Earnings Call Transcript - SNBR Q1 2023

Operator, Operator

Welcome to Sleep Number's Q1 2023 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.

Dave Schwantes, Vice President of Finance and Investor Relations

Good afternoon and welcome to the Sleep Number Corporation first quarter 2023 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 Chris Krusmark, our Interim CFO and Chief Human Resources 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.

Shelly Ibach, Chair, President and CEO

Good afternoon and thank you for joining our first quarter 2023 earnings call. My Sleep IQ score was 88 last night. Agility, resilience, and ingenuity continue to be hallmarks of our Sleep Number team as we navigate macroeconomic challenges. These traits help us execute in the current environment while also advancing our long-term strategy. We have strategically maintained our focus on innovations that strengthen our competitive advantages. This includes evolving our SmartFed ecosystem into a progressive, adaptive health and wellness technology platform that generates a high level of engagement from our community of more than 2.5 million smart sleepers. Their monthly average engagement with our SmartBank ecosystem is greater than 80%, a best-in-class metric for digital products and a strong driver of future revenue potential through referrals, products, and services. Our first quarter performance was consistent with our expectations. Through our team's exceptional execution, we overcame incremental demand pressures late in the quarter as consumer sentiment dropped 5 points in March versus February. We leveraged our fulfillment network to deliver incremental smart beds from our existing backlog. As a result, we delivered 90,000 smart beds and net sales of $527 million for the quarter. After nearly 2 years of supply disruption, the consistent and steady flow of Microchip has enabled us to return to more efficient operations. First quarter gross margin of 58.9% was up 160 basis points from a year ago as we benefited from pricing actions, modest easing in commodity prices, and our newly unified, more flexible supply network. Our Q1 gross margin rate also represented a 350 basis point step-up from the back half of last year. Net operating profit of $26 million was up $22 million over prior year and earnings per share were $0.51 versus $0.09 in last year's first quarter. We are intently focused on driving improved demand in Q2 and beyond in what remains a challenged backdrop of historically low consumer sentiment. A couple of weeks ago, we kicked off a sequence of new demand drivers, starting with the presale of our next-generation i10 and M7 smart beds, our new FlexFit 2 and 3 smart adjustable bases, and new lifestyle furniture. These validations are designed to help sleepers achieve their next level of sleep and realize their full potential through every stage of life. This first phase will be set in all stores by mid-May. Phase 2 planned for early Q3 includes the remainder of our smart beds. This cadence enables us to optimize the closeout and introduction cycle with our selling process while also being fully transitioned well ahead of Labor Day. Our next-gen smart beds have advanced from our original award-winning Sleep Number 360 smart beds by using insights from more than 19 billion hours of proprietary longitudinal fleet data. These groundbreaking innovations use embedded research-grade sensors to learn each sleeper's biometrics and sleep patterns and then automatically adjust to support the sleeper's changing needs. All our new smart beds will also feature ceramic gel and use foam layers that help balance temperatures to stay comfortably cool all night. In addition, the next-gen smart beds benefit from our new health and wellness technology platform which was introduced in October 2022 with our Climate 360 smart bed. The integration of physical and digital technologies creates our Smart Bed ecosystem by combining AI and machine learning algorithms to support future digital products and services. We are introducing these innovations with a new sleep next-level advertising campaign that showcases our smart sleeper couple, award-winning actress Gabrielle Union Wade and her husband, NBA Hall of Famer Dwyane Wade. With more than 80 million social media followers, they bring authenticity and credibility to the smart bed features and benefits highlighted in this campaign. Our consumer research indicates strong alignment between benefit messaging, relatability, and consumers' heightened interest in their improved well-being. New campaign highlights can be viewed on our Investor Relations site. While the macroeconomic environment remains challenging, innovation is a proven demand driver. The stronger-than-expected sales of our Climate 360 smart bed since its introduction is a great example. We are building on that success with our next-gen smart beds, new creative, simplified online experience, and the power of more than 2.5 million smart sleepers, our most loyal customers who drive referral and repeat sales. With these integrated initiatives and the strong execution by our purpose-driven team, we expect year-over-year demand trends to improve throughout the year, especially in the third and fourth quarters. Now, Chris will provide additional details on first quarter results and our outlook for the second quarter and full year 2023.

