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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 26, 2020
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 x 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 x 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 x
As of September 26, 2020, 27,757,000 shares of the registrant’s Common Stock were outstanding.

Table of contents
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 | 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 | 13
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 24
Item 4. | Controls and Procedures | 24
PART II: OTHER INFORMATION |  | 25
Item 1. | Legal Proceedings | 25
Item 1A. | Risk Factors | 25
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 27
Item 3. | Defaults Upon Senior Securities | 27
Item 4. | Mine Safety Disclosures | 27
Item 5. | Other Information | 27
Item 6. | Exhibits | 28
SIGNATURES |  | 29

i

Table of contents
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 26, 2020 |  | December 28, 2019
Assets |  |  |
Current assets: |  |  |
Cash and cash equivalents | $ | 1,365 |  |  | $ | 1,593 |
Accounts receivable, net of allowance for doubtful accounts of $823 and $898, respectively | 32,688 |  |  | 19,978 |
Inventories | 83,258 |  |  | 87,065 |
Prepaid expenses | 10,923 |  |  | 15,335 |
Other current assets | 36,127 |  |  | 36,397 |
Total current assets | 164,361 |  |  | 160,368 |
Non-current assets: |  |  |
Property and equipment, net | 178,482 |  |  | 197,421 |
Operating lease right-of-use assets | 311,179 |  |  | 327,017 |
Goodwill and intangible assets, net | 73,508 |  |  | 73,226 |
Other non-current assets | 52,587 |  |  | 48,011 |
Total assets | $ | 780,117 |  |  | $ | 806,043 |
Liabilities and Shareholders’ Deficit |  |  |
Current liabilities: |  |  |
Borrowings under credit facility | $ | 33,500 |  |  | $ | 231,000 |
Accounts payable | 167,139 |  |  | 134,594 |
Customer prepayments | 75,043 |  |  | 34,248 |
Accrued sales returns | 24,085 |  |  | 19,809 |
Compensation and benefits | 61,751 |  |  | 40,321 |
Taxes and withholding | 32,030 |  |  | 22,171 |
Operating lease liabilities | 60,561 |  |  | 59,561 |
Other current liabilities | 58,449 |  |  | 53,070 |
Total current liabilities | 512,558 |  |  | 594,774 |
Non-current liabilities: |  |  |
Deferred income taxes | 7,037 |  |  | 3,808 |
Operating lease liabilities | 281,733 |  |  | 298,090 |
Other non-current liabilities | 81,616 |  |  | 68,802 |
Total liabilities | 882,944 |  |  | 965,474 |
Shareholders’ deficit: |  |  |
Undesignated preferred stock; 5,000 shares authorized, no shares issued and outstanding | — |  |  | — |
Common stock, $0.01 par value; 142,500 shares authorized, 27,757 and 27,961 shares issued and outstanding, respectively | 278 |  |  | 280 |
Additional paid-in capital | 14,390 |  |  | — |
Accumulated deficit | (117,495) |  |  | (159,711) |
Total shareholders’ deficit | (102,827) |  |  | (159,431) |
Total liabilities and shareholders’ deficit | $ | 780,117 |  |  | $ | 806,043 |

See accompanying notes to condensed consolidated financial statements.
1

Table of contents
SLEEP NUMBER CORPORATION
AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
(unaudited - in thousands, except per share amounts)

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Net sales | $ | 531,155 |  |  | $ | 474,778 |  |  | $ | 1,288,659 |  |  | $ | 1,257,186 |
Cost of sales | 196,195 |  |  | 178,388 |  |  | 488,558 |  |  | 481,377 |
Gross profit | 334,960 |  |  | 296,390 |  |  | 800,101 |  |  | 775,809 |
Operating expenses: |  |  |  |  |  |  |
Sales and marketing | 211,574 |  |  | 213,133 |  |  | 549,483 |  |  | 568,799 |
General and administrative | 44,127 |  |  | 35,098 |  |  | 111,915 |  |  | 102,466 |
Research and development | 9,644 |  |  | 9,007 |  |  | 28,399 |  |  | 25,440 |
Total operating expenses | 265,345 |  |  | 257,238 |  |  | 689,797 |  |  | 696,705 |
Operating income | 69,615 |  |  | 39,152 |  |  | 110,304 |  |  | 79,104 |
Interest expense, net | 1,827 |  |  | 3,131 |  |  | 8,111 |  |  | 8,968 |
Income before income taxes | 67,788 |  |  | 36,021 |  |  | 102,193 |  |  | 70,136 |
Income tax expense | 16,468 |  |  | 7,967 |  |  | 24,363 |  |  | 12,384 |
Net income | $ | 51,320 |  |  | $ | 28,054 |  |  | $ | 77,830 |  |  | $ | 57,752 |
Basic net income per share: |  |  |  |  |  |  |
Net income per share – basic | $ | 1.83 |  |  | $ | 0.96 |  |  | $ | 2.79 |  |  | $ | 1.93 |
Weighted-average shares – basic | 27,973 |  |  | 29,085 |  |  | 27,918 |  |  | 29,859 |
Diluted net income per share: |  |  |  |  |  |  |
Net income per share – diluted | $ | 1.79 |  |  | $ | 0.94 |  |  | $ | 2.73 |  |  | $ | 1.88 |
Weighted-average shares – diluted | 28,634 |  |  | 29,796 |  |  | 28,560 |  |  | 30,688 |

See accompanying notes to condensed consolidated financial statements.
2

Table of contents
SLEEP NUMBER CORPORATION
AND SUBSIDIARIES
Condensed Consolidated Statements of Shareholders’ Deficit
(unaudited - in thousands)

| Common Stock |  |  |  | Additional Paid-in Capital |  | Accumulated Deficit |  | Total
| Shares |  | Amount |  |  |  |  |  |
Balance at December 28, 2019 | 27,961 |  |  | $ | 280 |  |  | $ | — |  |  | $ | (159,711) |  |  | $ | (159,431) |
Net income | — |  |  | — |  |  | — |  |  | 39,140 |  |  | 39,140 |
Exercise of common stock options | 167 |  |  | 1 |  |  | 3,282 |  |  | — |  |  | 3,283 |
Stock-based compensation | 396 |  |  | 4 |  |  | 2,047 |  |  | — |  |  | 2,051 |
Repurchases of common stock | (888) |  |  | (9) |  |  | (5,329) |  |  | (35,614) |  |  | (40,952) |
Balance at March 28, 2020 | 27,636 |  |  | $ | 276 |  |  | $ | — |  |  | $ | (156,185) |  |  | $ | (155,909) |
Net loss | — |  |  | — |  |  | — |  |  | (12,630) |  |  | (12,630) |
Exercise of common stock options | 33 |  |  | — |  |  | 817 |  |  | — |  |  | 817 |
Stock-based compensation | 71 |  |  | 1 |  |  | 5,032 |  |  | — |  |  | 5,033 |
Repurchases of common stock | (15) |  |  | — |  |  | (330) |  |  | 1 |  |  | (329) |
Balance at June 27, 2020 | 27,725 |  |  | $ | 277 |  |  | $ | 5,519 |  |  | $ | (168,814) |  |  | $ | (163,018) |
Net income | — |  |  | — |  |  | — |  |  | 51,320 |  |  | 51,320 |
Exercise of common stock options | 20 |  |  | 1 |  |  | 549 |  |  | — |  |  | 550 |
Stock-based compensation | 14 |  |  | — |  |  | 8,470 |  |  | — |  |  | 8,470 |
Repurchases of common stock | (2) |  |  | — |  |  | (148) |  |  | (1) |  |  | (149) |
Balance at September 26, 2020 | 27,757 |  |  | $ | 278 |  |  | $ | 14,390 |  |  | $ | (117,495) |  |  | $ | (102,827) |

| Common Stock |  |  |  | Additional Paid-in Capital |  | Accumulated Deficit |  | Total
| Shares |  | Amount |  |  |  |  |  |
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) |

