FORM 10-Q 3RD QUARTER


 


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q


QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the Quarterly Period Ended October 1, 2005
 
 
Commission File No. 0-25121

____________________



SELECT COMFORT CORPORATION
(Exact name of registrant as specified in its charter)


Minnesota
(State or other jurisdiction of
incorporation or organization)
41-1597886
(I.R.S. Employer
Identification No.)
 
6105 Trenton Lane North
Minneapolis, Minnesota
(Address of principal executive offices)
 
 
55442
(Zip code)
 
Registrant’s telephone number, including area code: (763) 551-7000


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 o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
YES x NO o

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

As of October 21, 2005, 35,130,896 shares of Common Stock of the Registrant were outstanding.

 



SELECT COMFORT CORPORATION
AND SUBSIDIARIES



INDEX

PART I: FINANCIAL INFORMATION
     
Item 1.
Page
     
 
October 1, 2005 and January 1, 2005
 
3
     
 
for the Three and Nine Months ended
October 1, 2005 and October 2, 2004
 
 
4
     
 
for the Three and Nine Months ended
October 1, 2005 and October 2, 2004
5
     
 
6
     
Item 2.
 
10
     
Item 3.
17
     
Item 4.
18
     
PART II: OTHER INFORMATION
 
     
Item 1.
19
     
Item 2.
20
     
Item 3.
21
     
Item 4.
21
     
Item 5.
21
     
Item 6.
21




PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SELECT COMFORT CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
(in thousands, except share and per share amounts)
 

 
   
(Unaudited) 
       
 
   
October 1,
2005 
   
January 1,
2005
 
Assets
             
Current assets:
             
Cash and cash equivalents
 
$
16,222
 
$
15,066
 
Marketable securities   current (note 2)
   
29,654
   
35,747
 
Accounts receivable, net of allowance for doubtful accounts of $841 and $685, respectively
   
10,754
   
8,644
 
Inventories (note 3)
   
22,023
   
20,481
 
Prepaid expenses
   
10,032
   
7,375
 
Deferred tax assets
   
6,264
   
5,287
 
Total current assets
   
94,949
   
92,600
 
Marketable securities   non-current (note 2)
   
42,513
   
40,930
 
Property and equipment, net
   
52,046
   
43,911
 
Deferred tax assets
   
12,788
   
10,755
 
Other assets
   
3,563
   
3,617
 
Total assets
 
$
205,859
 
$
191,813
 
               
Liabilities and Shareholders’ Equity
             
Current liabilities:
             
Accounts payable
 
$
29,076
 
$
26,267
 
Consumer prepayments
   
13,288
   
9,368
 
Accruals:
             
Sales returns
   
5,248
   
5,038
 
Compensation and benefits
   
22,334
   
13,913
 
Taxes and withholding
   
8,488
   
6,392
 
Other
   
11,078
   
8,143
 
Total current liabilities
   
89,512
   
69,121
 
               
Long-term liabilities
   
10,427
   
8,348
 
Total liabilities
   
99,939
   
77,469
 
               
Shareholders' equity (notes 4 and 5):
             
Undesignated preferred stock; 5,000,000 shares authorized, no shares issued and outstanding
   
-
   
-
 
Common stock, $.01 par value; 95,000,000 shares authorized, 35,308,777 and 35,828,222 shares issued and outstanding, respectively
   
353
   
358
 
Additional paid-in capital
   
61,112
   
95,548
 
Unearned compensation
   
(3,685
)
 
(1,752
)
Retained earnings
   
48,140
   
20,190
 
Total shareholders' equity
   
105,920
   
114,344
 
Total liabilities and shareholders' equity
 
$
205,859
 
$
191,813
 

See accompanying notes to consolidated financial statements.


3


SELECT COMFORT CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
(in thousands, except per share amounts)
(Unaudited)


 
 
Three Months Ended 
Nine Months Ended
 
   
October 1,
2005 
   
October 2,
2004
   
October 1,
2005
   
October 2,
2004
 
                           
Net sales
 
$
175,833
 
$
144,348
 
$
503,185
 
$
409,031
 
Cost of sales
   
71,041
   
57,366
   
206,806
   
159,101
 
Gross profit
   
104,792
   
86,982
   
296,379
   
249,930
 
Operating expenses:
                         
Sales and marketing
   
72,866
   
63,851
   
211,939
   
185,438
 
General and administrative
   
13,791
   
10,425
   
40,476
   
31,109
 
Operating income
   
18,135
   
12,706
   
43,964
   
33,383
 
Other income:
                         
Interest income
   
405
   
351
   
1,543
   
1,003
 
Income before income taxes
   
18,540
   
13,057
   
45,507
   
34,386
 
Income tax expense
   
7,094
   
5,008
   
17,557
   
13,269
 
Net income
 
$
11,446
 
$
8,049
 
$
27,950
 
$
21,117
 
                           
Net income per share (note 4)   basic
 
$
0.32
 
$
0.22
 
$
0.78
 
$
0.59
 
Weighted average shares –  basic
   
35,638
   
35,970
   
35,754
   
36,097
 
                           
Net income per share (note 4) –  diluted
 
$
0.30
 
$
0.20
 
$
0.72
 
$
0.53
 
Weighted average shares –  diluted
   
38,328
   
39,313
   
38,815
   
39,880
 

See accompanying notes to consolidated financial statements.



