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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 28, 2019

OR

☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 000-25121

SLEEP NUMBER CORPORATION

(Exact name of registrant as specified in its charter)

Minnesota |  | 41-1597886
(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)

1001 Third Avenue South |  |
Minneapolis, Minnesota |  | 55404
(Address of principal executive offices) |  | (Zip Code)

Registrant’s telephone number, including area code: (763) 551-7000

Securities registered pursuant to Section 12(b) of the Act:

Title of each class |  | Trading Symbol(s) |  | Name of each exchange on which registered
Common Stock, par value $0.01 per share |  | SNBR |  | Nasdaq Global Select Market

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ NO ☐

Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). Yes ☒ NO ☐

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer | ☒ |  | Accelerated filer | ☐
Non-accelerated filer | ☐ |  | Smaller reporting company | ☐
|  |  | Emerging growth company | ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ☐ NO ☒

As of September 28, 2019, 28,427,000 shares of the Registrant’s Common Stock were outstanding.

SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

INDEX

| Page
PART I: FINANCIAL INFORMATION | 1
Item 1. | Financial Statements (unaudited) | 1
| Condensed Consolidated Balance Sheets | 1
| Condensed Consolidated Statements of Operations | 2
| Condensed Consolidated Statements of Shareholders' (Deficit) Equity | 3
| Condensed Consolidated Statements of Cash Flows | 4
| Notes to Condensed Consolidated Financial Statements | 5
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 12
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 21
Item 4. | Controls and Procedures | 21
PART II: OTHER INFORMATION | 22
Item 1. | Legal Proceedings | 22
Item 1A. | Risk Factors | 22
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 23
Item 3. | Defaults Upon Senior Securities | 23
Item 4. | Mine Safety Disclosures | 23
Item 5. | Other Information | 23
Item 6. | Exhibits | 24
SIGNATURES | 25

i

PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(unaudited - in thousands, except per share amounts)

|  | September 28, 2019 |  |  | December 29, 2018 |
Assets |  |  |  |  |  |  |  |
Current assets: |  |  |  |  |  |  |  |
Cash and cash equivalents |  | $ | 1,545 |  |  | $ | 1,612 |
Accounts receivable, net of allowance for doubtful accounts of $753 and $699, respectively |  |  | 25,541 |  |  |  | 24,795 |
Inventories |  |  | 86,508 |  |  |  | 84,882 |
Prepaid expenses |  |  | 10,997 |  |  |  | 8,009 |
Other current assets |  |  | 35,002 |  |  |  | 31,559 |
Total current assets |  |  | 159,593 |  |  |  | 150,857 |
Non-current assets: |  |  |  |  |  |  |  |
Property and equipment, net |  |  | 201,755 |  |  |  | 205,631 |
Operating lease right-of-use assets |  |  | 321,048 |  |  |  | — |
Goodwill and intangible assets, net |  |  | 73,772 |  |  |  | 75,407 |
Other non-current assets |  |  | 46,154 |  |  |  | 38,243 |
Total assets |  | $ | 802,322 |  |  | $ | 470,138 |
Liabilities and Shareholders’ Deficit |  |  |  |  |  |  |  |
Current liabilities: |  |  |  |  |  |  |  |
Borrowings under revolving credit facility |  | $ | 213,700 |  |  | $ | 199,600 |
Accounts payable |  |  | 151,357 |  |  |  | 144,781 |
Customer prepayments |  |  | 39,824 |  |  |  | 27,066 |
Accrued sales returns |  |  | 23,833 |  |  |  | 19,907 |
Compensation and benefits |  |  | 39,383 |  |  |  | 27,700 |
Taxes and withholding |  |  | 24,699 |  |  |  | 18,380 |
Operating lease liabilities |  |  | 57,912 |  |  |  | — |
Other current liabilities |  |  | 52,361 |  |  |  | 51,234 |
Total current liabilities |  |  | 603,069 |  |  |  | 488,668 |
Non-current liabilities: |  |  |  |  |  |  |  |
Deferred income taxes |  |  | 3,927 |  |  |  | 4,822 |
Operating lease liabilities |  |  | 293,333 |  |  |  | — |
Other non-current liabilities |  |  | 66,480 |  |  |  | 86,198 |
Total liabilities |  |  | 966,809 |  |  |  | 579,688 |
Shareholders’ deficit: |  |  |  |  |  |  |  |
Undesignated preferred stock; 5,000 shares authorized, no shares issued and outstanding |  |  | — |  |  |  | — |
Common stock, $0.01 par value; 142,500 shares authorized, 28,427 and 30,868 shares issued and outstanding, respectively |  |  | 284 |  |  |  | 309 |
Additional paid-in capital |  |  | — |  |  |  | — |
Accumulated deficit |  |  | (164,771 | ) |  |  | (109,859 | )
Total shareholders’ deficit |  |  | (164,487 | ) |  |  | (109,550 | )
Total liabilities and shareholders’ deficit |  | $ | 802,322 |  |  | $ | 470,138 |

See accompanying notes to condensed consolidated financial statements.

1

SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

(unaudited - in thousands, except per share amounts)

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Net sales |  | $ | 474,778 |  |  | $ | 414,779 |  |  | $ | 1,257,186 |  |  | $ | 1,119,750 |
Cost of sales |  |  | 178,388 |  |  |  | 164,262 |  |  |  | 481,377 |  |  |  | 442,868 |
Gross profit |  |  | 296,390 |  |  |  | 250,517 |  |  |  | 775,809 |  |  |  | 676,882 |
Operating expenses: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Sales and marketing |  |  | 213,133 |  |  |  | 188,458 |  |  |  | 568,799 |  |  |  | 511,481 |
General and administrative |  |  | 35,098 |  |  |  | 29,385 |  |  |  | 102,466 |  |  |  | 89,947 |
Research and development |  |  | 9,007 |  |  |  | 7,353 |  |  |  | 25,440 |  |  |  | 21,146 |
Total operating expenses |  |  | 257,238 |  |  |  | 225,196 |  |  |  | 696,705 |  |  |  | 622,574 |
Operating income |  |  | 39,152 |  |  |  | 25,321 |  |  |  | 79,104 |  |  |  | 54,308 |
Interest expense, net |  |  | 3,131 |  |  |  | 1,836 |  |  |  | 8,968 |  |  |  | 3,814 |
Income before income taxes |  |  | 36,021 |  |  |  | 23,485 |  |  |  | 70,136 |  |  |  | 50,494 |
Income tax expense |  |  | 7,967 |  |  |  | 5,228 |  |  |  | 12,384 |  |  |  | 7,945 |
Net income |  | $ | 28,054 |  |  | $ | 18,257 |  |  | $ | 57,752 |  |  | $ | 42,549 |
Basic net income per share: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Net income per share – basic |  | $ | 0.96 |  |  | $ | 0.53 |  |  | $ | 1.93 |  |  | $ | 1.18 |
Weighted-average shares – basic |  |  | 29,085 |  |  |  | 34,231 |  |  |  | 29,859 |  |  |  | 36,204 |
Diluted net income per share: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Net income per share – diluted |  | $ | 0.94 |  |  | $ | 0.52 |  |  | $ | 1.88 |  |  | $ | 1.15 |
Weighted-average shares – diluted |  |  | 29,796 |  |  |  | 35,039 |  |  |  | 30,688 |  |  |  | 37,077 |

See accompanying notes to condensed consolidated financial statements.

2

SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Condensed Consolidated Statements of Shareholders’ (Deficit) Equity

(unaudited - in thousands)

|  | Common Stock |  |  | Additional Paid-in |  |  | Accumulated |  |  |  |  |
|  | Shares |  |  | Amount |  |  | Capital |  |  | Deficit |  |  | Total |
Balance at December 29, 2018 |  |  | 30,868 |  |  | $ | 309 |  |  | $ | — |  |  | $ | (109,859 | ) |  | $ | (109,550 | )
Net income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 25,418 |  |  |  | 25,418 |
Exercise of common stock options |  |  | 151 |  |  |  | 2 |  |  |  | 2,834 |  |  |  | — |  |  |  | 2,836 |
Stock-based compensation |  |  | 364 |  |  |  | 3 |  |  |  | 3,635 |  |  |  | — |  |  |  | 3,638 |
Repurchases of common stock |  |  | (1,170 | ) |  |  | (12 | ) |  |  | (6,469 | ) |  |  | (40,501 | ) |  |  | (46,982 | )
Balance at March 30, 2019 |  |  | 30,213 |  |  | $ | 302 |  |  | $ | — |  |  | $ | (124,942 | ) |  | $ | (124,640 | )
Net income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 4,280 |  |  |  | 4,280 |
Exercise of common stock options |  |  | 115 |  |  |  | 1 |  |  |  | 2,158 |  |  |  | — |  |  |  | 2,159 |
Stock-based compensation |  |  | 99 |  |  |  | 1 |  |  |  | 4,249 |  |  |  | — |  |  |  | 4,250 |
Repurchases of common stock |  |  | (1,104 | ) |  |  | (11 | ) |  |  | (6,407 | ) |  |  | (36,933 | ) |  |  | (43,351 | )
Balance at June 29, 2019 |  |  | 29,323 |  |  | $ | 293 |  |  | $ | — |  |  | $ | (157,595 | ) |  | $ | (157,302 | )
Net income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 28,054 |  |  |  | 28,054 |
Exercise of common stock options |  |  | 33 |  |  |  | — |  |  |  | 757 |  |  |  | — |  |  |  | 757 |
Stock-based compensation |  |  | 10 |  |  |  | — |  |  |  | 4,146 |  |  |  | — |  |  |  | 4,146 |
Repurchases of common stock |  |  | (939 | ) |  |  | (9 | ) |  |  | (4,903 | ) |  |  | (35,230 | ) |  |  | (40,142 | )
Balance at September 28, 2019 |  |  | 28,427 |  |  | $ | 284 |  |  | $ | — |  |  | $ | (164,771 | ) |  | $ | (164,487 | )