See accompanying notes to condensed consolidated financial statements.
3

Table of contents
SLEEP NUMBER CORPORATION
AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(unaudited - in thousands)

| Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019
Cash flows from operating activities: |  |  |
Net income | $ | 77,830 |  |  | $ | 57,752 |
Adjustments to reconcile net income to net cash provided by operating activities: |  |  |
Depreciation and amortization | 46,244 |  |  | 46,267 |
Stock-based compensation | 15,554 |  |  | 12,034 |
Net loss (gain) on disposals and impairments of assets | 208 |  |  | (409) |
Deferred income taxes | 3,229 |  |  | (895) |
Changes in operating assets and liabilities: |  |  |
Accounts receivable | (12,710) |  |  | (746) |
Inventories | 3,807 |  |  | (1,626) |
Income taxes | 5,103 |  |  | 535 |
Prepaid expenses and other assets | 3,666 |  |  | (8,065) |
Accounts payable | 58,547 |  |  | 45,051 |
Customer prepayments | 40,795 |  |  | 12,758 |
Accrued compensation and benefits | 21,376 |  |  | 11,763 |
Other taxes and withholding | 4,756 |  |  | 5,784 |
Other accruals and liabilities | 18,877 |  |  | 9,629 |
Net cash provided by operating activities | 287,282 |  |  | 189,832 |
Cash flows from investing activities: |  |  |
Purchases of property and equipment | (28,074) |  |  | (46,757) |
Proceeds from sales of property and equipment | 53 |  |  | 2,577 |
Purchase of intangible assets | (945) |  |  | — |
Net cash used in investing activities | (28,966) |  |  | (44,180) |
Cash flows from financing activities: |  |  |
Repurchases of common stock | (41,923) |  |  | (139,178) |
Net decrease in short-term borrowings | (220,968) |  |  | (11,270) |
Proceeds from issuance of common stock | 4,650 |  |  | 5,752 |
Debt issuance costs | (303) |  |  | (1,023) |
Net cash used in financing activities | (258,544) |  |  | (145,719) |
Net decrease in cash and cash equivalents | (228) |  |  | (67) |
Cash and cash equivalents, at beginning of period | 1,593 |  |  | 1,612 |
Cash and cash equivalents, at end of period | $ | 1,365 |  |  | $ | 1,545 |

See accompanying notes to condensed consolidated financial statements.
4

Table of Contents
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 26, 2020 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 26, 2020 and December 28, 2019, 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. Additionally, based on the duration and severity of the current global situation involving the novel coronavirus (COVID-19) pandemic, including but not limited to general economic conditions, consumer confidence, store closings mandated by federal, state or local authorities and possible supply chain disruptions, the extent to which COVID-19 will impact our business and our consolidated financial results will depend on future developments, which are highly uncertain and cannot be predicted.
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 28, 2019 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. In addition, during the current environment involving COVID-19, predicting future events will be especially challenging for management. Changes in these estimates will be reflected in the consolidated financial statements in future periods and could be material. 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
In April 2020, the Financial Accounting Standards Board (FASB) issued a Staff Q&A, Topic 842 and 840: Accounting For Lease Concessions Related to the Effects of the COVID-19 Pandemic. To provide clarity in response to the COVID-19 pandemic crisis, the FASB staff believes that it would be acceptable for entities to make an election to account for lease concessions related to the effects of the COVID-19 pandemic consistent with how those concessions would be accounted for under Topic 842 as though enforceable rights and obligations for those concessions existed (regardless of whether those enforceable rights and obligations for the concessions explicitly exist in the contract).
Consequently, for concessions related to the effects of the COVID-19 pandemic, we are not required to analyze each contract to determine whether enforceable rights and obligations for concessions exist in the contract and can elect to apply or not apply the lease modification guidance in Topic 842 to those contracts. This election is available for concessions related to the effects of the COVID-19 pandemic that do not result in a substantial increase in the rights of the lessor or our obligations as the lessee. For example, this election is available for concessions that result in the total payments required by the modified contract being substantially the same as or less than total payments required by the original contract. The FASB staff expects that reasonable judgment will be exercised in making those determinations. Some concessions will provide a deferral of payments with no substantive changes to the consideration in the original contract. A deferral affects the timing, but the amount of the consideration is substantially the same as that required by the original contract. The staff expects that there will be multiple ways to account for those deferrals, none of which the staff believes are more preferable than the others. Two of those methods are:
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Notes to Condensed Consolidated Financial Statements
(unaudited)
a.Account for the concessions as if no changes to the lease contract were made. Under that accounting, a lessor would increase its lease receivable, and a lessee would increase its accounts payable as receivables/payments accrue. In its income statement, a lessor would continue to recognize income, and a lessee would continue to recognize expense during the deferral period.
b.Account for the deferred payments as variable lease payments.
We adopted option a. above and continue to recognize rent expense on a straight-line basis. We have deferred approximately $3.7 million in rent cash payments from the second and third quarter of fiscal 2020 to future periods, including $3.6 million of rent payments related to leases where we have a signed agreement related to the deferrals and the remainder related to leases we are still in the process of negotiating with the lessors. See Note 6. Leases, for further information.
2. Fair Value Measurements
At September 26, 2020 and December 28, 2019, we had $11 million and $8 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 $11 million and $8 million at September 26, 2020 and December 28, 2019, 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 26, 2020 |  | December 28, 2019
Raw materials | $ | 8,197 |  |  | $ | 6,231 |
Work in progress | 103 |  |  | 31 |
Finished goods | 74,958 |  |  | 80,803 |
| $ | 83,258 |  |  | $ | 87,065 |

4. Goodwill and Intangible Assets, Net
Goodwill and Indefinite-Lived Intangible Assets
Goodwill was $64 million at September 26, 2020 and December 28, 2019. Indefinite-lived trade name/trademarks totaled $1.4 million at September 26, 2020 and December 28, 2019.
Definite-Lived Intangible Assets
Developed Technologies
The gross carrying amount of our developed technologies was $19 million at September 26, 2020 and December 28, 2019. Accumulated amortization was $13 million and $11 million at September 26, 2020 and December 28, 2019, respectively.
Amortization expense for the three months ended September 26, 2020 and September 28, 2019, was $0.6 million and $0.5 million, respectively. Amortization expense for the nine months ended September 26, 2020 and September 28, 2019, was $1.7 million and $1.6 million, respectively.
Other
In June 2020, we purchased certain other definite-lived intangible assets for a total purchase price of $2 million and will amortize them over an average of nine years. Amortization expense for the three and nine months ended September 26, 2020 was $55 thousand.
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Notes to Condensed Consolidated Financial Statements
(unaudited)
Annual amortization for definite-lived intangible assets for subsequent years are as follows (in thousands):

2020 (excluding the nine months ended September 26, 2020) |  | $ | 638 |
2021 |  | 2,403 |
2022 |  | 2,403 |
2023 |  | 1,431 |
2024 |  | 222 |
2025 |  | 226 |
Thereafter |  | 743 |
Total future amortization for definite-lived intangible assets |  | $ | 8,066 |

5. Credit Agreement
Our credit facility as of September 26, 2020, had a total commitment amount of $450 million. The credit facility is for general corporate purposes and to meet our seasonal working capital requirements. 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). 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. 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 matures in February 2024. We were in compliance with all financial covenants as of September 26, 2020.
On April 3, 2020, we amended the credit agreement to add a 364-day term loan facility up to an aggregate commitment of $75 million under our credit agreement for a total commitment amount of $525 million, with an additional $75 million remaining available under our accordion (subject to lenders' approval). The additional borrowings were undertaken as a precautionary measure to provide increased liquidity and preserve financial flexibility in light of disruption and uncertainty resulting from the COVID-19 pandemic. On September 24, 2020, we repaid the 364-day, $75 million term loan. On October 5, 2020, we further amended the credit agreement to remove the share repurchase restriction and eliminate the floor based on LIBOR of at least 0.75% from our $450 million credit agreement that were added in the April 3, 2020 amendment.
The following table summarizes our borrowings under the credit facility ($ in thousands):

| September 26, 2020 |  | December 28, 2019
Outstanding borrowings | $ | 33,500 |  |  | $ | 231,000 |
Outstanding letters of credit | $ | 3,997 |  |  | $ | 3,497 |
Additional borrowing capacity | $ | 412,503 |  |  | $ | 215,503 |
Weighted-average interest rate | 2.5 | % |  | 3.5 | %

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.
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 can be reasonably
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Notes to Condensed Consolidated Financial Statements
(unaudited)
estimated. Future payments for real estate taxes and certain building operating expenses for which we are obligated are not included in operating lease costs.
At September 26, 2020, our finance right-of-use assets and lease liabilities were not significant.
Operating lease costs were as follows (in thousands):

