Q1 2024 Sleep Number Corp Earnings Call

Participants

Dave Schwantes; Vice President – Finance, Investor Relations and Decision Support; Sleep Number Corp

Shelly Ibach; Chairman of the Board, President, Chief Executive Officer; Sleep Number Corp

Francis Lee; Chief Financial Officer, Executive Vice President; Sleep Number Corp

Peter Keith; Analyst; Piper Sandler

Robert Griffin; Analyst; Raymond James

Seth Basham; Analyst; Wedbush Morgan

Dan Silverstein; Analyst; UBS

Bradley Thomas; Analyst; KeyBanc

Presentation

Operator

Welcome to Sleep Number's Q1 2024 earnings conference call. (Operator Instructions)
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

Good afternoon and welcome to 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 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.

Shelly Ibach

Good afternoon, everyone, and thank you for joining us. My sleep IQ score last night was 90. Since our last earnings call in February, our team members 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 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 remained in a historic recession, with demand for the category likely down mid-single digits for the first quarter after incurring two previous years of double-digit mattress unit declines. While consumer sentiment is showing signs of improvement, the consumer's 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; and they are 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 Presidents' 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 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 attitude on our segments to optimize our media strategy and lower our cost while maintaining impressions and increasing traffic. Next marketing messaging to convey more clearly, the differentiated benefits of our our smart bed our new Wei to 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 number one, 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 intenders, and finally, 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 touch points. These actions drove a 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 the 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 C. one smart bed will be priced at nine 99 everyday. We expect the strong value equation of smart adjustability 13 under $1,000 to resonate with the scrutinizing consumer. In addition, we will be taking $200 in pricing on our C. two 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 above. We also remain intently focused on returning our gross margin rate to our historical average in the low 60s and we expect our actions to restore our adjusted EBITDA margin 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. and AR. and 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 process through 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. Fleet 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 numbers. 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 in 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.

Francis Lee

Thank you, Shelly, and good afternoon, everyone. I will focus my remarks today on three primary areas. One 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, a little higher than planned and net sales, a couple of million 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 ARU down 1% versus 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 continued to make meaningful progress in driving efficiencies in our business and were 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 the balance of the year. As a reminder, our 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 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 on 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 two-plus 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 EBITDA ratio was 4.2 times at the end of the first quarter compared to our covenant maximum of 5.0 times for the quarter. We continue to expect our debt to EBITDA leverage to peak in Q2 and end the year below 3.75 times.
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 five to six 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. And we look forward to sharing our ongoing progress with you as we proceed throughout the year.
With that, operator, please open the line for questions.
Thank you.

Question and Answer Session

Operator

(Operator Instructions)
Peter Keith, Piper Sandler.

Peter Keith

I think Good afternoon, everyone. I hope all is well, and I just wanted to dig into the demand trends, just to clarify a few things. I think the quarter ended at negative mid-single digit on a demand basis. I think at the time of the Q4 call, you were also in a negative mid-single digit. So I guess is it fair to say that I guess in March you just kind of continue this negative mid-single-digit trend? And any comments around that, what we're seeing so far in Q2?

Shelly Ibach

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

Peter Keith

Fair enough. But I would agree with that. And then you mentioned you are launching the C. one product in Q three, and I think I'm adjusting pricing on the on the security that's coming down a little bit. And does that have any implications on the gross margin as we just think about maybe back half of the year, as I said, those pricing adjustments come in and new products coming.

Shelly Ibach

And yes, in a positive way, the C. two, we're taking pricing on the C2. So we're actually increasing the price of the C. two by $200 in the C. one will be at nine 99, and that's certainly a value engineered innovation that our teams have developed here in in a short period of time. And we like the opening price point for a smart bed with adjustable firmness. And we see the combination of these actions to be a positive contributor to our gross margin improvement expectations in the back half. And again, we continue to expect about 100 basis points of gross margin rate improvement on the year, primarily in the back half.

Peter Keith

Okay. Very helpful. One last one for me. And Shelly, this is kind of an off-the-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 and quite a wise manner. And I'm just thinking about that if you were to go to more of a specialized manner, we are one of the two key retailers and a nice way to expand the brand, take some share and you should be taking advantage of environment where retailers are looking for it, new innovative products.

Shelly Ibach

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

Peter Keith

Okay. Thank you and good luck.

Operator

Robert Griffin, Raymond James.