|  | Common Stock |  |  | Additional Paid-in |  |  | Retained Earnings (Accumulated |  |  |  |  |
|  | Shares |  |  | Amount |  |  | Capital |  |  | Deficit) |  |  | Total |
Balance at December 30, 2017 |  |  | 38,813 |  |  | $ | 388 |  |  | $ | — |  |  | $ | 88,768 |  |  | $ | 89,156 |
Net income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 20,548 |  |  |  | 20,548 |
Exercise of common stock options |  |  | 68 |  |  |  | 1 |  |  |  | 856 |  |  |  | — |  |  |  | 857 |
Stock-based compensation |  |  | 211 |  |  |  | 2 |  |  |  | 3,082 |  |  |  | — |  |  |  | 3,084 |
Repurchases of common stock |  |  | (2,149 | ) |  |  | (22 | ) |  |  | (3,938 | ) |  |  | (73,688 | ) |  |  | (77,648 | )
Balance at March 31, 2018 |  |  | 36,943 |  |  | $ | 369 |  |  | $ | — |  |  | $ | 35,628 |  |  | $ | 35,997 |
Net income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 3,744 |  |  |  | 3,744 |
Exercise of common stock options |  |  | 56 |  |  |  | — |  |  |  | 739 |  |  |  | — |  |  |  | 739 |
Stock-based compensation |  |  | 43 |  |  |  | 1 |  |  |  | 3,657 |  |  |  | — |  |  |  | 3,658 |
Repurchases of common stock |  |  | (2,149 | ) |  |  | (21 | ) |  |  | (4,396 | ) |  |  | (60,875 | ) |  |  | (65,292 | )
Balance at June 30, 2018 |  |  | 34,893 |  |  | $ | 349 |  |  | $ | — |  |  | $ | (21,503 | ) |  | $ | (21,154 | )
Net income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 18,257 |  |  |  | 18,257 |
Exercise of common stock options |  |  | 33 |  |  |  | — |  |  |  | 488 |  |  |  | — |  |  |  | 488 |
Stock-based compensation |  |  | 7 |  |  |  | — |  |  |  | 3,356 |  |  |  | — |  |  |  | 3,356 |
Repurchases of common stock |  |  | (1,717 | ) |  |  | (17 | ) |  |  | (3,844 | ) |  |  | (51,438 | ) |  |  | (55,299 | )
Balance at September 29, 2018 |  |  | 33,216 |  |  | $ | 332 |  |  | $ | — |  |  | $ | (54,684 | ) |  | $ | (54,352 | )

See accompanying notes to condensed consolidated financial statements.

3

SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(unaudited - in thousands)

|  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |
Cash flows from operating activities: |  |  |  |  |  |  |  |
Net income |  | $ | 57,752 |  |  | $ | 42,549 |
Adjustments to reconcile net income to net cash provided by operating activities: |  |  |  |  |  |  |  |
Depreciation and amortization |  |  | 46,267 |  |  |  | 46,655 |
Stock-based compensation |  |  | 12,034 |  |  |  | 10,098 |
Net gain on disposals and impairments of assets |  |  | (409 | ) |  |  | (17 | )
Deferred income taxes |  |  | (895 | ) |  |  | 7,263 |
Changes in operating assets and liabilities: |  |  |  |  |  |  |  |
Accounts receivable |  |  | (746 | ) |  |  | (4,816 | )
Inventories |  |  | (1,626 | ) |  |  | (6,682 | )
Income taxes |  |  | 535 |  |  |  | (13,777 | )
Prepaid expenses and other assets |  |  | (8,065 | ) |  |  | 5,195 |
Accounts payable |  |  | 45,051 |  |  |  | 26,007 |
Customer prepayments |  |  | 12,758 |  |  |  | 18,351 |
Accrued compensation and benefits |  |  | 11,763 |  |  |  | (2,685 | )
Other taxes and withholding |  |  | 5,784 |  |  |  | 4,265 |
Other accruals and liabilities |  |  | 9,629 |  |  |  | 2,044 |
Net cash provided by operating activities |  |  | 189,832 |  |  |  | 134,450 |
Cash flows from investing activities: |  |  |  |  |  |  |  |
Purchases of property and equipment |  |  | (46,757 | ) |  |  | (34,012 | )
Proceeds from sales of property and equipment |  |  | 2,577 |  |  |  | 174 |
Net cash used in investing activities |  |  | (44,180 | ) |  |  | (33,838 | )
Cash flows from financing activities: |  |  |  |  |  |  |  |
Repurchases of common stock |  |  | (139,178 | ) |  |  | (198,239 | )
Net (decrease) increase in short-term borrowings |  |  | (11,270 | ) |  |  | 94,147 |
Proceeds from issuance of common stock |  |  | 5,752 |  |  |  | 2,084 |
Debt issuance costs |  |  | (1,023 | ) |  |  | (1,014 | )
Net cash used in financing activities |  |  | (145,719 | ) |  |  | (103,022 | )
Net decrease in cash and cash equivalents |  |  | (67 | ) |  |  | (2,410 | )
Cash and cash equivalents, at beginning of period |  |  | 1,612 |  |  |  | 3,651 |
Cash and cash equivalents, at end of period |  | $ | 1,545 |  |  | $ | 1,241 |

See accompanying notes to condensed consolidated financial statements.

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SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

1. Business and Summary of Significant Accounting Policies

Business & Basis of Presentation

We prepared the condensed consolidated financial statements as of and for the three and nine months ended September 28, 2019 of Sleep Number Corporation and our 100%-owned subsidiaries (Sleep Number or the Company), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and they reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly our financial position as of September 28, 2019 and December 29, 2018, and the consolidated results of operations and cash flows for the periods presented. Our historical and quarterly consolidated results of operations may not be indicative of the results that may be achieved for the full year or any future period.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with our most recent audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 29, 2018 and other recent filings with the SEC.

The preparation of condensed consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of sales, expenses and income taxes during the reporting period. Predicting future events is inherently an imprecise activity and, as such, requires the use of judgment. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates will be reflected in the consolidated financial statements in future periods. Our critical accounting policies consist of stock-based compensation, goodwill and indefinite-lived intangible assets, warranty liabilities and revenue recognition.

The condensed consolidated financial statements include the accounts of Sleep Number Corporation and our 100%-owned subsidiaries. All significant intra-entity balances and transactions have been eliminated in consolidation.

New Accounting Pronouncements

Recently Adopted Accounting Guidance

Effective December 30, 2018 (beginning of fiscal 2019), we adopted ASC Topic 842, Leases, using the modified-retrospective approach. We have chosen the effective date as the date of initial application and have applied the new guidance to all existing leases.

The new guidance establishes a right-of-use (ROU) model that requires us to recognize an ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. We have elected the following practical expedients and accounting policies related to the adoption of the new lease standard:

| • | We did not reassess our prior conclusions about lease identification, lease classification and initial direct costs;

| • | We did not elect the use of hindsight;

| • | We adopted an accounting policy for short-term leases allowing us to not recognize ROU assets and lease liabilities for leases with a term of 12 months or less; and

| • | We elected the option to not separate lease and non-lease components for all of our leases.

In accordance with the new guidance on December 30, 2018, we recorded $299 million of net operating lease ROU assets and $327 million of operating lease liabilities ($52 million recorded in current operating lease liabilities and $275 million in non-current operating lease liabilities). Deferred rent and lease incentive liabilities associated with historical operating leases totaling $28 million were reclassified to the operating lease ROU assets as required by ASC Topic 842. The adoption of the new guidance had no impact on accumulated deficit, net income or net cash provided by operating activities. At December 30, 2018, our finance ROU assets and lease liabilities were not significant.

See Note 6, Leases, for further information.

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SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

2. Fair Value Measurements

At September 28, 2019 and December 29, 2018, we had $8 million and $6 million, respectively, of debt and equity securities that fund our deferred compensation plan and are classified in other non-current assets. We also had corresponding deferred compensation plan liabilities of $8 million and $6 million at September 28, 2019 and December 29, 2018, respectively, which are included in other non-current liabilities. The majority of the debt and equity securities are Level 1 as they trade with sufficient frequency and volume to enable us to obtain pricing information on an ongoing basis. Unrealized gains/(losses) on the debt and equity securities offset those associated with the corresponding deferred compensation plan liabilities.

3. Inventories

Inventories consisted of the following (in thousands):

|  | September 28, 2019 |  |  | December 29, 2018 |
Raw materials |  | $ | 5,782 |  |  | $ | 4,549 |
Work in progress |  |  | 130 |  |  |  | 3 |
Finished goods |  |  | 80,596 |  |  |  | 80,330 |
|  | $ | 86,508 |  |  | $ | 84,882 |

4. Goodwill and Intangible Assets, Net

Goodwill and Indefinite-Lived Intangible Assets

Goodwill was $64 million at September 28, 2019 and December 29, 2018. Indefinite-lived trade name/trademarks totaled $1.4 million at September 28, 2019 and December 29, 2018.