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Operating lease costs(1) | $ | 22,512 |  |  | $ | 21,583 |  |  | $ | 67,815 |  |  | $ | 63,719 |
Variable lease costs | $ | 333 |  |  | $ | 466 |  |  | $ | 608 |  |  | $ | 1,387 |

___________________________
(1)Includes short-term lease costs which are not significant.
The maturities of operating lease liabilities as of September 26, 2020, were as follows(1) (in thousands):

2020 (excluding the nine months ended September 26, 2020) | 21,175 |
2021 | 80,946 |
2022 | 72,566 |
2023 | 62,641 |
2024 | 50,846 |
2025 | 41,941 |
Thereafter | 96,068 |
Total lease payments(2) | 426,183 |
Less: Interest | 83,889 |
Present value of operating lease liabilities(3) | $ | 342,294 |

___________________________
(1)We have deferred certain lease payments initially due in the second and third quarters of fiscal 2020 to future periods. These deferred rent payments of $3.7 million are excluded from this table and are included in Other current liabilities and Other non-current liabilities. See Note 1, Business and Summary of Significant Accounting Policies, New Accounting Pronouncements, Recently Adopted Accounting Guidance.
(2)Total lease payments exclude $56 million of legally binding minimum lease payments for leases signed but not yet commenced.
(3)Includes the current portion of $61 million for operating lease liabilities.
Other information related to operating leases was as follows:

|  | September 26, 2020 |  | December 28, 2019
Weighted-average remaining lease term (years) |  | 6.4 |  | 6.6
Weighted-average discount rate |  | 7.0 | % |  | 7.2 | %

|  | Nine Months Ended |  |
(in thousands) |  | September 26, 2020 |  | September 28, 2019
Cash paid for amounts included in present value of operating lease liabilities |  | $ | 64,208 |  |  | $ | 60,512 |
Right-of-use assets obtained in exchange for operating lease liabilities |  | $ | 28,772 |  |  | $ | 53,230 |

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Notes to Condensed Consolidated Financial Statements
(unaudited)
7. Repurchases of Common Stock
Repurchases of our common stock were as follows (in thousands):

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Amount repurchased under Board-approved share repurchase program | $ | — |  |  | $ | 40,000 |  |  | $ | 38,111 |  |  | $ | 120,900 |
Amount repurchased in connection with the vesting of employee restricted stock grants | 149 |  |  | 142 |  |  | 3,319 |  |  | 9,575 |
Total amount repurchased (based on trade dates) | $ | 149 |  |  | $ | 40,142 |  |  | $ | 41,430 |  |  | $ | 130,475 |

As of September 26, 2020, the remaining authorization under our Board-approved share repurchase program was $437 million.
In light of the uncertainty surrounding the impact of COVID-19, we temporarily suspended all share repurchases under our Board-approved share repurchase program. In October 2020, we resumed our share repurchase program.
8. Revenue Recognition
Deferred contract assets and deferred contract liabilities are included in our condensed consolidated balance sheets as follows (in thousands):

| September 26, 2020 |  | December 28, 2019
Deferred Contract Assets included in: |  |  |
Other current assets | $ | 25,454 |  |  | $ | 23,568 |
Other non-current assets | 35,836 |  |  | 33,782 |
| $ | 61,290 |  |  | $ | 57,350 |

| September 26, 2020 |  | December 28, 2019
Deferred Contract Liabilities included in: |  |  |
Other current liabilities | $ | 34,369 |  |  | $ | 34,204 |
Other non-current liabilities | 47,103 |  |  | 44,970 |
| $ | 81,472 |  |  | $ | 79,174 |

During both the three months ended September 26, 2020 and September 28, 2019, we recognized revenue of $9 million, that were included in the deferred contract liability balances at the beginning of the respective periods. During the nine months ended September 26, 2020 and September 28, 2019, we recognized revenue of $27 million and $25 million, respectively, that were included in the deferred contract liability balances 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 the three and nine months ended September 26, 2020 and September 28, 2019.
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Notes to Condensed Consolidated Financial Statements
(unaudited)
Net sales were as follows (in thousands):

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Retail | $ | 456,756 |  |  | $ | 437,871 |  |  | $ | 1,097,872 |  |  | $ | 1,158,096 |
Online and phone | 72,688 |  |  | 34,520 |  |  | 187,067 |  |  | 89,695 |
Total Retail | 529,444 |  |  | 472,391 |  |  | 1,284,939 |  |  | 1,247,791 |
Wholesale/Other | 1,711 |  |  | 2,387 |  |  | 3,720 |  |  | 9,395 |
Total Company | $ | 531,155 |  |  | $ | 474,778 |  |  | $ | 1,288,659 |  |  | $ | 1,257,186 |

Obligation for Sales Returns
The activity in the sales returns liability account was as follows (in thousands):

| Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019
Balance at beginning of year | $ | 19,809 |  |  | $ | 19,907 |
Additions that reduce net sales | 55,086 |  |  | 60,962 |
Deductions from reserves | (50,810) |  |  | (57,036) |
Balance at end of period | $ | 24,085 |  |  | $ | 23,833 |

9. Stock-Based Compensation Expense
Total stock-based compensation expense was as follows (in thousands):

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Stock awards | $ | 7,930 |  |  | $ | 3,527 |  |  | 13,776 |  |  | $ | 10,256 |
Stock options | 540 |  |  | 619 |  |  | 1,778 |  |  | 1,778 |
Total stock-based compensation expense (1) | 8,470 |  |  | 4,146 |  |  | 15,554 |  |  | 12,034 |
Income tax benefit | 2,081 |  |  | 984 |  |  | 3,795 |  |  | 2,948 |
Total stock-based compensation expense, net of tax | $ | 6,389 |  |  | $ | 3,162 |  |  | $ | 11,759 |  |  | $ | 9,086 |

___________________________
(1) Changes in 2020 stock-based compensation expense reflect the cumulative impact of the change in the expected achievements of certain performance targets.
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 26, 2020 and September 28, 2019, our contributions, net of forfeitures, were $2.1 million and $1.5 million, respectively. During the nine months ended September 26, 2020 and September 28, 2019, our contributions, net of forfeitures, were $4.2 million and $4.5 million, respectively.
Effective May 2020, due to the business impact of the COVID-19 pandemic, we temporarily suspended making discretionary 401(k) plan contributions. In September 2020, we reinstated the discretionary 401(k) plan contributions for 2020.
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Notes to Condensed Consolidated Financial Statements
(unaudited)
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 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Net income | $ | 51,320 |  |  | $ | 28,054 |  |  | $ | 77,830 |  |  | $ | 57,752 |
Reconciliation of weighted-average shares outstanding: |  |  |  |  |  |  |
Basic weighted-average shares outstanding | 27,973 |  |  | 29,085 |  |  | 27,918 |  |  | 29,859 |
Dilutive effect of stock-based awards | 661 |  |  | 711 |  |  | 642 |  |  | 829 |
Diluted weighted-average shares outstanding | 28,634 |  |  | 29,796 |  |  | 28,560 |  |  | 30,688 |
Net income per share – basic | $ | 1.83 |  |  | $ | 0.96 |  |  | $ | 2.79 |  |  | $ | 1.93 |
Net income per share – diluted | $ | 1.79 |  |  | $ | 0.94 |  |  | $ | 2.73 |  |  | $ | 1.88 |

For the three and nine months ended September 26, 2020 and September 28, 2019, anti-dilutive stock-based awards excluded from the diluted net income per share calculations were immaterial.
12. Commitments and Contingencies
Warranty Liabilities
The activity in the accrued warranty liabilities account was as follows (in thousands):

| Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019
Balance at beginning of year | $ | 11,345 |  |  | $ | 10,389 |
Additions charged to costs and expenses for current-year sales | 9,111 |  |  | 8,033 |
Deductions from reserves | (8,034) |  |  | (8,159) |
Changes in liability for pre-existing warranties during the current year, including expirations | (381) |  |  | 1,189 |
Balance at end of period | $ | 12,041 |  |  | $ | 11,452 |