Robert Griffin

Hey, guys, good afternoon. This is Bobby on. Thanks for taking my questions. I guess first, I wanted to go back to I think it was in your prepared remarks, you talked a little bit about the change in some of the promotional aspects. So I was hoping can you just unpack kind of what you guys have changed and maybe share some of the data that you're seeing that gives you confidence that the different promotional aspects is not driving an impact in sales because I think right now, you know, a lot of investors are zeroed in on getting the sales return in this business given kind of the flow-through.

Shelly Ibach

Thanks for your questions, Bobby. And you know, maybe I'll just start with one, you know, with with media and you are aware where we have media planned and where we get to how we spend and in Q1. So we continuing to plan about 14% of sales. We expect efficiency from our initiatives, especially in this very challenging environment. And in the first quarter, we were down mid single digits in our media spend. The same as as demand. We are focused on continuing to test, learn and make adjustments and building on the initiatives that we started in the fourth quarter around the segments who were targeting around the media allocation of messaging and also our promotional strategy. And in addition to the econometric model that we've been utilizing for 12 since 2013, and that is quite helpful in media allocation and the new model with predictive analytics that we have built around promotional and the promotional strategy is informing our actions to be more precise and how we spend our promotional and financing dollars so that we benefit to the greatest degree driving efficiency, improving our efficiency. So we can allocate more dollars to media in this environment. And so we've continued to learn. We have been very effective in our test results and we are ready to apply this and have begun applying this at greater scale in the second quarter and I would turn to the results in Q1. Although constrained around demand, the effectiveness of our results drove drove a higher mix and a higher gross margin profile overall. And so that is very important in in our durable operating model to be able to be more efficient and effective with our media dollars.
If this continues to be a time of real pressure on our industry.
Our industry normally benefits from new natural traffic flow in the macro, which contributes about 20% of have sales in just a regular industry environment with strong consumer sentiment. And right now that that base is only about 12%. So the effectiveness of our dollars is really important for us, and that's what we're excited about with the advanced machine learning models that we have and taking the in reviewing them in a holistic manner and both our media dollars and promotional dollars and how we will apply them for the balance of the year to be able to generate and deliver against our margin and revenue goals.

Robert Griffin

Okay, thank you. And I guess my second question before I turn back over to others is just on the store on the store portfolio changes. We've started some of the closing process and I know it's still early, 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?

Francis Lee

Hey, 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. And 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.

Robert Griffin

Thank you. I'll turn it over to somebody else, but best of luck here in the second quarter.

Shelly Ibach

Thank you.

Operator

Seth Basham, Wedbush.

Seth Basham

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

Francis Lee

Yes, I can certainly thanks for the question, Seth. This is Francis. I can certainly share with you our outlook for the year, we anticipate ARU and units to be flattish for the year on a demand basis, in line with our expectations on the when we split it out and look at it first half versus second half of the year. We're looking at that area to be down slightly in first half and up low single digits in the second half of the year. But those are those are right in line with our expectations for our plans or guidance.

Seth Basham

And that change is being driven by comparisons is it being driven by a mix, Art or attachments or promotions.

Shelly Ibach

What's driving it is that I think you were asking specifically about EQ. one ARU. and the ARU. from Q4 to Q1 came up about $200. And that was driven by mix and mix within the smart bed line, driving a stronger innovation mix. And we continue to have strength with our our climate three, 60 year over year compare, you're right, it was down slightly. And we do, as Francis said, continue to see these two metrics being about flat for the year, flattish. And there's there will be some fluctuations on when you look at last year's a argue we it was the first quarter that we were if we had the Flex Fit threes in the FlexFit twos back into our assortment after not having them for about 18 months. So there was some pent up a tad on the flex Pit three at that time. And so, you know, does this composition with a higher ARPU than fourth quarter, but yet a little lower than prior year? And there is a relationship driving up. The smart bed line drove higher and, you know, higher mix and ARPU and margin overall. So we spent less promotion dollars in financing in the quarter from both a rate and a dollar perspective.

Seth Basham

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

Shelly Ibach

Yes. When 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, kind of as you think about new models and and how effective they are going between cash discounts versus longer financing terms is what we saw in the quarter, more indicative of how you plan to adjust going forward or is are our considerations around 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 periods, and we will continue to leaned into other I have other tactics on, especially with our smart sleepers and some of the non promotional or non market share periods.