Definite-Lived Intangible Assets

The gross carrying amount of our developed technologies was $19 million at September 28, 2019 and December 29, 2018. Accumulated amortization was $11 million and $9 million at September 28, 2019 and December 29, 2018, respectively.

Amortization expense for both the three months ended September 28, 2019 and September 29, 2018, was $0.5 million. Amortization expense for both the nine months ended September 28, 2019 and September 29, 2018 was $1.6 million.

5. Credit Agreement

Our $450 million credit facility is for general corporate purposes, to meet our seasonal working capital requirements and to repurchase our stock. The credit agreement provides the lenders with a collateral security interest in substantially all of our assets and those of our subsidiaries and requires us to comply with, among other things, a maximum leverage ratio (4.5x) and a minimum interest coverage ratio (3.0x). Under the terms of the credit agreement, we pay a variable rate of interest and a commitment fee based on our leverage ratio. The credit agreement includes an accordion feature which allows us to increase the amount of the credit facility from $450 million to $600 million, subject to lenders' approval. The credit agreement matures in February 2024. We were in compliance with all financial covenants as of September 28, 2019.

The following table summarizes our borrowings under the credit facility ($ in thousands):

|  | September 28, 2019 |  |  | December 29, 2018 |
Outstanding borrowings |  | $ | 213,700 |  |  | $ | 199,600 |
Outstanding letters of credit |  | $ | 3,497 |  |  | $ | 3,497 |
Additional borrowing capacity |  | $ | 232,803 |  |  | $ | 96,903 |
Weighted-average interest rate |  |  | 3.9 | % |  |  | 4.2 | %

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SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

6. Leases

We lease our retail, office and manufacturing space under operating leases which, in addition to the minimum lease payments, may require payment of a proportionate share of the real estate taxes and certain building operating expenses. While our local market development approach generally results in long-term participation in given markets, our retail store leases generally provide for an initial lease term of five to 10 years. Our office and manufacturing leases provide for an initial lease term of up to 15 years. In addition, our mall-based retail store leases may require payment of variable rent based on net sales in excess of certain thresholds. Certain leases may contain options to extend the term of the original lease. The exercise of lease renewal options is at our sole discretion. Lease options are included in the lease term only if exercise is reasonably certain at lease commencement. Our lease agreements do not contain any material residual value guarantees. We also lease vehicles and certain equipment under operating leases with an initial lease term of three to five years.

We determine if an arrangement is a lease at inception. Beginning in 2019 in conjunction with our adoption of ASC Topic 842, Leases, right-of-use (ROU) assets and operating lease liabilities are recognized at the lease commencement date based on the estimated present value of future lease payments over the lease term. Most of our leases do not provide an implicit interest rate nor is the rate available to us from our lessors. As an alternative, we use our estimated incremental borrowing rate, which is derived from information available at the lease commencement date, including publicly available data, in determining the present value of lease payments.

Our operating lease costs include facility, vehicle and equipment lease costs, but exclude variable lease costs. Operating lease costs are recognized on a straight-line basis over the lease term, after consideration of rent escalations and rent holidays. The lease term for purposes of the calculation begins on the earlier of the lease commencement date or the date we take possession of the property. During lease renewal negotiations that extend beyond the original lease term, we estimate straight-line rent expense based on current market conditions. Variable lease costs are recorded when it is probable the cost has been incurred and the amount is reasonably estimable. Future payments for real estate taxes and certain building operating expenses for which we are obligated are not included in operating lease costs. Leases with an initial term of 12 months or less are not recorded on the balance sheet as an ROU asset or operating lease liability. We recognize operating lease costs for these short-term leases, primarily small equipment leases, on a straight-line basis over the lease term. At September 28, 2019, our finance ROU assets and lease liabilities were not significant.

Operating lease costs were as follows (in thousands):

|  |  |  | Three Months Ended |  |  | Nine Months Ended |
|  |  |  | September 28, 2019 |  |  | September 28, 2019 |
Operating lease costs(1) |  |  |  | $ | 21,583 |  |  | $ | 63,719 |
Variable lease costs |  |  |  | $ | 466 |  |  | $ | 1,387 |

(1) | Includes short-term lease costs which are not significant.

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SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

The maturities of operating lease liabilities as of September 28, 2019, were as follows (in thousands):

2019 (excluding the nine months ended September 28, 2019) |  | $ | 21,045 |
2020 |  |  | 79,652 |
2021 |  |  | 72,354 |
2022 |  |  | 64,339 |
2023 |  |  | 54,970 |
2024 |  |  | 43,393 |
Thereafter |  |  | 110,847 |
Total lease payments(1) |  |  | 446,600 |
Less: Interest |  |  | 95,355 |
Present value of operating lease liabilities(2) |  | $ | 351,245 |

(1) | Total lease payments exclude $51 million of legally binding minimum lease payments for leases signed but not yet commenced.

(2) | Includes the current portion of $58 million for operating lease liabilities.

The aggregate future commitments under operating leases as of December 30, 2018, were expected to be as follows (in thousands):

2019 |  | $ | 78,337 |
2020 |  |  | 73,331 |
2021 |  |  | 66,491 |
2022 |  |  | 59,515 |
2023 |  |  | 51,076 |
Thereafter |  |  | 149,318 |
Total lease payments(1) |  | $ | 478,068 |

(1) | Total lease payments include $62 million of legally binding minimum lease payments for leases signed but not yet commenced.

Other information related to operating leases was as follows:

|  | September 28, 2019 |
Weighted-average remaining lease term (years) |  |  | 6.7 |
Weighted-average discount rate |  | 7.3% |

|  | Nine Months Ended |
(in thousands) |  | September 28, 2019 |
Cash paid for amounts included in present value of operating lease liabilities |  | $ | 60,512 |
Right-of-use assets obtained in exchange for operating lease liabilities(1) |  | $ | 53,230 |

(1) | See Note 1, Recently Adopted Accounting Guidance, which discusses the impact of our initial adoption of the new lease standard.

7. Repurchases of Common Stock

Repurchases of our common stock were as follows (in thousands):

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Amount repurchased under Board-approved share repurchase program |  | $ | 40,000 |  |  | $ | 55,000 |  |  | $ | 120,900 |  |  | $ | 195,000 |
Amount repurchased in connection with the vesting of employee restricted stock grants |  |  | 142 |  |  |  | 299 |  |  |  | 9,575 |  |  |  | 3,239 |
Total amount repurchased |  | $ | 40,142 |  |  | $ | 55,299 |  |  | $ | 130,475 |  |  | $ | 198,239 |

Effective as of September 29, 2019, our board approved an increase in our total remaining share repurchase authorization to $500 million.

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SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

8. Revenue Recognition

Deferred contract assets and deferred contract liabilities are included in our consolidated balance sheets as follows (in thousands):

|  | September 28, 2019 |  |  | December 29, 2018 |
Deferred Contract Assets included in: |  |  |  |  |  |  |  |
Other current assets |  | $ | 22,765 |  |  | $ | 20,553 |
Other non-current assets |  |  | 32,758 |  |  |  | 29,456 |
|  | $ | 55,523 |  |  | $ | 50,009 |

|  | September 28, 2019 |  |  | December 29, 2018 |
Deferred Contract Liabilities included in: |  |  |  |  |  |  |  |
Other current liabilities |  | $ | 33,885 |  |  | $ | 32,395 |
Other non-current liabilities |  |  | 44,088 |  |  |  | 42,194 |
|  | $ | 77,973 |  |  | $ | 74,589 |

During the three months ended September 28, 2019 and September 29, 2018, we recognized revenue of $9 million and $8 million, respectively, that was included in the deferred contract liability balance at the beginning of the respective periods. During the nine months ended September 28, 2019 and September 29, 2018, we recognized revenue of $25 million and $22 million, respectively, that was included in the deferred contract liability balance at the beginning of the respective periods.

Revenue from goods and services transferred to customers at a point in time accounted for approximately 98% of our revenues for both the three and nine months ended September 28, 2019 and September 29, 2018.

Net sales from each of our channels was as follows (in thousands):

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Retail |  | $ | 437,871 |  |  | $ | 383,886 |  |  | $ | 1,158,096 |  |  | $ | 1,026,808 |
Online and phone |  |  | 34,520 |  |  |  | 28,686 |  |  |  | 89,695 |  |  |  | 81,580 |
Company-Controlled channel |  |  | 472,391 |  |  |  | 412,572 |  |  |  | 1,247,791 |  |  |  | 1,108,388 |
Wholesale/Other channel |  |  | 2,387 |  |  |  | 2,207 |  |  |  | 9,395 |  |  |  | 11,362 |
Total |  | $ | 474,778 |  |  | $ | 414,779 |  |  | $ | 1,257,186 |  |  | $ | 1,119,750 |

Obligation for Sales Returns

The activity in the sales returns liability account was as follows (in thousands):

|  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |
Balance at beginning of year |  | $ | 19,907 |  |  | $ | 19,270 |
Additions that reduce net sales |  |  | 60,962 |  |  |  | 57,296 |
Deductions from reserves |  |  | (57,036 | ) |  |  | (56,031 | )
Balance at end of period |  | $ | 23,833 |  |  | $ | 20,535 |

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SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

9. Stock-Based Compensation Expense

Total stock-based compensation expense was as follows (in thousands):

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Stock awards |  | $ | 3,527 |  |  | $ | 2,759 |  |  | $ | 10,256 |  |  | $ | 8,247 |
Stock options |  |  | 619 |  |  |  | 597 |  |  |  | 1,778 |  |  |  | 1,851 |
Total stock-based compensation expense |  |  | 4,146 |  |  |  | 3,356 |  |  |  | 12,034 |  |  |  | 10,098 |
Income tax benefit |  |  | 984 |  |  |  | 802 |  |  |  | 2,948 |  |  |  | 2,454 |
Total stock-based compensation expense, net of tax |  | $ | 3,162 |  |  | $ | 2,554 |  |  | $ | 9,086 |  |  | $ | 7,644 |

10. Profit Sharing and 401(k) Plan

Under our profit sharing and 401(k) plan, eligible employees may defer up to 50% of their compensation on a pre-tax basis, subject to Internal Revenue Service limitations. Each pay period, we may make a discretionary contribution equal to a percentage of the employee’s contribution. During the three months ended September 28, 2019 and September 29, 2018, our contributions, net of forfeitures, were $1.5 million. During the nine months ended September 28, 2019 and September 29, 2018, our contributions, net of forfeitures, were $4.5 million and $4.2 million, respectively.

