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Edited Transcript of SNBR earnings conference call or presentation 22-Apr-20 9:00pm GMT

Q1 2020 Sleep Number Corp Earnings Call

MINNEAPOLIS Jun 10, 2020 (Thomson StreetEvents) -- Edited Transcript of Sleep Number Corp earnings conference call or presentation Wednesday, April 22, 2020 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David R. Callen

Sleep Number Corporation - CFO & Senior VP

* David W. Schwantes

Sleep Number Corporation - VP of Finance, IR & Decision Support

* Shelly R. Ibach

Sleep Number Corporation - CEO, President & Executive Director

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Conference Call Participants

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* Atul Maheswari

UBS Investment Bank, Research Division - Associate

* Bradley Bingham Thomas

KeyBanc Capital Markets Inc., Research Division - Director and Equity Research Analyst

* Curtis Smyser Nagle

BofA Merrill Lynch, Research Division - VP

* John Allen Baugh

Stifel, Nicolaus & Company, Incorporated, Research Division - MD

* Peter Jacob Keith

Piper Sandler & Co., Research Division - Director & Senior Research Analyst

* Robert Kenneth Griffin

Raymond James & Associates, Inc., Research Division - Senior Research Associate

* Seth Mckain Basham

Wedbush Securities Inc., Research Division - MD Of Equity Research

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Presentation

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Operator [1]

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Welcome to Sleep Number's Q1 2020 Earnings Conference Call. (Operator Instructions)

Today's call is being recorded. (Operator Instructions).

At this time, I would like to introduce Dave Schwantes, Vice President of Finance and Investor Relations. Thank you. You may begin.

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David W. Schwantes, Sleep Number Corporation - VP of Finance, IR & Decision Support [2]

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Good afternoon, and welcome to the Sleep Number Corporation First Quarter 2020 Earnings Conference Call. Thank you for joining us. I am Dave Schwantes, Vice President of Finance and Investor Relations. With me today are Shelly Ibach, our President and CEO; and David Callen, our Chief Financial Officer. The 3 of us are in our Minneapolis offices for the call today but are social distancing as we sit apart in our conference room. 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.

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [3]

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Good afternoon, and welcome to our 2020 first quarter earnings call. My SleepIQ score was 83 last night. In just a few short weeks, our live businesses and economy have radically changed, and we are all navigating an unfamiliar environment. The COVID-19 pandemic is a human and economic crisis unlike anything our world has ever experienced. Our hearts go out to the health care workers, our team, customers, partners, and all the families and businesses who have been hurt by this virus. As a purpose-driven company, we have focused our energy and resources on keeping our team members safe. Serving our customers and ensuring our business continuity. We have closely adhered to the guidelines provided by the CDC and national and local governments. As a result, our headquarters, labs, customer service and store teams began working remotely mid-March. And by March 31, 80% of our stores were closed. Our teams have quickly implemented innovative alternative solutions to serve our customers and support our operations.

As we announced 2 weeks ago, we have taken swift actions to preserve our financial flexibility, increase liquidity and control expenses. In mid-March, we drew down the remaining $262 million available under our revolving credit facility and added $75 million in cash through a term loan on April 3. We began executing more than $150 million of expense reductions and have decreased capital deployment plans by more than $100 million. We made the difficult decision to furlough or reduce hours for approximately 70% of our team members. And we reduced Board, senior leadership and company-wide comp and benefits through variable incentive programs and other actions. These near-term measures are necessary to effectively manage through the current environment. In parallel, we remain intently focused on retaining our Sleep leadership position, market share gains and superior shareholder value creation as this crisis abates and the economy recovers.

Our significant competitive advantages enabled exceptional first quarter results and extended the double-digit demand growth trend of our prior 6 consecutive quarters through the second week of March. Disciplined execution of our differentiated consumer innovation strategy produced record first quarter results despite the severe adverse impact caused by COVID-19 on demand in the back half of March.

Q1 results included 11% net sales growth to $473 million with a 7% comp gain and 5 points from new stores. 61% growth in net operating profit to 11% of net sales, 70% growth in earnings per share to $1.36 and 54% growth in free cash flow to $75 million. During the quarter, units grew 10%, and average revenue per unit rose 2%, driving a 240 basis point increase in gross margin rate to nearly 64%. These results reflect accelerating consumer demand for the health and wellness benefits provided by our revolutionary 360 smart beds. In addition to improved operating efficiencies, we drove strong premium mix across good, better and best, with growth in the attachment of our smart bases with Partner Snore and foot-warming features. Our ability to drive growth from both ARU and units over time is a key outcome of our strategy. Importantly, these consistent top decile results are the real underlying potential for our business and the performance we expect to return to after this unprecedented crisis.