4


SELECT COMFORT CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(in thousands)
(Unaudited)
 
 
 
Nine Months Ended 
 
   
October 1,
2005 
   
October 2,
2004
 
               
Cash flows from operating activities:
             
Net income
 
$
27,950
 
$
21,117
 
Adjustments to reconcile net income to net cash provided by operating activities:
             
Depreciation and amortization
   
11,586
   
10,084
 
Non-cash compensation
   
549
   
294
 
Loss on disposal of assets and impaired assets
   
165
   
-
 
Deferred tax benefit
   
(3,010
)
 
(3,391
)
Changes in operating assets and liabilities:
             
Accounts receivable
   
(2,110
)
 
(798
)
Inventories
   
(1,542
)
 
(3,527
)
Prepaid expenses
   
(2,657
)
 
(1,261
)
Other assets
   
28
   
(307
)
Accounts payable
   
2,809
   
10,698
 
Accrued sales returns
   
210
   
1,166
 
Accrued compensation and benefits
   
8,421
   
(1,012
)
Accrued taxes and withholding
   
4,487
   
10,054
 
Consumer prepayments
   
3,920
   
(109
)
Other accruals and liabilities
   
5,014
   
1,025
 
Net cash provided by operating activities
   
55,820
   
44,033
 
               
Cash flows from investing activities:
             
Purchases of property and equipment
   
(19,860
)
 
(14,938
)
Investments in marketable securities
   
(22,615
)
 
(60,908
)
Proceeds from maturity of marketable securities
   
27,125
   
46,256
 
Net cash used in investing activities
   
(15,350
)
 
(29,590
)
               
Cash flows from financing activities:
             
Repurchase of common stock
   
(46,201
)
 
(14,886
)
Proceeds from issuance of common stock
   
6,887
   
5,380
 
Net cash used in financing activities
   
(39,314
)
 
(9,506
)
 
Increase in cash and cash equivalents
   
1,156
   
4,937
 
Cash and cash equivalents, at beginning of period
   
15,066
   
24,725
 
Cash and cash equivalents, at end of period
 
$
16,222
 
$
29,662
 
 
See accompanying notes to consolidated financial statements.



5


SELECT COMFORT CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements






1. Basis of Financial Statement Presentation

The consolidated financial statements for the quarter and nine months ended October 1, 2005 of Select Comfort Corporation and subsidiaries (“Select Comfort” or the “Company”) have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly the financial position of the Company as of October 1, 2005 and January 1, 2005 and the results of operations and cash flows for the periods presented.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although management believes the disclosures are adequate to make the information presented not misleading. These consolidated financial statements should be read in conjunction with our most recent audited consolidated financial statements and related notes included in our Annual Report to Shareholders and annual report on Form 10-K for the fiscal year ended January 1, 2005. Operating results for any quarterly period may not be indicative of operating results for the full year. Certain prior year amounts have been reclassified to conform to the current year presentation.

In April 2005, the Securities and Exchange Commission (SEC) approved a new rule that delays the effective date of SFAS No. 123 Revised, “Share-Based Payment” requiring compensation cost for all share-based payments (including employee stock options) to be recognized in the financial statements at fair value. Under the SEC’s rule, the provisions of the standard are now effective as of the first quarter of fiscal 2006. We are evaluating the requirements of SFAS 123R and expect that the adoption of SFAS 123R will have a material impact on our consolidated results of operations and earnings per share. Our pro forma disclosures reported the cost of share-based compensation payments as having an annual impact to diluted earnings per share in the range of $0.06 to $0.11 for fiscal years 2002 through 2004. We have not determined whether adoption of SFAS 123R will result in amounts that are similar to our current or historical pro forma disclosures under SFAS 123.

No additional new accounting pronouncements have been issued that are expected to have a material effect on our financial results.

2. Marketable Securities

We invest our cash in highly liquid investment grade debt instruments issued by the US government and related agencies, municipalities and corporations with investment grade ratings.

Our investments have an original maturity of up to 35 months with a weighted-average time to maturity of 13 months as of October 1, 2005. Investments with an original maturity of less than 90 days are classified as cash equivalents. Investments with an original maturity of greater than 90 days are classified as marketable securities. Marketable securities with a remaining maturity of greater than one year are classified as long-term. Investments are classified as held-to-maturity and carried at amortized cost. Marketable securities held at October 1, 2005 carried an amortized cost of $72.2 million and a fair value of $71.5 million.


6


3. Inventories

Inventories consist of the following (in thousands):
 
   
October 1,
2005
   
January 1,
2005
 
               
Raw materials
 
$
6,713
 
$
8,498
 
Work in progress
   
169
   
170
 
Finished goods
   
15,141
   
11,813
 
   
$
22,023
 
$
20,481
 

4. Net Income per Common Share

The following computations reconcile reported net income and net income per share basic and diluted (in thousands, except per share amounts):

 
 
Three Months Ended 
 Nine Months Ended
 
   
October 1,
2005 
   
October 2,
2004
   
October 1,
2005
   
October 2,
2004
 
                           
Net income
 
$
11,446
 
$
8,049
 
$
27,950
 
$
21,117
 
                           
Reconciliation of weighted average shares outstanding:
                         
Basic weighted average shares outstanding
   
35,638
   
35,970
   
35,754
   
36,097
 
Effect of dilutive securities:
                         
Options
   
1,573
   
1,882
   
1,694
   
2,285
 
Warrants
   
909
   
1,308
   
1,173
   
1,352
 
Restricted shares
   
208
   
153
   
194
   
146
 
Diluted weighted average shares outstanding
   
38,328
   
39,313
   
38,815
   
39,880
 
                           
Net income per share –  basic
 
$
0.32
 
$
0.22
 
$
0.78
 
$
0.59
 
Net income per share –  diluted
 
$
0.30
 
$
0.20
 
$
0.72
 
$
0.53
 

Additional potentially dilutive securities totaling 746,000 and 677,000 for the three and nine month periods ended October 1, 2005 and 753,000 and 540,000 for the three and nine month periods ended October 2, 2004, have been excluded from diluted EPS because these securities’ exercise price was greater than the average market price of the Company’s common shares.