Chris Krusmark, Interim CFO and Chief Human Resources Officer

Thank you, Shelly. I would like to start by emphasizing a few points. Our first quarter results were in line with our expectations from both a top and bottom-line perspective. Given the current macro environment, we remain cautious in our outlook for the balance of the year, even as we begin to lap easier comparisons. Our commitment to drive performance is evident with the demand initiatives Shelly outlined. We continue to operate with flexibility and agility as we navigate the current environment and are prepared to pull back on costs if conditions warrant. Now let me turn to more detailed comments on our financial results. First-quarter net sales and delivered smart bed units were both consistent with the expectations we outlined on our February earnings call. Net sales of $527 million were flat versus prior year with a comparable sales decline of 2%, offset by 2 points of growth from net new store additions. We delivered 90,000 smart beds in the quarter as planned, which was 16% less than the prior year. Our first quarter ARU increased 19% versus the prior year, which included high single-digit ARU growth on a demand basis. As a reminder, a shortage of semiconductor chips in last year's first quarter impacted deliveries of our higher-priced FlexFit 3 adjustable bases and related smart beds, which pressured the prior year delivered ARU. During the quarter, we reduced our excess backlog by approximately $15 million and expect to return to normalized backlog levels by the end of the second quarter. Our first quarter gross margin rate of 58.9% was up 160 basis points versus the prior year and in line with our expectations. The 160 basis point year-over-year increase in our gross profit rate included the benefit of pricing actions taken last year, product mix changes year-over-year, and operating efficiencies resulting from a steady flow of semiconductor chips. Our progress in first quarter gross margin rate is an important milestone on our path to delivering at least 150 basis points of gross margin rate expansion in 2023. First quarter net operating profit grew $22 million year-over-year on net sales that were consistent with last year. This operating profit growth was driven by an $8 million gross profit increase and a $14 million reduction in operating expenses. Disciplined spending in the quarter included a year-over-year reduction in media spend in line with our first-quarter demand expectations. General and administrative expenses as well as R&D expenses were also down a combined $4 million versus the prior year on lower headcount. First quarter earnings per share of $0.51 compared with $0.09 last year. This reflects the gross margin rate expansion and effective cost controls. We ended the quarter with $347 million of liquidity under our revolving credit facility and a leverage ratio of 4x EBITDA, below our amended 5x covenant. We are reiterating our 2023 full-year EPS outlook range of $1.25 to $2 per share. Here are a few items to highlight regarding the full-year guidance and second-quarter expectations. For the full year, we continue to expect net sales to be flat to down mid-single digits. We continue to expect improvement in the back half of the year, with net sales down low single digits to up mid-single digits when we face easier comparisons and fully benefit from new smart bed introductions. We intend to generate more than $100 million in cash from operations in 2023 and positive free cash flows and plan no share repurchases for the year. For the second quarter, we are expecting demand to be flat to down low single digits compared to last year with net sales down low double digits to mid-teens. As a reminder, last year's second quarter net sales grew 13% year-over-year, benefiting from over $100 million of backlog reduction in the quarter. We are expecting a net loss for the second quarter in our seasonally lowest demand quarter and with an expected year-over-year net sales decline. I will now turn the call back to Shelly for a few closing comments prior to opening up the call for Q&A.

Shelly Ibach, Chair, President and CEO

I'm so proud of our team for their perseverance and passion. They have enabled us to address an array of global challenges over the past three years while continuing to deliver life-changing innovations. Our team has maintained a flexible mindset, which will allow us to capitalize on profitable opportunities throughout our business as the environment improves and to quickly pivot if external conditions worsen. Above all, their dedication to our purpose and strategic priorities are at the heart of our commitment to deliver tangible long-term health benefits for smart sleepers and superior value for all stakeholders. Now Chris, Dave and I will respond to your questions. Christy, please open the line.

Operator, Operator

Our first question comes from Bobby Griffin from Raymond James.

Bobby Griffin, Analyst

Good afternoon, everyone. Great job on achieving many of the objectives you set out and executing the plan effectively. Chris, you mentioned in your comments that demand in the second quarter is expected to be flat to down in low single digits, if I understood correctly. Last time we spoke, the quarter-to-date was showing a decline in high singles. I'm interested in understanding how the quarter has shaped up, particularly where demand has improved and if you're observing the current trend as we approach the end of March and other periods.