The near-term challenges caused by the pandemic are substantial. However, the strength of our business and balance sheet and the measures we have taken in recent weeks, combined with our highly engaged and resilient team, give me great confidence in our ability to rebound with strength. Here are a few highlights, which demonstrate our agility and innovative mindset to ensure business continuity under the current circumstances. With closed stores and a significant media reduction, we refocused our April marketing efforts to target our loyal insiders and brand advocates. We often highlight how important our referral and repeat business is, which represents more than 45% of our overall sales. Our ability to quickly lean into these life-long relationships in this time of uncertainty is a powerful advantage and performance driver. We implemented numerous digital CRM solutions to enable customers to easily engage and transact with us while retaining the value of our relationship-based selling model. Our new digital capabilities include a blended operating model of team members selling from home via phone and chat, open stores and online. As a result of our actions, the composition of our sales in April include approximately 25% of our sales coming from closed stores, another 25% from open stores and 50% of our sales from online live chat in phone with online sales up 250% over the prior year. We also implemented customer self-service digital solutions, including service request, rescheduling and a contact-less delivery solution. Results include sustaining levels of service with approximately 80% of our markets open for home delivery and record-high customer satisfaction scores. As a result of these pivots, our sales orders per day have steadily improved in April. During the last 2 weeks of March, as government mandate, closed 80% of our stores, our sales orders also abruptly declined almost 80% to the prior year.

With the actions we've taken, our sales have improved to down approximately 50% in April. We rapidly modified our manufacturing operations in supply chain to reflect our lower near-term sales outlook. In addition, we are working with our suppliers on plans for acceleration in an ambiguous time frame. These actions demonstrate the agility, real-time visibility and controls inherent in our vertically integrated business model as well as the seasoned leadership, a repressible resilience and purpose-driven commitment of our team.

As the pandemic redefines how we all live, shop and work, these further advancements in our digital capabilities and technology will be part of how we operate in the future.

I couldn't be more proud of our Sleep Number team during this difficult time. And I am deeply grateful for their tenacity and ingenuity. Every day, I see evidence that they are making a difference for each other, our customers, our company and our community. Our Irmo, South Carolina manufacturing plant, for example, is supporting the South Carolina Hospital Association by refurbishing nearly 200,000 N95 masks, fulfilling a much needed supply for health care workers.

Sleep Number has forged a strong positive connection between proven quality sleep and overall wellness. The current environment has heightened individuals' concerns about their immunity and emotional and mental resilience. It is more important than ever for society to benefit from the proven quality sleep that our life-changing 360 smart beds provide. Near-term, we plan to advance our exclusive 360 smart bed software features to provide all of our SleepIQ customers with personalized wellness reporting, circadian rhythm and heart rate variability insights delivering a deeper understanding of the link between sleep and overall health and wellness.

We also moved our new 360 smart bed launch from second to third quarter, when in-store operations and media spend are expected to be recovering from current low levels. Though we were prepared to launch in April, our business model responsiveness is allowing us to postpone introduction without adverse impact to inventory, marketing or training. We expect this kind of agility combined with our mission-driven culture to enable us to quickly rescale our store, manufacturing and logistics operations. We are excited for the launch of this new line to be an important part of our rebound.

Given the uncertainty around the impact and duration of COVID-19, we withdrew our 2020 guidance. We expect the existing government-mandated closures to continue to place meaningful pressure on sales through May and to a lesser extent, into June, followed by a gradual recovery in the back half of the year. As we have more clarity, we will continue to share updates on our outlook. We are doing everything in our power, financially, strategically and operationally to effectively navigate through this crisis, continue to keep our team and customers safe and help our communities achieve higher quality sleep. We are extremely grateful to our valued partners and suppliers for their support, which has been instrumental in ensuring our business continuity. Consumer demand for our life-changing 360 smart beds was exceptional going into the pandemic, and we expect it to be exceptional after this crisis. Our digital traffic remains at double-digit increases over the prior year. Our brand metrics remain at all-time high, and we will use this dislocation to accelerate our mission and strategic opportunity around health and wellness.

