SLEEP-NUMBER Earningcall Transcript Of Q2 of 2024
Shelly Radue Ibach -- Chairman, President, and Chief Executive Officer Good afternoon, everyone, and thank you for joining us. My SleepIQ score was 86 last night. In October of last year, we communicated plans to transform our operating model to improve financial resilience and profitability in a range of economic environments. These transformative initiatives, coupled with the industry-leading innovation we continue to bring to market, position us to accelerate our performance and profitability as the industry recovers. Through the first half of 2024, we are slightly ahead of our expectations for both gross margin rate expansion and adjusted EBITDA despite facing a tougher sales environment than we anticipated. My comments today will highlight the actions we are taking to improve our operating margins and generate cash to pay down debt. The financial results of our actions, including the favorable impact on both near-term performance and the long-term durability of our operating model, and the ongoing intense focus we have on recalibrating our business for the difficult demand environment that the bedding industry continues to face. As a reminder, we previously communicated 2024 full-year financial targets related to restoring our margins, which included adjusted EBITDA of $125 million to $145 million, additional operating cost reductions of $40 million to $45 million, which are on top of the $85 million of reductions we delivered in 2023, and approximately 100 basis points of gross margin rate expansion. We are on track with each of these goals. Through the first six months of 2024, we reduced operating expenses $44 million versus the prior year. We drove 60 basis points of gross margin rate expansion year over year, and we generated $9 million of free cash flow as planned, a $21 million improvement from last year. Our better-than-expected adjusted EBITDA for the first half of 2024 was driven by sustainable improvements in our cost base across our operations, including reductions in material cost, efficiency improvements in our logistics and fulfillment networks, and reductions in operating expenses supported by lower store operating costs and ongoing diligent G&A expense management. We are aggressively managing four principal areas that are within our control, including cost of acquisition, cost to serve, cost of goods sold, and G&A, R&D leverage. Cost of acquisition is benefiting from greater precision in media and promotional investment, driven by expanding our AI-based models into our sales decision tools and further segmenting our media targeting to deliver more efficient demand generation. In cost to serve, we have outsourced select operational activities and further leverage third-party expertise in information technology and services. These operating model changes give us additional flexibility in supporting peak volumes in our customer contact centers and home delivery operations. In cost of goods, we have driven efficiencies in our procurement process, manufacturing, and end-to-end fulfillment by introducing new best-in-class operating practices, based on extensive assessments and cost controls. In G&A and R&D expense management, we have incorporated additional rigor to streamline our organizational design, remove inefficiencies, and increase productivity. All these initiatives are contributing to our ability to achieve our 2024 EBITDA and cash flow targets. When market growth inevitably returns to normal levels. The important business improvements we are now implementing will enable us to capitalize on our innovation leadership and accelerate our profitable growth, delivering increased value to shareholders. The mattress industry demand environment remains challenging, amid low consumer sentiment, a notable decline in home sales, and pressures on consumer purchasing power that include higher cost of living and interest rates that are reducing personal savings, tight consumer credit, and uncertainty related to geopolitical events and the upcoming U.S. election. With pinched wallets, consumers are spending more on essential items like food and clothing, while reducing or delaying purchases of discretionary durable items, such as furniture and home furnishings. Mattress industry sales for 2024 are estimated around 25 million mattress units compared to a normalized level of about 32 million units based on long-term history and per capita spending trends. Our second quarter demand performance represents a slight sequential improvement from first quarter. These results remained more pressured than we expected and were largely aligned with the reported industry trends. The scrutinizing consumer continues to concentrate their purchases during holiday promotional events like Memorial Day. As a result, we delivered both sales and unit growth in May, which was our strongest demand month since the start of the industry recession in February 2022. Based on our first-half demand performance and current industry and economic forecast for the remainder of the year, we now expect our demand in the back half of the year to be flat to down low single-digits versus our prior estimate of low single-digit growth. This outlook still represents a sequential improvement from our first-half demand performance, which was down mid-single digits. We expect this improvement to result from easier compares, especially in the third quarter, higher media investments than the first half, and other demand-driving initiatives we've implemented and honed over the last three quarters. These media and selling strategies are focused on leading with differentiated benefits of our superior innovations, including adjustable