7


5. Stock-Based Compensation

Statement of Financial Accounting Standards (SFAS) No. 123 (SFAS No. 123), “Accounting for Stock-Based Compensation” encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. We have chosen to continue to account for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation cost has been recognized for fixed-price stock options because the exercise prices of the stock options equal the market value of our common stock at the date of grant.

The following table illustrates the effect on our net income and earnings per share if we had applied the fair value recognition provision of SFAS No. 123 (in thousands, except per share amounts):
 
 
Three Months Ended 
 Nine Months Ended
 
   
October 1,
2005 
   
October 2,
2004
   
October 1,
2005
   
October 2,
2004
 
                           
Net income, as reported
 
$
11,446
 
$
8,049
 
$
27,950
 
$
21,117
 
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
   
(884
)
 
(787
)
 
(2,485
)
 
(2,241
)
 
Pro forma net income
 
$
10,562
 
$
7,262
 
$
25,465
 
$
18,876
 
                           
Net income per share:
                         
Basic –  as reported
 
$
0.32
 
$
0.22
 
$
0.78
 
$
0.59
 
Basic –  pro forma
 
$
0.30
 
$
0.20
 
$
0.71
 
$
0.52
 
                           
Diluted –  as reported
 
$
0.30
 
$
0.20
 
$
0.72
 
$
0.53
 
Diluted –  pro forma
 
$
0.28
 
$
0.18
 
$
0.66
 
$
0.47
 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:

 
 
Three Months Ended 
 Nine Months Ended
 
   
October 1,
2005 
   
October 2,
2004
   
October 1,
2005
   
October 2,
2004
 
                           
Expected dividend yield
   
0
%
 
0
%
 
0
%
 
0
%
Expected stock price volatility
   
80
%
 
55
%
 
80
%
 
55
%
Risk-free interest rate
   
4.0
%
 
2.0
%
 
4.0
%
 
2.0
%
Expected life in years
   
4.0
   
3.6
   
4.0
   
3.6
 
Weighted average fair value at grant date
 
$
12.01
 
$
7.18
 
$
12.44
 
$
10.33
 



8


6. Litigation

In August 2003, a lawsuit was filed against our company in Superior Court of the State of California, County of Ventura. This suit was filed by two former store managers alleging misclassification of employment position and seeking class certification. The plaintiffs sought judgment for unpaid overtime compensation for store managers and lost meal and break times for store managers and other store personnel alleged to exceed $1.0 million, together with related penalties, restitution, attorneys’ fees and costs. In September 2005, the court approved the settlement of all alleged claims for an aggregate sum of $750,000, which costs were accrued in our fiscal 2004 results of operations.

In October 2004, a lawsuit was filed against our company in Hennepin County District Court in the State of Minnesota by one of our customers alleging deceptive trade practices, fraud and breach of warranty related to the alleged propensity of our products to develop mold. The complaint seeks class certification and various forms of legal and equitable relief, including but not limited to rescission and/or actual damages in an amount to be determined at trial, including interest, costs and attorney’s fees. In December 2004, we filed a motion to dismiss the claims in their entirety. The district court dismissed plaintiff’s false advertising claim and deceptive trade practice damage claim. The court initially denied the motion to dismiss the remaining fraud and warranty claims, but has reheard arguments on our motion to dismiss. The court’s decisions on both our renewed motion to dismiss and on plaintiff’s motion seeking class certification remain pending. We believe that the complaint is without merit and intend to vigorously defend the claims. As this case is in the early stages, the financial impact to our company, if any, cannot be predicted.

We are involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, any losses that may occur from these other matters are adequately covered by insurance or are provided for in the consolidated financial statements and the ultimate outcome of these other matters will not have a material effect on our consolidated financial position or results of operations.

9


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

The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included herein. This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. You can identify forward-looking statements by those that are not historical in nature, particularly those that use terminology such as “may,”  “will,”  “should,”  “expects,”  “anticipates,”  “contemplates,”  “estimates,”  “believes,”  “plans,”  “projects,”  “predicts,”  “potential” or “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. Important factors known to us that could cause such material differences are identified and discussed in Part I, Item 1 of our Annual Report on Form 10-K for the fiscal year ended January 1, 2005, which discussion is incorporated herein by reference. These important factors include, but are not limited to:

·  
Our ability to continue to successfully execute our strategic initiatives and growth strategy;
·  
Our ability to effectively manage our growth, which has and will continue to place strains on our management, production capacity, manufacturing quality, distribution systems, information systems and other resources;
·  
The efficiency and effectiveness of our Sleep Number advertising campaign and other marketing programs in building product and brand awareness, driving traffic to our points of sale and increasing sales;
·  
The level of consumer acceptance of our products, new product offerings and brand image;
·  
Our ability to execute our retail store distribution strategy, including increased sales and profitability through our existing stores and our ability to cost-effectively lease store locations and close under-performing store locations;
·  
Our ability to secure and retain wholesale accounts on a profitable basis and to profitably manage growth in wholesale distribution, including the impact on our retail stores and other company-controlled distribution channels;
·  
The success of our program with Radisson Hotels and Resorts® in achieving planned levels of placement of our beds with the hotels and resorts and in driving consumer awareness of our product and brand;
·  
Our ability to maintain cost-effective sales, production and delivery of our products;
·  
Our ability to secure adequate sources of supply, especially considering our single source strategy and just-in-time manufacturing process, as well as potential shortages of commodities;
·  
Our ability to maintain sales volumes and profit margins and effectively manage the effects of inflationary pressures caused by rising fuel and commodity costs as well as fluctuating currency rates and increasing industry regulatory requirements, all which could increase product and service costs;
·  
Our ability to cost-effectively secure third party services for product delivery, product assembly services and consumer credit options through credit providers;
·  
The impact of outstanding litigation claims, including the potential impact of any adverse publicity;
·  
Our ability to successfully identify and respond to emerging and competitive trends in the bedding industry;
·  
The level of competition in the bedding industry; and
·  
General economic conditions and consumer confidence.

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

10


Overview

Select Comfort® is the leading developer, manufacturer and marketer of premium-quality, adjustable-firmness beds. The air-chamber technology of our proprietary Sleep Number bed allows adjustable firmness on each side of the mattress and provides a sleep surface that is clinically proven to provide better sleep quality and greater relief of back pain compared to traditional mattress products. In addition, we market and sell accessories and other sleep related products designed to provide personalized comfort to complement the Sleep Number bed and to provide a better night’s sleep to the consumer.

We generate revenue by selling our products through four complementary distribution channels. Three of these channels: retail, direct marketing and e-commerce, are company-controlled and sell directly to consumers. Our wholesale channel sells to leading home furnishings retailers, specialty bedding retailers, the QVC shopping channel and to several end users such as Radisson Hotels and Resorts®.
 
 
Three Months Ended
 
Nine Months Ended
 
October 1,
2005
 
October 2,
2004
 
October 1,
2005
 
October 2,
2004
                       
The percentages of our total net sales, by dollar volume, from each of our channels are summarized as follows:
Percent of sales:
                     
Retail
77%
   
78%
   
76%
   
77%
 
Direct
10%
   
11%
   
11%
   
12%
 
E-Commerce
5%
   
4%
   
5%
   
5%
 
Wholesale
8%
   
7%
   
8%
   
6%
 
Total
100%
   
100%
   
100%
   
100%
 
 
The components of sales growth, including comparable store sales increases, are as follows:
Sales growth:
Same-store sales growth
15%
   
15%
   
14%
   
18%
 
New/closed stores, net
5%
   
7%
   
7%
   
8%
 
Retail total
20%
   
22%
   
21%
   
26%
 
Direct
10%
   
5%
   
17%
   
15%
 
E-Commerce
41%
   
24%
   
32%
   
36%
 
Wholesale
48%
   
113%
   
56%
   
88%
 
Total
22%
   
23%
   
23%
   
27%
 
                       
The numbers of company-owned retail stores and independently owned and operated retail partner stores, are as follows:
Company-owned retail stores:
                     
Beginning of period
369 
   
360 
   
370 
   
344 
 
Opened
19 
   
   
32 
   
23 
 
Closed
   
   
 (14)
   
(5)
 
End of period
388 
   
362 
   
388 
   
362 
 
                       
Retail partner stores
264 
   
86 
   
264 
   
86 
 

We anticipate opening at least five new retail stores during the fourth quarter of 2005 with no store closures planned. We are also developing relationships with major mattress retailers and will add at least 20 new locations during the fourth quarter with new retail partners as we work to expand distribution to improve consumer convenience and leverage our growing brand awareness.

Our growth plans are centered on increasing consumer awareness of our products and stores through expansion of media, increasing distribution   primarily through new retail store openings supplemented with sales through other mattress retailers, and through improvement and expansion of our product lines. Our primary market consists of the sale
 

11


of products directly to consumers in the U.S. domestic market. We believe that opportunities exist longer term for sales internationally and to commercial markets.

Increases in sales, along with controlling costs, have provided significant improvement to our operating income and operating margin. The majority of operating margin improvement has been generated through leverage in selling expenses (increased sales through the existing store base) and leverage of our existing infrastructure (we generally expect future G&A growth rates to be lower than the rate of sales growth due to leveraging the fixed component of G&A expenses across a higher sales base, although we anticipate no leverage in 2005 assuming incentive compensation returns to historical levels). We expect any future improvements in operating margin to be derived from similar sources. Rising commodity and fuel costs are expected to increase our product costs which could adversely affect our profit margins. We will continue to evaluate the impact of these higher costs and manage the effect on our results of operations through cost reduction initiatives and/or pricing actions, where appropriate.

As previously reported, we were recently notified by one of our suppliers about a delay they were experiencing in the delivery of materials used to manufacture the foam that we use in our mattresses. This delay was industry-wide and has been attributed in part to the recent hurricanes along the Gulf Coast. We have implemented contingency plans which include seeking alternative suppliers to minimize any potential impact on our customers. While foam supplies in October have been restricted, we have experienced no significant delivery delays to our customers. This situation appears to be improving and accordingly, does not impact our outlook for the remainder of 2005.