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 San Diego County Superior Court, 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. The parties have executed a settlement agreement, including the settlement and release of certain additional related claims that are contained in a consolidated complaint,
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Notes to Condensed Consolidated Financial Statements
(unaudited)
which received preliminary Court approval on July 29, 2020 and is proceeding through final administrative processes. We intend to continue vigorously defending this matter in the event the settlement is not ultimately finalized.
On March 27, 2018, Level Sleep, LLC (Level Sleep) 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. On January 14, 2020, the Court granted summary judgment in favor of Sleep Number, finding that Sleep Number’s products do not infringe the Patents. Level Sleep has filed an appeal of the Court’s summary judgment order, which is currently pending with the Federal Circuit Court of Appeals. We intend to continue vigorously defending this matter.
13. COVID-19 Pandemic
The COVID-19 pandemic and ensuing government restrictions resulted in the temporary closure of most of our retail stores starting in mid-March. While prioritizing the safety of our team, serving our customers and ensuring business continuity, we swiftly took decisive actions to strengthen our liquidity, cash flows and financial position, and mitigate the future impact on our operations and financial performance.
For the nine months ended September 26, 2020, net sales increased 3% and net income increased by 35% compared with the same period one year ago, despite a 20% decline in net sales during the three months ended June 27, 2020 when 47% of our stores were closed on average. Approximately 98% of our stores were open on average during the three months ended September 26, 2020.
While we have generated strong financial performance during the first nine months of 2020, the volatility, length and severity of the pandemic's impact on consumer demand and the resulting impact on our future financial performance remains uncertain. See Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations and Part II: Item 1A. Risk Factors for additional discussion on the COVID-19 pandemic and the impact on our business.
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Index
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 eight sections:
•Forward-Looking Statements and Risk Factors
•Business Overview
•COVID-19 Pandemic - Impact on our Business
•Results of Operations
•Liquidity and Capital Resources
•Non-GAAP Data Reconciliations
•Off-Balance-Sheet Arrangements and Contractual Obligations
•Critical Accounting Policies
Forward-Looking Statements and 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;
•Risks inherent in outbreaks of pandemics or contagious disease, including the COVID-19 pandemic;
•The effectiveness of our marketing messages;
•The efficiency of our advertising and promotional efforts;
•Our ability to execute our Total Retail 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;
•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, outbreaks of pandemics or contagious diseases, strikes 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; and
•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” below in Part II: Item 1A of this Quarterly Report on Form 10-Q and under the same caption 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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Business Overview
Individuality is core to Sleep Number. Our purpose driven company is comprised of more than 4,000 passionate team members who are dedicated to our mission of improving lives by individualizing sleep experiences. Our 360® smart beds provide each sleeper with adjustable, personalized comfort for proven quality sleep. We have improved nearly 13 million lives as we strive to improve society’s wellbeing through higher quality sleep. Sleep science and data are the foundation of our innovations. Our award-winning 360® smart beds benefit from our proprietary SleepIQ® technology - learning from nearly 8 billion hours of highly accurate sleep data - to provide effortless comfort and individualized sleep health insights, including your daily SleepIQ® score.
Our vertically integrated business model and role as the exclusive designer, manufacturer, marketer, retailer and servicer of Sleep Number® beds allows us to offer consumers high-quality, individualized sleep solutions and services.
We generate revenue by marketing our innovations to new and existing customers, and selling products through Total Retail and Wholesale/Other. Total Retail, which includes Stores, Online, Chat and Phone, sells directly to consumers. Wholesale/Other sells to and through selected wholesale customers in the United States.
We are committed to delivering superior shareholder value by: (1) increasing consumer demand; (2) leveraging our business model; and (3) deploying capital efficiently.
COVID-19 Pandemic - Impact on our Business
The COVID-19 pandemic and ensuing government restrictions resulted in the temporary closure of most of our retail stores starting in mid-March. While prioritizing the safety of our team, serving our customers and ensuring business continuity, we swiftly took decisive actions to strengthen our liquidity, cash flows and financial position, and mitigate the future impact on our operations and financial performance.
For the nine months ended September 26, 2020, net sales increased 3% and net income increased by 35% compared with the same period one year ago, despite a 20% decline in net sales during the three months ended June 27, 2020 when 47% of our stores were closed on average. Approximately 98% of our stores were open on average during the three months ended September 26, 2020.
While we have generated strong financial performance during the first nine months of 2020, the volatility, length and severity of the pandemic's impact on consumer demand and the resulting impact on our future financial performance remains uncertain. See Part II: Item 1A. Risk Factors for additional discussion on the COVID-19 pandemic and the impact on our business.
Health and Safety of our Team Members and Customers. Upon onset of the COVID-19 pandemic, we implemented precautionary and sanitary guidelines throughout our operations, including stores, manufacturing, home delivery and headquarters based on the Centers for Disease Control and Prevention’s (CDC) recommendations, and other best practices.
Expense Management. With the reduction in second-quarter revenue due to the pandemic, we implemented appropriate expense management actions, including:
•In April 2020, we furloughed nearly 40% of our team members with another 30% working reduced hours. T he majority of our team members returned to work as stores reopened and customer demand increased. In response to changes in the business, we restructured some teams, which resulted in approximately 10% of positions being eliminated from across the country as we reallocated headcount to support the changing needs of our business.
•We temporarily reduced our sales and marketing expenses. During the three months ended September 26, 2020, we increased media spending 6% year-over-year, supporting a 12% increase in net sales.
•We negotiated rent deferrals and abatements for stores closed due to COVID-19.
Liquidity, Cash Flows and Financial Position. We took the following actions to preserve cash, increase liquidity and strengthen our financial position:
•Added $75 million of additional liquidity on April 3, 2020 through an incremental 364-day term loan under our credit facility’s $150 million accordion. On September 24, 2020, repaid the $75 million term loan with cash provided by operating activities.
•In March 2020, temporarily suspended share repurchases under our Board-approved share repurchase program. In October 2020, resumed share repurchases.
•Temporarily reduced capital expenditures to $28 million for the nine months ended September 26, 2020, compared with $47 million during the comparable period one year ago. We remained committed to our long-term innovation initiatives, including investing $28 million in research and development expenses during the nine months ended September 26, 2020.
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•Net liquidity available under our credit facility was $413 million at September 26, 2020 - $180 million greater than one year ago.
•Our leverage ratio as defined in our credit agreement was 1.9x as of September 26, 2020. The maximum leverage ratio under our credit agreement is 4.5x.
CARES Act. On March 27, 2020, the President signed the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) into law. The CARES Act includes the following relief, among others:
•Amended federal tax laws to permit 100% bonus depreciation for eligible qualified improvement property placed in service by the taxpayer after December 31, 2017 and before January 1, 2023.
•Employers are eligible for a 50 percent refundable payroll tax credit on wages paid up to $10,000, per employee, during the crisis. The credit would be available to employers whose businesses were disrupted due to virus shutdowns and those that had a decrease in gross receipts of 50 percent or more when compared to the same quarter last year. The credit can be claimed for employees who are retained but not currently working due to the crisis for firms with more than 100 employees.
•Provides for deferred payment of the employer portion of social security taxes through the end of 2020, with 50% of the deferred amount due December 31, 2021 and the remaining 50% due December 31, 2022. This has provided us with additional liquidity during 2020.
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. In addition, based on the duration and severity of the current global situation involving the COVID-19 pandemic, the extent to which our business and our condensed consolidated financial results are impacted, will depend on future developments, which are highly uncertain and cannot be predicted. 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 three months ended September 26, 2020 were as follows:
•Net sales for the three months ended September 26, 2020 increased 12% to $531 million, compared with $475 million for the same period one year ago.
•The 12% net sales increase included an 11% comparable sales increase in Total Retail, in addition to 1 percentage point (ppt.) of sales growth from net new stores opened in the past 12 months. For additional details, see the components of total net sales change on page 17.
•Sales per store (sales for stores open at least one year, Total Retail, including online and phone sales) on a trailing twelve-month basis for the period ended September 26, 2020 totaled $2.9 million, 2% higher than the same period last year.
•Operating income for the three months ended September 26, 2020 was $70 million, an increase of $30 million, or 78%, compared with $39 million in the prior-year period. The $30 million increase in operating income resulted from the 12% increase in net sales, a 0.7 ppt. increase in our gross profit rate and 4.2 ppt. reduction in our operating expenses rate.
•The 0.7 ppt. gross profit rate increase was primarily due to leverage from the 12% net sales increase, including the associated operational and logistics efficiencies.
•The 4.2 ppt. reduction in our operating expense rate resulted from the leveraging impact of the 12% net sales increase and actions taken to manage expenses as we navigated the uncertainties of the COVID-19 pandemic, while continuing to support our innovation initiatives. During the three months ended September 26, 2020, we continued to prioritize investments in near- and long-term growth drivers, including $9.6 million of R&D expenses.
•Net income for the three months ended September 26, 2020 increased by 83% to $51 million, compared with net income of $28 million for the same period one year ago. Net income per diluted share was $1.79, a 90% increase compared with net income per diluted share of $0.94 last year.
•We achieved a return on invested capital (ROIC) of 20.8% on a trailing twelve-month basis for the period ended September 26, 2020, compared with 18.4% for the comparable period one year ago.
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•Cash provided by operating activities for the nine months ended September 26, 2020 increased by $97 million, or 51%, to $287 million, compared with $190 million for the same period one year ago.
•At September 26, 2020, we had $34 million of borrowings under our credit facility. Net liquidity available under our credit facility was $413 million at September 26, 2020.
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 26, 2020 |  |  |  | September 28, 2019 |  |  |  | September 26, 2020 |  |  |  | September 28, 2019 |  |
Net sales | $ | 531.2 |  |  | 100.0 | % |  | $ | 474.8 |  |  | 100.0 | % |  | $ | 1,288.7 |  |  | 100.0 | % |  | $ | 1,257.2 |  |  | 100.0 | %
Cost of sales | 196.2 |  |  | 36.9 | % |  | 178.4 |  |  | 37.6 | % |  | 488.6 |  |  | 37.9 | % |  | 481.4 |  |  | 38.3 | %
Gross profit | 335.0 |  |  | 63.1 | % |  | 296.4 |  |  | 62.4 | % |  | 800.1 |  |  | 62.1 | % |  | 775.8 |  |  | 61.7 | %
Operating expenses: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Sales and marketing | 211.6 |  |  | 39.8 | % |  | 213.1 |  |  | 44.9 | % |  | 549.5 |  |  | 42.6 | % |  | 568.8 |  |  | 45.2 | %
General and administrative | 44.1 |  |  | 8.3 | % |  | 35.1 |  |  | 7.4 | % |  | 111.9 |  |  | 8.7 | % |  | 102.5 |  |  | 8.2 | %
Research and development | 9.6 |  |  | 1.8 | % |  | 9.0 |  |  | 1.9 | % |  | 28.4 |  |  | 2.2 | % |  | 25.4 |  |  | 2.0 | %
Total operating expenses | 265.3 |  |  | 50.0 | % |  | 257.2 |  |  | 54.2 | % |  | 689.8 |  |  | 53.5 | % |  | 696.7 |  |  | 55.4 | %
Operating income | 69.6 |  |  | 13.1 | % |  | 39.2 |  |  | 8.2 | % |  | 110.3 |  |  | 8.6 | % |  | 79.1 |  |  | 6.3 | %
Interest expense, net | 1.8 |  |  | 0.3 | % |  | 3.1 |  |  | 0.7 | % |  | 8.1 |  |  | 0.6 | % |  | 9.0 |  |  | 0.7 | %
Income before income taxes | 67.8 |  |  | 12.8 | % |  | 36.0 |  |  | 7.6 | % |  | 102.2 |  |  | 7.9 | % |  | 70.1 |  |  | 5.6 | %
Income tax expense | 16.5 |  |  | 3.1 | % |  | 8.0 |  |  | 1.7 | % |  | 24.4 |  |  | 1.9 | % |  | 12.4 |  |  | 1.0 | %
Net income | $ | 51.3 |  |  | 9.7 | % |  | $ | 28.1 |  |  | 5.9 | % |  | $ | 77.8 |  |  | 6.0 | % |  | $ | 57.8 |  |  | 4.6 | %
Net income per share: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic | $ | 1.83 |  |  |  |  | $ | 0.96 |  |  |  |  | $ | 2.79 |  |  |  |  | $ | 1.93 |  |  |
Diluted | $ | 1.79 |  |  |  |  | $ | 0.94 |  |  |  |  | $ | 2.73 |  |  |  |  | $ | 1.88 |  |  |
Weighted-average number of common shares: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic | 28.0 |  |  |  |  | 29.1 |  |  |  |  | 27.9 |  |  |  |  | 29.9 |  |  |
Diluted | 28.6 |  |  |  |  | 29.8 |  |  |  |  | 28.6 |  |  |  |  | 30.7 |  |  |