Now David will provide additional financial details on our first quarter and our actions to navigate in this challenging environment.

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [4]

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Thank you, Shelly. I'd like to add my best wishes for the health and safety of your loved ones through this unprecedented challenge. The depth of this crisis and the duration of the recovery are unknowable. That makes business planning and financial forecasting in this environment, extremely complex. We've pressure tested our liquidity forecast with a variety of inputs including some severe what-if scenarios. One example was to model our liquidity if sales were just 20% of the prior year for the balance of 2020. That model indicated our current liquidity would take us deep into the fourth quarter.

Now an 80% sales decline is not realistic since it's materially worse than our actual experience. However, it does illustrate the sufficiency of our liquidity and the variety of inputs we've considered to effectively manage the business in a highly uncertain environment. While we are not providing guidance today, we are sharing 1 set of possible outcomes we used to inform our cost and capital deployment decisions.

With nearly all states under some form of say at home order, we expect the most COVID-19 impact on consumers and businesses here in the second quarter. Therefore, we modeled Q2 sales at about half of the prior year. Also remember that Q2 is our seasonally low sales and cash generation quarter. While no one knows what government mandates may still be in effect, we assume consumer confidence and business conditions will improve through the back half of the year. One of our models assumes a Q3 sales decline versus the prior year of about half the Q2 decline. Then with the benefit of the extra week, we modeled Q4 sales to be about flat with the prior year. Based on these quarterly models and our cost and capital deployment cuts, our net debt would peak at the end of Q2, with a leverage ratio still below our 4.5x EBITDA covenant. They also indicate free cash consumption of more than $50 million in the first half this year and generation of more than $50 million in the back half. What's important to understand is that we are actively managing all the levers in our control to balance near-term financial risks with our commitment to sustain our advantaged strategy.

Our orientation for long-term performance embraces an approach now that enables us to rebound from this challenge with pace. This bias inform the actions we've taken to date. Our priority, along with the safety of our teams and customers is capital preservation. The meaningful and abrupt decline in daily sales in mid-March prompted the immediate suspension of our share repurchases. We also drew down the revolver and kicked off the accordion expansion process. These actions were taken out of caution rather than need as our modeling indicates, we'll repay the $75 million loan unused at the end of its 364-day term.

The realities of COVID-19 are dynamic. Each week, we learn more. The actions we've taken to date are based on the modeling I've outlined today. Our approach is to preserve maximum flexibility to rebound quickly should business conditions improve faster. Alternatively, if conditions worsen, other actions are certainly available and will be pursued as needed. Having control of our vertically integrated business model enables us to be nimble. We will continue to act with pace. Other actions across our business to preserve liquidity and profits include: real-time adjustments to our component flow to properly balance our inventory enabled by our close ongoing partnerships with suppliers; deferral or negotiated concessions from important marketing partners; rent deferrals for stores and operating locations impacted by COVID-19 mandatory closures, plus advantaged accounting treatment for those deferrals; decisions to close approximately 25 stores on month-to-month leases with high probability for sales, transfers and of the profits associated; labor and sales tax recoveries under the Cares Act; and continued evaluation of other liquidity sources, including the remaining accordion availability of $75 million and other liquidity markets, though we expect to meet our liquidity needs in 2020 from operating cash flow and existing credit facilities.

The fundamentals of our business and our balance sheet are strong as a result of years of prioritized investment and our decisive actions in recent weeks. We continue to execute for the long-term as we allocate capital. Given the current environment, we are preserving flexibility by prioritizing projects with more immediate benefits to profits. For example, our store investments generally have a 2-year payback. So we have delayed about half of the planned 2020 store actions. On the other hand, the cost-benefit assessment of our new $3.5 million assembly distribution center in Los Angeles, indicated we should proceed as planned. We expect lower total cost of operations when this ADC replaces the existing hub in early May. The business disruption from COVID-19 pandemic and our related actions to date will delay but not derail the significant value-creating prospects of our business. Our continuously improving initiatives across the business that delivered compelling value creation in 2019 did so again in the first quarter of 2020. The financial performance in the first quarter highlights the strength of the business. Our net sales of $473 million grew 11%, including 7% comp and 5 points from new stores. Units were up 10% and ARU grew 2%. Average trailing 12-month sales per store of $2.9 million grew 7%, with 32% of our stores, generating more than $3 million per store. Online and phone sales in Q1 grew 21% over the prior year. Our Q1 gross margin improved 240 basis points over the prior year's first quarter, with favorable mix and operating efficiencies more than offsetting delivery labor inflation. We also drove a 350 basis point increase in our net operating profit rate to 11% of net sales while spending to support our near- and long-term growth drivers, including a 25% year-over-year increase in our R&D spending. These investments plus approximately $3 million in net COVID-19 payroll costs were partially offset by approximately $6 million lower broad participation, cash incentive compensation.