Our target is to sustain sales growth rates of at least 15% to 20% with same-store growth between 7% and 12%, and annual earnings growth rates of at least 20% to 25%. Our annual earnings growth rate target excludes the incremental effects on compensation expense within cost of sales and operating expenses resulting from our planned adoption of SFAS 123R during the first quarter of fiscal 2006.

Results of Operations

The following table sets forth, for the periods indicated, 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
 
October 1, 2005
 
October 2, 2004
 
October 1, 2005
 
October 2, 2004
Net sales
$175.8
 
100.0%
 
$144.3
 
100.0%
 
$503.2
 
100.0%
 
$409.0
 
100.0%
Cost of sales
71.0
 
40.4%
 
57.4
 
39.7%
 
206.8
 
41.1%
 
159.1
 
38.9%
Gross profit
104.8
 
59.6%
 
87.0
 
60.3%
 
296.4
 
58.9%
 
249.9
 
61.1%
                               
Operating expenses:
                             
Sales and marketing
72.9
 
41.4%
 
63.9
 
44.2%
 
211.9
 
42.1%
 
185.4
 
45.3%
General and administrative
13.8
 
7.8%
 
10.4
 
7.2%
 
40.5
 
8.0%
 
31.1
 
7.6%
Total operating expenses
86.7
 
49.3%
 
74.3
 
51.5%
 
252.4
 
50.2%
 
216.5
 
52.9%
Operating income
18.1
 
10.3%
 
12.7
 
8.8%
 
44.0
 
8.7%
 
33.4
 
8.2%
Other income, net
0.4
 
0.2%
 
0.4
 
0.2%
 
1.5
 
0.3%
 
1.0
 
0.2%
                               
Income before income taxes
18.5
 
10.5%
 
13.1
 
9.0%
 
45.5
 
9.0%
 
34.4
 
8.4%
Income tax expense
7.1
 
4.0%
 
5.0
 
3.5%
 
17.6
 
3.5%
 
13.3
 
3.2%
Net income
$ 11.4
 
6.5%
 
$ 8.0
 
5.6%
 
$ 28.0
 
5.6%
 
$ 21.1
 
5.2%
                               
Net income per share:
                             
Basic
$ 0.32
 
$ 0.22
 
$ 0.78
 
$ 0.59
Diluted
$ 0.30
 
$ 0.20
 
$ 0.72
 
$ 0.53
Weighted-average number of common shares:
                             
Basic
35.6
 
36.0
 
35.8
 
36.1
Diluted
38.3
 
39.3
 
38.8
 
39.9
 

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Net sales
We record revenue at the time product is shipped to our customer, except when beds are delivered and set up by our home delivery employees, in which case revenue for products and home delivery services is recorded at the time the bed is delivered and set up in the home. We reduce sales at the time revenue is recognized for estimated returns. This estimate is based on historical return rates, which have been reasonably consistent from period to period. If actual returns vary from expected rates, revenue in future periods is adjusted, which could have a material adverse effect on future results of operations. Historically, we have not experienced material adjustments to the financial statements due to changes to these estimates.

Cost of sales
Cost of sales includes costs associated with purchasing materials, manufacturing costs and costs to deliver our products to our customers. Cost of sales also includes estimated costs to service warranty claims of customers. This estimate is based on historical claim rates during the warranty period and on projected cost of materials required to fulfill warranty commitments. Because our warranty obligations cover an extended period of time, a revision of estimated claim rates or the projected cost of materials could have a material adverse effect on future results of operations.

Gross profit
Our gross profit margin is dependent on a number of factors and may fluctuate from quarter to quarter. These factors include the mix of products sold, the level at which we offer promotional discounts to purchase our products, the cost of materials, delivery and manufacturing and the mix of sales between wholesale and company-controlled distribution channels. Sales of products manufactured by third parties, such as accessories and our adjustable foundation, generate lower gross margins. Sales directly to consumers through company-controlled channels, where we capture both the manufacturer’s and retailer’s margin, generate higher gross margins than sales through our wholesale channels.

Sales and marketing expenses
Sales and marketing expenses include advertising and media production, other marketing and selling materials such as brochures, videos, customer mailings and in-store signage, sales compensation, store occupancy costs and customer service costs. We expense all store opening and advertising costs as incurred. Future advertising expenditures will depend on the effectiveness and efficiency of the advertising in creating awareness of our products and brand name, generating consumer inquiries and driving consumer traffic to our points of sale.

General and administrative expenses
General and administrative expenses include costs associated with management of functional areas, including information technology, human resources, finance, sales and marketing administration, investor relations, risk management and research and development. Costs include salaries, bonus and benefits, information system hardware, software and maintenance, office facilities, insurance, shareholder relations costs and other overhead.

Store closings and asset impairments
Store closing and asset impairment expenses include charges made against operating expenses for store-related or other capital assets that have been written off when a store is underperforming and generating negative cash flows. We evaluate our long-lived assets, including leaseholds and fixtures in existing stores and stores expected to be remodeled, based on expected cash flows through the remainder of the lease term after considering the potential impact of planned operational improvements and marketing programs. Expected cash flows may not be realized, which could cause long-lived assets to become impaired in future periods and could have a material adverse effect on future results of operations. Store assets are written off when we believe these costs will not be recovered through future operations.
 