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

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Total Retail | 99.7 | % |  | 99.5 | % |  | 99.7 | % |  | 99.3 | %
Wholesale/Other | 0.3 | % |  | 0.5 | % |  | 0.3 | % |  | 0.7 | %
Total Company | 100.0 | % |  | 100.0 | % |  | 100.0 | % |  | 100.0 | %

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

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Sales change rates: |  |  |  |  |  |  |
Retail comparable-store sales (1) | 2 | % |  | 9 | % |  | (8 | %) |  | 7 | %
Online and phone | 111 | % |  | 20 | % |  | 109 | % |  | 10 | %
Total Retail comparable sales change (1) | 11 | % |  | 10 | % |  | 1 | % |  | 8 | %
Net opened/closed stores | 1 | % |  | 4 | % |  | 2 | % |  | 5 | %
Total Retail | 12 | % |  | 14 | % |  | 3 | % |  | 13 | %
Wholesale/Other | (28 | %) |  | 8 | % |  | (60 | %) |  | (17 | %)
Total Company net sales change | 12 | % |  | 14 | % |  | 3 | % |  | 12 | %

___________________________
(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.
Other sales metrics were as follows:

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Average sales per store (1) ($ in thousands) | $ | 2,920 |  |  | $ | 2,858 |  |  |  |  |
Average sales per square foot (1) | $ | 1,012 |  |  | $ | 1,029 |  |  |  |  |
Stores > $2 million in net sales (2) | 64 | % |  | 70 | % |  |  |  |
Stores > $3 million in net sales (2) | 26 | % |  | 28 | % |  |  |  |
Average revenue per mattress unit (3) | $ | 4,802 |  |  | $ | 4,788 |  |  | $ | 4,824 |  |  | $ | 4,837 |

___________________________
(1)Trailing-twelve months Total Retail 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 Total Retail net sales divided by Total Retail mattress units.
The number of retail stores operating was as follows:

| Three Months Ended |  |  |  | Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Beginning of period | 598 |  |  | 594 |  |  | 611 |  |  | 579 |
Opened | 6 |  |  | 15 |  |  | 20 |  |  | 47 |
Closed | (8) |  |  | (7) |  |  | (35) |  |  | (24) |
End of period | 596 |  |  | 602 |  |  | 596 |  |  | 602 |