With sales up 11% in the quarter and operating profit up 61%, our earnings per diluted share grew 70% to $1.36 while absorbing approximately $0.11 of income tax headwind year-over-year. The utility of our infrastructure drove a 37% increase in trailing 12-month cash from operations, a 19.1% ROIC and a Q1 ending leverage ratio of 2.6x EBITDAR. We ended the quarter with $239 million of cash on our balance sheet and added another $75 million through our new facility funded on April 3.

These metrics convey the health of our business ahead of COVID-19. They also provide insights of how we'll overcome the challenge ahead. Sleep Number innovations improve health and wellness while being highly attainable with a value-packed starting price of $999 for our c2 360 smart bed. We expect demand to grow significantly as we are able to reopen stores and consumer confidence improves. We also expect investors to again be rewarded over time.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from John Baugh of Stifel.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [2]

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Congrats on the great first quarter and kudos to management sharing in the economic pain. I'm going to jump right in. Could you talk, Shelly, to any states, maybe Florida, that have recently "opened" and what exactly is happening with your stores, if anything, in those states or what you anticipate near-term in states that open?

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [3]

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Sure, John. As we look at the stores that have reopened or are open, there is variation depending on the state. And it really speaks to what is transpiring locally, whether it's in a county or a state, and so you see that variation across the country. So some markets opened with significant -- I'd say, significant -- we have low transaction, low traffic with high ARU, but customers coming in-store kind of close to a regular-type environment. And then you have other states where we've reopened and the customers coming in are all based on our reach out with customers to bring them in. So it's different by state. I think it's interesting because normally, under a normal situation, our business is quite consistent across the country. We don't see big, big swings in traffic. Sometimes you have some weather impact, but it's very short term. So generally, it's pretty consistent. And we're seeing this a little different. What I really like about what we've learned and executed over these last 4 weeks is our team's ability to rise above their circumstances and utilize innovative solutions to continue to drive performance. It is so impressive, John. It speaks to our mission-driven culture and the tenacity that our team has to figure out a way. And so we're not sitting here in a situation where we're opening stores and then dependent on our marketing, driving in traffic because of our relationship-based selling model and the lead strategy that we have and the ongoing relationships with our insiders, which represent such a significant portion of our business, gives us the ability to drive performance. And I'm really, really pleased with what we've been able to accomplish over the last 4 weeks in unbelievable circumstances.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [4]

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Yes. It's unprecedented for sure. I've been -- I'm just curious how your customers that either come in from your prompting or maybe come in off the Street, what their comfort level is in laying on a bed and how you're addressing that anxiety or whether -- because your selling function included typically getting on a bed if you're a new customer and finding your Sleep Number. So I'm curious as to how you're navigating that.

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [5]

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John, we strictly follow CDC guidelines, have since the beginning on social distancing, on hygiene and sanitation. Our stores are low traffic, low occupancy, and we have -- and offer private appointments. We have many ways to work with our customers. We're, obviously, very clean and cautious and we have separate hours for elderly and vulnerable populations as needed. And from the beginning, we have kept the prioritization of keeping our team members safe and our customers and contributing to our communities and ensuring the business continuity and have consistently hourly been able to pivot and find the best way forward. So we have -- back to my earlier response, there are some markets where customers are behaving very normally. And then other markets where they are more apprehensive. And yet, with the way we conduct our business and our small store environment with the only customer in the store, it quickly mitigates any type of concern. Our team is still professional. And they have had so much experience already. So it's been going quite well.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [6]

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All right. And then my last question just is clarity maybe for David. Could you walk us through again the April comments? It was down 80%? It was down 50%? That walk us through precisely orders versus shipments, that wasn't quite clear.