Quarterly and annual results
Quarterly and annual operating results may fluctuate significantly as a result of a variety of factors, including increases or decreases in comparable store sales, the timing, amount and effectiveness of advertising expenditures, any changes in sales return rates or warranty experience, the timing of new store openings and related expenses, net sales contributed by new stores, the timing of promotional offerings, competitive factors, changes in commodity costs, any disruptions in supplies or third-party service providers, seasonality of retail sales, timing of QVC shows and wholesale sales, consumer confidence, and general economic conditions. Furthermore, a substantial portion of net sales is often realized in the last month of a quarter, due in part to our promotional schedule and commission
 

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structure. As a result, we may be unable to adjust spending in a timely manner, and our business, financial condition and operating results may be significantly harmed. Our historical results of operations may not be indicative of the results that may be achieved for any future period.
 
Comparison of Three Months Ended October 1, 2005 with Three Months Ended October 2, 2004

Net sales
Net sales increased 22% to $175.8 million for the three months ended October 1, 2005 from $144.3 million for the three months ended October 2, 2004, due to a 22% increase in mattress unit sales and higher average selling prices in our company-controlled channels, partially offset by changes in channel mix (i.e., increased percentage of total net sales of products with lower average selling prices from our lower margin channels). The average selling price per bed in our company-controlled channels was $2,064, an increase of approximately 5% over third quarter last year. The higher average selling price resulted primarily from a price increase introduced at the beginning of 2005. The increase in mattress unit sales was driven primarily by growth in same-store sales and distribution expansion.

The increase in net sales by sales channel was attributable to (i) a $22.8 million increase in sales from our retail stores, including an increase in comparable store sales of $16.4 million and an increase of $6.4 million from new stores, net of stores closed, (ii) a $1.6 million increase in direct marketing sales, (iii) a $2.5 million increase in sales through our e-commerce channel and (iv) a $4.6 million increase in sales through our wholesale channel.

Gross profit
Gross profit decreased to 59.6% for the three months ended October 1, 2005 from 60.3% for the three months ended October 2, 2004, primarily due to changes in product mix (i.e., increased percentage of our total net sales from our lower margin products), changes in channel mix (i.e., increased percentage of our total net sales from our lower margin channels), and increased product and delivery costs resulting from rising commodity and fuel costs.
 
Sales and marketing expenses
Sales and marketing expenses increased 14% to $72.9 million for the three months ended October 1, 2005 from $63.9 million for the three months ended October 2, 2004 and decreased as a percentage of net sales to 41.4% from 44.2% for the comparable prior-year period. The $9.0 million increase was primarily due to additional media investments, increased number of stores and variable costs due to higher sales. The decrease as a percentage of net sales was comprised primarily of a 1.2 percentage point (ppt) increase in leverage of media investments and a 1.6 ppt leverage of fixed costs (occupancy, base sales compensation and certain marketing expenses) over higher sales. With additional sales growth, we expect sales and marketing expenses as a percentage of net sales to decline as we achieve greater leverage from our base sales compensation and occupancy costs while reinvesting some of these leverage benefits into higher levels of media investments.
 
General and administrative expenses
General and administrative (G&A) expenses increased 32% to $13.8 million for the three months ended October 1, 2005 from $10.4 million for the three months ended October 2, 2004 and increased as a percentage of net sales to 7.8% from 7.2% for the prior-year period. The dollar increase in G&A was comprised primarily of additional incentive compensation costs resulting from our improved performance, increased compensation and benefits expenses related to additional headcount and higher professional fees. We generally expect future G&A growth rates to be lower than the rate of sales growth due to leveraging the fixed component of G&A expenses across a higher sales base, although we anticipate no leverage in 2005 assuming incentive compensation returns to historical levels.

Other income
Other income was $0.4 million for the three months ended October 1, 2005 and October 2, 2004.

Income tax expense
Income tax expense increased $2.1 million to $7.1 million for the three months ended October 1, 2005 from $5.0 million for the three months ended October 2, 2004. The effective tax rate was 38.3% in 2005 and 38.4% in 2004.
 

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Comparison of Nine Months Ended October 1, 2005 with Nine Months Ended October 2, 2004

Net sales
Net sales increased 23% to $503.2 million for the nine months ended October 1, 2005 from $409.0 million for the nine months ended October 2, 2004, due to a 19% increase in mattress unit sales and higher average selling prices. The average selling price per bed in our company-controlled channels was $1,983, an increase of approximately 5% over the first nine months of last year. The higher average selling price resulted primarily from a price increase introduced at the beginning of 2005. The increase in mattress unit sales was driven primarily by growth in same-store sales and distribution expansion.
 
The increase in net sales by sales channel was attributable to (i) a $65.2 million increase in sales from our retail stores, including an increase in comparable store sales of $44.4 million and an increase of $20.8 million from new stores, net of stores closed, (ii) a $8.2 million increase in direct marketing sales, (iii) a $5.9 million increase in sales through our e-commerce channel and (iv) a $14.7 million increase in sales through our wholesale channel.

Gross profit
Gross profit decreased to 58.9% for the nine months ended October 1, 2005 from 61.1% for the nine months ended October 2, 2004, primarily due to changes in product mix (i.e., increased percentage of our total net sales from our lower margin products), changes in channel mix (i.e., increased percentage of our total net sales from our lower margin channels), and increased product and delivery costs resulting from rising commodity and fuel costs and higher warranty reserves.