Seth Basham

Got it. Thank you very much.

Shelly Ibach

Yes, thanks, Seth.

Operator

Dan Silverstein, UBS.

Dan Silverstein

Hey, guys. This is Dan calling in on behalf of Michael Lasser. Thanks for taking our questions.
And congrats on the quarter. I think stand next to me if you as well on just a quick question on the demand comp expectations. So for the full year guidance contemplates a low single digit decline kind of 2Q 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 multiyear compares in the back half this year, it gets a lot easier. So just wondering is that just, you know, some level of conservatism? I guess first question.

Shelly Ibach

Yes. Well, let's start with, you know, 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 on that's about one point of additional pressure. And you're right to as we lap Q. three Q. three for us and for the industry was was down double digits. We were and we had even more pressure in Q2, three 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 and it remains a very choppy environment as we experienced in January with a consumer pullback in and weather and also into the consumer behavior in March. And yet, you know some some good strength in February.
So the environment remains choppy. And we we do expect improvement in the third quarter and in the back half as we comps 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 and that we like everyone. We're anxious to see a better environment for the consumer and for this industry.

Dan Silverstein

Got it. Thank you. And then just a second question on gross margins. Maybe kind of more of a longer-term one, if you achieve the guidance, are you guys laid out for 100 bps of expansion this year. What gets you what's the glide path to 60% plus from there? Is it just continued operational work? Or if you could just a few comments on the major drivers that are that remain the opportunity that remains that?

Francis Lee

Yes. Hey, Dan. We are working on making sustainable changes in our in our operating model across a variety of areas that I referenced in my prepared remarks around gross margin around sourcing manufacturing and how we deliver the product. And so as we come, those are sustainable changes. Some of those changes come in this year. They'll be more fully annualized into next year and beyond. So you couple that with also some volume uptick when the industry returns and you'll be getting essentially gross margin leverage going forward so that you'll be back into a more normalized I've zone that we've seen in the past.

Dan Silverstein

Thank you and best of luck.

Shelly Ibach

Great. Thank you, Dan.

Operator

Bradley Thomas, KeyBanc.

Bradley Thomas

And thanks for that, John here from Shelly. I wanted to just follow up on the C. two and relaunch and the price increase. And for one, maybe can you give us any early insights into how the product is different? If from the prior version as you refresh it. And just the $200 price increase does seem pretty significant I'm on and what is it about $1,100?
I think the list prices today, pretty significant just in the context of we know the consumer spend a bit stretched and I think it was only a quarter or two ago that you were talking about being a little bit more promotional to make sure you drove demand. So just a little bit more about your confidence that price increase and is something that is the right move here for that product at this time?

Shelly Ibach

Yes, Brad, thank you for your question. And so we are introducing an additional smart bed called the C. one, and we're introducing that bed at nine 99. And so that 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 C. two by $200. So that's of a step-up story. So we'll offer the C. one Sleep Number smart bed with adjustability, effortless adjustable firmness and all the features of the smart bed at nine 99 every day. And then we will take pricing of $200 on the C2. And then, of course, we'll continue with with our other models. So the C. ones in addition catch up.

Bradley Thomas

Okay. That's that's that's helpful. And then just if I could follow up with a margin question of my own on. I know that the company is committed to on 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 on to properly still be able to drive growth, but also be disciplined and just how you're thinking about that and in short, sort of the short term and longer term?

Shelly Ibach

Yes, I'll comment on the four. The four areas that I mentioned in my script that we will be measuring on an ongoing basis. When we think about our durable operating model and the cost of acquisition, the cost of goods, the cost of goods, the cost to serve customers and then G&A and R&D leverage. So we'll always be be timed out to those principal areas and in the future. And that helps us with ongoing discipline over time on each of those areas and areas in each of those areas. So I think that's a good way to think about it as we think about it. And we're driving some significant R&D reduction here this year in our operating model, and we've really prioritized them for efficiency, have many of the resources, which is helping us get after our cost of goods sold right now as well as innovations like the C. one, the addition of C. one and other and other strong innovation pipeline items that we are having have coming in. And you know, as we approach 2025.

Bradley Thomas

Got you.
That's helpful. Thanks so much.

Shelly Ibach

Yes. Thank you.

Operator

That concludes the Q&A session. I'll now turn the conference back over company for closing remarks.

Dave Schwantes

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.

Operator

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