firmness and temperature, starting at a value-orientated cost of $9.99 with our c1 Smart Bed, amplifying our differentiated smart bed message, applying our models, predictive capabilities to shift investment efficiently into higher traffic driving media, activating our loyal customer base for increased referral and repeat sales through social advocacy, and driving conversion through improved sales training and execution excellence focused on our relationship-based approach. As we enter the fourth quarter, we also expect to benefit from the introduction of an exciting new smart bed called Climate Cool, which addresses a specific sleep need of customers. More than two-thirds of sleepers report sleeping too hot or experiencing temperature fluctuation during the night. The new Climate Cool smart bed that builds on our successful Climate360 smart bed technology actively cools by drawing warm air away from your body. This is very different than competitors' products to push air through warm foam or use water to cool. In fact, the Climate Cool smart bed cools over 20 times faster than competitors' products, and like our Climate360 smart bed, Climate Cool effortlessly adjusts and actively cools up to 15 degrees on each side of the bed for each sleeper's ideal firmness and sleep temperature. Additionally, the Climate Cool smart bed features scientifically proven cooling program routines, which are designed to provide deeper more comfortable sleep. Sleepers can choose from these cooling programs, or they can personalize for their needs. Sleepers will also be able to see the results in their Sleep Number app, along with other sleep health insights. Our teams accelerated the commercialization of this revolutionary innovation to the fourth quarter of this year as part of our margin improvement initiatives. In the current pressure demand environment, we are forecasting sales of Climate Cool to come primarily from positive mix shifts, which we expect to contribute 20 basis points to 30 basis points of accretion to our fourth quarter gross margin rate. The queen-size Climate Cool smart bed with integrated base will be priced at $54.99. Our extensive analytical rigor and deliberate business improvement actions are restoring margins and generating cash despite a persistently prolonged mattress industry recession. While 2024 demand remains pressured, our gross margin improvement supports our full-year adjusted EBITDA guidance range of $125 million to $145 million. In our updated Investor Relations presentation available on our website, we illustrate the significant upside we expect for Sleep Number's business as the mattress category recovers. Industry units have contracted to 2016 unit levels and are currently around 6 million to 7 million units below expected consumption levels. With the actions we've taken in assuming the industry returns to normalized demand levels of nearly 32 million units, we would expect to realize more than $500 million of incremental net sales and about $175 million of incremental adjusted EBITDA, compared to current performance levels. In a more normalized mattress industry environment, the actions we have taken to transform our operating model position us to achieve adjusted EBITDA margins in the mid-teens and free cash flow of more than $200 million annually. I want to express my deepest appreciation to our Sleep Number team for your tenacity and ingenuity in navigating this challenging environment and for your shared belief in our purpose. Your commitment and strong execution of our operating model transformation has resulted in sustainable cost and gross margin improvement. Now, Francis will provide additional details about our performance and outlook for the year. Francis Lee -- Chief Financial Officer Thank you, Shelly, and good afternoon, everyone. Our team continues to drive efficiencies throughout the business as we build greater durability and financial resilience into our operating model. These intensive efforts have led to both operating expenses and gross margin rate performance coming in better than expected for the quarter. We also drove improved cash flow for the first half of the year with free cash flow of $9 million, $21 million higher than prior year's first half, even with pressure from the year-over-year net sales decline. Now, let's turn to a review of our second quarter results. Second-quarter net sales of $408 million were down 11% versus last year and were a couple of points below our expectations. Our net sales growth for the quarter included a mid-single-digit demand decline and six points of headwind from year-over-year backlog changes. Our delivered units decreased 8% for the quarter with our ARU down 3% versus the prior year. We remain intently focused on restoring our gross margin rate to higher levels as evidenced by the 59.1% gross margin rate delivered in the second quarter. This was up 150 basis points versus the prior year's second quarter and ahead of our expectations. Some of the specific drivers of our year-over-year improvement for the second quarter included cost of goods sold reductions through product redesign, including reducing the number of parts for selected components, ongoing supplier negotiations for all material components. For example, we redistributed our foam business across our partners, resulting in product cost reductions. Year-over-year cost efficiencies in our home delivery and logistics operations, including implementing a flexible labor model in our home delivery operations with the use of more external delivery partners providing cost savings and increased flexibility for peak volume periods. We have also leveraged fixed assets such as our home delivery trucks as freight shuttles