Sales and marketing expenses
Sales and marketing expenses increased 14% to $211.9 million for the nine months ended October 1, 2005 from $185.4 million for the nine months ended October 2, 2004 and decreased as a percentage of net sales to 42.1% from 45.3% for the comparable prior-year period. The $26.5 million increase was primarily due to additional media investments, increased number of stores and variable costs due to higher sales. The decrease as a percentage of net sales was comprised primarily of a 1.4 percentage point (ppt) increase in leverage of media investments and a 1.8 ppt leverage of fixed costs (occupancy, base sales compensation and certain marketing expenses) over higher sales.
 
General and administrative expenses
General and administrative (G&A) expenses increased 30% to $40.5 million for the nine months ended October 1, 2005 from $31.1 million for the nine months ended October 2, 2004 and increased as a percentage of net sales to 8.0% from 7.6% for the prior-year period. The dollar increase in G&A was comprised primarily of higher professional fees, increased compensation and benefits expenses related to additional headcount and additional incentive compensation costs resulting from our improved performance.

Other income
Other income was $1.4 million for the nine months ended October 1, 2005 compared to $1.0 million for the nine months ended October 2, 2004. The improvement is primarily due to increased interest income resulting from higher average balances of invested cash and higher interest rates.

Income tax expense
Income tax expense increased $4.3 million to $17.6 million for the nine months ended October 1, 2005 from $13.3 million for the nine months ended October 2, 2004. The effective tax rate was 38.6% in each of 2005 and 2004.

Liquidity and Capital Resources

As of October 1, 2005, we had cash and marketable securities of $88.4 million, of which $45.9 million was classified as a current asset. As of January 1, 2005, cash and marketable securities totaled $91.7 million, of which $50.8 million was classified as a current asset. Net working capital totaled $5.4 million as of October 1, 2005 compared to $23.5 million as of January 1, 2005. The decrease in net working capital was due primarily to cash used for stock repurchases and working capital needs. The $3.3 million decline in cash and marketable securities was the result of generating $36.0 million of operating free cash flow ($55.8 million of cash provided by operating activities, reduced by $19.9 million of capital expenditures), offset by $39.3 million of cash used in financing activities, principally to
 

15


repurchase shares of our stock. We expect to continue to generate positive cash flows from operations in the future, while not anticipating any significant additional working capital requirements.

We generated cash from operations for the nine months ended October 1, 2005 and October 2, 2004 of $55.8 million and $44.0 million, respectively. The $11.8 million year-to-year improvement in cash from operations resulted primarily from improved operating income for the nine months ended October 1, 2005 and higher noncash depreciation expense of $1.5 million partially offset by increases in net operating assets and liabilities of $2.8 million.

Net cash used in investing activities was $15.4 million and $29.6 million for the nine months ended October 1, 2005 and October 2, 2004, respectively. The decrease in net cash used in investing activities was principally due to our stock repurchases which has resulted in lower levels of cash investments, partially offset by increased capital expenditures during the first nine months of 2005. In both periods, our capital expenditures related primarily to new and remodeled retail stores and investments in information technology. In the first nine months of 2005 we opened 32 retail stores, while in the first nine months of 2004 we opened 23 stores. We anticipate opening at least five new retail stores during the fourth quarter of 2005 and 40 or more stores during 2006. We will fund the investment in new and upgraded stores with cash on hand and cash generated from operations. We expect our new stores to be cash flow positive within the first 12 months of operations and, as a result, do not anticipate a negative effect on net cash provided by operations.

Net cash used in financing activities totaled $39.3 million for the nine months ended October 1, 2005, compared to $9.5 million net cash used in financing activities for the nine months ended October 2, 2004. The $29.8 million increase in cash used in financing activities resulted from a $31.3 million increase in repurchases of common stock partially offset by an increase of $1.5 million received for exercises of stock options and warrants and for employee purchases of common stock. We may make additional purchases of our common stock from time-to-time, subject to market conditions and at prevailing market prices, through open market purchases. Total outstanding stock repurchase authorization at October 1, 2005 was $8.7 million. We expect that repurchase authorization will increase during the fourth quarter under our formula-based Board authorization. We may terminate or limit the stock repurchase program at any time.

Cash generated from operations should be a sufficient source of liquidity for the short- and long- term and should provide adequate funding for capital expenditures and common stock repurchases, if any. In addition, our business model, which can operate with minimal working capital, does not require significant additional capital to fund operations.

In May 2003, we obtained a $15 million bank revolving line of credit to provide additional cash flexibility in the case of unexpected significant external or internal developments. The line of credit is a three-year senior secured revolving facility. The interest rate on borrowings is calculated using LIBOR plus 1.50% to 2.25% with the incremental rate dependent on our leverage ratio, as defined by the lender. We are subject to certain financial covenants under the agreement, principally consisting of minimum liquidity requirements, working capital and leverage ratios. We have remained and expect to remain in the foreseeable future in full compliance with the financial covenants. We currently have no borrowings outstanding under this credit agreement.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions. Predicting future events is inherently an imprecise activity and as such requires the use of judgment. Actual results may vary from estimates in amounts that may be material to the financial statements. The accounting policies discussed below are considered critical because changes to certain judgments and assumptions inherent in these policies could materially affect the financial statements.

Our critical accounting policies relate to stock-based compensation, revenue recognition, accrued sales returns, accrued warranty costs and store closing and long-lived asset impairment expenses.