11. Net Income per Common Share

The components of basic and diluted net income per share were as follows (in thousands, except per share amounts):

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Net income |  | $ | 28,054 |  |  | $ | 18,257 |  |  | $ | 57,752 |  |  | $ | 42,549 |
Reconciliation of weighted-average shares outstanding: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic weighted-average shares outstanding |  |  | 29,085 |  |  |  | 34,231 |  |  |  | 29,859 |  |  |  | 36,204 |
Dilutive effect of stock-based awards |  |  | 711 |  |  |  | 808 |  |  |  | 829 |  |  |  | 873 |
Diluted weighted-average shares outstanding |  |  | 29,796 |  |  |  | 35,039 |  |  |  | 30,688 |  |  |  | 37,077 |
Net income per share – basic |  | $ | 0.96 |  |  | $ | 0.53 |  |  | $ | 1.93 |  |  | $ | 1.18 |
Net income per share – diluted |  | $ | 0.94 |  |  | $ | 0.52 |  |  | $ | 1.88 |  |  | $ | 1.15 |

For the three and nine months ended September 28, 2019 and September 29, 2018, anti-dilutive stock-based awards excluded from the diluted net income per share calculations were immaterial.

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SLEEP NUMBER CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

12. Commitments and Contingencies

Warranty Liabilities

The activity in the accrued warranty liabilities account was as follows (in thousands):

|  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |
Balance at beginning of year |  | $ | 10,389 |  |  | $ | 9,320 |
Additions charged to costs and expenses for current-year sales |  |  | 8,033 |  |  |  | 9,275 |
Deductions from reserves |  |  | (8,159 | ) |  |  | (8,461 | )
Changes in liability for pre-existing warranties during the current year, including expirations |  |  | 1,189 |  |  |  | 177 |
Balance at end of period |  | $ | 11,452 |  |  | $ | 10,311 |

Legal Proceedings

We are involved from time to time in various legal proceedings arising in the ordinary course of our business, including primarily commercial, product liability, employment and intellectual property claims. In accordance with U.S. generally accepted accounting principles, we record a liability in our consolidated financial statements with respect to any of these matters when it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated. If a material loss is reasonably possible but not known or probable, and may be reasonably estimated, the estimated loss or range of loss is disclosed. With respect to currently pending legal proceedings, we have not established an estimated range of reasonably possible material losses either because we believe that we have valid defenses to claims asserted against us, the proceeding has not advanced to a stage of discovery that would enable us to establish an estimate, or the potential loss is not material. We currently do not expect the outcome of pending legal proceedings to have a material effect on our consolidated results of operations, financial position or cash flows. Litigation, however, is inherently unpredictable, and it is possible that the ultimate outcome of one or more claims asserted against us could adversely impact our consolidated results of operations, financial position or cash flows. We expense legal costs as incurred.

On September 18, 2018, two former Home Delivery team members filed suit, now venued in Superior Court in Fresno County, California, alleging representative claims on a purported class action basis under the California Labor Code Private Attorney General Act. While the two representative plaintiffs were in the Home Delivery workforce, the Complaint does not limit the purported plaintiff class to that group. The plaintiffs allege that Sleep Number failed or refused to adopt adequate practices, policies and procedures relating to wage payments, record keeping, employment disclosures, meal and rest breaks, among other claims, under California law. The Complaint sought damages in the form of civil penalties and plaintiffs’ attorneys’ fees, and expressly disclaims the recovery of any purported individual specific relief or underpaid wages. The parties tentatively reached a settlement pending Court approval, which includes the settlement and release of certain additional related claims. We intend to continue vigorously defending this matter in the event it does not settle.

On March 27, 2018, Level Sleep, LLC filed a patent infringement lawsuit against Sleep Number in the Federal District Court for the Eastern District of Texas. In its Complaint, Level Sleep claims that Sleep Number infringed two patents owned by Level Sleep, U.S. Patent Nos. 6,807,698 and 7,036,172 (the “Patents”), by, among other things, making, using, offering for sale, or selling within the United States, and/or importing into the United States, beds with sleep surfaces having foam with multiple zones in the longitudinal direction. Level Sleep has asserted that five non-360 beds no longer sold and two current non-360 beds infringe the Patents. Level Sleep seeks damages in the form of a reasonable royalty. Sleep Number has asserted that the Patents are invalid and that our products do not infringe the Patents. The case is scheduled for trial in February 2020. We intend to vigorously defend this matter.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our condensed consolidated financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in seven sections:

• | Risk Factors

• | Company Overview

• | Results of Operations

• | Liquidity and Capital Resources

• | Non-GAAP Data

• | Off-Balance-Sheet Arrangements and Contractual Obligations

• | Critical Accounting Policies

Risk Factors

The discussion in this Quarterly Report contains certain forward-looking statements that relate to future plans, events, financial results or performance. You can identify forward-looking statements by those that are not historical in nature, particularly those that use terminology such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “believe,” “estimate,” “plan,” “project,” “predict,” “intend,” “potential,” “continue” or the negative of these or similar terms. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. These risks and uncertainties include, among others:

• | Current and future general and industry economic trends and consumer confidence;

• | The effectiveness of our marketing messages;

• | The efficiency of our advertising and promotional efforts;

• | Our ability to execute our Company-Controlled distribution strategy;

• | Our ability to achieve and maintain acceptable levels of product and service quality, and acceptable product return and warranty claims rates;

• | Our ability to continue to improve and expand our product line, and consumer acceptance of our products, product quality, innovation and brand image;

• | Industry competition, the emergence of additional competitive products and the adequacy of our intellectual property rights to protect our products and brand from competitive or infringing activities;

• | The potential for claims that our products, processes, advertising, or trademarks infringe the intellectual property rights of others;

• | Availability of attractive and cost-effective consumer credit options;

• | Our manufacturing processes with minimal levels of inventory, which may leave us vulnerable to shortages in supply;

• | Our dependence on significant suppliers and third parties and our ability to maintain relationships with key suppliers or third parties, including several sole-source suppliers or providers of services;

• | Rising commodity costs and other inflationary pressures;

• | Risks inherent in global sourcing activities, including tariffs and the potential for shortages in supply;

• | Risks of disruption in the operation of any of our main manufacturing facilities or assembly facilities;

• | Increasing government regulation;

• | Pending or unforeseen litigation and the potential for adverse publicity associated with litigation;

• | The adequacy of our and third-party information systems to meet the evolving needs of our business and existing and evolving risks and regulatory standards applicable to data privacy and security;

• | The costs and potential disruptions to our business related to upgrading our information systems;

• | The vulnerability of our and third-party information systems to attacks by hackers or other cyber threats that could compromise the security of our systems, result in a data breach or disrupt our business;

• | Our ability to attract, retain and motivate qualified management, executive and other key team members, including qualified retail sales professionals and managers.

Additional information concerning these, and other risks and uncertainties is contained under the caption “Risk Factors” in our Annual Report on Form 10-K.

We have no obligation to publicly update or revise any of the forward-looking statements contained in this Quarterly Report on Form 10-Q.

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Company Overview

Sleep Number Corporation, based in Minneapolis, Minnesota, was founded in 1987. We are listed on The Nasdaq Stock Market LLC (Nasdaq Global Select Market) under the symbol “SNBR.”

Sleep Number is the exclusive designer, manufacturer, marketer, retailer and servicer of Sleep Number® beds and the leader in sleep innovation. We offer our customers high-quality, individualized sleep solutions and services, including a complete line of Sleep Number beds, bases and bedding accessories. We are also the pioneer and leader in biometric sleep innovation and tracking. Our proprietary SleepIQ® technology, the operating system of the 360® smart bed, works with our proprietary algorithms and artificial intelligence to track user’s sleep patterns and biometric changes. SleepIQ allows each bed to use the sleeper’s own data to automatically and effortlessly adjust the bed’s firmness, delivering proven quality sleep.

Our relentless focus on developing benefit-driven innovation for our customers is resulting in superior shareholder value, as we: (i) increase consumer demand; (ii) leverage our business model; and (iii) deploy capital efficiently.