Shelly Ibach, Chair, President and CEO

Great. Thank you, Bobby. And you kind of touched a little bit there at the end but I think I captured the majority of your question. Yes, did you see business improve throughout the quarter in 1Q and into April? How do we get down high single to down flat to low? Yes. Thank you for the question. This is an important area especially speaking about the shape and I'll maybe start with a little commentary on the shape in Q1 and then we'll move into why we expect the demand improvement here in Q2. So, for Q1, when we communicated on our fourth quarter year-end earnings call, we were running down high single digits which was a big step-up from where Q4 landed. And then, of course, we're pleased with delivering on our Q1 expectations. Then with the drop in consumer sentiment from February to March, a drop of 5 points, we also saw increased pressure in our demand trend in the month of March. So March ended up being tougher for us, down double digits, down low double digits. As we moved into April, April is on track with our expectations as Q1 was and we have had some improvement in April. It's early in the quarter. And April is historically one of our lower months. So I think that's important to highlight. But we do expect Q2 demand to be flat to down low single digits with positive year-over-year growth as we move into May and June. And there are 2 big changes that are occurring. One is easier comparison because of the significant drop last year down to double-digit decline in May and then that continues the balance of the year. And secondly, the initiatives, the demand-driving initiatives that we have. We are just starting this sequence of demand drivers, including the full introduction of our next-generation smart beds here over Q2 and early Q3 and then also our new campaign which was just released yesterday. So our stores will all be set by mid-May and that's when everything moves to a higher degree and then later in the quarter, early Q3, we'll introduce the balance of the line. So we're really excited with all the initiatives we have. These have been proven initiatives for Sleep Number over the years and yet recognize that this is still a very challenged environment. We experienced that in Q1 with the banking crisis occurring, which dropped consumer spending, especially at the high end, and that was a fairly abrupt change. Yet there's resilience out there with the consumer, too. So we're contemplating this challenging backdrop for the balance of the year while recognizing the compares are a lot different, the balance of the year than they were in Q1 and we have big initiatives.

Bobby Griffin, Analyst

That was helpful. And I guess just lastly for me before I turn it over. Can you talk a little bit about the marketing spend you mentioned it was down in the quarter, just how kind of you're approaching that? Have you been just falling back across all meats or just kind of different areas? And then as a second part of that, have you guys put any meaningful dollars behind the Climate 360 bed yet? Or is the early success in that just being driven by word of mouth and kind of store associates?

Shelly Ibach, Chair, President and CEO

I'll address the first part of the question and then the second. So to begin with, yes, media is down and we expect efficiency out of our media. Last year, we were in a really difficult environment. And we also did not have our full assortment and we had extended delivery windows that lasted through the full year. So we do expect our media to work more efficiently and we're excited about the new creative and what that will mean to efficiency as well. And at the same time, as the environment evolves, we will respond accordingly with our media spending. And then the second part of your question was around climate. We did have a fair amount of our creative execution focused on the Climate 360 and it was absolutely a driver of consumers wanting those temperature benefits.

Matthew Egger, Analyst

This is Matt Egger on for Peter. First one from me is just curious on what you're seeing on input costs, whether that be with foam or transportation and how those are trending real-time.

Shelly Ibach, Chair, President and CEO

Yes, Matt. We have seen some easing of commodity costs and Dave will share some specifics.

Dave Schwantes, Vice President of Finance and Investor Relations

Yes, Matt, so when we provided our guidance back in February, we did expect about $15 million to $20 million of commodity easing for the year. And it's great to see that here we are in Q1 and we've realized a nice ratable percentage of that commodity relief. So we're seeing some improvement. We're not banking on a lot more than the $15 million to $20 million this year, but part of that improvement we saw in our gross margin rate in Q1 getting to 58.9% was tied to some of the commodity relief that we did expect.

Matthew Egger, Analyst

That's great to hear. And then secondly, curious on if you're seeing any impact with maybe your higher ticket sales or your adjustable base attachment rates given kind of the higher financing costs and the pressure on consumer sentiment that you talked about in the prepared remarks.

Shelly Ibach, Chair, President and CEO

From a financing perspective, we are not experiencing pressure. We have made some adjustments to our financing to offset the higher costs, and these changes seem to be positively received by our customers. Additionally, we have observed strong average revenue per unit. Based on what I have read about the consumer environment in March, there was an additional impact that particularly affected higher-end consumers, leading to some demand pressure. Thus, there is a correlation there.