In certain instances, U.S. generally accepted accounting principles allow for the selection of alternative accounting methods. One such significant accounting policy involves the selection from alternative methods of accounting for stock options.
 

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Stock-based compensation

Two alternative methods currently exist for accounting for stock options: the intrinsic value method and the fair value method. We use the intrinsic value method of accounting for stock options, and accordingly, no compensation expense has been recognized in the financial statements for options granted to employees, or for the discount feature of our employee stock purchase plan. We are required to change our accounting practice for stock options to the fair value method effective the first quarter of fiscal 2006. We expect that this change in accounting policy will have a material impact on our consolidated results of operations and earnings per share. See Notes 1 and 5 to the Consolidated Financial Statements.

Revenue recognition

We record revenue at the time product is shipped to our customer, except when beds are delivered and set up by our home delivery employees, in which case revenue is recorded at the time the bed is delivered and set up in the home.

Accrued sales returns

We reduce sales at the time revenue is recognized for estimated returns. This estimate is based on historical return rates, which are reasonably consistent from period to period. If actual returns vary from expected rates, revenue in future periods is adjusted, which could have a material adverse effect on future results of operations.

Accrued warranty costs

The estimated cost to service warranty claims of customers is included in cost of sales. This estimate is based on historical claim rates during the warranty period and on projected cost of materials required to fulfill warranty commitments. Because our warranty obligations cover an extended period of time, a revision of estimated claim rates or the projected cost of materials could have a material adverse effect on future results of operations.

Store closing and asset impairment expenses

We evaluate our long-lived assets, including leaseholds and fixtures in existing stores, based on expected cash flows through the remainder of the lease term after considering the potential impact of planned operational improvements and marketing programs. Expected cash flows may not be realized, which could cause long-lived assets to become impaired in future periods and could have a material adverse effect on future results of operations. Store assets are written off when we believe these costs will not be recovered through future operations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Financial instruments that potentially subject us to concentrations of credit risk consist principally of investments. The counterparties to the agreements consist of government agencies and various major corporations of investment grade credit standing. We do not believe we are exposed to significant risk of non-performance by these counterparties because we limit the amount of credit exposure to any one financial institution and any one type of investment.
 

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation 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 us in the reports that we file or submit 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 and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Our management, with the participation of our chief executive officer and chief 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 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 report.

Changes in Internal Controls

There was no change in our internal control over financial reporting that occurred during our quarter ended October 1, 2005 that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting.
 

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PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In August 2003, a lawsuit was filed against our company in Superior Court of the State of California, County of Ventura. This suit was filed by two former store managers alleging misclassification of employment position and seeking class certification. The plaintiffs sought judgment for unpaid overtime compensation for store managers and lost meal and break times for store managers and other store personnel alleged to exceed $1.0 million, together with related penalties, restitution, attorneys’ fees and costs. In September 2005, the court approved the settlement of all alleged claims for an aggregate sum of $750,000, which costs were accrued in our fiscal 2004 results of operations.

In October 2004, a lawsuit was filed against our company in Hennepin County District Court in the State of Minnesota by one of our customers alleging deceptive trade practices, fraud and breach of warranty related to the alleged propensity of our products to develop mold. The complaint seeks class certification and various forms of legal and equitable relief, including but not limited to rescission and/or actual damages in an amount to be determined at trial, including interest, costs and attorney’s fees. In December 2004, we filed a motion to dismiss the claims in their entirety. The district court dismissed plaintiff’s false advertising claim and deceptive trade practice damage claim. The court initially denied the motion to dismiss the remaining fraud and warranty claims, but has reheard arguments on our motion to dismiss. The court’s decisions on both our renewed motion to dismiss and on plaintiff’s motion seeking class certification remain pending. We believe that the complaint is without merit and intend to vigorously defend the claims. As this case is in the early stages, the financial impact to our company, if any, cannot be predicted.

We are involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, any losses that may occur from these other matters are adequately covered by insurance or are provided for in the consolidated financial statements and the ultimate outcome of these other matters is not expected to have a material effect on our consolidated financial position or results of operations.
 

19


ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

   (a) 
  (b)
  Not applicable.
       
   (c) 
 
  Issuer Purchases of Equity Securities
     
 (in thousands, except per share amounts)
 

Period
 
Total Number of Shares including Non-Qualified
 
Average Price Paid per Share
 
Total number of Shares Purchased as Part of Publicly Announced Plans or Programs (1)
 
Availability
Fiscal July 2005
 
26
   
$20.69
 
26
     
Fiscal August 2005
 
832
   
$20.49
 
824
     
Fiscal September 2005
 
827
   
$19.82
 
827
   
$8,683
Total
 
1,685
   
$20.17
 
1,677
     
 
 
(1) The Audit Committee of the Board of Directors reviews, on a quarterly basis, the authority granted as well as any repurchases under this program. This authorization is currently not subject to expiration.
 

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ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS

Exhibit Number
Description
   
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.



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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.


 
SELECT COMFORT CORPORATION
   
   
   
 
/s/ William R. McLaughlin
November 2, 2005
William R. McLaughlin
 
Chairman and Chief Executive Officer
(principal executive officer)
   
   
   
   
 
/s/ James C. Raabe
 
James C. Raabe
 
Senior Vice President and Chief Financial Officer
(principal financial and accounting officer)



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EXHIBIT INDEX

Exhibit Number
Description
   
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.


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