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Comparison of Three Months Ended September 26, 2020 with Three Months Ended September 28, 2019
Net sales
Net sales for the three months ended September 26, 2020 increased by $56 million, or 12%, to $531 million, compared with $475 million for the same period one year ago.
The 12% net sales increase consisted of an 11% comparable sales increase in Total Retail in addition to 1 percentage point (ppt.) of sales growth from net new stores opened in the past 12 months. For additional details, see the components of total net sales change on page 17. Online and phone sales (included in comparable sales noted above) made up 14% of total net sales compared with 7% in the prior year as consumers embrace transacting remotely with Sleep Number as well as in our stores.
The $56 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $48 million increase in our Total Retail comparable net sales; and (ii) a $9 million increase resulting from net store openings; partially offset by (iii) a $1 million decrease in Wholesale/Other sales. Total Retail mattress unit sales increased 12% compared with the prior year. Total Retail average revenue per mattress unit increased to $4,802, compared with $4,788 in the prior-year period.
Gross profit
Gross profit of $335 million increased by $39 million, or 13%, compared with $296 million for the same period one year ago. The gross profit rate improved to 63.1% of net sales for the three months ended September 26, 2020, compared with 62.4% for the prior-year comparable period. The current-year gross profit rate improvement of 0.7 ppt. was mainly due to: (i) leverage from the 12% net sales increase, including associated operational and logistics efficiencies (1.0 ppt.); partially offset by (ii) higher performance-based incentive compensation expense. In addition, our gross profit rate will fluctuate from quarter to quarter due to a variety of other factors, including return and exchange costs.
Sales and marketing expenses
Sales and marketing expenses for the three months ended September 26, 2020 were $212 million, or 39.8% of net sales, compared with $213 million, or 44.9% of net sales, for the same period one year ago. The current-year sales and marketing expenses rate decrease of 5.1 ppt. was primarily due to: (i) actions taken to manage expenses in response to the uncertainty related to the COVID-19 pandemic; and (ii) the leveraging impact of the 12% net sales increase. Expense management actions included leveraging our media spending, which increased by 6% compared with the prior year, while net sales increased by 12%, and lower payroll costs due to reduced store operating hours and improved productivity.
General and administrative expenses
General and administrative (G&A) expenses totaled $44 million, or 8.3% of net sales, for the three months ended September 26, 2020, compared with $35 million, or 7.4% of net sales, in the prior-year period. The $9 million increase in G&A expenses consisted primarily of: (i) a $10 million increase in employee compensation primarily resulting from a year-over-year increase in company-wide performance-based incentive compensation; partially offset by (ii) a $1 million decrease in travel expenses, professional fees and other miscellaneous expenses. The G&A expenses rate increased by 0.9 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 to $9.6 million for the three months ended September 26, 2020, compared with $9.0 million for the same period last year as we continued to prioritize our long-term innovation initiatives.
Interest expense, net
Interest expense, net decreased to $1.8 million for the three months ended September 26, 2020, compared with $3.1 million for the same period one year ago. The $1.3 million decrease was mainly driven by a lower level of outstanding borrowings during the three months ended September 26, 2020 and a decrease in the weighted-average interest rate on borrowings, compared with the same period one year ago.
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Income tax expense
Income tax expense totaled $16 million for the three months ended September 26, 2020, compared with $8 million last year. The effective income tax rate for the three months ended September 26, 2020 was 24.3%, compared with 22.1% for the comparable period last year, reflecting higher stock-based compensation excess tax benefits in the prior-year period.
Comparison of Nine Months Ended September 26, 2020 with Nine Months Ended September 28, 2019
Net sales
Net sales for the nine months ended September 26, 2020 increased by $31 million, or 3%, to $1.3 billion. The COVID-19 pandemic and ensuing government restrictions resulted in the temporary closure of most of our retail stores starting in mid-March, with 47% of our stores closed on average during the three months ended June 27, 2020. Approximately 98% of our stores were open on average during the three months ended September 26, 2020. For additional details, see "COVID-19 Pandemic - Impact on our Business" above.
The 3% net sales increase consisted of a 1% comparable sales increase in Total Retail in addition to 2 percentage points (ppt.) of sales growth from net new stores opened in the past 12 months. For additional details, see the components of total net sales change on page 17.
The $31 million net sales increase compared with the same period one year ago was comprised of the following: (i) an $8 million increase in our Total Retail comparable net sales; (ii) a $29 million increase resulting from net store openings; partially offset by (iii) a $6 million decrease in Wholesale/Other sales. Total Retail mattress unit sales increased 3%, compared with the prior year. Average revenue per mattress unit in Total Retail was $4,824, compared with $4,837 in the prior-year period.
Gross profit
Gross profit of $800 million increased by $24 million, or 3%, compared with $776 million for the same period one year ago. The gross profit rate was 62.1% of net sales for the nine months ended September 26, 2020, compared with 61.7% for the prior-year comparable period. The current-year gross profit rate improvement of 0.4 ppt. was mainly due to the leverage from our first quarter and third quarter net sales growth, including associated operational and logistics efficiencies, partially offset by a reduction in our gross profit rate during the second quarter of 2020 due to the pandemic's disruption on our business. In addition, our gross profit rate will fluctuate from quarter to quarter due to a variety of other factors, including return and exchange costs, and performance-based incentive compensation.
Sales and marketing expenses
Sales and marketing expenses for the nine months ended September 26, 2020 were $549 million, or 42.6% of net sales, compared with $569 million, or 45.2% of net sales, for the same period one year ago. The $19 million decrease was primarily due to the decisive actions taken in April 2020 to manage expenses in response to the COVID-19 pandemic and the ensuing government restrictions that resulted in the temporary closure of most of our stores during the second quarter. These actions resulted in lower payroll costs mainly due to furloughs and reduced team members' hours, and a 2% reduction in media expenses compared with the same period last year (6% increase in media expenses for the three months ended September 26, 2020). The sales and marketing expenses rate decreased by 2.6 ppt. in the current-year period, compared with the same period one year ago due to the items discussed above and the leveraging impact of the 3% net sales increase.
General and administrative expenses
General and administrative (G&A) expenses totaled $112 million, or 8.7% of net sales, for the nine months ended September 26, 2020, compared with $102 million, or 8.2% of net sales, in the prior-year period. The $9 million increase in G&A expenses consisted of: (i) a $9 million increase in employee compensation primarily resulting from a year-over-year increase in company-wide performance-based incentive compensation; and (ii) $1 million of severance costs resulting from the permanent elimination of certain roles due to changing business needs based on the COVID-19 pandemic; partially offset by (iii) a $1 million decrease in travel expenses, professional fees and other miscellaneous expenses. The G&A expenses rate increased by 0.5 ppt. in the current-year period, compared with the same period one year ago due to the increased expenses discuss above, partially offset by the leveraging impact of the 3% net sales increase.
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Research and development expenses
Research and development (R&D) expenses increased by 12% to $28 million for the nine months ended September 26, 2020, compared with $25 million for the same period one year ago. The R&D expense rate for the nine months ended September 26, 2020 increased to 2.2% of net sales, compared with 2.0% of net sales for the prior year. The spending level increase supports our ongoing consumer innovation strategy.
Interest expense, net
Interest expense, net decreased to $8.1 million for the nine months ended September 26, 2020, compared with $9.0 million for the same period one year ago. The $0.9 million decrease was driven by a reduction in the weighted-average interest rate on borrowings during the nine months ended September 26, 2020, compared with the same period one year ago.
Income tax expense
Income tax expense totaled $24 million for the nine months ended September 26, 2020, compared with $12 million last year. The effective income tax rate for the nine months ended September 26, 2020 was 23.8%, compared with 17.7% for the comparable period last year, reflecting higher stock-based compensation excess tax benefits, additional tax credits and the favorable resolution of a tax matter in the prior-year period.
Liquidity and Capital Resources
Managing our liquidity and capital resources is an important part of our commitment to deliver superior shareholder value over time. The COVID-19 pandemic and ensuing government restrictions resulted in the temporary closure of most of our retail stores in mid-March, with 47% of our retail stores on average closed during the three months ended June 27, 2020. For the nine months ended September 26, 2020, net sales increased 3% and net income increased by 35% compared with the same period one year ago, and cash generated from operations increased 51%. Approximate 98% of our stores were open on average during the three months ended September 26, 2020. The following actions were taken to manage liquidity and capital resources at the onset of the COVID-19 pandemic. Our strong performance year-to-date has dramatically improved our risk profile and we have taken subsequent liquidity and capital deployment actions as a result:
•On September 24, 2020, we repaid the $75 million, 364-day term loan we added under our credit agreement on April 3, 2020. The $75 million term loan provided increased liquidity and preserved financial flexibility in consideration of the disruption and uncertainty resulting from the COVID-19 pandemic. On September 24, 2020, we repaid the $75 million term loan. On October 5, 2020, we amended the credit agreement to remove the share repurchase restriction and eliminate the floor based on LIBOR of at least 0.75% from our $450 million credit agreement. Net liquidity available under our credit facility was $413 million at September 26, 2020.
•We resumed share repurchases under our Board-approved share repurchase program in October 2020, after it was temporarily discontinued along with reduced capital expenditures in response to COVID-19. We also expect to return to a normalized amount of capital spending going forward.
•We negotiated rent deferrals and abatements for stores closed due to COVID-19.
•W e furloughed nearly 40% of our team members with another 30% working reduced hours. T he majority of our team members returned to work as stores reopened and customer demand increased. In response to changes in the business, we have restructured some teams, which resulted in approximately 10% of positions being eliminated from across the country as we reallocated headcount to support the changing needs of our business.
•We temporarily suspended the Company's 401(k) match and selected other benefit programs. In September 2020, we reinstated the discretionary 401(k) plan contributions for 2020.
•We also temporarily reduced our sales and marketing expenses, and most discretionary projects, while continuing to support our innovation initiatives. As our stores reopened and market conditions warranted, we increased our sales and marketing expenses, and restarted selected discretionary projects to support the future growth of business.
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.
Changes in the cash and cash equivalents during the nine months ended September 26, 2020 primarily consisted of $287 million of cash provided by operating activities, offset by $28 million of cash used to purchase property and equipment, a $221 million decrease in short-term borrowings and $42 million of cash used to repurchase our common stock (based on settlement, $39 million under our Board-approved share repurchase program and $3 million in connection with the vesting of employee restricted stock grants).
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The following table summarizes our cash flows ($ in millions). Amounts may not add due to rounding differences:

| Nine Months Ended |  |
| September 26, 2020 |  | September 28, 2019
Total cash provided by (used in): |  |  |
Operating activities | $ | 287.3 |  |  | $ | 189.8 |
Investing activities | (29.0) |  |  | (44.2) |
Financing activities | (258.5) |  |  | (145.7) |
Net decrease in cash and cash equivalents | $ | (0.2) |  |  | $ | (0.1) |