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [7]

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John, you're asking for clarity around Q1 performance.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [8]

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April, the month of April. There was commentary about orders falling off 80% and 50%, and I wasn't clear on precisely how April is tracked so far.

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [9]

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Sure. Well, I'm actually going to start with Q1 because I think it just helps understand the performance intervals. So we came into Q1 with momentum into our seventh quarter of double-digit demand. And we had a sales growth of up 17% quarter-to-date through the second week of March. And then we were hit with the results of the COVID-19 pandemic, and our sales have roughly declined. And by the end of March, by March 31, we had 80% of our stores closed, and our sales were down nearly 80% at that time as well.

And every week through April, we've been able to improve. We look at, right now, our average revenue per day as well as the week and different trend lines, 3 days, 10 days, 7 days. And we've been able to steadily improve our performance with all of the different digital capabilities and new selling model that we've been able to create. And so we've had consistent improvement, and now we're looking at April of being down approximately 50%.

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Operator [10]

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Your next question is from Brad Thomas of KeyBanc Capital.

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Bradley Bingham Thomas, KeyBanc Capital Markets Inc., Research Division - Director and Equity Research Analyst [11]

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I just want to follow-up on John's last question and talk a little bit about the sales in April. You gave some details on this in the prepared remarks, Shelly, but of the sales that you converted in April, could you talk a little bit about how much of that dollar value came from maybe an Internet purchase? And how much of that came from a customer that didn't even go into a store? I just understand -- trying to understand the strength of your business for customers that may not even go into a store and how much of that business to be retained if the consumer wants to stay away from stores for some time.

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [12]

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Yes. Brad, when you look at the composition of sales in April, now I'll start here. 25% came from stores that are closed. So that means Sleep professionals selling from their home, either over the phone or via chat. So no customer interaction at all. 25% was generated from stores that are open, and that's a mix of phone calls and follow-ups and customers coming into the store. And then 50% of the total sales from online, chat and phone through our more traditional channel method.

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Bradley Bingham Thomas, KeyBanc Capital Markets Inc., Research Division - Director and Equity Research Analyst [13]

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Great. That's very helpful. And so to move over to the -- maybe the cost side of the equation here, you talked about maybe a scenario model of 2Q and revenues potentially being down in the 50% range. Can you give us a sense of maybe what operating income might look like, if this is where revenues might play out for 2Q and help us think about the cost side of the equation here on the run rate on costs.

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [14]

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Yes. Brad, I'm not going to provide guidance. We've pulled our guidance for a reason. This is a very unusual circumstance that we're all working our way through and trying to predict what will happen and when is a bit futile. Now what we've provided you is some of the modeling that we've used to help us make decisions. We certainly need to make decisions in this environment. We've done that. However, you can bet that we are going to be working hard to deliver the best possible results that we can, and we'll continue to update you and the rest of the group as we progress through the year.

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Operator [15]

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Your next question is from Bobby Griffin of Raymond James.

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Robert Kenneth Griffin, Raymond James & Associates, Inc., Research Division - Senior Research Associate [16]

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I congratulate you on a great first quarter. The first question I want to talk about, Dave, is maybe on -- or David, sorry. On the way back up in the recovery, can you talk about what you're kind of looking forward to open up stores? Is it a market-by-market basis, store by store, if some demand comes back slower than others, do you have the ability to keep some stores dark while that demand is not quite ready yet in that market?

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [17]

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Yes. Bobby, we follow our local and national government mandates for reopening stores. So that is our approach following CDC guidelines and the government mandates. And we are reopening as such. We have, with our unique selling model and process as a vertically integrated company, we're able to generate business. And we've demonstrated that in every single situation to date. So I'll give you the example of last week. We reopened 44 stores last week. And these 44 stores were in a variety of different states with different community environments. And each and every store was able to generate a decent demand for their business. Now it came in different ways. Some markets had traffic, some did not. And this is where we're able to utilize and really focus on our insiders right now, our brand advocates as well as the significant digital traffic we have to be able to build that relationship and convert sales.

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Robert Kenneth Griffin, Raymond James & Associates, Inc., Research Division - Senior Research Associate [18]

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Okay. That's helpful, and I appreciate that example. Secondly, can you talk about from the consumer financing side of your business, the Synchrony financing program is an important program, has been very successful, completely different type of slowdown than the last recession. But what exactly are you hearing from them in terms of consumer credit availability? Or what are you seeing in terms of consumer credit availability within your program?