Results of Operations

Quarterly and Year-to-Date Results

Quarterly and year-to-date operating results may fluctuate significantly as a result of a variety of factors, including increases or decreases in sales, timing, amount and effectiveness of advertising expenditures, changes in sales return rates or warranty experience, timing of investments in growth initiatives and infrastructure, timing of store openings/closings and related expenses, changes in net sales resulting from changes in our store base, timing of new product introductions and related expenses, timing of promotional offerings, competitive factors, changes in commodity costs, disruptions in supplies or third-party service providers, seasonality of retail and bedding industry sales, consumer confidence and general economic conditions. Therefore, our historical results of operations may not be indicative of the results that may be achieved for any future period.

Highlights

Financial highlights for the period ended September 28, 2019 were as follows:

• | Net sales for the three months ended September 28, 2019 increased 14% to $475 million, compared with $415 million for the same period one year ago. Net sales for the three months ended September 29, 2018 were impacted by an approximately $24 million shift in sales from our third quarter to our fourth quarter.

• | The 14% net sales increase resulted from a 10% comparable sales increase in our Company-Controlled channel and a 5 percentage point (ppt.) increase in sales from 33 net new stores opened in the past 12 months. For additional details, see the components of total net sales change on page 14.

• | Sales per store (Company-Controlled channel sales for stores open at least one year, including online and phone sales) on a trailing twelve-month basis for the period ended September 28, 2019 totaled $2.9 million, 8% higher than the same period one year ago.

• | Operating income for the three months ended September 28, 2019 was $39 million, an increase of 55%, or $14 million, from the prior-year period. Our operating income rate increased to 8.2% of net sales, compared with 6.1% of net sales for the same period last year. The prior-period's operating income and operating income rate were affected by the sales shift highlighted above.

• | The current-period's operating income and operating income rate were positively impacted by the 14% increase in net sales and a 2.0 ppt. improvement in the gross profit rate. The 2.0 ppt. gross profit rate improvement was primarily due to three factors: (i) a favorable sales mix of high-margin products; (ii) the elimination of prior year’s product transition costs; and (iii) current-period manufacturing and supply chain efficiency gains, and benefit-driven product price increases.

• | Net income for the three months ended September 28, 2019 increased 54% to $28 million, compared with $18 million for the same period one year ago. Earnings per diluted share were $0.94, up 81% compared with $0.52 last year.

• | Cash provided by operating activities for the nine months ended September 28, 2019 increased by $55 million to $190 million, compared with $134 million for the same period one year ago.

• | At September 28, 2019, we ended the quarter with $214 million of borrowings under our $450 million revolving credit facility.

• | During the three months ended September 28, 2019, we repurchased 0.9 million shares of our common stock under our Board-approved share repurchase program at a cost of $40 million (based on trade date, at an average of $42.77 per share). Effective as of September 29, 2019, our Board approved an increase in the remaining authorization under our Board-approved share repurchase program to $500 million.

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The following table sets forth our results of operations expressed as dollars and percentages of net sales. Figures are in millions, except percentages and per share amounts. Amounts may not add due to rounding differences.

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Net sales |  | $ | 474.8 |  |  |  | 100.0 | % |  | $ | 414.8 |  |  |  | 100.0 | % |  | $ | 1,257.2 |  |  |  | 100.0 | % |  | $ | 1,119.8 |  |  |  | 100.0 | %
Cost of sales |  |  | 178.4 |  |  |  | 37.6 | % |  |  | 164.3 |  |  |  | 39.6 | % |  |  | 481.4 |  |  |  | 38.3 | % |  |  | 442.9 |  |  |  | 39.6 | %
Gross profit |  |  | 296.4 |  |  |  | 62.4 | % |  |  | 250.5 |  |  |  | 60.4 | % |  |  | 775.8 |  |  |  | 61.7 | % |  |  | 676.9 |  |  |  | 60.4 | %
Operating expenses: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Sales and marketing |  |  | 213.1 |  |  |  | 44.9 | % |  |  | 188.5 |  |  |  | 45.4 | % |  |  | 568.8 |  |  |  | 45.2 | % |  |  | 511.5 |  |  |  | 45.7 | %
General and administrative |  |  | 35.1 |  |  |  | 7.4 | % |  |  | 29.4 |  |  |  | 7.1 | % |  |  | 102.5 |  |  |  | 8.2 | % |  |  | 89.9 |  |  |  | 8.0 | %
Research and development |  |  | 9.0 |  |  |  | 1.9 | % |  |  | 7.4 |  |  |  | 1.8 | % |  |  | 25.4 |  |  |  | 2.0 | % |  |  | 21.1 |  |  |  | 1.9 | %
Total operating expenses |  |  | 257.2 |  |  |  | 54.2 | % |  |  | 225.2 |  |  |  | 54.3 | % |  |  | 696.7 |  |  |  | 55.4 | % |  |  | 622.6 |  |  |  | 55.6 | %
Operating income |  |  | 39.2 |  |  |  | 8.2 | % |  |  | 25.3 |  |  |  | 6.1 | % |  |  | 79.1 |  |  |  | 6.3 | % |  |  | 54.3 |  |  |  | 4.9 | %
Interest expense, net |  |  | 3.1 |  |  |  | 0.7 | % |  |  | 1.8 |  |  |  | 0.4 | % |  |  | 9.0 |  |  |  | 0.7 | % |  |  | 3.8 |  |  |  | 0.3 | %
Income before income taxes |  |  | 36.0 |  |  |  | 7.6 | % |  |  | 23.5 |  |  |  | 5.7 | % |  |  | 70.1 |  |  |  | 5.6 | % |  |  | 50.5 |  |  |  | 4.5 | %
Income tax expense |  |  | 8.0 |  |  |  | 1.7 | % |  |  | 5.2 |  |  |  | 1.3 | % |  |  | 12.4 |  |  |  | 1.0 | % |  |  | 7.9 |  |  |  | 0.7 | %
Net income |  | $ | 28.1 |  |  |  | 5.9 | % |  | $ | 18.3 |  |  |  | 4.4 | % |  | $ | 57.8 |  |  |  | 4.6 | % |  | $ | 42.5 |  |  |  | 3.8 | %
Net income per share: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic |  | $ | 0.96 |  |  |  |  |  |  | $ | 0.53 |  |  |  |  |  |  | $ | 1.93 |  |  |  |  |  |  | $ | 1.18 |  |  |  |  |
Diluted |  | $ | 0.94 |  |  |  |  |  |  | $ | 0.52 |  |  |  |  |  |  | $ | 1.88 |  |  |  |  |  |  | $ | 1.15 |  |  |  |  |
Weighted-average number of common shares: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic |  |  | 29.1 |  |  |  |  |  |  |  | 34.2 |  |  |  |  |  |  |  | 29.9 |  |  |  |  |  |  |  | 36.2 |  |  |  |  |
Diluted |  |  | 29.8 |  |  |  |  |  |  |  | 35.0 |  |  |  |  |  |  |  | 30.7 |  |  |  |  |  |  |  | 37.1 |  |  |  |  |

The percentage of our total net sales, by dollar volume, from each of our channels was as follows:

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Company-Controlled channel |  |  | 99.5 | % |  |  | 99.5 | % |  |  | 99.3 | % |  |  | 99.0 | %
Wholesale/Other channel |  |  | 0.5 | % |  |  | 0.5 | % |  |  | 0.7 | % |  |  | 1.0 | %
Total |  |  | 100.0 | % |  |  | 100.0 | % |  |  | 100.0 | % |  |  | 100.0 | %

The components of total net sales change, including comparable net sales changes, were as follows:

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Sales change rates: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Retail comparable-store sales (1) |  |  | 9 | % |  |  | (1 | %) |  |  | 7 | % |  |  | 0 | %
Online and phone |  |  | 20 | % |  |  | 10 | % |  |  | 10 | % |  |  | 11 | %
Company-Controlled comparable sales change (1) |  |  | 10 | % |  |  | 0 | % |  |  | 8 | % |  |  | 1 | %
Net opened/closed stores |  |  | 5 | % |  |  | 3 | % |  |  | 5 | % |  |  | 3 | %
Total Company-Controlled channel |  |  | 15 | % |  |  | 3 | % |  |  | 13 | % |  |  | 4 | %
Wholesale/Other channel |  |  | 8 | % |  |  | (21 | %) |  |  | (17 | %) |  |  | (31 | %)
Total net sales change |  |  | 14 | % |  |  | 3 | % |  |  | 12 | % |  |  | 4 | %

(1) | Stores are included in the comparable-store calculations in the 13th full month of operations. Stores that have been remodeled or repositioned within the same shopping center remain in the comparable-store base.

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Index

Other sales metrics were as follows:

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Average sales per store (1) ($ in thousands) |  | $ | 2,858 |  |  | $ | 2,635 |  |  |  |  |  |  |  |  |
Average sales per square foot (1) |  | $ | 1,029 |  |  | $ | 977 |  |  |  |  |  |  |  |  |
Stores > $2 million in net sales (2) |  |  | 70 | % |  |  | 62 | % |  |  |  |  |  |  |  |
Stores > $3 million in net sales (2) |  |  | 28 | % |  |  | 23 | % |  |  |  |  |  |  |  |
Average revenue per mattress unit – Company- Controlled channel (3) |  | $ | 4,788 |  |  | $ | 4,387 |  |  | $ | 4,837 |  |  | $ | 4,432 |

(1) | Trailing-twelve months Company-Controlled comparable sales per store open at least one year.

(2) | Trailing-twelve months for stores open at least one year (excludes online and phone sales).

(3) | Represents Company-Controlled channel total net sales divided by Company-Controlled channel mattress units.