Cash provided by operating activities for the nine months ended September 26, 2020 was $287 million, compared with $190 million for the nine months ended September 28, 2019. Significant components of the year-over-year change in cash provided by operating activities included: (i) a $20 million increase in net income for the nine months ended September 26, 2020, compared with the same period one year ago; (ii) a $28 million fluctuation in customer prepayments due to the strong recovery in customer demand during the three months ended September 26, 2020 that outperformed forecasts and suppliers' fulfillment, which had been curtailed to navigate the challenges of the COVID-19 pandemic; (iii) a $13 million fluctuation in accounts payable resulting from the growth of our business and timing of payments; (iv) a $12 million fluctuation in prepaid expenses and other assets due to both periods being impacted by the timing of rent payments and the current-year changes in business activities due to the pandemic; and (v) a $12 million fluctuation in accounts receivable based on strong sales growth during the three months ended September 26, 2020.
Net cash used in investing activities to purchase property and equipment was $28 million for the nine months ended September 26, 2020, compared with $47 million for the same period one year ago. The year-over-year decrease was primarily due to actions taken to temporarily reduce capital spending based on the economic uncertainties associated with the pandemic.
Net cash used in financing activities was $259 million for the nine months ended September 26, 2020, compared with $146 million for the same period last year. During the nine months ended September 26, 2020, we repurchased $42 million of our stock (based on settlement dates, $39 million under our Board-approved share repurchase program and $3 million in connection with the vesting of employee restricted stock awards), compared with $139 million during the same period one year ago. Short-term borrowings decreased by $221 million during the current-year period due to a $198 million decrease in borrowings under our revolving credit facility to $34 million and a decrease in book overdrafts which are included in the net change in short-term borrowings. Short-term borrowings were reduced by $11 million during the prior-year period due to a decrease in book overdrafts, partially offset by a $14 million increase in borrowings under our credit facility to $214 million.
Under our Board-approved share repurchase program, we repurchased 0.8 million shares at a cost of $38 million (based on trade dates, an average of $49.42 per share) during the nine months ended September 26, 2020. During the nine months ended September 28, 2019, we repurchased 3.0 million shares at a cost of $121 million (an average of $40.19 per share). The remaining authorization under our Board-approved share repurchase program at September 26, 2020 was $437 million. There is no expiration date governing the period over which we can repurchase shares. In light of the uncertainty surrounding the impact of COVID-19, in March 2020 we temporarily suspended all share repurchases under our Board-approved share repurchase program. We resumed share repurchases in October 2020.
As of September 26, 2020, we had $34 million of borrowings under our revolving credit facility. We also had $4 million in outstanding letters of credit. Net liquidity available under our credit facility was $413 million at September 26, 2020. 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). Our leverage ratio as defined in our credit agreement was 1.9x as of September 26, 2020. 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. 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 is for general corporate purposes and to meet our seasonal working capital requirements. As of September 26, 2020, the weighted-average interest rate on borrowings under the credit facility was 2.5% 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 consistent with our credit agreement. As of September 26, 2020, we were in compliance with all financial covenants.
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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. As the accounts are owned by Synchrony Bank, at no time are the accounts purchased or acquired from us. We are not liable to Synchrony Bank for our customers’ credit defaults.
Non-GAAP Data Reconciliations
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 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Net income | $ | 51,320 |  |  | $ | 28,054 |  |  | $ | 101,923 |  |  | $ | 84,742 |
Income tax expense | 16,468 |  |  | 7,967 |  |  | 30,642 |  |  | 21,421 |
Interest expense | 1,829 |  |  | 3,131 |  |  | 10,829 |  |  | 11,064 |
Depreciation and amortization | 15,083 |  |  | 14,963 |  |  | 61,071 |  |  | 61,155 |
Stock-based compensation | 8,470 |  |  | 4,146 |  |  | 20,177 |  |  | 13,348 |
Asset impairments | 11 |  |  | 29 |  |  | 276 |  |  | 150 |
Adjusted EBITDA | $ | 93,181 |  |  | $ | 58,290 |  |  | $ | 224,918 |  |  | $ | 191,880 |

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 26, 2020 |  | September 28, 2019 |  | September 26, 2020 |  | September 28, 2019
Net cash provided by operating activities | $ | 287,282 |  |  | $ | 189,832 |  |  | $ | 286,610 |  |  | $ | 186,922 |
Subtract: Purchases of property and equipment | 28,074 |  |  | 46,757 |  |  | 40,556 |  |  | 58,260 |
Free cash flow | $ | 259,208 |  |  | $ | 143,075 |  |  | $ | 246,054 |  |  | $ | 128,662 |

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Non-GAAP Data Reconciliations (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 26, 2020 |  | September 28, 2019
Net operating profit after taxes (NOPAT) |  |  |
Operating income | $ | 143,295 |  |  | $ | 117,224 |
Add: Rent expense (1) | 91,142 |  |  | 85,807 |
Add: Interest income | 97 |  |  | 4 |
Less: Depreciation on capitalized operating leases (2) | (23,700) |  |  | (21,821) |
Less: Income taxes (3) | (50,584) |  |  | (44,298) |
NOPAT | $ | 160,250 |  |  | $ | 136,916 |
Average invested capital |  |  |
Total deficit | $ | (102,827) |  |  | $ | (164,487) |
Add: Long-term debt (4) | 34,177 |  |  | 214,482 |
Add: Capitalized operating lease obligations (5) | 729,136 |  |  | 686,456 |
Total invested capital at end of period | $ | 660,486 |  |  | $ | 736,451 |
Average invested capital (6) | $ | 770,197 |  |  | $ | 743,271 |
Return on invested capital (ROIC) (7) | 20.8 | % |  | 18.4 | %

___________________________
(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 5) 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 24.0% and 24.4% for 2020 and 2019, 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.
Off-Balance-Sheet Arrangements and Contractual Obligations
As of September 26, 2020, we were not involved in any unconsolidated special purpose entity transactions. Other than our $4 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 the amendments to our credit agreement, since the end of fiscal 2019. 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 28, 2019 for additional information regarding our other contractual obligations.
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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 28, 2019. There were no significant changes in our critical accounting policies since the end of fiscal 2019 other than adding goodwill and indefinite-lived intangible assets as a critical accounting policy.

Description |  | Judgments and Uncertainties |  | Effect if Actual Results Differ from Assumptions
Goodwill and Indefinite-Lived Intangible Assets |  |  |  |
Goodwill represents the excess of cost over the fair value of identifiable net assets of businesses acquired. Our indefinite-lived intangible assets include trade names/trademarks. See Note 1, Business and Summary of Significant Accounting Policies, and Note 5, Goodwill and Intangible Assets, Net, to the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of the 2019 Annual Report on Form 10-K, for a complete discussion of our goodwill and indefinite-lived intangible assets. |  | The determination of fair value involves uncertainties because it requires management to make assumptions and to apply judgment to estimate industry and economic factors and the profitability of future business strategies. Management’s assumptions also include projected revenues, operating profit levels and discount rates, as well as consideration of any other factors that may indicate potential impairment. |  | In the fourth quarter of fiscal 2019, management completed its annual goodwill and other indefinite-lived intangible asset impairment tests and determined there was no impairment. We believe our assumptions and judgments used in estimating cash flows and determining fair value were reasonable. However, unexpected changes to such assumptions and judgments could affect our impairment analyses and future results of operations, including an impairment charge that could be material. There have been no significant changes for the nine months ended September 26, 2020.