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [19]

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Well, Bobby, counterparty risk is certainly something that we keep very close to as well and have been tightly connected with Synchrony and their management team. We connect with them on a regular basis. And their business is very different, obviously, from the last recession. Back in '08, '09, they were part of a bigger company that was cash-constrained versus today they are highly cash capitalized. And so they have significant deposits on accounts and their balance sheet is very strong. So they have continued to reiterate to me that they're in it with us. They love our customer base. We tend to skew a little higher income and a little bit older, and they love our customer base. And their only business is -- as a publicly traded company as well is generating business through their credit operations. And so they're in it with us, and they've committed that that's going to continue.

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Operator [20]

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Your next question is from Peter Keith of Piper Sandler.

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Peter Jacob Keith, Piper Sandler & Co., Research Division - Director & Senior Research Analyst [21]

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Really nice Q1, guys that well, shaped out to be quite a strong quarter. It still finished quite strong. I'd even say expectations were down 50% in April, much better than we were expecting. Shelly, I wanted to ask you just about the advertising and how you're approaching that in terms of pulling back on the advertising spend? And is there any delay effect where maybe the heavy advertising of March is helping April but pull back in April, could impact May or June. How do you think about that kind of a ripple effect over a couple of weeks or a couple of months?

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [22]

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Yes. Thank you, Peter. We responded immediately in March right away when we saw the decline in sales. So that takes us back to the middle of March. And so could we have some hangover here in April from the customer having the awareness possibly. But at the same time, we're not completely dark. I mean, we certainly pulled back significantly on our media spend and thinking about it more on the same level as our sales increase. So it's a good way for you to consider how deep we've cut. At the same time, we continue to see double-digit digital traffic, which we're very encouraged by along with our -- net over the prior year, along with incredible satisfaction in brand metrics, and it does speak to the extraordinary demand we've been seeing. We just lapped our sixth quarter here of double-digit growth. So this is the third quarter of lapping double-digit sales growth from the prior year in the first quarter. So it speaks to the strength in the demand of the 360 smart beds.

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Peter Jacob Keith, Piper Sandler & Co., Research Division - Director & Senior Research Analyst [23]

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Okay. I also just wanted to understand maybe the mix of sales and attach rate with adjustable bases. It sounded like your orders are kind of running down 50%, and you would expect sales in April to be right down 50%. So maybe really no change to the mix. But could you confirm that for us just in terms of ARU and attach rate?

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [24]

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Yes. We're -- we have a mix change, definitely. When you look at the composition of our sales was 50% coming from online, phone and chat. It's very different than our normal composition. And our selling process in in-store experience has superior ARU, as you know. And that speaks highly to the experience in the store, but also that interaction with our team members. So there will be change in mix. And what's -- a big advantage of our strategy, Peter, is the fact that we can drive growth from both ARU and units. And ideally, we're always driving it from both. We certainly do on an annual basis. And you can see in a quarter like Q1, we have growth in both in the quarter, it's quite explosive. And we're really pleased with our 64% gross margin in Q1 as well. During this time, and certainly during April, you're going to see fluctuation in ARU in our mix, and it's going to impact margin as well. And we're probably not going to be attaching at the same rate as we were before. And at the same time, we'll probably mix down because of the online sales. I think it's important to remember that these are short term. This is in the short term. There's going to be the fluctuation. The great thing is that we can still drive performance from both. And we're going to be trying lots of different tactics. We quickly pivoted and changed our strategy for April to drive sales, to focus more on insiders where we don't have to spend the level of marketing, and we're really pleased with what we've been able to do with our advantaged model and competitive advantages.

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Peter Jacob Keith, Piper Sandler & Co., Research Division - Director & Senior Research Analyst [25]

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Okay. That's great. Certainly, I think down 50% is much better than we would have expected at this point. And lastly for me is just on the deliveries, because people have to have sleep number or agents come into their home to assemble the beds, has there been any pushback on that, maybe customers are hesitant or delaying some of the shipments? Just kind of understanding how that could carry forward in the coming months.