The number of retail stores operating was as follows:

|  | Three Months Ended |  |  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Beginning of period |  |  | 594 |  |  |  | 565 |  |  |  | 579 |  |  |  | 556 |
Opened |  |  | 15 |  |  |  | 9 |  |  |  | 47 |  |  |  | 33 |
Closed |  |  | (7 | ) |  |  | (5 | ) |  |  | (24 | ) |  |  | (20 | )
End of period |  |  | 602 |  |  |  | 569 |  |  |  | 602 |  |  |  | 569 |

Comparison of Three Months Ended September 28, 2019 with Three Months Ended September 29, 2018

Net sales

Net sales for the three months ended September 28, 2019 increased by $60 million, or 14%, to $475 million, compared with $415 million for the same period one year ago. Net sales for the three months ended September 29, 2018 were impacted by an approximately $24 million shift in sales from our third quarter to our fourth quarter.

The 14% net sales increase resulted from a 10% comparable sales increase in our Company-Controlled channel and 5 percentage points (ppt.) of sales growth from 33 net new stores opened in the past 12 months.

The $60 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $37 million increase in our Company-Controlled comparable net sales; and (ii) a $23 million increase resulting from net store openings. Wholesale/Other channel sales increased slightly year-over-year. Company-Controlled mattress unit sales increased 5% compared with the prior year. Average revenue per mattress unit in our Company-Controlled channel totaled $4,788, a 9% increase compared with $4,387 in the prior-year period.

Gross profit

Gross profit of $296 million increased by $46 million, or 18%, compared with $251 million for the same period one year ago. The gross profit rate improved to 62.4% of net sales for the three months ended September 28, 2019, compared with 60.4% for the prior-year comparable period. The current-year gross profit rate increase of 2.0 ppt. was primarily due to three factors: (i) a favorable sales mix of high-margin products (1.2 ppt.); (ii) the elimination of prior year’s product transition costs and temporary inefficiencies associated with operating two supply chains (0.7 ppt.); and (iii) current-period manufacturing and supply chain efficiency gains, and benefit-driven product price increases (0.6 ppt.). These three positive factors were partially offset by: (i) increased tariff costs (0.3 ppt.); and (ii) customer delivery cost inflation (0.2 ppt.). In addition, our gross profit rate will fluctuate from quarter to quarter due to a variety of other factors, including warranty expenses, return and exchange costs, and performance-based incentive compensation.

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Sales and marketing expenses

Sales and marketing expenses for the three months ended September 28, 2019 were $213 million, or 44.9% of net sales, compared with $188 million, or 45.4% of net sales, for the same period one year ago. The 0.5 ppt. decrease in the sales and marketing expense rate was primarily due to the expense leverage from the 14% increase in net sales; partially offset by an increase in media expenses that drove additional customer traffic to our sales channels, including stores, online and phone.

General and administrative expenses

General and administrative (G&A) expenses totaled $35 million, or 7.4% of net sales, for the three months ended September 28, 2019, compared with $29 million, or 7.1% of net sales, in the prior-year period. The $5.7 million increase in G&A expenses consisted primarily of: (i) a $4.3 million increase in employee compensation primarily resulting from a year-over-year increase in performance-based incentive compensation; and (ii) a $1.1 million increase in professional fees. The G&A expense rate increased by 0.3 ppt. in the current-year period, compared with the same period one year ago due to the items discussed above, partially offset by the leveraging impact of the 14% net sales increase.

Research and development expenses

Research and development (R&D) expenses increased by 22% to $9 million for the three months ended September 28, 2019, compared with $7 million for the same period one year ago. The R&D expense rate for the three months ended September 28, 2019 increased to 1.9% of net sales, compared with 1.8% of net sales for the prior year. The spending level increase supports our consumer innovation strategy.

Interest expense, net

Interest expense, net increased to $3.1 million for the three months ended September 28, 2019, compared with $1.8 million for the same period one year ago. The $1.3 million change was due to our planned increase in borrowings under our revolving credit facility. At September 28, 2019, we ended the quarter with $214 million of borrowings under our revolving credit facility, compared with $136 million one year ago.

Income tax expense

Income tax expense totaled $8.0 million for the three months ended September 28, 2019, compared with $5.2 million last year. The effective income tax rate for the three months ended September 28, 2019 was 22.1%, compared with 22.3% for the comparable period last year. Both periods benefited from: (i) the recognition of additional tax credits; and (ii) stock-based compensation excess tax benefits.

Comparison of Nine Months Ended September 28, 2019 with Nine Months Ended September 29, 2018

Net sales

Net sales for the nine months ended September 28, 2019 increased by $137 million, or 12%, to $1.3 billion, compared with $1.1 billion for the same period one year ago. Net sales for the nine months ended September 29, 2018 were impacted by an approximately $24 million shift in sales from our third quarter to our fourth quarter.

The 12% net sales increase resulted from an 8% comparable sales increase in our Company-Controlled channel and 5 percentage points (ppt.) of sales growth from 33 net new stores opened in the past 12 months.

The $137 million net sales increase compared with the same period one year ago was comprised of the following: (i) an $80 million increase in our Company-Controlled comparable net sales; and (ii) a $59 million increase resulting from net store openings. Wholesale/Other channel sales decreased slightly year-over-year. Company-Controlled mattress unit sales increased 3% compared with the prior year. Average revenue per mattress unit in our Company-Controlled channel totaled $4,837, a 9% increase, compared with $4,432 in the prior-year period.

Gross profit

Gross profit of $776 million for the nine months ended September 28, 2019 increased by $99 million, or 15%, compared with $677 million for the same period one year ago. The gross profit rate improved to 61.7% of net sales, compared with 60.4% for the prior-year comparable period. The current-year gross profit rate improvement of 1.3 ppt. was primarily due to three factors: (i) current-period manufacturing and supply chain efficiency gains, and benefit-driven product price increases (0.8 ppt.); (ii) the elimination of

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Index

prior year’s product transition costs (0.8 ppt.); and (iii) a favorable sales mix of high-margin products (0.2 ppt.). These t hree positive factors were partially offset by: (i) increased tariff costs (0.3 ppt.); and (ii) customer delivery cost inflation (0.2 ppt.). In addition, our gross profit rate will fluctuate from quarter to quarter due to a variety of other factors, including warranty expenses, return and exchange costs, and performance-based incentive compensation.

Sales and marketing expenses

Sales and marketing expenses for the nine months ended September 28, 2019 were $569 million, or 45.2% of net sales, compared with $511 million, or 45.7% of net sales, for the same period one year ago. The 0.5 ppt. decrease in the sales and marketing expense rate was primarily due to the expense leverage from the 12% increase in net sales, partially offset by an increase in media expenses that drove additional customer traffic to our sales channels, including stores, online and phone.

General and administrative expenses

General and administrative (G&A) expenses totaled $102 million, or 8.2% of net sales, for the nine months ended September 28, 2019, compared with $90 million, or 8.0% of net sales, in the prior-year period. The $12.5 million increase in G&A expenses consisted of the following: (i) a $8.1 million increase in employee compensation primarily resulting from a year-over-year increase in performance-based incentive compensation; (ii) a $2.8 million increase in professional fees; and (iii) a $1.6 million net increase in miscellaneous other expenses. The G&A expense rate increased by 0.2 ppt. in the current-year period, compared with the same period one year ago due to the items discussed above, partially offset by the leveraging impact of the 12% net sales increase.

Research and development expenses

Research and development (R&D) expenses increased by 20% to $25 million for the nine months ended September 28, 2019, compared with $21 million for the same period one year ago. The R&D expense rate for the nine months ended September 28, 2019 increased to 2.0% of net sales, compared with 1.9% of net sales for the prior year. The spending level increase supports our consumer innovation strategy.

Interest expense, net

Interest expense, net increased to $9.0 million for the nine months ended September 28, 2019, compared with $3.8 million for the same period one year ago. The $5.2 million increase was due to our planned increase in borrowings under our revolving credit facility and the year-over-year increase in LIBOR rates. At September 28, 2019, we ended the quarter with $214 million of borrowings under our revolving credit facility, compared with $136 million one year ago.

Income tax expense

Income tax expense totaled $12.4 million for the nine months ended September 28, 2019, compared with $7.9 million last year. Both periods benefited from discrete tax items. The effective income tax rate for the nine months ended September 28, 2019 was 17.7% reflecting stock-based compensation excess tax benefits, additional tax credits and the favorable resolution of a tax matter. The effective tax rate for the nine months ended September 29, 2018 was 15.7% reflecting the changes associated with the Tax Cuts and Jobs Act, including a $2.9 million increase in the 2017 provisional tax benefit in the second-quarter 2018 and stock-based compensation excess tax benefits.

Liquidity and Capital Resources

Managing our liquidity and capital resources is an important part of our commitment to deliver superior shareholder value. Our primary sources of liquidity are cash flows provided by operating activities and cash available under our $450 million revolving credit facility. The cash generated from ongoing operations, and cash available under our revolving credit facility are expected to be adequate to maintain operations, and fund anticipated expansion and strategic initiatives for the foreseeable future.

As of September 28, 2019, cash and cash equivalents totaled $2 million. Available borrowing capacity under our revolving credit facility was $233 million at September 28, 2019. Changes in the cash and cash equivalents primarily consisted of $190 million of cash provided by operating activities, which was offset by $47 million of cash used to purchase property and equipment, and $139 million of cash used to repurchase our common stock (based on settlement, $130 million under our Board-approved share repurchase program and $9 million in connection with the vesting of employee restricted stock grants).

