both a rate and a dollar perspective.

Got you. And that's a good segue. So improving rates and margin dollars on a gross basis, but what about after taking into account promotional financing costs, as we noticed that your 0% financing terms extended later in the quarter.

Yes. When I mentioned that the promo, so promo and financing combined year-over-year, our dollars and rate were lower on a demand basis than the prior year.

As you think about your new models and how effective they are going between cash discounts versus longer financing terms is what we saw later in the quarter more indicative of how you plan to adjust going forward? Or is there considerations around a holiday market share periods versus non-holiday periods?

There are absolutely considerations in the different periods. And we are seeing the strength of the business in the market share period, and we will continue to lean into other tactics, especially with our Smart Sleepers in some of the non-promotional or non-market share period.

This is Dan calling in on behalf of Michael Lasser. Congrats on the quarter.

Yes. Thanks, Dan. Nice to meet you.

Just a quick question on the demand comp expectations. So for the full-year guidance contemplates a low single-digit decline, kind of Q2 to date is in the down mid-singles range. So I guess that implies a slight acceleration in the back half, but shouldn't this accelerate a lot? Like if you look at the multi-year compares in the back half this year, it gets a lot easier. So just wondering, is that just some level of conservatism? I guess that's the first question.

Well, let's start with the industry overall. We continue to expect a pressured industry even with multiple years of double-digit unit declines. We still expect the industry to be pressured this year and we have a little bit of additional pressure with our store actions. That's about a one-point additional pressure. And you're right, as we lap Q3, Q3 for us and for the industry was down double digits. We had even more pressure in Q3, and more opportunity, I should say, around our messaging this year, which we expect to be much stronger. So we do expect improvement in the back half. It remains a very choppy environment as we experienced in January with a consumer pullback and weather and also the consumer behavior in March and yet some good strength in February. So the environment remains choppy. We do expect improvement in the third quarter and in the back half as we comp easier compares but also as we advance our initiatives around competing more effectively, and it gives us confidence in being able to deliver on our commitments. But we, like everyone, we're anxious to see a better environment for the consumer and for this industry.

I have a second question about gross margins, which might be more of a long-term consideration. If you meet the guidance for 100 basis points of expansion this year, what is the path to achieving over 60% from that point? Is it simply ongoing operational efforts, or could you share some insights on the key drivers and opportunities that are still available?

We are focused on implementing sustainable changes in our operating model across various areas, including gross margin, sourcing, manufacturing, and product delivery. Some of these changes will take effect this year, while others will be more fully realized next year and beyond. Additionally, as the industry experiences a rebound in volume, we will achieve gross margin leverage, allowing us to return to the more normalized levels we have seen in the past.

Shelly, I wanted to follow up on the C2 relaunch and the price increase. Can you provide any early insights into how this product differs from the previous version? The $200 price increase seems significant considering it's around $1,100. Given that consumer spending is somewhat stretched, and your earlier comments about being more promotional to drive demand, can you share more about your confidence in this price increase being the right decision for the product at this time?

Yes, Brad, thank you for your question. So we are introducing an additional Smart Bed called the C1, and we're introducing that bed at $999. So that comes in lower than our current C2, and at the same time, we're taking pricing, not relaunching, but just taking pricing, increasing the price of the C2 by $200. So that's a step-up story. So we'll offer the C1 Sleep Number Smart Bed with Adjustability, Effortless Adjustable Firmness, and all the features of the Smart Bed at $999 every day. And then we will take pricing of $200 on the C2 and then, of course, we'll continue with our other models. So the C1 is an addition.

That's helpful. And then just if I could follow up with a margin question of my own. I know that the company is committed to R&D and innovation. But just wondering as you reflect on the current margin trends in the current environment, if there's any updated thinking about what the right level of R&D spend is for the company to properly still be able to drive growth but also be disciplined and just how you're thinking about that in short sort of the short term and longer term?

I will address the four key areas we will consistently evaluate in relation to our sustainable operating model, which include the cost of acquisition, the cost of goods, the cost of customer service, and the leverage of general and administrative expenses and research and development. We will continuously monitor these essential aspects going forward. This approach will help us maintain ongoing discipline in each area. We anticipate making substantial reductions in R&D within our operating model this year and have reallocated many resources for greater efficiency, which is currently assisting us in managing our cost of goods sold, along with innovations like the C1 and other promising items in our pipeline as we move toward 2025.

Thank you for joining us today. We look forward to discussing our second quarter 2024 performance with you in July. Sleep well and dream big.