Brad Thomas, Analyst

My first question was just around gross margin. And I was hoping you can talk a little bit more about the drivers here in 1Q. I know there's kind of an unusual sort of mix that you were delivering on here in the quarter. And so, sort of wondering how much does the supply chain improvement versus the mix in the quarter. And then just thinking about the line of sight to how much improving supply chain cost might be a tailwind here for gross margin going forward?

Dave Schwantes, Vice President of Finance and Investor Relations

Thank you for the question, Brad. Focusing on Q1, the main contributors were in line with our expectations. Firstly, we've seen benefits from the price increases implemented over the last year, including some taken in mid-last year and again in December. This cumulative effect accounts for the largest portion of the 160 basis points year-over-year improvement. Additionally, we are observing positive trends in commodity prices, which serve as the second largest contributor to the year-over-year improvement. Regarding product mix, I wouldn't attribute much of the Q1 results to that factor. Last year, we experienced greater changes in product mix moving from Q1 to Q2, which were more pronounced. This year, while we did see some benefits from Climate 360 million orders delivered in Q1 that positively impacted our gross margin rate, they were largely in line with our expectations. Looking ahead to Q2, we anticipate a slight sequential decline from Q1, expecting a drop from 58.9% to a range of 57% to 58%. This is primarily due to normal seasonal trends in our business, where we typically see lower unit volumes in Q2. We expect this trend to continue, and the product mix may vary a bit as well. However, we do foresee a seasonal dip in Q2. For the latter half of the year, we expect to see a return to levels similar to Q1, around the 59% mark. Year-over-year, this will show the most significant improvement as we are comparing against a more challenging second half from last year. Thus, we anticipate notable improvements in the back half of the year.

Brad Thomas, Analyst

That's really helpful, Dave. And maybe just to dovetail off of that, as we think about the ARU and the $5,800 range this quarter, if you go back to the last few quarters, I mean, really a pretty wide range, partly due to quarters where some of the deliveries were a little bit unusual. Is this level a good level to be thinking of as kind of building off of with the potential if that keeps going higher here with the new products rolling out? Or how do you think about the ARU at a high level?

Dave Schwantes, Vice President of Finance and Investor Relations

Yes. Let me provide a few comments on ARU because I think it is an interesting metric year-over-year. So if you look at ARU, it's up 19%. As Chris said in his remarks, on a demand basis, ARU was actually up high single digits. So we had a lot of benefit year-over-year from comparing to last year's Q1 when we had a shortage of chips, which impacted the ability to deliver our high-end beds and our high-end smart bases. So it led to a very depressed ARU last year, which we're comparing to in Q1. As you pivot to Q2, you're going to see the whipsaw that last year where we then delivered a lot of those bases and the higher-end product and it led to an ARU which was $6,500 for the quarter. More specifically, Brad, is kind of your question, we aren't giving a specific number by quarter, but I think as you look at Q2 and the balance of the year, something around that $6,000 range is appropriate. We've largely worked through the backlog. We're not looking at any major shifts as you go forward. So I think that's a reasonable number. And what that would translate into would be for the first half of the year, we are still expecting kind of a high single-digit ARU growth and probably a similar growth in the back half of the year as well, kind of in that high single-digit range, maybe a little bit higher.

Seth Basham, Analyst

Thanks a lot and good afternoon. My question is on the new product launches. If you could give us some color as to how much you expect them to benefit your sales rate this year as well as some of the costs associated with the launches both from a cost of goods and SG&A standpoint, that would be great.

Shelly Ibach, Chair, President and CEO

We expect that the integrated initiatives of the next-generation smart beds and the new smart bases lifestyle furniture will contribute to improving our demand trends, especially as we approach the second half of the year when our full line is available. The costs for equipping all our stores will be approximately $6 million spread over the second and third quarters.

Seth Basham, Analyst

And then are you planning on a material step-up in advertising to support the product launches? I know you alluded to some increase. I'm not sure if that's directly related or not.

Shelly Ibach, Chair, President and CEO

Yes. Again, we expect efficiency of our media based on where we were last year. And based on the performance and the additional headwinds that we had by not having our full assortment with the constrained semiconductor chips and the long delivery window. So we are benefiting from some incremental efficiency there and we expect that to continue, and we'll continue to read the environment and lean in or pull back accordingly.

Seth Basham, Analyst

Got it. Okay. And then my last question is just if you could remind us what compares look like from a demand standpoint in the back half of the year and how you're thinking about demand on a 2-year stack basis as we move through the balance of the year?