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Index

The following table summarizes our cash flows ($ in millions). Amounts may not add due to rounding differences:

|  | Nine Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |
Total cash provided by (used in): |  |  |  |  |  |  |  |
Operating activities |  | $ | 189.8 |  |  | $ | 134.5 |
Investing activities |  |  | (44.2 | ) |  |  | (33.8 | )
Financing activities |  |  | (145.7 | ) |  |  | (103.0 | )
Net decrease in cash and cash equivalents |  | $ | (0.1 | ) |  | $ | (2.4 | )

Cash provided by operating activities for the nine months ended September 28, 2019 was $190 million, compared with $134 million for the nine months ended September 29, 2018. Significant components of the year-over-year change in cash provided by operating activities included: (i) a $15 million increase in net income for the nine months ended September 28, 2019, compared with the same period one year ago; (ii) a $19 million fluctuation in accounts payable with both periods impacted by business changes and timing of payments; (iii) a $14 million fluctuation in accrued compensation and benefits that primarily resulted from year-over-year changes in company-wide performance-based incentive compensation that was accrued and paid in the two comparable periods (higher incentive compensation paid in 2018 and lower incentive compensation accrued in the first nine months of 2018); (iv) a $14 million fluctuation in income taxes reflecting the changes associated with the Tax Cuts and Jobs Act; and (v) a $13 million fluctuation in prepaid expenses and other assets with both periods impacted by the timing of rent payments and changes in business activities.

Net cash used in investing activities to purchase property and equipment was $47 million for the nine months ended September 28, 2019, compared with $34 million for the same period one year ago. The year-over-year increase was primarily due to the timing of cash flows associated with new and remodeled stores’ property and equipment.

Net cash used in financing activities was $146 million for the nine months ended September 28, 2019, compared with $103 million for the same period one year ago. During the nine months ended September 28, 2019, we repurchased $139 million of our stock (based on settlement, $130 million under our Board-approved share repurchase program and $9 million in connection with the vesting of employee restricted stock awards), compared with $198 million during the same period one year ago. Short-term borrowings were reduced by $11 million during the current-year period due to a decrease in book overdrafts which are included in the net change in short-term borrowings, partially offset by a $14 million increase in borrowings under our revolving credit facility to $214 million. Short-term borrowings increased by $94 million during the prior-year period due to a $111 million increase in borrowings under our revolving credit facility to $136 million, partially offset by a decrease in book overdrafts.

Under our Board-approved share repurchase program, we repurchased 3.0 million shares at a cost of $121 million (based on trade date, at an average of $40.19 per share) during the nine months ended September 28, 2019. During the nine months ended September 29, 2018, we repurchased 5.9 million shares at a cost of $195 million (an average of $32.93 per share). Effective as of September 29, 2019, our Board approved an increase in the remaining authorization under our Board-approved share repurchase program to $500 million. There is no expiration date governing the period over which we can repurchase shares.

In February 2019, we amended our revolving credit facility to increase our net aggregate availability from $300 million to $450 million. We maintained the accordion feature, which allows us to increase the amount of the credit facility from $450 million to $600 million, subject to lenders' approval. The amended credit facility matures in February 2024. There were no other significant changes to the credit agreement’s terms and conditions.

As of September 28, 2019, we had $214 million of borrowings under our credit facility and $3 million in outstanding letters of credit. Our available borrowing capacity was $233 million. The credit agreement provides the lenders with a collateral security interest in substantially all of our assets and those of our subsidiaries and requires us to comply with, among other things, a maximum leverage ratio (4.5x) and a minimum interest coverage ratio (3.0x). Under the terms of the credit agreement we pay a variable rate of interest and a commitment fee based on our leverage ratio. The credit facility is for general corporate purposes, to meet our seasonal working capital requirements and to repurchase our stock. As of September 28, 2019, the weighted-average interest rate on borrowings under the credit facility was 3.9% and we were in compliance with all financial covenants.

We have an agreement with Synchrony Bank to offer qualified customers revolving credit arrangements to finance purchases from us (Synchrony Agreement). The Synchrony Agreement contains financial covenants consistent with our credit facility, including a maximum leverage ratio and a minimum interest coverage ratio. As of September 28, 2019, we were in compliance with all financial covenants.

Under the terms of the Synchrony Agreement, Synchrony Bank sets the minimum acceptable credit ratings, the interest rates, fees and all other terms and conditions of the customer accounts, including collection policies and procedures, and is the owner of the accounts.

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Index

Non-GAAP Data

Earnings before Interest, Taxes, Depreciation and Amortization (Adjusted EBITDA)

We define earnings before interest, taxes, depreciation and amortization (Adjusted EBITDA) as net income plus: income tax expense, interest expense, depreciation and amortization, stock-based compensation and asset impairments. Management believes Adjusted EBITDA is a useful indicator of our financial performance and our ability to generate cash from operating activities. Our definition of Adjusted EBITDA may not be comparable to similarly titled definitions used by other companies. The table below reconciles Adjusted EBITDA, which is a non-GAAP financial measure, to the comparable GAAP financial measure.

Our Adjusted EBITDA calculations are as follows (in thousands):

|  | Three Months Ended |  |  | Trailing-Twelve Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Net income |  | $ | 28,054 |  |  | $ | 18,257 |  |  | $ | 84,742 |  |  | $ | 58,340 |
Income tax expense |  |  | 7,967 |  |  |  | 5,228 |  |  |  | 21,421 |  |  |  | 12,064 |
Interest expense |  |  | 3,131 |  |  |  | 1,836 |  |  |  | 11,064 |  |  |  | 4,044 |
Depreciation and amortization |  |  | 14,963 |  |  |  | 15,483 |  |  |  | 61,155 |  |  |  | 61,658 |
Stock-based compensation |  |  | 4,146 |  |  |  | 3,356 |  |  |  | 13,348 |  |  |  | 14,052 |
Asset impairments |  |  | 29 |  |  |  | 30 |  |  |  | 150 |  |  |  | 135 |
Adjusted EBITDA |  | $ | 58,290 |  |  | $ | 44,190 |  |  | $ | 191,880 |  |  | $ | 150,293 |

Free Cash Flow

Our “free cash flow” data is considered a non-GAAP financial measure and is not in accordance with, or preferable to, “net cash provided by operating activities,” or GAAP financial data. However, we are providing this information as we believe it facilitates analysis for investors and financial analysts.

The following table summarizes our free cash flow calculations (in thousands):

|  | Nine Months Ended |  |  | Trailing-Twelve Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |  |  | September 28, 2019 |  |  | September 29, 2018 |
Net cash provided by operating activities |  | $ | 189,832 |  |  | $ | 134,450 |  |  | $ | 186,922 |  |  | $ | 131,003 |
Subtract: Purchases of property and equipment |  |  | 46,757 |  |  |  | 34,012 |  |  |  | 58,260 |  |  |  | 56,228 |
Free cash flow |  | $ | 143,075 |  |  | $ | 100,438 |  |  | $ | 128,662 |  |  | $ | 74,775 |

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Index

Non-GAAP Data (continued)

Return on Invested Capital (ROIC)

(dollars in thousands)

ROIC is a financial measure we use to determine how efficiently we deploy our capital. It quantifies the return we earn on our invested capital. Management believes ROIC is also a useful metric for investors and financial analysts. We compute ROIC as outlined below. Our definition and calculation of ROIC may not be comparable to similarly titled definitions and calculations used by other companies. The tables below reconcile net operating profit after taxes (NOPAT) and total invested capital, which are non-GAAP financial measures, to the comparable GAAP financial measures:

|  | Trailing-Twelve Months Ended |
|  | September 28, 2019 |  |  | September 29, 2018 |
Net operating profit after taxes (NOPAT) |  |  |  |  |  |  |  |
Operating income |  | $ | 117,224 |  |  | $ | 74,427 |
Add: Rent expense (1) |  |  | 85,807 |  |  |  | 77,797 |
Add: Interest income |  |  | 4 |  |  |  | 21 |
Less: Depreciation on capitalized operating leases (2) |  |  | (21,821 | ) |  |  | (20,012 | )
Less: Income taxes (3) |  |  | (44,298 | ) |  |  | (34,751 | )
NOPAT |  | $ | 136,916 |  |  | $ | 97,482 |
Average invested capital |  |  |  |  |  |  |  |
Total deficit |  | $ | (164,487 | ) |  | $ | (54,352 | )
Add: Long-term debt (4) |  |  | 214,482 |  |  |  | 136,683 |
Add: Capitalized operating lease obligations (5) |  |  | 686,456 |  |  |  | 622,376 |
Total invested capital at end of period |  | $ | 736,451 |  |  | $ | 704,707 |
Average invested capital (6) |  | $ | 743,271 |  |  | $ | 710,325 |
Return on invested capital (ROIC) (7) |  |  | 18.4 | % |  |  | 13.7 | %

(1) | Rent expense is added back to operating income to show the impact of owning versus leasing the related assets.

(2) | Depreciation is based on the average of the last five fiscal quarters' ending capitalized operating lease obligations (see note 6) for the respective reporting periods with an assumed thirty-year useful life. This life assumption is based on our long-term participation in given markets though specific retail location lease commitments are generally 5 to 10 years at inception. This is subtracted from operating income to illustrate the impact of owning versus leasing the related assets.