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [26]

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Peter, we've been able to continue to deliver in about 80% of the market. At one point, this was down to around 75%, and now it's 80%. Clearly, follow the CDC guidelines and all the sanitary, precautionary approaches here. People -- at the same time, people want their bed. They may be in a situation where they don't have a bed or in many situations, people are recognizing the importance of their sleep right now for their overall health and wellness, and they want this bed that delivers proven quality sleep. In addition, we also added a capability of rescheduling online. And so that gives customers the ability, especially with marketplace changes to be able to create a reschedule, and that's very efficient and effective for both the customer and for us.

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Operator [27]

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Your next question is from Atul Maheswari of UBS.

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Atul Maheswari, UBS Investment Bank, Research Division - Associate [28]

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So when you did the stress test on sales being down 80% for the full year, what fixed cost did you assume in that analysis? There's obviously rent for your stores and for your manufacturing or distribution facilities. And then you have the corporate center cost. So what other fixed costs did you assume? And are you able to size or quantify these costs for us in any way?

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [29]

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Well, at our level, all of our costs are variable and are just about -- and so we are -- in that model, it's a very unusual one to model out because it's -- that's not a normal business operating situation, obviously. So it required significant reductions in our cost structure across the business. However, the intent was to be relatively conservative in our assumptions so that we could see what the -- how we would flatten our liquidity burn in a way that would support the business as long as possible. So it's just one of the many scenarios that we ran. I provided that as an illustration. I wouldn't suggest that you use it in your modeling of how we -- what we expect from the business this year. But nonetheless. The cash commentary I talked about, regarding our free cash usage in the first half versus the free cash generation in the back half, are more illustrative of what we're directionally talking about is a reason -- more reasonable set of parameters for the -- for what we're seeing so far.

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Atul Maheswari, UBS Investment Bank, Research Division - Associate [30]

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Understood. That's very helpful. And just as my follow-up, in the past, what percentage of your sales involve delivery and assembly of products at customers' homes? And then along those lines on your contactless delivery initiative, can you just provide a little bit more color on how you're going about it? And so for example, are you providing some sort of an online tutorial to your shoppers so that they can assemble the beds themselves? Just any color here would be very helpful.

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Shelly R. Ibach, Sleep Number Corporation - CEO, President & Executive Director [31]

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With our smart beds, all of our beds are home delivered. And that's a change that transpired when we moved to all smart beds, 7 quarters ago. Regarding the contactless delivery, we're in early stages of it. We've just been testing it here in the last couple of weeks, but it's essentially assembling the bed for the customer and delivering it complete in their garage or adjacent. So no, we do not have, here's how you assemble it online. It is a specific -- it is a specific response to a customer who wants this type of delivery. It's very small in the percentage, but importantly, we have a

solution.

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Operator [32]

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Your next question is from Curtis Nagle of Bank of America.

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Curtis Smyser Nagle, BofA Merrill Lynch, Research Division - VP [33]

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Great. First one, I just wanted a quick follow-up on the question on Synchrony. Are you guys seeing at this point, any tightening in terms of the standards or the credit standards that they're putting through? Or do you have an expectation that, that could occur? And if you could remind us, what percent of sales credit accounts for?

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [34]

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Sure. We have not seen any tightening at all. And I don't really expect that to happen in the near term. Obviously, credit conditions for some of their customers may be different than what they're seeing with our portfolio. But they've been an exceptional partner for us, engaged with us and being creative about how to do business in this environment. And we very much appreciate that partnership. About half of our business in 2019 was financed.

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Curtis Smyser Nagle, BofA Merrill Lynch, Research Division - VP [35]

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Great. And then just a quick one in terms of, I guess, just order and cost flow. I'm just curious if the demand falls, you guys started to see in the second half of March shift to P&L in March or perhaps it didn't until 2Q, given that there's a lag between orders and when deliveries occur.

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [36]

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Curtis, I'm a little -- I don't know if I heard that quite clearly. Are you asking about cost from a COVID-19?

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Curtis Smyser Nagle, BofA Merrill Lynch, Research Division - VP [37]

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Yes. So for -- yes. So the question I'm asking is, I mean, basically, a revenue cost recognition problem, so not -- problem question. So the question is, you saw a big falloff in demand in orders in the back part of March, at least the second half, did that all flow through in March? Or did it spill over into the second quarter just because of there being a lag between those orders and when the deliveries actually occur and when costs will be recognized.