Shelly Ibach, Chair, President and CEO

Yes. Demand, starting in May was down double digits for the balance of the year. One other comment I'll make about the media to Seth is just a reminder that we use the econometric model, which is a really effective tool for us for both regression and predictive and has many factors built into it. So it gives us confidence about where to place those dollars as we move forward, recognizing the changing consumer environment and also to what degree. Dave, do you want to comment on the 2-year trend and maybe expected 2019?

Dave Schwantes, Vice President of Finance and Investor Relations

Yes. So, maybe just relative to the specifics on 22 demand. So in the first quarter, we were down mid-single digits year-over-year. We talked a lot about the shape of that quarter previously. If you look at the last 3 quarters of the year, we were down double digits, and the most challenging quarters were in the back half. So we certainly saw the most significant disruption in the back half of the year. If you want to look at it kind of on a multi-year compare basis, which I think was part of your question, the compares really in the first part of the year relative to, call it, 2019, you're still looking at numbers last year that were trending, call it, 30% plus above 2019. And when you get to the back half of the year, those compares go down to being single digits. So there's a pretty significant trajectory change in terms of the comparison. And also a reminder, if you think about our performance in the back half of last year, we saw the most significant disruption from lack of full product assortment and having extended delivery times. It certainly ratcheted up as consumer sentiment took a hit in May. And so as we lap those numbers, we have the new products. We have the full assortment of products in our hands. We have normalized delivery times, new marketing creative. So there's a lot of things going, we think, for us. But part of that is the fact that we were even more disrupted in some cases than the industry was in what was a very difficult demand environment.

Atul Maheswari, Analyst

Shelly, you mentioned that consumer sentiment has declined further since your last guidance, yet you are still projecting a back-half demand that is down low single-digit to up mid-single-digit. Why not adopt a more cautious approach given the worsening economic conditions? Do you really need an improvement in sentiment to meet this outlook?

Shelly Ibach, Chair, President and CEO

Yes, thank you for the question. I appreciate the opportunity to clarify. Consumer sentiment did rise in January and February but then decreased by 5 points in March. Since then, it has increased by about 2 points in April. Online sentiment remains under pressure at historically low levels, and we anticipate this environment to persist. We were expecting this situation when we provided our earlier guidance, and it continues. It’s still early in the year, and we are undergoing significant changes in the business with new demand-driving initiatives planned for Q2 and Q3 while facing different comparisons. We do anticipate an improvement, although we recognize the current challenging macro environment will lead to fluctuations. This is what I was illustrating—the sensitivity of the environment, where a single event, like the banking situation, can affect consumer behavior. Sometimes these situations resolve within weeks, while at other times they may take longer. We have been navigating this disruptive environment for the past couple of years, especially since last May when consumer sentiment fell to historic lows.

Atul Maheswari, Analyst

Got it. That makes sense. And Shelly, as my follow-up, to the extent demand just weakened more than what you'd expect. How much more room do you have to cut costs given that you've already managed costs pretty tightly? Like what are the key areas that you could target in a slower-demand environment? And at what point does it become very hard to cut costs without jeopardizing future revenues?

Shelly Ibach, Chair, President and CEO

Well, we are operating with very thorough risk management processes and mitigants. We're very clear on the additional cost actions that we will take if the environment worsens. And we would do so expediently. We do have a wide range of additional cost cuts in our view and are well prepared to execute with great flexibility and agility as we continue to navigate the environment.

Atul Maheswari, Analyst

Understood. If I could just sneak in one last one. What's the leverage ratio do you expect to end the second quarter given the slight loss expectations that you have?

Dave Schwantes, Vice President of Finance and Investor Relations

Yes. We ended the first quarter at 4.0, and to clarify, we anticipate finishing the year with a leverage ratio below 4. Last year's second quarter was notably strong due to some backlog that contributed throughout the quarter. As we replace that quarter with this year's second quarter, we expect the leverage ratio to increase. Last year, we took the initiative to raise our covenant to 5.0 through the second quarter, anticipating that this quarter would be somewhat softer than the same period in 2022. We remain within that covenant range of 5.0. While we won't provide specific figures, we do expect the ratio to rise and then decrease over the remainder of the year, ultimately ending below 4.

Operator, Operator

There are no further questions at this time. I would like to turn the call back over to our host for closing remarks.

Dave Schwantes, Vice President of Finance and Investor Relations

Thank you for joining us today. We look forward to discussing our second quarter 2023 performance with you in July. Sleep well and dream big.

Operator, Operator

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