(3) | Reflects annual effective income tax rates, before discrete adjustments, of 24.4% and 26.3% for 2019 and 2018, respectively.

(4) | Long-term debt includes existing finance lease liabilities.

(5) | A multiple of eight times annual rent expense is used as an estimate for capitalizing our operating lease obligations. The methodology utilized aligns with the methodology of a nationally recognized credit rating agency.

(6) | Average invested capital represents the average of the last five fiscal quarters' ending invested capital balances.

(7) | ROIC equals NOPAT divided by average invested capital.

Note - Our ROIC calculation and data are considered non-GAAP financial measures and are not in accordance with, or preferable to, GAAP financial data. However,

we are providing this information as we believe it facilitates analysis of the Company's financial performance by investors and financial analysts.

GAAP - generally accepted accounting principles in the U.S.

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Off-Balance-Sheet Arrangements and Contractual Obligations

As of September 28, 2019, we were not involved in any unconsolidated special purpose entity transactions. Other than our $3 million in outstanding letters of credit, we do not have any off-balance-sheet financing.

There have been no material changes in our contractual obligations, other than in the ordinary course of business, since the end of fiscal 2018. See Note 5, Credit Agreement, of the Notes to our Condensed Consolidated Financial Statements for information regarding our credit agreement. See our Annual Report on Form 10-K for the fiscal year ended December 29, 2018 for additional information regarding our other contractual obligations.

Critical Accounting Policies

We discuss our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 29, 2018. There were no significant changes in our critical accounting policies since the end of fiscal 2018.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to changes in market-based short-term interest rates that will impact our net interest expense. If overall interest rates were one percentage point higher than current rates, our annual net income would decrease by $1.6 million based on the $214 million of borrowings under our revolving credit facility at September 28, 2019. We do not manage the interest-rate volatility risk of borrowings under our credit facility through the use of derivative instruments.

ITEM 4. CONTROLS AND PROCEDURES

Conclusions Regarding the Effectiveness of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e), that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Our management, with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

Changes in Internal Control

There were no changes in our internal control over financial reporting during the fiscal quarter ended September 28, 2019, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are involved from time to time in various legal proceedings arising in the ordinary course of our business, including primarily commercial, product liability, employment and intellectual property claims. In accordance with U.S. generally accepted accounting principles, we record a liability in our consolidated financial statements with respect to any of these matters when it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated. If a material loss is reasonably possible but not known or probable, and may be reasonably estimated, the estimated loss or range of loss is disclosed. With respect to currently pending legal proceedings, we have not established an estimated range of reasonably possible material losses either because we believe that we have valid defenses to claims asserted against us, the proceeding has not advanced to a stage of discovery that would enable us to establish an estimate, or the potential loss is not material. We currently do not expect the outcome of pending legal proceedings to have a material effect on our consolidated results of operations, financial position or cash flows. Litigation, however, is inherently unpredictable, and it is possible that the ultimate outcome of one or more claims asserted against us could adversely impact our consolidated results of operations, financial position or cash flows. We expense legal costs as incurred.

On September 18, 2018, two former Home Delivery team members filed suit, now venued in Superior Court in Fresno County, California, alleging representative claims on a purported class action basis under the California Labor Code Private Attorney General Act. While the two representative plaintiffs were in the Home Delivery workforce, the Complaint does not limit the purported plaintiff class to that group. The plaintiffs allege that Sleep Number failed or refused to adopt adequate practices, policies and procedures relating to wage payments, record keeping, employment disclosures, meal and rest breaks, among other claims, under California law. The Complaint sought damages in the form of civil penalties and plaintiffs’ attorneys’ fees, and expressly disclaims the recovery of any purported individual specific relief or underpaid wages. The parties tentatively reached a settlement pending Court approval, which includes the settlement and release of certain additional related claims. We intend to continue vigorously defending this matter in the event it does not settle.

On March 27, 2018, Level Sleep, LLC filed a patent infringement lawsuit against Sleep Number in the Federal District Court for the Eastern District of Texas. In its Complaint, Level Sleep claims that Sleep Number infringed two patents owned by Level Sleep, U.S. Patent Nos. 6,807,698 and 7,036,172 (the “Patents”), by, among other things, making, using, offering for sale, or selling within the United States, and/or importing into the United States, beds with sleep surfaces having foam with multiple zones in the longitudinal direction. Level Sleep has asserted that five non-360 beds no longer sold and two current non-360 beds infringe the Patents. Level Sleep seeks damages in the form of a reasonable royalty. Sleep Number has asserted that the Patents are invalid and that our products do not infringe the Patents. The case is scheduled for trial in February 2020. We intend to vigorously defend this matter.

ITEM 1A. RISK FACTORS

Our business, financial condition and operating results are subject to a number of risks and uncertainties, including both those that are specific to our business and others that affect all businesses operating in a global environment. Investors should carefully consider the information in this report under the heading, Management’s Discussion and Analysis of Financial Condition and Results of Operations and also the information under the heading, Risk Factors in our most recent Annual Report on Form 10-K. The risk factors discussed in the Annual Report on Form 10-K and in this Quarterly Report on Form 10-Q do not identify all risks that we face because our business operations could also be affected by additional risk factors that are not presently known to us or that we currently consider to be immaterial to our operations.

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ITEM 2. UNREGISTERED SALES OF EQUI TY SECURITIES AND USE OF PROCEEDS

(a) – (b) Not applicable.

(c) Issuer Purchases of Equity Securities

Fiscal Period |  | Total Number of Shares Purchased(1)(2) |  |  | Average Price Paid per Share |  |  | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(1) |  |  | Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs(3) |
June 30, 2019 through July 27, 2019 |  |  | 290,864 |  |  | $ | 41.37 |  |  |  | 290,203 |  |  | $ | 92,995,000 |
July 28, 2019 through August 24, 2019 |  |  | 280,514 |  |  | $ | 45.34 |  |  |  | 279,600 |  |  |  | 80,316,000 |
August 25, 2019 through September 28, 2019 |  |  | 367,256 |  |  | $ | 41.91 |  |  |  | 365,450 |  |  |  | 65,000,000 |
Total |  |  | 938,634 |  |  | $ | 42.77 |  |  |  | 935,253 |  |  | $ | 65,000,000 |

(1) | Under our Board-approved share repurchase program, we repurchased 935,253 shares of our common stock at a cost of $40 million (based on trade dates) during the three months ended September 28, 2019.

(2) | In connection with the vesting of employee restricted stock grants, we also repurchased 3,381 shares of our common stock at a cost of $142 thousand during the three months ended September 28, 2019.

(3) | Effective as of September 29, 2019, our Board approved an increase in the total remaining share repurchase authorization to $500 million. There is no expiration date governing the period over which we can repurchase shares under our Board-approved share repurchase program. Any repurchased shares are constructively retired and returned to an unissued status.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

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ITEM 6. EXHIBITS

Exhibit Number |  | Description |
10.1 |  | Third Amendment to Lease Agreement dated August 27, 2019 between the Company and IPT SALT LAKE CITY DC II LLC (successor in interest to CLFP – SLIC 8, L.P.) |
10.2 |  | Form of Non-Statutory Stock Option Award Agreement (Employee) under the Sleep Number Corporation Amended and Restated 2010 Omnibus Incentive Plan |
10.3 |  | Form of Performance Adjusted Restricted Stock Unit Award Agreement (ROIC) (Senior Team) under the Sleep Number Corporation Amended and Restated 2010 Omnibus Incentive Plan |
10.4 |  | Form of Performance Adjusted Restricted Stock Unit Award Agreement under the Sleep Number Corporation Amended and Restated 2010 Omnibus Incentive Plan |
10.5 |  | Form of Restricted Stock Unit Award Agreement (Non-Employee Director) under the Sleep Number Corporation Amended and Restated 2010 Omnibus Incentive Plan |
10.6 |  | Form of Restricted Stock Unit Award Agreement (3-Year Ratable Vest) under the Sleep Number Corporation Amended and Restated 2010 Omnibus Incentive Plan |
10.7 |  | Form of Restricted Stock Unit Award Agreement (3-Year Cliff Vest) under the Sleep Number Corporation Amended and Restated 2010 Omnibus Incentive Plan |
10.8 |  | Form of Non-Statutory Stock Option Award Agreement (Non-Employee Director) under the Sleep Number Corporation Amended and Restated 2010 Omnibus Incentive Plan |
31.1 |  | Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
31.2 |  | Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
32.1 |  | Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350 |
32.2 |  | Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350 |
101.INS |  | XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |
101.SCH |  | XBRL Taxonomy Extension Schema Document |
101.CAL |  | XBRL Taxonomy Extension Calculation Linkbase Document |
101.DEF |  | XBRL Taxonomy Extension Definition Linkbase Document |
101.LAB |  | XBRL Taxonomy Extension Label Linkbase Document |
101.PRE |  | XBRL Taxonomy Extension Presentation Linkbase Document |
104 |  | Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101) |

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

|  | SLEEP NUMBER CORPORATION |
|  | (Registrant) |
Dated: | October 25, 2019 | By: |  | /s/ Shelly R. Ibach |  |
|  |  |  | Shelly R. Ibach |
|  |  |  | Chief Executive Officer |
|  |  |  | (principal executive officer) |
|  | By: |  | /s/ Robert J. Poirier |
|  |  |  | Robert J. Poirier |
|  |  |  | Chief Accounting Officer |
|  |  |  | (principal accounting officer) |

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