during low volume periods, yielding net lower logistics costs. In addition, we switched our primary parcel provider resulting in significant cost savings. The progress we have made in the first half of the year positions us well for a gross margin rate approaching 60% for the back half of this year. We also made meaningful progress in reducing our operating costs, which were down $19 million versus the prior year's second quarter before restructuring costs, and down $44 million year to date. Cost reductions have been broad-based, including a year-over-year reduction in media, lower selling expenses as we benefit from a net store count reduction, and reduced R&D spending. We have achieved these cost reductions through systematic scrutiny and reset of our cost base across our entire operations with active cross-functional engagement throughout the company and external benchmarking. Here are some specific examples of the transformation initiatives we have taken. We expanded our self-service customer content saving over $5 million annually. We also rationalized technology tools used across the business to reduce total vendors and deliver $1 million of annual savings. Our R&D teams have further streamlined their costs while also supporting gross margin rate improvement initiatives. We anticipate operating expenses for the back half of the year to be in line with the prior year's second half as we lap significant cost reductions in the back half of last year and increase our funding of media. We generated $28 million of adjusted EBITDA in the quarter, compared with $35 million last year, with the year-over-year decrease due to the decline in net sales, partially offset by a higher gross margin rate and $19 million of operating expense reductions. Our second-quarter adjusted EBITDA was slightly ahead of our expectations despite net sales being a couple of points below plan. We continue to focus on maximizing adjusted EBITDA and cash generation as demand for our category continues to bounce around bottoming levels. For the full year, we now expect free cash flow of $50 million to $70 million, which we intend to use to pay down our credit line. This is a $10 million decrease than our prior expectations, primarily due to our reduced sales guidance, which negatively impacts our working capital expectations for the year. Our updated outlook implies $40 million to $60 million of free cash flow for the second half with an expectation of higher net income in the back half of the year, as well as expected benefit from working capital changes coming off of seasonally low levels at the end of Q2. Turning to our 2024 outlook. 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 our expectations for the remainder of the year, including some specific color about third quarter. We expect net sales to be down mid-single digits for the year. For the back half of the year, we expect both demand and net sales to be flat to down low single digits versus the prior year, as we lap easier comparisons and benefit from demand-driving initiatives. Our full-year net sales guidance continues to assume three percentage points of headwind from year-over-year backlog changes and one percentage point of headwind from lower average store count. We expect at least 100 basis points of gross margin rate expansion in 2024 with the gross margin rate expected to approach 60% for the back half of the year. We expect $14 million of restructuring costs for the year with less than $2 million expected for the balance of the year. We continue to expect capital expenditures of approximately $30 million for the year, down nearly 50% from the prior year. Turning to third quarter performance. We are expecting net sales to be down low to mid-single digits versus the prior year's third quarter with demand flat to down low single digits and with three to four points of headwind from year-over-year backlog changes. We expect third-quarter adjusted EBITDA to be $25 million to $30 million. We also want to provide an update on how we are performing against our bank covenants. Our debt-to-EBITDAR ratio was 4.4 times at the end of the second quarter, compared to our covenant maximum of 5.5 times for the quarter. We continue to expect our debt-to-EBITDAR leverage to improve the balance of the year and end the year below 3.75 times. This includes a meaningful improvement in our trailing 12-month adjusted EBITDA, as we benefit from year-over-year improvement in our gross margin rate. As we look forward, here is some context on how to think about our covenants in 2025. Starting in Q1 of next year, our covenant maximum will be 4.0 times, and we expect to be below 3.75 times entering the year. For illustrative purposes, with the changes to our cost structure and gross margin rate advancements, we would expect to remain within our leverage covenants through 2025, even if there were no material improvement in the current recessionary demand environment for our category. Based on our current cost structure, we would require minimum net sales of approximately $1.8 billion to stay below our 4.0 times covenant maximum in 2025. While the demand environment has remained soft, we continue to drive operating efficiencies in both cost of goods sold and operating expenses to maintain our full-year adjusted EBITDA guidance. We continue to maintain maximum flexibility and optionality to navigate alternative demand environments. I want to thank the entire Sleep Number team who are transforming the business and positioning us to achieve profitable growth when the demand environment improves. With that, operator, please open the line for questions. Operator Questions & Answers: |
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