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [38]

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Right. Shelly highlighted that both 2Q through the second week, we had really strong demand. In the last 3 weeks of the quarter demand was affected as were deliveries. The close she highlighted as well that at one point, a portion of our delivery capability was shut down as well of about 1/4 of the country. And so there was some impact in Q1 on our deliveries and our demand capabilities in total demand within the quarter.

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Operator [39]

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Your last question is from Seth Basham of Wedbush.

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Seth Mckain Basham, Wedbush Securities Inc., Research Division - MD Of Equity Research [40]

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My first question is just a clarifying question to the last one. Just thinking about the timing of the impact on the P&L from the slowdown in activity at the end of the quarter. Given that lag between the time that you take orders and you actually deliver them, I would presume that most of the P&L impact, both on top and bottom lines from that slowdown didn't occur in the first quarter, it occurred in the second quarter. Is that correct?

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [41]

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Well, a couple of things you can point to is, look, our demand, as Shelly highlighted, was up 17% quarter-to-date through March, second week in March. And we posted net sales growth of 11%. So there was certainly some impact on our total sales recognition in the quarter, in the first quarter. Certainly, would have been much stronger, if not for COVID-19 if that's what you're looking for. In terms of costs, clearly, we had cost impacts in the quarter as well. We didn't have the efficiencies of our operations. Those last 3 weeks as well. Our factories weren't as busy, things of that nature. So we absorbed quite a bit of cost pressure those last 3 weeks.

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Seth Mckain Basham, Wedbush Securities Inc., Research Division - MD Of Equity Research [42]

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Got you. And second point of clarification is just on the April commentary of negative 50% sales rate. Is that a current run rate? Or is that a month-to-date figure?

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [43]

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That was month-to-date.

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Seth Mckain Basham, Wedbush Securities Inc., Research Division - MD Of Equity Research [44]

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Month-to-date. Okay. And so presumably, it was worse than that beginning of April and it's improved better in that at this point in time.

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [45]

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Yes. And as Shelly said, it was even worse the last couple of weeks in April -- or I mean in March and then proceeded to get consecutively better each week this month.

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Seth Mckain Basham, Wedbush Securities Inc., Research Division - MD Of Equity Research [46]

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Got it. And then the last question I had is thinking about the scenario analysis that you laid out with cash generation of $50 million in the second half based on your sales assumptions, et cetera, there's obviously some cost assumptions involved in that scenario. And I understand that you're not going to provide any insight into exactly what you're thinking from a cost management standpoint. But just more broadly, how are you thinking about your labor management as demand ramps back up? How are you going to bring back labor relative to your sales? Can you manage that pretty fluidly?

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [47]

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Yes. I think the evidence is in the decisiveness we've already demonstrated, Seth. I think having 70% of our teams on either furlough or reduced hours and then labor cost reduction initiatives on a lot of other fronts as well across the entire company. And we've taken about 1/4 of our costs out of our operating expenses from what we planned, the balance that last 9 months of the year. And we believe that we'll be cautious on bringing labor back. We obviously want to see demand come before we start to accelerate our labor, but they do go hand in hand in some cases, and we'll manage that very closely.

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Seth Mckain Basham, Wedbush Securities Inc., Research Division - MD Of Equity Research [48]

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And related to that, when you think about the risk of losing employees that you have on furlough? Is that contemplating your plans? Is that a real risk?

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [49]

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Well, certainly, we are -- it's a real -- we think of our team members as family. And so the pain that we incurred when we had to make that -- those decisions is challenging, but this is necessary for the overall health of the total business. And then certainly, all of the actions that we're taking to drive strong performance faster so that we can bring people back sooner. Certainly, that's top of mind for everybody.

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Seth Mckain Basham, Wedbush Securities Inc., Research Division - MD Of Equity Research [50]

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Okay. And last question is just on labor. In terms of when you're operating a store, what's the minimum labor requirement to operate that store on a daily basis?

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David R. Callen, Sleep Number Corporation - CFO & Senior VP [51]

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Well, it depends because we've actually gone to a modified hour structure, so it's less than it once was. And so we're able to staff our stores with a couple of people where, in the past, it was a minimal look like 3 across the country.

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Operator [52]

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There are no further questions at this time. I will turn the call over to the company for closing remarks.

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David W. Schwantes, Sleep Number Corporation - VP of Finance, IR & Decision Support [53]

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

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Operator [54]

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This concludes today's conference call. Thank you for your participation. You may now disconnect.