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 $0.3 million based on the $34 million of borrowings under our credit facility at September 26, 2020. 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 26, 2020, 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 San Diego County Superior Court, 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. The parties have executed a settlement agreement, including the settlement and release of certain additional related claims that are contained in a consolidated complaint, which received preliminary Court approval on July 29, 2020 and is proceeding through final administrative processes. We intend to continue vigorously defending this matter in the event the settlement is not ultimately finalized.
On March 27, 2018, Level Sleep, LLC (Level Sleep) 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. On January 14, 2020, the Court granted summary judgment in favor of Sleep Number, finding that Sleep Number’s products do not infringe the Patents. Level Sleep has filed an appeal of the Court’s summary judgment order, which is currently pending with the Federal Circuit Court of Appeals. We intend to continue vigorously defending this matter.
ITEM 1A. RISK FACTORS
In addition to the risks discussed below and other information set forth in this Quarterly Report on Form 10-Q, 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.
The COVID-19 pandemic has had, and may continue to have, an adverse effect on our business and our financial results.
The COVID-19 pandemic has created significant volatility, uncertainty and economic disruption, which has adversely affected our business operations and our financial results. Consumer concern about becoming ill with the virus and recommendations and/or mandates from federal, state and local authorities to close certain businesses, stay at home, practice social distancing or self-quarantine resulted in the temporary closure of the majority of our stores nationwide for a period of time between mid-March and mid-May. Approximately 98% of our stores were open on average during the three months ended September, but as the COVID-19 pandemic continues, we may need to temporarily close some or all of our stores again. These actions have adversely affected our business, operations, demand for our product, traffic to our stores, and macroeconomic factors that affect us, such as consumer confidence and spending which have, in turn resulted in a loss of sales and profits. Even as certain restrictions have been or are beginning to be eased or lifted, consumers may continue to take additional precautions that could cause a reduction in foot-traffic to certain of our locations or other changes in consumer spending behavior over time, and new restrictions may be implemented. With temporary closures to our retail store locations across the country and our delivery operations adversely impacted, we scaled our digital capabilities including: remote retail selling, customer service, private appointments, flexible work schedules, solutions for contactless delivery, and remote access for team members across the country. This shift to our team members working remotely has amplified certain risks to our
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business, including increased demand on our information technology resources and systems and increased risk of cybersecurity breaches and IT outages. In addition, as recommendations and/or mandates have been eased or lifted across the country, we have implemented new health and safety policies at headquarters, stores, and our manufacturing and assembly locations as well as for our home delivery teams, which are intended to reduce the risk of contracting or spreading the coronavirus for team members, contractors, and customers who are unable to perform their roles or transact business remotely. The Company has incurred additional costs and has diverted certain internal resources to develop and implement these new policies as well as provide, and in some cases manufacture, the personal protective equipment necessary to follow these new policies. The return to working in-person presents the risk that our new health and safety policies may not adequately protect our team members, contractors, and customers from contracting or spreading the coronavirus. We continue to monitor the effectiveness of our new policies to inform our future plans for welcoming all team members, even those who can work remotely, back to our facilities.
As the COVID-19 pandemic continues, we may further restrict the operations of our stores, delivery operations, and manufacturing and distribution facilities if we deem this necessary or if recommended or mandated by authorities and these measures could have a further material impact on our sales and profits.
In addition, we expect to continue to incur increased costs in our response to the pandemic, including, but not limited to, costs incurred to implement the operational changes described above and certain payments to or other costs relating to team members who are not working during the pandemic or whose jobs have been eliminated.
In response to the COVID-19 pandemic, including the significant reduction in customer visits to, and spending at, our stores caused by COVID-19, we did and in some situations continue to take actions to maintain liquidity including:
•in March, temporarily discontinued share repurchases under our Board-approved share repurchase program, and in October 2020, resumed share repurchases;
•temporarily reduced capital expenditures;
•negotiated rent deferrals and abatements for stores closed due to COVID-19;
•initially furloughed nearly 40% of our team members and reducing the working hours of another 30% of our team members;
•currently, t he majority of our team members returned to work as stores reopened and customer demand increased during the quarter. In response to changes in the business, we have restructured some teams, which resulted in approximately 10% of positions being eliminated from across the country as we reallocated headcount to support the changing needs of our business;
•CEO, board members and most of our leadership team deferred all or a portion of their cash compensation for the balance of the year in exchange for restricted stock units;
•temporarily suspended our discretionary 401(k) contributions and select other employee benefit programs, and in September 2020, reinstated the discretionary 401(k) plan contributions for 2020;
•temporarily reduced our sales and marketing expenses, and during the three months ended-September 26, 2020, we increased media spending 6% year-over-year; and
•temporarily reduced discretionary projects across the Company.
It is possible that our cost reduction efforts may be insufficient to maintain adequate liquidity. Also, if we do not respond appropriately to the pandemic, or if customers do not perceive our response to be adequate for a particular region or our company as a whole, we could suffer damage to our reputation and our brand, which could continue to adversely affect our business and financial results in the future.
We are highly dependent on the effectiveness of our marketing messages and the efficiency of our advertising expenditures in generating consumer awareness and sales of our products. In light of our overall reduced marketing expenses and adjustments due to COVID-19, we may not be as successful in developing effective messages and achieving efficiency in our advertising expenditures.
Our business depends heavily on the uninterrupted operation of our two main manufacturing plants located in Irmo, South Carolina and Salt Lake City, Utah as well as our assembly distribution centers, two of which are co-located at the manufacturing plants and others located in Baltimore, Maryland and the greater Los Angeles, California area. Our business also depends on the successful operation of our bedding collection fulfillment center in Brooklyn Park, Minnesota and headquarters in Minneapolis, Minnesota. The operation of all of our facilities is critically dependent on our team members who staff these locations, and COVID-19 could directly threaten or impact their health and/or ability to work, and, therefore, adversely affect the operations of our facilities. In addition, COVID-19 and governmental mandates or recommendations in these jurisdictions could require closures of our facilities and otherwise limit or adversely impact our ability to continue these operations.
COVID-19 also impacted, and may continue to impact, our retail stores, home delivery operations, logistics, and domestic and foreign supply chain, including raw materials and components we source from third parties as well as our sole source of supply for adjustable
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foundations, particularly as a result of governmental mandates or recommendations. We expect that these impacts will continue through the remainder of 2020, and may continue to impact our results into 2021.
Our temporary reduction of discretionary spending across the Company and the inability or limitations of certain suppliers, both domestic and foreign, to operate due to governmental mandates or recommendations has delayed and may continue to delay the introduction of new product lines.
We have seen, and may continue to see, significant deterioration in macroeconomic factors that typically affect us, such as consumer confidence and spending.
The situation surrounding COVID-19 remains fluid and the potential for an adverse effect on our business and our financial results increases the longer the virus impacts activity levels in the United States and globally. For this reason, we cannot reasonably estimate with any degree of certainty the extent of the impact COVID-19 will have on our business. The extent and duration of the impact of COVID-19 on our business, operations, and financial results will depend on future developments, including the duration and spread of the outbreak, governmental mandates and recommendations, business and workforce disruptions, and the related impact on consumer confidence and spending, all of which are highly uncertain and unpredictable.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(a) – (b) Not applicable.
(c) Issuer Purchases of Equity Securities

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 28, 2020 through July 25, 2020 |  | — |  |  | $ | — |  |  | — |  |  | $ | 436,889,000 |
July 26, 2020 through August 22, 2020 |  | 280 |  |  | $ | 45.78 |  |  | — |  |  | $ | 436,889,000 |
August 23, 2020 through September 26, 2020 |  | 2,815 |  |  | $ | 48.09 |  |  | — |  |  | $ | 436,889,000 |
Total |  | 3,095 |  |  | $ | 47.88 |  |  | — |  |  | $ | 436,889,000 |

___________________________
(1)We did not repurchase any shares under our Board-approved $500 million share repurchase program (effective September 29, 2019), during the three months ended September 26, 2020.
(2)In connection with the vesting of employee restricted stock grants, we repurchased 3,095 shares of our common stock at a cost of $0.1 million during the three months ended September 26, 2020.
(3)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. In light of the uncertainty surrounding the impact of COVID-19, we temporarily suspended all share repurchases under our Board-approved share repurchase program. We resumed share repurchases in October 2020.
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 Amended and Restated Credit and Security Agreement, dated as of July 30, 2020 among Sleep Number Corporation, U.S. Bank National Association and the several banks and other financial institutions from time to time party thereto
10.2* |  | Fourth Amendment to Amended and Restated Credit and Security Agreement, dated as of October 5, 2020 among Sleep Number Corporation, U.S. Bank National Association and the several banks and other financial institutions from time to time party thereto
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)

* Filed Herewith
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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 23, 2020 | 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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